|UNITED STATES                                                                                                                                                                                                                                                                                                                                           
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|SECURITIES AND EXCHANGE COMMISSION                                                                                                                                                                                                                                                                                                                      
|Washington, D.C. 20549                                                                                                                                                                                                                                                                                                                                  
|                                                                                                                                                                                                                                                                                                                                                        
|FORM 10-Q                                                                                                                                                                                                                                                                                                                                               
|                                                                                                                                                                                                                                                                                                                                                        
|[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934                                                                                                                                                                                                                                                                   
|                                                                                                                                                                                                                                                                                                                                                        
|For the quarterly period ended                                                                                                                                                                                                                                                                                                                          
|                                                                                                                                                                                                                                                                                                                                                        
|                                                                                                                                                                                                                                                                                                                                                        
|[   ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934                                                                                                                                                                                                                                                          
|                                                                                                                                                                                                                                                                                                                                                        
|or                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                        
|For the transition period from                                                                                                                                                                                                                                                                                                                          
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|Commission file number:                                                                                                                                                                                                                                                                                                                                 
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|                                                                                                                                                                                                                                                                                                                                                        
|Merchants Bancshares, Inc.                                                                                                                                                                                                                                                                                                                              
|                                                                                                                                                                                                                                                                                                                                                        
|(Exact Name Of Registrant As Specified In Its Charter)                                                                                                                                                                                                                                                                                                  
|                                                                                                                                                                                                                                                                                                                                                        
|Delaware                                                                                                                                                                                                                                                                                                                                                
|                                                                                                                                                                                                                                                                                                                                                        
|(State or other jurisdiction of incorporation or organization)                                                                                                                                                                                                                                                                                          
|                                                                                                                                                                                                                                                                                                                                                        
|275 Kennedy Drive, South Burlington, Vermont                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                        
|(Address Of Principal Executive Offices)                                                                                                                                                                                                                                                                                                                
|                                                                                                                                                                                                                                                                                                                                                        
|802-658-3400                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                        
|(Registrant's Telephone Number, Including Area Code)                                                                                                                                                                                                                                                                                                    
|                                                                                                                                                                                                                                                                                                                                                        
|                                                                                                                                                                                                                                                                                                                                                        
|                                                                                                                                                                                                                                                                                                                                                        
|(Former Name, Former Address And Former Fiscal Year, If Changed Since Last Report)                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                        
|Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
|[X] Yes      [   ] No                                                                                                                                                                                                                                                                                                                                   
|                                                                                                                                                                                                                                                                                                                                                        
|Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer 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 October 22, 2007, there were 6,115,607 shares of the registrant's common stock, par value $0.01 per share, outstanding.                                                                                                                                                                                                                           

<PAGE>

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

<PAGE>

|MERCHANTS BANCSHARES, INC.    
|------------------------------
|PART I - FINANCIAL INFORMATION
|                              
|ITEM 1. Financial Statements  
|                              
|Merchants Bancshares, Inc.    
|Consolidated Balance Sheets   
|(unaudited)                   
|                              

|(In thousands except share and per share data)                           |                          |           | September 30,
2007 |           | December 31,
2006
|------------------------------------------------------------------------ | ------------------------ | --------- | ------------------ | --------- | -----------------
|                                                                        
|ASSETS                                                                   |                          |           |                    |           |                  
|Cash and cash equivalents                                                |                          |           | $                  | 33,839    |                  
|Federal funds sold and other short-term investments                      |                          |           |                    | 15,500    |                  
|                                                                        
|Total cash and cash equivalents                                          |                          |           |                    | 49,339    |                  
|Investments:                                                             |                          |           |                    |           |                  
|Securities available for sale, at fair value                             |                          |           |                    | 298,338   |                  
|Securities held to maturity (fair value of $4,557 and $5,804)            |                          |           |                    | 4,395     |                  
|                                                                        
|Total investments                                                        |                          |           |                    | 302,733   |                  
|                                                                        
|Loans                                                                    |                          |           |                    | 739,175   |                  
|Less: Allowance for loan losses                                          |                          |           |                    | 7,726     |                  
|                                                                        
|Net loans                                                                |                          |           |                    | 731,449   |                  
|                                                                        
|Federal Home Loan Bank stock                                             |                          |           |                    | 5,114     |                  
|Bank premises and equipment, net                                         |                          |           |                    | 11,627    |                  
|Investment in real estate limited partnerships                           |                          |           |                    | 7,691     |                  
|Other assets                                                             |                          |           |                    | 8,126     |                  
|                                                                        
|Total assets                                                             |                          |           | $                  | 1,116,079 |                  
|                                                                        
|LIABILITIES                                                              |                          |           |                    |           |                  
|Deposits:                                                                |                          |           |                    |           |                  
|Demand deposits                                                          |                          |           | $                  | 123,237   |                  
|Savings, NOW and money market accounts                                   |                          |           |                    | 413,558   |                  
|Time deposits $100 thousand and greater                                  |                          |           |                    | 86,795    |                  
|Other time deposits                                                      |                          |           |                    | 243,358   |                  
|                                                                        
|Total deposits                                                           |                          |           |                    | 866,948   |                  
|                                                                        
|Securities sold under agreements to repurchase and other short-term      |                          |           |                    |           |                  
|borrowings                                                               |                          |           |                    | 84,484    |                  
|Securities sold under agreements to repurchase, long-term                |                          |           |                    | 20,000    |                  
|Other long-term debt                                                     |                          |           |                    | 44,586    |                  
|Junior subordinated debentures issued to unconsolidated subsidiary trust |                          |           |                    | 20,619    |                  
|Other liabilities                                                        |                          |           |                    | 7,435     |                  
|                                                                        
|Total liabilities                                                        |                          |           |                    | 1,044,072 |                  
|                                                                        
|Commitments and contingencies (Note 6)                                   |                          |           |                    |           |                  
|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        |                  
|Shares authorized                                                        | 10,000,000               |           |                    |           |                  
|Issued                                                                   | As of September 30, 2007 | 6,651,760 |                    |           |                  
|                                                                         | As of December 31, 2006  | 6,651,760 |                    |           |                  
|Outstanding                                                              | As of September 30, 2007 | 5,790,837 |                    |           |                  
|                                                                         | As of December 31, 2006  | 5,873,290 |                    |           |                  
|Capital in excess of par value                                           |                          |           |                    | 37,260    |                  
|Retained earnings                                                        |                          |           |                    | 51,365    |                  
|Treasury stock, at cost                                                  |                          |           |                    | (18,759)  |                  
|                                                                         | As of September 30, 2007 | 860,923   |                    |           |                  
|                                                                         | As of December 31, 2006  | 778,470   |                    |           |                  
|Deferred compensation arrangements                                       |                          |           |                    | 5,980     |                  
|Accumulated other comprehensive loss                                     |                          |           |                    | (3,906)   |                  
|                                                                        
|Total shareholders' equity                                               |                          |           |                    | 72,007    |                  
|                                                                        
|Total liabilities and shareholders' equity                               |                          |           | $                  | 1,116,079 |                  
|                                                                        
|                                                                        
|See accompanying notes to interim consolidated financial statements     

