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

|For the transition period from                                                                                                                                                                                                                                                                                                                           |                         | to                                   | 
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ----------------------- | ------------------------------------ | 
|                                                                                                                                                                                                                                                                                                                                                        
|Commission file number:                                                                                                                                                                                                                                                                                                                                  | 0-11595                
|                                                                                                                                                                                                                                                                                                                                                         |                        
|                                                                                                                                                                                                                                                                                                                                                         |                        
|Merchants Bancshares, Inc.                                                                                                                                                                                                                                                                                                                              
|                                                                                                                                                                                                                                                                                                                                                        
|(Exact name of registrant as specified in its charter)                                                                                                                                                                                                                                                                                                  
|                                                                                                                                                                                                                                                                                                                                                        
|Delaware                                                                                                                                                                                                                                                                                                                                                 |                         | 03-0287342                          
|                                                                                                                                                                                                                                                                                                                                                         |                         |                                     
|(State or other jurisdiction of incorporation or organization)                                                                                                                                                                                                                                                                                           |                         | (I.R.S. Employer Identification No.)
|                                                                                                                                                                                                                                                                                                                                                         |                         |                                     
|275 Kennedy Drive, South Burlington, Vermont                                                                                                                                                                                                                                                                                                             |                         | 05403                               
|                                                                                                                                                                                                                                                                                                                                                         |                         |                                     
|(Address of principal executive offices)                                                                                                                                                                                                                                                                                                                 |                         | (Zip Code)                          
|                                                                                                                                                                                                                                                                                                                                                         |                         |                                     
|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 or a nonaccelerated filer. See the definition of "accelerated filer" and "large accelerated filer" in Rule 12b-2 of the Exchange Act.                                                                                                                  
|Large Accelerated Filer [    ]                                                                                                                                                                                                                                                                                                                           | Accelerated Filer [ X ] | Nonaccelerated Filer [    ]         
|                                                                                                                                                                                                                                                                                                                                                        
|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 April 10, 2007, there were 6,176,911 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.                       
|                              
|                              
|                              
|                              
|                              
|                              
|                              
|                              
|                              
|                              
|                              
|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)                                 |                         |           | March 31,
2007 |        | December 31,
2006
|------------------------------------------------------------------------------ | ----------------------- | --------- | -------------- | ------ | -----------------
|                                                                              
|ASSETS                                                                         |                         |           |                |        |                  
|Cash and due from banks:                                                       |                         |           | $     33,024   |        | $     36,706     
|Federal funds sold and other short-term investments                            |                         |           | 66,000         |        | 42,000           
|                                                                              
|Total cash and cash equivalents                                                |                         |           | 99,024         |        | 78,706           
|Investments:                                                                   |                         |           |                |        |                  
|Securities available for sale, at fair value                                   |                         |           | 315,253        |        | 333,958          
|Securities held to maturity (fair value of $5,382 and $5,804)                  |                         |           | 5,193          |        | 5,615            
|                                                                              
|Total investments                                                              |                         |           | 320,446        |        | 339,573          
|                                                                              
|Loans                                                                          |                         |           | 694,379        |        | 689,283          
|Less: Allowance for loan losses                                                |                         |           | 7,026          |        | 6,911            
|                                                                              
|Net loans                                                                      |                         |           | 687,353        |        | 682,372          
|                                                                              
|Federal Home Loan Bank stock                                                   |                         |           | 5,114          |        | 5,486            
|Bank premises and equipment, net                                               |                         |           | 12,116         |        | 12,538           
|Investment in real estate limited partnerships                                 |                         |           | 8,936          |        | 9,389            
|Other assets                                                                   |                         |           | 8,189          |        | 8,894            
|                                                                              
|Total assets                                                                   |                         |           | $1,141,178     |        | $1,136,958       
|                                                                              
|LIABILITIES                                                                    |                         |           |                |        |                  
|Deposits:                                                                      |                         |           |                |        |                  
|Demand deposits                                                                |                         |           | $   119,999    |        | $     122,036    
|Savings, NOW and money market accounts                                         |                         |           | 436,634        |        | 442,442          
|Time deposits $100 thousand and greater                                        |                         |           | 83,462         |        | 76,822           
|Other time deposits                                                            |                         |           | 250,611        |        | 236,052          
|                                                                              
|Total deposits                                                                 |                         |           | 890,706        |        | 877,352          
|                                                                              
|Securities sold under agreements to repurchase and other short-term borrowings |                         | 84,604    |                | 90,547
|Securities sold under agreements to repurchase, long-term                      |                         |           | 20,000         |        | 20,000           
|Other long-term debt                                                           |                         |           | 48,782         |        | 53,863           
|Junior subordinated debentures issued to unconsolidated subsidiary trust       |                         |           | 20,619         |        | 20,619           
|Other liabilities                                                              |                         |           | 5,488          |        | 4,880            
|                                                                              
|Total liabilities                                                              |                         |           | 1,070,199      |        | 1,067,261        
|                                                                              
|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                                                   |                         |           | 67             |        | 67               
|Shares authorized                                                              | 10,000,000              |           |                |        |                  
|Issued                                                                         | As of March 31, 2007    | 6,651,760 |                |        |                  
|                                                                               | As of December 31, 2006 | 6,651,760 |                |        |                  
|Outstanding                                                                    | As of March 31, 2007    | 5,863,577 |                |        |                  
|                                                                               | As of December 31, 2006 | 5,873,290 |                |        |                  
|Capital in excess of par value                                                 |                         |           | 37,316         |        | 37,413           
|Retained earnings                                                              |                         |           | 49,489         |        | 48,609           
|Treasury stock, at cost                                                        |                         |           | (17,100)       |        | (16,766)         
|                                                                               | As of March 31, 2007    | 788,183   |                |        |                  
|                                                                               | As of December 31, 2006 | 778,470   |                |        |                  
|Deferred compensation arrangements                                             |                         |           | 5,716          |        | 5,833            
|Accumulated other comprehensive loss                                           |                         |           | (4,509)        |        | (5,459)          
|                                                                              
|Total shareholders' equity                                                     |                         |           | 70,979         |        | 69,697           
|                                                                              
|Total liabilities and shareholders' equity                                     |                         |           | $1,141,178     |        | $1,136,958       
|                                                                              
|                                                                               |                         |           |                |        |                  
|See accompanying notes to interim consolidated financial statements.          

