UNITED
STATES SECURITIES AND EXCHANGE COMMISSION


Washington,
D.C.  20549





FORM
10-K





T ANNUAL REPORT
PURSUANT TO SECTION 13 OR 15(d) OF


THE
SECURITIES EXCHANGE ACT OF 1934





For
the fiscal year ended December 31, 2007





OR





£ TRANSITION
REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE


SECURITIES
EXCHANGE ACT OF 1934


For
the transition period from _________ to __________.





Commission
File Number:000-26099





FARMERS
& MERCHANTS BANCORP


(Exact
name of registrant as specified in its charter)





Delaware
            94-3327828(State
      or other jurisdiction of incorporation or organization)
            (I.R.S.
      Employer Identification No.)





111
      W. Pine Street, Lodi, California
            95240(Address
      of principal executive offices)
            (Zip
      Code)





Registrant's
telephone number, including area code (209) 367-2300





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





Securities
registered pursuant to Section 12(g) of the Act:  Common Stock, $0.01 Par Value Per
Share





Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.  Yes £  No
T





Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act.  Yes £  No
T





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.  Yes T  No
£





Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.  T





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer or a smaller reporting company. See
definition of “large accelerated filer”, “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act (Check one):


Large
accelerated filer £           Accelerated
filer T           Non-accelerated
filer £           Smaller
Reporting Company £





(Do not
check if a smaller reporting company)





Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Act)  Yes £  No
T





The
aggregate market value of the Registrant's common stock held by non-affiliates
on June 30, 2007 (based on the last reported trade on June 28, 2007) was
$389,154,720.





The
number of shares of Common Stock outstanding as of February 29, 2008:
797,883





Documents
Incorporated by Reference:


Portions
of the definitive Proxy Statement for the 2008 Annual Meeting of Shareholders to
be filed with the Securities and Exchange Commission pursuant to Regulation 14A
are incorporated by reference in Part III, Items 10 through 14.













FARMERS & MERCHANTSBANCORP


FORM
10-K





TABLE OF
CONTENTS





PagePART
      IIntroduction
            3Item 1.
            Business
            3Item 1A.
            Risk Factors
            12Item 1B.
            Unresolved Staff Comments
            16Item 2.
            Properties
            16Item 3.
            Legal Proceedings
            16Item 4.
            Submission of Matters to a Vote of Security
      Holders
            16PART
      IIItem 5.
            Market for the Registrant’s Common Equity, Related
      Stockholder Matters and Issuer Purchases of Equity
      Securities
            16Item 6.
            Selected Financial Data
            19Item 7.
            Management's Discussion and Analysis of Financial Condition
      and Results of Operations
            20Item 7A.
            Quantitative and Qualitative Disclosures About Market
      Risk
            41Item 8.
            Financial Statements and Supplementary
    Data
            44Item 9.
            Changes in and Disagreements with Accountants on Accounting
      and Financial Disclosure
            72Item 9A.
            Controls and Procedures
            72Item 9B.
            Other Information
            72PART
      IIIItem 10.
            Directors, Executive Officers and Corporate
      Governance
            73Item 11.
            Executive Compensation
            73Item 12.
            Security Ownership of Certain Beneficial Owners and
      Management and Related Stockholder Matters
            73Item 13.
            Certain Relationships and Related Transactions, and
      Director Independence
            74Item 14.
            Principal Accountant Fees and Services
            74PART
      IVItem 15.
            Exhibits and Financial Statement
    Schedules
            74Signatures
            75Index to Exhibits
            76





2
 Table of Contents





Introduction– Forward Looking Statements





This Form
10-K contains various forward-looking statements, usually containing the words
“estimate,” “project,” “expect,” “objective,” “goal,” or similar expressions and
includes assumptions concerning the Company’s operations, future results, and
prospects. These forward-looking statements are based upon current expectations
and are subject to risk and uncertainties. In connection with the “safe-harbor”
provisions of the Private Securities Litigation Reform Act of 1995, the Company
provides the following cautionary statement identifying important factors which
could cause the actual results of events to differ materially from those set
forth in or implied by the forward-looking statements and related
assumptions.





Such
factors include the following: (i) the effect of changing regional and national
economic conditions; (ii) significant changes in interest rates and prepayment
speeds; (iii) credit risks of lending and investment activities; (iv) changes in
federal and state banking laws or regulations; (v) competitive pressure in the
banking industry; (vi) changes in governmental fiscal or monetary policies;
(vii) uncertainty regarding the economic outlook resulting from the continuing
war on terrorism, as well as actions taken or to be taken by the U.S. or other
governments as a result of further acts or threats of terrorism; and (viii)
other factors discussed in Item 1A. Risk Factors.





Readers
are cautioned not to place undue reliance on these forward-looking statements
which speak only as of the date hereof. The Company undertakes no obligation to
update any forward-looking statements to reflect events or circumstances arising
after the date on which they are made.





PART I





Item 1. Business





General
Development of the Business





August 1,
1916, marked the first day of business for Farmers & Merchants Bank of Lodi.
The Bank was incorporated under the laws of the State of California and was
licensed by the California Department of Financial Institutions as a
state-chartered bank. The Bank prospered and grew even through the Depression
years. Farmers & Merchants’ first venture out of Lodi occurred in response
to the closure of the only bank serving the community of Galt, requiring area
residents to drive miles away for the simplest banking transaction. To meet this
need, the Galt office was opened in 1948. Shortly thereafter branches were
opened in Linden, North Modesto and South Sacramento. On April 12, 1957, the
Bank’s name was changed to Farmers & Merchants Bank of Central
California.





The Bank
continued expansion in the Lodi market area and also acquired three offices in
Turlock and Hilmar in 1985. The service area was next expanded by opening a loan
production office in the community of Elk Grove. This office was later converted
to a full service branch. A third office was also opened in Modesto. The year
2002 saw the opening of the Lincoln Center office, the Company’s first branch in
the city of Stockton. In September 2003 the Bank opened its fourth office in
Modesto. Located across from the Vintage Faire Mall, this branch incorporates
state of the art technology throughout and represents the template for the
Bank’s future branch expansions and renovations.





During
2004 the Company initiated a major branch expansion, relocation and renovation
program. A second Galt office was opened in June 2005 and a new full-service
branch in downtown Sacramento was opened in February 2006. In October 2006 the
Company opened its sixth Lodi office on the southwest side of town in the
Vintner’s Square shopping center and in November 2006 the Company’s flagship
commercial branch was opened on March Lane in Stockton. The downtown Turlock
branch, currently operating in a leased facility, will be relocated to a new
owned facility during the first half of 2008. Many branches received renovations
during the previous three years, both to update these facilities and to comply
with the Americans with Disabilities Act. The Company currently estimates that
the capital expenditures associated with this multi-year program, which began in
2004, will be in excess of $10 million, which will result in increases in the
Company’s occupancy and equipment expenses.





3
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In
addition to the preceding 21 full-service branches, the Bank serves the needs of
its customers through two stand-alone ATM’s located on the grounds of the Lodi
Grape Festival and California State University-Stanislaus. In 2007 the Bank
began offering certain products over the internet at
www.fmbonline.com.





On March
10, 1999, Farmers & Merchants Bancorp (together with its subsidiaries, the
“Company”), pursuant to a reorganization, acquired all of the voting stock of
Farmers & Merchants Bank of Central California (the “Bank”). Farmers &
Merchants Bancorp is a bank holding company incorporated in the State of
Delaware, and registered under the Bank Holding Company Act of 1956, as amended.
The Company’s outstanding securities as of December 31, 2007, consisted of
800,112 shares of common stock, $0.01 par value and no shares of preferred stock
issued. The Bank is the Company’s principal asset.





The
Bank’s two wholly owned subsidiaries are Farmers & Merchants Investment
Corporation and Farmers/Merchants Corp. Farmers & Merchants Investment
Corporation is currently dormant and Farmers/Merchants Corp. acts as trustee on
deeds of trust originated by the Bank.





F & M
Bancorp, Inc. was created in March 2002 to protect the name “F & M Bank”.
During 2002, the Company completed a fictitious name filing in California to
begin using the streamlined name, “F & M Bank” as part of a larger effort to
enhance the Company’s image and build brand name recognition. Since 2002, the
Company has converted most of its daily operating and image advertising to the
“F & M Bank” name and the Company’s logo, slogan and signage were redesigned
to incorporate the trade name, “F & M Bank”.





During
2003 the Company formed a wholly owned Connecticut statutory business trust,
FMCB Statutory Trust I, for the sole purpose of issuing trust preferred
securities. See Note 17 located in “Item 8. Financial Statements and
Supplementary Data.”





The
Company’s principal business is to serve as a holding company for the Bank and
for other banking or banking related subsidiaries which the Company may
establish or acquire. As a legal entity separate and distinct from its
subsidiary, the Company’s principal source of funds is, and will continue to be,
dividends paid by and other funds advanced from the Bank. Legal limitations are
imposed on the amount of dividends that may be paid and loans that may be made
by the Bank to the Company. See “Item 1. Business - Dividends and Other Transfer
of Funds.”





The
Bank’s deposit accounts are insured under the Federal Deposit Insurance Act up
to applicable limits.





As a bank
holding company, the Company is subject to regulation and examination by the
Board of Governors of the Federal Reserve System (“FRB”). The Bank is a
California state-chartered non-fed member bank subject to the regulation and
examination of the California Department of Financial Institutions (“DFI”) and
the Federal Deposit Insurance Corporation (“FDIC”).





Service
Area





The
Company services the northern Central Valley of California with 21 banking
offices. The area includes Sacramento, San Joaquin, Stanislaus and Merced
Counties with branches in Sacramento, Elk Grove, Galt, Lodi, Stockton, Linden,
Modesto, Turlock and Hilmar.





Through
its network of banking offices, the Company emphasizes personalized service
along with a full range of banking services to businesses and individuals
located in the service areas of its offices. Although the Company focuses on
marketing its services to small and medium sized businesses, a full range of
retail banking services are made available to the local consumer
market.





The
Company offers a wide range of deposit instruments. These include checking,
savings, money market, time certificates of deposit, individual retirement
accounts and online banking services for both business and personal accounts.
The Company also serves as a federal tax depository for its business
customers.





The
Company provides a full complement of lending products, including commercial,
real estate construction, agribusiness, installment, credit card and real estate
loans. Commercial products include lines of credit and other working capital
financing and letters of credit. Financing products for individuals include
automobile financing, lines of credit, residential real estate, home improvement
and home equity lines of credit.





4
 Table of Contents





The
Company also offers a wide range of specialized services designed for the needs
of its commercial accounts. These services include a credit card program for
merchants, collection services, lockbox, investment sweep, on-line account
access, and electronic funds transfers by way of domestic and international wire
and automated clearinghouse.





The
Company makes investment products available to customers, including mutual funds
and annuities. These investment products are offered through a third party,
which employs investment advisors to meet with and provide investment advice to
the Company’s customers.





Employees





At
December 31, 2007, the Company employed a total of 308 full time equivalent
employees. The Company believes that its employee relations are
satisfactory.





Competition





The
banking and financial services industry in California generally, and in the
Company’s market areas specifically, is highly competitive. The increasingly
competitive environment is a result primarily of changes in regulation, changes
in technology and product delivery systems, and the accelerating pace of
consolidation among financial service providers. The Company competes with other
major commercial banks, diversified financial institutions, credit unions,
savings and loan associations, money market and other mutual funds, mortgage
companies, and a variety of other non-banking financial services and advisory
companies. Federal legislation encourages competition between different types of
financial service providers and has fostered new entrants into the financial
services market, and it is anticipated that this trend will continue. Using the
financial holding company structure, insurance companies and securities firms
may compete more directly with banks and bank holding companies.





Many of
our competitors are much larger in total assets and capitalization, have greater
access to capital markets and offer a broader range of financial services than
the Company. In order to compete with other financial service providers, the
Company relies upon personal contact by its officers, directors, employees, and
shareholders, along with various promotional activities and specialized
services. In those instances where the Company is unable to accommodate a
customer’s needs, the Company may arrange for those services to be provided
through its correspondents.





Government
Policies





The
Company’s profitability, like most financial institutions, is primarily
dependent on interest rate differentials. The difference between the interest
rates paid by the Company on interest-bearing liabilities, such as deposits and
other borrowings, and the interest rates received by the Company on its
interest-earning assets, such as loans extended to its customers and securities
held in its investment portfolio, comprise the major portion of the Company’s
earnings. These rates are highly sensitive to many factors that are beyond the
control of the Company and the Bank, such as inflation, recession and
unemployment, and the impact which future changes in economic conditions might
have on the Company and the Bank cannot be predicted.





The
business of the Company is also influenced by the monetary and fiscal policies
of the federal government and the policies of regulatory agencies, particularly
the Board of Governors of the Federal Reserve System (the “FRB”). The FRB
implements national monetary policies (with objectives such as curbing inflation
and combating recession) through its open-market operations in U.S. Government
securities by adjusting the required level of reserves for depository
institutions subject to its reserve requirements, and by varying the target
federal funds and discount rates applicable to borrowings by depository
institutions. The actions of the FRB in these areas influence the growth of bank
loans, investments, and deposits and also affect interest rates earned on
interest-earning assets and paid on interest-bearing liabilities. The nature and
impact on the Company of any future changes in monetary and fiscal policies
cannot be predicted.





5
 Table of Contents





From time
to time, legislative acts, as well as regulations, are enacted which have the
effect of increasing the cost of doing business, limiting or expanding
permissible activities, or affecting the competitive balance between banks and
other financial services providers. Proposals to change the laws and regulations
governing the operations and taxation of banks, bank holding companies, and
other financial institutions and financial services providers are frequently
made in the U.S. Congress, in the state legislatures, and before various
regulatory agencies. This legislation may change banking statutes and the
operating environment of the Company and its subsidiaries in substantial and
unpredictable ways. If enacted, such legislation could increase or decrease the
cost of doing business, limit or expand permissible activities or affect the
competitive balance among banks, savings associations, credit unions, and other
financial institutions. The Company cannot predict whether any of this potential
legislation will be enacted, and if enacted, the effect that it, or any
implementing regulations, would have on the financial condition or results of
operations of the Company or any of its subsidiaries. See “Item 1. Business —
Supervision and Regulation.”





Supervision
and Regulation





General


Bank
holding companies and banks are extensively regulated under both federal and
state law. The regulation is intended primarily for the protection of depositors
and the deposit insurance fund and not for the benefit of shareholders of the
Company. Set forth below is a summary description of the material laws and
regulations, which relate to the operations of the Company and the Bank. This
description does not purport to be complete and is qualified in its entirety by
reference to the applicable laws and regulations.





The
Company


The
Company is a registered bank holding company and is subject to regulation under
the Bank Holding Company Act of 1956 (“BHCA”), as amended. Accordingly, the
Company’s operations are subject to extensive regulation and examination by the
FRB. The Company is required to file with the FRB quarterly and annual reports
and such additional information as the FRB may require pursuant to the Bank
Holding Company Act. The FRB conducts periodic examinations of the
Company.





The FRB
may require that the Company terminate an activity or terminate control of or
liquidate or divest certain subsidiaries of affiliates when the FRB believes the
activity or the control of the subsidiary or affiliate constitutes a significant
risk to the financial safety, soundness or stability of any of its banking
subsidiaries. The FRB also has the authority to regulate provisions of certain
bank holding company debt. Under certain circumstances, the Company must file
written notice and obtain approval from the FRB prior to purchasing or redeeming
its equity securities.





Under the
BHCA and regulations adopted by the FRB, a bank holding company and its
non-banking subsidiaries are prohibited from requiring certain tie-in
arrangements in connection with an extension of credit, lease or sale of
property or furnishing of services. For example, with certain exceptions, a bank
may not condition an extension of credit on a promise by its customer to obtain
other services provided by it, its holding company or other subsidiaries, or on
a promise by its customer not to obtain other services from a competitor. In
addition, federal law imposes certain restrictions on transactions between
Farmers & Merchants Bancorp and its subsidiaries. Further, the Company is
required by the FRB to maintain certain levels of capital. See “Item 1. Business
- Supervision and Regulation - Capital Standards.”





The
Company is prohibited by the BHCA, except in certain statutorily prescribed
instances, from acquiring direct or indirect ownership or control of more than
5% of the outstanding voting shares of any company that is not a bank or bank
holding company and from engaging directly or indirectly in activities other
than those of banking, managing or controlling banks or furnishing services to
its subsidiaries. However, the Company, subject to the prior approval of the
FRB, may engage in any, or acquire shares of companies engaged in, activities
that are deemed by the FRB to be so closely related to banking or managing or
controlling banks as to be a proper incident thereto.





Under FRB
regulations, a bank holding company is required to serve as a source of
financial and managerial strength to its subsidiary banks and may not conduct
its operations in an unsafe or unsound manner. In addition, it is the FRB’s
policy that in serving as a source of strength to its subsidiary banks, a bank
holding company should stand ready to use available resources to provide
adequate capital funds to its subsidiary banks during periods of financial
stress or adversity and should maintain the financial flexibility and
capital-raising capacity to obtain additional resources for assisting its
subsidiary banks. This support may be required at times when a bank holding
company may not be able to provide such support. A bank holding company’s
failure to meet its obligations to serve as a source of strength to its
subsidiary banks will generally be considered by the FRB to be an unsafe and
unsound banking practice or a violation of the FRB’s regulations or
both.





6
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The
Gramm-Leach-Bliley Act of 1999 (“GLBA”) eliminated many of the restrictions
placed on the activities of bank holding companies that become financial holding
companies. Among other things, GLBA repealed certain Glass-Steagall Act
restrictions on affiliations between banks and securities firms, and amended the
BHCA to permit bank holding companies that are financial holding companies to
engage in activities, and acquire companies engaged in activities, that are:
financial in nature (including insurance underwriting, insurance company
portfolio investment, financial advisory, securities underwriting, dealing and
market-making, and merchant banking activities); incidental to financial
activities; or complementary to financial activities if the FRB determines that
they pose no substantial risk to the safety or soundness of depository
institutions or the financial system in general. The Company has not become a
financial holding company. GLBA also permits national banks to engage in
activities considered financial in nature through a financial subsidiary,
subject to certain conditions and limitations.





The
Company’s securities are registered with the Securities and Exchange Commission
under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). As
such, the Company is subject to the reporting, proxy solicitation and other
requirements and restrictions of the Exchange Act.





The
Bank


The Bank,
as a California chartered non-fed member bank, is subject to primary
supervision, periodic examination and regulation by the California Department of
Financial Institutions and the Federal Deposit Insurance Corporation. If, as a
result of an examination of the Bank, the FDIC should determine that the
financial condition, capital resources, asset quality, earnings prospects,
management, liquidity, or other aspects of the Bank’s operations are
unsatisfactory or that the Bank or its management is violating or has violated
any law or regulation, various remedies are available to the FDIC. Such remedies
include the power to enjoin “unsafe or unsound” practices, to require
affirmative action to correct any conditions resulting from any violation or
practice, to issue an administrative order that can be judicially enforced, to
direct an increase in capital, to restrict the growth of the Bank, to assess
civil monetary penalties, to remove officers and directors and ultimately to
terminate the Bank’s deposit insurance, which for a California chartered bank
would result in a revocation of the Bank’s charter. The DFI has many of the same
remedial powers.





Various
requirements and restrictions under the laws of the State of California and the
United States affect the operations of the Bank. State and federal statutes and
regulations relate to many aspects of the Bank’s operations, including reserves
against deposits, ownership of deposit accounts, interest rates payable on
deposits, loans, investments, mergers and acquisitions, borrowings, dividends,
locations of branch offices, and capital requirements. Further, the Bank is
required to maintain certain levels of capital. See “Capital
Standards.”





The
USA Patriot Act


Title III
of the United and Strengthening America by Providing Appropriate Tools Required
to Intercept and Obstruct Terrorism Act of 2001 (the “USA Patriot Act”) includes
numerous provisions for fighting international money laundering and blocking
terrorism access to the U.S. financial system. The USA Patriot Act requires
certain additional due diligence and record keeping practices, including, but
not limited to, new customers, correspondent and private banking
accounts.





Part of
the USA Patriot Act requires covered financial institutions to: (i) establish an
anti-money laundering program; (ii) establish appropriate anti-money laundering
policies, procedures and controls; (iii) appoint a Bank Secrecy Act officer
responsible for day-to-day compliance; and (iv) conduct independent audits. The
Patriot Act also expands penalties for violation of the anti-money laundering
laws, including expanding the circumstances under which funds in a bank account
may be forfeited. The Patriot Act also requires covered financial institutions
to respond under certain circumstances to requests for information from federal
banking agencies within 120 hours.





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Privacy
Restrictions


The GLBA,
in addition to the previous described changes in permissible non-banking
activities permitted to banks, bank holding companies and financial holding
companies, also requires financial institutions in the U.S. to provide certain
privacy disclosures to customers and consumers, to comply with certain
restrictions on the sharing and usage of personally identifiable information,
and to implement and maintain commercially reasonable customer information
safeguarding standards.





The
Company believes that it complies with all provisions of the GLBA and all
implementing regulations and the Bank has developed appropriate policies and
procedures to meet its responsibilities in connection with the privacy
provisions of GLBA.





Dividends
and Other Transfer of Funds


Dividends
from the Bank constitute the principal source of income to the Company. The
Company is a legal entity separate and distinct from the Bank. The Bank is
subject to various statutory and regulatory restrictions on its ability to pay
dividends to the Company. Under such restrictions, the amount available for
payment of dividends to the Company by the Bank totaled $24.4 million at
December 31, 2007.





The FDIC
and the DFI also have authority to prohibit the Bank from engaging in activities
that, in their opinion, constitute unsafe or unsound practices in conducting its
business. It is possible, depending upon the financial condition of the bank in
question and other factors, that the FDIC and the DFI could assert that the
payment of dividends or other payments might, under some circumstances, be an
unsafe or unsound practice. Further, the FRB and the FDIC have established
guidelines with respect to the maintenance of appropriate levels of capital by
banks or bank holding companies under their jurisdiction. Compliance with the
standards set forth in such guidelines and the restrictions that are or may be
imposed under the prompt corrective action provisions of federal law could limit
the amount of dividends which the Bank or the Company may pay. An insured
depository institution is prohibited from paying management fees to any
controlling persons or, with certain limited exceptions, making capital
distributions if after such transaction the institution would be
undercapitalized. The DFI may impose similar limitations on the Bank. See
“Prompt Corrective Regulatory Action and Other Enforcement Mechanisms” and
“Capital Standards” for a discussion of these additional restrictions on capital
distributions.





Transactions
with Affiliates


The Bank
is subject to certain restrictions imposed by federal law on any extensions of
credit to, or the issuance of a guarantee or letter of credit on behalf of, the
Company or other affiliates, the purchase of, or investments in, stock or other
securities thereof, the taking of such securities as collateral for loans, and
the purchase of assets of the Company or other affiliates. Such restrictions
prevent the Company and other affiliates from borrowing from the Bank unless the
loans are secured by marketable obligations of designated amounts. Further, such
secured loans and investments by the Bank to or in the Company or to or in any
other affiliates are limited, individually, to 10% of the Bank’s capital and
surplus (as defined by federal regulations), and such secured loans and
investments are limited, in the aggregate, to 20% of the Bank’s capital and
surplus (as defined by federal regulations).





In
addition, the Company and its operating subsidiaries generally may not purchase
a low-quality asset from an affiliate, and other specified transactions between
the Company or its operating subsidiaries and an affiliate must be on terms and
conditions that are consistent with safe and sound banking
practices.





Also, the
Company and its operating subsidiaries may engage in transactions with
affiliates only on terms and under conditions that are substantially the same,
or at least as favorable to the Company or its subsidiaries, as those prevailing
at the time for comparable transactions with (or that in good faith would be
offered to) non-affiliated companies.





California
law also imposes certain restrictions with respect to transactions with
affiliates. Additionally, limitations involving the transactions with affiliates
may be imposed on the Bank under the prompt corrective action provisions of
federal law. See “Item 1. Business – Supervision and Regulation - Prompt
Corrective Action and Other Enforcement Mechanisms.”





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Capital
Standards


The FRB
and the FDIC have established risk-based capital guidelines with respect to the
maintenance of appropriate levels of capital by United States banking
organizations. These guidelines are intended to provide a measure of capital
that reflects the risk associated with a banking organization’s operations for
both transactions reported on the balance sheet as assets and transactions, such
as letters of credit and recourse arrangements, which are recorded as off
balance sheet items. Under these guidelines, nominal dollar amounts of assets
and credit equivalent amounts of off balance sheet items are multiplied by one
of several risk adjustment percentages, which range from 0% for assets with low
credit risk, such as certain U.S. Treasury securities, to 100% for assets with
relatively high credit risk, such as commercial loans.





The
federal banking agencies require a minimum ratio of qualifying total capital to
risk-weighted assets of 8% and a minimum ratio of Tier 1 capital to
risk-weighted assets of 4%. In addition to the risk-based guidelines, federal
banking regulators require banking organizations to maintain a minimum amount of
Tier 1 capital to total assets, referred to as the leverage ratio. For a banking
organization rated in the highest of the five categories used by regulators to
rate banking organizations, the minimum leverage ratio of Tier 1 capital to
total assets must be 4%. In addition to these uniform risk-based capital
guidelines and leverage ratios that apply across the industry, the regulators
have the discretion to set individual minimum capital requirements for specific
institutions at rates significantly above minimum guidelines and ratios. For
further information on the Company and the Bank’s risk-based capital ratios, see
Note 10 located in “Item 8. Financial Statements and Supplementary
Data.”





Prompt
Corrective Action and Other Enforcement Mechanisms


The
Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), among
other things, identifies five capital categories for insured depository
institutions (well capitalized, adequately capitalized, undercapitalized,
significantly undercapitalized and critically undercapitalized) and requires the
respective Federal regulatory agencies to implement systems for “prompt
corrective action” for insured depository institutions that do not meet minimum
capital requirements within such categories. FDICIA imposes progressively more
restrictive constraints on operations, management and capital distributions,
depending on the category in which an institution is classified. Failure to meet
the capital guidelines could also subject a banking institution to capital
raising requirements. An “undercapitalized” Company must develop a capital
restoration plan. At December 31, 2007, the Bank exceeded all of the required
ratios for classification as “well capitalized.” It should be noted, however,
that the Bank’s capital category is determined solely for the purpose of
applying the federal banking agencies’ prompt corrective action regulations and
the capital category may not constitute an accurate representation of the Bank’s
overall financial condition or prospects.





An
institution that, based upon its capital levels, is classified as well
capitalized, adequately capitalized, or undercapitalized may be treated as
though it were in the next lower capital category if the appropriate federal
banking agency, after notice and opportunity for hearing, determines that an
unsafe or unsound condition or practice warrants such treatment. At each
successive lower capital category, an insured depository institution is subject
to more restrictions.





Banking
agencies have also adopted regulations which mandate that regulators take into
consideration: (i) concentrations of credit risk; (ii) interest rate risk (when
the interest rate sensitivity of an institution’s assets does not match the
sensitivity of its liabilities or its off-balance-sheet position); and (iii)
risks from non-traditional activities, as well as an institution’s ability to
manage those risks, when determining the adequacy of an institution’s capital.
That evaluation will be made as a part of the institution’s regular safety and
soundness examination. In addition, the banking agencies have amended their
regulatory capital guidelines to incorporate a measure for market risk. In
accordance with the amended guidelines, the Company and any company with
significant trading activity must incorporate a measure for market risk in its
regulatory capital calculations.





In
addition to measures taken under the prompt corrective action provisions,
commercial banking organizations may be subject to potential enforcement actions
by the federal banking agencies for unsafe or unsound practices in conducting
their businesses or for violations of any law, rule, regulation or any condition
imposed in writing by the agency or any written agreement with the agency.
Enforcement actions may include the imposition of a conservator or receiver, the
issuance of a cease-and-desist order that can be judicially enforced, the
termination of insurance of deposits (in the case of a depository institution),
the imposition of civil money penalties, the issuance of directives to increase
capital, the issuance of formal and informal agreements, the issuance of removal
and prohibition orders against institution-affiliated parties and the
enforcement of such actions through injunctions or restraining orders based upon
a judicial determination that the agency would be harmed if such equitable
relief was not granted. Additionally, a holding company's inability to serve as
a source of strength to its subsidiary banking organizations could serve as an
additional basis for a regulatory action against the holding
company.





9
 Table of Contents





Federal
banking regulators have also issued final guidance regarding commercial real
estate (“CRE”) lending. This guidance suggests that institutions that are
potentially exposed to significant CRE concentration risk will be subject to
increased regulatory scrutiny. Institutions that have experienced rapid growth
in CRE lending, have notable exposure to a specific type of CRE lending, or are
approaching or exceed certain supervisory criteria that measure an institution’s
CRE portfolio against its capital levels, may be subject to such increased
regulatory scrutiny. Our CRE portfolio may be viewed as falling within one or
more of the foregoing categories, and accordingly we may become subject to
increased regulatory scrutiny because of our CRE portfolio. Institutions that
are determined by their regulator to have an undue concentration in CRE lending
may be required to maintain levels of capital in excess of the statutory minimum
requirements and/or be required to reduce their concentration in CRE loans. The
FDIC has determined that the Company does not have any undue concentrations in
CRE lending.





Safety
and Soundness Standards


The
federal banking agencies have adopted guidelines designed to assist in
identifying and addressing potential safety and soundness concerns before
capital becomes impaired. The guidelines set forth operational and managerial
standards relating to: (i) internal controls, information systems and internal
audit systems; (ii) loan documentation; (iii) credit underwriting; (iv) asset
growth; (v) earnings; and (vi) compensation, fees and benefits. In addition, the
federal banking agencies have also adopted safety and soundness guidelines with
respect to asset quality and earnings standards. These guidelines provide six
standards for establishing and maintaining a system to identify problem assets
and prevent those assets from deteriorating. Under these standards, any insured
depository institution should: (i) conduct periodic asset quality reviews to
identify problem assets; (ii) estimate the inherent losses in problem assets and
establish reserves that are sufficient to absorb estimated losses; (iii) compare
problem asset totals to capital; (iv) take appropriate corrective action to
resolve problem assets; (v) consider the size and potential risks of material
asset concentrations; and (vi) provide periodic asset quality reports with
adequate information for management and the Board of Directors to assess the
level of asset risk. These guidelines also set forth standards for evaluating
and monitoring earnings and for ensuring that earnings are sufficient for the
maintenance of adequate capital and reserves.





Premiums
for Deposit Insurance


Effective
January 1, 2007, the FDIC has adopted a new rule for the insurance assessment on
deposits based upon risk assessment classifications. Under the new rule the
charge for annual insurance deposit assessments will range from a minimum of 5
basis points to a maximum of 43 basis points per $100 of insured deposits
depending upon an institution’s risk assessment category. Insured institutions
are not all allowed to disclose their risk assessment classification and no
assurance can be given as to what the future level of premiums will
be.





The
Federal Deposit Insurance Reform Act of 2005, among other things, granted a
one-time initial assessment credit of approximately $4.7 billion to recognize
institutions’ past contributions to the fund. The Company’s one-time assessment
credit is $755,000. This credit can be used to offset assessments until
exhausted.  The Company’s assessment credit will be fully used by June
2008.





