|UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
|-----------------------------------------------------------------------
|                                                                       
|FORM 10-Q                                                              
|                                                                       
|[X]                                                                    
|                                                                       
|For the quarterly period ended                                         
|                                                                       
|                                                                       
|or                                                                     
|                                                                       

|[   ] | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|----- | ----------------------------------------------------------------------------------------
|     

|For the transition period from |  | to | 
|------------------------------ |  | -- | 
|                               |  |    | 
|                               |  |    | 

|Commission file number: | 0-11595
|----------------------- | -------
|                        |        
|                        |        

|                                                                                                                                                                                                                                                                                                                                                        
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Merchants Bancshares, Inc.                                                                                                                                                                                                                                                                                                                              
|(Exact Name Of Registrant As Specified In Its Charter)                                                                                                                                                                                                                                                                                                  
|                                                                                                                                                                                                                                                                                                                                                        
|Delaware                                                                                                                                                                                                                                                                                                                                                
|                                                                                                                                                                                                                                                                                                                                                        
|(State or other jurisdiction of incorporation or organization)                                                                                                                                                                                                                                                                                          
|                                                                                                                                                                                                                                                                                                                                                        
|275 Kennedy Drive, South Burlington, Vermont                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                        
|(Address Of Principal Executive Offices)                                                                                                                                                                                                                                                                                                                
|                                                                                                                                                                                                                                                                                                                                                        
|802-658-3400                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                        
|(Registrant's Telephone Number, Including Area Code)                                                                                                                                                                                                                                                                                                    
|                                                                                                                                                                                                                                                                                                                                                        
|                                                                                                                                                                                                                                                                                                                                                        
|                                                                                                                                                                                                                                                                                                                                                        
|(Former Name, Former Address And Former Fiscal Year, If Changed Since Last Report)                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                        
|Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
|[X]Yes[]No                                                                                                                                                                                                                                                                                                                                              
|                                                                                                                                                                                                                                                                                                                                                        
|Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a nonaccelerated filer or a smaller reporting company. See the definitions of "large accelerated filer", "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act.                                                       
|                                                                                                                                                                                                                                                                                                                                                        
|Large Accelerated Filer []Accelerated Filer [X]Nonaccelerated Filer []Smaller Reporting Company []                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                        
|Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).                                                                                                                                                                                                                                        
|[]Yes[X]No                                                                                                                                                                                                                                                                                                                                              
|                                                                                                                                                                                                                                                                                                                                                        
|As of July 16, 2008, there were 6,061,570 shares of the registrant's common stock, par value $0.01 per share, outstanding.                                                                                                                                                                                                                              

<PAGE>

|MERCHANTS BANCSHARES, INC.
FORM 10-Q
TABLE OF CONTENTS
|------------------------------------------------------
|                                                      
|PART I - FINANCIAL INFORMATION                        
|                                                      
|Item 1.                                               
|                                                      
|                                                      
|                                                      
|                                                      
|                                                      
|                                                      
|                                                      
|                                                      
|                                                      
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|                                                      
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|                                                      
|                                                      
|Item 2.                                               
|                                                      
|                                                      
|Item 3                                                
|                                                      
|Item 4.                                               
|                                                      
|PART II - OTHER INFORMATION                           
|                                                      
|Item 1.                                               
|                                                      
|Item 1A.                                              
|                                                      
|Item 2.                                               
|                                                      
|Item 3.                                               
|                                                      
|Item 4.                                               
|                                                      
|Item 5.                                               
|                                                      
|Item 6.                                               
|                                                      
|Signatures                                            
|                                                      
|Exhibits                                              

<PAGE>

|MERCHANTS BANCSHARES, INC.
PART I - FINANCIAL INFORMATION               
|------------------------------------------------------------------------
|                                                                        
|ITEM 1. Financial Statements                                            
|                                                                        
|Merchants Bancshares, Inc.
Consolidated Balance Sheets
(unaudited)      
|                                                                        
|(In thousands except share and per share data)                          
|                                                                        
|ASSETS                                                                  
|Cash and cash equivalents                                               
|Federal funds sold and other short-term investments                     
|                                                                        
|Total cash and cash equivalents                                         
|Investments:                                                            
|Securities available for sale, at fair value                            
|Securities held to maturity (fair value of $3,623 and $4,283)           
|                                                                        
|Total investments                                                       
|                                                                        
|Loans                                                                   
|Less: Allowance for loan losses                                         
|                                                                        
|Net loans                                                               
|                                                                        
|Federal Home Loan Bank stock                                            
|Bank premises and equipment, net                                        
|Investment in real estate limited partnerships                          
|Other assets                                                            
|                                                                        
|Total assets                                                            
|                                                                        
|LIABILITIES                                                             
|Deposits:                                                               
|Demand deposits                                                         
|Savings, NOW and money market accounts                                  
|Time deposits $100 thousand and greater                                 
|Other time deposits                                                     
|                                                                        
|Total deposits                                                          
|                                                                        
|Securities sold under agreements to repurchase and other short-term debt
|Securities sold under agreements to repurchase, long-term               
|Other long-term debt                                                    
|Junior subordinated debentures issued to unconsolidated subsidiary trust
|Other liabilities                                                       
|                                                                        
|Total liabilities                                                       
|                                                                        
|Commitments and contingencies (Note 5)                                  
|SHAREHOLDERS' EQUITY                                                    
|Preferred stock Class A non-voting                                      
|Shares authorized - 200,000, none outstanding                           
|Preferred stock Class B voting                                          
|Shares authorized - 1,500,000, none outstanding                         
|Common stock, $.01 par value                                            
|Shares authorized                                                       
|Issued                                                                  
|Outstanding                                                             
|                                                                        
|Capital in excess of par value                                          
|Retained earnings                                                       
|Treasury stock, at cost                                                 
|                                                                        
|                                                                        
|Deferred compensation arrangements                                      
|Accumulated other comprehensive loss                                    
|                                                                        
|Total shareholders' equity                                              
|                                                                        
|Total liabilities and shareholders' equity                              
|                                                                        
|                                                                        

|See accompanying notes to interim consolidated financial statements
|-------------------------------------------------------------------

<PAGE>  1

|Merchants Bancshares, Inc.
Consolidated Statements of Income
(Unaudited)
|------------------------------------------------------------------------
|                                                                        

|                                                                                           | Three Months Ended
June 30, | Six Months Ended
June 30,
|------------------------------------------------------------------------------------------ | --------------------------- | -------------------------
|(In thousands except per share data)                                                       | 2008                        | 2007                     
|                                                                                          
|INTEREST AND DIVIDEND INCOME                                                               |                             |                          
|Interest and fees on loans                                                                 | $11,373                     | $11,744                  
|Investment income:                                                                         |                             |                          
|Interest on debt securities                                                                | 5,462                       | 3,663                    
|Dividends                                                                                  | 56                          | 85                       
|Interest on fed funds sold, short term investments
          and interest bearing deposits | 51                          | 497                      
|                                                                                          
|Total interest and dividend income                                                         | 16,942                      | 15,989                   
|                                                                                          
|INTEREST EXPENSE                                                                           |                             |                          
|Savings, NOW and money market accounts                                                     | 993                         | 1,210                    
|Time deposits $100 thousand and greater                                                    | 1,026                       | 668                      
|Other time deposits                                                                        | 2,359                       | 2,565                    
|Other borrowed funds                                                                       | 415                         | 836                      
|Long-term debt                                                                             | 1,659                       | 1,143                    
|                                                                                          
|Total interest expense                                                                     | 6,452                       | 6,422                    
|                                                                                          
|Net interest income                                                                        | 10,490                      | 9,567                    
|Provision for credit losses                                                                | 50                          | 150                      
|                                                                                          
|Net interest income after provision for credit losses                                      | 10,440                      | 9,417                    
|                                                                                          
|NONINTEREST INCOME                                                                         |                             |                          
|Trust company income                                                                       | 473                         | 472                      
|Service charges on deposits                                                                | 1,356                       | 1,377                    
|Gain/(loss) on investment securities                                                       | --                          | --                       
|Equity in losses of real estate limited partnerships, net                                  | (461)                       | (422)                    
|Other noninterest income                                                                   | 937                         | 914                      
|                                                                                          
|Total noninterest income                                                                   | 2,305                       | 2,341                    
|                                                                                          
|NONINTEREST EXPENSE                                                                        |                             |                          
|Salaries and wages                                                                         | 3,255                       | 2,995                    
|Employee benefits                                                                          | 936                         | 872                      
|Occupancy expense                                                                          | 832                         | 798                      
|Equipment expense                                                                          | 659                         | 716                      
|Legal and professional fees                                                                | 696                         | 589                      
|Marketing                                                                                  | 592                         | 335                      
|State franchise taxes                                                                      | 278                         | 259                      
|Other real estate owned                                                                    | 24                          | 292                      
|Other noninterest expense                                                                  | 1,678                       | 1,385                    
|                                                                                          
|Total noninterest expense                                                                  | 8,950                       | 8,241                    
|                                                                                          
|Income before provision for income taxes                                                   | 3,795                       | 3,517                    
|Provision for income taxes                                                                 | 911                         | 821                      
|                                                                                          
|NET INCOME                                                                                 | $  2,884                    | $  2,696                 
|                                                                                          
|                                                                                           |                             |                          
|Basic earnings per common share                                                            | $    0.48                   | $    0. 44               
|Diluted earnings per common share                                                          | $    0.47                   | $    0.44                

|See accompanying notes to interim consolidated financial statements
|-------------------------------------------------------------------