<PAGE>  1

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

|                                                                    | Three Months Ended |        | Nine Months Ended
|------------------------------------------------------------------- | ------------------ | ------ | -----------------
|                                                                    | September 30,      |        | September 30,    
|(In thousands except per share data)                                | 2007               |        | 2006             
|                                                                   
|INTEREST AND DIVIDEND INCOME                                        |                    |        |                  
|Interest and fees on loans                                          | $                  | 12,073 |                  
|Investment income:                                                  |                    |        |                  
|Interest on debt securities                                         |                    | 3,480  |                  
|Dividends                                                           |                    | 83     |                  
|Interest on fed funds sold, short term investments and              |                    |        |                  
|interest bearing deposits                                           |                    | 348    |                  
|                                                                   
|Total interest and dividend income                                  |                    | 15,984 |                  
|                                                                   
|INTEREST EXPENSE                                                    |                    |        |                  
|Savings, NOW and money market accounts                              |                    | 1,200  |                  
|Time deposits $100 thousand and greater                             |                    | 676    |                  
|Other time deposits                                                 |                    | 2,642  |                  
|Other borrowed funds                                                |                    | 839    |                  
|Long-term debt                                                      |                    | 1,125  |                  
|                                                                   
|Total interest expense                                              |                    | 6,482  |                  
|                                                                   
|Net interest income                                                 |                    | 9,502  |                  
|Provision for credit losses                                         |                    | 700    |                  
|                                                                   
|Net interest income after provision for credit losses               |                    | 8,802  |                  
|                                                                   
|NONINTEREST INCOME                                                  |                    |        |                  
|Trust company income                                                |                    | 492    |                  
|Service charges on deposits                                         |                    | 1,196  |                  
|Loss on investment securities                                       |                    | (60)   |                  
|Equity in losses of real estate limited partnerships, net           |                    | (423)  |                  
|Other                                                               |                    | 951    |                  
|                                                                   
|Total noninterest income                                            |                    | 2,156  |                  
|                                                                   
|NONINTEREST EXPENSE                                                 |                    |        |                  
|Salaries and wages                                                  |                    | 3,061  |                  
|Employee benefits                                                   |                    | 792    |                  
|Occupancy expense, net                                              |                    | 787    |                  
|Equipment expense                                                   |                    | 680    |                  
|Legal and professional fees                                         |                    | 523    |                  
|Marketing                                                           |                    | 282    |                  
|State franchise taxes                                               |                    | 222    |                  
|Other                                                               |                    | 1,204  |                  
|                                                                   
|Total noninterest expense                                           |                    | 7,551  |                  
|                                                                   
|Income before provision for income taxes                            |                    | 3,407  |                  
|Provision for income taxes                                          |                    | 778    |                  
|                                                                   
|NET INCOME                                                          | $                  | 2,629  |                  
|                                                                   
|                                                                    |                    |        |                  
|Basic earnings per common share                                     | $                  | 0.43   |                  
|Diluted earnings per common share                                   | $                  | 0.43   |                  
|                                                                   
|See accompanying notes to interim consolidated financial statements

<PAGE>  2

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

|                                                                         | Three Months Ended |       | Nine Months Ended
|------------------------------------------------------------------------ | ------------------ | ----- | -----------------
|                                                                         | September 30,      |       | September 30,    
|(In thousands)                                                           | 2007               |       | 2006             
|                                                                        
|Net income                                                               | $                  | 2,629 |                  
|Other comprehensive income, net of tax:                                  |                    |       |                  
|Change in net unrealized gain on securities available for                |                    |       |                  
|sale, net of taxes of $1,173, $2,040, $755 and $213                      |                    | 2,178 |                  
|Reclassification adjustments for securities losses included              |                    |       |                  
|in net income, net of taxes of $21, $158, $34 and $158                   |                    | 39    |                  
|Impact of transfer of securities from available for sale to              |                    |       |                  
|held to maturity, net of taxes of $0, $1, $0 and $1                      |                    | -     |                  
|Amortization of previously recorded benefit plan amount,                 |                    |       |                  
|net of taxes of $16, $0, $47 and $0                                      |                    | 29    |                  
|                                                                        
|Other comprehensive income                                               |                    | 2,246 |                  
|                                                                        
|Comprehensive income                                                     | $                  | 4,875 |                  
|                                                                        
|                                                                        
|See accompanying notes to the interim consolidated financial statements.

<PAGE>  3

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

|For the nine months ended September 30,                                           | 2007 |          | 2006
|--------------------------------------------------------------------------------- | ---- | -------- | ----
|                                                                                 
|(In thousands)                                                                    |      |          |     
|CASH FLOWS FROM OPERATING ACTIVITIES:                                             |      |          |     
|Net income                                                                        | $    | 7,942    |     
|Adjustments to reconcile net income to net cash provided by operating activities: |      |          |     
|Provision for loan losses                                                         |      | 850      |     
|Depreciation and amortization                                                     |      | 2,321    |     
|Amortization of stock grant                                                       |      | 12       |     
|Loss on sale of investment securities                                             |      | 97       |     
|Proceeds from sales of loans, net                                                 |      | 1,262    |     
|Net losses on disposition of premises and equipment                               |      | 10       |     
|Net gains on sales of other real estate owned                                     |      | (41)     |     
|Equity in losses of real estate limited partnerships, net                         |      | 1,270    |     
|Changes in assets and liabilities:                                                |      |          |     
|Decrease (increase) in interest receivable                                        |      | 151      |     
|(Increase) decrease in other assets                                               |      | (168)    |     
|(Decrease) increase in interest payable                                           |      | (41)     |     
|Increase in other liabilities                                                     |      | 6,252    |     
|                                                                                 
|Net cash provided by operating activities                                         |      | 19,917   |     
|                                                                                 
|                                                                                  |      |          |     
|CASH FLOWS FROM INVESTING ACTIVITIES:                                             |      |          |     
|Proceeds from sales of investment securities available for sale                   |      | 5,468    |     
|Proceeds from maturities of investment securities available for sale              |      | 49,807   |     
|Proceeds from maturities of investment securities held to maturity                |      | 1,220    |     
|Proceeds from redemption of Federal Home Loan Bank stock                          |      | 372      |     
|Purchases of investment securities available for sale                             |      | (21,645) |     
|Net change in loans                                                               |      | (51,262) |     
|Purchases of Federal Home Loan Bank stock                                         |      | --       |     
|Proceeds from sales of other real estate owned                                    |      | 299      |     
|Investments in real estate limited partnerships                                   |      | (36)     |     
|Purchases of bank premises and equipment                                          |      | (565)    |     
|                                                                                 
|Net cash used in investing activities                                             |      | (16,342) |     
|                                                                                 
|                                                                                  |      |          |     
|CASH FLOWS FROM FINANCING ACTIVITIES:                                             |      |          |     
|Net (decrease) increase in deposits                                               |      | (10,404) |     
|Net decrease in short-term borrowings                                             |      | --       |     
|Proceeds from long-term debt                                                      |      | 1,825    |     
|Net (decrease) increase in securities sold under agreement to repurchase-         |      |          |     
|short term                                                                        |      | (6,063)  |     
|Principal payments on long-term debt                                              |      | (11,102) |     
|Cash dividends paid                                                               |      | (4,616)  |     
|Purchases of treasury stock                                                       |      | (2,916)  |     
|Sale of treasury stock                                                            |      | 11       |     
|Increase in deferred compensation arrangements                                    |      | 153      |     
|Proceeds from exercise of stock options, net of withholding taxes                 |      | 155      |     
|Tax benefit from exercise of stock options                                        |      | 15       |     
|                                                                                 
|Net cash (used in) provided by financing activities                               |      | (32,942) |     
|                                                                                 
|                                                                                  |      |          |     
|Decrease in cash and cash equivalents                                             |      | (29,367) |     
|Cash and cash equivalents beginning of year                                       |      | 78,706   |     
|                                                                                 
|Cash and cash equivalents end of period                                           | $    | 49,339   |     
|                                                                                 
|                                                                                  |      |          |     
|SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:                                 |      |          |     
|Total interest payments                                                           | $    | 19,491   |     
|Total income tax payments                                                         |      | 2,600    |     
|SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND                                 |      |          |     
|FINANCING ACTIVITIES                                                              |      |          |     
|Increase in payable for investments purchased                                     | $    | 3,448    |     
|Distribution of stock under deferred compensation arrangements                    |      | 268      |     
|Distribution of treasury stock in lieu of cash dividend                           |      | 570      |     
|Transfer of loans to other real estate owned                                      |      | --       |     
|                                                                                 
|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                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|Principles of Consolidation                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|The accompanying unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements. All adjustments necessary for a fair presentation of the interim consolidated financial statements of Merchants as of September 30, 2007 and 2006, and for the three and nine months ended September 30, 2007 and 2006, have been included. The information was prepared from the unaudited financial statements of Merchants and its subsidiaries, Merchants Bank ("Bank"), Merchants Trust Company, Merchants Properties, Inc. and MBVT Statutory Trust I. Amounts reported for prior periods are reclassified, where necessary, to be consistent with the current period presentation.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|Management's Use of Estimates in Preparation of Financial Statements                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of income and expenses during the reporting periods. The most significant estimates include those used in determining the allowance for loan losses, income taxes, and interest income recognition on loans. Operating results in the future may vary from the amounts derived from management's estimates and assumptions.                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|Note 2: Earnings Per Share                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|The following table presents reconciliations of the calculations of basic and diluted earnings per common share for the periods indicated:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             

