**UNITED
STATES**


**SECURITIES
AND EXCHANGE COMMISSION**


**Washington,
D.C. 20549**


**Form
10-K**


**þ******
    **ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934**




**For
the fiscal year ended December 31, 2004**




**o******
    **TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934**




**For
the transition period from** **** **to** **** **.**






**Commission
File Number: 000-24715**




**Merrill
Merchants Bancshares, Inc.**


*(Exact
name of registrant as specified in its charter)*


**Maine**
      *(State
      or other jurisdiction*
      *of
      incorporation or organization)*
    
    **01-0471507**
      *(I.R.S.
      Employer*
      *Identification
      Number)***201
      Main Street**
      **Bangor,
      Maine**
      *(Address
      of principal executive offices)*
    
    **04402-0925**
      *(Zip
      Code)*




**Registrant’s
telephone number, including area
code: (207) 942-4800**




**Securities
registered pursuant to Section 12(b) of the Act:**




**Title
      of Class**
    
    **Name
      of Each Exchange on Which Registered**Common
      Stock, $1.00 par value
    
    NASDAQ
      Stock Market, Inc.




**Securities
registered pursuant to Section 12(g) of the Act: Not
Applicable**




Indicate
by check mark whether the Registrant (1) has filed all reports required by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months and (2) has been subject to such filing
requirements for the past 90 days. Yes þ No o




Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K 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. þ




Indicate
by check mark whether the Registrant is an accelerated filer (as defined in
Exchange Act Rule 12b-2). Yes o No þ




The
aggregate market value of the outstanding common stock, other than shares held
by persons who may be deemed affiliates of the registrant, as of the last
business day of the registrant’s most recently completed second fiscal quarter
was approximately $53,867,000. As of February 11, 2005, there were 3,340,310
shares of common stock, par value $1.00 per share, of the registrant
outstanding.




**DOCUMENTS
INCORPORATED BY REFERENCE**




Portions
of the definitive Proxy Statement for the Annual Meeting of Stockholders to be
held on April 27, 2005 are incorporated by reference into Part III,
Items 10-14 of this Form 10-K.















**TABLE
OF CONTENTS**   **Page**PART
      IITEM
      1.
    BUSINESS
    1ITEM
      2.
    PROPERTIES
    9ITEM
      3.
    LEGAL
      PROCEEDINGS
    10ITEM
      4.
    SUBMISSION
      OF MATTERS TO A VOTE OF SECURITY HOLDERS
    10PART
      IIITEM
      5.
    MARKET
      FOR THE COMPANY’S COMMON STOCK, RELATEDSTOCKHOLDER
      MATTERS AND ISSUER PURCHASES OF SECURITIES
    11ITEM
      6.
    SELECTED
      FINANCIAL DATA
    12ITEM
      7.
    MANAGEMENT’S
      DISCUSSION AND ANALYSIS OF FINANCIALCONDITION
      AND RESULTS OF OPERATIONS
    12ITEM
      7A.
    QUANTITATIVE
      AND QUALITATIVE DISCLOSURES ABOUTMARKET
      RISK
    29ITEM
      8.
    FINANCIAL
      STATEMENTS AND SUPPLEMENTARY DATA
    30ITEM
      9.
    CHANGES
      IN AND DISAGREEMENTS WITH ACCOUNTANTS ONACCOUNTING
      AND FINANCIAL DISCLOSURE
    55ITEM
      9A.
    CONTROLS
      AND PROCEDURES
    55ITEM
      9B.
    OTHER
      INFORMATION
    55PART
      IIIITEM
      10.
    DIRECTORS
      AND EXECUTIVE OFFICERS OF THE COMPANY
    55ITEM
      11.
    EXECUTIVE
      COMPENSATION
    55ITEM
      12.
    SECURITY
      OWNERSHIP OF CERTAIN BENEFICIAL OWNERS ANDMANAGEMENT
      AND RELATED STOCKHOLDER MATTERS
    56ITEM
      13.
    CERTAIN
      RELATIONSHIPS AND RELATED TRANSACTIONS
    56ITEM
      14.
    PRINCIPAL
      ACCOUNTING FEES AND SERVICES
    56PART
      IVITEM
      15.
    EXHIBITS,
      FINANCIAL STATEMENT SCHEDULES
    56SIGNATURES
    58


**Forward
Looking Statements**


This
Annual Report on Form 10-K contains certain forward-looking statements. 
These forward-looking statements also may be contained elsewhere in other
filings with the Securities and Exchange Commission (the “SEC”) and in other
communications by Merrill Merchants Bancshares, Inc. (the “Company”) and its
wholly-owned subsidiary, Merrill Merchants Bank (the “Bank”), which are made in
good faith pursuant to the “safe harbor” provisions of the Private Securities
Litigation Reform Act of 1995.  The words “may,” “could,” “should,”
“would,” “believe,” “anticipate,” “estimate,” “expect,” “intend,” “plan” and
similar expressions are intended to identify forward-looking statements. 
In preparing these disclosures, management must make assumptions, including, but
not limited to, the level of future interest rates, prepayments on loans and
investment securities, required levels of capital, needs for liquidity, and the
adequacy of the allowance for loan losses. These forward-looking statements may
be subject to significant known and unknown risks uncertainties, and other
factors, including, but not limited to, those matters referred to in the
preceding sentence.





Although
we believe that the expectations reflected in such forward-looking statements
are reasonable, actual results may differ materially from the results discussed
in these forward-looking statements. You are cautioned not to place undue
reliance on these forward-looking statements, which speak only as of the date
hereof. The Company undertakes no obligation to republish revised
forward-looking statements to reflect events or circumstances after the date
hereof or to reflect the occurrence of unanticipated events. You are also urged
to carefully review and consider the various disclosures made by the Company
which attempt to advise interested parties of the facts which affect the
Company’s business.













**PART
I**





**ITEM
1.** **BUSINESS**





**General**





Merrill
Merchants Bancshares, Inc. (the “Company”), a Maine corporation organized in
March 1992, is a registered bank holding company under the Bank Holding Company
Act of 1956, as amended (“BHCA”). The Company is also a registered financial
holding company under the BHCA. In October 1992, the Company became the bank
holding company for Merrill Merchants Bank (the “Bank”) and holds 100% of the
Bank’s outstanding common stock (the “Bank Stock”). The Company, through its
ownership of the Bank, is engaged in a general commercial and retail banking
business, along with trust and investment services. Unless the context otherwise
requires, references herein to the Company shall include the Company and the
Bank on a consolidated basis.





The
Company is an entity legally separate and distinct from the Bank. The Company’s
sources of income and cash flow are derived from dividends paid on the Bank
Stock, tax benefits received by the Company and earnings from amounts deposited
by the Company in interest bearing accounts and investments.





The Bank
was established in 1992 to purchase assets and assume liabilities of certain
branch banking offices formerly held by a large out of state bank. Merrill
Merchants Bank is headquartered in Bangor, Maine, which is located 76 miles
north of Augusta, Maine, the state capital. Presently, the Bank maintains eleven
banking offices (collectively, the “Branch Banks”) in nine area communities. The
three Bangor offices provide city-wide convenience and are complemented by: (i)
an office in Brewer, Bangor’s sister city located on the eastern shore of the
Penobscot River; (ii) a branch in Orono, home of the University of Maine’s
flagship campus; (iii) a branch in Pittsfield, a small rural town of 4,000
people located about 30 miles southwest of Bangor; (iv) a convenience store
branch in Orrington which serves as a satellite office to the Brewer Branch; (v)
a convenience store branch in Milford which serves as a satellite office to the
Orono Branch; (vi) a branch in Holden, a small town located next to Brewer;
(vii) a private banking office located in Waterville; and (viii) a supermarket
branch in Newport, a small town neighboring Pittsfield, approximately 25 miles
southwest of Bangor. The Newport Branch is located at the juncture of Interstate
95 and Route 2, which is the main travel route to the winter and summer tourist
area of the Moosehead Lake Region. In addition to the Branch Banks, the Bank has
17 ATM locations in its primary market area.





The Bank
conducts a general commercial and retail banking business that includes the
acceptance of deposits from the general public and the application of those
funds to the origination of a variety of commercial loans, commercial and
residential real estate loans and consumer loans. As of December 31, 2004, the
Company had total assets of $368.7 million, loans of $283.0 million, deposits of
$299.8 million and shareholders’ equity of $31.3 million. The Bank also
established a Trust and Investment Services Department, which has grown since
inception in April 1994 to $356.4 million in assets under management as of
December 31, 2004.





The
Bank’s income is derived principally from interest and fees earned in connection
with its lending activities, interest and dividends on investment securities,
and service charges and fees on deposit and trust accounts. Its main expenses
are the interest paid on deposits and operating expenses. The Bank’s customer
deposits are insured, up to the applicable limits, by the Federal Deposit
Insurance Corporation (“FDIC”).





**Community
Banking Strategy**





Having
identified the need for community banking services in its market area, the Bank
has worked to position itself as a service-oriented community bank. The Bank is
staffed by experienced management personnel, all of whom reside in the area and
who know the Bank’s customers and are able to provide personalized service for
these customers. This strategy has been deliberately developed and implemented
at a time when consolidation within the industry has resulted in an increasing
depersonalization among the larger financial institutions. The Bank has focused
on fostering banking relationships with customers which include multiple
financial services that range from basic checking to investment management
accounts.





1


As a part
of this strategy, the Company and the Bank have attracted local business people,
who actively promote the Bank in the community, to serve on their Boards of
Directors. In an effort to broaden the community’s awareness of the Bank and
attract new business, the Company has also obtained additional investments in
and support for the Company from local investors.





The Bank
is active in small business lending and has earned the designation “Preferred
Lender” by the Small Business Administration (SBA). The Bank is also active in
residential mortgage lending, and a number of products, including government
insured loan programs, are available to meet the demands of both the consumer
and the commercial markets. The Company’s affiliations with third party vendors
have enabled the Bank to deliver sophisticated products such as Internet
banking, automated telephone banking, and check imaging while maintaining a
local, friendly flavor in its Branch Banks. This same strategy has been
implemented by the Trust and Investment Services Department which is also
serving many clients who appreciate the personal attention and customer service
provided locally. The depository custody services and investment advisory
services provided by the Trust Department are supported through its affiliation
with The Northern Trust Company.





**Market
Area and Competition**





The
Bank’s primary market area, Greater Bangor, is at the center of commercial
activity for the northeastern and central region of the State of Maine. Nearly
100,000 people live in the Bank’s primary market area. The Bank is part of a
strategic link to Canada, as Bangor is the closest U.S. metropolitan area to
Eastern Quebec and the Canadian Maritime provinces. Many regional and national
companies site their operations in the Bangor area. Services, trades,
manufacturing and government are the four largest fields of employment in the
metropolitan Bangor region. Bangor is also a healthcare center for central,
eastern and northern Maine. The city is a regional financial center and is also
serviced by several statewide and regional accounting firms, law firms,
insurance companies and security and investment firms. Bangor is also a hub for
government services, with many local, state and federal offices located within
the city. Bangor is accessible by multiple exits from Interstate 95, a major
interstate highway which transits the eastern seaboard of the United States.
Major routes to all regions of the state bisect Bangor from various directions.
Bangor International Airport provides domestic and international passenger and
cargo service for a significant portion of the state.





Major
competitors in our market areas include local branches of large regional and
national bank affiliates, as well as local independent banks, thrift
institutions and credit unions. Other competitors for deposits and loans within
our market area include insurance companies, money market funds, consumer
finance companies and financing affiliates of consumer durable goods
manufactures.





The
Company believes that there will continue to be a need for a bank in the Bank’s
primary market area with local management having decision-making power and
emphasizing loans to small and medium sized businesses and to individuals. The
Bank has concentrated on extending business loans to such customers in the
Bank’s primary market area and to extending trust services to clients with
accounts of all sizes. The Bank’s management also makes decisions based upon,
among other things, the knowledge of the Bank’s employees regarding the
communities and customers in the Bank’s primary market area. The individuals
employed by the Bank, to a large extent, reside near the Branch Banks and thus
are generally familiar with the Branch Banks’ communities and customers. This is
important in local decision-making as it allows the Bank to respond to customer
questions and concerns on a timely basis and fosters quality customer
service.





2


The Trust
and Investment Services Department of the Bank has taken advantage of
opportunities created as the larger banks have altered their personal service
commitment to clients not meeting established account criteria. The Bank is able
to offer a comprehensive array of trust and investment services to individuals,
businesses, non-profit organizations and municipalities of varying asset size
and to provide the highest level of personal service. The staff includes an
attorney as well as investment and employee benefits professionals with trust
and banking experience.





The Bank
has worked and will continue to work to position itself to be competitive in its
market area. The Bank’s ability to make decisions close to the marketplace,
management’s commitment to providing quality banking products, the caliber of
the professional staff, and the community involvement of the Bank’s employees
are all factors affecting the Bank’s ability to be competitive. If the Company
and the Bank are unable to compete successfully, however, the business and
operations could be adversely affected.





**Employees**




The
Company employees approximately 128 people on a full-time equivalent basis. The
employees are not represented by a collective bargaining unit, and we believe
that we enjoy good relations with all personnel.





**Lending
Activity**





The Bank
has experienced loan growth since it was established in October 1992. 
One of the primary factors contributing to the growth has been an experienced
local lending group.  Many commercial lending relationships have been
developed by the Bank as a result of long standing business associations over
many years.  Many of the Bank’s officers have held lending positions with
Bangor area banks for in excess of twenty years.  Management believes that
these relationships have not only been instrumental in loan growth but also in
developing quality customers.





The
Company strives to provide a full range of financial products and services to
small and medium sized businesses and consumers.  The Bank has an
established Officer Loan Committee which meets weekly to review and approve
credits and a Director Loan Committee which meets bi-monthly, or as necessary,
to approve credits in excess of $250,000.  The Bank’s loan mix is subject
to the discretion of its Board of Directors and the demands of the local
marketplace.  Management has established relationships with local area
legal and accounting professionals to cultivate referrals.  Asset quality
is a top priority for the Bank and a significant consideration in business
development efforts.





*Commercial
and Commercial Real Estate Lending*





Loans in
this category principally include loans to service, retail, medical,
construction, wholesale and light manufacturing businesses.  Commercial
loans are made based on the management, financial strength and repayment ability
of the borrower.  As of December 31, 2004, commercial and commercial
real estate loans represented the largest class of loans at $157.0 million or
55% of total loans.  The Bank participates in government guaranteed lending
including programs with the Finance Authority of Maine (FAME) and Rural
Development (RD). The Bank is a leading lender in the State of Maine for the
Small Business Administration.





The
Bank’s commercial real estate loans are ordinarily made at variable rates of
interest, and amortized up to fifteen years, although some loans are originated
for shorter terms at fixed rates of interest.  A broad range of
short-to-medium term commercial loans, both collateralized and uncollateralized,
are made available to businesses for working capital (including inventory and
receivables), business expansion (including improvements of real estate) and the
purchase of equipment and machinery.  The purpose of a particular loan
generally determines its structure.  The commercial real estate loans are
secured by a variety of properties, including buildings occupied by
small-to-medium sized businesses, apartment complexes and non-owner/user office
and retail business.





3


The
Bank’s commercial loans primarily are underwritten in the Bank’s primary market
area on the basis of the borrowers’ ability to service such debt from
income.  Many of these loans involve lines of credit written at variable
rates of interest on a demand basis, or for terms not exceeding one year, while
others are written on a term basis typically for up to five years, generally at
variable rates of interest.  As a general practice, the Bank takes as
collateral a security interest in any available real estate, equipment or other
chattel although such loans may also be made on an uncollateralized basis. 
As additional security for commercial loans, the Bank normally requires the
personal guarantee of the principals and may require financial performance
covenants.





*Residential
Mortgage Lending*





The Bank
endeavors to meet the needs of its individual customers by making residential
mortgage loans. Residential loans include the origination of conventional
mortgages, residential lot loans and residential acquisition, development and
construction loans for the purchase or construction of single-family housing or
lots. The Bank offers fixed and adjustable rate mortgages (“ARMs”).  With
these loans, the real estate normally constitutes the primary
collateral.





Loans in
this category include both portfolio loans which are held by the Bank until
maturity and loans which are sold on the secondary market.  In the case of
secondary market loans, all servicing rights are retained by the Bank which
maintains the service connection to the customer.  The Bank participates in
government guaranteed programs and has also helped coordinate several innovative
programs including a partnership with Penquis Community Action Program in its
“Own Me” program which assists low income women in the purchase of a home, and
housing workshops for the hearing impaired.





As of
December 31, 2004, residential loans accounted for a total of $60.3 million
representing 21% of total loans.  The Bank’s secondary market servicing
portfolio totaled $122.1 million at December 31, 2004.





*Construction
Lending*





The
Company originates construction loans to individuals for the construction of
one- to four-family residences and to businesses for owner-occupancy.
Residential and commercial construction loans generally provide for the payment
of interest only during the construction phase, which is usually between six and
twelve months. At the end of the construction phase, the loan converts to a
permanent mortgage loan. At December 31, 2004, construction loans totaled
$12.9 million representing 5% of total loans.





Construction
lending generally involves a higher degree of risk than single-family permanent
mortgage lending or a commercial real estate loan because of the greater
potential for disagreements between borrowers and builders and the failure of
builders to pay subcontractors. Additional risk often exists because of the
inherent difficulty in estimating both a property’s value and the estimated cost
of the property.





*Home
Equity Lending*





The
Company originates home equity loans on a fixed and variable interest rate
basis.  At December 31, 2004, fixed-rate loans totaled $17.5 million
and variable-rate loans amounted to $16.7 million representing 12% of total
loans.  These home equity loans are generally secured by a second mortgage
on the principal residential property.





4


*Consumer
Lending*





Consumer
loans made by the Bank have included home improvement, automobile, boat and
recreational vehicle loans, credit cards and overdraft protection
accounts.  The Bank’s consumer loan portfolio consists primarily of loans
to individuals for various consumer purposes.  A majority of these loans
are for terms of less than 60 months and although generally collateralized by
liens on various personal assets of the borrower may be made
uncollateralized.  Consumer loans are made at fixed and variable interest
rates. Consumer loans totaled $18.7 million and represented 7% of the Company’s
loan portfolio at December 31, 2004.





**Joint
Venture**





In 1996,
the Bank and MSB Leasing, Inc., a subsidiary of Machias Savings Bank, a state
chartered mutual savings bank, formed M&M Consulting Limited Liability
Company (“M&M”), a jointly owned subsidiary.  M&M was established
to provide a review of various internal bank risk control functions. 
M&M, which has a former FDIC examiner as one of its principals, provides the
Bank, Machias Savings Bank and over fifty other financial institutions in
northern New England access to experienced individuals who are highly trained in
loan review, regulatory compliance, training and internal auditing in a
cost-efficient and timely manner.





**Supervision
and Regulation**





*General*





The
Company, as a financial holding company under the Bank Holding Company Act (the
“BHCA”), is subject to the rules and regulations of the Federal Reserve Board
(the “FRB”). The Company is also subject to the rules and regulations of the SEC
and The NASDAQ National Market. The Bank is a Maine-chartered community bank
whose deposit accounts are insured up to applicable limits by the Federal
Deposit Insurance Corporation (“FDIC”). The Bank is subject to extensive
regulation, examination and supervision by the Maine Bureau of Financial
Institutions (the “Bureau”) as its primary corporate regulator, by the FRB as
its primary federal regulator, and by the FDIC as its deposit insurer. Both the
Company and the Bank are subject to the provisions of the Maine Revised Statues
applicable to financial institutions, and the rules and regulations of the
Bureau.




The
following references to the laws and regulations under which the Bank and the
Company are regulated are brief summaries thereof, do not purport to be
complete, and are qualified in their entirety by reference to such laws and
regulations. These laws and regulations have been established primarily for the
protection of depositors and the deposit insurance funds, not Company
stockholders.




*Maine
Banking Laws and Supervision*





The
Company and the Bank are subject to Maine law and the rules and regulations of
the Bureau. The approval of the Bureau is required to establish or close
branches, to merge with another bank, to form a bank holding company, to issue
stock or to undertake many other activities. Any Maine bank that does not
operate in accordance with the regulations, policies and directives of the
Bureau is subject to sanctions. The Bureau may, under certain circumstances,
suspend or remove directors or officers of a bank who have violated the law,
conducted a bank’s business in a manner which is unsafe, unsound or contrary to
the depositors’ interests, or breached their fiduciary duties.




*Loans-to-One-Borrower
Limitations* . With
certain exceptions, the total obligations of a single borrower to the Bank may
not exceed 20% of the Bank’s equity. The Bank currently complies with applicable
loans-to-one-borrower limitations.




5


*Dividends.* Under
Maine law, the Company may declare and pay a dividend on its capital stock
provided that adequate levels of capital are maintained. The Bureau’s minimum
capital requirements are the same as those set forth by federal banking
regulations. See “ - Federal Banking Regulations - Capital Requirements.” In
addition, federal law also may limit the amount of dividends that may be paid by
the Bank.




*Examination
and Enforcement* . The
Bureau is required to regularly examine each state-chartered bank at least once
every 36 months.




*Federal
Banking Regulations*





*Capital
Requirements.* Under
FDIC regulations, the Bank is required to maintain minimum levels of capital.
The FDIC regulations define two classes of capital known as Tier 1 and Tier 2
capital. For an institution with a rating of 1 (the highest examination rating
of the FDIC for banks) under the Uniform Financial Institutions Rating System,
the minimum capital leverage requirement is a ratio of Tier 1 capital to total
assets of 3%. For all other banks, the minimum leverage capital requirement is
4%, unless the particular circumstances or risk profile of the depository
institution warrants a higher leverage capital ratio.





The FDIC
regulations also require that banks meet a risk-based capital standard. The
risk-based capital standard requires the maintenance of a ratio of total capital
(which is defined as the sum of Tier 1 capital and Tier 2 capital) to
risk-weighted assets of at least 8% and a ratio of Tier 1 capital to
risk-weighted assets of at least 4%. In determining the amount of risk-weighted
assets, all assets, plus certain off balance sheet items, are multiplied by a
risk-weight of 0% to 100%, based on the risks the FDIC believes are inherent in
the type of asset or item.





The
federal banking agencies, including the FDIC, have also adopted regulations to
require an assessment of an institution’s exposure to declines in the economic
value of a bank’s capital due to changes in interest rates when assessing the
Bank’s capital adequacy. Under such a risk assessment, examiners will evaluate a
bank’s capital for interest rate risk on a case-by-case basis, with
consideration of both quantitative and qualitative factors.





Institutions
with significant interest rate risk may be required to hold additional capital.
The agencies also issued a joint policy statement providing guidance on interest
rate risk management, including a discussion of the critical factors affecting
the agencies’ evaluation of interest rate risk in connection with capital
adequacy. The Bank was considered “well-capitalized” under FDIC guidelines at
December 31, 2004.





*Enforcement.* The FDIC
has extensive enforcement authority over insured state-chartered commercial bank
and trust companies, including the Bank. This enforcement authority includes,
among other things, the ability to assess civil money penalties, to issue cease
and desist orders and to remove directors and officers. In general, these
enforcement actions may be initiated in response to violations of laws and
regulations and to unsafe or unsound practices.





The FDIC
is required, with certain exceptions, to appoint a receiver or conservator for
an insured state bank if that bank is “critically undercapitalized.” For this
purpose, “critically undercapitalized” means having a ratio of tangible capital
to total assets of less than 2%. The FDIC may also appoint a conservator or
receiver for a state bank on the basis of the institution’s financial condition
or upon the occurrence of certain events.