<PAGE>  2

|Merchants Bancshares, Inc.
Consolidated Statements of Comprehensive Income
(Unaudited)
|--------------------------------------------------------------------------------------
|                                                                                      

|                                                                                                                      | Three Months Ended
June 30, | Six Months Ended
June 30,
|--------------------------------------------------------------------------------------------------------------------- | --------------------------- | -------------------------
|(In thousands)                                                                                                        | 2008                        | 2007                     
|                                                                                                                     
|Net income                                                                                                            | $ 2,884                     | $ 2,696                  
|Other comprehensive income, net of tax:                                                                               |                             |                          
|Change in net unrealized loss on securities available for sale, netof taxes of $(2,490),  $(892), $(1,559) and $(418) | (4,624)                     | (1,657)                  
|Reclassification adjustments for securities (gains)/losses included                                                   |                             |                          
|in net income,net of taxes of $0, $0, $(29) and $13                                                                   | 1                           | --                       
|Amortization of previously recorded benefit plan amount, net
      of taxes of $12, $8, $28 and $32                   | 23                          | 14                       
|                                                                                                                     
|Other comprehensive loss                                                                                              | (4,600)                     | (1,643)                  
|                                                                                                                     
|Comprehensive (loss) income                                                                                           | $(1,716)                    | $ 1,053                  
|                                                                                                                     
|                                                                                                                     

|See accompanying notes to the interim consolidated financial statements.
|------------------------------------------------------------------------

<PAGE>  3

|Merchants Bancshares, Inc.
Consolidated Statements of Cash Flows
(Unaudited)     
|---------------------------------------------------------------------------------
|                                                                                 
|For the six months ended June 30,                                                
|                                                                                 
|(In thousands)                                                                   
|                                                                                 
|CASH FLOWS FROM OPERATING ACTIVITIES:                                            
|Net income                                                                       
|Adjustments to reconcile net income to net cash provided by operating activities:
|Provision for loan losses                                                        
|Depreciation and amortization                                                    
|Stock option expense                                                             
|Net (gains) losses on investment securities                                      
|Net gains on sales of other real estate owned                                    
|Equity in losses of real estate limited partnerships, net                        
|Changes in assets and liabilities:                                               
|(Increase) decrease in interest receivable                                       
|Decrease in other assets                                                         
|Increase  (decrease) in interest payable                                         
|Increase (decrease) in other liabilities                                         
|                                                                                 
|Net cash provided by operating activities                                        
|                                                                                 
|                                                                                 
|CASH FLOWS FROM INVESTING ACTIVITIES:                                            
|Proceeds from sales of investment securities available for sale                  
|Proceeds from maturities of investment securities available for sale             
|Proceeds from maturities of investment securities held to maturity               
|Proceeds from redemption of Federal Home Loan Bank stock                         
|Purchases of investment securities available for sale                            
|Loan originations in excess of principal payments                                
|Purchases of Federal Home Loan Bank stock                                        
|Proceeds from sales of loans, net                                                
|Proceeds from sales of premises and equipment                                    
|Proceeds from sales of other real estate owned                                   
|Real estate limited partnership investments                                      
|Purchases of bank premises and equipment                                         
|                                                                                 
|Net cash (used in) provided by investing activities                              
|                                                                                 
|                                                                                 
|CASH FLOWS FROM FINANCING ACTIVITIES:                                            
|Net increase (decrease) in deposits                                              
|Net increase (decrease) in short-term borrowings                                 
|Proceeds from long-term debt                                                     
|Net decrease in securities sold under agreement to repurchase-short term         
|Net increase in securities sold under agreement to repurchase-long term          
|Principal payments on long-term debt                                             
|Cash dividends paid                                                              
|Purchases of treasury stock                                                      
|Sale of treasury stock                                                           
|Increase in deferred compensation arrangements                                   
|Proceeds from exercise of stock options, net of withholding taxes                
|Tax benefit from exercise of stock options                                       
|                                                                                 
|Net cash provided by (used in) financing activities                              
|                                                                                 
|                                                                                 
|Decrease in cash and cash equivalents                                            
|Cash and cash equivalents beginning of period                                    
|                                                                                 
|Cash and cash equivalents end of period                                          
|                                                                                 
|                                                                                 
|SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:                                
|Total interest payments                                                          
|Total income tax payments                                                        
|SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND                                
|FINANCING ACTIVITIES                                                             
|Distribution of stock under deferred compensation arrangements                   
|Distribution of treasury stock in lieu of cash dividend                          
|Loan related to sale-leaseback transaction                                       
|Deferred gain from sale-leaseback transaction                                    
|                                                                                 
|See accompanying notes to interim consolidated financial statements              

<PAGE>  4

|Notes To Interim Consolidated Financial Statements                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|See Merchants Bancshares, Inc. ("Merchants") 2007 Annual Report on Form 10-K for additional information.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Note 1: Financial Statement Presentation                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Principles of Consolidation                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|The accompanying unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements. All adjustments necessary for a fair presentation of the interim consolidated financial statements of Merchants as of June 30, 2008 and 2007, and for the three and six months ended June 30, 2008 and 2007 have been included. The information was prepared from the unaudited financial statements of Merchants and its subsidiaries, Merchants Bank ("Bank"), Merchants Trust Company, Merchants Properties, Inc. And MBVT Statutory Trust I. Amounts reported for prior periods are reclassified, where necessary, to be consistent with the current period presentation.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Management's Use of Estimates in Preparation of Financial Statements                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of income and expenses during the reporting periods. The most significant estimates include those used in determining the allowance for loan losses, income taxes, and interest income recognition on loans. Operating results in the future may vary from the amounts derived from management's estimates and assumptions.                                                                                                                                                                                                                                                                                                                                                           
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Note 2: Earnings Per Share                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|The following table presents reconciliations of the calculations of basic and diluted earnings per common share for the periods indicated:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       

|                                              | For the
Three Months
Ended June 30, | For the
Six Months
Ended June 30,
|--------------------------------------------- | ----------------------------------- | ---------------------------------
|                                              |                                     |                                  
|                                              | 2008                                | 2007                             
|                                              |                                     |                                  
|(In thousands except per share data)          |                                     |                                  
|Net income                                    | $2,884                              | $2,696                           
|                                              |                                     |                                  
|Weighted average common shares outstanding    | 6,069                               | 6,172                            
|Dilutive effect of common stock equivalents   | 12                                  | 15                               
|                                              |                                     |                                  
|Weighted average common and common equivalent | 6,081                               | 6,187                            
|shares outstanding                            |                                     |                                  
|Basic earnings per common share               | $  0.48                             | $  0.44                          
|Diluted earnings per common share             | $  0.47                             | $  0.44                          
|                                              |                                     |                                  

|Basic earnings per common share were computed by dividing net income by the weighted average number of shares of common stock outstanding for the three and six month periods ended June 30, 2008 and 2007. For the three and six months ended June 30, 2008 and 2007 there were average stock options outstanding of 10,000 and 10,921, respectively that were not included in the calculation of earnings per share because they were anti-dilutive.                                                                                                                                                                                                                                                                   
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|Note 3: Pension                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|Prior to January 1995 Merchants maintained a noncontributory defined benefit pension plan (the "Plan") covering all eligible employees. The Plan was a final average pay plan with benefits based on the average salary rates using the five consecutive Plan years of the last ten years that produce the highest average salary. It was Merchants' policy to fund the cost of benefits expected to accrue during the year plus amortization of any unfunded accrued liability that had accumulated prior to the valuation date based on IRS regulations for funding. During 1995 the Plan was curtailed. Accordingly, all accrued benefits were fully vested and no additional years of service or age will be accrued.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|The following table summarizes the components of net periodic benefit costs for the periods indicated:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   



<PAGE>  5



|                               | Three months ended
June 30, | Six months ended
June 30,
|------------------------------ | --------------------------- | -------------------------
|(In thousands)                 | 2008                        | 2007                     
|                              
|Interest cost                  | $ 115                       | $ 115                    
|Service cost                   | 11                          | 10                       
|Expected return on Plan assets | (147)                       | (134)                    
|Amortization of net loss       | 40                          | 31                       
|                               |                            
|Net periodic benefit cost      | $   19                      | $   22                   
|                               |                            
|                               |                            

|No contributions have been made to the Plan during 2008 to date. Merchants has no required contribution for 2008.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|Note 4: Stock Repurchase Program                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|In January 2007, Merchants' Board approved a stock repurchase program, pursuant to which Merchants may repurchase 200,000 shares of its common stock on the open market from time to time through January 2008. The Board extended the program through January 2009 at its January 2008 meeting. Under the program 114,918 shares have been purchased at an average price per share of $23.06; shares purchased during the three and six months ended June 30, 2008 totaled 16,567 and 55,800 at an average price per share of $23.01 and $23.24, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|Note 5: Commitments and Contingencies                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|Merchants is a party to financial instruments with off balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments primarily include commitments to extend credit and financial guarantees. Such instruments involve, to varying degrees, elements of credit and interest rate risk that are not recognized in the accompanying consolidated balance sheets.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|Merchants does not issue any guarantees that would require liability recognition or disclosure, other than its standby letters of credit. Standby letters of credit are conditional commitments issued by Merchants to guarantee the performance of a customer to a third party. Standby letters of credit generally arise in connection with lending relationships. The credit risk involved in issuing these instruments is essentially the same as that involved in extending loans to customers. Contingent obligations under standby letters of credit totaled approximately $4.97 million at June 30, 2008 and represent the maximum potential future payments Merchants could be required to make. Typically, these instruments have terms of 12 months or less and expire unused; therefore, the total amounts do not necessarily represent future cash requirements. Each customer is evaluated individually for creditworthiness under the same underwriting standards used for commitments to extend credit for on balance sheet instruments. Merchants' policies governing loan collateral apply to standby letters of credit at the time of credit extension. Loan-to-value ratios are generally consistent with loan-to-value requirements for other commercial loans secured by similar types of collateral. The fair value of Merchants' standby letters of credit at June 30, 2008 was insignificant.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|Merchants is involved in routine legal proceedings that occur in the ordinary course of business, which, in the aggregate, are believed by management to be immaterial to its financial condition and results of operations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|Note 6: Recent Accounting Pronouncements                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|In May 2008, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 162, "The Hierarchy of Generally Accepted Accounting Principles". SFAS No. 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles in the United States. It is effective 60 days following the Security and Exchange Commission's ("SEC's") approval of the Public Company Accounting Oversight Board amendments to AU Section 411, "The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles". SFAS No. 162 is not expected to have a material impact on our financial condition or results of operations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|In March 2008, the FASB issued SFAS No. 161 "Disclosures about Derivative Instruments and Hedging Activities--an amendment of FASB Statement No. 133." SFAS No. 161 requires enhanced disclosures about an entity's derivative and hedging activities and thereby improves the transparency of financial reporting. Entities are required to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under Statement 133 and its related interpretations, and (c) how derivative instruments and related hedged items affect an entity's financial position, financial performance, and cash flows. SFAS No. 161 is effective for                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         