|                                              | For the             |       | For the            
|--------------------------------------------- | ------------------- | ----- | -------------------
|                                              | Three Months        |       | Nine Months        
|                                              | Ended September 30, |       | Ended September 30,
|(In thousands except per share data)          | 2007                |       | 2006               
|                                             
|Net income                                    | $                   | 2,629 |                    
|                                             
|Weighted average common shares outstanding    |                     | 6,123 |                    
|Dilutive effect of common stock equivalents   |                     | 16    |                    
|                                             
|Weighted average common and common equivalent |                     | 6,139 |                    
|shares outstanding                            |                     |       |                    
|Basic earnings per common share               | $                   | 0.43  |                    
|Diluted earnings per common share             | $                   | 0.43  |                    
|                                              |                     |       |                    

|Basic earnings per common share were computed by dividing net income by the weighted average number of shares of common stock outstanding for the three and nine month periods ended September 30, 2007 and 2006. For the three and nine months ended September 30, 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. Average anti-dilutive stock options outstanding for the three and nine months ended September 30, 2006 were 4,891 and 1,648, respectively.                                                                                                                                            
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|Note 3: Pension                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|Prior to January 1995 Merchants maintained a noncontributory defined benefit pension plan (the "Plan") covering all eligible employees. The Plan was a final average pay plan with benefits based on the average salary rates using the five consecutive Plan years of the last ten years that produce the highest average salary. It was Merchants' policy to fund the cost of benefits expected to accrue during the year plus amortization of any unfunded accrued liability that had accumulated prior to the valuation date based on IRS regulations for funding. During 1995 the Plan was curtailed. Accordingly, all accrued benefits were fully vested and no additional years of service or age will be accrued.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|The following table summarizes the components of net periodic benefit costs for the periods indicated:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   

<PAGE>  5

|                               | Three months ended |       | Nine months ended
|------------------------------ | ------------------ | ----- | -----------------
|                               | September 30,      |       | September 30,    
|(In thousands)                 | 2007               |       | 2006             
|                              
|Interest cost                  | $                  | 115   |                  
|Service cost                   |                    | 10    |                  
|Expected return on Plan assets |                    | (129) |                  
|Amortization of net loss       |                    | 45    |                  
|                              
|Net periodic benefit cost      | $                  | 41    |                  
|                              
|                              

|A contribution of $500 thousand was made during the quarter ended September 30, 2007. No additional contributions are projected for 2007.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
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|Note 4: Impaired Loans                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|Total impaired loans were $9.28 million at September 30, 2007 and were $2.30 million at December 31, 2006. The allowance for loan losses associated with such loans was $600 thousand and $37 thousand, respectively. Interest payments on impaired loans are generally recorded as principal reductions if the remaining loan balance is not expected to be paid in full. If full collection of the remaining loan balance is expected, interest income is recognized on a cash basis. Merchants recorded interest income on impaired loans of approximately $1 thousand and $2 thousand for the quarter and nine months ended September 30, 2007. The amount of interest which was not earned, but which would have been earned had Merchants' nonaccrual and restructured loans performed in accordance with their original terms and conditions, was approximately $200 thousand and $437 thousand for the quarter and nine months ended September 30, 2007. The average balance of impaired loans was $6.23 million and $4.88 million for the quarter and nine months ended September 30, 2007.                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|Note 5: 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 completed the purchase of 200,000 shares of its common stock on the open market under the program, at an average per share price of $23.81, of which 33,289 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. Under the new program 37,141 shares have been purchased at an average price per share of $22.68. Additionally, Merchants purchased 10,000 shares of its stock, not on the open market, at a price of $23.00 per share during the second quarter of 2007, and 43,420 shares, not on the open market, at a price of $23.08 during August 2007.                                                                                                                                                                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|Note 6: 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 $6.06 million at September 30, 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 September 30, 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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    

<PAGE>  6

|Note 7: 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.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|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 at adoption any tax positions that contained significant uncertainties.                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Merchants has no interest or penalties recognized in its consolidated statements of income for the three and nine months ended September 30, 2007 and 2006 or in its consolidated balance sheets at September 30, 2007. Such interest and penalties would be classified as other noninterest expense in its consolidated statement of income.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|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 return was audited by the IRS with only insignificant adjustments made to the return as filed.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Note 8: Recent Accounting Pronouncements                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159 ("SFAS 159"), "The Fair Value Option for Financial Assets and Financial Liabilities." This Statement permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS 159 is effective for fiscal years beginning after November 15, 2007. Management has not completed its evaluation of the impact of this standard; however, Merchants does not expect adoption of SFAS 159 to have a material effect on its consolidated financial position, results of operations or cash flows.                                                     
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Forward Looking Statements                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Except for the historical information contained herein, this Quarterly Report on Form 10-Q of Merchants may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 (the "Exchange Act"). Investors are cautioned that forward-looking statements are inherently uncertain. Actual performance and results of operations may differ materially from those projected or suggested in the forward-looking statements due to certain risks and uncertainties, including, without limitation:                                                                                                                                                                                                                                                                                                                                                    
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|(i)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|(ii)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|(iii)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|(iv)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           

