SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
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For the fiscal year ended December 31, 2014 |
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or |
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[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
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For the transition period from to |
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Commission file number 0-11595 |
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Merchants Bancshares, Inc. |
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(Exact name of registrant as specified in its charter) |
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Delaware |
03-0287342 |
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(State or other jurisdiction of incorporation or organization) |
(I.R.S. Employer Identification No.) |
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275 Kennedy Drive, South Burlington, Vermont |
05403 |
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(Address of principal executive offices) |
(Zip Code) |
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Registrant’s telephone number, including area code: (802) 658 – 3400 |
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Securities registered pursuant to Section 12(b) of the Act: |
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Title of each class |
Name of each exchange on which registered |
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Common Stock, par value $0.01 per share |
The NASDAQ Stock Market LLC |
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Securities registered pursuant to Section 12(g) of the Act: None |
Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. [ ] Yes [X] No
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.[ ] Yes [X] No
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [X] Yes [ ] No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). [X] Yes [ ] No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ]
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a nonaccelerated filer or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act. Large Accelerated Filer [ ] Accelerated Filer [X] Nonaccelerated Filer [ ] Smaller Reporting Company [ ]
Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act). [ ] Yes [X] No
The aggregate market value of the registrant’s common stock held by non-affiliates was $151,193,957 as computed using the per share price, as reported on the NASDAQ, as of market close on June 30, 2014.
As of February 28, 2015, there were 6,328,818 shares of the registrant’s common stock, par value $0.01 per share, outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement to Shareholders for the registrants’ Annual Meeting of Shareholders to be held on May 28, 2015 are incorporated herein by reference in Part III.
MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES
ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2014
TABLE OF CONTENTS
PART I |
Page Reference |
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4 |
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10 |
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16 |
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16 |
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16 |
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16 |
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PART II |
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17 |
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20 |
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Management's Discussion and Analysis of Financial Condition and Results of Operations |
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37 |
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41 |
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Changes in and Disagreements with Accountants on Accounting and Financial Disclosure |
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85 |
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85 |
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PART III* |
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85 |
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85 |
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Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters |
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Certain Relationships and Related Transactions, and Director Independence |
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85 |
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PART IV |
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86 |
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89 |
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* The information required by Part III is incorporated herein by reference to Merchants’ Proxy Statement for the Annual Meeting of Shareholders to be held on May 28, 2015. |
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FORWARD-LOOKING STATEMENTS
Certain statements contained in this Annual Report on Form 10-K 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 our 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. These statements include, among others, statements regarding our intent, belief or expectations with respect to economic conditions, trends affecting our financial condition or results of operations, and our exposure to market, interest rate and credit risk.
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 other factors, adverse conditions in the capital and debt markets; changes in interest rates; competitive pressures from other financial institutions; weakness in general economic conditions on a national basis or in the local markets in which we operate, including changes which adversely affect borrowers’ ability to service and repay our loans; changes in the value of securities and other assets; changes in loan default and charge-off rates; the adequacy of loan loss reserves; reductions in deposit levels necessitating increased borrowing to fund loans and investments; changes in government regulation; and changes in assumptions used in making such forward-looking statements, as well as the other risks and uncertainties detailed in Item 1A. “Risk Factors,” beginning on page 10 of this Annual Report on Form 10-K. Forward-looking statements speak only as of the date on which they are made. 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 statement is made.
USE OF NON-GAAP FINANCIAL MEASURES
Certain information in Item 7, “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 results with prior periods as well as demonstrating the effects of significant gains and charges in the current period. We believe that a meaningful analysis of our financial performance requires an understanding of the factors underlying that performance. We believe that investors may use these non-GAAP financial measures to analyze financial performance without the impact of unusual items that may obscure trends in our underlying performance. 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. 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” on page 24. A 35.0% tax rate was used in both 2014 and 2013.
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PART I
OVERVIEW
Merchants Bancshares, Inc. (“Merchants”) is a bank holding company originally organized under Vermont law in 1983 (and subsequently reincorporated in Delaware in 1987) for the purpose of owning all of the outstanding capital stock of Merchants Bank. Merchants Bank, which is Merchants’ primary subsidiary, is a Vermont commercial bank with 32 full-service banking offices located throughout the state of Vermont.
Merchants Bank was organized in 1849; and as of December 31, 2014, is the sole remaining independent statewide commercial banking operation headquartered in Vermont, with deposits totaling $1.31 billion, gross loans of $1.18 billion, and total assets of $1.72 billion. As used herein, “Merchants,” “we,” “us,” and “our” shall mean Merchants Bancshares, Inc. and our subsidiaries unless otherwise noted or the context otherwise requires.
Merchants Bank’s trust division offers investment management, financial planning and trustee services. As of December 31, 2014, this division had fiduciary responsibility for assets having a market value in excess of $637 million, of which more than $588 million constituted managed assets.
MBVT Statutory Trust I (the “Trust”) was formed on December 15, 2004 as part of our private placement of an aggregate of $20 million of trust preferred securities through a pooled trust preferred program. The Trust was formed for the sole purpose of issuing non-voting capital securities. The proceeds from the sale of the capital securities were loaned to us under junior subordinated debentures issued to the Trust. The debentures are the only asset of the Trust and payments under the debentures are the sole revenue of the Trust.
EMPLOYEES
As of December 31, 2014, we employed 287 full-time and 27 part-time employees. We maintain comprehensive employee benefits programs for employees, including major medical and dental insurance, long-term and short-term disability insurance, life insurance and a 401(k) Plan. We believe that relations with our employees are favorable.
COMPETITION
Presently, there are thirteen independent banks headquartered in the State of Vermont and ten regional or national banks that have operations in Vermont. Merchants Bank remains the only independent statewide bank headquartered in the State of Vermont. Of the ten regional or national banks in Vermont, eight are headquartered in either Connecticut, Massachusetts, New Hampshire, New York, Delaware or Ohio, and two other banking companies are owned by a parent headquartered outside of the United States (one in Canada and one in the United Kingdom). Based upon the FDIC deposit market share data report for June 30, 2014, Merchants has 11.14% of the Vermont deposit market.
We compete in Vermont for deposit and loan business not only with other commercial and savings banks, and savings and loan associations, but also with credit unions and other non-bank financial providers. Credit unions are increasingly becoming more direct competitors of ours. As of December 31, 2014, there were more than twenty three state- or federally-chartered credit unions operating in Vermont. As a bank holding company and state-chartered commercial bank, we are subject to extensive regulation and supervision, including, in many cases, regulation that limits the type and scope of our activities. The non-bank financial service providers that compete with us may be subject to less restrictive regulation and supervision. Competition from nationally-chartered banks and credit unions continues to be active.
The fact that we are a locally-managed, independent bank has, we believe, contributed significantly to the growth in average loans and deposits between 2006 and 2014. Customers have cited the local management and decision-making as important considerations when choosing a bank, and the sale of several independent Vermont-based financial institutions since 2007 has narrowed the base of independent Vermont-based financial institutions that such customers may favor.
From a retail product standpoint, we have seen a significant change in the competitive landscape in the past few years. Federal legislation enacted during 2010, coupled with the extended period of low interest rates, has prompted many banks to evaluate their transaction account structures and make changes to their product offerings. We continued to evaluate our deposit product line-up and fee structure in 2014.
No material part of our business is dependent upon one, or a few, customers, or upon a particular industry segment, the loss of which would have a material adverse impact on our operations.
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REGULATION AND SUPERVISION
General
As a bank holding company registered under the Bank Holding Company Act of 1956, as amended (the “BHCA”), we are subject to regulation and supervision by the Board of Governors of the Federal Reserve System (the “FRB”). As an FDIC-insured state-chartered commercial bank, Merchants Bank is subject to regulation and supervision by the Federal Deposit Insurance Corporation (the “FDIC”) and by the Commissioner of the Department of Financial Regulation of the State of Vermont (the “Commissioner”). This regulatory framework is intended to protect depositors, the federal deposit insurance fund, consumers and the banking system as a whole, and not necessarily investors in the Company. The following discussion is qualified in its entirety by reference to the full text of the statutes, regulations, policies and guidelines described below.
Bank Holding Company Regulation
Source of Strength. Under the BHCA, as amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), the Company is required to serve as a source of financial strength for Merchants Bank. This support may be required at times when the Company may not have the resources to provide support to Merchants Bank. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a bank subsidiary will be assumed by the bankruptcy trustee and entitled to a priority of payment.
Acquisitions and Activities. The BHCA prohibits a bank holding company, without prior approval of the FRB, from acquiring all or substantially all the assets of a bank, acquiring control of a bank, merging or consolidating with another bank holding company, or acquiring direct or indirect ownership or control of any voting shares of another bank or bank holding company if, after such acquisition, the acquiring bank holding company would control more than 5% of the voting shares of such other bank or bank holding company. The BHCA also prohibits a bank holding company from engaging directly or indirectly in activities other than those of banking, managing or controlling banks or furnishing services to its subsidiary banks. However, a bank holding company may engage in and may own shares of companies engaged in certain activities that the FRB determines to be closely related to banking or managing and controlling banks.
Limitations on Acquisitions of Company Common Stock. The Change in Bank Control Act prohibits a person or group of persons acting in concert from acquiring “control” of a bank holding company unless the FRB has been notified and has not objected to the transaction. Under a rebuttable presumption established by the FRB, the acquisition of 10% or more of a class of voting securities of a bank holding company, such as the Company, with a class of securities registered under Section 12 of the Exchange Act, would, under the circumstances set forth in the presumption, constitute the acquisition of control of a bank holding company. In addition, the BHCA prohibits any company from acquiring control of a bank or bank holding company without first having obtained the approval of the FRB. Among other circumstances, under the BHCA, a company has control of a bank or bank holding company if the company owns, controls or holds with power to vote 25% or more of a class of voting securities of the bank or bank holding company, controls in any manner the election of a majority of directors or trustees of the bank or bank holding company, or the FRB has determined, after notice and opportunity for hearing, that the company has the power to exercise a controlling influence over the management or policies of the bank or bank holding company.
Enforcement Powers. The FRB has the authority to issue orders to bank holding companies to cease and desist from unsafe or unsound banking practices and violations of law and regulations or conditions imposed by, or violations of agreements with, or commitments to, the FRB. The FRB is also empowered to assess civil money penalties against companies or individuals who violate the BHCA or orders or regulations thereunder, to order termination of non-banking activities of non-banking subsidiaries of bank holding companies, and to order termination of ownership and control of a non-banking subsidiary by a bank holding company.
Regulation of Merchants Bank
As an FDIC-insured state-chartered bank, Merchants Bank is subject to the supervision of and regulation by the Commissioner and the FDIC. This supervision and regulation is for the protection of depositors, the Deposit Insurance Fund (“DIF”) of the FDIC, and consumers, and is not for the protection of Merchants’ shareholders. The prior approval of the FDIC and the Commissioner is required, among other things, for Merchants Bank to establish or relocate an additional branch office, assume deposits, or engage in any merger, consolidation, purchase or sale of all or substantially all of the assets of any bank. Under the Dodd-Frank Act, the FRB may directly examine the subsidiaries of Merchants, including Merchants Bank.
Deposit Insurance. Substantially all of the deposits of Merchants Bank are insured up to applicable limits by the DIF and are subject to deposit insurance assessments to maintain the DIF. The Dodd-Frank Act permanently increased the FDIC deposit insurance limit to $250,000 per depositor for deposits maintained in the same right and capacity at a particular insured depository institution. The Federal Deposit Insurance Act (the “FDIA”), as amended by the Federal Deposit Insurance Reform Act and the Dodd-Frank Act, requires the FDIC to take steps as may be necessary to cause the ratio of deposit insurance reserves to estimated insured deposits – the designated reserve ratio – to reach 1.35% by September 30, 2020, and it mandates that the reserve ratio designated by the FDIC for any year may not be less than 1.35%. The FDIC utilizes a risk-based assessment system that imposes insurance premiums based upon a risk matrix that takes into account a bank’s capital level and supervisory rating. Assessment rates may also vary for certain institutions based on long-term debt issuer ratings, secured or brokered deposits. Deposit premiums are based on assets. To determine its deposit insurance premium, Merchants Bank computes the base amount of its average consolidated assets less its average tangible
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equity (defined as the amount of Tier I capital) and the applicable assessment rate. The FDIC has the power to adjust deposit insurance assessment rates at any time. In addition, under the FDIA, the FDIC may terminate deposit insurance upon a finding that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. Merchants Bank’s FDIC insurance expense in 2014 was $857 thousand.
Acquisitions and Branching. Merchants Bank must seek prior regulatory approval from the Commissioner and the FDIC to acquire another bank or establish a new branch office. Well capitalized and well managed banks may acquire other banks in any state, subject to certain deposit concentration limits and other conditions, pursuant to the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, as amended by the Dodd-Frank Act. In addition, the Dodd-Frank Act authorizes a state-chartered bank, such as Merchants Bank; to establish new branches on an interstate basis to the same extent a bank chartered by the host state may establish branches.
Activities and Investments of Insured State-Chartered Banks. Section 24 of the FDIA generally limits the types of equity investments an FDIC-insured state-chartered bank, such as Merchants Bank, may make and the kinds of activities in which such a bank may engage, as a principal, to those that are permissible for national banks. Further, the Gramm-Leach-Bliley Act of 1999 (the “GLBA”) permits national banks and state banks, to the extent permitted under state law, to engage – via financial subsidiaries – in certain activities that are permissible for subsidiaries of a financial holding company. In order to form a financial subsidiary, a state-chartered bank must be well capitalized, and such banks would be subject to certain capital deduction, risk management and affiliate transaction rules, among other things.
Lending Restrictions. Federal law limits a bank’s authority to extend credit to its directors, executive officers and 10% shareholders, as well as to entities controlled by such persons. Among other things, extensions of credit to insiders are required to be made on terms that are substantially the same as, and follow credit underwriting procedures that are not less stringent than, those prevailing for comparable transactions with unaffiliated persons. Also, the terms of such extensions of credit may not involve more than the normal risk of repayment or present other unfavorable features and may not exceed certain limitations on the amount of credit extended to such persons, individually and in the aggregate, which limits are based, in part, on the amount of the bank’s capital. The Dodd-Frank Act explicitly provides that an extension of credit to an insider includes credit exposure arising from a derivatives transaction, repurchase agreement, reverse repurchase agreement, securities lending transaction or securities borrowing transaction. Additionally, the Dodd-Frank Act requires that asset sale transactions with insiders must be on market terms, and if the transaction represents more than 10% of the capital and surplus of Merchants Bank, be approved by a majority of the disinterested directors of Merchants Bank.
Brokered Deposits. Section 29 of the FDIA and FDIC regulations generally limit the ability of an insured depository institution to accept, renew or roll over any brokered deposit unless the institution’s capital category is “well capitalized” or, with the FDIC’s approval, “adequately capitalized.” Depository institutions, other than those in the lowest risk category, that have brokered deposits in excess of 10% of total deposits will be subject to increased FDIC deposit insurance premium assessments.
Community Reinvestment Act. The Community Reinvestment Act (“CRA”) requires the FDIC to evaluate Merchants Bank’s performance in helping to meet the credit needs of the entire communities it serves, including low and moderate-income neighborhoods, consistent with its safe and sound banking operations, and to take this record into consideration when evaluating certain applications. The FDIC’s CRA regulations are generally based upon objective criteria of the performance of institutions under three key assessment tests: (i) a lending test, to evaluate the institution’s record of making loans in its service areas; (ii) an investment test, to evaluate the institution’s record of investing in community development projects, affordable housing, and programs benefiting low or moderate income individuals and businesses; and (iii) a service test, to evaluate the institution’s delivery of services through its branches, ATMs, and other offices. Failure of an institution to receive at least a “Satisfactory” rating could inhibit Merchants Bank or the Company from undertaking certain activities, including engaging in activities permitted as a financial holding company under GLBA and acquisitions of other financial institutions. Merchants Bank has achieved a rating of “Satisfactory” on its most recent examination dated November 14, 2011. Vermont has enacted substantially similar community reinvestment requirements.
Enforcement Powers. The FDIC and the Commissioner have the authority to issue orders to banks under their supervision to cease and desist from unsafe or unsound banking practices and violations of law and regulation or conditions imposed by, or violations of agreements with, or commitments to, the FDIC or Commissioner. The FDIC and the Commissioner are also empowered to assess civil money penalties against companies or individuals who violate banking laws, orders or regulations.
Capital Adequacy and Safety and Soundness
Regulatory Capital Requirements. The FRB and the FDIC have issued substantially similar risk-based and leverage capital rules applicable to U.S. banking organizations such as the Company and the Bank. These guidelines are intended to reflect the relationship between the banking organization’s capital and the degree of risk associated with its operations based on transactions recorded on-balance sheet as well as off-balance sheet items. The FRB and the FDIC may from time to time require that a banking organization maintain capital above the minimum levels discussed below, due to the banking organization’s financial condition or actual or anticipated growth.
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The capital adequacy rules define qualifying capital instruments and specify minimum amounts of capital as a percentage of assets that banking organizations are required to maintain. Tier I capital for banks and bank holding companies generally consists of the sum of common shareholders’ equity non-cumulative perpetual preferred stock, and related surplus and, in certain cases and subject to limitations, minority interest in consolidated subsidiaries, less goodwill, other non-qualifying intangible assets and certain other deductions. Tier II capital generally consists of hybrid capital instruments, perpetual debt and mandatory convertible debt securities, cumulative perpetual preferred stock, term subordinated debt and intermediate-term preferred stock, and, subject to limitations, allowances for loan losses. The sum of Tier I and Tier II capital less certain required deductions represents qualifying total risk-based capital. Prior to the effectiveness of certain provisions of the Dodd-Frank Act, bank holding companies were permitted to include trust preferred securities and cumulative perpetual preferred stock in Tier I capital, subject to limitations. However, the FRB’s capital rule applicable to bank holding companies permanently grandfathers non-qualifying capital instruments, including trust preferred securities, issued before May 19, 2010 by depository institution holding companies with less than $15 billion in total assets as of December 31, 2009, subject to a limit of 25% of Tier I capital. In addition, under rules that became effective January 1, 2015, accumulated other comprehensive income (positive or negative) must be reflected in Tier I capital; however, the Company will make a one-time, permanent election to continue to exclude accumulated other comprehensive income from capital. If the Company does not make this election, unrealized gains and losses, net of taxes, will be included in the calculation of the Company’s regulatory capital.
Under the capital rules, risk-based capital ratios are calculated by dividing Tier I and total risk-based capital, respectively, by risk-weighted assets. Assets and off-balance sheet credit equivalents are assigned a risk weight based primarily on relative risk. Under rules in effect through December 31, 2014, the minimum required Tier I risk-based capital ratio was 4% and the minimum total risk-based capital ratio was 8%. As of December 31, 2014, the Company’s Tier I risk-based capital ratio was 15.70% and its total risk-based capital ratio was 16.95%.
In addition to the risk-based capital requirements, under rules in effect through December 31, 2014, the FRB required top-rated bank holding companies to maintain a minimum leverage capital ratio of Tier I capital (defined by reference to the risk-based capital guidelines) to its average total consolidated assets of at least 3.0%. For most other bank holding companies (including the Company), the minimum leverage capital ratio was 4.0%. Bank holding companies with supervisory, financial, operational or managerial weaknesses, as well as bank holding companies that are anticipating or experiencing significant growth, were expected to maintain capital ratios well above the minimum levels. The Company’s Tier I leverage ratio as of December 31, 2014 was 8.76%.
Prior to the effectiveness of the Dodd-Frank Act, the FDIC had adopted a statement of policy regarding the capital adequacy of state-chartered banks and promulgated regulations to implement the system of prompt corrective action established by Section 38 of the FDIA. Under the FDIC regulations, which were in effect through December 31, 2014, a bank was considered “well capitalized” if it had: (i) a total risk-based capital ratio of 10.0% or greater; (ii) a Tier I risk-based capital ratio of 6.0% or greater; (iii) a leverage capital ratio of 5.0% or greater; and (iv) was not subject to any written agreement, order, capital directive, or prompt corrective action directive to meet and maintain a specific capital level for any capital measure.
In 2010, the Basel Committee on Banking Supervision released new capital requirements, known as Basel III, setting forth higher capital requirements, enhanced risk coverage, a global leverage ratio, provisions for counter-cyclical capital, and liquidity standards. In 2013, the FRB, along with the other federal banking agencies, issued final rules implementing the Basel III capital standards and establishing the minimum capital requirements for banks and bank holding companies required under the Dodd-Frank Act. These rules, which became effective January 1, 2015, establish a minimum common equity Tier I capital ratio requirement of 4.5%, a minimum Tier I capital ratio requirement of 6%, a minimum total capital requirement of 8% and a minimum leverage ratio requirement of 4%. Additionally, subject to a transition schedule, these rules require an institution to establish a capital conservation buffer of common equity Tier I capital in an amount above the minimum risk-based capital requirements for “adequately capitalized” institutions equal to 2.5% of total risk weighted assets, or face restrictions on the ability to pay dividends, pay discretionary bonuses, and to engage in share repurchases.
Under rules effective January 1, 2015, a bank holding company, such as the Company, is considered “well capitalized” if the bank holding company (i) has a total risk based capital ratio of at least 10%, (ii) has a Tier I risk-based capital ratio of at least 6%, and (iii) is not subject to any written agreement order, capital directive or prompt corrective action directive to meet and maintain a specific capital level for any capital measure. In addition, the FDIC has amended its prompt corrective action rules to reflect the revisions made by the new capital rules implementing Basel III. Under the FDIC’s revised rules, which became effective January 1, 2015, an FDIC supervised institution is considered “well capitalized” if it (i) has a total risk-based capital ratio of 10.0% or greater; (ii) a Tier I risk-based capital ratio of 8.0% or greater; (iii) a common Tier I equity ratio of at least 6.5% or greater, (iv) a leverage capital ratio of 5.0% or greater; and (iv) is not subject to any written agreement, order, capital directive, or prompt corrective action directive to meet and maintain a specific capital level for any capital measure.
The Company and Merchants Bank are considered “well capitalized” under all regulatory definitions.
Safety and Soundness Standards. The FDIA requires the federal bank regulatory agencies to prescribe standards, by regulations or guidelines, relating to internal controls, information systems and internal audit systems, risk management, loan documentation, credit underwriting, interest rate risk exposure, asset growth, asset quality, earnings, stock valuation and compensation, fees and benefits,
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and such other operational and managerial standards as the agencies deem appropriate. Guidelines adopted by the federal bank regulatory agencies establish general standards relating to internal controls and information systems, internal audit systems, risk management, loan documentation, credit underwriting, interest rate exposure, asset growth and compensation, and fees and benefits. In general, these guidelines require, among other things, appropriate systems and practices to identify and manage the risk and exposures specified in the guidelines. The guidelines prohibit excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director or principal stockholder. In addition, the federal banking agencies adopted regulations that authorize, but do not require, an agency to order an institution that has been given notice by an agency that it is not satisfying any of such safety and soundness standards to submit a compliance plan. If, after being so notified, an institution fails to submit an acceptable compliance plan or fails in any material respect to implement an acceptable compliance plan, the agency must issue an order directing action to correct the deficiency and may issue an order directing other actions of the types to which an undercapitalized institution is subject under the “prompt corrective action” provisions of the FDIA. See “—Regulatory Capital Requirements” above. If an institution fails to comply with such an order, the agency may seek to enforce such order in judicial proceedings and to impose civil money penalties.
Dividend Restrictions
We are a legal entity separate and distinct from Merchants Bank. Our revenue (on a parent company only basis) is derived primarily from interest and dividends paid to us by Merchants Bank. Our right, and consequently the right of our shareholders, to participate in any distribution of the assets or earnings of any subsidiary through the payment of such dividends or otherwise is necessarily subject to the prior claims of creditors of the subsidiary (including depositors, in the case of Merchants Bank), except to the extent that certain claims of Merchants in a creditor capacity may be recognized.
It is the policy of the FRB that bank holding companies should pay dividends only out of current earnings and only if, after paying such dividends; the bank holding company would remain adequately capitalized. The FRB has the authority to prohibit a bank holding company, such as us, from paying dividends if it deems such payment to be an unsafe or unsound practice. The FRB has indicated generally that it may be an unsafe or unsound practice for bank holding companies to pay dividends unless the bank holding company’s net income over the preceding year is sufficient to fund the dividends and the expected rate of earnings retention is consistent with the organization’s capital needs, asset quality and overall financial condition. Further, our ability to pay dividends would be restricted if we do not maintain the capital conservation buffer. See “—Capital Adequacy and Safety and Soundness—Regulatory Capital Requirements” above.
The FDIC has the authority to use its enforcement powers to prohibit a bank from paying dividends if, in its opinion, the payment of dividends would constitute an unsafe or unsound practice. Federal law also prohibits the payment of dividends by a bank that will result in the bank failing to meet its applicable capital requirements on a pro forma basis. Vermont law requires the approval of state bank regulatory authorities if the dividends declared by state banks exceed prescribed limits.
Certain Transactions by Bank Holding Companies with their Affiliates
There are various statutory restrictions on the extent to which bank holding companies and their non-bank subsidiaries may borrow, obtain credit from or otherwise engage in “covered transactions” with their insured depository institution subsidiaries. The Dodd-Frank Act amended the definition of affiliate to include an investment fund for which the depository institution or one of its affiliates is an investment adviser. An insured depository institution (and its subsidiaries) may not lend money to, or engage in covered transactions with, its non-depository institution affiliates if the aggregate amount of covered transactions outstanding involving the bank, plus the proposed transaction, exceeds the following limits: (i) in the case of any one such affiliate, the aggregate amount of covered transactions of the insured depository institution and its subsidiaries cannot exceed 10% of the capital stock and surplus of the insured depository institution; and (ii) in the case of all affiliates, the aggregate amount of covered transactions of the insured depository institution and its subsidiaries cannot exceed 20% of the capital stock and surplus of the insured depository institution. For this purpose, “covered transactions” are defined by statute to include a loan or extension of credit to an affiliate; a purchase of or investment in securities issued by an affiliate; a purchase of assets from an affiliate unless, exempted by the FRB; the acceptance of securities issued by an affiliate as collateral for a loan or extension of credit to any person or company; the issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate; securities borrowing or lending transactions with an affiliate that creates a credit exposure to such affiliate; or a derivatives transaction with an affiliate that creates a credit exposure to such affiliate. Covered transactions are also subject to certain collateral security requirements. Covered transactions as well as other types of transactions between a bank and a bank holding company must be on market terms and not otherwise unduly favorable to the holding company or an affiliate of the holding company. Moreover, the Bank Holding Company Act Amendments of 1970 provide that, to further competition, a bank holding company and its subsidiaries are prohibited from engaging in certain tying arrangements in connection with any extension of credit, lease or sale of property of any kind, or furnishing of any service.
Consumer Protection Regulation
We are subject to a number of federal and state laws designed to protect consumers and prohibit unfair or deceptive business practices, including the Equal Credit Opportunity Act, the Fair Housing Act, Home Ownership Protection Act, the Fair Credit Reporting Act, as amended by the Fair and Accurate Credit Transactions Act of 2003 (the “FACT Act”), the GLBA, the Truth in Lending Act, the CRA, the Home Mortgage Disclosure Act, the Real Estate Settlement Procedures Act, the National Flood Insurance Act and various state law counterparts. These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must interact with customers when taking deposits, making loans, collecting loans and providing other services. Further,
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the Dodd-Frank Act established the CFPB, which has the responsibility for making rules and regulations under the federal consumer protection laws relating to financial products and services. The CFPB also has a broad mandate to prohibit unfair or deceptive acts and practices and is specifically empowered to require certain disclosures to consumers and draft model disclosure forms. Failure to comply with consumer protection laws and regulations can subject financial institutions to enforcement actions, fines and other penalties. The FDIC examines Merchants Bank for compliance with CFPB rules and enforces CFPB rules with respect to Merchants Bank.
Mortgage Reform. The Dodd-Frank Act prescribes certain standards that mortgage lenders must consider before making a residential mortgage loan, including verifying a borrower’s ability to repay such mortgage loan, and allows borrowers to assert violations of certain provisions of the Truth in Lending Act as a defense to foreclosure proceedings. Under the Dodd-Frank Act, prepayment penalties are prohibited for certain mortgage transactions and creditors are prohibited from financing insurance policies in connection with a residential mortgage loan or home equity line of credit. In addition, the Dodd-Frank Act prohibits mortgage originators from receiving compensation based on the terms of residential mortgage loans and generally limits the ability of a mortgage originator to be compensated by others if compensation is received from a consumer. The Dodd-Frank Act requires mortgage lenders to make additional disclosures prior to the extension of credit, in each billing statement and for negative amortization loans and hybrid adjustable rate mortgages.
Privacy and Customer Information Security. The GLBA requires financial institutions to implement policies and procedures regarding the disclosure of nonpublic personal information about consumers to nonaffiliated third parties. In general, we must provide our customers with an annual disclosure that explains our policies and procedures regarding the disclosure of such nonpublic personal information and, except as otherwise required or permitted by law, we are prohibited from disclosing such information except as provided in such policies and procedures. The GLBA also requires that we develop, implement and maintain a comprehensive written information security program designed to ensure the security and confidentiality of customer information (as defined under the GLBA), to protect against anticipated threats or hazards to the security or integrity of such information; and to protect against unauthorized access to or use of such information that could result in substantial harm or inconvenience to any customer. We are also required to send a notice to customers whose sensitive information has been compromised if unauthorized use of this information is reasonably possible. Most of the states, including the state where we operate, have enacted legislation concerning breaches of data security and our duties in response to a data breach. Congress continues to consider federal legislation that would require consumer notice of data security breaches. Pursuant to the FACT Act, we must develop and implement a written identity theft prevention program to detect, prevent, and mitigate identity theft in connection with the opening of certain accounts or certain existing accounts. Additionally, the FACT Act amends the Fair Credit Reporting Act to generally prohibit a person from using information received from an affiliate to make a solicitation for marketing purposes to a consumer, unless the consumer is given notice and a reasonable opportunity and a reasonable and simple method to opt out of the making of such solicitations.
Anti-Money Laundering
The Bank Secrecy Act. Under the Bank Secrecy Act (“BSA”) a financial institution is required to have systems in place to detect certain transactions, based on the size and nature of the transaction. Financial institutions are generally required to report to the United States Treasury any cash transactions involving more than $10,000. In addition, financial institutions are required to file suspicious activity reports for transactions that involve more than $5,000 and which the financial institution knows, suspects or has reason to suspect involves illegal funds, is designed to evade the requirements of the BSA or has no lawful purpose. The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “USA PATRIOT Act”), which amended the BSA, together with the implementing regulations of various federal regulatory agencies, has caused financial institutions, such as Merchants Bank, to adopt and implement additional policies or amend existing policies and procedures with respect to, among other things, anti-money laundering compliance, suspicious activity, currency transaction reporting, customer identity verification and customer risk analysis. In evaluating an application under Section 3 of the BHCA to acquire a bank or an application under the Bank Merger Act to merge banks or affect a purchase of assets and assumption of deposits and other liabilities, the applicable federal banking regulator must consider the anti-money laundering compliance record of both the applicant and the target.
OFAC. The U.S. has imposed economic sanctions that affect transactions with designated foreign countries, nationals and others. These sanctions, which are administered by the U.S. Treasury’s Office of Foreign Assets Control (“OFAC”), take many different forms. Generally, however, they contain one or more of the following elements: (i) restrictions on trade with or investment in a sanctioned country, including prohibitions against direct or indirect imports from and exports to a sanctioned country and prohibitions on “U.S. persons” engaging in financial or other transactions relating to a sanctioned country or with certain designated persons and entities; (ii) a blocking of assets in which the government or specially designated nationals of the sanctioned country have an interest, by prohibiting transfers of property subject to U.S. jurisdiction (including property in the possession or control of U.S. persons); and (iii) restrictions on transactions with or involving certain persons or entities. Blocked assets (for example, property and bank deposits) cannot be paid out, withdrawn, set off or transferred in any manner without a license from OFAC. Failure to comply with these sanctions could have serious legal and reputational consequences for the Company.
Volcker Rule Restrictions on Proprietary Trading and Sponsorship of Hedge Funds and Private Equity Funds
The Dodd-Frank Act bars banking organizations, such as the Company, from engaging in proprietary trading and from sponsoring and investing in hedge funds and private equity funds, except as permitted under certain circumstances, in a provision commonly referred
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to as the “Volcker Rule.” Under the Dodd-Frank Act, proprietary trading generally means trading by a banking entity or its affiliate for its trading account. Hedge funds and private equity funds are described by the Dodd-Frank Act as funds that would be registered under the Investment Company Act but for certain enumerated exemptions. The Volcker Rule restrictions apply to the Company, Merchants Bank and all of their subsidiaries and affiliates.
Federal Home Loan Bank System
Merchants Bank is a member of the Federal Home Loan Bank of Boston (the “FHLBB”), which is one of the regional Federal Home Loan Banks comprising the Federal Home Loan Bank System. Each Federal Home Loan Bank provides a central credit facility primarily for member institutions. A member institution is required to acquire and hold shares of capital stock in the FHLBB in an amount at least equal to the sum of 0.35% of the aggregate principal amount of its unpaid residential mortgage loans and similar obligations at the beginning of each year and 4.5% of its advances (borrowings) from the FHLBB. We were in compliance with this requirement at December 31, 2014 with an investment in FHLBB stock as of December 31, 2014 of $4.38 million. We receive dividends on our FHLBB stock. The FHLBB has recently declared dividends equal to an annual yield of approximately the daily average three-month LIBOR yield plus 125 basis points for the quarter for which the dividend has been declared. Dividend income on FHLBB stock of $107 thousand was recorded during 2014.
Any advances from the FHLBB must be secured by specified types of collateral, and long-term advances may be used for the purpose of providing funds for residential housing finance, commercial lending and to purchase investments. Long term advances may also be used to help alleviate interest rate risk for asset and liability management purposes. As of December 31, 2014, we had no FHLBB advances.
AVAILABLE INFORMATION
We file annual, quarterly, and current reports, proxy statements, and other documents with the SEC. The public may read and copy any materials that we have filed with the SEC at the SEC's Public Reference Room at 100 F Street, NE, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Also, the SEC maintains an Internet website that contains reports, proxy and information statements, and other information regarding issuers, including us, that file electronically with the SEC. The public can obtain any documents that we have filed with the SEC at the SEC website at www.sec.gov.
We also make available free of charge on or through our Internet website at www.mbvt.com our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and, if applicable, amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, as soon as reasonably practicable after Merchants electronically files such materials with or furnishes them to the SEC. We also make all filed insider transactions available through our website free of charge. In addition, our Audit and Risk Management Committee, Compensation Committee, and Nominating and Governance Committee charters as well as our Code of Business Conduct and Ethics Policy for Senior Financial Officers, are available free of charge on our website.
Sustained low interest rates and interest rate volatility may reduce our profitability.