<PAGE>  1

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

|                                                                                       | Three Months Ended
March 31,
|-------------------------------------------------------------------------------------- | ----------------------------
|(In thousands except per share data)                                                   | 2007                        
|                                                                                      
|INTEREST AND DIVIDEND INCOME                                                           |                             
|Interest and fees on loans                                                             | $11,465                     
|Interest and dividends on investments, fed funds sold and other short-term investments |                             
|U.S. Treasury and Agency obligations                                                   | 1,759                       
|Other                                                                                  | 2,836                       
|                                                                                      
|Total interest and dividend income                                                     | 16,060                      
|                                                                                      
|INTEREST EXPENSE                                                                       |                             
|Savings, NOW and money market accounts                                                 | 1,223                       
|Time deposits $100 thousand and greater                                                | 2,025                       
|Other time deposits                                                                    | 1,200                       
|Other borrowed funds                                                                   | 928                         
|Long-term debt                                                                         | 1,170                       
|                                                                                      
|Total interest expense                                                                 | 6,546                       
|                                                                                      
|Net interest income                                                                    | 9,514                       
|Provision for credit losses                                                            | --                          
|                                                                                      
|Net interest income after provision for credit losses                                  | 9,514                       
|                                                                                      
|NONINTEREST INCOME                                                                     |                             
|Trust company income                                                                   | 487                         
|Service charges on deposits                                                            | 1,091                       
|Loss on investment securities                                                          | (37)                        
|Equity in losses of real estate limited partnerships, net                              | (451)                       
|Other                                                                                  | 752                         
|                                                                                      
|Total noninterest income                                                               | 1,842                       
|                                                                                      
|NONINTEREST EXPENSE                                                                    |                             
|Salaries and wages                                                                     | 3,012                       
|Employee benefits                                                                      | 924                         
|Occupancy expense, net                                                                 | 829                         
|Equipment expense                                                                      | 685                         
|Legal and professional fees                                                            | 646                         
|Marketing                                                                              | 284                         
|State franchise taxes                                                                  | 223                         
|Other                                                                                  | 1,367                       
|                                                                                      
|Total noninterest expense                                                              | 7,970                       
|                                                                                      
|Income before provision for income taxes                                               | 3,386                       
|Provision for income taxes                                                             | 769                         
|                                                                                      
|NET INCOME                                                                             | $  2,617                    
|                                                                                      
|                                                                                       |                             
|Basic earnings per common share                                                        | $0.42                       
|Diluted earnings per common share                                                      | $0.42                       
|                                                                                       |                             

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

<PAGE>  2

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

|                                                                           | Three months ended
March 31,
|-------------------------------------------------------------------------- | ----------------------------
|(In thousands)                                                             | 2007                        
|                                                                          
|Net income                                                                 | $2,617                      
|Other comprehensive income (loss), net of tax:                             |                             
|Change in net unrealized gain (loss) on securities available for sale, net |                             
|of taxes of $474 and $(1,143)                                              | 881                         
|Reclassification adjustments for securities losses included in             |                             
|net income, net of taxes of $13                                            | 24                          
|Amortization of net actuarial loss, net of taxes of $25                    | 45                          
|                                                                          
|Other comprehensive income (loss)                                          | 950                         
|                                                                          
|Comprehensive income                                                       | $3,567                      
|                                                                          
|                                                                           |                             

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

<PAGE>  3

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

|For the three months ended March 31,                                                | 2007      |  | 2006      
|----------------------------------------------------------------------------------- | --------- |  | ----------
|                                                                                   
|(In thousands)                                                                      |           |  |           
|CASH FLOWS FROM OPERATING ACTIVITIES:                                               |           |  |           
|Net income                                                                          | $  2,617  |  | $   2,722 
|Adjustments to reconcile net income to net cash provided by operating activities:   |           |  |           
|Depreciation and amortization                                                       | 800       |  | 1,127     
|Amortization of stock grant                                                         | 4         |  | --        
|Loss on sales of investment securities                                              | 37        |  | --        
|Equity in losses of real estate limited partnerships, net                           | 453       |  | 423       
|Changes in assets and liabilities:                                                  |           |  |           
|Increase in interest receivable                                                     | 245       |  | 3         
|(Increase) decrease in other assets                                                 | (133)     |  | 868       
|Increase (decrease) in interest payable                                             | 55        |  | (150)     
|Increase in other liabilities                                                       | 626       |  | 1,132     
|                                                                                   
|Net cash provided by operating activities                                           | 4,704     |  | 6,125     
|                                                                                   
|                                                                                    |           |  |           
|CASH FLOWS FROM INVESTING ACTIVITIES:                                               |           |  |           
|Proceeds from sales of investment securities available for sale                     | 1,463     |  | --        
|Proceeds from maturities of investment securities available for sale                | 18,444    |  | 19,615    
|Proceeds from maturities of investment securities held to maturity                  | 422       |  | 557       
|Proceeds from redemption of Federal Home Loan Bank stock                            | 372       |  | --        
|Purchases of investment securities available for sale                               | --        |  | (39,725)  
|Net change in loans                                                                 | (5,547)   |  | (16,216)  
|Proceeds from sales of loans, net                                                   | 494       |  | --        
|Investments in real estate limited partnerships                                     | --        |  | (910)     
|Purchases of bank premises and equipment                                            | (76)      |  | (379)     
|                                                                                   
|Net cash provided by (used in) investing activities                                 | 15,572    |  | (37,058)  
|                                                                                   
|                                                                                    |           |  |           
|CASH FLOWS FROM FINANCING ACTIVITIES:                                               |           |  |           
|Net increase (decrease) in deposits                                                 | 13,354    |  | (2,129)   
|Net (decrease) increase in short-term borrowings                                    | (1,957)   |  | 22,762    
|Proceeds from long-term debt                                                        | --        |  | 10,000    
|Net (decrease) increase in securities sold under agreement to repurchase-short term | (3,986)   |  | 456       
|Principal payments on long-term debt                                                | (5,081)   |  | (10,576)  
|Cash dividends paid                                                                 | (1,546)   |  | (1,561)   
|Purchases of treasury stock                                                         | (825)     |  | (535)     
|Sale of treasury stock                                                              | 5         |  | 3         
|Increase in deferred compensation arrangements                                      | 63        |  | 58        
|Proceeds from exercise of stock options, net of withholding taxes                   | --        |  | 72        
|Tax benefit from exercise of stock options                                          | 15        |  | --        
|                                                                                   
|Net cash provided by financing activities                                           | 42        |  | 18,550    
|                                                                                   
|                                                                                    |           |  |           
|Increase (decrease) in cash and cash equivalents                                    | 20,318    |  | (12,383)  
|Cash and cash equivalents beginning of year                                         | 78,706    |  | 45,214    
|                                                                                   
|Cash and cash equivalents end of period                                             | $99,024   |  | $ 32,831  
|                                                                                   
|                                                                                    |           |  |           
|SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:                                   |           |  |           
|Total interest payments                                                             | $  6,491  |  | $   5,057 
|Total income tax payments                                                           | 400       |  | --        
|SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND
FINANCING ACTIVITIES              |           |  |           
|Distribution of stock under deferred compensation arrangements                      | $     268 |  | $      282
|Distribution of treasury stock in lieu of cash dividend                             | 190       |  | 205       
|Transfer of loans to other real estate owned                                        | --        |  | 312       
|                                                                                    |           |  |           
|See accompanying notes to interim consolidated financial statements.               

