**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**


**Form
      10-K**





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




**For
      the fiscal year ended December 31, 2006**




**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 each class
            Name
                of each exchange on which registeredCommon
                Stock, $1.00 par value
            The
                NASDAQ Stock Market LLC





**Securities
      registered pursuant to Section 12(g) of the Act:** None




Indicate
      by check mark whether the Registrant is a well-known seasoned issuer, as defined
      in Rule 405 of the Securities Act. Yes o No þ




Indicate
      by check mark whether the Registrant is not required to file reports pursuant
      to
      Section 13 or 15(d) of the Act. Yes o No þ




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 a large accelerated filer, an
      accelerated filer, or a non-accelerated filer, as defined in Rule 12b-2 of
      the Exchange Act.




Large
      accelerated filer o Accelerated
      filero Non-accelerated
      filerþ




Indicate
      by check mark whether the Registrant is a shell company (as defined in Rule
      12b-2 of the Act). 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 $56,670,000. As of February 15, 2007, there were 3,555,844
      shares of common stock, par value $1.00 per share, of the registrant
      outstanding.







**TABLE
      OF CONTENTS**


**Page****PART
                  I**ITEM1.
              BUSINESS
              
              1ITEM1A.
              RISK
                  FACTORS
              
              14ITEM1B.
              UNRESOLVED
                  STAFF COMMENTS
              
              16ITEM2.
              PROPERTIES
              
              17ITEM3.
              LEGAL
                  PROCEEDINGS
              
              17ITEM4.
              SUBMISSION
                  OF MATTERS TO A VOTE OF SECURITY HOLDERS
              
              17**PART
                  II**ITEM5.
              MARKET
                  FOR THE REGISTRANT’S COMMON STOCK, RELATEDSTOCKHOLDERMATTERS
                  AND ISSUER PURCHASES OF EQUITY SECURITIES
              
              18ITEM6.
              SELECTED
                  FINANCIAL DATA
              
              19ITEM7.
              MANAGEMENT'S
                  DISCUSSION AND ANALYSIS OF FINANCIALCONDITION
                  AND RESULTS OF OPERATIONS
              
              20ITEM7A.
              QUANTITATIVE
                  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
              
              36ITEM8.
              FINANCIAL
                  STATEMENTS AND SUPPLEMENTARY DATA
              
              36ITEM9.
              CHANGES
                  IN AND DISAGREEMENTS WITH ACCOUNTANTS ONACCOUNTING
                  AND FINANCIAL DISCLOSURE
              
              36ITEM9A.
              CONTROLS
                  AND PROCEDURES
              
              36ITEM9B.
              OTHER
                  INFORMATION
              
              37**PART
                  III**ITEM10.
              DIRECTORS,
                  EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
              
              37ITEM11.
              EXECUTIVE
                  COMPENSATION
              
              40ITEM12.
              SECURITY
                  OWNERSHIP OF CERTAIN BENEFICIAL OWNERS ANDMANAGEMENT
                  AND RELATED STOCKHOLDER MATTERS
              
              46ITEM13.
              CERTAIN
                  RELATIONSHIPS AND RELATED TRANSACTIONS, ANDDIRECTOR
                  INDEPENDENCE
              
              47ITEM14.
              PRINCIPAL
                  ACCOUNTING FEES AND SERVICES
              
              47**PART
                  IV**ITEM15.
              EXHIBITS,
                  FINANCIAL STATEMENT SCHEDULES
              
              48SIGNATURES
              
              50





**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.


i


**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 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 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 fourteen 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, 2006,
      the
      Company had total assets of $449.1 million, loans of $338.9 million, deposits
      of
      $359.9 million and shareholders’ equity of $38.6 million. The Bank also
      established a Trust and Investment Services Department, which has grown since
      inception in April 1994 to $389.0 million in assets under management as of
      December 31, 2006.





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
      know the Bank’s customers and are able to provide personalized service for these
      customers. The Bank has focused on fostering banking relationships with
      customers that include multiple financial services ranging from 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 branches. This same strategy has been implemented
      by the Trust and Investment Services Department which also serves 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 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 branches and thus
      are
      generally familiar with the 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.





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.


2


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 employs approximately 144 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 $500,000.  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, 2006, commercial and commercial
      real estate loans represented the largest class of loans at $185.4 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 the leading community bank lender in
      the State of Maine for the Small Business Administration.




The
      Bank’s commercial real estate loans are made at variable and fixed rates of
      interest, and amortize up to fifteen years. Loans originated at fixed interest
      rates typically reprice within a three to five year period.  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.




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.  As additional security for commercial loans, the Bank normally
      requires the personal guarantee of the principals and may require financial
      performance covenants.


3


*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.  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, 2006, residential loans accounted for a total of $63.7
      million, representing 19% of total loans.  The Bank’s secondary market
      servicing portfolio totaled $154.8 million at December 31, 2006.





*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, 2006, construction loans totaled
      $15.8 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, 2006, fixed-rate loans totaled $26.8 million
      and variable-rate loans amounted to $20.6 million, representing 14% of total
      loans.  These home equity loans are generally secured by a second mortgage
      on the principal residential property.




*Consumer
      Lending*





Consumer
      loans made by the Bank include personal unsecured, boat and recreational vehicle
      loans, mobile home, home improvement, overdraft protection accounts and indirect
      automobile and recreational vehicle loans.  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.
      Consumer loans are generally collateralized by liens on various personal assets
      of the borrower however consumer loans may be made uncollateralized. 
Consumer loans are made at fixed and variable interest rates. Consumer loans
      totaled $26.7 million and represented 8% of the Company’s loan portfolio at
      December 31, 2006.


4


**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 provides the Bank, Machias Savings Bank and over seventy 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.** Merrill
      Merchants Bank is
      a
      Maine-chartered commercial bank, the deposit accounts of which are insured
      up to
      applicable limits by the Federal Deposit Insurance Corporation. Merrill
      Merchants Bank is
      also a
      member of the Federal Reserve System. Merrill Merchants Bank is subject to
      extensive regulation, examination and supervision by the Maine Bureau of
      Financial Institutions as its chartering regulator, by the Federal Deposit
      Insurance Corporation as its deposit insurer and by the Board of Governors
      of
      the Federal Reserve System (the “FRB”) as its primary federal regulator.
      Merrill, as a financial holding company under the Bank Holding Company Act
      of
      1956, as amended (the “BHCA”), is subject to the rules and regulations of the
      FRB. In addition, Merrill is subject to the rules and regulations of the
      Securities and Exchange Commission and the National Association of Security
      Dealers. Both Merrill and Merrill Merchants Bank are subject to the provisions
      of the Maine Revised Statues applicable to financial institutions, and the
      rules
      and regulations of the Maine Bureau of Financial Institutions.




The
      following references to the laws and regulations under which Merrill Merchants
      Bank and Merrill 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. Any change in such laws and regulations, whether by the Maine
      Bureau of Financial Institutions, the Federal Deposit Insurance Corporation,
      the
      FRB or the Securities and Exchange Commission or through legislation, could
      have
      a material adverse impact on Merrill and Merrill Merchants Bank and their
      operations and stockholders.




**Maine
      Banking Laws and Supervision.** Merrill
      and Merrill Merchants Bank are subject to Maine law and the rules and
      regulations of the Maine Bureau of Financial Institutions. The approval of
      the
      Maine Bureau of Financial Institutions 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
      Maine
      Bureau of Financial Institutions is subject to sanctions.




*Loans-to-One-Borrower
      Limitations* .
      With
      certain exceptions, the total obligations of a single borrower to Merrill
      Merchants Bank may not exceed 20% of Merrill Merchants Bank’s total capital.
      Total loans or other extensions of credit in excess of 10% of total capital
      must
      be approved by a majority of the governing body or the executive committee
      of
      the bank. Merrill Merchants Bank currently complies with applicable
      loans-to-one-borrower limitations.




*Dividends.* Under
      Maine law, Merrill may declare and pay a dividend on its capital stock provided
      that adequate levels of capital are maintained. The Maine Bureau of Financial
      Institutions’ minimum capital requirements are set by regulation, and must be at
      least as stringent as those set forth by federal banking regulations. See
“ *Federal
      Regulation of Merrill Merchants Bank - Capital Requirements* .”
In
      addition, federal law also may limit the amount of dividends that may be paid
      by
      Merrill Merchants Bank.




*Examination* .
      The
      Maine Bureau of Financial Institutions is required to regularly examine each
      state-chartered bank at least once every 36 months.


5


*Enforcement.* The
      Maine Bureau of Financial Institutions is authorized to issue cease and desist
      orders to any state-chartered bank that is engaging in or has engaged in: an
      unsafe or unsound practice; a violation of a law, rule or regulation relating
      to
      the supervision of the institution; a violation of any condition, imposed in
      writing, in connection with the approval of any application by the
      superintendent; a violation of any written agreement entered into with the
      superintendent; or an anticompetitive or deceptive practice, or one that is
      otherwise injurious to the public interest.




The
      Maine
      Bureau of Financial Institutions may, under certain circumstances, suspend
      or
      remove directors or officers of a bank if: (1) the directors or officers have
      violated a law, rule, regulation or cease and desist order that has become
      final; engaged in or participated in any unsafe or unsound practice; or
      committed or engaged in any act, omission, or practice that constitutes a breach
      of the fiduciary duty of the officer or director; (2) by reason of the
      violation, practice or breach the bank has suffered or will probably suffer
      financial loss or other damage; the interests of the bank's depositors or
      creditors or the public have been or could be prejudiced; or the officer or
      director has received financial gain or other benefit; and (3) the violation,
      practice or breach involves personal dishonesty or demonstrates willful or
      continuing disregard for the safety or soundness of the bank.




**Federal
      Regulation of Merrill.** As
      a
      financial holding company, Merrill is subject to the laws of the United States
      and the regulations of the FRB.




*Capital
      Requirements.* The FRB
      has adopted capital adequacy guidelines pursuant to which it assesses the
      adequacy of capital in examining and supervising a bank holding company and
      in
      analyzing applications to it under the BHCA. The FRB capital adequacy guidelines
      generally require bank holding companies to maintain total regulatory capital
      equal to 8% of total risk-adjusted assets, with at least one-half of that amount
      consisting of Tier 1, or core capital, and up to one-half of that amount
      consisting of Tier 2, or supplementary capital. Tier 1 capital for bank holding
      companies generally consists of the sum of common stockholders’ equity and
      perpetual preferred stock (subject in the case of the latter to limitations
      on
      the kind and amount of such stocks which may be included as Tier 1 capital),
      less goodwill and, with certain exceptions, intangibles. Tier 2 capital
      generally consists of hybrid capital instruments; perpetual preferred stock
      which is not eligible to be included as Tier 1 capital; term subordinated debt
      and intermediate-term preferred stock; and, subject to limitations, general
      allowances for loan losses. Assets are adjusted under the risk-based guidelines
      to take into account different risk characteristics, with the categories ranging
      from 0% (requiring no additional capital) for assets such as cash to 100% for
      the bulk of assets which are typically held by a bank holding company, including
      multi-family residential and commercial real estate loans, commercial business
      loans and consumer loans. Single-family residential first mortgage loans which
      are not past-due (90 days or more) or non-performing and which have been made
      in
      accordance with prudent underwriting standards are assigned a 50% level in
      the
      risk-weighing system, as are certain privately-issued mortgage-backed securities
      representing indirect ownership of such loans. Off-balance sheet items also
      are
      adjusted to take into account certain risk characteristics.




In
      addition to the risk-based capital requirements, the FRB requires bank holding
      companies to maintain a minimum leverage capital ratio of Tier 1 capital to
      total assets of 3.0%. Total assets for this purpose does not include goodwill
      and any other intangible assets and investments that the FRB determines should
      be deducted from Tier 1 capital. The FRB has announced that the 3.0% Tier 1
      leverage capital ratio requirement is the minimum for the top-rated bank holding
      companies without any supervisory, financial or operational weaknesses or
      deficiencies or those that are not experiencing or anticipating significant
      growth. Other bank holding companies are expected to maintain Tier 1 leverage
      capital ratios of at least 4.0% to 5.0% or more, depending on their overall
      condition.




Merrill
      is in compliance with the above-described FRB regulatory capital requirements.




*Activities.* The BHCA
      prohibits a bank holding company from acquiring direct or indirect ownership
      or
      control of more than 5% of the voting shares or substantially all of the assets
      of any bank, or merging or consolidating with another bank holding company,
      without the prior approval of the FRB.




6


The
      BHCA
      also prohibits a bank holding company, with certain exceptions, from acquiring
      more than 5% of the voting shares of any company that is not a bank and from
      engaging in any business other than banking or managing or controlling banks.
      Under the BHCA, the FRB is authorized to approve the ownership of shares by
      a
      bank holding company in any company, the activities of which the FRB has
      determined to be so closely related to banking or to managing or controlling
      banks as to be a proper incident thereto. In making such determinations, the
      FRB
      is required to weigh the expected benefit to the public, such as greater
      convenience, increased competition or gains in efficiency, against the possible
      adverse effects, such as undue concentration of resources, decreased or unfair
      competition, conflicts of interest or unsound banking practices.




In
      addition, a bank holding company which does not qualify and elect to be treated
      as a financial holding company under the Gramm-Leach-Bliley Financial Services
      Modernization Act is generally prohibited from engaging in, or acquiring, direct
      or indirect control of any company engaged in non banking activities. One of
      the
      principal exceptions to this prohibition is for activities found by the FRB
      to
      be so closely related to banking or managing or controlling banks as to be
      permissible.




Bank
      holding companies may qualify to become financial holding companies if they
      meet
      certain criteria set forth by the FRB. In 2003, Merrill elected to be treated
      as
      a financial holding company under the BHCA. As a financial holding company,
      Merrill 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 Community Reinvestment Act exam. See “ *Federal
      Regulation of Merrill Merchants Bank - Community Reinvestment* ”
      below.




*The
      Sarbanes-Oxley Act.* As a
      public company, Merrill is subject to the Sarbanes-Oxley Act of 2002, which
      implements a broad range of corporate governance and accounting measures for
      public companies designed to promote honesty and transparency in corporate
      America and better protect investors from corporate wrongdoing. The
      Sarbanes-Oxley Act’s principal legislation and the derivative regulation and
      rule making promulgated by the Securities and Exchange Commission
      includes:




§
            the
                creation of an independent accounting oversight
                board;




§
            auditor
                independence provisions which restrict non-audit services that accountants
                may provide to their audit clients;




§
            additional
                corporate governance and responsibility measures, including the
                requirement that the chief executive officer and chief financial
                officer
                certify financial statements;




§
            a
                requirement that companies establish and maintain a system of internal
                control over financial reporting and that a company’s management provide
                an annual report regarding its assessment of the effectiveness of
                such
                internal control over financial reporting to the company’s independent
                accountants and that such accountants provide an attestation report
                with
                respect to management’s assessment of the effectiveness of the company’s
                internal control over financial reporting (Merrill, as a non-accelerated
                filer, is not subject to this provision until the year ending December
                31,
                2007);




7




§
            the
                forfeiture of bonuses or other incentive-based compensation and profits
                from the sale of an issuer’s securities by directors and senior officers
                in the twelve month period following initial publication of any financial
                statements that later require
                restatement;




§
            an
                increase in the oversight of, and enhancement of certain requirements
                relating to audit committees of public companies and how they interact
                with Merrill’s independent
                auditors;




§
            the
                requirement that audit committee members must be independent and
                are
                absolutely barred from accepting consulting, advisory or other
                compensatory fees from the issuer;




§
            the
                requirement that companies disclose whether at least one member of
                the
                committee is a “financial expert” (as such term is defined by the
                Securities and Exchange Commission) and if not, why
                not;




§
            expanded
                disclosure requirements for corporate insiders, including accelerated
                reporting of stock transactions by insiders and a prohibition on
                insider
                trading during pension blackout
                periods;




§
            a
                prohibition on personal loans to directors and officers, except certain
                loans made by insured financial
                institutions;




§
            disclosure
                of a code of ethics and filing a Form 8-K for a change or waiver
                of such
                code;




§
            mandatory
                disclosure by analysts of potential conflicts of interest; and




§
            a
                range of enhanced penalties for fraud and other
                violations.




Section
      402 of the Sarbanes-Oxley Act of 2002 prohibits the extension of personal loans
      to directors and executive officers of issuers. The prohibition, however, does
      not apply to mortgages advanced by an insured depository institution, such
      as
      Merrill Merchants Bank, that are subject to the insider lending restrictions
      of
      Section 22(h) of the Federal Reserve Act. See “ *Federal
      Regulation of Merrill Merchants Bank - Loans to Insiders* ”
      below.




Although
      Merrill has and will continue to incur additional expense in complying with
      the
      provisions of the Sarbanes-Oxley Act and the resulting regulations, such
      compliance will not have a material impact on its results of operations or
      financial condition.




*Federal
      Securities Law.* Merrill’s common stock is registered with the Securities and Exchange Commission
      under Section 12(g) of the Securities Exchange Act of 1934, as amended (the
      “Exchange Act”). Thus, Merrill is subject to information, proxy solicitation,
      insider trading restrictions, and other requirements under the Exchange
      Act.




**Federal
      Regulation of Merrill Merchants Bank.** The
      Bank
      is subject to federal banking laws and the regulations of the FRB.





*Capital
      Requirements.* Under
      FRB regulations, Merrill Merchants Bank is required to maintain minimum levels
      of capital. The FRB 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 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.


8


The
      FRB
      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, minus certain
      investments or holdings) 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 FRB believes
      are inherent in the type of asset or item.





The
      federal banking agencies, including the FRB, also have 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
      Merrill Merchants 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. Merrill Merchants Bank was considered “well capitalized” under FRB
      guidelines at December 31, 2006.





*Activity
      Restrictions on State-Chartered Banks* .
      Section
      24 of the Federal Deposit Insurance Act (“FDIA”), as amended, which was added by
      the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”),
      generally limits the activities and investments of state-chartered Federal
      Deposit Insurance Corporation-insured banks and their subsidiaries to those
      permissible for national banks and their subsidiaries, unless such activities
      and investments are specifically exempted by Section 24 or consented to by
      the
      Federal Deposit Insurance Corporation.




Before
      making a new investment or engaging in a new activity not permissible for a
      national bank or not otherwise permissible under Section 24 or the Federal
      Deposit Insurance Corporation regulations thereunder, an insured bank must
      seek
      approval from the Federal Deposit Insurance Corporation to make such investment
      or engage in such activity. The Federal Deposit Insurance Corporation will
      not
      approve the activity unless Merrill Merchants Bank meets its minimum capital
      requirements and the Federal Deposit Insurance Corporation determines that
      the
      activity does not present a significant risk to the Federal Deposit Insurance
      Corporation insurance funds.




*Enforcement.* The FRB
      has extensive enforcement authority over state-chartered member banks, including
      Merrill Merchants 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.





*Deposit
      Insurance* .
      Merrill
      Merchants Bank is a member of the Deposit Insurance Fund maintained by the
      Federal Deposit Insurance Corporation, and pays its deposit insurance
      assessments to the Deposit Insurance Fund. The Deposit Insurance Fund was formed
      on March 31, 2006 following the merger of the Bank Insurance Fund and the
      Savings Association Insurance Fund in accordance with the Federal Deposit
      Insurance Reform Act of 2005 (“DIF Act”). In addition to merging the insurance
      funds, the DIF Act established a statutory minimum and maximum designated
      reserve ratio for the Deposit Insurance Fund and granted the Federal Deposit
      Insurance Corporation greater flexibility in establishing the required reserve
      ratio. In its regulations implementing the DIF Act, the Federal Deposit
      Insurance Corporation has set the current annual designated reserve ratio for
      the Deposit Insurance Fund at 1.25%.


9


In
      order
      to maintain the Deposit Insurance Fund, member institutions are assessed an
      insurance premium. The amount of each institution’s premium is currently based
      on the balance of insured deposits and the degree of risk the institution poses
      to the Deposit Insurance Fund. Under the assessment system, the Federal Deposit
      Insurance Corporation assigns an institution to one of nine risk categories
      using a two-step process based first on capital ratios (the capital group
      assignment) and then on other relevant information (the supervisory subgroup
      assignment). Each risk category is assigned an assessment rate. Assessment
      rates
      currently range from 0% of deposits for an institution in the highest category
      (i.e., well-capitalized and financially sound, with no more than a few minor
      weaknesses) to 0.43% of deposits for an institution in the lowest category
      (i.e., undercapitalized and substantial supervisory concerns). The Federal
      Deposit Insurance Corporation is authorized to raise the assessment rates as
      necessary to maintain the Deposit Insurance Fund. Merrill Merchants Bank’s
      assessment rate at December 31, 2006 was 0%. Any increase in insurance
      assessments could have an adverse effect on the earnings of insured
      institutions, including Merrill Merchants Bank.




In
      addition, all Federal Deposit Insurance Corporation-insured institutions are
      required to pay a pro rata portion of the interest due on obligations issued
      by
      the Financing Corporation to fund the closing and disposal of failed thrift
      institutions by the Resolution Trust Corporation. At December 31, 2006, the
      Federal Deposit Insurance Corporation assessed Deposit Insurance Fund -insured
      deposits 1.24 basis points per $100 of deposits to cover those obligations.
      The
      Financing Corporation rate is adjusted quarterly to reflect changes in
      assessment bases of the Deposit Insurance Fund. This obligation will continue
      until the Financing Corporation bonds mature in 2017.




Under
      the
      Federal Deposit Insurance Act, the Federal Deposit Insurance Corporation 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 or has violated any applicable law, regulation,
      rule, order or condition imposed by the Federal Deposit Insurance Corporation.
      The management of Merrill Merchants Bank does not know of any practice,
      condition or violation that might lead to termination of deposit
      insurance.




*Transactions
      with Affiliates of Merrill Merchants Bank* .
      Merrill
      Merchants Bank’s authority to engage in transactions with its affiliates is
      limited by the FRB’s Regulation W and Sections 23A and 23B of the Federal
      Reserve Act. In general, these transactions must be on terms which are as
      favorable to Merrill Merchants Bank as comparable transactions with
      non-affiliates. In addition, certain types of these transactions referred to
      as
“covered transactions” are subject to quantitative limits based on a percentage
      of Merrill Merchants Bank’s capital, thereby restricting the total dollar amount
      of transactions Merrill Merchants Bank may engage in with each individual
      affiliate and with all affiliates in the aggregate. The term “covered
      transaction” includes the making of loans, purchase of assets, issuance of
      guarantees and other similar types of transactions. Affiliates must pledge
      qualifying collateral in amounts between 100% and 130% of the covered
      transaction in order to receive loans from Merrill Merchants Bank. In addition,
      applicable regulations prohibit Merrill Merchants Bank from lending to any
      of
      its affiliates that engage in activities that are not permissible for bank
      holding companies and from purchasing low-quality (i.e., non-performing) assets
      from an affiliate or purchasing the securities of any affiliate, other than
      a
      subsidiary.




*Loans
      to Insiders.* Merrill
      Merchants Bank’s authority to extend credit to its directors, executive officers
      and principal 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
      Federal Reserve Act and Regulation O of the FRB. Among other things, these
      provisions require that extensions of credit to insiders:




§
            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 third parties and that do not involve
                more that the normal risk of repayment or present other features
                that are
                unfavorable to Merrill Merchants Bank;
                and




10


§
            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 Merrill Merchants 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 Merrill Merchants Bank’s Board of
      Directors.