Our consolidated earnings and financial condition are primarily dependent upon net interest income, which is the difference between interest earned from loans and investments and interest paid on deposits and borrowings. The narrowing of that difference could adversely affect our earnings and financial condition. We cannot predict with certainty or control changes in interest rates. Regional and local economic conditions and the policies of regulatory authorities, including monetary policies of the FRB, affect interest income and interest expense. While we have ongoing policies and procedures designed to manage the risks associated with changes in market interest rates, changes in interest rates may have an adverse effect on our profitability. Increases in interest rates could affect the amount of loans that we originate, because higher rates could cause customers to apply for fewer loans. Higher interest rates could also cause depositors to shift funds from accounts that have a comparatively lower cost, to accounts with a higher cost. If the cost of interest-bearing deposits increases at a rate greater than the yields on interest-earning assets, net interest income will be negatively affected.
Our loan portfolio is concentrated in Vermont and we may be adversely affected by regional economic conditions and real estate values.
Because our loan portfolio is in Vermont, we may be adversely affected by regional economic conditions. Further, because a substantial portion of our loan portfolio is secured by real estate in Vermont, the value of the associated collateral is also subject to regional real estate market conditions. If these areas experience adverse economic, political or business conditions, we would likely experience higher rates of loss and delinquency on our loan portfolio than if it was more geographically diverse.
Our financial condition and results of operations have been adversely affected, and may continue to be adversely affected, by general market and economic conditions.
We have been, and continue to be, impacted by general business and economic conditions in the United States and, to a lesser extent, abroad. These conditions include short-term and long-term interest rates, inflation, money supply, political issues, legislative and
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regulatory changes, fluctuations in both debt and equity capital markets, broad trends in industry and finance, unemployment and the strength of the U.S. economy and the local economies in which we operate, all of which are beyond our control. Deterioration or continued weakness in any of these conditions could result in increases in loan delinquencies and nonperforming assets, decreases in loan collateral values, the value of our investment portfolio and demand for our products and services. While the U.S. economy is improving, the recovery has been slow and there remains some uncertainty regarding its sustainability.
If our allowance for loan losses is not sufficient to cover actual loan losses, our earnings could decrease.
Our loan customers may not repay their loans according to the terms of the loans, and the collateral securing the payment of these loans may be insufficient to pay any remaining loan balance. We therefore may experience significant loan losses, which could have a material adverse effect on our operating results. Material additions to our allowance for loan losses also would materially decrease our net income, and the charge-off of loans may cause us to increase the allowance.
We make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. We rely on our loan quality reviews, our experience and our evaluation of economic conditions, among other factors, in determining the amount of the allowance for loan losses. If our assumptions prove to be incorrect, our allowance for loan losses may not be sufficient to cover probable incurred losses in our loan portfolio, resulting in additions to our allowance. In addition, bank regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs, which may have a material adverse effect on our financial condition and results of operations.
Our commercial, commercial real estate and construction loan portfolio may expose us to increased credit risks.
At December 31, 2014, approximately 52% of our loan portfolio was comprised of commercial, commercial real estate, and construction loans with three of those relationships exceeding $18 million, exposing us to the risks inherent in financings based upon analyses of credit risk, the value of underlying collateral, including real estate, and other more intangible factors, which are considered in making commercial loans. In general, commercial and commercial real estate loans historically pose greater credit risks than owner occupied residential mortgage loans. The repayment of commercial real estate loans depends on the business and financial condition of borrowers, and a number of our borrowers have more than one commercial real estate loan outstanding with us. Economic events and changes in government regulations, which we and our borrowers cannot control or reliably predict, could have an adverse impact on the cash flows generated by properties securing our commercial real estate loans and on the values of the properties securing those loans. Repayment of commercial loans depends substantially on the borrowers’ underlying business, financial condition and cash flows. Commercial loans are generally collateralized by equipment, inventory, accounts receivable and other fixed assets. Compared to real estate, that type of collateral is more difficult to monitor, its value is harder to ascertain, it may depreciate more rapidly and it may not be as readily saleable if repossessed.
Environmental liability associated with our lending activities could result in losses.
In the course of business, we may acquire, through foreclosure, properties securing loans we have originated or purchased that are in default. Particularly in commercial real estate lending, there is a risk that material environmental violations could be discovered at these properties. In this event, we might be required to remedy these violations at the affected properties at our sole cost and expense. The cost of remedial action could substantially exceed the value of affected properties. We may not have adequate remedies against the prior owner or other responsible parties and could find it difficult or impossible to sell the affected properties. These events could have an adverse effect on our financial condition and results of operations.
We operate in a highly regulated environment and may be adversely affected by changes in laws and regulations.
We are subject to regulation and supervision by the FRB and Merchants Bank is subject to regulation and supervision by the FDIC and the Commissioner. Federal and state laws and regulations govern numerous matters affecting us, including changes in the ownership or control of banks and bank holding companies, maintenance of adequate capital and the financial condition of a financial institution, permissible types, amounts and terms of extensions of credit and investments, permissible nonbanking activities, the level of reserves against deposits and restrictions on dividend payments. The FDIC and the Commissioner possess the power to issue cease and desist orders to prevent or remedy unsafe or unsound practices or violations of law by banks subject to their regulation, and the FRB possesses similar powers with respect to bank holding companies. These and other restrictions limit the manner in which we may conduct business and obtain financing.
We are also affected by the monetary policies of the FRB. Changes in monetary or legislative policies may affect the interest rates we must offer to attract deposits and the interest rates we must charge on our loans, as well as the manner in which we offer deposits and make loans. These monetary policies have had, and are expected to continue to have, significant effects on the operating results of depository institutions generally, including Merchants Bank.
The laws, rules, regulations, and supervisory guidance and policies applicable to us are subject to regular modification and change. It is impossible to predict the competitive impact that any such changes would have on the banking and financial services industry in general or on our business in particular. Such changes may, among other things, increase the cost of doing business, limit permissible activities, or affect the competitive balance between banks and other financial institutions. The Dodd-Frank Act instituted major changes to the banking and financial institutions regulatory regimes in light of government intervention in the financial services sector following the 2008 financial crisis. Other changes to statutes, regulations, or regulatory policies, including changes in interpretation or
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implementation of statutes, regulations, or policies, could affect us in substantial and unpredictable ways. Such changes could subject us to additional costs, limit the types of financial services and products we may offer, and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations, or policies could result in sanctions by regulatory agencies, civil money penalties, and/or reputation damage, which could have a material adverse effect on our business, financial condition, and results of operations. See Item 1, “Business—Regulation and Supervision.”
Additional requirements imposed by the Dodd-Frank Act could adversely affect us.
The Dodd-Frank Act comprehensively reformed the regulation of financial institutions, products and services. In addition, the Dodd-Frank Act established the CFPB as an independent bureau of the FRB. The CFPB has the authority to prescribe rules for all depository institutions governing the provision of consumer financial products and services, which may result in rules and regulations that reduce the profitability of such products and services or impose greater costs and restrictions on us and our subsidiaries. The Dodd-Frank Act also established new minimum mortgage underwriting standards for residential mortgages, and the regulatory agencies have focused on the examination and supervision of mortgage lending and servicing activities.
On December 10, 2013, pursuant to the Dodd-Frank Act, federal banking and securities regulators issued final rules to implement Section 619 of the Dodd-Frank Act, commonly referred to as the “Volcker Rule.” Generally, the Volcker Rule restricts banking organizations and their affiliated companies from engaging in proprietary trading and from sponsoring and investing in hedge funds and private equity funds, except as permitted under certain limited circumstances. After a conformance period, which is currently set to end on July 21, 2015 (except for certain investments and activities existing before December 31, 2013), the Volcker Rule restrictions will apply to Merchants, Merchants Bank and all of our subsidiaries and affiliates. Under the final rule, we may be required to divest some or all of our collateralized loan obligations once the conformance period ends. As a result, we took an impairment charge totaling $166 thousand during the fourth quarter of 2013, however there were no impairment charges taken in 2014 and we divested the remaining CLO portfolio during the first quarter of 2014.
The CFPB’s new qualified mortgage rule, or “QM Rule,” became effective on January 10, 2014. The QM Rule is designed to clarify how lenders can manage the potential legal liability under the Dodd-Frank Act which would hold lenders accountable for insuring a borrower’s ability to repay a mortgage. Loans that meet the definition of “qualified mortgage” will be presumed to have complied with the new ability-to-repay standard. The QM Rule on qualified mortgages and similar rules could limit the Merchant Bank’s ability to make certain types of loans or loans to certain borrowers, or could make it more expensive and time-consuming to make these loans, which could limit the Bank’s growth or profitability.
Current and future legal and regulatory requirements, restrictions, and regulations, including those imposed under the Dodd-Frank Act, may adversely impact our profitability and may have a material and adverse effect on our business, financial condition, and results of operations; may require us to invest significant management attention and resources to evaluate and make any changes required by the legislation and related regulations; and may make it more difficult for us to attract and retain qualified executive officers and employees.
We will become subject to more stringent capital requirements.
The federal banking agencies issued a joint final rule, or the “Final Capital Rule,” that implemented the Basel III capital standards and established the minimum capital levels required under the Dodd-Frank Act. As of January 1, 2015 we are required to comply with the Final Capital Rule. The Final Capital Rule established a minimum common equity Tier I capital ratio of 6.5% of risk-weighted assets for a “well capitalized” institution and increased the minimum Tier I capital ratio for a “well capitalized” institution from 6.0% to 8.0%. Additionally, subject to a transition period, the Final Capital Rule requires an institution to maintain a 2.5% common equity Tier I capital conservation buffer over the 6.5% minimum risk-based capital requirement for “adequately capitalized” institutions, or face 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 I capital. The Final Capital Rule increased the required capital for certain categories of assets, including high-volatility construction real estate loans and certain exposures related to securitizations; however, the Final Capital Rule retained the current capital treatment of residential mortgages. Under the Final Capital Rule, we may make a one-time, permanent election to continue to exclude accumulated other comprehensive income from capital. If we do not make this election, unrealized gains and losses will be included in the calculation of our regulatory capital. Merchants Bank has made this election. Implementation of these standards, or any other new regulations, may adversely affect our ability to pay dividends, or require us to reduce business levels or raise capital, including in ways that may adversely affect our results of operations or financial condition.
We may incur fines, penalties and other negative consequences from regulatory violations, possibly even inadvertent or unintentional violations.
We maintain systems and procedures designed to ensure that we comply with applicable laws and regulations. However, some legal/regulatory frameworks provide for the imposition of fines or penalties for noncompliance even though the noncompliance was inadvertent or unintentional and even though there was in place at the time systems and procedures designed to ensure compliance. For example, we are subject to regulations issued by the Office of Foreign Assets Control, or “OFAC,” that prohibit financial institutions from participating in the transfer of property belonging to the governments of certain foreign countries and designated nationals of those countries and certain other persons or entities whose interest in property is blocked by OFAC-administered sanctions. OFAC may impose penalties for inadvertent or unintentional violations even if reasonable processes are in place to prevent
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the violations. There may be other negative consequences resulting from a finding of noncompliance, including restrictions on certain activities. Such a finding may also damage our reputation as described below and could restrict the ability of institutional investment managers to invest in our securities.
We face significant legal risks, both from regulatory investigations and proceedings and from private actions brought against us.
From time to time we are named as a defendant or are otherwise involved in various legal proceedings, including class actions and other litigation or disputes with third parties. There is no assurance that litigation with private parties will not increase in the future. Actions currently pending against us may result in judgments, settlements, fines, penalties or other results adverse to us, which could materially adversely affect our business, financial condition or results of operations, or cause serious reputational harm to us. As a participant in the financial services industry, it is likely that we will continue to experience a high level of litigation related to our businesses and operations.
Our businesses and operations are also subject to increasing regulatory oversight and scrutiny, which may lead to additional regulatory investigations or enforcement actions. These and other initiatives from federal and state officials may subject us to further judgments, settlements, fines or penalties, or cause us to be required to restructure our operations and activities, all of which could lead to reputational issues, or higher operational costs, thereby reducing our revenue.
Competition in the local banking industry may impair our ability to attract and retain customers at current levels.
Competition in the markets in which we operate may limit our ability to attract and retain customers. In particular, our competitors include major financial companies whose greater resources may afford them a marketplace advantage by enabling them to maintain numerous banking locations and mount extensive promotional and advertising campaigns. Additionally, banks and other financial institutions with larger capitalization, as well as financial intermediaries not subject to bank regulatory restrictions, have larger lending limits and are able to serve the credit and investment needs of larger customers. There is also increased competition by out-of-market competitors through the Internet. If we are unable to attract and retain customers, we may be unable to continue our loan growth and our results of operations and financial condition may otherwise be negatively impacted.
Prepayments of loans may negatively impact our business.
Generally, our customers may prepay the principal amount of their outstanding loans at any time. The speed at which such prepayments occur, as well as the size of such prepayments, are within our customers’ discretion. If customers prepay the principal amount of their loans, and we are unable to lend those funds to other borrowers or invest the funds at the same or higher interest rates, our interest income will be reduced. A significant reduction in interest income could have a negative impact on our results of operations and financial condition.
We may incur significant losses as a result of ineffective risk management processes and strategies.
We seek to monitor and control our risk exposure through a risk and control framework encompassing a variety of separate but complementary financial, credit, operational, compliance and legal reporting systems, internal controls, management review processes and other mechanisms. While we employ a broad and diversified set of risk monitoring and risk mitigation techniques, those techniques and the judgments that accompany their application may not be effective and may not anticipate every economic and financial outcome in all market environments or the specifics and timing of such outcomes. Market conditions over the last several years have involved unprecedented dislocations and highlight the limitations inherent in using historical data to manage risk.
We face security risks, including denial of service attacks, hacking and identity theft that could result in the disclosure of confidential information, adversely affect our business or reputation and create significant legal and financial exposure.
Our computer systems and network infrastructure are subject to potential security risks and could be targeted by cyber-attacks, such as denial of service attacks, hacking, terrorist activities or identity theft. Financial services institutions and companies engaged in data processing have reported breaches in the security of their websites or other systems, some of which have involved sophisticated and targeted attacks intended to obtain unauthorized access to confidential information, destroy data, disable or degrade service, or sabotage systems, often through the introduction of computer viruses or malware, cyber-attacks and other means. Denial of service attacks have been launched against a number of large financial services institutions. We expect to be subject to similar attacks in the future. Hacking and identity theft risks, in particular, could cause serious reputational harm. Cyber threats are rapidly evolving and we may not be able to anticipate or prevent all such attacks and could be held liable for any security breach or loss.
Despite efforts to ensure the integrity of our systems, we will not be able to anticipate all security breaches of these types, nor will we be able to implement guaranteed preventive measures against such security breaches. Persistent attackers may succeed in penetrating defenses given enough resources, time and motive. The techniques used by cyber criminals change frequently, may not be recognized until launched and can originate from a wide variety of sources, including outside groups such as external service providers, organized crime affiliates, terrorist organizations or hostile foreign governments. These risks may increase in the future as we continue to increase our mobile and internet-based product offerings and expand our internal usage of web-based products and applications.
Even the most advanced internal control environment may be vulnerable to compromise. Targeted social engineering attacks are becoming more sophisticated and are extremely difficult to prevent. The successful social engineer will attempt to fraudulently induce employees, customers or other users of our systems to disclose sensitive information in order to gain access to its data or that of its clients.
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A successful penetration or circumvention of system security could cause us serious negative consequences, including significant disruption of operations, misappropriation of confidential information, or damage to our computers or systems or those of our customers and counterparties. A successful security breach could result in violations of applicable privacy and other laws, financial loss to us or to our customers, loss of confidence in our security measures, significant litigation exposure, and harm to our reputation, all of which could have a material adverse effect on the Company.
We may be unable to attract and retain key personnel.
Our success depends, in large part, on our ability to attract and retain key personnel. Competition for qualified personnel in the financial services industry and in the Vermont marketplace can be intense and we may not be able to hire or retain the key personnel that we depend upon for success. The unexpected loss of services of one or more of our key personnel could have a material adverse impact on our business because of their skills, knowledge of the markets in which we operate, years of industry experience and the difficulty of promptly finding qualified replacement personnel.
Our ability to attract and retain customers and employees, and maintain relationships with vendors, third-party service providers and others, could be adversely affected to the extent our reputation is harmed.
We are dependent on our reputation within our market area, as a trusted and responsible financial company, for all aspects of our relationships with customers, employees, vendors, third-party service providers, and others, with whom we conduct business or potential future business. Our ability to attract and retain customers and employees, and maintain relationships with vendors, third-party service providers and others, could be adversely affected to the extent our reputation is damaged. Our actual or perceived failure to address various issues could give rise to reputational risk that could cause harm to us and our business prospects, including failure to properly address operational risks. These issues also include, but are not limited to, legal and regulatory requirements; privacy; properly maintaining customer and associate personal information; record keeping; money-laundering; sales and trading practices; ethical issues; appropriately addressing potential conflicts of interest; and the proper identification of the legal, reputational, credit, liquidity and market risks inherent in our products. Failure to appropriately address any of these issues could also give rise to additional regulatory restrictions, reputational harm and legal risks, which could, among other consequences, increase the size and number of litigation claims and damages asserted or subject us to enforcement actions, fines and penalties and cause us to incur related costs and expenses.
We may suffer losses as a result of operational risk or technical system failures.
The potential for operational risk exposure exists throughout our organization. Integral to our performance is the continued efficacy of our internal processes, systems, relationships with third parties and the associates and executives in our day-to-day and ongoing operations. Operational risk also encompasses the failure to implement strategic objectives in a successful, timely and cost-effective manner. Failure to properly manage operational risk subjects us to risks of loss that may vary in size, scale and scope, including loss of customers, operational or technical failures, unlawful tampering with our technical systems, ineffectiveness or exposure due to interruption in third party support, as well as the loss of key individuals or failure on the part of key individuals to perform properly. Although we seek to mitigate operational risk through a system of internal controls, losses from operational risk could take the form of explicit charges, increased operational costs, harm to our reputation or foregone opportunities.
We rely on other companies to provide key components of our business infrastructure.
Third party vendors provide key components of our business infrastructure such as internet connections, network access and core application processing. While we have selected these third party vendors carefully, we do not control their actions. Any problems caused by these third parties, including as a result of their not providing us their services for any reason or their performing their services poorly, could adversely affect our ability to deliver products and services to our customers or otherwise conduct our business efficiently and effectively. Replacing these third party vendors could also entail significant delay and expense.
The market price and trading volume of our common stock may be volatile.
The market price of our common stock may be volatile. In addition, the trading volume in our common stock may fluctuate and cause significant price variations to occur. We cannot assure you that the market price of our common stock will not fluctuate or decline significantly in the future. Some of the factors that could negatively affect our share price or result in fluctuations in the price or trading volume of our common stock include:
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quarterly variations in our operating results or the quality of our assets; |
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operating results that vary from the expectations of Management, securities analysts and investors; |
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changes in expectations as to our future financial performance; |
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announcements of innovations, new products, strategic developments, significant contracts, acquisitions and other material events by us or our competitors; |
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reputational issues or events; |
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the operating and securities price performance of other companies that investors believe are comparable to us; |
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our past and future dividend practices; |
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future sales of our equity or equity-related securities; and |
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changes in global financial markets and global economies and general market conditions, such as interest or foreign exchange rates, stock, commodity or real estate valuations or volatility. |
We are a holding company and depend on Merchants Bank for dividends, distributions and other payments.
We are legal entity that is separate and distinct from Merchants Bank. Our revenue (on a parent company only basis) is derived primarily from interest and dividends paid to us by Merchants Bank. Our right, and consequently the right of our shareholders, to participate in any distribution of the assets or earnings of any subsidiary through the payment of such dividends or otherwise is necessarily subject to the prior claims of creditors of the subsidiary (including depositors, in the case of Merchants Bank), except to the extent that certain claims of Merchants in a creditor capacity may be recognized. See Item 1, “Business—Regulation and Supervision—Capital Adequacy and Safety and Soundness.”
Our shareholders may not receive dividends on our common stock.
Holders of our common stock are entitled to receive dividends only when, as and if declared by our board of directors. Although we have historically declared cash dividends on our common stock, we are not required to do so and our board of directors may reduce or eliminate our common stock dividend in the future. It is the policy of the FRB that bank holding companies should pay dividends only out of current earnings and only if, after paying such dividends, the bank holding company would remain adequately capitalized. The FRB has the authority to prohibit a bank holding company, such as us, from paying dividends if it deems such payment to be an unsafe or unsound practice. The FDIC has the authority to use its enforcement powers to prohibit a bank from paying dividends if, in its opinion, the payment of dividends would constitute an unsafe or unsound practice. Federal law also prohibits the payment of dividends by a bank that will result in the bank failing to meet its applicable capital requirements on a pro forma basis. Further, when the Final Capital Rule comes into effect our ability to pay dividends would be restricted if we do not maintain a capital conservation buffer. A reduction or elimination of dividends could adversely affect the market price of our common stock. See Item 1, “Business—Regulation and Supervision—Dividend Restrictions” and “Business—Regulation and Supervision—Capital Adequacy and Safety and Soundness —Regulatory Capital Requirements.”
Changes in accounting standards can be difficult to predict and can materially impact how we record and report our financial condition and results of operations.
Our accounting policies and methods are fundamental to how we record and report our financial condition and results of operations. From time to time, the Financial Accounting Standards Board (“FASB”) changes the financial accounting and reporting standards that govern the preparation of our financial statements. These changes can be hard to anticipate and implement and can materially impact how we record and report our financial condition and results of operations.
Our financial statements are based in part on assumptions and estimates, which, if wrong, could cause unexpected losses in the future.
Pursuant to GAAP, we are required to use certain assumptions and estimates in preparing our financial statements, including in determining credit loss reserves, reserves related to litigation and the fair value of certain assets and liabilities, among other items. If assumptions or estimates underlying our financial statements are incorrect, we may experience material losses. For additional information, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Policies.”
There are potential risks associated with future acquisitions and expansions.
We evaluate acquisition and other expansion opportunities and strategies. To the extent we acquire other companies in the future, our business may be negatively impacted by certain risks inherent with such acquisitions. Some of these risks include the following:
· |
the risk that the acquired business will not perform in accordance with Management’s expectations; |
· |
the risk that difficulties will arise in connection with the integration of the operations of the acquired business with the operations of our business; |
· |
the risk that Management will divert its attention from other aspects of our business; |
· |
the risk that we may lose key employees of the combined business; and |
· |
the risks associated with entering into geographic and product markets in which we have limited or no direct prior experience. |
We may need to raise additional capital in the future and such capital may not be available when needed.
As a bank holding company, we are required by regulatory authorities to maintain adequate levels of capital to support our operations. We may need to raise additional capital in the future to provide us with sufficient capital resources and liquidity to meet our
15
commitments and business needs. Our ability to raise additional capital, if needed, will depend on, among other things, conditions in the capital markets at that time, which are outside of our control, and our financial performance. We cannot assure you that such capital will be available to us on acceptable terms or at all. Our inability to raise sufficient additional capital on acceptable terms when needed could subject us to certain activity restrictions or to a variety of enforcement remedies available to the regulatory authorities, including limitations on our ability to pay dividends or pursue acquisitions, the issuance by regulatory authorities of a capital directive to increase capital and the termination of deposit insurance by the FDIC.
Certain provisions of our articles of incorporation may have an anti-takeover effect.
Provisions of our certificate of incorporation and bylaws and regulations and federal banking laws, including regulatory approval requirements, could make it more difficult for a third party to acquire us, even if doing so would be perceived to be beneficial to our shareholders. The combination of these provisions may inhibit a non-negotiated merger or other business combination, which, in turn, could adversely affect the market price of our common stock.
ITEM 1B – UNRESOLVED STAFF COMMENTS
None.
As of December 31, 2014, we operated thirty two full-service banking offices and thirty eight ATMs throughout the state of Vermont. Our headquarters are located at 275 Kennedy Drive, South Burlington, Vermont, which also houses our operations and administrative offices and our Trust division.
We lease certain premises from third parties, including our headquarters, under current market terms and conditions. All offices are in good physical condition with modern equipment and facilities considered adequate to meet the banking needs of customers in the communities served. Additional information relating to our properties is set forth in Note 6 to the consolidated financial statements included in Item 8 of this Annual Report on Form 10-K.
We are involved in various legal proceedings arising from our normal business activities. In the opinion of Management, based upon input from counsel on the anticipated outcome of such proceedings, final disposition of these proceedings will not have a material adverse effect on our consolidated financial position.
ITEM 4 – MINE SAFETY DISCLOSURES
Not applicable.
16
PART II
ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Common Stock and Dividends
The common stock of Merchants is traded on the NASDAQ Global Select Market under the trading symbol “MBVT”. Merchants currently pays dividends on a quarterly basis. Quarterly stock prices and dividends per share paid for each quarterly period during the last two years were as follows:
|
|
|
Dividends |
Quarter Ended |
High |
Low |
Paid |
December 31, 2014 |
$ 32.47
|
$ 27.74
|
$ 0.28
|
September 30, 2014 |
32.38 | 28.19 | 0.28 |
June 30, 2014 |
33.00 | 28.32 | 0.28 |
March 31, 2014 |
33.85 | 28.82 | 0.28 |
December 31, 2013 |
$ 33.55
|
$ 28.78
|
$ 0.28
|
September 30, 2013 |
33.65 | 28.54 | 0.28 |
June 30, 2013 |
31.25 | 27.07 | 0.28 |
March 31, 2013 |
31.14 | 27.22 | 0.28 |
High and low stock prices are based upon quotations as reported by the NASDAQ Global Select Market. Prices of transactions between private parties may vary from the ranges quoted above.
As of March 13, 2015, Merchants had 690 shareholders of record. Merchants declared and distributed dividends totaling $1.12 per share during 2014. In January 2015, Merchants declared a dividend of $0.28 per share for the fourth quarter of 2014, which was paid on February 26, 2015, to shareholders of record as of February 12, 2015. Future dividends will depend upon the financial condition and earnings of Merchants and its subsidiaries, its need for funds and other factors, including applicable government regulations.
Merchants Bancshares, Inc. is a legal entity that is separate and distinct from Merchants Bank. The revenue of Merchants (on a parent company-only basis) is derived primarily from interest and dividends paid to it by Merchants Bank. See “Business—Regulation and Supervision—Dividend Restrictions” above, which is incorporated herein by reference, for a discussion on statutory restrictions on the payment of dividends by Merchants Bancshares, Inc. and Merchants Bank.
Performance Graph
The line-graph presentation below compares cumulative five-year shareholder returns with the NASDAQ Bank Index and the Russell 2000 Index. The comparison assumes the investment, on December 31, 2009, of $100 in Merchants’ common stock and each of the foregoing indices and reinvestment of all dividends.
17
The performance graph and related information furnished under Item 5 of this Annual Report on Form 10-K shall not be deemed to be “soliciting material” or to be “filed” with the SEC, or subject to Regulation 14A or 14C, other than as provided in Item 201 of Regulation S-K, or to the liabilities of Section 18 of the Exchange Act. Such information shall not be incorporated by reference into any future filing under the Securities Act or Exchange Act except to the extent that Merchants specifically incorporates it by reference into such filing.
Securities Authorized for Issuance under Equity Compensation Plans
We maintain two equity compensation plans: the 2008 Deferred Compensation Plan for Non-Employee Directors and Trustees and the Amended and Restated Merchants Bancshares, Inc. 2008 Stock Incentive Plan. Each of these plans has been approved by our shareholders. The following table includes information as of December 31, 2014 about these plans. See Note 13 to the consolidated financial statements included in Item 8 for a description of these plans.
Plan Category |
Number of Securities to be Issued Upon Exercise of Outstanding Options, Warrants and Rights |
|
Weighted-Average Price of Outstanding Options, Warrants and Rights |
|
Number of Securities Remaining Available for Future Issuance Under Equity Compensation Plans (Excluding Securities Reflected in First Column) |
Equity Compensation Plans Approved by Security Holders |
82,084 |
(a) |
$ 23.00
|
(b) |
549,270 |
Equity Compensation Plans Not Approved by Security Holders |
0 |
|
0 |
|
0 |
Total |
82,084 |
|
$ 23.00
|
|
549,270 |
(a)This number relates to the Amended and Restated Merchants Bancshares, Inc. 2008 Stock Incentive Plan.
(b)This price reflects the weighted-average exercise price of outstanding stock options under the Amended and Restated Merchants Bancshares, Inc. 2008 Stock Incentive Plan.
18
Issuer Repurchase of Equity Securities
We extended our stock buyback program through January 2016. Under the program, which was originally adopted in January 2007, we may repurchase up to 200,000 shares of our common stock on the open market from time to time, and have purchased 143,475 shares at an average price per share of $23.00 since the program's adoption. We did not repurchase any of our shares during 2014, 2013 or 2012 and do not expect to repurchase shares in the near future.
19
ITEM 6 - SELECTED FINANCIAL DATA
The supplementary financial data presented in the following tables contain information highlighting certain significant trends in our financial condition and results of operations over an extended period of time.
The following information should be analyzed in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and with the audited consolidated financial statements and related notes included in Item 8 of this Annual Report on Form 10-K.
Merchants Bancshares, Inc. |
||||||
Five Year Summary of Financial Data |
||||||
At or For the Year Ended December 31, |
||||||
(In thousands except share and per share data) |
2014 |
2013 |
2012 |
2011 |
2010 |
|
Results For The Year |
||||||
Interest and dividend income |
$ 50,972
|
$ 53,967
|
$ 56,857
|
$ 58,018
|
$ 60,262
|
|
Interest expense |
4,525 | 5,070 | 6,883 | 8,644 | 11,107 | |
Net interest income |
46,447 | 48,897 | 49,974 | 49,374 | 49,155 | |
Provision (credit) for loan losses |
150 | 800 | 950 | 750 | (1,750) | |
Net interest income after provision (credit) for loan losses |
46,297 | 48,097 | 49,024 | 48,624 | 50,905 | |
Noninterest income |
11,574 | 11,630 | 12,613 | 11,838 | 12,942 | |
Noninterest expense |
42,214 | 39,534 | 40,950 | 40,770 | 41,937 | |
Income before income taxes |
15,657 | 20,193 | 20,687 | 15,810 | 21,781 | |
Provision for income taxes |
3,532 | 5,062 | 5,493 | 4,890 | 6,320 | |
Net income |
$ 12,125
|
$ 15,131
|
$ 15,194
|
$ 14,620
|
$ 15,461
|
|
Share Data |
||||||
Basic earnings per common share |
$ 1.92
|
$ 2.40
|
$ 2.43
|
$ 2.35
|
$ 2.51
|
|
Diluted earnings per common share |
$1.91 $ |
$2.40 $ |
$ 2.42
|
$ 2.35
|
$ 2.51
|
|
Cash dividends declared per common share |
$ 1.12
|
$ 1.12
|
$ 1.12
|
$ 1.12
|
$ 1.12
|
|
Weighted average common shares outstanding (1) |
6,326,142 | 6,302,494 | 6,258,832 | 6,212,187 | 6,167,446 | |
Period end common shares outstanding (2) |
6,327,226 | 6,318,708 | 6,282,385 | 6,232,783 | 6,186,363 | |
Year-end book value per share |
$ 20.91
|
$ 19.94
|
$ 19.84
|
$ 18.54
|
$ 16.95
|
|
Year-end book value per share (2) |
$ 19.89
|
$ 18.93
|
$ 18.82
|
$ 17.57
|
$ 16.06
|
|
Key Performance Ratios |
||||||
Return on average shareholders' equity |
9.84% | 12.97% | 13.37% | 14.11% | 16.18% | |
Return on average assets |
0.73% | 0.90% | 0.92% | 0.97% | 1.07% | |
Average equity to average assets |
7.39% | 6.95% | 6.89% | 6.87% | 6.64% | |
Tier 1 leverage ratio |
8.76% | 8.44% | 8.08% | 8.08% | 7.90% | |
Tangible equity ratio |
7.30% | 6.93% | 6.92% | 6.80% | 6.68% | |
Dividend payout ratio |
58.64% | 46.67% | 46.28% | 47.66% | 44.62% | |
Allowance for loan losses to total loans at year-end |
1.00% | 1.03% | 1.07% | 1.03% | 1.11% | |
Nonperforming loans as a percentage of total loans |
0.07% | 0.08% | 0.27% | 0.24% | 0.45% | |
Net interest margin |
3.03% | 3.15% | 3.28% | 3.51% | 3.65% | |
Average Balances |
||||||
Total assets |
$ 1,667,665
|
$ 1,677,342
|
$ 1,648,393
|
$ 1,507,656
|
$ 1,438,730
|
|
Earning assets |
1,603,460 | 1,617,225 | 1,587,190 | 1,461,359 | 1,379,475 | |
Gross loans |
1,165,586 | 1,133,637 | 1,057,446 | 971,003 | 912,363 | |
Investments (3) |
358,274 | 455,679 | 509,384 | 436,170 | 437,058 | |
Total deposits |
1,320,389 | 1,299,449 | 1,222,423 | 1,120,234 | 1,053,503 | |
Shareholders' equity |
123,283 | 116,640 | 113,621 | 103,639 | 95,580 | |
At Year-End |
||||||
Total assets |
$ 1,723,464
|
$ 1,725,469
|
$ 1,708,550
|
$ 1,611,869
|
$ 1,487,644
|
|
Gross loans |
1,182,334 | 1,166,233 | 1,082,923 | 1,027,626 | 910,794 | |
Allowance for loan losses |
11,833 | 12,042 | 11,562 | 10,619 | 10,135 | |
Investments (3) |
346,272 | 400,835 | 517,233 | 520,939 | 475,386 | |
Total deposits |
1,308,772 | 1,323,576 | 1,271,080 | 1,177,880 | 1,092,196 | |
Shareholders' equity |
125,821 | 119,611 | 118,221 | 109,537 | 99,331 | |
(1) Weighted average common shares outstanding includes an average of 301,757; 312,606; 316,920; 318,110; and 318,549 shares held in Rabbi Trusts for deferred compensation plans for directors for 2014, 2013, 2012, 2011, and 2010, respectively. |
||||||
(2) Period end common shares outstanding and year-end book value include 308,670; 319,854; 324,515; 325,703; and 327,100 shares held in Rabbi Trusts for deferred compensation plans for directors for 2014, 2013, 2012, 2011, and 2010 respectively. |
20
(3) Includes Federal Home Loan Bank stock of $4.38 million for 2014, $7.50 million for 2013, $8.15 million for 2012 and $8.63 million for 2011, and 2010. |
Merchants Bancshares, Inc.