<PAGE>  7

|(v)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |  | the fact that at September 30, 2007, approximately 81% of Merchants' loan portfolio was comprised of residential real estate and commercial real estate loans, exposing Merchants to the risks inherent in financings based upon analyses of credit risk and the value of underlying collateral. Accordingly, Merchants' profitability may be negatively impacted by errors in risk analyses, by loan defaults, and the ability of certain borrowers to repay such loans may be adversely affected by any downturn in general economic conditions;                                                       
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|(vi)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |  | the fact that acts or threats of terrorism and actions taken by the United States or other governments as a result of such acts or threats, including possible military action, could further adversely affect business and economic conditions in the United States of America generally and in Merchants' markets, which could adversely affect Merchants' financial performance, that of Merchants' borrowers, the financial markets and the price of Merchants' common stock;                                                                                                                        
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|(vii)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |  | the fact that changes in the extensive laws, regulations and policies governing bank holding companies and their subsidiaries could alter Merchants' business environment or affect Merchants' operations;                                                                                                                                                                                                                                                                                                                                                                                               
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|(viii)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |  | the fact that the potential need to adapt to industry changes in information technology systems, on which Merchants is highly dependent to secure bank and customer financial information, could present operational issues, require significant capital spending or impact Merchants' reputation;                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|(ix)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |  | the fact that Merchants' customers conduct their business within global financial systems, which may subject Merchants' customers' businesses and their financial data to potential risks or weaknesses within those systems; and                                                                                                                                                                                                                                                                                                                                                                        
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|(x)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |  | the fact that Merchants actively evaluates acquisition and other expansion opportunities and strategies, the implementation of which could affect Merchants' financial performance.                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|These factors, as well as general economic and market conditions in the United States of America, may materially and adversely affect the market price of shares of Merchants' common stock. Because of these and other factors, past financial performance should not be considered an indicator of future performance. The forward looking statements contained herein represent Merchants' judgment as of the date of this Form 10-Q; Merchants cautions readers not to place undue reliance on such statements.                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|General                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|All adjustments necessary for a fair presentation of Merchants' interim consolidated financial statements as of September 30, 2007, and for the three and nine months ended September 30, 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.                                                                                                                                                                                                                                                                                                                                                                                                                                     
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|Results of Operations                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|Overview                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Net income for the third quarter of 2007 was $2.63 million and was $7.94 million for the first nine months of 2007, compared to net income of $2.65 million and $8.04 million for the third quarter and the first nine months of 2006. The return on average assets for the quarter and nine months ended September 30, 2007 were 0.94% and 0.95%, respectively, compared to 0.95% and 0.97%, respectively, for the quarter and nine months ended September 30, 2006. The return on average equity for the quarter and nine months ended September 30, 2007 were 15.04% and 15.14%, respectively, compared to 16.16% and 16.42%, respectively, for the quarter and nine months ended September 30, 2006. The following were the major factors contributing to the results for the quarter and nine months ended September 30, 2007, compared to the same periods in 2006:
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|o                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |  | The net interest margin decreased during the third quarter of 2007 to 3.57% compared to 3.63% for the second quarter of 2007, and 3.72% for the third quarter of 2006. As discussed in more detail below, net interest income decreased $361 thousand for the third quarter of 2007 compared to 2006, and $364 thousand for the nine months ended September 30, 2007 compared to the same period in the prior year.                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|o                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |  | Merchants recorded a $700 thousand provision for credit losses during the quarter, and $850 thousand year to date, primarily as a result of an increase in nonperforming loans. Nonperforming loans increased to $9.93 million at September 30, 2007 from $2.70 million at December 31, 2006. The net increase in nonperforming loans is primarily attributable to $6.90 million in loans related to a residential construction project that were moved to nonaccrual during the third quarter of this year. There was no provision recorded during the quarter and nine months ended September 30, 2006.

<PAGE>  8

|o                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |  | Noninterest income excluding losses on investment securities increased to $2.22 million for the third quarter of 2007 compared to $1.98 million for the third quarter of 2006, and increased to $6.26 million compared to $5.91 million for the first nine months of 2007 compared to 2006. Noninterest expense decreased by $411 thousand to $7.55 million from $7.96 million for the third quarter of 2007 compared to the third quarter of 2006, and decreased $355 thousand to $23.59 million compared to $23.94 million for the first nine months of the current year compared to last year.
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|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|o                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |  | Average quarterly gross loans increased $67.09 million, or 10.16%, over the third quarter of 2006.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|o                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |  | Merchants' average quarterly securities portfolio decreased $90.12 million, over the third quarter of 2006; at the same time its average quarterly short-term investment position increased $26.27 million over the third quarter of 2006.                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|o                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |  | Average quarterly deposits increased $8.87 million, or 1.03% over the third quarter of 2006.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|Net Interest Income                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Merchants' net interest income decreased $361 thousand for the third quarter of 2007 compared to 2006, and was $364 thousand less for the first nine months of this year compared to last year. Merchants' net interest margin decreased 15 basis points to 3.57% from 3.72% for the third quarter of 2007 compared to the third quarter of 2006, and decreased eleven basis points for the first nine months of 2007 compared to 2006. Merchants transferred a $6.9 million relationship to nonaccrual during the quarter, the loss of third quarter interest income on this relationship was approximately $82 thousand, and accounts for approximately three basis points of the decrease in net interest margin. The balance of the decrease in the margin is primarily due to overall higher funding costs. Merchants' total average earning assets have changed very little from the third quarter of 2006 to the third quarter of 2007, however the make-up of those earning assets has changed as funds from the investment portfolio have been redeployed into the higher yielding loan portfolio. Quarterly average loans for the third quarter of 2007 compared to the third quarter of 2006 increased by $67.09 million to $727.16 million at an average rate for the third quarter of 2007 of 6.60%, compared to 6.75% for the same quarter last year, as rates have trended downward during the third quarter of 2007. At the same time Merchants' quarterly average investment portfolio has decreased by $90.12 million to $303.62 million and the average yield has dropped by nine basis points to 4.66%. The decrease in balance and rate was partially offset by an increase in average short-term investments to $26.39 million for the third quarter of 2007 from $123 thousand for the third quarter of 2006.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|Merchants' deposits have continued to shift from lower cost savings, NOW and money market accounts to higher rate time deposits as shown in the table on pages 11-12, however this shift has slowed down considerably during the current year. Merchants' average cost of interest bearing liabilities increased to 2.81% for the third quarter of 2007 compared to 2.62% for the third quarter of 2006. As shown on the following table, most of this increase is attributable to the average rate paid on time deposits which increased to 4.07% for the third quarter of this year compared to 3.54% for the third quarter of 2006, as Merchants raised time deposit rates to be competitive in the current marketplace. Additionally, Merchants has experienced an increase in the cost of its long-term FHLB debt as lower cost borrowings taken out in a lower interest rate environment continue to run off.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|The following table attributes changes in Merchants' net interest income (on a fully taxable equivalent basis) to changes in either average balances or average rates for the three and nine months ended September 30, 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>  9

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

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

|The following tables set forth certain information regarding net interest margin for the three and nine months ended September 30, 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>  10

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

|                                         | Three Months Ended                                                                                                   
|---------------------------------------- | ---------------------------------------------------------------------------------------------------------------------
|                                         |                                                                                                                      
|                                         | September 30, 2007                                                                                                   
|                                         |                                                                                                                      
|                                         |                                                                                                                      
|                                         |                                                                                                                      
|                                         |                                                                                                                      
|(In thousands, fully taxable equivalent) |                                                                                                                      
|ASSETS:                                  |                                                                                                                      
|Loans, including fees on loans (a)       | $                                                                                                                    
|Investments (b) (c)                      |                                                                                                                      
|Federal funds sold and interest bearing  |                                                                                                                      
|deposits with banks                      |                                                                                                                      
|                                         |                                                                                                                      
|Total interest earning assets            |                                                                                                                      
|                                         |                                                                                                                      
|Allowance for loan losses                |                                                                                                                      
|Cash and due from banks                  |                                                                                                                      
|Premises and equipment, net              |                                                                                                                      
|Other assets                             |                                                                                                                      
|                                         |                                                                                                                      
|Total assets                             | $                                                                                                                    
|                                         |                                                                                                                      
|                                         |                                                                                                                      
|LIABILITIES AND SHAREHOLDERS'            |                                                                                                                      
|EQUITY:                                  |                                                                                                                      
|Interest bearing deposits:               |                                                                                                                      
|Savings, NOW & money market accounts     | $                                                                                                                    
|Time deposits                            |                                                                                                                      
|                                         |                                                                                                                      
|Total interest bearing deposits          |                                                                                                                      
|                                         |                                                                                                                      
|Federal Home Loan Bank short-term        |                                                                                                                      
|borrowings                               |                                                                                                                      
|Securities sold under agreements to      |                                                                                                                      
|repurchase and other short-term debt     |                                                                                                                      
|Securities sold under agreements to      |                                                                                                                      
|repurchase, long-term                    |                                                                                                                      
|Other long-term debt                     |                                                                                                                      
|Junior subordinated debentures issued to |                                                                                                                      
|Unconsolidated subsidiary trust          |                                                                                                                      
|                                         |                                                                                                                      
|Total interest bearing liabilities       |                                                                                                                      
|                                         |                                                                                                                      
|Noninterest bearing deposits             |                                                                                                                      
|Other liabilities                        |                                                                                                                      
|Shareholders' equity                     |                                                                                                                      
|                                         |                                                                                                                      
|Total liabilities and shareholders'      |                                                                                                                      
|equity                                   | $                                                                                                                    
|                                         |                                                                                                                      
|                                         |                                                                                                                      
|Net interest earning assets              | $                                                                                                                    
|                                         |                                                                                                                      
|                                         |                                                                                                                      
|Net interest income (fully taxable       |                                                                                                                      
|equivalent)                              |                                                                                                                      
|                                         |                                                                                                                      
|Tax equivalent adjustment                |                                                                                                                      
|                                         |                                                                                                                      
|Net interest income                      |                                                                                                                      
|                                         |                                                                                                                      
|                                         |                                                                                                                      
|Net interest rate spread                 |                                                                                                                      
|                                         |                                                                                                                      
|                                         |                                                                                                                      
|Net interest margin                      |                                                                                                                      
|                                         |                                                                                                                      
|                                        
|(a)                                      | Includes principal balance of non-accrual loans and fees on loans.                                                   
|(b)                                      | Available for sale securities are included at fair value, held to maturity securities are included at amortized cost.
|(c)                                      | Tax exempt interest has been converted to a tax equivalent basis using the Federal tax rate of 35%.                  