<PAGE>  6



|financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. SFAS No. 161 is not expected to have a material impact on our financial condition or results of operations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
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|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|In December 2007, the FASB issued revised SFAS No. 141, "Business Combinations," or SFAS No. 141(R). SFAS No. 141(R) retains the fundamental requirements of SFAS No. 141 that the acquisition method of accounting (formerly the purchase method) be used for all business combinations; that an acquirer be identified for each business combination; and that intangible assets be identified and recognized separately from goodwill. SFAS No. 141(R) requires the acquiring entity in a business combination to recognize the assets acquired, the liabilities assumed and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values as of that date, with limited exceptions. Additionally, SFAS No. 141(R) changes the requirements for recognizing assets acquired and liabilities assumed arising from contingencies and recognizing and measuring contingent consideration. SFAS No. 141(R) also enhances the disclosure requirements for business combinations. SFAS No. 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008 and may not be applied before that date.                                                                                                                                                                                                                
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|In December 2007, the FASB issued SFAS No. 160, "Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51," or SFAS No. 160. SFAS No. 160 amends Accounting Research Bulletin No. 51, "Consolidated Financial Statements" to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. Among other things, SFAS No. 160 clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements and requires consolidated net income to be reported at amounts that include the amounts attributable to both the parent and the noncontrolling interest. SFAS No. 160 also amends SFAS No. 128, "Earnings per Share," so that earnings per share calculations in consolidated financial statements will continue to be based on amounts attributable to the parent. SFAS No. 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008 and is applied prospectively as of the beginning of the fiscal year in which it is initially applied, except for the presentation and disclosure requirements which are to be applied retrospectively for all periods presented. SFAS No. 160 is not expected to have a material impact on our financial condition or results of operations.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|Note 7: Fair Value Measurements                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|In February 2007, the FASB issued "SFAS No. 159", "The Fair Value Option for Financial Assets and Financial Liabilities." This Statement generally permits the measurement of selected eligible financial instruments at fair value at specified election dates. SFAS No. 157, "Fair Value Measurements", generally establishes the definition of fair value, expands disclosures about fair value measurement and establishes a hierarchy of the levels of fair value measurement techniques. SFAS No. 157 and SFAS No. 159 are effective for fiscal years beginning after November 15, 2007. Effective January 1, 2008, Merchants adopted SFAS No. 159 and SFAS No. 157, but has not elected to apply fair value option to any financial assets or liabilities. In accordance with FASB Staff Position No. 157-2, "Effective Date of FASB Statement No. 157," Merchants has delayed the application of SFAS No. 157 for nonfinancial assets and nonfinancial liabilities until January 1, 2009.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|Under SFAS No. 157, the three levels of the fair value hierarchy are: Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities; Level 2 - Quoted prices for similar assets or liabilities in active markets, quoted prices in markets that are not active, or inputs that are observable, either directly or indirectly, for substantially the full term of the asset or liability; Level 3 - Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e. supported by little or no market activity). A financial instrument's level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|As of June 30, 2008, there were securities classified as available for sale with fair values totaling $441.83 million which had gross unrealized losses of $4.64 million. The following table presents the financial instruments recorded at fair value as of and for the six months ended June 30, 2008.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    

|                              |           | Fair Value Measurements at Reporting Date Using
|----------------------------- | --------- | -----------------------------------------------
|                              |           |                                                
|                              |           | Quoted Prices in                               
|(In thousands)                |           | Active Markets for                             
|                              |           | Identical Assets                               
|Description                   | 6/30/2008 | (Level 1)                                      
|                             
|Available for sale securities | $ 441,834 | $ -                                            
|                              |          
|Total                         | $ 441,834 | $ -                                            
|                              |          
|                              |          

|Fair values for available for sale securities are estimated by an independent bond pricing service for identical assets or significantly similar securities. The pricing service uses a variety of techniques to arrive at fair value including market maker bids, quotes and pricing models. Inputs to the pricing models include recent trades, benchmark interest rates, spreads and actual and projected cash flows.
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<PAGE>  7

|Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|Forward Looking Statements                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Except for the historical information contained herein, this Quarterly Report on Form 10-Q of Merchants may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 (the "Exchange Act"). Investors are cautioned that forward-looking statements are inherently uncertain. Actual performance and results of operations may differ materially from those projected or suggested in the forward-looking statements due to certain risks and uncertainties, including, without limitation:
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           

| | (i)   | the fact that Merchants' success is dependent upon general economic conditions in Vermont and Vermont's ability to attract new business;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | ----- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | (ii)  | the fact that Merchants' earnings depend to a great extent upon the level of net interest income (the difference between interest income earned on loans and investments and the interest expense paid on deposits and other borrowings) generated by Merchants and thus Merchants' results of operations may be adversely affected by increases or decreases in interest rates or by the shape of the yield curve;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | (iii) | the fact that the banking business is highly competitive and the profitability of Merchants depends upon Merchants' ability to attract loans and deposits in Vermont, where Merchants competes with a variety of traditional banking and nontraditional institutions such as credit unions and finance companies;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | (iv)  | the fact that at June 30, 2008, approximately 49.3% of Merchants' loan portfolio was comprised of commercial, commercial real estate and construction loans with some relationships exceeding ten million dollars, exposing Merchants to the risks inherent in financings based upon analyses of credit risk, the value of underlying collateral, including real estate, and other more intangible factors, which are considered in making commercial loans;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | (v)   | the fact that if real estate values in Merchants' market decline or become stagnant, business could be adversely affected. At June 30, 2008, approximately 87.1% of Merchants' loan portfolio was comprised of residential real estate and commercial real estate and construction loans, exposing Merchants to the risks inherent in financings based upon analyses of credit risk and the value of underlying collateral. Real estate prices in some parts of the country have recently become stagnant or declined and there has been a significant decline in real estate construction and housing starts. These trends could ultimately impact the value and liquidity of the real estate or other collateral securing Merchants' loans. Merchants' profitability may be negatively impacted by errors in risk analyses, by loan defaults, and the ability of certain borrowers to repay such loans may be adversely affected by any downturn in general economic conditions;
| |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | (vi)  | the fact that acts or threats of terrorism and actions taken by the United States or other governments as a result of such acts or threats, including possible military action, could further adversely affect business and economic conditions in the United States of America generally and in Merchants' markets, which could adversely affect Merchants' financial performance, that of Merchants' borrowers, the financial markets and the price of Merchants' common stock;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | (vii) | the fact that changes in the extensive laws, regulations and policies governing bank holding companies and their subsidiaries could alter Merchants' business environment or affect Merchants' operations;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        



<PAGE>  8



|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | (viii) | the fact that the potential need to adapt to industry changes in information technology systems, on which Merchants is highly dependent to secure bank and customer financial information, could present operational issues, require significant capital spending or impact Merchants' reputation;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------ | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | (ix)   | the fact that Merchants' customers conduct their business within global financial systems, which may subject Merchants' customers' businesses and their financial data to potential risks or weaknesses within those systems; and                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | (x)    | the fact that Merchants actively evaluates acquisition and other expansion opportunities and strategies, the implementation of which could affect Merchants' financial performance.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|These factors, as well as general economic and market conditions in the United States of America, may materially and adversely affect the market price of shares of Merchants' common stock. Because of these and other factors, past financial performance should not be considered an indicator of future performance. The forward looking statements contained herein represent Merchants' judgment as of the date of this Form 10-Q; Merchants cautions readers not to place undue reliance on such statements.                                                                                                                                                                                                                                                    
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|General                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|All adjustments necessary for a fair presentation of Merchants' interim consolidated financial statements as of June 30, 2008, and for the three and six months ended June 30, 2008 and 2007, have been included. The information was prepared from the unaudited financial statements of Merchants and its subsidiaries, Merchants Bank, Merchants Trust Company, Merchants Properties, Inc. and MBVT Statutory Trust I.                                                                                                                                                                                                                                                                                                                                              
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|Results of Operations                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|Overview                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Net income was $2.88 million and $5.54 million for the second quarter and first six months of 2008, compared to net income of $2.70 million and $5.31 million for the second quarter and the first six months of 2007. The return on average assets for the quarter and six months ended June 30, 2008 were 0.90% and 0.89%, respectively, compared to 0.97% and 0.95%, respectively, for the quarter and six months ended June 30, 2007. The return on average equity for the quarter and six months ended June 30, 2008 were 15.26% and 14.54%, respectively, compared to 15.33% and 15.19%, respectively. The following were the major factors contributing to the results for the quarter and six months ended June 30, 2008, compared to the same periods in 2007:
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |       | Merchants' net interest income increased to $10.49 million from $9.57 million for the second quarter of 2008 compared to 2007; and increased to $20.13 million for the first six months of 2008 compared to $19.08 million for the first six months of 2007. At the same time net interest margin decreased by 15 basis points to 3.48% from 3.63% for the second quarter of 2008 compared to 2007, and decreased by 17 basis points to 3.44% from 3.61% for the first half of 2008 compared to the same period in 2007. The net interest margin for the second quarter of 2008 expanded by eight basis points compared to the first quarter of the year as Merchants was able to reduce funding costs over the course of the quarter.                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |       | Merchants recorded a $50 thousand provision for credit losses during the second quarter of 2008 compared to $300 thousand during the first quarter of 2008, and $150 thousand for the second quarter of 2007. Merchants recorded a $350 thousand provision for the first six months of 2008 compared to $150 thousand for the same period last year. The decreased provision during the second quarter of 2008 compared to the first quarter of this year was primarily a result of reductions in non-performing loans over the course of the quarter. The increased provision during the first half of 2008 compared to 2007 was primarily a result of increases in nonperforming loans since June 30, 2007, combined with overall growth in the loan portfolio, as well as continued economic uncertainty.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |       | Noninterest income decreased slightly to $2.31 million for the second quarter of 2008 compared to $2.34 million for the second quarter of 2007; and, excluding gains/losses on security sales, increased slightly to $4.47 million from $4.43 million for the first six months of 2008 compared to 2007. Noninterest expense increased $709 thousand to $8.95 million for the second quarter of 2008 from $8.24 million for second quarter of 2007; and increased to $17.07 million for the first six months of 2008 compared to $16.42 million for the first six months of 2007.                                                                                                                                                                                                                           
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |       | Average quarterly gross loans increased $58.78 million over the second quarter of 2007. Gross loans ended the second quarter of 2008 at $774.19 million, an increase of $42.69 million over year end 2007 balances.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         