Summary of Quarterly Financial Information
(Unaudited)
(In thousands except per share data) |
2014 |
2013 |
||||||||||
Q4 |
Q3 |
Q2 |
Q1 |
Year |
Q4 |
Q3 |
Q2 |
Q1 |
Year |
|||
Interest and dividend income |
$ 12,557
|
$ 12,564
|
$ 12,836
|
$ 13,015
|
$ 50,972
|
$ 13,416
|
$ 13,384
|
$ 13,620
|
$ 13,547
|
$ 53,967
|
||
Interest expense |
1,045 | 1,066 | 1,223 | 1,191 | 4,525 | 1,229 | 1,232 | 1,310 | 1,299 | 5,070 | ||
Net interest income |
11,512 | 11,498 | 11,613 | 11,824 | 46,447 | 12,187 | 12,152 | 12,310 | 12,248 | 48,897 | ||
Provision for loan losses |
0 | 0 | 50 | 100 | 150 | 0 | 400 | 150 | 250 | 800 | ||
Noninterest income |
2,804 | 2,876 | 2,984 | 2,910 | 11,574 | 3,522 | 2,786 | 2,765 | 2,647 | 11,630 | ||
Noninterest expense |
11,206 | 10,724 | 10,130 | 10,154 | 42,214 | 10,669 | 9,630 | 9,576 | 9,749 | 39,624 | ||
Income before income taxes |
3,111 | 3,649 | 4,416 | 4,480 | 15,657 | 5,040 | 4,908 | 5,349 | 4,896 | 20,193 | ||
Provision for income taxes |
608 | 843 | 1,003 | 1,077 | 3,532 | 1217 | 1234 | 1324 | 1287 | 5,062 | ||
Net income |
$ 2,503
|
$ 2,806
|
$ 3,413
|
$ 3,403
|
$ 12,125
|
$ 3,823
|
$ 3,674
|
$ 4,025
|
$ 3,609
|
$ 15,131
|
||
Basic earnings per share |
0.40 | 0.44 | 0.54 | 0.54 | $ 1.92
|
0.61 | 0.58 | 0.64 | 0.57 | $ 2.40
|
||
Diluted earnings per share |
0.39 | 0.44 | 0.54 | 0.54 | $ 1.91
|
0.60 | 0.58 | 0.64 | 0.57 | $ 2.40
|
||
Cash dividends declared and paid per share |
$ 0.28
|
$ 0.28
|
$ 0.28
|
$ 0.28
|
$ 1.12
|
$ 0.28
|
$ 0.28
|
$ 0.28
|
$ 0.28
|
$ 1.12
|
ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
CRITICAL ACCOUNTING POLICIES
Management’s discussion and analysis of our financial condition and results of operations is based on the consolidated financial statements, which are prepared in accordance with accounting principles generally accepted in the United States. The preparation of such consolidated financial statements requires Management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Management evaluates its estimates on an ongoing basis. Management bases its estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis in making judgments about financial statement amounts. Actual results could differ from the amount derived from Management’s estimates and assumptions under different conditions.
Our significant accounting policies are described in more detail in Note 1 to the consolidated financial statements included in Item 8 of this Annual Report on Form 10-K. Management believes the following accounting policies are the most critical to the preparation of the consolidated financial statements.
Allowance for Credit Losses: The allowance for credit losses (“Allowance”) includes the allowance for loan losses (“ALL”) and the reserve for undisbursed lines of credit and standby letters of credit. The Allowance, which is established through the provision for credit losses, is based on Management’s evaluation of the level of allowance required in relation to probable incurred losses in the loan portfolio and undisbursed lines of credit and standby letters of credit. Management believes the Allowance is a significant estimate and therefore evaluates its adequacy each quarter. When determining the appropriate amount of the Allowance, Management considers factors such as previous loss experience, the size and composition of the loan portfolio, current economic and real estate market conditions, the performance of individual loans in relation to contract terms, and the estimated fair value of collateral that secures the loans. The use of different estimates or assumptions could produce a different Allowance.
Income Taxes: We estimate our income taxes for each period for which a statement of income is presented. This involves estimating our actual current tax exposure, as well as assessing temporary differences resulting from differing timing of recognition of expenses, income and tax credits, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in our consolidated balance sheets. We must also assess the likelihood that any deferred tax assets will be recovered from future taxable income and, to the extent that recovery is not likely, a valuation allowance must be established. Significant Management judgment is required in determining income tax expense, and deferred tax assets and liabilities. As of December 31, 2014, we determined that no valuation allowance for deferred tax assets was necessary.
21
Valuation of Investment Securities: Management evaluates securities for other-than-temporary impairment on at least a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. When an other-than-temporary impairment has occurred, the amount of the other-than-temporary impairment recognized in earnings depends on whether we intend to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss. To determine whether impairment is other‑than‑temporary, we consider all available information relevant to the collectability of the security, including past events, current conditions, and reasonable and supportable forecasts when developing estimates of cash flows expected to be collected. Factors considered in this assessment includes the reasons for the impairment, the severity and duration of the impairment, changes in value subsequent to year‑end, forecasted performance of the investee, and the general market conditions in the geographic area or industry the investee operates in.
If we intend to sell the security or it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss, the impairment is recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. If we do not intend to sell the security and it is not more likely than not that we will be required to sell the security before recovery of its amortized cost basis less any current-period credit loss, the other-than-temporary impairment is separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total other-than-temporary impairment related to the credit loss is recognized in earnings. The amount of the total impairment related to other factors is recognized in other comprehensive income, net of applicable income taxes.
GENERAL
The following discussion and analysis of financial condition and results of operations of Merchants and its subsidiaries for the three years ended December 31, 2014 should be read in conjunction with the consolidated financial statements and Notes thereto and selected statistical information appearing elsewhere in this Annual Report on Form 10-K. The financial condition and results of operations of Merchants essentially reflect the operations of its principal subsidiary, Merchants Bank. Certain statements contained in this section are forward-looking statements subject to certain risks and uncertainties described in this Annual Report on Form 10-K under the headings “Forward-Looking Statements” and “Risk Factors.”
Non-GAAP Financial Measures
Certain measurements contained in this section that are presented on a fully taxable equivalent basis constitute non-GAAP financial measures as described in this Annual Report on Form 10-K under the heading “Use of Non-GAAP Financial Measures” above.
RESULTS OF OPERATIONS
Overview
We realized net income of $12.13 million, $15.13 million and $15.19 million for the years ended December 31, 2014, 2013 and 2012, respectively. Basic earnings per share were $1.92, $2.40 and $2.43 and diluted earnings per share were $1.91, $2.40 and $2.42 for the years ended December 31, 2014, 2013 and 2012, respectively. We declared and distributed total dividends of $1.12 per share each year during 2014, 2013 and 2012. On January 29, 2015, we declared a dividend of $0.28 per share for the fourth quarter of 2014, which was paid on February 26, 2015, to shareholders of record as of February 12, 2015. Total assets were $1.72 billion at December 31, 2014, flat compared to year end 2013. Total shareholders’ equity was $125.82 million at December 31, 2014, an increase of 5.2% over the balance at December 31, 2013.
Our return on average equity was 9.84%, 12.97% and 13.37% for 2014, 2013 and 2012, respectively, and our return on average assets was 0.73%, 0.90% and 0.92% for 2014, 2013 and 2012, respectively. Book value per share increased to $19.89 during 2014. Our capital ratios remain strong, with a Tier 1 leverage ratio of 8.76%, a total risk-based capital ratio of 15.70% and a tangible capital ratio of 7.30%.
Ø |
Net interest income: Our fully taxable equivalent net interest income was $48.53 million for 2014, a decrease of $2.43 million from 2013. Our net interest margin for 2014 was 3.03%, a 12 basis point decrease from 2013. |
Ø |
Provision for Credit Losses: Asset quality remained strong throughout 2014. We booked a provision for credit losses of $150 thousand for 2014, compared to $800 thousand for 2013. |
Ø |
Loans: Total loans at December 31, 2014 were $1.17 billion, an increase of $16.10 million, or 1.38%, over the total loan balance at December 31, 2013. |
Ø |
Investments: Total investments at year end 2014 were $346.27 million, a decrease of $54.56 million from year end 2013. |
Ø |
Deposits: Total deposits at year end 2014 were $1.31 billion, a decrease of $14.80 million over the balance at year end 2013. |
22
Net Interest Income
2014 compared with 2013
As shown on the table on page 24, our taxable equivalent net interest income was $48.53 million for the year ended December 31, 2014 compared to $50.96 million for 2013. We used cash flows from the investment portfolio to fund loan growth during 2014. We grew average loans for 2014 by $31.95 million, funded in part by a $97.41 million reduction in the average investment portfolio; the reduction in the investment portfolio was due to management’s decision to reduce price volatility risk. Overall earning assets decreased by $13.77 million during 2014; due to an extended low interest rate environment combined with competitive pressure on spreads resulted in overall lower asset yields and lower levels of net interest income for 2014 compared to 2013. Our fully taxable equivalent net interest margin decreased 12 basis points to 3.03% for 2014 from 3.15% for 2013. Margin compression during 2014 was the result of reduced earning asset yields, which decreased 15 basis points during 2014. Average loan yields decreased 21 basis points and average investment yields increased 4 basis points. One of the factors influencing our loan yields is management’s effort to maintain the percentage of variable rate loans. Adjustable rate loans were $308.9 million as of December 31, 2014, or 26.14% of the loan portfolio. These loans have a lower current yield than fixed rate loans, but will have higher yields when short-term rates start to rise.
Average interest bearing deposits decreased $126.40 million during 2014; the mix of those deposits changed during the year. Interest Expense on time deposits decreased $63.74 million, and interest expense on transaction accounts decreased by $62.66 million. The decrease in interest bearing transaction accounts was solely the result of converting certain deposit products from interest bearing to non-interest bearing. We also succeeded in growing our noninterest bearing checking account categories during 2014, growing that funding source by $147.34 million primarily due to the aforementioned transfer. The average cost of interest bearing liabilities for 2014 was 0.40%, an increase of one basis point from 2013.
2013 compared with 2012
Our taxable equivalent net interest income was $50.96 million for the year ended December 31, 2013 compared to $51.99 million for 2012. We used cash flows from the investment portfolio to fund loan growth during 2013, and grew average loans for 2013 by $76.19 million, funded in part by a $53.71 million reduction in the average investment portfolio. Overall earning assets increased by $30.03 million during 2013; however, the extended low interest rate environment combined with competitive pressure on spreads resulted in overall lower asset yields and lower levels of net interest income for 2013 compared to 2012. Our taxable equivalent net interest margin decreased 13 basis points to 3.15% for 2013 from 3.28% for 2012. Margin compression during 2013 was the result of reduced asset yields, which decreased 25 basis points during 2013. Average loan yields decreased 38 basis points and average investment yields decreased 14 basis points. One of the factors influencing our loan yields was an increase in variable rate loans. Average variable rate loans for the fourth quarter of 2013 were $315.58 million, an increase of $53.63 million from the fourth quarter of 2012. These loans have a lower current yield than fixed rate loans, but will have higher yields when short-term rates start to rise.
Average interest bearing deposits increased $45.13 million during 2013; however, the mix of those deposits changed during the year. Relatively expensive time deposits decreased $20.95 million, while low cost transaction accounts increased by $66.08 million. The increase in interest bearing deposits was primarily the result of intentional migration out of our collateralized deposit, or repurchase agreement, categories to deposit categories, allowing us to free up collateral while also preserving this low cost funding source. We also succeeded in growing our noninterest bearing checking account categories during 2013, growing that funding source by $31.90 million. The average cost of interest bearing liabilities for 2013 was 0.39%, a decrease of 13 basis points from 2012.
23
The following table presents an analysis of net interest income and illustrates 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 (“FTE”) basis, using a 35% rate. Nonaccrual loans are included in the average loan balance outstanding.
Distribution of Assets, Liabilities and Shareholders' Equity; Interest Rates and Net Interest Margin |
|||||||||||||||
2014 |
2013 |
2012 |
|||||||||||||
Interest |
Average |
Interest |
Average |
Interest |
Average |
||||||||||
Taxable equivalent |
Average |
Income/ |
Yield/ |
Average |
Income/ |
Yield/ |
Average |
Income/ |
Yield/ |
||||||
(In thousands) |
Balance |
Expense |
Rate |
Balance |
Expense |
Rate |
Balance |
Expense |
Rate |
||||||
ASSETS: |
|||||||||||||||
Loans, including fees on loans |
$ |
1,165,586 |
$ |
44,893 | 3.85% |
$ |
1,133,637 |
$ |
46,045 | 4.06% |
$ |
1,057,446 |
$ |
46,992 | 4.44% |
Investments |
358,274 | 7,965 | 2.22% | 455,679 | 9,912 | 2.18% | 509,384 | 11,834 | 2.32% | ||||||
Federal funds sold, securities sold under agreements to repurchase and interest bearing deposits with banks |
79,599 | 192 | 0.24% | 27,909 | 68 | 0.24% | 20,360 | 46 | 0.23% | ||||||
Total earning assets |
1,603,459 |
$ |
53,050 | 3.31% | 1,617,225 |
$ |
56,025 | 3.46% | 1,587,190 |
$ |
58,872 | 3.71% | |||
Allowance for loan losses |
(12,123) | (11,935) | (11,182) | ||||||||||||
Cash and cash equivalents |
27,351 | 27,087 | 25,217 | ||||||||||||
Premises and equipment |
15,616 | 16,443 | 14,874 | ||||||||||||
Bank owned life insurance |
10,150 | 0 | 0 | ||||||||||||
Other assets |
23,213 | 28,522 | 32,294 | ||||||||||||
Total assets |
$ |
1,667,666 |
$ |
1,677,342 |
$ |
1,648,393 | |||||||||
LIABILITIES AND SHAREHOLDERS' EQUITY: |
|||||||||||||||
Interest bearing deposits: |
|||||||||||||||
Savings, interest bearing checking and money market accounts |
$ |
668,815 |
$ |
1,647 | 0.25% |
$ |
731,476 |
$ |
1,184 | 0.16% |
$ |
665,399 |
$ |
776 | 0.12% |
Time deposits |
258,220 | 1,725 | 0.67% | 321,962 | 2,166 | 0.67% | 342,911 | 2,775 | 0.81% | ||||||
Total interest bearing deposits |
927,035 | 3,372 | 0.36% | 1,053,438 | 3,350 | 0.32% | 1,008,310 | 3,551 | 0.35% | ||||||
Federal funds purchased and Federal Home Loan Bank short-term borrowings |
212 | 1 | 0.47% | 17,260 | 51 | 0.30% | 38,290 | 108 | 0.28% | ||||||
Securities sold under agreements to repurchase, short-term |
192,868 | 352 | 0.18% | 212,644 | 863 | 0.41% | 230,281 | 1,682 | 0.73% | ||||||
Other long-term debt |
2,358 | 48 | 2.04% | 2,439 | 50 | 2.04% | 13,667 | 363 | 2.66% | ||||||
Junior subordinated debentures issued to unconsolidated subsidiary trust |
20,619 | 752 | 3.65% | 20,619 | 756 | 3.78% | 20,619 | 1,179 | 5.80% | ||||||
Total borrowed funds |
216,057 | 1,153 | 0.53% | 252,962 | 1,720 | 0.68% | 302,857 | 3,332 | 1.10% | ||||||
Total interest bearing liabilities |
1,143,092 |
$ |
4,525 | 0.40% | 1,306,400 |
$ |
5,070 | 0.39% | 1,311,167 |
$ |
6,883 | 0.52% | |||
Demand deposits |
393,355 | 246,011 | 214,113 | ||||||||||||
Other liabilities |
7,936 | 8,291 | 9,492 | ||||||||||||
Shareholders' equity |
123,283 | 116,640 | 113,621 | ||||||||||||
Total liabilities & shareholders' equity |
$ |
1,667,666 |
$ |
1,677,342 |
$ |
1,648,393 | |||||||||
Net interest income, FTE |
$ |
48,525 |
$ |
50,955 |
$ |
51,989 | |||||||||
Tax equivalent adjustment |
(2,078) | (2,058) | (2,015) | ||||||||||||
Net interest income, GAAP |
$ |
46,447 |
$ |
48,897 |
$ |
49,974 | |||||||||
Yield spread |
2.91% | 3.07% | 3.19% | ||||||||||||
Net interest margin |
3.03% | 3.15% | 3.28% |
24
The following table presents 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 |
||||||
2014 compared to 2013 |
||||||
Due to |
||||||
Increase |
Volume/ |
|||||
(In thousands) |
2014 |
2013 |
(Decrease) |
Volume |
Rate |
Rate |
Fully taxable equivalent interest income: |
||||||
Loans, including fees on loans |
$ 44,893 |
$ 46,045 |
$ (1,152) |
$ 327 |
$ (600) |
$ (879) |
Investments |
7,965 | 9,912 | (1,947) | (534) | 55 | (1,468) |
Federal funds sold, securities sold under agreements to repurchase and interest bearing deposits with banks |
192 | 68 | 124 | 32 | 0 | 92 |
Total interest income |
53,050 | 56,025 | (2,975) | (175) | (545) | (2,255) |
Less interest expense: |
||||||
Savings, interest bearing checking and money market accounts |
1,647 | 1,184 | 463 | (26) | 156 | 334 |
Time deposits |
1,725 | 2,166 | (441) | (108) | (4) | (330) |
Federal funds purchased and Federal Home Loan Bank short-term borrowings |
1 | 51 | (50) | (13) | 1 | (38) |
Securities sold under agreements to repurchase, short-term |
352 | 863 | (511) | (20) | (120) | (371) |
Other long-term debt |
48 | 50 | (2) | 0 | 0 | (2) |
Junior subordinated debentures issued to unconsolidated subsidiary trust |
752 | 756 | (4) | 0 | (1) | (3) |
Total interest expense |
4,525 | 5,070 | (545) | (167) | 32 | (410) |
Net interest income |
$ 48,525 |
$ 50,955 |
$ (2,430) |
$ (8) |
$ (577) |
$ (1,845) |
2013 compared to 2012 |
||||||
Due to |
||||||
Increase |
Volume/ |
|||||
(In thousands) |
2013 |
2012 |
(Decrease) |
Volume |
Rate |
Rate |
Fully taxable equivalent interest income: |
||||||
Loans, including fees on loans |
$ 46,045 |
$ 46,992 |
$ (947) |
3,386 | (4,042) |
$ (291) |
Investments |
9,912 | 11,834 | (1,922) | (1,248) | (753) |
$ 79 |
Federal funds sold, securities sold under agreements to repurchase and interest bearing deposits with banks |
68 | 46 | 21 | 17 | 3 |
$ 1 |
Total interest income |
56,025 | 58,872 | (2,847) | 2,155 | (4,792) | (210) |
Less interest expense: |
||||||
Savings, interest bearing checking and money market accounts |
1,184 | 776 | 408 | 77 | 301 |
$ 30 |
Time deposits |
2,166 | 2,775 | (609) | (170) | (468) | 29 |
Federal funds purchased and Federal Home Loan Bank short-term borrowings |
51 | 108 | (57) | (59) | 5 | (3) |
Securities sold under agreements to repurchase, short-term |
863 | 1,682 | (820) | (129) | (748) | 57 |
Securities sold under agreements to repurchase, long-term |
0 | 0 | 0 | 0 | 0 | 0 |
Other long-term debt |
50 | 363 | (313) | (298) | (84) | 69 |
Junior subordinated debentures issued to unconsolidated subsidiary trust |
756 | 1,179 | (422) | 0 | (415) | (7) |
Total interest expense |
5,070 | 6,883 | (1,813) | (579) | (1,409) | 175 |
Net interest income |
$ 50,955 |
$ 51,989 |
$ (1,034) |
$ 2,734 |
$ (3,383) |
$ (385) |
25
Provision for Credit Losses
The allowance for loan losses at December 31, 2014 was $11.83 million, or 1.00% of total loans and 1,496% of nonperforming loans, compared to the December 31, 2013 balance of $12.04 million, or 1.03% of total loans and 1,329% of nonperforming loans. We recorded a provision of $150 thousand during 2014 compared to $800 thousand during 2013. Our credit quality continues to be strong; modest loan growth during 2014 was the primary factor for the provision in 2014. Performing loans past due 31-90 days were 0.04% of total loans at December 31, 2014 compared to 0.03% at December 31, 2013. Nonperforming loans as a percent of total loans were 0.07% at December 31, 2014 compared to 0.08% at December 31, 2013. Accruing substandard loans increased to 2.55% of total loans at December 31, 2014 compared to 2.16% at December 31, 2013. Net charge-offs for 2014 total $163 thousand, compared to net charge-offs of $284 thousand during 2013. All of these factors are taken into consideration during Management’s quarterly review of the Allowance. For a more detailed discussion of our Allowance and nonperforming assets, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Credit Quality and Allowance for Credit Losses” below.
NONINTEREST INCOME AND EXPENSES
Noninterest income
2014 compared to 2013
Total noninterest income decreased $56 thousand to $11.57 million for 2014 compared to 2013. Excluding net gains on investment securities and gains on sales of other assets, total noninterest income increased $454 thousand to $11.47 million for 2014 compared to $11.01 million for 2013. In 2014, a net gain was realized on sale of investment securities of $107 thousand. We realized a one-time gain of $898 thousand during the fourth quarter of 2013 in conjunction with the sale of one of our branch locations. The gross gain on the sale was $1.83 million; the balance of the gain of $934 thousand was deferred and amortized over 10 years, as we are leasing back a portion of the sold property. We had an impairment charge in 2013 totaling $166 thousand related to our $37.91 million portfolio of collateralized loan obligations (“CLOs”). Please refer to the discussion of investments for more information about this charge. Increases in cash management fees and other service charge income offset continued reductions in overdraft fees. Trust division income increased $331 thousand to $3.39 million for 2014 compared to 2013. In 2013, Merchants invested $10 million in bank owned life insurance which resulted in $311 thousand of income in 2014.
2013 compared to 2012
Total noninterest income decreased $983 thousand to $11.63 million for 2013 compared to 2012. Excluding net gains on investment securities and gains on sales of other assets, total noninterest income decreased $9 thousand to $11.01 million for 2013 compared to 2012. We realized a one-time gain of $898 thousand during the fourth quarter of 2013 in conjunction with the sale of one of our branch locations. The gross gain on the sale was $1.83 million; the balance of the gain of $934 thousand will be deferred and amortized over 10 years, as we are leasing back a portion of the sold property. We also took an impairment charge in 2013 totaling $166 thousand related to our $37.91 million portfolio of collateralized loan obligations (“CLOs”). Please refer to the discussion of investments for more information about this charge. Increases in cash management fees and other service charge income offset continued reductions in overdraft fees. Trust division income increased $377 thousand to $3.06 million for 2013 compared to 2012. Other noninterest income decreased $318 thousand to $1.09 million for 2013 compared to 2012; $168 thousand of this reduction was a result of the discontinuation of our credit card affinity program at the end of 2012.
Noninterest expense
2014 compared to 2013
Total noninterest expense increased $2.64 million to $42.21 million for 2014 compared to 2013. Excluding $1.32 million related to the core conversion project, noninterest expense increased $1.32 million for 2014 compared to 2013.
· |
Total compensation and benefits increased $1.59 million to $20.76 million for the year ended December 31, 2014 compared to 2013; the increase was primarily attributable to severance accruals of $925 thousand. Expenses related to our group health insurance plan were $276 thousand higher for the year ended December 31, 2014 compared to 2013. Lastly, deferred loan costs in 2014 were $243 thousand less due to fewer loan originations than in 2013. |
· |
Occupancy and equipment expenses increased $409 thousand to $8.47 million for year ended December 31, 2014 compared to 2013. This increase was a result of additional investments we made in our facilities and in technology, new core processing services to increase efficiency and improve customer service. Prior to conversion the core processing expenses were included in legal and professional fees. |
· |
The marketing expense decreased $211 thousand to $1.22 million for year ended December 31, 2014 compared to 2013. Initiatives were postponed due to the core processing conversion. |
· |
Other expense increased $630 thousand to $6.37 million for year ended December 31, 2014 compared to 2013. The expense associated with mobile and internet banking increased $152 thousand as the need to offer advanced technology and 24 hour account access has increased costs. |
26
The effective tax rate for the year 2014 was 23% compared to 25% for 2013, the rates were impacted by the adoption of FASB ASU 2014-01, as discussed in “Income Taxes” section below. Additional investments in 2014 produced a higher level of tax credits compared to 2013. The 2013 tax rate was benefited by the donation of our branch building in North Bennington, Vermont, to a non-profit organization.
2013 compared to 2012
Total noninterest expense decreased $1.37 million to $39.58 million for 2013 compared to 2012. Excluding a $1.36 million prepayment penalty incurred during 2012, noninterest expense decreased $2.37 million for 2013 compared to 2012.
· |
Total compensation and benefits decreased $417 thousand to $19.17 million for the year ended December 31, 2013 compared to 2012, primarily a result of lower employee benefit costs. Normal salary increases were offset by a lower incentive accrual for 2013 compared to 2012. Expenses related to our group health insurance plan were $146 thousand lower for the year ended December 31, 2013 compared to 2012. Lastly, the overfunded status of our pension plan produced $162 thousand in income for us in 2013 compared to an expense of $252 thousand in 2012. |
· |
Occupancy and equipment expenses increased $605 thousand to $8.06 million for year ended December 31, 2013 compared to 2012. This increase was a result of additional investments we made in our facilities and in technology to increase efficiency and improve customer service. Additionally, we will be changing our core system provider during 2013 and have accelerated the write off of certain assets related to the current core system. |
· |
The timing of investments in low income housing partnerships and their associated tax credits led to a reduction in expenses related to real estate limited partnerships to $1.04 million for the year ended December 31, 2013 compared to $1.88 million for 2012. This is now being presented in the income tax line with adoption of FASB ASU 2014-01 as discussed below. |
Our effective tax rate for 2013 was negatively impacted by the timing of investments in low income housing partnerships discussed above, which produced a lower level of tax credits for us in 2013 compared to 2012. The 2013 tax rate was benefited by the donation of our branch building in North Bennington, Vermont, to a non-profit organization.
Income Taxes
We recognized $2.53 million, $1.75 million and $2.12 million, respectively, during 2014, 2013, and 2012, in low-income housing, historic rehabilitation and qualified school construction bond tax credits as a reduction in the provision for income taxes. These credits, combined with tax exempt income earned on our municipal loan portfolio, resulted in an effective tax rate of 23%, 25% and 29% for 2014, 2013, and 2012, respectively. During the first quarter of 2014 Merchants adopted, Financial Accounting Standards Board Accounting Standards Update 2014-01, “Accounting for Investments in Qualified Affordable Housing Projects” and applied retrospectively and prior periods have been reclassified accordingly. This adoption allows investors in low income housing tax credit entities that meet certain conditions to account for the investments entirely in income tax expense, which more accurately reflects the economics of the investment. The application of this standard reduced total noninterest expense by $1.31 million, $1.04 million and $1.52 million for the year ended December 31, 2014, 2013, and 2012, respectively.
BALANCE SHEET ANALYSIS
Our total assets remained constant at $1.72 billion at December 31, 2014 from $1.73 billion at December 31, 2013, while our average earning assets also remained constant at $1.60 billion at December 31, 2014 from $1.62 billion at December 31, 2013.
Loans
Average loans for 2014 were $1.17 billion, a $31.95 million, or 2.8%, increase over average loans for 2013 of $1.13 billion. Loans at December 31, 2014 reached a new record high of $1.18 billion, a $16.10 million increase over 2013 ending balance of $1.17 billion. Growth for 2014 in our commercial loan portfolio was driven by new customer acquisition and expansion of existing relationships.
27
The composition of our loan portfolio is shown in the following table:
|
Ending Loan Balances as of December 31, |
|||||||
(In thousands) |
2014 |
2013 |
2012 |
2011 |
2010 |
|||
$ 177,597
|
$ 172,810
|
$ 165,023
|
$ 146,990
|
$ 112,514
|
||||
Municipal |
94,366 | 94,007 | 84,689 | 101,705 | 67,861 | |||
Real estate – residential |
469,529 | 489,706 | 460,395 | 420,425 | 406,960 | |||
Real estate – commercial |
412,447 | 371,319 | 357,178 | 333,308 | 300,317 | |||
Real estate – construction |
23,858 | 31,841 | 10,561 | 18,993 | 16,420 | |||
Installment |
4,504 | 5,655 | 4,701 | 5,806 | 6,284 | |||
All other loans |
33 | 895 | 376 | 399 | 438 | |||
$ 1,182,334
|
$ 1,166,233
|
$ 1,082,923
|
$ 1,027,626
|
$ 910,794
|
Totals above are shown net of deferred loans fees of $734 thousand, $618 thousand, $250 thousand, $11 thousand, and $(80) thousand for 2014, 2013, 2012, 2011 and 2010, respectively. No reclassifications were necessary in 2014 or 2013. Ending loan balances for 2012, 2011 and 2010 in the table above reflect the reclassification of $29.56 million, $19.39 million, and $16.02 million, respectively, in non-owner occupied residential real estate loans from the residential real estate category to the commercial real estate category. This presentation more accurately presents the risk profile of these loans.
At December 31, 2014, we serviced $974 thousand in residential mortgage loans for investors such as the Federal National Mortgage Association (“FNMA”) and the Federal Home Loan Mortgage Corporation (“FHLMC”), and other financial investors and government agencies. This servicing portfolio continued to decrease during 2014. We have not sold a residential mortgage on the secondary market in over fifteen years.
The following table presents the contractual maturities of our loan portfolio at December 31, 2014:
Over One |
||||
One Year |
Through |
Over Five |
||
(In thousands) |
Or Less |
5 Years |
Years |
Total |
Commercial, financial & agricultural |
$ 60,071
|
$ 77,025
|
$ 40,501
|
$ 177,597
|
Municipal |
50,529 | 3,814 | 40,023 | 94,366 |
Real estate – residential |
5,734 | 30,098 | 433,697 | 469,529 |
Real estate – commercial |
27,174 | 236,211 | 149,062 | 412,447 |
Real estate – construction |
14,141 | 6,580 | 3,137 | 23,858 |
Installment |
2,448 | 1,782 | 274 | 4,504 |
All other loans |
33 | 0 | 0 | 33 |
$ 160,130
|
$ 355,510
|
$ 666,694
|
$ 1,182,334
|
The following table presents loans maturing after one year which have predetermined interest rates and floating or adjustable interest rates as of December 31, 2014:
(In thousands) |
Fixed |
Adjustable |
Commercial, financial & agricultural |
$ 78,545
|
$ 38,981
|
Municipal |
43,837 | 0 |
Real estate – residential |
421,362 | 42,433 |
Real estate – commercial |
240,818 | 144,455 |
Real estate – construction |
4,361 | 5,356 |
Installment |
2,056 | 0 |
Other |
0 | 0 |
$ 790,979
|
$ 231,225
|
It is our policy to make loans to directors, executive officers, and associates of such persons on substantially the same terms, including interest rates and collateral, as those prevailing for comparable lending transactions with other persons.
28
Investments
The investment portfolio is used to generate interest income, manage liquidity and mitigate interest rate sensitivity. Our investment portfolio totaled $341.89 million at December 31, 2014, a decrease of $51.45 million from the December 31, 2013 ending balance of $393.34 million.
We purchased bonds with a total book value of $55.50 million during 2014. We sold bonds with a book value of $56.89 million during 2014 for a net pre-tax gain of $107 thousand. We intentionally allowed the investment portfolio to run off using the cash flow to fund our loan growth and reduce the price volatility. This will help us control overall asset growth and strengthen our capital ratios and returns as rates rise.
During 2014, we transferred securities with a total amortized cost of $12.63 million, and a corresponding fair value of $12.64 million, from available for sale to held to maturity. The net unrealized gain, net of taxes, on these securities at the dates of the transfers was $8.31 thousand. The unrealized holding gain at the time of transfer continues to be reported in accumulated other comprehensive income, net of tax and is amortized over the remaining lives of the securities as an adjustment of the yield. During 2013, securities with an unrealized loss were transferred from available for sale to held to maturity. The amortization of the unamortized holding loss reported in accumulated other comprehensive income offsets the effect on interest income of the discount for the transferred securities. The remaining unamortized balance of the losses for the securities transferred from available for sale to held to maturity was $2.82 million at December 31, 2014.
In 2014 all of the $35.75 million of CLOs were sold for a small loss and no impairment charge on the remaining portfolio was taken. In 2013 an impairment charge was taken totaling $166 thousand related to the $37.91 million CLO portfolio.
The composition of our investment portfolio at carrying amounts is shown in the following table:
As of December 31, |
|||
(In thousands) |
2014 |
2013 |
2012 |
Available for Sale: |
|||
U.S. Treasury Obligations |
$ 25,093
|
$ 100
|
$ 100
|
U.S. Agency Obligations |
0 | 0 | 10,897 |
U.S. Government Sponsored Enterprises (“U.S. GSEs”) |
0 | 0 | 59,366 |
FHLB Obligations |
0 | 0 | 24,585 |
Residential Real Estate Mortgage-backed Securities (“Agency MBSs”) |
95,407 | 99,271 | 148,767 |
Agency Commercial Mortgage Backed Securities ("Agency CMBSs") |
21,704 | 17,638 | 5,029 |
Agency Collateralized Mortgage Obligations (“Agency CMOs”) |
60,882 | 97,209 | 230,399 |
Collateralized Loan Obligations ("CLOs") |
0 | 37,907 | 24,527 |
Non-agency Collateralized Mortgage Obligations (“Non-Agency CMOs”) |
0 | 0 | 4,593 |
Asset Backed Securities (“ABSs”) |
387 | 388 | 418 |
Total available for sale |
203,473 | 252,513 | 508,681 |
Held to maturity: |
|||
U.S. Agency Obligations |
22,072 | 23,580 | 0 |
U.S. GSEs |
9,498 | 9,442 | 0 |
FHLB Obligations |
4,720 | 4,684 | 0 |
Agency MBSs |
8,109 | 9,015 | 407 |
Agency CMOs |
94,022 | 94,105 | 0 |
Total held to maturity |
138,421 | 140,826 | 407 |
Total Securities |
$ 341,894
|
$ 393,339
|
$ 509,088
|
Agency 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 CMBS consists of bonds backed by commercial real estate which are guaranteed by FNMA and GNMA. CLOs were floating rate securities that consist primarily of pools of senior secured commercial loans structured to provide very strong over collateralization and subordination.
We use external pricing services to obtain fair market values for our investment portfolio. We have obtained and reviewed the service providers’ pricing and reference data documentation. Evaluations are based on market data and vary by asset class and incorporate available trade, bid and other market information. Because many fixed income securities do not trade on a daily basis, the service provider’s evaluated pricing applications apply available information as applicable through processes such as benchmark curves, benchmarking of like securities, sector groupings, and matrix pricing, to prepare evaluations. In addition, model processes,
29
such as the Option Adjusted Spread model are used to assess interest rate impact and develop prepayment scenarios, with inputs determined based on knowledge of the market. For CLOs, the issuer, structure, collateral type, performance and deal and class triggers are also reviewed. We periodically test the values provided to us by the pricing service through a combination of back testing on actual sales of securities and by obtaining prices on all bonds from an alternative pricing source.
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 basis, which may be maturity.