*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 FRB, 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 FRB adopted regulations
      to
      require a bank that is given notice by the FRB that it is not satisfying any
      of
      such safety and soundness standards to submit a compliance plan to the FRB.
      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
      FRB
      may issue an order directing corrective and other actions of the types to which
      a significantly undercapitalized institution would be subject under the “prompt
      corrective action” provisions of the FDICIA. If a bank fails to comply with such
      an order, the FRB 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 FRB, 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. In addition, the Bank
      is
      prohibited from paying dividends or other capital distributions or paying
      management fees to any controlling person if, following such distribution,
      Merrill Merchants Bank would be undercapitalized.




*Community
      Reinvestment* .
      Under
      the Community Reinvestment Act, all insured depository institutions, including
      Merrill Merchants Bank, have a continuing and affirmative obligation, consistent
      with its safe and sound operations, to help meet the credit needs of its entire
      community, including low and moderate-income neighborhoods. The Community
      Reinvestment Act 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 Community Reinvestment Act requires the FRB 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 Community Reinvestment Act requires the FRB to provide
      a
      written evaluation of an institution’s Community Reinvestment Act performance
      utilizing a four-tiered descriptive rating system, and the institution is
      required to publicly disclose its Community Reinvestment Act rating. The four
      descriptive ratings are “outstanding,” “satisfactory,” “needs to improve” and
“substantial noncompliance.” Merrill Merchants Bank received a “Satisfactory”
rating on its last Community Reinvestment Act exam dated January 16, 2006.




Community
      Reinvestment Act regulations rate an institution based on its actual performance
      in meeting community needs based on applicable performance criteria. As an
      “intermediate small bank” for Community Reinvestment Act purposes, Merrill
      Merchants Bank is assessed pursuant to the following tests:




11




§
            a
                lending test, to evaluate the institution’s record of making loans in its
                assessment areas;




§
            a
                community development test, to evaluate the institution’s community
                development performance in terms of number and amount of community
                development loans and qualified investments as well as in terms of
                the
                extent of the institution’s community development
                services.




*Federal
      Home Loan Bank System* .
      Merrill
      Merchants Bank is a member of the Federal Home Loan Bank system, which consists
      of 12 regional Federal Home Loan Banks. The Federal Home Loan Bank provides
      a
      central credit facility primarily for member institutions. Merrill Merchants
      Bank, as a member of the Federal Home Loan Bank of Boston, is required to
      acquire and hold shares of capital stock in the FHLB-Boston in an amount equal
      to at least 0.35% of Merrill Merchants Bank’s “Membership Stock Investment
      Base,” as defined by the FHLB-Boston, or $10,000, whichever is greater. Merrill
      Merchants Bank is also required to own activity based stock, which is based
      on
      4.5% of Merrill Merchants Bank’s outstanding advances. However, the activity
      based stock investment requirement for overnight advances is 3%. These
      percentages are subject to change by the Federal Home Loan Bank of Boston.
      Merrill Merchants Bank was in compliance with this requirement with an
      investment in Federal Home Loan Bank of Boston stock at December 31, 2006 of
      $1.7 million. Any Federal Home Loan Bank advances must be secured by specified
      types of collateral, and all long-term advances may be obtained only for the
      purpose of providing funds for residential housing finance.




The
      Federal Home Loan Banks are required to provide funds for certain purposes,
      including contributing funds for affordable housing programs. These requirements
      could reduce the amount of dividends that the Federal Home Loan Banks pay to
      their members and result in the Federal Home Loan Banks imposing a higher rate
      of interest on advances to their members. If dividends were reduced, or interest
      on future Federal Home Loan Bank advances increased, Merrill Merchants Bank’s
      net interest income would be affected.




*Federal
      Reserve System* .
      Merrill
      Merchants Bank is subject to provisions of the Federal Reserve Act and the
      FRB’s
      regulations pursuant to which depository institutions may be required to
      maintain non-interest-earning reserves against their deposit accounts and
      certain other liabilities. Currently, reserves must be maintained against
      transaction accounts (primarily NOW and regular checking accounts). The FRB
      regulations exempt $8.5 million of otherwise reservable balances from the
      reserve requirement. A 3% reserve is required for transaction account balances
      over $8.5 million and up to $45.8 million. Transaction account balances over
      $45.8 million are subject to a reserve requirement of $1,119,000 plus 10% of
      any
      amount over $45.8 million. Merrill Merchants Bank is in compliance with the
      foregoing reserve requirements. Because required reserves must be maintained
      in
      the form of either vault cash, a non-interest-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 Merrill Merchants Bank’s interest-earning
      assets. The balances maintained to meet the reserve requirements imposed by
      the
      FRB may be used to satisfy liquidity requirements imposed by the FRB. Federal
      Home Loan Bank System members also are authorized to borrow from the FRB
      discount window, but FRB regulations require such institutions to exhaust all
      Federal Home Loan Bank sources before borrowing from the FRB.




*The
      Bank Secrecy Act.* Merrill
      Merchants Bank and Merrill are subject to the Bank Secrecy Act, as amended
      by
      the USA PATRIOT Act, which gives the federal government powers to address money
      laundering and terrorist threats through enhanced domestic security measures,
      expanded surveillance powers, and mandatory transaction reporting obligations.
      By way of example, the Bank Secrecy Act imposes an affirmative obligation on
      Merrill Merchants Bank to report currency transactions that exceed certain
      thresholds and to report other transactions determined to be
      suspicious.




Title
      III
      of the USA PATRIOT Act takes measures intended to encourage information sharing
      among financial institutions, bank regulatory agencies and law enforcement
      bodies. Further, certain provisions of Title III impose affirmative obligations
      on a broad range of financial institutions, including banks, thrifts, brokers,
      dealers, credit unions, money transfer agents and parties registered under
      the
      Commodity Exchange Act. Among other requirements, the USA PATRIOT Act imposes
      the following obligations on financial institutions:




12




§
            all
                financial institutions must establish anti-money laundering programs
                that
                include, at minimum: (i) internal policies, procedures, and controls;
                (ii)
                specific designation of an anti-money laundering compliance officer;
                (iii)
                ongoing employee training programs; and (iv) an independent audit
                function
                to test the anti-money laundering
                program;




§
            all
                financial institutions must establish and meet minimum standards
                for
                customer due diligence, identification and
                verification;




§
            financial
                institutions that establish, maintain, administer, or manage private
                banking accounts or correspondent accounts in the United States for
                non-United States persons or their representatives (including foreign
                individuals visiting the United States) must establish appropriate,
                specific, and, where necessary, enhanced due diligence policies,
                procedures, and controls designed to detect and report money laundering
                through those accounts (Merrill, as a non-accelerated filer, is not
                subject to this provision until the year ending December 31,
                2007);




§
            financial
                institutions are prohibited from establishing, maintaining, administering
                or managing correspondent accounts for foreign shell banks (foreign
                banks
                that do not have a physical presence in any country), and are subject
                to
                certain recordkeeping obligations with respect to correspondent accounts
                of foreign banks; and




§
            bank
                regulators are directed to consider a bank’s or holding company’s
                effectiveness in combating money laundering when ruling on Federal
                Reserve
                Act and Bank Merger Act
                applications.




*Office
      of Foreign Asset Control.* Merrill
      Merchants Bank and Merrill, like all United States companies and individuals,
      are prohibited from transacting business with certain individuals and entities
      named on the Office of Foreign Asset Control’s list of Specially Designated
      Nationals and Blocked Persons. Failure to comply may result in fines and other
      penalties. The Office of Foreign Asset Control has issued guidance directed
      at
      financial institutions in which it asserts that it may, in its discretion,
      examine institutions determined to be high-risk or to be lacking in their
      efforts to comply with these prohibitions.




*Acquisition
      of Merrill or Merrill Merchants Bank.* Under
      the federal Change in Bank Control Act, any person (including a company), or
      group acting in concert, seeking to acquire 10% or more of the outstanding
      shares of Merrill’s common stock will be required to submit prior notice to the
      Federal Reserve, unless the Federal Reserve has found that the acquisition
      of
      such shares will not result in a change in control of Merrill. Under the Change
      in Bank Control Act, the Federal Reserve has 60 days within which to act on
      such
      notices, taking into consideration factors, including the financial and
      managerial resources of the acquiror, the convenience and needs of the
      communities served by Merrill and Merrill Merchants Bank, and the anti-trust
      effects of the acquisition. Under the BHCA, any company would be required to
      obtain prior approval from the Federal Reserve before it may obtain “control,”
within the meaning of the BHCA, of Merrill. The term “control” is defined
      generally under the BHCA to mean the ownership or power to vote 25% more of
      any
      class of voting securities of an institution or the ability to control in any
      manner the election of a majority of the institution’s directors. An existing
      bank holding company would require Federal Reserve approval prior to acquiring
      more than 5% of any class of voting stock of Merrill.




**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.


13


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
      1A.**  **RISK
      FACTORS**





***Our
      loan portfolio includes loans with a higher risk of loss.*** We
      originate commercial mortgage loans, commercial loans, consumer loans, and
      residential mortgage loans primarily within our market area. Commercial
      mortgage, commercial, and consumer loans may expose a lender to greater credit
      risk than loans secured by residential real estate because the collateral
      securing these loans may not be sold as easily as residential real estate.
      In
      addition, commercial real estate and commercial business loans may also involve
      relatively large loan balances to individual borrowers or groups of borrowers.
      These loans also have greater credit risk than residential real estate for
      the
      following reasons:




·
            *Commercial
                Mortgage Loans.*Repayment is dependent upon income being generated in amounts sufficient
                to cover operating expenses and debt
                service.




·
            *Commercial
                Loans.*****Repayment
                is generally dependent upon the successful operation of the borrower’s
                business.




·
            *Consumer
                Loans.*Consumer
                loans (such as personal lines of credit) may or may not be collateralized
                with assets that provide an adequate source of payment of the loan
                due to
                depreciation, damage, or loss.





Any
      downturn in the real estate market or local economy could adversely affect
      the
      value of the properties securing the loans or revenues from the borrower’s
      business thereby increasing the risk of non-performing loans. At this time,
      however, there is no downturn in the local economy or real estate market and
      we
      are not aware of any adverse effects in property values or business declines
      as
      a result of the local economy.




***If
      our allowance for loan losses is not sufficient to cover actual loan losses,
      our
      earnings could decrease.*** Our loan
      customers may not repay their loans according to their terms and the collateral
      securing the payment of these loans may be insufficient to pay any remaining
      loan balance. We therefore may experience significant loan losses, which could
      have a material adverse effect on our operating results.




Material
      additions to our allowance for loan losses also would materially decrease our
      net income, and the charge-off of loans may cause us to increase the allowance.
      We make various assumptions and judgments about the collectibility of our loan
      portfolio, including the creditworthiness of our borrowers and the value of
      the
      real estate and other assets serving as collateral for the repayment of many
      of
      our loans. We rely on our loan quality reviews, our experience and our
      evaluation of economic conditions, among other factors, in determining the
      amount of the allowance for loan losses. If our assumptions prove to be
      incorrect, our allowance for loan losses may not be sufficient to cover losses
      inherent in our loan portfolio, resulting in additions to our allowance.




***Changes
      in interest rates could adversely affect our results of operations and financial
      condition.*** Our
      profitability, like that of most financial institutions, depends substantially
      on our net interest income, which is the difference between the interest income
      earned on our interest-earning assets and the interest expense paid on our
      interest-bearing liabilities. Increases in interest rates may decrease loan
      demand and make it more difficult for borrowers to repay adjustable rate loans.
      In addition, as market interest rates rise, we will have competitive pressures
      to increase the rates we pay on deposits, which will result in a decrease of
      our
      net interest income.


14


We
      also
      are subject to reinvestment risk associated with changes in interest rates.
      Changes in interest rates may affect the average life of loans and
      mortgage-related securities. Decreases in interest rates can result in increased
      prepayments of loans and mortgage-related securities as borrowers refinance
      to
      reduce borrowing costs. Under these circumstances, we are subject to
      reinvestment risk to the extent that we are unable to reinvest the cash received
      from such prepayments at rates that are comparable to the rates on existing
      loans and securities.




Our
      earnings may be adversely impacted by a decrease in interest rates because
      a
      portion of our interest-earning assets are variable rate loans indexed to prime
      rate that will reprice as short-term interest rates decrease while a portion
      of
      our interest-bearing liabilities are expected to remain at fixed interest rates.
      Therefore, in a declining interest rate environment, our yield earned on our
      loan portfolio is expected to decrease more rapidly than our cost of funds.
      A
      declining rate environment is expected to cause a narrowing of our net interest
      rate spread and a decrease in our net interest income.




***Our
      local economy may affect our future growth possibilities.*** Our
      current market area is principally located in Greater Bangor, Maine. Our future
      growth opportunities depend on the growth and stability of our regional economy
      and our ability to expand our market area. A downturn in our local economy
      may
      limit funds available for deposit and may negatively affect our borrowers’
ability to repay their loans on a timely basis, both of which could have an
      impact on our profitability.




***We
      depend on our executive officers and key personnel to continue the
      implementation of our long-term business strategy and could be harmed by the
      loss of their services.*** We
      believe that our continued growth and future success will depend in large part
      upon the skills of our management team. The competition for qualified personnel
      in the financial services industry is intense, and the loss of our key personnel
      or an inability to continue to attract, retain and motivate key personnel could
      adversely affect our business. We cannot assure you that we will be able to
      retain our existing key personnel or attract additional qualified personnel.
      Although we have employment agreements with our Chairman and Chief Executive
      Officer, our President and our Executive Vice President and Treasurer that
      each
      contains a non-compete provision, the loss of the services of one or more of
      our
      executive officers and key personnel could impair our ability to continue to
      develop our business strategy.




***We
      operate in a highly regulated environment, and changes in laws and regulations
      to which we are subject may adversely affect our results of
      operations.*** We are
      subject to extensive regulation, supervision and examination by the Maine Bureau
      of Financial Institutions (the “Bureau”), as our chartering authority, and by
      the Federal Deposit Insurance Corporation (the “FDIC”) as the insurer of our
      deposits up to certain limits. In addition, the Federal Reserve Board (the
      “FRB”) regulates and oversees the Company, as the holding company of the Bank.
      We also belong to the Federal Home Loan Bank System and, as a member of such
      system, we are subject to certain limited regulations promulgated by the Federal
      Home Loan Bank of Boston. This regulation and supervision limits the activities
      in which we may engage. The purpose of regulation and supervision is primarily
      to protect our depositors and borrowers and, in the case of FDIC regulation,
      the
      FDIC’s insurance fund. Regulatory authorities have extensive discretion in the
      exercise of their supervisory and enforcement powers. They may, among other
      things, impose restrictions on the operation of a banking institution, the
      classification of assets by such institution and such institution’s allowance
      for loan losses. Regulatory and law enforcement authorities also have wide
      discretion and extensive enforcement powers under various consumer protection
      and civil rights laws, including the Truth-in-Lending Act, the Equal Credit
      Opportunity Act, the Fair Housing Act, and the Real Estate Settlement Procedures
      Act. Any change in the laws or regulations applicable to us, or in banking
      regulators’ supervisory policies or examination procedures, whether by the
      Bureau, the FDIC, the FRB, other state or federal regulators, the United States
      Congress or the Maine legislature could have a material adverse effect on our
      business, financial condition, results of operations and cash
      flows.




15


***Competition
      in our primary market area may reduce our ability to attract and retain deposits
      and originate loans.*** We
      operate in a competitive market for both attracting deposits, which is our
      primary source of funds, and originating loans. Historically, our most direct
      competition for savings deposits has come from credit unions, community banks,
      large commercial banks and thrift institutions in our primary market area.
      Particularly in times of extremely low or extremely high interest rates, we
      have
      faced additional significant competition for investors’ funds from brokerage
      firms and other firms’ short-term money market securities and corporate and
      government securities. Our competition for loans comes principally from mortgage
      brokers, commercial banks, other thrift institutions, and insurance companies.
      Such competition for the origination of loans may limit our future growth and
      earnings prospects. Competition for loan originations and deposits may limit
      our
      future growth and earnings prospects.


***If
      we fail to maintain an effective system of internal control over financial
      reporting, we may not be able to accurately report our financial results or
      prevent fraud, and, as a result, investors and depositors could lose confidence
      in our financial reporting, which could adversely affect our business, the
      trading price of our stock and our ability to attract additional
      deposits.*** Beginning with our annual report for the fiscal year ending December 31, 2007,
      we will have to include in our annual reports filed with the Securities and
      Exchange Commission (the “SEC”) a report of our management regarding internal
      control over financial reporting. As a result, we recently have begun to
      document and evaluate our internal control over financial reporting in order
      to
      satisfy the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 (the
      “Sarbanes-Oxley Act”) and SEC rules and regulations, which require an annual
      management report on our internal control over financial reporting, including,
      among other matters, management’s assessment of the effectiveness of internal
      control over financial reporting and an attestation report by our independent
      auditors addressing these assessments. Accordingly, management has allocated
      resources necessary to support us in (i) assessing and documenting the adequacy
      of our internal control over financial reporting, (ii) improving control
      processes, where appropriate, and (iii) verifying through testing that controls
      are functioning as documented. If we fail to identify and correct any
      significant deficiencies in the design or operating effectiveness of our
      internal control over financial reporting or fail to prevent fraud, current
      and
      potential stockholders and depositors could lose confidence in our financial
      reporting, which could adversely affect our business, financial condition and
      results of operations, the trading price of our stock and our ability to attract
      additional deposits.




***Our
      charter and bylaws may prevent a transaction you may favor or limit our growth
      opportunities, which could cause the market price of our common stock to
      decline.*** Certain
      provisions of our charter and bylaws and applicable provisions of Maine and
      federal law and regulations may delay, inhibit or prevent an organization or
      person from gaining control of the Company though a tender offer, business
      combination, proxy context or some other method, even though you might be in
      favor of the transaction.




***We
      may not be able to pay dividends in the future in accordance with past practice.*** We
      pay a
      quarterly dividend to stockholders. However, we are dependent primarily upon
      the
      Bank for our earnings and funds to pay dividends on our common stock. The
      payment of dividends also is subject to legal and regulatory restrictions.
      Any
      payment of dividends in the future will depend, in large part, on the Bank’s
      earnings, capital requirements, financial condition and other factors considered
      relevant by our Board of Directors.





**ITEM
      1B.**  **UNRESOLVED
      STAFF COMMENTS**





Not
      applicable.




16





**ITEM
      2.**  **PROPERTIES**





At
      December 31, 2006, 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.




The
      following table sets forth certain information regarding the Bank’s properties
      at December 31, 2006.





**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, 2006.





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





None.


17


**PART
      II**





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





*Market
      Information and Related Matters*




Our
      common stock is traded on The Nasdaq National Market. The following table sets
      forth the high and low sale 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 dividend in 2006 and
      2005.




**Market
                Price**
            
            **Dividends
                Declared****2006**
            
            **High**
            
            **Low**
            
            **Per
                Share**First
                Quarter
            
            $
            24.48
            
            $
            22.35
            
            $
            0.170Second
                Quarter
            
            
            27.50
            
            
            22.60
            
            
            0.180Third
                Quarter
            
            
            26.10
            
            
            22.57
            
            
            0.180Fourth
                Quarter
            
            
            26.45
            
            
            23.24
            
            
            0.190**2005**First
                Quarter
            
            $
            24.97
            
            $
            20.27
            
            $
            0.146Second
                Quarter
            
            
            22.72
            
            
            19.52
            
            
            0.155Third
                Quarter
            
            
            23.84
            
            
            20.49
            
            
            0.155Fourth
                Quarter
            
            
            24.52
            
            
            22.88
            
            
            0.165





As
      of
      February 15, 2007, there were 3,555,844 shares of common stock outstanding
      which
      were held by approximately 1,150 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, 2006, the Company repurchased 3,757 shares
      at
      an average price per share of $23.58. For the three month period ended December
      31, 2006, the Company did not purchase any shares of common stock.





*Performance
      Graph*





Set
      forth
      below is a line graph comparing the five-year cumulative total return of $100.00
      invested in the Company’s common stock (“MERB”), assuming reinvestment of all
      cash dividends and retention of all stock dividends, with a comparable amount
      invested in the Russell 2000 Stock Index (“Russell”) and the NASDAQ Bank Stock
      Index (“NASDAQ Bank”). The NASDAQ Bank Index is a capitalization-weighted index
      designed to measure the performance of all NASDAQ stocks in the banking
      sector.


18











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




*(Dollars
              in thousands, except per share
              data)***For
                the Year**
            
            2006
            
            
            2005
            
            
            2004
            
            
            2003
            
            
            2002Net
                income
            
            $
            6,295
            
            
            $
            5,738
            
            
            $
            4,907
            
            
            $
            4,302
            
            
            $
            3,845Net
                interest income
            
            
            17,089
            
            
            
            15,770
            
            
            
            13,773
            
            
            
            12,479
            
            
            
            12,463Non-interest
                income
            
            
            5,503
            
            
            
            5,206
            
            
            
            4,933
            
            
            
            4,958
            
            
            
            3,910Non-interest
                expense
            
            
            12,773
            
            
            
            11,947
            
            
            
            10,970
            
            
            
            10,495
            
            
            
            10,152**Per
                Common Share**(adjusted for 3% stock dividend in 2006)Basic
                earnings per share
            
            $
            1.77
            
            
            $
            1.62
            
            
            $
            1.37
            
            
            $
            1.19
            
            
            $
            1.16Diluted
                earnings per share
            
            
            1.76
            
            
            
            1.61
            
            
            
            1.36
            
            
            
            1.18
            
            
            
            1.05Dividends
                per share
            
            
            0.72
            
            
            
            0.62
            
            
            
            0.53
            
            
            
            0.44
            
            
            
            0.36Book
                value per share at year end
            
            
            10.89
            
            
            
            9.71
            
            
            
            8.84
            
            
            
            8.41
            
            
            
            8.09Stock
                price:High
            
            
            27.50
            
            
            
            24.97
            
            
            
            24.18
            
            
            
            19.97
            
            
            
            14.44Low
            
            
            22.35
            
            
            
            19.52
            
            
            
            18.95
            
            
            
            13.39
            
            
            
            9.75Close
            
            
            26.45
            
            
            
            23.88
            
            
            
            20.35
            
            
            
            19.88
            
            
            
            13.86**Key
                Performance Ratios**Return
                on average equity
            
            
            17.32
            %
            
            
            17.59
            %
            
            
            16.06
            %
            
            
            14.74
            %
            
            
            13.93
            %Return
                on average assets
            
            
            1.45
            
            
            
            1.47
            
            
            
            1.36
            
            
            
            1.34
            
            
            
            1.33Equity
                to assets at year end
            
            
            8.61
            
            
            
            8.24
            
            
            
            8.50
            
            
            
            8.93
            
            
            
            9.24Non-performing
                assets to total assets
            
            
            0.32
            
            
            
            0.10
            
            
            
            0.44
            
            
            
            0.18
            
            
            
            0.25Net
                charge-offs to average loans
            
            
            0.06
            
            
            
            0.06
            
            
            
            0.05
            
            
            
            0.04
            
            
            
            0.07Efficiency
                ratio
            
            
            56.63
            
            
            
            57.37
            
            
            
            59.29
            
            
            
            60.51
            
            
            
            62.01Dividend
                payout ratio
            
            
            40.59
            
            
            
            38.33
            
            
            
            38.32
            
            
            
            37.16
            
            
            
            31.27**At
                Year End**Total
                assets
            
            $
            449,099
            
            
            $
            417,073
            
            
            $
            368,690
            
            
            $
            342,189
            
            
            $
            307,316Loans
            
            
            338,880
            
            
            
            318,965
            
            
            
            282,988
            
            
            
            246,512
            
            
            
            214,729Deposits
            
            
            359,922
            
            
            
            331,414
            
            
            
            299,782
            
            
            
            258,848
            
            
            
            238,857Borrowed
                funds
            
            
            45,443
            
            
            
            47,008
            
            
            
            33,524
            
            
            
            49,260
            
            
            
            36,932Shareholders’
                equity
            
            
            38,649
            
            
            
            34,352
            
            
            
            31,329
            
            
            
            30,553
            
            
            
            28,388


19


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


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




The
      discussion and analysis that follows focuses on the results of operations of
      the
      Company during 2006, 2005 and 2004 and its financial condition at December
      31,
      2006 and 2005. This section should be read in conjunction with the Consolidated
      Financial Statements and related notes thereto.