<PAGE>  9



|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |  | Merchants' quarterly average investment portfolio increased $127.29 million, over the second quarter of 2007. Total investments ended the second quarter of 2008 at $445.28 million, a $79.69 million increase over year end 2007 balances.
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|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |   |                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |  | Average quarterly deposits increased $48.32 million, over the second quarter of 2007. Total deposits ended the second quarter of 2008 at $945.64 million, a $78.21 million increase over year end 2007 balances.                           
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|Net Interest Income                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|Merchants' net interest income increased $923 thousand, or 9.7%, for the second quarter of 2008 compared to 2007 and was $1.05 million higher for the first six months of 2008 compared to 2007. Additionally, Merchants increased its net interest income by $852 thousand when comparing the second quarter of 2008 to the first quarter of 2008. These increases are a result of strong growth in both loans and deposits, and a result of the leverage that Merchants put on at the end of the first quarter and beginning of the second quarter of 2008 to take advantage of the favorable interest rate environment. Average interest earning assets for the second quarter of 2008 were $1.22 billion, compared to $1.06 billion for the second quarter of 2007 and $1.14 billion for the first quarter of 2008. Quarterly average loans were $58.78 million higher than the same quarter of 2007 and were $25.15 million higher than the first quarter of 2008. Merchants' quarterly average investment portfolio for the second quarter of 2008 was $445.53 million, an increase of $127.29 million over the same quarter of 2007; and was $67.13 million higher than the first quarter of 2008. The growth in assets was funded by a mix of increased deposits and borrowed funds. Quarterly average deposits were $48.32 million higher than the second quarter of 2007, and were $43.04 million higher than the first quarter of 2008. Quarterly average borrowed funds increased by $98.62 over the same quarter of 2007, and and increased by $30.66 million for the second quarter of 2008 compared to the first quarter of this year.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|Merchants' net interest margin increased by eight basis points during the second quarter of 2008 compared to the first quarter of this year. Merchants' net interest margin was 15 basis points lower than the same quarter in 2007; and 17 basis points lower when comparing the first six months of 2008 to the same period in 2007. The average rate on interest earning assets for the current quarter was 44 basis points lower than the second quarter of 2007 and was 37 basis points lower for the first half of 2008 compared to the same period in 2007. This decrease was primarily due to decreased loan rates for 2008 compared to 2007, a result of the competitive environment and decreases in the prime lending rate. Lower loan rates were partially offset by a higher yield on investments for 2008 when compared to 2007.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|Merchants was able to reduce its overall funding costs by 38 basis points for the second quarter of 2008 compared to 2007, and by 17 basis points for the first half of 2008 compared to 2007. The average cost of deposits decreased by 19 basis points when comparing the second quarter of this year to the same period in the prior year and 20 basis points compared to the first quarter of 2008. Additionally, Merchants has continued to layer on borrowings in the current low interest rate environment, our cost of borrowed funds for the second quarter of 2008 was 165 basis points lower than the second quarter of 2007 and decreased 125 basis points for the first 6 months of 2008 compared to the same period in 2007.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|The following table attributes changes in Merchants' net interest income (on a fully taxable equivalent basis) to changes in either average balances or average rates for the three and six months ended June 30, 2008. Changes due to both interest rate and volume have been allocated to change due to volume and change due to rate in proportion to the relationship of the absolute dollar amounts of the change in each category:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             

<PAGE>  10

|Analysis of Changes in Fully Taxable Equivalent Net Interest Income
|-------------------------------------------------------------------
|                                                                   
|Three Months Ended June 30,                                        
|                                                                   
|                                                                   
|                                                                   
|(In thousands)                                                     
|                                                                   
|Fully taxable equivalent interest income:                          
|Loans                                                              
|Investments                                                        
|Federal funds sold, securities sold under agreements to            
|repurchase and interest bearing deposits with banks                
|                                                                   
|Total interest income                                              
|                                                                   
|Less interest expense:                                             
|Savings, money market & NOW accounts                               
|Time deposits                                                      
|Federal Home Loan Bank short-term borrowings                       
|Securities sold under agreements to repurchase                     
|and other short-term debt                                          
|Securities sold under agreement to repurchase, long-term           
|Other long-term debt                                               
|Junior subordinated debt                                           
|                                                                   
|Total interest expense                                             
|                                                                   
|Net interest income                                                
|                                                                   
|                                                                   

|Six Months Ended June 30,                               
|--------------------------------------------------------
|                                                        
|                                                        
|                                                        
|(In thousands)                                          
|                                                        
|Fully taxable equivalent interest income:               
|Loans                                                   
|Investments                                             
|Federal funds sold, securities sold under agreements to 
|repurchase and interest bearing deposits with banks     
|                                                        
|Total interest income                                   
|                                                        
|Less interest expense:                                  
|Savings, money market & NOW accounts                    
|Time deposits                                           
|Federal Home Loan Bank short-term borrowings            
|Securities sold under agreements to repurchase          
|and other short-term debt                               
|Securities sold under agreement to repurchase, long-term
|Other long-term debt                                    
|Junior subordinated debt                                
|                                                        
|Total interest expense                                  
|                                                        
|Net interest income                                     
|                                                        
|                                                        

|The following tables set forth certain information regarding net interest margin for the three and six months ended June 30, 2008 and 2007. For the periods indicated, the total dollar amount of interest income from average earning assets and the resultant yields, as well as the interest expense on average interest bearing liabilities, are expressed both in dollars and rates, and on a tax equivalent basis.
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<PAGE>  11

|Merchants Bancshares, Inc.
Average Balance Sheets and Average Rates
(Unaudited)
|-------------------------------------------------------------------------------
|                                                                               

|                                                | Three Months Ended
|----------------------------------------------- | ------------------
|                                                |                   
|                                                | June 30, 2008     
|                                                |                   
|(In thousands, fully taxable equivalent)        | Average
Balance   
|                                                |                   
|ASSETS:                                         |                   
|Loans, including fees on loans (a)              | $   762,761       
|Investments (b) (c)                             | 445,534           
|Federal funds sold and interest bearing         |                   
|deposits with banks                             | 7,627             
|                                                |                   
|Total interest earning assets                   | 1,215,922         
|                                                |                   
|Allowance for loan losses                       | (8,423)           
|Cash and cash equivalents                       | 34,012            
|Bank premises and equipment, net                | 11,824            
|Other assets                                    | 24,489            
|                                                |                   
|Total assets                                    | $1,277,824        
|                                                |                   
|                                                |                   
|LIALIABILITIES AND SHAREHOLDERS' EQUITY:        |                   
|Interest bearing deposits:                      |                   
|Savings, NOW & money market accounts            | $   428,681       
|Time deposits                                   | 380,558           
|                                                |                   
|Total interest bearing deposits                 | 809,239           
|                                                |                   
|Federal funds purchased                         | 3,352             
|Federal Home Loan Bank short-term borrowings    | 3,451             
|Securities sold under agreements to repurchase  |                   
|and other short-term debt                       | 82,982            
|Securities sold under agreements to repurchase, |                   
|long-term                                       | 71,143            
|Other long-term debt                            | 82,682            
|Junior subordinated debentures issued to        |                   
|Unconsolidated subsidiary trust                 | 20,619            
|                                                |                   
|Total borrowed funds                            | 264,229           
|                                                |                   
|Total interest bearing liabilities              | 1,073,468         
|                                                |                   
|Noninterest bearing deposits                    | 112,645           
|Other liabilities                               | 16,094            
|Shareholders' equity                            | 75,617            
|                                                |                   
|Total liabilities and shareholders' equity      | $1,277,824        
|                                                |                   
|                                                |                   
|Net interest earning assets                     | $   142,454       
|                                                |                   
|                                                |                   
|Net interest income (fully taxable equivalent)  |                   
|                                                |                   
|Tax equivalent adjustment                       |                   
|                                                |                   
|Net interest income                             |                   
|                                                |                   
|                                                |                   
|Net interest rate spread                        |                   
|                                                |                   
|                                                |                   
|Net interest margin                             |                   
|                                                |                   
|                                                |                   

|(a) | Includes principal balance of non-accrual loans and fees on loans.                                                   
|--- | ---------------------------------------------------------------------------------------------------------------------
|(b) | Available for sale securities are included at fair value, held to maturity securities are included at amortized cost.
|(c) | Tax exempt interest has been converted to a tax equivalent basis using the Federal tax rate of 35%.                  