The contractual final maturity distribution of the debt securities classified as available for sale and held to maturity as of December 31, 2014, was as follows:
SECURITIES AVAILABLE FOR SALE (at fair value):
|
|
|
|
|
|
(In thousands) |
Within One Year |
After One But Within Five Years |
After Five But Within Ten Years |
After Ten Years |
Total |
U.S. Treasury Obligations |
$ 0
|
$ 25,093
|
$ 0
|
$ 0
|
$ 25,093
|
Agency MBSs |
32 | 2,674 | 21,265 | 71,436 | $ 95,407
|
Agency CMBSs |
0 | 13,831 | 3,668 | 4,205 | $ 21,704
|
Agency CMOs |
0 | 0 | 2,301 | 58,581 | $ 60,882
|
ABSs |
0 | 0 | 0 | 387 | $ 387
|
$ 32
|
$ 41,598
|
$ 27,234
|
$ 134,609
|
$ 203,473
|
|
Weighted average investment yield |
3.68% | 1.43% | 2.44% | 2.23% | |
SECURITIES HELD TO MATURITY (at amortized cost):
(In thousands) |
Within One Year |
After One But Within Five Years |
After Five But Within Ten Years |
After Ten Years |
Total |
U.S. Agency Obligations |
$ 0
|
$ 0
|
$ 0
|
$ 22,072
|
$ 22,072
|
U.S. GSEs |
0 | 0 | 9,498 | 0 | $ 9,498
|
FHLB Obligations |
0 | 0 | 4,720 | 0 | $ 4,720
|
Agency CMOs |
0 | 0 | 0 | 94,022 | $ 94,022
|
Agency MBSs |
0 | 13 | 98 | 7,998 | $ 8,109
|
$ 0
|
$ 13
|
$ 14,316
|
$ 124,092
|
$ 138,421
|
|
Weighted average investment yield |
0% | 6.41% | 6.39% | 2.11% |
Actual maturities will differ from contractual maturities because borrowers may have rights to call or prepay obligations. Maturities of mortgage-backed securities and collateralized mortgage obligations are based on final contractual maturities.
As a member of the Federal Home Loan Bank system, we are required to invest in stock of the FHLBB in an amount determined based on our borrowings from the FHLBB. At December 31, 2014, our investment in FHLBB stock totaled $4.38 million. Dividend income on FHLBB stock of $107 thousand and $27 thousand was recorded during 2014 and 2013, respectively. The FHLBB continues to be classified as “adequately capitalized” by its primary regulator. Based on current available information, we have concluded that our investment in FHLBB stock is not impaired. We will continue to monitor our investment in FHLBB stock.
Other Assets
Bank premises and equipment decreased to $15.49 million at December 31, 2014 from $15.57 million at December 31, 2013. During 2014, we converted the core operating system and disposed of the remaining value of the previous capital assets. The new platform and conversion costs have been capitalized and will be amortized over the life of the contract. In December 2013 we sold one of our branch buildings for a total gain of $1.83 million, of which $934 thousand will be deferred and amortized over ten years as we are leasing back a portion of the sold property. In June 2008, we entered into a sale leaseback arrangement for our principal office in South Burlington, Vermont. Deferred gains on the sale leaseback transaction resulted in a $423 thousand offset to rent expense per year through 2017 and $212 thousand in 2018.
30
Investments in real estate limited partnerships increased $565 thousand due to additional investments made. These partnerships provide affordable housing in the communities in which we do business, and provide us with tax credits and a high targeted rate of return on our investment.
At the end of December 2013, we made a $10 million investment in bank owned life insurance (“BOLI”). BOLI provides a means to mitigate increasing employee benefit costs. We expect to benefit from the BOLI contracts as a result of the tax-free growth in cash surrender value and death benefits that are expected to be generated over time. The largest risk to the BOLI program is credit risk of the insurance carrier. To mitigate this risk, an annual financial condition review is completed on the carrier. Our investment in BOLI is invested in a hybrid separate account product. Hybrid separate account BOLI invests in bank-eligible bond funds, money market funds, and comparable investments, managed by third-party fund managers with oversight of the managers by the carrier. BOLI is included in the consolidated statements of condition at its cash surrender value. Increases in BOLI’s cash surrender value are reported as a component of noninterest income in the consolidated statements of income.
Deposits
Our deposit balances at December 31, 2014 decreased $14.80 million, or 1.11%, to $1.31 billion from $1.32 billion at December 31, 2013. Total average deposits for 2014 were $1.32 billion, a $20.94 million increase over average balances for 2013. This represents a 1.61% annualized growth rate. The composition of our deposit balances is shown in the following table:
As of December 31, |
||||
(In thousands) |
2014 |
2013 |
2012 |
|
Demand |
$ 566,366
|
$ 266,299
|
$ 240,491
|
|
Savings, interest bearing checking & money market accounts |
530,722 | 752,171 | 700,191 | |
Time deposits |
211,684 | 305,106 | 330,398 | |
Total |
$ 1,308,772
|
$ 1,323,576
|
$ 1,271,080
|
The decrease in interest bearing transaction accounts was solely the result of converting certain deposit products from interest bearing to non-interest bearing. Growth during 2014 has been concentrated in our transaction account categories, with continued reductions in time deposit balances. The Transaction Account Guarantee (“TAG”) program, which provided unlimited coverage of noninterest-bearing transaction deposit accounts, expired on January 1, 2013. We have offered customers affected by the expiration of the TAG program an alternative account that will provide them the same benefit. We did not see any material deposit outflows related to the expiration of TAG.
Time deposits of $250 thousand and greater at December 31, 2014 and 2013 had the following schedule of maturities:
As of December 31, |
||
(In thousands) |
2014 |
2013 |
Three months or less |
$ 12,133
|
$ 5,443
|
Three to six months |
5,174 | 10,376 |
Six to twelve months |
5,623 | 20,317 |
One to five years |
4,714 | 7,917 |
Total |
$ 27,644
|
$ 44,053
|
Other Liabilities
Securities sold under agreement to repurchase, which represent collateralized customer accounts increased $8.15 million to $258.46 million at December 31, 2014 compared to $250.31 million at December 31, 2013. The increase is primarily a result of the success in growing the municipal business.
On December 15, 2004, we closed our private placement of an aggregate of $20 million of trust preferred securities. The placement occurred through a newly-formed Delaware statutory trust affiliate, MBVT Statutory Trust I (the “Trust”) as part of a pooled trust preferred program. The Trust was formed for the sole purpose of issuing capital securities; these securities are non-voting. We own all of the common securities of the Trust. The proceeds from the sale of the capital securities were loaned to us under subordinated debentures issued to the Trust. The debentures are the only asset of the Trust and payments under the debentures are the sole revenue of the Trust. Our primary source of funds to pay interest on the debentures held by the Trust is current dividends from our principal subsidiary, Merchants Bank. Accordingly, our ability to service the debentures is dependent upon the continued ability of Merchants Bank to pay dividends to us.
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These hybrid securities qualify as regulatory capital, up to certain regulatory limits. At the same time, they are considered debt for tax purposes, and as such, interest payments are fully deductible. The trust preferred securities total $20.62 million, and carried a fixed rate of interest through December 2009, at which time the rate became variable and adjusts quarterly at three-month LIBOR plus 1.95%. We have entered into an interest rate swap arrangement for $10 million of our trust preferred issuance. The swap fixes the rate on $10 million at 5.23% and expires on December 15, 2016. The impact on net interest income for 2014, 2013 and 2012 from the interest expense on the trust preferred securities was $752 thousand, $756 thousand and $1.18 million per year, respectively. The trust preferred securities mature on December 31, 2034, and are redeemable without penalty at our option, subject to prior approval by the FRB.
CREDIT QUALITY AND ALLOWANCE FOR CREDIT LOSSES
The United States economy continued to show modest improvement during 2014. Although Vermont, our primary market, was not immune to the recent economic turmoil, the downturn was less severe and therefore the recovery not as dramatic, 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
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 composition of the nonperforming pool is dynamic with accounts moving in and out of this category over time. The following table summarizes our nonperforming loans (“NPL”) and nonperforming assets (“NPA”) as of December 31, 2010, through December 31, 2014:
(In thousands) |
2014 |
2013 |
2012 |
2011 |
2010 |
Nonaccrual loans |
$ 598
|
$ 425
|
$ 2,355
|
$ 1,953
|
$ 3,171
|
Loans past due greater than 90 days and accruing |
0 | 75 | 0 | 0 | 384 |
Troubled debt restructurings (“TDR”) |
193 | 406 | 557 | 558 | 549 |
Total nonperforming loans |
791 | 906 | 2,912 | 2,511 | 4,104 |
OREO |
0 | 108 | 0 | 358 | 191 |
Total nonperforming assets |
$ 791
|
$ 1,014
|
$ 2,912
|
$ 2,869
|
$ 4,295
|
Nonperforming loans at December 31, 2014 were $791 thousand. The decrease compared to December 31, 2013 was primarily due to loan payoffs.
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. There were four restructured residential mortgages at December 31, 2014 with balances totaling $147 thousand. There were three restructured commercial loans at December 31, 2014 with a balance of $46 thousand. All TDRs at December 31, 2014 continue to pay as agreed according to the modified terms and are considered well-secured.
Excluded from the nonperforming balances discussed above are our loans that are 31 to 90 days past due, which are not necessarily considered classified or impaired. Accruing loans 31 to 90 days past due as a percentage of total loans as of the periods indicated are presented in the following table:
Year Ended |
31-90 Days |
December 31, 2014 |
0.04% |
December 31, 2013 |
0.03% |
December 31, 2012 |
0.00% |
December 31, 2011 |
0.02% |
December 31, 2010 |
0.14% |
Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or
32
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 91 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 non-accruing 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 non-accruing 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 non-accruing 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 $791 thousand and $906 thousand at December 31, 2014 and 2013, respectively. At December 31, 2014, $431 thousand of impaired loans had specific reserve allocations totaling $63 thousand.
Substandard loans at December 31, 2014 totaled $30.65 million, of which $30.11 million in 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 December 31, 2014 reflect a $4.88 million increase in balances since December 31, 2013. At December 31, 2014, accruing substandard loans related to owner-occupied commercial real estate totaled $20.40 million, investor commercial real estate loans totaled $1.56 million, residential mortgage loans totaled $3 thousand, residential investment real estate loans totaled $317 thousand, and $7.83 million in substandard loans are outstanding to corporate borrowers in a variety of different industries. Twelve borrowers in a variety of industries account for 87% of the total accruing substandard loans, and approximately $591 thousand of the total accruing substandard loans carry some form of government guarantee.
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 ALL and the reserve for undisbursed lines and standby letters of credit. 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
33
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.
The following table summarizes the allowance for loan losses allocated by loan type:
(In thousands) |
2014 |
2013 |
2012 |
2011 |
2010 |
Commercial, financial & agricultural |
$ 2,583
|
$ 2,740
|
$ 2,915
|
$ 2,412
|
$ 2,112
|
Municipal |
623 | 758 | 494 | 307 | 236 |
Real estate – residential |
3,038 | 2,995 | 3,333 | 2,892 | 2,277 |
Real estate – commercial |
5,209 | 5,040 | 4,605 | 4,575 | 5,188 |
Real estate – construction |
325 | 481 | 187 | 393 | 277 |
Installment |
13 | 18 | 17 | 23 | 24 |
All other loans |
42 | 10 | 11 | 17 | 21 |
Allowance for loan losses |
$ 11,833
|
$ 12,042
|
$ 11,562
|
$ 10,619
|
$ 10,135
|
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 increased or diminished, 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.
The following table reflects our loan loss experience and activity in the allowance for credit losses for the past five years:
(In thousands) |
2014 |
2013 |
2012 |
2011 |
2010 |
|
Average loans outstanding |
$ 1,165,586
|
$ 1,133,637
|
$ 1,057,446
|
$ 971,003
|
$ 912,363
|
|
Allowance beginning of year |
12,828 | 12,312 | 11,353 | 10,754 | 11,702 | |
Charge-offs: |
||||||
Commercial, financial & agricultural and all other loans |
(34) | (20) | (9) | (80) | (1,691) | |
Real estate – residential |
(25) | (289) | (20) | (83) | (25) | |
Real estate – commercial |
0 | (1) | (32) | (60) | (259) | |
Real estate – construction |
0 | 0 | 0 | (96) | 0 | |
Installment, other |
(172) | (102) | 0 | (10) | (2) | |
Total charge-offs |
(231) | (412) | (61) | (329) | (1,977) | |
Recoveries: |
||||||
Commercial, financial & agricultural and all other loans |
10 | 62 | 30 | 101 | 2,128 | |
Real estate – residential |
24 | 6 | 14 | 4 | 20 | |
Real estate – commercial |
1 | 40 | 1 | 44 | 31 | |
Real estate – construction |
0 | 1 | 25 | 25 | 593 | |
Installment, other |
33 | 19 | 0 | 4 | 7 | |
Total recoveries |
68 | 128 | 70 | 178 | 2,779 | |
Net recoveries (charge-offs) |
(163) | (284) | 9 | (151) | 802 | |
Provision (credit) for credit losses |
150 | 800 | 950 | 750 | (1,750) | |
Allowance end of year |
$ 12,815
|
$ 12,828
|
$ 12,312
|
$ 11,353
|
$ 10,754
|
|
Ratio of net (charge-offs) recoveries to average loans outstanding |
(0.01)% |
(0.02)% |
0.00% |
(0.02)% |
0.09% | |
Components: |
||||||
Allowance for loan losses |
$ 11,833
|
$ 12,042
|
$ 11,562
|
$ 10,619
|
$ 10,135
|
|
Reserve for undisbursed lines of credit |
982 | 786 | 750 | 734 | 619 | |
Allowance for credit losses |
$ 12,815
|
$ 12,828
|
$ 12,312
|
$ 11,353
|
$ 10,754
|
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Strong credit quality supports Merchants decision for a zero provision during the third and fourth quarters of 2014, and modest loan growth supports the 2014 year to date provision of $150 thousand.
The following table reflects our nonperforming asset and coverage ratios as of the dates indicated:
2014 |
2013 |
2012 |
2011 |
2010 |
|
NPL to total loans |
0.07% | 0.08% | 0.27% | 0.24% | 0.45% |
NPA to total assets |
0.05% | 0.06% | 0.17% | 0.18% | 0.29% |
Allowance for loan losses to total loans |
1.00% | 1.03% | 1.07% | 1.03% | 1.11% |
Allowance for loan losses to NPL |
1,496% | 1,329% | 397% | 423% | 247% |
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 loan officers 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 lenders. These authorized lending limits are reviewed at least annually and are based upon the lender's knowledge and 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 million or greater to any one borrower, or related party interest, are reviewed and approved by the Loan Committee of Merchants Bank’s Board of Directors. Short-term Revenue Anticipation and Tax Anticipation extensions of credit of $8 million or greater to a municipality are reviewed and approved by the Loan Committee of Merchants Bank’s Board of Directors.
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 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, construction and residential loan portfolios. The commercial loan review firm reviews a minimum threshold of our commercial loan portfolio each year. 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.
EFFECTS OF INFLATION
The financial nature of our consolidated balance sheet and statement of income is more clearly affected by changes in interest rates than by inflation, but inflation does affect us because as prices increase the money supply tends to increase, the size of loans requested tends to increase, total company assets increase, and interest rates are affected by inflationary expectations. In addition, operating expenses tend to increase without a corresponding increase in productivity. There is no precise method, however, to measure the effects of inflation on our financial statements. Accordingly, any examination or analysis of the financial statements should take into consideration the possible effects of inflation.
Liquidity and Capital Resource Management
General
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’s Board of Directors, based upon Merchants Bank’s policies. 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 prepayments are greatly
35
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 December 31, 2014, we could borrow up to $65 million in overnight funds through unsecured borrowing lines established with correspondent banks. We have established both overnight and longer term lines of credit with 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 $369.78 million at December 31, 2014. We have additional borrowing capacity with the FHLBB of $246.92 million as of December 31, 2014. We have also established a borrowing facility with the 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 MBS and Agency CMO, with certain approved counterparties. Our investment portfolio, which is managed by the ALCO, had a book value of $339.58 million at December 31, 2014, of which $315.11 million was pledged. The portfolio is a reliable source of cash flow for us. We closely monitor our short term cash position. Any excess funds are either left on deposit at the FRB, or are in a fully insured account with one of our correspondent banks.
Presented below are our short-term borrowings during the periods indicated:
Year Ended December 31, 2014 |
Year Ended December 31, 2013 |
|
FHLBB and other short-term borrowings |
||
Amount outstanding at end of period |
$ 0
|
$ 0
|
Maximum during the period amount outstanding |
18,900 | 72,500 |
Average amount outstanding |
212 | 17,259 |
Weighted average-rate during the period |
0.31% | 0.30% |
Weighted average rate at period end |
0% | 0% |
Securities sold under agreement to repurchase, short-term |
||
Amount outstanding at end of period |
258,464 | $ 250,314
|
Maximum during the period amount outstanding |
292,692 | 284,297 |
Average amount outstanding |
192,868 | 212,644 |
Weighted average-rate during the period |
0.18% | 0.41% |
Weighted average rate at period end |
0.26% | 0.18% |
Contractual Obligations
We have certain long-term contractual obligations, including long-term debt agreements, operating leases for branch operations, and time deposits. The maturity schedules for these obligations are as follows:
(In thousands) |
Less than One year |
One Year To Three Years |
Three Years To Five Years |
Over Five Years |
Total |
Debt maturities |
$ 84
|
$ 172
|
$ 180
|
$ 1,884
|
$ 2,320
|
Junior subordinated debentures |
0 | 0 | 0 | 20,619 | 20,619 |
Operating lease payments |
1,554 | 2,595 | 1,861 | 5,844 | 11,854 |
Time deposits |
145,648 | 44,207 | 20,937 | 892 | 211,684 |
$ 147,286
|
$ 46,974
|
$ 22,978
|
$ 29,239
|
$ 246,477
|
Commitments and Off-Balance Sheet Risk
We are a party to financial instruments with off‑balance 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. Such instruments involve, to varying degrees, elements of credit and interest rate risk that are not recognized in the accompanying consolidated balance sheets.
Exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and financial guarantees written is represented by the contractual amount of those instruments. We use the same credit policies in making commitments as we do for on‑balance sheet instruments. The contractual amounts of these financial instruments at December 31, 2014 are as follows:
36
(In thousands) |
Contractual Amount |
Financial instruments whose contract amounts represent credit risk: |
|
Commitments to originate loans |
37,651 |
Unused lines of credit |
197,682 |
Standby letters of credit |
8,768 |
Loans sold with recourse |
0 |
Equity commitments to affordable housing limited partnerships |
3,019 |
Commitments to originate loans are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments to originate loans generally have expiration dates within 60 days of the commitment. Unused lines of credit have expiration dates ranging from one to two years from the date of the commitment. Because a portion of the commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent a future cash requirement. We evaluate each customer's creditworthiness on a case‑by‑case basis. Upon extension of credit, we obtain an appropriate amount of real and/or personal property as collateral based on our credit evaluation of the counterparty.
We do not issue any guarantees that would require liability-recognition or disclosure, other than standby letters of credit. We have issued conditional commitments in the form of standby letters of credit to guarantee payment on behalf of a customer and guarantee the performance of a customer to a third party. Standby letters of credit generally arise in connection with lending relationships. The credit risk involved in issuing these instruments is essentially the same as that involved in extending loans to customers. Contingent obligations under standby letters of credit totaled approximately $8.77 million and $4.73 million at December 31, 2014 and 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. Each customer is evaluated individually for creditworthiness under the same underwriting standards used for commitments to extend credit and on-balance sheet instruments. Our policies governing loan collateral apply to standby letters of credit at the time of credit extension. LTV ratios are generally consistent with LTV requirements for other commercial loans secured by similar types of collateral. The fair value of our standby letters of credit at December 31, 2014 and 2013 was insignificant.
Equity commitments to affordable housing partnerships represent funding commitments for certain limited partnerships. These partnerships were created for the purpose of acquiring, constructing and/or redeveloping affordable housing projects. The funding of these commitments is generally contingent upon substantial completion of the project and none extend beyond the fifth anniversary of substantial completion.
Capital Resources
In general, capital growth is essential to support deposit and asset growth and to ensure our strength and safety. Net income increased our capital by $12.13 million in 2014, $15.13 million in 2013 and $15.19 million in 2012. Payment of dividends decreased our capital by $7.09 million in 2014, $7.05 million in 2013, and $7.01 million in 2012, while the use of treasury stock to fund our dividend reinvestment plan increased our capital by $622 thousand and $683 thousand during 2013 and 2012, respectively. In 2014, Merchants Bank purchased shares in the market to fund our dividend reinvestment plan which resulted in a decrease in our capital by $82 thousand. In December 2004, we privately placed $20 million in capital securities as part of a pooled trust preferred program. The securities qualify as regulatory capital under regulatory adequacy guidelines.
Changes in the market value of our available for sale investment portfolio, net of tax, increased capital by $1.64 million in 2014 and decreased capital by $6.32 million in 2013. Our unrecognized net actuarial loss in our pension plan resulted in a cumulative after-tax charge to equity of $1.61 million. Our unrealized loss on our interest rate swaps, net of taxes, at December 31, 2014, reduced capital by a cumulative $161 thousand. We recognized $472 thousand and $237 thousand of amortization of unrealized holding losses of securities transferred from available for sale to held to maturity, net of taxes, in 2014 and 2013, respectively.
We extended our stock buyback program through January 31, 2016. Under the program, which was originally adopted in January 2007, we may repurchase up to 200,000 shares of our common stock on the open market from time to time, and have purchased 143,475 shares at an average price per share of $22.94 since the program's adoption. We did not repurchase any of our shares during 2014, 2013 or 2012 and do not expect to repurchase shares in the near future.
ITEM 7A – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
RISK MANAGEMENT
General
Our Management and Board of Directors are committed to sound risk management practices throughout the organization. We have
37
developed and implemented a centralized risk management monitoring program. Risks associated with our business activities and products are identified and measured as to probability of occurrence and impact on us (low, moderate, or high), and the control or other activities in place to manage those risks are identified and assessed. Periodically, department-level and senior managers re-evaluate and report on the risk management processes for which they are responsible. This documented program provides us with a comprehensive framework for monitoring our risk profile from a macro perspective. It also serves as a tool for assessing internal controls over financial reporting as required under the FDIA and the Sarbanes-Oxley Act of 2002.
Market Risk
Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates or prices such as interest rates, foreign currency exchange rates, commodity prices, and equity prices. Our primary market risk exposure is interest rate risk. An important component of our asset and liability management process is the ongoing monitoring and management of this risk, which is governed by established policies that are reviewed and approved annually by our Board of Directors. Our Investment Policy details the types of securities that may be purchased, and establishes portfolio limits and maturity limits for the various sectors. The Investment Policy also establishes specific investment quality limits. Our Board of Directors has established a Board-level Asset/Liability Committee, which delegates responsibility for carrying out the asset/liability management policies to the Management-level Asset/Liability Committee (the “Management ALCO”). The Management ALCO, chaired by the Chief Financial Officer and composed of members of senior management, develops guidelines and strategies impacting our asset and liability management related activities based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends. The Management ALCO manages the investment portfolio. As the portfolio has grown, the Management ALCO has used portfolio diversification as a way to mitigate the risk of being too heavily invested in any single asset class. We continued to work to maximize net interest income while mitigating risk during the year through further repositioning of the investment portfolio, selective sales of specific securities, as well as carefully monitoring the overall duration and average life of the portfolio, and monitoring individual securities, among other strategies.
Liquidity Risk
Our liquidity is measured by our ability to raise cash when needed at a reasonable cost. We must be capable of meeting expected and unexpected obligations to customers at any time. Given the uncertain nature of customer demands as well as the need to maximize earnings, we must have available reasonably priced sources of funds, on- and off-balance sheet, which can be accessed quickly in time of need. As discussed above under Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resource Management,” we have several sources of readily available funds, including the ability to borrow using our investment portfolio as collateral. We also monitor our liquidity on a quarterly basis in compliance with our Liquidity Contingency Plan. Our liquidity monitoring process identifies early liquidity stress triggers, and also allows us to model worst case liquidity scenarios, and various responses to those scenarios.
Financial markets have been volatile and challenging for many financial institutions. Because of our favorable credit quality and strong balance sheet, we did not experience any liquidity constraints through the end of 2014. During the past several quarters, our liquidity position has been strong, as depositors and investors in the wholesale funding markets seek strong financial institutions.
Interest Rate Risk
Interest rate risk is the exposure to a movement in interest rates, which, as described above, affects our net interest income. Asset and liability management is governed by policies reviewed and approved annually by Merchants Bank’s Board of Directors. The ALCO meets frequently to review and develop asset/liability management strategies and tactics.
The ALCO is responsible for evaluating and managing the interest rate risk which arises naturally from imbalances in repricing, maturity and cash flow characteristics of our assets and liabilities. Techniques used by the ALCO take into consideration the cash flow and repricing attributes of balance sheet and off-balance sheet items and their relation to possible changes in interest rates. The ALCO manages interest rate exposure by using a combination of on-balance sheet and off-balance sheet strategies. On-balance sheet strategies generally consist of management of the duration, rate sensitivity and average lives of our various investments, and by extending or shortening maturities of borrowed funds, as well as carefully managing and monitoring the pricing and average lives of loans and the pricing and maturity of deposits. We also use off-balance sheet strategies, such as interest rate swaps and interest rate caps and floors, to help minimize our exposure to changes in interest rates. By using derivative financial instruments to hedge exposures to changes in interest rates we are exposed to credit risk and market risk. Credit risk is the failure of the counterparty to perform under the terms of the derivative contract. When the fair value of a derivative contract is positive, the counterparty owes us, creating credit risk. We minimize credit risk in derivative instruments by entering into transactions only with high-quality counterparties. The market risk associated with interest-rate contracts is managed by establishing and monitoring parameters that limit the types and degree of market risk that may be undertaken.
The ALCO is responsible for ensuring that our Board of Directors receives accurate information regarding our interest rate risk position at least quarterly. The investment advisory firm and ALCO consultant meet collectively with the board and Management-level ALCOs on a quarterly basis. During these meetings the ALCO consultant reviews our current position and discusses future strategies, as well as reviewing the result of rate shocks of our balance sheet and a variety of other analyses. The investment advisor reports on the overall performance of the portfolio and performs modeling of the cash flow, effective duration, and yield characteristics of the portfolio under various interest rate scenarios; and also reviews and provides detail on individual holdings in the
38
portfolio.
The ALCO consultant’s most recent review was as of December 31, 2014. The consultant ran a base simulation assuming no changes in rates as well as a 200 basis point rising and, because rates continue to be very low, a 100 basis point falling interest rate scenario that assumes a parallel and pro rata shift of the yield curve over a one-year period, and no growth assumptions. Additionally, the consultant ran a 400 basis point rising simulation that assumed a parallel shift of the curve over 24 months, a 500 basis point rising simulation which assumed the curve flattened over a 24 month time frame, and a 500 basis point rising simulation which assumed the increase in rates was delayed by two years. A summary of the results is as follows:
Current/Flat Rates: Net interest income levels are projected to trend downward throughout the simulation. The sustained low rate environment causes continued margin pressures as assets continue to reprice, and are replaced at lower rates than the existing portfolio, while funding costs are at or near their floors.
Falling Rates: If rates fall 100 basis points our net interest income is projected to trend in line with the base case scenario for most of year one as we are able to drop funding costs to near zero. Thereafter margins decline as asset yields continue to reprice lower with no relief on the funding side.
Rising Rates: Net interest income is projected to increase throughout the simulation given a rise in rates regardless of the shape of the yield curve because our interest rate risk position is structurally asset sensitive due to our strong core funding position which supports a shorter term asset base. If rates remain at current low levels for another two years, the benefit of rising rates is muted because the starting point for asset yields will be lower.
We have established a target range for the change in net interest income in year one of zero to 7.5%. The net interest income simulation as of December 31, 2014 showed that the change in net interest income for the next 12 months from our expected or “most likely” forecast was as follows:
Rate Change |
Percent Change in Net Interest Income |
|
Up 200 basis points |
3.93 |
% |
Down 100 basis points |
0.03 |
% |
The change in net interest income in the second year of the simulation shows a more pronounced downward trend in the flat and down 100 basis points scenarios, the projected change is (4.52)% and (13.36)%, respectively, while the up 200 basis points simulation produces an increase of 7.23%. The degree to which this exposure materializes will depend, in part, on our ability to manage our balance sheet as interest rates rise or fall.
Actual results may differ materially from those projected. The analysis assumes a static balance sheet. All rate changes are ramped over a 12 month time horizon based upon a parallel yield curve shift. In the down 100 basis points scenario, Federal funds and Treasury yields are floored at 0.01% while Prime is floored at 3.00%. All other market rates (e.g. LIBOR, FHLB) are floored at 0.25% to reflect credit spreads. The model used to perform the balance sheet simulation assumes a parallel shift of the yield curve over 12 months and reprices every interest-bearing asset and liability on our balance sheet. The model incorporates product specific loan prepayment assumptions and uses contractual repricing dates for variable rate loan products and contractual maturities for fixed rate products. The model uses product-specific assumptions for deposits which are subject to repricing based on current market conditions. The model uses the Yield Book, Inc. system to analyze the investment portfolio which produces bond specific cash flows forecasts for each rate scenario tested in the analysis. The analysis details bond maturity, amortization, repricing characteristics, and optionality. The cash flow forecasts take into consideration assumptions for absolute rate movements, the period over which rates are assumed to shift and assumed changes in the shape of the yield curve. The model also assumes that the rate at which residential mortgage related assets prepay will vary as rates rise and fall, based on prepayment estimates derived from Applied Financial Technologies.
The preceding sensitivity analysis does not represent our forecast and should not be relied upon as being indicative of expected operating results. These estimates are based upon numerous assumptions including without limitation: the nature and timing of interest rate levels including yield curve shape, prepayments on loans and securities, deposit run-off rates, pricing decisions on loans and deposits and reinvestment/replacement of asset and liability cash flows, among others. While assumptions are developed based upon current economic and local market conditions, we cannot make any assurances as to the predictive nature of these assumptions including how customer preferences or competitor influences might change. As market conditions vary from those assumed in the sensitivity analysis, actual results will likely differ due to: the varying impact of changes in the balances and mix of loans and deposits differing from those assumed, the impact of possible off balance sheet hedging strategies, and other internal/external variables. Furthermore, the sensitivity analysis does not reflect all actions that the ALCO might take in responding to or anticipating changes in interest rates.
The most significant ongoing factor affecting market risk exposure of net interest income during the year ended December 31, 2014 was the sustained low interest rate environment. Net interest income exposure is also significantly affected by the shape and level of
39
the U.S. Government securities and interest rate swap yield curves, and changes in the size and composition of the loan, investment and deposit portfolios. During 2014, the two year Constant Maturity Treasury note increased 21 basis points to 0.59%. The spread between the two year CMT and the ten year CMT at December 31, 2014 was 139 basis points, compared to 266 basis points at December 31, 2013.
Credit Risk
The Board of Directors reviews and approves our loan policy on an annual basis. Among other things, the loan policy establishes restrictions regarding the types of loans that may be granted, and the distribution of loan types within our portfolio. Our loan portfolio is continuously monitored for performance, creditworthiness and strength of documentation through the use of a variety of management reports and the assistance of an external loan review firm. Credit ratings are assigned to commercial loans and are routinely reviewed. Loan officers, under the supervision of the Senior Lender and Senior Credit Officer, take remedial actions to assure full and timely payment of loan balances when necessary. Our policy is to discontinue the accrual of interest on loans when scheduled payments become contractually past due 90 or more days and the ultimate collectability of principal or interest become doubtful. In certain instances the accrual of interest is discontinued prior to 90 days past due if Management determines that the borrower will not be able to continue making timely payments.
40
ITEM 8 – FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Merchants Bancshares, Inc.
Consolidated Balance Sheets
December 31, |
December 31, |
|||
(In thousands except share and per share data) |
2014 |
2013 |
||
ASSETS |
||||
Cash and due from banks |
$ |
23,745 |
$ |
30,434 |
Interest earning deposits with banks and other short-term investments |
130,714 | 85,037 | ||
Total cash and cash equivalents |
154,459 | 115,471 | ||
Investments: |
||||
Securities available for sale, at fair value |
203,473 | 252,513 | ||
Securities held to maturity (fair value of $139,171 and $137,087) |
138,421 | 140,826 | ||
Total investments |
341,894 | 393,339 | ||
Loans |
1,182,334 | 1,166,233 | ||
Less: Allowance for loan losses |
11,833 | 12,042 | ||
Net loans |
1,170,501 | 1,154,191 | ||
Federal Home Loan Bank stock |
4,378 | 7,496 | ||
Bank premises and equipment, net |
15,492 | 15,572 | ||
Investment in real estate limited partnerships |
5,196 | 4,631 | ||
Bank owned life insurance |
10,311 | 10,000 | ||
Other assets |
21,233 | 24,769 | ||
Total assets |
$ |
1,723,464 |
$ |
1,725,469 |
LIABILITIES |
||||
Deposits: |
||||
Demand (noninterest bearing) |
$ |
566,366 |
$ |
266,299 |
Savings, interest bearing checking and money market accounts |
530,722 | 752,171 | ||
Time Deposits |
211,684 | 305,106 | ||
Total deposits |
1,308,772 | 1,323,576 | ||
Securities sold under agreements to repurchase |
258,464 | 250,314 | ||
Other long-term debt |
2,320 | 2,403 | ||
Junior subordinated debentures issued to unconsolidated subsidiary trust |
20,619 | 20,619 | ||
Other liabilities |
7,468 | 8,946 | ||
Total liabilities |
1,597,643 | 1,605,858 | ||
SHAREHOLDERS' EQUITY |
||||
Preferred stock |
||||
Class A non-voting shares authorized - 200,000, none outstanding |
0 | 0 | ||
Class B voting shares authorized - 1,500,000, none outstanding |
0 | 0 | ||
Common stock, $.01 par value |
67 | 67 | ||
Authorized: 10,000,000 shares; Issued: 6,651,760 at December 31, 2014 and December 31, 2013 |
||||
Outstanding: 6,327,226 at December 31, 2014 and 6,318,708 at December 31, 2013 |
||||
Capital in excess of par value |
37,404 | 37,129 | ||
Retained earnings |
100,697 | 95,657 | ||
Treasury stock, at cost: 324,534 shares at December 31, 2014 and 333,052 shares at December 31, 2013 |
(13,865) | (14,043) | ||
Deferred compensation arrangements: 308,670 shares at December 31, 2014 and 319,854 shares at December 31, 2013 |
6,566 | 6,521 | ||
Accumulated other comprehensive (loss) income |
(5,048) | (5,720) | ||
Total shareholders' equity |
125,821 | 119,611 | ||
Total liabilities and shareholders' equity |
$ |
1,723,464 |
$ |
1,725,469 |
See accompanying notes to consolidated financial statements |
41
Merchants Bancshares, Inc.