<PAGE>  11

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

|                                         | Nine Months Ended                                                                                                    
|---------------------------------------- | ---------------------------------------------------------------------------------------------------------------------
|                                         |                                                                                                                      
|                                         | September 30, 2007                                                                                                   
|                                         |                                                                                                                      
|                                         |                                                                                                                      
|                                         |                                                                                                                      
|(In thousands, fully taxable equivalent) |                                                                                                                      
|                                         |                                                                                                                      
|ASSETS:                                  |                                                                                                                      
|Loans, including fees on loans (a)       | $                                                                                                                    
|Investments (b) (c)                      |                                                                                                                      
|Federal funds sold, securities purchased |                                                                                                                      
|under agreements to resell and interest  |                                                                                                                      
|bearing deposits with banks              |                                                                                                                      
|                                         |                                                                                                                      
|Total interest earning assets            |                                                                                                                      
|                                         |                                                                                                                      
|Allowance for loan losses                |                                                                                                                      
|Cash and due from banks                  |                                                                                                                      
|Premises and equipment, net              |                                                                                                                      
|Other assets                             |                                                                                                                      
|                                         |                                                                                                                      
|Total assets                             | $                                                                                                                    
|                                         |                                                                                                                      
|                                         |                                                                                                                      
|LIABILITIES AND SHAREHOLDERS'            |                                                                                                                      
|EQUITY:                                  |                                                                                                                      
|Interest bearing deposits:               |                                                                                                                      
|Savings, NOW & Money Market accounts     | $                                                                                                                    
|Time deposits                            |                                                                                                                      
|                                         |                                                                                                                      
|Total interest bearing deposits          |                                                                                                                      
|                                         |                                                                                                                      
|Federal Home Loan Bank short-term        |                                                                                                                      
|borrowings                               |                                                                                                                      
|Securities sold under agreement to       |                                                                                                                      
|repurchase and other short term debt     |                                                                                                                      
|Securities sold under agreement to       |                                                                                                                      
|repurchase, long term                    |                                                                                                                      
|Other long-term debt                     |                                                                                                                      
|Junior subordinated debentures issued to |                                                                                                                      
|Unconsolidated subsidiary trust          |                                                                                                                      
|                                         |                                                                                                                      
|Total interest bearing liabilities       |                                                                                                                      
|                                         |                                                                                                                      
|Noninterest bearing deposits             |                                                                                                                      
|Other liabilities                        |                                                                                                                      
|Shareholders' equity                     |                                                                                                                      
|                                         |                                                                                                                      
|Total liabilities and shareholders'      |                                                                                                                      
|equity                                   | $                                                                                                                    
|                                         |                                                                                                                      
|                                         |                                                                                                                      
|Net interest earning assets              | $                                                                                                                    
|                                         |                                                                                                                      
|                                         |                                                                                                                      
|Net interest income (fully taxable       |                                                                                                                      
|equivalent)                              |                                                                                                                      
|                                         |                                                                                                                      
|Tax equivalent adjustment                |                                                                                                                      
|                                         |                                                                                                                      
|Net interest income                      |                                                                                                                      
|                                         |                                                                                                                      
|                                         |                                                                                                                      
|Net interest rate spread                 |                                                                                                                      
|                                         |                                                                                                                      
|                                         |                                                                                                                      
|Net interest margin                      |                                                                                                                      
|                                         |                                                                                                                      
|                                        
|(a)                                      | Includes principal balance of non-accrual loans and fees on loans.                                                   
|(b)                                      | Available for sale securities are included at fair value, held to maturity securities are included at amortized cost.
|(c)                                      | Tax exempt interest has been converted to a tax equivalent basis using the Federal tax rate of 35%.                  

<PAGE>  12

|Provision for Credit Losses: Merchants recorded a $700 thousand provision for credit losses during the quarter, and $850 thousand year to date, primarily as a result of an increase in nonperforming loans. Nonperforming loans increased to $9.93 million at September 30, 2007 from $2.70 million at December 31, 2006. The net increase in nonperforming loans is primarily attributable to $6.90 million in loans related to a residential construction project that were moved to nonaccrual during the third quarter of this year. There was no provision recorded during the quarter and nine months ended September 30, 2006. Merchants recorded net charge-offs totaling $107 thousand for the nine months ended September 30, 2007 and recorded net recoveries of $142 thousand for the same period in 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 for loan losses was $7.73 million, 1.05% of total loans and 78% of nonperforming loans at September 30, 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. See the discussion of Nonperforming Assets on pages 15-17 for additional information on the Allowance and the allowance for loan losses.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|Noninterest Income: Total noninterest income increased $626 thousand to $2.16 million for the third quarter of 2007 from $1.53 million for the third quarter of 2006 and increased $712 thousand for the first nine months of 2007 compared to the first nine months of 2006. Excluding security losses of $60 thousand for the third quarter of 2007 and $452 thousand for the third quarter of 2006, noninterest income increased $234 thousand to $2.22 million for the third quarter of the current year from $1.98 million for the third quarter of last year. Excluding security losses of $97 thousand for the first nine months of 2007 and $452 thousand for the first nine months of 2006, noninterest income has increased $357 thousand to $6.26 million from $5.91 million for the first nine months of this year compared to last year. Trust company income increased $64 thousand and $131 thousand for the quarter and nine months ended September 30, 2007 compared to the same period in 2006, a 9.9% increase year to date. This increase is the result of successful new business efforts. Other noninterest income increased $131 thousand and $265 thousand for the quarter and nine months ended September 30, 2007 compared to the same periods in 2006; this increase is primarily attributable to increases in net ATM/debit card revenue.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|Noninterest Expense: Total noninterest expense decreased $411 thousand to $7.55 million for the third quarter of 2007 from $7.96 million for the third quarter of 2006, and decreased $355 thousand to $23.59 million for the first nine months of 2007 from $23.94 million for the first nine months of 2006. Employee benefits decreased $144 thousand and $444 thousand for the three and nine months ended September 30, 2007, respectively, compared to the three and nine months ended September 30, 2006. This decrease is primarily a result of a decrease in the employer match in Merchants' 401(k) plan, accompanied by a decrease in pension expense as a result of strong investment returns on pension assets. Other noninterest expenses decreased $51 thousand and increased $251 thousand for the three and nine months ended September 30, 2007, respectively, from the same periods in 2006. Merchants incurred $300 thousand in expenses related to a nonperforming asset during the second quarter of 2007 and experienced a defalcation during the first quarter which was subject to a $100 thousand insurance deductible. Both of these are included in Other noninterest expense. Merchants has not been required to pay an FDIC insurance premium for several years. As a result of the Federal Deposit Insurance Reform Act of 2005 Merchants was required, as of January 1, 2007 to pay an insurance premium equal to five basis points of its assessable deposit base. The Reform Act also allowed eligible institutions to share a one time assessment credit. Merchants' one-time credit was sufficient to cover the entire increased premium for the first nine months of 2007, and is expected to cover the remainder of the year. Additionally, the one-time credit is expected to cover a portion of the 2008 increased premium. Merchants expects its non-interest expense to increase by approximately $200 thousand, net of the credit, during 2008 as a result of this regulatory change.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|Balance Sheet Analysis                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|Merchants has continued to change the overall make up of its balance sheet as it has continued to shift earning assets from investments to the loan portfolio. Loans made up 69% of average earning assets for the third quarter of 2007, compared to 63% of earning assets for the third quarter of 2006. This shift in the make up of the balance sheet carries with it some amount of increased risk, as loans have a higher risk profile than investments, but also have a higher average yield. Average loans for the third quarter of 2007 were $727.16 million, an increase of $67.09 million, or 10.2%, over the average balance for the third quarter of 2006 of $660.07 million. The increase since December 31, 2006 is made up primarily of residential mortgages, commercial and industrial loans and construction loans.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|Balances of real estate construction loans increased to $41.01 million at September 30, 2007 from $33.17 million at December 31, 2006. For approximately $23 million of the outstanding construction loans at September 30, 2007 the primary source of repayment will be the sale of residential housing units. Included in this amount is the $6.9 million nonaccrual relationship described previously. Approximately $7 million of the remaining $18 million is attributable to construction of multifamily housing and will be repaid by conversion to term financing and future rental income. The                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         