<PAGE>  12

|Merchants Bancshares, Inc.
Average Balance Sheets and Average Rates
(Unaudited)
|-------------------------------------------------------------------------------
|                                                                               

|                                                | Six Months Ended
|----------------------------------------------- | ----------------
|                                                |                 
|                                                | June 30, 2008   
|                                                |                 
|(In thousands, fully taxable equivalent)        | Average
Balance 
|                                                |                 
|ASSETS:                                         |                 
|Loans, including fees on loans (a)              | $   750,187     
|Investments (b) (c)                             | 411,971         
|Federal funds sold, securities purchased under  |                 
|agreements to resell and interest bearing       |                 
|deposits with banks                             | 17,131          
|                                                |                 
|Total interest earning assets                   | 1,179,289       
|                                                |                 
|Allowance for loan losses                       | (8,275)         
|Cash and cash equivalents                       | 34,736          
|Bank premises and equipment, net                | 11,806          
|Other assets                                    | 22,589          
|                                                |                 
|Total assets                                    | $1,240,145      
|                                                |                 
|                                                |                 
|LIALIABILITIES AND SHAREHOLDERS' EQUITY:        |                 
|Interest bearing deposits:                      |                 
|Savings, NOW & money market accounts            | $   420,001     
|Time deposits                                   | 365,541         
|                                                |                 
|Total interest bearing deposits                 | 785,542         
|                                                |                 
|Federal funds purchased                         | 1,742           
|Federal Home Loan Bank short-term borrowings    | 2,217           
|Securities sold under agreements to repurchase  |                 
|and other short-term debt                       | 85,036          
|Securities sold under agreements to repurchase, |                 
|long-term                                       | 60,621          
|Other long-term debt                            | 78,667          
|Junior subordinated debentures issued to        |                 
|Unconsolidated subsidiary trust                 | 20,619          
|                                                |                 
|Total borrowed funds                            | 248,902         
|                                                |                 
|Total interest bearing liabilities              | 1,034,444       
|                                                |                 
|Noninterest bearing deposits                    | 114,823         
|Other liabilities                               | 14,665          
|Shareholders' equity                            | 76,213          
|                                                |                 
|Total liabilities and shareholders' equity      | $1,240,145      
|                                                |                 
|                                                |                 
|Net interest earning assets                     | $   144,845     
|                                                |                 
|                                                |                 
|Net interest income (fully taxable equivalent)  |                 
|                                                |                 
|Tax equivalent adjustment                       |                 
|                                                |                 
|Net interest income                             |                 
|                                                |                 
|                                                |                 
|Net interest rate spread                        |                 
|                                                |                 
|                                                |                 
|Net interest margin                             |                 
|                                                |                 
|                                                |                 

|(a) | Includes principal balance of non-accrual loans and fees on loans.                                                   
|--- | ---------------------------------------------------------------------------------------------------------------------
|(b) | Available for sale securities are included at fair value, held to maturity securities are included at amortized cost.
|(c) | Tax exempt interest has been converted to a tax equivalent basis using the Federal tax rate of 35%.                  

<PAGE>  13

|Provision for Credit Losses: Merchants recorded a $50 thousand provision for credit losses during the second quarter of 2008 and $350 thousand year to date, compared to $150 thousand for the second quarter and first six months of 2007. The allowance for loan losses was $8.44 million; 1.09% of total loans and 158% of nonperforming loans at June 30, 2008, compared to $8.00 million, 1.09% of total loans and 87% of nonperforming loans at December 31, 2007; and $7.18 million, .99% of total loans and 226% of nonperforming loans at June 30, 2007. Nonperforming loans decreased during the second quarter of 2008 to $5.34 million from $7.17 million at the end of the first quarter of this year, and $9.23 million at December 31, 2007; but are still $2.15 million higher than June 30, 2007 balances. Gross loans ended the second quarter of 2008 at $774.19 million, a $42.69 million increase over year end balances. Merchants recorded net recoveries totaling $65 thousand for the first six months of 2008 and recorded net recoveries of $51 thousand for the same period in 2007. All of these factors are taken into consideration during management's quarterly review of the Allowance which management continues to deem adequate under current market conditions. See the discussion of Nonperforming Assets on pages 18-20 for additional information on the Allowance and the allowance for loan losses.                                                                                                                                                                                                                                                                                                                                                                                                                           
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|Noninterest Income: Total noninterest income decreased slightly to $2.31 million for the second quarter of 2008 from $2.34 million for the second quarter of 2007. Noninterest income excluding gains/losses on investment securities increased slightly to $4.47 million for the first six months of 2008 compared to $4.43 million for the first six months of 2007.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|Noninterest Expense:Total noninterest expense increased $709 thousand to $8.95 million for the second quarter of 2008 from $8.24 million for the second quarter of 2007; and increased $652 thousand to $17.07 million for the first six months of 2008 compared to the same period in 2007. Salaries and Employee benefits increased $324 thousand to $4.19 million for the second quarter of 2008 compared to the same period in 2007, and increased $417 thousand to $8.22 million for the first half of 2008 compared to the first half of 2007. This increase is primarily a result of additional staff that Merchants has hired in the corporate banking and executive areas during the first half of 2008. Marketing expenses increased $257 thousand to $592 thousand for the second quarter of 2008 compared to the second quarter of 2007, and $377 thousand to $996 thousand for the first six months of this year compared to the same period last year as a result of the timing of expenses related to the rollout of Merchants' new Cash Rewards Checking product. Other noninterest expenses increased $293 thousand to $1.68 million for the second quarter of 2008 compared to the second quarter of 2007, and increased $55 thousand to $2.97 million for the first six months of 2008 compared to the same period in 2007. Merchants recorded a $150 thousand expense related to fraudulent debit card activity during the second quarter of 2008. Merchants is actively working with its debit card processor to identify the cause of the breach and has installed additional safeguards to assist in mitigating future losses due to this type of activity. Merchants intends to pursue appropriate recourse. Merchants experienced a defalcation during the first quarter of last year which was subject to a $100 thousand insurance deductible.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|Balance Sheet Analysis                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|Loans ended the second quarter of 2008 at $774.19 million, an increase of $42.69 million over December 31, 2007 balances of $731.51 million. The increase since December 31, 2007 is made up primarily of residential and commercial mortgages. Merchants has hired additional lenders in its corporate banking group which has led to increased loan production. Additionally, Merchants' status as the last independent statewide bank has proven to have appeal to business owners and has helped the Bank attract new commercial customers. The combination of lower interest rates and reduced competition in the residential area has provided Merchants with additional opportunities to gain new retail customers.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|Balances of real estate construction loans decreased slightly to $39.26 million at June 30, 2008 from $39.35 million at December 31, 2007. For approximately $16.00 million of the outstanding construction loans at June 30, 2008 the primary source of repayment will be the sale of residential housing units. Approximately $13.50 million is attributable to construction of multifamily housing and will be repaid by conversion to term financing and future rental income. The balance of $9.80 million will be repaid by equity investments in affordable housing projects, conversion of loans to commercial and industrial or commercial real estate borrowers to term financing, and conversion of loans to individual borrowers to conventional mortgage financing.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|The following table summarizes the components of Merchants' loan portfolio as of June 30, 2008 and December 31, 2007:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         



<PAGE>  14



|(In thousands)                         | June 30,
2008 | December 31, 
2007
|-------------------------------------- | ------------- | ------------------
|                                      
|Commercial, financial and agricultural | $  91,183     | $  92,740         
|Real estate loans - residential        | 384,352       | 356,472           
|Real estate loans - commercial         | 250,921       | 234,675           
|Real estate loans - construction       | 39,256        | 39,347            
|Installment loans                      | 7,618         | 7,220             
|All other loans                        | 864           | 1,054             
|                                      
|Total loans                            | $774,194      | $731,508          
|                                      
|                                      

|Merchants' investment portfolio totaled $445.28 million at June 30, 2008, an increase of $79.69 million from December 31, 2007 ending balances of $365.59 million. Merchants began taking advantage of the steeper yield curve during the second half of 2007 and the first half of 2008 to redeploy funds into the investment portfolio. Merchants continued to increase the portfolio through the first two quarters of 2008, and purchased $163.57 million in securities during the first half of 2008 at an average yield of 5.18%. The securities purchased were a mix of 15 and 30 year agency mortgage backed securities ("MBS") and agency collateralized mortgage obligations ("CMO"). These purchases were funded in part by the sale of securities in early 2008 with a total amortized cost of $26.93 million. The balance of the purchases was funded by $80.00 million in borrowings at an average cost of 3.14%, as well as monthly amortization from the investment portfolio and deposit growth. The borrowed funds are a mix of two, three and five year amortizing and bullet Federal Home Loan Bank advances, and five year structured repurchase agreements with embedded caps that are callable after two or three years. Merchants has no corporate debt exposure on its books, including any perpetual preferred stock issued by the Federal National Mortgage Association ("FNMA") or Federal Home Loan Mortgage Corporation ("FHLMC"), nor any interests in pooled trust preferred securities. Merchants does occasionally use a mutual fund to manage its short term funds position, the fund is invested solely in U.S. Agency securities.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|Merchants' investment portfolio at June 30, 2008, including both held-to-maturity and available for sale securities, consisted of the following:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      