*Deposit
Insurance* . The
FDIC has adopted a risk-based deposit insurance assessment system. Under the
risk-based deposit insurance assessment system, the FDIC assigns an institution
to one of three capital categories based on the institution’s financial
information, as of the most recent quarterly report filed with the applicable
bank regulatory agency prior to the assessment period. The three capital
categories are: (1) well capitalized, (2) adequately capitalized and (3)
undercapitalized, using capital ratios that are substantially similar to the
prompt corrective action capital ratios discussed below. See “-Federal Banking
Regulation - Prompt Corrective Action” below. The FDIC also assigns an
institution to a supervisory subgroup based on a supervisory evaluation provided
to the FDIC by the institution’s primary federal regulator and information that
the FDIC determines to be relevant to the institution’s financial condition and
the risk posed to the deposit insurance funds (which may include, if applicable,
information provided by the institution’s state supervisor). An institution’s
assessment rate depends on the capital category and supervisory category to
which it is assigned. Any increase in insurance assessments could have an
adverse effect on the earnings of insured institutions, including the
Bank.





6


Under the
Federal Deposit Insurance Act (the “FDIA”), the FDIC may terminate the insurance
of an institution’s deposits upon a finding that the institution has engaged in
unsafe or 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. The management of the Bank does not know of any
practice, condition or violation that might lead to termination of deposit
insurance.





*Transactions
with Affiliates of the Bank* .
Transactions between an insured bank, such as the Bank, and any of its
affiliates are governed by Sections 23A and 23B of the Federal Reserve Act (the
“FRA”). An affiliate of a bank is any company or entity that controls, is
controlled by or is under common control with the Bank. A subsidiary of a bank
that is not also a depository institution is not treated as an affiliate of the
Bank for purposes of Sections 23A and 23B.





Section
23A limits the extent to which the Bank or its subsidiaries may engage in
“covered transactions” with any one affiliate to an amount equal to 10% of such
bank’s capital stock and retained earnings, and limit on all such transactions
with all affiliates to an amount equal to 20% of such capital stock and retained
earnings; and requires that all such transactions be on terms that are
consistent with safe and sound banking practices.





The term
“covered transaction” includes the making of loans, purchase of assets, issuance
of guarantees and other similar types of transactions. Further, most loans by a
bank to any of its affiliates must be secured by collateral in amounts ranging
from 100 to 130 percent of the loan amounts. In addition, any covered
transaction by a bank with an affiliate and any purchase of assets or services
by a bank from an affiliate must be on terms that are substantially the same, or
at least as favorable to the Bank, as those that would be provided to a
non-affiliate.





Effective
April 1, 2003, the FRB rescinded its interpretations of Sections 23A and 23B of
the FRA and replaced these interpretations with Regulation W. In addition,
Regulation W makes various changes to existing law regarding Sections 23A and
23B, including expanding the definition of what constitutes an affiliate subject
to Sections 23A and 23B and exempting certain subsidiaries of state-chartered
banks from the restrictions of Sections 23A and 23B. We do not expect that the
changes made by Regulation W will have a material adverse effect on our
business.





The
Bank’s authority to extend credit to its directors, executive officers and 10%
shareholders, as well as to entities controlled by such persons, is currently
governed by the requirements of Sections 22(g) and 22(h) of the FRA and
Regulation O of the FRB. Among other things, these provisions require that
extensions of credit to insiders (a) 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 and
that do not involve more than the normal risk of repayment or present other
unfavorable features and (b) 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 regulations allow
small discounts on fees on residential mortgages for directors, officers and
employees. In addition, extensions for credit in excess of certain limits must
be approved by the Bank’s Board of Directors.





7


Section
402 of the Sarbanes-Oxley Act of 2002 prohibits the extension of personal loans
to directors and executive officers of issuers (as defined in Sarbanes-Oxley).
The prohibition, however, does not apply to loans advanced by an insured
depository institution, such as the Bank, that are subject to the insider
lending restrictions of Section 22(h) of the FRA.





*Safety
and Soundness Standards* .
Pursuant to the requirements of the FDIA, as amended by the Riegle Community
Development and Regulatory Improvement Act of 1994, each federal banking agency,
including the FDIC, has adopted guidelines establishing general standards
relating to internal controls, information and internal audit systems, loan
documentation, credit underwriting, interest rate exposure, asset growth, asset
quality, earnings and compensation, fees and benefits. In general, the
guidelines require, among other things, appropriate systems and practices to
identify and manage the risks 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 FDIC adopted regulations to
require a bank that is given notice by the FDIC that it is not satisfying any of
such safety and soundness standards to submit a compliance plan to the FDIC. If,
after being so notified, a bank fails to submit an acceptable compliance plan or
fails in any material respect to implement an accepted compliance plan, the FDIC
may issue an order directing corrective and other actions of the types to which
a significantly undercapitalized institution is subject under the “prompt
corrective action” provisions of the FDICIA. If a bank fails to comply with such
an order, the FDIC may seek to enforce such an order in judicial proceedings and
to impose civil monetary penalties.





*Prompt
Corrective Action* . The
FDIA also established a system of prompt corrective action to resolve the
problems of undercapitalized institutions. The FDIC, as well as the other
federal banking regulators, adopted regulations governing the supervisory
actions that may be taken against undercapitalized institutions. The regulations
establish five categories, consisting of “well capitalized,” “adequately
capitalized,” “undercapitalized,” “significantly undercapitalized” and
“critically undercapitalized.” The severity of the action authorized or required
to be taken under the prompt corrective action regulations increases as a bank’s
capital decreases within the three undercapitalized categories. The Bank is
prohibited from paying dividends or other capital distributions or paying
management fees to any controlling person if, following such distribution, the
Bank would be undercapitalized.





*Community
Reinvestment* . Under
the Community Reinvestment Act (“CRA”), any insured depository institution,
including the Bank has a continuing and affirmative obligation consistent with
its safe and sound operation to help meet the credit needs of its entire
community, including low and moderate-income neighborhoods. The CRA does not
establish specific lending requirements or programs for financial institutions
nor does it limit an institution’s discretion to develop the types of products
and services that it believes are best suited to its particular community. The
CRA requires the FDIC to assess the depository institution’s record of meeting
the credit needs of its community and to take such record into account in its
evaluation of certain applications by such institution, including applications
for additional branches and acquisitions. The CRA requires the FDIC to provide a
written evaluation of an institution’s CRA performance utilizing a four-tiered
descriptive rating system, and the institution is required to publicly disclose
its CRA rating. The Bank received a “Satisfactory” rating on its last CRA exam
in September 2003.





*Federal
Reserve System* . Under
FRB regulations, the Bank is required to maintain noninterest-earning reserves
against its transaction accounts. Current Federal Reserve Board regulations
generally require that reserves of 3% must be maintained against aggregate
transaction accounts of $47.6 million or less, subject to adjustment by the FRB.
Total transaction accounts in excess of $47.6 million are required to have a
reserve of 10% held against them, which are also subject to adjustment by the
FRB. The first $7.0 million of otherwise reservable balances, subject to
adjustments by the FRB, are exempted from the reserve requirements. The Bank is
in compliance with these requirements. Because required reserves must be
maintained in the form of either vault cash, a noninterest-bearing account at a
Federal Reserve Bank or a pass-through account as defined by the FRB, the effect
of this reserve requirement is to reduce the Bank’s interest-earning
assets.





8


*Financial
Holding Company Regulation* . As a
bank holding company, the Company is subject to examination, regulation and
periodic reporting under the BHCA, as administered by the FRB. The FRB has
adopted capital adequacy guidelines for bank holding companies on a consolidated
basis substantially similar to those of the FDIC for the Bank. As of December
31, 2004, the Company’s total capital and Tier 1 capital ratios exceeded these
minimum capital requirements.





In 2001,
the Company elected to be treated as a financial holding company under the BHCA.
As a financial holding company, the Company may conduct activities that are
considered “financial in nature” under the BHCA. Such activities
include:





·
    Activities
      permissible for bank holding companies prior to the enactment of the
      Act;


·
    Lending,
      exchanging, transferring, investing for others, or safeguarding money or
      securities;


·
    Underwriting
      and selling insurance;


·
    Providing
      financial, investment, or advisory
services;


·
    Selling
      pools of assets;


·
    Underwriting,
      dealing in, or making a market in securities;
and


·
    Merchant
      banking.





In order
to commence a new activity, Merrill Merchants Bank must have received a
“satisfactory” on its latest CRA exam.





**Taxation**





The
Company is subject to those rules of federal income taxation generally
applicable to corporations under the Internal Revenue Code. The Company and the
Bank, as members of an affiliated group of corporations within the meaning of
Section 1504 of the Internal Revenue Code, file a consolidated federal income
tax return, which has the effect of eliminating inter-company distributions,
including dividends and inter-company interest income and expense, from the
computation of consolidated taxable income.





The
Company, on a consolidated basis, is subject to a separate state franchise tax
in lieu of state corporate income tax. The amount of the tax is the sum of 1% of
Maine net income and $.08 per $1,000 of Maine assets as defined in Maine law.
Maine assets are the corporation’s total end of the year assets as reported on
the federal income tax return. Maine net income is the corporation’s net income
or loss as reported on the federal income tax return which is apportioned to
Maine under Maine law.





**ITEM
2. PROPERTIES**





At
December 31, 2004, the Bank conducted its business from the headquarters office
in Bangor, Maine, its operations center in Bangor, Maine, and its ten branch
offices in Bangor, Brewer, Holden, Milford, Newport, Orono, Orrington,
Pittsfield and Waterville, Maine.




In July
2004, the Bank acquired a historic building located at 183 Main Street, Bangor,
Maine. This property is adjacent to the Bank’s headquarters located at 201 Main
Street. Construction is in progress to renovate the historic building, add a
third floor to its headquarters building and to link the properties with a
three-story connecting corridor. The $1.5 million project is targeted for
completion in September 2005.




9


The
following table sets forth certain information regarding the Bank’s properties
at December 31, 2004.


Owned
    
    **Leased**Corporate
      Office
    
    Operations
      Center201
      Main Street
    
    359
      Perry RoadBangor,
      Maine 04401
    
    Bangor,
      Maine 04401183
      Main Street
    
    920
      Stillwater AvenueBangor,
      Maine 04401
    
    Bangor,
      Maine 044011007
      Main Road
    
    992
      Union StreetHolden,
      Maine 04429
    
    Bangor,
      Maine 0440127
      Main Street
    
    366
      Wilson StreetPittsfield,
      Maine 04967
    
    Brewer,
      Maine 044122
      Main StreetMilford,
      Maine 0446144
      Moosehead TrailNewport,
      Maine 0495369
      Main StreetOrono,
      Maine 04473191
      River RoadOrrington,
      Maine 0447458
      Elm StreetWaterville,
      Maine 04901


**ITEM
3.** **LEGAL
PROCEEDINGS**





Although
the Bank and the Company, from time to time, are involved in routine litigation
incidental to the business, there are no material legal proceedings to which the
Bank or the Company are a party or to which any of its property is subject, or,
to the Company’s knowledge, any such proceedings that any governmental authority
is contemplating, as of the date of this Form 10-K for the fiscal year ended
December 31, 2004.





**ITEM
4.** **SUBMISSION
OF MATTERS TO A VOTE OF SECURITY HOLDERS**





None.








10


**PART
II**





**ITEM
5.** **MARKET
FOR THE COMPANY’S COMMON STOCK, RELATED** **STOCKHOLDER
MATTERS AND ISSUER PURCHASES OF SECURITIES**





*Market
Information and Related Matters*




Our
common stock is traded on The Nasdaq Stock Market, Inc.’s National Market. The
following table sets forth the high and low prices of our common stock and the
dividends declared per share of common stock for the periods indicated. Per
share data information has been adjusted to reflect the 3% stock dividends in
both 2004 and 2003, respectively.








**Market
      Price**
    ****
    **Dividends
      Declared****2004**
    
    **High**
    ****
    **Low**
    ****
    **Per
      Share**First
      Quarter
    
    $
    25.39
    
    $
    20.11
    
    $
    0.130Second
      Quarter
    
    
    25.65
    
    
    22.00
    
    
    0.140Third
      Quarter
    
    
    23.95
    
    
    20.25
    
    
    0.140Fourth
      Quarter
    
    
    22.60
    
    
    20.75
    
    
    0.150**2003**First
      Quarter
    
    $
    15.55
    
    $
    14.21
    
    $
    0.107Second
      Quarter
    
    
    16.46
    
    
    14.28
    
    
    0.117Third
      Quarter
    
    
    18.90
    
    
    15.68
    
    
    0.117Fourth
      Quarter
    
    
    21.18
    
    
    18.01
    
    
    0.126


As of
December 31, 2004, there were 3,340,310 shares of common stock outstanding which
were held by approximately 1,200 holders of record.





We have
historically paid quarterly cash dividends on our common stock and currently
intend to continue to do so in the foreseeable future. Our ability to pay
dividends depends on a number of factors, however, including restrictions on the
ability of the Company to pay dividends under federal laws and regulations and
as a result there can be no assurance that dividends will be paid in the
future.





*Share
Repurchases*





On June
17, 2004, the Board of Directors approved a fourth stock repurchase program
authorizing the Company to repurchase up to 169,995 shares of the Company’s
common stock. The authority may be exercised from time to time and in such
amounts as market conditions warrant.  Shares are being repurchased for
other corporate purposes.  The program does not have an expiration date.
During the year ended December 31, 2004, the Company repurchased 89,592 shares
at an average price per share of $24.06. For the three month period ended
December 31, 2004, the Company did not purchase any shares of common
stock.








11


**ITEM
6.** **SELECTED
FINANCIAL DATA**




*(Dollars in thousands, except per share
      data)***For
      the Year**
    
    2004
    
    2003
    
    2002
    
    2001
    
    2000Net
      income
    
    $
    4,907
    
    $
    4,302
    
    $
    3,845
    
    $
    3,254
    
    $
    2,619Net
      interest income
    
    
    13,773
    
    
    12,479
    
    
    12,463
    
    
    11,542
    
    
    10,026Non-interest
      income
    
    
    5,005
    
    
    5,181
    
    
    3,963
    
    
    3,299
    
    
    3,155Non-interest
      expense
    
    
    11,042
    
    
    10,718
    
    
    10,205
    
    
    9,468
    
    
    8,823**Per
      Common Share**(adjusted for 3% stock dividend in 2004)Basic
      earnings per share
    
    $
    1.46
    
    $
    1.26
    
    $
    1.24
    
    $
    1.10
    
    $
    0.87Diluted
      earnings per share
    
    
    1.44
    
    
    1.26
    
    
    1.11
    
    
    0.95
    
    
    0.77Dividends
      per share
    
    
    0.56
    
    
    0.47
    
    
    0.38
    
    
    0.28
    
    
    0.22Book
      value per share at year end
    
    
    9.38
    
    
    8.92
    
    
    8.59
    
    
    8.92
    
    
    8.00Stock
      price:High
    
    
    25.65
    
    
    21.18
    
    
    15.32
    
    
    10.52
    
    
    10.77Low
    
    
    20.11
    
    
    14.21
    
    
    10.34
    
    
    8.44
    
    
    5.78Close
    
    
    21.59
    
    
    21.09
    
    
    14.70
    
    
    10.34
    
    
    7.77**Key
      Performance Ratios**Return
      on average equity
    
    
    16.06
    %
    
    14.74
    %
    
    13.93
    %
    
    13.18
    %
    
    11.94
    %Return
      on average assets
    
    
    1.36
    
    
    1.34
    
    
    1.33
    
    
    1.26
    
    
    1.16Equity
      to assets at year end
    
    
    8.50
    
    
    8.93
    
    
    9.24
    
    
    9.34
    
    
    9.45Non-performing
      assets to total assets
    
    
    0.44
    
    
    0.18
    
    
    0.25
    
    
    0.26
    
    
    0.25Net
      charge-offs to average loans
    
    
    0.05
    
    
    0.04
    
    
    0.07
    
    
    0.08
    
    
    0.03Efficiency
      ratio
    
    
    59.29
    
    
    60.51
    
    
    62.01
    
    
    63.96
    
    
    66.63Dividend
      payout ratio
    
    
    38.32
    
    
    37.16
    
    
    31.27
    
    
    25.87
    
    
    25.52**At
      Year End**Total
      assets
    
    $
    368,690
    
    $
    342,189
    
    $
    307,316
    
    $
    278,197
    
    $
    246,413Loans
    
    
    282,988
    
    
    246,512
    
    
    214,729
    
    
    188,080
    
    
    165,923Deposits
    
    
    299,782
    
    
    258,848
    
    
    238,857
    
    
    219,309
    
    
    200,451Long-term
      borrowings
    
    
    15,670
    
    
    17,977
    
    
    8,656
    
    
    9,752
    
    
    2,450Shareholders’
      equity
    
    
    31,329
    
    
    30,553
    
    
    28,388
    
    
    25,985
    
    
    23,292





**ITEM
7.** **MANAGEMENT’S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS**


**(In
thousands, except per share data)**





The
discussion and analysis that follows focuses on the results of operations of the
Company during 2004, 2003 and 2002 and its financial condition at December 31,
2004 and 2003. The Consolidated Financial Statements and related notes should be
read in conjunction with the review.





**General**





The
Company owns all of the common stock of the Bank. The Bank is a full-service
community bank headquartered in Bangor, Maine, providing a wide range of
consumer, commercial, and trust and investment services through its eleven
locations in central and eastern Maine. In addition, the Bank provides indirect
auto and recreational vehicle lending through its consumer finance
division.





The Bank
is committed to providing outstanding customer service and building long term
banking relationships with customers. Delivery on this commitment through local
decision-making and personal service has helped distinguish the Company from its
competitors. This will continue to be strategically significant as larger banks
consolidate and their service delivery channels become more depersonalized.





The
Company’s goal is to sustain profitable, controlled growth by focusing on
increased loan and deposit market share; managing yields on earning assets and
rates on interest-bearing liabilities; increasing non-interest income; and being
prepared for acquisitions and expansion opportunities within the financial
services industry.





12


**Executive
Overview**





The
Company’s net income increased 14% to $4,907 in 2004 and diluted earnings per
share was $1.44 in 2004 as compared to $1.26 in 2003, an increase of $0.18 per
diluted share or 14%. The following were significant factors related to 2004
results as compared to 2003:





·
    Total
      loans grew 15% in 2004. Real estate lending was strong with construction
      balances increasing 33%, home equity balances growing 20% and residential
      mortgages up 9%. The commercial and commercial real estate portfolio grew
      at a rate of 16% and consumer loans increased 8% from a year
      ago.





·
    We
      continue to maintain strong asset quality with net charge-offs of $134 in
      2004 representing 0.05% of average net loans compared to 0.04% in 2003.
      Non-performing assets as a percentage of total assets were 0.44% at
      year-end, up from 0.18% at the close of 2003. Despite the increase in
      non-performing assets to $1,609 at year-end, 67% of the balance is
      guaranteed by the SBA.





·
    The
      direct mail marketing campaign to businesses and individuals under the
      High Performance Checking program combined with business development
      efforts has resulted in a 15% increase in checking account balances in
      2004. Money market and savings accounts increased 19% while certificate of
      deposit balances grew 13% in 2004.





·
    The
      effects of the decline in net interest margin of 8 basis points in 2004
      were offset by growth in average loans.





·
    Non-interest
      income declined 3% in 2004 due to the substantial drop in mortgage
      refinance activity which resulted in a decline in the gain on loan sales
      of $911. We experienced growth in all other fee categories with service
      fees on deposit accounts increasing 20%, trust fees growing 17% and gains
      on investment securities increasing $206 from a year ago.





·
    Our
      efficiency ratio continued to improve decreasing to 59.3%, down from 60.5%
      in 2003. Non-interest expenses increased only 3% in 2004 as increases in
      salaries and employee benefits, occupancy costs, and data processing costs
      were offset by declines in equipment expense, merchant processing expense
      and mortgage servicing rights amortization.





**Critical
Accounting Policies**





Management’s
discussion and analysis of the Company’s financial condition are based on the
consolidated financial statements which are prepared in accordance with
accounting principles generally accepted in the United States. The preparation
of such 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. On an
ongoing basis, management evaluates its estimates, including those related to
the allowance for loan losses. Management bases its estimates on historical
experience and on various other assumptions that are believed to be reasonable
under the circumstances, the results of which form the basis for making
judgments about the carrying values of assets that are not readily apparent from
other sources. Actual results could differ from the amount derived from
management’s estimates and assumptions under different assumptions or
conditions.





*Allowance
for Loan Losses* .
Management believes the allowance for loan losses is a critical accounting
policy that requires the most significant estimates and assumptions used in the
preparation of the consolidated financial statements. The allowance for loan
losses is based on management’s evaluation of the level of the allowance
required in relation to the estimated loss exposure in the loan portfolio.
Management believes the allowance for loan losses is a significant estimate and
therefore regularly evaluates it for adequacy by taking into consideration
factors such as prior loan loss experience, the character and size of the loan
portfolio, business and economic conditions and management’s estimation of
probable losses. The use of different estimates or assumptions could produce
different provisions for loan losses.





13


*Mortgage
Servicing Rights* .
Servicing assets are recognized as separate assets when servicing rights are
acquired through sale of residential mortgage assets. Capitalized servicing
rights are reported in other assets and are amortized into non-interest expense
in proportion to, and over the period of, the estimated future net servicing
income of the underlying financial residential mortgage assets. Servicing assets
are evaluated for impairment based upon the fair value of the rights as compared
to amortized costs. Fair value is determined based upon discounted cash flows
using market-based assumptions. When the book value exceeds its fair value, an
impairment allowance is recognized so that mortgage servicing rights is carried
at the lower of amortized book value or fair value. In periods of falling market
interest rates, accelerated loan prepayment speeds can adversely impact the fair
value of these mortgage servicing rights relative to their book value. In the
event that the fair value of these assets were to increase in the future, the
Company can recognize the increased fair value to the extent of the impairment
allowance but cannot recognize an asset in excess of its amortized book value.
Future changes in management’s assessment of the impairment of these servicing
assets, as a result of changes in observable market data relating to market
interest rates, loan prepayment speeds, and other factors, could impact the
Company’s financial condition and results of operations either positively or
adversely. On a quarterly basis, an independent third party determines the
valuation of the Company’s mortgage servicing rights asset.





**Review
of Financial Statements**





The
Company declared a 3% stock dividend both in 2004 and 2003. All financial data
included herein has been restated to reflect the impact of the stock
dividends.





**Results
of Operations**





*Comparison
of 2004 and 2003*





*Summary*





The
Company ended 2004 with consolidated assets of $368,690 representing growth of
$26,501 or 8%.  Asset growth was attributable to strong real estate loan
demand.  The Company reported net income of $4,907 or $1.46 per basic share
and $1.44 per diluted share in 2004, compared to $4,302 or $1.26 per basic share
and diluted share in 2003.  This represented earnings growth of $605 or
14%.  Return on average assets increased to 1.36% in 2004 compared to 1.34%
in 2003, and return on average equity increased to 16.06% in 2004 from 14.74% in
2003.





**


*Net
Interest Income*





The
Company’s primary source of operating income is net interest income.  Net
interest income was $13,773 for 2004 and $12,479 for 2003.  Net interest
income is the difference between the income earned on earning assets and the
interest paid on interest-bearing liabilities.  Both net interest income
and the net interest margin, which is net interest income expressed as a
percentage of average earning assets, are affected by the volume and mix of
earning assets and interest-bearing liabilities and the interest rates earned or
paid on them.








14


**Table
1 - Three-Year Average Balance Sheets**





The
following table sets forth, for the years indicated, information regarding (i)
the total dollar amount of interest income of the Company from interest-earning
assets and the resultant average yields; (ii) the total dollar amount of
interest expense on interest-bearing liabilities and the resultant average
costs; (iii) net interest income; (iv) net interest rate spread; and (v) net
interest margin.