In
addition to the assessment for deposit insurance, institutions are required to
make payments on bonds issued in the late 1980’s by the Financing Corporation to
recapitalize a predecessor deposit insurance fund.  This payment is
established quarterly and during the year ending December 31, 2007, averaged
1.14 basis points of assessable deposits.





The FDIC
has authority to increase insurance assessments.  A significant
increase in insurance premiums could have an adverse effect on the operating
expenses and results of operations of the Company.   Management
cannot predict what insurance assessment rates will be in the
future.  Insurance of deposits may be terminated by the FDIC upon a
finding that the institution has engaged in unsafe or unsound practices, is in
an unsafe or unsound condition to continue operations or has violated any
applicable law, regulation, rule, order or condition imposed by the FDIC or the
Office of Thrift Supervision.  Management of the Company is not aware
of any practice, condition or violation that might lead to termination of the
Company’s deposit insurance.





10
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Community
Reinvestment Act (“CRA”) and Fair Lending


The Bank
is subject to certain fair lending requirements involving lending, investing and
other CRA activities. CRA requires each insured depository institution to
identify the communities served by the institution’s offices and to identify the
types of credit and investments the institution is prepared to extend within
such communities including low and moderate income neighborhoods. It also
requires the institution’s regulators to assess the institution’s performance in
meeting the credit needs of its community and to take such assessment into
consideration in reviewing applications for mergers, acquisitions, relocation of
existing branches, opening of new branches and other transactions. A bank may be
subject to substantial penalties and corrective measures for a violation of
certain fair lending laws.





A bank’s compliance with
the Community Reinvestment Act is based on a performance based evaluation system
which bases CRA ratings on an institution’s lending service and investment
performance. An unsatisfactory rating may be the basis for denying a merger
application.The Bank’s latest CRA examination was completed by the
Federal Deposit Insurance Corporation. The lending test portion included a
review of small business, small farm, and home mortgage loans originated during
calendar years 2005 and 2006. The Bank’s community development lending as well
as investment and service activities were reviewed between January 20, 2004, and
April 16, 2007. The FDIC provided the Bank with a High Satisfactory rating in
the lending test and an Outstanding rating for both the investment and service
tests. Consequently, the Bank received an overall Outstanding rating in
complying with its CRA obligations. The FDIC cited the volume of loans within
geographies of differing income levels; the number of loans to individuals and
small businesses of different income levels; the significant community
development services provided within the Bank’s communities; and, the variety
and depth of products and services tailored to the needs of the communities as
key factors in their overall rating assessment.





The
Sarbanes-Oxley Act of 2002


This
legislation addresses certain accounting oversight and corporate governance
matters.





·
            The
      creation of a five-member oversight board that sets standards for
      accountants and has investigative and disciplinary
  powers.





·
            The
      prohibition of accounting firms from providing various types of consulting
      services to public clients and requires accounting firms to rotate
      partners among public client assignments every five
  years.





·
            Increased
      penalties for financial crimes.





·
            Expanded
      disclosure of corporate operations and internal controls and certification
      of financial statements.





·
            Enhanced
      controls on, and reporting of, insider
trading.





·
            Prohibition
      on lending to officers and directors of public companies, although the
      bank may continue to make these loans within the constraints of existing
      banking regulations.





As a
public reporting company, the Company is subject to the requirements of this
legislation and related rules and regulations issued by the Securities and
Exchange Commission (the “SEC”). The Company does not expect that compliance
with the Act (the “Act”) will have a material impact upon its business. However,
other non-interest expense items, including professional expenses and other
costs related to compliance with the reporting requirements of the securities
laws have significantly increased and can be expected to continue to
increase.





Available
Information





Company
reports filed with the Securities and Exchange Commission including the annual
report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form
8-K, proxy statements and ownership reports filed by Directors, executive
officers and principal shareholders can be accessed through the Company’s web
site at http://www.fmbonline.com. The link to the Securities and Exchange
Commission is on the About F
& M Bank page.





11
 Table of Contents





Item 1A. RiskFactors





An
investment in our common stock is subject to risks inherent in our business. The
material risks and uncertainties that management believes may affect our
business are described below. Before making an investment decision, you should
carefully consider the risks and uncertainties described below together with all
of the other information included or incorporated by reference in this report.
The risks and uncertainties described below are not the only ones facing our
business. Additional risks and uncertainties that management is not aware of or
focused on or that management currently deems immaterial may also impair our
business operations. This report is qualified in its entirety by these risk
factors.





If any of
the following risks actually occur, our financial condition and results of
operations could be materially and adversely affected. If this were to happen,
the value of our common stock could decline significantly, and you could lose
all or part of your investment.





Risks
Associated With Our Business





The Current Changing Economic
Environment Poses Significant Challenges For Us -Financial institutions
continue to be affected by the softening of the real estate market and the
economy in general.  While we have very limited direct exposure to the
residential real estate market and while we have no sub-prime residential loans
or securities backed by such loans on our books, we are nevertheless affected by
these economic events.  Continued declines in real estate values, home
sales volumes and financial stress on borrowers as a result of the uncertain
economic environment, including job losses, interest rate resets on adjustable
rate mortgage loans and other factors could have adverse effects on our
borrowers which would adversely affect our financial condition and results of
operations.  This deterioration in economic conditions could drive
losses beyond that which is provided for in our allowance for loan
losses.





We Are Dependent On Real Estate And
Downturns In The Real Estate Market Could Hurt Our Business -Although
our regulators have determined that we do not have significant CRE concentration
risk, a significant portion of our loan portfolio is dependent on real estate.
See “Item 1. Business – Supervision and Regulation - Prompt Corrective Action
and Other Enforcement Mechanisms.” At December 31, 2007, real estate served as
the principal source of collateral with respect to approximately 66% of our loan
outstandings, 17% were secured by production agricultural properties. A
continuing decline in current economic conditions or rising interest rates could
have an adverse effect on the demand for new loans, the ability of borrowers to
repay outstanding loans, the value of real estate and other collateral securing
loans and the value of real estate owned by us, as well as our financial
condition and results of operations in general and the market value of our
common stock.





Acts of
nature, including earthquakes, floods and fires, which may cause uninsured
damage and other loss of value to real estate that secures these loans, may also
negatively impact our financial condition.





Our Real Estate Lending Also Exposes
Us To The Risk Of Environmental Liabilities -In the course of our
business, we may foreclose and take title to real estate, and could be subject
to environmental liabilities with respect to these properties. We may be held
liable to a governmental entity or to third persons for property damage,
personal injury, investigation and clean-up costs incurred by these parties in
connection with environmental contamination, or may be required to investigate
or clean up hazardous or toxic substances, or chemical releases at a property.
The costs associated with investigation or remediation activities could be
substantial. In addition, as the owner or former owner of a contaminated site,
we may be subject to common law claims by third parties based on damages and
costs resulting from environmental contamination emanating from the property. If
we ever become subject to significant environmental liabilities, our business,
financial condition, liquidity and results of operations could be materially and
adversely affected.





12
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Our Business Is Subject To Interest
Rate Risk And Changes In Interest Rates May Adversely Affect Our Performance And
Financial Condition - Our earnings are impacted by changing interest
rates. Changes in interest rates impact the demand for new loans, the credit
profile of our borrowers, the rates received on loans and securities and rates
paid on deposits and borrowings. The difference between the rates received on
loans and securities and the rates paid on deposits and borrowings is known as
interest rate spread. Although we believe our current level of interest rate
sensitivity is reasonable, significant fluctuations in interest rates and
increasing competition may have an adverse effect on our business, financial
condition and results of operations. See “Item 7A. Quantitative and Qualitative
Disclosures About Market Risk - Interest Rate Risk.”





A
sustained decrease in market interest rates could adversely affect our earnings.
The Board of Governors of the Federal Reserve System regulates the supply of
money and credit in the United States. Its policies determine, in large part,
the cost of funds for lending and investing and the yield earned on those loans
and investments, both of which impact the Company’s net interest margin. Between
June 30, 2004, and December 31, 2006, the Federal Open Market Committee of the
Federal Reserve Bank (“FOMC”) adopted a policy of monetary tightening, and as a
result market interest rates increased during this period. The FRB has recently
adopted an easing bias in response to the current state of the national economy
and housing market as well as the volatility of financial markets. As a result,
market interest rates have declined 225 basis points since September 2007. When
interest rates decline, borrowers tend to refinance higher-rate, fixed-rate
loans at lower rates, prepaying their existing loans. Under those circumstances,
we would not be able to reinvest those prepayments in assets earning interest
rates as high as the rates on the prepaid loans. In addition, our commercial
real estate and commercial loans, which carry interest rates that, in general,
adjust in accordance with changes in the prime rate, will adjust to lower rates.
We are also significantly affected by the level of loan demand available in our
market. The inability to make sufficient loans directly affects the interest
income we earn. Lower loan demand will generally result in lower interest income
realized as we place funds in lower yielding investments. See “Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of
Operations – Looking Forward: 2008 and Beyond.”





Failure To Successfully Execute Our
Strategy Could Adversely Affect Our Performance-Our financial performance
and profitability depends on our ability to execute our corporate growth
strategy. Continued growth, however, may present operating and other problems
that could adversely affect our business, financial condition and results of
operations. Accordingly, there can be no assurance that we will be able to
execute our growth strategy or maintain the level of profitability that we have
recently experienced. Factors that may adversely affect our ability to attain
our long-term financial performance goals include those stated elsewhere in this
section, as well as the:





·
            inability
      to control non-interest expense, including, but not limited to, rising
      employee and healthcare costs;





·
            inability
      to increase non-interest income;
and





·
            continuing
      ability to expand through de novo branching or
  otherwise.





Economic Conditions In Our Service
Areas Could Adversely Affect Our Operations And/Or Cause Us To Sustain
Losses-Our
retail and commercial banking operations are concentrated primarily in
Sacramento, San Joaquin, Stanislaus and Merced Counties. As a result of this
geographic concentration, our results of operations depend largely upon economic
conditions in this area. A significant source of risk arises from the
possibility that losses will be sustained if a significant number of our
borrowers, guarantors and related parties fail to perform in accordance with the
terms of their loans. This risk increases when the economy is weak. We have
adopted underwriting and credit monitoring procedures and credit policies,
including the establishment and review of the allowance for loan losses, that
management believes are appropriate to minimize this risk by assessing the
likelihood of nonperformance, tracking loan performance and diversifying our
credit portfolio. These policies and procedures, however, may not prevent
unexpected losses that could materially adversely affect our results of
operations in general and the market value of our stock. See “Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of
Operations – Looking Forward: 2008 and Beyond.”





This
Company’s service areas can be significantly impacted by the seasonal and
cyclical trends of the agricultural industry. As a result, the Company’s
financial results are influenced by the seasonal banking needs of its
agricultural customers (e.g., during the spring and summer customers draw down
their deposit balances and increase loan borrowing to fund the purchase of
equipment and the planting of crops. Correspondingly, deposit balances are
replenished and loans repaid in late fall and winter as crops are harvested and
sold). Additionally, although the Company’s loan portfolio is believed to be
well diversified, at various times during the year approximately 33% of the
Company’s loan balances can be outstanding to agricultural borrowers.
Commitments are well diversified across various commodities, including dairy,
grapes, walnuts, almonds, cherries, apples, pears, walnuts, and various row
crops. Additionally, many individual borrowers are themselves diversified across
commodity types, reducing their exposure, and therefore the Company’s, to
cyclical downturns in any one commodity.





13
 Table of Contents





We Face Strong Competition From
Financial Service Companies And Other Companies That Offer Banking Services That
Could Hurt Our Business - The financial services business in our market
areas is highly competitive. It is becoming increasingly competitive due to
changes in regulation, technological advances, and the accelerating pace of
consolidation among financial services providers. We face competition both in
attracting deposits and in making loans. We compete for loans principally
through the interest rates and loan fees we charge and the efficiency and
quality of services we provide. Increasing levels of competition in the banking
and financial services business may reduce our market share, decrease loan
demand, cause the prices we charge for our services to fall, or decrease our net
interest margin by forcing us to offer lower lending interest rates and pay
higher deposit interest rates. Therefore, our results may differ in future
periods depending upon the nature or level of competition.





Technology
and other changes are allowing parties to complete financial transactions that
historically have involved banks through alternative methods. For example,
consumers can now maintain funds that would have historically been held as bank
deposits in brokerage accounts or mutual funds. Consumers can also complete
transactions such as paying bills and/or transferring funds directly without the
assistance of banks. The process of eliminating banks as intermediaries, known
as “disintermediation,” could result in the loss of fee income, as well as the
loss of customer deposits and the related income generated from those deposits.
The loss of these revenue streams and the lower cost deposits as a source of
funds could have a material adverse effect on our financial condition and
results of operations.





We May Not Be Able To Attract And
Retain Skilled People - Our success depends, in large part, on our
ability to attract and retain key people. Competition for the best people in
most of our activities can be intense and we may not be able to hire people or
to retain them. The unexpected loss of services of one or more of our key
personnel could have a material adverse impact on our business because of their
skills, knowledge of our market, years of industry experience and the difficulty
of promptly finding qualified replacement personnel.





Our Internal Operations Are Subject
To A Number Of Risks-We are subject to certain operations risks, including, but not limited
to, information system failures and errors, customer or employee fraud and
catastrophic failures resulting from terrorist acts or natural disasters. We
maintain a system of internal controls to mitigate against such occurrences and
maintain insurance coverage for such risks that are insurable, but should such
an event occur that is not prevented or detected by our internal controls,
uninsured or in excess of applicable insurance limits, it could have a
significant adverse impact on our business, financial condition or results of
operations.





We rely
heavily on communications and information systems to conduct our business. Any
failure, interruption or breach in security of these systems could result in
failures or disruptions in our customer relationship management, general ledger,
deposit, loan and other systems. While we have policies and procedures designed
to prevent or limit the effect of the failure, interruption or security breach
of our information systems, there can be no assurance that any such failures,
interruptions or security breaches will not occur or, if they do occur, that
they will be adequately addressed. The occurrence of any failures, interruptions
or security breaches of our information systems could damage our reputation,
result in a loss of customer business, subject us to additional regulatory
scrutiny, or expose us to civil litigation and possible financial liability, any
of which could have a material adverse effect on our financial condition and
results of operations.





The
financial services industry is continually undergoing rapid technological change
with frequent introductions of new technology-driven products and services. The
effective use of technology increases efficiency and enables financial
institutions to better serve customers and to reduce costs. Our future success
depends, in part, upon our ability to address the needs of our customers by
using technology to provide products and services that will satisfy customer
demands, as well as to create additional efficiencies in our operations. Many of
our competitors have substantially greater resources to invest in technological
improvements. We may not be able to effectively implement new technology-driven
products and services or be successful in marketing these products and services
to our customers. Failure to successfully keep pace with technological change
affecting the financial services industry could have a material adverse impact
on our business and, in turn, our financial condition and results of
operations.





14
 Table of Contents





Severe
weather, natural disasters, acts of war or terrorism and other adverse external
events could have a significant impact on our ability to conduct business. Such
events could affect the stability of our deposit base, impair the ability of
borrowers to repay outstanding loans, impair the value of collateral securing
loans, cause significant property damage, result in loss of revenue and/or cause
us to incur additional expenses. Operations in several of our markets could be
disrupted by both the evacuation of large portions of the population as well as
damage and or lack of access to our banking and operation facilities. While we
have not experienced such an occurrence to date, other severe weather or natural
disasters, acts of war or terrorism or other adverse external events may occur
in the future. Although management has established disaster recovery policies
and procedures, the occurrence of any such event could have a material adverse
effect on our business, which, in turn, could have a material adverse effect on
our financial condition and results of operations.





We Depend On Cash Dividends From Our
Subsidiary Bank To Meet Our Cash Obligations-As a holding company,
dividends from our subsidiary bank provide a substantial portion of our cash
flow used to service the interest payments on our Trust Preferred Securities and
our other obligations, including cash dividends. See “Item 5. Market for the
Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of
Equity Securities.” Various statutory provisions restrict the amount of
dividends our subsidiary bank can pay to us without regulatory
approval.





Risks
Associated With Our Industry





We Are Subject To Government
Regulation That Could Limit Or Restrict Our Activities, Which In Turn Could
Adversely Impact Our Operations - The financial services industry is
regulated extensively. Federal and state regulations are designed primarily to
protect the deposit insurance funds and consumers, and not to benefit our
shareholders. These regulations can sometimes impose significant limitations on
our operations.





New laws
and regulations or changes in existing laws and regulations or repeal of
existing laws and regulations may adversely impact our business.





Further,
federal monetary policy, particularly as implemented through the Federal Reserve
System, significantly affects economic conditions for us.





New Legislative And Regulatory
Proposals May Affect Our Operations And Growth-Proposals to change the
laws and regulations governing the operations and taxation of, and federal
insurance premiums paid by, banks and other financial institutions and companies
that control such institutions are frequently raised in the U.S. Congress, the
California legislature and before bank regulatory authorities. The likelihood of
any major changes in the future and the impact such changes might have on us or
our subsidiaries are impossible to determine. Similarly, proposals to change the
accounting treatment applicable to banks and other depository institutions are
frequently raised by the SEC, the federal banking agencies, the IRS and other
appropriate authorities. The likelihood and impact of any additional future
changes in law or regulation and the impact such changes might have on us or our
subsidiaries are impossible to determine at this time.





Risks
Associated With Our Stock





Our Stock Trades Less Frequently
Than Others-The
Company’s common stock is not widely held or listed on any exchange. However,
trades may be reported on the OTC Bulletin Board under the symbol "FMCB.OB".
Management is aware that there are private transactions in the Company’s common
stock. However, the limited trading market for the Company’s common stock may
make it difficult for stockholders to dispose of their shares.





Our Stock Price Is Affected By A
Variety Of Factors-Stock price volatility may make it more difficult for you to resell your
common stock when you want and at prices you find attractive. Our stock price
can fluctuate significantly in response to a variety of factors discussed in
this section, including, among other things:





15
 Table of Contents





·
            actual
      or anticipated variations in quarterly results of
    operations;





·
            operating
      and stock price performance of other companies that investors deem
      comparable to our Company;





·
            news
      reports relating to trends, concerns and other issues in the financial
      services industry; and





·
            perceptions
      in the marketplace regarding our Company and/or its
      competitors.





Our Common Stock Is Not An Insured
Deposit-Our
common stock is not a bank deposit and, therefore, is not insured against loss
by the FDIC, any other deposit insurance fund or by any other public or private
entity. Investment in our common stock is inherently risky for the reasons
described in this “Risk Factors” section and elsewhere in this report and is
subject to the same market forces that affect the price of common stock in any
company. As a result, if you acquire our common stock, you may lose some or all
of your investment.





Item 1B. UnresolvedStaff Comments





The
Company has no unresolved comments received from staff at the SEC.





Item 2. Properties





Farmers
& Merchants Bancorp along with its subsidiaries are headquartered in Lodi,
California. Executive offices are located at 111 W. Pine Street. Banking
services are provided in twenty-one branch locations in the Company's service
area. Of the twenty-one locations, fourteen are owned and seven are leased. The
expiration of these leases occurs between the years 2008 and 2016. See Note 14
located in “Item 8. Financial Statements and Supplementary Data.”





Item 3. LegalProceedings





Certain
lawsuits and claims arising in the ordinary course of business have been filed
or are pending against the Company or its subsidiaries. Based upon information
available to the Company, its review of such lawsuits and claims and
consultation with its counsel, the Company believes the liability relating to
these actions, if any, would not have a material adverse effect on its
consolidated financial statements.





There are
no material proceedings adverse to the Company to which any Director, officer or
affiliate of the Company is a party.





Item 4. Submissionof Matters to a Vote of Security
Holders





No
matters were submitted to a vote of the Company’s stockholders during the fourth
quarter of 2007.





PART II





Item 5. Marketfor Registrant’s Common Equity, Related
Stockholder Matters and Issuer Purchases of Equity Securities





The
common stock of Farmers & Merchants Bancorp is not widely held or listed on
any exchange. However, trades may be reported on the OTC Bulletin Board under
the symbol “FMCB.OB”. Additionally, management is aware that there are private
transactions in the Company’s common stock.





The
following table summarizes the actual high, low and close sale prices for the
Company's common stock since the first quarter of 2006. These figures are based
on activity posted on the OTC Bulletin Board and on private transactions between
individual shareholders that are reported to the Company.





16
 Table of Contents




Cash
      DividendsCalendar
      Quarter
            
            High
            
            
            Low
            
            
            Close
            
            
            Declared (Per
      Share)2007
            Fourth
      quarter
            
            $
            460
            
            
            $
            381
            
            
            $
            460
            
            
            $
            5.35Third
      quarter
            
            
            480
            
            
            
            412
            
            
            
            435
            
            
            
            -Second
      quarter
            
            
            525
            
            
            
            475
            
            
            
            480
            
            
            
            4.35First
      quarter
            
            
            535
            
            
            
            507
            
            
            
            515
            
            
            
            -2006
            Fourth
      quarter
            
            $
            557
            
            
            $
            505
            
            
            $
            515
            
            
            $
            4.80Third
      quarter
            
            
            565
            
            
            
            505
            
            
            
            550
            
            
            
            -Second
      quarter
            
            
            550
            
            
            
            475
            
            
            
            550
            
            
            
            3.75First
      quarter
            
            
            510
            
            
            
            485
            
            
            
            510
            
            
            
            -





As of
January 31, 2008, there were approximately 1,498 shareholders of record of the
Company’s common stock.





Beginning
in 1975 and continuing through 2005 the Company issued a 5% stock dividend
annually. However, this dividend was discontinued in 2006.





There are
limitations under Delaware corporate law as to the amounts of dividends that may
be paid by the Company. Additionally, if we decided to defer interest on our
subordinated debentures, we would be prohibited from paying cash dividends on
the Company’s common stock. The Company is dependent on dividends paid by the
Bank to fund its dividend payments to its stockholders. There are regulatory
limitations on cash dividends that may be paid by the Bank under state and
federal laws. See “Item 1. Business – Supervision and Regulation.”





In 1998,
the Board approved the Company’s first stock repurchase program which expired on
May 1, 2001. During the second quarter of 2004, the Board approved a second
stock repurchase program because it concluded that the Company continued to have
more capital than it needed to meet present and anticipated regulatory
guidelines for the Bank to be classified as “well capitalized.” On April 4,
2006, the Board unanimously approved expanding the repurchase program to allow
the repurchase of up to $15 million of stock between May 1, 2006, and April 30,
2009.





Repurchases
under the program will continue to be made on the open market or through private
transactions. The repurchase program also requires that no purchases may be made
if the Bank would not remain “well-capitalized” after the repurchase. All shares
repurchased under the repurchase program will be retired.





The
following table indicates the number of shares repurchased by Farmers &
Merchants Bancorp during the fourth quarter of 2007.





Period
            
            Number of Shares
            
            
            Average Price per Share
            
            
            Number of Shares Purchased as Part of a Publicly
      Announced Plan or Program
            
            
            Approximate Dollar Value of Shares that May Yet Be
      Purchased Under the Plan or ProgramOctober
      2007
            
            
            -
            
            
            $
            -
            
            
            
            -
            
            
            $
            7,884,174November
      2007
            
            
            1,898
            
            
            
            460.00
            
            
            
            1,898
            
            
            
            7,011,094December 2007
            
            
            3,658
            
            
            
            460.00
            
            
            
            3,658
            
            
            
            5,328,414Total
            
            
            5,556
            
            
            $
            460.00
            
            
            
            5,556
            
            
            $
            5,328,414





All of
the above shares were repurchased in private transactions.





17
 Table of Contents





Performance
Graphs





The
following graphs compare the yearly percentage change in the Company’s
cumulative total stockholder return on common stock with: (i) a published index
compiled by Hemscott Group (formerly Core Data) of banks and bank holding
companies throughout the United States; and (ii) the cumulative total return of
the American Stock Exchange market index. The following comparisons cover the
period January 1, 2003, to December 31, 2007. The graphs assume an initial
investment of $100 on January 1, 2003, and reinvestment of dividends. The stock
price performance set forth in the following graphs is not necessarily
indicative of future price performance. The Company’s stock price data is based
on activity posted on the OTC Bulletin Board and on private transactions between
individual shareholders that are reported to the Company.




These
graphs shall not be deemed filed or incorporated by reference into any filing
under the Securities Act of 1933 or under the Exchange Act , except to the
extent that we specifically incorporate these graphs by reference.









18
 Table of Contents





Item 6. SelectedFinancial Data





Farmers
& Merchants Bancorp


Five
Year Financial Summary of Operations


(in
thousands except per share data)





Summary of Income:
            
            2007
            
            
            2006
            
            
            2005
            
            
            2004
            
            
            2003Total
      Interest Income
            
            $
            95,775
            
            
            $
            88,396
            
            
            $
            72,458
            
            
            $
            59,300
            
            
            $
            54,884Total Interest Expense
            
            
            32,225
            
            
            
            24,621
            
            
            
            14,032
            
            
            
            9,818
            
            
            
            11,073Net
      Interest Income
            
            
            63,550
            
            
            
            63,775
            
            
            
            58,426
            
            
            
            49,482
            
            
            
            43,811Provision for Loan Losses
            
            
            1,495
            
            
            
            275
            
            
            
            425
            
            
            
            1,275
            
            
            
            625Net
      Interest Income After Provision for Loan Losses
            
            
            62,055
            
            
            
            63,500
            
            
            
            58,001
            
            
            
            48,207
            
            
            
            43,186Total
      Non-Interest Income
            
            
            15,455
            
            
            
            12,063
            
            
            
            11,274
            
            
            
            14,267
            
            
            
            12,918Total Non-Interest Expense
            
            
            41,945
            
            
            
            43,121
            
            
            
            40,617
            
            
            
            36,175
            
            
            
            33,286Income
      Before Income Taxes
            
            
            35,565
            
            
            
            32,442
            
            
            
            28,658
            
            
            
            26,299
            
            
            
            22,818Provision for Income Taxes
            
            
            12,870
            
            
            
            11,813
            
            
            
            10,230
            
            
            
            9,625
            
            
            
            8,043Net
      Income Before Cumulative Effect of Change in Accounting
      Principle
            
            
            22,695
            
            
            
            20,629
            
            
            
            18,428
            
            
            
            16,674
            
            
            
            14,775Cumulative Effect of a Change in Accounting
      Principle (net of tax)
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (224
            )
            
            
            -Net
      Income
            
            $
            22,695
            
            
            $
            20,629
            
            
            $
            18,428
            
            
            $
            16,450
            
            
            $
            14,775Balance Sheet Data:Total
      Assets
            
            $
            1,519,172
            
            
            $
            1,411,233
            
            
            $
            1,352,989
            
            
            $
            1,226,295
            
            
            $
            1,148,565Loans
            
            
            1,140,969
            
            
            
            1,046,912
            
            
            
            973,257
            
            
            
            866,908
            
            
            
            806,906Allowance
      for Loan Losses
            
            
            18,483
            
            
            
            18,099
            
            
            
            17,860
            
            
            
            17,727
            
            
            
            17,220Investment
      Securities
            
            
            247,637
            
            
            
            243,867
            
            
            
            267,940
            
            
            
            275,440
            
            
            
            261,922Deposits
            
            
            1,310,790
            
            
            
            1,198,528
            
            
            
            1,103,340
            
            
            
            1,002,110
            
            
            
            904,349Federal
      Home Loan Bank Advances
            
            
            28,954
            
            
            
            47,532
            
            
            
            98,847
            
            
            
            80,889
            
            
            
            111,928Shareholders' Equity
            
            
            143,418
            
            
            
            132,340
            
            
            
            123,648
            
            
            
            116,547
            
            
            
            109,605Selected
      Ratios:Return
      on Average Assets
            
            
            1.56
            %
            
            
            1.51
            %
            
            
            1.46
            %
            
            
            1.40
            %
            
            
            1.36
            %Return
      on Average Equity
            
            
            16.26
            %
            
            
            16.16
            %
            
            
            15.26
            %
            
            
            14.50
            %
            
            
            13.68
            %Dividend
      Payout Ratio(1)
            
            
            34.51
            %
            
            
            33.77
            %
            
            
            34.55
            %
            
            
            34.79
            %
            
            
            32.05
            %Average
      Loans to Average Deposits
            
            
            86.86
            %
            
            
            90.24
            %
            
            
            87.28
            %
            
            
            86.41
            %
            
            
            85.29
            %Average
      Equity to Average Assets
            
            
            9.60
            %
            
            
            9.38
            %
            
            
            9.58
            %
            
            
            9.68
            %
            
            
            9.97
            %Period-end
      Shareholders' Equity to Total Assets
            
            
            9.44
            %
            
            
            9.38
            %
            
            
            9.14
            %
            
            
            9.50
            %
            
            
            9.54
            %Per
      Share Data:Net
      Income (2)
      (3)
            
            $
            28.05
            
            
            $
            25.25
            
            
            $
            22.24
            
            
            $
            19.68
            
            
            $
            17.55Cash
      Dividends Per Share (1)(3)
            
            $
            9.70
            
            
            $
            8.55
            
            
            $
            7.68
            
            
            $
            6.85
            
            
            $
            5.63





(1)
              Not
      including cash paid in lieu of fractional shares related to stock
      dividend.


(2)
              Based
      on the weighted average number of shares outstanding of 809,057, 817,044,
      828,537, 835,746 and 841,857 for the years ended December 31, 2007, 2006,
      2005, 2004, and 2003,
respectively.


(3)
              Per
      share data has been adjusted, where applicable, for stock dividends issued
      in any of the above years.





19
 Table of Contents





Item 7. Management'sDiscussion and Analysis of Financial
Condition and Results of Operations





Overview





The
Company’s primary service area encompasses the northern Central Valley of
California, a region that can be significantly impacted by the seasonal needs of
the agricultural industry. Accordingly, discussion of the Company’s Financial
Condition and Results of Operations is influenced by the seasonal banking needs
of its agricultural customers (e.g., during the spring and summer customers draw
down their deposit balances and increase loan borrowing to fund the purchase of
equipment and planting of crops. Correspondingly, deposit balances are
replenished and loans repaid in late fall and winter as crops are harvested and
sold).





The
Five Year Period: 2003 through 2007


The
following table presents key performance data for the Company over the past five
years.





