Certain statements contained in this Quarterly Report on Form 10-Q that are not historical facts may constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are intended to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve risks and uncertainties. These statements, which are based on certain assumptions and describe Merchants' future plans, strategies and expectations, can generally be identified by the use of the words "may," "will," "should," "could," "would," "plan," "potential," "estimate," "project," "believe," "intend," "anticipate," "expect," "target" and similar expressions. Forward-looking statements are based on the current assumptions and beliefs of management and are only expectations of future results. Our actual results could differ materially from those projected in the forward-looking statements as a result of, among others, continued weakness in general, national, regional or local economic conditions, the performance of our investment portfolio, quality of credits or the overall demand for services; changes in loan default and charge-off rates which could affect the allowance for credit losses; declines in the equity and financial markets; reductions in deposit levels which could necessitate increased and/or higher cost borrowing to fund loans and investments; declines in mortgage loan refinancing, equity loan and line of credit activity which could reduce net interest and non-interest income; changes in the domestic interest rate environment and inflation; changes in the carrying value of investment securities and other assets; misalignment of our interest-bearing assets and liabilities; increases in loan repayment rates affecting interest income and the value of mortgage servicing rights; changing business, banking, or regulatory conditions or policies, or new legislation affecting the financial services industry that could lead to changes in the competitive balance among financial institutions, restrictions on bank activities, changes in costs (including deposit insurance premiums), increased regulatory scrutiny, declines in consumer confidence in depository institutions, or changes in the secondary market for bank loan and other products; and changes in accounting rules, federal and state laws,
IRSregulations, and other regulations and policies governing financial holding companies and their subsidiaries which may impact our ability to take appropriate action to protect our financial interests in certain loan situations. Investors should not place undue reliance on our forward-looking statements, and are cautioned that forward-looking statements are inherently uncertain. Actual performance and results of operations may differ materially from those projected or suggested in the forward-looking statements due to certain risks and uncertainties, which are included in more detail in our Annual Report on Form 10-K, as updated by our Quarterly Reports on Form 10-Q and other filings submitted to the Securities and Exchange Commission. We do not undertake any obligation to update any forward-looking statement to reflect circumstances or events that occur after the date the forward-looking statements are made.
USE OF NON-GAAP FINANCIAL MEASURES
Certain information in Item 2, "Management's Discussion and Analysis of Financial Condition and Results of Operations" contains financial information determined by methods other than in accordance with accounting principles generally accepted in
the United States of America("GAAP"). We use these "non-GAAP" measures in our analysis of our performance and believe that these non-GAAP financial measures provide a greater understanding of ongoing operations and enhance comparability of our results with prior periods and with the results of other financial institutions. These disclosures should not be viewed as a substitute for operating results determined in accordance with GAAP, nor are they necessarily comparable to non-GAAP performance measures that may be presented by other companies. In several places net interest income is presented on a fully taxable equivalent basis. Specifically included in interest income is tax-exempt interest income from certain tax-exempt loans. An amount equal to the tax benefit derived from this tax exempt income is added back to the interest income total, to produce net interest income on a fully taxable equivalent basis. We believe the disclosure of taxable equivalent net interest income information improves the clarity of financial analysis, and is particularly useful to investors in understanding and evaluating the changes and trends in our results of operations. Other financial institutions commonly present net interest income on a taxable equivalent basis. This adjustment is considered helpful in the comparison of one financial institution's net interest income to that of another, as each will have a different proportion of taxable exempt interest from its earning assets. Moreover, net interest income is a component of a second financial measure commonly used by financial institutions, net interest margin, which is the ratio of net interest income to average earning assets. For purposes of this measure as well, other financial institutions generally use taxable equivalent net interest income. We follow these practices. A reconciliation of taxable equivalent financial information to our consolidated financial statements prepared in accordance with GAAP appears at the bottom of the table entitled "Distribution of Assets, Liabilities and Shareholders' Equity; Interest Rates and Net Interest Margin." A 35.0% tax rate was used in both 2014 and 2013. An additional non-GAAP financial measure we use is the tangible capital ratio. Because we have no intangible assets, our tangible shareholder's equity is the same as our shareholder's equity. 27
The following discussion and analysis of financial condition as of
June 30, 2014and December 31, 2013and results of operations of Merchants and its subsidiaries for the three and six months ended June 30, 2014and 2013 should be read in conjunction with the consolidated financial statements and notes thereto and selected statistical information appearing elsewhere in this Quarterly Report on Form 10-Q. The financial condition and results of operations of Merchants essentially reflect the operations of its principal subsidiary, Merchants Bank. RESULTS OF OPERATIONS Overview We realized net income of $3.41 millionand $6.82 million, or diluted earnings per share of $0.54and $1.07for the three and six months ended June 30, 2014, respectively. This compares to net income of $4.03 millionand $7.63 million, or diluted earnings per share of $0.64and $1.21for the three and six months ended June 30, 2013, respectively. The return on average assets was 0.82% for the three and six months ended June 30, 2014, respectively, compared to 0.96% and 0.91% for the same periods in 2013. The return on average equity was 11.15% and 11.23% for the three and six months ended June 30, 2014, respectively, compared to 13.61% and 12.96% for the same periods in 2013. We declared and distributed dividends of $0.28and $0.56per share during the three and six months ended June 30, 2014. We declared a dividend of $0.28per share, payable August 14, 2014, to shareholders of record as of July 31, 2014. Shareholders' equity ended the quarter at $124.96 million, and our book value per share increased to $19.75per share at June 30, 2014from $18.93at December 31, 2013. Our capital ratios remain strong at June 30, 2014. Our Tier 1 leverage ratio was 8.79%, total risk-based capital ratio increased to 16.76% and our tangible capital ratio increased to 7.77%.