**2004**
    
    
    **2003**
    
    
    **2002****Average
      Balance**
    
    ****
      **Interest**
    
    **Yield/**
      **Rate**
    
    
    **Average
      Balance**
    
    **Interest**
    
    **Yield/**
      **Rate**
    
    
    **Average
      Balance**
    
    **Interest**
    
    **Yield/**
      **Rate**Assets:Interest-earning
      assets:Loans
      (1)
    
    $
    269,091
    
    $
    16,609
    
    
    6.17
    %
    
    $
    234,279
    
    $
    15,302
    
    
    6.53
    %
    
    $
    202,377
    
    $
    14,959
    
    
    7.39
    %Investment
      securities
    
    
    70,259
    
    
    2,071
    
    
    2.95
    %
    
    
    68,387
    
    
    1,911
    
    
    2.79
    %
    
    
    67,790
    
    
    3,347
    
    
    4.94
    %Other
      earning assets
    
    
    1,595
    
    
    28
    
    
    1.76
    %
    
    
    105
    
    
    -
    
    
    -
    
    
    
    90
    
    
    1
    
    
    1.11
    %Total
      interest-earning assets
    
    
    340,945
    
    
    18,708
    
    
    5.49
    %
    
    
    302,771
    
    
    17,213
    
    
    5.69
    %
    
    
    270,257
    
    
    18,307
    
    
    6.77
    %Non-earning
      assets
    
    
    18,727
    
    
    
    
    
    
    
    
    
    17,308
    
    
    
    
    
    
    
    
    
    17,812Total
      assets
    
    $
    359,672
    
    
    
    
    
    
    
    
    $
    320,079
    
    
    
    
    
    
    
    
    $
    288,069Liabilities
      and shareholders' equity:Interest-bearing
      liabilities:Savings
      deposits and interest-
      bearing
      checking
    
    $
    129,774
    
    
    818
    
    
    0.63
    %
    
    $
    112,372
    
    
    689
    
    
    0.61
    %
    
    $
    103,259
    
    
    1,354
    
    
    1.31
    %Certificates
      of deposit
    
    
    103,881
    
    
    3,223
    
    
    3.10
    %
    
    
    91,675
    
    
    3,250
    
    
    3.55
    %
    
    
    87,393
    
    
    3,653
    
    
    4.18
    %Securities
      sold under agreement
      to
      repurchase
    
    
    17,357
    
    
    139
    
    
    0.80
    %
    
    
    19,797
    
    
    162
    
    
    0.82
    %
    
    
    17,096
    
    
    240
    
    
    1.40
    %Short-term
      borrowings
    
    
    5,464
    
    
    62
    
    
    1.13
    %
    
    
    9,911
    
    
    125
    
    
    1.26
    %
    
    
    3,822
    
    
    65
    
    
    1.70
    %Long-term
      borrowings
    
    
    18,767
    
    
    693
    
    
    3.69
    %
    
    
    12,170
    
    
    508
    
    
    4.17
    %
    
    
    9,933
    
    
    532
    
    
    5.36
    %Total
      interest-bearing liabilities
    
    
    275,243
    
    
    4,935
    
    
    1.79
    %
    
    
    245,925
    
    
    4,734
    
    
    1.92
    %
    
    
    221,503
    
    
    5,844
    
    
    2.64
    %Other
      liabilities
    
    
    53,881
    
    
    
    
    
    
    
    
    
    44,962
    
    
    
    
    
    
    
    
    
    38,965Shareholders'
      equity
    
    
    30,548
    
    
    
    
    
    
    
    
    
    29,192
    
    
    
    
    
    
    
    
    
    27,601Total
      liabilities and shareholders'
      equity
    
    $
    359,672
    
    
    
    
    
    
    
    
    $
    320,079
    
    
    
    
    
    
    
    
    $
    288,069Net
      interest income
    
    
    
    
    $
    13,773
    
    
    
    
    
    
    
    
    $
    12,479
    
    
    
    
    
    
    
    
    $
    12,463Net
      interest rate spread
    
    
    
    
    
    
    
    
    3.69
    %
    
    
    
    
    
    
    
    
    3.77
    %
    
    
    
    
    
    
    
    
    4.13
    %Net
      interest margin
    
    
    
    
    
    
    
    
    4.04
    %
    
    
    
    
    
    
    
    
    4.12
    %
    
    
    
    
    
    
    
    
    4.61
    %





(1) Loans
include portfolio loans, loans held for sale and nonperforming loans, but unpaid
interest on nonperforming loans has not been included for purposes of
determining interest income.





15


**Table
2 - Changes in Net Interest Income**





The
following table presents the changes in interest income and expense attributable
to changes in interest rates (change in rate multiplied by prior year volume),
changes in volume (change in volume multiplied by prior year rate) and changes
in rate/volume (change in rate multiplied by change in volume) for
interest-earning assets and interest-bearing liabilities.





**December
      31, 2004 vs. 2003**
    
    **December
      31, 2003 vs. 2002****Increase
      (Decreased) Due to Change in:**
    
    **Increase
      (Decreased) Due to Change in:****Volume**
    
    **Rate**
    
    ****Rate/**Volume**
    
    **Total**
    
    **Volume**
    
    **Rate**
    
    ****Rate/**Volume**
    
    **Total****Interest-earning
      assets:****Loans**
    
    **$**
    **2,274**
    
    **$**
    **(842**
    **)**
    **$**
    **(125**
    **)**
    **$**
    **1,307**
    
    **$**
    **2,358**
    
    **$**
    **(1,741**
    **)**
    **$**
    **(274**
    **)**
    **$**
    **343****Investment
      securities**
    
    
    **52**
    
    
    **105**
    
    
    **3**
    
    
    **160**
    
    
    **29**
    
    
    **(1,453**
    **)**
    
    **(12**
    **)**
    
    **(1,436**
    **)****Other
      earning assets**
    
    
    **-**
    
    
    **2**
    
    
    **26**
    
    
    **28**
    
    
    **-**
    
    
    **(1**
    **)**
    
    **-**
    
    
    **(1**
    **)****Total
      interest income**
    
    
    **2,326**
    
    
    **(735**
    **)**
    
    **(96**
    **)**
    
    **1,495**
    
    
    **2,387**
    
    
    **(3,195**
    **)**
    
    **(286**
    **)**
    
    **(1,094**
    **)****Interest-bearing
      liabilities:****Savings
      deposits and interest-****bearing
      checking**
    
    
    **107**
    
    
    **19**
    
    
    **3**
    
    
    **129**
    
    
    **119**
    
    
    **(721**
    **)**
    
    **(63**
    **)**
    
    **(665**
    **)****Certificates
      of deposit**
    
    
    **433**
    
    
    **(406**
    **)**
    
    **(54**
    **)**
    
    **(27**
    **)**
    
    **179**
    
    
    **(555**
    **)**
    
    **(27**
    **)**
    
    **(403**
    **)****Securities
      sold under agreement****to
      repurchase**
    
    
    **(20**
    **)**
    
    **(3**
    **)**
    
    **-**
    
    
    **(23**
    **)**
    
    **38**
    
    
    **(100**
    **)**
    
    **(16**
    **)**
    
    **(78**
    **)****Short-term
      borrowings**
    
    
    **(56**
    **)**
    
    **(13**
    **)**
    
    **6**
    
    
    **(63**
    **)**
    
    **104**
    
    
    **(17**
    **)**
    
    **(27**
    **)**
    
    **60****Long-term
      borrowings**
    
    
    **275**
    
    
    **(59**
    **)**
    
    **(31**
    **)**
    
    **185**
    
    
    **120**
    
    
    **(117**
    **)**
    
    **(27**
    **)**
    
    **(24**
    **)****Total
      interest expense**
    
    
    **739**
    
    
    **(462**
    **)**
    
    **(76**
    **)**
    
    **201**
    
    
    **560**
    
    
    **(1,510**
    **)**
    
    **(160**
    **)**
    
    **(1,110**
    **)****Net
      interest income**
    
    **$**
    **1,587**
    
    **$**
    **(273**
    **)**
    **$**
    **(20**
    **)**
    **$**
    **1,294**
    
    **$**
    **1,827**
    
    **$**
    **(1,685**
    **)**
    **$**
    **(126**
    **)**
    **$**
    **16**


Net
interest income increased by $1,294 in 2004 compared to 2003.  The increase
was due to growth in the loan portfolio which was slightly offset by a decline
in the Company’s net interest margin to 4.04% for 2004 compared to 4.12% for
2003.  After maintaining a historically low Federal Funds rate, the Federal
Reserve increased the Federal Funds rate five times in the second half of
2004.   The Federal Funds rate, as set by the Federal Reserve,
averaged 1.34% in 2004 and 1.12% in 2003.





Interest
income was $18,708 in 2004, a 9% increase from 2003.  The increase was
driven by growth in the average earning assets of $38,174 or 13% which was
offset by a decline in the yield on average earning assets to 5.49% in 2004 from
5.69% in 2003.





Interest
expense increased to $4,935 in 2004 from $4,734 in 2003, representing a 4%
increase.  This increase was a result of growth in average interest-bearing
liabilities of $29,318 or 12% which was offset by a decline in the cost of funds
to 1.79% in 2004 from 1.92% in 2003.





Management
currently anticipates that net interest income will continue to increase in 2005
due to expected growth in earning assets (primarily loans) combined with the
benefit of the increase in the Federal Funds rate.





*Provision
and Allowance for Loan Losses*








The
provision for loan losses is a result of management’s periodic analysis of the
adequacy of the allowance for loan losses. The provision for loan losses was
$348 for 2004 and $444 for 2003, a decrease of $96 or 22%. The allowance for
loan losses represented 1.37% of loans outstanding at December 31, 2004,
compared to 1.48% at December 31, 2003. Net charge-offs were $134 during 2004 or
..05% of average loans outstanding, compared to $87 in 2003 or .04%. The low
level of net loan charge-offs is indicative of the Company’s loan quality and
credit administration standards and the generally stable economic environment
existing in the Company’s primary market area.





The
allowance for loan losses is maintained at a level determined to be adequate by
management to absorb future charge-offs of loans deemed uncollectible. This
allowance is increased by provisions charged to operating expense and by
recoveries on loans previously charged off. A high degree of judgment is
necessary to determine the appropriate level of allowance for loan losses and
requires management’s ongoing evaluation of adequacy. The adequacy of the loan
loss allowance is determined by use of a risk rating system. The evaluation
process includes, among other things, industry standards, management’s
experience, the Bank’s historical loan loss experience, evaluation of economic
conditions and regular reviews of delinquencies and loan portfolio quality.
Although management believes it uses the best information available to make
determinations with respect to the allowance for loan losses, future adjustments
may be necessary if economic conditions differ from the economic conditions in
the assumptions used in making the final determinations.





16


Future
provisions for loan losses depend on such factors as asset quality, net loan
charge-offs, loan growth and other criteria discussed above. The appropriate
level of the allowance for loan losses and the corresponding provision will
continue to be determined quarterly. Management anticipates that there will be a
provision for loan losses in 2005; however, the specific amount cannot be
determined at this time. Changes in circumstances affecting the various factors
of the Company’s methodology will determine the provision amount in
2005.





*Non-Interest
Income*





Non-interest
income was $5,005 for 2004 compared to $5,181 for 2003, a decrease of $176.
Non-interest income declined 3% in 2004 due to the substantial drop in mortgage
refinance activity which resulted in a decline in the gain on loan sales of
$911. We experienced growth in all other fee categories with service fees on
deposit accounts increasing 20%, trust fees growing 17% and gains on investment
securities increasing $206 from a year ago.





Mortgage
refinance activity has slowed considerably in 2004 resulting in a decline in
mortgage gains to $897 in 2004 from $1,808 in 2003. The Company’s portfolio of
residential mortgages serviced for secondary market investors at December 31,
2004 of $122,125 increased by $15,261, or 14%, from December 31,
2003.





Service
fees on deposit accounts increased 20% to $1,399 in 2004. Overdraft fee income
increased to $947 in 2004, a 47% increase over 2003 due to new account activity
combined with a risk based approach to the overdraft process that was
implemented during 2003. In addition, ATM fees increased 20% in
2004.





Trust
fees increased 17% to $1,382 in 2004. The market value of client assets under
administration increased $40,894 to $356,436 at December 31, 2004 compared with
trust assets of $315,542 at December 31, 2003. The increase in trust assets was
achieved through new business development combined with market
appreciation.





The
generation of mortgage sale gains and trust fees is dependent on the market and
economic conditions and, as a result, there can be no assurance that income
levels reported in prior periods can be achieved in the future.





*Non-Interest
Expense*





Non-interest
expense was $11,042 for 2004 compared to $10,718 in 2003. The $324 or 3%
increase was related to the increase in salaries and employee benefits of $423,
data processing costs of $60 and occupancy expense of $47 which were offset by a
decline in equipment expense of $31 and other expenses of $175. The Company’s
efficiency ratio (non-interest expense divided by the sum of net interest income
and other income) improved to 59.3% for 2004 compared to 60.5% for
2003.





Salaries
and employee benefits expense increased 7% to $6,310 for 2004. The 2004 increase
was a result of normal annual salary increases and additional staffing required
as a result of loan and deposit growth. Data processing costs increased 10% for
2004 as a result of increased volume of item processing transactions. Other
non-interest expense decreased 6% for 2004 due to a decrease in amortization of
mortgage servicing rights of $121 and a decrease in merchant processing expense
of $48 related to the Company exiting this line of business.





17


Annual
operating expenses are also expected to increase in future periods due to future
branching, and product expansion.





*Comparison
of 2003 and 2002*





*Summary*





The
Company ended 2003 with consolidated assets of $342,189 representing growth of
$34,873 or 11%. Asset growth was attributable to strong real estate loan demand.
The Company reported net income of $4,302 for 2003, or $1.26 per diluted share,
compared with net income of $3,845, or $1.11 per diluted share, for 2002. Return
on average assets and return on average equity were 1.34% and 14.74%,
respectively, for 2003 and 1.33% and 13.93%, respectively, for
2002.





*Net
Interest Income*





Net
interest income totaled $12,479 for 2003 and $12,463 for 2002. The slight
increase in 2003 of $16 was due to growth in the loan portfolio which was offset
by a decline in the Company’s net interest margin to 4.12% for 2003 compared to
4.61% for 2002.





*Non-Interest
Income*





Non-interest
income was $5,181 for 2003 compared to $3,963 for 2002.  The $1,218 or 31%
increase was driven by the increase in gain on mortgage loan sales of $1,012 in
2003 and growth in most fee income categories.





Gain on
the sale of mortgage loans increased to $1,808 for 2003 compared to $796 for
2002 due to the record level mortgage refinances resulting from the favorable
interest rate environment nationally.  The Company’s portfolio of
residential mortgages serviced for secondary market investors at
December 31, 2003 of $106,864 increased by $11,769, or 12%, from
December 31, 2002.





High
Performance Checking, the retail banking initiative we introduced in late 2002,
proved its real worth in 2003 as we doubled the number of checking accounts
opened year over year and benefited from additional fee income associated with
the accounts.  Overdraft fee income increased to $644 in 2003, a 114%
increase over 2002 due to new account activity combined with a new risk based
approach to the overdraft process.  In addition, ATM fees increased 23% in
2003 and merchant processing fees declined $351 or 85% as the result of the
Company exiting this line of business.





Trust
fees increased 10% to $1,186 in 2003.  The market value of client assets
under administration increased $78,362 to $315,542 at December 31, 2003
compared with trust assets of $237,180 at December 31, 2002. The increase
in trust assets was achieved through new business development combined with
market appreciation.





*Non-Interest
Expense*





Non-interest
expense was $10,718 for 2003 compared to $10,205 in 2002.  The $513 or 5%
increase was related to increases in salaries and employee benefits of $435,
data processing costs of $68 and other expenses of $103 which were offset by a
decline in occupancy and equipment costs of $93.  The Company’s efficiency
ratio (non-interest expense divided by the sum of net interest income and other
income) improved to 60.5% for 2003 compared to 62.0% for 2002.





18


Salaries
and employee benefits expense increased 8% to $5,887 for 2003.  The 2003
increase was a result of normal annual salary increases, additional staffing
required as a result of asset growth and market expansion and a 31% increase in
health insurance costs.  Data processing costs increased 12% for 2003 as a
result of loan and deposit growth during the year.  Other non-interest
expense increased 4% for 2003 reflecting an increase in marketing expenses of
$261 related to the direct mail advertising campaign for High Performance
Checking and an increase in loan expense of $162 related to the accelerated
amortization of mortgage servicing rights.  Other expenses also reflects a
decline in merchant processing expense of $347 related to the Company exiting
this line of business.





**Financial
Condition**





The
Company’s consolidated total assets increased $26,501, or 8%, from $342,189 at
December 31, 2003 to $368,690 at December 31, 2004. Total average assets were
$359,672 and $320,079 in 2004 and 2003, respectively. These increases were due
to internal loan growth. Total liabilities increased by $25,725 in 2004 which
was driven by deposit growth of $40,934 offset by a decline in borrowings of
$15,736 in 2004. Shareholders’ equity totaled $31,329 and $30,553 at December 31
2004 and 2003, respectively.





*Investment
Securities*





The
Company’s investment portfolio is utilized for several purposes. It serves as a
vehicle to manage interest rate and prepayment risk, generates interest and
dividend income from the investment of excess funds, provides liquidity to meet
liquidity requirements and is used as collateral for public deposits and other
borrowing sources.





The
average balance of the securities portfolio, which consists of securities
available for sale, was $70,259 in 2004 and $68,387 in 2003, an increase of
$1,872. The securities portfolio consists primarily of collateralized mortgage
obligations and U.S. Government and agency securities. The majority of
securities are rated AAA or equivalently rated. Collateralized mortgage
obligations and mortgage-backed securities comprised 72% of the securities
portfolio at December 31, 2004 compared to 68% at December 31, 2003. The average
yield on securities was 2.95% during 2004, compared to 2.79% during 2003, which
reflects declines in interest rates during 2003 along with maintaining a short
duration on the securities portfolio.





**Table
3 - Investment Securities**





The
following table sets forth the Company’s investment securities at the dates
indicated:


****
    ********
    ****
    **2004**
    ****
    
    **December
      31,**
      **2003**
    ****
    
    **2002**
    ********
    ****
    ****
    ****
    **%
      of**
    ****
    
    ****
    ****
    **%
      of**
    ****
    
    ****
    ****
    **%
      of**
    ********
    ****
    **Amount**
    ****
    **Total**
    ****
    
    **Amount**
    ****
    **Total**
    ****
    
    **Amount**
    ****
    **Total**Collateralized
      mortgage obligations
    
    $
    43,553
    
    
    66
    %
    
    $
    46,441
    
    
    61
    %
    
    $
    31,246
    
    
    46
    %U.S.
      Government agencies andcorporations
    
    
    10,297
    
    
    16
    %
    
    
    12,351
    
    
    16
    %
    
    
    11,520
    
    
    17
    %Mortgage-backed
      securities
    
    
    3,982
    
    
    6
    %
    
    
    5,500
    
    
    7
    %
    
    
    1,888
    
    
    3
    %U.S.
      Government and agency moneymarket
      funds
    
    
    480
    
    
    1
    %
    
    
    2,105
    
    
    3
    %
    
    
    11,935
    
    
    18
    %Certificates
      of deposit
    
    
    1,346
    
    
    2
    %
    
    
    2,957
    
    
    4
    %
    
    
    4,158
    
    
    6
    %State
      and local government debt securities
    
    
    2,311
    
    
    3
    %
    
    
    2,682
    
    
    4
    %
    
    
    2,925
    
    
    4
    %Total
      debt securities
    
    
    61,969
    
    
    94
    %
    
    
    72,036
    
    
    95
    %
    
    
    63,672
    
    
    94
    %Equity
      securities
    
    
    3,825
    
    
    6
    %
    
    
    3,550
    
    
    5
    %
    
    
    4,382
    
    
    6
    %Total
      securities available for sale
    
    
    65,794
    
    
    100
    %
    
    
    75,586
    
    
    100
    %
    
    
    68,054
    
    
    100
    %Net
      unrealized gains
    
    
    305
    
    
    
    
    
    
    554
    
    
    
    
    
    
    813Fair
      value of securities available for sale
    
    $
    66,099
    
    
    
    
    
    $
    76,140
    
    
    
    
    
    $
    68,867


19


**Table
4 - Maturities of Debt Securities**





The
following table sets forth the contractual maturities and the weighted average
yields (based on amortized cost) of the Company’s debt securities at December
31, 2004. Actual maturities will differ from contractual maturities because
borrowers may have the right to call or prepay obligations with or without call
or prepayment penalties.





**Amortized
      Cost Maturing in****Less
      than****one
      year**
    
    
    **1
      to 5 years**
    
    
    **More
      than 5 to****10
      years**
    
    
    **More
      than****Over
      10 years**
    
    
    **Total****Amount**
    
    **Yield**
    
    
    **Amount**
    
    **Yield**
    
    
    **Amount**
    
    **Yield**
    
    
    **Amount**
    
    **Yield**
    
    
    **Amount**
    
    **Yield**Collateralized
      mortgage obligations
    
    $
    --
    
    
    --
    
    
    $
    1,094
    
    
    4.82
    %
    
    $
    16,836
    
    
    3.12
    %
    
    $
    25,623
    
    
    3.41
    %
    
    $
    43,553
    
    
    3.34
    %U.S.
      Government agencies and
      corporations
    
    
    2,004
    
    
    3.92
    %
    
    
    8,293
    
    
    3.04
    %
    
    
    --
    
    
    --
    
    
    
    --
    
    
    --
    
    
    
    10,297
    
    
    3.21
    %Mortgage-backed
      securities
    
    
    --
    
    
    --
    
    
    
    810
    
    
    4.14
    %
    
    
    3,172
    
    
    2.98
    %
    
    
    --
    
    
    --
    
    
    
    3,982
    
    
    3.22
    %U.S.
      Government and agency money
      market
      funds
    
    
    480
    
    
    1.80
    %
    
    
    --
    
    
    --
    
    
    
    --
    
    
    --
    
    
    
    --
    
    
    --
    
    
    
    480
    
    
    1.80
    %Certificates
      of deposit
    
    
    1,271
    
    
    2.47
    %
    
    
    75
    
    
    2.11
    %
    
    
    --
    
    
    --
    
    
    
    --
    
    
    --
    
    
    
    1,346
    
    
    2.45
    %State
      and local government debt
      securities
    
    
    92
    
    
    3.43
    %
    
    
    435
    
    
    4.34
    %
    
    
    1,635
    
    
    4.44
    %
    
    
    149
    
    
    4.74
    %
    
    
    2,311
    
    
    4.40
    %Total
    
    $
    3,847
    
    
    3.17
    %
    
    $
    10,707
    
    
    3.35
    %
    
    $
    21,643
    
    
    3.20
    %
    
    $
    25,772
    
    
    3.42
    %
    
    $
    61,969
    
    
    3.11
    %





*Loans*





The Bank
offers a broad range of personal and business loan products. Total loans (which
includes loans held for sale) averaged $269,091 during 2004 compared to $234,279
during 2003, an increase of $34,812, or 15%. Total loans grew 15% in 2004. Real
estate lending was strong with construction balances increasing 33%, home equity
balances growing 20% and residential mortgages up 9%. The commercial and
commercial real estate portfolio grew at a rate of 16% and consumer loans
increased 8% from a year ago.





The
average yield on loans decreased to 6.17% in 2004 from 6.53% in 2003. The prime
rate average was 4.34% for 2004 and 4.12% for 2003. Management anticipates an
increase on loan yields as the prime rate increases which may be offset by
increased competition from banks and non-traditional credit
providers.