(in
thousands, except per share data)


Financial Performance
    Indicator
            
            2007
            
            
            2006
            
            
            2005
            
            
            2004
            
            
            2003Net
      Income
            
            $
            22,695
            
            
            $
            20,629
            
            
            $
            18,428
            
            
            $
            16,450
            
            
            $
            14,775Total
      Assets
            
            $
            1,519,172
            
            
            $
            1,411,233
            
            
            $
            1,352,989
            
            
            $
            1,226,295
            
            
            $
            1,148,565Total
      Loans
            
            $
            1,140,969
            
            
            $
            1,046,912
            
            
            $
            973,257
            
            
            $
            866,908
            
            
            $
            806,906Total
      Deposits
            
            $
            1,310,790
            
            
            $
            1,198,528
            
            
            $
            1,103,340
            
            
            $
            1,002,110
            
            
            $
            904,349Total
      Shareholders’ Equity
            
            $
            143,418
            
            
            $
            132,340
            
            
            $
            123,648
            
            
            $
            116,547
            
            
            $
            109,605Total
      Risk-Based Capital Ratio
            
            
            12.21
            %
            
            
            12.17
            %
            
            
            12.32
            %
            
            
            13.34
            %
            
            
            13.24
            %Non-Performing
      Loans as a % of Total Loans
            
            
            0.02
            %
            
            
            0.01
            %
            
            
            0.07
            %
            
            
            0.03
            %
            
            
            0.32
            %Net
      Charge-Offs to Average Loans
            
            
            0.10
            %
            
            
            0.00
            %
            
            
            0.03
            %
            
            
            0.08
            %
            
            
            0.01
            %Loan
      Loss Allowance as a % of Total Loans
            
            
            1.62
            %
            
            
            1.72
            %
            
            
            1.83
            %
            
            
            2.04
            %
            
            
            2.13
            %Return
      on Average Assets
            
            
            1.56
            %
            
            
            1.51
            %
            
            
            1.46
            %
            
            
            1.40
            %
            
            
            1.36
            %Return
      on Average Equity
            
            
            16.26
            %
            
            
            16.16
            %
            
            
            15.26
            %
            
            
            14.50
            %
            
            
            13.68
            %Earnings
      Per Share (1)
            
            $
            28.05
            
            
            $
            25.25
            
            
            $
            22.24
            
            
            $
            19.68
            
            
            $
            17.55Cash
      Dividends Per Share (1)
      (2)
            
            $
            9.70
            
            
            $
            8.55
            
            
            $
            7.68
            
            
            $
            6.85
            
            
            $
            5.63Cash
      Dividends Declared (2)
            
            $
            7,831
            
            
            $
            6,966
            
            
            $
            6,366
            
            
            $
            5,723
            
            
            $
            4,736#
      Shares Repurchased During Year
            
            
            11,821
            
            
            
            11,718
            
            
            
            8,066
            
            
            
            7,981
            
            
            
            5,732Average
      Share Price of Repurchased Shares
            
            $
            460
            
            
            $
            507
            
            
            $
            496
            
            
            $
            389
            
            
            $
            256High
      Stock Price – Fourth Quarter
            
            $
            460
            
            
            $
            557
            
            
            $
            500
            
            
            $
            455
            
            
            $
            375Low
      Stock Price – Fourth Quarter
            
            $
            381
            
            
            $
            505
            
            
            $
            465
            
            
            $
            400
            
            
            $
            300Closing
      Stock Price – Fourth Quarter
            
            $
            460
            
            
            $
            515
            
            
            $
            490
            
            
            $
            404
            
            
            $
            300


_______________________________________________________


(1)
      Prior years have been restated for stock dividends issued in 2003 through
      2005.  No stock dividend was issued in 2006 or
    2007.


(2)
      Not including cash paid in lieu of fractional shares related to stock
      dividends.  These payments totaled $639,000 between 2003 and
      2005.





During
the five-year period 2003 through 2007, the Company’s operating performance
improved every year.





·
            Annual
      net income increased 54% to $22.7 million from $14.8
    million.





·
            Earnings
      Per Share increased 60% to $28.05 from
$17.55.





·
            Return
      on Average Equity increased 258 basis points to 16.26% from
      13.68%.





·
            Total
      assets increased 32% to $1.5
billion.





20
 Table of Contents





·
            Total
      loans increased 41% to $1.1
billion.





Importantly,
during this period of asset and earnings growth:





·
            The
      Bank’s risk based capital ratio has remained above the 10% level that
      federal and state banking regulators require for banks to be considered
      “well capitalized.” See “Financial Condition –
  Capital.”





·
            The
      Company’s asset quality has remained strong, as reflected by net
      charge-offs never exceeding 0.10% of average loans in any year and
      non-performing loans totaling 0.02% of total loans at December 31, 2007.
      See “Financial Condition – Non-Performing
  Assets.”





·
            The
      Company’s allowance for loan losses has been maintained above 1.6% of
      total loans, reflecting a conservative approach to providing for loan
      losses. See “Results of Operations – Provision and Allowance for Loan
      Losses.”





As a
result of this strong earnings performance, capital position and asset quality,
shareholders have benefited well in excess of overall Bank and Bank Holding
Company stock market returns over the past five years.





·
            Return
      on Average Equity has increased every year from 13.68% in 2003 to 16.26%
      in 2007.





·
            Cash
      Dividends per Share, restated for stock dividends issued, have increased
      87% since 2002, and totaled $38.41 per share over the five year
      period.





·
            The
      total return on the Company’s stock over the past five years compares very
      favorably to overall stock market returns as represented by the Hemscott
      Group Index of Banks and Bank Holding Companies. See “Item 5. Market for
      Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Security - Performance
  Graphs.”





The
Current Year: 2007


At the
completion of our 91st  year,
management and the Board are pleased to report the highest net income in the
Company’s history. For the year ended December 31, 2007, Farmers & Merchants
Bancorp reported net income of $22.7 million, earnings per share of $28.05,
return on average assets of 1.56% and return on average equity of
16.30%.





The
Company’s continuing strong earnings performance in 2007 was due to a carefully
implemented strategy to balance growth with asset quality and margin protection,
which resulted in: (1) 6.3% growth in average earning assets; (2) improvement in
the mix of earning assets as reflected by an increase in loans as a percentage
of average earning assets from 79% in 2006 to 81% in 2007; and (3) improvement
in the efficiency ratio from 56.9% in 2006 to 53.0% in 2007.  These
factors offset a decline in the net interest margin from 5.18% in 2006 to 4.85%
in 2007.





The
following is a summary of the financial accomplishments achieved during 2007 as
compared to 2006.





·
            Net
      income increased 10.0% to $22.7 million from $20.6
  million.





·
            Earnings
      per share increased 11.1% to $28.05 from
$25.25.





·
            Total
      assets increased 7.6% to $1.52 billion from $1.41
  billion.





·
            Gross
      loans increased 9.0% to $1.1 billion from $1.0
  billion.





·
            Total
      deposits increased 9.4% to $1.3 billion from $1.2
  billion.





·
            Total
      shareholders’ equity increased 8.4% to $143.4 million from $132.3 million,
      after dividends of $7.8 million and stock repurchases of $5.5
      million.





21
 Table of Contents





Looking
Forward: 2008 and Beyond


In
management’s opinion, the following key issues will influence the financial
results of the Company in 2008 and future years:





·
            The
      Company’s earnings are sensitive to changes in market interest rates. See
      “Item 7A. Quantitative and Qualitative Disclosures About Market Risk -
      Interest Rate Risk.”





-
            Between
      2004 and 2006, as a result of the FRB increasing market interest rates,
      the Company’s net interest margin improved approximately 81 basis points
      to a high of 5.37% in the first quarter of
2006.


-
            Once
      short-term market rates stabilized in 2006, since increases in the
      Company’s deposit rates typically lag increases in loan rates, the
      Company’s net interest margin dropped by 48 bps to 4.89% in the second
      quarter of 2007.


-
            In
      September 2007 the FRB began decreasing short-term market rates, resulting
      in further pressure on the Company’s net interest margin, which declined
      to 4.78% in the fourth quarter of
2007.





In
addition to changes in market interest rates, the Company’s net interest margin
has come under pressure from (1) competitor pricing strategies for both loans
and deposits that the Company needs to respond to in order to retain key
customers and (2) changes in deposit mix as customers move funds from low or
non-interest bearing transaction and savings accounts to higher yielding time
deposits.





·
            The
      Company’s results can be influenced by changes in the credit quality of
      its borrowers. See “Provision and Allowance for Loan Losses” and
      “Non-Performing Assets.” Non-performing loans totaled $203,000 or 0.02% of
      total loans at December 31, 2007, and $54,000 or 0.01% of total loans at
      December 31, 2006. Management believes that these levels are adequately
      covered by the Company’s current loan loss reserves, however, general
      economic conditions in the Company’s service area have softened over the
      past year and may continue to do so in 2008.   Accordingly,
      future financial results could be impacted should deterioration in
      economic conditions or other factors that affect credit quality cause the
      level of the Company’s non-performing loans to
  increase.





In
addition to the preceding issues, over the past several years management has
reviewed the Company’s existing branch delivery system, along with the
availability and desirability of additional branch locations, and initiated a
major branch expansion, relocation and renovation program. New branches were
opened during 2006 in Sacramento, Lodi and Stockton and the downtown Turlock
branch will be relocated to a new facility in 2008. In management’s opinion,
these moves are integral to the long-term strategic positioning of the
Company.





The
Company currently estimates that the total capital expenditures associated with
this multi-year branch program, which began in 2004, will be in excess of $13
million which will result in an increase in the Company’s future occupancy
expense as compared to prior years. Approximately $10 million has been spent as
of December 31, 2007. In addition, the increased staffing and other operating
expense associated with these new branches will place pressure on the Company’s
earnings over the next 24-36 months, the timeframe in which these branches are
estimated to reach break-even.





Results
of Operations





The
following discussion and analysis is intended to provide a better understanding
of Farmers & Merchants Bancorp and its subsidiaries’ performance during each
of the years in the three-year period ended December 31, 2007, and the material
changes in financial condition, operating income and expense of the Company and
its subsidiaries as shown in the accompanying financial statements.





Net
Interest Income/Net Interest Margin


The
tables on the following pages reflect the Company's average balance sheets and
volume and rate analysis for the years ending 2007, 2006 and 2005. Average
balance amounts for assets and liabilities are the computed average of daily
balances.





22
 Table of Contents





Net
interest income is the amount by which the interest and fees on loans and other
interest earning assets exceed the interest paid on interest bearing sources of
funds. For the purpose of analysis, the interest earned on tax-exempt
investments and municipal loans is adjusted to an amount comparable to interest
subject to normal income taxes. This adjustment is referred to as “tax
equivalent” adjustment and is noted wherever applicable.





The
Volume and Rate Analysis of Net Interest Income summarizes the changes in
interest income and interest expense based on changes in average asset and
liability balances (volume) and changes in average rates (rate). For each
category of interest-earning assets and interest-bearing liabilities,
information is provided with respect to changes attributable to: (1) changes in
volume (change in volume multiplied by initial rate); (2) changes in rate
(change in rate multiplied by initial volume); and (3) changes in rate/volume
(allocated in proportion to the respective volume and rate
components).





The
Company’s earning assets and rate sensitive liabilities are subject to repricing
at different times, which exposes the Company to income fluctuations when
interest rates change. In order to minimize income fluctuations, the Company
attempts to match asset and liability maturities. However, some maturity
mismatch is inherent in the asset and liability mix. See “Item 7A. Quantitative
and Qualitative Disclosures About Market Risk - Interest Rate
Risk.”





2007
Compared to 2006


Net
interest income decreased 0.4% to $63.6 million during 2007. During 2006 net
interest income was $63.8 million, representing an increase of 9.2% from 2005.
On a fully tax equivalent basis, net interest income decreased 0.4% and totaled
$65.1 million during 2007, compared to $65.4 million for 2006. As more fully
discussed below, the decrease in net interest income was primarily due to
increasing deposit costs, but, beginning in September 2007 the FRB began
dropping market interest rates which has resulted in declining loan yields
during the fourth quarter of 2007, a trend that will continue into 2008 as the
FRB dropped rates by 125 basis points in January.





Net
interest income on a tax equivalent basis, expressed as a percentage of average
total earning assets, is referred to as the net interest margin. For 2007, the
Company’s net interest margin was 4.85% compared to 5.18% in 2006. Recent trends
in: (1) market interest rates; and (2) competitive pricing of both loans and
deposits will continue, in management’s opinion, to place pressure on the
Company’s net interest margin in future quarters. See “Overview – Looking
Forward: 2008 and Beyond” for a discussion of factors impacting the Company’s
future net interest margin.





Loans,
generally the Company’s highest earning assets, increased $94.0 million as of
December 31, 2007, compared to December 31, 2006. See “Financial Condition –
Loans” for further discussion of this increase. On an average balance basis,
loans increased by $91.6 million for the year ended December 31, 2007. As a
result of this loan growth, the mix of the Company’s earning assets improved as
loans increased from 79.1% of average earning assets during 2006 to 81.2% in
2007. Despite decreases in market rates from mid- September through December
2007 the year-to-date yield on the loan portfolio remained almost unchanged at
7.71% for the year ended December 31, 2007, compared to 7.70% for the year ended
December 31, 2006. Some of this resilience in loan yields is due to pricing
floors that the Bank has placed in some of its customer loan agreements.
However, these floors typically expire annually and are renegotiated based upon
current market conditions. Even with no increase in yield, the growth in loan
balances resulted in interest revenue from loans increasing 9.4% to $84.1
million for 2007. The Company has been experiencing aggressive competitor
pricing for loans that it may need to continue to respond to in order to retain
key customers. This, in conjunction with recent and possible future decreases in
market interest rates by the FRB, could place even greater negative pressure on
future loan yields and net interest margin.





23
 Table of Contents





Farmers
& Merchants Bancorp


Year-to-Date
Average Balances and Interest Rates


(Interest
and Rates on a Taxable Equivalent Basis)


(in
thousands)





Year
      Ended December 31,2007Assets
            
            Balance
            
            
            Interest
            
            
            RateFederal
      Funds Sold and Securities Purchased Under Agreements to
    Resell
            
            $
            10,443
            
            
            $
            538
            
            
            
            5.15
            %Investment
      Securities Available-for-SaleU.S.
      Agencies
            
            
            -
            
            
            
            -
            
            
            
            -Municipals
      - Non-Taxable
            
            
            11,065
            
            
            
            786
            
            
            
            7.10
            %Mortgage-backed
      Securities
            
            
            114,984
            
            
            
            5,995
            
            
            
            5.21
            %Other
            
            
            6,315
            
            
            
            297
            
            
            
            4.70
            %Total Investment Securities
      Available-for-Sale
            
            
            132,364
            
            
            
            7,078
            
            
            
            5.35
            %Investment
      Securities Held-to-MaturityU.S.
      Agencies
            
            
            30,490
            
            
            
            1,271
            
            
            
            4.17
            %Municipals
      - Non-Taxable
            
            
            68,987
            
            
            
            4,005
            
            
            
            5.81
            %Mortgage-backed
      Securities
            
            
            7,700
            
            
            
            295
            
            
            
            3.83
            %Other
            
            
            2,100
            
            
            
            61
            
            
            
            2.90
            %Total Investment Securities
      Held-to-Maturity
            
            
            109,277
            
            
            
            5,632
            
            
            
            5.15
            %LoansReal
      Estate
            
            
            628,490
            
            
            
            45,917
            
            
            
            7.31
            %Home
      Equity
            
            
            65,975
            
            
            
            5,188
            
            
            
            7.86
            %Agricultural
            
            
            195,482
            
            
            
            16,417
            
            
            
            8.40
            %Commercial
            
            
            180,006
            
            
            
            14,823
            
            
            
            8.23
            %Consumer
            
            
            13,493
            
            
            
            1,184
            
            
            
            8.77
            %Credit
      Card
            
            
            5,435
            
            
            
            537
            
            
            
            9.88
            %Other
            
            
            1,102
            
            
            
            15
            
            
            
            1.36
            %Total Loans
            
            
            1,089,983
            
            
            
            84,081
            
            
            
            7.71
            %Total
      Earning Assets
            
            
            1,342,067
            
            
            $
            97,329
            
            
            
            7.25
            %Unrealized
      Loss on Securities Available-for-Sale
            
            
            (1,232
            )Allowance
      for Loan Losses
            
            
            (17,940
            )Cash
      and Due From Banks
            
            
            38,761All Other Assets
            
            
            92,389Total Assets
            
            $
            1,454,045Liabilities
      & Shareholders' EquityInterest
      Bearing DepositsInterest
      Bearing DDA
            
            $
            130,723
            
            
            $
            102
            
            
            
            0.08
            %Savings
            
            
            290,611
            
            
            
            4,386
            
            
            
            1.51
            %Time Deposits
            
            
            554,936
            
            
            
            25,472
            
            
            
            4.59
            %Total
      Interest Bearing Deposits
            
            
            976,270
            
            
            
            29,960
            
            
            
            3.07
            %Other
      Borrowed Funds
            
            
            26,428
            
            
            
            1,397
            
            
            
            5.29
            %Subordinated Debt
            
            
            10,310
            
            
            
            868
            
            
            
            8.42
            %Total
      Interest Bearing Liabilities
            
            
            1,013,008
            
            
            $
            32,225
            
            
            
            3.18
            %Interest
      Rate Spread
            
            
            
            
            
            
            
            
            
            
            4.07
            %Demand
      Deposits
            
            
            278,625All Other Liabilities
            
            
            22,836Total
      Liabilities
            
            
            1,314,469Shareholders' Equity
            
            
            139,576Total Liabilities & Shareholders'
      Equity
            
            $
            1,454,045Impact
      of Non-Interest Bearing Deposits and Other Liabilities
            
            
            
            
            
            
            
            
            
            
            0.78
            %Net
      Interest Income and Margin on Total Earning Assets
            
            
            
            
            
            
            65,104
            
            
            
            4.85
            %Tax Equivalent Adjustment
            
            
            
            
            
            
            (1,554
            )Net Interest Income
            
            
            
            
            
            $
            63,550
            
            
            
            4.74
            %


Notes: Yields
on municipal securities have been calculated on a fully taxable equivalent
basis.  Loan interest income includes fee income and unearned discount
of $2.2 million for the year ended December 31, 2007. Nonaccrual loans and lease
financing receivables have been included in the average balances. Yields on
securities available-for-sale are based on historical cost.





24
 Table of Contents





Farmers
& Merchants Bancorp


Year-to-Date
Average Balances and Interest Rates


(Interest
and Rates on a Taxable Equivalent Basis)


(in
thousands)





Year
      Ended December 31,2006Assets
            
            Balance
            
            
            Interest
            
            
            RateFederal
      Funds Sold and Securities Purchased Under Agreements to
    Resell
            
            $
            1,030
            
            
            $
            49
            
            
            
            4.76
            %Investment
      Securities Available-for-SaleU.S.
      Agencies
            
            
            27,295
            
            
            
            1,112
            
            
            
            4.07
            %Municipals
      - Non-Taxable
            
            
            15,121
            
            
            
            957
            
            
            
            6.33
            %Mortgage-backed
      Securities
            
            
            103,763
            
            
            
            4,981
            
            
            
            4.80
            %Other
            
            
            6,870
            
            
            
            385
            
            
            
            5.60
            %Total Investment Securities
      Available-for-Sale
            
            
            153,049
            
            
            
            7,435
            
            
            
            4.86
            %Investment
      Securities Held-to-MaturityU.S.
      Agencies
            
            
            30,593
            
            
            
            1,270
            
            
            
            4.15
            %Municipals
      - Non-Taxable
            
            
            67,490
            
            
            
            3,947
            
            
            
            5.85
            %Mortgage-backed
      Securities
            
            
            9,785
            
            
            
            375
            
            
            
            3.83
            %Other
            
            
            2,120
            
            
            
            62
            
            
            
            2.92
            %Total Investment Securities
      Held-to-Maturity
            
            
            109,988
            
            
            
            5,654
            
            
            
            5.14
            %LoansReal
      Estate
            
            
            567,479
            
            
            
            40,915
            
            
            
            7.21
            %Home
      Equity
            
            
            67,251
            
            
            
            5,356
            
            
            
            7.96
            %Agricultural
            
            
            164,897
            
            
            
            13,843
            
            
            
            8.39
            %Commercial
            
            
            178,528
            
            
            
            14,976
            
            
            
            8.39
            %Consumer
            
            
            13,587
            
            
            
            1,205
            
            
            
            8.87
            %Credit
      Card
            
            
            5,445
            
            
            
            536
            
            
            
            9.84
            %Municipal
            
            
            1,215
            
            
            
            41
            
            
            
            3.37
            %Total Loans
            
            
            998,402
            
            
            
            76,872
            
            
            
            7.70
            %Total
      Earning Assets
            
            
            1,262,469
            
            
            $
            90,010
            
            
            
            7.13
            %Unrealized
      Gain (Loss) on Securities Available-for-Sale
            
            
            (3,629
            )Allowance
      for Loan Losses
            
            
            (18,280
            )Cash
      and Due From Banks
            
            
            37,906All Other Assets
            
            
            83,238Total Assets
            
            $
            1,361,704Liabilities
      & Shareholders' EquityInterest
      Bearing DepositsInterest
      Bearing DDA
            
            $
            128,199
            
            
            $
            89
            
            
            
            0.07
            %Savings
            
            
            277,185
            
            
            
            2,310
            
            
            
            0.83
            %Time Deposits
            
            
            424,745
            
            
            
            16,231
            
            
            
            3.82
            %Total
      Interest Bearing Deposits
            
            
            830,129
            
            
            
            18,630
            
            
            
            2.24
            %Other
      Borrowed Funds
            
            
            99,484
            
            
            
            5,164
            
            
            
            5.19
            %Subordinated Debt
            
            
            10,310
            
            
            
            827
            
            
            
            8.02
            %Total
      Interest Bearing Liabilities
            
            
            939,923
            
            
            $
            24,621
            
            
            
            2.62
            %Interest
      Rate Spread
            
            
            
            
            
            
            
            
            
            
            4.51
            %Demand
      Deposits
            
            
            276,289All Other Liabilities
            
            
            17,824Total
      Liabilities
            
            
            1,234,036Shareholders' Equity
            
            
            127,668Total Liabilities & Shareholders'
      Equity
            
            $
            1,361,704Impact
      of Non-Interest Bearing Deposits and Other Liabilities
            
            
            
            
            
            
            
            
            
            
            0.67
            %Net
      Interest Income and Margin on Total Earning Assets
            
            
            
            
            
            
            65,389
            
            
            
            5.18
            %Tax Equivalent Adjustment
            
            
            
            
            
            
            (1,614
            )Net Interest Income
            
            
            
            
            
            $
            63,775
            
            
            
            5.05
            %


Notes: Yields
on municipal securities have been calculated on a fully taxable equivalent
basis.  Loan interest income includes fee income and unearned discount
of $2.7 million for the year ended December 31, 2006. Nonaccrual loans and lease
financing receivables have been included in the average balances. Yields on
securities available-for-sale are based on historical cost.





25
 Table of Contents





Farmers
& Merchants Bancorp


Year-to-Date
Average Balances and Interest Rates


(Interest
and Rates on a Taxable Equivalent Basis)


(in
thousands)





Year
      Ended December 31,2005Assets
            
            Balance
            
            
            Interest
            
            
            RateFederal
      Funds Sold and Securities Purchased Under Agreements to
    Resell
            
            $
            5,593
            
            
            $
            188
            
            
            
            3.36
            %Investment
      Securities Available-for-SaleU.S.
      Agencies
            
            
            58,226
            
            
            
            2,187
            
            
            
            3.76
            %Municipals
      - Taxable
            
            
            81
            
            
            
            5
            
            
            
            6.17
            %Municipals
      - Non-Taxable
            
            
            15,987
            
            
            
            976
            
            
            
            6.10
            %Mortgage-backed
      Securities
            
            
            79,290
            
            
            
            3,112
            
            
            
            3.92
            %Other
            
            
            4,582
            
            
            
            255
            
            
            
            5.57
            %Total Investment Securities
      Available-for-Sale
            
            
            158,166
            
            
            
            6,535
            
            
            
            4.13
            %Investment
      Securities Held-to-MaturityU.S.
      Agencies
            
            
            28,255
            
            
            
            1,167
            
            
            
            4.13
            %Municipals
      - Non-Taxable
            
            
            64,968
            
            
            
            3,880
            
            
            
            5.97
            %Mortgage-backed
      Securities
            
            
            12,223
            
            
            
            465
            
            
            
            3.80
            %Other
            
            
            432
            
            
            
            26
            
            
            
            6.02
            %Total Investment Securities
      Held-to-Maturity
            
            
            105,878
            
            
            
            5,538
            
            
            
            5.23
            %LoansReal
      Estate
            
            
            507,315
            
            
            
            34,133
            
            
            
            6.73
            %Home
      Equity
            
            
            65,397
            
            
            
            4,172
            
            
            
            6.38
            %Agricultural
            
            
            142,008
            
            
            
            9,880
            
            
            
            6.96
            %Commercial
            
            
            170,081
            
            
            
            12,012
            
            
            
            7.06
            %Consumer
            
            
            12,694
            
            
            
            1,106
            
            
            
            8.71
            %Credit
      Card
            
            
            5,046
            
            
            
            491
            
            
            
            9.73
            %Municipal
            
            
            1,029
            
            
            
            44
            
            
            
            4.28
            %Total Loans
            
            
            903,570
            
            
            
            61,838
            
            
            
            6.84
            %Total
      Earning Assets
            
            
            1,173,207
            
            
            $
            74,099
            
            
            
            6.32
            %Unrealized
      Gain (Loss) on Securities Available-for-Sale
            
            
            (1,856
            )Allowance
      for Loan Losses
            
            
            (17,910
            )Cash
      and Due From Banks
            
            
            35,453All Other Assets
            
            
            72,235Total Assets
            
            $
            1,261,129Liabilities
      & Shareholders' EquityInterest
      Bearing DepositsInterest
      Bearing DDA
            
            $
            117,460
            
            
            $
            79
            
            
            
            0.07
            %Savings
            
            
            298,181
            
            
            
            1,319
            
            
            
            0.44
            %Time Deposits
            
            
            351,552
            
            
            
            8,430
            
            
            
            2.40
            %Total
      Interest Bearing Deposits
            
            
            767,193
            
            
            
            9,828
            
            
            
            1.28
            %Other
      Borrowed Funds
            
            
            78,719
            
            
            
            3,561
            
            
            
            4.52
            %Subordinated Debt
            
            
            10,310
            
            
            
            643
            
            
            
            6.24
            %Total
      Interest Bearing Liabilities
            
            
            856,222
            
            
            $
            14,032
            
            
            
            1.64
            %Interest
      Rate Spread
            
            
            
            
            
            
            
            
            
            
            4.68
            %Demand
      Deposits
            
            
            268,038All Other Liabilities
            
            
            16,092Total
      Liabilities
            
            
            1,140,352Shareholders' Equity
            
            
            120,777Total Liabilities & Shareholders'
      Equity
            
            $
            1,261,129Impact
      of Non-Interest Bearing Deposits and Other Liabilities
            
            
            
            
            
            
            
            
            
            
            0.44
            %Net
      Interest Income and Margin on Total Earning Assets
            
            
            
            
            
            
            60,067
            
            
            
            5.12
            %Tax Equivalent Adjustment
            
            
            
            
            
            
            (1,641
            )Net Interest Income
            
            
            
            
            
            $
            58,426
            
            
            
            4.98
            %


Notes: Yields
on municipal securities have been calculated on a fully taxable equivalent
basis.  Loan interest income includes fee income and
unearned discount of $3.5 million for the year ended December 31, 2005.
Nonaccrual loans and lease financing receivables have been included
in the average balances. Yields on securities available-for-sale are based
on historical cost.





26
 Table of Contents





Farmers
& Merchants Bancorp


Volume
and Rate Analysis of Net Interest Revenue


(Interest
and Rates on a Taxable Equivalent Basis)


(in
thousands)





2007 versus 2006
              Amount of Increase (Decrease) Due to Change
      in:Interest Earning Assets
            
            Volume
            
            
            Rate
            
            
            Net Chg.Federal
      Funds Sold
            
            $
            485
            
            
            $
            4
            
            
            $
            489Investment
      Securities Available-for-SaleU.S.
      Agencies
            
            
            (1,112
            )
            
            
            -
            
            
            
            (1,112
            )Municipals
      - Non-Taxable
            
            
            (278
            )
            
            
            107
            
            
            
            (171
            )Mortgage-backed
      Securities
            
            
            564
            
            
            
            450
            
            
            
            1,014Other
            
            
            (29
            )
            
            
            (59
            )
            
            
            (88
            )Total Investment Securities
      Available-for-Sale
            
            
            (855
            )
            
            
            498
            
            
            
            (357
            )Investment
      Securities Held-to-MaturityU.S.
      Agencies
            
            
            (4
            )
            
            
            5
            
            
            
            1Municipals
      - Non-Taxable
            
            
            87
            
            
            
            (29
            )
            
            
            58Mortgage-backed
      Securities
            
            
            (80
            )
            
            
            -
            
            
            
            (80
            )Other
            
            
            (1
            )
            
            
            -
            
            
            
            (1
            )Total Investment Securities
      Held-to-Maturity
            
            
            2
            
            
            
            (24
            )
            
            
            (22
            )Loans:Real
      Estate
            
            
            4,451
            
            
            
            551
            
            
            
            5,002Home
      Equity
            
            
            (101
            )
            
            
            (67
            )
            
            
            (168
            )Agricultural
            
            
            2,569
            
            
            
            5
            
            
            
            2,574Commercial
            
            
            124
            
            
            
            (277
            )
            
            
            (153
            )Consumer
            
            
            (8
            )
            
            
            (13
            )
            
            
            (21
            )Credit
      Card
            
            
            (1
            )
            
            
            2
            
            
            
            1Other
            
            
            (4
            )
            
            
            (22
            )
            
            
            (26
            )Total Loans
            
            
            7,030
            
            
            
            179
            
            
            
            7,209Total Earning Assets
            
            
            6,662
            
            
            
            657
            
            
            
            7,319Interest
      Bearing LiabilitiesInterest
      Bearing Deposits:Interest
      Bearing DDA
            
            
            2
            
            
            
            11
            
            
            
            13Savings
            
            
            117
            
            
            
            1,959
            
            
            
            2,076Time Deposits
            
            
            5,579
            
            
            
            3,662
            
            
            
            9,241Total
      Interest Bearing Deposits
            
            
            5,698
            
            
            
            5,632
            
            
            
            11,330Other
      Borrowed Funds
            
            
            (3,860
            )
            
            
            93
            
            
            
            (3,767
            )Subordinated Debt
            
            
            -
            
            
            
            41
            
            
            
            41Total Interest Bearing
      Liabilities
            
            
            1,838
            
            
            
            5,766
            
            
            
            7,604Total Change
            
            $
            4,824
            
            
            $
            (5,109
            )
            
            $
            (285
            )


Notes: Rate/volume
variance is allocated based on the percentage relationship of changes in volume
and changes
in rate to the total "net change."  The above figures have been
rounded to the nearest whole number.