Ø Net interest income - Our taxable equivalent net interest income was
respectively, compared to
periods in 2013. Our taxable equivalent net interest margin was 3.06% and 3.08%
for the quarter and six months ended
for the same periods in 2013.
Ø Provision for Credit Losses - The provision for credit losses was
2013. Our nonperforming loans were 0.08% of total loans at
past due 30-89 days were 0.01% of total loans at
during 2014 have been negligible.
Ø Loans - Quarterly average loan balances for the second quarter of 2014 were
second quarter of 2013. Ending loan balances at
impacted by seasonal fluctuations in municipal cash flows.
Ø Deposits - Quarterly average deposits for the second quarter of 2014 were
second quarter of 2013. Total deposits at
Ø Non-interest expense - Total noninterest expense increased
2013 and increased
2014 compared to the same periods in 2013. Excluding core system conversion
costs, total noninterest expense increased
the second quarter of 2014 compared to the same period in 2013 and increased
the same period in 2013. Net Interest Income As shown on the tables on pages 29 and 30, our taxable equivalent net interest income was
$12.14 millionand $24.49 millionfor the three and six months ended June 30, 2014, respectively, compared to $12.80 millionand $25.53 millionfor the same periods in 2013. Our taxable equivalent net interest margin was 3.06% and 3.08% for the quarter and six months ended June 30, 2014, compared to 3.17% and 3.18% for the same periods in 2013. We have increased liquidity and reduced price volatility exposure in our investment portfolio by allowing the investment portfolio to run off and holding a larger percentage of our balance sheet in cash, which has compressed asset yields. These changes have shortened our assets and caused us to give up some current income, but have reduced price volatility exposure on our balance sheet and better positioned us for rising rates. At the same time our loan yields have continued to compress due to a combination of the extended low interest rate environment, tighter credit spreads, and competitive pressures. We have also increased our variable rate loan portfolio. Average variable rate loans for the second quarter of 2014 were $328.98 million, a $44.46 millionincrease over average balances for the second quarter of 2013. These loans have a lower current yield than fixed-rate loans, but will have higher yields when rates start to rise. Our average funding costs remain low at 0.39%. 28
-------------------------------------------------------------------------------- The following tables present an analysis of net interest income and illustrate interest income earned and interest expense charged for each major component of interest earning assets and interest bearing liabilities. Yields/rates are computed on a fully taxable-equivalent basis, using a 35% rate. Nonaccrual loans are included in the average loan balance outstanding. Three Months Ended June 30, 2014 June 30, 2013 Interest Interest Average Income/ Average Average Income/ Average (In thousands, fully taxable equivalent) Balance Expense Rate Balance Expense Rate ASSETS: Loans, including fees on loans
$ 1,169,339 $ 11,2813.87% $ 1,122,201 $ 11,5294.12% Investments 359,332 2,046 2.28% 474,405 2,563 2.17% Interest-earning deposits with banks and other short-term investments 60,928 34 0.22% 23,371 13 0.22% Total interest earning assets 1,589,599 $ 13,3613.37% 1,619,977 $ 14,1053.49% Allowance for loan losses (12,206)
Cash and due from banks 26,906
Bank premises and equipment, net 15,380 16,425 Bank owned life insurance 10,110 - Other assets 27,916 31,654 Total assets
$ 1,657,705 $ 1,681,747LIABILITIES AND SHAREHOLDERS' EQUITY: Interest-bearing deposits: Savings, interest bearing checking and money market accounts $ 777,090 $ 4830.25% $ 711,895 $ 1750.10% Time deposits 271,658 453 0.67% 324,157 553 0.68% Total interest bearing deposits 1,048,748 936 0.36% 1,036,052 728 0.28% Short-term borrowings 752 1 0.30% 28,565 20 0.28% Securities sold under agreements to repurchase, short-term 181,593 87 0.19% 228,726 357 0.63% Other long-term debt 2,369 12 2.04% 2,450 12 2.04% Junior subordinated debentures issued to unconsolidated subsidiary trust 20,619 187 3.71% 20,619 193 3.81% Total borrowed funds 205,333 287 0.56% 280,360 582 0.83% Total interest bearing liabilities 1,254,081 $ 1,2230.39% 1,316,412 $ 1,3100.40% Noninterest bearing deposits 272,334 239,601 Other liabilities 8,813 7,465 Shareholders' equity 122,477 118,269 Total liabilities and shareholders' equity $ 1,657,705 $ 1,681,747Net interest earning assets $ 335,518 $ 303,565Net interest income (fully taxable equivalent) $ 12,138 $ 12,795Tax equivalent adjustment (525) (485) Net interest income $ 11,613 $ 12,310Net interest rate spread 2.98% 3.09% Net interest margin 3.06% 3.17% 29
Six Months Ended June 30, 2014 June 30, 2013 Interest Interest Average Income/ Average Average Income/ Average (In thousands, fully taxable equivalent) Balance Expense Rate Balance Expense Rate ASSETS: Loans, including fees on loans