**Table
5 - Composition of Loan Portfolio**





The
following table summarizes the composition of the Bank’s loan portfolio by type
of loan at the dates indicated:




**At
      December 31,****2004**
    
    
    **2003**
    
    
    **2002**
    
    
    **2001**
    
    
    **2000****Amount**
    
    **%**
    
    
    **Amount**
    
    **%**
    
    
    **Amount**
    
    **%**
    
    
    **Amount**
    
    **%**
    
    
    **Amount**
    
    **%**Real EstateCommercial
    
    $
    96,956
    
    
    34
    %
    
    $
    80,212
    
    
    32
    %
    
    $
    70,247
    
    
    33
    %
    
    $
    69,209
    
    
    37
    %
    
    $
    59,277
    
    
    36
    %Construction
    
    
    12,854
    
    
    5
    %
    
    
    9,669
    
    
    4
    %
    
    
    13,379
    
    
    6
    %
    
    
    6,678
    
    
    4
    %
    
    
    4,623
    
    
    3
    %Residential
    
    
    60,314
    
    
    21
    %
    
    
    55,380
    
    
    22
    %
    
    
    40,362
    
    
    19
    %
    
    
    35,040
    
    
    19
    %
    
    
    26,112
    
    
    16
    %Home
      equity
    
    
    34,139
    
    
    12
    %
    
    
    28,496
    
    
    12
    %
    
    
    19,889
    
    
    9
    %
    
    
    17,675
    
    
    9
    %
    
    
    18,830
    
    
    11
    %Total
      real estate
    
    
    204,263
    
    
    72
    %
    
    
    173,757
    
    
    70
    %
    
    
    143,877
    
    
    67
    %
    
    
    128,602
    
    
    69
    %
    
    
    108,842
    
    
    66
    %Commercial
    
    
    60,010
    
    
    21
    %
    
    
    55,486
    
    
    23
    %
    
    
    54,920
    
    
    26
    %
    
    
    43,533
    
    
    23
    %
    
    
    42,459
    
    
    25
    %Consumer
    
    
    18,715
    
    
    7
    %
    
    
    17,269
    
    
    7
    %
    
    
    15,932
    
    
    7
    %
    
    
    15,945
    
    
    8
    %
    
    
    14,622
    
    
    9
    %Total
      loans
    
    $
    282,988
    
    
    100
    %
    
    $
    246,512
    
    
    100
    %
    
    $
    214,729
    
    
    100
    %
    
    $
    188,080
    
    
    100
    %
    
    $
    165,923
    
    
    100
    %Less
      allowance for loan losses
    
    
    (3,866
    )
    
    
    
    
    
    (3,652
    )
    
    
    
    
    
    (3,295
    )
    
    
    
    
    
    (2,986
    )
    
    
    
    
    
    (2,658
    )Total
    
    $
    279,122
    
    
    
    
    
    $
    242,860
    
    
    
    
    
    $
    211,434
    
    
    
    
    
    $
    185,094
    
    
    
    
    
    $
    163,265
  20


**Table
6 - Scheduled Contractual Amortization of Certain Loans at December 31,
2004**





The
following table sets forth the scheduled contractual amortization of
construction loans and commercial business loans at December 31, 2004, as well
as the amount of such loans which are scheduled to mature after one year which
have fixed or adjustable interest rates.


**Commercial**
    
    **Construction****Business
      Loans**
    
    **Loans**
    
    **Total**Amounts
      due:Within
      one year
    
    $
    29,952
    
    $
    12,854
    
    $
    42,806After
      one year through five years
    
    
    19,860
    
    
    -
    
    
    19,860Beyond
      five years
    
    
    10,198
    
    
    -
    
    
    10,198Total
    
    $
    60,010
    
    $
    12,854
    
    $
    72,864Interest
      rate terms on amounts due after one year:Fixed
    
    $
    5,213
    
    $
    -
    
    $
    5,213Adjustable
    
    
    24,845
    
    
    -
    
    
    24,845


Management
seeks to maintain a high quality of assets through prudent underwriting and
sound lending practices. Approximately 30% of the Company’s loan portfolio is
collateralized by first liens on primarily owner-occupied residential homes
which have historically carried a relatively low credit risk. The Bank also
maintains a commercial real estate portfolio comprised primarily of
owner-occupied commercial businesses.





The Bank
participates in government guaranteed loan programs including the Small Business
Administration (“SBA”), Rural Development (“RD”) and the Finance Authority of
Maine (“FAME”). At December 31, 2004, loans under these programs totaled $15,174
of which $11,211, or 4% of the total loan portfolio outstanding, is guaranteed
by the various federal and state government entities.





The Bank
continues to focus on asset quality issues and emphasizes loan review and
underwriting procedures. The Bank utilizes the services of a consultant, M&M
Consulting, LLC (a joint venture owned 50% by the Bank), to perform periodic
loan and documentation review. Management has established a risk rating and
review process with the objective of quickly identifying, evaluating and
initiating necessary corrective action for all commercial and commercial real
estate loans. The goal of the risk rating process is to address the watch list,
substandard and non-performing loans, as early as possible. These components of
risk management are integral elements of the Bank’s loan program which have
contributed to the loan portfolio performance to date. Nonetheless, management
maintains a cautious outlook in attempting to anticipate the potential effects
of uncertain economic conditions (both locally and nationally).





*Non-Performing
Assets*





Non-performing
assets consist of non-accrual loans, other loans past due over 90 days,
foreclosed assets and other real estate owned. Total non-performing assets as a
percentage of total assets increased to .44% or $1,609 at December 31, 2004,
compared to .18% or $617 at December 31, 2003. Included in non-performing assets
at December 31, 2004 are loans guaranteed by the SBA totaling
$1,071.





Loans are
placed on non-accrual status when, in the judgment of management, principal
repayment is doubtful, whether current or past due. When a loan is placed on
non-accrual status, previously accrued but unpaid interest is deducted from
interest income. As a matter of policy, interest is generally not accrued on
loans past due 90 days or more. The Bank does not return a loan to accrual
status until it is brought current with respect to both principal and interest,
future payments are no longer in doubt, and the loan has been performing for at
least six consecutive months.





21
 
 ****
 **Table
7- Five-Year Schedule of Non-Performing Assets**





The
      following table presents a summary of non-performing assets at the dates
      indicated.





**At
      December 31,****2004**
    
    
    **2003**
    
    
    **2002**
    
    
    **2001**
    
    
    **2000**Loans:Non-accrual
      loans
    
    $
    1,571
    
    
    $
    598
    
    
    $
    432
    
    
    $
    432
    
    
    $
    421Loans
      90 days or more past due but still
      accruing
    
    
    4
    
    
    
    8
    
    
    
    37
    
    
    
    75
    
    
    
    104Restructured
      loans
    
    
    4
    
    
    
    8
    
    
    
    132
    
    
    
    -
    
    
    
    -Non-performing
      loans
    
    
    1,579
    
    
    
    614
    
    
    
    601
    
    
    
    507
    
    
    
    525OREO
      and repossessed assets
    
    
    30
    
    
    
    3
    
    
    
    165
    
    
    
    221
    
    
    
    90Non-performing
      assets
    
    $
    1,609
    
    
    $
    617
    
    
    $
    766
    
    
    $
    728
    
    
    $
    615Non-performing
      loans as a percentage of total loans
    
    
    0.56
    %
    
    
    0.25
    %
    
    
    0.28
    %
    
    
    0.27
    %
    
    
    0.32
    %Non-performing
      assets as a percentage of total assets
    
    
    0.44
    %
    
    
    0.18
    %
    
    
    0.25
    %
    
    
    0.26
    %
    
    
    0.25
    %Non-performing
      assets as a percentage of total loans and
      OREO/repossessed
      assets
    
    
    0.57
    %
    
    
    0.25
    %
    
    
    0.36
    %
    
    
    0.39
    %
    
    
    0.37
    %





At
December 31, 2004, loans on non-accrual status totaled $1,571. Interest income
not recognized on non-accrual loans was $47 in 2004. There was no interest
income recognized on non-accrual loans in 2004.





*Adversely
Classified Assets*





The
Bank’s management adversely classifies certain assets as “substandard,”
“doubtful” or “loss” based on criteria established under banking regulations. An
asset is considered substandard if inadequately protected by the current net
worth and paying capacity of the obligor or of the collateral pledged, if any.
Substandard assets include those characterized by the “distinct possibility”
that the insured institution will sustain “some loss” if existing deficiencies
are not corrected. Assets classified as doubtful have all the weaknesses
inherent in those classified substandard with the added characteristic that the
weaknesses present make “collection or liquidation in full,” on the basis of
currently existing facts, conditions, and values, “highly questionable and
improbable.” Assets classified as loss are those considered “uncollectible” and
of such little value that their continuance as assets without the establishment
of a specific loss reserve is not warranted.





At
December 31, 2004 and 2003, loans classified as substandard amounted to $8,417
and $5,587, respectively, and loans classified as doubtful totaled $36 and $81,
respectively. Performing loans represent 83% and 95% of the adversely classified
balances as of December 31, 2004 and 2003, respectively. The Bank had no loans
which were classified as loss at either date. Total classified loans as a
percentage of total loans increased to 2.9% at December 31, 2004 from 2.3% at
December 31, 2003. Classified loans represent loans that, in the opinion of
management, could potentially migrate to non-performing or loss status.
Delinquent loans may or may not be adversely classified depending upon
management’s judgment with respect to each individual loan. As of December 31,
2004 and 2003, the portion of loans guaranteed by either the SBA, RD or FAME for
each year amounted to 15% and 20%, respectively, of the total loan balances
adversely classified.




22


**Table
8 - Five-Year Table of Activity in the Allowance for Loan Losses and Net
Charge-offs as a Percent of Average Loans Outstanding**





The
following table presents net charge-offs by loan type and the activity in the
allowance for loan losses during the periods indicated.




**Year
      Ended December 31,****2004**
    
    
    **2003**
    
    
    **2002**
    
    
    **2001**
    
    **2000**Allowance
      at beginning of year
    
    $
    3,652
    
    
    $
    3,295
    
    
    $
    2,986
    
    
    $
    2,658
    
    $
    2,274Charge-offs:Commercial
      real estate
    
    
    -
    
    
    
    -
    
    
    
    -
    
    
    
    -
    
    
    -Residential
      real estate
    
    
    -
    
    
    
    -
    
    
    
    -
    
    
    
    -
    
    
    -Home
      equity loans
    
    
    (10
    )
    
    
    -
    
    
    
    -
    
    
    
    (20
    )
    
    (14
    )Commercial
      business loans
    
    
    (24
    )
    
    
    (7
    )
    
    
    (28
    )
    
    
    (65
    )
    
    (9
    )Consumer
    
    
    (144
    )
    
    
    (113
    )
    
    
    (161
    )
    
    
    (99
    )
    
    (42
    )Total
      loans charged-off
    
    
    (178
    )
    
    
    (120
    )
    
    
    (189
    )
    
    
    (184
    )
    
    (65
    )Recoveries:Commercial
      real estate
    
    
    -
    
    
    
    -
    
    
    
    -
    
    
    
    -
    
    
    -Residential
      real estate
    
    
    -
    
    
    
    -
    
    
    
    27
    
    
    
    22
    
    
    22Home
      equity loans
    
    
    -
    
    
    
    -
    
    
    
    -
    
    
    
    -
    
    
    -Commercial
      business loans
    
    
    12
    
    
    
    4
    
    
    
    5
    
    
    
    1
    
    
    1Consumer
    
    
    32
    
    
    
    29
    
    
    
    13
    
    
    
    15
    
    
    3Total
      loans recovered
    
    
    44
    
    
    
    33
    
    
    
    45
    
    
    
    38
    
    
    26Net
      charge-offs
    
    
    (134
    )
    
    
    (87
    )
    
    
    (144
    )
    
    
    (146
    )
    
    (39
    )Provisions
      for loan losses
    
    
    348
    
    
    
    444
    
    
    
    453
    
    
    
    474
    
    
    423Allowance
      at end of year
    
    $
    3,866
    
    
    $
    3,652
    
    
    $
    3,295
    
    
    $
    2,986
    
    $
    2,658Total
      net loans outstanding at the end of year (1)
    
    $
    279,122
    
    
    $
    242,860
    
    
    $
    211,434
    
    
    $
    185,094
    
    $
    163,265Average
      net loans outstanding during the year (1)
    
    $
    264,616
    
    
    $
    229,392
    
    
    $
    198,120
    
    
    $
    171,692
    
    $
    150,553Ratios:Net
      charge-offs to average loans outstanding
    
    
    0.05
    %
    
    
    0.04
    %
    
    
    0.07
    %
    
    
    0.08
    %
    
    0.03
    %Net
      charge-offs to loans, end of period
    
    
    0.05
    %
    
    
    0.04
    %
    
    
    0.07
    %
    
    
    0.08
    %
    
    0.02
    %Allowance
      for loan losses to average loans outstanding
    
    
    1.44
    %
    
    
    1.57
    %
    
    
    1.64
    %
    
    
    1.71
    %
    
    1.74
    %Allowance
      for loan losses to loans, end of year
    
    
    1.37
    %
    
    
    1.48
    %
    
    
    1.53
    %
    
    
    1.59
    %
    
    1.60
    %Allowance
      for loan losses to non-performing loans
    
    
    244.84
    %
    
    
    594.79
    %
    
    
    548.25
    %
    
    
    588.95
    %
    
    506.29
    %


___________________________


(1)
Excludes loans held for sale.


****


****


23


**Table
9 - Allocation of the Allowance for Loan Losses - Five-Year
Schedule**





The
following table sets forth the breakdown of the allowance for loan losses by
loan category for the periods indicated. Management believes that the allowance
can be allocated by category only on an approximate basis. The allocation of an
allowance to each category is not necessarily indicative of future losses and
does not restrict the use of the allowance to absorb losses in any other
category.




**At
      December 31,****2004**
    ****
    
    ****
    **2003**
    ****
    
    ****
    **2002**
    ****
    
    ****
    **2001**
    ****
    
    ****
    **2000****Amount**
    
    
    **%
      of Loans to Total Loans**
    
    
    
    **Amount**
    
    
    **%
      of Loans to Total Loans**
    
    
    
    **Amount**
    
    
    **%
      of Loans to Total Loans**
    
    
    
    **Amount**
    
    
    **%
      of Loans to Total Loans**
    
    
    
    **Amount**
    
    
    **%
      of Loans to Total Loans**Commercial
      and
      Commercial
      Real Estate (1)
    
    $
    2,818
    
    
    56
    %
    
    $
    2,774
    
    
    55
    %
    
    $
    1,881
    
    
    58
    %
    
    $
    1,574
    
    
    60
    %
    
    $
    1,321
    
    
    61
    %Construction
    
    
    64
    
    
    4
    %
    
    
    48
    
    
    4
    %
    
    
    67
    
    
    6
    %
    
    
    33
    
    
    4
    %
    
    
    23
    
    
    3
    %Residential
    
    
    214
    
    
    21
    %
    
    
    181
    
    
    22
    %
    
    
    361
    
    
    19
    %
    
    
    285
    
    
    19
    %
    
    
    223
    
    
    16
    %Home
      equity
    
    
    91
    
    
    12
    %
    
    
    74
    
    
    12
    %
    
    
    248
    
    
    9
    %
    
    
    220
    
    
    9
    %
    
    
    236
    
    
    11
    %Consumer
    
    
    354
    
    
    7
    %
    
    
    277
    
    
    7
    %
    
    
    460
    
    
    8
    %
    
    
    424
    
    
    8
    %
    
    
    310
    
    
    9
    %Off-Balance
      Sheet
    
    
    212
    
    
    -
    
    
    
    125
    
    
    -
    
    
    
    278
    
    
    -
    
    
    
    212
    
    
    -
    
    
    
    -
    
    
    -Unallocated
    
    
    113
    
    
    -
    
    
    
    173
    
    
    -
    
    
    
    -
    
    
    -
    
    
    
    238
    
    
    -
    
    
    
    545
    
    
    -Total
      allowance for loan losses
    
    $
    3,866
    
    
    100
    %
    
    $
    3,652
    
    
    100
    %
    
    $
    3,295
    
    
    100
    %
    
    $
    2,986
    
    
    100
    %
    
    $
    2,658
    
    
    100
    %


___________________________


(1)
    Commercial
      and commercial real estate loans have been combined in allocating the
      allowance for loan losses as the Company utilizes an internal risk rating
      system for these loans on a consolidated
basis.





The
allowance for loan losses represents the amount available for credit losses
inherent in the Company’s loan portfolio. Loans are charged off when they are
deemed uncollectible, after giving consideration to factors such as the
customer’s financial condition, underlying collateral and guarantees, as well as
general and industry economic conditions.








In
general, the Company determines the appropriate overall allowance for loan
losses based upon periodic, systematic reviews of its portfolio to identify
inherent losses based on management’s judgment about various qualitative
factors. These reviews result in the identification and quantification of loss
factors, which are used in determining the amount of the allowance for loan
losses. The Company periodically evaluates prevailing economic and business
conditions, industry concentrations, changes in the size and characteristics of
the portfolio and other pertinent factors. Portions of the allowance for loan
losses are quantified to cover the estimated losses inherent in each loan
category based on the results of this detailed review process.





Commercial
loans are individually reviewed and assigned a credit risk rating from “1" (low
risk of loss) to “8" (high risk of loss). For non-impaired loans with a credit
risk rating of “1" to “6", estimated loss factors based on historical loss
experience (ranging from two to five years) are used to calculate a loan loss
reserve for each credit risk rating classification. Qualitative adjustments are
also made based upon management’s assessment of prevailing economic conditions,
trends in volumes and terms of loans, levels and trends in delinquencies and
non-accruals, and the effect of changes in lending policies. A specific
allocation is made for impaired loans, or loans no longer accruing interest as a
result of the deemed uncollectibility of interest due, which are measured at the
net present value of future cash flows, discounted at the loan’s effective
interest rate, or at fair market value of collateral if the loan is collateral
dependent. The combination of these analyses is the basis for the determination
of the commercial loan portion of the allowance for loan losses.





Consumer
loans, which include residential mortgages, home equity loans, and
direct/indirect loans, are generally evaluated as a group based on product type.
The determination of the consumer loan portion of the allowance for loan losses
is based on a five-year average of annual historical losses, adjusted for the
qualitative factors noted above.





24


The
results of all analyses are reviewed and discussed by the Board of Directors on
a quarterly basis. An integral component of the Company’s risk management
process is to ensure the proper quantification of the reserve for loan losses
based upon an analysis of risk characteristics, demonstrated losses, loan
segmentations, and other factors. Reserve methodology is reviewed on a periodic
basis and modified as appropriate. Based on this analysis, including the
aforementioned assumptions, the Company believes that the allowance for loan
losses is adequate as of December 31, 2004. The unallocated component of the
allowance for loan losses represents management’s view that, given the
complexities of the loan portfolio, there are estimable losses that have been
incurred within the portfolio but not yet tied to specific loans. Although
management utilizes its best judgment in providing for possible losses, there
can be no assurance the Bank will not have to increase its provision for
possible losses in the future due to increases in non-performing assets or
otherwise, which would adversely affect the results of operations.





*Funding
and Liquidity*





The
Company’s principal sources of funding are deposits and borrowed funds. The
Company has a comprehensive liquidity management program in place. It maintains
adequate funding for its assets by monitoring anticipated sources and uses of
funding. Deposits are attracted principally from within the Company’s primary
market area through the offering of a broad variety of deposit products,
including checking accounts, money market accounts, savings accounts,
certificates of deposit (including jumbo certificates in denominations of $100
or more) and retirement savings plans. In addition to traditional in-market
deposit sources, the Company has other sources of liquidity, including proceeds
from maturing investment securities and loans, the sale of investment
securities, Federal Funds through correspondent bank relationships, brokered
deposits and Federal Home Loan Bank (FHLB) borrowings. Additional liquidity is
available in the loan portfolio through sale of residential mortgages and the
guaranteed portion of SBA loans. The Company also maintains a $5,000 credit line
with a correspondent bank. Management believes that the current level of
liquidity is sufficient to meet current and future funding
requirements.





*Deposits*





In 2004,
total deposits increased by $40,934 to $299,782, a 16% increase over 2003.
Comparing year-end balances at 2004 to 2003, checking account balances increased
15%, money market balances increased 35%, savings accounts grew 4% and retail
certificates of deposit decreased 1%. Certificates of deposit obtained on the
national market increased $13,172 from a year ago as the Company obtained
longer-term funding at favorable interest rates.





The
Company’s focus on quality customer service combined with the marketing of the
High Performance Checking program contributed to the deposit growth in 2004. The
program includes free checking accounts for businesses and individuals, direct
mail advertising, Tell-A-Friend referrals and an attractive selection of premium
gifts. The Company continues to develop consumer and commercial deposit
relationships through referrals and additional contacts within its market
area.





The
Bank’s average cost of deposits (including non-interest checking) was 1.42% for
the year 2004, compared to 1.60% during 2003.




25


**Table
10 - Average Deposit Balances and Rates**





The
following table sets forth the average balances and weighted average rates for
the Bank’s categories of deposits for the periods indicated:




**Year
      Ended December 31,****2004**
    
    
    
    **2003**
    
    
    
    **2002****Average****Balance**
    
    
    **Average****Rate**
    
    
    **%
      of**
      **Total**
      **Deposits**
    
    
    
    **Average**
      **Balance**
    
    
    **Average**
      **Rate**
    
    
    **%
      of**
      **Total**
      **Deposits**
    
    
    
    **Average**
      **Balance**
    
    
    **Average**
      **Rate**
    
    
    **%
      of**
      **Total**
      **Deposits**Non-interest
      checking
    
    $
    50,331
    
    
    -
    
    
    18
    %
    
    $
    41,740
    
    
    -
    
    
    17
    %
    
    $
    35,917
    
    
    -
    
    
    16
    %Interest
      checking
    
    
    40,693
    
    
    0.36
    %
    
    14
    %
    
    
    34,188
    
    
    0.28
    %
    
    14
    %
    
    
    28,628
    
    
    0.65
    %
    
    13
    %Money
      market
    
    
    45,852
    
    
    1.12
    %
    
    16
    %
    
    
    36,943
    
    
    0.95
    %
    
    15
    %
    
    
    32,203
    
    
    1.77
    %
    
    14
    %Savings
    
    
    43,229
    
    
    0.37
    %
    
    15
    %
    
    
    41,241
    
    
    0.58
    %
    
    17
    %
    
    
    42,428
    
    
    1.41
    %
    
    19
    %Certificates
      of deposit
    
    
    103,881
    
    
    3.10
    %
    
    37
    %
    
    
    91,675
    
    
    3.55
    %
    
    37
    %
    
    
    87,393
    
    
    4.18
    %
    
    38
    %Total
    
    $
    283,986
    
    
    1.42
    %
    
    100
    %
    
    $
    245,787
    
    
    1.60
    %
    
    100
    %
    
    $
    226,569
    
    
    2.21
    %
    
    100
    %





The Bank
does not have a concentration of deposits from any one source, the loss of which
would have a material adverse effect on the business of the Bank. Management
believes that substantially all the Bank’s depositors are residents in its
primary market area except for $39,114 in brokered deposits at December 31,
2004.





The
following table summarizes at December 31, 2004 the Bank’s certificates of
deposit (CD) of $100 or more and by time remaining until maturity:








Maturity
      Period:Less
      than three months
    
    $
    8,858Over
      three months through six months
    
    
    5,713Over
      six months through twelve months
    
    
    8,911Over
      twelve months
    
    
    32,195Total
    
    $
    55,677





*Borrowings*





Borrowings
supplement deposits as a source of liquidity. Borrowed funds consist mainly of
securities sold under agreement to repurchase and advances from the FHLB. Total
borrowings were $33,524 at December 31, 2004 compared to $49,260 at December 31,
2003, a decrease of $15,736. Other short-term borrowings include federal funds
purchased, commercial lines of credit, Treasury, tax and loan deposits and
interest-bearing demand notes due to the U.S. Treasury. See Note 11 to the
Consolidated Financial Statements for more information regarding securities sold
under agreement to repurchase.