Consolidated Statements of Income
Twelve Months Ended |
||||||
December 31, |
||||||
(In thousands except per share data) |
2014 |
2013 |
2012 |
|||
INTEREST AND DIVIDEND INCOME |
||||||
Interest and fees on loans |
$ |
42,815 |
$ |
43,987 |
$ |
44,977 |
Investment income: |
||||||
Interest and dividends on investment securities |
7,965 | 9,912 | 11,834 | |||
Interest on interest earning deposits with banks and other short-term investments |
192 | 68 | 46 | |||
Total interest and dividend income |
50,972 | 53,967 | 56,857 | |||
INTEREST EXPENSE |
||||||
Savings, interest bearing checking and money market accounts |
1,647 | 1,184 | 776 | |||
Time deposits |
1,725 | 2,166 | 2,775 | |||
Securities sold under agreement to repurchase and other short-term debt |
353 | 914 | 1,790 | |||
Long-term debt |
800 | 806 | 1,542 | |||
Total interest expense |
4,525 | 5,070 | 6,883 | |||
Net interest income |
46,447 | 48,897 | 49,974 | |||
Provision for credit losses |
150 | 800 | 950 | |||
Net interest income after provision for credit losses |
46,297 | 48,097 | 49,024 | |||
NONINTEREST INCOME |
||||||
Impairment losses on securities |
0 | (166) | 0 | |||
Net gains (losses) on investment securities |
107 | (12) | 507 | |||
Trust division income |
3,393 | 3,062 | 2,685 | |||
Service charges on deposits |
3,842 | 3,989 | 4,078 | |||
Net debit card income |
2,660 | 2,875 | 2,854 | |||
Gain on sale of other assets |
0 | 794 | 1,083 | |||
Earnings on Bank Owned Life Insurance |
311 | 0 | 0 | |||
Other |
1,261 | 1,088 | 1,406 | |||
Total noninterest income |
11,574 | 11,630 | 12,613 | |||
NONINTEREST EXPENSE |
||||||
Compensation and benefits |
20,758 | 19,165 | 19,582 | |||
Occupancy expense |
4,319 | 4,165 | 3,826 | |||
Equipment expense |
4,148 | 3,892 | 3,626 | |||
Legal and professional fees |
2,997 | 2,755 | 2,545 | |||
Marketing |
1,218 | 1,429 | 1,730 | |||
State franchise taxes |
1,435 | 1,439 | 1,295 | |||
FDIC insurance |
857 | 872 | 866 | |||
Prepayment penalty on long-term debt |
0 | 0 | 1,363 | |||
Other Real Estate Owned ("OREO") expenses |
111 | 121 | 197 | |||
Other |
6,371 | 5,696 | 5,920 | |||
Total noninterest expense |
42,214 | 39,534 | 40,950 | |||
Income before provision for income taxes |
15,657 | 20,193 | 20,687 | |||
Provision for income taxes |
3,532 | 5,062 | 5,493 | |||
NET INCOME |
$ |
12,125 |
$ |
15,131 |
$ |
15,194 |
Basic earnings per common share |
$ |
1.92 |
$ |
2.40 |
$ |
2.43 |
Diluted earnings per common share |
$ |
1.91 |
$ |
2.40 |
$ |
2.42 |
See accompanying notes to consolidated financial statements |
42
Merchants Bancshares, Inc.
Consolidated Statements of Comprehensive Income
Twelve Months Ended |
|||||||
December 31, |
|||||||
(In thousands) |
2014 |
2013 |
2012 |
||||
Net income |
$ |
12,125 |
$ |
15,131 |
$ |
15,194 | |
Other comprehensive (loss) income, net of tax: |
|||||||
Unrealized holding gain (losses) on securities available for sale, net of taxes of $921, $(3,398), and $(181) |
1,705 | (6,311) | (336) | ||||
Unrealized holding gains (losses) arising during the period for securities transferred from available for sale to held to maturity, net of taxes of $4, $(1,902), and $0 |
8 | (3,533) | 0 | ||||
Amortization of unrealized holding losses of securities transferred from available for sale to held to maturity, net of taxes of $254, $128, and $0 |
472 | 237 | 0 | ||||
Reclassification adjustments for net securities losses (gains) included in net income, net of taxes of $(38), $62, and $(177) |
(69) | 116 | (329) | ||||
Change in net unrealized loss on interest rate swaps, net of taxes of $86, $116, and $122 |
161 | 216 | 226 | ||||
Pension liability adjustment, net of taxes of $(863), $721, and $(241) |
(1,605) | 1,340 | (448) | ||||
Other comprehensive (loss) income |
672 | (7,935) | (887) | ||||
Comprehensive (loss) income |
$ |
12,797 | 7,196 | 14,307 | |||
See accompanying notes to consolidated financial statements |
43
Merchants Bancshares, Inc.
Consolidated Statements of Changes in Shareholders' Equity
For the Years Ended December 31, 2014, 2013, and 2012
Accumulated |
||||||||||||||
Capital in |
Deferred |
Other |
||||||||||||
Common |
Excess of |
Retained |
Treasury |
Compensation |
Comprehensive |
|||||||||
(In thousands except per share data) |
Stock |
Par Value |
Earnings |
Stock |
Arrangements |
Income (loss) |
Total |
|||||||
Balance at December 31, 2011 |
$ |
67 |
$ |
36,544 |
$ |
79,393 |
$ |
(15,817) |
$ |
6,248 |
$ |
3,102 |
$ |
109,537 |
Net income |
0 | 0 | 15,194 | 0 | 0 | 0 | 15,194 | |||||||
Dividends paid ($1.12 per share) |
0 | 0 | (7,007) | 0 | 0 | 0 | (7,007) | |||||||
Sale of treasury stock |
0 | 2 | 0 | 16 | 0 | 0 | 18 | |||||||
Distribution of stock under deferred compensation arrangements |
0 | 0 | 0 | 386 | (386) | 0 | 0 | |||||||
Shares granted under stock plans and deferral of director fees, including excess tax benefit |
0 | 41 | 0 | 380 | 90 | 0 | 511 | |||||||
Share based compensation expense |
0 | 72 | 0 | 0 | 100 | 0 | 172 | |||||||
Dividend reinvestment plan |
0 | 83 | 0 | 249 | 351 | 0 | 683 | |||||||
Other comprehensive loss |
0 | 0 | 0 | 0 | 0 | (887) | (887) | |||||||
Balance at December 31, 2012 |
$ |
67 |
$ |
36,742 |
$ |
87,580 |
$ |
(14,786) |
$ |
6,403 |
$ |
2,215 |
$ |
118,221 |
Net income |
0 | 0 | 15,131 | 0 | 0 | 0 | 15,131 | |||||||
Dividends paid ($1.12 per share) |
0 | 0 | (7,054) | 0 | 0 | 0 | (7,054) | |||||||
Sale of treasury stock |
0 | 3 | 0 | 12 | 0 | 0 | 15 | |||||||
Distribution of stock under deferred compensation arrangements |
0 | 0 | 0 | 450 | (450) | 0 | 0 | |||||||
Shares granted under stock plans and deferral of director fees, including excess tax benefit |
0 | 223 | 0 | 140 | 61 | 0 | 424 | |||||||
Share based compensation expense |
0 | 27 | 0 | 0 | 160 | 0 | 187 | |||||||
Dividend reinvestment plan |
0 | 134 | 0 | 141 | 347 | 0 | 622 | |||||||
Other comprehensive income |
0 | 0 | 0 | 0 | 0 | (7,935) | (7,935) | |||||||
Balance at December 31, 2013 |
$ |
67 |
$ |
37,129 |
$ |
95,657 |
$ |
(14,043) |
$ |
6,521 |
$ |
(5,720) |
$ |
119,611 |
Net income |
0 | 0 | 12,125 | 0 | 0 | 0 | 12,125 | |||||||
Dividends paid ($1.12 per share) |
0 | 0 | (7,085) | 0 | 0 | 0 | (7,085) | |||||||
Purchase of treasury stock |
0 | 0 | 0 | (82) | 0 | 0 | (82) | |||||||
Distribution of stock under deferred compensation arrangements & stock plans |
0 | 0 | 0 | 553 | (553) | 0 | 0 | |||||||
Shares granted under stock plans and deferral of director fees, including excess tax benefit |
0 | 275 | 0 | 164 | 22 | 0 | 461 | |||||||
Share based compensation expense |
0 | 0 | 0 | (122) | 241 | 0 | 119 | |||||||
Dividend reinvestment plan |
0 | 0 | 0 | (335) | 335 | 0 | (0) | |||||||
Other comprehensive income |
0 | 0 | 0 | 0 | 0 | 672 | 672 | |||||||
Balance at December 31, 2014 |
$ |
67 |
$ |
37,404 |
$ |
100,697 |
$ |
(13,865) |
$ |
6,566 |
$ |
(5,048) |
$ |
125,821 |
See accompanying notes to consolidated financial statements |
44
Merchants Bancshares, Inc.
Consolidated Statements of Cash Flows
Twelve Months Ended December 31, |
||||||
(In thousands) |
2014 |
2013 |
2012 |
|||
CASH FLOWS FROM OPERATING ACTIVITIES: |
||||||
Net income |
$ |
12,125 |
$ |
15,131 |
$ |
15,194 |
Adjustments to reconcile net income to net cash provided by operating activities: |
||||||
Provision for loan losses |
150 | 800 | 950 | |||
Deferred tax expense (benefit) |
(175) | 4,329 | 772 | |||
Depreciation and amortization |
2,452 | 2,181 | 1,948 | |||
Amortization of investment security premiums and accretion of discounts, net |
707 | 1,101 | 2,330 | |||
Stock based compensation |
119 | 187 | 172 | |||
Contribution to pension plan |
0 | 0 | (5,000) | |||
Net losses (gains) on sales of investment securities |
(107) | 12 | (507) | |||
Other-than-temporary impairment losses on investment securities |
0 | 166 | 0 | |||
Net gains on sale of loans |
0 | 0 | 0 | |||
Net (gains) losses on sale of premises, equipment and other assets |
104 | (794) | (1,040) | |||
Deferred (gain) on sale of premises |
(517) | (934) | 0 | |||
(Gains) losses on sale of other real estate owned |
35 | (20) | (7) | |||
Bank owned life insurance |
(311) | 0 | 0 | |||
Amortization of real estate limited partnership investments |
1,257 | 1,039 | 1,516 | |||
Changes in assets and liabilities: |
||||||
Net change in interest receivable |
195 | 386 | 753 | |||
Net change in other assets |
790 | (1,635) | (2,333) | |||
Net change in interest payable |
(49) | (19) | 2,196 | |||
Net change in other liabilities |
(861) | 634 | (11,282) | |||
Net cash provided by operating activities |
15,915 | 22,564 | 5,662 | |||
CASH FLOWS FROM INVESTING ACTIVITIES: |
||||||
Proceeds from sales of investment securities available for sale |
56,889 | 53,215 | 129,936 | |||
Proceeds from maturities of investment securities available for sale |
37,235 | 99,979 | 186,540 | |||
Proceeds from maturities of investment securities held to maturity |
15,486 | 7,254 | 151 | |||
Proceeds from redemption of Federal Home Loan Bank stock |
3,118 | 649 | 485 | |||
Purchases of investment securities available for sale |
(55,495) | (60,580) | (316,251) | |||
Loan originations in excess of principal payments |
(16,264) | (86,185) | (55,428) | |||
Proceeds from sales of loans, net |
0 | 2,378 | 0 | |||
Proceeds from sale of other assets |
0 | 0 | 334 | |||
Proceeds from sale of premises and equipment |
0 | 3,026 | 788 | |||
Proceeds from sales of other real estate owned |
68 | 171 | 505 | |||
Real estate limited partnership investments |
(1,822) | (247) | (1,750) | |||
Investment in bank owned life insurance |
0 | (10,000) | 0 | |||
Purchases of bank premises and equipment |
(2,477) | (3,019) | (3,877) | |||
Net cash provided by (used in) investing activities |
36,738 | 6,640 | (58,567) | |||
CASH FLOWS FROM FINANCING ACTIVITIES: |
||||||
Net change in deposits |
(14,804) | 52,496 | 93,200 | |||
Net change in securities sold under agreement to repurchase, short-term |
8,150 | (37,206) | 24,993 | |||
Principal payments on long-term debt |
(83) | (80) | (20,079) | |||
Cash dividends paid |
(7,085) | (6,432) | (6,324) | |||
Purchase of Treasury Stock |
(82) | 0 | 0 | |||
Sale of treasury stock |
0 | 15 | 18 | |||
Increase in deferred compensation arrangements |
0 | 237 | 213 | |||
Proceeds from exercise of stock options, net of withholding taxes |
225 | 0 | 280 | |||
Tax benefit from exercise of stock options and distribution of shares in deferred compensation arrangements |
14 | 8 | 20 | |||
Net cash provided by financing activities |
(13,665) | 9,038 | 92,321 | |||
Increase (decrease) in cash and cash equivalents |
38,988 | 38,243 | 39,416 | |||
Cash and cash equivalents beginning of period |
115,471 | 77,228 | 37,812 |
45
Cash and cash equivalents end of period |
$ |
154,459 | 0 | 115,471 |
$ |
77,228 |
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: |
||||||
Total interest payments |
$ |
4,574 |
$ |
5,051 |
$ |
4,687 |
Total income tax payments |
8,054 | 800 | 5,950 | |||
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES |
||||||
Distribution of stock under deferred compensation arrangements |
$ |
553 |
$ |
450 |
$ |
391 |
Distribution of treasury stock in lieu of cash dividend under dividend reinvestment plan |
0 | 622 | 683 | |||
Non-cash exercise of stock options |
124 | 181 | 130 | |||
Transfer of loans to other real estate owned |
0 | 213 | 140 | |||
Transfer of securities from available for sale to held to maturity |
12,626 | 152,887 | 0 | |||
Decrease in payable for investments purchased |
0 | 0 | (9,461) | |||
See accompanying notes to consolidated financial statements |
46
Merchants Bancshares, Inc.
Notes to Consolidated Financial Statements
December 31, 2014, 2013 and 2012
NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of Merchants Bancshares, Inc. (the “Company”), and its wholly-owned subsidiary Merchants Bank (the “Bank,” and collectively with the Company, “Merchants”, “we,” “us, or “our”). All material intercompany accounts and transactions are eliminated in consolidation. We offer a full range of deposit, loan, cash management, and trust services to meet the financial needs of individual consumers, businesses and municipalities at 32 full-service banking offices throughout the state of Vermont as of December 31, 2014.
Management’s Use of Estimates in Preparation of Financial Statements
The preparation of financial statements in conformity with U.S. Generally Accepted Accounting Principles (“GAAP”) requires Management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of income and expenses during the reporting periods. The most significant estimates include those used in determining the allowance for credit losses, income taxes, interest income recognition on loans and investments and analysis of other-than-temporary impairment of our investment securities portfolio. Operating results in the future may vary from the amounts derived from Management's estimates and assumptions.
Cash and Cash Equivalents
Cash and cash equivalents consist of cash on hand, amounts due from banks, Federal Funds sold and other short-term investments, with maturities at time of purchase of less than 90 days, in the accompanying consolidated statements of cash flows.
Investment Securities
We classify certain of our investments in debt securities as held to maturity, which are carried at amortized cost, if we have the positive intent and ability to hold such securities to maturity. Investments in debt securities that are not classified as held to maturity and equity securities that have readily determinable fair values are classified as available for sale securities or trading securities. Available for sale securities are investments not classified as trading or held to maturity. Available for sale securities are carried at fair value which is measured at each reporting date. The resulting unrealized gain or loss is reflected in accumulated other comprehensive income (loss) net of the associated tax effects. Gains and losses on sales of investment securities are recognized through the statement of income using the specific identification method.
Transfers from securities available for sale to securities held to maturity are recorded at the securities’ fair values on the date of the transfer. Any net unrealized gains or losses continue to be included as a separate component of accumulated other comprehensive income (loss), on a net of tax basis. As long as the securities are carried in the held to maturity portfolio, such amounts are amortized (accreted) over the estimated remaining life of the transferred securities as an adjustment to yield in a manner consistent with the amortization of premiums and discounts.
Interest and dividend income, including amortization of premiums and discounts, are recorded in earnings for all categories of investment securities. Discounts and premiums related to debt securities are amortized using the level-yield method which anticipates prepayments for amortizing securities.
Management evaluates securities for other-than-temporary impairment (“OTTI”) on at least a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For securities in an unrealized loss position, management considers the extent and duration of the unrealized loss, and the financial condition and near-term prospects of the issuer. Management also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings. For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: 1) OTTI related to credit loss, which must be recognized in the income statement and 2) other-than-temporary impairment (OTTI) related to other factors, which is recognized in other comprehensive income. The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. For equity securities, the entire amount of impairment is recognized through earnings.
Federal Home Loan Bank System
We are a member of the Federal Home Loan Bank System, which consists of 12 regional Federal Home Loan Banks. The Federal Home Loan Bank of Boston (“FHLBB”) provides a central credit facility primarily for member institutions. Member institutions are required to acquire and hold shares of capital stock in the FHLBB in an amount at least equal to the sum of 0.35% of the aggregate principal amount of its unpaid residential mortgage loans and similar obligations at the beginning of each year. We were in compliance with this requirement at December 31, 2014. FHLBB stock is carried at cost, classified as a restricted security, and periodically evaluated for impairment based on ultimate recovery of par value. Both cash and stock dividends are reported as income.
47
Bank Owned Life Insurance
We purchased life insurance policies on certain key executives where the Bank is the beneficiary. Bank owned life insurance is recorded at the amount that can be realized under the insurance contract at the balance sheet date, which is the cash surrender value (“CSV”) adjusted for other charges or other amounts due that are probable at settlement. Increases in the CSV of the policies, as well as death benefits received, net of any CSV, are recorded in noninterest income, and are not subject to income taxes.
Loans
Loans that management has the intent and ability to hold for the foreseeable future or until maturity or payoff are reported at the principal balance outstanding, net of deferred loan fees and costs, and an allowance for loan losses. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized in interest income using the level-yield method without anticipating prepayments.
Allowance for Credit Losses
The allowance for credit losses (“Allowance”) is comprised of the allowance for loan losses and the reserve for undisbursed lines of credit, and is based on Management’s estimate of the amount required to reflect probable incurred credit losses in the loan portfolio. Factors considered in evaluating the adequacy of the Allowance 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 allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired when, based on current information and events, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loans for which the terms have been modified resulting in a concession, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings (“TDR”) and classified as impaired.
Commercial and commercial real estate loans are individually evaluated for impairment when a loan meets any of the specific criteria identified in our methodology. If a loan is impaired, the loan is either charged down, or a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Large groups of smaller balance homogeneous loans, such as consumer and residential real estate loans are collectively evaluated for impairment, and accordingly, they are not separately identified for impairment disclosures.
Loans for which the terms have been modified resulting in a concession, and for which the borrower is experiencing financial difficulties, are considered TDRs. Concessions that result in a loan being considered a TDR usually consists of a reduction in interest rate to a below market rate, taking into account the credit quality of the note, or a deferment or reduction of payments, principal or interest, which alters the Bank’s position or significantly extends the note’s maturity date, such that the present value of cash flows to be received is less than those contractually established at the loan’s origination. TDRs are measured at the present value of estimated future cash flows using the loans effective rate at inception. If a TDR is considered to be a collateral dependent loan, the loan is reported, net, at the fair value of the collateral. For troubled debt restructurings that subsequently default, we determine the amount of reserve in accordance with the accounting policy for the allowance for loan losses.
Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed.
The general component covers non-impaired loans and is based on historical loss experience adjusted for current factors. The historical loss experience is determined by portfolio segment and is based on the actual loss history experienced by us over the most recent 5 years. This actual loss experiences is supplemented with other factors based on the risks present for each portfolio segment. These factors include consideration of the following: levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations. Due to the added risks associated with loans which are graded as pass-watch, special mention, and substandard that are not classified as impaired, an additional analysis is performed to determine whether an allowance is needed that is not fully captured by the historical loss experience. While historical loss experience by loan segment and migration of loans into higher risk classifications are considered, the following factors are also considered in determining the level of needed allowance on such loans: the historical loss rates of loans specifically classified as pass-watch, special mention, or substandard; and the trends in the collateral on the loans included within these classifications. This analysis created an additional $1.23 million at December 31, 2014 compared to $1.55 million at December 31, 2013 in needed allowance for loan loss.
We have divided the loan portfolio into portfolio segments, each with different risk characteristics and methodologies for assessing
48
risk. Each portfolio segment is broken down into class segments where appropriate. Class segments contain unique measurement attributes, risk characteristics and methods for monitoring and assessing risk that are necessary to develop the allowance for loan and lease losses. Unique characteristics such as borrower type, loan type, collateral type, and risk characteristics define each class segment. A description of the segments follows:
Commercial, financial and agricultural: We offer a variety of loan options to meet the specific needs of commercial customers including term loans and lines of credit. Such loans are made available to businesses for working capital such as inventory and receivables, business expansion and equipment purchases. Generally, a collateral lien is placed on equipment, receivables, inventory or other assets owned by the borrower. These loans carry a higher risk than commercial real estate loans by the nature of the underlying collateral, and the collateral value may change daily. To reduce the risk, management generally employs enhanced monitoring requirements, obtains personal guarantees and, where appropriate, may also attempt to secure real estate as collateral.
Municipal: Municipal loans primarily consist of term and time loans issued on a tax-exempt and taxable basis which are general obligations of the municipality. These loans are viewed as lower risk as municipalities can utilize taxing power to meet financial obligations.
Real Estate – Residential: Residential real estate loans consist primarily of loans secured by first or second mortgages on primary residences. We originate adjustable-rate and fixed-rate, one- to four-family residential real estate loans for the construction, purchase or refinancing of a mortgage. These loans are generally collateralized by owner-occupied properties located in our market area. Loans on one- to four-family residential real estate are generally originated in amounts of no more than 80% of the purchase price or appraised value (whichever is lower). Hazard insurance is required. Mortgage title insurance is also required for all first mortgages and for second mortgages in excess of $100,000.
Real Estate – Commercial: We offer commercial real estate loans to finance real estate purchases and refinancing of existing commercial properties. These commercial real estate loans are generally secured by first liens on the real estate, which may include both owner occupied and non-owner occupied facilities. The types of facilities financed include apartments, hotels, warehouses, retail facilities, manufacturing facilities and office buildings. Our underwriting analysis includes credit verification, independent appraisals, a review of the borrower's financial condition, and a detailed analysis of the borrower’s underlying cash flows.
Real Estate – Construction: We offer construction loans for the construction, expansion and improvement of residential and commercial properties which are secured by the real estate being developed. A review of all plans and budgets is performed prior to approval, third party progress documents are required during construction, and an independent approval process for all draw and release requests is maintained to ensure that funding is prudently administered and that funds are sufficient to complete the project.
Installment: We offer traditional direct consumer installment loans for various personal needs, including vehicle and boat financing. The vast majority of these loans are secured by a lien on the purchased vehicle and are underwritten using credit scores and income verification. We do not provide any indirect consumer lending activities.
Income Recognition on Impaired and Nonaccrual Loans
Interest income on mortgage and commercial loans is discontinued and placed on non-accrual status at the time the loan is 90 days delinquent unless the loan is well-secured and in process of collection. Mortgage loans, and commercial loans are charged off to the extent principal or interest is deemed uncollectible. Consumer and credit card loans continue to accrue interest until they are charged off no later than 120 days past due unless the loan is well secured and is in the process of collection. Past-due status is based on the contractual terms of the loan. In all cases, loans are placed on non-accrual or charged-off at an earlier date if collection of principal or interest is considered doubtful. Non-accrual loans and loans past due 90 days still on accrual include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified impaired loans.
All interest accrued but not received for loans placed on non-accrual is reversed against interest income. Interest received on such loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Under the cost-recovery method, interest income is not recognized until the loan balance is reduced to zero. Under the cash-basis method, interest income is recorded when the payment is received in cash. 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 had 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.
Premises and Equipment
Land is carried at cost. Premises and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation and
49
amortization are provided using straight-line and accelerated methods at rates that depreciate the original cost of the premises and equipment over the shorter of their estimated useful lives or the expected lease term in the case of leasehold improvements. Expenditures for maintenance, repairs and renewals of minor items are generally charged to expense as incurred. When premises and equipment are replaced, retired, or deemed no longer useful they are written down to estimated selling price less costs to sell by a charge to current earnings.
Investments in Real Estate Limited Partnerships
We have investments in various real estate limited partnerships that acquire, develop, own and operate low and moderate-income housing. Our ownership interest in these limited partnerships ranges from 5.36% to 99.9% as of December 31, 2014. These investments are made directly in Low Income Housing Tax Credit, or LIHTC, partnerships formed by third parties. As a limited partner in these operating partnerships, we receive tax credits and tax deductions for losses incurred by the underlying properties.
Effective January 1, 2014, the Company adopted Accounting Standards Update (“ASU”) 2014-01, “Investments – Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Qualified Affordable Housing Projects.” The amendment permits an entity to amortize the initial cost of the investment in proportion to the amount of the tax credits and other tax benefits received and recognize the net investment performance in the income statement as a component of income tax expense. This ASU was applied retrospectively and prior periods have been reclassified accordingly. The adoption of this ASU had had a net effect of $0 to net income in the years presented in these financial statements. Merchants has unfunded commitments of $3,019,280 at year-end related to qualified affordable housing project investments, which will be paid in 2015 and 2016. There were no impairment losses during the year resulting from the forfeiture or ineligibility of tax credits related to qualified affordable housing project investments.
Other Real Estate Owned
Collateral acquired through foreclosure is initially recorded at the lower of cost or fair value, less estimated costs to sell, at the time of acquisition, establishing a new cost basis. Any cost in excess of the estimated fair value on the transfer date is charged to the allowance for credit losses. Subsequent decreases in the fair value of other real estate owned (“OREO”) are reflected as a write-down and charged to expense. Net operating income or expense related to foreclosed property is included in noninterest expense in the accompanying consolidated statements of income.
Repurchase Agreements
Repurchase agreements are accounted for as secured financing transactions since we maintain effective control over the transferred securities and the transfer meets the other criteria for such accounting. Obligations to repurchase securities sold are reflected as a liability in the consolidated balance sheets. The securities underlying the agreements are delivered to a custodial account for the benefit of the repurchase agreement holders. The repurchase agreement holders, who may sell, loan or otherwise dispose of such securities to other parties in the normal course of their operations, agree to resell to us the same securities at the maturities of the agreements.
Stock-Based Compensation
The Amended and Restated Merchants Bancshares, Inc. 2008 Stock Incentive Plan provides grants of up to 600,000 stock options or restricted stock awards to certain key employees. We recognize compensation expense for services received in a share-based payment transaction over the required service period, generally defined as the vesting period. The compensation cost is based on the grant-date fair value of the award (as determined by quoted market prices). Stock awards are granted at fair market value on the date of the grant and vest based on a three year service period.
The fair value of an option grant is estimated on the grant date using the Black-Scholes option-pricing model that requires us to develop estimates for assumptions used in the model. The Black-Scholes valuation model uses the following assumptions: expected volatility, expected term of option, risk-free interest rate and dividend yield. Expected volatility estimates are developed by us based on historical volatility of our stock. We use historical data to estimate the expected term of the options. The risk-free interest rate for periods within the expected life of the option is based on the U.S. Treasury yield in effect at the grant date.
Employee Benefit Costs
Prior to 1995, we maintained a non-contributory pension plan covering substantially all employees that met eligibility requirements. The plan was curtailed in 1995. The cost of this plan, based on actuarial computations of current and future benefits, is charged to current operating expenses. We recognize the overfunded or underfunded status of a single employer defined benefit post retirement plan as an asset or liability on the consolidated balance sheets and recognize changes in the funded status in comprehensive income in the year in which the change occurred.
Income Taxes
Deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. Low-income housing tax credits and historic rehabilitation credits are recognized as a reduction of income tax expense in the year in which they are earned. We recognize interest and/or penalties related to income tax matters in other noninterest expense in our consolidated statements of income. Penalties and/or interest were zero or immaterial for 2014, 2013 and 2012. Our policy is to reduce deferred tax assets by a valuation allowance if, based on the weight of available
50
evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.
A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.
Earnings Per Share
Basic earnings per share are calculated by dividing net income available to common shareholders by the weighted average number of common shares outstanding. Diluted earnings per share are computed in a manner similar to that of basic earnings per share except that the weighted average number of common shares outstanding is increased to include the number of additional common shares that would have been outstanding if all potentially dilutive common shares (such as stock options) were issued during the period, computed using the treasury stock method. Shares held in rabbi trusts related to deferred compensation plans are considered outstanding for purposes of computing earnings per share.
Comprehensive Income
Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes unrealized gains and losses on securities available for sale, unrealized gains and losses on cash flow hedges and changes in the funded status of the pension plan, which are also recognized as separate components of equity.
Loss Contingencies
Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there now are such matters that will have a material effect on the financial statements.
Restrictions on Cash
Cash on hand or on deposit with the Federal Reserve Bank was required to meet regulatory reserve and clearing requirements.
Derivative Financial Instruments and Hedging Activities
At the inception of a derivative contract, we designate the derivative as one of three types based on our intentions and belief as to likely effectiveness as a hedge. These three types are (1) a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (“fair value hedge”), (2) a hedge of a forecasted transaction or the variability of cash flows to be received or paid related to a recognized asset or liability (“cash flow hedge”), or (3) an instrument with no hedging designation (“stand-alone derivative”). For a fair value hedge, the gain or loss on the derivative, as well as the offsetting loss or gain on the hedged item, are recognized in current earnings as fair values change. For a cash flow hedge, the gain or loss on the derivative is reported in other comprehensive income and is reclassified into earnings in the same periods during which the hedged transaction affects earnings. For both types of hedges, changes in the fair value of derivatives that are not highly effective in hedging the changes in fair value or expected cash flows of the hedged item are recognized immediately in current earnings. Changes in the fair value of derivatives that do not qualify for hedge accounting are reported currently in earnings, as noninterest income.
Net cash settlements on derivatives that qualify for hedge accounting are recorded in interest income or interest expense, based on the item being hedged. Net cash settlements on derivatives that do not qualify for hedge accounting are reported in noninterest income. Cash flows on hedges are classified in the cash flow statement the same as the cash flows of the items being hedged.
We formally document the relationship between derivatives and hedged items, as well as the risk-management objective and the strategy for undertaking hedge transactions at the inception of the hedging relationship. This documentation includes linking fair value or cash flow hedges to specific assets and liabilities on the balance sheet or to specific firm commitments or forecasted transactions. We also formally assess, both at the hedge’s inception and on an ongoing basis, whether the derivative instruments that are used are highly effective in offsetting changes in fair values or cash flows of the hedged items.
When hedge accounting is discontinued, subsequent changes in fair value of the derivative are recorded as noninterest income. When a fair value hedge is discontinued, the hedged asset or liability is no longer adjusted for changes in fair value and the existing basis adjustment is amortized or accreted over the remaining life of the asset or liability. When a cash flow hedge is discontinued, but the hedged cash flows or forecasted transactions are still expected to occur, gains or losses that were accumulated in other comprehensive income are amortized into earnings over the same periods which the hedged transactions will affect earnings.
Segment Reporting
Our operations are solely in the financial services industry and include providing to our customers traditional banking and other financial services. We operate primarily in the state of Vermont. Management makes operating decisions and assesses performance based on an ongoing review of our consolidated financial results. Therefore, we have a single operating segment for financial reporting purposes.
51
Fair Value Measurements
Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in a separate note. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments, and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect these estimates.
Reclassifications
Reclassifications are made to prior years’ consolidated financial statements whenever necessary to conform to the current year’s presentation. Reclassifications had no effect on prior year net income or shareholders’ equity.
NOTE 2: RECENT ACCOUNTING PRONOUNCEMENTS
In May 2014 the FASB amended existing guidance related to revenue from contracts with customers. This amendment supersedes and replaces nearly all existing revenue recognition guidance, including industry-specific guidance, establishes a new control-based revenue recognition model, changes the basis for deciding when revenue is recognized over time or at a point in time, provides new and more detailed guidance on specific topics and expands and improves disclosures about revenue. In addition, this amendment specifies the accounting for some costs to obtain or fulfill a contract with a customer. These amendments are effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. Early application is not permitted. The amendments should be applied retrospectively to all periods presented or retrospectively with the cumulative effect recognized at the date of initial application. The Company is currently evaluating the impact of this new accounting standard on the consolidated financial statements.
NOTE 3: INVESTMENT SECURITIES
Investments in securities are classified as available for sale or held to maturity as of December 31, 2014 and 2013. The amortized cost and fair values of the securities classified as available for sale and held to maturity as of December 31, 2014 are as follows:
Gross |
Gross |
|||||||
Amortized |
Unrealized |
Unrealized |
Fair |
|||||
(In thousands) |
Cost |
Gains |
Losses |
Value |
||||
Available for Sale: |
||||||||
U.S. Treasury Obligations |
$ |
25,048 |
$ |
57 |
$ |
12 |
$ |
25,093 |
Residential Real Estate Mortgage-backed Securities ("Agency MBSs") |
92,827 | 2,680 | 100 | 95,407 | ||||
Agency Commercial Mortgage Backed Securities ("Agency CMBSs") |
22,056 | 20 | 372 | 21,704 | ||||
Agency Collateralized Mortgage Obligations ("Agency CMOs") |
60,880 | 241 | 239 | 60,882 | ||||
Asset Backed Securities ("ABSs") |
351 | 36 | 0 | 387 | ||||
Total Available for Sale |
$ |
201,162 |
$ |
3,034 |
$ |
723 |
$ |
203,473 |
Gross |
Gross |
|||||||
Amortized |
Unrecognized |
Unrecognized |
Fair |
|||||
Cost |
Gains |
Losses |
Value |
|||||
Held to Maturity: |
||||||||
U.S. Agency Obligations |
$ |
22,072 |
$ |
597 |
$ |
0 |
$ |
22,669 |
U.S. Government Sponsored Enterprises ("U.S. GSEs") |
9,498 | 59 | 0 | 9,557 | ||||
Federal Home Loan Bank ("FHLB") Obligations |
4,720 | 100 | 0 | 4,820 | ||||
Agency CMOs |
94,022 | 280 | 519 | 93,783 | ||||
Agency MBSs |
8,109 | 233 | 0 | 8,342 | ||||
Total Held to Maturity |
$ |
138,421 |
$ |
1,269 |
$ |
519 |
$ |
139,171 |
52
The amortized cost and fair values of the securities classified as available for sale and held to maturity as of December 31, 2013 are as follows:
Gross |
Gross |
|||||||
Amortized |
Unrealized |
Unrealized |
Fair |
|||||
(In thousands) |
Cost |
Gains |
Losses |
Value |
||||
Available for Sale: |
||||||||
U.S. Treasury Obligations |
$ |
100 |
$ |
0 |
$ |
0 |
$ |
100 |
Agency MBSs |
97,882 | 2,876 | 1,487 | 99,271 | ||||
Agency CMBSs |
18,398 | 0 | 760 | 17,638 | ||||
Agency CMOs |
98,162 | 254 | 1,207 | 97,209 | ||||
Collateralized Loan Obligations ("CLOs") |
37,834 | 73 | 0 | 37,907 | ||||
ABSs |
357 | 31 | 0 | 388 | ||||
Total Available for Sale |
$ |
252,733 |
$ |
3,234 |
$ |
3,454 |
$ |
252,513 |
Gross |
Gross |
|||||||
Amortized |
Unrealized |
Unrealized |
Fair |
|||||
Cost |
Gains |
Losses |
Value |
|||||
Held to Maturity: |
||||||||
U.S. Agency Obligations (SBA's only) |
$ |
23,580 |
$ |
0 |
$ |
458 |
$ |
23,122 |
U.S. GSEs |
9,442 | 0 | 512 | 8,930 | ||||
FHLB Obligations |
4,684 | 0 | 191 | 4,493 | ||||
Agency CMOs |
94,105 | 0 | 2,426 | 91,679 | ||||
Agency MBSs |
9,015 | 25 | 177 | 8,863 | ||||
Total Held to Maturity |
$ |
140,826 |
$ |
25 |
$ |
3,764 |
$ |
137,087 |
The contractual final maturity distribution of the debt securities classified as available for sale of December 31, 2014, are as follows:
After One |
After Five |
|||||||||
Within |
But Within |
But Within |
After Ten |
|||||||
(In thousands) |
One Year |
Five Years |
Ten Years |
Years |
Total |
|||||
Available for Sale (at fair value): |
||||||||||
U.S. Treasury Obligations |
$ |
0 |
$ |
25,093 |
$ |
0 |
$ |
0 |
$ |
25,093 |
Agency MBSs |
32 | 2,674 | 21,265 | 71,436 | 95,407 | |||||
Agency CMBSs |
0 | 13,831 | 3,668 | 4,205 | 21,704 | |||||
Agency CMOs |
0 | 0 | 2,301 | 58,581 | 60,882 | |||||
ABSs |
0 | 0 | 0 | 387 | 387 | |||||
Total Available for Sale |
$ |
32 |
$ |
41,598 |
$ |
27,234 |
$ |
134,609 |
$ |
203,473 |
Available for Sale (at amortized cost): |
||||||||||
U.S. Treasury Obligations |
$ |
0 |
$ |
25,048 |
$ |
0 |
$ |
0 |
$ |
25,048 |
Agency MBSs |
31 | 2,538 | 20,514 | 69,744 | 92,827 | |||||
Agency CMBSs |
0 | 13,989 | 3,740 | 4,327 | 22,056 | |||||
Agency CMOs |
0 | 0 | 2,292 | 58,588 | 60,880 | |||||
ABSs |
0 | 0 | 0 | 351 | 351 | |||||
Total Available for Sale |
$ |
31 |
$ |
41,575 |
$ |
26,546 |
$ |
133,010 |
$ |
201,162 |
53
The contractual final maturity distribution of the debt securities classified as held to maturity of December 31, 2014, are as follows:
After One |
After Five |
|||||||||
Within |
But Within |
But Within |
After Ten |
|||||||
(In thousands) |
One Year |
Five Years |
Ten Years |
Years |
Total |
|||||
Held to Maturity (at fair value): |
||||||||||
U.S. Agency Obligations |
$ |
0 |
$ |
0 |
$ |
0 |
$ |
22,669 |
$ |
22,669 |
U.S. GSEs |
0 | 0 | 9,557 | 0 | 9,557 | |||||
FHLB Obligations |
0 | 0 | 4,820 | 0 | 4,820 | |||||
Agency CMOs |
0 | 0 | 0 | 93,783 | 93,783 | |||||
Agency MBSs |
0 | 13 | 111 | 8,218 | 8,342 | |||||
Total Held to Maturity |
$ |
0 |
$ |
13 |
$ |
14,488 |
$ |
124,670 |
$ |
139,171 |
Held to Maturity (at amortized cost): |
||||||||||
U.S. Agency Obligations |
$ |
0 |
$ |
0 |
$ |
0 |
$ |
22,072 |
$ |
22,072 |
U.S. GSEs |
0 | 0 | 9,498 | 0 | 9,498 | |||||
FHLB Obligations |
0 | 0 | 4,720 | 0 | 4,720 | |||||
Agency CMOs |
0 | 0 | 0 | 94,022 | 94,022 | |||||
Agency MBSs |
0 | 13 | 98 | 7,998 | 8,109 | |||||
Total Held to Maturity |
$ |
0 |
$ |
13 |
$ |
14,316 |
$ |
124,092 |
$ |
138,421 |
Actual maturities will differ from contractual maturities because borrowers may have rights to call or prepay obligations. Maturities of Agency MBSs and Agency CMOs in the table above are based on final contractual maturities.