27
 Table of Contents





Farmers
& Merchants Bancorp


Volume
and Rate Analysis of Net Interest Revenue


(Interest
and Rates on a Taxable Equivalent Basis)


(in
thousands)





2006 versus 2005
              Amount of Increase (Decrease) Due to Change
      in:Interest Earning Assets
            
            Volume
            
            
            Rate
            
            
            Net Chg.Federal
      Funds Sold
            
            $
            (195
            )
            
            $
            56
            
            
            $
            (139
            )Investment
      Securities Available-for-SaleU.S.
      Agencies
            
            
            (1,247
            )
            
            
            172
            
            
            
            (1,075
            )Municipals
      - Taxable
            
            
            (2
            )
            
            
            (3
            )
            
            
            (5
            )Municipals
      - Non-Taxable
            
            
            (54
            )
            
            
            35
            
            
            
            (19
            )Mortgage-backed
      Securities
            
            
            1,085
            
            
            
            784
            
            
            
            1,869Other
            
            
            128
            
            
            
            2
            
            
            
            130Total Investment Securities
      Available-for-Sale
            
            
            (90
            )
            
            
            990
            
            
            
            900Investment
      Securities Held-to-MaturityU.S.
      Agencies
            
            
            97
            
            
            
            6
            
            
            
            103Municipals
      - Non-Taxable
            
            
            149
            
            
            
            (82
            )
            
            
            67Mortgage-backed
      Securities
            
            
            (94
            )
            
            
            4
            
            
            
            (90
            )Other
            
            
            56
            
            
            
            (20
            )
            
            
            36Total Investment Securities
      Held-to-Maturity
            
            
            208
            
            
            
            (92
            )
            
            
            116Loans:Real
      Estate
            
            
            4,229
            
            
            
            2,553
            
            
            
            6,782Home
      Equity
            
            
            121
            
            
            
            1,063
            
            
            
            1,184Agricultural
            
            
            1,736
            
            
            
            2,227
            
            
            
            3,963Commercial
            
            
            620
            
            
            
            2,344
            
            
            
            2,964Consumer
            
            
            79
            
            
            
            20
            
            
            
            99Credit
      Card
            
            
            39
            
            
            
            6
            
            
            
            45Other
            
            
            7
            
            
            
            (10
            )
            
            
            (3
            )Total Loans
            
            
            6,831
            
            
            
            8,203
            
            
            
            15,034Total Earning Assets
            
            
            6,754
            
            
            
            9,157
            
            
            
            15,911Interest
      Bearing LiabilitiesInterest
      Bearing Deposits:Interest
      Bearing DDA
            
            
            7
            
            
            
            3
            
            
            
            10Savings
            
            
            (99
            )
            
            
            1,090
            
            
            
            991Time Deposits
            
            
            2,026
            
            
            
            5,775
            
            
            
            7,801Total
      Interest Bearing Deposits
            
            
            1,934
            
            
            
            6,868
            
            
            
            8,802Other
      Borrowed Funds
            
            
            1,028
            
            
            
            575
            
            
            
            1,603Subordinated Debt
            
            
            -
            
            
            
            184
            
            
            
            184Total Interest Bearing
      Liabilities
            
            
            2,962
            
            
            
            7,627
            
            
            
            10,589Total Change
            
            $
            3,792
            
            
            $
            1,530
            
            
            $
            5,322


Notes: Rate/volume
variance is allocated based on the percentage relationship of changes in volume
and changes
in rate to the total "net change."  The above figures have been
rounded to the nearest whole number.





28
 Table of Contents





The
investment portfolio is the other main component of the Company’s earning
assets. The Company invests primarily in mortgage-backed securities issued by
government-sponsored entities, U.S. Government Agencies, and high-grade
municipals. Since the risk factor for these types of investments is
significantly lower than that of loans, the yield earned on investments is
generally less than that of loans.





Average
investment securities decreased $21.4 million in 2007 compared to the average
balance during 2006 reflecting a redeployment to loans. Interest income on
securities decreased $379,000 to $12.7 million for the year ended December 31,
2007, compared to $13.1 million for the year ended December 31, 2006. The
average yield, on a tax equivalent basis, in the investment portfolio was 5.3%
in 2007 compared to 5.0% in 2006. See “Financial Condition – Investment
Securities” for a discussion of the Company’s repositioning of its securities
portfolio during 2006 which resulted in this increase in yield. Net interest
income on the Schedule of Year-to-Date Average Balances and Interest Rates shown
on a tax equivalent basis, which is higher than net interest income as reflected
on the Consolidated Statement of Income because of adjustments that relate to
income on securities that are exempt from federal income taxes.





Average
interest-bearing sources of funds increased $73.1 million or 7.8% during 2007.
Of that increase, average borrowed funds, primarily Federal Home Loan Bank
Advances, decreased $73.0 million, interest-bearing deposits increased $146.1
million, and subordinated debt remained unchanged.





During
2007 the Company was able to grow average interest bearing deposits by $146.1
million. The increase was primarily in time deposits, which grew $130.2 million,
as lower cost savings and interest bearing DDA increased by $15.9 million. See
“Financial Condition – Deposits” for a discussion of trends in the Company’s
deposit base. Total interest expense on deposits was $30.0 million in 2007 as
compared to $18.6 million in 2006. The average rate paid on interest-bearing
deposits was 3.1% in 2007 and 2.2% in 2006. This increase in rates is a result
of the lagging impact of increases in market interest rates that occurred in
mid-2004 through mid-2006. Since September 2007 the FRB has been lowering market
rates. The Company has begun to feel this impact as the average rate paid on
interest-bearing deposits declined to 3.0% in December 2007. The Company
anticipates that this decline in deposit rates will continue into 2008,
particularly if the FRB continues to lower market interest rates. See “Overview
– Looking Forward: 2008 and Beyond” for a discussion of factors impacting the
Company’s future deposit rates and their impact on net interest
margin.





2006
Compared to 2005


Net
interest income increased 9.2% to $63.8 million during 2006. During 2005 net
interest income was $58.4 million, representing an increase of 18.1% from 2004.
On a fully tax equivalent basis, net interest income increased 8.9% and totaled
$65.4 million during 2006 compared to $60.1 million for 2005. The increase in
net interest income was due to a combination of: (1) growth in average earning
assets in 2006; and (2) improvement in the net interest margin.





Net
interest income on a tax equivalent basis, expressed as a percentage of average
total earning assets, is referred to as the net interest margin. For 2006 the
Company’s net interest margin was 5.18% compared to 5.12% in 2005. This
improvement was due to the continuing residual impact of increases in market
interest rates that occurred in mid-2004 through mid-2006.





Loans,
generally the Company’s highest earning assets, increased $73.7 million as of
December 31, 2006, compared to December 31, 2005. On an average balance basis,
loans increased by $94.8 million for the year ended December 31, 2006. As a
result of this loan growth, the mix of the Company’s earning assets improved as
loans increased from 77.0% of average earning assets during 2005 to 79% in 2006.
Due to increases in market rates from mid- 2004 through mid-2006 the
year-to-date yield on the loan portfolio increased 86 basis points to 7.70% for
the year ended December 31, 2006, compared to 6.84% for the year ended December
31, 2005. This increase in yield plus the growth in loan balances resulted in
interest revenue from loans increasing 24.3% to $76.9 million for
2006.





The
investment portfolio is the other main component of the Company’s earning
assets. The Company invests primarily in mortgage-backed securities, U.S.
Government Agencies, and high-grade municipals. Since the risk factor for these
types of investments is significantly lower than that of loans, the yield earned
on investments is generally less than that of loans.





29
 Table of Contents





Average
investment securities decreased $1.0 million in 2006 compared to the average
balance during 2005. Interest income on securities increased $1.0 million to
$13.1 million for the year ended December 31, 2006 compared to $12.1 million for
the year ended December 31, 2005. The average yield, on a tax equivalent basis,
in the investment portfolio was 5.0% in 2006 compared to 4.6% in 2005. Net
interest income on the Schedule of Year-to-Date Average Balances and Interest
Rates shown on a tax equivalent basis, which is higher than net interest income
as reflected on the Consolidated Statement of Income because of adjustments that
relate to income on securities that are exempt from federal income
taxes.





Average
interest-bearing sources of funds increased $83.7 million or 9.8% during 2006.
Of that increase, average borrowed funds (primarily FHLB Advances) increased
$20.8 million, interest-bearing deposits increased $62.9 million, and
subordinated debt remained unchanged.





During
2006 the Company was able to grow average interest bearing deposits by $62.9
million. The increase was primarily in time deposits, which grew $73.2 million,
as lower cost savings and interest bearing DDA decreased by $10.3 million. Total
interest expense on deposit accounts for 2006 was $18.6 million as compared to
$9.8 million in 2005. As deposits increased, interest expense on deposits
increased 89.6% or $8.8 million in 2006. The average rate paid on
interest-bearing deposits was 2.2% in 2006 and 1.3% in 2005. This increase in
rates is a result of the lagging impact of increases in market interest rates
that occurred in mid-2004 through mid-2006.





Provision
and Allowance for Loan Losses


As a
financial institution that assumes lending and credit risks as a principal
element of its business, credit losses will be experienced in the normal course
of business. The allowance for loan losses is maintained at a level considered
by management to be adequate to provide for risks inherent in the loan
portfolio. The allowance is increased by provisions charged to operating expense
and reduced by net charge-offs. In determining the adequacy of the allowance for
loan losses, management takes into consideration examinations by the Company’s
supervisory authorities, results of internal credit reviews, financial condition
of borrowers, loan concentrations, prior loan loss experience, and general
economic conditions. The allowance is based on estimates and ultimate losses may
vary from the current estimates. Management reviews these estimates periodically
and, when adjustments are necessary, they are reported in the period in which
they become known.





The
Company has established credit management policies and procedures that govern
both the approval of new loans and the monitoring of the existing portfolio. The
Company manages and controls credit risk through comprehensive underwriting and
approval standards, dollar limits on loans to one borrower and by restricting
loans made primarily to its principal market area where management believes it
is better able to assess the applicable risk. Additionally, management has
established guidelines to ensure the diversification of the Company’s credit
portfolio such that even within key portfolio sectors such as real estate or
agriculture, the portfolio is diversified across factors such as location,
building type, crop type, etc. See “Item 7A. Quantitative and Qualitative
Disclosures About Market Risk – Credit Risk.” Management reports regularly to
the Board of Directors regarding trends and conditions in the loan portfolio and
regularly conducts credit reviews of individual loans. Loans that are performing
but have shown some signs of weakness are subjected to more stringent reporting
and oversight.





The
provision for loan losses totaled $1.5 million in 2007 compared to $275,000 in
2006 and $425,000 in 2005. Changes in the provision between years were the
result of management’s evaluation of the adequacy of the allowance for loan
losses relative to factors such as the credit quality of the loan portfolio,
loan growth, current loan losses and the prevailing economic climate and its
effect on borrowers’ ability to repay loans in accordance with the terms of the
notes. See “Critical Accounting Policies and Estimates – Allowance for Loan
Losses” and “Item 7A. Quantitative and Qualitative Disclosures About Market
Risk-Credit Risk” and “Overview – Looking Forward: 2008 and
Beyond.”




.





30
 Table of Contents








(in
      thousands)
            
            2007
            
            
            2006
            
            
            2005
            
            
            2004
            
            
            2003Allowance
      for Loan Losses Beginning of Year
            
            $
            18,099
            
            
            $
            17,860
            
            
            $
            17,727
            
            
            $
            17,220
            
            
            $
            16,684Provision
      Charged to Expense
            
            
            1,495
            
            
            
            275
            
            
            
            425
            
            
            
            1,275
            
            
            
            625Charge
      Offs:Commercial
      Real Estate
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            1Real
      Estate Construction
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Residential
      1st Mortgages
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Home
      Equity Lines and Loans
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Agricultural
            
            
            254
            
            
            
            333
            
            
            
            199
            
            
            
            5
            
            
            
            0Commercial
            
            
            722
            
            
            
            121
            
            
            
            442
            
            
            
            700
            
            
            
            282Consumer
            
            
            52
            
            
            
            41
            
            
            
            26
            
            
            
            7
            
            
            
            175Credit
      Card
            
            
            202
            
            
            
            284
            
            
            
            200
            
            
            
            243
            
            
            
            239Other
            
            
            143
            
            
            
            60
            
            
            
            -
            
            
            
            -
            
            
            
            -Total Charge Offs
            
            
            1,373
            
            
            
            839
            
            
            
            867
            
            
            
            955
            
            
            
            697Recoveries:Commercial
      Real Estate
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            143Real
      Estate Construction
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Residential
      1st Mortgages
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Home
      Equity Lines and Loans
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Agricultural
            
            
            79
            
            
            
            75
            
            
            
            376
            
            
            
            26
            
            
            
            17Commercial
            
            
            30
            
            
            
            624
            
            
            
            134
            
            
            
            209
            
            
            
            394Consumer
            
            
            11
            
            
            
            37
            
            
            
            19
            
            
            
            32
            
            
            
            25Credit
      Card
            
            
            42
            
            
            
            26
            
            
            
            46
            
            
            
            31
            
            
            
            29Other
            
            
            100
            
            
            
            41
            
            
            
            -
            
            
            
            -
            
            
            
            -Total Recoveries
            
            
            262
            
            
            
            803
            
            
            
            575
            
            
            
            298
            
            
            
            608Net (Charge-Offs)
Recoveries
            
            
            (1,111
            )
            
            
            (36
            )
            
            
            (292
            )
            
            
            (657
            )
            
            
            (89
            )Less Reclassification
      Adjustment*
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (111
            )
            
            
            -Total Allowance for Loan
    Losses
            
            $
            18,483
            
            
            $
            18,099
            
            
            $
            17,860
            
            
            $
            17,727
            
            
            $
            17,220


*As of
December 31, 2004, the Company reclassified $111,000 of the Allowance for Loan
Losses that pertained to commitments under commercial and standby letters of
credit to the “Other Liabilities” section of the Consolidated Balance
Sheet.





Ratios:Allowance
      for Loan Losses to:Loans
      at Year End
            
            
            1.62
            %
            
            
            1.72
            %
            
            
            1.83
            %
            
            
            2.04
            %
            
            
            2.13
            %Average
      Loans
            
            
            1.70
            %
            
            
            1.81
            %
            
            
            1.98
            %
            
            
            2.15
            %
            
            
            2.33
            %Consolidated
      Net Charge-Offs to:Loans
      at Year End
            
            
            0.10
            %
            
            
            0.00
            %
            
            
            0.03
            %
            
            
            0.08
            %
            
            
            0.01
            %Average
      Loans
            
            
            0.10
            %
            
            
            0.00
            %
            
            
            0.03
            %
            
            
            0.08
            %
            
            
            0.01
            %





For a
description of the Company’s policy regarding the Allowance for Loan Losses, see
Note 1 located in “Item 8. Financial Statements and Supplementary
Data.”





Allowance Allocation at December
      31,(in thousands)
            
            2007
            
            
            2006
            
            
            2005
            
            
            2004
            
            
            2003Commercial
      Real Estate
            
            $
            2,527
            
            
            $
            4,175
            
            
            $
            3,974
            
            
            $
            3,989
            
            
            $
            4,663Real
      Estate Construction
            
            
            2,896
            
            
            
            880
            
            
            
            1,088
            
            
            
            427
            
            
            
            1,080Residential
      1st Mortgages
            
            
            1,652
            
            
            
            1,373
            
            
            
            1,370
            
            
            
            1,147
            
            
            
            1,553Home
      Equity Lines and Loans
            
            
            836
            
            
            
            436
            
            
            
            416
            
            
            
            170
            
            
            
            471Agricultural
            
            
            5,335
            
            
            
            3,564
            
            
            
            1,786
            
            
            
            4,342
            
            
            
            4,681Commercial
            
            
            3,923
            
            
            
            6,007
            
            
            
            8,317
            
            
            
            5,849
            
            
            
            3,957Consumer
            
            
            346
            
            
            
            92
            
            
            
            89
            
            
            
            133
            
            
            
            104Other
            
            
            815
            
            
            
            1,199
            
            
            
            543
            
            
            
            1,312
            
            
            
            569Unallocated
            
            
            153
            
            
            
            373
            
            
            
            277
            
            
            
            358
            
            
            
            142Total
            
            $
            18,483
            
            
            $
            18,099
            
            
            $
            17,860
            
            
            $
            17,727
            
            
            $
            17,220





31
 Table of Contents





Non-Interest
Income


Non-interest
income includes: (1) service charges and fees from deposit accounts; (2) net
gains and losses from investment securities; (3) credit card merchant fees; (4)
ATM fees; (5) investment gains and losses on non-qualified deferred compensation
plans; (6) increases in the cash surrender value of bank owned life insurance;
and (7) fees from other miscellaneous business services.





2007
Compared to 2006


Non-interest
income totaled $15.4 million, an increase of $3.4 million or 28.1% from
non-interest income of $12.1 million for 2006.





Service
charges on deposit accounts totaled $7.3 million, an increase of $1.2 million or
20.5% from service charges on deposit accounts of $6.0 million in 2006. This
increase was due to fees related to the Company’s Overdraft Privilege Service,
which was offered to eligible customers with deposit accounts in good standing
beginning May 1, 2006.





Net loss
on investment securities improved by $461,000 or 21.3% in 2007 and was a loss of
$1.7 million compared to a loss of $2.2 million for 2006. During 2006 the
Company made the decision to sell some of its investment portfolio at a loss in
order to better align the portfolio with its evolving asset/liability management
objectives. During 2007 the Company recognized an impairment loss on investment
securities. See “Financial Condition-Investment Securities.”





ATM fees
totaled $1.4 million, an increase of $174,000 or 14.5% over fees in 2006. The
increase in these fees is due to the convenience and increased number of ATM’s
at strategic locations, which benefit both customers and
non-customers.





During
2007 the Company received an $869,000 liquidating dividend from the Company’s
partial ownership in WSBA, a credit card processing company whose operating
assets were sold during 2006 and subsequently liquidated in 2007.





Investment
gains on non-qualified deferred compensation plan balances increased $505,000 in
2007 to $1.1 million. See Note 11. located in “Item 8. Financial Statements and
Supplementary Data” for a description of these plans. Gain/loss on these plans
fluctuates depending on the type of investments held and market trends in
interest rates and stock prices.  All gains/losses are offset by a
corresponding impact on salary expense resulting in no effect on the Company’s
net income.





2006
Compared to 2005


Non-interest
income totaled $12.1 million, an increase of $789,000 or 7.0% from non-interest
income of $11.3 million for 2005.





Most of
the increase in 2006 occurred in service charges on deposit accounts. Service
charges totaled $6.0 million, an increase of $1.7 million or 38.5% from service
charges on deposit accounts of $4.4 million in 2005. This increase was due to
fees related to the Company’s Overdraft Privilege Service which was offered to
eligible customers with deposit accounts in good standing beginning May 1,
2006.





The
increase in service charges was offset by an increase in loss on sale of
investment securities, which was a loss of $2.2 million in 2006 as compared to a
loss of $953,000 for 2005. During 2006 the Company made the decision to sell
some of its investment portfolio at a loss in order to better align the
portfolio with its evolving asset/liability management objectives.





ATM fees
totaled $1.2 million, an increase of $211,000 or 21.3% over fees in 2005. The
increase in these fees is due to the convenience and increased number of ATM’s
at strategic locations, which benefit both customers and
non-customers.





32
 Table of Contents





Non-Interest
Expense


Non-interest
expense for the Company includes expenses for salaries and employee benefits,
occupancy, equipment, supplies, legal fees, professional services, data
processing, marketing, deposit insurance, merchant bankcard operations, and
other miscellaneous expenses.





2007
Compared to 2006


Overall,
non-interest expense totaled $41.9 million, a decrease of $1.2 million or 2.7%
for the year ended December 31, 2007.





Salaries
and employee benefits decreased $456,000 due to: (1) increased cost deferrals
under “FAS 91”as a result of loan growth; and (2) reduced contributions to bonus
and retirement plans primarily as a result of a reduction in the number of
certain key individuals eligible to participate in the plans. At the end of 2007
the Company had 308 full time equivalent employees compared to 302 at the end of
2006.





Equipment
expense in 2007 totaled $2.9 million, a decrease of $343,000 or 10.7% from 2006.
During 2007 the Company made fewer equipment repairs/replacements than in
2006.





Marketing
expense was $463,000 in 2007, a decrease of $704,000 or 60.3% from $1.2 million
in 2006. The majority of this decrease was due to the continued reduction in
expenses related to customer direct mail.





2006
Compared to 2005


Overall,
non-interest expense totaled $43.1 million, an increase of $2.5 million or 6.2%
for the year ended December 31, 2006.





Salaries
and employee benefits increased $1.0 million due to: (1) officer salary merit
increases which occurred in November 2005;(2) increased
contributions to the Company’s incentive compensation and supplemental
retirement plans; and (3) increased staff related to the three new branches
opened during 2006. At the end of 2006 the Company had 302 full time equivalent
employees compared to 294 at the end of 2005.





Occupancy
and equipment expenses represent the cost of operating and maintaining branch
and administrative facilities, including the purchase and maintenance of
furniture, fixtures, and office equipment and data processing equipment.
Occupancy expense in 2006 totaled $2.5 million, an increase of $382,000 or 18.4%
over 2005. This increase was due to: (1) three new branches opened in 2006; (2)
increased utilities due to increased gas and electricity prices; (3) increased
rents on leased properties; and (4) increased property taxes.





Equipment
expense in 2006 totaled $3.2 million, an increase of $709,000 or 28.3% over
2005. This increase was due to: (1) annual computer hardware/software
maintenance and upgrades; and (2) increased furniture and equipment depreciation
related to remodeling and adding branch locations.





Marketing
expense was $1.2 million in 2006 a decrease of $355,000 or 23.3% from $1.5
million in 2005. In 2005 there were significant marketing expenses for a new
high performance checking product started in November 2004, including the
associated direct mail and other ancillary expenses incurred to promote this
product. These same expenses were not required in 2006.





Other
operating expense totaled $6.9 million, a 9.7% increase from the prior year.
This increase in other operating expense during 2006 was due to: (1) $228,000
early payoff penalties on FHLB advances; (2) operating losses related to
non-sufficient funds and electronic funds transactions; and (3) increased
stationery and printing expense related to the Company’s 90th
anniversary logo.





Income
Taxes


The
provision for income taxes increased $2.1 million during 2007. The effective tax
rate in 2007 was 36.2% compared to 36.4% in 2006 and 35.7% in 2005. The
effective rates were lower than the statutory rate of 42% due primarily to
benefits regarding the cash surrender value of life insurance, California
enterprise zone interest income exclusion, and tax-exempt interest income on
municipal securities and loans.





33
 Table of Contents





Current
tax law causes the Company’s current taxes payable to approximate or exceed the
current provision for taxes on the income statement. Three provisions have had a
significant effect on the Company’s current income tax liability: the
restrictions on the deductibility of loan losses, deductibility of pension and
other long-term employee benefits only when paid and the statutory deferral of
deductibility of California franchise taxes on the Company’s federal
return.





Financial
Condition





Investment
Securities


The
investment portfolio provides the Company with an income alternative to loans.
The Company’s investment portfolio at the end of 2007 was $247.6 million, an
increase of $3.8 million or 1.6% from 2006.   The investment
portfolio remained relatively flat in 2007 as the Company deployed funds
generated by deposit growth into its loan portfolio.





During
2006 the Company sold $63.3 million in available-for-sale investment securities
at a loss of $2.2 million. These securities generally had a remaining life under
three years and yields below current market rates. Funds not invested in loans
or used to pay down short-term borrowings were reinvested in higher yielding,
somewhat longer term (5-7 years) securities which management believes should
strengthen the Company’s net interest margin and reduce the Company’s asset
sensitivity, thereby better protecting against future declines in market
interest rates.





The
Company's total investment portfolio represented 16.3% of the Company’s total
assets during 2007 and 17.3% of the Company’s total assets during 2006. Not
included in the investment portfolio are overnight investments in Federal Funds
Sold. In 2007 average Federal Funds Sold on a year to date basis was $10.4
million compared to $1.0 million in 2006.





The
Company classifies its investments as held-to-maturity, trading or
available-for-sale. Securities are classified as held-to-maturity and are
carried at amortized cost when the Company has the intent and ability to hold
the securities to maturity. Trading securities are securities acquired for
short-term appreciation and are carried at fair value, with unrealized gains and
losses recorded in non-interest income. As of December 31, 2007, and 2006 there
were no securities in the trading portfolio. Securities classified as
available-for-sale include securities which may be sold to effectively manage
interest rate risk exposure, prepayment risk, satisfy liquidity demands and
other factors. These securities are reported at fair value with aggregate,
unrealized gains or losses excluded from income and included as a separate
component of shareholders’ equity, net of related income taxes.





The debt
securities in the Company’s investment portfolio are comprised primarily of
Mortgage-backed securities, U.S. Government Agencies and high grade municipals.
All of the Mortgage-backed securities are issued by government-sponsored
entities.





During
2007 impairment losses of $1.7 million were recorded on a strategic investment
made over time in the equity securities of another bank holding
company.  Over the past eighteen months the market value of bank
stocks in general, and this investment specifically, have
declined.  In Management’s opinion these industry and company trends
may continue for an undetermined period of time, resulting in “other than
temporary” impairment.





34
 Table of Contents





Investment
Portfolio


The
following table summarizes the balances and distributions of the investment
securities held on the dates indicated.





Available
            
            
            Held
      to
            
            
            Available
            
            
            Held
      to
            
            
            Available
            
            
            Held
      tofor Sale
            
            
            Maturity
            
            
            for Sale
            
            
            Maturity
            
            
            for Sale
            
            
            MaturityDecember 31:(in
      thousands)
            
            2007
            
            
            2006
            
            
            2005U.
      S. Agency
            
            $
            -
            
            
            $
            30,435
            
            
            $
            -
            
            
            $
            30,539
            
            
            $
            29,926
            
            
            $
            30,644Municipal
            
            
            9,979
            
            
            
            66,375
            
            
            
            11,274
            
            
            
            69,910
            
            
            
            15,576
            
            
            
            66,260Mortgage-backed
      Securities
            
            
            126,144
            
            
            
            6,731
            
            
            
            109,385
            
            
            
            8,677
            
            
            
            106,433
            
            
            
            10,881Other
            
            
            5,920
            
            
            
            2,053
            
            
            
            11,968
            
            
            
            2,114
            
            
            
            6,094
            
            
            
            2,126Total Book Value
            
            $
            142,043
            
            
            $
            105,594
            
            
            $
            132,627
            
            
            $
            111,240
            
            
            $
            158,029
            
            
            $
            109,911Fair Value
            
            $
            142,043
            
            
            $
            106,253
            
            
            $
            132,627
            
            
            $
            110,132
            
            
            $
            158,029
            
            
            $
            108,060





Analysis
of Investment Securities Available-for-Sale


The
following table is a summary of the relative maturities and yields of the
Company’s investment securities Available-for-Sale as of December 31, 2007.
Non-taxable municipal securities have been calculated on a fully taxable
equivalent basis.





Fair
            
            
            AverageDecember 31, 2007(in
      thousands)
            
            Value
            
            
            YieldMunicipal
      - Non-TaxableOne
      year or less
            
            $
            2,440
            
            
            
            6.28
            %After
      one year through five years
            
            
            3,693
            
            
            
            7.09
            %After ten years
            
            
            3,846
            
            
            
            8.62
            %Total Non-Taxable Municipal
      Securities
            
            
            9,979
            
            
            
            7.48
            %Mortgage-backed
      SecuritiesAfter
      five years through ten years
            
            
            1,561
            
            
            
            4.70
            %After ten years
            
            
            124,583
            
            
            
            5.25
            %Total Mortgage-backed
      Securities
            
            
            126,144
            
            
            
            5.24
            %OtherOne
      year or less
            
            
            5,920
            
            
            
            4.15
            %Total Investment Securities Available for
      Sale
            
            $
            142,043
            
            
            
            5.35
            %


Note:  The
average yield for floating rate securities is calculated using the current
stated yield.





Analysis
of Investment Securities Held-to-Maturity


The
following table is a summary of the relative maturities and yields of the
Company's investment securities Held-to-Maturity as of December 31, 2007.
Non-taxable municipal securities have been calculated on a fully taxable
equivalent basis.





Book
            
            
            AverageDecember 31, 2007(in
      thousands)
            
            Value
            
            
            YieldU.S.
      AgencyAfter one year through five
      years
            
            $
            30,435
            
            
            
            4.20
            %Municipal
      - Non-TaxableOne
      year or less
            
            
            5,340
            
            
            
            4.81
            %After
      one year through five years
            
            
            4,148
            
            
            
            4.90
            %After
      five years through ten years
            
            
            16,277
            
            
            
            5.52
            %After ten years
            
            
            40,610
            
            
            
            6.21
            %Total Non-Taxable Municipal
      Securities
            
            
            66,375
            
            
            
            5.85
            %Mortgage-backed
      SecuritiesAfter one year through five
      years
            
            
            6,731
            
            
            
            3.89
            %OtherAfter
      five years through ten years
            
            
            72
            
            
            
            9.13
            %After ten years
            
            
            1,981
            
            
            
            2.55
            %Total Other Securities
            
            
            2,053
            
            
            
            2.78
            %Total Investment Securities
      Held-to-Maturity
            
            $
            105,594
            
            
            
            5.19
            %





35
 Table of Contents





Loans


The
Company's loan portfolio at December 31, 2007, increased $94.0 million or 9.0%
from December 31, 2006. The increase was due to continuing strong loan demand in
the Company’s market area, along with a focused calling program on selected loan
prospects. Most of the current year’s growth occurred in Agricultural Loans,
Commercial Real Estate Loans (primarily those secured by production agricultural
properties) and Commercial Loans, market segments where the Company believes
that current market rates and/or credit risks are more reasonable than in the
areas of Consumer, Home Equity and Real Estate Construction loans.





Beginning
in late 2006 and continuing into 2007 the Company purposely reduced its exposure
to Real Estate Construction Loans as the residential housing market
softened.  Additionally, the Company’s Residential 1st
Mortgage portfolio is comprised primarily of 15 and 20 year mortgages to local
customers. The Company does not originate sub-prime residential mortgage loans,
nor does it hold any in its loan portfolio.





On an
average balance basis, loans have increased $91.6 million or 9.2%. In 2006
average balances increased 10.5% or $94.8 million from the prior year. The
following table sets forth the distribution of the loan portfolio by type and
percent as of December 31st of the
years indicated.