*Contractual
Obligations and Commitments*





**Table
11 - Contractual Obligations and Commitments**





The
following tables summarize the Company’s contractual cash obligations and other
commitments at December 31, 2004.





Payments
      Due by Period:**Contractual
      Obligations**
    
    Total
      Amount of Obligation
    
    Less
      than 1 Year
    
    1 -
      3 years
    
    4 -
      5 years
    
    After
      5 yearsOperating
      leases
    
    $
    949
    
    $
    251
    
    $
    413
    
    $
    231
    
    $
    54Long-term
      debt (FHLB borrowings)
    
    
    15,670
    
    
    2,594
    
    
    7,461
    
    
    4,712
    
    
    903Total
      contractual obligations
    
    $
    16,619
    
    $
    2,845
    
    $
    7,874
    
    $
    4,943
    
    $
    957







26





Commitment
      Expires in:**Other
      Commitments**
    
    Total
      Amount Committed
    
    Less
      than 1 Year
    
    1 -
      3 years
    
    4 -
      5 years
    
    After
      5 yearsLetters
      of credit
    
    $
    1,417
    
    $
    1,300
    
    $
    117
    
    $
    -
    
    $
    -Other
      commitments to extend credit
    
    
    65,487
    
    
    45,806
    
    
    495
    
    
    1,936
    
    
    17,250Total
      commitments
    
    $
    66,904
    
    $
    47,106
    
    $
    612
    
    $
    1,936
    
    $
    17,250






At
December 31, 2004, the Company had interest rate swap agreements with notional
amounts of $10,000. The following table summarizes the Company’s obligations
under the interest rate swap agreements.





Payments
      Due by Period:Less
      than 1 Year
    
    1 -
      3 Years
    
    4 -
      5 Years
    
    After
      5 YearsFixed
      payments from counterparty
    
    $
    593
    
    $
    282
    
    $
    -
    
    $
    -Payments
      based on prime rate
    
    
    425
    
    
    249
    
    
    -
    
    
    -Net
      cash flow
    
    $
    68
    
    $
    32
    
    $
    -
    
    $
    -





See Note
4 to the Consolidated Financial Statements for more information regarding the
nature and business purpose of derivative financial instruments.





**Asset/Liability
Management**





*Market
Risk*





Market
risk is the risk of loss in a financial instrument arising from adverse changes
in market rates/prices, such as interest rates, foreign currency exchange rates,
commodity prices and equity prices. The Company’s primary market risk exposure
is interest rate risk. The ongoing monitoring and management of this risk is an
important component of the Company’s asset/liability management process, which
is governed by policies established by the Board of Directors that are reviewed
and approved annually.





The Board
of Directors delegates responsibility for carrying out the asset/liability
management policies to its Asset/Liability Committee (ALCO). In this capacity,
ALCO develops guidelines and strategies impacting the Company’s asset/liability
management activities based upon estimated market risk sensitivity, policy
limits and overall market interest rate levels/trends.





*Interest
Rate Risk*





Interest
rate risk represents the sensitivity of earnings to changes in market interest
rates. As interest rates change, the interest income and expense streams
associated with the Company’s financial instruments also change, thereby
impacting net interest income (“NII”), the primary component of the Company’s
earnings. ALCO utilizes the results of a detailed and dynamic simulation model
to quantify the estimated exposure of NII to sustained interest rate changes.
While ALCO routinely monitors simulated NII sensitivity over a rolling two-year
horizon, it also utilizes additional tools to monitor potential longer-term
interest rate risk.





The
simulation model captures the impact of changing interest rates on the interest
income earned and interest expense incurred on all interest-earning assets and
interest-bearing liabilities reflected in the Company’s statement of financial
condition. This sensitivity analysis is compared to ALCO policy limits which
specify a maximum tolerance level for NII exposure over a one-year horizon,
assuming no asset growth, given a 200 basis point (bp) upward and a 100 bp
downward shift in interest rates. A parallel and pro rata shift in rates over a
12-month period is assumed. The following reflects the Company’s NII sensitivity
analysis as measured during the 4th quarter of 2004.





27





EstimatedRate
      Change
    
    Change
      in NII+200bp
    
    
    1.60%-100bp
    
    
    (2.24)%




The
preceding sensitivity analysis does not represent a Company forecast and should
not be relied upon as being indicative of expected operating results. These
hypothetical estimates are based upon numerous assumptions including, among
others, the nature and timing of interest rate levels, yield curve shape,
prepayments on loans and securities, deposit decay rates, pricing decisions on
loans and deposits, and reinvestment/replacement of asset and liability cash
flows. While assumptions are developed based upon current economic and local
market conditions, the Company cannot make any assurances as to the predictive
nature of these assumptions, including how customer preferences or competitor
influences might change.





When
appropriate, the Company may utilize derivative financial instruments, such as
interest rate floors, caps and swaps to hedge its interest rate risk position.
The Board of Directors’ approved hedging policy statements govern the use of
these instruments. As of December 31, 2004, the Company had a notional principal
of $10,000 in interest rate swap agreements. ALCO monitors derivative activities
relative to its expectation and the Company’s hedging policy. These instruments
are more fully described in Note 4 - Derivative Financial Instruments within the
“Notes to Consolidated Financial Statements” section.





In 2004,
the Company acquired interest rate swap agreements to convert a portion of the
loan portfolio from a variable rate based upon the prime rate to a fixed rate.
The $10,000 of interest rate swap agreements mature in 2006. In a purchased
interest rate swap agreement, cash interest payments are exchanged between the
Company and counterparty. The estimated effects of these derivative financial
instruments on the Company’s earnings are included in the sensitivity analysis
presented above. The risks
associated with entering into this transaction are the risk of default by the
counterparty with whom the Company has entered into the agreement and poor
correlation between the rate being swapped and the yield on the hedged assets.
The Company’s risk from default of a counterparty is limited to the expected
cash flow anticipated from the counterparty, not the notional
value.





*Capital
Resources*





At
December 31, 2004, shareholders’ equity totaled $31,329 or 8.5% of total assets,
as compared to $30,553 or 8.9% at December 31, 2003. The net increase in
shareholders’ equity was attributable to: net income of $4,907; stock option
exercises and the related tax benefit of $87, less share repurchases of $2,156;
and $1,885 in cash dividends.





During
2004, the Company repurchased 89,592 shares of common stock at an average price
of $24.06 and in 2003 the Company repurchased 75,031 shares of common stock at
an average price of $16.23. Upon completion of the third stock repurchase
program, the Board of Directors approved a fourth stock repurchase program in
June 2004 authorizing the Company to repurchase up to 169,995, or 5%, of its
outstanding shares of common stock. As of December 31, 2004, 16,637 shares had
been repurchased under this program. No shares were repurchased during the
fourth quarter of 2004. Future repurchases will be made from time to time at the
discretion of Company management.





Capital
guidelines issued by the Federal Reserve Board require the Company to maintain
certain ratios. The Company’s risk-based capital ratios for Tier 1 and Tier 2
Capital (as defined by federal banking agency regulations) at December 31, 2004
of 11.83% and 13.09%, respectively, exceed regulatory guidelines for capital
adequacy. The Company’s Tier 1 and Tier 2 risk-based capital ratios at December
31, 2003 were 12.85% and 14.10%, respectively. The Bank is also subject to
federal regulatory capital requirements. At December 31, 2004, the Bank was
deemed to be “well capitalized” under the applicable regulations. See Note 17 to
the Consolidated Financial Statements.





**





28


**


*Equity
Ratios*





**Table
12 - Equity Ratios**





The
following tables summarize the Company’s key equity ratios at December 31,
2004, 2003 and 2002.




****
    **2004**
    ****
    **2003**
    ****
    **2002**
    ****Return
      on average assets
    
    
    1.36
    %
    
    1.34
    %
    
    1.33
    %Return
      on average equity
    
    
    16.06
    %
    
    14.74
    %
    
    13.93
    %Dividend
      payout ratio
    
    
    38.32
    %
    
    37.16
    %
    
    31.27
    %Average
      equity to average assets
    
    
    8.49
    %
    
    9.12
    %
    
    9.58
    %


*Impact
of New Accounting Standards*





For
information on the impact of new accounting standards, see Note 1 to the
Consolidated Financial Statements.





**ITEM
7A.** **QUANTITATIVE
AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK**





The
information contained in the section captioned “Management’s Discussion and
Analysis of Financial Condition and Results of Operations - Asset/Liability
Management” in Item 7 hereof is incorporated herein by
reference.


29


**ITEM
8.** **FINANCIAL
STATEMENTS AND SUPPLEMENTARY DATA**





**MERRILL
MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES**


**Consolidated
Statements of Financial Condition**


December
      31,(In
      thousands, except number of shares and per share data)
    
    2004
    
    2003**ASSETS**Cash
      and due from banks
    
    $
    10,092
    
    $
    10,682Interest-bearing
      deposits with banks
    
    
    128
    
    
    64Total
      cash and cash equivalents
    
    
    10,220
    
    
    10,746Investment
      securities - available for sale
    
    
    66,099
    
    
    76,140Loans
      held for sale
    
    
    617
    
    
    789Loans
      receivable
    
    
    282,988
    
    
    246,512Less
      allowance for loan losses
    
    
    3,866
    
    
    3,652Net
      loans receivable
    
    
    279,122
    
    
    242,860Properties
      and equipment, net
    
    
    3,850
    
    
    3,335Cash
      surrender value of life insurance
    
    
    3,854
    
    
    3,729Deferred
      income tax benefit
    
    
    1,079
    
    
    859Accrued
      income and other assets
    
    
    3,849
    
    
    3,731Total
      assets
    
    $
    368,690
    
    $
    342,189**LIABILITIES
      AND SHAREHOLDERS’ EQUITY**Demand
      deposits
    
    $
    51,945
    
    $
    47,880Savings
      and NOW deposits
    
    
    142,614
    
    
    117,951Certificates
      of deposit
    
    
    105,223
    
    
    93,017Total
      deposits
    
    
    299,782
    
    
    258,848Securities
      sold under agreements torepurchase
      (term and demand)
    
    
    16,486
    
    
    20,362Other
      borrowed funds
    
    
    17,038
    
    
    28,898Accrued
      expenses and other liabilities
    
    
    4,055
    
    
    3,528Total
      liabilities
    
    
    337,361
    
    
    311,636Commitments
      (Notes 4, 8, 9, 13, 17 and 18)Shareholders’
      equityCommon
      stock, par value $1; authorized 4,000,000 shares, issued andoutstanding
      3,340,310 shares in 2004 and issued 3,335,293 shares andoutstanding
      3,323,797 shares in 2003
    
    
    3,340
    
    
    3,335Capital
      surplus
    
    
    22,037
    
    
    21,762Retained
      earnings
    
    
    5,763
    
    
    5,305Accumulated
      other comprehensive (loss) incomeUnrealized
      gain on securities available for sale, net of tax
    
    
    203
    
    
    366Net
      unrealized depreciation on derivative instruments marked to
      market,net
      of tax
    
    
    (14
    )
    
    -Treasury
      stock, at cost (11,496 shares in 2003)
    
    
    -
    
    
    (215
    )Total
      shareholders’ equity
    
    
    31,329
    
    
    30,553Total
      liabilities and shareholders’ equity
    
    $
    368,690
    
    $
    342,189


The
accompanying notes are an integral part of these consolidated financial
statements.


30


**MERRILL
MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES**


**Consolidated
Statements of Income**








Years
      Ended December 31,(In
      thousands, except number of shares and per share data)
    
    2004
    
    2003
    
    2002Interest
      and dividend incomeInterest
      and fees on loans
    
    $
    16,609
    
    $
    15,302
    
    $
    14,959Interest
      on investment securities
    
    
    1,953
    
    
    1,754
    
    
    3,090Dividends
      on investment securities
    
    
    118
    
    
    157
    
    
    257Interest
      on federal funds sold
    
    
    28
    
    
    -
    
    
    1Total
      interest and dividend income
    
    
    18,708
    
    
    17,213
    
    
    18,307Interest
      expenseInterest
      on deposits
    
    
    4,041
    
    
    3,939
    
    
    5,007Interest
      on borrowed funds
    
    
    894
    
    
    795
    
    
    837Total
      interest expense
    
    
    4,935
    
    
    4,734
    
    
    5,844Net
      interest income
    
    
    13,773
    
    
    12,479
    
    
    12,463Provision
      for loan losses
    
    
    348
    
    
    444
    
    
    453Net
      interest income after provision forloan
      losses
    
    
    13,425
    
    
    12,035
    
    
    12,010Non-interest
      incomeService
      charges on deposit accounts
    
    
    1,399
    
    
    1,161
    
    
    858Other
      service charges and fees
    
    
    790
    
    
    706
    
    
    944Trust
      fees
    
    
    1,382
    
    
    1,186
    
    
    1,075Net
      gain on sale of mortgage loans
    
    
    897
    
    
    1,808
    
    
    796Net
      gain (loss) on investment securities
    
    
    155
    
    
    (51
    )
    
    (30
    )Other
    
    
    382
    
    
    371
    
    
    320Total
      non-interest income
    
    
    5,005
    
    
    5,181
    
    
    3,963Non-interest
      expenseSalaries
      and employee benefits
    
    
    6,310
    
    
    5,887
    
    
    5,452Occupancy
      expense
    
    
    858
    
    
    811
    
    
    825Equipment
      expense
    
    
    606
    
    
    637
    
    
    716Data
      processing
    
    
    686
    
    
    626
    
    
    558Other
    
    
    2,582
    
    
    2,757
    
    
    2,654Total
      non-interest expense
    
    
    11,042
    
    
    10,718
    
    
    10,205Income
      before income taxes
    
    
    7,388
    
    
    6,498
    
    
    5,768Income
      tax expense
    
    
    2,481
    
    
    2,196
    
    
    1,923Net
      income
    
    $
    4,907
    
    $
    4,302
    
    $
    3,845






Per
      share dataBasic
      earnings per common share
    
    $
    1.46
    
    $
    1.26
    
    $
    1.24Diluted
      earnings per common share
    
    $
    1.44
    
    $
    1.26
    
    $
    1.11








The
accompanying notes are an integral part of these consolidated financial
statements.


31


**MERRILL
MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES**


**Consolidated
Statements of Changes in Shareholders’ Equity**


(In
      thousands, except number of shares and per share data)

Convertible
    
    
    
    
    
    
    
    AccumulatedCumulative
    
    
    
    
    
    
    
    OtherPreferred
    
    Common
    
    Capital
    
    Retained
    
    Comprehensive
    
    TreasuryStock
    
    Stock
    
    Surplus
    
    Earnings
    
    Income
      (Loss)
    
    Stock
    
    TotalBalance
      at December 31, 2001
    
    $
    20
    
    $
    2,741
    
    $
    18,794
    
    $
    4,601
    
    $
    600
    
    $
    (771
    )
    $
    25,985Net
      income
    
    
    -
    
    
    -
    
    
    -
    
    
    3,845
    
    
    -
    
    
    -
    
    
    3,845Change
      in unrealized gain on securities available forsale,
      net of deferred income taxes of $18
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    (64
    )
    
    -
    
    
    (64
    )Comprehensive
      income
    
    
    -
    
    
    -
    
    
    -
    
    
    3,845
    
    
    (64
    )
    
    -
    
    
    3,781Conversion
      of cumulative preferred stock and mandatoryconvertible
      debentures to common stock
    
    
    (20
    )
    
    306
    
    
    14
    
    
    -
    
    
    -
    
    
    -
    
    
    300Common
      stock options exercised, 153,424 shares
    
    
    -
    
    
    65
    
    
    185
    
    
    (519
    )
    
    -
    
    
    959
    
    
    690Tax
      benefit related to exercise of stock options
    
    
    -
    
    
    -
    
    
    267
    
    
    -
    
    
    -
    
    
    -
    
    
    2673%
      common stock dividend declared
    
    
    -
    
    
    82
    
    
    1,121
    
    
    (1,205
    )
    
    -
    
    
    -
    
    
    (2
    )Treasury
      stock purchased (91,949 shares at anaverage
      price of $15.32)
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    (1,409
    )
    
    (1,409
    )Common
      stock cash dividends declared, $.40 per share
    
    
    -
    
    
    -
    
    
    -
    
    
    (1,192
    )
    
    -
    
    
    -
    
    
    (1,192
    )Convertible
      cumulative preferred stock dividendsdeclared,
      $1.63 per share
    
    
    -
    
    
    -
    
    
    -
    
    
    (32
    )
    
    -
    
    
    -
    
    
    (32
    )Balance
      at December 31, 2002
    
    $
    -
    
    $
    3,194
    
    $
    20,381
    
    $
    5,498
    
    $
    536
    
    $
    (1,221
    )
    $
    28,388Net
      income
    
    
    -
    
    
    -
    
    
    -
    
    
    4,302
    
    
    -
    
    
    -
    
    
    4,302Change
      in unrealized gain on securities available forsale,
      net of deferred income taxes of $89
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    (170
    )
    
    -
    
    
    (170
    )Comprehensive
      income
    
    
    
    
    
    -
    
    
    -
    
    
    -
    
    
    4,302
    
    
    (170
    )
    
    -Common
      stock options exercised, 184,142 shares
    
    
    -
    
    
    45
    
    
    (57
    )
    
    (1,458
    )
    
    -
    
    
    2,224
    
    
    754Tax
      benefit related to exercise of stock options
    
    
    -
    
    
    -
    
    
    98
    
    
    -
    
    
    -
    
    
    -
    
    
    983%
      common stock dividend declared
    
    
    -
    
    
    96
    
    
    1,340
    
    
    (1,438
    )
    
    -
    
    
    -
    
    
    (2
    )Treasury
      stock purchased (75,031 shares at anaverage
      price of $16.23)
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    (1,218
    )
    
    (1,218
    )Common
      stock cash dividends declared, $.48 per share
    
    
    -
    
    
    -
    
    
    -
    
    
    (1,599
    )
    
    -
    
    
    -
    
    
    (1,599
    )Balance
      at December 31, 2003
    
    $
    -
    
    $
    3,335
    
    $
    21,762
    
    $
    5,305
    
    $
    366
    
    $
    (215
    )
    $
    30,553Net
      income
    
    
    -
    
    
    -
    
    
    -
    
    
    4,907
    
    
    -
    
    
    -
    
    
    4,907Unrealized
      loss on derivative instruments, net ofdeferred
      taxes of $7
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    (13
    )
    
    -
    
    
    (13
    )Change
      in unrealized gain on securities available forsale,
      net of deferred income taxes of $85
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    (164
    )
    
    -
    
    
    (164
    )Comprehensive
      income
    
    
    -
    
    
    -
    
    
    -
    
    
    4,907
    
    
    (177
    )
    
    -
    
    
    4,730Common
      stock options exercised, 7,628 shares
    
    
    -
    
    
    2
    
    
    9
    
    
    (42
    )
    
    -
    
    
    97
    
    
    66Tax
      benefit related to exercise of stock options
    
    
    -
    
    
    -
    
    
    21
    
    
    -
    
    
    -
    
    
    -
    
    
    213%
      common stock dividend declared
    
    
    -
    
    
    100
    
    
    2,422
    
    
    (2,526
    )
    
    -
    
    
    -
    
    
    (4
    )Treasury
      stock purchased (72,592 shares at anaverage
      price of $24.80)
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    (1,801
    )
    
    (1,801
    )
    
    -Treasury
      stock retirement
    
    
    -
    
    
    (80
    )
    
    (1,839
    )
    
    -
    
    
    -
    
    
    1,919
    
    
    -Common
      stock repurchased (17,000 shares at anaverage
      price of $20.88)
    
    
    -
    
    
    (17
    )
    
    (338
    )
    
    -
    
    
    -
    
    
    -
    
    
    (355
    )Common
      stock cash dividends declared, $.56 per share
    
    
    -
    
    
    -
    
    
    -
    
    
    (1,881
    )
    
    -
    
    
    -
    
    
    (1,881
    )Balance
      at December 31, 2004
    
    $
    -
    
    $
    3,340
    
    $
    22,037
    
    $
    5,763
    
    $
    189
    
    $
    -
    
    $
    31,329


The
accompanying notes are an integral part of these consolidated financial
statements.


32


**MERRILL
MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES**


**Consolidated
Statements of Cash Flows**





Years
      Ended December 31,(In
      thousands)
    
    2004
    
    2003
    
    2002Cash
      flows from operating activitiesNet
      income
    
    $
    4,907
    
    $
    4,302
    
    $
    3,845Adjustments
      to reconcile net income to net cash provided by operating
      activitiesDepreciation
    
    
    392
    
    
    457
    
    
    504Amortization
    
    
    523
    
    
    650
    
    
    436Net
      amortization on investment securities
    
    
    800
    
    
    979
    
    
    44Deferred
      income taxes
    
    
    (129
    )
    
    (125
    )
    
    (113
    )Provision
      for loan losses
    
    
    348
    
    
    444
    
    
    453Net
      gain on sale of mortgage loans, investment securities andproperty
      and equipment
    
    
    (651
    )
    
    (788
    )
    
    (332
    )Net
      change in:Loans
      held for sale
    
    
    172
    
    
    431
    
    
    (160
    )Deferred
      loan fees, net
    
    
    (29
    )
    
    26
    
    
    10Accrued
      income and other assets
    
    
    (211
    )
    
    (31
    )
    
    (342
    )Accrued
      expenses and other liabilities
    
    
    527
    
    
    389
    
    
    328Net
      cash provided by operating activities
    
    
    6,649
    
    
    6,734
    
    
    4,673Cash
      flows from investing activitiesNet
      loans made to customers
    
    
    (36,581
    )
    
    (31,895
    )
    
    (26,944
    )Acquisition
      of premises and equipment and computer software
    
    
    (1,033
    )
    
    (295
    )
    
    (420
    )Purchase
      of investment securities available for sale
    
    
    (56,511
    )
    
    (79,253
    )
    
    (111,316
    )Proceeds
      from sales and maturities of investment securitiesavailable
      for sale
    
    
    65,658
    
    
    70,691
    
    
    113,902Acquisition
      of life insurance policies
    
    
    -
    
    
    -
    
    
    (535
    )Proceeds
      from sale of other real estate owned
    
    
    -
    
    
    153
    
    
    217Net
      cash used by investing activities
    
    
    (28,467
    )
    
    (40,599
    )
    
    (25,096
    )Cash
      flows from financing activitiesNet
      increase in demand, savings and NOW deposits
    
    
    28,728
    
    
    18,859
    
    
    11,314Net
      increase in certificates of deposit
    
    
    12,206
    
    
    1,132
    
    
    8,234Net
      (decrease) increase in securities sold underagreements
      to repurchase
    
    
    (3,876
    )
    
    1,126
    
    
    98Net
      (decrease) increase in other borrowed funds
    
    
    (9,553
    )
    
    1,881
    
    
    8,138Long-term
      advances from the Federal Home Loan Bank
    
    
    3,290
    
    
    10,000
    
    
    3,746Payments
      on long-term advances
    
    
    (5,597
    )
    
    (679
    )
    
    (4,842
    )Dividends
      paid on common stock
    
    
    (1,816
    )
    
    (1,511
    )
    
    (1,123
    )Repurchase
      of common stock
    
    
    (2,156
    )
    
    (1,218
    )
    
    (1,409
    )Proceeds
      from stock issuance
    
    
    66
    
    
    754
    
    
    690Net
      cash provided by financing activities
    
    
    21,292
    
    
    30,344
    
    
    24,846Net
      (decrease) increase in cash and cash equivalents
    
    
    (526
    )
    
    (3,521
    )
    
    4,423Cash
      and cash equivalents, beginning of year
    
    
    10,746
    
    
    14,267
    
    
    9,844Cash
      and cash equivalents, end of year
    
    $
    10,220
    
    $
    10,746
    
    $
    14,267Supplemental
      disclosures of cash flow informationCash
      paid for interest
    
    $
    4,719
    
    $
    4,717
    
    $
    5,823Transfers
      to other real estate owned
    
    
    -
    
    
    -
    
    
    141Income
      tax paid
    
    
    2,668
    
    
    1,999
    
    
    1,914


The
accompanying notes are an integral part of these consolidated financial
statements.