$ 1,168,210 $ 22,5763.90% $ 1,104,344 $ 22,7614.16% Investments 373,252 4,260 2.30% 493,020 5,348 2.19% Interest-earning deposits with banks and other short-term investments 60,225 73 0.24% 21,044 25 0.24% Total interest earning assets 1,601,687 $ 26,9093.39% 1,618,408 $ 28,1343.51% Allowance for loan losses (12,162)
Cash and due from banks 27,532
Bank premises and equipment, net 15,403 16,356 Bank owned life insurance 10,070 - Other assets 25,469 33,065 Total assets
$ 1,667,999 $ 1,681,440LIABILITIES AND SHAREHOLDERS' EQUITY: Interest-bearing deposits: Savings, interest bearing checking and money market accounts $ 768,129 $ 9130.24% $ 704,071 $ 3420.10% Time deposits 283,142 925 0.66% 329,237 1,132 0.69% Total interest bearing deposits 1,051,271 1,838 0.35% 1,033,308 1,474 0.29% Short-term borrowings 378 1 0.30% 21,260 30 0.28% Securities sold under agreements to repurchase, short-term 195,514 179 0.18% 246,705 704 0.58% Other long-term debt 2,379 24 2.03% 2,460 25 2.03% Junior subordinated debentures issued to unconsolidated subsidiary trust 20,619 372 3.64% 20,619 376 3.79% Total borrowed funds 218,890 576 0.53% 291,044 1,135 0.79% Total interest bearing liabilities 1,270,161 $ 2,4140.38% 1,324,352 $ 2,6090.40% Noninterest bearing deposits 267,752 231,468 Other liabilities 8,689 7,851 Shareholders' equity 121,397 117,769 Total liabilities and shareholders' equity $ 1,667,999 $ 1,681,440Net interest earning assets $ 331,526 $ 294,056Net interest income (fully taxable equivalent) $ 24,495 $ 25,525Tax equivalent adjustment (1,058) (967) Net interest income $ 23,437 $ 24,558Net interest rate spread 3.01% 3.11% Net interest margin 3.08% 3.18% 30
-------------------------------------------------------------------------------- The following tables present the extent to which changes in interest rates and changes in the volume of earning assets and interest bearing liabilities have affected interest income and interest expense during the periods indicated. Information is presented in each category with respect to: (i) changes attributable to changes in volume (changes in volume multiplied by prior rate), (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume) and (iii) changes in volume/rate (change in volume multiplied by change in rate). Analysis of Changes in Fully Taxable Equivalent Net Interest Income Three Months Ended June 30, Increase Due to (In thousands) 2014 2013 (Decrease) Volume Rate Volume/Rate Fully taxable equivalent interest income: Loans
$ 11,281 $ 11,529 $ (248) $ 484 $ (703) $ (29)Investments 2,046 2,563 (517) (622) 138 (33) Interest earning deposits with banks and other short-term investments 34 13 21 21 - - Total interest income 13,361 14,105 (744) (117) (565) (62) Less interest expense: Savings, interest bearing checking and money market accounts 483 175 308 16 268 24 Time deposits 453 553 (100) (90) (12) 2 FHLB and other short-term borrowings 1 20 (19) (19) 2 (2) Securities sold under agreements to repurchase, short-term 87 357 (270) (74) (248) 52 Other long-term debt 12 12 - - - - Junior subordinated debentures issued to unconsolidated subsidiary trust 187 193 (6) - (5) (1) Total interest expense 1,223 1,310 (87) (167) 5 75 Net interest income $ 12,138 $ 12,795 $ (657) $ 50 $ (570) $ (137)Six Months Ended June 30, Increase Due to (In thousands) 2014 2013 (Decrease) Volume Rate Volume/Rate Fully taxable equivalent interest income: Loans $ 22,576 $ 22,761 $ (185) $ 662 $ (724) $ (123)Investments 4,260 5,348 (1,088) (654) 137 (571) Interest earning deposits with banks and other short-term investments 73 25 48 23 - 25 Total interest income 26,909 28,134 (1,225) 31 (587) (669) Less interest expense: Savings, interest bearing checking and money market accounts 913 342 571 16 245 310 Time deposits 925 1,132 (207) (79) (26) (102) FHLB and other short-term borrowings 1 30 (29) (15) 1 (15) Securities sold under agreements to repurchase, short-term 179 704 (525) (74) (243) (208) Other long-term debt 24 25 (1) - - (1) Junior subordinated debentures issued to unconsolidated subsidiary trust 372 376 (4) - (8) 4 Total interest expense 2,414 2,609 (195) (152) (31) (12) Net interest income $ 24,495 $ 25,525 $ (1,030) $ 183 $ (556) $ (657)31
Provision for Credit Losses The allowance for loan losses at
June 30, 2014was $12.04 million, or 1.07% of total loans and 1,356% of non-performing loans. We recorded a $50 thousandand $150 thousandprovision for credit losses during the three and six months ended June 30, 2014, respectively. Asset quality improved further during the quarter and remains strong. Our nonperforming loans were 0.08% of total loans at June 30, 2014, and loans past due 30-89 days were 0.01% of total loans at June 30, 2014. Net charge-offs during 2014 were not material. All of these factors are taken into consideration during Management's quarterly review of the allowance for credit losses ("Allowance"). For a more detailed discussion of the Allowance and nonperforming assets, see "Credit Quality and Allowance for Credit Losses" beginning on page 34.
