Summary of MERCHANTS BANCSHARES INC

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Forward Looking Statements

Except for the historical information contained herein, this Quarterly Report on Form 10-Q of Merchants may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 (the "Exchange Act"). When used, the words "anticipate," "believe," "estimate," "expect," "intend," "may," "might," "plan," "project," "result," "should," "will" and similar expressions which do not relate solely to historical matters are intended to identify forward-looking statements. These statements include, among other things, statements regarding Merchants' intent, belief or expectations with respect to economic conditions, trends affecting Merchants' financial condition or results of operations, and Merchants' exposure to market, interest rate and credit risk.

Investors are cautioned that forward-looking statements are inherently uncertain. Actual performance and results of operations may differ materially from those projected or suggested in the forward-looking statements due to certain risks and uncertainties, which are included in more detail in Section 1A
- "Risk Factors" beginning on page 22 of this document.

General

All adjustments necessary for a fair presentation of Merchants' interim consolidated financial statements as of March 31, 2009, and for the three months ended March 31, 2009 and 2008, have been included. The information was prepared from the unaudited financial statements of Merchants and its subsidiaries, Merchants Bank, Merchants Trust Company and MBVT Statutory Trust I.

Recent Market Developments

Certain segments of the financial services industry are facing unprecedented challenges in the face of the current national and global economic crisis. The global and U.S. economies are experiencing significantly reduced business activity as a result of disruptions in the financial system during the past year, among other things. In some areas, dramatic declines in the housing market, increasing foreclosures and rising unemployment, have resulted in significant write-downs of asset values by financial institutions, including government-sponsored entities and major commercial and investment banks. These write-downs have caused many financial institutions to seek additional capital; to merge with larger and stronger institutions; and, in some cases, to fail. Merchants is fortunate that, to date, the markets it serves have been impacted to a lesser extent than many areas around the country. However, a prolonged recession and persistently adverse economic conditions would likely impact these markets over time, and have a negative impact upon Merchants' financial condition and performance.

In response to the financial crises affecting the banking system and financial markets, there have been several recent announcements of Federal programs designed to purchase or insure assets from, provide equity capital to, and guarantee the liquidity of, the industry.

In response to the financial crises affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions, on October 3, 2008, the Emergency Economic Stabilization Act of 2008 (the "EESA") was signed into law. Pursuant to the EESA, the U.S. Treasury was given the authority to, among other things, purchase up to $700 billion of mortgages, mortgage-backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets. EESA also immediately increased the FDIC deposit insurance limit from $100,000 to $250,000 through December 31, 2009.

On October 14, 2008, the Secretary of the Department of the Treasury announced that the Department of the Treasury will purchase equity stakes in a wide variety of banks and thrifts. Under the program, known as the Troubled Asset Relief Program Capital Purchase Program (the "TARP Capital Purchase Program"), from the $700 billion authorized by the EESA, the Treasury made $250 billion of capital available to U.S. financial institutions in the form of preferred stock. In conjunction with the purchase of preferred stock, the Treasury received, from participating financial institutions, warrants to purchase common stock with an aggregate market price equal to 15% of the preferred investment. Participating financial institutions were required to adopt the Treasury's standards for executive compensation and corporate governance for the period during which the Treasury holds equity issued under the TARP Capital Purchase Program. On December 24, 2008, Merchants announced that, although it had applied for and been preliminarily approved for funds through the TARP Capital Purchase Program, it would not participate in the program given the strength of its capital position.

Results of Operations

Overview

Net income was $2.91 million for the first quarter of 2009, compared to net income of $2.66 million for the first quarter of 2008. The return on average assets for the quarter ended March 31, 2009 was 0.87%, compared to 0.88% for the first quarter of 2008. The return on average equity for the first quarter of 2009 was 14.50% compared to 13.83% for the first quarter of 2008. The following were the major factors contributing to the results for the quarter ended March 31, 2009, compared to the same period in 2008:

Net interest income for the first quarter of 2009 was $12.34 million, a $2.70 million, or 28%, increase over the same period in 2008. Merchants' net interest margin for the first quarter of 2009 was 3.85%, a 45 basis point increase over the same period in 2008. The increase in the net interest margin was primarily a result of an overall larger interest earning asset base funded by low cost funding sources.