| |                                    | Amortized
Cost | Fair
Value  | 
| | ---------------------------------- | -------------- | ----------- | 
| |                                    |                |            
| | U. S. Treasury Obligations         | $       250    | $       254 | 
| | Federal Home Loan Bank Obligations | 7,322          | 7,419       | 
| | Agency MBS                         | 285,675        | 283,318     | 
| | Agency CMO                         | 97,797         | 98,112      | 
| | Non-Agency CMO                     | 32,956         | 31,399      | 
| | Commercial MBS                     | 20,611         | 20,191      | 
| | Asset Backed Securities            | 5,313          | 4,763       | 
| |                                    |                |            
| |                                    | $449,924       | $445,456    | 
| |                                    |                |            
| |                                    |                |             | 



|Agency MBS and Agency CMOs consist of pools of residential mortgages which are guaranteed by FNMA, FHLMC or Government National Mortgage Association ("GNMA") with various origination dates and maturities. Non-Agency CMO, Commercial MBS and ABS are tracked individually by our investment manager with updates on the performance of the underlying collateral provided monthly.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Deposits ended the quarter at $945.64 million, an increase of $78.21 million over year end balances of $867.44 million. Total time deposits have increased by $56.06 million during 2008. Merchants' savings, NOW and money market accounts have grown $26.00 million during the first six months of 2008, while demand deposits have decreased $3.85 million. Merchants continues to experience the highest growth in its time deposit category as depositors seek higher yields; however the shift from money market categories to time deposits has slowed. Time deposits were 41.1% of total deposits at June 30, 2008, compared to 40.5% of total deposits at March 31, 2008; 38.4% of total deposits at December 31, 2007 and 36.6% of total deposits at June 30, 2007. As of June 30, 2008, $27.52 million in deposits have moved off balance sheet into the Certificate of Deposit Account Registry Service ("CDARS") which has attracted some larger dollar relationships looking for both a higher yield and full insurance coverage.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Merchants offers a cash management sweep product; balances in this product totaled $78.61 million at June 30, 2008 and are included with "Securities sold under agreements to repurchase and other short-term debt" on the accompanying consolidated balance sheet.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            



<PAGE>  15



|On June 27, 2008 Merchants entered into two agreements effecting the sale and lease-back of its principal office in South Burlington, VT. The sale price of the building was $5.70 million and the Bank will lease back the property for an initial term of ten years and two optional terms of five years each. The base annual rent will be $483 thousand for each of the first ten years, $557 thousand for each of years 11-15, and $612 thousand for each of years 16-20. The sale of the building generated a deferred gain of approximately $4.20 million which will be recognized over the term of the lease. Depreciation expense related to the building prior to the sale totalled $167 thousand annually.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|In the ordinary course of business, Merchants makes commitments for possible future extensions of credit. At June 30, 2008, Merchants was obligated to fund $4.97 million of standby letters of credit. No losses are anticipated in connection with these commitments.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities." This Statement generally permits the measurement of selected eligible financial instruments at fair value at specified election dates. SFAS No. 157, "Fair Value Measurements", generally establishes the definition of fair value, expands disclosures about fair value measurement and establishes a hierarchy of the levels of fair value measurement techniques. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. Effective January 1, 2008, Merchants adopted SFAS No. 157. The adoption of SFAS No. 157 had no financial statement impact, other than enhanced disclosure. Merchants has no assets for which the fair value is derived using significant unobservable inputs, as defined by SFAS No. 157.                                                                                                                                                                                                                                                                                                                                                   
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|Income Taxes                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|Merchants and its subsidiaries are taxed on income at the federal level by the Internal Revenue Service. The State of Vermont levies franchise taxes on banks primarily based upon average deposit levels in lieu of taxing income. Vermont franchise taxes totaled $239 thousand and $190 thousand for the second quarters of 2008 and 2007, respectively, and totaled $479 thousand and $401 thousand for the first six months of 2008 and 2007 respectively. Total income tax expense was $911 thousand for the second quarter of 2008 compared to $821 thousand for the same period in 2007, and was $1.71 million for the first six months of 2008 compared to $1.59 million for the first six months of 2007. Merchants recognized favorable tax benefits from federal affordable housing tax credits of $799 thousand for the first six months of 2008 and $819 thousand for the same period in 2007. Merchants' statutory tax rate was 35% for all periods. The recognition of affordable housing tax credits is the principal reason for Merchants' effective tax rate of 24.01% and 23.59% for the three and six months ended June 30, 2008, respectively, and 23.34% and 23.03% for the same period in 2007.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|Liquidity and Capital Resources                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|Merchants' liquidity is monitored by the Asset and Liability Committee (the "ALCO") of Merchants Bank's Board of Directors, based upon Merchants Bank policies. Merchants had $6.11 million in overnight funds sold and other short-term investments at June 30, 2008. Additionally, Merchants has an overnight line of credit with the FHLB of $5 million and an estimated additional borrowing capacity with the FHLB of $94.13 million. Merchants has $44 million in available federal funds lines of credit at June 30, 2008 and the ability to borrow through the use of repurchase agreements, collateralized by Merchants' investments, with certain approved counterparties. Merchants' investment portfolio, which is managed by the ALCO, totaled $445.28 million at June 30, 2008, of which $187.46 million was pledged. The portfolio is a reliable source of cash flow for Merchants.                                                                                                                                                                                                                                                                                                                     
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|In January 2007, Merchants' Board approved a stock repurchase program, pursuant to which Merchants may repurchase 200,000 shares of its common stock on the open market from time to time through January 2008. The Board extended the program through January 2009 at its January 2008 meeting. Under the program 114,918 shares have been purchased at an average price per share of $23.06; shares purchased during the first half of 2008 totaled 55,800 at an average price per share of $23.24.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|As of June 30, 2008, Merchants exceeded all applicable regulatory capital requirements. The following table represents the actual capital ratios and capital adequacy requirements for Merchants as of June 30, 2008 and 2007:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         



<PAGE>  16



|                          | Actual              | For Capital
Adequacy Purposes
|------------------------- | ------------------- | -----------------------------
|                          |                    
|(In thousands)            | Amount (1)          | Percent                      
|                         
|                          | As of June 30, 2008
|                          |                    
|Tier 1 leverage capital   | $  94,932           | 7.43%                        
|Tier 1 risk-based capital | 94,932              | 12.30%                       
|Total risk-based capital  | 103,697             | 13.43%                       
|                          |                     |                              
|                          | As of June 30, 2007
|                          |                    
|Tier 1 leverage capital   | $  93,767           | 8.41%                        
|Tier 1 risk-based capital | 93,767              | 12.57%                       
|Total risk-based capital  | 101,249             | 13.58%                       
|                          |                     |                              

|(1)                                                                                                                                                                                                                                                                                                                                                                                                                         | Amounts include $20 million in trust preferred securities issued in December 2004. These hybrid securities qualify as regulatory capital up to certain limits.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                           
|Nonperforming Assets and the Allowance                                                                                                                                                                                                                                                                                                                                                                                     
|Stringent credit quality is a major strategic focus of Merchants. Merchants cannot assure that problem assets will remain at current levels, particularly in light of current or future economic conditions. The asset balances in this category will be dynamic and subject to change as problem loans are either resolved or moved to nonperforming based upon current developments and the latest available information.
|                                                                                                                                                                                                                                                                                                                                                                                                                           
|The following table summarizes Merchants' nonperforming assets at the dates indicated:                                                                                                                                                                                                                                                                                                                                     
|                                                                                                                                                                                                                                                                                                                                                                                                                           

|(In thousands)                           | June 30, 2008 | March 31, 2008 | December 31, 2007 | June 30, 2007
|---------------------------------------- | ------------- | -------------- | ----------------- | -------------
|                                        
|Nonaccrual loans                         | $5,187        | $6,965         | $9,018            | $2,969       
|Loans past due 90 days or more and still |               |                |                   |              
|accruing interest                        | --            | 52             | 57                | 48           
|Troubled debt restructurings             | 148           | 152            | 156               | 164          
|                                        
|Total nonperforming loans ("NPL")        | 5,335         | 7,169          | 9,231             | 3,181        
|Other Real Estate Owned ("OREO")         | --            | --             | 475               | --           
|                                        
|Total nonperforming assets ("NPA")       | $5,335        | $7,169         | $9,706            | $3,181       
|                                        
|                                        

|Nonperforming assets decreased to $5.34 million at June 30, 2008 from $9.71 million at December 31, 2007. The net decrease of $4.37 million in nonperforming assets during the first half of 2008 is primarily a result of payments received on a large residential construction project that was moved to nonaccrual status during the third quarter of 2007. In addition, Merchants completed several OREO sales during the first half of 2008, reducing OREO balances to zero. Excluded from the balances above are Merchants' loans that are 30-89 days past due. These loans are not necessarily considered classified or impaired. Loans past due 30-89 days totaled $1.34 million at June 30, 2008, compared to $634 thousand at March 31, 2008 and to $676 thousand at December 31, 2007. $892 thousand of these past due loans were brought current within the first two weeks of July.                                                                                                                                                                                                            
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|A loan is considered impaired, based on current information and events, if it is probable that Merchants will be unable to collect the scheduled payments of principal or interest when due, according to the contractual terms of the loan agreement. Loans deemed impaired at June 30, 2008 totaled $5.33 million, of which $5.19 million are included as nonaccrual loans in the table above. Impaired loans at June 30, 2008 have decreased $3.89 million since December 31, 2007. This decrease is primarily attributable to payments on the loan discussed above.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|Merchants' management maintains an internal listing that includes all criticized and classified loans. Merchants' management believes that classified loans have well-defined weaknesses which, if left unattended, could lead to collection problems. The oversight process on these loans includes an active risk management approach. A management committee reviews the status of these loans each quarter and determines or confirms the appropriate risk rating and accrual status. The findings of this review process are instrumental in determining the adequacy of the Allowance. Excluded from nonperforming loans are approximately $18.74 million of internally classified loans as of June 30, 2008, compared to $19.60 million as of December 31, 2007. Included in internally classified loans at June 30, 2008 are $4.79 million in commercial real estate loans and commercial loans to a manufacturer of residential housing units. No other significant internally classified loans are tied to the housing or any other specific industry. Approximately $5.19 million is attributable