**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.





On
      January 19, 2007, Chittenden Corporation (“Chittenden”) and the Company jointly
      announced the execution of a definitive agreement pursuant to which Chittenden
      will acquire the Company in an exchange of cash and stock. The Bank will operate
      as a separate unit of Chittenden, maintaining its name and senior management
      team. The merger, which was unanimously approved by the boards of directors
      of
      Chittenden and the Company, is expected to close in the second quarter of 2007,
      subject to regulatory and the Company's shareholder approval.





Under
      the
      terms of the agreement, stockholders of the Company will be entitled to receive
      either cash or shares of Chittenden common stock, subject to election and
      allocation procedures which are intended to ensure that, in aggregate, 40%
      of
      the shares of the Company are converted into the right to receive cash of $31.00
      per share, and that 60% are converted into the right to receive a fixed exchange
      of 1.02 shares of Chittenden common stock for each share of the
      Company.





**Executive
      Overview**





The
      Company’s net income increased 10% to $6,295 in 2006 and diluted earnings per
      share was $1.76 in 2006 compared to $1.61 in 2005, an increase of $0.15 per
      diluted share or 9%. The following were significant factors related to 2006
      results as compared to 2005:





·
            Total
                loans grew 6% in 2006. Loan growth occurred in all areas with growth
                in
                commercial business loans of $7.0 million, home equity balances increased
                $5.9 million, consumer loans grew $5.5 million and
                residential/construction balances increased $1.5
                million.





·
            We
                continue to maintain strong asset quality with net charge-offs of
                $212 in
                2006 representing 0.06% of average loans compared to 0.06% in 2005.
                Nonperforming assets as a percentage of total assets was 0.32% at
                year-end
                compared to 0.10% at the close of
                2005.





·
            Deposits
                grew 9% in 2006. Checking account balances increased $4.0 million
                or 4%.
                Savings and money market accounts declined $6.2 million or 6% compared
                to
                the prior year, as short-term interest rate increases and stock market
                volatility have spurred a migration of funds to certificate of deposit
                accounts (CDs). This movement, coupled with an influx of new funds
                to
                higher yielding CDs, contributed to CD growth of $30.8 million or
                25% from
                a year ago.




20


·
            The
                Company’s net interest margin decreased to 4.13% for 2006, compared to
                4.25% for 2005 as the cost of funds increased by 91 basis points
                while the
                yield on earning assets increased 65 basis points.





·
            Non-interest
                income grew 6% in 2006 with increases in trust fees of 13%, other
                service
                charges of 4% and service fees on deposit accounts of
                5%.





·
            Our
                efficiency ratio improved to 56.6% compared to 57.4% in 2005. Operating
                expenses increased 7% in 2006 due to increases in salaries and employee
                benefits, occupancy costs, and other expenses. As we have experienced
                growth in loans, deposits and trust assets under management, personnel
                costs have increased due to the additional employees required to
                deliver
                on our promise of “Where Service
                Matters.”





**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.





*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 are 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 in 2006 and 2005. All financial data
      included herein has been restated to reflect the impact of the stock
      dividends.


21


**Results
      of Operations**





*Comparison
      of 2006 and 2005*





*Summary*





The
      Company ended 2006 with consolidated assets of $449,099, representing growth
      of
      $32,026 or 8%.  Asset growth was attributable to solid loan demand and
      purchase of investment securities.  The Company reported net income of
      $6,295 or $1.77 per basic share and $1.76 per diluted share in 2006, compared
      to
      $5,738 or $1.62 per basic share and $1.61 per diluted share in 2005.  This
      represented earnings growth of $557 or 10%.  Return on average assets was
      1.45% in 2006 compared to 1.47% in 2005, and return on average equity was 17.32%
      in 2006 compared to 17.59% in 2005.




*Net
      Interest Income*





The
      Company’s primary source of operating income is net interest income.  Net
      interest income was $17,089 for 2006 and $15,770 for 2005.  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.




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.





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





**2006**
            
            
            **2005**
            
            
            **2004****Average
                Balance**
            
            **Interest**
            
            **Yield/**
              **Rate**
            
            
            **Average
                Balance**
            
            **Interest**
            
            **Yield/**
              **Rate**
            
            
            **Average
                Balance**
            
            **Interest**
            
            **Yield/**
              **Rate**Assets:Interest-earning
                assets:Loans
                (1)
            
            $
            329,350
            
            $
            24,500
            
            
            7.44
            %
            
            $
            299,353
            
            $
            20,368
            
            
            6.80
            %
            
            $
            269,091
            
            $
            16,609
            
            
            6.17
            %Investment
                securities
            
            
            79,634
            
            
            3,427
            
            
            4.30
            %
            
            
            67,741
            
            
            2,338
            
            
            3.45
            %
            
            
            70,259
            
            
            2,071
            
            
            2.95
            %Other
                earning assets
            
            
            4,832
            
            
            253
            
            
            5.24
            %
            
            
            3,620
            
            
            118
            
            
            3.26
            %
            
            
            1,595
            
            
            28
            
            
            1.76
            %Total
                interest-earning assets
            
            
            413,816
            
            
            28,180
            
            
            6.81
            %
            
            
            370,714
            
            
            22,824
            
            
            6.16
            %
            
            
            340,945
            
            
            18,708
            
            
            5.49
            %Non-earning
                assets
            
            
            21,083
            
            
            
            
            
            
            
            
            
            19,886
            
            
            
            
            
            
            
            
            
            18,727Total
                assets
            
            $
            434,899
            
            
            
            
            
            
            
            
            $
            390,600
            
            
            
            
            
            
            
            
            $
            359,672Liabilities
                and shareholders' equity:Interest-bearing
                liabilities:Savings
                deposits and interest-bearing checking
            
            $
            148,731
            
            
            3,369
            
            
            2.27
            %
            
            $
            146,732
            
            
            2,076
            
            
            1.41
            %
            
            $
            129,774
            
            
            818
            
            
            0.63
            %Certificates
                of deposit
            
            
            143,594
            
            
            5,935
            
            
            4.13
            %
            
            
            111,612
            
            
            3,719
            
            
            3.33
            %
            
            
            103,881
            
            
            3,223
            
            
            3.10
            %Borrowings
            
            
            48,796
            
            
            1,787
            
            
            3.66
            %
            
            
            42,664
            
            
            1,259
            
            
            2.95
            %
            
            
            41,588
            
            
            894
            
            
            2.15
            %Total
                interest-bearing liabilities
            
            
            341,121
            
            
            11,091
            
            
            3.25
            %
            
            
            301,008
            
            
            7,054
            
            
            2.34
            %
            
            
            275,243
            
            
            4,935
            
            
            1.79
            %Other
                liabilities
            
            
            57,420
            
            
            
            
            
            
            
            
            
            56,973
            
            
            
            
            
            
            
            
            
            53,881Shareholders'
                equity
            
            
            36,358
            
            
            
            
            
            
            
            
            
            32,619
            
            
            
            
            
            
            
            
            
            30,548Total
                liabilities and shareholders'equity
            
            $
            434,899
            
            
            
            
            
            
            
            
            $
            390,600
            
            
            
            
            
            
            
            
            $
            359,672Net
                interest income
            
            
            
            
            $
            17,089
            
            
            
            
            
            
            
            
            $
            15,770
            
            
            
            
            
            
            
            
            $
            13,773Net
                interest rate spread
            
            
            
            
            
            
            
            
            3.56
            %
            
            
            
            
            
            
            
            
            3.82
            %
            
            
            
            
            
            
            
            
            3.70
            %Net
                interest margin
            
            
            
            
            
            
            
            
            4.13
            %
            
            
            
            
            
            
            
            
            4.25
            %
            
            
            
            
            
            
            
            
            4.04
            %


______________________


(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.


22


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.





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





**December
                31, 2006 vs. 2005**
            
            **December
                31, 2005 vs. 2004****Increase
                (Decrease) Due to Change in:**
            
            **Increase
                (Decrease) Due to Change in:****Rate/**
            
            
            
            
            
            
            
            
            
            **Rate/****Volume**
            
            **Rate**
            
            **Volume**
            
            
            **Total**
            
            **Volume**
            
            
            **Rate**
            
            **Volume**
            
            **Total**Interest-earning
                assets:Loans
            
            $
            2,041
            
            $
            1,901
            
            $
            190
            
            
            $
            4,132
            
            $
            1,868
            
            
            $
            1,700
            
            $
            191
            
            $
            3,759Investment
                securities
            
            
            410
            
            
            577
            
            
            102
            
            
            
            1,089
            
            
            (74
            )
            
            
            354
            
            
            (13
            )
            
            267Other
                earning assets
            
            
            40
            
            
            72
            
            
            23
            
            
            
            135
            
            
            36
            
            
            
            24
            
            
            30
            
            
            90Total
                interest income
            
            
            2,491
            
            
            2,550
            
            
            315
            
            
            
            5,356
            
            
            1,830
            
            
            
            2,078
            
            
            208
            
            
            4,116Interest-bearing
                liabilities:Savings
                deposits and interest-bearing
                checking
            
            
            28
            
            
            1,248
            
            
            17
            
            
            
            1,293
            
            
            107
            
            
            
            1,018
            
            
            133
            
            
            1,258Certificates
                of deposit
            
            
            1,066
            
            
            894
            
            
            256
            
            
            
            2,216
            
            
            240
            
            
            
            238
            
            
            18
            
            
            496Borrowings
            
            
            181
            
            
            303
            
            
            44
            
            
            
            528
            
            
            23
            
            
            
            333
            
            
            9
            
            
            365Total
                interest expense
            
            
            1,275
            
            
            2,445
            
            
            317
            
            
            
            4,037
            
            
            370
            
            
            
            1,589
            
            
            160
            
            
            2,119Net
                interest income
            
            $
            1,216
            
            $
            105
            
            $
            (2
            )
            
            $
            1,319
            
            $
            1,460
            
            
            $
            489
            
            $
            48
            
            $
            1,997





Net
      interest income increased by $1,319 in 2006 compared to 2005.  The increase
      was driven by $43.1 million of growth in average earning assets for 2006
      compared to the same period in 2005. The Company’s net interest margin decreased
      to 4.13% for 2006, compared to 4.25% for 2005 as the cost of funds increased
      by
      91 basis points while the yield on earning assets increased 65 basis points.




Interest
      income was $28,180 in 2006, a 23% increase from 2005.  The increase was
      driven by growth in the average earning assets of $43,102 or 12% and an increase
      in the yield on average earning assets to 6.81% in 2006 from 6.16% in 2005.




Interest
      expense increased to $11,091 in 2006 from $7,054 in 2005, representing a 57%
      increase.  This increase was a result of growth in average interest-bearing
      liabilities of $40,113 or 13% and an increase in the cost of funds to 3.25%
      in
      2006 from 2.34% in 2005.




Management
      currently anticipates that net interest income will continue to increase in
      2007
      primarily due to expected loan growth.





*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
      $358 for 2006 and $397 for 2005, a decline of $39 or 10%. The allowance for
      loan
      losses represented 1.21% of loans outstanding at December 31, 2006, compared
      to
      1.28% at December 31, 2005. Net charge-offs were $212 during 2006 or .06% of
      average loans outstanding, compared to $177 in 2005 or .06%. 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.





23


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 2007; 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
      2007.





*Non-Interest
      Income*





Non-interest
      income was $5,503 for 2006 compared to $5,206 for 2005, an increase of $297.
      We
      experienced growth in trust fees of 13%, service fees on deposit accounts
      increased 5% and other service charges and fees increased 4%.





Trust
      fees increased $196 to $1,763 in 2006. The market value of client assets under
      administration increased $23,036 to $388,986 at December 31, 2006 compared
      with
      trust assets of $365,950 at December 31, 2005. The increase in trust assets
      was
      achieved through new business development combined with market
      appreciation.





Service
      fees on deposit accounts increased $73 to $1,569 in 2006. The increase was
      attributable to an increase in overdraft fee income of 12% which was offset
      by a
      decline in business service fees of 23%. The increase in overdraft fees is
      the
      result of new account activity and the decline in business service fees is
      related to accounts transitioning to a “totally free business checking account”
combined with an increase in the earnings credit rate that offsets business
      service fees.  Other
      service charges and fees increased $37 to $873 in 2006 due to an increase in
      debit card interchange income.





Mortgage
      banking income increased $100 to $745 in 2006 excluding a one-time gain on
      the
      sale of the credit card portfolio of $106 in 2005. The Company’s portfolio of
      residential mortgages serviced for secondary market investors at December 31,
      2006 of $154,817 increased by $13,692 or 10% from December 31,
      2005.





The
      generation of mortgage banking income 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 $12,773 for 2006 compared to $11,947 in 2005. The $826 or 7%
      increase was related to the increase in salaries and employee benefits of $633,
      occupancy expense of $63 and other expenses of $113. The Company’s efficiency
      ratio (non-interest expense divided by the sum of net interest income and
      non-interest income adjusted for non-recurring items) improved to 56.6% for
      2006
      compared to 57.4% for 2005.





Salaries
      and employee benefits expense increased 9% to $7,468 for 2006. The 2006 increase
      was a result of normal annual salary increases and additional staffing required
      as a result of loan, deposit and trust growth. Occupancy expense increased
      7%
      primarily from moving into the recently renovated Merrill Financial Center,
      a
      9,000 square foot historic building. Other expenses increased in several areas
      including: postage cost, debit card interchange expense, education costs and
      trust expenses.


24


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





*Comparison
      of 2005 and 2004*





*Summary*





The
      Company ended 2005 with consolidated assets of $417,073, representing growth
      of
      $48,383 or 13%.  Asset growth was attributable to strong loan demand. 
The Company reported net income of $5,738 or $1.62 per basic share and $1.61
      per
      diluted share in 2005, compared to $4,907 or $1.37 per basic share and $1.36
      per
      diluted share in 2004.  This represented earnings growth of $831 or
      17%.  Return on average assets increased to 1.47% in 2005 compared to 1.36%
      in 2004, and return on average equity increased to 17.59% in 2005 from 16.06%
      in
      2004.





*Net
      Interest Income*





Net
      interest income was $15,770 for 2005 and $13,773 for 2004.  The increase
      was due to growth in the loan portfolio combined with an increase in the
      Company’s net interest margin to 4.25% for 2005 compared to 4.04% for
      2004.





*Non-Interest
      Income*





Non-interest
      income was $5,206 for 2005 compared to $4,933 for 2004, an increase of $273.
      We
      experienced growth in most fee categories with service fees on deposit accounts
      increasing 7%, trust fees growing 13% and other fees increasing 41%. Gains
      on
      investment securities declined $136 and mortgage banking income and gain on
      credit card loans declined $74 from 2004.





Mortgage
      refinance activity slowed considerably in 2005 resulting in a decline in
      mortgage gains to $645 in 2005 from $825 in 2004. The Company’s portfolio of
      residential mortgages serviced for secondary market investors at December 31,
      2005 of $141,125 increased by $19,000, or 16%, from December 31,
      2004.





Service
      fees on deposit accounts increased 7% to $1,496 in 2005. Overdraft fee income
      increased to $1,088 in 2005, a 15% increase over 2004 due to new account
      activity combined with a centralized approach to the overdraft process. Other
      fees increased $155 due to increases in financial service income of $62, income
      on cash surrender value of life insurance of $38 and income from M&M of $30.





Trust
      fees increased 13% to $1,567 in 2005. The market value of client assets under
      administration increased $9,514 to $365,950 at December 31, 2005 compared with
      trust assets of $356,436 at December 31, 2004. The increase in trust assets
      was
      achieved through new business development combined with market
      appreciation.





*Non-Interest
      Expense*





Non-interest
      expense was $11,947 for 2005 compared to $10,970 in 2004. The $977 or 9%
      increase was related to the increase in salaries and employee benefits of $525,
      occupancy expense of $101 and other expenses of $196. The Company’s efficiency
      ratio (non-interest expense divided by the sum of net interest income and other
      income) improved to 57.4% for 2005 compared to 59.3% for 2004.





Salaries
      and employee benefits expense increased 8% to $6,835 for 2005. The 2005 increase
      was a result of normal annual salary increases and additional staffing required
      as a result of loan and deposit growth. Occupancy expense increased 12% as
      maintenance and repairs increased 45% and heat and utilities costs grew 23%
      between years. Professional fees increased $125 or 33% due to an increase in
      directors’ fees and the use of consultants for technology, compliance and
      collection projects.


25


**Financial
      Condition**





The
      Company’s consolidated total assets at December 31, 2006 were $449,099, an
      increase of $32,026, or 8%, from December 31, 2005. The change in assets
      consisted primarily of an increase in net loans of $19,892, an increase in
      investment securities of $14,015 and a decrease in cash and cash equivalents
      of
      $3,380. The asset growth was primarily funded by an increase in total deposits
      of $28,508, driven by an increase in certificates of deposit of $30,772. In
      addition, total shareholders’ equity increased $4,297 as a result of current
      year earnings less common stock repurchases and shareholder dividends
      paid.





*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 $79,634 in 2006 and $67,741 in 2005, an increase of
      $11,893. The securities portfolio consists primarily of collateralized mortgage
      obligations and U.S. Government sponsored enterprises securities. The majority
      of securities are rated AAA or equivalently rated. Collateralized mortgage
      obligations and mortgage-backed securities comprised 63% of the securities
      portfolio at December 31, 2006 compared to 60% at December 31, 2005. The average
      yield on securities was 4.30% during 2006, compared to 3.45% during 2005, which
      is due to the reinvestment of maturing securities into higher yielding
      investments related to the increase in market rates.





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





**Table
      3 - Investment Securities**





**December
                31,****2006**
            
            
            **2005**
            
            
            **2004****%
                of**
            
            
            
            
            
            **%
                of**
            
            
            
            
            **%
                of****Amount**
            
            **Total**
            
            
            **Amount**
            
            
            **Total**
            
            
            **Amount**
            
            **Total**Collateralized
                mortgage obligations
            
            $
            47,379
            
            
            55
            %
            
            $
            39,386
            
            
            
            54
            %
            
            $
            43,553
            
            
            66
            %U.S.
                Government sponsored enterprises
            
            
            16,738
            
            
            19
            %
            
            
            16,417
            
            
            
            23
            %
            
            
            10,297
            
            
            16
            %Mortgage-backed
                securities
            
            
            7,097
            
            
            8
            %
            
            
            4,354
            
            
            
            6
            %
            
            
            3,982
            
            
            6
            %U.S.
                Government sponsored enterprisesmoney
                market funds
            
            
            -
            
            
            -
            
            
            
            1,050
            
            
            
            1
            %
            
            
            480
            
            
            1
            %Certificates
                of deposit
            
            
            8,255
            
            
            10
            %
            
            
            4,827
            
            
            
            7
            %
            
            
            1,346
            
            
            2
            %State
                and local government debt securities
            
            
            3,386
            
            
            4
            %
            
            
            2,933
            
            
            
            4
            %
            
            
            2,311
            
            
            3
            %Total
                debt securities
            
            
            82,855
            
            
            96
            %
            
            
            68,967
            
            
            
            95
            %
            
            
            61,969
            
            
            94
            %Equity
                securities
            
            
            3,332
            
            
            4
            %
            
            
            3,774
            
            
            
            5
            %
            
            
            3,825
            
            
            6
            %Total
                securities available for sale
            
            
            86,187
            
            
            100
            %
            
            
            72,741
            
            
            
            100
            %
            
            
            65,794
            
            
            100
            %Net
                unrealized gains (losses)
            
            
            317
            
            
            
            
            
            
            (252
            )
            
            
            
            
            
            
            305Fair
                value of securities available for sale
            
            $
            86,504
            
            
            
            
            
            $
            72,489
            
            
            
            
            
            
            $
            66,099





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, 2006. 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.


26


**Table
      4 - Maturities of Debt Securities**





**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
                mortgageobligations
            
            $
            -
            
            
            -
            
            
            $
            3,801
            
            
            4.28
            %
            
            $
            20,078
            
            
            4.57
            %
            
            $
            23,500
            
            
            5.02
            %
            
            $
            47,379
            
            
            4.77
            %U.S.
                Government sponsoredenterprises
            
            
            3,249
            
            
            3.86
            %
            
            
            6,606
            
            
            4.56
            %
            
            
            5,919
            
            
            5.50
            %
            
            
            964
            
            
            5.40
            %
            
            
            16,738
            
            
            4.80
            %Mortgage-backed
                securities
            
            
            -
            
            
            -
            
            
            
            2,155
            
            
            4.42
            %
            
            
            2,409
            
            
            4.28
            %
            
            
            2,533
            
            
            5.32
            %
            
            
            7,097
            
            
            4.70
            %Certificates
                of deposit
            
            
            1,758
            
            
            4.77
            %
            
            
            6,497
            
            
            5.26
            %
            
            
            -
            
            
            -
            
            
            
            -
            
            
            -
            
            
            
            8,255
            
            
            5.15
            %State
                and local government debtsecurities
            
            
            515
            
            
            3.96
            %
            
            
            1,127
            
            
            4.20
            %
            
            
            1,613
            
            
            2.80
            %
            
            
            131
            
            
            4.74
            %
            
            
            3,386
            
            
            3.52
            %Total
            
            $
            5,522
            
            
            4.16
            %
            
            $
            20,186
            
            
            4.70
            %
            
            $
            30,019
            
            
            4.64
            %
            
            $
            27,128
            
            
            5.06
            %
            
            $
            82,855
            
            
            4.76
            %





*Loans*





The
      Bank
      offers a broad range of personal and business loan products. Total loans (which
      includes loans held for sale) averaged $329,350 during 2006 compared to $299,353
      during 2005, an increase of $29,997, or 10%. Total loans grew 6% in 2006 to
      $338,880 at December 31, 2006. Loan growth occurred in all areas with growth
      in
      commercial business loans and commercial real estate loans of 4% each, home
      equity balances increased 14%, consumer loans grew 26% and
      residential/construction balances increased 2%.





The
      average yield on loans increased to 7.44% in 2006 from 6.80% in 2005. The prime
      rate average was 7.96% for 2006 and 6.19% for 2005. Management anticipates
      a
      decrease on loan yields for 2007 due to a flat prime rate combined with strong
      competition from banks and non-traditional credit providers.