Merchants recorded a $900 thousand loan loss provision during the quarter compared to a $300 thousand loan loss provision for the same quarter of 2008. Increased loan production, as well as increased nonperforming loans and net charge-offs resulted in a higher provision expense for the first quarter of 2009 when compared to the first quarter of 2008.

Merchants' quarterly average investment portfolio was $429.33 million, an increase of $50.92 million over the same quarter of 2008.

Total non-interest income decreased to $1.93 million for the first quarter of 2009 from $2.24 million for the first quarter of 2008. Non-interest income excluding gains/losses on investment securities and asset sales decreased to $1.95 million for the first quarter of 2009, compared to $2.16 million for the first quarter of 2008. Total non-interest expense increased $1.42 million to $9.54 million for the first quarter of 2009 from $8.12 million for the first quarter of 2008.

Net Interest Income

Merchants' net interest income increased $2.70 million, or 28.0%, for the first quarter of 2009 compared to 2008. This increase was a result of strong growth in both loans and deposits, and a result of lowered funding costs during the quarter. Average interest earning assets for the quarter were $1.30 billion, compared to $1.14 billion for the first quarter of 2008. Merchants' net interest margin for the first quarter of 2009 was 3.85%, 45 basis points higher than the first quarter of 2008.

The average rate on interest earning assets for the first quarter of 2009 was 48 basis points lower than the first quarter of 2008. This decrease was primarily due to decreased loan rates for 2009 compared to 2008, a result of dramatic decreases in the prime lending rate over the last year, and an overall lower interest rate environment. Lower loan rates were partially offset by a slightly higher average yield on Merchants' primarily fixed rate investment portfolio for the first quarter of 2009 compared to 2008.

Merchants was able to reduce its overall funding costs by 108 basis points for the first quarter of 2009 compared to 2008. The average cost of deposits decreased by 102 basis points when comparing the first quarter of this year to the same period in the prior year. Most of this decrease came in the cost of time deposits as these funds repriced in a lower interest rate environment, the cost of this funding source decreased 162 basis points. Additionally, the cost of Merchants' Savings, NOW and money market accounts decreased 54 basis points. Merchants' cost of borrowed funds decreased 146 basis points when comparing the first quarter of 2009 to 2008 and Merchants' cost of securities sold under agreements to repurchase and other short-term debt decreased 261 basis points for the first quarter of 2009 compared to 2008, primarily a result of the 200 basis points decrease in the target federal funds rate over the last twelve months. Merchants' average cost of long-term borrowed funds for the first quarter of 2009 was 81 basis points lower than the first quarter of 2008.

The following table attributes changes in Merchants' net interest income (on a fully taxable equivalent basis) to changes in either average balances or average rates for the three months ended March 31, 2009. Changes due to both interest rate and volume have been allocated to change due to volume and change due to rate in proportion to the relationship of the absolute dollar amounts of the change in each category:

      Analysis of Changes in Fully Taxable Equivalent Net Interest Income


Three Months Ended March 31,
                                                        Increase        Due to
(In thousands)                         2009     2008   (Decrease)  Volume    Rate
Fully taxable equivalent interest
income:
 Loans                               $ 11,786 $ 11,585   $   201  $ 1,801  $ (1,600)
 Investments                            5,263    4,632       631      585        46
 Federal funds sold, securities sold
under
  agreements to repurchase and
interest
  bearing deposits with banks               4      251      (247)    (114)     (133)
  Total interest income                17,053   16,468       585    2,272    (1,687)
Less interest expense:
 Savings, money market & NOW
accounts                                  548    1,061      (513)      72      (585)
 Time deposits                          2,288    3,455    (1,167)     396    (1,563)
 Fed funds purchased, Federal Home
Loan
 Bank and other short-term
borrowings                                 20        9        11       24       (13)
 Securities sold under agreements to
repurchase
  and other short-term debt               65       629      (564)       6      (570)
 Securities sold under agreement to
repurchase,
  long-term                               475      558       (83)      39      (122)
 Other long-term debt                   1,000      801       199      358      (159)
 Junior subordinated debt                 298      298        --       --        --
  Total interest expense                4,694    6,811    (2,117)     895    (3,012)
  Net interest income                $ 12,359 $  9,657  $  2,702  $ 1,377  $  1,325

The following table sets forth certain information regarding net interest margin for the three months ended March 31, 2009 and 2008. For the periods indicated, the total dollar amount of interest income from average earning assets and the resultant yields, as well as the interest expense on average interest bearing liabilities, are expressed both in dollars and rates, and on a tax equivalent basis.