2007
            
            
            2006
            
            
            2005
            
            
            2004
            
            
            2003(in
      thousands)
            
            Amount
            
            
            Percent
            
            
            Amount
            
            
            Percent
            
            
            Amount
            
            
            Percent
            
            
            Amount
            
            
            Percent
            
            
            Amount
            
            
            PercentCommercial
      Real Estate
            
            $
            453,815
            
            
            
            39.7
            %
            
            $
            410,458
            
            
            
            39.1
            %
            
            $
            324,609
            
            
            
            33.3
            %
            
            $
            328,012
            
            
            
            37.7
            %
            
            $
            316,708
            
            
            
            39.1
            %Real
      Estate Construction
            
            
            80,651
            
            
            
            7.1
            %
            
            
            95,378
            
            
            
            9.1
            %
            
            
            110,235
            
            
            
            11.3
            %
            
            
            62,446
            
            
            
            7.2
            %
            
            
            77,115
            
            
            
            9.5
            %Residential
      1st Mortgages
            
            
            109,764
            
            
            
            9.6
            %
            
            
            106,148
            
            
            
            10.1
            %
            
            
            107,769
            
            
            
            11.0
            %
            
            
            103,734
            
            
            
            11.9
            %
            
            
            70,027
            
            
            
            8.7
            %Home
      Equity Lines and Loans
            
            
            65,953
            
            
            
            5.8
            %
            
            
            67,132
            
            
            
            6.4
            %
            
            
            69,013
            
            
            
            7.1
            %
            
            
            63,782
            
            
            
            7.3
            %
            
            
            55,827
            
            
            
            6.9
            %Agricultural
            
            
            215,798
            
            
            
            18.9
            %
            
            
            183,589
            
            
            
            17.5
            %
            
            
            170,657
            
            
            
            17.5
            %
            
            
            151,002
            
            
            
            17.4
            %
            
            
            134,862
            
            
            
            16.7
            %Commercial
            
            
            197,108
            
            
            
            17.2
            %
            
            
            165,412
            
            
            
            15.8
            %
            
            
            174,530
            
            
            
            17.9
            %
            
            
            142,133
            
            
            
            16.4
            %
            
            
            136,955
            
            
            
            16.9
            %Consumer
            
            
            12,706
            
            
            
            1.1
            %
            
            
            13,949
            
            
            
            1.3
            %
            
            
            12,653
            
            
            
            1.3
            %
            
            
            11,933
            
            
            
            1.4
            %
            
            
            11,979
            
            
            
            1.5
            %Credit
      Card
            
            
            5,499
            
            
            
            0.5
            %
            
            
            5,543
            
            
            
            0.5
            %
            
            
            5,353
            
            
            
            0.5
            %
            
            
            5,021
            
            
            
            0.6
            %
            
            
            4,549
            
            
            
            0.6
            %Other
            
            
            1,856
            
            
            
            0.2
            %
            
            
            1,730
            
            
            
            0.2
            %
            
            
            952
            
            
            
            0.1
            %
            
            
            1,019
            
            
            
            0.1
            %
            
            
            976
            
            
            
            0.1
            %Total
      Loans
            
            
            1,143,150
            
            
            
            100.0
            %
            
            
            1,049,339
            
            
            
            100.0
            %
            
            
            975,771
            
            
            
            100.0
            %
            
            
            869,082
            
            
            
            100.0
            %
            
            
            808,998
            
            
            
            100.0
            %Less:Unearned
      Income
            
            
            2,181
            
            
            
            
            
            
            
            2,427
            
            
            
            
            
            
            
            2,514
            
            
            
            
            
            
            
            2,174
            
            
            
            
            
            
            
            2,092Allowance for Loan Losses
            
            
            18,483
            
            
            
            
            
            
            
            18,099
            
            
            
            
            
            
            
            17,860
            
            
            
            
            
            
            
            17,727
            
            
            
            
            
            
            
            17,220Loans, Net
            
            $
            1,122,486
            
            
            
            
            
            
            $
            1,028,813
            
            
            
            
            
            
            $
            955,397
            
            
            
            
            
            
            $
            849,181
            
            
            
            
            
            
            $
            789,686


There
were no concentrations of loans exceeding 10% of total loans which were not
otherwise disclosed as a category of loans in the above table.





The
following table shows the maturity distribution and interest rate sensitivity of
the loan portfolio of the Company on December 31, 2007.





Over
      OneYear
      to
            
            
            OverOne
      Year
            
            
            Five
            
            
            Five(in thousands)
            
            or Less
            
            
            Years
            
            
            Years
            
            
            TotalCommercial
      Real Estate
            
            $
            30,173
            
            
            $
            72,321
            
            
            $
            351,321
            
            
            $
            453,815Real
      Estate Construction
            
            
            54,299
            
            
            
            19,119
            
            
            
            7,233
            
            
            
            80,651Residential
      1st Mortgages
            
            
            3,503
            
            
            
            3,798
            
            
            
            102,463
            
            
            
            109,764Home
      Equity Lines and Loans
            
            
            14
            
            
            
            195
            
            
            
            65,744
            
            
            
            65,953Agricultural
            
            
            105,889
            
            
            
            96,790
            
            
            
            13,119
            
            
            
            215,798Commercial
            
            
            87,785
            
            
            
            89,910
            
            
            
            19,413
            
            
            
            197,108Consumer, Credit Card &
      Other
            
            
            7,610
            
            
            
            10,906
            
            
            
            1,545
            
            
            
            20,061Total
            
            $
            289,273
            
            
            $
            293,039
            
            
            $
            560,838
            
            
            $
            1,143,150Rate
      Sensitivity:Predetermined
      Rate
            
            $
            229,706
            
            
            $
            181,934
            
            
            $
            369,617
            
            
            $
            781,257Floating Rate
            
            
            59,567
            
            
            
            111,104
            
            
            
            191,222
            
            
            
            361,893Total
            
            $
            289,273
            
            
            $
            293,038
            
            
            $
            560,839
            
            
            $
            1,143,150Percent
            
            
            25.30
            %
            
            
            25.63
            %
            
            
            49.06
            %
            
            
            100.00
            %





36
 Table of Contents





In the
ordinary course of business, the Company enters into commitments to extend
credit to its customers. These commitments are not reflected in the accompanying
consolidated financial statements. As of December 31, 2007, the Company had
entered into loan commitments amounting to $440.2 million compared to $442.5
million at December 31, 2006. In addition, letters of credit issued by the
Company to guarantee the performance of a customer to a third party at December
31, 2007, and December 31, 2006, were $8.4 million and $10.9 million,
respectively.





Non-Performing
Assets


Loans on
which the accrual of interest has been discontinued are designated as
non-accrual loans. Accrual of interest on loans is generally discontinued either
when: (1) a loan becomes contractually past due by 90 days or more with respect
to interest or principal; or (2) the loan is considered by management to be
impaired because it is probable that the Company will be unable to collect all
amounts due according to the contractual terms of the loan agreement. When loans
are 90 days past due, but in Management's judgment are well secured and in the
process of collection, they may not be classified as non-accrual. When a loan is
placed on non-accrual status, all interest previously accrued but not collected
is reversed. Income on such loans is then recognized only to the extent that
cash is received and where the future collection of principal is
probable.





Interest
income on non-accrual loans which would have been recognized during the year
ended December 31, 2007, if all such loans had been current in accordance with
their original terms, totaled $31,000.





Loans
where the collateral has been repossessed are classified as other real estate
owned ("OREO") or, if the collateral is personal property, the loan is
classified as other assets on the Company's financial statements.




The
following table sets forth the amount of the Company's non-performing assets as
of the dates indicated:





December 31,(in thousands)
            
            2007
            
            
            2006
            
            
            2005
            
            
            2004
            
            
            2003Non-Accrual
      LoansCommercial
      Real Estate
            
            $
            -
            
            
            $
            3
            
            
            $
            277
            
            
            $
            214
            
            
            $
            1,454Real
      Estate Construction
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Residential
      1st Mortgages
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Home
      Equity Lines and Loans
            
            
            -
            
            
            
            -
            
            
            
            94
            
            
            
            -
            
            
            
            31Agricultural
            
            
            -
            
            
            
            -
            
            
            
            93
            
            
            
            -
            
            
            
            185Commercial
            
            
            179
            
            
            
            36
            
            
            
            142
            
            
            
            -
            
            
            
            516Consumer
            
            
            6
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            181Credit
      Card
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Other
            
            
            1
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Total Non-Accrual Loans
            
            
            186
            
            
            
            39
            
            
            
            606
            
            
            
            214
            
            
            
            2,367Accruing
      Loans Past Due 90 Days or MoreCommercial
      Real Estate
            
            
            -
            
            
            
            -
            
            
            
            66
            
            
            
            -
            
            
            
            139Real
      Estate Construction
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Residential
      1st Mortgages
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Home
      Equity Lines and Loans
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Agricultural
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Commercial
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            41Consumer
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Credit
      Card
            
            
            17
            
            
            
            15
            
            
            
            22
            
            
            
            11
            
            
            
            37Other
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Total Accruing Loans Past Due 90 Days or
      More
            
            
            17
            
            
            
            15
            
            
            
            88
            
            
            
            11
            
            
            
            217Total Non-Performing Loans
            
            $
            203
            
            
            $
            54
            
            
            $
            694
            
            
            $
            225
            
            
            $
            2,584Other Real Estate Owned
            
            $
            251
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -Non-Performing Loans as a Percent of Total
      Loans
            
            
            0.02
            %
            
            
            0.01
            %
            
            
            0.07
            %
            
            
            0.03
            %
            
            
            0.32
            %Allowance for Loan Losses as a Percent of Total
      Non-Performing Loans
            
            
            9104.93
            %
            
            
            33516.67
            %
            
            
            2573.49
            %
            
            
            7878.67
            %
            
            
            666.41
            %





Although
management believes that non-performing loans are generally well-secured and
that potential losses are provided for in the Company’s allowance for loan
losses, there can be no assurance that future deterioration in economic
conditions or collateral values will not result in future credit
losses.





37
 Table of Contents





Deposits


One of
the key sources of funds to support earning assets is the generation of deposits
from the Company’s customer base. The ability to grow the customer base and
subsequently deposits is a significant element in the performance of the
Company.





The
Company saw an overall increase in deposit growth during 2007 along with a
continuing shift in the mix of deposits to higher yielding Time Deposits as
customers sought to maximize the interest earned on their deposit
balances.





The
following table sets forth, by time remaining to maturity, the Company’s time
deposits in amounts of $100,000 or more at December 31, 2007.





(in thousands)
            
            December 31, 2007Time
      Deposits of $100,000 or MoreThree
      Months or Less
            
            $
            211,443Over
      Three Months Through Six Months
            
            
            135,866Over
      Six Months Through Twelve Months
            
            
            36,678Over Twelve Months
            
            
            4,304Total Time Deposits of $100,000 or
      More
            
            $
            388,291


Refer to
the Year-to-Date Average Balances and Rate Schedules located on this “Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of
Operations” for information on separate deposit categories.





At
December 31, 2007, deposits totaled $1.3 billion.  This represents an
increase of 9.4% or $112.3 million from December 31, 2006. Core deposits
(exclusive of Public Time Deposits) increased 8.8% over the same
period.  Public Time Deposits totaled $144.3 million at December 31,
2007, an increase of $17.7 million since December 31, 2006, primarily because of
the Company’s decision to increase its use of State of California time deposits
for short-term funding needs instead of using FHLB Advances (see “Federal Home
Loan Bank Advances”).





The
primary area of deposit growth in 2007 has been in Time deposits as customers
have moved deposit balances from low or non-interest bearing accounts to
higher-yielding Time deposits. Overall, Time deposits grew $63.6 million or
12.7% from December 31, 2006. However, as a result of a focused calling program
on selected deposit prospects, the Company has also experienced growth in
Demand, Interest Bearing Transaction and Savings deposits in the amount of $48.6
million or 6.9% since December 31, 2006.





Federal
Home Loan Bank Advances


Advances
from the Federal Home Loan Bank are another key source of funds to support
earning assets. These advances are also used to manage the Bank’s interest rate
risk exposure, and as opportunities exist to borrow and invest the proceeds at a
positive spread through the investment portfolio. FHLB advances as of December
31, 2007, were $28.9 million compared to $47.5 million as of December 31, 2006.
This decrease of $18.6 million in borrowings occurred as a result of the
Company’s management of its liquidity needs using State of California Time
deposits (a strategy which it first implemented in 2006) which generally have
rates from 20 to 30 basis points lower than FHLB advances. The average rate on
FHLB advances during 2007 was 5.3% compared to 5.2% in 2006.





Subordinated
Debentures


On
December 17, 2003, the Company raised $10 million through an offering of trust
preferred securities. See Note 17 located in “Item 8. Financial Statements and
Supplementary Data.” Although this amount is reflected as subordinated debt on
the Company’s balance sheet, under applicable regulatory guidelines, trust
preferred securities qualify as regulatory capital. See “Capital.” These
securities accrue interest at a variable rate based upon 3-month LIBOR plus
2.85%. Interest rates reset quarterly (the next reset is March 16, 2008) and the
rate was 7.84% as of December 31, 2007. The average rate paid for these
securities in 2007 was 8.42% compared to 8.02% in 2006. Additionally, if the
Company decided to defer interest on the subordinated debentures, the Company
would be prohibited from paying cash dividends on the Company’s common
stock.





38
 Table of Contents





Capital


The
Company relies primarily on capital generated through the retention of earnings
to satisfy its capital requirements. The Company engages in an ongoing
assessment of its capital needs in order to support business growth and to
insure depositor protection. Shareholders’ Equity totaled $143.4 million at
December 31, 2007, and $132.3 million at the end of 2006.





The
Company and the Bank are subject to various regulatory capital requirements
administered by the federal banking agencies. Failure to meet minimum capital
requirements can initiate certain mandatory, and possibly discretionary, actions
by regulators that, if undertaken, could have a direct material effect on the
Company and the Bank's financial statements. Under capital adequacy guidelines
and the regulatory framework for prompt corrective action, the Company and the
Bank must meet specific capital guidelines that involve quantitative measures of
the Company’s and the Bank's assets, liabilities, and certain off-balance-sheet
items as calculated under regulatory accounting practices. The Company’s and the
Bank's capital amounts and classification are also subject to qualitative
judgments by the regulators about components, risk weightings, and other
factors.





Quantitative
measures established by regulation to ensure capital adequacy require the
Company and the Bank to maintain minimum amounts and ratios of Total and Tier 1
capital to risk-weighted assets (as defined in the regulations), and of Tier 1
capital to average assets (as defined in the regulations). Management believes,
as of December 31, 2007, that the Company and the Bank meet all capital adequacy
requirements to which they are subject. For further information on the Company
and the Bank’s risk-based capital ratios, see Note 10 located in “Item 8.
Financial Statements and Supplementary Data.”





As
previously discussed (see “Subordinated Debentures”), in order to supplement its
regulatory capital base, during December 2003 the Company issued $10 million of
trust preferred securities. See Note 17 located in “Item 8. Financial Statements
and Supplementary Data.” On March 1, 2005, the Federal Reserve Board issued its
final rule effective April 11, 2005, concerning the regulatory capital treatment
of trust preferred securities (“TPS”) by bank holding companies (“BHCs”). Under
the final rule BHCs may include TPS in Tier 1 capital in an amount equal to 25%
of the sum of core capital net of goodwill. The quantitative limitation
concerning goodwill will not be effective until March 31, 2009. Any portion of
trust preferred securities not qualifying as Tier 1 capital would qualify as
Tier 2 capital subject to certain limitations. The Company has received
notification from the Federal Reserve Bank of San Francisco that all of the
Company’s trust preferred securities currently qualify as Tier 1
capital.





In
accordance with the provisions of Financial Accounting Standard Board
Interpretation No. 46, “Consolidation of Variable Interest
Entities” (“FIN 46”), the Company does not consolidate the subsidiary
trust which has issued the trust preferred securities.





In 1998,
the Board approved the Company’s first stock repurchase program. During the
second quarter of 2004, the Board approved a second stock repurchase program
because it concluded that the Company continued to have more capital than it
needed to meet present and anticipated regulatory guidelines for the Bank to be
classified as “well capitalized.”





On April
4, 2006, the Board unanimously approved expanding the repurchase program to
allow the repurchase of up to $15 million of stock through April 30, 2009.
Repurchases under the program will continue to be made on the open market or
through private transactions. The repurchase program also requires that no
purchases may be made if the Bank would not remain “well-capitalized” after the
repurchase. All shares repurchased under the repurchase program will be retired.
See Part II, “Item 5. Market for Registrant’s Common Equity, Related Stockholder
Matters and Issuer Purchases of Equity Securities.”





During
2007 the Company repurchased 11,821 shares at an average share price of $460 per
share. In 2006 the Company repurchased 11,718 shares at an average share price
of $507. Since the second share repurchase program was expanded in 2006 the
Company has repurchased over 20,000 shares for total consideration of $9.7
million.





39
 Table of Contents





Critical
Accounting Policies and Estimates





This
“Management’s Discussion and Analysis of Financial Condition and Results of
Operations,” is based upon the Company’s consolidated financial statements,
which have been prepared in accordance with accounting principles generally
accepted in the United States. In preparing the Company’s financial statements
management makes estimates and judgments that affect the reported amounts of
assets, liabilities, revenues and expenses. Management believes that the most
significant subjective judgments that it makes include the
following:





·
            Allowance for Loan
      Losses. As a financial institution which assumes lending and credit
      risks as a principle element in its business, the Company anticipates that
      credit losses will be experienced in the normal course of business.
      Accordingly, the allowance for loan losses is maintained at a level
      considered adequate by management to provide for losses that are inherent
      in the portfolio. The allowance is increased by provisions charged to
      operating expense and reduced by net charge-offs. Management employs a
      systematic methodology for determining the allowance for loan losses. On a
      quarterly basis, management reviews the credit quality of the loan
      portfolio and considers problem loans, delinquencies, internal credit
      reviews, current economic conditions, loan loss experience and other
      factors in determining the adequacy of the allowance
    balance.





While the
Company utilizes a systematic methodology in determining its allowance, the
allowance is based on estimates, and ultimate losses may vary from current
estimates. The estimates are reviewed periodically and, as adjustments become
necessary, are reported in earnings in the periods in which they become known.
For additional information, see Note 3 located in “Item 8. Financial Statements
and Supplementary Data.”





·
            Fair Value. The Company
      discloses the fair value of financial instruments and the methods and
      significant assumptions used to estimate those fair values. The estimated
      fair value amounts have been determined by the Company using available
      market information and appropriate valuation methodologies. The use of
      assumptions and various valuation techniques, as well as the absence of
      secondary markets for certain financial instruments, will likely reduce
      the comparability of fair value disclosures between financial
      institutions. In some cases, book value is a reasonable estimate of fair
      value due to the relatively short period of time between origination of
      the instrument and its expected realization. For additional information,
      see “Item 7A. Quantitative and Qualitative Disclosures About Market Risk –
      Credit Risk” and Note 12 located in “Item 8. Financial Statements and
      Supplementary Data.”





·
            Income Taxes. The
      Company uses the liability method of accounting for income taxes. This
      method results in the recognition of deferred tax assets and liabilities
      that are reflected at currently enacted income tax rates applicable to the
      period in which the deferred tax assets or liabilities are expected to be
      realized or settled. As changes in tax laws or rates are enacted, deferred
      tax assets and liabilities are adjusted through the provision for income
      taxes. The deferred provision for income taxes is the result of the net
      change in the deferred tax asset and deferred tax liability balances
      during the year. This amount combined with the current taxes payable or
      refundable results in the income tax expense for the current
      year.





On
January 1, 2007, the Company adopted Financial Accounting Standards Board
(“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income
Taxes (“FIN 48”).” The adoption of FIN 48 did not have a material impact
on the Company’s financial position, results of operations or cash
flows. For additional information, see Note 1 and Note 7 located in “Item
8. Financial Statements and Supplementary Data.”





Off-Balance
Sheet Arrangements and Aggregate Contractual Obligations and
Commitments





Off-balance
sheet arrangements are any contractual arrangement to which an unconsolidated
entity is a party, under which the Company has: (1) any obligation under a
guarantee contract; (2) a retained or contingent interest in assets transferred
to an unconsolidated entity or similar arrangement that serves as credit,
liquidity or market risk support to that entity for such assets; (3) any
obligation under certain derivative instruments; or (4) any obligation under a
material variable interest held by us in an unconsolidated entity that provides
financing, liquidity, market risk or credit risk support to the Company, or
engages in leasing, hedging or research and development services with the
Company.





40
 Table of Contents





Our most
significant off-balance sheet arrangements are limited to: (1) the full and
unconditional payment guarantee of accrued distributions relating to $10 million
of Trust Preferred Securities issued by FMCB Statutory Trust (see Note 17
located in “Item 8. Financial Statements and Supplementary Data”); (2)
derivative instruments indexed to the Prime Rate (see Note 13 located in “Item
8. Financial Statements and Supplementary Data”); (3) obligations under
guarantee contracts such as financial and performance standby letters of credit
for our credit customers (see Note 14 located in “Item 8. Financial Statements
and Supplementary Data”); (4) unfunded commitments to lend (see Note 14 located
in “Item 8. Financial Statements and Supplementary Data”); and (5) lease
contracts (see Note 14 located in “Item 8. Financial Statements and
Supplementary Data”). It is our belief that none of these arrangements expose us
to any greater risk of loss than is already reflected on our balance sheet. We
do not have any off-balance sheet arrangements in which we have any retained or
contingent interest (as we do not transfer or sell our assets to entities in
which we have a continuing involvement), any exposure to derivative instruments
that are indexed to stock indices nor any variable interests in any
unconsolidated entity to which we may be a party.





The
following table presents, as of December 31, 2007, our significant and
determinable contractual obligations by payment date. The payment amounts
represent those amounts contractually due to the recipient and do not include
any unamortized premiums or discount, hedge basis adjustments or other similar
carrying value adjustments. For further information on the nature of each
obligation type, see applicable note disclosure located in “Item 8. Financial
Statements and Supplementary Data.”





Payments
Due By Period


(in
thousands)





Contractual Obligations
            
            Total
            
            
            1 Year or Less
            
            
            2-3 Years
            
            
            4-5 Years
            
            
            More Than 5 YearsOperating
      Lease Obligations
            
            $
            2,385
            
            
            $
            447
            
            
            $
            742
            
            
            $
            527
            
            
            $
            669FHLB
      Advances
            
            
            28,954
            
            
            
            28,200
            
            
            
            -
            
            
            
            -
            
            
            
            754Long-Term
      Subordinated Debentures
            
            
            10,310
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            10,310Deferred Compensation(1)
            
            
            14,106
            
            
            
            503
            
            
            
            332
            
            
            
            425
            
            
            
            12,846Total
            
            $
            55,755
            
            
            $
            29,150
            
            
            $
            1,074
            
            
            $
            952
            
            
            $
            24,579




(1) These
amounts represent payments to participants under the Company's non-qualified
deferred compensation and supplemental retirement plans. See Note 11 located in
“Item 8. Financial Statements and Supplementary Data.”








Item 7A. Quantitativeand Qualitative Disclosures About Market
Risk





Risk
Management





The
Company has adopted a Risk Management Plan, which aims to ensure the proper
control and management of all risk factors inherent in the operation of the
Company. Specifically, credit risk, interest rate risk, liquidity risk,
compliance risk, strategic risk, reputation risk and price risk can all affect
the market risk of the Company. These specific risk factors are not mutually
exclusive. It is recognized that any product or service offered by the Company
may expose the Company to one or more of these risk factors.





Credit
Risk


Credit
risk is the risk to earnings or capital arising from an obligor’s failure to
meet the terms of any contract or otherwise fail to perform as agreed. Credit
risk is found in all activities where success depends on counterparty, issuer or
borrower performance.





Credit
risk in the investment portfolio and correspondent bank accounts is addressed
through defined limits in the Company’s policy statements. In addition, certain
securities carry insurance to enhance credit quality of the bond.





Credit
risk in the loan portfolio is controlled by limits on industry concentration,
aggregate customer borrowings and geographic boundaries. Standards on loan
quality also are designed to reduce loan credit risk. Senior Management,
Directors’ Committees, and the Board of Directors are regularly provided with
information intended to identify, measure, control and monitor the credit risk
of the Company.





41
 Table of Contents





The
Company’s methodology for assessing the appropriateness of the allowance is
applied on a regular basis and considers all loans. The systematic methodology
consists of two major elements. The first major element includes a detailed
analysis of the loan portfolio in two phases. The first phase is conducted in
accordance with SFAS No. 114, “Accounting by Creditors for the
Impairment of a Loan” as amended by SFAS No. 118, “Accounting by Creditors for
Impairment of a Loan — Income Recognition and Disclosures.” Individual
loans are reviewed to identify loans for impairment. A loan is impaired when
principal and interest are deemed uncollectible in accordance with the original
contractual terms of the loan. Impairment is measured as either the expected
future cash flows discounted at each loan’s effective interest rate, the fair
value of the loan’s collateral if the loan is collateral dependent, or an
observable market price of the loan (if one exists). Upon measuring the
impairment, the Company will ensure an appropriate level of allowance is present
or established.





Central
to the first phase and the Company’s credit risk management is its loan risk
rating system. The originating credit officer assigns borrowers an initial risk
rating, which is based primarily on a thorough analysis of each borrower’s
financial position in conjunction with industry and economic trends. Approvals
are made based upon the amount of inherent credit risk specific to the
transaction and are reviewed for appropriateness by senior credit administration
personnel. Credits are monitored by credit administration personnel for
deterioration in a borrower’s financial condition, which would impact the
ability of the borrower to perform under the contract. Risk ratings are adjusted
as necessary.





Based on
the risk rating system, specific allowances are established in cases where
management has identified significant conditions or circumstances related to a
credit that management believes indicates the possibility of loss. Management
performs a detailed analysis of these loans, including, but not limited to, cash
flows, appraisals of the collateral, conditions of the marketplace for
liquidating the collateral and assessment of the guarantors. Management then
determines the inherent loss potential and allocates a portion of the allowance
for losses as a specific allowance for each of these credits.





The
second phase is conducted by segmenting the loan portfolio by risk rating and
into groups of loans with similar characteristics in accordance with SFAS No. 5,
“Accounting for
Contingencies”. In this second phase, groups of loans are reviewed and
applied the appropriate allowance percentage to determine a portfolio formula
allowance.





The
second major element of the analysis, which considers all known relevant
internal and external factors that may affect a loan’s collectibility, is based
upon management’s evaluation of various conditions, the effects of which are not
directly measured in the determination of the formula and specific allowances.
The evaluation of the inherent loss with respect to these conditions is subject
to a higher degree of uncertainty because they are not identified with specific
problem credits or portfolio segments. The conditions evaluated in connection
with the second element of the analysis of the allowance include, but are not
limited to the following conditions that existed as of the balance sheet
date:





·
            then-existing
      general economic and business conditions affecting the key lending areas
      of the Company;


·
            credit
      quality trends (including trends in non-performing loans expected to
      result from existing conditions);


·
            collateral
      values;


·
            loan
      volumes and concentrations;


·
            seasoning
      of the loan portfolio;


·
            specific
      industry conditions within portfolio
segments;


·
            recent
      loss experience within portfolio
segments;


·
            duration
      of the current business cycle;


·
            bank
      regulatory examination results; and


·
            findings
      of the Company’s internal credit
examiners.





Management
reviews these conditions in discussion with the Company’s senior credit
officers. To the extent that any of these conditions are evidenced by a
specifically identifiable problem credit or portfolio segment as of the
evaluation date, management’s estimate of the effect of such condition may be
reflected as a specific allowance applicable to such credit or portfolio
segment. Where any of these conditions is not evidenced by a specifically
identifiable problem credit or portfolio segment as of the evaluation date,
management’s evaluation of the inherent loss related to such condition is
reflected in the second major element allowance.





42
 Table of Contents





Implicit
in lending activities is the risk that losses will and do occur and that the
amount of such losses will vary over time. Consequently, the Company maintains
an allowance for loan losses by charging a provision for loan losses to
earnings. Loans determined to be losses are charged against the allowance for
loan losses. The Company’s allowance for loan losses is maintained at a level
considered by management to be adequate to provide for estimated losses inherent
in the existing portfolio.





Management
believes that the allowance for loan losses at December 31, 2007, was adequate
to provide for both recognized losses and estimated inherent losses in the
portfolio. No assurances can be given that future events may not result in
increases in delinquencies, non-performing loans or net loan charge-offs that
would increase the provision for loan losses and thereby adversely affect the
results of operations.





Interest
Rate Risk


The
mismatch between maturities of interest sensitive assets and liabilities results
in uncertainty in the Company’s earnings and economic value and is referred to
as interest rate risk. The Company does not attempt to predict interest rates
and positions the balance sheet in a manner which seeks to minimize, to the
extent possible, the effects of changing interest rates.





The
Company measures interest rate risk in terms of potential impact on both its
economic value and earnings. The methods for governing the amount of interest
rate risk include: (1) analysis of asset and liability mismatches (GAP
analysis); (2) the utilization of a simulation model; and (3) limits on
maturities of investment, loan and deposit products which reduces the market
volatility of those instruments.





The Gap
analysis measures, at specific time intervals, the divergence between earning
assets and interest bearing liabilities for which repricing opportunities will
occur. A positive difference, or Gap, indicates that earning assets will reprice
faster than interest-bearing liabilities. This will generally produce a greater
net interest margin during periods of rising interest rates and a lower net
interest margin during periods of declining interest rates. Conversely, a
negative Gap will generally produce a lower net interest margin during periods
of rising interest rates and a greater net interest margin during periods of
decreasing interest rates.





The
interest rates paid on deposit accounts do not always move in unison with the
rates charged on loans. In addition, the magnitude of changes in the rates
charged on loans is not always proportionate to the magnitude of changes in the
rate paid for deposits. Consequently, changes in interest rates do not
necessarily result in an increase or decrease in the net interest margin solely
as a result of the differences between repricing opportunities of earning assets
or interest bearing liabilities.





The
Company also utilizes the results of a dynamic simulation model to quantify the
estimated exposure of net interest income to sustained interest rate changes.
The sensitivity of the Company’s net interest income is measured over a rolling
one-year horizon.





The
simulation model estimates the impact of changing interest rates on interest
income from all interest earning assets and the interest expense paid on all
interest bearing liabilities reflected on the Company’s balance sheet. This
sensitivity analysis is compared to policy limits, which specify a maximum
tolerance level for net interest income exposure over a one-year horizon
assuming no balance sheet growth, given a 200 basis point upward and a 200 basis
point downward shift in interest rates. A shift in rates over a 12-month period
is assumed. Results that exceed policy limits, if any, are analyzed for risk
tolerance and reported to the Board with appropriate recommendations. At
December 31, 2007, the Company’s estimated net interest income sensitivity to
changes in interest rates, as a percent of net interest income was a decrease in
net interest income of 0.40% if rates increase by 200 basis points and an
increase in net interest income of 0.90% if rates decline 200 basis
points.





43
 Table of Contents





The
estimated sensitivity does not necessarily represent a Company forecast and the
results may not be indicative of actual changes to the Company’s net interest
income. These estimates are based upon a number of assumptions including: the
nature and timing of interest rate levels including yield curve shape;
prepayments on loans and securities; pricing strategies on loans and deposits;
replacement of asset and liability cash flows; and other assumptions. While the
assumptions used are based on current economic and local market conditions,
there is no assurance as to the predictive nature of these conditions including
how customer preferences or competitor influences might change.





Liquidity
Risk


Liquidity
risk is the risk to earnings or capital resulting from the Company’s inability
to meet its obligations when they come due without incurring unacceptable
losses. It includes the ability to manage unplanned decreases or changes in
funding sources and to recognize or address changes in market conditions that
affect the Company’s ability to liquidate assets or acquire funds quickly and
with minimum loss of value. The Company endeavors to maintain a cash flow
adequate to fund operations, handle fluctuations in deposit levels, respond to
the credit needs of borrowers and to take advantage of investment opportunities
as they arise. The principal sources of liquidity include credit facilities from
correspondent banks, brokerage firms and the Federal Home Loan Bank, as well as
interest and principal payments on loans and investments, proceeds from the
maturity or sale of investments, and growth in deposits.





In
general, liquidity risk is managed daily by controlling the level of Federal
Funds and the use of funds provided by the cash flow from the investment
portfolio. The Company maintains overnight investments in Federal Funds as a
cushion for temporary liquidity needs. During 2007 Federal Funds Sold averaged
$10.4 million. The Company maintains Federal Funds credit lines of $99 million
with major banks subject to the customary terms and conditions for such
arrangements and $150 million in repurchase lines with major brokers. In
addition, the Company has additional borrowing capacity of $196.4 million from
the Federal Home Loan Bank.





At
December 31, 2007, the Company had available sources of liquidity, which
included cash and cash equivalents and unpledged investment securities of
approximately $65.9 million, which represents 4.3% of total assets.