NONINTEREST INCOME AND EXPENSES
Total noninterest income increased
$184 thousandto $2.95 millionfor the second quarter of 2014 compared to the second quarter of 2013 and increased $447 thousandfor the first six months of 2014 compared to the first six months of 2013. Excluding net gains on investment securities, total noninterest income increased $154 thousandand $291 thousandfor the second quarter and first half of 2014, respectively, compared to the same periods in 2013. Trust division income increased $69 thousandand $162 thousandfor the three and six months ended June 30, 2014, respectively, compared to the same periods in 2013 as trust division assets under management have continued to show strong growth and now total $632 million. Service charges on deposits increased $23 thousandand $43 thousandfor the three and six months ended June 30, 2014, respectively, compared to the same period in 2013, a result of an increase in cash management fees and business checking service charges. Overdraft fees decreased $33 thousandand $94 thousandfor the three and six months ended June 30, 2014. This revenue source continues to come under pressure, but the rate of decrease has slowed. Noninterest expense Total noninterest expense increased $519 thousandto $10.10 millionfor the second quarter of 2014 compared to the same period in 2013 and increased $924 thousandto $20.25 millionfor the first six months of 2014 compared to the same periods in 2013. Excluding core system conversion costs total noninterest expense increased $301 thousandto $9.88 millionfor the second quarter of 2014 compared to the same period in 2013 and increased $536 thousandto $19.86 millionfor the first six months of 2014 compared to the same period in 2013. Compensation and benefits increased $328 thousandand $456 thousandfor the three and six months ended June 30, 2014, respectively, compared to the same periods in 2013. The increase was a result of additional investments we have made in the Finance and Risk areas combined with lower credits related to loan originations. Additionally expenses associated with our self-funded employee health insurance plan were higher for the first half of 2014 compared to 2013. During the second quarter of 2013, we reversed $225 thousandof our accrued health insurance expense as a result of positive claims experience. The increase in health insurance expense for 2014 was partially offset by a larger credit from our overfunded pension plan. Occupancy and equipment costs were $95 thousandhigher for the second quarter of 2014 compared to 2013, and were $227 thousandhigher for the first half of 2014 compared to 2013, a result of investments we have made recently to update our facilities. Legal and professional fees were $74 thousandhigher for the second quarter of 2014 compared to 2013, and were $25 thousandhigher for the first half of 2014 compared to 2013, a result of additional resources for our compliance and risk areas. Marketing expenses for the second quarter of 2014 were $323 thousand, $162 thousandlower than the second quarter of 2013, and were $642 thousandyear to date, $123 thousandlower than the first half of 2013, a result of our transition to a new marketing partner which will push some expenses into later in the year.
During the first quarter of 2014 we adopted, and applied retrospectively, Financial Accounting Standards Board Accounting Standards Update 2014-01, "Accounting for Investments in Qualified Affordable Housing Projects" which allows investors in low income housing tax credit entities that meet certain conditions to account for the investments entirely in income tax expense, which we believe more accurately reflects the economics of the investment. The application of this standard reduced total noninterest expense by
$327 thousandand $654 thousandfor the quarter and six months ended June 30, 2014, respectively; and by $270 thousandand $540 thousandfor the quarter and six months ended June 30, 2013, respectively and increased income tax expense by an equivalent amount. The application of the standard also increased our effective tax rate to 23% from 17% for the three and six months ended June 30, 2014, and to 25% and 26% from 21% and 21% for the three and six months ended June 30, 2013, respectively. 32
BALANCE SHEET ANALYSIS Loans Quarterly average loan balances for the second quarter of 2014 were
$1.17 billion, $47.14 millionhigher than quarterly average balances for the second quarter of 2013. Ending loan balances at June 30, 2014were impacted by seasonal fluctuations in municipal cash flows, causing municipal loan balances at June 30, 2014to be $46.82 millionlower than at March 31, 2014; as of July 10, 2014, municipal loan balances had increased by $40.49 millionto $86.85 million. The composition of our loan portfolio is shown in the following table as of the dates indicated: (In thousands) June 30, 2014 March 31, 2014 December 31, 2013 June 30, 2013 Commercial, financial and agricultural $ 193,806 $ 190,840$ 172,810 $ 169,215Municipal loans 46,358 93,176 94,007 45,319 Real estate loans - residential 476,696 482,775 489,706 485,764 Real estate loans - commercial 372,825 372,155 371,319 365,693 Real estate loans - construction 32,336 27,567 31,841 31,813 Installment loans 4,238 4,993 5,655 5,667 All other loans 252 231 895 544 Total loans $ 1,126,511 $ 1,171,737 $ 1,166,233 $ 1,104,015
Totals above are shown net of deferred loan fees of
Growth in our commercial loan categories has been driven by new customer acquisition and expansion of existing relationships, offset by increased prepayment activity. Growth in new business in our commercial real estate categories has been offset by scheduled amortization and prepayments. Mortgage refinancing activity has slowed considerably, leading to reduced residential real estate balances. We expect this trend to continue in our residential real estate portfolio. Investments The investment portfolio is used to generate interest income, manage liquidity and mitigate interest rate sensitivity. The average investment portfolio for the second quarter of 2014 was