                           Merchants Bancshares, Inc.

                    Average Balance Sheets and Average Rates

                                  (Unaudited)


                                                           Three Months Ended
                                            March 31, 2009                    March 31, 2008
                                                 Interest                          Interest
(In thousands, fully taxable          Average     Income/  Average      Average     Income/  Average
equivalent)                           Balance     Expense   Rate        Balance     Expense   Rate
ASSETS:
Loans, including fees on loans
(a)                                 $   865,962  $ 11,786    5.52%    $   737,614  $ 11,585    6.32%
Investments (b) (c)                     429,329     5,263    4.97%        378,409     4,632    4.92%
Federal funds sold, securities
purchased under
 agreements to resell and
interest bearing
 deposits with banks                      5,073         4    0.35%         26,634       251    6.79%
  Total interest earning assets       1,300,364  $ 17,053    5.32%      1,142,657  $ 16,468    5.80%
Allowance for loan losses                (9,238)                           (8,128)
Cash and cash equivalents                26,142                            35,461
Bank premises and equipment, net         11,588                            11,788
Other assets                             14,814                            20,689
  Total assets                      $ 1,343,670                       $ 1,202,467

LIABILITIES AND SHAREHOLDERS'
EQUITY:
Interest bearing deposits:
 Savings, NOW & money market
accounts                            $   441,930  $    548    0.50%    $   411,321  $  1,061    1.04%
 Time deposits                          396,439     2,288    2.34%        350,525     3,455    3.96%
  Total interest bearing deposits       838,369     2,836    1.37%        761,846     4,516    2.39%
Federal funds purchased                   1,144         1    0.46%            132         1    4.26%
Federal Home Loan Bank and other
short-term borrowings                    24,473        19    0.31%            983         8    3.19%
Securities sold under agreements
to repurchase
 and other short-term debt               87,904        65    0.30%         87,089       629    2.90%
Securities sold under agreements
to repurchase,
 long-term                               54,000       475    3.57%         50,099       558    4.48%
Other long-term debt                    114,073     1,000    3.55%         74,651       801    4.31%
Junior subordinated debentures
issued to
 Unconsolidated subsidiary trust         20,619       298    5.77%         20,619       298    5.77%
  Total borrowed funds                  302,214     1,858    2.49%        233,573     2,295    3.95%
  Total interest bearing
liabilities                           1,140,582  $  4,694    1.67%        995,419  $  6,811    2.75%
Noninterest bearing deposits            110,115                           117,001
Other liabilities                        12,819                            13,238
Shareholders' equity                     80,154                            76,809
  Total liabilities and
shareholders' equity                $ 1,343,670                       $ 1,202,467

Net interest earning assets         $   159,782                       $   147,238

Net interest income (fully
taxable equivalent)                              $ 12,359                          $  9,657
Tax equivalent adjustment                             (18)                              (19)
Net interest income                              $ 12,341                          $  9,638

Net interest rate spread                                     3.65%                             3.04%

Net interest margin                                          3.85%                             3.40%

(a)

Includes principal balance of non-accrual loans and fees on loans.

(b)

Available for sale securities are included at fair value, held to maturity securities are included at amortized cost. Includes FHLB stock.

(c)

Tax exempt interest has been converted to a tax equivalent basis using the Federal tax rate of 35%.

Provision for Credit Losses: Merchants recorded a $900 thousand provision for credit losses during the first quarter of 2009 compared to $300 thousand for the first quarter of 2008. The increase in the provision is primarily a result of overall loan growth combined with increased net charge-offs and continued economic uncertainty. The allowance for loan losses was $9.45 million; 1.06% of total loans and 82% of nonperforming loans at March 31, 2009, compared to $8.89 million, 1.05% of total loans and 76% of nonperforming loans at December 31, 2008; and $8.31 million, 1.10% of total loans and 116% of nonperforming loans at March 31, 2008. Nonperforming loans decreased slightly to $11.52 million at March 31, 2009 from $11.64 million at December 31, 2008. Additions to nonperforming loans during the quarter were offset by principal pay downs, scheduled amortization and charge-downs. Approximately 75% of nonaccruing loans are concentrated in five relationships. Additionally, approximately $3.1 million of the loans in nonperforming status carry some form of government guarantee. Gross loans ended the first quarter of 2009 at $892.58 million, a $45.45 million increase over year end balances. Merchants recorded net charge-offs of $348 thousand for the first three months of 2009 and recorded net recoveries of $10 thousand for the same period in 2008. All of these factors are taken into consideration during management's quarterly review of the Allowance for credit losses (the "Allowance") which management continues to deem adequate under current market conditions. See the discussion of Nonperforming Assets and the Allowance on pages 17-18 for additional information on the provision, the Allowance and the allowance for loan losses.