Item 8. FinancialStatements and Supplementary Data





INDEX TO CONSOLIDATED FINANCIAL
STATEMENTS


AND
FINANCIAL STATEMENT SCHEDULES





PageReport
      of Management on Internal Control Over Financial Reporting
            45Reports
      of Independent Registered Public Accounting Firms
            46Consolidated
      Financial StatementsConsolidated
      Statement of Income – Years ended December 31, 2007, 2006 and
      2005
            48Consolidated
      Balance Sheet – December 31, 2007, and 2006
            49Consolidated
      Statement of Changes in Shareholders' Equity – Years ended December 31,
      2007, 2006 and 2005
            50Consolidated
      Statement of Comprehensive Income.
            51Consolidated
      Statement of Cash Flows - Years Ended December 31, 2007, 2006 and
      2005
            52Notes
      to Consolidated Financial Statements
            53





44
 Table of Contents





Farmers
& Merchants Bancorp





Report
of Management on Internal Control Over Financial Reporting








Management
is responsible for establishing and maintaining adequate internal control over
financial reporting at Farmers & Merchants Bancorp (“the
Company”). Internal control over financial reporting includes controls over
the preparation of financial statements in accordance with the instructions to
the Consolidated Financial Statements for Bank Holding Companies (Form FR Y-9C)
to comply with the reporting requirements of Section 112 of the Federal Deposit
Insurance Corporation Improvement Act (“FDICIA”).





Management
has assessed the effectiveness of the Company’s internal control over financial
reporting as of December 31, 2007, based on criteria described in “Internal
Control-Integrated Framework” issued by the Committee of Sponsoring
Organizations of the Treadway Commission. Based on that assessment, management
concluded that the Company maintained effective internal control over financial
reporting as of December 31, 2007.





Perry-Smith
LLP, the independent registered public accounting firm that audited the
financial statements included in this Annual Report has issued an attestation
report on the Company’s internal control over financial
reporting.











/s/
      Kent A. Steinwert
            /s/
      Stephen W. HaleyKent
      A. Steinwert
            Stephen
      W. HaleyPresident
      & Chief Executive Officer
            Executive
      Vice President & Chief Financial
Officer





45
 Table of Contents





REPORT OF INDEPENDENT
REGISTERED PUBLIC ACCOUNTING FIRM











The
Shareholders and Board of Directors


Farmers
& Merchants Bancorp


Lodi,
California








We have
audited the accompanying consolidated balance sheet of Farmers & Merchants
Bancorp and subsidiaries (the "Company") as of December 31, 2007, and 2006 and
the related consolidated statements of income, changes in shareholders' equity,
comprehensive income, and cash flows for each of the years in the three-year
period ended December 31, 2007.  We also have audited the Company's
internal control over financial reporting as of December 31, 2007, based on
criteria established in Internal Control – Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission (the "COSO
criteria").  The Company's management is responsible for these
financial statements, for maintaining effective internal control over financial
reporting, and for its assessment of the effectiveness of internal control over
financial reporting included in the accompanying Report of Management on
Internal Control over Financial Reporting.  Our responsibility is to
express an opinion on these consolidated financial statements and an opinion on
the Company's internal control over financial reporting based on our
audits.





We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audits to obtain reasonable assurance about whether
the consolidated financial statements are free of material misstatement and
whether effective internal control over financial reporting was maintained in
all material respects.  Our audits of the consolidated financial
statements included examining, on a test basis, evidence supporting the amounts
and disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation.  Our audit of internal control over
financial reporting included obtaining an understanding of internal control over
financial reporting, assessing the risk that a material weakness exists, and
testing and evaluating the design and operating effectiveness of internal
control based on the assessed risk.  Our audits also included
performing such other procedures as we considered necessary in the
circumstances.  We believe that our audits provide a reasonable basis
for our opinions.





46
 Table of Contents





REPORT OF INDEPENDENT
REGISTERED PUBLIC ACCOUNTING FIRM


(Continued)








A
company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles.  Management’s
assessment and our audit of internal control over financial reporting included
controls over the Company’s preparation of financial statements in accordance
with the instructions to the Consolidated Financial Statements for Bank Holding
Companies (Form FR Y9C) to comply with the requirements of Section 112 of the
Federal Deposit Insurance Corporation Improvement Act (FDICIA).  A
company's internal control over financial reporting includes those policies and
procedures that (1) pertain to the maintenance of records that, in reasonable
detail, accurately and fairly reflect the transactions and dispositions of the
assets of the company; (2) provide reasonable assurance that transactions are
recorded as necessary to permit preparation of financial statements in
accordance with generally accepted accounting principles, and that receipts and
expenditures of the company are being made only in accordance with
authorizations of management and directors of the company; and (3) provide
reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use, or disposition of the company's assets that could have a
material effect on the financial statements.





Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of Farmers & Merchants
Bancorp and subsidiaries as of December 31, 2007, and 2006 and the results of
their operations and their cash flows for each of the years in the three-year
period ended December 31, 2007, in conformity with accounting principles
generally accepted in the United States of America.  Also, in our
opinion, Farmers & Merchants Bancorp and subsidiaries maintained, in all
material respects, effective internal control over financial reporting as of
December 31, 2007, based on the COSO criteria.











/s/
      Perry-Smith LLP











Sacramento,
California


March 4,
2008





47
 Table of Contents




Farmers
& Merchants Bancorp


Consolidated
Statement of Income





(in
thousands except per share data)





Year
      Ended December 31,2007
            
            
            2006
            
            
            2005Interest
      IncomeInterest
      and Fees on Loans
            
            $
            84,081
            
            
            $
            76,872
            
            
            $
            61,838Interest
      on Federal Funds Sold and Securities PurchasedUnder Agreements to
      Resell
            
            
            538
            
            
            
            49
            
            
            
            188Interest
      on Investment Securities:Taxable
            
            
            7,920
            
            
            
            8,184
            
            
            
            7,217Exempt from Federal Tax
            
            
            3,236
            
            
            
            3,291
            
            
            
            3,215Total Interest Income
            
            
            95,775
            
            
            
            88,396
            
            
            
            72,458Interest
      ExpenseDeposits
            
            
            29,960
            
            
            
            18,630
            
            
            
            9,828Borrowed
      Funds
            
            
            1,397
            
            
            
            5,164
            
            
            
            3,561Subordinated Debentures
            
            
            868
            
            
            
            827
            
            
            
            643Total Interest Expense
            
            
            32,225
            
            
            
            24,621
            
            
            
            14,032Net
      Interest Income
            
            
            63,550
            
            
            
            63,775
            
            
            
            58,426Provision for Loan Losses
            
            
            1,495
            
            
            
            275
            
            
            
            425Net Interest Income After Provision for Loan
      Losses
            
            
            62,055
            
            
            
            63,500
            
            
            
            58,001Non-Interest
      IncomeService
      Charges on Deposit Accounts
            
            
            7,287
            
            
            
            6,046
            
            
            
            4,364Net
      Loss on Investment Securities
            
            
            (1,707
            )
            
            
            (2,168
            )
            
            
            (953
            )Credit
      Card Merchant Fees
            
            
            2,181
            
            
            
            2,124
            
            
            
            2,039Increase
      in Cash Surrender Value of Life Insurance
            
            
            1,737
            
            
            
            1,645
            
            
            
            1,563ATM
      Fees
            
            
            1,376
            
            
            
            1,202
            
            
            
            991Other
            
            
            4,581
            
            
            
            3,214
            
            
            
            3,270Total Non-Interest Income
            
            
            15,455
            
            
            
            12,063
            
            
            
            11,274Non-Interest
      ExpenseSalaries
      and Employee Benefits
            
            
            27,364
            
            
            
            27,820
            
            
            
            26,773Occupancy
            
            
            2,559
            
            
            
            2,455
            
            
            
            2,073Equipment
            
            
            2,875
            
            
            
            3,218
            
            
            
            2,509Credit
      Card Merchant Expense
            
            
            1,640
            
            
            
            1,569
            
            
            
            1,458Marketing
            
            
            463
            
            
            
            1,167
            
            
            
            1,522Other
            
            
            7,044
            
            
            
            6,892
            
            
            
            6,282Total Non-Interest Expense
            
            
            41,945
            
            
            
            43,121
            
            
            
            40,617Income
      Before Income Taxes
            
            
            35,565
            
            
            
            32,442
            
            
            
            28,658Provision for Income Taxes
            
            
            12,870
            
            
            
            11,813
            
            
            
            10,230Net Income
            
            $
            22,695
            
            
            $
            20,629
            
            
            $
            18,428Earnings Per Share
            
            $
            28.05
            
            
            $
            25.25
            
            
            $
            22.24


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





48
 Table of Contents





Farmers
& Merchants Bancorp


Consolidated
Balance Sheet





(in
thousands except share data)





December 31,Assets
            
            2007
            
            
            2006Cash
      and Cash Equivalents:Cash
      and Due from Banks
            
            $
            50,240
            
            
            $
            47,006Federal Funds Sold and Securities Purchased Under
      Agreements to Resell
            
            
            1,150
            
            
            
            -Total Cash and Cash
    Equivalents
            
            
            51,390
            
            
            
            47,006Investment
      Securities:Available-for-Sale
            
            
            142,043
            
            
            
            132,627Held-to-Maturity
            
            
            105,594
            
            
            
            111,240Total Investment Securities
            
            
            247,637
            
            
            
            243,867Loans:
            
            
            1,140,969
            
            
            
            1,046,912Less: Allowance for Loan
    Losses
            
            
            18,483
            
            
            
            18,099Loans, Net
            
            
            1,122,486
            
            
            
            1,028,813Premises
      and Equipment, Net
            
            
            20,188
            
            
            
            20,496Bank
      Owned Life Insurance
            
            
            40,180
            
            
            
            38,444Interest Receivable and Other
      Assets
            
            
            37,291
            
            
            
            32,607Total Assets
            
            $
            1,519,172
            
            
            $
            1,411,233LiabilitiesDeposits:Demand
            
            $
            307,299
            
            
            $
            295,142Interest-Bearing
      Transaction
            
            
            138,665
            
            
            
            132,875Savings
            
            
            301,678
            
            
            
            271,019Time
            
            
            563,148
            
            
            
            499,492Total Deposits
            
            
            1,310,790
            
            
            
            1,198,528Federal
      Home Loan Bank Advances
            
            
            28,954
            
            
            
            47,532Subordinated
      Debentures
            
            
            10,310
            
            
            
            10,310Interest Payable and Other
      Liabilities
            
            
            25,700
            
            
            
            22,523Total Liabilities
            
            
            1,375,754
            
            
            
            1,278,893Commitments
      & Contingencies (See Note 14)Shareholders'
      EquityPreferred
      Stock:  No Par Value.  1,000,000 Authorized, None
      Issued or Outstanding
            
            
            -
            
            
            
            -Common
      Stock:  Par Value $0.01, 20,000,000 Shares Authorized, 800,112
      and 811,933 Issued and Outstanding at December 31, 2007 and 2006,
      respectively
            
            
            8
            
            
            
            8Additional
      Paid-In Capital
            
            
            84,437
            
            
            
            89,926Retained
      Earnings
            
            
            57,990
            
            
            
            43,126Accumulated Other Comprehensive Gain
      (Loss)
            
            
            983
            
            
            
            (720
            )Total Shareholders' Equity
            
            
            143,418
            
            
            
            132,340Total Liabilities and Shareholders'
      Equity
            
            $
            1,519,172
            
            
            $
            1,411,233


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





49
 Table of Contents





Farmers
& Merchants Bancorp


Consolidated
Statement of Changes in Shareholders' Equity





(in
thousands except share and per share data)





AccumulatedCommon
            
            
            
            
            
            Additional
            
            
            
            
            
            Other
            
            
            TotalShares
            
            
            Common
            
            
            Paid-In
            
            
            Retained
            
            
            Comprehensive
            
            
            Shareholders'Outstanding
            
            
            Stock
            
            
            Capital
            
            
            Earnings
            
            
            Gain (Loss)
            
            
            EquityBalance, December 31, 2004
            
            
            792,722
            
            
            $
            8
            
            
            $
            82,237
            
            
            $
            35,332
            
            
            $
            (1,030
            )
            
            $
            116,547Net
      Income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            18,428
            
            
            
            
            
            
            
            18,428Cash
      Dividends Declared on Common Stock ($7.68 per share)
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (6,366
            )
            
            
            
            
            
            
            (6,366
            )5%
      Stock Dividend
            
            
            38,995
            
            
            
            
            
            
            
            17,641
            
            
            
            (17,641
            )
            
            
            
            
            
            
            -Cash
      Paid in Lieu of Fractional Shares Related to Stock
Dividend
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (290
            )
            
            
            
            
            
            
            (290
            )Repurchase
      of Stock
            
            
            (8,066
            )
            
            
            
            
            
            
            (4,016
            )
            
            
            
            
            
            
            
            
            
            
            (4,016
            )Change
      in Net Unrealized Gains on Derivative Instruments
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (14
            )
            
            
            (14
            )Minimum
      Pension Plan Liability Adjustment
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            1,018
            
            
            
            1,018Change
      in Net Unrealized Loss onSecurities
      Available-for-Sale
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (1,659
            )
            
            
            (1,659
            )Balance, December 31, 2005
            
            
            823,651
            
            
            
            8
            
            
            
            95,862
            
            
            
            29,463
            
            
            
            (1,685
            )
            
            
            123,648Net
      Income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            20,629
            
            
            
            
            
            
            
            20,629Cash
      Dividends Declared on Common Stock ($8.55 per share)
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (6,966
            )
            
            
            
            
            
            
            (6,966
            )Repurchase
      of Stock
            
            
            (11,718
            )
            
            
            
            
            
            
            (5,936
            )
            
            
            
            
            
            
            
            
            
            
            (5,936
            )Change
      in Net Unrealized Gains onDerivative
      Instruments
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (7
            )
            
            
            (7
            )Change
      in Net Unrealized Loss onSecurities
      Available-for-Sale
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            972
            
            
            
            972Balance, December 31, 2006
            
            
            811,933
            
            
            
            8
            
            
            
            89,926
            
            
            
            43,126
            
            
            
            (720
            )
            
            
            132,340Net
      Income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            22,695
            
            
            
            
            
            
            
            22,695Cash
      Dividends Declared on Common Stock ($9.70 per share)
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (7,831
            )
            
            
            
            
            
            
            (7,831
            )Repurchase
      of Stock
            
            
            (11,821
            )
            
            
            
            
            
            
            (5,489
            )
            
            
            
            
            
            
            
            
            
            
            (5,489
            )Change
      in Net Unrealized Gains on Derivative Instruments
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            2
            
            
            
            2Change
      in Net Unrealized Loss onSecurities
      Available-for-Sale
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            1,701
            
            
            
            1,701Balance, December 31, 2007
            
            
            800,112
            
            
            $
            8
            
            
            $
            84,437
            
            
            $
            57,990
            
            
            $
            983
            
            
            $
            143,418


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





50
 Table of Contents





Farmers
& Merchants Bancorp


Consolidated
Statement of Comprehensive Income





(in
thousands)





Year
      Ended December 31,2007
            
            
            2006
            
            
            2005Net
      Income
            
            $
            22,695
            
            
            $
            20,629
            
            
            $
            18,428Other
      Comprehensive Income (Loss)Unrealized
      Gains (Losses) on Derivative Instruments:Unrealized
      holding gains arising during the period, net of income tax effects of $0,
      $0 and $0 for the years ended December 31, 2007, 2006 and 2005,
      respectively.
            
            
            -
            
            
            
            -
            
            
            
            -Less:
      Reclassification adjustment for realized gains included in net income, net
      of related income tax effects of $1, $(6) and $(10) for the years ended
      December 31, 2007, 2006 and 2005, respectively.
            
            
            2
            
            
            
            (7
            )
            
            
            (14
            )Unrealized
      Gains on Minimum Pension Liability Adjustment:Unrealized
      gains arising during the period, net of income tax effects of $738 for the
      year ended December 31, 2005.
            
            
            -
            
            
            
            -
            
            
            
            1,018Unrealized
      Gains (Losses) on Securities:Unrealized
      holding gains (losses) arising during the period, net of income tax
      effects of $517, $(206), and  $(1,605) for the years ended
      December 31, 2007, 2006 and 2005, respectively.
            
            
            712
            
            
            
            (284
            )
            
            
            (2,211
            )Less:
      Reclassification adjustment for realized losses included in net income,
      net of related income tax effects of $718, $912, and $401 for the years
      ended December 31, 2007, 2006 and 2005, respectively.
            
            
            989
            
            
            
            1,256
            
            
            
            552Total Other Comprehensive Income
      (Loss)
            
            
            1,703
            
            
            
            965
            
            
            
            (655
            )Comprehensive Income
            
            $
            24,398
            
            
            $
            21,594
            
            
            $
            17,773


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





51
 Table of Contents





Farmers
& Merchants Bancorp


Consolidated
Statement of Cash Flows





(in
thousands)





Year
      Ended December 31,2007
            
            
            2006
            
            
            2005Operating
      ActivitiesNet
      Income
            
            $
            22,695
            
            
            $
            20,629
            
            
            $
            18,428Adjustments
      to Reconcile Net Income to Net Cash Provided by Operating
      Activities:Provision
      for Loan Losses
            
            
            1,495
            
            
            
            275
            
            
            
            425Depreciation
      and Amortization
            
            
            1,933
            
            
            
            1,892
            
            
            
            1,611Provision
      for Deferred Income Taxes
            
            
            (2,316
            )
            
            
            (1,169
            )
            
            
            (1,874
            )Net
      Amortization (Accretion) of Investment Security Premium &
      Discounts
            
            
            213
            
            
            
            (166
            )
            
            
            602Net
      Loss on Investment Securities
            
            
            1,707
            
            
            
            2,168
            
            
            
            953Net
      Gain on Sale of Property & Equipment
            
            
            (12
            )
            
            
            (6
            )
            
            
            (1
            )Net
      Change in Operating Assets & Liabilities:Net
      Increase in Interest Receivable and Other Assets
            
            
            (5,338
            )
            
            
            (9,133
            )
            
            
            (2,846
            )Net Increase (Decrease) in Interest Payable and
      Other Liabilities
            
            
            3,177
            
            
            
            6,329
            
            
            
            (245
            )Net Cash Provided by Operating
      Activities
            
            
            23,554
            
            
            
            20,819
            
            
            
            17,053Investing
      ActivitiesSecurities
      Available-for-Sale:Purchased
            
            
            (43,577
            )
            
            
            (72,910
            )
            
            
            (70,058
            )Sold,
      Matured or Called
            
            
            35,254
            
            
            
            98,041
            
            
            
            93,179Securities
      Held-to-Maturity:Purchased
            
            
            (2,424
            )
            
            
            (7,347
            )
            
            
            (30,622
            )Matured
      or Called
            
            
            7,994
            
            
            
            5,964
            
            
            
            10,583Net
      Loans Originated or Acquired
            
            
            (95,430
            )
            
            
            (74,494
            )
            
            
            (107,216
            )Principal
      Collected on Loans Previously Charged Off
            
            
            262
            
            
            
            803
            
            
            
            575Net
      Additions to Premises and Equipment
            
            
            (1,625
            )
            
            
            (4,866
            )
            
            
            (4,162
            )Proceeds from Sale of Property &
      Equipment
            
            
            12
            
            
            
            6
            
            
            
            1Net Cash Used by Investing
      Activities
            
            
            (99,534
            )
            
            
            (54,803
            )
            
            
            (107,720
            )Financing
      ActivitiesNet
      Increase (Decrease) in Demand, Interest-Bearing Transaction and
      Savings Deposits
            
            
            48,606
            
            
            
            (48,256
            )
            
            
            64,055Net
      Increase in Time Deposits
            
            
            63,656
            
            
            
            143,444
            
            
            
            37,175Net
      (Decrease) Increase in Federal Funds Purchased
            
            
            -
            
            
            
            (650
            )
            
            
            650Net
      (Decrease) Increase in Federal Home Loan Bank Advances
            
            
            (18,578
            )
            
            
            (51,315
            )
            
            
            17,958Stock
      Repurchases
            
            
            (5,489
            )
            
            
            (5,936
            )
            
            
            (4,016
            )Cash Dividends
            
            
            (7,831
            )
            
            
            (6,966
            )
            
            
            (6,656
            )Net Cash Provided by Financing
      Activities
            
            
            80,364
            
            
            
            30,321
            
            
            
            109,166(Decrease) Increase in Cash and Cash
      Equivalents
            
            
            4,384
            
            
            
            (3,663
            )
            
            
            18,499Cash and Cash Equivalents at Beginning of
      Year
            
            
            47,006
            
            
            
            50,669
            
            
            
            32,170Cash and Cash Equivalents at End of
      Year
            
            $
            51,390
            
            
            $
            47,006
            
            
            $
            50,669Supplementary
      DataCash
      Payments Made for Income Taxes
            
            $
            14,995
            
            
            $
            12,138
            
            
            $
            12,900Interest Paid
            
            $
            31,287
            
            
            $
            22,857
            
            
            $
            13,345


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





52
 Table of Contents





Notes
to Consolidated Financial Statements




1.
Significant Accounting Policies





Farmers
& Merchants Bancorp (the Company) was organized March 10, 1999. Primary
operations are related to traditional banking activities through its subsidiary
Farmers & Merchants Bank of Central California (the Bank) which was
established in 1916. The Bank’s wholly owned subsidiaries include Farmers &
Merchants Investment Corporation and Farmers/Merchants Corp. Farmers &
Merchants Investment Corporation has been dormant since 1991. Farmers/Merchants
Corp. acts as trustee on deeds of trust originated by the Bank.





The
Company’s other subsidiaries include F & M Bancorp, Inc. and FMCB Statutory
Trust I. F & M Bancorp, Inc. was created in March 2002 to protect the name F
& M Bank. During 2002, the Company completed a fictitious name filing in
California to begin using the streamlined name, “F & M Bank” as part of a
larger effort to enhance the Company’s image and build brand name recognition.
In December 2003, the Company formed a wholly owned subsidiary, FMCB Statutory
Trust I. FMCB Statutory Trust I is a non-consolidated subsidiary per generally
accepted accounting principles (GAAP), and was formed for the sole purpose of
issuing Trust Preferred Securities. The accounting and reporting policies of the
Company conform to accounting principles generally accepted in the United States
of America and prevailing practice within the banking industry. The following is
a summary of the significant accounting and reporting policies used in preparing
the consolidated financial statements.





Basis
of Presentation


The
accompanying consolidated financial statements of the Company have been prepared
in accordance with accounting principles generally accepted in the United States
of America for financial information and with the instructions to Form 10-K and
Article 9 of Regulation S-X.





The
accompanying consolidated financial statements include the accounts of the
Company and the Company’s wholly owned subsidiaries, F & M Bancorp, Inc. and
the Bank, along with the Bank’s wholly owned subsidiaries, Farmers &
Merchants Investment Corporation and Farmers/Merchants Corp. Significant
inter-company transactions have been eliminated in consolidation.





The
preparation of consolidated financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions. These estimates and assumptions
affect the reported amounts of assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses during
the reporting period. Actual results could differ from these
estimates.





Certain
amounts in the prior years' financial statements and related footnote
disclosures have been reclassified to conform to the current-year presentation.
These reclassifications have no effect on previously reported
income.





Cash
and Cash Equivalents


For
purposes of the Consolidated Statement of Cash Flows, the Company has defined
cash and cash equivalents as those amounts included in the balance sheet
captions Cash and Due from Banks, Federal Funds Sold and Securities Purchased
Under Agreements to Resell. Generally, these transactions are for one-day
periods. For these instruments, the carrying amount is a reasonable estimate of
fair value.





Investment
Securities


Investment
securities are classified at the time of purchase as held-to-maturity if it is
management’s intent and the Company has the ability to hold the securities until
maturity. These securities are carried at cost, adjusted for amortization of
premium and accretion of discount using a level yield of interest over the
estimated remaining period until maturity. Losses, reflecting a decline in value
judged by the Company to be other than temporary, are recognized in the period
in which they occur.





Securities
are classified as available-for-sale if it is management’s intent, at the time
of purchase, to hold the securities for an indefinite period of time and/or to
use the securities as part of the Company’s asset/liability management strategy.
These securities are reported at fair value with aggregate unrealized gains or
losses excluded from income and included as a separate component of
shareholders’ equity, net of related income taxes. Fair values are based on
quoted market prices or broker/dealer price quotations on a specific
identification basis. Gains or losses on the sale of these securities are
computed using the specific identification method.





53
 Table of Contents





Trading
securities, if any, are acquired for short-term appreciation and are recorded in
a trading portfolio and are carried at fair value, with unrealized gains and
losses recorded in non-interest income.





Investment
securities are evaluated for impairment on at least a quarterly basis and more
frequently when economic or market conditions warrant such an evaluation to
determine whether a decline in their value is other than temporary. Management
utilizes criteria such as the magnitude and duration of the decline and the
intent and ability of the Company to retain its investment in the securities for
a period of time sufficient to allow for an anticipated recovery in fair value,
in addition to the reasons underlying the decline, to determine whether the loss
in value is other than temporary. The term “other than temporary” is not
intended to indicate that the decline is permanent, but indicates that the
prospect for a near-term recovery of value is not necessarily favorable, or that
there is a lack of evidence to support a realizable value equal to or greater
than the carrying value of the investment. Once a decline in value is determined
to be other than temporary, the value of the security is reduced and a
corresponding charge to earnings is recognized.





Loans


Loans are
reported at the principal amount outstanding net of unearned discounts and
deferred loan fees and costs. Interest income on loans is accrued daily on the
outstanding balances using the simple interest method. Loan origination fees are
deferred and recognized over the contractual life of the loan as an adjustment
to the yield. Loans are placed on non-accrual status when the collection of
principal or interest is in doubt or when they become past due for 90 days or
more unless they are both well-secured and in the process of collection. For
this purpose a loan is considered well-secured if it is collateralized by
property having a net realizable value in excess of the amount of the loan or is
guaranteed by a financially capable party. When a loan is placed on non-accrual
status, the accrued and unpaid interest receivable is reversed and charged
against current income; thereafter, interest income is recognized only as it is
collected in cash. Loans placed on non-accrual status are returned to accrual
status when the loans are paid current as to principal and interest and future
payments are expected to be made in accordance with the contractual terms of the
loan.





A loan is
impaired when, based on current information and events, it is probable that the
Company will be unable to collect all amounts due according to the contractual
terms of the loan agreement. When a loan is impaired, the recorded amount of the
loan in the Consolidated Balance Sheet is based on the present value of expected
future cash flows discounted at the loan’s effective interest rate, or the
observable or estimated market price of the loan or on the fair value of the
collateral if the loan is collateral dependent. Interest income on impaired
loans is reported on a cash basis.





Allowance
for Loan Losses


As a
financial institution which assumes lending and credit risks as a principal
element in its business, the Company anticipates that credit losses will be
experienced in the normal course of business. Accordingly, the allowance for
loan losses is maintained at a level considered adequate by management to
provide for losses that are inherent in the portfolio. The allowance is reduced
by charge-offs and increased by provisions charged to operating expense and by
recoveries on loans previously charged off. Management employs a systematic
methodology for determining the allowance for loan losses. On a quarterly basis,
management reviews the credit quality of the loan portfolio and considers many
factors in determining the adequacy of the allowance at the balance sheet
date.





The
factors evaluated in connection with the allowance may include existing general
economic and business conditions affecting the key lending areas of the Company,
current levels of problem loans and delinquencies, credit quality trends,
collateral values, loan volumes and concentration, seasoning of the loan
portfolio, specific industry conditions, recent loss experience, duration of the
current business cycle, bank regulatory examination results and findings of the
Company’s internal credit examiners.





54
 Table of Contents





The
allowance also incorporates the results of measuring impaired loans as provided
in Statement of Financial Accounting Standards (SFAS) No. 114, “Accounting by Creditors for
Impairment of a Loan” and SFAS No. 118, “Accounting by Creditors for
Impairment of a Loan-Income Recognition and Disclosures.” These
accounting standards prescribe the measurement methods, income recognition and
disclosures related to impaired loans, which are discussed more fully in Note 3
to these Consolidated Financial Statements.





While the
Company utilizes a systematic methodology in determining its allowance, the
allowance is based on estimates, and ultimate losses may vary from current
estimates. In addition, the Federal Deposit Insurance Corporation and the
California Department of Financial Institutions, as an integral part of their
examination process, review the allowance for loan losses. These agencies may
require additions to the allowance for loan losses based on their judgment about
information available at the time of their examinations.





Premises
and Equipment


Premises,
equipment and leasehold improvements are stated at cost, less accumulated
depreciation and amortization. Depreciation is computed principally by the
straight line method over the estimated useful lives of the assets. Estimated
useful lives of buildings range from 30 to 40 years, and for furniture and
equipment from 3 to 7 years. Leasehold improvements are amortized over the
lesser of the terms of the respective leases, or their useful lives, which are
generally 5 to 10 years. Remodeling and capital improvements are capitalized
while maintenance and repairs are charged directly to occupancy
expense.





Other
Real Estate


Other
real estate, which is included in other assets, is comprised of properties no
longer utilized for business operations and property acquired through
foreclosure in satisfaction of indebtedness. These properties are recorded at
fair value less estimated selling costs upon acquisition. Revised estimates to
the fair value less cost to sell are reported as adjustments to the carrying
amount of the asset, provided that such adjusted value is not in excess of the
carrying amount at acquisition. Initial losses on properties acquired through
full or partial satisfaction of debt are treated as credit losses and charged to
the allowance for loan losses at the time of acquisition. Subsequent declines in
value from the recorded amounts, routine holding costs, and gains or losses upon
disposition, if any, are included in non-interest income or expense as
incurred.





Income
Taxes


The
Company uses the liability method of accounting for income taxes. This method
results in the recognition of deferred tax assets and liabilities that are
reflected at currently enacted income tax rates applicable to the period in
which the deferred tax assets or liabilities are expected to be realized or
settled. As changes in tax laws or rates are enacted, deferred tax assets and
liabilities are adjusted through the provision for income taxes. The deferred
provision for income taxes is the result of the net change in the deferred tax
asset and deferred tax liability balances during the year. This amount combined
with the current taxes payable or refundable results in the income tax expense
for the current year.





On
January 1, 2007, the Company adopted Financial Accounting Standards Board
(“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income
Taxes (“FIN 48”).”  FIN 48 clarifies the accounting for
uncertainty in income taxes recognized in an enterprise’s financial statements
in accordance with FASB Statement No. 109, “Accounting for Income
Taxes.”  FIN 48 prescribes a recognition threshold and
measurement standard for the financial statement recognition and measurement of
an income tax position taken or expected to be taken in a tax return.  In
addition, FIN 48 provides guidance on derecognition, classification, interest
and penalties, accounting in interim periods, disclosure and
transition.





The
provisions of FIN 48 have been applied to all tax positions of the Company as of
January 1, 2007. Only tax provisions that met the more-likely-than-not
recognition threshold on January 1, 2007, were recognized or continue to be
recognized upon adoption. The Company previously recognized income tax positions
based on management’s estimate of whether it was reasonably possible that a
liability had been incurred for all recognized tax benefits by applying
Statement of Financial Accounting Standards No. 5, “Accounting for
Contingencies.”





The
adoption of FIN 48 did not have a material impact on the Company’s financial
position, results of operations or cash flows.