33


**MERRILL
MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES**


**Notes
to Consolidated Financial Statements**


**(Presented
in thousands, except number of shares and per share data)**





**1.** **Summary
of Significant Accounting Policies**





The
accounting and reporting policies conform with U.S. generally accepted
accounting principles and to general practice within the banking industry.
Merrill Merchants Bancshares, Inc. (the “Company”) is a financial holding
company that owns all of the common stock of Merrill Merchants Bank (the
“Bank”). The Company’s principal business activity is retail and commercial
banking and trust and investment services which are provided through its eleven
branch locations in eastern and central Maine. The Bank is under the supervision
of the Board of Governors of the Federal Reserve System and the State of Maine
Bureau of Financial Institutions, and its deposits are insured by the Federal
Deposit Insurance Corporation (FDIC) to the fullest extent permitted by law. The
following is a description of the more significant accounting and reporting
policies.





***Estimates***





The
preparation of financial statements in conformity with U.S. generally accepted
accounting principles 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 revenues and expenses during the reporting period.
Actual results could differ from those estimates.





Material
estimates that are particularly susceptible to significant change in the near
term relate to the determination of the allowance for loan losses and the
valuation of real estate acquired in connection with foreclosures or in
satisfaction of loans. In connection with the determination of the allowance for
loan losses and the carrying value of other real estate owned, management
obtains independent appraisals for significant properties.





***Financial
Statement Presentation***





The
accompanying consolidated financial statements include the accounts of Merrill
Merchants Bancshares, Inc. and its wholly-owned subsidiaries, Merrill Merchants
Bank, a state-chartered bank, and Maine Acceptance Corporation (formerly a
separate subsidiaries of the Company, was merged into the Bank effective March
29, 2002). All intercompany accounts and transactions have been eliminated in
the consolidated financial statements.





Statement
of Financial Accounting Standards (SFAS) No. 131, “Disclosures about Segments of
an Enterprise and Related Information,” requires a company to disclose certain
income statement and balance sheet information by operating segment. Since the
Company’s operations include only its banking and financing activities, no
additional disclosure standards are required by the Statement.





***Investment
Securities***





Investment
debt securities are classified as available for sale and are carried at fair
value. Unrealized gains and losses on securities available for sale, net of
income taxes, are recognized as direct increases or decreases in shareholders'
equity. Market values of securities are obtained from independent market
sources. Cost of securities sold is recognized using the specific identification
method.





Premiums
are amortized and discounts are accreted using methods approximating the
interest method.










34


**MERRILL
MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES**


**Notes
to Consolidated Financial Statements – (Continued)**


***Loans
Held for Sale***





Residential
mortgage loans originated and intended for sale in the secondary market are
carried at the lower of aggregate cost or estimated market value. Gains or
losses on sales of loans are recognized at the time of sale and are based upon
the difference between the selling price and the carrying amount of loans
sold.





***Other
Real Estate Owned***





Other
real estate owned (OREO) includes real estate and repossessed personal property
held for sale which have been acquired principally through foreclosure or a
similar conveyance of title. Real estate may be considered to be in-substance
foreclosed and included in OREO prior to the conveyance of title when specific
criteria are met. Both foreclosed and in-substance foreclosed real estate, as
well as repossessed personal property, are carried at the lower of their
recorded amounts or fair value less estimated costs of disposal. Any write-downs
at, or prior to, the dates of acquisition are charged to the allowance for loan
losses. Subsequent write-downs are recorded in other expense. Expenses incurred
in connection with holding such assets and gains and losses upon sale are
included in other expense or other income.





***Loans
Receivable***





Loans
receivable that management has the intent and ability to hold for the
foreseeable future or until maturity or pay-off are reported at their
outstanding principal adjusted for any charge-offs, the allowance for loan
losses, and any deferred fees or costs.





Interest
on loans is accrued and credited to income based on the principal amount
outstanding.  The accrual of interest on loans is discontinued when, in the
opinion of management, there is an indication that the borrower may be unable to
meet payments as they become due or the loan becomes past due 90 days or more
unless the credit is well-secured and in process of collection. Upon such
discontinuance, all unpaid accrued interest is reversed.  Interest income
is subsequently recognized only to the extent cash payments are received. 
Loans 30 days or more past due are considered delinquent.





The
Company’s provision for loan losses charged to operations is based upon
management’s evaluation of the loan portfolio.  Loans deemed uncollectible
are charged to the allowance.  The allowance for loan losses is maintained
at a level that management believes, to the best of its knowledge, is at a level
at each reporting date to cover known and inherent losses in the loan portfolio
that are both probable and reasonably estimable.  The ongoing evaluation
process includes a formal analysis of the allowance each quarter, which
considers, among other factors, the character and size of the loan portfolio,
business and economic conditions, loan growth, delinquency trends, charge-off
experience and other asset quality factors.  While management uses
available information to recognize losses on loans, future additions to the
allowance may be necessary based on changes in economic conditions.  In
addition, various regulatory agencies, as an integral part of their examination
process, periodically review the Company’s allowance for loan losses.  Such
agencies may require the Company to recognize adjustments to the allowance based
on their judgments about information available to them at the time of their
examinations.





Commercial
real estate and commercial business loans are considered impaired when it is
probable that the Company will not be able to collect all amounts due according
to the contractual terms of the loan agreement. Factors considered by management
in determining impairment include payment status and collateral value. Loans
considered to be impaired are reduced to the present value of expected future
cash flows or to the fair value of collateral.  Management takes into
consideration impaired loans in determining the appropriate level of allowance
for loan losses.







35


******


*****MERRILL
MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES***
**Notes
to Consolidated Financial Statements – (Continued)****


***Loan
Servicing***





The cost
of mortgage servicing rights is amortized in proportion to, and over the period
of, estimated net servicing revenues. Impairment of mortgage servicing rights is
assessed based on the fair value of those rights. Fair values are estimated
using discounted cash flows based on a current market interest rate. For
purposes of measuring impairment, the rights are stratified based on loan type,
investor type, and interest rate. The amount of impairment recognized is the
amount by which the capitalized mortgage servicing rights for a stratum exceed
their fair value.





***Properties
and Equipment***





Properties
and equipment are stated at cost, less accumulated depreciation. The provision
for depreciation is computed on the straight-line method and by accelerated
methods over the estimated useful lives of the assets.





***Goodwill***





Effective
January 1, 2002, the Company discontinued amortization of goodwill in accordance
with SFAS Nos. 142, “Goodwill and Other Intangible Assets,” and 147,
“Acquisitions of Certain Financial Institutions.” Prior to 2002, goodwill was
being amortized using the straight-line method over seven and fifteen years. In
accordance with SFAS No. 142, goodwill will be reviewed for impairment on an
annual basis and if certain conditions occur.





***Loan
Origination Fees and Costs***





Loan
origination fees and certain direct origination costs are capitalized and
recognized as an adjustment of the yield on the related loan.





***Income
Taxes***





The
Company records deferred tax assets and liabilities for future tax consequences
attributable to differences between the financial statement carrying amounts of
assets and liabilities and their respective tax bases. Deferred tax assets and
liabilities are measured using enacted tax rates expected to apply to taxable
income in the years in which those temporary differences are expected to be
recovered or settled.





***Off-Balance-Sheet
Financial Instruments***





In the
ordinary course of business, the Bank has entered into off-balance-sheet
financial instruments consisting of commitments to extend credit, letters of
credit, unadvanced commitments under commercial and home equity lines of credit,
credit cards, and overdraft protection accounts. Such financial instruments are
recorded in the consolidated financial statements when funded.





***Derivative
Financial Instruments***





The
Company recognizes all derivatives in the statement of financial condition at
fair value. On the date the derivative is entered into, the Company designates
whether the derivative is part of a hedging relationship (cash flow or fair
value hedge). The Company formally documents relationships between hedging
instruments and hedged items, as well as its risk management objective and
strategy for undertaking hedge transactions. The Company also assesses, both at
the hedge’s inception and on an ongoing basis, whether the derivatives used in
hedging transactions are highly effective in offsetting changes in cash flows or
fair values of hedged items.





36





**MERRILL
MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES**
**Notes
to Consolidated Financial Statements – (Continued)**
****


Changes
in fair value of a derivative that is highly effective and that qualifies as a
cash flow hedge are recorded in other comprehensive income and are reclassified
into earnings when the related forecasted transaction affects earnings. For fair
value hedges that are fully effective, the gain or loss on the hedge would
exactly offset the loss or gain on the hedged item attributable to the hedged
risk. Any difference that does arise would be the result of hedge
ineffectiveness, which is recognized in earnings. The Company discontinues hedge
accounting when it is determined that the derivative is no longer highly
effective in offsetting changes in the hedged risk of the hedge item, because it
is unlikely that the forecasted transaction will occur, or management determines
that the designation of the derivative as a hedging instrument is no longer
appropriate.





***Cash
and Cash Equivalents***





For the
purpose of presentation in the consolidated statements of cash flows, cash and
cash equivalents are defined as cash and due from banks and interest-bearing
deposits with banks.





***Earnings
Per Share***





The basic
earnings per share computation is based upon the weighted-average number of
shares of stock outstanding during the period. Potential common stock is
considered in the calculation of weighted-average shares outstanding for diluted
earnings per share.





The
Company declared a 3% stock dividend in 2004, 2003 and 2002. Earnings and cash
dividends per share and weighted-average shares outstanding have been
retroactively restated to reflect the stock dividends.





***Impact
of Recently Issued Accounting Standards***





The
Financial Accounting Standards Board (FASB) has issued SFAS No. 123 (revised
2004) (SFAS No. 123(R)), “Share-Based Payment.” SFAS No. 123(R) will, with
certain exceptions, require entities that grant stock options and shares to
employees to recognize the fair value of those options and shares as
compensation cost over the service (vesting) period in their financial
statements. The measurement of that cost will be based on the fair value of the
equity or liability instruments issued.





SFAS No.
123(R) will be effective for the Company’s quarterly interim financial reporting
period ending September 30, 2005. Management expects adoption of SFAS No. 123(R)
will not have a material effect on the Company’s consolidated financial
statements.





******


***Reclassifications***





Certain
amounts in previously issued financial statements have been reclassified in the
currently presented financial statements.


****


**2.  Cash and Cash
Equivalents**





The
Federal Reserve Board requires the Bank to maintain a rolling average
compensating balance of $400 in amounts on deposit. The Company maintains its
cash in bank deposit accounts which, at times, may exceed federally insured
limits. The Company has not experienced any losses in such accounts. The Company
believes it is not exposed to any significant risk with respect to these
accounts.


****


**3. Investment
Securities Available for Sale**





The
amortized cost of investment securities as shown in the consolidated statements
of financial condition and their approximate fair values at December 31,
2004 and 2003 follow:





37


****


****MERRILL
MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES**
**Notes
to Consolidated Financial Statements – (Continued)****




**Amortized**
    
    **Unrealized**
    
    **Unrealized**
    
    **Fair****Cost**
    
    **Gains**
    
    **Losses**
    
    **Value****December
      31, 2004**Collateralized
      mortgage obligations
    
    $
    43,553
    
    $
    30
    
    $
    (315
    )
    $
    43,268U.S.
      Government agencies and corporations
    
    
    10,297
    
    
    18
    
    
    (34
    )
    
    10,281Mortgage-backed
      securities
    
    
    3,982
    
    
    38
    
    
    (40
    )
    
    3,980U.S.
      Government and agency money market funds
    
    
    480
    
    
    -
    
    
    -
    
    
    480Certificates
      of deposit
    
    
    1,346
    
    
    -
    
    
    -
    
    
    1,346State
      and local government debt securities
    
    
    2,311
    
    
    -
    
    
    -
    
    
    2,311Total
      debt securities
    
    
    61,969
    
    
    86
    
    
    (389
    )
    
    61,666Equity
      securities
    
    
    3,825
    
    
    608
    
    
    -
    
    
    4,433Total
      securities available for sale
    
    $
    65,794
    
    $
    694
    
    $
    (389
    )
    $
    66,099







**Amortized**
    
    **Unrealized**
    
    **Unrealized**
    
    **Fair****Cost**
    
    **Gains**
    
    **Losses**
    
    **Value****December
      31, 2003**Collateralized
      mortgage obligations
    
    $
    46,441
    
    $
    113
    
    $
    (301
    )
    $
    46,253U.S.
      Government agencies and corporations
    
    
    12,351
    
    
    125
    
    
    (3
    )
    
    12,473Mortgage-backed
      securities
    
    
    5,500
    
    
    27
    
    
    -
    
    
    5,527U.S.
      Government and agency money market funds
    
    
    2,105
    
    
    -
    
    
    -
    
    
    2,105Certificates
      of deposit
    
    
    2,957
    
    
    -
    
    
    -
    
    
    2,957State
      and local government debt securities
    
    
    2,682
    
    
    -
    
    
    -
    
    
    2,682Total
      debt securities
    
    
    72,036
    
    
    265
    
    
    (304
    )
    
    71,997Equity
      securities
    
    
    3,550
    
    
    593
    
    
    -
    
    
    4,143Total
      securities available for sale
    
    $
    75,586
    
    $
    858
    
    $
    (304
    )
    $
    76,140





During
2004, 2003 and 2002, the Company sold investment securities available for sale
for total proceeds of $41,002, $26,549 and $82,055, respectively. The sales
resulted in gross realized gains of $155 for 2004, gross realized losses of $51
for 2003 and gross realized losses of $30 for 2002.





The
amortized cost and fair value of debt securities at December 31, 2004 by
contractual maturity are shown below. Expected maturities may differ from
contractual maturities because borrowers may have the right to call or prepay
obligations with or without call or prepayment penalties. Mortgage-backed
securities and collateralized mortgage obligations are allocated among the above
maturity groupings based on their final maturity dates.


**Amortized**
    ****
    **Fair**
    ********
    ****
    **Cost**
    ****
    **Value**Due
      in one year or less
    
    $
    3,847
    
    $
    3,852Due
      from one to five years
    
    
    10,707
    
    
    10,704Due
      from five to ten years
    
    
    21,643
    
    
    21,525Due
      after ten years
    
    
    25,772
    
    
    25,585Total
      debt securities
    
    $
    61,969
    
    $
    61,666


Management
reviews securities with unrealized losses for other than temporary impairment.
As of December 31, 2004, there were 36 securities with unrealized losses held in
the Company’s portfolio. These securities were temporarily impaired as a result
of changes in interest rates reducing their fair market value. Eighteen
securities have been temporarily impaired for 12 months or more. At the present
time, there have been no material changes in the credit quality of these
securities. Information regarding securities temporarily impaired is summarized
below:





38






**MERRILL
MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES**
 **Notes
to Consolidated Financial Statements –
(Continued)**


**Less
      than 1 year******
    ****
    ************More
      than 1 year****
    ****
    ************Total****
    ********
    ****
    **Fair**
    ****
    **Unrealized**
    ****
    **Fair**
    ****
    **Unrealized**
    ****
    **Fair**
    ****
    **Unrealized**
    ********
    ****
    **Value**
    ****
    **Losses**
    ****
    **Value**
    ****
    **Losses**
    ****
    **Value**
    ****
    **Losses**Collateralized
      mortgage obligations
    
    $
    12,852
    
    $
    (105
    )
    $
    21,033
    
    $
    (210
    )
    $
    33,885
    
    $
    (315
    )U.S.
      Government agencies andcorporations
    
    
    5,024
    
    
    (22
    )
    
    997
    
    
    (12
    )
    
    6,021
    
    
    (34
    )Mortgage-backed
      securities
    
    
    2,270
    
    
    (40
    )
    
    -
    
    
    -
    
    
    2,270
    
    
    (40
    )$
    20,146
    
    $
    (167
    )
    $
    22,030
    
    $
    (222
    )
    $
    42,176
    
    $
    (389
    )


**4.Derivative Financial
Instruments**





The
Company has interest rate swap agreements with notional amounts of $10,000 at
December 31, 2004. Under these agreements, the Company exchanges a variable rate
asset for a fixed rate asset, thus protecting certain asset yields from falling
interest rates. In accordance with SFAS No. 133, “Accounting for Derivative
Instruments and Hedging Activities,” and related pronouncements, management
designated these swaps as cash flow hedges and determined the hedging
transaction to be 100% effective. Therefore, the changes in fair value of the
swap agreements are recorded in other comprehensive income. As of December 31,
2004, the swaps represented a liability of $20, less tax of $7, which has been
recorded as other comprehensive income in the consolidated statements of changes
in shareholders’ equity.





The
Company uses derivative instruments as partial hedges against large fluctuations
in interest rates. The Company uses interest rate swap instruments to hedge
against potentially lower yields on the variable prime rate loan category in a
declining rate environment. If rates were to decline, resulting in reduced
income on the adjustable rate loans, there would be an increased income flow
from the interest rate swap.





On a
quarterly basis, derivative instruments are reviewed as part of the
asset/liability management process. Any derivatives are factored into the
Company’s overall interest rate risk position. The Company regularly reviews the
credit quality of the counterparty from which the instruments have been
purchased. As of December 31, 2004, the Company had $10,000 (notional principal
amount) in swap contracts in which the Company is hedging prime-based variable
commercial loans to a fixed rate of 5.93%. The interest rate swap agreements
mature in 2006.





****


**5. Loans
Receivable**





The
components of loans receivable follow:





**2004**
    ****
    **2003**Real
      estate:Commercial
      real estate
    
    $
    96,956
    
    $
    80,212Residential
      real estate
    
    
    60,314
    
    
    55,380Construction
    
    
    12,854
    
    
    9,669Home
      equity
    
    
    34,139
    
    
    28,496Total
      real estate
    
    
    204,263
    
    
    173,757Commercial
    
    
    60,111
    
    
    55,616Consumer
    
    
    18,715
    
    
    17,269Less
      deferred loan fees
    
    
    (101
    )
    
    (130
    )Total
    
    $
    282,988
    
    $
    246,512





39








**MERRILL
MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES**
 **Notes
to Consolidated Financial Statements – (Continued)**
 
 The
Bank’s lending activities are conducted principally in eastern and central
Maine.  The Bank grants single family and multi-family residential loans,
commercial real estate loans, commercial loans, and a variety of consumer
loans.  The Bank grants loans for the construction of residential homes,
multi-family properties and commercial real estate properties.  In
addition, the Bank provides indirect auto and recreational vehicle lending, as
well as other types of loans, including personal unsecured, recreational
vehicle, automobile, mobile home, and home equity loans. Most loans granted by
the Bank are either collateralized by real estate or guaranteed by federal and
local governmental authorities.  The ability and willingness of the single
family residential and consumer borrowers to honor their repayment commitments
is generally dependent on the level of overall economic activity within the
borrowers’ geographic areas and real estate values.  The ability and
willingness of commercial real estate, commercial and construction loan
borrowers to honor their repayment commitments is generally dependent on the
health of the real estate economic sector in the borrowers’ geographic areas and
the general economy.





As of
December 31, 2004 and 2003, non-accrual loans were $1,571 and $598,
respectively. Interest foregone was $47, $24 and $36 for 2004, 2003 and 2002,
respectively. Accruing loans which are 90 days past due or more totaled $4 and
$8 at December 31, 2004 and 2003, respectively.





Impaired
loans are commercial and commercial real estate loans which the Company believes
will probably not result in the collection of all amounts due according to the
contractual terms of the loan agreement. The definition of “impaired loans” is
not the same as the definition of “non-accrual loans,” although the two
categories overlap. All commercial and commercial real estate impaired loans are
non-accrual loans, but not all non-accrual loans are considered impaired
loans.





The
following table sets forth information on impaired loans:




**2004**
    ****
    **2003**
    ****
    **2002**Impaired
      loansValuation
      allowance required
    
    $
    -
    
    $
    222
    
    $
    333No
      valuation allowance required
    
    
    5
    
    
    77
    
    
    -Total
      impaired loans
    
    $
    5
    
    $
    299
    
    $
    333Average
      balance of impaired loans during the year
    
    $
    256
    
    $
    687
    
    $
    272Portion
      of allowance for loan losses allocated to theimpaired
      loan balance
    
    
    1
    
    
    60
    
    
    33


Interest
income recognized for cash payments on impaired loans during 2004, 2003 and 2002
was not material to the consolidated financial statements.





The Bank
has entered into loan transactions with its directors, executive officers,
significant shareholders of the Company and their affiliates (related parties).
Such transactions were made in the ordinary course of business on substantially
the same terms and conditions, including interest rates and collateral, as those
prevailing at the same time for comparable transac-tions with other customers,
and did not, in the opinion of management, involve more than normal credit risk
or present other unfavorable features. Loans to related parties which in
aggregate exceed $60 follows:




Commitments,
as described in Note 13, to related parties which in aggregate exceed $60
totaled $1,254 and $1,579 at December 31, 2004 and 2003, respectively.





40




**MERRILL
MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES**
 **Notes
to Consolidated Financial Statements –
(Continued)**


**6. Allowance for
Loan Losses**





A summary
of changes in the allowance for loan losses follows:




**2004**
    ****
    **2003**
    ****
    **2002**Balance
      at beginning of year
    
    $
    3,652
    
    $
    3,295
    
    $
    2,986Add:  
      Provision for loan losses
    
    
    348
    
    
    444
    
    
    453Recoveries
      of previous charge-offs
    
    
    44
    
    
    33
    
    
    45Less:
      Loans charged off
    
    
    (178
    )
    
    (120
    )
    
    (189
    )Balance
      at end of year
    
    $
    3,866
    
    $
    3,652
    
    $
    3,295


**7. Mortgage
Servicing**





Residential
real estate mortgages are originated by the Company both for portfolio and for
sale into the secondary market. The sale of loans is to institutional investors
such as the Federal National Mortgage Association. Under loan sale and servicing
agreements with the investor, the Company generally continues to service the
residential real estate mortgages. The Company pays the investor an agreed-upon
rate on the loan, which is less than the interest rate the Company receives from
the borrower. The Company retains the difference as a fee for servicing the
residential real estate mortgages. As required by SFAS No. 140, the Company
capitalizes the mortgage servicing rights at their fair value upon sale of the
related loans.





The
following summarizes mortgage servicing rights capitalized and amortized, along
with the activity in the related valuation allowance:


**2004**
    
    **2003**
    
    **2002**Balance
      of loans serviced for others
    
    $
    122,125
    
    $
    106,864
    
    $
    95,095Mortgage
      servicing rightsBalance
      at beginning of year
    
    $
    792
    
    $
    423
    
    $
    340Mortgage
      servicing rights capitalized
    
    
    494
    
    
    869
    
    
    361Amortization
      charged against mortgage servicing income
    
    
    (355
    )
    
    (476
    )
    
    (278
    )Valuation
      adjustment
    
    
    7
    
    
    (24
    )
    
    -Balance
      at end of year
    
    $
    938
    
    $
    792
    
    $
    423
 
 Valuation
      allowanceBalance
      at beginning of year
    
    $
    (24
    )
    $
    -
    
    $
    -Increase
      in impairment reserve
    
    
    (15
    )
    
    (38
    )
    
    -Reduction
      of impairment reserve
    
    
    22
    
    
    14
    
    
    -Balance
      at end of year
    
    $
    (17
    )
    $
    (24
    )
    
    -


Mortgage
loans serviced for others are not included in the accompanying consolidated
statements of financial condition of the Company.