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





**Table
      5 - Composition of Loan Portfolio**




**At
                December 31,****2006**
            
            
            **2005**
            
            
            **2004**
            
            
            **2003**
            
            
            **2002****Amount**
            ****
            **%**
            ****
            ****
            **Amount**
            ****
            **%**
            ****
            ****
            **Amount**
            ****
            **%**
            ****
            ****
            **Amount**
            ****
            **%**
            ****
            ****
            **Amount**
            ****
            **%**Real
                EstateCommercial
            
            $
            112,852
            
            
            33
            %
            
            $
            108,553
            
            
            34
            %
            
            $
            96,956
            
            
            34
            %
            
            $
            80,212
            
            
            32
            %
            
            $
            70,247
            
            
            33
            %Construction
            
            
            15,758
            
            
            5
            %
            
            
            15,345
            
            
            5
            %
            
            
            12,854
            
            
            5
            %
            
            
            9,669
            
            
            4
            %
            
            
            13,379
            
            
            6
            %Residential
            
            
            63,691
            
            
            19
            %
            
            
            62,568
            
            
            19
            %
            
            
            60,314
            
            
            21
            %
            
            
            55,380
            
            
            22
            %
            
            
            40,362
            
            
            19
            %Home
                equity
            
            
            47,370
            
            
            14
            %
            
            
            41,469
            
            
            13
            %
            
            
            34,139
            
            
            12
            %
            
            
            28,496
            
            
            12
            %
            
            
            19,889
            
            
            9
            %Total
                real estate
            
            
            239,671
            
            
            71
            %
            
            
            227,935
            
            
            71
            %
            
            
            204,263
            
            
            72
            %
            
            
            173,757
            
            
            70
            %
            
            
            143,877
            
            
            67
            %Commercial
            
            
            72,518
            
            
            21
            %
            
            
            69,799
            
            
            22
            %
            
            
            60,010
            
            
            21
            %
            
            
            55,486
            
            
            23
            %
            
            
            54,920
            
            
            26
            %Consumer
            
            
            26,691
            
            
            8
            %
            
            
            21,231
            
            
            7
            %
            
            
            18,715
            
            
            7
            %
            
            
            17,269
            
            
            7
            %
            
            
            15,932
            
            
            7
            %Total
                loans
            
            
            338,880
            
            
            100
            %
            
            
            318,965
            
            
            100
            %
            
            
            282,988
            
            
            100
            %
            
            
            246,512
            
            
            100
            %
            
            
            214,729
            
            
            100
            %Less
                allowance for loan losses
            
            
            (4,109
            )
            
            
            
            
            
            (4,086
            )
            
            
            
            
            
            (3,866
            )
            
            
            
            
            
            (3,652
            )
            
            
            
            
            
            (3,295
            )Total
            
            $
            334,771
            
            
            
            
            
            $
            314,879
            
            
            
            
            
            $
            279,122
            
            
            
            
            
            $
            242,860
            
            
            
            
            
            $
            211,434





The
      following table sets forth the scheduled contractual amortization of
      construction loans and commercial business loans at December 31, 2006, as well
      as the amount of such loans which are scheduled to mature after one year which
      have fixed or adjustable interest rates.


27


**Table
      6 - Scheduled Contractual Amortization of Certain Loans at December 31,
      2006**





**Commercial**
            
            **Construction****Business
                Loans**
            
            **Loans**
            
            **Total**Amounts
                due:Within
                one year
            
            $
            38,364
            
            $
            15,758
            
            $
            54,122After
                one year through five years
            
            
            22,299
            
            
            -
            
            
            22,299Beyond
                five years
            
            
            11,855
            
            
            -
            
            
            11,855Total
            
            $
            72,518
            
            $
            15,758
            
            $
            88,276Interest
                rate terms on amounts due after one year:Fixed
            
            $
            9,697
            
            $
            -
            
            $
            9,697Adjustable
            
            
            24,457
            
            
            -
            
            
            24,457





Management
      seeks to maintain a high quality of assets through prudent underwriting and
      sound lending practices. Approximately 27% 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, 2006, loans under these programs totaled $21,157
      of which $15,565, or 5% 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 M&M 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 was .32% or $1,417 at December 31, 2006 compared
      to
      .10% or $420 at December 31, 2005.




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.




28


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





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


**At
                December 31,****2006**
            
            
            **2005**
            
            
            **2004**
            
            
            **2003**
            
            
            **2002**Loans:Non-accrual
                loans
            
            $
            1,226
            
            
            $
            378
            
            
            $
            1,571
            
            
            $
            598
            
            
            $
            432Loans
                90 days or more past due but still accruing
            
            
            115
            
            
            
            -
            
            
            
            4
            
            
            
            8
            
            
            
            37Restructured
                loans
            
            
            -
            
            
            
            -
            
            
            
            4
            
            
            
            8
            
            
            
            132Non-performing
                loans
            
            
            1,341
            
            
            
            378
            
            
            
            1,579
            
            
            
            614
            
            
            
            601OREO
                and repossessed assets
            
            
            76
            
            
            
            42
            
            
            
            30
            
            
            
            3
            
            
            
            165Non-performing
                assets
            
            $
            1,417
            
            
            $
            420
            
            
            $
            1,609
            
            
            $
            617
            
            
            $
            766Non-performing
                loans as a percentage of total loans
            
            
            0.40
            %
            
            
            0.12
            %
            
            
            0.56
            %
            
            
            0.25
            %
            
            
            0.28
            %Non-performing
                assets as a percentage of total assets
            
            
            0.32
            %
            
            
            0.10
            %
            
            
            0.44
            %
            
            
            0.18
            %
            
            
            0.25
            %Non-performing
              assets as a percentage of total loans andOREO/repossessed
                assets
            
            
            0.42
            %
            
            
            0.13
            %
            
            
            0.57
            %
            
            
            0.25
            %
            
            
            0.36
            %





At
      December 31, 2006, loans on non-accrual status totaled $1,226. Interest income
      not recognized on non-accrual loans was $72 in 2006. There was no interest
      income recognized on non-accrual loans in 2006.





*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, 2006 and 2005, loans classified as substandard amounted to $2,665
      and $11,252, respectively, and loans classified as doubtful totaled $481 and
      $397, respectively. Performing loans represent 68% and 79% of the adversely
      classified balances as of December 31, 2006 and 2005, respectively. The Bank
      had
      no loans which were classified as loss at either date. Total classified loans
      as
      a percentage of total loans declined to 0.9% at December 31, 2006 from 3.7%
      at
      December 31, 2005. 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,
      2006 and 2005, the portion of loans guaranteed by either the SBA, RD or FAME
      for
      each year amounted to 25% and 10%, respectively, of the total loan balances
      adversely classified. At December 31, 2006, related party loans totaling $197
      were classified as substandard and over 30 days past due.





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


29


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





**Year
                Ended December 31,****2006**
            
            **2005**
            
            **2004**
            
            **2003**
            
            **2002**Allowance
                for loan losses, at beginning of year
            
            $
            4,086
            
            $
            3,866
            
            $
            3,652
            
            $
            3,295
            
            $
            2,986Loans
                charged off:Commercial
                real estate
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Residential
                real estate
            
            
            (14
            )
            
            -
            
            
            -
            
            
            -
            
            
            -Home
                equity loans
            
            
            (12
            )
            
            -
            
            
            (10
            )
            
            -
            
            
            -Commercial
                business loans
            
            
            (73
            )
            
            (72
            )
            
            (24
            )
            
            (7
            )
            
            (28
            )Overdrafts
                on deposit accounts
            
            
            (61
            )
            
            (58
            )
            
            -
            
            
            -
            
            
            -Consumer
            
            
            (106
            )
            
            (96
            )
            
            (144
            )
            
            (113
            )
            
            (161
            )Total
                loans charged off
            
            
            (266
            )
            
            (226
            )
            
            (178
            )
            
            (120
            )
            
            (189
            )Recoveries:Commercial
                real estate
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -Residential
                real estate
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            27Home
                equity loans
            
            
            -
            
            
            1
            
            
            -
            
            
            -
            
            
            -Commercial
                business loans
            
            
            10
            
            
            -
            
            
            12
            
            
            4
            
            
            5Overdrafts
                on deposit accounts
            
            
            23
            
            
            18
            
            
            -
            
            
            -
            
            
            -Consumer
            
            
            21
            
            
            30
            
            
            32
            
            
            29
            
            
            13Total
                loans recovered
            
            
            54
            
            
            49
            
            
            44
            
            
            33
            
            
            45Net
                loans charged off
            
            
            (212
            )
            
            (177
            )
            
            (134
            )
            
            (87
            )
            
            (144
            )Provisions
                for loan losses
            
            
            358
            
            
            397
            
            
            348
            
            
            444
            
            
            453Transfer
                to liability for unfunded commitments
            
            
            (123
            )
            
            -
            
            
            -
            
            
            -
            
            
            -Allowance
                for loan losses, at year-end
            
            $
            4,109
            
            $
            4,086
            
            $
            3,866
            
            $
            3,652
            
            $
            3,295Components
                of allowance for credit lossesAllowance
                for loan losses
            
            $
            4,109
            
            $
            4,086
            
            $
            3,866
            
            $
            3,652
            
            $
            3,295Liability
                for unfunded credit commitment
            
            
            123
            
            
            -
            
            
            -
            
            
            -
            
            
            -Balance
                of allowance for credit losses at year-end.
            
            $
            4,232
            
            $
            4,086
            
            $
            3,866
            
            $
            3,652
            
            $
            3,295Total
                net loans outstanding at the end of year (1)
            
            $
            334,771
            
            $
            314,879
            
            $
            279,122
            
            $
            242,860
            
            $
            211,434verage
                net loans outstanding during the year (1)
            
            $
            324,567
            
            $
            294,571
            
            $
            264,616
            
            $
            229,392
            
            $
            198,120Net
                charge-offs to average loans outstanding
            
            
            0.06
            %
            
            0.06
            %
            
            0.05
            %
            
            0.04
            %
            
            0.07
            %Net
                charge-offs to loans, end of period
            
            
            0.06
            %
            
            0.06
            %
            
            0.05
            %
            
            0.04
            %
            
            0.07
            %Allowance
                for credit losses to average loans outstanding
            
            
            1.29
            %
            
            1.37
            %
            
            1.44
            %
            
            1.57
            %
            
            1.64
            %Allowance
                for credit losses to loans, end of year
            
            
            1.25
            %
            
            1.28
            %
            
            1.37
            %
            
            1.48
            %
            
            1.53
            %Allowance
                for credit losses to non-performing loans
            
            
            315.59
            %
            
            1080.95
            %
            
            244.84
            %
            
            594.79
            %
            
            548.25
            %


___________________________


(1)
      Excludes loans held for sale.





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.


30


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


**At
                  December 31,****2006**
              
              
              
              **2005**
              
              
              
              **2004**
              
              
              
              **2003**
              
              
              **2002****%
                  of**
              
              
              
              
              
              **%
                  of**
              
              
              
              
              
              **%
                  of**
              
              
              
              
              
              **%
                  of**
              
              
              
              
              
              **%
                  of****Loans
                  to**
              
              
              
              
              
              **Loans
                  to**
              
              
              
              
              
              **Loans
                  to**
              
              
              
              
              
              **Loans
                  to**
              
              
              
              
              
              **Loans
                  to****Total**
              
              
              
              
              
              **Total**
              
              
              
              
              
              **Total**
              
              
              
              
              
              **Total**
              
              
              
              
              
              **Total****Amount**
              
              **Loans**
              
              
              **Amount**
              
              **Loans**
              
              
              **Amount**
              
              **Loans**
              
              
              **Amount**
              
              **Loans**
              
              
              **Amount**
              
              **Loans**Commercial
                andCommercial
                  Real Estate (1)
              
              $
              2,895
              
              
              54
              %
              
              $
              3,115
              
              
              56
              %
              
              $
              2,818
              
              
              56
              %
              
              $
              2,774
              
              
              55
              %
              
              $
              1,881
              
              
              58
              %Construction
              
              
              79
              
              
              5
              %
              
              
              77
              
              
              5
              %
              
              
              64
              
              
              4
              %
              
              
              48
              
              
              4
              %
              
              
              67
              
              
              6
              %Residential
              
              
              147
              
              
              19
              %
              
              
              198
              
              
              20
              %
              
              
              214
              
              
              21
              %
              
              
              181
              
              
              22
              %
              
              
              361
              
              
              19
              %Home
                  equity
              
              
              137
              
              
              14
              %
              
              
              114
              
              
              12
              %
              
              
              91
              
              
              12
              %
              
              
              74
              
              
              12
              %
              
              
              248
              
              
              9
              %Consumer
              
              
              367
              
              
              8
              %
              
              
              340
              
              
              7
              %
              
              
              354
              
              
              7
              %
              
              
              277
              
              
              7
              %
              
              
              460
              
              
              8
              %Other
              
              
              484
              
              
              -
              
              
              
              242
              
              
              -
              
              
              
              325
              
              
              -
              
              
              
              298
              
              
              -
              
              
              
              278
              
              
              -Total
                  allowance for loan losses
              
              $
              4,109
              
              
              100
              %
              
              $
              4,086
              
              
              100
              %
              
              $
              3,866
              
              
              100
              %
              
              $
              3,652
              
              
              100
              %
              
              $
              3,295
              
              
              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.





At
      December 31, 2006, the reserve allocated to the commercial and commercial real
      estate category constitutes 70% of the total allowance for loan losses compared
      to 76% at December 31, 2005. The change is due to a decrease in adversely
      classified loans. The allocation of the allowance for loan losses for
      construction, residential, home equity, consumer and off-balance sheet remains
      consistent between years.


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 appropriate as of December 31, 2006. 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.




31





The
      other
      category is the allowance considered necessary by management based on its
      assessment of historical loss experience, industry trends, and the impact of
      the
      local and regional economy on the Company’s borrowers that have not been
      captured in the specific risk classifications. Due to the imprecise nature
      of
      the loan loss estimation process and the effects of changing environmental
      conditions, these risk attributes may not be adequately captured in the data
      related to the formula-based loan loss components used to determine allocations
      in the Company’s analysis of the adequacy of the allowance for loan
      losses.





Prior
      to
      the Company’s recognition in 2006 of a separate reserve for unfunded
      commitments, a portion of the other category was reserved for inherent losses
      in
      the off-balance sheet exposures, which are now recognized in the separate
      liability.





*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
      2006,
      total deposits increased by $28,508 to $359,922, a 9% increase over 2005. The
      combination of rising short-term interest rates and special deposit promotions
      resulted in certificates of deposit growth of 25%, while savings and money
      market accounts declined 6%. The direct mail marketing campaign to businesses
      and individuals under the High Performance Checking program continues to spur
      core deposit growth with checking account balances increasing 4% in
      2006.





The
      Company’s focus on quality customer service combined with the marketing of the
      High Performance Checking program contributed to the deposit growth in 2006.
      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 2.70% for
      the year 2006, compared to 1.86% during 2005. The increase was due to rising
      short-term interest rates.





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


32


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





**Year
                Ended December 31,****2006**
            
            
            **2005**
            
            
            
            **2004****Average**
              **Balance**
            
            **Average**
              **Rate**
            
            
            **%**
              **of****Total**
              **Deposits**
            
            
            **Average**
              **Balance**
            
            **Average**
              **Rate**
            
            
            **%**
              **of****Total**
              **Deposits**
            
            
            **Average**
              **Balance**
            
            
            **Average**
              **Rate**
            
            
            **%**
              **of****Total**
              **Deposits**Non-interest
                checking
            
            $
            52,439
            
            
            -
            
            
            
            15
            %
            
            $
            52,869
            
            
            -
            
            
            
            17
            %
            
            $
            50,331
            
            
            
            -
            
            
            
            18
            %Interest
                checking
            
            
            43,788
            
            
            1.29
            %
            
            
            13
            %
            
            
            42,886
            
            
            0.69
            %
            
            
            14
            %
            
            
            40,693
            
            
            
            0.36
            %
            
            
            14
            %Money
                market
            
            
            52,200
            
            
            3.62
            %
            
            
            15
            %
            
            
            53,087
            
            
            2.26
            %
            
            
            17
            %
            
            
            45,852
            
            
            
            1.12
            %
            
            
            16
            %Savings
            
            
            52,742
            
            
            1.73
            %
            
            
            15
            %
            
            
            50,759
            
            
            1.14
            %
            
            
            16
            %
            
            
            43,229
            
            
            
            0.37
            %
            
            
            15
            %Brokered
                deposits
            
            
            56,856
            
            
            4.40
            %
            
            
            17
            %
            
            
            44,271
            
            
            3.89
            %
            
            
            14
            %
            
            
            37,937
            
            
            
            3.88
            %
            
            
            14
            %Certificates
                of deposit
            
            
            86,738
            
            
            3.96
            %
            
            
            25
            %
            
            
            67,341
            
            
            2.96
            %
            
            
            22
            %
            
            
            65,944
            
            
            
            2.65
            %
            
            
            23
            %Total
            
            $
            344,763
            
            
            2.70
            %
            
            
            100
            %
            
            $
            311,213
            
            
            1.86
            %
            
            
            100
            %
            
            $
            283,986
            
            
            
            1.42
            %
            
            
            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 $59,805 in brokered deposits at December 31,
      2006.





The
      following table summarizes at December 31, 2006 the Bank’s certificates of
      deposit (CD) of $100 or more and by time remaining until maturity:




Maturity
                Period:Less
                than three months
            
            $
            13,532Over
                three months through six months
            
            
            9,335Over
                six months through twelve months
            
            
            15,609Over
                twelve months
            
            
            35,367Total
            
            $
            73,843





*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 $45,443 at December 31, 2006 compared to $47,008 at December
      31,
      2005, a decrease of $1,565. Short-term borrowings include federal funds
      purchased, commercial lines of credit, FHLB overnight, Treasury, tax and loan
      deposits and interest-bearing demand notes due to the U.S. Treasury. The
      following table sets forth certain information regarding short-term borrowed
      funds for the years ended December 31, 2006, 2005 and 2004.





**2006**
            
            **2005**
            
            **2004**Balance
                outstanding at end of year
            
            $
            25,690
            
            $
            24,074
            
            $
            17,854Average
                balance during the year
            
            
            27,658
            
            
            19,851
            
            
            22,820Maximum
                outstanding at any month-end during the year
            
            
            36,888
            
            
            24,074
            
            
            35,932Average
                interest rate during the year
            
            
            3.54
            %
            
            1.87
            %
            
            0.89
            %Average
                interest rate at end of the year
            
            
            3.64
            %
            
            2.49
            %
            
            1.12
            %





*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.


33


*Contractual
      Obligations and Commitments*





The
      following tables summarize the Company’s contractual cash obligations and other
      commitments at December 31, 2006.





**Table
      11 - Contractual Obligations and Commitments**





Payments
                Due by Period:**Contractual
                Obligations**
            
            Total
                Amount of Obligation
            
            Less
                than 1 Year
            
            1
                -
                3 years
            
            4
                -
                5 years
            
            After
                5 yearsOperating
                leases
            
            $
            2,221
            
            $
            351
            
            $
            525
            
            $
            250
            
            $
            1,095Long-term
                debt (FHLB borrowings)
            
            
            19,753
            
            
            4,795
            
            
            7,274
            
            
            6,463
            
            
            1,221Total
                contractual obligations
            
            $
            21,974
            
            $
            5,146
            
            $
            7,799
            
            $
            6,713
            
            $
            2,316





Commitment
                Expires in:**Other
                Commitments**
            
            Total
                Amount Committed
            
            Less
                than 1 Year
            
            1
                -
                3 years
            
            4
                -
                5 years
            
            After
                5 yearsLetters
                of credit
            
            $
            1,676
            
            $
            1,272
            
            $
            254
            
            $
            150
            
            $
            -Commitments
                to investment securities
            
            
            1,350
            
            
            1,350
            
            
            -
            
            
            -
            
            
            -Other
                commitments to extend credit
            
            
            92,160
            
            
            49,351
            
            
            6,852
            
            
            1,256
            
            
            34,701Total
                commitments
            
            $
            95,186
            
            $
            51,973
            
            $
            7,106
            
            $
            1,406
            
            $
            34,701





**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 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 2006.




34




EstimatedRate
                Change
            
            Change
                in NII+200bp
            
            0.2%-200bp
            
            (2.3)%




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.





*Capital
      Resources*





At
      December 31, 2006, shareholders’ equity totaled $38,649 or 8.6% of total assets,
      as compared to $34,352 or 8.2% at December 31, 2005. The net increase in
      shareholders’ equity was attributable to: net income of $6,295, proceeds from
      stock option exercises and the related tax benefit of $224 and changes in the
      unrealized gain or loss on securities and derivatives of $428. This was offset
      by cash dividends of $2,561 million and common stock repurchases of $89.





During
      2006, the Company repurchased 3,757 shares of common stock at an average price
      of $23.58 and in 2005 the Company repurchased 5,500 shares of common stock
      at an
      average price of $21.70. 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,
      2006, 25,894 shares had been repurchased under this program. No shares were
      repurchased during the fourth quarter of 2006. 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,
      2006
      of 11.23% and 12.58%, respectively, exceed regulatory guidelines for capital
      adequacy. The Company’s Tier 1 and Tier 2 risk-based capital ratios at December
      31, 2005 were 11.06% and 12.40%, respectively. The Bank is also subject to
      federal regulatory capital requirements. At December 31, 2006, the Bank was
      deemed to be “well capitalized” under the applicable regulations. See Note 17 to
      the Consolidated Financial Statements.




*Equity
      Ratios*





The
      following tables summarize the Company’s key equity ratios at December 31,
      2006, 2005 and 2004.


35


**Table
      12 - Equity Ratios**





**2006**
            
            **2005**
            
            **2004**Return
                on average assets
            
            
            1.45
            %
            
            1.47
            %
            
            1.36
            %Return
                on average equity
            
            
            17.32
            %
            
            17.59
            %
            
            16.06
            %Dividend
                payout ratio
            
            
            40.59
            %
            
            38.33
            %
            
            38.32
            %Average
                equity to average assets
            
            
            8.36
            %
            
            8.35
            %
            
            8.49
            %





*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.





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





The
      following financial statements are contained on pages F-1 through F-25 of this
      Annual Report on Form 10-K.




Report
                of Independent Registered Public Accounting Firm
            F-1Consolidated
                Statements of Financial Conditionfor
                the Years Ended December 31, 2006 and 2005
            F-2Consolidated
                Statements of Incomefor
                the Years Ended December 31, 2006, 2005, and 2004
            F-3Consolidated
                Statements of Changes in Shareholders’ Equityfor
                the Years Ended December 31, 2006, 2005, and 2004
            F-4Consolidated
                Statements of Cash Flowsfor
                the Years Ended December 31, 2006, 2005, and 2004
            F-5Notes
                to Consolidated Financial Statements
            F-6





**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 to ensure that information required to be disclosed in the
      reports the Company files and submits under the Exchange Act is (i) recorded,
      processed, summarized and reported as and when required and (ii) accumulated
      and
      communicated to the Company’s management, including the Company’s Chairman,
      Chief Executive Officer and Principal Executive Officer and Executive Vice
      President, Treasurer and Principal Financial Officer, as appropriate to allow
      timely decisions regarding required disclosures.