55
 Table of Contents





When tax
returns are filed, it is highly certain that some positions taken would be
sustained upon examination by the taxing authorities, while others are subject
to uncertainty about the merits of the position taken or the amount of the
position that would be ultimately sustained.  The benefit of a tax position
is recognized in the financial statements in the period during which, based on
all available evidence, management believes it is more likely than not that the
position will be sustained upon examination, including the resolution of appeals
or litigation processes, if any.  Tax positions taken are not offset or
aggregated with other positions.  Tax positions that meet the
more-likely-than-not recognition threshold are measured as the largest amount of
tax benefit that is more than 50 percent likely of being realized upon
settlement with the applicable taxing authority.  The portion of the
benefits associated with tax positions taken that exceeds the amount measured as
described above is reflected as a liability for unrecognized tax benefits in the
accompanying balance sheet along with any associated interest and penalties that
would be payable to the taxing authorities upon examination.





Interest
expense and penalties associated with unrecognized tax benefits are classified
as income tax expense in the consolidated statement of income.





Dividends
and Earnings Per Share


Farmers
& Merchants Bancorp common stock is not traded on any exchange. The shares
are primarily held by local residents and are not actively traded.





No stock
dividends were declared during 2007 and 2006. The Board of Directors declared a
5% stock dividend in 2005. Common stock shareholders received one share of
common stock for every 20 shares of common stock owned. Fractional shares were
not issued. For common stock share lots of less than 20 shares, a cash dividend
in the amount of $22.62 was paid in lieu of the stock dividend for the year
2005.





Total
cash dividends during 2007 were $7,831,000 or $9.70 per share of common stock,
an increase of 13.4% from $6,966,000 or $8.55 per share in 2006. In 2005 cash
dividends totaled $6,366,000 or $7.68 per share. Prior periods have been
restated where applicable for stock dividends paid.





Earnings
per share for the years ending December 31, 2007, 2006 and 2005 were $28.05,
$25.25 and $22.24, respectively, and were computed by dividing net income by the
weighted average number of common shares outstanding for the period. The
weighted average number of shares outstanding for the three years ending
December 31, 2007, 2006 and 2005 were 809,057, 817,044 and 828,537,
respectively. Prior periods have been restated where applicable for stock
dividends paid.





Segment
Reporting


Statement
of Financial Accounting Standards No. 131, “Disclosures about Segments of an
Enterprise and Related Information” requires that public companies report
certain information about operating segments. It also requires that public
companies report certain information about their products and services, the
geographic areas in which they operate, and their major customers. The Company
is a holding company for a community bank which offers a wide array of products
and services to its customers. Pursuant to its banking strategy, emphasis is
placed on building relationships with its customers, as opposed to building
specific lines of business. As a result, the Company is not organized around
discernable lines of business and prefers to work as an integrated unit to
customize solutions for its customers, with business line emphasis and product
offerings changing over time as needs and demands change. Therefore, the Company
only reports one segment.





Derivative
Instruments and Hedging Activities


Statement
of Financial Accounting Standards, No. 133, “Accounting for Derivative
Instruments and Certain Hedging Activities” as amended by the Statement
of Financial Accounting Standards, No. 138, establishes accounting and reporting
standards for derivative instruments, including certain derivative instruments
embedded in other contracts, and for hedging activities. All derivatives,
whether designated in hedging relationships or not, are required to be recorded
on the balance sheet at fair value. Changes in the fair value of those
derivatives are accounted for depending on the intended use of the derivative
and the resulting designation under specified criteria. If the derivative is
designated as a fair value hedge, the changes in the fair value of the
derivative and of the hedged item attributable to the hedged risk are recognized
in earnings. If the derivative is designated as a cash flow hedge, designed to
minimize interest rate risk, the effective portions of the change in the fair
value of the derivative are recorded in other comprehensive income (loss), net
of related income taxes. Ineffective portions of changes in the fair value of
cash flow hedges are recognized in earnings.





56
 Table of Contents





The
Company utilizes derivative financial instruments such as interest rate caps,
floors, swaps and collars. These instruments are purchased and/or sold to reduce
the Company’s exposure to changing interest rates. The Company marks to market
the value of its derivative financial instruments and reflects gain or loss in
earnings in the period of change or in other comprehensive income (loss). The
Company was not utilizing any derivative instruments as of December 31,
2007.





Comprehensive
Income


Statement
of Financial Accounting Standards No. 130, “Reporting Comprehensive
Income” establishes standards for the reporting and display of
comprehensive income and its components in the financial statements. Other
comprehensive income refers to revenues, expenses, gains and losses that
generally accepted accounting principles recognize as changes in value to an
enterprise but are excluded from net income. For the Company, comprehensive
income (loss) includes net income and changes in fair value of its
available-for-sale investment securities, minimum pension liability adjustments
and cash flow hedges.





2.
Investment Securities





The
amortized cost, fair values and unrealized gains and losses of the securities
available-for-sale are
as follows:


(in
thousands)





Amortized
            
            
            Gross Unrealized
            
            
            Fair/BookDecember 31, 2007
            
            Cost
            
            
            Gains
            
            
            Losses
            
            
            ValueObligations
      of States and Political Subdivisions
            
            $
            9,957
            
            
            $
            22
            
            
            $
            -
            
            
            $
            9,979Mortgage-backed
      Securities
            
            
            124,470
            
            
            
            1,778
            
            
            
            104
            
            
            
            126,144Other
            
            
            5,920
            
            
            
            -
            
            
            
            -
            
            
            
            5,920Total
            
            $
            140,347
            
            
            $
            1,800
            
            
            $
            104
            
            
            $
            142,043





Amortized
            
            
            Gross Unrealized
            
            
            Fair/BookDecember 31, 2006
            
            Cost
            
            
            Gains
            
            
            Losses
            
            
            ValueObligations
      of States and Political Subdivisions
            
            $
            11,224
            
            
            $
            59
            
            
            $
            9
            
            
            $
            11,274Mortgage-backed
      Securities
            
            
            110,568
            
            
            
            109
            
            
            
            1,292
            
            
            
            109,385Other
            
            
            12,075
            
            
            
            -
            
            
            
            107
            
            
            
            11,968Total
            
            $
            133,867
            
            
            $
            168
            
            
            $
            1,408
            
            
            $
            132,627





Included
with the 2007 available-for-sale “Other
Securities Fair/Book Value” total of $ 5.9 million was $ 4.8 million of FHLB
stock. Included with the 2006 available-for-sale“Other
Securities Fair/Book Value” total of $11.9 million was $7.7 million of FHLB
stock.





The book
values, estimated fair values and unrealized gains and losses of investments
classified as held-to-maturity are as
follows: (in
thousands)





Book
            
            
            Gross Unrealized
            
            
            FairDecember 31, 2007
            
            Value
            
            
            Gains
            
            
            Losses
            
            
            ValueSecurities
      of U.S. Government Agencies
            
            $
            30,435
            
            
            $
            352
            
            
            $
            5
            
            
            $
            30,782Obligations
      of States and Political Subdivisions
            
            
            66,375
            
            
            
            460
            
            
            
            122
            
            
            
            66,713Mortgage-backed
      Securities
            
            
            6,731
            
            
            
            -
            
            
            
            28
            
            
            
            6,703Other
            
            
            2,053
            
            
            
            2
            
            
            
            -
            
            
            
            2,055Total
            
            $
            105,594
            
            
            $
            814
            
            
            $
            155
            
            
            $
            106,253





57
 Table of Contents




Book
            
            
            Gross Unrealized
            
            
            FairDecember 31, 2006
            
            Value
            
            
            Gains
            
            
            Losses
            
            
            ValueSecurities
      of U.S. Government Agencies
            
            $
            30,539
            
            
            $
            -
            
            
            $
            735
            
            
            $
            29,804Obligations
      of States and Political Subdivisions
            
            
            69,910
            
            
            
            319
            
            
            
            334
            
            
            
            69,895Mortgage-backed
      Securities
            
            
            8,677
            
            
            
            -
            
            
            
            365
            
            
            
            8,312Other
            
            
            2,114
            
            
            
            7
            
            
            
            -
            
            
            
            2,121Total
            
            $
            111,240
            
            
            $
            326
            
            
            $
            1,434
            
            
            $
            110,132





Fair
values are based on quoted market prices or dealer quotes. If a quoted market
price or dealer quote is not available, fair value is estimated using quoted
market prices for similar securities.





The
remaining principal maturities of debt securities as of December 31, 2007, and
2006 are shown in the following tables. Mortgage-Backed Securities are presented
based on expected maturities. Expected maturities may differ from contractual
maturities as borrowers may have the right to call or prepay obligations with or
without call or prepayment penalties.





After
      1
            
            
            After
      5
            
            
            
            
            
            TotalSecurities
      Available-for-Sale
            
            Within
            
            
            but
            
            
            but
            
            
            Over
            
            
            FairDecember 31, 2007(in
      thousands)
            
            1 Year
            
            
            Within 5
            
            
            Within 10
            
            
            10 years
            
            
            ValueObligations
      of States and Political Subdivisions
            
            $
            2,440
            
            
            $
            3,693
            
            
            $
            -
            
            
            $
            3,846
            
            
            $
            9,979Mortgage-backed
      Securities
            
            
            -
            
            
            
            -
            
            
            
            1,561
            
            
            
            124,583
            
            
            
            126,144Other
            
            
            5,920
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            5,920Total
            
            $
            8,360
            
            
            $
            3,693
            
            
            $
            1,561
            
            
            $
            128,429
            
            
            $
            142,0432006 Totals
            
            $
            14,558
            
            
            $
            6,436
            
            
            $
            -
            
            
            $
            111,633
            
            
            $
            132,627





After
      1
            
            
            After
      5
            
            
            
            
            
            TotalSecurities
      Held-to-Maturity
            
            Within
            
            
            but
            
            
            but
            
            
            Over
            
            
            BookDecember 31, 2007(in
      thousands)
            
            1 Year
            
            
            Within 5
            
            
            Within 10
            
            
            10 years
            
            
            ValueSecurities
      of U.S. Government Agencies
            
            $
            -
            
            
            $
            30,435
            
            
            $
            -
            
            
            $
            -
            
            
            $
            30,435Obligations
      of States and Political Subdivisions
            
            
            5,340
            
            
            
            4,148
            
            
            
            16,277
            
            
            
            40,610
            
            
            
            66,375Mortgage-backed
      Securities
            
            
            -
            
            
            
            6,731
            
            
            
            -
            
            
            
            -
            
            
            
            6,731Other
            
            
            -
            
            
            
            -
            
            
            
            72
            
            
            
            1,981
            
            
            
            2,053Total
            
            $
            5,340
            
            
            $
            41,314
            
            
            $
            16,349
            
            
            $
            42,591
            
            
            $
            105,5942006 Totals
            
            $
            3,769
            
            
            $
            28,468
            
            
            $
            29,628
            
            
            $
            49,375
            
            
            $
            111,240





The
following tables show those investments with gross unrealized losses and their
market value aggregated by investment category and length of time that
individual securities have been in a continuous unrealized loss position at the
dates indicated.





Less Than 12 Months
            
            
            12 Months or More
            
            
            TotalDecember
      31, 2007
            
            Fair
            
            
            Unrealized
            
            
            Fair
            
            
            Unrealized
            
            
            Fair
            
            
            Unrealized(in thousands)
            
            Value
            
            
            Loss
            
            
            Value
            
            
            Loss
            
            
            Value
            
            
            LossSecurities
      of U.S. Government Agencies
            
            $
            -
            
            
            $
            -
            
            
            $
            9,995
            
            
            $
            5
            
            
            $
            9,995
            
            
            $
            5Obligations
      of States and Political Subdivisions
            
            
            4,974
            
            
            
            33
            
            
            
            14,338
            
            
            
            89
            
            
            
            19,312
            
            
            
            122Mortgage-backed
      Securities
            
            
            -
            
            
            
            -
            
            
            
            19,057
            
            
            
            132
            
            
            
            19,057
            
            
            
            132Other
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Total
            
            $
            4,974
            
            
            $
            33
            
            
            $
            43,390
            
            
            $
            226
            
            
            $
            48,364
            
            
            $
            259





58
 Table of Contents




Less Than 12 Months
            
            
            12 Months or More
            
            
            TotalDecember
      31, 2006
            
            Fair
            
            
            Unrealized
            
            
            Fair
            
            
            Unrealized
            
            
            Fair
            
            
            Unrealized(in thousands)
            
            Value
            
            
            Loss
            
            
            Value
            
            
            Loss
            
            
            Value
            
            
            LossSecurities
      of U.S. Government Agencies
            
            $
            -
            
            
            $
            -
            
            
            $
            29,804
            
            
            $
            735
            
            
            $
            29,804
            
            
            $
            735Obligations
      of States and Political Subdivisions
            
            
            10,520
            
            
            
            40
            
            
            
            19,435
            
            
            
            304
            
            
            
            29,955
            
            
            
            344Mortgage-backed
      Securities
            
            
            66,583
            
            
            
            589
            
            
            
            32,785
            
            
            
            1,067
            
            
            
            99,368
            
            
            
            1,656Other
            
            
            3,893
            
            
            
            107
            
            
            
            -
            
            
            
            -
            
            
            
            3,893
            
            
            
            107Total
            
            $
            80,996
            
            
            $
            736
            
            
            $
            82,024
            
            
            $
            2,106
            
            
            $
            163,020
            
            
            $
            2,842





As of
December 31, 2007, the Company held 187 investment securities of which 9 were in
a loss position for less than twelve months and 32 were in a loss position and
had been in a loss position for twelve months or more. Management periodically
evaluates each investment security for other than temporary impairment relying
primarily on industry analyst reports and observations of market conditions and
interest rate fluctuations. Management believes it will be able to collect all
amounts due according to the contractual terms of the underlying investment
securities.





Securities
of U.S. Government Agencies and Obligations of States and Political
Subdivisions


The
unrealized losses on the Company's investments in U.S. government agencies and
obligations of states and political subdivisions were caused by interest rate
increases. The contractual terms of these investments do not permit the issuer
to settle the securities at a price less than the amortized cost of the
investment. Because the Company has the ability and intent to hold these
investments until a recovery of fair value, which may be maturity, the Company
does not consider these investments to be other-than-temporarily impaired at
December 31, 2007.





Mortgage-backed
Securities


The
unrealized losses on the Company's investment in mortgage-backed securities were
caused by interest rate increases. The contractual cash flows of these
investments are guaranteed by an agency of the U.S. government. Accordingly, it
is expected that the securities would not be settled at a price less than the
amortized cost of the Company's investment. Because the decline in market value
is attributable to changes in interest rates and not credit quality, and because
the Company has the ability and intent to hold these investments until a
recovery of fair value, which may be maturity, the Company does not consider
these investments to be other-than-temporarily impaired at December 31,
2007.





Proceeds
from sales of securities available-for-sale were as follows:


(in
      thousands)
            
            Gross
            
            
            Gross
            
            
            GrossProceeds
            
            
            Gains
            
            
            Losses2007
            
            $
            2,006
            
            
            $
            1
            
            
            $
            112006
            
            
            63,760
            
            
            
            1
            
            
            
            2,1692005
            
            
            64,635
            
            
            
            163
            
            
            
            1,116





As of
December 31, 2007, securities carried at $218,687,000 were pledged to secure
public deposits, FHLB borrowings and other government agency deposits as
required by law. This amount at December 31, 2006, was
$196,459,000.





59
 Table of Contents





3.
Loans and Allowance for Loan Losses





Loans as
of December 31, consisted of the following:




(in thousands)
            
            2007
            
            
            2006Commercial
      Real Estate
            
            $
            453,815
            
            
            $
            410,458Real
      Estate Construction
            
            
            80,651
            
            
            
            95,378Residential
      1st Mortgages
            
            
            109,764
            
            
            
            106,148Home
      Equity Lines and Loans
            
            
            65,953
            
            
            
            67,132Agricultural
            
            
            215,798
            
            
            
            183,589Commercial
            
            
            197,108
            
            
            
            165,412Consumer and Other
            
            
            20,061
            
            
            
            21,222Subtotal
            
            
            1,143,150
            
            
            
            1,049,339Deferred
      Loan Origination Fees, Net
            
            
            (2,181
            )
            
            
            (2,427
            )Allowance for Loan Losses
            
            
            (18,483
            )
            
            
            (18,099
            )Net Loans
            
            $
            1,122,486
            
            
            $
            1,028,813





A portion
of pledged loans totaling $223,859,000 were used to secure Federal Home Loan
Bank advances of $28,200,000 and the unused commitments.





Changes
in the allowance for loan losses consisted of the following:






(in thousands)
            
            2007
            
            
            2006
            
            
            2005Balance,
      January 1
            
            $
            18,099
            
            
            $
            17,860
            
            
            $
            17,727Provision
      Charged to Operating Expense
            
            
            1,495
            
            
            
            275
            
            
            
            425Recoveries
      of Loans Previously Charged Off
            
            
            262
            
            
            
            803
            
            
            
            575Loans Charged Off
            
            
            (1,373
            )
            
            
            (839
            )
            
            
            (867
            )Balance, December 31
            
            $
            18,483
            
            
            $
            18,099
            
            
            $
            17,860





All
impaired loans have been assigned a related allowance for loan losses. As of
December 31, 2007, and 2006 the total recorded investment in impaired loans was
$186,000 and $39,000, respectively. The related allowance for impaired loans was
$28,000 and $10,000 for the years ended 2007 and 2006, respectively. The average
balance of impaired loans was $427,000, $250,000 and $412,000 for the years
ended 2007, 2006 and 2005, respectively. There was no interest income reported
on impaired loans in 2007, 2006 and 2005. Interest income forgone on loans
placed on non-accrual status was $31,000­­­­, $15,000 and
$50,000 for the years ended December 31, 2007, 2006 and 2005,
respectively.





4.
Premises and Equipment





Premises
and equipment as of December 31, consisted of the following:




(in thousands)
            
            2007
            
            
            2006Land
      and Buildings
            
            $
            24,288
            
            
            $
            24,248Furniture,
      Fixtures and Equipment
            
            
            18,457
            
            
            
            16,984Leasehold Improvements
            
            
            2,368
            
            
            
            2,257Subtotal
            
            
            45,113
            
            
            
            43,489Less:  Accumulated Depreciation and
      Amortization
            
            
            24,925
            
            
            
            22,993Total
            
            $
            20,188
            
            
            $
            20,496





Depreciation
and amortization on premises and equipment included in occupancy and equipment
expense amounted to $1,973,000, $1,892,000 and $1,611,000 for the years ended
December 31, 2007, 2006 and 2005, respectively. Total rental expense for
premises was $496,000, $375,000 and $268,000 for the years ended December 31,
2007, 2006 and 2005, respectively. Rental income was $153,000, $116,000 and
$109,000 for the years ended December 31, 2007, 2006 and 2005,
respectively.





60
 Table of Contents





5.
Other Real Estate





The Bank
reported $251,000 in other real estate at December 31, 2007, and none in 2006.
Other real estate includes property no longer utilized for business operations
and property acquired through foreclosure proceedings. These properties are
carried at the lower of cost or fair value less selling costs determined at the
date acquired. Losses arising from properties acquired through foreclosure are
charged against the allowance for loan losses. Subsequent declines in value,
routine holding costs and net gains or losses on disposition are included in
other operating expense as incurred.





6.
Time Deposits





Time
Deposits of $100,000 or more as of December 31, were as follows:


(in
thousands)


2007
            
            
            2006Balance
            
            $
            388,291
            
            
            $
            340,287





At
December 31, 2007, the scheduled maturities of time deposits were as
follows:





Scheduled(in thousands)
            
            Maturities2008
            
            $
            548,6612009
            
            
            10,7522010
            
            
            2,8902011
            
            
            7162012 & Thereafter
            
            
            129Total
            
            $
            563,148





7.
Income Taxes





Current
and deferred income tax expense (benefit) provided for the years ended December
31, consisted of the following:





(in
      thousands)
            
            2007
            
            
            2006
            
            
            2005CurrentFederal
            
            $
            11,340
            
            
            $
            9,443
            
            
            $
            8,826State
            
            
            3,984
            
            
            
            3,539
            
            
            
            3,278Total
      Current
            
            
            15,324
            
            
            
            12,982
            
            
            
            12,104DeferredFederal
            
            
            (1,963
            )
            
            
            (950
            )
            
            
            (1,508
            )State
            
            
            (491
            )
            
            
            (219
            )
            
            
            (366
            )Total
      Deferred
            
            
            (2,454
            )
            
            
            (1,169
            )
            
            
            (1,874
            )Total
      Provision for Taxes
            
            $
            12,870
            
            
            $
            11,813
            
            
            $
            10,230





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The total
provision for income taxes differs from the federal statutory rate as
follows:




(in
thousands)


2007
            
            
            2006
            
            
            2005Amount
            
            
            Rate
            
            
            Amount
            
            
            Rate
            
            
            Amount
            
            
            RateTax
      Provision at Federal Statutory Rate
            
            $
            12,448
            
            
            
            35.0
            %
            
            $
            11,355
            
            
            
            35.0
            %
            
            $
            10,030
            
            
            
            35.0
            %Interest
      on Obligations of States and Political Subdivisions Exempt from Federal
      Taxation
            
            
            (1,014
            )
            
            
            (2.9
            )%
            
            
            (1,062
            )
            
            
            (3.3
            )%
            
            
            (1,081
            )
            
            
            (3.7
            )%State
      and Local Income Taxes,Net of Federal Income Tax Benefit
            
            
            2,331
            
            
            
            6.6
            %
            
            
            2,158
            
            
            
            6.7
            %
            
            
            1,893
            
            
            
            6.6
            %Bank
      Owned Life Insurance
            
            
            (640
            )
            
            
            (1.8
            )%
            
            
            (675
            )
            
            
            (2.1
            )%
            
            
            (636
            )
            
            
            (2.2
            )%Other, Net
            
            
            (255
            )
            
            
            (0.7
            )%
            
            
            37
            
            
            
            0.1
            %
            
            
            24
            
            
            
            0.0
            %Total Provision for Taxes
            
            $
            12,870
            
            
            
            36.2
            %
            
            $
            11,813
            
            
            
            36.4
            %
            
            $
            10,230
            
            
            
            35.7
            %





The
components of the net deferred tax assets as of December 31 are as
follows:




(in thousands)
            
            2007
            
            
            2006Deferred
      Tax AssetsAllowance
      for Loan Losses
            
            $
            7,831
            
            
            $
            7,670Accrued
      Liabilities
            
            
            2,608
            
            
            
            2,214Deferred
      Compensation
            
            
            4,299
            
            
            
            3,372State
      Franchise Tax
            
            
            1,416
            
            
            
            1,249Unrealized
      Losses on Securities Available-for-Sale
            
            
            -
            
            
            
            522Impairment
      and Capital Loss Carry Forward
            
            
            352
            
            
            
            -Interest on Non-Accrual
    Loans
            
            
            13
            
            
            
            6Total Deferred Tax Assets
            
            $
            16,519
            
            
            $
            15,033Deferred
      Tax LiabilitiesPremises
      and Equipment
            
            $
            (388
            )
            
            $
            (444
            )Securities
      Accretion (zero coupon securities)
            
            
            (591
            )
            
            
            (877
            )Unrealized
      Losses on Securities Available-for-Sale
            
            
            (713
            )
            
            
            -Other
            
            
            (406
            )
            
            
            (510
            )Total Deferred Tax
    Liabilities
            
            
            (2,098
            )
            
            
            (1,831
            )Net Deferred Tax Assets
            
            $
            14,421
            
            
            $
            13,202





The net
deferred tax assets are reported in Interest Receivable and Other Assets on the
Company's Consolidated Balance Sheet.





The
Company and its subsidiaries file income tax returns in the U.S. federal and
California jurisdictions. With few exceptions, the Company is no longer subject
to U.S. federal, state and local, or non-U.S. income tax examinations by tax
authorities for years before 2003.





8.
Short Term Borrowings





As of
December 31, 2007, and 2006 the Company had unused lines of credit available for
short term liquidity purposes of $444 million and $405 million, respectively.
Federal Funds purchased and advances from the Federal Reserve Bank are generally
issued on an overnight basis. There were no Federal Funds purchased or advances
from the Federal Reserve Bank at December 31, 2007 and 2006.





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9.
Federal Home Loan Bank Advances





The
Company’s advances from the Federal Home Loan Bank of San Francisco consist of
the following as of December 31,





(in thousands)
            
            2007
            
            
            20065.60%
      amortizing note, interest and principal payable monthly with final
      maturity of September 25, 2018.
            
            $
            754
            
            
            $
            8025.38%
      fixed rate credit advance, interest payable at month end and maturity of
      January 11, 2007
            
            
            -
            
            
            
            25,0005.34%
      fixed rate credit advance, interest payable daily with a maturity of
      January 2, 2007
            
            
            -
            
            
            
            21,7303.80%
      fixed rate credit advance, interest payable daily with a maturity of
      January 2, 2008
            
            
            20,000
            
            
            
            -3.30% fixed rate credit advance, interest payable
      daily with a maturity of January 2, 2008
            
            
            8,200
            
            
            
            -Total
            
            $
            28,954
            
            
            $
            47,532





In
accordance with the Collateral Pledge and Security Agreement, advances are
secured by all Federal Home Loan Bank stock held by the Company and by agency
and mortgage-backed securities, with carrying values of $1,560,000. A
portion of pledged loans totaling $223,859,000 were used to secure Federal Home
Loan Bank advances of $28,200,000 and the unused commitments.





10.
Shareholders' Equity





From 1975
through 2005 the Company issued an annual 5% stock dividend. In 2006 the stock
dividend was discontinued. Earnings and cash dividends per share amounts have
been restated where applicable for stock dividends.





During
the second quarter of 2004, the Board of Directors of Farmers & Merchants
Bancorp approved a resolution authorizing the repurchase, from time to time, of
outstanding shares of the common stock of the Company. Repurchases will be made
on the open market or through private transactions. When the Company repurchases
shares in private transactions the price is determined based upon the most
recent transactions that have occurred between third party shareholders. The
aggregate price to be paid by the Company for all repurchased stock will not
exceed $10 million.





On April
4, 2006, the Board unanimously approved expanding the repurchase program to
allow the repurchase of up to $15 million of stock through April 30, 2009.
Repurchases under the program will continue to be made on the open market or
through private transactions. The repurchase program also requires that no
purchases may be made if the Bank would not remain “well-capitalized” after the
repurchase. All shares repurchased under the repurchase program will be
retired.





Dividends
from the Bank constitute the principal source of cash to the Company. The
Company is a legal entity separate and distinct from the Bank. Under regulations
controlling California state chartered banks, the Bank is, to some extent,
limited in the amount of dividends that can be paid to shareholders without
prior approval of the California Department of Financial Institutions. These
regulations require approval if total dividends declared by a state chartered
bank in any calendar year exceed the bank's net profits for that year combined
with its retained net profits for the preceding two calendar years. As of
December 31, 2007, the Bank could declare dividends of $24,357,000 without
approval of the California Department of Financial Institutions.





The
Company and the Bank are subject to various regulatory capital requirements
administered by the federal banking agencies. Failure to meet minimum capital
requirements can initiate certain mandatory, and possibly discretionary, actions
by regulators that, if undertaken, could have a direct material effect on the
Company’s and the Bank's financial statements. Under capital adequacy guidelines
and the regulatory framework for prompt corrective action, the Company’s and the
Bank must meet specific capital guidelines that involve quantitative measures of
the Company and the Bank's assets, liabilities, and certain off-balance sheet
items as calculated under regulatory accounting practices. The Company and the
Bank's capital amounts and classification are also subject to qualitative
judgments by the regulators about components, risk weightings, and other
factors.





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Quantitative
measures established by regulation to ensure capital adequacy require the
Company and the Bank to maintain minimum amounts and ratios set forth in the
following table of Total and Tier 1 capital to risk-weighted assets (as defined
in the regulations), and of Tier 1 capital to average assets (as defined in the
regulations). Management believes, as of December 31, 2007, that the Company and
the Bank meet all capital adequacy requirements to which they are
subject.





In
addition, the most recent notification from the FDIC categorized the Bank as
well capitalized under the regulatory framework for prompt corrective action. To
be categorized as well capitalized, the Bank must maintain minimum total
risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the
following tables. There are no conditions or events since that notification that
management believes have changed the Bank’s category.





(in
      thousands)
            
            Actual
            
            
            Regulatory
              Capital
      Requirements
            
            
            Well
      Capitalized Under Prompt Corrective ActionDecember 31, 2007
            
            Amount
            
            
            Ratio
            
            
            Amount
            
            
            Ratio
            
            
            Amount
            
            
            RatioTotal
      Bank Capital to Risk Weighted Assets
            
            $
            165,398
            
            
            
            11.93
            %
            
            $
            110,917
            
            
            
            8.0
            %
            
            $
            138,646
            
            
            
            10.0
            %Total
      Consolidated Capital to Risk Weighted Assets
            
            $
            169,837
            
            
            
            12.21
            %
            
            $
            111,272
            
            
            
            8.0
            %
            
            
            N/A
            
            
            
            N/ATier
      1 Bank Capital to Risk Weighted Assets
            
            $
            148,052
            
            
            
            10.68
            %
            
            $
            55,458
            
            
            
            4.0
            %
            
            $
            83,188
            
            
            
            6.0
            %Tier
      1 Consolidated Capital to Risk Weighted Assets
            
            $
            152,435
            
            
            
            10.96
            %
            
            $
            55,636
            
            
            
            4.0
            %
            
            
            N/A
            
            
            
            N/ATier
      1 Bank Capital to Average Assets
            
            $
            148,052
            
            
            
            10.07
            %
            
            $
            58,827
            
            
            
            4.0
            %
            
            $
            73,534
            
            
            
            5.0
            %Tier
      1 Consolidated Capital to Average Assets
            
            $
            152,435
            
            
            
            10.34
            %
            
            $
            58,951
            
            
            
            4.0
            %
            
            
            N/A
            
            
            
            N/ADecember 31, 2006
            
            Amount
            
            
            Ratio
            
            
            Amount
            
            
            Ratio
            
            
            Amount
            
            
            RatioTotal
      Bank Capital to Risk Weighted Assets
            
            $
            152,118
            
            
            
            11.69
            %
            
            $
            104,101
            
            
            
            8.0
            %
            
            $
            130,126
            
            
            
            10.0
            %Total
      Consolidated Capital to Risk Weighted Assets
            
            $
            159,336
            
            
            
            12.17
            %
            
            $
            104,698
            
            
            
            8.0
            %
            
            
            N/A
            
            
            
            N/ATier
      1 Bank Capital to Risk Weighted Assets
            
            $
            135,827
            
            
            
            10.44
            %
            
            $
            52,051
            
            
            
            4.0
            %
            
            $
            78,076
            
            
            
            6.0
            %Tier
      1 Consolidated Capital to Risk Weighted Assets
            
            $
            142,954
            
            
            
            10.92
            %
            
            $
            52,349
            
            
            
            4.0
            %
            
            
            N/A
            
            
            
            N/ATier
      1 Bank Capital to Average Assets
            
            $
            135,827
            
            
            
            9.93
            %
            
            $
            54,736
            
            
            
            4.0
            %
            
            $
            68,420
            
            
            
            5.0
            %Tier
      1 Consolidated Capital to Average Assets
            
            $
            142,954
            
            
            
            10.40
            %
            
            $
            54,979
            
            
            
            4.0
            %
            
            
            N/A
            
            
            
            N/A





11.
Employee Benefit Plans





Pension
Plan


The
Company, through the Bank, sponsored a defined benefit Pension Plan (the Plan)
that covered substantially all full-time employees of the Company. Effective
June 9, 2001, the Plan was amended to freeze the benefit accruals in the Plan.
With the exception of employees who had reached age 55 and who had accumulated
10 years of Plan service, the effect of the amendment was to freeze the
participants’ monthly pension benefit.