<PAGE>  17



|to commercial borrowers in a variety of industries, $4.27 million to non-owner occupied commercial real estate and $4.50 million to owner-occupied commercial real estate. To date all payments have been made as agreed by these customers and Merchants appears adequately secured. Merchants' management will continue to closely monitor asset quality.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                           
|The following table reflects Merchants' nonperforming asset and coverage ratios as of the dates indicated:                                                                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                           



|                                         | June 30, 2008 | March 31, 2008 | December 31,
2007 | June 30, 2007
|---------------------------------------- | ------------- | -------------- | ----------------- | -------------
|                                        
|NPL to total loans                       | 0.69%         | 0.95%          | 1.26%             | 0.44%        
|NPA to total assets                      | 0.41%         | 0.56%          | 0.83%             | 0.29%        
|Allowance for loan losses to total loans | 1.09%         | 1.10%          | 1.09%             | 0.99%        
|Allowance for loan losses to NPL         | 158%          | 116%           | 87%               | 226%         
|                                         |               |                |                   |              

|The Allowance is comprised of the allowance for loan losses and the reserve for unfunded credit commitments. The Allowance is based on management's estimate of the amount required to reflect the inherent losses in the loan portfolio, based on circumstances and conditions at each reporting date. Merchants reviews the adequacy of the Allowance at least quarterly. Factors considered in evaluating the adequacy of the Allowance include previous loss experience, current economic conditions and their effect on the borrowers, the performance of individual loans in relation to contract terms and estimated fair values of properties to be foreclosed. The method used in determining the amount of the Allowance is not based on maintaining a specific percentage of allowance for loan losses to total loans or total NPA. Rather, the methodology is a comprehensive analytical process of assessing the credit risk inherent in the loan portfolio. This assessment incorporates a broad range of factors, which indicate both general and specific credit risk, as well as a consistent methodology for quantifying probable credit losses.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|The following table summarizes year-to-date activity in Merchants' Allowance through the dates indicated:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  



|(In thousands)                            | June 30, 2008 | March 31, 2008 | December 31, 2007 | June 30, 2007
|----------------------------------------- | ------------- | -------------- | ----------------- | -------------
|                                         
|Balance, beginning of year                | $8,350        | $8,350         | $7,281            | $7,281       
|Charge-offs :                             |               |                |                   |              
|Commercial, lease financing and all other | (4)           | (4)            | (170)             | (78)         
|Real estate - mortgage                    | --            | --             | (242)             | (85)         
|Installment and other consumer            | --            | --             | (20)              | (20)         
|                                         
|Total charge-offs                         | (4)           | (4)            | (432)             | (183)        
|                                         
|Recoveries:                               |               |                |                   |              
|Commercial, lease financing and all other | 59            | 4              | 271               | 217          
|Real estate - mortgage                    | 10            | 10             | 79                | 17           
|Installment and other consumer            | --            | --             | 1                 | --           
|                                         
|Total recoveries                          | 69            | 14             | 351               | 234          
|                                         
|Net (charge-offs) recoveries              | 65            | 10             | (81)              | 51           
|                                         
|Provision for credit losses               | 350           | 300            | 1,150             | 150          
|                                         
|Balance end of period                     | $8,765        | $8,660         | $8,350            | $7,482       
|                                         
|                                          |               |                |                   |              
|Components:                               |               |                |                   |              
|Allowance for loan losses                 | $8,439        | $8,312         | $8,002            | $7,184       
|Reserve for undisbursed lines of credit   | 326           | 348            | 348               | 298          
|                                         
|Allowance for Credit Losses               | $8,765        | $8,660         | $8,350            | $7,482       
|                                         
|                                         

|Losses are charged against the allowance for loan losses when management believes that the collectibility of principal is doubtful. To the extent management determines the level of anticipated losses in the portfolio has significantly increased or diminished, the allowance for loan losses is adjusted through current earnings. As part of Merchants' analysis of specific credit risk, detailed and extensive reviews are performed on larger credits and problematic credits identified on the watched asset list, nonperforming asset listings and internal credit rating reports. An outside loan review firm examines portions of Merchants' commercial loan portfolio three times per year. Over the course of the year, approximately 70% of commercial loan balances are reviewed, including all relationships over $1.0 million and criticized and classified loans over $500 thousand. Issues addressed by the loan review process include the accuracy of Merchants' internal risk ratings system, loan quality, and adequacy of the allowance for loan losses.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

<PAGE>  18



|The Allowance reflects management's current strategies and efforts to maintain the Allowance at a level adequate to provide for losses based on an evaluation of known and inherent risks in the loan portfolio, as well as the potential risk from unfunded loan commitments and letters of credit. Among the factors that management considers in establishing the level of the Allowance are overall findings from an analysis of individual loans, the overall risk characteristics and size of the loan portfolio, past credit loss history, management's assessment of current economic and real estate market conditions and estimates of the current value of the underlying collateral. A credit loss provision of $50 thousand and $350 thousand was recorded during the three and six months ended June 30, 2008, respectively, primarily as a result of increased levels of nonperforming loans over the last year, overall growth in the loan portfolio and continued economic uncertainty. Management considers the balance of the Allowance adequate at June 30, 2008.                                                                                                                                                                                                                                                                                                                             
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|Item 3. Quantitative and Qualitative Disclosures About Market Risk                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|General                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|Merchants' management and Board of Directors are committed to sound risk management practices throughout the organization. Merchants has developed and implemented a centralized risk management monitoring program. Risks associated with Merchants' business activities and products are identified and measured as to probability of occurrence and impact on Merchants (low, moderate, or high), and the control or other activities in place to manage those risks are identified and assessed. Periodically, department-level and senior managers re-evaluate and report on the risk management processes for which they are responsible. This documented program provides management with a comprehensive framework for monitoring Merchants' risk profile from a macro perspective; it also serves as a tool for assessing internal controls over financial reporting as required under the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), and the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|Market Risk                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|Market risk is defined as the risk of loss in a financial instrument arising from adverse changes in market rates and prices such as interest rates, foreign currency exchange rates, commodity prices, and equity prices. Merchants' primary market risk exposure is to interest rate and credit risk. An important component of Merchants' asset and liability management process is the ongoing monitoring and management of these risks, which are governed by established policies that are reviewed and approved annually by Merchants Bank's Board of Directors.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|Interest Rate Risk                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|Responsibility for carrying out the asset and liability management policies is delegated to the ALCO. In this capacity the ALCO develops guidelines and strategies impacting Merchants' asset and liability management related activities based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends. Merchants has an outside investment advisory firm which provides assistance in identifying opportunities for increased yield without significantly increasing risk in the investment portfolio.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|The ALCO is responsible for evaluating and managing the interest rate risk which arises naturally from imbalances in repricing, maturity and cash flow characteristics of Merchants' assets and liabilities. It is also responsible for ensuring that Merchants Bank's Board of Directors receives accurate information regarding Merchants' interest rate risk position at least quarterly. The ALCO uses an outside consultant to perform rate shocks of Merchants' balance sheet, and to perform a variety of other analyses. The consultant's most recent review was as of May 31, 2008. The consultant ran a base simulation assuming no changes in rates or balance sheet mix at the May 31, 2008 review. Additionally, the consultant modeled a 200 basis point rising and, because rates are quite low, a 100 basis point falling interest rate scenario which assume a parallel and pro rata shift of the yield curve over a one-year period and assumed no changes or growth in the balance sheet.                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|At May 31, 2008 Merchants' one-year static gap position was a $332.33 million liability-sensitive position compared to a $247.17 million liability-sensitive position at the end of 2007. In the base case model, which assumes interest rates and Merchants' balance sheet and mix remain similar to those of May 31, 2008, net interest income is projected to increase as Merchants' time deposit portfolio, and maturing wholesale funding continue to roll down in a lower rate environment. Net interest income begins to flatten out toward the end of year one and is expected to trend downward over the long-term as asset cash flows are replaced at much lower rates. If rates fall, with a parallel yield curve shift, net interest income is projected to increase during the first two years of the simulation as the short term funding base reprices more quickly than assets, in part due to the leverage strategy implemented over the last two quarters. If the yield curve steepens as rates fall net interest income is projected to increase even further. If rates rise, net interest income is expected to be slightly lower initially as increased funding costs offset the benefit of floating rate assets. Once rates stabilize net interest income is projected to begin an upward trend as funding costs stabilize while asset cash flow is replaced in the higher rate environment.