<PAGE>  13

|balance of $11 million will be repaid by equity investments in affordable housing projects, conversion of loans to commercial and industrial or commercial real estate borrowers to term financing and conversion of loans to individual borrowers to conventional mortgage financing.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                      
|The following table summarizes the components of Merchants' loan portfolio as of September 30, 2007 and December 31, 2006:                                                                                                                                                            
|                                                                                                                                                                                                                                                                                      

| |                                        | September 30, |         | December 31, |  
| | -------------------------------------- | ------------- | ------- | ------------ | -
| | (In thousands)                         | 2007          |         | 2006         |  
| |                                        |              
| | Commercial, financial and agricultural | $             | 89,437  |              | $
| | Real estate loans - residential        |               | 353,934 |              |  
| | Real estate loans - commercial         |               | 246,650 |              |  
| | Real estate loans - construction       |               | 41,008  |              |  
| | Installment loans                      |               | 7,398   |              |  
| | All other loans                        |               | 748     |              |  
| |                                        |              
| | Total loans                            | $             | 739,175 |              | $
| |                                        |              
| |                                        |              

|Merchants' average investment portfolio totaled $303.62 million for the quarter ended September 30, 2007, a decrease of $90.12 million from the quarter ended September 30, 2006 average balance of $393.74 million. Merchants decided during 2006 to discontinue further investments in the portfolio because of the persistent flat to inverted yield curve environment. The yield curve has steepened during 2007 and Merchants began to redeploy funds into the investment portfolio during the third quarter of 2007.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|Average deposits for the third quarter of 2007 were $871.97 million compared to $863.10 million for the third quarter of 2006, and $864.97 million for the fourth quarter of 2006. This modest deposit growth is consistent with industry trends, the FDIC reported that nationwide deposits in domestic offices grew 1.0% during the first quarter of this year, and declined by 0.5% for the second quarter of 2007, with growth in interest bearing accounts offset by declines in non-interest bearing accounts. Consistent with industry trends, Merchants' quarterly average deposits have grown by 1.0% when comparing the third quarter of 2007 to the third quarter of 2006, and have grown by 2.2% when comparing year to date averages for 2007 and 2006. At the same time, depositors continue to seek higher yields causing ongoing shifts within product categories. Quarterly average savings, NOW and money market balances have decreased by $33.62 million over the last year while average time deposit balances have increased by $40.38 million over the same time period. During 2007 $44.68 million in deposits have moved off balance sheet toward the Certificate of Deposit Account Registry Service ("CDARS") which has attracted larger dollar relationships looking for both a higher yield and full insurance coverage. The recent announcement of the acquisition of Chittenden Corporation by People's United Financial leaves Merchants as the sole remaining state wide bank headquartered in the state of Vermont, which may provide some opportunity for increased market share.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|Merchants' 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 $80.48 million at September 30, 2007 and are included with "Securities sold under agreements to repurchase and other short-term investments" on the accompanying consolidated balance sheet.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|In the ordinary course of business, Merchants makes commitments for possible future extensions of credit. At September 30, 2007, Merchants was obligated to fund $6.06 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 totaled $222 thousand and $250 thousand for the quarters ended September 30, 2007 and 2006, respectively, and were $733 thousand and $736 thousand for the nine months ended September 30, 2007 and 2006, respectively. Total income tax expense was $778 thousand for the quarter ended September 30, 2007 compared to $785 thousand for the quarter ended September 30, 2006 and was $2.37 million and $2.42 million for the nine months ended September 30, 2007 and 2006, respectively. Merchants recognized favorable tax benefits from federal affordable housing tax credits of $409 thousand for the third quarter of 2007, compared to $413 thousand for the third quarter of 2006, and $1.23 million for the nine months ended September 30, 2007 compared to $1.24 million for the first nine months 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 22.8% for the quarter ended September 30, 2007, and 22.9% for the quarter ended September 30, 2006.                                                                                                                                                                                                                                                                        

<PAGE>  14

|Liquidity and Capital Resources                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|Merchants' liquidity is monitored by the Asset and Liability Committee (the "ALCO") of Merchants Bank's Board of Directors, based upon Merchants Bank policies. Merchants had $15.50 million in overnight funds sold and other short-term investments at September 30, 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 $131 million. Merchants has $44 million in available federal funds lines of credit at September 30, 2007 and the ability to borrow through the use of repurchase agreements, collateralized by Merchants' investments, with certain approved counterparties. Merchants' investment portfolio, which is managed by the ALCO, totaled $302.73 million at September 30, 2007, of which $123.89 million was pledged. The portfolio 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 could 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 completed the purchase of 200,000 shares of its common stock on the open market under the program, at an average per share price of $23.81, of which 33,289 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. Under the new program 37,141 shares have been purchased at an average price per share of $22.68. Additionally, Merchants purchased 10,000 shares of its stock, not on the open market, at a price of $23.00 per share during the second quarter of 2007, and 43,420 shares, not on the open market, at a price of $23.08 during August 2007.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|As of September 30, 2007, Merchants exceeded all applicable regulatory capital requirements. The following table represents the actual capital ratios and capital adequacy requirements for Merchants as of September 30, 2007 and 2006:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  

|                          |                                                                                                                                                                |         | For Capital      
|------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------- | -----------------
|                          | Actual                                                                                                                                                         |         | Adequacy Purposes
|                          |                                                                                                                                                                |         |                  
|(In thousands)            | Amount (1)                                                                                                                                                     |         | Percent          
|                         
|                          | As of September 30, 2007                                                                                                                                      
|Tier 1 leverage capital   | $                                                                                                                                                              | 94,103  |                  
|Tier 1 risk-based capital |                                                                                                                                                                | 94,103  |                  
|Total risk-based capital  |                                                                                                                                                                | 102,127 |                  
|                          |                                                                                                                                                                |         |                  
|                          | As of September 30, 2006                                                                                                                                      
|Tier 1 leverage capital   | $                                                                                                                                                              | 92,376  |                  
|Tier 1 risk-based capital |                                                                                                                                                                | 92,376  |                  
|Total risk-based capital  |                                                                                                                                                                | 99,600  |                  
|                         
|(1)                       | Amounts include $20 million in trust preferred securities issued in December 2004. These hybrid securities qualify as regulatory capital up to certain limits.
|                          |                                                                                                                                                               