<PAGE>  4

|Notes To Interim Consolidated Financial Statements                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|See Merchants Bancshares, Inc. ("Merchants") 2006 Annual Report on Form 10-K for additional information.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|Note 1:  Financial Statement Presentation                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|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 March 31, 2007, and for the three months ended March 31, 2007 and 2006, 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.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|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 March 31, | 
| | --------------------------------------------- |  | ------------------------------------ | 
| |                                               |  |                                      | 
| |                                               |  | 2007                                 | 
| |                                               |  |                                      | 
| |                                               |  |                                      | 
| | (In thousands except per share data)          |  |                                      | 
| | Net income                                    |  | $2,617                               | 
| |                                               |  |                                      | 
| | Weighted average common shares outstanding    |  | 6,187                                | 
| | Dilutive effect of common stock equivalents   |  | 18                                   | 
| |                                               |  |                                      | 
| | Weighted average common and common equivalent |  |                                      | 
| | shares outstanding                            |  | 6,205                                | 
| | Basic earnings per share                      |  | $  0.42                              | 
| | Diluted earnings per share                    |  | $  0.42                              | 
| |                                               |  |                                      | 

|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 month periods ended March 31, 2007 and 2006. For the three months ended March 31, 2007 there was an average of 10,000 stock options outstanding that were not included in the calculation of earnings per share because they were anti-dilutive. There were no anti-dilutive stock options outstanding during the three months ended March 31, 2006.                                                                                                                                                                                                             
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|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 pension benefit costs for the periods indicated:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         



| |                                |  | Pension Benefits             | 
| | ------------------------------ |  | ---------------------------- | 
| |                                |  | Three months ended
March 31, | 
| | (In thousands)                 |  | 2007                         | 
| |                                | 
| | Interest cost                  |  | $ 115                        | 
| | Expected return on Plan assets |  | (125)                        | 
| | Amortization of net loss       |  | 70                           | 
| |                                |  |                              | 
| | Net periodic benefit cost      |  | $   60                       | 
| |                                |  |                              | 



<PAGE>  5

|No contributions have been made to the Plan during 2007 to date. Merchants has no required contribution for 2007.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|Note 4:  Stock Repurchase Program                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|In October 2005 Merchants' Board of Directors approved a stock repurchase program, pursuant to which Merchants may repurchase up to 200,000 shares of its common stock from time to time through October 2006. The Board of Directors voted to extend the program through October 2007 at its October 2006 meeting. Merchants has purchased 199,277 shares of its common stock on the open market under the program, at an average per share price of $23.82, of which 32,566 shares were purchased during 2007. In January 2007, Merchants' Board approved a new 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 new program will commence when there are no shares remaining to be purchased as authorized under the previous stock repurchase program.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|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 $6.49 million at March 31, 2007 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 March 31, 2007 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:  Accounting for Uncertainty in Income Taxes                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|In June 2006, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 48, "Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109" ("FIN 48"). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements by prescribing a recognition threshold of more-likely-than-not, and a measurement attributable for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return in order for the related tax benefits to be recognized or continue to be recognized. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosures and transitions. FIN 48 is effective for fiscal years beginning after December 15, 2006 and is to be applied to all tax positions upon initial adoption of this standard.                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
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|On January 1, 2007 Merchants adopted the provisions of FIN 48 and there was no impact to the consolidated financial statements. Upon the adoption of this standard, Merchants performed an analysis of its tax positions to determine whether there may be uncertainties that require further analysis under FIN 48 based upon their specific facts and circumstances. Merchants did not identify any tax positions that contained significant uncertainties at January 1, 2007 or March 31, 2007.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
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|Merchants has no interest or penalties recognized in its consolidated statements of income for the three months ended March 31, 2007 and 2006, or in its consolidated balance sheets at March 31, 2007. Such interest and penalties would be classified as other noninterest expense in its consolidated statement of income.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
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|Merchants is currently open to audit under the statute of limitations by the Internal Revenue Service for the years ending December 31, 2003 through 2006. Merchants' state income tax returns are also open to audit under the statute of limitations for the years ending December 31, 2003 through 2006. Merchants' 2004 federal income tax was audited by the IRS with only small adjustments made to the return as filed.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
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|Note 7:  Reclassifications                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|Amounts reported for prior periods are reclassified, where necessary, to be consistent with the current period presentation.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            