<PAGE>  19



|The change in net interest income for the next twelve months from Merchants' expected or "most likely" forecast at the May 31, 2008 review is shown in the following table. The degree to which this exposure materializes will depend, in part, on Merchants' ability to manage deposit rates as interest rates rise or fall.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|The analysis discussed above assumes a parallel shift of the yield curve and includes no growth assumptions. Merchants' consultant ran additional simulations which modeled a downward movement in rates with a steepening yield curve, as well as flattening scenarios as rates increase. Falling rates, accompanied by a yield curve that steepens in the short end, resulted in larger net interest income increases. Interest rate increases, accompanied by a flattening yield curve resulted in more dramatic decreases in net interest income. These types of dynamic analyses give the ALCO a more thorough understanding of how Merchants' balance sheet will perform in a variety of rate environments.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|The ALCO uses off-balance sheet strategies, such as interest rate caps and floors and interest rate swaps, as well as borrowings with embedded caps and floors to help minimize Merchants' exposure to changes in interest rates. Merchants purchased a $30 million interest rate cap in January of 2007 to help mitigate its exposure to rising short term interest rates. The cap is recorded on Merchants' balance sheet at fair value with subsequent changes in fair value recorded through earnings each quarter. Additionally, Merchants has entered into borrowing arrangements with embedded caps and floors that will provide additional protection as interest rates change. Merchants currently has $54.00 million in repurchase agreements with embedded caps or embedded double caps on its books, and $20.00 million in repurchase agreements with an embedded cap, and an embedded floor that has come into the money this year.                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|The preceding sensitivity analysis does not represent Merchants' forecast and should not be relied upon as indicative of expected operating results. These estimates are based upon numerous assumptions, including without limitation: the nature and timing of interest rate levels including yield curve shape, prepayments on loans and securities, deposit run-off rates, pricing decisions on loans and deposits and reinvestment/replacement of asset and liability cash flows, among others. While assumptions are developed based upon current economic and local market conditions, Merchants cannot make any assurances as to the predictive nature of these assumptions, including how customer preferences or competitor influences might change.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|The model used to perform the balance sheet simulation assumes a parallel shift of the yield curve over twelve months and reprices every interest bearing asset and liability on Merchants' balance sheet. The model uses contractual repricing dates for variable products, contractual maturities for fixed rate products, and product-specific assumptions for deposits such as Free Checking for LifeÒ
 accounts and money market accounts which are subject to repricing based on current market conditions. Investment securities with call provisions are examined on an individual basis in each rate environment to estimate the likelihood of a call. The model also assumes that the rate at which certain mortgage related assets prepay will vary as rates rise and fall, based on prepayment estimates derived from the Office of Thrift Supervision's Net Portfolio Value Model.                                                                                                                                                                                                                                                                                                                                                             
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|As market conditions vary from those assumed in the sensitivity analysis, actual results will likely differ due to: the varying impact of changes in the balances and mix of loans and deposits differing from those assumed, the impact of possible off balance sheet hedging strategies, and other internal/external variables. Furthermore, the sensitivity analysis does not reflect all actions that the ALCO might take in responding to or anticipating changes in interest rates.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|Credit Risk                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Merchants Bank's Board of Directors reviews and approves Merchants Bank's investment and loan policies on an annual basis. The investment policy establishes minimum investment quality guidelines, as well as specific limits on asset classes within the investment portfolio. The Bank's outside investment advisor tracks Non-Agency securities individually and presents monthly updates on the performance of the underlying collateral. The loan policy establishes restrictions regarding the types of loans that may be granted, and the distribution of loan types within Merchants' portfolio. Merchants Bank's Board of Directors grants each loan officer the authority to originate loans on behalf of Merchants, subject to certain limitations. These authorized lending limits are reviewed at least annually and are based upon the officer's knowledge and experience. Loan requests that exceed an officer's authority require the signature of Merchants' credit division manager, senior loan officer, and/or president. All extensions of credit of $2.5 million or greater to any one borrower or related party are reviewed and approved by the Loan Committee of Merchants Bank's Board of Directors. Merchants' loan portfolio is



<PAGE>  20



|continuously monitored for performance, creditworthiness and strength of documentation through the use of a variety of management reports and with the assistance of an external loan review firm. Credit ratings are assigned to commercial loans and are routinely reviewed. Loan officers or the loan workout function take remedial actions to assure full and timely payment of loan balances when necessary.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Item 4. Controls and Procedures                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|The principal executive officer, principal financial officer, and other members of Merchants' senior management have evaluated Merchants' disclosure controls and procedures as of the end of the period covered by this quarterly report. Based on this evaluation, Merchants' principal executive officer and principal financial officer have concluded that the disclosure controls and procedures effectively ensure that information required to be disclosed in Merchants' filings and submissions with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), is accumulated and communicated to Merchants' management (including the principal executive officer and principal financial officer), and is recorded, processed, summarized and reported within the time periods specified by the Securities and Exchange Commission. In addition, Merchants has reviewed its internal controls over financial reporting and there have been no changes in its internal control over financial reporting during the quarter ended June 30, 2008 that have materially affected, or are reasonably likely to materially affect, its internal control over financial reporting.



<PAGE>  21



|MERCHANTS BANCSHARES, INC.
PART II - OTHER INFORMATION                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Item 1. Legal Proceedings                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|None.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Item 1A. Risk Factors                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Please read the factors discussed in "Risk Factors" in Merchants' Annual Report on Form 10-K for the fiscal year ended December 31, 2007, which could materially adversely affect Merchants' business, financial condition and operating results. These risks are not the only ones facing Merchants. Additional risks and uncertainties not currently known to Merchants or that Merchants currently deems to be immaterial also may materially adversely effect Merchants' business, financial condition and operating results.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Item 2. Unregistered Sales of Equity Securities and Use of Proceeds                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Issuer Purchases of Equity Securities by the Issuer                                                                                                                                                                                                                                                                                                                                                                                                                                                                              



|Period                   | Total Number
of Shares
Purchased | Average
Price Paid
per Share | Total Number of
Shares Purchased as
Part of Publicly
Announced Plans or
Programs | Maximum Number of
Shares that May Yet
Be Purchased Under
the Plans or
Programs
|------------------------ | -------------------------------- | ---------------------------- | -------------------------------------------------------------------------------- | ------------------------------------------------------------------------------
|                        
|April 1 through April 30 | -                                | -                            | -                                                                                | 101,649                                                                       
|May 1 through May 31     | 4,422                            | $23.55                       | 4,422                                                                            | 97,227                                                                        
|June 1 through June 30   | 12,145                           | 22.82                        | 12,145                                                                           | 85,082                                                                        
|                         |                                 
|Total                    | 16,567                           | $23.01                       | 16,567                                                                           | -                                                                             
|                         |                                 
|                         |                                 

|In January 2007, Merchants Board approved a stock repurchase program, pursuant to which Merchants may repurchase 200,000 shares of its common stock on the open market from time to time through January 2008. The Board extended the program through January 2009 at its January 2008 meeting. Under the program 114,918 shares have been purchased at an average price per share of $23.06; shares purchased during the second quarter of 2008 totaled 16,567 at an average price per share of $23.01.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|Item 3. Defaults Upon Senior Securities                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|None.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|Item 4. Submission of Matters to a Vote of Security Holders                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|Merchants held its Annual Meeting of Shareholders on Tuesday, May 6, 2008, for the purpose of:                                                                                                                                                                                                                                                                                                                                                                                                          
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        



| | Electing four directors, Michael G. Furlong, Robert A. Skiff, Lorilee A. Lawton and John A. Kane, each to serve for a three-year term expiring on the date of the Annual Meeting of Shareholders in 2011, and until their successors are duly elected and qualified in accordance with Merchants' Bylaws;
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  |                                                                                                                                                                                                                                                                                                          
| | Electing one director, Scott F. Boardman to serve for a one-year term expiring on the date of the Annual Meeting of Shareholders in 2009, and until his successor is duly elected and qualified in accordance with Merchants' Bylaws;                                                                    
|  |                                                                                                                                                                                                                                                                                                          
| | Ratifying and approving the Merchants Bancshares, Inc. and Subsidiaries 2008 Compensation Plan for Non-Employee Directors and Trustees; and                                                                                                                                                              
|  |                                                                                                                                                                                                                                                                                                          
| | Ratifying and approving the Merchants Bancshares, Inc. 2008 Stock Option Plan.                                                                                                                                                                                                                           
|  |                                                                                                                                                                                                                                                                                                          

|Shares voted either in person or by proxy totaled 5,617,581, or 92.20% of the shares entitled to vote. The following table sets forth the results of the voting for the directors who were elected:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

<PAGE>  22

| | Name         | Votes For | VotesWithheld | % Votes For | 
| | ------------ | --------- | ------------- | ----------- | 
| |              |           |               |             | 
| | Mr. Furlong  | 5,478,173 | 139,408       | 89.91       | 
| | Dr. Skiff    | 5,383,494 | 234,087       | 88.36       | 
| | Ms. Lawton   | 5,382,011 | 235,570       | 88.34       | 
| | Mr. Kane     | 5,296,699 | 320,882       | 86.94       | 
| | Mr. Boardman | 5,409,712 | 207,869       | 88.79       | 
| |              |           |               |             | 



|The following table sets forth the results of the voting for the last two proposals listed above:
|-------------------------------------------------------------------------------------------------
|                                                                                                 



|Name                                                                                                           | Votes For | Votes
Against | Votes Abstained | Broker Non
Votes | % Votes For
|-------------------------------------------------------------------------------------------------------------- | --------- | ------------- | --------------- | ---------------- | -----------
|                                                                                                               |           |               |                 |                  |            
|Merchants Bancshares, Inc. and
  Subsidiaries 2008 Compensation Plan
  for Non-Employee Directors and Trustees | 4,209,146 | 238,825       | 139,345         | 1,030,266        | 69.09      
|                                                                                                               |           |               |                 |                  |            
|Merchants Bancshares, Inc. 2008 Stock
  Option Plan                                                            | 3,743,417 | 801,071       | 42,827          | 1,030,266        | 61.44      
|                                                                                                               |           |               |                 |                  |            



|Item 5. Other Information
|-------------------------
|                         
|None.                    
|                         
|Item 6. Exhibits         
|                         
|(a)                      
|                         
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|                         
|                         
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|                         

<PAGE>  23

|MERCHANTS BANCSHARES, INC.
SIGNATURES                                                                                                                                                   
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                        
|Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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<PAGE>  24