36


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,
      EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE**





**Directors**





The
      Company’s Board of Directors currently consists of nine (9) members. The
      directors are as follows:





**William
      C. Bullock, Jr.,** 70,
      served as Chairman of the Company and the Bank from 1992 to April 2004. He
      is
      the former Chairman of The Merrill Trust Company and its successor bank,
      Merrill/Norstar Bank. He also served as an executive vice president and director
      of the holding company, Fleet/Norstar Financial Group of Providence, Rhode
      Island. Prior to moving to Maine in 1969, he held a number of officer positions
      with Morgan Guaranty Trust Company of New York. Mr. Bullock has served on and
      chaired several committees of the American Bankers Association (“ABA”) and is a
      former chairman of the Maine Bankers Association (“MBA”). From 1987 to 1989, Mr.
      Bullock was a Class A director of the Federal Reserve Bank of Boston. Mr.
      Bullock is a graduate of Yale University. He is a former trustee of the State
      of
      Maine Retirement System, Maine Maritime Academy, the Maine Community Foundation
      and Bangor Theological Seminary. Mr. Bullock is a former director of a number
      of
      companies including Fieldcrest Cannon, Bangor & Aroostook Railroad and
      Bangor Hydro-Electric Company and he served as a director of Eastern Maine
      Healthcare. Mr. Bullock’s term expires in 2007.





**Edwin
      N. Clift,** 67,
      has
      served as Chairman and Chief Executive Officer of the Company and Bank since
      April 2004 and served as President and Chief Executive Officer of the Company
      and the Bank from its inception in 1992 to April 2004. Prior to that, Mr. Clift
      was associated with three other Maine banks including more than 20 years as
      an
      executive of The Merrill Trust Company. Mr. Clift is a graduate of Strayer
      College in Washington, D.C. Mr. Clift is chairman of the St. Joseph Healthcare
      Foundation board of trustees, past president and current director of the Bangor
      Target Area Development Corporation and director and treasurer of the Bangor
      Historical Society. He is former chairman of the Maine Committee for Employer
      Support for the Guard and Reserve and a member of the Advisory Board for Maine’s
      Bureau of Financial Institutions. Mr. Clift also serves as a member of the
      ABA’s
      Community Bankers Council. Mr. Clift completed a three-year term in 2000 as
      a
      Class A director of the Federal Reserve Bank of Boston. He is a past chairman
      of
      the MBA and a past president of the Independent Community Bankers Association
      of
      Maine. He serves as chairman of the board of directors of Seven Islands Land
      Company, a privately held company that manages one million acres of certified
      forest in Maine. Mr. Clift’s term expires in 2007.





**Joseph
      H. Cyr** ,
      66, **** has
      served as a Director of the Company and the Bank since 1992. He has been the
      owner of John T. Cyr & Sons, Inc., Old Town, Maine, a privately held charter
      bus service, since 1967. Mr. Cyr has been involved in that business since 1962.
      He was formerly a director of Norstar Bank in Bangor. He has been active in
      a
      number of civic and charitable organizations including: trustee of Husson
      College and St. Joseph Hospital and president of the Bangor Area Chamber of
      Commerce. He is a former director of Bangor Hydro-Electric Company and the
      Maine
      Community Foundation. Mr. Cyr’s term expires in 2009.


**John
      R. Graham, III** ,
      69, has
      served as a director of the Bank since its inception in 1992. Mr. Graham is
      the
      president of Automatic Distributors, Inc. in Bangor, a wholesale and retail
      distribution company he has
      owned and operated for over thirty years. He has also been involved in real
      estate development in the Bangor area for many years. Mr. Graham’s term expires
      in 2009.




37




**Perry
      B. Hansen** ,
      59, has
      been a Director of the Company and the Bank since 1992. He is chairman of THE
      National Bank, Bettendorf, Iowa and a director of its bank holding company,
      National Bancshares, Inc. Mr. Hansen’s thirty-seven years of banking experience
      includes management of two other banks in the Quad City area. Presently he
      is
      also an investor, holding senior management positions in several privately
      held
      companies. Mr. Hansen’s term expires in 2008.




**William
      P. Lucy** ,
      age 48,
      has served as President of the Company and Bank since April 2004, as Executive
      Vice President of the Bank since December 1999, and as Senior Loan Officer
      of
      the Bank since 1992. Mr. Lucy began his banking career at The Merrill Trust
      Company in 1981, and he has both commercial lending and branch administration
      experience. He is a graduate of the University of Maine and Williams College
      School of Banking. Mr. Lucy serves on the board of directors of the Penobscot
      Community Healthcare, New Hope Hospice, Action Committee of 50 and M & J
      Company, a subsidiary of St. Joseph Healthcare Foundation. In addition, he
      is a
      trustee of the YMCA Foundation and he formerly served as chairman of the United
      Way Campaign. Mr. Lucy’s term expires in 2009.




**Frederick
      A. Oldenburg, Jr., M.D.** ,
      59, has
      served as a Director of the Company since 1999 and a Director of the Bank since
      1996. He has been a practicing physician since 1973 and a director of Penobscot
      Respiratory, P.A. He was head of Respiratory Care at St. Joseph Hospital in
      Bangor from 1993 to 2003. He is a graduate of Dartmouth College and Case Western
      Reserve University Medical School. Dr. Oldenburg is past president of the
      National Association for the Medical Direction of Respiratory Care. He also
      has
      been involved in real estate development in Bangor and Brooksville, Maine.
      Dr.
      Oldenburg’s term expires in 2008.




**Michael
      T. Shea** ,
      57, has
      served as a director of the Bank since 2004. Mr. Shea is the president and
      chief
      executive officer of Webber Energy Fuels of Bangor, a position he has held
      since
      2000. He also serves as a director
      of the Webber board. Prior to assuming his current responsibilities, he had
      been
      with the company for four years and his career in the petroleum business spans
      over thirty years. He is a member of the Board of Governors of the New England
      Fuel Institute, serves as the vice chair of the board of trustees of St. Joseph
      College, his alma mater, and he recently completed a term as chairman of the
      board of United Way of Eastern Maine.




**Dennis
      L. Shubert, M.D., Ph.D.** ,
      59, **** has
      served as a Director of the Company since May 1998 and a Director of the Bank
      since 1992. He is a neurosurgeon and past president of Maine Neurosurgery of
      Bangor and Portland, Maine. Dr. Shubert is a Bangor native who graduated from
      Tufts University, received an M.D. from George Washington University, a Ph.D.
      from the University of Minnesota, and a M.S. in Health Care Management from
      Harvard. He serves as executive director of Maine Quality Forum and served
      as a
      director of Eastern Maine Healthcare. Dr. Shubert has been active in a number
      of
      professional organizations including: president of the Penobscot County Medical
      Association and president of the Maine Neurosurgical Society. Dr. Shubert’s term
      expires in 2008.




**Executive
      Officers**




The
      following individuals are executive officers of the Company and the Bank and
      hold the offices set forth below opposite their names.




**Position
                Held**Edwin N. Clift
            Chairman and Chief Executive Officer
              of the
              Company and BankWilliam P. Lucy
            President of the Company and
              BankDeborah A. Jordan
            Secretary/Treasurer of the Company
              andExecutive Vice President/Treasurer of
              the
              Bank


38


The
      Board
      of Directors elects the executive officers of the Company and the Bank annually.
      The elected officers hold office until their respective successors have been
      elected and qualified, or until death, resignation or removal by the Board
      of
      Directors.




Biographical
      information of the executive officer who is not a director of the Company,
      is
      set forth below.





**Deborah
      A. Jordan** ,
      age 41,
      has served as Executive Vice President since December 1999, and as Chief
      Financial Officer of the Bank and Treasurer of the Company since 1993. From
      1987
      to 1992, she was employed as an audit manager at Arthur Andersen, LLP in Boston.
      She is a graduate of Husson College, Eastern Maine Technical College and is
      a
      Certified Public Accountant. Ms. Jordan serves as a director of Eastern Maine
      Community College Foundation.





**Audit
      Committee**




The
      Company’s Audit Committee is comprised of Directors Shubert (Chair), Shea and
      Hansen, each of whom is independent, as defined under The Nasdaq Stock Market
      listing standards. The Board of Directors has determined that Perry B. Hansen
      qualifies as an Audit Committee Financial Expert, as the term is defined by
      SEC
      regulations and in satisfaction of The Nasdaq Stock Market listing standards.
      The Audit Committee met nine times during 2006. The Audit Committee meets the
      requirements of Section 3(a)(58)(A) of the Securities Exchange Act of 1934,
      as
      amended, and operates under a written charter adopted by the Board of Directors
      of the Company and attached as an appendix to the proxy statement for the 2004
      Annual Meeting and filed with the SEC on March 18, 2004.




The
      Audit
      Committee of the Board of Directors of the Company serves as the representative
      of the Board by overseeing the audit coverage and monitoring the accounting,
      financial reporting, data processing, regulatory and internal control
      environments. The primary duties and responsibilities of the Audit Committee
      are
      to: (1) serve as an independent and objective party to monitor the Company’s
      financial reporting process and internal control systems; (2) select and monitor
      the independent registered public accountants; (3) pre-approve all audit and
      permissible non-audit services performed by the independent registered public
      accountants; (4) review and appraise the audit efforts of the Company’s
      independent registered public accountants and internal audit department; (5)
      review the Company’s quarterly financial performance, as well as its compliance
      with laws and regulations; (6) oversee management’s establishment and
      enforcement of financial policies; (7) provide an open avenue of communication
      among the independent registered public accountants, financial and senior
      management, the internal audit department, and the Board; and (8) establish
      procedures for the receipt, retention and treatment of complaints or concerns,
      including confidential employee submissions, about accounting, internal
      accounting controls or auditing matters. The Company’s independent registered
      public accounting firm, Berry, Dunn, McNeil & Parker, is responsible for
      expressing an opinion on the fairness of presentation of the Company’s audited
      financial statements in accordance with generally accepted accounting
      principles.





**Section
      16(a) Beneficial Ownership Reporting Compliance**




Section
      16(a) of the Securities Exchange Act of 1934 requires that the Company’s
      directors, executive officers, and any person holding more than ten percent
      of
      the Company’s common stock file with the SEC reports of their ownership and
      changes in ownership of the Company’s securities. The Company believes that
      during 2006, its directors, executive officers and 10% shareholders complied
      with all Section 16(a) filing requirements. In making this statement, the
      Company has relied upon examination of the copies of Forms 3, 4 and 5 provided
      to the Company and the representations of its directors, executive officers
      and
      10% shareholders.


**Code
      of Ethics**





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.




39





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**





**Compensation
      Discussion and Analysis**




*Compensation
      Objectives.* The
      overall goals of the Company are to attract, motivate, retain, and pay key
      executives for performance. The methods used to achieve these goals are strongly
      influenced by the compensation and employment practices of the Company’s
      competitors within the financial services industry for executive talent. Other
      considerations included each executive officer’s individual performance as well
      as the encouragement of behaviors directed towards attainment of corporate
      goals
      and performance, not all of which are financial in nature or capable of being
      quantified.





*Decision-Making
      and Policy-Making.* ****** Our
      by-laws require that executive officer compensation be set by the Board of
      Directors or a board committee to which decision-making authority has been
      delegated. As a Nasdaq Stock Market listed company, we must observe governance
      standards that require executive officer compensation decisions to be made
      by
      the independent director members of our board or by a committee of independent
      directors. Consistent with these requirements, our Board of Directors has
      established a Compensation Committee all of whose members are independent
      directors.




The
      Compensation Committee has been delegated authority from our board to oversee
      executive compensation by approving salary increases and by reviewing general
      personnel matters such as staff performance evaluations. The Compensation
      Committee has established a compensation program but does not have a formal
      charter. The compensation program consists of three components: (1) base salary;
      (2) bonuses; and (3) long-term incentives (e.g., deferred compensation and
      fringe benefits).




The
      Compensation Committee meets at least twice a year. It considers the
      expectations of the Chief Executive Officer with respect to their own
      compensation and their recommendations with respect to the compensation of
      more
      junior executive officers, as well as empirical data and the recommendations
      of
      advisors. The Compensation Committee does not delegate it duties to
      others.




*Use
      of Outside Advisors and Survey Data* .
      The
      Compensation Committee uses its own criteria coupled with an independent
      compensation consultant salary survey of executive officer positions of similar
      financial institutions located in New England to establish base salaries. In
      addition, the Financial Institutions Compensation Survey (survey of forty-three
      financial service providers in Maine, New Hampshire and Vermont), compiled
      by
      the certified public accountants and management consulting firm of Berry, Dunn,
      McNeil & Parker, is utilized to measure salaries at the officer
      level.




**Elements
      of Compensation**




Compensation
      is broken out into the following components:





***Base
      Salary*** .
      Base
      salaries for our executives are established based on each individual’s job
      responsibilities and contribution to the Company, while taking into account
      total compensation levels at other companies for similar positions. Generally,
      we believe that executive base salaries should be targeted near the median
      of
      the range of salaries while providing higher bonuses based on the performance
      of
      the Company and the individual. Base salaries are reviewed
      annually.


40


***Bonuses*** .
      The
      Short-Term Incentive Program is the annual cash incentive awards, made for
      attaining specific fiscal targets (return on equity, growth goals and efficiency
      ratio), as determined by the Compensation Committee, and accomplishing
      predetermined personal objectives by participants. Executive officers are
      eligible to receive up to 50% of annual salary, provided Company financial
      targets and individual performance objectives are achieved.





***Long-Term
      Incentives.*** The
      Company provides a non-qualified supplemental executive retirement plan (the
      “SERP”) for the benefit of key employees which provides a benefit payment upon
      retirement which is indexed to the financial performance of insurance policies
      owned by the Bank over the Bank’s cost of funds expense. The Company has
      provided these SERPs in order to offer competitive total compensation to its
      key
      employees with this total compensation coming at a reasonable cost as it is
      based upon the performance of underlying insurance policies after reduction
      by
      the Bank’s cost of funds expense.





In
      December 2006, the Company established the Officers’ Deferred Compensation Plan
      of Merrill Merchants Bancshares, Inc. which permits certain executive officers
      to make an annual election to defer receipt of all or a portion of his or her
      cash compensation received from the Company and the Bank with the deferred
      amounts credited with interest at an annual rate equal to the rate on one-year
      Treasury instruments for that year or according to the investment return of
      other assets as may be selected by the Board of Directors. This plan was
      implemented in order to provide a competitive compensation package to its
      executive officers by providing the executives the opportunity to defer taxation
      on amounts otherwise payable to them in order to assist such executives’ ability
      to save for retirement.





**Compensation
      Committee Interlocks and Insider Participation**





The
      Compensation Committee consists of Directors Hansen (Chair), Cyr, Oldenburg,
      Shea, and Shubert. No member of the Compensation Committee was an officer or
      employee of the Company or the Bank during 2006 or was formerly an officer
      of
      the Company or the Bank. In addition, no executive officer of the Company served
      as a member of another entity’s Board of Directors or as a member of the
      Compensation Committee of another entity (or other board committee performing
      equivalent functions) during 2006, which entity had an executive officer serving
      on the Board of Directors of the Company or the Bank.





**Compensation
      Committee Report**





The
      Compensation Committee has reviewed the Compensation Discussion and Analysis
      included in this proxy statement and has discussed it with management. Based
      on
      such review and discussion, the Compensation Committee recommended to the Board
      of Directors that the Compensation Discussion and Analysis be included in this
      proxy statement.




*Perry
      B. Hansen, Chair*


*Joseph
      H. Cyr*


*Frederick
      A. Oldenburg, Jr., M.D.*


*Michael
      T. Shea*


*Dennis
      L. Shubert, M.D., Ph.D.*


41


**Executive
      Compensation**





The
      table
      below sets forth for 2006 the compensation of each of our named executive
      officers.




**SUMMARY
      COMPENSATION TABLE**




**Name
                and Principal Positions**
            
            **Year**
            
            **Salary****(1)**
              **($)**
            
            **Bonus****(1)**
              **($)**
            
            **Change
                in Pension Value and Nonqualified Deferred Compensation
                Earnings****(2)******
              **($)**
            
            **All
                Other Compensation**
              **(3)
                (4)******
              **($)**
            
            **Total**
              **($)**Edwin N.
              Clift,Chairman,
                and Chief Executive Officer
            
            
            2006
            
            $
            200,000
            
            $
            110,000
            
            $
            -
            
            $
            14,840
            
            $
            324,840Deborah
              A. Jordan,Executive
                Vice President (Principal Financial Officer)
            
            
            2006
            
            
            127,500
            
            
            45,000
            
            
            10,220
            
            
            15,157
            
            
            197,877William
                P. Lucy,President
            
            
            2006
            
            
            156,000
            
            
            50,000
            
            
            5,188
            
            
            13,393
            
            
            224,581




(1)
            The
                figures shown for salary and bonus represent amounts earned for the
                fiscal
                year, whether or not actually paid during such year, and include
                amounts
                deferred pursuant to non-incentive deferred compensation plans.


(2)
            Includes
                for each named executive officer the increase (if any) for the fiscal
                year
                in the present value of the individual’s accrued benefit (whether not
                vested) under each non-qualified actuarial or defined benefit plan
                calculated by comparing the present value of each individual’s accrued
                benefit under each such plan in accordance with Statement of Financial
                Accounting Standards 87 (“FAS 87”) as of the plan’s measurement date in
                such fiscal year to the present value of the individual’s accrued benefit
                as of the plan’s measurement date in the prior fiscal
                year.


(3)
            The
                named executive officers participate in certain group life, health,
                disability insurance and medical reimbursement plans, not disclosed
                in the
                Summary Compensation Table, that are generally available to salaried
                employees and do not discriminate in scope, terms and operation.
                Totals
                for 2006 in this column are comprised of: (a) employer contributions
                to
                the 401(k) plan of $7,500 each for Mr. Clift, Ms. Jordan and Mr.
                Lucy; (b)
                dollar value of premiums paid by the Bank with respect to life insurance
                under the Life Insurance Endorsement Method Split-Dollar Plan Agreement
                of
                $1,606 for Mr. Clift, $128 for Ms. Jordan and $139 for Mr. Lucy;
                and (c)
                the value to the officers of a Company-owned vehicle of $5,734 for
                Mr.
                Clift, $7,529 for Ms. Jordan and $5,754 for Mr. Lucy.


(4)
            We
                provide non-cash perquisites that do not exceed $10,000 in the aggregate
                for any individual and are not included in the reported
                figures.




**Compensation
      Plans**





***Supplemental
      Executive Retirement Plans.*** The
      Company provides a non-qualified supplemental executive retirement plan (the
      “SERP”) for the benefit of key employees. Life insurance policies were acquired
      for the purpose of serving as the primary funding source. 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 first year’s
      projected retirement benefit for Mr. Clift is $35,000. Assuming twenty years
      of
      service, the projected retirement benefits for Mr. Lucy and Ms. Jordan are
      $30,000 per year. The SERP provides that in the event of a change of control
      and
      the executive suffers a termination of service, then the executive shall receive
      full retirement benefits upon early retirement age.


42


Under
      the
      split dollar life insurance in place under this plan, the beneficiaries of
      Mr.
      Clift, Mr. Lucy and Ms. Jordan would have received cash payments of
      approximately $524,817, $182,770 and $245,960, respectively, had they died
      on
      December 31, 2006. Similarly, upon a change in control the present value of
      the
      accumulated benefit would increase for Ms. Jordan and Mr. Lucy by approximately
      $147,153 and $177,899, respectively. There would be no increase due to a change
      in control for Mr. Clift because he is fully vested in his SERP.




The
      following table sets forth information regarding SERP benefits accrued by the
      named executive officers during the last fiscal year.




**PENSION
      BENEFITS TABLE**




**Name**
            
            **Plan
                Name**
            
            **Number
                of Years of Credited Service**
              **(#)****(1)**
            
            **Present
                Value of Accumulated Benefit**
              **($)****(1)**
            
            **Payments
                During Last Fiscal Year**
              **($)**Edwin
                N. Clift
            
            
            SERP
            
            
            14
            
            $
            396,419
            
            $
            -Deborah
                A. Jordan
            
            
            SERP
            
            
            14
            
            
            27,235
            
            
            -William
                P. Lucy
            
            
            SERP
            
            
            14
            
            
            31,286
            
            
            -




(1)
            The
                figures shown are determined as of the plan's measurement date during
                2006
                under FAS 87 for purposes of the Company's audited financial statements
                using the assumptions stated therein.





**Employment
      Agreements**





The
      Company currently has an employment agreement with Mr. Bullock. This agreement
      provides for the payment of an annual salary of $24,000 through April 2007
      and a
      $24,000 annual payment thereafter for the remainder of Mr. Bullock’s life or his
      spouse, whichever survives.





The
      agreement also provides that, to the extent not inconsistent with applicable
      federal, state or local law (including common law), or with the Articles of
      Incorporation or Bylaws of the Company and the Bank, and to the extent that
      Mr.
      Bullock is not in material breach of the agreement, the Company will provide
      for
      representation on or will recommend nomination for election to the Board of
      Directors of the Company and the Bank for Mr. Bullock, another designee of
      the
      Bullock Family Trust (the “Trust”) or a member of Mr. Bullock’s immediate
      family, so long as the Trust and/or Mr. Bullock’s immediate family owns more
      than 3% of the common stock of the Company. In addition, Mr. Bullock will
      receive a lump sum payment under the agreement of $48,000 upon a change in
      control.





The
      Bank
      has also entered into employment agreements with each of Edwin N. Clift, William
      P. Lucy and Deborah A. Jordan to secure their services to the Bank in their
      current positions. The employment agreements may be renewed annually after
      a
      review of each executive's performance. These agreements provide for a minimum
      annual salary of $200,000, $162,300 and $132,600 to be paid to Mr. Clift, Mr.
      Lucy and Ms. Jordan, respectively. The employment agreements also provide for
      discretionary cash bonuses and participation on generally applicable terms
      and
      conditions in other compensation and fringe benefit plans. The Bank may
      terminate each executive's employment, and each executive may resign, at any
      time with or without cause. However, in the event of termination during the
      term
      without cause, the Bank will owe the executive severance benefits generally
      equal to the value of the salary that the executive would have received if
      he or
      she had continued working for the remaining unexpired term of the agreement
      plus
      continued insurance benefits for the remaining unexpired term of the agreement.
      The same severance benefits would be payable if an executive resigns during
      the
      term following a material breach of contract by the Bank which is not cured
      within 30 days. For 90 days after a change in control, each executive may also
      resign for any reason and collect severance benefits as if he or she had been
      discharged without cause calculated as if the remaining unexpired term of the
      agreement is two years. If a termination event had occurred on December 31,
      2006
      (whether due to change in control or termination by the Company without cause),
      Mr. Clift, Mr. Lucy and Ms. Jordan would have received cash severance of
      approximately $400,000, $312,000 and $255,000, respectively, and would be been
      provided with insurance coverage for a maximum of two years on the same basis
      as
      currently provided which is estimated to have a present value of approximately
      $19,230, $16,961 and $16,439 (using applicable IRS discount
      rates).


43


If
      the
      Company or the Bank experiences a change in ownership, a change in effective
      ownership or control or a change in the ownership of a substantial portion
      of
      their assets as contemplated by section 280G of the Internal Revenue Code
      ("Section 280G"), the severance payments under the employment agreements will
      be
      capped at 2.99 multiplied by each executive's respective "base amount" as such
      term is defined in Section 280G such that no amount might constitute an "excess
      parachute payment" under current federal tax laws. The effect of this provision
      is that deductions for payments made under the employment agreements to Mr.
      Clift, Mr. Lucy and Ms. Jordan will not be disallowed due to Section
      280G.