<PAGE>  6

|Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
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|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:
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|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.                                                                        
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|General                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|All adjustments necessary for a fair presentation of Merchants' interim consolidated financial statements as of March 31, 2007, and for the three months ended March 31, 2007 and 2006, 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.                                                                                                                                                                        



<PAGE>  7



|Results of Operations                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
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|Overview                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|Net income for the first quarter of 2007 was $2.62 million compared to net income of $2.72 million for the first quarter of 2006. The return on average assets and return on average equity for the first quarter of 2007 were 0.93% and 15.05%, respectively, compared to 1.01% and 16.47%, respectively, for the first quarter of 2006. The following were the major factors contributing to the results for the first quarter of 2007 compared to the first and/or fourth quarters of 2006:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
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|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
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|Net Interest Income                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|Merchants' net interest income decreased $115 thousand for the first quarter of 2007 compared to the first quarter of 2006. Merchants' net interest margin decreased 23 basis points to 3.60% from 3.83% for the first quarter of 2007 compared to the first quarter of 2006, and decreased by 2 basis points when comparing the first quarter of 2007 to the fourth quarter of 2006. These decreases are attributable to a number of factors. Merchants' liability sensitivity has continued to increase due to changes in its balance sheet mix over the past year while short-term interest rates rose higher, accompanied by a sustained flat yield curve. Merchants' average yield on interest earnings assets increased by 5 basis points during the first quarter of 2007 as compared to the fourth quarter of 2006, and by 30 basis points over the first quarter of 2006, while its cost of interest bearing liabilities increased by 8 basis points in the first quarter of 2007 as compared to fourth quarter of 2006, and 61 basis points over the first quarter of 2006. The shift from variable rate to fixed rate loans in Merchants' combined commercial mortgage and commercial loan portfolios has continued as customers locked in their rates in the current flat yield curve environment. As shown in the table on pages 9-10, Merchants' deposits have continued to shift from lower cost savings, NOW and money market accounts to higher rate time deposits. Merchants has continued to make adjustments to its time deposit rates, rather than make even greater changes in money market account rates. Merchants' rate paid on long-term debt has increased 5 basis points over the fourth quarter of 2006 as long-term debt taken out in a lower interest rate environment runs off. The cost of short-term securities sold under agreements to repurchase has decreased by 12 basis points from the fourth quarter of 2006 to the first quarter of 2007 as Merchants has been able to make small downward adjustments to these rates and still remain competitive.
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|The following table attributes changes in Merchants' net interest income (on a fully taxable equivalent basis) to changes in either average balances or average rates for the three months ended March 31, 2007. 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>  8



|Analysis of Changes in Fully Taxable Equivalent Net Interest Income
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|                                                                   

|Three Months Ended March 31,                   |          |  |          |  |                     |  |       
|---------------------------------------------- | -------- |  | -------- |  | ------------------- |  | ------
|                                              
|                                               |          |  |          |  |                     |  | Due to
|                                               |          |  |          |  |                     |  |       
|(In thousands)                                 | 2007     |  | 2006     |  | Increase
(Decrease) |  | Volume
|                                              
|Fully taxable equivalent interest income:      |          |  |          |  |                     |  |       
|Loans                                          | $11,474  |  | $  9,910 |  | $1,564              |  | $1,344
|Investments                                    | 4,008    |  | 4,629    |  | (621)               |  | (879) 
|Federal funds sold, securities sold under      |          |  |          |  |                     |  |       
|agreements to repurchase and interest          |          |  |          |  |                     |  |       
|bearing deposits with banks                    | 587      |  | 2        |  | 585                 |  | 583   
|                                              
|Total interest income                          | 16,069   |  | 14,541   |  | 1,528               |  | 1,048 
|                                              
|Less interest expense:                         |          |  |          |  |                     |  |       
|Savings, NOW & money market accounts           | 1,223    |  | 1,247    |  | (24)                |  | (106) 
|Time deposits                                  | 3,225    |  | 1,846    |  | 1,379               |  | 584   
|Federal Home Loan Bank short-term borrowings   | 19       |  | 812      |  | (793)               |  | (930) 
|Securities sold under agreements to repurchase |          |  |          |  |                     |  |       
|and other short-term debt                      | 909      |  | -        |  | 909                 |  | -     
|Securities sold under agreement to repurchase, |          |  |          |  |                     |  |       
|long-term                                      | 285      |  | 250      |  | 35                  |  | -     
|Other long-term debt                           | 587      |  | 454      |  | 133                 |  | (19)  
|Junior subordinated debt                       | 298      |  | 297      |  | 1                   |  | -     
|                                              
|Total interest expense                         | 6,546    |  | 4,906    |  | 1,640               |  | (471) 
|                                              
|Net interest income                            | $  9,523 |  | $  9,635 |  | $  (112)            |  | $1,519
|                                              
|                                               |          |  |          |  |                     |  |       

|The following tables set forth certain information regarding net interest margin for the three months ended March 31, 2007 and 2006. 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>  9