41
 **MERRILL
MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES**
 **Notes
to Consolidated Financial Statements - (Continued)**


**8. Properties
and Equipment**





A summary
of properties and equipment follows:


**2004**
    ****
    **2003**Land
      and land improvements
    
    $
    559
    
    $
    559Bank
      premises
    
    
    2,347
    
    
    2,370Construction
      in progress
    
    
    687
    
    
    -Furniture
      and equipment
    
    
    3,221
    
    
    3,079Leasehold
      improvements
    
    
    400
    
    
    400Total
      cost
    
    
    7,214
    
    
    6,408Less
      accumulated depreciation
    
    
    3,364
    
    
    3,073Net
      properties and equipment
    
    $
    3,850
    
    $
    3,335


Depreciation
expense amounted to $392, $457 and $504 in 2004, 2003 and 2002,
respectively.





In July
2004, the Bank acquired a historic building located at 183 Main Street, Bangor,
Maine. This property is adjacent to the Bank’s headquarters property at 201 Main
Street. Construction is in progress to renovate the historic building, add a
third floor to its headquarters building and to link the properties with a
three-story connecting corridor. The $1,500 project is targeted for completion
in September 2005.





Certain
Bank facilities and equipment are leased under various operating leases. Rental
expense was $348, $343 and $309 for 2004, 2003 and 2002, respectively. Future
minimum rental commitments under non-cancelable leases at December 31, 2004
follow:


2005
    
    $
    2512006
    
    
    2302007
    
    
    1832008
    
    
    1252009
    
    
    106Thereafter
    
    
    54$
    949


**9. Employee
Benefit Plans**





The
Company has established a defined contribution pension plan under Section 401(k)
of the Internal Revenue Code. Plan participants, who consist of all employees
meeting minimum age and service requirements who elect to participate, are
permitted to contribute a percentage of their wages to the plan on a pre-tax
basis. The Company matches a portion of each employee’s contribution, resulting
in an expense of $134, $114 and $101 for 2004, 2003 and 2002, respectively.





The
Company adopted a nonqualified supplemental executive retirement plan for the
benefit of key employees. Life insurance policies were acquired to generate
income to offset the cost of the plan. During 2002, additional life insurance
policies acquired totaled $535. The amount of each annual benefit is indexed to
the financial performance of each insurance policy owned by the Bank over the
Bank’s cost of funds expense. The present value of these benefits is being
expensed over the employment service period which amounted to $247, $187 and
$127 for 2004, 2003 and 2002, respectively. The cash value of these policies was
$3,854 and $3,729 at December 31, 2004 and 2003, respectively.





42


****


****MERRILL
MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES**
**Notes
to Consolidated Financial Statements –
(Continued)**** **10. Deposits**





The
aggregate amount of certificates of deposit with a minimum denomination of $100
was $55,677 and $41,511 at December 31, 2004 and 2003, respectively.
Certificates of deposit included brokered deposits in the amount of $39,114 and
$25,942 at December 31, 2004 and 2003, respectively.





At
December 31, 2004, the scheduled maturities of certificates of deposit
follow:


2005
    
    $
    45,0972006
    
    
    21,5582007
    
    
    26,2992008
    
    
    4,2852009
    
    
    4,568Thereafter
    
    
    3,416$
    105,223


**11. Borrowed
Funds**





Borrowed
funds consists of advances from the Federal Home Loan Bank (FHLB), commercial
bank line of credit advances, Treasury, tax and loan notes and securities sold
under agreements to repurchase with municipal, nonprofit and commercial
customers.





At
December 31, 2004 and 2003, investment securities with amortized cost of $55,575
and $53,346 and fair value of $54,986 and $53,315, respectively, were pledged to
secure public deposits, Treasury, tax and loan deposits, securities sold under
agreements to repurchase and borrowings and for other purposes required or
permitted by law.





Securities
sold under agreements to repurchase generally mature within one to four days
from the transaction date. Information concerning securities sold under
agreements to repurchase is summarized as follows:


**2004**
    ****
    **2003**
    ****
    **2002**Balance
      outstanding at end of year
    
    $
    16,486
    
    $
    20,362
    
    $
    19,236Average
      balance during the year
    
    
    17,357
    
    
    19,797
    
    
    17,096Maximum
      outstanding at any month-end during the year
    
    
    20,317
    
    
    23,570
    
    
    19,248Average
      interest rate during the year
    
    
    0.80
    %
    
    0.82
    %
    
    1.40
    %Average
      interest rate at end of the year
    
    
    1.10
    %
    
    0.66
    %
    
    1.07
    %


Short-
and long-term borrowings from the FHLB consist of fixed rate borrowings and are
collateralized by all stock in the FHLB and a blanket lien on qualified
collateral consisting primarily of loans with first mortgages secured by
one-to-four family properties and other qualified assets. The Company, through
its banking subsidiaries, has an available line of credit with the FHLB of
$3,509.





At
December 31, 2004, the Company had a $5,000 commercial bank line of credit that
expires in 2005. The floating rate note is based on the one month London
Interbank Offer Rate (2.40% at December 31, 2004) plus 1.75%.








43
 **MERRILL
MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES**
 **Notes
to Consolidated Financial Statements - (Continued)**


A summary
of the borrowings from the Federal Home Loan Bank follows:


**December
      31, 2004**
    ****
    **December
      31, 2003****MaturityDates**
    
    **Principal****Amounts**
    ****
    **Interest
      Rates**
    ****
    **Maturity****Dates**
    ****
    **Principal****Amounts**
    ****
    **Interest
      Rates**2005
    
    $
    2,594
    
    
    0.00
      - 7.34
    %
    
    2004
    
    $
    2,594
    
    
    1.14
      - 7.34
    %2006
    
    
    2,929
    
    
    0.00
      - 6.47
    %
    
    2005
    
    
    2,590
    
    
    1.14
      - 7.34
    %2007
    
    
    4,532
    
    
    0.00
      - 6.47
    %
    
    2006
    
    
    5,924
    
    
    1.14
      - 6.47
    %2008
    
    
    3,943
    
    
    0.00
      - 3.82
    %
    
    2007
    
    
    4,528
    
    
    2.31
      - 6.47
    %2009
    
    
    769
    
    
    0.00
      - 3.38
    %
    
    2008
    
    
    738
    
    
    3.38
    %Thereafter
    
    
    903
    
    
    0.00
      - 3.38
    %
    
    Thereafter
    
    
    1,603
    
    
    3.38
    %$
    15,670
    
    
    
    
    
    
    
    $
    17,977





**12. Income
Taxes**





The
current and deferred components of income tax expense follow:


**2004**
    ****
    **2003**
    ****
    **2002**CurrentFederal
    
    $
    2,530
    
    $
    2,249
    
    $
    1,974State
    
    
    80
    
    
    72
    
    
    622,610
    
    
    2,321
    
    
    2,036DeferredFederal
    
    
    (129
    )
    
    (125
    )
    
    (113
    )$
    2,481
    
    $
    2,196
    
    $
    1,923
 The
following table reconciles the expected federal income tax expense (computed by
applying the federal statutory tax rate to income before taxes) to recorded
income tax expense:


**2004**
    ****
    **2003**
    ****
    **2002**Computed
      federal tax expense
    
    $
    2,512
    
    $
    2,210
    
    $
    1,961State
      franchise tax, net of federal benefits
    
    
    53
    
    
    48
    
    
    41Benefit
      of tax-exempt income
    
    
    (36
    )
    
    (47
    )
    
    (52
    )Increase
      in cash surrender value of life insurance
    
    
    (43
    )
    
    (40
    )
    
    (53
    )Other,
      net
    
    
    (5
    )
    
    25
    
    
    26Recorded
      income tax expense
    
    $
    2,481
    
    $
    2,196
    
    $
    1,923
 The tax
effects of temporary differences that give rise to deferred income tax assets
and liabilities follow:


**2004**
    ****
    **2003**Deferred
      income tax assetsAllowance
      for loan losses
    
    $
    1,107
    
    $
    1,003Accrued
      post-retirement benefits
    
    
    382
    
    
    302Other
    
    
    146
    
    
    150Total
      gross deferred income tax assets
    
    
    1,635
    
    
    1,455
 
 Deferred
      income tax liabilitiesMortgage
      servicing rights
    
    
    319
    
    
    269Depreciation
      and amortization
    
    
    133
    
    
    139Unrealized
      gain on securities available for sale
    
    
    104
    
    
    188Total
      gross deferred income tax liabilities
    
    
    556
    
    
    596Net
      deferred income tax asset
    
    $
    1,079
    
    $
    859


44





**MERRILL
MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES**
 **Notes
to Consolidated Financial Statements – (Continued)**


Management
expects the Company will realize all deferred income tax benefits to offset the
income tax liabilities arising from the reversal of taxable temporary
differences and taxable income generated in future years. Accordingly, the
Company has not established a valuation allowance for deferred income tax
benefits.





**13. Financial
Instruments With Off-Balance-Sheet Risk**





The Bank
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 which involve,
to varying degrees, elements of credit risk in excess of the amount recognized
in the consolidated statements of financial condition. The Bank’s exposure to
credit loss in the event of nonperformance by the other party to the financial
instrument for commitments to extend credit is represented by the contractual
notional amount of those instruments.





The Bank
follows the same credit policies in making commitments and conditional
obligations as it does for on-balance-sheet instruments, including requiring
collateral or other security to support financial instruments with credit risk.
Since many of the commitments are expected to expire without being drawn upon,
the total amount does not necessarily represent future cash requirements. The
Company has not incurred any losses on its commitments in 2004, 2003 or
2002.





A summary
of financial instruments with off-balance sheet risk at December 31, 2004 and
2003 follow:


**2004**
    ****
    **2003**Commitments
      to extend credit
    
    $
    12,676
    
    $
    14,299Letters
      of credit
    
    
    1,417
    
    
    1,496Unadvanced
      commitmentsSecured
      by real estate
    
    
    23,983
    
    
    22,134Commercial
      lines of credit
    
    
    23,759
    
    
    26,114Consumer
      lines of credit
    
    
    5,069
    
    
    4,619Interest
      rate swaps (notional)
    
    
    10,000
    
    
    -


**14. Shareholders’
Equity**





The
Company distributed a 3% stock dividend in April of 2004, 2003 and 2002.
Earnings per share for 2004, 2003 and 2002 have been restated to reflect these
stock dividends.





In June
2004, the Board of Directors approved a fourth stock repurchase program
authorizing the Company to repurchase up to 169,995, or 5%, of its outstanding
shares of common stock. During 2004, the Company repurchased 89,592 shares at a
total cost of $2,156. A total of 153,358 shares remain under this authorization
at December 31, 2004.





A
revision to the Maine Business Corporation Act requires that stock reacquired by
a corporation be classified as "authorized but unissued,” effectively
eliminating a company’s ability to hold stock in treasury. In order to recognize
the effect of the revision, the Company effectively retired its treasury stock
and reclassified the June 30, 2004 shareholders' equity balances to reflect the
changes as follows:




Decreased
      common stock
    
    $
    80Decreased
      capital surplus
    
    
    1,839Eliminated
      treasury stock
    
    $
    1,919


In 2002,
the preferred stock was converted into 229,433 shares of common stock and the
mandatory convertible debentures were converted into 76,474 shares of common
stock, increasing shareholders’ equity by $300.


45
 **MERRILL
MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES**
 **Notes
to Consolidated Financial Statements - (Continued)**


****


**15. Earnings Per
Share**





The
following table sets forth the computation of basic and diluted earnings per
share (in thousands, except for number of shares and per share
data):


**2004**
    ****
    **2003**
    ****
    **2002****Basic
      earnings per share**Net
      income, as reported
    
    $
    4,907
    
    $
    4,302
    
    $
    3,845Preferred
      stock dividends declared
    
    
    -
    
    
    -
    
    
    (32
    )Income
      available to common shareholders
    
    $
    4,907
    
    $
    4,302
    
    $
    3,813Weighted-average
      shares outstanding
    
    
    3,371,147
    
    
    3,404,872
    
    
    3,079,525Basic
      earnings per share
    
    $
    1.46
    
    $
    1.26
    
    $
    1.24**Diluted
      earnings per share**Net
      income, as reported
    
    $
    4,907
    
    $
    4,302
    
    $
    3,845Interest
      on mandatory convertible debentures, net of tax
    
    
    -
    
    
    -
    
    
    9Income
      available to common shareholders
    
    $
    4,907
    
    $
    4,302
    
    $
    3,854Weighted-average
      shares outstanding
    
    
    3,371,147
    
    
    3,404,872
    
    
    3,079,525Effect
      of stock options, net of assumed stock purchases
    
    
    28,559
    
    
    21,025
    
    
    149,590Effect
      of convertible preferred stock
    
    
    -
    
    
    -
    
    
    182,185Effect
      of mandatory convertible debentures
    
    
    -
    
    
    -
    
    
    65,175Adjusted
      weighted-average shares outstanding
    
    
    3,399,706
    
    
    3,425,897
    
    
    3,476,475Diluted
      earnings per share
    
    $
    1.44
    
    $
    1.26
    
    $
    1.11


Options
to purchase 44,663 shares of common stock at $14.89 were outstanding at December
31, 2002 but were not included in the computation of diluted earnings per share
because the options’ exercise price was greater than the average market price of
the common stock.





**16. Other
Expense**





The
following table presents other non-interest expense during the periods
indicated.




**2004**
    ****
    **2003**
    ****
    **2002**Advertising
      and promotion
    
    $
    578
    
    $
    607
    
    $
    346Professional
      fees
    
    
    375
    
    
    397
    
    
    459Printing,
      postage, stationery and supplies
    
    
    328
    
    
    290
    
    
    266Loan
      expense
    
    
    112
    
    
    266
    
    
    104ATM
      expense
    
    
    218
    
    
    202
    
    
    159Telephone
    
    
    153
    
    
    150
    
    
    182Travel,
      meetings, seminars and employee education
    
    
    137
    
    
    145
    
    
    131Trust
      expense
    
    
    138
    
    
    136
    
    
    137Merchant
      processing expense (credit)
    
    
    (7
    )
    
    41
    
    
    388Other
    
    
    550
    
    
    523
    
    
    482Total
    
    $
    2,582
    
    $
    2,757
    
    $
    2,654


46
 **MERRILL
MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES**
 **Notes
to Consolidated Financial Statements - (Continued)**


**17. Regulatory
Matters**





The
Company and Bank are subject to various regulatory capital requirements
administered by the 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 the Company and Bank’s consolidated financial statements.
Under capital adequacy guidelines and the regulatory framework for prompt
corrective action, the Company and Bank must meet specific capital guidelines
that involve quantitative measures of the Company’s and Bank’s assets,
liabilities and certain off-balance-sheet items as calculated under regulatory
accounting practices. The Company’s and Bank’s 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 the
Company and Bank to maintain minimum amounts and ratios (set forth in the table
on the next page) of total and Tier I capital (as defined in the regulations) to
risk-weighted assets (as defined), and of Tier I capital (as defined) to average
assets (as defined). Management believes as of December 31, 2004 that the
Company and Bank meet all capital adequacy requirements to which they are
subject.





As of
December 31, 2004, the most recent notification from the Federal Reserve
Bank categorized the Bank as well capitalized under the regulatory framework for
prompt corrective action. To be categorized “well capitalized,” the Bank must
maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios
as set forth in the table. There are no conditions or events since that
notification that management believes have changed this category.





The
following table summarizes the Company’s and Bank’s actual and minimum capital
amounts and ratios at December 31, 2004 and 2003. No deduction was made from
capital for interest-rate risk in 2004 and 2003.





****
    ****
    ****
    
    ****
    ****
    ****
    ****
    
    **********To
      be well**
    ********
    ****
    ****
    ****
    ****
    ****
    
    **For
      capital**********
    ****
    
    **********capitalized
      under**
    ********
    ****
    ****
    ****
    ****
    ****
    
    **adequacy**********
    ****
    
    **********prompt
      corrective**
    ********
    ****
    **Actual**********
    ****
    
    **purposes**********
    ****
    
    **********action
      provisions**
    ********
    ****
    **Amount**
    ****
    **Ratio**
    ****
    
    **Amount**
    ****
    **Ratio**
    ****
    
    **Amount**
    ****
    **Ratio****As
      of December 31, 2004**Total
      capital (to risk-weighted assets)Consolidated
    
    $
    33,867
    
    
    13.09
    %
    
    $
    20,706
    
    
    8.00
    %
    
    
    N/ABank
    
    
    32,447
    
    
    12.60
    
    
    
    20,597
    
    
    8.00
    
    
    $
    25,746
    
    
    10.00
    %Tier
      1 capital (to risk-weighted assets)Consolidated
    
    
    30,624
    
    
    11.83
    
    
    
    10,353
    
    
    4.00
    
    
    
    N/ABank
    
    
    29,221
    
    
    11.35
    
    
    
    10,298
    
    
    4.00
    
    
    
    15,447
    
    
    6.00Tier
      1 capital ratio (to average assets)Consolidated
    
    
    30,624
    
    
    8.26
    
    
    
    14,824
    
    
    4.00
    
    
    
    N/ABank
    
    
    29,221
    
    
    7.91
    
    
    
    11,079
    
    
    3.00
    
    
    
    18,465
    
    
    5.00**As
      of December 31, 2003**Total
      capital (to risk-weighted assets)Consolidated
    
    $
    32,584
    
    
    14.10
    %
    
    $
    18,486
    
    
    8.00
    %
    
    
    N/ABank
    
    
    28,991
    
    
    12.65
    
    
    
    18,332
    
    
    8.00
    
    
    $
    22,915
    
    
    10.00
    %Tier
      1 capital (to risk-weighted assets)Consolidated
    
    
    29,686
    
    
    12.85
    
    
    
    9,243
    
    
    4.00
    
    
    
    N/ABank
    
    
    26,117
    
    
    11.40
    
    
    
    9,166
    
    
    4.00
    
    
    
    13,749
    
    
    6.00Tier
      1 capital ratio (to average assets)Consolidated
    
    
    29,686
    
    
    8.83
    
    
    
    13,451
    
    
    4.00
    
    
    
    N/ABank
    
    
    26,117
    
    
    7.86
    
    
    
    9,971
    
    
    3.00
    
    
    
    16,619
    
    
    5.00








47





****MERRILL
MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES**
**Notes
to Consolidated Financial Statements –
(Continued)****


****


**18. Stock
Options**





Under the
Employee and Director Stock Option Plan, the incentive stock option plan for
officers and employees and the nonstatutory stock option plan for directors
provide for the issuance of up to 763,314 shares of common stock.  The
purchase price of the stock covered by each option shall be its fair market
value, which must be equal to at least 100% of the book value of common stock,
on the date such option is granted.  Options granted through 1997 were
subject to an initial vesting period which ended on December 31, 1997,
after which options become exercisable until May 26, 2003.  Options granted
after 1997 were granted subject to an initial vesting period of one, two or
three years, after which options become exercisable until ten years from the
grant date.





The
Company accounts for these options in accordance with Accounting Principles
Board Opinion No. 25, “Accounting for Stock Issued to Employees.”  As the
exercise price of each option equals the market price of the Company’s stock on
the date of grant, no compensation cost has been recognized for the plan. 
Had compensation cost for the plan been determined based on the fair value of
the options at the grant dates consistent with the method described in SFAS No.
123, “Accounting for Stock-Based Compensation,” the Company’s 2004, 2003 and
2002 net income and earnings per share would have been reduced to the pro forma
amounts indicated below.


Year
      Ended December 31,2004
    
    2003
    
    2002Net
      income, as reported
    
    $
    4,907
    
    $
    4,302
    
    $
    3,845Deduct:
      Total stock-based employee compensation expensedetermined
      under fair value based method for all awards,net
      of deferred income taxes
    
    
    (23
    )
    
    (28
    )
    
    (16
    )Proforma
      net income
    
    $
    4,884
    
    $
    4,274
    
    $
    3,829Earnings
      per share:Basic
      - as reported
    
    $
    1.46
    
    $
    1.26
    
    $
    1.24Basic
      - proforma
    
    $
    1.45
    
    $
    1.26
    
    $
    1.24Diluted
      - as reported
    
    $
    1.44
    
    $
    1.26
    
    $
    1.11Diluted
      - proforma
    
    $
    1.44
    
    $
    1.25
    
    $
    1.10


The fair
value of each option is estimated on the date of grant using the Black-Scholes
option-pricing model with the following weighted-average assumptions used for
all grants; in 2003 dividend yield of 2.93%, expected volatility of 19%,
risk-free interest rate of 4.4%, and expected lives of three years; in 2002
dividend yield of 2.56%, expected volatility of 20%, risk-free interest rate of
4.4%, and expected lives of three years in 2002.





48
 **MERRILL
MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES**
 **Notes
to Consolidated Financial Statements - (Continued)**


A summary
of the status of the stock option plan as of December 31, 2004, 2003 and 2002,
and changes during the years then ended, is presented below.


**2004**
    ****
    **2003**
    ****
    **2002**
    ********
    ****
    ****
    ****
    **Weighted**
    ****
    
    ****
    ****Weighted****
    ****
    ****
    ****
    ****Weighted****
    ********
    ****
    **Number**
    ****
    **Average**
    ****
    **Number**
    ****
    **Average**
    ****
    **Number**
    ****
    **Average**
    ********
    ****
    **of**
    ****
    **Exercise**
    ****
    **of**
    ****
    **Exercise**
    ****
    **of**
    ****
    **Exercise**
    ********
    ****
    **Shares**
    ****
    **Price**
    ****
    **Shares**
    ****
    **Price**
    ****
    **Shares**
    ****
    **Price**Outstanding
      at beginningof year
    
    
    75,107
    
    $
    12.60
    
    
    279,333
    
    $
    7.32
    
    
    384,682
    
    $
    5.44Granted
    
    
    -
    
    
    -
    
    
    3,000
    
    
    15.50
    
    
    50,000
    
    
    15.53Exercised
    
    
    (7,277
    )
    
    9.86
    
    
    (186,142
    )
    
    5.01
    
    
    (153,424
    )
    
    4.81Forfeited
    
    
    (9,859
    )
    
    15.08
    
    
    (26,654
    )
    
    7.92
    
    
    (11,886
    )
    
    7.35Additional
      shares for whichoptions
      are exercisable due tostock
      dividends
    
    
    2,115
    
    
    -
    
    
    5,570
    
    
    -
    
    
    9,961
    
    
    -Outstanding
      at end of year
    
    
    60,086
    
    $
    12.13
    
    
    75,107
    
    $
    12.60
    
    
    279,333
    
    $
    7.32Options
      exercisable at year end
    
    
    29,441
    
    $
    9.29
    
    
    30,028
    
    $
    8.93
    
    
    222,298
    
    $
    5.40Weighted-average
      fair value ofoptions
      granted during the year
    
    
    
    
    $
    -
    
    
    
    
    $
    2.13
    
    
    
    
    $
    2.27





The
following information applies to options outstanding at December 31,
2004:


Options
      Outstanding
    
    Options
      ExercisableWtd.
      Avg.Number
    
    Remaining
    
    Wtd.
      Avg.
    