The following table presents the proceeds, gross gains and gross losses on available for sale securities.
(In thousands) |
2014 |
2013 |
2012 |
|||
Proceeds |
$ |
56,889 |
$ |
53,215 |
$ |
129,936 |
Gross gains |
303 | 548 | 811 | |||
Gross losses |
(196) | (560) | (304) | |||
Net gains (losses) |
$ |
107 |
$ |
(12) |
$ |
507 |
Securities with a carrying value of $317.22 million and $315.53 million at December 31, 2014 and 2013, respectively, were pledged to secure public deposits, securities sold under agreements to repurchase, and for other purposes required by law.
Gross unrealized losses on investment securities available for sale and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in continuous unrealized loss position, at December 31, 2014, were as follows:
Less Than 12 Months |
12 Months or More |
Total |
||||||||||
(In thousands) |
Fair Value |
Loss |
Fair Value |
Loss |
Fair Value |
Loss |
||||||
U.S. Treasury Obligations |
$ |
5,080 |
$ |
12 |
$ |
0 |
$ |
0 |
$ |
5,080 |
$ |
12 |
Agency MBSs |
7,893 | 23 |
$ |
10,763 | 77 | 18,656 | 100 | |||||
Agency CMBSs |
0 | 0 | 17,478 | 372 | 17,478 | 372 | ||||||
Agency CMOs |
11,384 | 49 | 10,962 | 190 | 22,346 | 239 | ||||||
Total |
$ |
24,357 |
$ |
84 |
$ |
39,203 |
$ |
639 |
$ |
63,560 |
$ |
723 |
Gross unrecognized losses on investment securities held to maturity and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in continuous unrealized loss position, at December 31, 2014, were as follows:
54
Less Than 12 Months |
12 Months or More |
Total |
||||||||||
(In thousands) |
Fair Value |
Loss |
Fair Value |
Loss |
Fair Value |
Loss |
||||||
Agency CMOs |
14,338 | 108 | 411 | 43,911 | 519 | 411 | 58,249 | 519 | ||||
Agency MBSs |
0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | ||||
Total |
$ |
14,338 |
$ |
108 |
$ |
43,911 |
$ |
411 |
$ |
58,249 |
$ |
519 |
Gross unrealized losses on investment securities available for sale and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in continuous unrealized loss position, at December 31, 2013, were as follows:
Less Than 12 Months |
12 Months or More |
Total |
||||||||||
(In thousands) |
Fair Value |
Loss |
Fair Value |
Loss |
Fair Value |
Loss |
||||||
Available for Sale |
||||||||||||
Agency MBSs |
46,547 | 1,487 | 0 | 0 | 46,547 | 1,487 | ||||||
Agency CMBSs |
12,778 | 578 | 4,860 | 182 | 17,638 | 760 | ||||||
Agency CMOs |
57,904 | 977 | 3,557 | 230 | 61,461 | 1,207 | ||||||
Total |
117,229 | 3,042 | 8,417 | 412 | 125,646 | 3,454 | ||||||
Less Than 12 Months |
12 Months or More |
Total |
||||||||||
(In thousands) |
Fair Value |
Loss |
Fair Value |
Loss |
Fair Value |
Loss |
||||||
Held to Maturity |
||||||||||||
U.S. Agency Obligations |
$ |
13,722 |
$ |
307 |
$ |
9,400 |
$ |
151 |
$ |
23,122 |
$ |
458 |
U.S. GSEs |
8,930 | 512 | 0 | 0 | 8,930 | 512 | ||||||
FHLB Obligations |
4,493 | 191 | 0 | 0 | 4,493 | 191 | ||||||
Agency CMOs |
66,203 | 1,410 | 25,476 | 1,016 | 91,679 | 2,426 | ||||||
Agency MBSs |
8,569 | 177 | 0 | 0 | 8,569 | 177 | ||||||
Total |
$ |
101,917 |
$ |
2,597 |
$ |
34,876 |
$ |
1,167 |
$ |
136,793 |
$ |
3,764 |
There were no securities classified as trading at December 31, 2014 and 2013.
Unrealized losses on investment securities result from the cost basis of the security being higher than its current fair value. These discrepancies generally occur because of changes in interest rates since the time of purchase, or because the credit quality of the issuer has deteriorated. We perform a quarterly analysis of each security in our portfolio to determine if impairment exists, and if it does, whether that impairment is other-than-temporary.
At December 31, 2014, all of our MBSs and CMOs held were issued by U.S. government-sponsored entities and agencies, primarily FNMA and FHLMC, institutions which the government has affirmed its commitment to support. Because the decline in fair value is attributable to changes in interest rates and illiquidity, and not credit quality, and because we do not have the intent to sell these securities and it is not likely that we will be required to sell the securities before their anticipated recovery, we do not consider these securities to be other-than-temporarily impaired at December 31, 2014.
Agency MBSs and Agency CMOs consist of pools of residential mortgages which are guaranteed by FNMA, FHLMC, or Government National Mortgage Association (“GNMA”) with various origination dates and maturities. Agency CMBS consists of bonds backed by commercial real estate which are guaranteed by FNMA and GNMA.
We use external pricing services to obtain fair market values for our investment portfolio. We have obtained and reviewed the service providers’ pricing and reference data documentation. Evaluations are based on market data and vary by asset class and incorporate available trade, bid and other market information. Because many fixed income securities do not trade on a daily basis, the service provider’s evaluated pricing applications apply available information as applicable through processes such as benchmark curves, benchmarking of like securities, sector groupings, and matrix pricing, to prepare evaluations. In addition, model processes, such as the Option Adjusted Spread model are used to assess interest rate impact and develop prepayment scenarios, with inputs determined based on knowledge of the market. We periodically test the values provided to us by the pricing service through a combination of back testing on actual sales of securities and by obtaining prices on all bonds from an alternative pricing source.
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.
55
During 2014, we transferred securities with a total amortized cost of $12.63 million, and a corresponding fair value of $12.64 million, from available for sale to held to maturity. The net unrealized gain, net of taxes, on these securities at the dates of the transfers was $8 thousand. During the third and fourth quarters of 2013, we transferred securities with a total amortized cost of $152.89 million, and a corresponding fair value of $147.45 million, from available for sale to held to maturity. The net unrealized holding loss, net of taxes, on these securities at the dates of the transfers were $3.53 million. The unrealized holding gains and losses at the time of transfer continues to be reported in accumulated other comprehensive income, net of tax and are amortized over the remaining lives of the securities as an adjustment of the yield. The amortization of the unamortized holding gains and losses reported in accumulated other comprehensive income will offset the effect on interest income of the premium and discount for the transferred securities. The remaining unamortized balance of the net losses for the securities transferred from available for sale to held to maturity was $4.35 million or $2.82 million, net of tax at December 31, 2014.
In 2014, the entire CLO portfolio was sold for a small net loss. In 2013 an impairment charge was taken totaling $166 thousand related to the $37.91 million CLO portfolio. Under the Volcker Rule, following a conformance period, we may have been required to divest some or all of our CLOs.
NOTE 4: LOANS AND THE ALLOWANCE FOR CREDIT LOSSES
Loans
The composition of our loan portfolio at December 31, 2014 and 2013 was as follows:
(In thousands) |
December 31, 2014 |
December 31, 2013 |
||
Commercial, financial and agricultural |
$ |
177,597 |
$ |
172,810 |
Municipal loans |
94,366 | 94,007 | ||
Real estate loans – residential |
469,529 | 489,706 | ||
Real estate loans – commercial |
412,447 | 371,319 | ||
Real estate loans – construction |
23,858 | 31,841 | ||
Installment loans |
4,504 | 5,655 | ||
All other loans |
33 | 895 | ||
Total loans |
$ |
1,182,334 |
$ |
1,166,233 |
We primarily originate residential real estate, commercial, commercial real estate, municipal obligations and installment loans to customers throughout the state of Vermont. There are no significant industry concentrations in the loan portfolio. Loans totaled $1.18 billion and $1.17 billion at December 31, 2014 and 2013, respectively. Total loans included $734 thousand and $618 thousand of net deferred loan origination costs at December 31, 2014 and December 31, 2013, respectively. The aggregate amount of overdrawn deposit balances classified as loan balances was $235 thousand and $895 thousand at December 31, 2014 and 2013, respectively.
The following table reflects our loan loss experience and activity in the allowance for credit losses for the twelve months ended December 31, 2014:
(In thousands) |
Commercial, financial and agricultural |
Municipal |
Real estate- residential |
Real estate- commercial |
Real estate-construction |
Installment |
All other |
Totals |
||||||||
Allowance for credit losses: |
||||||||||||||||
Beginning balance |
$ |
3,354 | 768 | 3,081 | 5,085 | 512 | 18 | 10 |
$ |
12,828 | ||||||
Charge-offs |
(34) | 0 | (25) | 0 | 0 | (2) | (170) | (231) | ||||||||
Recoveries |
10 | 0 | 24 | 1 | 0 | 2 | 31 | 68 | ||||||||
Provision (credit) |
1 | (132) | 47 | 165 | (97) | (5) | 171 | 150 | ||||||||
Ending balance |
$ |
3,331 |
$ |
636 |
$ |
3,127 |
$ |
5,251 |
$ |
415 |
$ |
13 |
$ |
42 |
$ |
12,815 |
The following table reflects our loan loss experience and activity in the allowance for credit losses for the twelve months ended December 31, 2013:
56
(In thousands) |
Commercial, financial and agricultural |
Municipal |
Real estate- residential |
Real estate- commercial |
Real estate-construction |
Installment |
All other |
Totals |
||||||||
Allowance for credit losses: |
||||||||||||||||
Beginning balance |
$ |
3,447 |
$ |
522 |
$ |
3,421 |
$ |
4,660 |
$ |
234 |
$ |
17 |
$ |
11 |
$ |
12,312 |
Charge-offs |
(20) | 0 | (289) | (1) | 0 | (9) | (93) | (412) | ||||||||
Recoveries |
62 | 0 | 6 | 40 | 1 | 6 | 13 | 128 | ||||||||
Provision (credit) |
(135) | 246 | (57) | 386 | 277 | 4 | 79 | 800 | ||||||||
Ending balance |
$ |
3,354 |
$ |
768 |
$ |
3,081 |
$ |
5,085 |
$ |
512 |
$ |
18 |
$ |
10 |
$ |
12,828 |
The following table reflects our loan loss experience and activity in the allowance for credit losses for the twelve months ended December 31, 2012:
(In thousands) |
Commercial, financial and agricultural |
Municipal |
Real estate- residential |
Real estate- commercial |
Real estate-construction |
Installment |
All other |
Totals |
||||||||
Allowance for credit losses: |
||||||||||||||||
Beginning balance |
$ |
2,905 |
$ |
309 |
$ |
3,017 |
$ |
4,605 |
$ |
477 |
$ |
23 |
$ |
17 |
$ |
11,353 |
Charge-offs |
(9) | 0 | (20) | (32) | 0 | 0 | 0 | (61) | ||||||||
Recoveries |
30 | 0 | 14 | 1 | 25 | 0 | 0 | 70 | ||||||||
Provision (credit) |
521 | 213 | 410 | 86 | (268) | (6) | (6) | 950 | ||||||||
Ending balance |
$ |
3,447 |
$ |
522 |
$ |
3,421 |
$ |
4,660 |
$ |
234 |
$ |
17 |
$ |
11 |
$ |
12,312 |
The allowance for credit losses consists of the allowance for loan losses and the reserve for undisbursed lines of credit. The reserve for undisbursed lines of credit is included in other liabilities on the balance sheet. The following presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment based upon impairment method at December 31, 2014:
(In thousands) |
Commercial, financial and agricultural |
Municipal |
Real estate- residential |
Real estate- commercial |
Real estate-construction |
Installment |
All other |
Totals |
||||||||
Allowance for credit losses: |
||||||||||||||||
Ending balance individually evaluated for impairment |
$ |
0 | 0 | 63 | 0 | 0 | 0 | 0 |
$ |
63 | ||||||
Ending balance collectively evaluated for impairment |
3,331 | 636 | 3,064 | 5,251 | 415 | 13 | 42 | 12,752 | ||||||||
Totals |
$ |
3,331 |
$ |
636 |
$ |
3,127 |
$ |
5,251 |
$ |
415 |
$ |
13 |
$ |
42 |
$ |
12,815 |
Financing receivables: |
||||||||||||||||
Ending balance individually evaluated for impairment |
$ |
134 | 0 | 657 | 0 | 0 | 0 | 0 |
$ |
791 | ||||||
Ending balance collectively evaluated for impairment |
177,463 | 94,366 | 468,872 | 412,447 | 23,858 | 4,504 | 33 | 1,181,543 | ||||||||
Totals |
$ |
177,597 |
$ |
94,366 |
$ |
469,529 |
$ |
412,447 |
$ |
23,858 |
$ |
4,504 |
$ |
33 |
$ |
1,182,334 |
Components: |
||||||||||||||||
Allowance for loan losses |
$ |
2,583 | 623 | 3,038 | 5,209 | 325 | 13 | 42 |
$ |
11,833 | ||||||
Reserve for undisbursed lines of credit |
748 | 13 | 89 | 42 | 90 | 0 | 0 | 982 | ||||||||
Total allowance for credit losses |
$ |
3,331 |
$ |
636 |
$ |
3,127 |
$ |
5,251 |
$ |
415 |
$ |
13 |
$ |
42 |
$ |
12,815 |
57
The following presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment based upon impairment method at December 31, 2013:
(In thousands) |
Commercial, financial and agricultural |
Municipal |
Real estate- residential |
Real estate- commercial |
Real estate-construction |
Installment |
All other |
Totals |
||||||||
Allowance for credit losses: |
||||||||||||||||
Ending balance individually evaluated for impairment |
$ |
2 |
$ |
0 |
$ |
41 |
$ |
69 |
$ |
0 |
$ |
0 |
$ |
0 |
$ |
112 |
Ending balance collectively evaluated for impairment |
3,352 | 768 | 3,040 | 5,016 | 512 | 18 | 10 | 12,716 | ||||||||
Totals |
$ |
3,354 |
$ |
768 |
$ |
3,081 |
$ |
5,085 |
$ |
512 |
$ |
18 |
$ |
10 |
$ |
12,828 |
Financing receivables: |
||||||||||||||||
Ending balance individually evaluated for impairment |
$ |
20 |
$ |
0 |
$ |
722 |
$ |
164 |
$ |
0 |
$ |
0 |
$ |
0 |
$ |
906 |
Ending balance collectively evaluated for impairment |
172,790 | 94,007 | 488,984 | 371,155 | 31,841 | 5,655 | 895 | 1,165,327 | ||||||||
Totals |
$ |
172,810 |
$ |
94,007 |
$ |
489,706 |
$ |
371,319 |
$ |
31,841 |
$ |
5,655 |
$ |
895 |
$ |
1,166,233 |
Components: |
||||||||||||||||
Allowance for loan losses |
$ |
2,740 |
$ |
758 |
$ |
2,995 |
$ |
5,040 |
$ |
481 |
$ |
18 |
$ |
10 |
$ |
12,042 |
Reserve for undisbursed lines of credit |
614 | 10 | 86 | 45 | 31 | 0 | 0 | 786 | ||||||||
Total allowance for credit losses |
$ |
3,354 |
$ |
768 |
$ |
3,081 |
$ |
5,085 |
$ |
512 |
$ |
18 |
$ |
10 |
$ |
12,828 |
The table below presents the recorded investment of loans, including nonperforming and restructured loans, segregated by class, with delinquency aging as of December 31, 2014:
31-60 Days |
61-90 Days |
91 Days or More |
Total Past |
91 Days or more past due and |
||||||||||
(In thousands) |
Past Due |
Past Due |
Past Due |
Due |
Current |
Total |
Accruing |
|||||||
Commercial, financial and agricultural |
$ |
49 | 0 | 0 |
$ |
49 |
$ |
177,548 |
$ |
177,597 |
$ |
0 | ||
Municipal |
0 | 0 | 0 | 0 | 94,366 | 94,366 | 0 | |||||||
Real estate-residential: |
||||||||||||||
First mortgage |
157 | 0 | 391 | 548 | 431,191 | 431,739 | 0 | |||||||
Second mortgage |
33 | 0 | 79 | 112 | 37,678 | 37,790 | 0 | |||||||
Real estate-commercial: |
||||||||||||||
Owner occupied |
0 | 22 | 0 | 22 | 260,075 | 260,097 | 0 | |||||||
Non-owner occupied |
202 | 0 | 0 | 202 | 152,148 | 152,350 | 0 | |||||||
Real estate-construction: |
||||||||||||||
Residential |
0 | 0 | 0 | 0 | 4,131 | 4,131 | 0 | |||||||
Commercial |
0 | 0 | 0 | 0 | 19,727 | 19,727 | 0 | |||||||
Installment |
0 | 0 | 0 | 0 | 4,504 | 4,504 | 0 | |||||||
Other |
0 | 0 | 0 | 0 | 33 | 33 | 0 | |||||||
Total |
$ |
441 |
$ |
22 |
$ |
470 |
$ |
933 |
$ |
1,181,401 |
$ |
1,182,334 |
$ |
0 |
Of the total past due loans in the aging table above, $519 thousand are non-performing of which $0 are restructured loans and $0 were 91 days or more past due and accruing. There were $414 thousand past due performing loans at December 31, 2014.
58
The table below presents the recorded investment of loans, including nonaccrual and restructured loans, segregated by class, with delinquency aging as of December 31, 2013:
31-60 Days |
61-90 Days |
91 Days or More |
Total Past |
91 Days or more past due and |
||||||||||
(In thousands) |
Past Due |
Past Due |
Past Due |
Due |
Current |
Total |
Accruing |
|||||||
Commercial, financial and agricultural |
$ |
0 |
$ |
0 |
$ |
20 |
$ |
20 |
$ |
172,790 |
$ |
172,810 |
$ |
0 |
Municipal |
0 | 0 | 0 | 0 | 94,007 | 94,007 | 0 | |||||||
Real estate-residential: |
||||||||||||||
First mortgage |
4 | 294 | 341 | 639 | 452,440 | 453,079 | 0 | |||||||
Second mortgage |
0 | 4 | 181 | 185 | 36,442 | 36,627 | 75 | |||||||
Real estate-commercial: |
||||||||||||||
Owner occupied |
0 | 0 | 0 | 0 | 224,416 | 224,416 | 0 | |||||||
Non-owner occupied |
72 | 0 | 0 | 72 | 146,831 | 146,903 | 0 | |||||||
Real estate-construction: |
||||||||||||||
Residential |
0 | 0 | 0 | 0 | 2,495 | 2,495 | 0 | |||||||
Commercial |
0 | 0 | 0 | 0 | 29,346 | 29,346 | 0 | |||||||
Installment |
0 | 0 | 0 | 0 | 5,655 | 5,655 | 0 | |||||||
Other |
0 | 0 | 0 | 0 | 895 | 895 | 0 | |||||||
Total |
$ |
76 |
$ |
298 |
$ |
542 |
$ |
916 |
$ |
1,165,317 |
$ |
1,166,233 |
$ |
75 |
Of the total past due loans in the aging table above, $542 thousand are non-performing of which $42 thousand are restructured loans and $75 thousand were greater than 90 days past due and accruing. There were $374 thousand past due performing loans at December 31, 2013.
Impaired loans by class at December 31, 2014 are as follows:
(In thousands) |
Recorded Investment |
Unpaid Principal Balance |
Related Allowance |
Average Recorded Investment |
||||
With no related allowance recorded |
||||||||
Commercial, financial and agricultural |
$ |
134 |
$ |
136 |
$ |
0 |
$ |
86 |
Real estate – residential: |
||||||||
First mortgage |
147 | 257 | 0 | 256 | ||||
Second mortgage |
79 | 79 | 0 | 136 | ||||
Real estate – commercial: |
||||||||
Owner occupied |
0 | 0 | 0 | 12 | ||||
Non-owner occupied |
0 | 0 | 0 | 0 | ||||
Installment |
0 | 0 | 0 | 0 | ||||
With related allowance recorded |
||||||||
Commercial, financial and agricultural |
0 | 0 | 0 | 12 | ||||
Real estate – residential: |
||||||||
First mortgage |
431 | 432 | 63 | 204 | ||||
Second mortgage |
0 | 0 | 0 | 0 | ||||
Real estate – commercial: |
||||||||
Owner occupied |
0 | 0 | 0 | 119 | ||||
Installment |
0 | 0 | 0 | 0 | ||||
Total |
||||||||
Commercial, financial and agricultural |
134 | 136 | 0 | 98 | ||||
Real estate – residential |
657 | 768 | 63 | 596 | ||||
Real estate – commercial |
0 | 0 | 0 | 131 | ||||
Installment |
0 | 0 | 0 | 0 | ||||
Total |
$ |
791 |
$ |
904 |
$ |
63 |
$ |
825 |
59
Impaired loans by class at December 31, 2013 are as follows:
(In thousands) |
Recorded Investment |
Unpaid Principal Balance |
Related Allowance |
Average Recorded Investment |
||||
With no related allowance recorded |
||||||||
Commercial, financial and agricultural |
$ |
0 |
$ |
0 |
$ |
0 |
$ |
211 |
Real estate – residential: |
||||||||
First mortgage |
410 | 629 | 0 | 541 | ||||
Second mortgage |
181 | 218 | 0 | 145 | ||||
Real estate – commercial: |
||||||||
Owner occupied |
0 | 0 | 0 | 93 | ||||
Non-owner occupied |
0 | 0 | 0 | 0 | ||||
Installment |
0 | 0 | 0 | 1 | ||||
With related allowance recorded |
||||||||
Commercial, financial and agricultural |
20 | 21 | 2 | 343 | ||||
Real estate – residential: |
||||||||
First mortgage |
131 | 135 | 41 | 512 | ||||
Second mortgage |
0 | 0 | 0 | 246 | ||||
Real estate – commercial: |
||||||||
Owner occupied |
164 | 175 | 69 | 170 | ||||
Installment |
0 | 0 | 0 | 5 | ||||
Total |
||||||||
Commercial, financial and agricultural |
20 | 21 | 2 | 554 | ||||
Real estate – residential |
722 | 982 | 41 | 1,444 | ||||
Real estate – commercial |
164 | 175 | 69 | 263 | ||||
Installment |
0 | 0 | 0 | 6 | ||||
Total |
$ |
906 |
$ |
1,178 |
$ |
112 |
$ |
2,267 |
Impaired loans by class at December 31, 2012 are as follows:
(In thousands) |
Recorded Investment |
Unpaid Principal Balance |
Related Allowance |
Average Recorded Investment |
||||
With no related allowance recorded |
||||||||
Commercial, financial and agricultural |
$ |
7 |
$ |
22 |
$ |
0 |
$ |
39 |
Real estate – residential: |
||||||||
First mortgage |
853 | 1,010 | 0 | 807 | ||||
Second mortgage |
16 | 17 | 0 | 247 | ||||
Real estate – commercial: |
||||||||
Owner occupied |
295 | 367 | 0 | 380 | ||||
Non-owner occupied |
0 | 0 | 0 | 0 | ||||
Installment |
0 | 0 | 0 | 1 | ||||
With related allowance recorded |
||||||||
Commercial, financial and agricultural |
226 | 228 | 149 | 37 | ||||
Real estate – residential: |
||||||||
First mortgage |
748 | 766 | 173 | 662 | ||||
Second mortgage |
700 | 700 | 188 | 320 | ||||
Real estate – commercial: |
||||||||
Non-owner occupied |
177 | 179 | 59 | 136 | ||||
Total |
||||||||
Commercial, financial and agricultural |
233 | 250 | 149 | 76 | ||||
Real estate – residential |
2,317 | 2,493 | 361 | 2,036 | ||||
Real estate – commercial |
472 | 546 | 59 | 516 | ||||
Installment and other |
0 | 0 | 0 | 1 | ||||
Total |
$ |
3,022 |
$ |
3,289 |
$ |
569 |
$ |
2,629 |
60
Interest income recorded on impaired loans was immaterial for the years ended December 31, 2014, 2013, and 2012.
Residential and commercial loans serviced for others at December 31, 2014 and 2013 amounted to approximately $13.53 million and $13.83 million, respectively.
Nonperforming loans at December 31, 2014 and 2013 are as follows:
(In thousands) |
December 31, 2014 |
December 31, 2013 |
||
Nonaccrual loans |
$ |
598 |
$ |
425 |
Loans greater than 90 days and accruing |
0 | 75 | ||
Troubled debt restructurings ("TDRs") |
193 | 406 | ||
Total nonperforming loans |
$ |
791 |
$ |
906 |
Of the total TDRs in the table above, $63 thousand at December 31, 2014 and $235 thousand at December 31, 2013, are non-accruing. There were three commercial loans restructured with a balance of $46 thousand and one residential loan restructured with a balance of $55 thousand in 2014. We have reviewed all restructurings that occurred on or after January 1, 2014 for identification as TDRs. We did not identify as a TDR any loans for which the allowance for credit losses had been measured under a general allowance for credit losses methodology.
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. There were four restructured residential mortgages at December 31, 2014 with balances totaling $147 thousand. There were three restructured commercial loans at December 31, 2014 with a balance of $46 thousand. No loans were restructured in 2013. All of the TDRs at December 31, 2014 continue to pay as agreed according to the modified terms. At December 31, 2014, there were no commitments to lend additional funds to borrowers whose loans have been modified in a troubled debt restructuring. We had no commitments to lend additional funds to borrowers whose loans were in nonaccrual status or to borrowers whose loans were 91 days past due and still accruing at December 31, 2014. Interest income on restructured loans during years ended December 31, 2014 and 2013 was insignificant.
Nonaccrual loans by class as of December 31, 2014 and 2013 are as follows:
(In thousands) |
December 31, 2014 |
December 31, 2013 |
||
Commercial, financial and agricultural |
$ |
88 |
$ |
20 |
Real estate - residential: |
||||
First mortgage |
431 | 299 | ||
Second mortgage |
79 | 106 | ||
Real estate - commercial: |
||||
Owner occupied |
0 | 0 | ||
Non owner occupied |
0 | 0 | ||
Installment |
0 | 0 | ||
Total nonaccruing non-TDR loans |
$ |
598 |
$ |
425 |
Nonaccruing TDR’s |
||||
Commercial, financial and agricultural |
5 | 0 | ||
Real estate – residential: |
||||
First mortgage |
58 | 71 | ||
Real estate - commercial: |
||||
Owner occupied |
0 | 164 | ||
Total nonaccrual loans including TDRs |
$ |
661 |
$ |
660 |
Commercial Grading System
We use risk rating definitions for our commercial loan portfolios and certain residential loans which are generally consistent with regulatory and banking industry norms. Loans are assigned a credit quality grade which is based upon management’s on-going assessment of risk based upon an evaluation of the quantitative and qualitative aspects of each credit. This assessment is a dynamic process and risk ratings are adjusted as each borrower’s financial situation changes. This process is designed to provide timely recognition of a borrower’s financial condition and appropriately focus management resources.
Pass rated loans exhibit acceptable risk to the bank in terms of financial capacity to repay their loans as well as possessing acceptable fallback repayment sources, typically collateral and personal guarantees. Pass rated commercial loan relationships with a total exposure of $1 million or greater are subject to a formal annual review process; additionally, management reviews the risk rating at the time of any late payments, overdrafts or other sign of deterioration in the interim.
61
Loans rated Pass-Watch require more than usual attention and monitoring by the account officer, though not to the extent that a formal remediation plan is warranted. Borrowers can be rated Pass-Watch based upon a weakened capital structure, marginally adequate cash flow and/or collateral coverage or early-stage declining trends in operations or financial condition.
Loans rated Special Mention possess potential weakness that may expose the bank to some risk of loss in the future. These loans require more frequent monitoring and formal reporting to Management.
Substandard loans reflect well-defined weaknesses in the current repayment capacity, collateral or net worth of the borrower with the possibility of some loss to the bank if these weaknesses are not corrected. Action plans are required for these loans to address the inherent weakness in the credit and are formally reviewed.
Residential real estate and consumer loans
We do not use a grading system for our performing residential real estate and consumer loans. Credit quality for these loans is based on performance and payment status.
Below is a summary of loans by credit quality indicator as of December 31, 2014:
Pass- |
Special |
Sub- |
||||||||||
(In thousands) |
Unrated |
Pass |
Watch |
Mention |
Standard |
Total |
||||||
Commercial, financial and agricultural |
$ |
352 | 143,813 | 21,563 | 3,942 | 7,927 |
$ |
177,597 | ||||
Municipal |
40 | 75,337 | 17,101 | 1,888 | 0 | 94,366 | ||||||
Real estate – residential: |
||||||||||||
First mortgage |
428,073 | 3,046 | 170 | 0 | 450 | 431,739 | ||||||
Second mortgage |
37,790 | 0 | 0 | 0 | 0 | 37,790 | ||||||
Real estate – commercial: |
||||||||||||
Owner occupied |
187 | 220,651 | 18,708 | 1,378 | 19,173 | 260,097 | ||||||
Non-owner occupied |
189 | 130,218 | 20,773 | 0 | 1,170 | 152,350 | ||||||
Real estate – construction: |
||||||||||||
Residential |
288 | 3,843 | 0 | 0 | 0 | 4,131 | ||||||
Commercial |
170 | 17,588 | 40 | 0 | 1,929 | 19,727 | ||||||
Installment |
4,504 | 0 | 0 | 0 | 0 | 4,504 | ||||||
All other loans |
33 | 0 | 0 | 0 | 0 | 33 | ||||||
Total |
$ |
471,626 |
$ |
594,496 |
$ |
78,355 |
$ |
7,208 |
$ |
30,649 |
$ |
1,182,334 |
Below is a summary of loans by credit quality indicator as of December 31, 2013:
Pass- |
Special |
Sub- |
||||||||||
(In thousands) |
Unrated |
Pass |
Watch |
Mention |
Standard |
Total |
||||||
Commercial, financial and agricultural |
$ |
242 |
$ |
152,466 |
$ |
14,092 |
$ |
96 |
$ |
5,914 |
$ |
172,810 |
Municipal |
28 | 65,474 | 26,548 | 1,957 | 0 | 94,007 | ||||||
Real estate – residential: |
||||||||||||
First mortgage |
449,951 | 2,520 | 0 | 65 | 543 | 453,079 | ||||||
Second mortgage |
36,599 | 0 | 0 | 0 | 28 | 36,627 | ||||||
Real estate – commercial: |
||||||||||||
Owner occupied |
165 | 187,779 | 17,236 | 2,342 | 16,894 | 224,416 | ||||||
Non-owner occupied |
171 | 134,222 | 9,841 | 270 | 2,399 | 146,903 | ||||||
Real estate – construction: |
||||||||||||
Residential |
904 | 1,591 | 0 | 0 | 0 | 2,495 | ||||||
Commercial |
738 | 28,127 | 481 | 0 | 0 | 29,346 | ||||||
Installment |
5,655 | 0 | 0 | 0 | 0 | 5,655 | ||||||
All other loans |
895 | 0 | 0 | 0 | 0 | 895 | ||||||
Total |
$ |
495,348 |
$ |
572,179 |
$ |
68,198 |
$ |
4,730 |
$ |
25,778 |
$ |
1,166,233 |
62
NOTE 5: FAIR VALUE OF FINANCIAL INSTRUMENTS
We record certain assets and liabilities at fair value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value measurements are also utilized to determine the initial value of certain assets and liabilities, to perform impairment assessments, and for disclosure purposes. We use quoted market prices and observable inputs to the maximum extent possible when measuring fair value. In the absence of quoted market prices, various valuation techniques are utilized to measure fair value. When possible, observable market data for identical or similar financial instruments are used in the valuation. When market data is not available, fair value is determined using valuation models that incorporate Management’s estimates of the assumptions a market participant would use in pricing the asset or liability.