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

|                                                                                                                          | Three Months Ended
|------------------------------------------------------------------------------------------------------------------------- | ------------------
|                                                                                                                          |                   
|                                                                                                                          | March 31, 2007    
|                                                                                                                          |                   
|(In thousands, fully taxable equivalent)                                                                                  | Average
Balance   
|                                                                                                                          |                   
|ASSETS:                                                                                                                   |                   
|Loans, including fees on loans (a)                                                                                        | $   690,045       
|Taxable investments (b) (c)                                                                                               | 336,886           
|Federal funds sold and interest bearing                                                                                   |                   
|deposits with banks                                                                                                       | 44,917            
|                                                                                                                          |                   
|Total interest earning assets                                                                                             | 1,071,848         
|                                                                                                                          |                   
|Allowance for loan losses                                                                                                 | (6,942)           
|Cash and due from banks                                                                                                   | 33,148            
|Premises and equipment, net                                                                                               | 12,371            
|Other assets                                                                                                              | 17,226            
|                                                                                                                          |                   
|Total assets                                                                                                              | $1,127,651        
|                                                                                                                          |                   
|                                                                                                                          |                   
|LIABILITIES AND SHAREHOLDERS' EQUITY:                                                                                     |                   
|Interest bearing deposits:                                                                                                |                   
|Savings, NOW & money market accounts                                                                                      | $   430,824       
|Time deposits                                                                                                             | 326,475           
|                                                                                                                          |                   
|Total interest bearing deposits                                                                                           | 757,299           
|                                                                                                                          |                   
|Federal Home Loan Bank short-term borrowings                                                                              | 1,438             
|Securities sold under agreements to repurchase                                                                            |                   
|and other short-term debt                                                                                                 | 85,222            
|Securities sold under agreements to repurchase,                                                                           |                   
|long-term                                                                                                                 | 20,000            
|Other long-term debt                                                                                                      | 50,273            
|Junior subordinated debentures issued to                                                                                  |                   
|Unconsolidated subsidiary trust                                                                                           | 20,619            
|                                                                                                                          |                   
|Total interest bearing liabilities                                                                                        | 934,851           
|                                                                                                                          |                   
|Noninterest bearing deposits                                                                                              | 117,478           
|Other liabilities                                                                                                         | 5,780             
|Shareholders' equity                                                                                                      | 69,542            
|                                                                                                                          |                   
|Total liabilities and shareholders' equity                                                                                | $1,127,651        
|                                                                                                                          |                   
|                                                                                                                          |                   
|Net interest earning assets                                                                                               | $   136,997       
|                                                                                                                          |                   
|                                                                                                                          |                   
|Net interest income (fully taxable equivalent)                                                                            |                   
|                                                                                                                          |                   
|Tax equivalent adjustment                                                                                                 |                   
|                                                                                                                          |                   
|Net interest income per book                                                                                              |                   
|                                                                                                                          |                   
|                                                                                                                          |                   
|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>  10

|Provision for Credit Losses: No provision for credit losses was recorded during the first three months of 2007 or 2006. This is primarily a result of Merchants' strong asset quality, and the fact that Merchants recorded net recoveries totaling $44 thousand for the first quarter of 2007 and recorded net recoveries of $43 thousand for the first quarter of 2006. The Allowance for credit losses ("Allowance") is comprised of the allowance for loan losses and the reserve for undisbursed lines of credit. The Allowance is reviewed by management at least quarterly and continues to be deemed adequate under current market conditions. The allowance for loan losses was $7.03 million, 1.01% of total loans and 279% of nonperforming loans at March 31, 2007, compared to $6.91 million, 1.00% of total loans and 256% of nonperforming loans at December 31, 2006. 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. There is no guarantee that a provision for credit losses will not be required in future quarters. See the discussion of Nonperforming Assets on pages 13 - 15 for additional information on the Allowance.
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|Noninterest Income: Total noninterest income decreased $24 thousand to $1.84 million for the first quarter of 2007 from $1.87 million for the first quarter of 2006. Merchants sold an available for sale corporate bond during the first quarter because of concerns about the company's exposure to the sub-prime mortgage market. A $37 thousand loss was recognized on the sale. There were no security gains or losses during the first quarter of 2006. Excluding the security losses, noninterest income increased by $13 thousand for the first quarter of 2007 compared to the first quarter of 2006. This increase was primarily driven by increased Trust department revenue as well as increases in net ATM/debit card revenue.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
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|Noninterest Expense: Total noninterest expense was $7.97 million for the first quarter of 2007 compared to $7.94 million for the first quarter of 2006. Salaries and wages were virtually unchanged when comparing the first quarter of 2007 to 2006. Employee benefits decreased $134 thousand to $924 thousand from $1.06 million for the first quarter of 2007 compared to 2006. This decrease is primarily a result of a decrease in the employer match in Merchants' 401(k) plan. Legal and professional fees increased $109 thousand to $646 thousand from $537 thousand relating to special projects undertaken during the first quarter of 2007. Marketing expenses decreased $56 thousand to $284 thousand from $340 thousand during the first quarter of 2007 related to the timing of services and expenses. Other noninterest expenses increased $107 thousand to $1.37 million for the first quarter of 2007 from $1.26 million for the first quarter of 2006. Merchants experienced a defalcation during the quarter; insurance coverage was subject to a $100 thousand deductible.                                                                                                                                                                                    
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|Balance Sheet Analysis                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Average loans for the first quarter of 2007 were $690.05 million, compared to $608.88 million for the first quarter of 2006 and $685.28 million for the fourth quarter of 2006. First quarter loan growth was slower than what Merchants experienced during the first quarter of 2006. Residential real estate and commercial loans made up most of the increase since the fourth quarter of 2006. Merchants continues to meet the competition on pricing to retain strong existing relationships and obtain high quality new business. Success in growing commercial real estate and commercial loans has required a sustained development program. Most of the growth during the first three months of 2007 can be attributed to the successful conclusion of several long-term prospecting efforts.                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
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|The following table summarizes the components of Merchants' loan portfolio as of March 31, 2007 and December 31, 2006:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
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| | (In thousands)                         | March 31, 2007 |  | December 31, 2006
| | -------------------------------------- | -------------- |  | -----------------
| |                                       
| | Commercial, financial and agricultural | $  79,550      |  | $  73,512        
| | Real estate loans - residential        | 328,840        |  | 323,885          
| | Real estate loans - commercial         | 245,628        |  | 250,526          
| | Real estate loans - construction       | 33,024         |  | 33,167           
| | Installment loans                      | 6,788          |  | 7,133            
| | All other loans                        | 549            |  | 1,060            
| |                                       
| | Total loans                            | $694,379       |  | $689,283         
| |                                       
| |                                       