$352.90 million, a reduction of $50.08 millionfrom average balances for the fourth quarter of 2013. The ending balance in the investment portfolio at June 30, 2014was $335.44 million, compared to $365.34 millionat March 31, 2014and $393.34 millionat December 31, 2013. As mentioned previously, we have increased liquidity and reduced price volatility exposure in the investment portfolio by allowing the portfolio to run off. The book balance of the portfolio at June 30, 2014includes a $2.24 millionunrealized gain on the available for sale portion of the investment portfolio, compared to an unrealized loss of ($220) thousandat December 31, 2013. Interest rates have trended down over the course of 2014 which has positively impacted the value of our largely fixed rate investment portfolio. We sold $18.57 millionin securities during the second quarter for a small gain. For the six months ended June 30, 2014, we sold $45.22 millionin securities for a $143 thousandgain. During the second quarter, we sold three CMOs totaling $8.26 millionthat had higher than average price volatility and lower than average yields to continue to reduce the exposure to rising rates and the risk to tangible capital in the investment portfolio. We also took advantage of an opportunity to exit two of our remaining CLO positions during the second quarter, totaling $9.89 million, at break even. Our remaining CLO position totals $9.41 million. 33
-------------------------------------------------------------------------------- The composition of our investment portfolio as of
June 30, 2014, including both available for sale and held to maturity securities, consisted of the following: Amortized Fair (In thousands) Cost Value Available for Sale: U.S. Treasury Obligations $ 100 $ 100
Non-agency Collateralized Mortgage Obligations ("Non-agency CMOs") 66,246
Collateralized Loan Obligations ("CLOs") 9,409
Asset Backed Securities ("ABSs") 355 393 Total Available for Sale
$ 186,352188,593 Held to Maturity: U.S. Agency Obligations 22,864 23,055 U.S. Government Sponsored Enterprises ("U.S. GSEs") 9,470
Federal Home Loan Bank("FHLB") Obligations 4,702
Agency Collateralized Mortgage Obligations 8,588 8,722 Agency MBSs 101,224 99,931 Total Held to Maturity 146,848 145,730 Total Securities
$ 333,200 $ 334,323Agency MBSs and Agency CMOs consist of pools of residential mortgages which are guaranteed by the FNMA, FHLMC, or Government National Mortgage Association("GNMA") with various origination dates and maturities. Agency CMBSs consist of bonds backed by commercial real estate which are guaranteed by FNMA. CLOs are floating rate securities that consist of pools of commercial loans structured to provide very strong over collateralization and subordination. All of our CLOs are the senior AAA tranche and are the first bond to get paid down. We do not intend to sell the investment securities that are in an unrealized loss position, and it is unlikely that we will be required to sell the investment securities before recovery of their amortized cost bases, which may be maturity.
Deposits and Other Liabilities
Quarterly average deposits for the second quarter of 2014 were
$1.32 billion, a $45.43 millionincrease over quarterly average deposits for the second quarter of 2013. Total deposits at June 30, 2014were $1.31 billion, a $12.88 milliondecrease compared to balances at December 31, 2013. Strong growth in demand deposits and money market categories has been offset by reduced time deposit balances. Securities sold under agreement to repurchase, which represent collateralized customer accounts, declined to $141.06 millionat June 30, 2014from $250.31 millionat December 31, 2013as a result of seasonal municipal cash flows.
CREDIT QUALITY AND ALLOWANCE FOR CREDIT LOSSES
The United Stateseconomy continues to show improvement into 2014; however, high unemployment and foreclosure rates continue in certain parts of the country. Although Vermont, our primary market, has not been immune to this economic turmoil, the state has one of the lowest foreclosure rates in the country, home price depreciation has been muted, and the unemployment rate is lower than the national average.
Credit quality is a major strategic focus and strength of our company. Although we actively manage current nonperforming and classified loans, there is no assurance that we will not have increased levels of problem assets in the future. The pool of nonperforming loans is dynamic with accounts moving in and out of this category over time. The following table summarizes our nonperforming loans and nonperforming assets as of the dates indicated: (In thousands) June 30, 2014 March 31, 2014 December 31, 2013 June 30, 2013 Nonaccrual loans $ 372 $ 473 $ 425
$ 1,116Loans past due 90 days or more and still accruing 79 79 75 75 Troubled debt restructurings ("TDR") 437 454 406 409 Total nonperforming loans ("NPL") 888 1,006 906 1,600 OREO - 85 108 140 Total nonperforming assets ("NPA") $ 888 $ 1,091 $ 1,014 $ 1,740Non-performing loans at June 30, 2014were $888 thousand, 0.08% of total loans. Of the $888 thousandin nonperforming loans in the table above, $227 thousandare commercial and commercial real estate loans and $661 thousandare residential mortgages and home equity loans. 34
-------------------------------------------------------------------------------- We originate traditional mortgage and home equity products that are fully documented and underwritten. We take a proactive risk management approach by conducting periodic stress-testing of the existing residential loan portfolio and adjusting underwriting requirements, if necessary, based upon the results of the analysis. The assumptions used in the stress testing include: credit score migration; calculation of possible losses using conservative assumptions of market decline; review of life-of-loan delinquency levels relative to loan size and credit score; analysis of the portfolio by loan size, and distribution within the portfolio by loan-to-value ratios. Based upon the results of assessments of the residential loan portfolio, Management concluded that current reserve levels were adequate.
Our analysis indicates that, through a combination of estimated collateral value and, where needed, an appropriately allocated reserve, any additional loss exposure on current non-accruing loans is minimal.