***Officers’
      Deferred Compensation Plan*** **.** The
      Company has established the Officers’ Deferred Compensation Plan of Merrill
      Merchants Bancshares, Inc. for the benefit of certain executive officers. Under
      the Officers’ Deferred Compensation Plan, each participant may make an annual
      election to defer receipt of all or a portion of his or her cash compensation
      received from the Company and the Bank. The deferred amounts are allocated
      to a
      deferral account and credited with interest at an annual rate equal to the
      rate
      on one-year Treasury instruments for that year or according to the investment
      return of other assets as may be selected by the Board of Directors. As of
      December 31, 2006, no amounts had been deferred into, or earned under, this
      plan.





The
      Deferred Compensation Plan is an unfunded, non-qualified plan that provides
      for
      distribution of the amounts deferred to participants or their designated
      beneficiaries upon the occurrence of certain events such as death, retirement,
      disability or termination of employment (as those terms are defined in the
      Deferred Compensation Plan).




**Director
      Compensation**





Each
      non-employee director of the Company receives the following fees:





·
            Directors
                of the Bank receive an annual retainer fee of
                $3,000.


·
            Directors
                of the Bank receive $500 per meeting for their attendance at monthly
                and
                any special meetings of the Board of
                Directors.


·
            Directors
                of the Company receive $200 per meeting for their attendance at monthly
                and any special meetings of the Board of Directors and any committee
                meeting held on the same day as the Board of Directors’
                meetings.


·
            Committee
                members also receive $300 for each committee meeting that is not
                held on
                the same day as the Board of Directors
                meetings.


·
            Chairs
                of the Compensation Committee and Audit Committee each receive an
                annual
                retainer of $5,000.





Non-employee
      directors may elect to have the payment of their directors’ fees deferred
      pursuant to the Directors’ Deferred Compensation Plan.




***Directors’
      Deferred Compensation Plan*** **.** The
      Company has established the Directors’ Deferred Compensation Plan of Merrill
      Merchants Bancshares, Inc. for the benefit of non-employee directors. Under
      the
      Deferred Compensation Plan, each non-employee director may make an annual
      election to defer receipt of all or a portion of his or her director fees
      received from the Company and the Bank. The deferred amounts are allocated
      to a
      deferral account and credited with interest at an annual rate equal to the
      rate
      on ten-year Treasury instruments for that year or according to the investment return of other assets
      as may be selected by the Board of Directors.




44




The
      Deferred Compensation Plan is an unfunded, non-qualified plan that provides
      for
      distribution of the amounts deferred to participants or their designated
      beneficiaries upon the occurrence of certain events such as death, retirement,
      disability or termination of employment (as those terms are defined in the
      Deferred Compensation Plan).




Total
      directors’ meeting and committee fees for fiscal 2006 were $92,800. We do not
      compensate our employees for service as directors. Directors are also entitled
      to the protection of certain indemnification provisions in our Articles of
      Incorporation and Bylaws.




The
      following table sets forth information regarding compensation earned by
      directors of the Company during the last fiscal year.




**Name**
            
            **Fees
                Earned**
              **or
                Paid in Cash**
              **($)****(1)**
            
            **Change
                in Pension Value**
              **($)****(2)**
            
            **All
                Other Compensation**
              **($)****(3)**
            
            **Total**
              **($)**William
                C. Bullock, Jr.
            
            $
            -
            
            $
            103,206
            
            $
            -
            
            $
            103,206Joseph
                H. Cyr
            
            
            15,500
            
            
            -
            
            
            2,759
            
            
            18,259John
                R. Graham III
            
            
            12,300
            
            
            -
            
            
            2,722
            
            
            15,022Perry
                B. Hansen
            
            
            16,800
            
            
            -
            
            
            -
            
            
            16,800Frederick
                A. Oldenburg, Jr., M.D.
            
            
            12,450
            
            
            -
            
            
            2,436
            
            
            14,886Michael
                T. Shea
            
            
            11,650
            
            
            -
            
            
            510
            
            
            12,160Dennis
                L. Shubert, M.D., Ph.D.
            
            
            20,250
            
            
            -
            
            
            1,141
            
            
            21,391Retired
                Director
            
            
            3,850
            
            
            -
            
            
            -
            
            
            3,850




(1)
            Includes
                retainer payments, meeting fees, and committee and/or chairmanship
                fees
                earned during the fiscal year, whether such fees were paid currently
                or
                deferred.


(2)
            Includes
                for each individual the increase for the fiscal year in the present
                value
                of the individual's accrued benefit under each non-qualified actuarial
                or
                defined benefit plan calculated by comparing the present value of
                each
                individual's accrued benefit under each such plan in accordance with
                Statement of Financial Accounting Standards 87 ("FAS 87") as of the
                plan's
                measurement date in such fiscal year to the present value of the
                individual's accrued benefit as of the plan's measurement date in
                the
                prior fiscal year.


(3)
            The
                figure shown for each named individual represents the interest credited
                in
                2006 to the deferred directors’ compensation balance at the ten-year
                Treasury rate.


45


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





*Security
      Ownership of Certain Beneficial Owners and Management* . The
      following table shows the amount of Merrill Merchants Bancshares, Inc. common
      stock beneficially owned by each person or entity (or group of affiliated
      persons or entities) known by management to beneficially own more than five
      percent of the outstanding common stock of the Company, the Company's directors,
      the executive officers named in the Summary Compensation Table and the directors
      and executive officers as a group. For purposes of the table below, in
      accordance with Rule 13(d)(3) of the Securities Exchange Act of 1934, as
      amended, a person is deemed to be the beneficial owner, for purposes of any
      shares of common stock: (1) over which he or she has or shares, directly or
      indirectly, voting or investment power; or (2) of which he or she has the right
      to acquire beneficial ownership at any time within 60 days after December 31,
      2006. As used in this proxy statement, "voting power" is the power to vote
      or
      direct the voting of shares, and "investment power" includes the power to
      dispose or direct the disposition of shares.





**Shares
                Beneficially Owned****As
                of December 31, 2006 (1****)****Name
                of Beneficial Owner**
            
            **Amount**
            
            
            **Percent**Directors
                and Executive Officers:The
                Bullock Family Trust
            
            
            214,055
            
            (2
            )
            
            6.03
            %William
                C. Bullock, Jr.
            
            
            -
            
            (2
            )
            
            6.03
            %Edwin
                N. Clift
            
            
            71,966
            
            
            
            
            2.03
            %Joseph
                H. Cyr
            
            
            175,753
            
            (3
            )
            
            4.95
            %John
                R. Graham
            
            
            64,599
            
            (4
            )
            
            1.82
            %Perry
                B. Hansen
            
            
            367,054
            
            (5
            )
            
            10.34
            %Deborah
                A. Jordan
            
            
            20,919
            
            (6
            )
            
            0.59
            %William
                P. Lucy
            
            
            20,031
            
            (7
            )
            
            0.56
            %Frederick
                A. Oldenburg, Jr., M.D.
            
            
            55,828
            
            (8
            )
            
            1.57
            %Dennis
                L. Shubert, M.D., Ph.D.
            
            
            67,426
            
            (9
            )
            
            1.90
            %All
                current directors and executive officers as a group (9
                persons)
            
            
            1,057,631
            
            
            
            
            29.79
            %




(1)
            Except
                as otherwise noted, each individual in the table above has sole voting
                and
                investment power over the shares listed.


(2)
            Mr.
                Bullock is the trustee of The Bullock Family Trust and as such, has
                voting
                and investment power over the shares held in the Trust. Mr. Bullock
                holds
                no other shares of common stock. Mr. Bullock’s mailing address is 44 Bald
                Hill Reach Road, Orrington, Maine 04474.


(3)
            Includes
                146,644 shares of common stock held jointly with
                spouse.


(4)
            Includes
                2,948 shares of common stock held by spouse and 5,870 shares of common
                stock held by Automatic Distributors,
                Inc.


(5)
            Mr.
                Hansen’s mailing address is P.O. Box 280, Rapids City, Illinois
                61278-0280.


(6)
            Includes
                449 shares of common stock held by
                spouse.


(7)
            Includes
                1,288 shares of common stock held by
                spouse.


(8)
            Includes
                25,006 shares of common stock held under the name Penobscot Respiratory
                PA
                FBO Frederick A. Oldenburg, Jr. and 20,793 shares of common stock
                held by
                spouse.


(9)
            Includes
                34,262 shares of common stock held by spouse. Also includes 4,223
                shares
                of common stock held in the name of Dr. Shubert’s children, of which his
                spouse serves as Trustee.




46




*Equity
      Compensation Plan Information* .
      The
      following table sets forth the aggregate information for the Company’s equity
      compensation plans in effect at December 31, 2006.





**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)
            
            
            43,838
            
            $
            11.17
            
            
            0Equity
                compensation plans not approved by security holders
            
            
            0
            
            
            N/A
            
            
            0Total
            
            
            43,838
            
            $
            11.17
            
            
            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, AND DIRECTOR
      INDEPENDENCE**





**Interests
      in Certain Transactions**




The
      Company’s executive officers, its directors and their associates have had, and
      can be expected to have in the future, financial transactions with the Bank
      in
      the ordinary course of business. All such transactions have been and will be
      made on substantially the same terms, including interest rates and collateral,
      as those prevailing at the time for comparable transactions with others. These
      transactions do not involve more than normal risk of collectibility or present
      other unfavorable features.




**Director
      Independence**




The
      Company has determined that Directors Cyr, Hansen, Oldenburg, Robinson, Shea
      and
      Shubert are independent as defined under The Nasdaq Stock Market listing
      standards. In addition, all members of the Compensation Committee, Nominating
      and Corporate Governance Committee or Audit Committee are independent as defined
      under The Nasdaq Stock Market listing standards.




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





During
      the fiscal year ended December 31, 2006, the Company retained and paid BDMP
      to
      provide audit and other services. The following table displays the aggregate
      fees for professional audit services for the audit of the financial statements
      for the years ended December 31, 2006 and 2005 and fees billed for other
      services during those periods by our independent registered public accountants.




**2006**
            
            **2005**Audit
                fees (1)
            
            $
            58,150
            
            $
            55,525Audit-related
                fees
            
            
            -
            
            
            -Tax
                fees (2)
            
            
            6,300
            
            
            8,290All
                other fees (3)
            
            
            6,435
            
            
            8,150Total
            
            $
            70,885
            
            $
            71,965




47


_______________


(1)
            Audit
                fees consisted of audit work performed in the preparation of financial
                statements as well as work generally only the independent registered
                public accountants can reasonably be expected to provide, such as
                statutory audits.


(2)
            Tax
                fees consisted of assistance with matters related to tax compliance,
                tax
                advice and tax planning. The nature of the services comprising the
                fees
                disclosed under this category are preparation of federal and state
                tax
                returns, review of estimated tax payments and review of tax planning,
                and
                assistance with an Internal Revenue Service
                audit.


(3)
            The
                nature of the services comprising the fees disclosed under this category
                are an employee benefit plan audit and training for the Board of
                Directors
                relative to Section 404 of the Sarbanes-Oxley
                Act.





The
      Audit
      Committee’s pre-approval policies and procedures require the Audit Committee
      Chair to pre-approve all audit and non-audit services, and report such
      pre-approvals to the Audit Committee at its next regularly scheduled meeting.




With
      respect to each of the services described in the table above, pre-approval
      by
      the Audit Committee pursuant to 17 CFR 210.2-01(c)(7)(i)(C) was not waived.




**PART
      IV**





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





(a)  The
      following financial statements are contained on pages F-1 through F-25 of this
      Annual Report on Form 10-K.




Report
                of Independent Registered Public Accounting Firm
            F-1Consolidated
                Statements of Financial Conditionfor
                the Years Ended December 31, 2006 and 2005
            F-2Consolidated
                Statements of Incomefor
                the Years Ended December 31, 2006, 2005, and 2004
            F-3Consolidated
                Statements of Changes in Shareholders’ Equityfor
                the Years Ended December 31, 2006, 2005, and 2004
            F-4Consolidated
                Statements of Cash Flowsfor
                the Years Ended December 31, 2006, 2005, and 2004
            F-5Notes
                to Consolidated Financial Statements
            F-6





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




2.1
            
            Agreement
                and Plan of Merger between Chittenden Corporation and Merrill Merchants
                Bancshares, Inc. dated as of January 18, 2007 (incorporated by reference
                to the Company’s Form 8-K filed on January 19, 2007).3.1
            
            Articles
                of Incorporation of Merrill Merchants Bancshares, Inc. (incorporated
                by
                reference to the Company’s Registration Statement on Form SB-2, File No.
                333-56197).3.2
            
            By-laws
                of Merrill Merchants Bancshares, Inc. (incorporated by reference
                to the
                Company’s Registration Statement on Form SB-2, File No.
                333-56197).4
            
            Specimen
                Stock Certificate of Merrill Merchants Bancshares, Inc. (incorporated
                by
                reference to the Company’s Registration Statement on Form SB-2, File No.
                333-56197).




48




10.1
            
            Operating
                Agreement between the Company and M&M Consulting Limited Liability
                Company (incorporated by reference to the Company’s Registration Statement
                on Form SB-2, File No. 333-56197).10.2
            
            Services
                Agreements between the Company and M&M Consulting Limited Liability
                Company (incorporated by reference to the Company’s Registration Statement
                on Form SB-2, File No. 333-56197).10.3
            
            Amended
                and Restated Employment Agreement with William C. Bullock, Jr.
                (incorporated by reference to the Company’s Form 10-Q for the quarter
                ended March 31, 2004).10.4
            
            Financial
                Services Agreement with Financial Institutions Service Corporation
                (incorporated by reference to the Company’s Registration Statement on Form
                SB-2, File No. 333-56197).10.5
            
            Form
                of Life Insurance Endorsement Method Split Dollar Plan Agreement
                (incorporated by reference to the Company’s Registration Statement on Form
                SB-2, File No. 333-56197).10.7
            
            Form
                of Amended and Restated Executive Supplemental Retirement
                Plan.10.8
            
            Form
                of Mandatory Convertible Debentures (incorporated by reference to
                the
                Company’s Registration Statement on Form SB-2, File No.
                333-56197).10.9
            
            Correspondent
                Trust Services Agreement with Northern Trust Company (incorporated
                by
                reference to the Company’s Registration Statement on Form SB-2, File No.
                333-56197).10.10
            
            Stock
                Option Plan, as amended (incorporated by reference to the Company’s
                Registration Statement on Form SB-2, File No.
                333-56197).10.11
            
            Form
                of Stock Option Agreement (incorporated by reference to the Company’s
                Registration Statement on Form SB-2, File No.
                333-56197).10.12
            
            Not
                used.10.13
            
            Employment
                Agreement between the Company and Edwin N. Clift (incorporated by
                reference to the Company’s Form 10-KSB for the year ended December 31,
                2003).10.14
            
            Employment
                Agreement between the Company and William P. Lucy (incorporated by
                reference to the Company’s Form 10-KSB for the year ended December 31,
                2003).10.15
            
            Employment
                Agreement between the Company and Deborah A. Jordan (incorporated
                by
                reference to the Company’s Form 10-KSB for the year ended December 31,
                2003).10.16
            
            2005
                Directors’ Deferred Compensation Plan (incorporated by reference to the
                Company’s Form 10-Q for the quarter ended March 31,
                2005).10.17
            
            Officers’
                Deferred Compensation Plan (incorporated by reference to the Company’s
                Form 8-K filed on December 22, 2006).14
            
            Code
                of Ethics (incorporated by reference to the Company’s Form 10-KSB for the
                year ended December 31, 2003).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.


49


**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
            
            
            February
              26, 2007*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. CliftEdwin
                N. Clift
            
            
            Director,
                Chairman and Chief Executive Officer (Principal executive
                officer)
            February
                  26, 2007/s/
                Deborah A. Jordan
            
            
            Treasurer
                (Principal financial officer)
            February
                    26, 2007Deborah
              A. Jordan/s/
                William C. Bullock, Jr.
            
            
            Director
            February
                    26, 2007William
              C. Bullock, Jr./s/
              Joseph H. CyrJoseph
                H. Cyr
            
            Director
            February
                  26, 2007/s/
                John R. Graham, III
            
            
            Director
            February
                  26, 2007John
                R. Graham, III/s/
              Perry B. Hansen
            
            
            Director
            February
                  26, 2007Perry
                B. Hansen/s/
                William P. Lucy
            
            
            Director
            February
                  26, 2007William
                P. Lucy/s/
                Frederick A. Oldenburg, Jr., M.D.
            
            
            Director
            February
                  26, 2007Frederick
                A. Oldenburg, Jr., M.D./s/
                Michael T. Shea
            
            
            Director
            February
                  26, 2007Michael
                T. Shea/s/
                Dennis L. Shubert, M.D., Ph.D.
            
            
            Director
            February
                  26, 2007Dennis
                L. Shubert, M.D., Ph.D.


50


**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 Subsidiary as of December 31, 2006 and
      2005, 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, 2006. 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 Subsidiary as of December 31, 2006 and 2005,
      and the consolidated results of their operations and their consolidated cash
      flows for each of the three years in the period ended December 31, 2006, in
      conformity with U.S. generally accepted accounting principles.











/s/Berry,
      Dunn, McNeil & Parker


BERRY
      DUNN MCNEIL & PARKER


Bangor,
      Maine


February
      15, 2007


F-1





**MERRILL
                MERCHANTS BANCSHARES, INC. AND SUBSIDIARY****Consolidated
                Statements of Financial Condition**December
                31,2006
            
            2005(In
                thousands, except number of shares and per share data)**ASSETS**Cash
                and due from banks
            
            $
            10,358
            
            $
            13,785Interest-bearing
                deposits with banks
            
            
            90
            
            
            43Total
                cash and cash equivalents
            
            
            10,448
            
            
            13,828Investment
                securities - available for sale
            
            
            86,504
            
            
            72,489Loans
                held for sale
            
            
            925
            
            
            925Loans
                receivable
            
            
            338,880
            
            
            318,965Less
                allowance for loan losses
            
            
            4,109
            
            
            4,086Net
                loans receivable
            
            
            334,771
            
            
            314,879Properties
                and equipment, net
            
            
            5,181
            
            
            4,863Cash
                surrender value of life insurance
            
            
            4,168
            
            
            4,018Deferred
                income tax benefit
            
            
            1,438
            
            
            1,372Accrued
                income and other assets
            
            
            5,664
            
            
            4,699Total
                assets
            
            $
            449,099
            
            $
            417,073**LIABILITIES
                AND SHAREHOLDERS’ EQUITY**Demand
                deposits
            
            $
            56,372
            
            $
            56,204Savings,
                money market and interest checking deposits
            
            
            149,366
            
            
            151,798Certificates
                of deposit
            
            
            154,184
            
            
            123,412Total
                deposit
            
            
            359,922
            
            
            331,414Securities
                sold under agreements torepurchase
                (term and demand)
            
            
            23,851
            
            
            18,534Other
                borrowed funds
            
            
            21,592
            
            
            28,474Accrued
                expenses and other liabilities
            
            
            5,085
            
            
            4,299Total
                liabilities
            
            
            410,450
            
            
            382,721Commitments
                (Notes 8, 10, 14, 17 and 18)Shareholders’
                equityCommon
                stock, par value $1; authorized 4,000,000 shares, issued andoutstanding
                3,550,410 shares in 2006 and 3,435,851 shares in 2005
            
            
            3,550
            
            
            3,436Capital
                surplus
            
            
            26,681
            
            
            24,188Retained
                earnings
            
            
            8,209
            
            
            6,947Accumulated
                other comprehensive income (loss)Unrealized
                gain (loss) on securities available for sale, net of tax
            
            
            209
            
            
            (167
            )Net
                  unrealized depreciation on derivative instruments marked to market,net of tax
            
            
            -
            
            
            (52
            )Total
                shareholders’ equity
            
            
            38,649
            
            
            34,352Total
                liabilities and shareholders’ equity
            
            $
            449,099
            
            $
            417,073





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


F-2


**MERRILL
                MERCHANTS BANCSHARES, INC. AND SUBSIDIARY****Consolidated
                Statements of Income**Years
                Ended December 31,(In
                thousands, except number of shares and per share data)
            
            2006
            
            2005
            
            2004Interest
                and dividend incomeInterest
                and fees on loans
            
            $
            24,500
            
            $
            20,368
            
            $
            16,609Interest
                on investment securities
            
            
            3,238
            
            
            2,192
            
            
            1,953Dividends
                on investment securities
            
            
            189
            
            
            146
            
            
            118Interest
                on federal funds sold
            
            
            253
            
            
            118
            
            
            28Total
                interest and dividend income
            
            
            28,180
            
            
            22,824
            
            
            18,708Interest
                expenseInterest
                on deposits
            
            
            9,304
            
            
            5,795
            
            
            4,041Interest
                on borrowed funds
            
            
            1,787
            
            
            1,259
            
            
            894Total
                interest expense
            
            
            11,091
            
            
            7,054
            
            
            4,935Net
                interest income
            
            
            17,089
            
            
            15,770
            
            
            13,773Provision
                for loan losses
            
            
            358
            
            
            397
            
            
            348Net
                interest income after provision for loan losses
            
            
            16,731
            
            
            15,373
            
            
            13,425Non-interest
                incomeService
                charges on deposit accounts
            
            
            1,569
            
            
            1,496
            
            
            1,399Other
                service charges and fees
            
            
            873
            
            
            836
            
            
            790Trust
                fees
            
            
            1,763
            
            
            1,567
            
            
            1,382Mortgage
                banking income and gain on credit card loans
            
            
            745
            
            
            751
            
            
            825Net
                gain on investment securities
            
            
            37
            
            
            19
            
            
            155Other
            
            
            516
            
            
            537
            
            
            382Total
                non-interest income
            
            
            5,503
            
            
            5,206
            
            
            4,933Non-interest
                expenseSalaries
                and employee benefits
            
            
            7,468
            
            
            6,835
            
            
            6,310Occupancy
                expense
            
            
            1,022
            
            
            959
            
            
            858Equipment
                expense
            
            
            674
            
            
            655
            
            
            606Advertising
                and promotion
            
            
            587
            
            
            634
            
            
            578Data
                processing
            
            
            625
            
            
            611
            
            
            686Professional
                fees
            
            
            531
            
            
            500
            
            
            375Other
            
            
            1,866
            
            
            1,753
            
            
            1,557Total
                non-interest expense
            
            
            12,773
            
            
            11,947
            
            
            10,970Income
                before income taxes
            
            
            9,461
            
            
            8,632
            
            
            7,388Income
                tax expense
            
            
            3,166
            
            
            2,894
            
            
            2,481Net
                income
            
            $
            6,295
            
            $
            5,738
            
            $
            4,907Per
                share dataBasic
                earnings per common share
            
            $
            1.77
            
            $
            1.62
            
            $
            1.37Diluted
                earnings per common share
            
            $
            1.76
            
            $
            1.61
            
            $
            1.36






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


F-3





**MERRILL
                MERCHANTS BANCSHARES, INC. AND SUBSIDIARY****Consolidated
                Statements of Changes in Shareholders’ Equity**(In
                thousands, except number of shares and per share data)
            
            
            
            
            
            AccumulatedOtherCommon
            
            Capital
            
            Retained
            
            Comprehensive
            
            TreasuryStock
            
            Surplus
            
            Earnings
            
            Income
                (Loss)
            
            Stock
            
            TotalBalance
                at December 31, 2003
            
            $
            3,335
            
            $
            21,762
            
            $
            5,305
            
            $
            366
            
            $
            (215
            )
            $
            30,553Net
                income
            