|Average deposits for the first quarter of 2007 were $874.78 million compared to $846.62 million for the first quarter of 2006, and $864.97 million for the fourth quarter of 2006. Merchants continues to focus on generating lower cost transaction accounts with a packaged offering featuring the historically popular free checking as the anchor product on the retail side, and CommerceLYNXâ
 checking on the business side. These programs have high value to Merchants' customers and provide funding that supports the net interest margin. Merchants has proactively addressed the competitive marketplace by offering appealing rates on CDs and on an innovative, flexible time deposit. These products have proven to be successful at offsetting declines in balances of core funding within Merchants' money market category. While numbers of accounts and households continue to rise at Merchants, the shift within deposit categories continues as depositors seek higher yields.
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<PAGE>  11

|Quarterly average savings, NOW and money market balances have decreased by $8.06 million from the fourth quarter of 2006 and have decreased $39.39 million from the first quarter of 2006 to the first quarter of 2007. At the same time, average time deposit balances have increased by $24.05 million from fourth quarter 2006 and increased $70.06 million from the first quarter of 2006 to the first quarter of 2007.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
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|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|Merchants' investment portfolio at March 31, 2007 has decreased $19.13 million since December 31, 2006. Because of the persistent flat to inverted yield curve environment, Merchants decided during 2006 to discontinue further investments in the portfolio. Merchants has used current cash flow from the portfolio to fund loan growth and pay down debt, and fund short- term investments rather than reinvest in the investment portfolio. Merchants' short-term investment position has increased $24.00 million since December 31, 2006. Merchants has performed a thorough analysis of its sub-prime exposure in the investment portfolio. Merchants sold one corporate bond totaling $1.50 million at a small loss because of concerns about the company's exposure to the sub-prime mortgage market. Merchants continues to hold asset backed securities totaling approximately $6.55 million that are classified as "sub-prime", representing less than 2% of the portfolio. Both bonds are AAA rated and are fully insured. The credit performance on both bonds has been excellent to date.                                                                                                           
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|Merchants' new cash management sweep product continues to be successful. This product is priced at an attractive cost of funds when compared to other short-term borrowing alternatives. Balances in this product totaled $84.61 million at March 31, 2007 and are included with "Securities sold under agreements to repurchase" on the accompanying consolidated balance sheet. These funds were used to replace higher cost FHLB short-term borrowings; balances in short term FHLB borrowings were zero at March 31, 2007, compared to $75 million one year earlier. FHLB long-term borrowings were $48.78 million at March 31, 2007 compared to $53.86 million at December 31, 2006.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|In the ordinary course of business, Merchants makes commitments for possible future extensions of credit. At March 31, 2007, Merchants was obligated to fund $6.49 million of standby letters of credit. No losses are anticipated in connection with these commitments.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|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 based upon average deposit levels in lieu of taxing income. Franchise taxes are included in noninterest expenses in the consolidated statements of income and totaled $223 thousand for the quarter ended March 31, 2007 compared to $239 for the quarter ended March 31, 2006. The decrease in state franchise taxes from 2006 to 2007 was attributable to Merchants' purchase of State of Vermont affordable housing tax credits. Total income tax expense was $769 thousand for the quarter ended March 31, 2007 compared to $831 thousand for the quarter ended March 31, 2006. Merchants recognized favorable tax benefits from federal affordable housing tax credits of $410 thousand for the first quarter of 2007, compared to $413 thousand for the first quarter of 2006. 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 22.7% for the quarter ended March 31, 2007, and 23.4% for the quarter ended March 31, 2006.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|In June 2006, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 48, "Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109" ("FIN 48"). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements by prescribing a recognition threshold of more-likely-than-not, and a measurement attributable for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return in order for the related tax benefits to be recognized or continue to be recognized. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosures and transitions. FIN 48 is effective for fiscal years beginning after December 15, 2006 and is to be applied to all tax positions upon initial adoption of this standard.                                                                                                                                                                                                                                                                     
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|On January 1, 2007 Merchants adopted the provisions of FIN 48 and there was no impact to the consolidated financial statements. Upon the adoption of this standard, Merchants performed an analysis of its tax positions to determine whether there may be uncertainties that require further analysis under FIN 48 based upon their specific facts and circumstances. Merchants did not identify any tax positions that contained significant uncertainties at January 1, 2007 or March 31, 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. For this purpose, liquidity means the ability to generate cash in the most economical way to satisfy loan demand, deposit withdrawal demand, and to fund other business opportunities which require cash. Merchants had $66 million in overnight funds sold and other short-term investments at March 31, 2007. Additionally, Merchants has an overnight line of credit with the FHLB of $5 million and an estimated additional borrowing capacity with the FHLB of $122 million. Additionally, Merchants has $28 million in available federal funds lines of credit at March 31, 2007 and the ability to borrow through the use of repurchase agreements, collateralized by Merchants' investments, with                                                                                                                                                                                                                                                                                                                                           

<PAGE>  12

|certain approved counterparties. Merchants' investment portfolio, which is managed by the ALCO, totaled $320.45 million at March 31, 2007, and is a reliable source of cash flow for Merchants.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|In October 2005 Merchants' Board of Directors approved a stock repurchase program, pursuant to which Merchants may repurchase up to 200,000 shares of its common stock from time to time through October 2006. Merchants' Board of Directors voted to extend the program through October 2007 at its October 2006 meeting. Merchants has purchased 199,277 shares of its common stock on the open market under the program, at an average per share price of $23.82, of which 32,566 shares were purchased during 2007 at an average price per share of $23.19. In January 2007, Merchants Board approved a new 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 new program will commence when there are no shares remaining under the previous stock repurchase program.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|As of March 31, 2007, Merchants exceeded all applicable regulatory capital requirements. The following table represents the actual capital ratios and capital adequacy requirements for Merchants as of March 31, 2007 and 2006:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               



|                          | Actual               |  | For CapitalAdequacy Purposes
|------------------------- | -------------------- |  | ----------------------------
|                          |                      |  |                             
|(In thousands)            | Amount (1)           |  | Percent                     
|                         
|                          | As of March 31, 2007
|Tier 1 leverage capital   | $  93,498            |  | 8.29%                       
|Tier 1 risk-based capital | 93,498               |  | 12.67%                      
|Total risk-based capital  | 100,823              |  | 13.66%                      
|                          |                      |  |                             
|                          | As of March 31, 2006
|Tier 1 leverage capital   | $  91,295            |  | 8.44%                       
|Tier 1 risk-based capital | 91,295               |  | 12.96%                      
|Total risk-based capital  | 98,421               |  | 13.97%                      
|                          |                      |  |                             