TDRs represent balances where the existing loan was modified involving a concession in rate, term or payment amount due to the distressed financial condition of the borrower. At
Excluded from the nonperforming balances discussed above are loans that are 30 to 89 days past due, which are not necessarily considered classified or impaired. Accruing loans 30 to 89 days past due as a percentage of total loans as of the periods indicated are presented in the following table: Period Ended 30-89 Days
June 30, 20140.01% March 31, 20140.17% December 31, 20130.03% June 30, 20130.02% Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days. If a loan or a portion of a loan is internally classified as impaired or is partially charged-off, the loan is generally classified as nonaccrual. Loans that are on a current payment status or past due less than 90 days may also be classified as nonaccrual if repayment in full of principal and/or interest is in doubt. Income accruals are suspended on all nonaccruing loans, and all previously accrued and uncollected interest is charged against current income. Loans may be returned to accrual status when there is a sustained period of repayment performance (generally a minimum of six months) by the borrower, in accordance with the contractual terms of the loans and all principal and interest amounts contractually due, including arrearages, are reasonably assured of repayment within an acceptable period of time. While a loan is classified as nonaccrual and the future collectability of the recorded loan balance is uncertain, any payments received are generally applied to reduce the principal balance. When the future collectability of the recorded loan balance is expected, interest income may be recognized on a cash basis. In the case where a nonaccrual loan has been partially charged-off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Interest collections in excess of that amount are recorded as a reduction of principal. A loan remains in nonaccruing status until the factors which suggest doubtful collectability no longer exist, the loan is liquidated, or when the loan is determined to be uncollectible, and is charged off against the allowance for loan losses. In those cases where a nonaccruing loan is secured by real estate, we can, and may, initiate foreclosure proceedings. The result of such action will either be to cause repayment of the loan with the proceeds of a foreclosure sale or to give us possession of the collateral in order to manage a future resale of the real estate. Foreclosed property is recorded at the lower of its cost or estimated fair value, less any estimated costs to sell and is actively marketed. Any cost in excess of the estimated fair value on the transfer date is charged to the allowance for loan losses, while further declines in market values are recorded as OREO expense in the consolidated statements of income. Impaired loans, which primarily consist of non-accruing residential mortgage and commercial real estate loans and TDRs, totaled $888 thousandand $906 thousandat June 30, 2014and December 31, 2013, respectively. At June 30, 2014, impaired loans with a recorded investment were $371 thousandand had specific reserve allocations totaling $119 thousand. Substandard loans at June 30, 2014totaled $32.63 million, of which $32.11 millionin loans continue to accrue interest. Loans identified as substandard have well-defined weaknesses that, if not addressed, could result in a loss. These accruing substandard loans have generally continued to pay promptly and Management conducts regularly scheduled comprehensive reviews of the borrowers' financial condition, payment performance, accrual status and collateral. These reviews also ensure that these troubled accounts are properly administered with a focus on loss mitigation and that any potential loss exposures are appropriately quantified, and reserved for. The findings of this review process are a key component in assessing the adequacy of our loan loss reserve. Accruing substandard loans at June 30, 2014reflect a $6.88 millionincrease in balances since December 31, 2013. At June 30, 2014, accruing substandard loans related to owner-occupied commercial and construction real estate totaled $18.62 million, investor commercial real estate loans totaled $2.33 million, residential mortgage loans totaled $178 thousand, residential investment real estate loans totaled $932 thousand, and $10.05 millionin substandard loans are outstanding to corporate borrowers in a variety of different industries. Twelve borrowers in a variety of industries account for 85% of the total accruing substandard loans, and approximately $675 thousandof the total accruing substandard loans carry some form of government guarantee. 35
-------------------------------------------------------------------------------- To date, with very few exceptions, payments due from accruing substandard borrowers have been made as agreed and Management's ongoing evaluation of these borrowers' financial condition and collateral indicates a reasonable certainty that these exposures are adequately secured. Management monitors asset quality closely and continuously performs detailed and extensive reviews on larger credits and problematic credits identified on the watched asset list, nonperforming asset listings and internal credit rating reports. In addition to frequent financial analysis and review of well-rated and adversely graded loans, Management incorporates active monitoring of key credit and non-credit risks for each customer, assessing risk through the daily reviews of overdrafts, delinquencies and usage of electronic banking products and tracking for timely receipt of all required financial statements.