|Nonperforming Assets and the Allowance                                                                                                                                                                                                                                                                                                                                                                                     
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                           
|Stringent credit quality is a major strategic focus of Merchants. Merchants cannot assure that problem assets will remain at current levels, particularly in light of current or future economic conditions. The asset balances in this category will be dynamic and subject to change as problem loans are either resolved or moved to nonperforming based upon current developments and the latest available information.
|                                                                                                                                                                                                                                                                                                                                                                                                                           
|The following table summarizes Merchants' nonperforming assets at the dates indicated:                                                                                                                                                                                                                                                                                                                                     
|                                                                                                                                                                                                                                                                                                                                                                                                                           

|                                   | September 30, |       | June 30, |   | December 31, |  | September 30,
|---------------------------------- | ------------- | ----- | -------- | - | ------------ |  | -------------
|(In thousands)                     | 2007          |       | 2007     |   | 2006         |  | 2006         
|                                  
|Nonaccrual loans                   | $             | 9,726 |          | $ | 2,969        |  | $            
|Loans past due 90 days or more and |               |       |          |   |              |  |              
|still accruing interest            |               | 48    |          |   | 48           |  |              
|Troubled debt restructurings       |               | 160   |          |   | 164          |  |              
|                                  
|Total nonperforming loans ("NPL")  | $             | 9,934 |          | $ | 3,181        |  | $            
|Other Real Estate Owned ("OREO")   |               | -     |          |   | -            |  |              
|                                  
|Total nonperforming assets ("NPA") | $             | 9,934 |          | $ | 3,181        |  | $            
|                                  
|                                  

|Nonperforming loans increased to $9.93 million at September 30, 2007 from $2.70 million at December 31, 2006. The net increase of $6.76 million in nonaccrual loans during the quarter ended September 30, 2007 is primarily attributable to $6.90
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

<PAGE>  15



|million in loans related to a residential construction project. Cost overruns on site work and infrastructure and slow unit sales reflecting the weakening housing market have strained the borrower's ability to fund its share of construction costs and service the loans.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|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 September 30, 2007 totaled $9.28 million, of which $9.20 million are included as nonaccrual loans in the table above. Impaired loans at September 30, 2007 have increased $6.31 million since June 30, 2007. This increase is primarily attributable to the loans discussed above.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|Merchants' management maintains an internal listing that includes all criticized and classified loans. Merchants' management believes that classified loans have well-defined weaknesses which, if left unattended, could lead to collection problems. The oversight process on these loans includes an active risk management approach. A management committee reviews the status of these loans each quarter and determines or confirms the appropriate risk rating and accrual status. The findings of this review process are instrumental in determining the adequacy of the Allowance. Excluded from nonperforming loans are approximately $14.13 million of internally classified loans as of September 30, 2007, compared to $14.07 million as of June 30, 2007 and $5.5 million as of December 31, 2006. Included in internally classified loans at September 30, 2007 are $5.19 million in owner-occupied commercial real estate and commercial loans to a residential home builder. No other internally classified loans are tied to the housing or any other specific industry. Approximately $2.92 million is attributable to commercial borrowers in a variety of industries, $2.31 million to non-owner occupied real estate and $3.70 million to owner-occupied real estate. To date all payments have been made as agreed by these customers and Merchants appears adequately secured. Merchants' management will continue to closely monitor asset quality.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|The increase in NPAs and internally classified loans in 2007 is primarily attributable to weakness in residential housing and construction industries.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|The following table reflects Merchants' nonperforming asset and coverage ratios as of the dates indicated:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             

|                                         | September 30, |  | June 30, |  | December 31, |  | September 30,
|---------------------------------------- | ------------- |  | -------- |  | ------------ |  | -------------
|                                         | 2007          |  | 2007     |  | 2006         |  | 2006         
|                                        
|NPL to total loans                       | 1.34%         |  | 0.44%    |  | 0.39%        |  | 0.42%        
|NPA to total loans plus OREO             | 1.34%         |  | 0.44%    |  | 0.43%        |  | 0.47%        
|NPA to total assets                      | 0.89%         |  | 0.29%    |  | 0.26%        |  | 0.28%        
|Allowance for loan losses to total loans | 1.05%         |  | 0.99%    |  | 1.00%        |  | 1.01%        
|Allowance to total loans                 | 1.09%         |  | 1.03%    |  | 1.06%        |  | 1.06%        
|Allowance for loan losses to NPL         | 78%           |  | 226%     |  | 256%         |  | 239%         
|Allowance for loan losses to NPA         | 78%           |  | 226%     |  | 234%         |  | 216%         
|                                         |               |  |          |  |              |  |              

|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>  16

|                                          | September 30, |       | June 30, |   | December 31, |  | September 30,
|----------------------------------------- | ------------- | ----- | -------- | - | ------------ |  | -------------
|(In thousands)                            | 2007          |       | 2007     |   | 2006         |  | 2006         
|                                         
|Balance, beginning of year                | $             | 7,281 |          | $ | 7,281        |  | $            
|Charge-offs :                             |               |       |          |   |              |  |              
|Commercial, lease financing and all other |               | (170) |          |   | (78)         |  |              
|Real estate - commercial                  |               | (181) |          |   | (85)         |  |              
|Real estate - mortgage                    |               | --    |          |   | --           |  |              
|Installment and other consumer            |               | (20)  |          |   | (20)         |  |              
|                                         
|Total charge-offs                         |               | (371) |          |   | (183)        |  |              
|                                         
|Recoveries:                               |               |       |          |   |              |  |              
|Commercial, lease financing and all other |               | 247   |          |   | 217          |  |              
|Real estate - commercial                  |               | 17    |          |   | 17           |  |              
|Real estate - mortgage                    |               | --    |          |   | --           |  |              
|Installment and other consumer            |               | --    |          |   | --           |  |              
|                                         
|Total recoveries                          |               | 264   |          |   | 234          |  |              
|                                         
|Net (charge-offs) recoveries              |               | (107) |          |   | 51           |  |              
|                                         
|Provision for credit losses               |               | 850   |          |   | 150          |  |              
|                                         
|Balance end of period                     | $             | 8,024 |          | $ | 7,482        |  | $            
|                                         
|                                          |               |       |          |   |              |  |              
|Components:                               |               |       |          |   |              |  |              
|Allowance for loan losses                 | $             | 7,726 |          | $ | 7,184        |  | $            
|Reserve for undisbursed lines of credit   |               | 298   |          |   | 298          |  |              
|                                         
|Allowance for Credit Losses               | $             | 8,024 |          | $ | 7,482        |  | $            
|                                         
|                                         

|Losses are charged against the allowance for loan losses when management believes that the collectibility of principal is doubtful. To the extent management determines the level of anticipated losses in the portfolio has significantly increased or diminished, the allowance for loan losses is adjusted through current earnings. As part of Merchants' analysis of specific credit risk, detailed and extensive reviews are performed on larger credits and problematic credits identified on the watched asset list, nonperforming asset listings and internal credit rating reports. An outside loan review firm examines portions of Merchants' commercial loan portfolio three times per year. Over the course of the year, approximately 70% of commercial loan balances are reviewed, including all relationships over $1.0 million and criticized and classified loans over $500 thousand. Issues addressed by the loan review process include the accuracy of Merchants' internal risk ratings system, loan quality, and adequacy of the allowance for loan losses.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|The Allowance reflects management's current strategies and efforts to maintain the Allowance at a level adequate to provide for losses based on an evaluation of known and inherent risks in the loan portfolio, as well as the potential risk from unfunded loan commitments and letters of credit. Among the factors that management considers in establishing the level of the Allowance are overall findings from an analysis of individual loans, the overall risk characteristics and size of the loan portfolio, past credit loss history, management's assessment of current economic and real estate market conditions and estimates of the current value of the underlying collateral. A credit loss provision of $700 thousand was recorded during the quarter ended September 30, 2007, primarily as a result of increased nonperforming loans during the quarter. Management considers the balance of the Allowance adequate at September 30, 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 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.                                                                 

<PAGE>  17



|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 August 31, 2007. At that time Merchants' one-year gap position was a $244.89 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 August 31,2007 review. Additionally, the consultant modeled 200 basis point rising and falling interest rate scenarios which assume a parallel and pro rata shift of the yield curve over a one-year period and assumed no changes or growth in the balance sheet. In the base case model, which assumes interest rates and Merchants' balance sheet and mix remain similar to those of August 31, 2007, net margins are expected to increase throughout the simulation as assets yields increase more quickly than funding costs. If rates fall, net interest income is projected to increase as a large portion of the funding base reprices to lower rates during the first year; 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 and a half 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 is 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 August 31, 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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     

| |                       | Percent Change in   | 
| | --------------------- | ------------------- | 
| | Rate Change           | Net Interest Income | 
| |                       |                    
| | Up 200 basis points   | (1.7)%              | 
| | Down 200 basis points | 3.1%                | 
| |                       |                    
| |                       |                    

|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 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.