|(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. Although Merchants has been successful to date in minimizing its problem assets, Merchants cannot assure that problem assets will remain at current levels, particularly in light of current or future economic conditions. There is also no assurance that Merchants will not need to increase the Allowance in the future.
|                                                                                                                                                                                                                                                                                                                                                                                              
|The following table summarizes Merchants' nonperforming assets at the dates indicated:                                                                                                                                                                                                                                                                                                        
|                                                                                                                                                                                                                                                                                                                                                                                              

| | (In thousands)                    |  | March 31, 2007 |  | December 31, 2006 |  | March 31, 2006 | 
| | --------------------------------- |  | -------------- |  | ----------------- |  | -------------- | 
| |                                   | 
| | Nonaccrual loans                  |  | $2,425         |  | $2,606            |  | $1,797         | 
| | Troubled debt restructurings      |  | 90             |  | 92                |  | 79             | 
| |                                   | 
| | Total nonperforming loans ("NPL") |  | $2,515         |  | $2,698            |  | $1,876         | 
| | Other Real Estate Owned ("OREO")  |  | 258            |  | 258               |  | 312            | 
| |                                   | 
| | Total nonperforming assets        |  |                |  |                   |  |                | 
| | ("NPA")                           |  | $2,773         |  | $2,956            |  | $2,188         | 
| |                                   | 
| |                                   |  |                |  |                   |  |                | 

|Nonperforming loans decreased to $2.52 million at March 31, 2007 from $2.70 million at December 31, 2006. Merchants has had one property held in OREO since the first quarter of 2006. This property is related to a loan secured by a small grocery store property in northeastern Vermont which was transferred to OREO during the first quarter of 2006.                                                                                                                                  
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|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 March 31, 2007 totaled $2.20 million, of which $2.06 million are included as nonaccrual loans in the table above. Loans past due 60 days are included in impaired loans.                                     
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|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

<PAGE>  13

|findings of this review process are instrumental in determining the adequacy of the Allowance. Excluded from nonperforming loans are approximately $10.60 million of internally classified loans as of March 31, 2007, compared to $5.5 million as of December 31, 2006. This increase is attributable to a downgrade of a $5.69 million relationship to a customer related to residential construction located in northern New England. The customer has suffered from the soft housing market.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|The following table reflects Merchants' nonperforming asset and coverage ratios as of the dates indicated:                                                                                                                                                                                                                                                                                                                                                                                      



| |                                  |  | March 31, 2007 |  | December 31, 2006 |  | March 31, 2006 | 
| | -------------------------------- |  | -------------- |  | ----------------- |  | -------------- | 
| |                                  | 
| | NPL to total loans               |  | 0.36%          |  | 0.39%             |  | 0.30%          | 
| | NPA to total loans plus OREO     |  | 0.40%          |  | 0.43%             |  | 0.35%          | 
| | Allowance for loan losses        |  |                |  |                   |  |                | 
| | to total loans                   |  | 1.01%          |  | 1.00%             |  | 1.07%          | 
| | Allowance to total loans         |  | 1.05%          |  | 1.06%             |  | 1.15%          | 
| | Allowance for loan losses to NPL |  | 279%           |  | 256%              |  | 354%           | 
| | Allowance for loan losses to NPA |  | 253%           |  | 234%              |  | 303%           | 
| |                                  |  |                |  |                   |  |                | 



|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:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         

<PAGE>  14



|(In thousands)                              | March 31, 2007 |  | December 31, 2006 |  | March 31, 2006
|------------------------------------------- | -------------- |  | ----------------- |  | --------------
|                                           
|Balance, beginning of year                  | $7,281         |  | $7,083            |  | $7,083        
|Charge-offs :                               |                |  |                   |  |               
|Commercial, lease financing and all other   | (78)           |  | (46)              |  | (2)           
|Real estate - construction                  | --             |  | --                |  | --            
|Real estate - commercial                    | (85)           |  | --                |  | --            
|Real estate - mortgage                      | --             |  | (13)              |  | --            
|Installment and other consumer              | (12)           |  | (4)               |  | (3)           
|                                           
|Total charge-offs                           | (175)          |  | (63)              |  | (5)           
|                                           
|Recoveries:                                 |                |  |                   |  |               
|Commercial, lease financing and all other   | 202            |  | 236               |  | 47            
|Real estate - commercial                    | 17             |  | --                |  | --            
|Real estate - mortgage                      | --             |  | 14                |  | --            
|Installment and other consumer              | --             |  | 11                |  | 1             
|                                           
|Total recoveries                            | 219            |  | 261               |  | 48            
|                                           
|Net recoveries                              | 44             |  | 198               |  | 43            
|                                           
|Provision for credit losses                 | --             |  | --                |  | --            
|                                           
|Balance end of period                       | $7,325         |  | $7,281            |  | $7,126        
|                                           
|                                            |                |  |                   |  |               
|Components:                                 |                |  |                   |  |               
|Allowance for loan losses                   | $7,026         |  | $6,911            |  | $6,637        
|Reserve for undisbursed lines of credit (1) | 299            |  | 370               |  | 489           
|                                           
|Allowance for Credit Losses                 | $7,325         |  | $7,281            |  | $7,126        
|                                           
|                                            |                |  |                   |  |               



|(1) | Effective March 31, 2006 Merchants transferred the portion of the allowance for loan losses related to commercial lending commitments and letters of credit to other liabilities.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|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.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|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. Management considered the balance of the Allowance adequate at March 31, 2007.                                                                                                                                                                                                                                                                                                   
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|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                                                                                                                                                                                                                                                                                                                                                                  