Allowance for Credit Losses
The Allowance is made up of two components: the allowance for loan losses ("ALL") and the reserve for undisbursed lines. The ALL is based on Management's estimate of the amount required to reflect the probable incurred losses in the loan portfolio, based on circumstances and conditions known at each reporting date. We review the adequacy of the ALL quarterly. Factors considered in evaluating the adequacy of the ALL include previous loss experience, the size and composition of the portfolio, risk rating composition, current economic and real estate market conditions and their effect on the borrowers, the performance of individual loans in relation to contractual terms and estimated fair values of properties that secure impaired loans. The adequacy of the ALL is determined using a consistent, systematic methodology, consisting of a review of both specific reserves for loans identified as impaired and general reserves for the various loan portfolio classifications. When a loan is impaired, we determine its impairment loss by comparing the excess, if any, of the loan's carrying amount over (1) the present value of expected future cash flows discounted at the loan's original effective interest rate, (2) the observable market price of the impaired loan, or (3) the fair value of the collateral securing a collateral-dependent loan. When a loan is deemed to have an impairment loss, the loan is either charged down to its estimated net realizable value, or a specific reserve is established as part of the overall allowance for loan losses if Management needs more time to evaluate all of the facts and circumstances relevant to that particular loan. The general allowance for loan losses is a percentage-based reflection of historical loss experience adjusted for qualitative factors and assigns a required allocation by loan classification based on a fixed percentage of all outstanding loan balances. The general allowance for loan losses employs a risk-rating model that grades loans based on their general characteristics of credit quality and relative risk. Appropriate reserve levels are estimated based on Management's judgments regarding the historical loss experience, current economic trends, trends in the portfolio mix, volume and trends in delinquencies and non-accrual loans. Losses are charged against the ALL when Management believes that the collectability of principal is doubtful. To the extent Management determines the level of anticipated losses in the portfolio has increased or decreased, the ALL is adjusted through current earnings. Overall, Management believes that the ALL is maintained at an adequate level, in light of historical and current factors, to reflect the level of credit risk in the loan portfolio. Loan loss experience and nonperforming asset data are presented and discussed in relation to their impact on the adequacy of the ALL. 36
The following table reflects our loan loss experience and activity in the Allowance for the periods indicated:
Three Months Six Months Twelve Months Six Months Ended Ended Ended Ended (In thousands) June 30, 2014 June 30, 2014 December 31, 2013 June 30, 2013 Average loans during the period
$ 1,169,339 $ 1,168,210 $ 1,133,637 $ 1,104,344Allowance beginning of the year 12,929 12,828 12,312 12,312 Charge-offs: Commercial, financial & agricultural (34) (34) (20) - Real estate - residential (16) (18) (289) (103) Real estate - commercial - - (1) (1) Real estate - construction - - - - Other (31) (51) (102) (48) Total charge-offs (81) (103) (412) (152) Recoveries: Commercial, financial & agricultural 1 3 62 49 Real estate - residential 2 20 6 4 Real estate - commercial - - 40 40 Real estate - construction - - 1 1 Installment 1 1 Other 4 7 19 4 Total recoveries 8 31 128 98 Net recoveries (charge-offs) (73) (72) (284) (54) Provision for credit losses 50 150 800 400 Allowance end of year $ 12,906 $ 12,906$ 12,828 $ 12,658Ratio of net (charge-offs) recoveries to average loans outstanding (0.03)% (0.01)% (0.02)% (0.05)% Components: Allowance for loan losses $ 12,040 $ 12,040$ 12,042 $ 11,890Reserve for undisbursed lines of credit 866 866 786 768
Allowance for credit losses
$ 12,658The following table reflects our nonperforming asset and coverage ratios as of the dates indicated: June 30, 2014 March 31, 2013 December 31, 2013 NPL to total loans 0.08% 0.09% 0.08% NPA to total assets 0.06% 0.07% 0.06% Allowance for loan losses to total loans 1.07% 1.04% 1.03% Allowance for loan losses to NPL 1356% 1210% 1329% We will continue to take all appropriate measures to restore nonperforming assets to performing status or otherwise liquidate these assets in an orderly fashion so as to maximize their value. There can be no assurances that we will be able to complete the disposition of nonperforming assets without incurring further losses. Loan Portfolio Monitoring Our Board of Directors grants each loan officer the authority to originate loans on our behalf, subject to certain limitations. The Board of Directors also establishes restrictions regarding the types of loans that may be granted and the distribution of loan types within our portfolio, and sets loan authority limits for each lender. These authorized lending limits are reviewed at least annually and are based upon the lender's experience. Loan requests that exceed a lender's authority require the signature of our Senior Lender, the Senior Credit Officer, and/or our President. With the exception of certain municipal loans, all extensions of credit of $5.0 millionor greater to any one borrower, or related party interest, are reviewed and approved by the Loan Committee of Merchants Bank'sBoard of Directors. Short-term revenue anticipation and tax anticipation extensions of credit of $8.0 millionor greater to a municipality are reviewed and approved by the Loan Committee of Merchants Bank'sBoard of Directors. 37
-------------------------------------------------------------------------------- The Loan Committee and the credit department regularly monitor our loan portfolio. The entire loan portfolio, as well as individual loans, is reviewed for loan performance, compliance with internal policy requirements and banking regulations, creditworthiness, and strength of documentation. We monitor loan concentrations by individual borrowers, industries and loan types. As part of the annual credit policy review process, targets are set by loan type for the total portfolio. Credit risk ratings assessing inherent risk in individual loans are assigned to commercial loans at origination and are routinely reviewed by lenders and Management on a periodic basis according to total exposure and risk rating. These internal reviews assess the adequacy of all aspects of credit administration, additionally, we maintain an on-going active monitoring process of loan performance during the year. We have also hired external loan review firms to assist in monitoring the commercial, municipal and residential loan portfolios. The commercial loan review firm annually reviews, at a minimum, 60% in dollar volume of our commercial loan portfolio and certain transactions based on amount and maturity date for our municipal loan portfolio. These comprehensive reviews assessed the accuracy of our risk rating system as well as the effectiveness of credit administration in managing overall credit risks.
All loan officers are required to service their loan portfolios and account relationships. Loan officers, a commercial workout officer, or collection personnel take remedial actions to assure full and timely payment of loan balances as necessary, with the supervision of the Senior Lender and the Senior Credit Officer.