Our valuation methodologies may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. While Management believes our valuation methodologies are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. Furthermore, the reported fair value amounts have not been comprehensively revalued since the presentation dates, and therefore, estimates of fair value after the balance sheet date may differ significantly from the amounts presented herein. A more detailed description of the valuation methodologies used for assets and liabilities measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy, is set forth below.
The fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurement) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are described below:
|
Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities. |
|
Level 2 - Quoted prices for similar assets or liabilities in active markets, quoted prices in markets that are not active, or inputs that are observable, either directly or indirectly, for substantially the full term of the asset or liability. |
|
Level 3 - Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e. supported by little or no market activity). |
A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.
The types of instruments valued based on quoted market prices in active markets include most U.S. government and Agency securities, liquid mortgage products, active listed equities and most money market securities. Such instruments are generally classified within Level 1 or Level 2 of the fair value hierarchy. We do not adjust the quoted price for such instruments.
The types of instruments valued based on quoted prices in markets that are not active, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency include most investment-grade and high-yield corporate bonds, less liquid mortgage products, less liquid Agency securities, less liquid listed equities, state, municipal and provincial obligations, and certain physical commodities. Such instruments are generally classified within Level 2 of the fair value hierarchy.
Level 3 is for positions that are not traded in active markets or are subject to transfer restrictions; valuations are adjusted to reflect illiquidity and/or non-transferability, and such adjustments are generally based on available market evidence. In the absence of such evidence, Management’s best estimate will be used. Management’s best estimate consists of both internal and external support on certain Level 3 investments. Subsequent to inception, Management only changes Level 3 inputs and assumptions when corroborated by evidence such as transactions in similar instruments, completed or pending third-party transactions in the underlying investment or comparable entities, subsequent rounds of financing, recapitalizations and other transactions across the capital structure, offerings in the equity or debt markets, and changes in financial ratios or cash flows.
63
Financial instruments on a recurring basis
The table below presents the balance of financial assets and liabilities at December 31, 2014 measured at fair value on a recurring basis:
Fair Value Measurements at Reporting Date Using |
||||||||
Quoted Prices in Active Markets for Identical Assets |
Significant Other Observable Inputs |
Significant Unobservable Inputs |
||||||
(In thousands) |
Total |
(Level 1) |
(Level 2) |
(Level 3) |
||||
Assets |
||||||||
U.S. Treasury Obligations |
$ |
25,093 |
$ |
0 |
$ |
25,093 |
$ |
0 |
Agency MBSs |
95,407 | 0 | 95,407 | 0 | ||||
Agency CMBSs |
21,704 | 0 | 21,704 | 0 | ||||
Agency CMOs |
60,882 | 0 | 60,882 | 0 | ||||
ABSs |
387 | 0 | 387 | 0 | ||||
Interest rate swap agreements |
618 | 0 | 618 | 0 | ||||
Total assets |
$ |
204,091 |
$ |
0 |
$ |
204,091 |
$ |
0 |
Liabilities |
||||||||
Interest rate swap agreements |
1,096 | 0 | 1,096 | 0 | ||||
Total liabilities |
$ |
1,096 |
$ |
0 |
$ |
1,096 |
$ |
0 |
The table below presents the balance of financial assets and liabilities at December 31, 2013 measured at fair value on a recurring basis:
Fair Value Measurements at Reporting Date Using |
||||||||
Quoted Prices in Active Markets for Identical Assets |
Significant Other Observable Inputs |
Significant Unobservable Inputs |
||||||
(In thousands) |
Total |
(Level 1) |
(Level 2) |
(Level 3) |
||||
Assets |
||||||||
U.S. Treasury Obligations |
$ |
100 |
$ |
0 |
$ |
100 |
$ |
0 |
Agency MBSs |
99,271 | 0 | 99,271 | 0 | ||||
Agency CMBSs |
17,638 | 0 | 17,638 | 0 | ||||
Agency CMOs |
97,209 | 0 | 97,209 | 0 | ||||
CLOs |
37,907 | 0 | 37,907 | 0 | ||||
ABSs |
388 | 0 | 388 | 0 | ||||
Interest rate swap agreements |
803 | 0 | 803 | 0 | ||||
Total assets |
$ |
253,316 |
$ |
0 |
$ |
253,316 |
$ |
0 |
Liabilities |
||||||||
Interest rate swap agreements |
1,529 | 0 | 1,529 | 0 | ||||
Total liabilities |
$ |
1,529 |
$ |
0 |
$ |
1,529 |
$ |
0 |
Investment securities are reported at fair value utilizing Level 2 inputs. The prices for these instruments are obtained through an independent pricing service or dealer market participant with whom we have historically transacted both purchases and sales of investment securities. Prices obtained from these sources include market quotations and matrix pricing. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things. More information regarding our investment securities can be found in Note 3 to these consolidated financial statements.
The interest rate swaps are reported at their fair value utilizing Level 2 inputs from third parties. The fair value of our interest rate swaps are determined using prices obtained from a third party advisor. The fair value measurement of the interest rate swap is determined by netting the discounted future fixed cash payments and the discounted expected variable cash receipts. The variable cash receipts are based on the expectation of future interest rates derived from observed market interest rate curves.
64
There were no transfers between Level 1 and Level 2 for the year ended December 31, 2014 or December 31, 2013. There were no Level 3 assets measured at fair value on a recurring basis during the year ended December 31, 2014.
Financial instruments on a non-recurring basis
Certain financial assets are also measured at fair value on a non-recurring basis, however they were not material at December 31, 2014 or December 31, 2013. These financial assets include impaired loans and OREO.
The fair value of Merchants’ financial instruments as of December 31, 2014 are summarized in the table below:
Carrying |
||||||||||
(In thousands) |
Amount |
Fair Value |
Level 1 |
Level 2 |
Level 3 |
|||||
Cash and cash equivalents |
$ |
154,459 |
$ |
154,459 |
$ |
154,459 |
$ |
0 |
$ |
0 |
Securities available for sale |
203,473 | 203,473 | 0 | 203,473 | 0 | |||||
Securities held to maturity |
138,421 | 139,171 | 0 | 139,171 | 0 | |||||
FHLB stock |
4,378 |
N/A |
N/A |
N/A |
N/A |
|||||
Loans, net of allowance for loan losses |
1,170,501 | 1,172,517 | 0 | 0 | 1,172,517 | |||||
Interest rate swap agreement |
618 | 618 | 0 | 618 | 0 | |||||
Accrued interest receivable |
3,787 | 3,787 | 0 | 847 | 2,940 | |||||
Total |
$ |
1,675,637 |
$ |
1,674,025 |
$ |
154,459 |
$ |
344,109 |
$ |
1,175,457 |
Deposits |
$ |
1,308,772 |
$ |
1,308,904 |
$ |
1,097,088 |
$ |
211,816 |
$ |
0 |
Securities sold under agreement to repurchase |
258,464 | 258,438 | 0 | 258,438 | 0 | |||||
Other long-term debt |
2,320 | 2,277 | 0 | 2,277 | 0 | |||||
Junior subordinated debentures issued to unconsolidated subsidiary trust |
20,619 | 14,476 | 0 | 14,476 | 0 | |||||
Interest rate swap agreement |
1,096 | 1,096 | 0 | 1,096 | 0 | |||||
Accrued interest payable |
165 | 165 | 19 | 146 | 0 | |||||
Total |
$ |
1,591,436 |
$ |
1,585,356 |
$ |
1,097,107 |
$ |
488,249 |
$ |
0 |
The fair value of Merchants’ financial instruments as of December 31, 2013 are summarized in the table below:
Carrying |
||||||||||
(In thousands) |
Amount |
Fair Value |
Level 1 |
Level 2 |
Level 3 |
|||||
Cash and cash equivalents |
$ |
115,471 |
$ |
115,471 |
$ |
115,471 |
$ |
0 |
$ |
0 |
Securities available for sale |
252,513 | 252,513 | 0 | 252,513 | 0 | |||||
Securities held to maturity |
140,826 | 137,087 | 0 | 137,087 | 0 | |||||
FHLB stock |
7,496 |
N/A |
N/A |
N/A |
N/A |
|||||
Loans, net of allowance for loan losses |
1,154,191 | 1,155,348 | 0 | 0 | 1,155,348 | |||||
Interest rate swap agreement |
803 | 803 | 0 | 803 | 0 | |||||
Accrued interest receivable |
3,982 | 3,982 | 0 | 958 | 3,024 | |||||
Total |
$ |
1,675,282 |
$ |
1,665,204 |
$ |
115,471 |
$ |
391,361 |
$ |
1,158,372 |
Deposits |
$ |
1,323,576 |
$ |
1,324,634 |
$ |
1,018,470 |
$ |
306,162 |
$ |
0 |
Securities sold under agreement to repurchase |
250,314 | 250,290 | 0 | 250,290 | 0 | |||||
Other long-term debt |
2,403 | 2,287 | 0 | 2,287 | 0 | |||||
Junior subordinated debentures issued to unconsolidated subsidiary trust |
20,619 | 14,189 | 0 | 14,189 | 0 | |||||
Interest rate swap agreement |
1,529 | 1,529 | 0 | 1,529 | 0 | |||||
Accrued interest payable |
214 | 214 | 15 | 199 | 0 | |||||
Total |
$ |
1,598,654 |
$ |
1,593,143 |
$ |
1,018,485 |
$ |
574,656 |
$ |
0 |
The carrying amounts reported in the consolidated balance sheets for cash and cash equivalents, accrued interest receivable and accrued interest payable approximate fair value. It is not practical to determine the fair value of FHLB stock due to restrictions placed on its transferability.
The methodologies for other financial assets and financial liabilities are discussed below.
65
Loans - The fair value for loans is estimated using discounted cash flow analyses, using interest rates and spreads currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.
Deposits - The fair value of deposits with no stated maturity, which includes demand, savings, interest bearing checking and money market accounts, is equal to the amount payable on demand resulting in a Level 1 classification. The fair value of variable rate, fixed term certificates of deposit also approximates the carrying amount reported in the consolidated balance sheets. The fair value of fixed rate and fixed term certificates of deposit is estimated using a discounted cash flow method which applies interest rates currently being offered for deposits of similar remaining maturities resulting in a Level 2 classification.
Debt - The fair value of debt is estimated using current market rates for borrowings of similar remaining maturity resulting in a Level 2 classification.
Commitments to Extend Credit and Standby Letters of Credit - The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of financial standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties. The fair value of commitments to extend credit and standby letters of credit is approximately $47 thousand at December 31, 2014 and $47 thousand as of December 31, 2013, respectively.
Limitations ‑ Fair value estimates are made at a specific point in time based on relevant market information and information about the financial instruments. Because no market exists for a significant portion of the financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other such factors.
These estimates do not reflect any premium or discount that could result from offering for sale at one time our entire holdings of a particular financial instrument. These estimates are subjective in nature and require considerable judgment to interpret market data. Accordingly, the estimates presented herein are not necessarily indicative of the amounts we could realize in a current market exchange, nor are they intended to represent the fair value of us as a whole. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. The fair value estimates presented herein are based on pertinent information available to Management as of the respective balance sheet date. Although we are not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued since the presentation dates, and therefore, estimates of fair value after the balance sheet date may differ significantly from the amounts presented herein.
Other significant assets, such as premises and equipment, other assets, and liabilities not defined as financial instruments, are not included in the above disclosures. Also, the fair value estimates for deposits do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market.
66
NOTE 6: PREMISES AND EQUIPMENT
The components of premises and equipment included in the accompanying consolidated balance sheets are as follows:
(In thousands) |
2014 |
2013 |
Estimated Useful Lives (In years) |
||
Land |
$ |
332 |
$ |
332 |
N/A |
Bank premises |
6,789 | 6,782 |
39 |
||
Leasehold improvements |
9,936 | 9,276 |
5 – 20 |
||
Furniture, equipment, and software |
19,346 | 17,694 |
3 – 7 |
||
Total gross fixed assets |
36,403 | 34,084 | |||
Less: accumulated depreciation and amortization |
20,911 | 18,512 | |||
Total net fixed assets |
$ |
15,492 |
$ |
15,572 |
Depreciation and amortization expense related to premises and equipment amounted to $2.45 million, $2.18 million and $1.95 million in 2014, 2013 and 2012, respectively.
We occupy certain banking offices under non-cancellable operating lease agreements expiring at various dates over the next 20 years. The majority of leases have multiple options with escalation clauses for increases associated with the cost of living or other variable expenses over time. Rent expense on these properties totaled $1.32 million, $1.20 million and $1.08 million for the years ended December 31, 2014, 2013 and 2012, respectively.
Minimum lease payments on these properties subsequent to December 31, 2014 are as follows:
(In thousands) |
Amount |
|
2015 |
$ |
1,554 |
2016 |
1,385 | |
2017 |
1,210 | |
2018 |
953 | |
2019 |
908 | |
Thereafter |
5,844 | |
Total |
$ |
11,854 |
We entered into a sale leaseback arrangement for our principal office in South Burlington, Vermont, in June 2008. The deferred gain on the sale leaseback transaction resulted in a $423 thousand offset to rent expense per year through 2017 and $212 thousand in 2018. The deferred gain included in other liabilities totaled $1,481 thousand and $1,904 thousand at December 31, 2014 and 2013, respectively.
We entered into a sale leaseback arrangement for one of our branch locations in Burlington, Vermont in December 2013. The deferred gain on the sale leaseback transaction will result in a $93 thousand offset to rent expense per year through 2023. The deferred gain included in other liabilities totaled $841 thousand and $934 thousand at December 31, 2014 and 2013.
NOTE 7: TIME DEPOSITS
Scheduled maturities of time deposits at December 31, 2014 were as follows:
(In thousands) |
||
Mature in year ending December 31, |
||
2015 |
145,648 | |
2016 |
36,042 | |
2017 |
8,165 | |
2018 |
10,055 | |
2019 |
10,882 | |
Thereafter |
892 | |
Total time deposits |
$ |
211,684 |
Time deposits greater than $250 thousand totaled $27.64 million and $44.05 million as of December 31, 2014 and 2013, respectively.
67
NOTE 8: SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE AND OTHER SHORT-TERM DEBT
FHLBB short-term borrowings and securities sold under agreements to repurchase mature daily. Securities sold under agreements to repurchase are collateralized by mortgage-backed securities and collateralized mortgage-backed obligations. We maintain effective control over the securities underlying the agreements.
As of December 31, 2014, we could borrow up to $65 million in overnight funds through unsecured borrowing lines established with correspondent banks. We have established both overnight and longer term lines of credit with the FHLBB. The 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 $369.78 million and $276.94 million at December 31, 2014 and 2013, respectively. We have $246.92 million in additional short or long-term borrowing capacity with FHLBB. We also have the ability to borrow short-term or long-term through the use of repurchase agreements, collateralized by our investments, with certain approved counterparties.
The following table provides certain information regarding other borrowed funds for the three years ended December 31, 2014, 2013 and 2012:
(In thousands) |
2014 |
2013 |
2012 |
||||||||
FHLB short-term borrowings |
|||||||||||
Amount outstanding at year end |
$ |
0 |
$ |
0 |
$ |
0 | |||||
Maximum amount outstanding during the year |
18,900 | 72,500 | 97,000 | ||||||||
Average amount outstanding during the year |
212 | 17,259 | 38,290 | ||||||||
Weighted average-rate during the year |
0.31 |
% |
0.30 |
% |
0.28 |
% |
|||||
Weighted average rate at year-end |
0 |
% |
0 |
% |
0 |
% |
|||||
Securities sold under agreement to repurchase |
|||||||||||
Amount outstanding at year end |
$ |
258,464 |
$ |
250,314 |
$ |
287,520 | |||||
Maximum amount outstanding during the year |
292,692 | 284,297 | 303,420 | ||||||||
Average amount outstanding during the year |
192,868 | 212,644 | 230,281 | ||||||||
Weighted average-rate during the year |
0.18 |
% |
0.41 |
% |
0.73 |
% |
|||||
Weighted average rate at year-end |
0.26 |
% |
0.18 |
% |
0.47 |
% |
NOTE 9: LONG-TERM DEBT
Long-term debt consisted of the following at December 31, 2014 and 2013:
(In thousands) |
2014 |
2013 |
||
Federal Home Loan Bank Notes, payable through March 2029, Rates ranging from 1.50% to 2.50% |
2,320 | 2,403 | ||
$ |
2,320 |
$ |
2,403 |
There were no prepayment penalties incurred during 2014 or during 2013. During 2012, we prepaid $20 million in long-term debt and incurred prepayment penalties totaling $1.36 million.
Contractual maturities and amortization of long-term debt subsequent to December 31, 2014, are as follows:
(In thousands) |
Amount |
|
2015 |
$ |
84 |
2016 |
85 | |
2017 |
87 | |
2018 |
89 | |
2019 |
91 | |
2020 and after |
1,884 | |
Total due |
$ |
2,320 |
68
NOTE 10: TRUST PREFERRED SECURITIES
On December 15, 2004, we closed our private placement of an aggregate of $20 million of trust preferred securities. The placement occurred through a newly formed Delaware statutory trust affiliate, MBVT Statutory Trust I (the “Trust”), as part of a pooled trust preferred program. The Trust was formed for the sole purpose of issuing capital securities which are non-voting. We own all of the common securities of the Trust. The proceeds from the sale of the capital securities were loaned to us under subordinated debentures issued to the Trust. The debentures are the only asset of the Trust and payments under the debentures are the sole revenue of the Trust. Our primary source of funds to pay interest on the debentures held by the Trust is current dividends from our principal subsidiary, Merchants Bank. Accordingly, our ability to service the debentures is dependent upon the continued ability of Merchants Bank to pay dividends to us.
These hybrid securities currently qualify as regulatory capital, up to certain regulatory limits. At the same time they are considered debt for tax purposes, and as such, interest payments are fully deductible. The trust preferred securities total $20.62 million, and carried a fixed rate of interest through December 2009 at which time the rate became variable and adjusts quarterly at three month LIBOR plus 1.95%. We entered into an interest rate swap arrangement for $10 million of our trust preferred issuance which was effective beginning on December 15, 2009. The swap fixes the rate on $10 million at 5.23% and expires on December 15, 2016. The impact on net interest income for 2014, 2013 and 2012 from the interest expense on the trust preferred securities was $752 thousand, $756 thousand and $1.18 million per year, respectively. The trust preferred securities mature on December 31, 2034, and are redeemable without penalty at our option, subject to prior approval by the FRB.
NOTE 11: INCOME TAXES
The components of the provision for income taxes were as follows for the years ended December 31, 2014, 2013 and 2012:
(In thousands) |
2014 |
2013 |
2012 |
|||
Current |
$ |
3,707 |
$ |
733 |
$ |
4,721 |
Deferred |
(175) | 4,329 | 772 | |||
Provision for income taxes |
$ |
3,532 |
$ |
5,062 |
$ |
5,493 |
Not included in the above table is the income tax impact associated with the unrealized gain or loss on securities available for sale and the income tax impact associated with the funded status of the pension plan, which are recorded directly in shareholders’ equity as a component of accumulated other comprehensive loss.
69
The tax effects of temporary differences and tax credits that give rise to deferred tax assets and liabilities at December 31, 2014 and 2013 are presented below:
(In thousands) |
2014 |
2013 |
||
Deferred tax assets: |
||||
Allowance for loan losses |
$ |
4,773 |
$ |
4,427 |
Postretirement benefit obligation |
1,797 | 951 | ||
Deferred compensation |
1,427 | 1,369 | ||
Installment sales |
0 | 71 | ||
Core deposit intangible |
0 | 31 | ||
Interest rate swap |
165 | 251 | ||
Qualified School Bond Tax Credits |
919 | 919 | ||
Affordable Housing/Other Tax Credits |
1,170 | 1,244 | ||
Other |
189 | 284 | ||
Net Operating Loss |
0 | 288 | ||
Investment in real estate limited partnerships, net |
335 | 121 | ||
Unrealized loss on securities available for sale |
0 | 99 | ||
Unrealized loss on securities held to maturity |
1,475 | 1,726 | ||
Total deferred tax assets |
$ |
12,250 |
$ |
11,781 |
Deferred tax liabilities: |
||||
Loan mark-to-market adjustment |
$ |
(3,736) |
$ |
(3,756) |
Deferred compensation |
0 | (3) | ||
Installment sales |
(30) | 0 | ||
Unrealized gain on securities available for sale |
(797) | 0 | ||
Depreciation |
(1,175) | (1,442) | ||
Accrued pension cost |
(3,106) | (2,963) | ||
Total deferred tax liabilities |
$ |
(8,844) |
$ |
(8,164) |
Net deferred tax asset |
$ |
3,406 |
$ |
3,617 |
In assessing the realizability of our total deferred tax assets, Management considers whether it is more likely than not that some portion or all of those assets will not be realized. Based upon Management’s consideration of historical and anticipated future pre-tax income, as well as the reversal period for the items giving rise to the deferred tax assets and liabilities, a valuation allowance for deferred tax assets was not considered necessary at December 31, 2014 and 2013. However, factors beyond management’s control, such as the general state of the economy, can affect future levels of taxable income and there can be no assurances that sufficient taxable income will be generated to fully realize the deferred tax assets in the future.
The following is a reconciliation of the federal income tax provision, calculated at the statutory rate of 35%, to the recorded provision for income taxes:
(In thousands) |
2014 |
2013 |
2012 |
|||
Applicable statutory Federal income tax |
$ |
5,402 |
$ |
6,972 |
$ |
7,241 |
(Reduction) increase in taxes resulting from: |
||||||
Low Income Housing Projects |
858 | 705 | 985 | |||
Tax-exempt income |
(729) | (708) | (719) | |||
Tax credits |
(1,936) | (1,798) | (2,164) | |||
Bank owned life insurance |
(107) | 0 | 0 | |||
Other, net |
44 | (109) | 150 | |||
Provision for income taxes |
$ |
3,532 |
$ |
5,062 |
$ |
5,493 |
We have not identified any of our tax positions that contain significant uncertainties. Housing tax credits are recognized using the flow through method. We are subject to federal and state income tax examinations for years after December 31, 2011.
70
The State of Vermont assesses a franchise tax for banks in lieu of income tax. The franchise tax is assessed based on deposits. Vermont franchise taxes, net of state credits amounted to approximately $1.43 million, $1.44 million and $1.30 million in 2014, 2013 and 2012, respectively, which is included as noninterest expense in the accompanying consolidated statement of income.
NOTE 12: EMPLOYEE BENEFIT PLANS
Pension Plan
Prior to January 1995, we maintained a noncontributory defined benefit plan (the “Pension Plan”) covering all eligible employees. During 1995, the Pension Plan was curtailed. Accordingly, all accrued benefits were fully vested and no additional years of service or age will be accrued.
We recognize the overfunded or underfunded status of a single employer defined benefit post retirement plan as an asset or liability on the consolidated balance sheets and recognize changes in the funded status in comprehensive income in the year in which the change occurred.
The following tables provide a reconciliation of the changes in the Pension Plan’s benefit obligations and fair value of assets over the two year period ending December 31, 2014, and a statement of the funded status as of December 31 of both years:
(In thousands) |
2014 |
2013 |
||
Reconciliation of benefit obligation |
||||
Benefit obligation at beginning of year |
$ |
9,611 |
$ |
10,801 |
Service cost including expenses |
44 | 53 | ||
Interest cost |
464 | 418 | ||
Actuarial (gain) loss |
2,013 | (1,117) | ||
Benefits paid and expected expenses |
(576) | (544) | ||
Benefit obligation at year-end |
$ |
11,556 |
$ |
9,611 |
Reconciliation of fair value of plan assets |
||||
Fair value of plan assets at beginning of year |
$ |
15,446 |
$ |
14,412 |
Actual return on plan assets |
489 | 1,569 | ||
Employer contributions |
0 | 0 | ||
Benefits paid and actual expenses |
(585) | (535) | ||
Fair value of plan assets at year-end |
$ |
15,350 |
$ |
15,446 |
Funded status at year end |
$ |
3,794 |
$ |
5,835 |
We have no minimum required contribution for 2015.
The accumulated benefit obligation is equal to the projected benefit obligation and was $11.56 million and $9.61 million at December 31, 2014 and 2013, respectively. Amounts recognized in accumulated other comprehensive income for net actuarial losses totaled $5.2 million and $2.8 million at December 31, 2014 and 2013, respectively.
71
The following tables summarize the components of net periodic benefit cost and other changes in Pension Plan assets and benefit obligations recognized in other comprehensive income for the years ended December 31, 2014, 2013 and 2012, respectively:
(In thousands) |
2014 |
2013 |
2012 |
|||
Interest cost |
$ |
464 |
$ |
418 |
$ |
478 |
Expected return on plan assets |
(1,059) | (988) | (600) | |||
Service costs |
44 | 53 | 48 | |||
Net loss amortization |
137 | 355 | 326 | |||
Net periodic pension cost |
$ |
(414) |
$ |
(162) |
$ |
252 |
(In thousands) |
2014 |
2013 |
2012 |
|||
Net loss (gain) |
$ |
2,606 |
$ |
(1,707) |
$ |
1,016 |
Net loss amortization |
(137) | (355) | (326) | |||
Total recognized in other comprehensive income |
$ |
2,469 |
$ |
(2,062) |
$ |
690 |
Total recognized in net periodic pension cost and |
||||||
other comprehensive income |
$ |
2,055 |
$ |
(2,224) |
$ |
942 |
The estimated net actuarial loss for the Pension Plan that will be amortized from accumulated other comprehensive income into net periodic pension cost for 2015 is $411 thousand.
The following table summarizes the assumptions used to determine the benefit obligations and net periodic benefit costs for the years ended December 31, 2014, 2013 and 2012:
2014 |
2013 |
2012 |
|||||
Benefit obligations |
|||||||
Discount rate |
3.97 |
% |
4.98 |
% |
3.98 |
% |
|
Net periodic benefit cost |
|||||||
Discount rate |
4.98 |
% |
3.98 |
% |
5.24 |
% |
|
Expected long-term return on plan assets |
7.00 |
% |
7.00 |
% |
7.00 |
% |
The discount rate reflects the rates at which pension benefits could be effectively settled. We look to rates of return on high-quality fixed income investments currently available and expected to be available during the period of maturity of the pension benefits. Consideration was given to the rates that would be used to settle plan obligations as of December 31, 2014 and to the rates of other indices at year-end. Our actuary constructed a hypothetical high quality bond portfolio with cash flows that match the expected monthly benefit payments under the pension plan and calculated a discount rate based upon that portfolio. The expected long-term rate of return on plan assets reflects long-term earnings expectations on existing plan assets and those contributions expected to be received during the current plan year. In estimating that rate, appropriate consideration was given to historical returns earned by plan assets in the fund and the rates of return expected to be available for reinvestment. Rates of return were adjusted to reflect current capital market assumptions and changes in investment allocations, if any.
The Board of Directors has chosen our Trust division as the investment manager for the Pension Plan. The investment objectives of the Pension Plan are to provide both income and capital appreciation and to assist with current and future spending needs of the Pension Plan while at the same time minimizing the risks of investing. The investment target of the Pension Plan is to achieve a total annual rate of return in excess of the change in the Consumer Price Index for the aggregate investments of the Pension Plan evaluated over a period of five years. A certain amount of risk must be assumed to achieve the Pension Plan's investment target rate of return. The Pension Plan uses a balanced portfolio which has a 5-15 year time horizon and is considered moderate risk. The portfolio strategy followed by the Pension Plan has a baseline allocation of 60% stock and 40% fixed income securities, but the investment manager may allocate funds within certain specified ranges. The range for equities is 35% to 75% and for fixed income securities the range is 25% to 60%. The allocation among categories will vary from the baseline allocation when opportunities are identified to improve returns and/or reduce risk.
72
The fair value of Pension Plan assets at December 31, 2014 by asset category are as follows:
Fair Value Measurements at Reporting Date Using: |
||||||||
(In thousands) |
Quoted Prices in Active Markets for Identical Assets |
Significant Other Observable Inputs |
Significant Unobservable Inputs |
|||||
Description |
Total |
(Level 1) |
(Level 2) |
(Level 3) |
||||
Cash |
$ |
6 |
$ |
6 |
$ |
0 |
$ |
0 |
Money Market Funds |
690 | 690 | 0 | 0 | ||||
Equity Securities: |
0 | |||||||
Large Cap Equity Mutual Funds |
3,770 | 3,770 | 0 | 0 | ||||
Small Cap Equity Mutual Funds |
128 | 128 | 0 | 0 | ||||
Global Equity Mutual Funds |
866 | 866 | 0 | 0 | ||||
International Equity Mutual Funds |
2,898 | 2,898 | 0 | 0 | ||||
Absolute Return Funds |
770 | 770 | 0 | 0 | ||||
Fixed Income: |
||||||||
Taxable Bond Mutual Funds |
6,222 | 6,222 | 0 | 0 | ||||
Total |
$ |
15,350 |
$ |
15,350 |
$ |
0 |
$ |
0 |
The fair value of Pension Plan assets at December 31, 2013 by asset category are as follows:
Fair Value Measurements at Reporting Date Using: |
||||||||
(In thousands) |
Quoted Prices in Active Markets for Identical Assets |
Significant Other Observable Inputs |
Significant Unobservable Inputs |
|||||
Description |
Total |
(Level 1) |
(Level 2) |
(Level 3) |
||||
Cash |
$ |
31 |
$ |
31 |
$ |
0 |
$ |
0 |
Money Market Funds |
434 | 434 | 0 | 0 | ||||
Equity Securities: |
||||||||
Large Cap Equity Mutual Funds |
3,630 | 3,630 | 0 | 0 | ||||
Small Cap Equity Mutual Funds |
140 | 140 | 0 | 0 | ||||
Domestic Equities |
256 | 256 | 0 | 0 | ||||
Global Equity Mutual Funds |
939 | 939 | 0 | 0 | ||||
International Equity Mutual Funds |
2,712 | 2,712 | 0 | 0 | ||||
Absolute Return Funds |
722 | 722 | 0 | 0 | ||||
Fixed Income: |
||||||||
International Bond Mutual Funds |
559 | 559 | 0 | 0 | ||||
Taxable Bond Mutual Funds |
6,023 | 6,023 | 0 | 0 | ||||
Total |
$ |
15,446 |
$ |
15,446 |
$ |
0 |
$ |
0 |
Large Cap Equity Mutual Funds: Funds in this category have a diversified, index and actively managed multi-manager approach to investing in domestic stocks. There are multiple fund managers that are included in the portfolio with multiple categories of industries being invested in by the managers in mid-size, to large-size publicly traded firms with a majority of funds invested in large companies.
Small Cap Equity Mutual Funds: Funds in this category have a diversified, active fund manager approach to investing in small company domestic stocks.
Global Equity Mutual Funds: Funds in this category are diversified, active global equity funds that have exposure to both large company domestic stocks as well as large company developed country international stocks.
International Equity Mutual Funds: Funds in this category have a diversified, index and actively managed multi-manager approach to investing in international developed country stocks and emerging market stocks.
73
Absolute Return Funds: Funds in this category are invested in a diversified portfolio of stocks, preferred stocks, convertible bonds, and bonds. The portfolio manager’s objective is to take advantage of inefficiencies in the stock and bond markets to capture a return on investment by using specialized trading strategies. The goal of these trading strategies is to provide investors with consistent, positive returns that are not necessarily correlated to the general equity markets.
International Bond Mutual Funds: Funds in this category have a diversified, actively managed approach to investing in international bonds, with an average credit rating for the majority of the portfolio being investment grade.
Taxable Bond Mutual Funds: Funds in this category have a diversified, actively managed multi-manager approach to investing in domestic and international bonds. A majority of funds are invested in domestic bonds with an average credit rating for the majority of the portfolio being investment grade.
The following table summarizes the estimated future benefit payments expected to be paid under the Pension Plan:
Pension |
||
(In thousands) |
Benefits |
|
2015 |
$ |
570 |
2016 |
591 | |
2017 |
630 | |
2018 |
672 | |
2019 |
679 | |
Years 2020 to 2024 |
$ |
3,559 |
The estimated future benefit payments expected to be paid under the Pension Plan are based on the same assumptions used to measure our benefit obligation at December 31, 2014. No future service estimates were included due to the frozen status of the Pension Plan.
401(k) Employee Stock Ownership Plan
Under the terms of our 401(k) Employee Stock Ownership Plan (“401(k)”) eligible employees are entitled to contribute up to 75% of their compensation, subject to IRS limitations, to the 401(k), and we contribute a percentage of the amounts contributed by the employees as authorized by Merchants’ Bank’s Board of Directors. We contributed approximately 48%, 46% and 47% of the amounts contributed by the employees in 2014, 2013 and 2012, respectively.
Summary of Expense
A summary of expense relating to our various employee benefit plans for each of the years in the three year period ended December 31, 2014 is as follows:
(In thousands) |
2014 |
2013 |
2012 |
|||
Pension plan |
$ |
(414) |
$ |
(162) |
$ |
252 |
401(k) |
585 | 565 | 590 | |||
Total |
$ |
171 |
$ |
403 |
$ |
842 |
NOTE 13: STOCK-BASED COMPENSATION PLANS
Merchants has established stock based compensation plans for directors and for certain employees. The Amended and Restated Merchants Bancshares, Inc. 2008 Stock Incentive Plan (the “Plan”) allows us to grant stock options and restricted stock grants to certain employees. The Plan allows for the issuance of up to 600,000 shares of stock. As of December 31, 2014, there were 450,094 shares that remain available for future grants under the Plan. The Merchants Bancshares, Inc. and Subsidiaries Amended and Restated 2008 Compensation Plan for Non-Employee Directors and Trustees allows us to issue up to 150,000 shares of stock. As of December 31, 2014 there were 104,469 shares that remain available for future issuance under the Plan.
The fair value of stock option and restricted stock awards, measured at the grant date are amortized to compensation expense on a straight-line basis over the vesting period. The total compensation cost related to stock option awards and restricted stock awards was $119 thousand, $187 thousand and $172 thousand for 2014, 2013 and 2012, respectively. Compensation cost related to stock option and restricted stock awards is included in salary expense in the accompanying consolidated statements of income. There is no remaining compensation expense relating to stock option grants. Remaining compensation expense related to current outstanding
74
restricted stock awards is $199 thousand.
Deferred Compensation Plans for Non-Employee Directors
Merchants has established deferred compensation plans for non-employee Directors and Trustees. The total number of shares of common stock available under the plan is 150,000 shares. Under the terms of these plans participating directors can elect to have all, or a specified percentage, of their director’s fees for a given year paid in the form of cash or deferred in the form of restricted shares of Merchants’ common stock. These shares are held in a rabbi trust and are considered outstanding for purposes of computing earnings per share. Directors who elect to have their compensation deferred are credited with a number of shares of Merchants’ common stock equal in value to the amount of fees deferred. The participating director may not sell, transfer or otherwise dispose of these shares prior to distribution. With respect to shares of common stock issued or otherwise transferred to a participating director, the participating director will have the right to receive dividends or other distributions thereon. Deferred director’s fees are recognized as an expense in the year incurred.