<PAGE>  15

|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 interest rate risk. An important component of Merchants' asset and liability management process is the ongoing monitoring and management of this risk, which is governed by established policies that are reviewed and approved annually by Merchants Bank's Board of Directors, which delegates responsibility for carrying out the asset and liability management policies 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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|Interest Rate Risk                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|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 February 28, 2007. At that time Merchants' one-year gap position was a $245.04 million liability-sensitive position compared to a $255.16 million liability-sensitive position at the end of 2006.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|The consultant ran a base simulation assuming no changes in rates or balance sheet mix at the February 28,2007 review. Additionally, the consultant modeled a 200 basis point rising and falling interest rate scenario which assumes a parallel and pro rata shift of the yield curve over a one-year period and assumes no changes or growth in the balance sheet. Assuming interest rates and Merchants' balance sheet and mix remain similar to what they were as of February 28, 2007, net interest income is projected to increase throughout the simulation as investment cash flows are reinvested into federal funds sold and short-term investments, driving up asset yields. Net interest income is projected to trend gradually upward in the second year and beyond. If money market balances continue to migrate toward time deposits, and regular time deposits continue to migrate into CD specials, this benefit will be mitigated. If rates fall net interest income is projected to increase during the first year as the large short-term funding position provides an immediate benefit; however, this trend is projected to reverse in year two as funding rates stabilize while asset yields continue to fall. If the yield curve should steepen as rates fall, levels of net interest income are projected to be higher than the base model throughout the simulation. If rates rise net interest income is expected to decrease during the first year as funding costs increase more quickly than the asset base. This trend starts to reverse itself during year two as asset yield improvements outpace slowing funding rate increases. Merchants purchased a $30 million interest rate cap during the first quarter of 2007 to help mitigate its exposure to rising short-term interest rates. The cap will be recorded on Merchants' balance sheet at fair value with subsequent changes in fair value recorded through earnings each quarter, which will introduce some additional volatility to Merchants' earnings stream.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|The change in net interest income for the next twelve months from Merchants' expected or "most likely" forecast at the February 28, 2007 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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          





|Rate Change           |  | Percent Change in
Net Interest Income
|--------------------- |  | -------------------------------------
|                     
|Up 200 basis points   |  | (1.7)%                               
|Down 200 basis points |  | 2.7%                                 
|                     

|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. Falling rates, accompanied by a yield curve that steepens in the short end, resulted in a modest net interest income increase during the first year of the simulation, followed by a substantial increase in the second year. 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 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                                                                                                                                                                                                                                                                                                                                                                               

<PAGE>  16

|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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
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|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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
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|Merchants periodically, if deemed appropriate, uses interest rate swaps, floors and caps, which are common derivative financial instruments, to hedge its interest rate risk position. Merchants Bank's Board of Directors has approved hedging policy statements governing Merchants' use of these instruments. As mentioned previously, Merchants purchased a $30 million interest rate cap during the first quarter of 2007 to help to mitigate its exposure to rising interest rates. The risks associated with entering into such transactions are the risk of default from the counterparty with whom Merchants has entered into agreement and a poor correlation between the item being hedged and the derivative instrument. Merchants' risk from default of the counterparty is limited to the expected cash flow anticipated from the counterparty, not the notional value.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
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|Credit Risk                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|Merchants Bank's Board of Directors reviews and approves Merchants Bank's loan policy on an annual basis. Among other things, the loan policy establishes restrictions regarding the types of loans that may be granted, and the distribution of loan types within 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 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. Merchants' policy is to discontinue the accrual of interest on loans when scheduled payments become contractually past due 90 or more days and the ultimate collectibility of principal or interest becomes doubtful. Merchants Bank's Credit Policy is updated as needed and changes presented to the Board for approval.
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|Item 4.  Controls and Procedures                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|The principal executive officer, principal financial officer, and other members of senior management of Merchants have evaluated the disclosure controls and procedures of Merchants 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 March 31, 2007 that have materially affected, or are reasonably likely to materially affect, its internal control over financial reporting.                                                                                                                                                                                                                                                                                                                                                                                                                                  

<PAGE>  17

|MERCHANTS BANCSHARES, INC.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
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|PART II - OTHER INFORMATION                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
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|Item 1.  Legal Proceedings                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
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|None.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
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|Item 1A.  Risk Factors                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
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|Please read the factors discussed in "Risk Factors" in Merchants' Annual Report on Form 10-K for the fiscal year ended December 31, 2006, 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.
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|Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds                                                                                                                                                                                                                                                                                                                                                                                                                                                             
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|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
| | ------------------------------ |  | -------------------------------- |  | ---------------------------- | ----- | -------------------------------------------------------------------------------- |  | ------------------------------------------------------------------------------
| |                               
| | January 1 through January 31   |  | 1,300                            |  |                              | 22.74 |                                                                                  |  | 1,300                                                                         
| | February 1 through February 28 |  | 25,004                           |  |                              | 23.25 |                                                                                  |  | 21,995                                                                        
| | March 1 through March 31       |  | 9,271                            |  |                              | 23.10 |                                                                                  |  | 9,271                                                                         
| |                                |  |                                 
| | Total                          |  | 35,575                           |  |                              | 23.19 |                                                                                  |  | 32,566                                                                        
| |                                |  |                                 



|In October 2005 Merchants' Board of Directors approved a stock repurchase program, pursuant to which Merchants may repurchase up to 200,000 shares of its common stock from time to time through October 2006. Merchants' Board of Directors voted to extend the program through October 2007 at its October 2006 meeting. Merchants has purchased 199,277 shares of its common stock on the open market under the program, at an average per share price of $23.82, of which 32,566 shares were purchased during 2007. In January 2007, Merchants' Board approved a new 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 new program will commence when there are no shares remaining to be purchased as authorized under the previous stock repurchase program.
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|Item 3.  Defaults Upon Senior Securities                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
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|None.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
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|Item 4.  Submission of Matters to a Vote of Security Holders                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
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|None.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
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|Item 5.  Other Information                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
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|None.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
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|Item 6.  Exhibits                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
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<PAGE>  18



|MERCHANTS BANCSHARES, INC.
SIGNATURES                                                                                                                                                   
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|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>  19