Noninterest Income: Total noninterest income decreased to $1.93 million for the first quarter of 2009 from $2.24 million for the first quarter of 2008. Merchants closed its branch in Windsor VT on December 31, 2008. The building was sold during the first quarter of 2009 for a gain of $180 thousand. Merchants sold three securities with a combined book value of $12.68 million during the first quarter of 2009 at a combined loss of $205 thousand. For more information about this security sale please see "Balance Sheet Analysis" below. Excluding both the gain on the sale of the building and gains/losses on investment securities noninterest income decreased to $1.95 million for the first quarter of 2009 compared to $2.16 million for the first quarter of 2008. Trust Company income decreased to $401 thousand from $505 thousand for the first quarter of 2009 compared to 2008. Although Merchants has experienced increases in overall trust relationships, these increases have not generated enough additional revenue to offset lost revenue due to market value declines in the current volatile environment. Additionally, Merchants has experienced slight decreases in overdraft income and net ATM/debit card income for the first quarter of this year compared to last as customers react to the current economic uncertainty by spending less and by managing overdraft activity more closely.

Noninterest Expense: Total noninterest expense increased $1.42 million to $9.54 million for the first quarter of 2009 from $8.12 million for the first quarter of 2008. Salaries and Wages increased $328 thousand to $3.42 million for the first quarter of 2009 compared to the same period in 2008. This increase is a result of normal pay increases combined with additional staff that Merchants hired in the corporate banking, executive and trust areas over the course of 2008. Employee benefits increased $328 thousand to $1.26 million for the first quarter of 2009 compared to 2008. This increase is a result of substantial increases in health insurance costs and pension plan expenses for 2009 over 2008. Legal and professional fees were $689 thousand for the first quarter, a $106 thousand increase over last year. These increases are a result of a combination of overall increased third party provider fees and professional fees related to specific projects. Other noninterest expenses increased $606 thousand to $1.89 million for the first quarter of 2009 compared to the first quarter of 2008. Merchants FDIC insurance expense increased by $289 thousand for the first quarter of this year compared to last year. Expenses related to OREO and problem loans increased to $133 thousand for the first quarter of 2009 compared to a credit balance of $10 thousand for 2008 as Merchants has more loans in various stages of workout this year compared to last year. Additionally, most categories of operating expenses have increased for 2009 compared to 2008.

Balance Sheet Analysis

Merchants' quarterly average loans were $865.96 million, an increase of $128.35 million, or 17% over the first quarter of 2008, and were $40.57 million, or 5% higher on a linked quarter basis. Loans ended the first quarter of 2009 at $892.58 million, an increase of $45.45 million over December 31, 2008 ending balances of $847.13 million. The increase since December 31, 2008 is made up of residential and commercial mortgages, and commercial loans. Merchants has hired additional lenders in its corporate banking group which has led to increased loan production. Additionally, Merchants believes that its status as the last independent statewide bank continues to have appeal to business owners and has helped the Bank attract new commercial customers. The combination of lower interest rates and reduced competition in the residential area coupled with the fact that Merchants does not originate loans for sale, have provided Merchants with additional opportunities to gain new retail customers.

Balances of real estate construction loans were relatively unchanged at $40.48 million at March 31, 2009 compared to December 31, 2008. For approximately $12.10 million of the outstanding construction loans at March 31, 2009, the primary source of repayment will be the sale of residential housing units. Approximately $15.40 million is attributable to construction of multifamily housing that is substantially complete, and will be repaid by conversion to term financing and future rental income. The balance of $12.98 million will be repaid by conversion of loans to commercial and industrial or commercial real estate borrowers to term financing, and conversion of loans to individual borrowers to conventional mortgage financing.