Restricted Stock
Restricted stock provides grantees with rights to shares of common stock upon completion of a service period. During the service period, all shares are considered outstanding and dividends are paid on the restricted stock. We made a grant of 7,120, 5,846 and 6,680 restricted shares in 2014, 2013 and 2012, respectively. The shares vest three years after the grant date. The grant date fair value of restricted stock granted during 2014, 2013 and 2012 was $28.60, $28.96 per share and $26.33 per share, respectively. A summary of Merchants’ restricted stock awards is as follows:
Shares |
Weighted Average Grant Date Fair Value |
|||
Non-Vested Shares at January 1, 2014 |
20,838 |
$ |
26.46 |
|
Granted |
7,120 |
28.60 |
||
Vested |
(9,569) |
25.00 |
||
Forfeited |
(4,424) |
28.09 |
||
Non-Vested Shares at December 31, 2014 |
13,965 |
$ |
28.03 |
The total fair value of shares vested during the year ending December 31, 2014 was $282 thousand. No shares vested prior to 2014.
Stock Options
Stock options were granted at 100% of fair market value and vest over three years. The last option granted was in May 2010. The fair value of each option grant was estimated on the grant date using the Black-Scholes option-pricing model that requires Merchants to develop estimates for assumptions used in the model. The Black-Scholes valuation model uses the following assumptions: expected volatility, expected term of option, risk-free interest rate and dividend yield. Expected volatility estimates are developed based on historical volatility of our stock. We use historical data to estimate the expected term of the options. The risk-free interest rate for periods within the expected life of the option is based on the U.S. Treasury yield in effect at the grant date. The dividend yield represents the expected dividends on our stock.
A summary of Merchants’ stock option plan as of December 31, 2014, 2013 and 2012 and changes during the years then ended are as follows, with numbers of shares in thousands:
2014 | 2013 | 2012 | |||||||
Weighted |
Weighted |
Weighted |
|||||||
Average |
Average |
Average |
|||||||
Number |
Exercise |
Number |
Exercise |
Number |
Exercise |
||||
Of |
Price |
Of |
Price |
Of |
Price |
||||
Shares |
Per Share |
Shares |
Per Share |
Shares |
Per Share |
||||
Options outstanding, beginning of year |
88 | 22.95 | 95 |
$ |
22.87 | 121 |
$ |
22.81 | |
Granted |
0 | 0 | 0 | 0 | 0 | 0 | |||
Exercised |
6 | 22.07 | 8 | 22.07 | 18 | 22.81 | |||
Forfeited |
0 | 0 | 0 | 0 | 8 | 22.07 | |||
Expired |
0 | 0 | 0 | 0 | 0 | 0 | |||
Options outstanding, end of year |
82 |
$ |
23.00 | 88 |
$ |
22.95 | 95 |
$ |
22.87 |
Options exercisable |
82 |
$ |
23.00 | 88 |
$ |
22.95 | 51 |
$ |
23.57 |
75
As of December 31, 2014, there were options outstanding within the following ranges: 72 thousand at an exercise price within the range of $22.07 to $22.93, and 10 thousand at $26.63.
The total intrinsic value of options exercised was $41 thousand, $52 thousand and $73 thousand for the three years ended December 31, 2014, 2013 and 2012, respectively. We generally use shares held in treasury for option exercises. Options exercisable at December 31, 2014 had an intrinsic value of $626 thousand and a weighted average remaining term of 5.03 years. The total cash received from employees, net of withholding taxes, as a result of employee stock option exercises was $0, $0 and $280 for the years ended December 31, 2014, 2013 and 2012, respectively. The tax benefit realized as a result of the stock option exercises was approximately $14 thousand, $8 thousand and $20 thousand for the years ended December 31, 2014, 2013 and 2012, respectively.
NOTE 14: EARNINGS PER SHARE
The following table presents reconciliations of the calculations of basic and diluted earnings per share for the years ended December 31, 2014, 2013 and 2012:
Twelve Months Ended |
||||||
December 31, |
||||||
(In thousands except per share data) |
2014 |
2013 |
2012 |
|||
Net income |
$ |
12,125 |
$ |
15,131 |
$ |
15,194 |
Weighted average common shares outstanding |
6,326 | 6,303 | 6,259 | |||
Dilutive effect of common stock equivalents |
18 | 13 | 12 | |||
Weighted average common and common equivalent |
||||||
shares outstanding |
6,344 | 6,316 | 6,271 | |||
Basic earnings per common share |
$ |
1.92 |
$ |
2.40 |
$ |
2.43 |
Diluted earnings per common share |
$ |
1.91 |
$ |
2.40 |
$ |
2.42 |
Basic earnings per common share were computed by dividing net income by the weighted average number of shares of common stock outstanding during the year. The computation of diluted earnings per share excludes the effect of assuming the exercise of certain outstanding stock options because the effect would be anti-dilutive. There were no anti-dilutive options outstanding for 2014, 2013 or 2012.
76
NOTE 15: PARENT COMPANY
Merchants Bancshares, Inc.’s (the “Parent Company”) investments in its subsidiaries are recorded using the equity method of accounting. Summarized financial information relative to the Parent Company only balance sheets at December 31, 2014 and 2013, and statements of income and cash flows for each of the years in the three year period ended December 31, 2014, are shown in the following table. The statement of changes in shareholders' equity for the Parent Company are not reported because they are identical to the consolidated financial statements.
Balance Sheets as of December 31, |
||||
(In thousands) |
2014 |
2013 |
||
Assets: |
||||
Investment in subsidiaries* |
$ |
144,533 |
$ |
137,810 |
Cash* |
2,197 | 2,797 | ||
Other assets |
323 | 461 | ||
Total assets |
$ |
147,053 |
$ |
141,068 |
Liabilities and shareholders’ equity: |
||||
Other liabilities |
$ |
613 |
$ |
838 |
Long term debt |
20,619 | 20,619 | ||
Shareholders’ equity |
125,821 | 119,611 | ||
Total liabilities and shareholders’ equity |
$ |
147,053 |
$ |
141,068 |
Statements of Income for the Years Ended December 31, |
||||||
(In thousands) |
2014 |
2013 |
2012 |
|||
Dividends from Merchants Bank* |
$ |
7,085 |
$ |
5,789 |
$ |
7,607 |
Equity in undistributed earnings of subsidiaries* |
5,857 | 10,211 | 8,721 | |||
Other expense, net |
(1,276) | (1,337) | (1,743) | |||
Benefit from income taxes |
459 | 468 | 609 | |||
Net income |
$ |
12,125 |
$ |
15,131 |
$ |
15,194 |
Statement of Cash Flows for the Years Ended December 31, |
||||||
(In thousands) |
2014 |
2013 |
2012 |
|||
Cash flow from operating activities: |
||||||
Net income |
$ |
12,125 |
$ |
15,131 |
$ |
15,194 |
Adjustments to reconcile net income to net cash provided by operating activities: |
||||||
Net change in other assets |
138 | 65 | 170 | |||
Net change in other liabilities |
(67) | (121) | (116) | |||
Equity in undistributed earnings of subsidiaries* |
(5,857) | (10,211) | (8,721) | |||
Net cash provided by operating activities |
6,339 | 4,864 | 6,527 | |||
Cash flows from financing activities: |
||||||
Sale of treasury stock |
0 | 15 | 18 | |||
Proceeds from exercise of stock options |
0 | 0 | 280 | |||
Tax benefit from exercises of stock options |
14 | 8 | 20 | |||
Cash dividends paid |
(7,167) | (6,432) | (6,324) | |||
Other, net |
214 | 226 | 200 | |||
Net cash used in financing activities |
(6,939) | (6,183) | (5,806) | |||
Increase (decrease) in cash and cash equivalents |
(600) | (1,319) | 721 | |||
Cash and cash equivalents at beginning of year |
2,797 | 4,116 | 3,395 | |||
Cash and cash equivalents at end of year |
$ |
2,197 |
$ |
2,797 |
$ |
4,116 |
* Account balances are partially or fully eliminated in consolidation |
77
NOTE 16: COMMITMENTS AND CONTINGENCIES
Financial Instruments with Off-Balance Sheet Risk
Merchants is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments primarily include commitments to extend credit and financial guarantees. Such instruments involve, to varying degrees, elements of credit and interest rate risk that are not recognized in the accompanying consolidated balance sheets.
Exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and financial guarantees written is represented by the contractual amount of those instruments. We use the same credit policies in making commitments as we do for on-balance sheet instruments.
The contractual amounts of these financial instruments at December 31, 2014 and 2013 were as follows:
(In thousands) |
2014 |
2013 |
||
Financial instruments whose contract amounts represent credit risk: |
||||
Commitments to originate loans |
$ |
37,651 |
$ |
12,728 |
Unused lines of credit |
197,682 | 195,510 | ||
Standby letters of credit |
8,768 | 4,729 | ||
Equity commitments to affordable housing limited partnerships |
3,019 | 2,841 |
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since a portion of the commitment is expected to expire without being drawn upon, the total commitment amount does not necessarily represent a future cash requirement. We evaluate each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained by us upon extension of credit is based on Management's credit evaluation of the counterparty, and an appropriate amount of real and/or personal property is typically obtained as collateral.
Disclosures are required regarding liability-recognition for the fair value at issuance of certain guarantees. We do not issue any guarantees that would require liability-recognition or disclosure, other than our standby letters of credit. We have issued conditional commitments in the form of standby letters of credit to guarantee payment on behalf of a customer and guarantee the performance of a customer to a third party. Standby letters of credit generally arise in connection with lending relationships. The credit risk involved in issuing these instruments is essentially the same as that involved in extending loans to customers. Contingent obligations under standby letters of credit totaled approximately $8.77 million and $4.73 million at December 31, 2014 and 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. Each customer is evaluated individually for creditworthiness under the same underwriting standards used for commitments to extend credit and on-balance sheet instruments. Our policies governing loan collateral apply to standby letters of credit at the time of credit extension. Loan-to-value ratios are generally consistent with loan-to-value requirements for other commercial loans secured by similar types of collateral.
We may enter into commitments to sell loans, which involve market and interest rate risk. There were no such commitments at December 31, 2014 or 2013.
Balances at the Federal Reserve Bank
At December 31, 2014 and 2013, amounts at the Federal Reserve Bank included $22.89 million and $17.03 million, respectively, held to satisfy certain reserve requirements of the Federal Reserve Bank.
Legal Proceedings
We have been named as defendants in various legal proceedings arising from our normal business activities. Although the amount of any ultimate liability with respect to such proceedings cannot be determined, in the opinion of Management, based upon input from counsel on the anticipated outcome of such proceedings, any such liability will not have a material effect on our consolidated financial position.
78
NOTE 17: ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)
The following table presents changes in accumulated other comprehensive income (loss) by component, net of tax for the year ending December 31, 2014.
(In thousands) |
Unrealized Gains (Losses) on Securities Available-For-Sale |
Unrealized Gains (Losses) on Securities Transferred From Available-For-Sale to Held-To-Maturity |
Pension Plan |
Interest Rate Swaps |
Accumulated Other Comprehensive Income (Loss) |
|||||
Beginning Balance |
$ |
(162) |
$ |
(3,296) |
$ |
(1,790) |
$ |
(472) |
$ |
(5,720) |
Other comprehensive income before reclassifications |
1,713 | 0 | (1,694) | 161 | 180 | |||||
Transfer of securities from available-for-sale to held-to-maturity |
(8) | 8 | 0 | 0 | (0) | |||||
Accretion of unrealized losses of securities transferred from available-for-sale to held-to-maturity recognized in other comprehensive income |
0 | 472 | 0 | 0 | 472 | |||||
Reclassification adjustments for (gains) losses reclassified into income |
(69) | 0 | 89 | 0 | 20 | |||||
Net current period other comprehensive (loss) income |
1,636 | 480 | (1,605) | 161 | 672 | |||||
Balance December 31, 2014 |
$ |
1,474 |
$ |
(2,816) |
$ |
(3,395) |
$ |
(311) |
$ |
(5,048) |
The following table presents changes in accumulated other comprehensive income (loss) by component, net of tax for the year ending December 31, 2013.
(In thousands) |
Unrealized Gains (Losses) on Securities Available-For-Sale |
Unrealized Gains (Losses) on Securities Transferred From Available-For-Sale to Held-To-Maturity |
Pension Plan |
Interest Rate Swaps |
Accumulated Other Comprehensive Income (Loss) |
|||||
Beginning Balance |
$ |
6,033 |
$ |
0 |
$ |
(3,130) |
$ |
(688) |
$ |
2,215 |
Other comprehensive income before reclassifications |
(9,844) | 0 | 1,110 | 216 | (8,518) | |||||
Transfer of securities from available-for-sale to held-to-maturity |
3,533 | (3,533) | 0 | 0 | 0 | |||||
Accretion of unrealized losses of securities transferred from available-for-sale to held-to-maturity recognized in other comprehensive income |
0 | 237 | 0 | 0 | 237 | |||||
Reclassification adjustments for (gains) losses reclassified into income |
116 | 0 | 230 | 0 | 346 | |||||
Net current period other comprehensive (loss) income |
(6,195) | (3,296) | 1,340 | 216 | (7,935) | |||||
Balance December 31, 2013 |
$ |
(162) |
$ |
(3,296) |
$ |
(1,790) |
$ |
(472) |
$ |
(5,720) |
79
Details of the reclassification adjustments in the above table for the year ended December 31, 2014 are presented below:
Details about Accumulated Other Comprehensive Income Components (In thousands) |
Amount Reclassified from Accumulated Other Comprehensive Income |
Affected Line Item in the Statement Where Net Income is Presented |
|
Unrealized gains (losses) securities |
|||
$ |
(107) |
Net losses (gains) on investment securities |
|
(107) |
Total before tax |
||
38 |
Provision for income taxes |
||
$ |
(69) |
Net of tax |
|
Amortization of defined benefit pension plan |
|||
$ |
137 |
Compensation and benefits |
|
137 |
Total before tax |
||
(48) |
Provision for income taxes |
||
$ |
89 |
Net of tax |
|
Total reclassification adjustments |
$ |
20 | |
Details of the reclassification adjustments in the above table for the year ended December 31, 2013 are presented below:
Details about Accumulated Other Comprehensive Income Components (In thousands) |
Amount Reclassified from Accumulated Other Comprehensive Income |
Affected Line Item in the Statement Where Net Income is Presented |
|
Unrealized gains (losses) securities |
|||
166 |
Net impairment losses |
||
$ |
12 |
Net losses (gains) on investment securities |
|
178 |
Total before tax |
||
(62) |
Provision for income taxes |
||
$ |
116 |
Net of tax |
|
Amortization of defined benefit pension plan |
|||
355 |
Compensation and benefits |
||
355 |
Total before tax |
||
(125) |
Provision for income taxes |
||
$ |
230 |
Net of tax |
|
Total reclassification adjustments |
$ |
346 |
80
NOTE 18: REGULATORY CAPITAL REQUIREMENTS
We are subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, 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, respectively, 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 it 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 December 31, 2014, that Merchants met all capital adequacy requirements to which it is subject.
As of December 31, 2014, the most recent notification from the FDIC categorized Merchants Bank as 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’s category. To be considered well capitalized under the regulatory framework for prompt corrective action, Merchants Bank must maintain minimum Tier 1 Leverage, Tier 1 Risk-Based, and Total Risk-Based Capital ratios. Set forth in the table below are those ratios as well as those for Merchants Bancshares, Inc.
The FRB has the authority to prohibit a bank holding company, such as us, from paying dividends if it deems such payment to be an unsafe or unsound practice. The FDIC has the authority to use its enforcement powers to prohibit a bank from paying dividends if, in its opinion, the payment of dividends would constitute an unsafe or unsound practice. Federal law also prohibits the payment of dividends by a bank that will result in the bank failing to meet its applicable capital requirements on a pro forma basis.
To Be Well- |
||||||||||||||
Capitalized Under |
||||||||||||||
For Capital |
Prompt Corrective |
|||||||||||||
Actual |
Adequacy Purposes |
Action Provisions |
||||||||||||
(In thousands) |
Amount |
Percent |
Amount |
Percent |
Amount |
Percent |
||||||||
As of December 31, 2014 |
||||||||||||||
Merchants Bancshares, Inc.: |
||||||||||||||
Tier 1 Leverage Capital |
$ |
148,045 | 8.76 |
% |
$ |
67,616 | 4.00 |
% |
N/A |
N/A |
||||
Tier 1 Risk-Based Capital |
148,045 | 15.70 |
% |
37,724 | 4.00 |
% |
N/A |
N/A |
||||||
Total Risk-Based Capital |
159,856 | 16.95 |
% |
75,447 | 8.00 |
% |
N/A |
N/A |
||||||
Merchants Bank: |
||||||||||||||
Tier 1 Leverage Capital |
$ |
145,823 | 8.60 |
% |
$ |
64,816 | 4.00 |
% |
$ |
87,770 | 5.00 |
% |
||
Tier 1 Risk-Based Capital |
145,823 | 15.36 |
% |
37,983 | 4.00 |
% |
56,974 | 6.00 |
% |
|||||
Total Risk-Based Capital |
157,704 | 16.61 |
% |
75,965 | 8.00 |
% |
94,957 | 10.00 |
% |
|||||
As of December 31, 2013 |
||||||||||||||
Merchants Bancshares, Inc.: |
||||||||||||||
Tier 1 Leverage Capital |
$ |
142,036 | 8.44 |
% |
$ |
67,344 | 4.00 |
% |
N/A |
N/A |
||||
Tier 1 Risk-Based Capital |
142,036 | 14.87 |
% |
38,216 | 4.00 |
% |
N/A |
N/A |
||||||
Total Risk-Based Capital |
153,999 | 16.12 |
% |
76,433 | 8.00 |
% |
N/A |
N/A |
||||||
Merchants Bank: |
||||||||||||||
Tier 1 Leverage Capital |
$ |
139,144 | 8.24 |
% |
$ |
67,530 | 4.00 |
% |
$ |
84,413 | 5.00 |
% |
||
Tier 1 Risk-Based Capital |
139,144 | 14.47 |
% |
38,470 | 4.00 |
% |
57,705 | 6.00 |
% |
|||||
Total Risk-Based Capital |
151,176 | 15.72 |
% |
76,940 | 8.00 |
% |
96,175 | 10.00 |
% |
Capital amounts for Merchants Bancshares, Inc. include $20 million in trust preferred securities issued in December 2004. These hybrid securities qualify as regulatory capital up to certain regulatory limits.
81
NOTE 19: DERIVATIVE FINANCIAL INSTRUMENTS
At December 31, 2014 and 2013, we had an interest rate swap with a notional amount of $10 million that was designated as a cash flow hedge. The swap was used to convert a portion of the floating rate interest on our trust preferred issuance to a fixed rate of interest of 5.23% through December 15, 2016. Each quarter we assess the effectiveness of the hedging relationships by comparing the changes in cash flows of the derivative hedging instruments with the changes in cash flows of the designated hedged item. There was no ineffective portion recognized in earnings during 2014, 2013 or 2012. The fair value of $(479) thousand and $(726) thousand was reflected in other liabilities in the accompanying consolidated balance sheets at December 31, 2014 and December 31, 2013, respectively.
We entered into interest rate swaps with a notional amount of $39.6 million with certain of our commercial customers. In order to minimize our risk, these customer derivatives (pay floating/receive fixed swaps) have been offset with essentially matching interest rate swaps with our counterparty totaling $39.6 million (pay fixed/receive floating swaps). At December 31, 2014, the weighted average receive rate of these interest rate swaps was 1.85%, the weighted average pay rate was 3.63% and the weighted average maturity was 12 years. The fair values of $618 thousand and $618 thousand were reflected in other assets and other liabilities, respectively, in the accompanying consolidated balance sheets at December 31, 2014. At December 31, 2013, the weighted average receive rate of these interest rate swaps was 1.76%, the weighted average pay rate was 3.37% and the weighted average maturity was 13.8 years. The fair values of $803 thousand and $803 thousand were reflected in other assets and other liabilities, respectively, in the accompanying consolidated balance sheets at December 31, 2013. Hedge accounting has not been applied for these derivatives. Because the terms of the swaps with our customer and the other financial institution offset each other, with the only difference being counterparty credit risk, changes in the fair value of the underlying derivative contracts are not materially different and do not significantly impact our results of operations.
We entered into interest rate swaps with notional amounts totaling $9.36 million at December 31, 2014, and $8.80 million at December 31, 2013, that were designated as fair value hedges of certain fixed rate loans with municipalities. At December 31, 2014, the weighted average receive rate of these interest rate swaps was 1.55%, the weighted average pay rate was 3.26% and the weighted average maturity was 17.6 years. At December 31, 2013, the weighted average receive rate of these interest rate swaps was 1.49, the weighted average pay rate was 3.11% and the weighted average maturity was 19.5 years. The amounts recognized in earnings and other assets for the ineffective portion of the interest swaps was immaterial.
We assessed our counterparty risk at December 31, 2014 and determined any credit risk inherent in our derivative contracts was insignificant. Information about the fair value of derivative financial instruments can be found in Note 5 to these consolidated financial statements.
82
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders
Merchants Bancshares, Inc.
Burlington, Vermont
We have audited the accompanying consolidated balance sheets of Merchants Bancshares, Inc. as of December 31, 2014 and 2013 and the related consolidated statements of income, comprehensive income, changes in shareholders’ equity and cash flows for the years then ended. We also have audited Merchants Bancshares, Inc.’s internal control over financial reporting as of December 31, 2014, based on criteria established in the 2013 Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Merchants Bancshares, Inc.’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these consolidated financial statements and an opinion on the company’s internal control over financial reporting based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the consolidated financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Merchants Bancshares, Inc. as of December 31, 2014 and 2013 and the results of its operations and its cash flows for years then ended in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, Merchants Bancshares, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2014, based on criteria established in the 2013 Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
/s/ Crowe Horwath, LLP
Crowe Horwath LLP
Cleveland, Ohio
March 13, 2015
83
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Shareholders
Merchants Bancshares, Inc.:
We have audited the accompanying consolidated statements of income, comprehensive income, changes in shareholders’ equity, and cash flows for each of the year ended December 31, 2012. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the results of operations of Merchants Bancshares, Inc. and subsidiaries and their cash flows for the the year ended December 31, 2012, in conformity with U.S. generally accepted accounting principles.
/s/ KPMG LLP
Albany, New York
March 5, 2013
84
ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A - CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures – Our principal executive officer, principal financial officer and other members of our senior management have evaluated our disclosure controls and procedures (as defined in Rules 13a-15(e) or 15d-15(e) under the Exchange Act) as of December 31, 2014. Based on this evaluation, our principal executive officer and principal financial officer have concluded that our disclosure controls and procedures effectively ensure that information required to be disclosed in our filings and submissions with the SEC under the Exchange Act is accumulated and communicated to our management (including the principal executive officer and principal financial officer), and is recorded, processed, summarized and reported within the time periods specified by the SEC.
Management’s Report on Internal Control Over Financial Reporting – Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f) or 15d-15(f). Our internal control system is designed to provide reasonable assurances to our Management and board of directors regarding the preparation and fair presentation of published financial statements. Under the supervision and with the participation of our Management, including our principal executive officer and principal financial officer, an evaluation of the effectiveness of our internal control over financial reporting was conducted, based on the framework in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework). Based on the evaluation under the framework in Internal Control – Integrated Framework, Management concluded that our internal control over financial reporting was effective as of December 31, 2014.
Crowe Horwath LLP, the independent registered public accounting firm that audited our consolidated financial statements, has issued an attestation report on our internal control over financial reporting as of December 31, 2014. This report can be found on page 83.
Changes in Internal Controls over Financial Reporting – During the fourth quarter of 2014, there have been no changes in the Company’s internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.
None
PART III
ITEM 10 – DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The information required by this Item 10 is incorporated by reference to the sections entitled “Information about our Board of Directors,” “Board Leadership Structure,” “Risk Oversight,” “Other Information the Board and its Committees,” “Code of Business Conduct and Ethics Policy,” and “Executive Officers” in our Proxy Statement.
ITEM 11 - EXECUTIVE COMPENSATION
The information required by this Item 11 is incorporated by reference to the sections entitled “Other Information about the Board and its Committees,” “Compensation Discussion and Analysis,” “Executive Compensation,” “Retirement Benefits,” and “Potential Payments upon Termination or Change in Control” in our Proxy Statement.
ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER MATTERS
The information required by this Item 12 is incorporated by reference to the sections entitled “Executive Compensation,” and “Compensation Committee Interlocks and Insider Participation,” in our Proxy Statement.
ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information required by this Item 13 is incorporated by reference to the sections entitled “Related Party Transactions,” “Security Ownership of Certain Beneficial Owners and Management,” in our Proxy Statement.
ITEM 14 - PRINCIPAL ACCOUNTING FEES AND SERVICES
The information required by this Item 14 is incorporated by reference to the section entitled “Principal Accounting Fees and Services” in our Proxy Statement.
85
PART IV
ITEM 15 – EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(1)The following consolidated financial statements are included:
Consolidated Balance Sheets, December 31, 2014, and December 31, 2013
Consolidated Statements of Income for the years ended December 31, 2014, 2013 and 2012
Consolidated Statements of Comprehensive Income for the years ended December 31, 2014, 2013 and 2012
Consolidated Statements of Changes in Shareholders’ Equity for the years ended December 31, 2014, 2013 and 2012
Consolidated Statements of Cash Flows for the years ended December 31, 2014, 2013 and 2012
Notes to Consolidated Financial Statements
(2)The following exhibits are either filed or attached as part of this report, or are incorporated herein by reference:
Exhibit Description
3.1.1 |
Certificate of Incorporation, filed on April 20, 1987 (Incorporated by reference to Exhibit 3.1.1 to Merchants’ Annual Report on Form 10-K filed March 8, 2012) |
3.1.2 |
Certificate of Merger, filed on June 5, 1987 (Incorporated by reference to Exhibit 3.1.2 to Merchants’ Annual Report on Form 10-K filed on March 16, 2007) |
3.1.3 |
Certificate of Amendment, filed on May 11, 1988 (Incorporated by reference to Exhibit 3.1.3 to Merchants’ Annual Report on Form 10-K filed on March 16, 2007) |
3.1.4 |
Certificate of Amendment, filed on April 29, 1991 (Incorporated by reference to Exhibit 3.1.4 to Merchants’ Annual Report on Form 10-K filed on March 16, 2007) |
3.1.5 |
Certificate of Amendment, filed on August 29, 2006 (Incorporated by reference to Exhibit 3.1.5 to Merchants’ Annual Report on Form 10-K filed on March 16, 2007) |
3.1.6 |
Certificate of Amendment, filed August 29, 2006 (Incorporated by reference to Exhibit 3.1.6 to Merchants’ Annual Report on Form 10-K filed on March 16, 2007) |
3.2 |
Amended and Restated Bylaws of Merchants Bancshares, Inc. (Incorporated by reference to Exhibit 3.2 to Merchants’ Annual Report on Form 10-K filed on March 10, 2014) |
4 |
Specimen of Merchants’ Common Stock Certificate (Incorporated by reference to Exhibit 4.1 to Merchants’ Annual Report on Form 10-K filed on March 13, 2008) |
10.1 |
Merchants Bancshares, Inc. Dividend Reinvestment and Stock Purchase Plan (Incorporated by reference to Exhibit 4.1 to Merchants’ Registration Statement on Form S-3 (Registration No. 333-151572) filed on June 11, 2008) |
10.2 |
Amended and Restated Merchants Bancshares, Inc. 2008 Stock Incentive Plan (Incorporated by reference to Exhibit 10.1 to Merchants’ Current Report on Form 8-K filed on May 6, 2011) + |
10.3 |
First Amendment to Amended and Restated Merchants Bancshares, Inc. 2008 Stock Incentive Plan (Incorporated by reference to Exhibit 10.3 to Merchants’ Annual Report on Form 10-K filed on March 8, 2012) + |
10.4 |
Form of Restricted Stock Agreement (Incorporated by reference to Exhibit 10.4 to Merchants’ Annual Report on Form 10-K filed on March 8, 2012) + |
10.5 |
The Merchants Bancshares, Inc. and Subsidiaries Amended and Restated 1996 Compensation Plan for Non-Employee Directors (Incorporated by reference to Exhibit 10.3 to Merchants’ Annual Report on Form 10-K filed on March 15, 2011) + |
10.6 |
The Merchants Bancshares, Inc. and Subsidiaries Amended and Restated 2008 Compensation Plan for Non-Employee Directors and Trustees (Incorporated by reference to Exhibit 10.4 to Merchants’ Annual Report on Form 10-K filed on March 15, 2011) + |
10.7 |
Merchants Bancshares, Inc. Executive Annual Incentive Plan (Incorporated by reference to Exhibit 10.1 to Merchants’ Report on Form 8-K filed on March 2, 2011) + |
10.8 |
Employment Agreement by and among Merchants Bancshares and Michael R. Tuttle, dated February 27, 2015* |
10.9 |
Employment Agreement by and among Merchants, Merchants Bank and Janet P. Spitler, dated March 17, 2011 (Incorporated by reference to Exhibit 10.2 to Merchants’ Current Report on Form 8-K filed on March 23, 2011) + |
86
10.10 |
The Merchants Bank Amended and Restated Deferred Compensation Plan for Directors (Incorporated by reference to Exhibit 10.7 to Merchants’ Annual Report on Form 10-K filed on March 15, 2011) + |
10.11 |
Trust under the Merchants Bank Amended and Restated Deferred Compensation Plan for Directors (Incorporated by reference to Exhibit 10.8 to Merchants’ Annual Report on Form 10-K filed on March 15, 2011) + |
10.12 |
Employment Agreement by and between Merchants Bank and Geoffrey R. Hesslink, dated March 17, 2011 (Incorporated by reference to Exhibit 10.5 to Merchants’ Current Report on Form 8-K filed on March 23, 2011) + |
10.13 |
Indenture, dated December 15, 2004, by and between Merchants Bancshares, Inc. and Wilmington Trust Company, as trustee (Incorporated by reference to Exhibit 10.5 to Merchants’ Annual Report on Form 10-K filed on March 9, 2005) |
|
|
10.14 |
Guarantee Agreement, dated December 15, 2004, by and between Merchants Bancshares, Inc. and Wilmington Trust Company dated December 15, 2004 for the benefit of the holders from time to time of the Capital Securities of MBVT Statutory Trust I (Incorporated by reference to Exhibit 10.5.3 to Merchants’ Annual Report on Form 10-K filed on March 9, 2005) |
10.15 |
Declaration of Trust of MBVT Statutory Trust I, dated December 2, 2004 (Incorporated by reference to Exhibit 10.5.2 to Merchants’ Annual Report on Form 10-K filed on March 9, 2005) |
10.16 |
Subscription Agreement, dated December 15, 2004, by and among MBVT Statutory Trust I, Merchants and Preferred Term Securities XVI, Ltd. (Incorporated by reference to Exhibit 10.5.1 to Merchants’ Annual Report on Form 10-K filed on March 9, 2005) |
10.17 |
Placement Agreement, dated December 7, 2004, by and among Merchants Bancshares, Inc., FTN Financial Capital Markets and Keefe, Bruyette & Woods, Inc. (Incorporated by reference to Exhibit 10.5.4 to Merchants’ Annual Report on Form 10-K filed on March 9, 2005) |
10.18 |
Purchase and Sale Agreement between Merchants Bank and Eastern Avenue Properties, L.L.C., dated as of June 27, 2008 (Incorporated by reference to Exhibit 10.18.1 to Merchants’ Quarterly Report on Form 10-Q filed on August 7, 2008) |
10.19 |
Leaseback Agreement between Merchants Bank and Farrell Exchange, L.L.C., dated as of June 27, 2008 (Incorporated by reference to Exhibit 10.18.2 to Merchants’ Quarterly Report on Form 10-Q filed on August 7, 2008) |
10.20 10.21 10.22 |
Employment Agreement by and between Merchants Bank and Thomas J. Meshako, dated November 10, 2014* + Employment Agreement by and between Merchants Bank and Molly Dillon, dated March 1, 2014* + Employment Agreement by and between Merchants Bank and Marie Thresher, dated December 19, 2013* + |
21 |
Subsidiaries of Merchants (Incorporated by reference to Exhibit 21 to Merchants’ Annual Report on Form 10-K filed on March 8, 2012) |
23.1 |
Consent of Crowe Horwath LLP* |
23.2 |
Consent of KPMG LLP* |
31.1 |
Certification of Chief Executive Officer Pursuant to Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934, as amended* |
31.2 |
Certification of Chief Financial Officer Pursuant to Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934, as amended* |
32.1 |
Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002** |
32.2 |
Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002** |
87
101 |
The following materials from Merchants Bancshares, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2014 formatted in XBRL: (i) Consolidated Balance Sheets at December 31, 2014 and December 31, 2013; (ii) Consolidated Statements of Income for the years ended December 31, 2014, 2013 and 2012; (iii) Consolidated Statements of Comprehensive Income for the years ended December 31, 2014, 2013 and 2012; (iv) Consolidated Statements of Changes in Shareholders’ Equity for the years ended December 31, 2014, 2013 and 2012; (v) Consolidated Statements of Cash Flows for the years ended December 31, 2014, 2013 and 2012; and (vi) Notes to Consolidated Financial Statements* |
+Management contract or compensatory plan or agreement *Filed herewith **Furnished herewith |
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SIGNATURES
Pursuant to the requirement of Section 13 or 15 (d) of the Securities Exchange Act of 1934 the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Merchants Bancshares, Inc.
Date |
March 13, 2015 |
By |
/s/ Michael R. Tuttle |
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Michael R. Tuttle, President and CEO |
Pursuant to the requirement of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of MERCHANTS BANCSHARES, INC., and in the capacities and on the date as indicated.
/s/ Michael R. Tuttle |
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March 13, 2015 |
Michael R. Tuttle, Director, |
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Date |
President and CEO of Merchants |
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/s/ Scott F. Boardman |
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March 13, 2015 |
Scott F. Boardman, Director |
Date |
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/s/Janette K. Bombardier |
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March 13, 2015 |
Janette Bombardier, Director |
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Date |
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/s/ Peter A. Bouyea |
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March 13, 2015 |
Peter A. Bouyea, Director |
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Date |
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/s/ Karen J. Danaher |
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March 13, 2015 |
Karen J. Danaher, Director |
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Date |
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/s/ Jeffrey L. Davis |
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March 13, 2015 |
Jeffrey L. Davis, Director |
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Date |
Chairman of the Board of Directors |
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/s/ Michael G. Furlong |
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March 13, 2015 |
Michael G. Furlong, Director |
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Date |
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/s/ Lorilee A. Lawton |
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March 13, 2015 |
Lorilee A. Lawton, Director |
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Date |
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/s/ Bruce M. Lisman |
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March 13, 2015 |
Bruce M. Lisman, Director |
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Date |
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/s/ Raymond C. Pecor, Jr. |
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March 13, 2015 |
Raymond C. Pecor, Jr. Director |
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Date |
/s/ Raymond C. Pecor III |
March 13, 2015 |
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Raymond C. Pecor III, Director |
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Date |
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/s/ Patrick S. Robins |
March 13, 2015 |
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Patrick S. Robins, Director |
Date |
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/s/ Thomas J. Meshako |
March 13, 2015 |
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Thomas J. Meshako, CFO, Treasurer, and Principal Accounting Officer of Merchants |
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Date |
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89