<PAGE>  18

|The model used to perform the balance sheet simulation assumes a parallel shift of the yield curve over twelve months and reprices every interest bearing asset and liability on Merchants' balance sheet. The model uses contractual repricing dates for variable products, contractual maturities for fixed rate products, and product-specific assumptions for deposits such as Free Checking for LifeÒ
 accounts and money market accounts which are subject to repricing based on current market conditions. Investment securities with call provisions are examined on an individual basis in each rate environment to estimate the likelihood of a call. The model also assumes that the rate at which certain mortgage related assets prepay will vary as rates rise and fall, based on prepayment estimates derived from the Office of Thrift Supervision's Net Portfolio Value Model.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|As market conditions vary from those assumed in the sensitivity analysis, actual results will likely differ due to: the varying impact of changes in the balances and mix of loans and deposits differing from those assumed, the impact of possible off balance sheet hedging strategies, and other internal/external variables. Furthermore, the sensitivity analysis does not reflect all actions that the ALCO might take in responding to or anticipating changes in interest rates.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|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 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 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.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|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 are presented to the Board for approval.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|Item 4. Controls and Procedures                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|The principal executive officer, principal financial officer, and other members of Merchants' senior management have evaluated Merchants' disclosure controls and procedures as of the end of the period covered by this quarterly report. Based on this evaluation, Merchants' principal executive officer and principal financial officer have concluded that the disclosure controls and procedures effectively ensure that information required to be disclosed in Merchants' filings and submissions with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), is accumulated and communicated to Merchants' management (including the principal executive officer and principal financial officer), and is recorded, processed, summarized and reported within the time periods specified by the Securities and Exchange Commission. In addition, Merchants has reviewed its internal controls over financial reporting and there have been no changes in its internal control over financial reporting during the quarter ended September 30, 2007 that have materially affected, or are reasonably likely to materially affect, its internal control over financial reporting.                                                                                                                                                                                                                                                                                                                                                                                                                                         

<PAGE>  19

|MERCHANTS BANCSHARES, INC.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|PART II - OTHER INFORMATION                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Item 1. Legal Proceedings                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|None.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Item 1A. Risk Factors                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Please read the factors discussed in "Risk Factors" in Merchants' Annual Report on Form 10-K for the fiscal year ended December 31, 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.
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Item 2. Unregistered Sales of Equity Securities and Use of Proceeds                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Issuer Purchases of Equity Securities by the Issuer                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 

|                                 |           |                | Total Number of     | Maximum Number    
|-------------------------------- | --------- | -------------- | ------------------- | ------------------
|                                 | Total     |                | Shares Purchased    | of Shares that May
|                                 | Number    |                | as Part of Publicly | Yet Be Purchased  
|                                 | of Shares | Average Price  | Announced Plans     | Under the Plans or
|Period                           | Purchased | Paid per Share | or Programs         | Programs          
|                                
|July 1 through July 31           | --        | --             | --                  | 164,647           
|August 1 through August 31       | 45,208    | --             | 1,788               | 162,859           
|September 1 through September 30 | --        | --             | --                  | 162,859           
|                                 |          
|Total                            | 45,208    | --             | 1,788               | --                
|                                 |          
|                                

|In January 2007, Merchants Board approved a stock repurchase program, pursuant to which Merchants may repurchase 200,000 shares of its common stock on the open market from time to time through January 2008. Under the program, which commenced during the quarter ended June 30, 2007, 37,141 shares have been purchased at an average price per share of $22.68. On June 28, 2007, Merchants purchased 10,000 shares of its stock at a price of $23.00 per share, not on the open market. On August 3, 2007, Merchants purchased 43,420 shares of its stock at a price of $23.08 per share, not on the open market. Both of these purchases were made from the Dudley Hale Davis Estate, of which Mr. Jeffrey L. Davis, a director of Merchants, is executor.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Item 3. Defaults Upon Senior Securities                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|None.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Item 4. Submission of Matters to a Vote of Security Holders                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|None.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Item 5. Other Information                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|None.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|Item 6. Exhibits                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|(a) Exhibits:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 

| | 3.1.1 | Certificate of Incorporation, filed April 20, 1987 (Incorporated by reference to Exhibit B to Pre-Effective Amendment No. 1 to Merchants' Definitive Proxy Statement on Schedule 14A, filed on April 25, 1987 for Merchants' Annual Meeting of Shareholders held June 2, 1987)
| | ----- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

<PAGE>  20

| | 3.1.2 | Certificate of Merger, filed June 5, 1987 (Incorporated by reference to Merchants' Annual Report on Form 10-K for the Year Ended December 31, 2006, filed on March 16, 2007)                                           
| | ----- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |       |                                                                                                                                                                                                                        
| | 3.1.3 | Certificate of Amendment, filed May 11, 1988 (Incorporated by reference to Merchants' Annual Report on Form 10-K for the Year Ended December 31, 2006, filed on March 16, 2007)                                        
| |       |                                                                                                                                                                                                                        
| | 3.1.4 | Certificate of Amendment, filed April 29, 1991 (Incorporated by reference to Merchants' Annual Report on Form 10-K for the Year Ended December 31, 2006, filed on March 16, 2007)                                      
| |       |                                                                                                                                                                                                                        
| | 3.1.5 | Certificate of Amendment, filed August 29, 2006 (Incorporated by reference to Merchants' Annual Report on Form 10-K for the Year Ended December 31, 2006, filed on March 16, 2007)                                     
| |       |                                                                                                                                                                                                                        
| | 3.1.6 | Certificate of Amendment, filed August 29, 2006 (Incorporated by reference to Merchants' Annual Report on Form 10-K for the Year Ended December 31, 2006, filed on March 16, 2007)                                     
| |       |                                                                                                                                                                                                                        
| | 3.2   | Amended By-Laws of Merchants (Incorporated by reference to Exhibit C to Merchants' Definitive Proxy Statement on Schedule 14A, filed on April 25, 1987 for Merchants' Annual Meeting of Shareholders held June 2, 1987)
| |       |                                                                                                                                                                                                                        
| | 31.1  | Certification of Chief Executive Officer of the Company Pursuant to Securities Exchange Act Rules 13a-14 and 15d-14                                                                                                    
| |       |                                                                                                                                                                                                                        
| | 31.2  | Certification of Chief Financial Officer of the Company Pursuant to Securities Exchange Act Rules 13a-14 and 15d-14                                                                                                    
| |       |                                                                                                                                                                                                                        
| | 32.1  | Certification of Chief Executive Officer of the Company pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                       
| |       |                                                                                                                                                                                                                        
| | 32.2  | Certification of Chief Financial Officer of the Company pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                       

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|MERCHANTS BANCSHARES, INC.                                                                                                                                                              
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|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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