Liquidity and Capital Resource Management
Liquid assets are maintained at levels considered adequate to meet our liquidity needs. Liquidity is adjusted as appropriate to meet asset and liability management objectives. Liquidity is monitored by the
Asset and Liability Committee("ALCO") of Merchants Bank'sBoard of Directors, based upon Merchants Bank'spolicies. Our primary sources of liquidity are deposits, amortization and prepayment of loans, maturities of investment securities and other short-term investments, periodic principal repayments on mortgage-backed and other amortizing securities, advances from the FHLBB, and earnings and funds provided from operations. While scheduled principal repayments on loans are a relatively predictable source of funds, deposit flows and loan and investment prepayments are greatly influenced by market interest rates, economic conditions, and rates offered by our competition. Interest rates on deposits are priced to maintain a desired level of total deposits. As of June 30, 2014, we could borrow up to $65 millionin overnight funds through unsecured borrowing lines established with correspondent banks. We have established both overnight and longer term lines of credit with the FHLBB. FHLBB borrowings are secured by residential mortgage loans. The total amount of loans pledged to the FHLBB for both short- and long-term borrowing arrangements totaled $269.5 millionat June 30, 2014. We have additional borrowing capacity with the FHLBB of $253.2 millionas of June 30, 2014. We have also established a borrowing facility with the Board of Governorsof the Federal Reserve System("FRB") which will enable us to borrow at the discount window. Additionally, we have the ability to borrow through the use of repurchase agreements, collateralized by Agency MBSs and Agency CMOs, with certain approved counterparties. Our investment portfolio, which is managed by the ALCO, has a cost basis of $333.20 millionat June 30, 2014, of which $257.89 millionwas pledged. The portfolio is a reliable source of cash flow for us. We closely monitor our short term cash position. Any excess funds are left on deposit at the FRB. The following table presents information regarding our short-term borrowings as of the dates indicated: Three Months Six Months Ended Ended (In thousands) June 30, 2014 June 30, 2014 FHLBB and other short-term borrowings Amount outstanding at end of period $ - $
Maximum during the period amount outstanding 18,900
Average amount outstanding 752
Weighted-average rate during the period 0.30%
Weighted-average rate at period end 0.00%
Securities sold under agreement to repurchase, short-term Amount outstanding at end of period
$ 141,064$ 141,064 Maximum during the period amount outstanding 212,474
Average amount outstanding 181,593
Weighted-average rate during the period 0.19%
Weighted-average rate at period end 0.18% 0.18% 38
Commitments and Off-Balance Sheet Risk
We are a party to financial instruments with offbalance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments primarily include commitments to extend credit and financial guarantees. Contingent obligations under standby letters of credit totaled approximately
$7.51 millionand $5.02 millionat June 30, 2014and June 30, 2013, respectively, and represent the maximum potential future payments we could be required to make. Typically, these instruments have terms of 12 months or less and expire unused; therefore, the total amounts do not necessarily represent future cash requirements. The fair value of our standby letters of credit at June 30, 2014and 2013 was insignificant. Capital Resources We are subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements results in certain mandatory, and the possibility of additional discretionary, actions by regulators that could have a direct material effect on our financial statements. Under capital adequacy guidelines, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. It is the policy of the FRB that banks and bank holding companies should pay dividends only out of current earnings and only if, after paying such dividends, the bank or bank holding company would remain adequately capitalized. We are also subject to the regulatory framework for prompt corrective action that requires us to meet specific capital guidelines to be considered well capitalized. Our capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Quantitative measures established by regulation to ensure capital adequacy require us to maintain minimum ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier 1 capital (as defined) to average assets (as defined). Management believes, as of June 30, 2014, that Merchants met all capital adequacy requirements to which it is subject. As of June 30, 2014, the most recent notification from the FDICcategorized Merchants Bankas well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that Management believes have changed Merchants Bank'scategory. We continue to be considered well capitalized under current applicable regulations. The Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") required the federal banking agencies to establish minimum leverage and risk-based capital requirements for insured banks and their holding companies. The federal banking agencies issued a joint final rule, or the "Final Capital Rule," that implements the Basel III capital standards and establishes the minimum capital levels required under the Dodd-Frank Act. We must comply with the Final Capital Rule by January 1, 2015. The Final Capital Rule establishes a minimum common equity Tier 1 capital ratio of 6.5% of risk-weighted assets for a "well capitalized" institution and increases the minimum Tier 1 capital ratio for a "well capitalized" institution from 6% to 8%. Additionally, the Final Capital Rule requires an institution to maintain a 2.5% common equity Tier 1 capital conservation buffer over the 6.5% minimum risk-based capital requirement to avoid restrictions on the ability to pay dividends, discretionary bonuses, and engage in share repurchases. The Final Capital Rule permanently grandfathers trust preferred securities issued before May 19, 2010, subject to a limit of 25% of Tier 1 capital. As of June 30, 2014, our capital ratios exceed all Basel III minimums, including the capital conservation buffer. 39
The following table represents our actual capital ratios and capital adequacy requirements as of
To Be Well- Capitalized Under For Capital Prompt Corrective Actual Adequacy Purposes Action Provisions (In thousands) Amount Percent Amount Percent Amount Percent
Merchants Bancshares, Inc.: Tier 1 Leverage Capital $ 145,6818.79% $ 66,3084.00% N/A N/A Tier 1 Risk-Based Capital 145,681 15.51% 37,574 4.00% N/A N/A Total Risk-Based Capital 157,437 16.76% 75,148 8.00% N/A N/A Merchants Bank: Tier 1 Leverage Capital $ 143,1818.61% $ 66,5044.00% $ 83,1305.00% Tier 1 Risk-Based Capital 143,181 15.14% 37,818 4.00% 56,727 6.00% Total Risk-Based Capital 155,013 16.40% 75,636 8.00% 94,545 10.00%
Capital amounts for