The following table summarizes the components of Merchants' loan portfolio as of March 31, 2009 and December 31, 2008:

     (In thousands)                         March 31, 2009 December 31, 2008
     Commercial, financial and agricultural      $ 140,866         $ 129,032
     Real estate loans - residential               423,161           395,834
     Real estate loans - commercial                279,041           273,526
     Real estate loans - construction               40,478            40,357
     Installment loans                               7,545             7,670
     All other loans                                 1,488               708
     Total loans                                 $ 892,579         $ 847,127

Merchants' investment portfolio totaled $399.06 million at March 31, 2009, a decrease of $32.55 million from December 31, 2008 ending balances of $431.61 million. Merchants sold three bonds with a book value of $12.68 million during the first quarter of 2009. One of the bonds was a non-agency Collateralized Mortgage Obligation ("CMO") that was downgraded below single A during the quarter; after careful review and analysis Merchants determined that the potential loss severities in this bond could potentially be quite high, and decided to sell the bond. The bond was sold at a loss of $542 thousand. The other two bonds sold were an agency CMO and an agency MBS, both with a 6% coupon. Both of the bonds had very short average lives, and prepayments at this coupon level are expected to be elevated in light of current interest rate levels. Merchants decided to sell these two bonds to lock in the embedded gain. These bonds were sold at a combined gain of $337 thousand. All remaining securities in Merchants' investment portfolio, with the exception of four bonds, were either Agency guaranteed or rated AAA by all rating agencies at March 31, 2009. The four securities have a split rating, with at least one rating agency continuing to carry a AAA rating and one or two others downgrading the bonds. One of these four securities was downgraded below A by one of the rating agencies during 2008. Merchants wrote this security down to its estimated fair value during the fourth quarter of 2008. Merchants, with the help of its investment advisor, has performed extensive cash flow analysis on its non-agency CMO portfolio. Merchants is closely tracking the performance of the underlying collateral on this portion of the portfolio. Merchants is also closely tracking the performance of its Commercial Mortgage-Backed Securities portfolio. Management has reviewed servicer reports on the underlying collateral that provide detail about defeasance levels, delinquencies, default rate and servicer watch lists. At this point, Merchants does not consider any of its securities to be other than temporarily impaired and has the intent and ability to hold these investments until a market price recovery, which could be maturity. Merchants has no corporate debt exposure on its books, including any perpetual preferred stock issued by FNMA or FHLMC nor any interests in pooled trust preferred securities.

Merchants' investment portfolio at March 31, 2009, including both held-to-maturity and available for sale securities, consisted of the following:

                                                Amortized     Fair
             (In thousands)                       Cost        Value
             U.S. Treasury Obligations          $     250   $     251
             Federal Home Loan Bank Obligations     6,634       6,752
             Agency MBS                           252,923     262,830
             Agency CMO                            85,466      87,844
             Non-Agency CMO                        24,770      21,791
             Commercial MBS                        16,658      15,793
             Asset Backed Securities                4,135       3,883
             Total invesments                   $ 390,836   $ 399,144

Agency MBS and Agency CMO consist of pools of residential mortgages which are guaranteed by FNMA, FHLMC or Government National Mortgage Association ("GNMA") with various origination dates and maturities. Although Merchants has the intent and ability to hold its various securities until maturity or a market price recovery, current market conditions are difficult. If conditions worsen, the fair market value of Merchants' investment portfolio could be adversely affected and it is possible that certain unrealized losses could be designated as other than temporary in future periods.

Quarterly average deposits were $948.48 million, an increase of $69.64 million, or 8%, over the same quarter of 2008. Deposits ended the quarter at $976.89 million, an increase of $46.09 million over year end balances of $930.80 million. Approximately $14 million of the new deposit growth is attributable to our new government banking group. Merchants hired two experienced government banking officers during 2008, who provide depository, lending and other banking services to municipalities, school districts and other governmental authorities or agencies in Merchants' service area. Merchants' time deposits grew $25.15 million to $410.27 million at March 31, 2009 compared to December 31, 2008. Merchants' Savings, NOW and money market balances increased $35.39 million to $463.34 million compared to $427.95 million at year end while demand deposits decreased $14.45 million. $10 million of the decrease in demand deposits and the . . .