    Number
    
    Wtd.
      Avg.of
    
    Contractual
    
    Exercise
    
    of
    
    ExerciseRange
      of Exercise Prices
    
    Shares
    
    Life
    
    Price
    
    Shares
    
    Price$
      7.77 - $ 9.61
    
    
    25,093
    
    
    5.3
    
    $
    8.67
    
    
    25,093
    
    $
    8.67$12.89
      - $14.89
    
    
    34,993
    
    
    7.9
    
    
    14.62
    
    
    4,348
    
    
    12.89





**19. Fair Value of
Financial Instruments**





Fair
value estimates, methods and assumptions are set forth below for the Company’s
financial instruments.





*Cash
and Cash Equivalents.* The fair
value of cash and due from banks and interest-bearing deposits with banks
approximates their relative book values at December 31, 2004 and 2003, as these
financial instruments have short maturities.





*Investment
Securities.* The fair
values of investment securities are estimated based on bid prices published in
financial newspapers or bid quotations received from securities
dealers.





*Loans
Held for Sale.* The fair
values of loans held for sale are based on quoted market prices from the Federal
National Mortgage Association.





*Loans
Receivable.* Fair
values are estimated for portfolios of loans receivable with similar financial
characteristics. The fair values approximate carrying value for all loans with
variable interest rates.





49





**MERRILL
MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES**
**Notes
to Consolidated Financial Statements - (Continued)**
****


The fair
values of fixed rate loans are calculated by discounting scheduled cash flows
through the estimated maturity using estimated market discount rates that
reflect the risk inherent in the loan. The estimates of maturity are based on
the Bank’s historical experience with repayments for each loan classification,
modified, as required, by an estimate of the effect of current economic and
lending conditions, and the effects of estimated prepayments.





Management
has made estimates of fair value using discount rates that it believes to be
reasonable. However, because there is no market for many of these financial
instruments, management has no basis to determine whether the fair value
presented below would be indicative of the value negotiated in the actual
sale.





*Cash
Surrender Value of Life Insurance.* The fair
value is based on the actual cash surrender value of life insurance
policies.





*Accrued
Interest Receivable.* The fair
value approximates the carrying value as this financial instrument has a short
maturity. It is the Bank’s policy to stop accruing interest on loans for which
it is probable that the interest is not collectible. Therefore, the fair value
of this financial instrument has been adjusted to reflect credit
risk.





*Capitalized
Mortgage Servicing Rights.* The fair
value of mortgage servicing rights is based on the expected present value of
future mortgage servicing income, net of estimated servicing costs, considering
market consensus loan prepayment predictions.





*Deposits.* The fair
value of deposits with no stated maturity, such as noninterest-bearing demand
deposits, savings, NOW accounts and money market accounts, is equal to the
amount payable on demand. The fair value of certificates of deposit is based on
the discounted value of contractual cash flows. The discount rate is estimated
using the rates currently offered for deposits of similar remaining
maturities.





The fair
value estimates do not include the benefit that results from the low-cost
funding provided by the deposits compared to the cost of borrowing funds in the
market. If that value were considered, the fair value of the Bank’s net assets
could increase.





*Borrowed
Funds.* The fair
value of borrowed funds is based on the discounted value of contractual cash
flows. The discount rate is estimated using the rates currently available for
borrowings of similar remaining maturities.





*Accrued
Interest Payable.* The fair
value approximates the book value as this financial instrument has a short
maturity.





*Off-Balance
Sheet Instruments.*  The
Company’s off-balance sheet instruments consist of loan commitments and
derivative financial instruments. Fair values for loan commitments have not been
presented as the future revenue derived from such financial instruments is not
significant. The fair values of interest rate swap contracts are based on quoted
market prices.





*Limitations.* Fair
value estimates are made at a specific point in time, based on relevant market
information and information about the financial instrument. These values do not
reflect any premium or discount that could result from offering for sale at one
time the Company’s entire holdings of a particular financial instrument. Because
no market exists for a significant portion of the Company’s 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 factors. These estimates are subjective
in nature and involve uncertainties and matters of significant judgment and
therefore cannot be determined with precision. Changes in assumptions could
significantly affect the estimates.





50





**MERRILL
MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES**
**Notes
to Consolidated Financial Statements - (Continued)**
****


Fair
value estimates are based on existing on and off-balance sheet financial
instruments without attempting to estimate the value of anticipated future
business and the value of assets and liabilities that are not considered
financial instruments. Other significant assets and liabilities that are not
considered financial instruments include property and equipment and other real
estate owned. In addition, the tax ramifications related to the realization of
the unrealized gains and losses can have a significant effect on fair value
estimates and have not been considered in any of the estimates.





A summary
of the estimated fair values for the Company’s significant financial instruments
at December 31, 2004 and 2003 follows:


**2004**********
    ****
    **2003**********
    ********
    ****
    
    ****
    ****Estimate****
    ****
    ****
    ****
    ****Estimate****
    ********
    ****
    **Carrying**
    ****
    **of
      Fair**
    ****
    **Carrying**
    ****
    **of
      Fair**
    ********
    ****
    **Value**
    ****
    **Value**
    ****
    **Value**
    ****
    **Value**Financial
      AssetsCash
      and cash equivalents
    
    $
    10,220
    
    $
    10,220
    
    $
    10,746
    
    $
    10,746Investment
      securities
    
    
    66,099
    
    
    66,099
    
    
    76,140
    
    
    76,140Loans
      held for sale
    
    
    617
    
    
    619
    
    
    789
    
    
    809Loans
      receivable, net
    
    
    279,122
    
    
    279,002
    
    
    242,860
    
    
    243,444Cash
      surrender value of life insurance
    
    
    3,854
    
    
    3,854
    
    
    3,729
    
    
    3,729Accrued
      interest receivable
    
    
    1,239
    
    
    1,239
    
    
    1,172
    
    
    1,172Capitalized
      mortgage servicing rights
    
    
    938
    
    
    1,190
    
    
    792
    
    
    994Financial
      LiabilitiesDeposits
      (with no stated maturity)
    
    
    194,559
    
    
    194,559
    
    
    165,831
    
    
    165,831Certificates
      of deposit
    
    
    105,223
    
    
    105,558
    
    
    93,017
    
    
    94,498Accrued
      interest payable
    
    
    637
    
    
    637
    
    
    421
    
    
    421Borrowed
      funds
    
    
    33,524
    
    
    33,493
    
    
    49,260
    
    
    49,819Interest
      rate swaps
    
    
    21
    
    
    21
    
    
    -
    
    
    -


**20. Parent
Company Financial Information**





Condensed
financial information for Merrill Merchants Bancshares, Inc. exclusive of its
subsidiaries follows:


**Balance
      Sheet****December
      31,**
    ********
    ****
    **2004**
    ****
    **2003**AssetsCash
    
    $
    12
    
    $
    8Investment
      securities at fair value
    
    
    2,420
    
    
    4,227Investment
      in subsidiaries
    
    
    29,524
    
    
    26,593Other
      assets
    
    
    1
    
    
    232Total
      assets
    
    $
    31,957
    
    $
    31,060Liabilities
      and shareholders’ equityDividend
      payable and accrued expenses
    
    $
    545
    
    $
    468Other
      liabilities
    
    
    83
    
    
    39Shareholders’
      equity
    
    
    31,329
    
    
    30,553Total
      liabilities and shareholders’ equity
    
    $
    31,957
    
    $
    31,060


51
 **MERRILL
MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES**
 **Notes
to Consolidated Financial Statements - (Continued)**


**Statements
of Income**
 **Years
      Ended December 31,**
    ********
    ****
    **2004**
    ****
    **2003**
    ****
    **2002**Operating
      income:Dividends
      from bank subsidiary
    
    $
    1,755
    
    $
    -
    
    $
    900Interest
      income on loan from subsidiary
    
    
    -
    
    
    -
    
    
    64Interest
      and dividend income on investments
    
    
    28
    
    
    90
    
    
    164Net
      gains (losses) on sales of securities
    
    
    155
    
    
    (51
    )
    
    (30
    )Total
      income
    
    
    1,938
    
    
    39
    
    
    1,098Operating
      expenses:Interest
      on borrowed funds
    
    
    1
    
    
    -
    
    
    14Operating
      expenses
    
    
    132
    
    
    97
    
    
    114Total
      operating expenses
    
    
    133
    
    
    97
    
    
    128Income
      (loss) before income tax expense (benefit) and equity inundistributed
      net income of subsidiaries
    
    
    1,805
    
    
    (58
    )
    
    970Income
      tax expense (benefit)
    
    
    17
    
    
    (29
    )
    
    30Income
      (loss) before equity in undistributed net income ofsubsidiaries
    
    
    1,788
    
    
    (29
    )
    
    940Equity
      in undistributed net income of subsidiaries
    
    
    3,119
    
    
    4,331
    
    
    2,905Net
      income
    
    $
    4,907
    
    $
    4,302
    
    $
    3,845
 
 **Statements
of Cash Flows**
 **Years
      Ended December 31,**
    ********
    ****
    **2004**
    ****
    **2003**
    ****
    **2002**Cash
      flows from operating activities:Net
      income
    
    $
    4,907
    
    $
    4,302
    
    $
    3,845Adjustments
      to reconcile net income to net cash provided byoperating
      activities:Undistributed
      net income from subsidiaries
    
    
    (3,119
    )
    
    (4,331
    )
    
    (2,905
    )Net
      gain (loss) on sale of investment securities
    
    
    (155
    )
    
    51
    
    
    30(Increase)
      decrease in other assets
    
    
    231
    
    
    (12
    )
    
    (64
    )Increase
      (decrease) in other liabilities
    
    
    69
    
    
    91
    
    
    17Net
      cash provided by operating activities
    
    
    1,933
    
    
    101
    
    
    923Cash
      flows from investing activities:Proceeds
      from sales and maturities of investment securities
    
    
    3,802
    
    
    6,248
    
    
    8,953Purchase
      of investment securities
    
    
    (1,825
    )
    
    (4,370
    )
    
    (13,654
    )Net
      repayment from subsidiaries
    
    
    -
    
    
    -
    
    
    5,569Net
      cash provided by investing activities
    
    
    1,977
    
    
    1,878
    
    
    868Cash
      flows from financing activities:Proceeds
      from issuance of common stock
    
    
    66
    
    
    754
    
    
    690Dividends
      paid
    
    
    (1,816
    )
    
    (1,511
    )
    
    (1,123
    )Repurchase
      of common stock
    
    
    (2,156
    )
    
    (1,218
    )
    
    (1,409
    )Net
      cash used by financing activities
    
    
    (3,906
    )
    
    (1,975
    )
    
    (1,842
    )Net
      increase (decrease) in cash
    
    
    4
    
    
    4
    
    
    (51
    )Cash,
      beginning of year
    
    
    8
    
    
    4
    
    
    55Cash,
      end of year
    
    $
    12
    
    $
    8
    
    $
    4


52
 **MERRILL
MERCHANTS BANCSHARES, INC. AND SUBSIDIARIES**
 **Notes
to Consolidated Financial Statements - (Continued)**


**21. Selected
Quarterly Data (unaudited)**


**2004**
    ****
    **2003**
    ********
    ****
    **Fourth**
    ****
    **Third**
    ****
    **Second**
    ****
    **First**
    ****
    **Fourth**
    ****
    **Third**
    ****
    **Second**
    ****
    **First**
    ********
    ****
    **Quarter**
    ****
    **Quarter**
    ****
    **Quarter**
    ****
    **Quarter**
    ****
    **Quarter**
    ****
    **Quarter**
    ****
    **Quarter**
    ****
    **Quarter**Interest
      and dividend income
    
    $
    4,957
    
    $
    4,782
    
    $
    4,563
    
    $
    4,406
    
    $
    4,400
    
    $
    4,181
    
    $
    4,261
    
    $
    4,371Interest
      expense
    
    
    1,341
    
    
    1,261
    
    
    1,176
    
    
    1,157
    
    
    1,136
    
    
    1,156
    
    
    1,201
    
    
    1,241Net
      interest income
    
    
    3,616
    
    
    3,521
    
    
    3,387
    
    
    3,249
    
    
    3,264
    
    
    3,025
    
    
    3,060
    
    
    3,130Provision
      for loan losses
    
    
    92
    
    
    88
    
    
    84
    
    
    84
    
    
    111
    
    
    111
    
    
    111
    
    
    111Net
      interest income afterprovision
      for loan losses
    
    
    3,524
    
    
    3,433
    
    
    3,303
    
    
    3,165
    
    
    3,153
    
    
    2,914
    
    
    2,949
    
    
    3,019Non-interest
      income
    
    
    1,224
    
    
    1,168
    
    
    1,304
    
    
    1,154
    
    
    1,323
    
    
    1,371
    
    
    1,335
    
    
    1,203Net
      gain (loss) on securities
    
    
    90
    
    
    -
    
    
    -
    
    
    65
    
    
    -
    
    
    -
    
    
    (41
    )
    
    (10
    )Non-interest
      expense
    
    
    2,833
    
    
    2,719
    
    
    2,815
    
    
    2,675
    
    
    2,727
    
    
    2,654
    
    
    2,671
    
    
    2,666Income
      before income taxes
    
    
    2,005
    
    
    1,882
    
    
    1,792
    
    
    1,709
    
    
    1,749
    
    
    1,631
    
    
    1,572
    
    
    1,546Income
      tax expense
    
    
    649
    
    
    648
    
    
    598
    
    
    586
    
    
    606
    
    
    529
    
    
    534
    
    
    527Net
      income
    
    $
    1,356
    
    $
    1,234
    
    $
    1,194
    
    $
    1,123
    
    $
    1,143
    
    $
    1,102
    
    $
    1,038
    
    $
    1,019Basic
      earnings per share
    
    $
    0.41
    
    $
    0.37
    
    $
    0.35
    
    $
    0.33
    
    $
    0.33
    
    $
    0.32
    
    $
    0.30
    
    $
    0.30Diluted
      earnings per share
    
    $
    0.40
    
    $
    0.37
    
    $
    0.35
    
    $
    0.33
    
    $
    0.33
    
    $
    0.32
    
    $
    0.30
    
    $
    0.30


**22. Subsequent
Event**





The Bank
sold its credit card portfolio on February 25, 2005. The outstanding balance
totaled $757 and a gain of approximately $106 will be reflected in the first
quarter 2005 financial statements.











53





**REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**








To the
Board of Directors and Shareholders


Merrill
Merchants Bancshares, Inc.





We have
audited the accompanying consolidated statements of financial condition of
Merrill Merchants Bancshares, Inc. and Subsidiaries as of December 31, 2004 and
2003, and the related consolidated statements of income, changes in
shareholders’ equity and cash flows for each of the three years in the period
ended December 31, 2004. 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
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 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 consolidated
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 audits provide a
reasonable basis for our opinion.





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Merrill
Merchants Bancshares, Inc. and Subsidiaries as of December 31, 2004 and
2003, and the consolidated results of their operations and their consolidated
cash flows for each of the three years in the period ended December 31, 2004, in
conformity with U.S. generally accepted accounting principles.











/s/Berry,
Dunn, McNeil & Parker


BERRY
DUNN MCNEIL & PARKER


Bangor,
Maine


February
22, 2005





54


**ITEM
9.** **CHANGES
IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE**





None.





**ITEM
9A.** **CONTROLS
AND PROCEDURES**





Management,
including the Company’s Chairman, Chief Executive Officer and Principal
Executive Officer and Executive Vice President, Treasurer and Principal
Financial Officer, has evaluated the effectiveness of the Company’s disclosure
controls and procedures (as defined in Exchange Act Rules 13a-15(f) and
15d-15(e)) as of the end of the period covered by this report. Based upon that
evaluation, the Chairman and Chief Executive Officer and Executive Vice
President and Treasurer concluded that the disclosure controls and procedures
were effective, in all material respects, to ensure that information required to
be disclosed in the reports the Company files and submits under the Exchange Act
is recorded, processed, summarized and reported as and when
required.




There
have been no changes in the Company’s internal control over financial reporting
identified in connection with the evaluation that occurred during the Company’s
last fiscal quarter that have materially affected, or that are reasonably likely
to materially affect, the Company’s internal control over financial
reporting.




**ITEM
9B.** **OTHER
INFORMATION**





None.





**PART
III**





**ITEM
10.** **DIRECTORS
AND EXECUTIVE OFFICERS OF THE COMPANY**





The
information included in the Proxy Statement under the captions “Voting
Securities,” “Section 16(a) Beneficial Ownership Reporting Compliance,”
“Election of Directors of Merrill Merchants Bancshares, Inc.,” “Board of
Directors and Its Committees - Audit Committee,” and “Remuneration of Directors
and Officers - Executive Officers” is incorporated herein by
reference.





The
Company has adopted a Code of Ethics that applies to all employees, officers and
directors of the Company, including the Company’s principal executive officer,
principal financial officer, principal accounting officer or controller or
person performing similar functions for the Company. The Code of Conduct and
Ethics meets the requirements of a “code of ethics” as defined by Item 406 of
Regulation S-K. The Company filed the Code of Ethics with the SEC as an exhibit
to the Annual Report on Form 10-K for the year ended December 31,
2003.





Copies of
the Code of Ethics are available free of charge upon written request to Deborah
A. Jordan, Secretary, Merrill Merchants Bancshares, Inc., 201 Main Street,
Bangor, ME 04402-0925.





**ITEM
11.** **EXECUTIVE
COMPENSATION**





The
information included in the Proxy Statement under the captions “Remuneration of
Directors and Officers,” “Compensation of Executive Officers and Transactions
with Management,” and “Performance Graph” is incorporated herein by
reference.


55





**ITEM
12.** **SECURITY
OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND** **MANAGEMENT
AND RELATED SHAREHOLDER MATTERS**





*Security
Ownership of Certain Beneficial Owners and Management* .
Information included in the Proxy Statement under the caption “Beneficial
Ownership of Common Stock by Certain Beneficial Owners and Management” is
incorporated herein by reference.





*Equity
Compensation Plan Information* . The
following table sets forth the aggregate information for the Company’s equity
compensation plans in effect at December 31, 2004.





**Equity
      Compensation Plan Information**
  Plan
      category
    
    Number of securities to
      be issued upon exercise
      of
      outstanding options, warrants and rights
    
    Weighted-average
      exercise price of outstanding options, warrants and
      rights
    
    Number of securities remaining
      available for future issuance
      under equity compensation plan (excluding
      securities referenced
      in
      column (a))(a)
    
    (b)
    
    (c)Equity
      compensation plans approved by security holders (1)
    
    
    60,086
    
    $
    12.13
    
    
    0Equity
      compensation plans not approved by security holders
    
    
    0
    
    
    N/A
    
    
    0Total
    
    
    60,086
    
    $
    12.13
    
    
    0





(1)
    
    Consists
      of options outstanding that were granted under the 1993 Plan prior to its
      expiration on April 26, 2003. The number of shares issued upon the
      exercise of outstanding options is subject to adjustment for any
      recapitalization of common stock, such as a stock dividend, stock split or
      reverse split of common stock.





**ITEM
13.** **CERTAIN
RELATIONSHIPS AND RELATED TRANSACTIONS**





The
information included in the Proxy Statement under the caption “Compensation of
Executive Officers and Transactions with Management - Interests in Certain
Transactions” is incorporated herein by reference.





**ITEM
14.** **PRINCIPAL
ACCOUNTING FEES AND SERVICES**





Information
included in the Proxy Statement under the caption “Ratification of Appointment
of Independent Public Accountants” is incorporated herein by
reference.





**PART
IV**





**ITEM
15.** **EXHIBITS,
FINANCIAL STATEMENT SCHEDULES**





(a)
    The
      following financial statements are incorporated by reference from Item 8
      hereof:





Consolidated
Statements of Financial Condition-December 31, 2004 and 2003;


Consolidated
Statements of Income-Years Ended December 31, 2004, 2003 and 2002;


Consolidated
Statements of Changes in Shareholders’ Equity-Years Ended December 31, 2004,
2003 and 2002;


Consolidated
Statements of Cash Flows-Years Ended December 31, 2004, 2003 and 2002;
and


Notes to
Consolidated Financial Statements





56


(b)
    Exhibits.The
      following exhibits are either filed as part of this report or are
      incorporated herein by reference:


3.1
    Articles
      of Incorporation of Merrill Merchants Bancshares, Inc.*3.2
    By-laws
      of Merrill Merchants Bancshares, Inc.*4
    Specimen
      Stock Certificate of Merrill Merchants Bancshares,
Inc.*10.1
    Operating
      Agreement between the Company and M&M Consulting Limited Liability
      Company.*10.2
    Services
      Agreements between the Company and M&M Consulting Limited Liability
      Company.*10.3
    Employment
      Agreement with William C. Bullock, Jr. **10.4
    Financial
      Services Agreement with Financial Institutions Service
      Corporation.*10.5
    Form
      of Life Insurance Endorsement Method Split Dollar Plan
      Agreement.*10.7
    Form
      of Executive Supplemental Retirement Plan.*10.8
    Form
      of Mandatory Convertible Debentures.*10.9
    Correspondent
      Trust Services Agreement with Northern Trust Company.*10.10
    Stock
      Option Plan, as amended.*10.11
    Form
      of Stock Option Agreement.*10.12
    1998
      Directors’ Deferred Compensation Plan.*10.13
    Employment
      Agreement between the Company and Edwin N. Clift.***10.14
    Employment
      Agreement between the Company and William P. Lucy.***10.15
    Employment
      Agreement between the Company and Deborah A. Jordan.***13
    Annual
      Report to Shareholders for the Year Ended December 31,
    2004.14
    Code
      of Ethics.***21
    Subsidiaries
      of the Registrant.23
    Consent
      of Berry, Dunn, McNeil & Parker.31.1
    Rule
      13a-14(a) / 15d-14(a) Certifications.32.1
    Section
      1350 Certifications.


___________


*
    Incorporated
      by reference to the Company’s Registration Statement on Form SB-2 (File
      No. 333-56197), and any amendments thereto filed with the Securities and
      Exchange Commission.


**
    Incorporated
      by reference to the Company’s Form 10-KSB for the year ended December 31,
      2001.


***
    Incorporated
      by reference to the Company’s Form 10-KSB for the year ended December 31,
      2003.


57


**SIGNATURES**





Pursuant
to the requirements of Section 13 or 15(d) of the Exchange Act, the registrant
has duly caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.





**MERRILL MERCHANTS
      BANCSHARES, INC.**By:
    /s/ Edwin N. Clift
    
    March
      10, 2005*Chairman and Chief Executive
      Officer*





In
accordance with the Exchange Act, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the
dates indicated.





Name
    
    Title
    
    Date/s/
      Edwin N. Clift
    
    Director,
      Chairman and Chief Executive
    
    March
      10, 2005Edwin
      N. Clift
    
    Officer (Principal executive officer)/s/
      Deborah A. Jordan
    
    Treasurer (Principal financial officer)
    
    March 10, 2005Deborah
      A. Jordan/s/
      William C. Bullock, Jr.
    
    Director
    
    March
      10, 2005William
      C. Bullock, Jr./s/
      Joseph H. Cyr
    
    Director
    
    March
      10, 2005Joseph
      H. Cyr/s/
      Perry B. Hansen
    
    Director
    
    March
      10, 2005Perry
      B. Hansen/s/
      Robert E. Knowles
    
    Director
    
    March
      10, 2005Robert
      E. Knowles/s/
      Frederick A. Oldenburg, Jr., M.D.
    
    Director
    
    March
      10, 2005Frederick
      A. Oldenburg, Jr., M.D./s/
      Lloyd D. Robinson
    
    Director
    
    March
      10, 2005Lloyd
      D. Robinson/s/
      Dennis L. Shubert, M.D., Ph.D.
    
    Director
    
    March
      10, 2005Dennis
      L. Shubert, M.D., Ph.D./s/
      Susan B. Singer
    
    Director
    
    March
      10, 2005Susan
      B. Singer







58