            
            -
            
            
            -
            
            
            4,907
            
            
            -
            
            
            -
            
            
            4,907Unrealized
                  loss on derivative instruments, net of deferred taxes of
                  $7
            
            
            -
            
            
            -
            
            
            -
            
            
            (13
            )
            
            -
            
            
            (13
            )Change
                  in unrealized gain on securities available for sale, 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 an average price of
                  $24.80)
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (1,801
            )
            
            (1,801
            )Treasury
                stock retirement
            
            
            (80
            )
            
            (1,839
            )
            
            -
            
            
            -
            
            
            1,919
            
            
            -Common
                  stock repurchased (17,000 shares at an average 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
            
            $
            -
            
            $
            31,329Net
                income
            
            
            -
            
            
            -
            
            
            5,738
            
            
            -
            
            
            -
            
            
            5,738Unrealized
                  loss on derivative instruments, net of deferred taxes of
                  $20
            
            
            -
            
            
            -
            
            
            -
            
            
            (38
            )
            
            -
            
            
            (38
            )Change
                in unrealized gain on securities available forsale,
                net of deferred income taxes of $189
            
            
            -
            
            
            -
            
            
            -
            
            
            (370
            )
            
            -
            
            
            (370
            )Comprehensive
                income
            
            
            -
            
            
            -
            
            
            5,738
            
            
            (408
            )
            
            -
            
            
            5,330Common
                stock options exercised, 1,005 shares
            
            
            1
            
            
            11
            
            
            -
            
            
            -
            
            
            -
            
            
            12Tax
                benefit related to exercise of stock options
            
            
            -
            
            
            2
            
            
            -
            
            
            -
            
            
            -
            
            
            23%
                common stock dividend declared
            
            
            100
            
            
            2,251
            
            
            (2,355
            )
            
            -
            
            
            -
            
            
            (4
            )Common
                  stock repurchased (5,500 shares at an average price of
                  $21.70)
            
            
            (5
            )
            
            (113
            )
            
            -
            
            
            -
            
            
            -
            
            
            (118
            )Common
                stock cash dividends declared, $.64 per share
            
            
            -
            
            
            -
            
            
            (2,199
            )
            
            -
            
            
            -
            
            
            (2,199
            )Balance
                at December 31, 2005
            
            $
            3,436
            
            $
            24,188
            
            $
            6,947
            
            $
            (219
            )
            $
            -
            
            $
            34,352Net
                income
            
            
            -
            
            
            -
            
            
            6,295
            
            
            -
            
            
            -
            
            
            6,295Change
                in unrealized loss on derivative instruments, net ofdeferred
                taxes of $27
            
            
            -
            
            
            -
            
            
            -
            
            
            52
            
            
            -
            
            
            52Change
                in unrealized gain on securities available forsale,
                net of deferred income taxes of $194
            
            
            -
            
            
            -
            
            
            -
            
            
            376
            
            
            -
            
            
            376Comprehensive
                income
            
            
            -
            
            
            -
            
            
            6,295
            
            
            428
            
            
            -
            
            
            6,723Common
                stock options exercised, 15,287 shares
            
            
            15
            
            
            167
            
            
            -
            
            
            -
            
            
            -
            
            
            182Tax
                benefit related to exercise of stock options
            
            
            -
            
            
            42
            
            
            -
            
            
            -
            
            
            -
            
            
            423%
                common stock dividend declared
            
            
            103
            
            
            2,369
            
            
            (2,478
            )
            
            -
            
            
            -
            
            
            (6
            )Common
                  stock repurchased (3,757 shares at an average price of
                  $23.58)
            
            
            (4
            )
            
            (85
            )
            
            -
            
            
            -
            
            
            -
            
            
            (89
            )Common
                stock cash dividends declared, $.72 per share
            
            
            -
            
            
            -
            
            
            (2,555
            )
            
            -
            
            
            -
            
            
            (2,555
            )Balance
                at December 31, 2006
            
            $
            3,550
            
            $
            26,681
            
            $
            8,209
            
            $
            209
            
            $
            -
            
            $
            38,649






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


F-4





**MERRILL
                MERCHANTS BANCSHARES, INC. AND SUBSIDIARY****Consolidated
                Statements of Cash Flows**Years
                Ended December 31,(In
                thousands)
            
            2006
            
            2005
            
            2004Cash
                flows from operating activitiesNet
                income
            
            $
            6,295
            
            $
            5,738
            
            $
            4,907Adjustments
                to reconcile net income to net cash provided by operating
                activitiesDepreciation
            
            
            444
            
            
            388
            
            
            392Amortization
            
            
            524
            
            
            256
            
            
            523Net
                amortization on investment securities
            
            
            42
            
            
            423
            
            
            800Deferred
                income taxes
            
            
            (287
            )
            
            (83
            )
            
            (129
            )Provision
                for loan losses
            
            
            358
            
            
            397
            
            
            348Net
                gain on sale of loans, credit card portfolio, investmentsecurities
                and property and equipment
            
            
            (664
            )
            
            (124
            )
            
            (150
            )Net
                change in:Loans
                held for sale
            
            
            -
            
            
            (308
            )
            
            172Deferred
                loan fees, net
            
            
            (62
            )
            
            (103
            )
            
            (29
            )Accrued
                income and other assets
            
            
            (626
            )
            
            (1,341
            )
            
            (712
            )Accrued
                expenses and other liabilities
            
            
            621
            
            
            244
            
            
            527Net
                cash provided by operating activities
            
            
            6,645
            
            
            5,487
            
            
            6,649Cash
                flows from investing activitiesNet
                loans made to customers
            
            
            (20,096
            )
            
            (36,808
            )
            
            (36,581
            )Proceeds
                from sale of credit card portfolio
            
            
            -
            
            
            863
            
            
            -Acquisition
                of premises and equipment and computer software
            
            
            (1,079
            )
            
            (1,478
            )
            
            (1,033
            )Purchase
                of investment securities available for sale
            
            
            (63,656
            )
            
            (53,993
            )
            
            (56,511
            )Proceeds
                from sales and maturities of investment securitiesavailable
                for sale
            
            
            50,205
            
            
            46,642
            
            
            65,658Net
                cash used by investing activities
            
            
            (34,626
            )
            
            (44,774
            )
            
            (28,467
            )Cash
                flows from financing activitiesNet
                increase (decrease) in demand, savings and NOW deposits
            
            
            (2,264
            )
            
            13,443
            
            
            28,728Net
                increase in certificates of deposit
            
            
            30,772
            
            
            18,189
            
            
            12,206Net
                increase (decrease) in securities sold underagreements
                to repurchase
            
            
            5,317
            
            
            2,048
            
            
            (3,876
            )Net
                increase (decrease) in other borrowed funds
            
            
            (3,701
            )
            
            4,172
            
            
            (9,553
            )Long-term
                advances from the Federal Home Loan Bank
            
            
            -
            
            
            10,000
            
            
            3,290Payments
                on long-term advances
            
            
            (3,181
            )
            
            (2,736
            )
            
            (5,597
            )Dividends
                paid on common stock
            
            
            (2,477
            )
            
            (2,115
            )
            
            (1,816
            )Repurchase
                of common stock
            
            
            (89
            )
            
            (118
            )
            
            (2,156
            )Proceeds
                from stock issuance
            
            
            224
            
            
            12
            
            
            66Net
                cash provided by financing activities
            
            
            24,601
            
            
            42,895
            
            
            21,292Net
                increase (decrease) in cash and cash equivalents
            
            
            (3,380
            )
            
            3,608
            
            
            (526
            )Cash
                and cash equivalents, beginning of year
            
            
            13,828
            
            
            10,220
            
            
            10,746Cash
                and cash equivalents, end of year
            
            $
            10,448
            
            $
            13,828
            
            $
            10,220Supplemental
                disclosures of cash flow informationCash
                paid for interest
            
            $
            10,872
            
            $
            6,935
            
            $
            4,710Transfers
                to other real estate owned
            
            
            31
            
            
            -
            
            
            -Income
                tax paid
            
            
            3,277
            
            
            3,028
            
            
            2,668






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


F-5


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


**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, mortgage
      servicing rights 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.
      In
      connection with the valuation of mortgage servicing rights, management obtains
      an independent third party valuation.





***Financial
      Statement Presentation***





The
      accompanying consolidated financial statements include the accounts of Merrill
      Merchants Bancshares, Inc. and its wholly-owned subsidiary, Merrill Merchants
      Bank, a state-chartered bank. All intercompany accounts and transactions have
      been eliminated in the consolidated financial statements. The Company accounts
      for its unconsolidated partially-owned entity on the equity method of
      accounting.





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.


F-6


***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.





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




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.


F-7


***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
      amortized using the straight-line method over seven and fifteen years. In
      accordance with SFAS No. 142, goodwill is reviewed for impairment on an annual
      basis and if certain conditions occur.





***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.





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.


F-8


***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.





***Advertising***





Advertising
      is expensed as incurred.





***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 2006, 2005 and 2004. 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***





SFAS
      No.
      156, “Accounting for Servicing of Financial Assets-an Amendment to FASB
      Statement No. 140,” requires all separately recognized servicing assets and
      servicing liabilities to be initially measured at fair value, if practicable.
      Servicing assets and servicing liabilities will subsequently be reported using
      the amortization method or the fair value measurement method. An entity should
      adopt SFAS No. 156 as of the beginning of its first fiscal year that begins
      after September 15, 2006 with earlier application permitted with certain
      restrictions. The initial application of the fair value measurement method
      would
      be reported as a cumulative effect adjustment to beginning retained earnings.
      SFAS No. 156 requires certain disclosures about the basis for measurement and
      regarding risks, activity, and fair value of servicing assets and of servicing
      liabilities. Management does not expect SFAS No. 156 to have a material impact
      on the Company’s financial statements.





The
      Financial Accounting Standards Board (“FASB”) has issued SFAS No. 123
      (revised 2004) (SFAS No. 123(R)), “Share-Based Payment.” SFAS
      No. 123(R), with certain exceptions, requires 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 is based on the fair value of the
      equity or liability instruments issued. The Securities and Exchange Commission
      (“SEC”) has issued Staff Accounting Bulletin (SAB) No. 107, which provides
      guidance regarding the interaction between SFAS No. 123(R) and certain SEC
      rules
      and regulations. The adoption of SFAS No. 123(R) did not have a material effect
      on the Company’s financial statements for the year ended December 31,
      2006.





In
      July
      2006, FASB issued Financial Accounting Standards Interpretation No. 48
      (“FIN 48”), “Accounting for Uncertainty in Income Taxes.” FIN 48 clarifies the
      accounting for uncertainty in income taxes recognized in a company’s financial
      statements in accordance with SFAS No. 109, “Accounting for Income Taxes.”
FIN 48 prescribes a recognition threshold and measurement attribute for the
      financial statement recognition and measurement of a tax position taken or
      expected to be taken in a tax return. FIN 48 also provides guidance on
      derecognition, classification, interest and penalties, accounting in interim
      periods, disclosures and transitions. FIN 48 is effective for fiscal years
      beginning after December 15, 2006. The Company does not expect FIN 48 to
      have a material effect on the financial condition and results of operations
      of
      the Company.


F-9


In
      September 2006, the SEC issued SAB No. 108, “Considering the Effects of Prior
      Year Misstatements when Quantifying Misstatements in Current Year Financial
      Statements.” SAB No. 108 requires registrants to evaluate the materiality of
      unadjusted financial statement misstatements using both the rollover and iron
      curtain methods. The rollover method quantifies a misstatement based on the
      amount of the error originating in the current period statement of income.
      The
      iron curtain method quantifies a misstatement based on the effects of correcting
      the misstatement existing in the statement of financial condition at the end
      of
      the current period, irrespective of the misstatement’s year(s) of origination.
      SAB No. 108 is effective for years ending after November 15, 2006. The
      cumulative effect of the initial application on prior years is required to
      be
      reported as an adjustment to retained earnings at the beginning of the year
      of
      initial application. The adoption of SAB No. 108 did not have a material effect
      on the Company’s financial statements for the year ended December 31,
      2006.





***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,
      2006 and 2005 follow:





**Amortized**
            
            **Unrealized**
            
            **Unrealized**
            
            **Fair****Cost**
            
            **Gains**
            
            **Losses**
            
            **Value********December
                31, 2006**Collateralized
                mortgage obligations
            
            $
            47,379
            
            $
            109
            
            $
            (429
            )
            $
            47,059U.S.
                Government sponsored enterprises
            
            
            16,738
            
            
            22
            
            
            (64
            )
            
            16,696Mortgage-backed
                securities
            
            
            7,097
            
            
            3
            
            
            (80
            )
            
            7,020Certificates
                of deposit
            
            
            8,255
            
            
            -
            
            
            -
            
            
            8,255State
                and local government debt securities
            
            
            3,386
            
            
            11
            
            
            -
            
            
            3,397Total
                debt securities
            
            
            82,855
            
            
            145
            
            
            (573
            )
            
            82,427Equity
                securities
            
            
            3,332
            
            
            745
            
            
            -
            
            
            4,077Total
                securities available for sale
            
            $
            86,187
            
            $
            890
            
            $
            (573
            )
            $
            86,504


F-10





**Amortized**
            
            **Unrealized**
            
            **Unrealized**
            
            **Fair****Cost**
            
            **Gains**
            
            **Losses**
            
            **Value********December
                31, 2005**Collateralized
                mortgage obligations
            
            $
            39,386
            
            $
            -
            
            $
            (628
            )
            $
            38,758U.S.
                Government sponsored enterprises
            
            
            16,417
            
            
            -
            
            
            (168
            )
            
            16,249Mortgage-backed
                securities
            
            
            4,354
            
            
            5
            
            
            (104
            )
            
            4,255U.S.
                Government and agency money market funds
            
            
            1,050
            
            
            -
            
            
            -
            
            
            1,050Certificates
                of deposit
            
            
            4,827
            
            
            -
            
            
            -
            
            
            4,827State
                and local government debt securities
            
            
            2,933
            
            
            -
            
            
            -
            
            
            2,933Total
                debt securities
            
            
            68,967
            
            
            5
            
            
            (900
            )
            
            68,072Equity
                securities
            
            
            3,774
            
            
            643
            
            
            -
            
            
            4,417Total
                securities available for sale
            
            $
            72,741
            
            $
            648
            
            $
            (900
            )
            $
            72,489





Included
      in equity securities are the Company’s investments in Federal Home Loan Bank and
      Federal Reserve Bank stock, carried at their cost basis of $2,061 and $2,493
      at
      December 31, 2006 and 2005, respectively. Management has determined that these
      investments are not impaired at December 31, 2006 and 2005.





During
      2006, 2005 and 2004, the Company sold investment securities available for sale
      for total proceeds of $2,309, $70 and $352, respectively. The sales resulted
      in
      gross realized gains of $67, $19 and $155 for 2006, 2005 and 2004, respectively,
      and gross realized losses of $30 for 2006.





The
      amortized cost and fair value of debt securities at December 31, 2006 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
            
            $
            5,522
            
            $
            5,507Due
                from one to five years
            
            
            20,186
            
            
            20,095Due
                from five to ten years
            
            
            30,019
            
            
            29,796Due
                after ten years
            
            
            27,128
            
            
            27,029Total
                debt securities
            
            $
            82,855
            
            $
            82,427





Management
      reviews securities with unrealized losses for other than temporary impairment.
      At the present time, there have been no material changes in the credit quality
      of these securities. The unrealized losses on the Company’s investments were
      caused by interest rate increases. Because the Company has the ability and
      intent to hold these investments until a recovery of their amortized cost,
      which
      may be at maturity, the Company does not consider these investments to be
      other-than-temporarily impaired at December 31, 2006. Information regarding
      securities temporarily impaired is summarized below:


F-11





**Less
                than 1 year**
            
            **More
                than 1 year**
            
            **Total****Fair**
            
            **Unrealized**
            
            **Fair**
            
            **Unrealized**
            
            **Fair**
            
            **Unrealized****Value**
            
            **Losses**
            
            **Value**
            
            **Losses**
            
            **Value**
            
            **Losses****December
                31, 2006**Collateralized
                mortgage obligations
            
            $
            4,914
            
            $
            (13
            )
            $
            25,328
            
            $
            (416
            )
            $
            30,242
            
            $
            (429
            )U.S.
                  Government sponsoredenterprises
            
            
            2,418
            
            
            (7
            )
            
            8,334
            
            
            (57
            )
            
            10,752
            
            
            (64
            )Mortgage-backed
                securities
            
            
            1,135
            
            
            (14
            )
            
            2,569
            
            
            (66
            )
            
            3,704
            
            
            (80
            )$
            8,467
            
            $
            (34
            )
            $
            36,231
            
            $
            (539
            )
            $
            44,698
            
            $
            (573
            )**Less
                than 1 year**
            
            
            **More
                than 1 year**
            
            
            **Total****Fair**
            
            
            **Unrealized**
            
            
            **Fair**
            
            
            **Unrealized**
            
            
            **Fair**
            
            
            **Unrealized****Value**
            
            
            **Losses**
            
            
            **Value**
            
            
            **Losses**
            
            
            **Value**
            
            
            **Losses****December
                31, 2005**Collateralized
                mortgage obligations
            
            $
            17,715
            
            $
            (236
            )
            $
            20,317
            
            $
            (392
            )
            $
            38,032
            
            $
            (628
            )U.S.
                  Government sponsoredenterprises
            
            
            10,263
            
            
            (95
            )
            
            5,985
            
            
            (73
            )
            
            16,248
            
            
            (168
            )Mortgage-backed
                securities
            
            
            1,448
            
            
            (28
            )
            
            1,726
            
            
            (76
            )
            
            3,174
            
            
            (104
            )$
            29,426
            
            $
            (359
            )
            $
            28,028
            
            $
            (541
            )
            $
            57,454
            
            $
            (900
            )




**4. 
      Derivative Financial Instruments**





The
      Company had interest rate swap agreements with notional amounts of $10,000
      at
      December 31, 2005. The interest rate swap agreements matured in June 2006.
      Under
      these agreements, the Company exchanged 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 were recorded in
      other comprehensive income. As of December 31, 2005, the swaps represented
      a
      liability of $79, less tax of $27, which has been recorded as other
      comprehensive loss 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. At December 31, 2005, the Company had $10,000 (notional principal
      amount) in swap contracts in which the Company was hedging prime-based variable
      commercial loans to a fixed rate of 5.93%.


F-12


**5. 
      Loans Receivable**





The
      components of loans receivable follow:





**2006**
            
            **2005**Real
                estate:Commercial
                real estate
            
            $
            112,852
            
            $
            108,553Residential
                real estate
            
            
            63,691
            
            
            62,568Construction
            
            
            15,758
            
            
            15,345Home
                equity
            
            
            47,370
            
            
            41,469Total
                real estate
            
            
            239,671
            
            
            227,935Commercial
            
            
            72,454
            
            
            69,797Consumer
            
            
            26,691
            
            
            21,231Plus
                deferred loan costs
            
            
            64
            
            
            2Total
            
            $
            338,880
            
            $
            318,965





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 and/or business assets 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, 2006 and 2005, non-accrual loans were $1,226 and $378,
      respectively. Interest foregone was $72, $11, and $47 for 2006, 2005 and 2004,
      respectively. Accruing loans which are 90 days past due or more totaled $115
      at
      December 31, 2006. There were no accruing loans 90 days past due or more at
      December 31, 2005.





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:





**2006**
            
            **2005**
            
            **2004**Impaired
                loansValuation
                allowance required
            
            $
            466
            
            $
            208
            
            $
            -No
                valuation allowance required
            
            
            -
            
            
            -
            
            
            5Total
                impaired loans
            
            $
            466
            
            $
            208
            
            $
            5Average
                balance of impaired loans during the year
            
            $
            298
            
            $
            89
            
            $
            256Portion
                  of allowance for loan losses allocated to the impaired loan
                  balance
            
            $
            211
            
            $
            112
            
            $
            1





Interest
      income recognized for cash payments on impaired loans during 2006, 2005 and
      2004
      was not material to the consolidated financial statements.




F-13





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
      follows:




**2006**
            
            **2005**
            
            **2004**Balance,
                January 1
            
            $
            12,614
            
            $
            15,852
            
            $
            14,500Loans
                made/advanced and additions
            
            
            9,212
            
            
            5,769
            
            
            6,533Repayments
                and reductions
            
            
            (4,570
            )
            
            (9,007
            )
            
            (5,181
            )Balance,
                December 31
            
            $
            17,256
            
            $
            12,614
            
            $
            15,852





Commitments,
      as described in Note 14, to related parties totaled $2,111 and $3,256 at
      December 31, 2006 and 2005, respectively.





**6. 
      Allowance for Loan Losses**





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





**2006**
            
            **2005**
            
            **2004**Balance
                at beginning of year
            
            $
            4,086
            
            $
            3,866
            
            $
            3,652Add:  
                Provision for loan losses
            
            
            358
            
            
            397
            
            
            348Recoveries
                of previous charge-offs
            
            
            54
            
            
            49
            
            
            44Less:  
                Loans charged off
            
            
            (266
            )
            
            (226
            )
            
            (178
            )Transfer
                to liability for unfunded commitments
            
            
            (123
            )
            
            -
            
            
            -Balance
                at end of year
            
            $
            4,109
            
            $
            4,086
            
            $
            3,866





**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, “Accounting for
      Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,”
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:


**2006**
              
              **2005**
              
              **2004**Balance
                  of loans serviced for others
              
              $
              154,817
              
              $
              141,125
              
              $
              122,125Mortgage
                  servicing rightsBalance
                  at beginning of year
              
              $
              1,013
              
              $
              938
              
              $
              792Mortgage
                  servicing rights capitalized
              
              
              630
              
              
              422
              
              
              494Amortization
                  charged against mortgage servicing income
              
              
              (459
              )
              
              (360
              )
              
              (355
              )Valuation
                  adjustment
              
              
              2
              
              
              13
              
              
              7Balance
                  at end of year
              
              $
              1,186
              
              $
              1,013
              
              $
              938Valuation
                  allowanceBalance
                  at beginning of year
              
              $
              (4
              )
              $
              (17
              )
              $
              (24
              )Increase
                  in impairment reserve
              
              
              (3
              )
              
              (48
              )
              
              (15
              )Reduction
                  of impairment reserve
              
              
              5
              
              
              61
              
              
              22Balance
                  at end of year
              
              $
              (2
              )
              $
              (4
              )
              $
              (17
              )
  F-14





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




**8. 
      Properties and Equipment**





A
      summary
      of properties and equipment follows:


**2006**
              
              **2005**Land
                  and land improvements
              
              $
              677
              
              $
              559Bank
                  premises
              
              
              4,214
              
              
              2,893Construction
                  in progress
              
              
              126
              
              
              1,267Furniture
                  and equipment
              
              
              3,162
              
              
              2,982Leasehold
                  improvements
              
              
              455
              
              
              409Total
                  cost
              
              
              8,634
              
              
              8,110Less
                  accumulated depreciation
              
              
              3,453
              
              
              3,247Net
                  properties and equipment
              
              $
              5,181
              
              $
              4,863




Depreciation
      expense amounted to $444, $388 and $392 in 2006, 2005 and 2004,
      respectively.





Construction
      is in progress for a full-service branch facility in Waterville, Maine and
      the
      $1,500 project is targeted for completion in June 2007.





Certain
      Bank facilities and equipment are leased under various operating leases. Rental
      expense was $328, $334 and $348 for 2006, 2005 and 2004, respectively. Future
      minimum rental commitments under non-cancelable leases at December 31, 2006
      follow:


2007
              
              $
              3512008
              
              
              2732009
              
              
              2522010
              
              
              1472011
              
              
              103Thereafter
              
              
              1,095$
              2,221




**9.
      Investment in Partially-Owned Entity**





Merrill
      Merchants Bank has a 50% ownership interest in M&M Consulting Limited
      Liability Company (“M&M”). M&M provides loan review, regulatory
      compliance, training and internal auditing to financial institutions. The
      Company’s investment in M&M as of December 31, 2006 and 2005 totaled $732
      and $502, respectively. Income recognized from such investment for the years
      ended 2006, 2005 and 2004 totaled $230, $187 and $158, respectively, and is
      included in other income.




**10.
      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 $107, $149 and $134 for 2006, 2005 and 2004, 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. 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 $307, $277
      and $247 for 2006, 2005 and 2004, respectively. The cash value of these policies
      was $4,168 and $4,018 at December 31, 2006 and 2005, respectively.




F-15





**11.
      Deposits**





The
      aggregate amount of certificates of deposit with a minimum denomination of
      $100
      was $73,843 and $62,310 at December 31, 2006 and 2005, respectively.
      Certificates of deposit included brokered deposits in the amount of $59,805
      and
      $47,762 at December 31, 2006 and 2005, respectively.





At
      December 31, 2006, the scheduled maturities of certificates of deposit
      follow:


2007
              
              $
              103,4712008
              
              
              25,9752009
              
              
              17,8442010
              
              
              5,7822011
              
              
              1,037Thereafter
              
              
              75$
              154,184




**12.
      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.





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 subsidiary, has an available line of credit with the FHLB of $3,509.





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


**December
                  31, 2006**
              
              **December
                  31, 2005****Maturity**
              
              **Principal**
              
              
              
              
              
              **Maturity**
              
              **Principal****Dates**
              
              **Amounts**
              
              **Interest
                  Rates**
              
              **Dates**
              
              **Amounts**
              
              **Interest
                  Rates**2007
              
              $
              4,795
              
              
              2.31
              %
              
              -6.47%
              
              
              2006
              
              $
              3,181
              
              
              3.38
              %
              
              -6.47%2008
              
              
              6,218
              
              
              3.38
              %
              
              -4.37%
              
              
              2007
              
              
              4,795
              
              
              2.31
              %
              
              -6.47%2009
              
              
              1,056
              
              
              3.38
              %
              
              -4.37%
              
              
              2008
              
              
              6,218
              
              
              3.02
              %
              
              -4.37%2010
              
              
              6,095
              
              
              3.38
              %
              
              -4.37%
              
              
              2009
              
              
              1,056
              
              
              3.38
              %
              
              -4.37%2011
              
              
              368
              
              
              3.38
              %
              
              -4.37%
              
              
              2010
              
              
              6,095
              
              
              3.38
              %
              
              -4.37%Thereafter
              
              
              1,221
              
              
              4.37
              %
              
              
              
              
              Thereafter
              
              
              1,589
              
              
              3.38
              %
              
              -4.37%$
              19,753
              
              
              
              
              
              
              
              
              
              
              $
              22,934


At
      December 31, 2006 and 2005, investment securities with amortized cost of $64,542
      and $62,651 and fair value of $64,116 and $61,755, 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. Balances outstanding at December 31 are shown in the table
      below:


**2006**
              
              **2005**Securities
                  sold under agreements to repurchase
              
              $
              23,851
              
              $
              18,534FHLB
                  overnight borrowings
              
              
              -
              
              
              3,500Treasury,
                  tax and loan deposits
              
              
              1,439
              
              
              2,040Federal
                  funds purchased
              
              
              400
              
              
              -$
              25,690
              
              $
              24,074Average
                  balance outstanding
              
              $
              27,658
              
              $
              19,851Weighted
                  average interest rate at end of the year
              
              
              3.64
              %
              
              2.49
              %
  F-16




At
      December 31, 2006, the Company had a $5,000 commercial bank line of credit
      that
      expires in 2007. The floating rate note is based on the one month London
      Interbank Offer Rate (5.35% at December 31, 2006) plus 1.75%.





**13.
      Income Taxes**





The
      current and deferred components of income tax expense follow:


**2006**
              
              **2005**
              
              **2004**CurrentFederal
              
              $
              3,347
              
              $
              2,892
              
              $
              2,530State
              
              
              106
              
              
              85
              
              
              803,453
              
              
              2,977
              
              
              2,610DeferredFederal
              
              
              (287
              )
              
              (83
              )
              
              (129
              )$
              3,166
              
              $
              2,894
              
              $
              2,481







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:


**2006**
              
              **2005**
              
              **2004**Computed
                  federal tax expense
              
              $
              3,217
              
              $
              2,935
              
              $
              2,512State
                  franchise tax, net of federal benefits
              
              
              70
              
              
              56
              
              
              53Benefit
                  of tax-exempt income
              
              
              (41
              )
              
              (34
              )
              
              (36
              )Increase
                  in cash surrender value of life insurance
              
              
              (51
              )
              
              (56
              )
              
              (43
              )Other,
                  net
              
              
              (29
              )
              
              (7
              )
              
              (5
              )Recorded
                  income tax expense
              
              $
              3,166
              
              $
              2,894
              
              $
              2,481





The
      tax
      effects of temporary differences that give rise to deferred income tax assets
      and liabilities follow:


**2006**
              
              **2005**Deferred
                  income tax assetsAllowance
                  for loan losses
              
              $
              1,205
              
              $
              1,165Accrued
                  post-retirement benefits
              
              
              467
              
              
              369Unrealized
                  loss on securities available for sale
              
              
              -
              
              
              86Other
              
              
              386
              
              
              237Total
                  gross deferred income tax assets
              
              
              2,058
              
              
              1,857Deferred
                  income tax liabilitiesMortgage
                  servicing rights
              
              
              403
              
              
              344Depreciation
                  and amortization
              
              
              109
              
              
              141Unrealized
                  gain on securities available for sale
              
              
              108
              
              
              -Total
                  gross deferred income tax liabilities
              
              
              620
              
              
              485Net
                  deferred income tax asset
              
              $
              1,438
              
              $
              1,372





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.




F-17





**14.
      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 2006, 2005 or
      2004.





A
      summary
      of financial instruments with off-balance sheet risk at December 31, 2006 and
      2005 follows:


**2006**
              
              **2005**Commitments
                  to extend credit
              
              $
              18,177
              
              $
              9,293Letters
                  of credit
              
              
              1,676
              
              
              1,392Unadvanced
                  commitmentsSecured
                  by real estate
              
              
              41,123
              
              
              38,680Commercial
                  lines of credit
              
              
              31,155
              
              
              23,483Consumer
                  lines of credit
              
              
              1,705
              
              
              1,700Commitments
                  to purchase investment securities
              
              
              1,350
              
              
              -Interest
                  rate swaps (notional)
              
              
              -
              
              
              10,000





**15.
      Shareholders’ Equity**





The
      Company distributed a 3% stock dividend in April of 2006 and 2005. Earnings
      per
      share for 2005 and 2004 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 2006, the Company repurchased 3,757 shares at
      a
      total cost of $89. A total of 144,101 shares remain under this program at
      December 31, 2006.





**16.
      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):


**2006**
              
              **2005**
              
              **2004****Basic
                  earnings per share**Net
                  income, as reported
              
              $
              6,295
              
              $
              5,738
              
              $
              4,907Weighted-average
                  shares outstanding
              
              
              3,547,299
              
              
              3,540,365
              
              
              3,576,450Basic
                  earnings per share
              
              $
              1.77
              
              $
              1.62
              
              $
              1.37**Diluted
                  earnings per share**Net
                  income, as reported
              
              $
              6,295
              
              $
              5,738
              
              $
              4,907Weighted-average
                  shares outstanding
              
              
              3,547,299
              
              
              3,540,365
              
              
              3,576,450Effect
                  of stock options, net of assumed stock purchases
              
              
              23,695
              
              
              29,459
              
              
              30,298Adjusted
                  weighted-average shares outstanding
              
              
              3,570,994
              
              
              3,569,824
              
              
              3,606,748Diluted
                  earnings per share
              
              $
              1.76
              
              $
              1.61
              
              $
              1.36





F-18





**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, 2006 that the
      Company and Bank meet all capital adequacy requirements to which they are
      subject.





As
      of
      December 31, 2006, 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, 2006 and 2005. No deduction was made from
      capital for interest-rate risk in 2006 and 2005.


**To
                  be well****capitalized
                  under****For
                  capital**
              
              
              **prompt
                  corrective****Actual**
              
              
              **adequacy
                  purposes**
              
              
              **action
                  provisions****Amount**
              
              **Ratio**
              
              
              **Amount**
              
              **Ratio**
              
              
              **Amount**
              
              **Ratio****As
                  of December 31, 2006**Total
                  capital (to risk-weighted assets)Consolidated
              
              $
              42,453
              
              
              12.58
              %
              
              $
              27,003
              
              
              8.00
              %
              
              
              N/ABank
              
              
              39,623
              
              
              11.79
              
              
              
              26,897
              
              
              8.00
              
              
              $
              33,621
              
              
              10.00
              %Tier
                  1 capital (to risk-weighted assets)Consolidated
              
              
              37,899
              
              
              11.23
              
              
              
              13,502
              
              
              4.00
              
              
              
              N/ABank
              
              
              35,420
              
              
              10.54
              
              
              
              13,448
              
              
              4.00
              
              
              
              20,173
              
              
              6.00Tier
                  1 capital (to average assets)Consolidated
              
              
              37,899
              
              
              8.43
              
              
              
              17,976
              
              
              4.00
              
              
              
              N/ABank
              
              
              35,420
              
              
              7.90
              
              
              
              13,448
              
              
              3.00
              
              
              
              22,413
              
              
              5.00**As
                  of December 31, 2005**Total
                  capital (to risk-weighted assets)Consolidated
              
              $
              38,188
              
              
              12.40
              %
              
              $
              24,629
              
              
              8.00
              %
              
              
              N/ABank
              
              
              36,008
              
              
              11.76
              
              
              
              24,486
              
              
              8.00
              
              
              $
              30,608
              
              
              10.00
              %Tier
                  1 capital (to risk-weighted assets)Consolidated
              
              
              34,048
              
              
              11.06
              
              
              
              12,314
              
              
              4.00
              
              
              
              N/ABank
              
              
              32,179
              
              
              10.51
              
              
              
              12,243
              
              
              4.00
              
              
              
              18,365
              
              
              6.00Tier
                  1 capital (to average assets)Consolidated
              
              
              34,048
              
              
              8.31
              
              
              
              16,396
              
              
              4.00
              
              
              
              N/ABank
              
              
              32,179
              
              
              7.88
              
              
              
              12,257
              
              
              3.00
              
              
              
              20,429
              
              
              5.00




F-19




**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 786,213 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 are subject to an initial
      vesting period of one, two or three years, after which options become
      exercisable until ten years from the grant date.




In
      2006,
      the Company adopted SFAS 123(R). As substantially all options were vested prior
      to 2006, adoption of SFAS 123(R) had no material effect on the financial
      statements. Prior to 2006, the Company accounted 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 2005 and 2004 net income and earnings per share
      would have been reduced to the proforma amounts indicated below.


**Year
                  Ended December 31,****2005**
              
              **2004**Net
                  income, as reported
              
              $
              5,738
              
              $
              4,907Deduct:
                  Total stock-based employee compensation expensedetermined
                  under fair value based method for all awards,net
                  of deferred income taxes
              
              
              (21
              )
              
              (23
              )Proforma
                  net income
              
              $
              5,717
              
              $
              4,884Earnings
                  per share:Basic
                  - as reported
              
              $
              1.62
              
              $
              1.37Basic
                  - proforma
              
              $
              1.61
              
              $
              1.37Diluted
                  - as reported
              
              $
              1.61
              
              $
              1.36Diluted
                  - proforma
              
              $
              1.60
              
              $
              1.36





There
      were no options granted in 2006, 2005 and 2004.





A
      summary
      of the status of the stock option plan as of December 31, 2006, 2005 and 2004,
      and changes during the years then ended, is presented below.


**2006**
                
                
                **2005**
                
                
                **2004****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
                
                
                57,816
                
                $
                11.67
                
                
                60,086
                
                $
                12.13
                
                
                75,107
                
                $
                12.60Exercised
                
                
                (15,287
                )
                
                11.90
                
                
                (1,005
                )
                
                12.22
                
                
                (7,277
                )
                
                9.86Forfeited
                
                
                (225
                )
                
                14.04
                
                
                (3,064
                )
                
                13.88
                
                
                (9,859
                )
                
                15.08Additional
                    shares for whichoptions
                      are exercisable due tostock
                      dividends
                
                
                1,534
                
                
                -
                
                
                1,799
                
                
                -
                
                
                2,115
                
                
                -Outstanding
                    at end of year
                
                
                43,838
                
                $
                11.17
                
                
                57,816
                
                $
                11.67
                
                
                60,086
                
                $
                12.13Options
                    exercisable at year end
                
                
                43,838
                
                $
                11.17
                
                
                54,539
                
                $
                11.52
                
                
                29,441
                
                $
                9.29
  F-20





The
      following information applies to options outstanding at December 31,
      2006:




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$7.33
                  - $ 9.06
              
              
              20,246
              
              
              3.5
              
              $
              8.16
              
              
              20,246
              
              $
              8.16$12.15
                  - $14.04
              
              
              23,592
              
              
              5.9
              
              
              13.75
              
              
              23,592
              
              
              13.75





**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, 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.





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.




F-21





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.





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 properties 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, 2006 and 2005 follows:


**2006**
              
              **2005****Estimate**
              
              
              
              **Estimate****Carrying**
              
              **of
                  Fair**
              
              **Carrying**
              
              **of
                  Fair****Value**
              
              **Value**
              
              **Value**
              
              **Value**Financial
                  AssetsCash
                  and cash equivalents
              
              $
              10,448
              
              $
              10,448
              
              $
              13,828
              
              $
              13,828Investment
                  securities
              
              
              86,504
              
              
              86,504
              
              
              72,489
              
              
              72,489Loans
                  held for sale
              
              
              925
              
              
              927
              
              
              925
              
              
              931Loans
                  receivable, net
              
              
              334,771
              
              
              331,378
              
              
              314,879
              
              
              310,243Cash
                  surrender value of life insurance
              
              
              4,168
              
              
              4,168
              
              
              4,018
              
              
              4,018Accrued
                  interest receivable
              
              
              1,846
              
              
              1,846
              
              
              1,605
              
              
              1,605Capitalized
                  mortgage servicing rights
              
              
              1,186
              
              
              2,090
              
              
              1,013
              
              
              1,463Financial
                  LiabilitiesDeposits
                  (with no stated maturity)
              
              
              205,738
              
              
              205,738
              
              
              208,002
              
              
              208,002Certificates
                  of deposit
              
              
              154,184
              
              
              153,388
              
              
              123,412
              
              
              121,743Accrued
                  interest payable
              
              
              975
              
              
              975
              
              
              756
              
              
              756Borrowed
                  funds
              
              
              45,443
              
              
              44,973
              
              
              47,008
              
              
              46,080Interest
                  rate swaps
              
              
              -
              
              
              -
              
              
              79
              
              
              79


F-22


**20. 
      Parent Company Financial Information**





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




Balance
      Sheet


**December
                  31,****2006**
              
              **2005**AssetsCash
              
              $
              1,643
              
              $
              21Investment
                  securities at fair value
              
              
              2,015
              
              
              2,974Investment
                  in subsidiary
              
              
              35,679
              
              
              32,059Other
                    assets
              
              
              42
              
              
              7Total
                  assets
              
              $
              39,379
              
              $
              35,061Liabilities
                  and shareholders’ equityDividend
                  payable and accrued expenses
              
              $
              730
              
              $
              709Shareholders’
                  equity
              
              
              38,649
              
              
              34,352Total
                  liabilities and shareholders’ equity
              
              $
              39,379
              
              $
              35,061





**Statements
      of Income**


**Years
                  Ended December 31,****2006**
              
              **2005**
              
              **2004**Operating
                  income:Dividends
                  from bank subsidiary
              
              $
              3,069
              
              $
              2,834
              
              $
              1,755Interest
                  and dividend income on investments
              
              
              26
              
              
              25
              
              
              28Net
                  gains on sales of securities
              
              
              67
              
              
              19
              
              
              155Total
                  income
              
              
              3,162
              
              
              2,878
              
              
              1,938Operating
                  expenses:Interest
                  on borrowed funds
              
              
              -
              
              
              1
              
              
              1Other
                  expenses
              
              
              136
              
              
              125
              
              
              132Total
                  operating expenses
              
              
              136
              
              
              126
              
              
              133Income
                  before income tax expense (benefit) and equity in undistributed
                  netincome
                    of subsidiary
              
              
              3,026
              
              
              2,752
              
              
              1,805Income
                  tax expense (benefit)
              
              
              (10
              )
              
              (22
              )
              
              17Income
                  before equity in undistributed net income of subsidiary
              
              
              3,036
              
              
              2,774
              
              
              1,788Equity
                  in undistributed net income of subsidiary
              
              
              3,259
              
              
              2,964
              
              
              3,119Net
                  income
              
              $
              6,295
              
              $
              5,738
              
              $
              4,907


F-23


**Statements
      of Cash Flows**




**Years
                    Ended December 31,****2006**
                
                **2005**
                
                **2004**Cash
                    flows from operating activities:Net
                    income
                
                $
                6,295
                
                $
                5,738
                
                $
                4,907Adjustments
                    to reconcile net income to net cash provided byoperating
                    activities:Undistributed
                    net income from subsidiary
                
                
                (3,259
                )
                
                (2,964
                )
                
                (3,119
                )Net
                    gain on sale of investment securities
                
                
                (67
                )
                
                (19
                )
                
                (155
                )(Increase)
                    decrease in other assets
                
                
                (27
                )
                
                (6
                )
                
                231Increase
                    (decrease) in other liabilities
                
                
                (106
                )
                
                (19
                )
                
                69Net
                    cash provided by operating activities
                
                
                2,836
                
                
                2,730
                
                
                1,933Cash
                    flows from investing activities:Proceeds
                    from sales and maturities of investment securities
                
                
                2,230
                
                
                2,225
                
                
                3,802Purchase
                    of investment securities
                
                
                (1,102
                )
                
                (2,725
                )
                
                (1,825
                )Net
                    cash (used) provided by investing activities
                
                
                1,128
                
                
                (500
                )
                
                1,977Cash
                    flows from financing activities:Proceeds
                    from issuance of common stock
                
                
                224
                
                
                12
                
                
                66Dividends
                    paid
                
                
                (2,477
                )
                
                (2,115
                )
                
                (1,816
                )Repurchase
                    of common stock
                
                
                (89
                )
                
                (118
                )
                
                (2,156
                )Net
                    cash used by financing activities
                
                
                (2,342
                )
                
                (2,221
                )
                
                (3,906
                )Net
                    increase in cash
                
                
                1,622
                
                
                9
                
                
                4Cash,
                    beginning of year
                
                
                21
                
                
                12
                
                
                8Cash,
                    end of year
                
                $
                1,643
                
                $
                21
                
                $
                12
  **21. 
        Selected Quarterly Data (unaudited)**
  **2006**
              
              
              **2005****Fourth**
              
              
              **Third**
              
              
              **Second**
              
              
              **First**
              
              
              **Fourth**
              
              
              **Third**
              
              
              **Second**
              
              
              **First****Quarter**
              
              
              **Quarter**
              
              
              **Quarter**
              
              
              **Quarter**
              
              
              **Quarter**
              
              
              **Quarter**
              
              
              **Quarter**
              
              
              **Quarter**Interest
                  and dividend income
              
              $
              7,501
              
              $
              7,349
              
              $
              6,909
              
              $
              6,421
              
              $
              6,311
              
              $
              5,951
              
              $
              5,503
              
              $
              5,059Interest
                  expense
              
              
              3,064
              
              
              2,947
              
              
              2,721
              
              
              2,359
              
              
              2,092
              
              
              1,890
              
              
              1,635
              
              
              1,437Net
                  interest income
              
              
              4,437
              
              
              4,402
              
              
              4,188
              
              
              4,062
              
              
              4,219
              
              
              4,061
              
              
              3,868
              
              
              3,622Provision
                  for loan losses
              
              
              12
              
              
              87
              
              
              131
              
              
              128
              
              
              97
              
              
              106
              
              
              100
              
              
              94Net
                  interest income afterprovision
                  for loan losses
              
              
              4,425
              
              
              4,315
              
              
              4,057
              
              
              3,934
              
              
              4,122
              
              
              3,955
              
              
              3,768
              
              
              3,528Non-interest
                  income
              
              
              1,483
              
              
              1,335
              
              
              1,382
              
              
              1,266
              
              
              1,426
              
              
              1,202
              
              
              1,281
              
              
              1,278Net
                  gain (loss) on securities
              
              
              (31
              )
              
              1
              
              
              36
              
              
              31
              
              
              -
              
              
              -
              
              
              -
              
              
              19Non-interest
                  expense
              
              
              3,240
              
              
              3,169
              
              
              3,194
              
              
              3,170
              
              
              3,086
              
              
              2,950
              
              
              2,992
              
              
              2,919Income
                  before income taxes
              
              
              2,637
              
              
              2,482
              
              
              2,281
              
              
              2,061
              
              
              2,462
              
              
              2,207
              
              
              2,057
              
              
              1,906Income
                  tax expense
              
              
              855
              
              
              835
              
              
              781
              
              
              695
              
              
              808
              
              
              745
              
              
              692
              
              
              649Net
                  income
              
              $
              1,782
              
              $
              1,647
              
              $
              1,500
              
              $
              1,366
              
              $
              1,654
              
              $
              1,462
              
              $
              1,365
              
              $
              1,257Basic
                  earnings per share
              
              $
              0.50
              
              $
              0.46
              
              $
              0.42
              
              $
              0.39
              
              $
              0.47
              
              $
              0.41
              
              $
              0.39
              
              $
              0.35Diluted
                  earnings per share
              
              $
              0.50
              
              $
              0.46
              
              $
              0.42
              
              $
              0.38
              
              $
              0.46
              
              $
              0.41
              
              $
              0.38
              
              $
              0.35


F-24


**22. 
      Subsequent Event**





On
      January 19, 2007, Chittenden Corporation (“Chittenden”) and the Company jointly
      announced the execution of a definitive agreement pursuant to which Chittenden
      will acquire the Company in an exchange of cash and stock. The Bank will operate
      as a separate unit of Chittenden, maintaining its name and senior management
      team. The merger, which was unanimously approved by the boards of directors
      of
      Chittenden and the Company, is expected to close in the second quarter of 2007,
      subject to regulatory and the Company's shareholder approval.





Under
      the
      terms of the agreement, stockholders of the Company will be entitled to receive
      either cash or shares of Chittenden common stock, subject to election and
      allocation procedures which are intended to ensure that, in aggregate, 40%
      of
      the shares of the Company are converted into the right to receive cash of $31.00
      per share, and that 60% are converted into the right to receive a fixed exchange
      of 1.02 shares of Chittenden common stock for each share of the
      Company.


F-25




















MERRILL
      MERCHANTS BANCSHARES, INC.


201
      Main
      Street


Post
      Office Box 925


Bangor,
      Maine 04402-0925


(207)
      942-4800


www.merrillmerchants.com