In
February 2005 the Board of Directors terminated the Plan. Benefits for those
employees who were still accruing benefits under the Plan were frozen on April
30, 2005, when the Plan was amended to halt all future benefit accruals. Those
employees now participate in the mandatory contributions to the Company’s Profit
Sharing Plan.





The
Company filed Form 500, Standard Termination Notice for Single Employer Plan,
with the Pension Benefit Guaranty Corporation (the “PBGC”) on October 21, 2005.
The Company did not receive a Notice of Noncompliance from the PBGC within sixty
days, so it distributed all benefits to all participants prior to December 31,
2005.





The
Company filed Form 5310, Application for Determination of Terminating Plan, with
the Internal Revenue Service on September 22, 2005. The Company received a
favorable determination letter from the Internal Revenue Service on June 19,
2006.





Because
of the Company’s decision to terminate the Plan in 2005 it elected to accelerate
the recognition of gain/loss over a two year amortization period effective
January 1, 2004, to match the remaining life of the Plan. This change in
amortization period resulted in a cumulative adjustment in the amount of
$387,000 ($224,000, net of tax).





64
 Table of Contents





The
components of the net periodic benefit costs are as follows:





(in thousands)
            
            2005Service
      Cost
            
            $
            53Interest
      Cost
            
            
            258Expected
      Return on Plan Assets
            
            
            (114
            )Amortization
      of :Unrecognized
      Prior Service Cost
            
            
            -Unrecognized Net Loss
            
            
            947Total
      Net Periodic Benefit Cost
            
            $
            1,144One-Time Charge Due to Plan
      Termination
            
            
            1,229Total Net Periodic Benefit
    Cost
            
            $
            2,373Decrease in Minimum Liability Included in Other
      Comprehensive Income
            
            $
            (1,756
            )





Weighted-average
assumptions used to determine benefit obligations at December 31,
2005.





2005Assumptions
      Used in the Accounting were:Discount
      Rate (Settlement Rate)
            
            
            4.89
            %Rate of Compensation
    Increase
            
            
            4.00
            %





Weighted-average
assumptions used to determine net benefit cost for year ended December
31,





2005Assumptions
      Used in the Accounting were:Discount
      Rate (Settlement Rate)
            
            
            4.89
            %Expected
      Return on Plan Assets
            
            
            3.00
            %Rate of Compensation
    Increase
            
            
            4.00
            %





The
Company’s Pension Plan had no weighted-average assets for the years ended
December 31, 2007, and 2006.





Profit
Sharing Plan


The
Company, through the Bank, sponsors a Profit Sharing Plan for substantially all
full-time employees of the Company with one or more years of service.
Participants receive up to two annual employer contributions, one is
discretionary and the other is mandatory. The discretionary contributions to the
Profit Sharing Plan are determined annually by the Board of Directors. The
discretionary contributions totaled $780,000, $775,000 and $725,000 for the
years ended December 31, 2007, 2006 and 2005, respectively. The mandatory
contributions to the Profit Sharing Plan are made according to a predetermined
set of criteria. Mandatory contributions totaled $780,000, $727,000 and $693,000
for the years ended December 31, 2007, 2006 and 2005, respectively. Company
employees are permitted, within limitations imposed by tax law, to make pretax
contributions to the 401(k) feature of the Profit Sharing Plan. The Company does
not match employee contributions within the 401(k) feature of the Profit Sharing
Plan and the Company can terminate the Profit Sharing Plan at any time. Benefits
pursuant to the Profit Sharing Plan vest 0% during the first year of
participation, 25% per full year thereafter and after five years such benefits
are fully vested.





Indexed
Retirement Plan and Life Insurance Arrangements


The
Company, through the Bank, sponsors an Indexed Retirement Plan for certain
employees. The Indexed Retirement Plan is a defined contribution supplemental
executive retirement plan and was developed to supplement the Company’s Profit
Sharing Plan which, as a qualified plan, has a ceiling on benefits as set by the
Internal Revenue Service.





The
Company made contributions to the Indexed Retirement Plan of $829,000, $856,000
and $802,000 for the years ended December 31, 2007, 2006 and 2005, respectively.
The Company’s total accrued liability under the Indexed Retirement Plan was
$3.88 million and $2.83 million as of December 31, 2007, and 2006, respectively.
The balance in each participant’s account is 0% vested during the first five
years of employment and becomes fully vested after five years of
employment.





65
 Table of Contents





The
Company has purchased single premium life insurance policies on the lives of the
Indexed Retirement Plan participants as well as certain other employees of the
Company. These policies provide: (1) financial protection to the Company in the
event of the death of a key employee and; (2) since the interest earned on the
cash surrender value of the policies is tax exempt as long as the policies are
used to finance employee benefits, significant income to the Company to offset
the expense associated with the Indexed Retirement Plan and other employee
benefit plans. As compensation to each employee for agreeing to allow the
Company to purchase an insurance policy on his or her life, split dollar
agreements have been entered into with those employees. These agreements provide
for a division of the life insurance death proceeds between the Company and each
employee’s designated beneficiary or beneficiaries.





The
Company earned tax exempt interest on the life insurance policies of $1.7
million for the year ended December 31, 2007, and $1.6 million for each of the
years ended December 31, 2006 and 2005. As of December 31, 2007, and 2006 the
total cash surrender value of the insurance policies was $40.2 million and $38.4
million, respectively.





Deferred
Bonus and Executive Retention Plans


The
Company, through the Bank, sponsors Deferred Bonus and Executive Retention Plans
for certain employees. Both plans grant bonuses based on the long-term
cumulative profitability and increase in market value of the Company. The
Company made contributions to both plans of $732,000, $1.4 million and $966,000
for the years ended December 31, 2007, 2006 and 2005, respectively. Benefits
pursuant to the Deferred Bonus Plan vest 0% during the first year of
participation, 25% per full year thereafter and after five years such benefits
are fully vested. Benefits pursuant to the Executive Retention Plan vest 10% per
year beginning in 2005 and after ten years are fully vested. The Company’s total
accrued liability under the Deferred Bonus and Executive Retention Plans was
$4.7 million and $3.6 million as of December 31, 2007, and 2006,
respectively.





12.
Fair Value of Financial Instruments





The
following disclosure of the estimated fair value of financial instruments is
made in accordance with the requirements of SFAS No. 107, “Disclosure about Fair Value of
Financial Instruments.” The estimated fair value amounts have been
determined by the Company using available market information and appropriate
valuation methodologies. The use of assumptions and various valuation
techniques, as well as the absence of secondary markets for certain financial
instruments, will likely reduce the comparability of fair value disclosures
between financial institutions. In some cases, book value is a reasonable
estimate of fair value due to the relatively short period of time between
origination of the instrument and its expected realization.





The
following table summarized the book value and estimated fair value of financial
instruments as of December 31:





2007
            
            
            2006Carrying
            
            
            Estimated
            
            
            Carrying
            
            
            EstimatedASSETS:(in
      thousands)
            
            Amount
            
            
            Fair Value
            
            
            Amount
            
            
            Fair ValueCash
      and Cash Equivalents
            
            $
            51,390
            
            
            $
            51,390
            
            
            $
            47,006
            
            
            $
            47,006Investment
      Securities Held-to-Maturity
            
            
            105,594
            
            
            
            106,253
            
            
            
            111,240
            
            
            
            110,132Investment
      Securities Available-for-Sale
            
            
            142,043
            
            
            
            142,043
            
            
            
            132,627
            
            
            
            132,627Loans,
      Net of Deferred Loan Origination Fees
            
            
            1,140,969
            
            
            
            1,147,264
            
            
            
            1,046,912
            
            
            
            1,025,363Cash
      Surrender Value of Life Insurance Policies
            
            
            40,180
            
            
            
            40,180
            
            
            
            38,444
            
            
            
            38,444Accrued
      Interest Receivable
            
            
            8,830
            
            
            
            8,830
            
            
            
            8,537
            
            
            
            8,537LIABILITIES:Deposits:Non-Interest
      Bearing
            
            
            307,299
            
            
            
            307,299
            
            
            
            295,142
            
            
            
            295,142Interest-Bearing
            
            
            1,003,491
            
            
            
            1,003,303
            
            
            
            903,386
            
            
            
            902,019Federal
      Home Loan Bank Advances
            
            
            28,954
            
            
            
            28,988
            
            
            
            47,532
            
            
            
            47,555Subordinated
      Debentures
            
            
            10,310
            
            
            
            10,184
            
            
            
            10,310
            
            
            
            10,281Accrued
      Interest Payable
            
            
            4,835
            
            
            
            4,835
            
            
            
            3,897
            
            
            
            3,897





66
 Table of Contents





The
methods and assumptions used to estimate the fair value of each class of
financial instrument listed in the table above are explained below.





Cash and Cash Equivalents:
The carrying amounts reported in the balance sheet for cash and due from banks,
federal funds sold and securities purchased under agreements to resell are a
reasonable estimate of fair value.





Investment Securities: Fair
values for investment securities are based on quoted market prices or dealer
quotes, where available. If quoted market prices or dealer quotes are not
available, fair values are based on quoted market prices of comparable
instruments.





Loans: For variable-rate
loans that reprice frequently and with no significant change in credit risk,
fair values are based on carrying values. The fair values for fixed-rate loans
are estimated using discounted cash flow analyses, using interest rates
currently being offered for loans with similar terms to borrowers of similar
credit quality. The carrying amount of accrued interest receivable approximates
its fair value.





Cash Surrender Value of Life
Insurance Policies: The fair value of life insurance policies are based
on cash surrender values at each reporting date as provided by the
insurers.





Deposit Liabilities: The fair
value of demand deposits, interest bearing transaction accounts and savings
accounts is the amount payable on demand. The fair value of fixed-maturity
certificates of deposit is estimated by discounting expected future cash flows
utilizing interest rates currently being offered for deposits of similar
remaining maturities. The carrying amount of accrued interest payable
approximates its fair value.





Borrowings: The fair value of
federal funds purchased and other short-term borrowings is approximated by the
book value. The fair value for Federal Home Loan Bank borrowings is determined
using discounted future cash flows.





Subordinated Debentures: Fair
values of subordinated debentures were determined based on the current market
value of like-kind instruments of a similar maturity and structure.





Limitations: Fair value
estimates presented herein are based on pertinent information available to
management as of December 31, 2007, and 2006. Although management is not aware
of any factors that would significantly affect the estimated fair value amounts,
such amounts have not been comprehensively revalued for purposes of these
financial statements since that date, and therefore, current estimates of fair
value may differ significantly from the amounts presented above.





13.
Derivative Instruments and Hedging Activities





The
Company uses derivative instruments to limit its exposure to changes in interest
rates. The Company has developed a Hedging Policy to provide guidelines that
address instruments to be used, authority limits, implementation guidelines,
guidelines for evaluating hedge alternatives, reporting requirements, and the
credit worthiness of the instrument’s counterparty.





The
Company reviews compliance with these guidelines annually with the ALCO
Committee and the Board of Directors. The guidelines may change as the Company’s
business needs dictate.





As
required, the Company records in the balance sheet the interest rate swaps at
fair value. Because the transactions meet the criteria for a cash-flow hedge,
changes in fair value are reported in other comprehensive income (loss). In the
event that a portion of the hedge becomes ineffective, the ineffective portion
of the derivative’s change in fair value will be immediately recognized in
earnings.





The
Company recognized a deferred gain on an interest rate swap agreement in the
amount of $37,500 in 2005 and 2006 and none in 2007.





67
 Table of Contents





14.
Commitments and Contingencies





In the
normal course of business, the Company is a party to financial instruments with
off-balance sheet risk to meet the financing needs of its customers and to
reduce its own exposure to fluctuations in interest rates. These instruments
include commitments to extend credit, letters of credit and financial guarantees
that are not reflected in the Consolidated Balance Sheet.





The
Company's exposure to credit loss in the event of nonperformance by the other
party with regard to standby letters of credit, undisbursed loan commitments and
financial guarantees is represented by the contractual notional amount of those
instruments. Commitments to extend credit are agreements to lend to a customer
as long as there is no violation of any condition established in the contract.
The Company uses the same credit policies in making commitments and conditional
obligations as it does for recorded balance sheet items. The Company may or may
not require collateral or other security to support financial instruments with
credit risk. Evaluations of each customer's creditworthiness are performed on a
case-by-case basis.





Standby
letters of credit are conditional commitments issued by the Company to guarantee
performance of or payment for a customer to a third party. The Company had
standby letters of credit outstanding of $8,409,000 at December 31, 2007, and
$10,929,000 at December 31, 2006. Outstanding standby letters of credit had
original terms ranging from 1 to 27 months with final expiration in 2010.
Commitments generally have fixed expiration dates or other termination clauses
and may require payment of a fee. Undisbursed loan commitments totaled
$440,258,000 and $442,544,000 as of December 31, 2007, and 2006,
respectively. Since many of these commitments are expected to expire without
fully being drawn upon, the total commitment amounts do not necessarily
represent future cash requirements.





The
Company is obligated under a number of noncancellable operating leases for
premises and equipment used for banking purposes. Minimum future rental
commitments under noncancellable operating leases as of December 31, 2007, were
$447,000, $393,000, $349,000, $307,000, and $220,000 for the years 2008 through
2012 and $669,000 thereafter.





In the
ordinary course of business, the Company becomes involved in litigation arising
out of its normal business activities. Management, after consultation with legal
counsel, believes that the ultimate liability, if any, resulting from the
disposition of such claims would not be material in relation to the financial
position of the Company.





The
Company may be required to maintain average reserves on deposit with the Federal
Reserve Bank primarily based on deposits outstanding. There were no reserve
requirements during 2007 or 2006.





15. Recent
Accounting Developments





In
September 2006 the FASB issued Statement No. 157 (SFAS 157), “Fair Value Measurements.”
SFAS 157 defines fair value, establishes a framework for measuring fair value
and expands disclosures about fair value measurements. SFAS 157 applies whenever
other standards require (or permit) assets or liabilities to be measured at fair
value but does not expand the use of fair value in any new circumstances. In
this standard, the FASB clarifies the principle that fair value should be based
on the assumptions market participants would use when pricing the asset or
liability. In support of this principle, SFAS 157 establishes a fair value
hierarchy that prioritizes the information used to develop those assumptions.
The provisions of SFAS 157 are effective for financial statements issued for
fiscal years beginning after November 15, 2007, and interim periods within those
fiscal years. Management has completed its evaluation of the adoption of SFAS
157 and has determined that it will not have a material impact on the Company’s
financial position or results of operations.





In
February 2007 the FASB issued SFAS No. 159, “The Fair Value Option for Financial
Assets and Financial Liabilities – Including an Amendment of FASB Statement No.
115.” This Statement permits entities to choose to measure many financial
instruments and certain other items at fair value. Unrealized gains and losses
on items for which the fair value option has been elected will be reported in
earnings. 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. This Statement is expected to expand the
use of fair value measurement, which is consistent with the FASB’s long-term
measurement objectives for accounting for financial instruments.  SFAS
No. 159 is effective for fiscal years beginning after November 15, 2007.
Management has completed its evaluation of the adoption of SFAS 159 and has
determined that it will not have a material impact on the Company’s financial
position or results of operations.





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In
September 2006 the FASB ratified the consensuses reached by the Task Force on
Issue No. 06-4 (EITF 06-4) “Accounting for Deferred Compensation
and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance
Arrangements.” A question arose when an employer enters into an
endorsement split-dollar life insurance arrangement related to whether the
employer should recognize a liability for the future benefits or premiums to be
provided to the employee. EITF 06-4 indicates that an employer should recognize
a liability for future benefits and that a liability for the benefit obligation
has not been settled through the purchase of an endorsement type policy. An
entity should apply the provisions of EITF 06-4 either through a change in
accounting principle through a cumulative-effect adjustment to retained earnings
as of the beginning of the year of adoption or a change in accounting principle
through retrospective application to all prior periods. The provisions of EITF
06-4 are effective for fiscal years beginning after December 15, 2007.
Management has completed its evaluation of the adoption of EITF 06-4 and has
determined that it will not have a material impact on the Company’s financial
position or results of operations.





16.
Parent Company Financial Information





The
financial information below is presented as of December 31, 2007, and December
31, 2006.





Farmers
& Merchants Bancorp


Condensed
Balance Sheet





(in thousands)
            
            2007
            
            
            2006Cash
            
            $
            174
            
            
            $
            386Investment
      in Farmers & Merchants Bank of Central California
            
            
            149,035
            
            
            
            135,169Investment
      Securities
            
            
            1,059
            
            
            
            4,203Capital
      Leases
            
            
            1
            
            
            
            826Other Assets
            
            
            3,692
            
            
            
            2,336Total Assets
            
            $
            153,961
            
            
            $
            142,920Subordinated
      Debentures
            
            $
            10,310
            
            
            $
            10,310Liabilities
            
            
            233
            
            
            
            270Shareholders' Equity
            
            
            143,418
            
            
            
            132,340Total Liabilities and Shareholders'
      Equity
            
            $
            153,961
            
            
            $
            142,920





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Farmers
& Merchants Bancorp


Condensed
Income Statements





Year
      Ended December 31,(in thousands)
            
            2007
            
            
            2006
            
            
            2005Equity
      in Undistributed Earnings in Farmers & Merchants Bank of Central
      California
            
            $
            12,224
            
            
            $
            2,973
            
            
            $
            9,160Dividends
      from Subsidiary
            
            
            12,430
            
            
            
            18,600
            
            
            
            10,000Interest
      Income
            
            
            79
            
            
            
            67
            
            
            
            59Other
      Expenses, Net
            
            
            (3,459
            )
            
            
            (1,695
            )
            
            
            (1,327
            )Tax Benefit
            
            
            1,421
            
            
            
            684
            
            
            
            536Net Income
            
            $
            22,695
            
            
            $
            20,629
            
            
            $
            18,428








Farmers
& Merchants Bancorp


Condensed
Statement of Cash Flows





Year
      Ended December 31,(in thousands)
            
            2007
            
            
            2006
            
            
            2005Cash
      Flows from Operating Activities:Net
      Income
            
            $
            22,695
            
            
            $
            20,629
            
            
            $
            18,428Adjustments
      to Reconcile Net Income to Net Cash Provided by Operating
      Activities:Equity
      in Undistributed Net Earnings from Subsidiary
            
            
            (12,224
            )
            
            
            (2,973
            )
            
            
            (9,160
            )Net
      Loss (Gain) on Investment Securities
            
            
            1,707
            
            
            
            -
            
            
            
            (143
            )Net
      Increase in Other Assets
            
            
            (1,402
            )
            
            
            (767
            )
            
            
            (522
            )Net (Decrease) Increase in Other
      Liabilities
            
            
            (37
            )
            
            
            43
            
            
            
            (136
            )Net Cash Provided by Operating
      Activities
            
            
            10,739
            
            
            
            16,932
            
            
            
            8,467Investing
      Activities:Securities
      Purchased
            
            
            -
            
            
            
            (3,893
            )
            
            
            -Securities
      Sold or Matured
            
            
            1,544
            
            
            
            -
            
            
            
            251Change in Capital Leases
            
            
            825
            
            
            
            (307
            )
            
            
            266Net Cash Provided (Used) by Investing
      Activities
            
            
            2,369
            
            
            
            (4,200
            )
            
            
            517Financing
      Activities:Stock
      Repurchased
            
            
            (5,489
            )
            
            
            (5,936
            )
            
            
            (4,016
            )Cash Dividends
            
            
            (7,831
            )
            
            
            (6,966
            )
            
            
            (6,656
            )Net Cash Used by Financing
      Activities
            
            
            (13,320
            )
            
            
            (12,902
            )
            
            
            (10,672
            )Increase
      in Cash and Cash Equivalents
            
            
            (212
            )
            
            
            (170
            )
            
            
            (1,688
            )Cash and Cash Equivalents at Beginning of
      Year
            
            
            386
            
            
            
            556
            
            
            
            2,244Cash and Cash Equivalents at End of
      Year
            
            $
            174
            
            
            $
            386
            
            
            $
            556





17.
Long-term Subordinated Debentures





In
December 2003, the Company formed a wholly owned Connecticut statutory business
trust, FMCB Statutory Trust I (“Statutory Trust I”), which issued $10,000,000 of
guaranteed preferred beneficial interests in the Company’s junior subordinated
deferrable interest debentures (the “Trust Preferred Securities”). These
debentures qualify as Tier 1 capital under Federal Reserve Board guidelines. All
of the common securities of Statutory Trust I are owned by the Company. The
proceeds from the issuance of the common securities and the Trust Preferred
Securities were used by FMCB Statutory Trust to purchase $10,310,000 of junior
subordinated debentures of the Company, which carry a floating rate based on
three-month LIBOR plus 2.85%. The debentures represent the sole asset of
Statutory Trust I. The Trust Preferred Securities accrue and pay distributions
at a floating rate of three-month LIBOR plus 2.85% per annum of the stated
liquidation value of $1,000 per capital security. The Company has entered into
contractual arrangements which, taken collectively, fully and unconditionally
guarantee payment of: (i) accrued and unpaid distributions required to be paid
on the Trust Preferred Securities; (ii) the redemption price with respect to any
Trust Preferred Securities called for redemption by Statutory Trust I; and (iii)
payments due upon a voluntary or involuntary dissolution, winding up or
liquidation of Statutory Trust I. The Trust Preferred Securities are mandatorily
redeemable upon maturity of the subordinated debentures on December 17, 2033, or
upon earlier redemption as provided in the indenture. The Company has the right
to redeem the subordinated debentures purchased by Statutory Trust I, in whole
or in part, on or after December 17, 2008. As specified in the indenture, if the
subordinated debentures are redeemed prior to maturity, the redemption price
will be the principal amount and any accrued but unpaid interest. Additionally,
if the Company decided to defer interest on the subordinated debentures, the
Company would be prohibited from paying cash dividends on the Company’s common
stock.





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18.
Quarterly Financial Information (Unaudited)





2007
            
            First
            
            
            Second
            
            
            Third
            
            
            Fourth(in thousands except per share
      data)
            
            Quarter
            
            
            Quarter
            
            
            Quarter
            
            
            Quarter
            
            
            TotalTotal
      Interest Income
            
            $
            23,139
            
            
            $
            23,970
            
            
            $
            24,567
            
            
            $
            24,099
            
            
            $
            95,775Total Interest Expense
            
            
            7,594
            
            
            
            8,104
            
            
            
            8,542
            
            
            
            7,985
            
            
            
            32,225Net
      Interest Income
            
            
            15,545
            
            
            
            15,866
            
            
            
            16,025
            
            
            
            16,114
            
            
            
            63,550Provision for Loan Losses
            
            
            -
            
            
            
            250
            
            
            
            -
            
            
            
            1,245
            
            
            
            1,495Net
      Interest Income AfterProvision
      for Loan Losses
            
            
            15,545
            
            
            
            15,616
            
            
            
            16,025
            
            
            
            14,869
            
            
            
            62,055Total
      Non-Interest Income
            
            
            3,752
            
            
            
            4,131
            
            
            
            3,536
            
            
            
            4,036
            
            
            
            15,455Total Non-Interest Expense
            
            
            11,021
            
            
            
            10,939
            
            
            
            10,215
            
            
            
            9,770
            
            
            
            41,945Income
      Before Income Taxes
            
            
            8,276
            
            
            
            8,808
            
            
            
            9,346
            
            
            
            9,135
            
            
            
            35,565Provision for Income Taxes
            
            
            2,807
            
            
            
            3,142
            
            
            
            3,471
            
            
            
            3,450
            
            
            
            12,870Net Income
            
            $
            5,469
            
            
            $
            5,666
            
            
            $
            5,875
            
            
            $
            5,685
            
            
            $
            22,695Earnings Per Share
            
            $
            6.74
            
            
            $
            6.98
            
            
            $
            7.26
            
            
            $
            7.07
            
            
            $
            28.05





2006
            
            First
            
            
            Second
            
            
            Third
            
            
            Fourth(in thousands except per share
      data)
            
            Quarter
            
            
            Quarter
            
            
            Quarter
            
            
            Quarter
            
            
            TotalTotal
      Interest Income
            
            $
            20,703
            
            
            $
            21,669
            
            
            $
            22,950
            
            
            $
            23,074
            
            
            $
            88,396Total Interest Expense
            
            
            4,754
            
            
            
            5,773
            
            
            
            6,856
            
            
            
            7,238
            
            
            
            24,621Net
      Interest Income
            
            
            15,949
            
            
            
            15,896
            
            
            
            16,094
            
            
            
            15,836
            
            
            
            63,775Provision for Loan Losses
            
            
            275
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            275Net
      Interest Income AfterProvision
      for Loan Losses
            
            
            15,674
            
            
            
            15,896
            
            
            
            16,094
            
            
            
            15,836
            
            
            
            63,500Total
      Non-Interest Income
            
            
            2,604
            
            
            
            3,499
            
            
            
            3,114
            
            
            
            2,846
            
            
            
            12,063Total Non-Interest Expense
            
            
            10,534
            
            
            
            11,376
            
            
            
            10,777
            
            
            
            10,434
            
            
            
            43,121Income
      Before Income Taxes
            
            
            7,744
            
            
            
            8,019
            
            
            
            8,431
            
            
            
            8,248
            
            
            
            32,442Provision for Income Taxes
            
            
            2,807
            
            
            
            2,925
            
            
            
            3,098
            
            
            
            2,983
            
            
            
            11,813Net Income
            
            $
            4,937
            
            
            $
            5,094
            
            
            $
            5,333
            
            
            $
            5,265
            
            
            $
            20,629Earnings Per Share
            
            $
            6.00
            
            
            $
            6.22
            
            
            $
            6.54
            
            
            $
            6.49
            
            
            $
            25.25





71
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Farmers
& Merchants Bancorp stock is not traded on any exchange. The shares are
primarily held by local residents and are not actively traded. Based on
information from shareholders and from Company stock transfer records, the
prices paid in 2007, 2006 and 2005 ranged from $381.00 to $565.00 per share.
Additional information about the Company’s common stock is available in Part II,
Item 5.





Item 9. Changesin and Disagreements with Accountants on
Accounting and Financial Disclosure





None





Item 9A. Controlsand Procedures





The
Company maintains controls and procedures designed to ensure that all relevant
information is recorded and reported in all filings of financial
reports.  Such information is reported to the Company’s management,
including its Chief Executive Officer and its Chief Financial Officer to allow
timely and accurate disclosure based on the definition of “disclosure controls
and procedures” in Rule 13a-15(e).  In accordance with Rule 13a-15(b)
of the Exchange Act, we carried out an evaluation as of December 31, 2007, under
the supervision and with the participation of our management, including our
Chief Executive Officer and Chief Financial Officer, of the effectiveness of the
design and operation of our disclosure controls and procedures as defined in
Rule 13a-15(e) under the Exchange Act.  Based on that evaluation, our
Chief Executive Officer and Chief Financial Officer have concluded that our
disclosure controls and procedures are effective as of December 31,
2007.





There
have been no significant changes in the Company’s internal controls or in other
factors that could significantly affect the internal controls subsequent to the
date the Company completed its evaluation.





Management’s
report on internal control over financial reporting is set forth “Item 8.
Financial Statements and Supplementary Data,” and is incorporated herein by
reference. Perry-Smith LLP, the independent registered public accounting firm
that audited the Company’s 2007 Consolidated Financial Statements, has issued an
attestation report on the Company’s internal control over financial reporting,
which is set forth in “Item 8. Financial Statements and Supplementary Data,” and
is incorporated herein by reference.





Item 9B. OtherInformation





None





72
 Table of Contents





PART III





Item 10. Directors, Executive Officers and Corporate
Governance





Set forth
below is certain information regarding the Executive Officers of the Company
and/or Bank:





Name and
      Position(s)
            Age
            Principal Occupation
      during the Past Five YearsKent
      A. Steinwert
              President
              &
      Chief Executive Officer
              of
      the Company and Bank
            55
            President
      & Chief Executive Officer of the Company and Bank.Richard
      S. Erichson
              Executive
      Vice President
              &
      Senior Credit Officer
              of
      the Company and Bank
            60
            Executive
      Vice President & Senior Credit Officer of the Company and
      Bank.Deborah E. Hodkin
              Executive
      Vice President & Chief
              Administrative
      Officer of the
              Company
      and Bank
            45
            Executive
      Vice President & Chief Administrative Officer of the Company and
      Bank.Stephen
      W. Haley
              Executive
      Vice President
              &
      Chief Financial Officer &
              Secretary
      of the Company and
              Bank
            54
            Executive
      Vice President & Chief Financial Officer of the Company and Bank since
      April 2003, prior thereto, President and Chief Operating Officer of
      Community West Bancshares.Kenneth
      W. Smith
              Executive
      Vice President & Head of
              Business
      Banking of the Bank
            48
            Executive
      Vice President & Head of Business Banking of the Bank since January
      2004, prior thereto, Senior Vice President and Credit Administrator of the
      Bank.





Also, see
“Election of Directors” and “Compliance with Section 16(a) of the Exchange Act”
in the Company’s definitive proxy statement for the 2008 Annual Meeting of
Shareholders which will be filed with the Commission and which is incorporated
herein by reference.  During 2007 there were no changes in procedures
for the election of directors.





The
Company has adopted a Code of Conduct which complies with the Code of Ethics
requirements of the Securities and Exchange Commission. A copy of the Code of
Conduct is posted on the Company’s website. The Company intends to disclose
promptly any amendment to, or waiver from any provision of, the Code of Conduct
applicable to senior financial officers, and any waiver from any provision of
the Code of Conduct applicable to Directors, on its website. The Company’s
website address is www.fmbonline.com.





Item 11. ExecutiveCompensation





The
information required by Item 11 of Form 10-K is incorporated by reference from
the information contained in the Company’s definitive proxy statement for the
2008 Annual Meeting of Shareholders which will be filed pursuant to Regulation
14A.





Item 12. SecurityOwnership of Certain Beneficial Owners and
Management and Related Stockholder Matters





The
information required by Item 12 of Form 10-K is incorporated by reference from
the information contained in the Company’s definitive proxy statement for the
2008 Annual Meeting of Shareholders which will be filed pursuant to Regulation
14A. The Company does not have any equity compensation plans which require
disclosure under Item 201(d) of Regulation S-K.





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Item 13. CertainRelationships and Related Transactions, and
Director Independence





The
information required by Item 13 of Form 10-K is incorporated by reference from
the information contained in the Company’s definitive proxy statement for the
2008 Annual Meeting of Shareholders which will be filed pursuant to Regulation
14A.





Item 14. PrincipalAccounting Fees and Services





The
information required by Item 14 of Form 10-K is incorporated by reference from
the information contained in the Company’s definitive proxy statement for the
2008 Annual Meeting of Shareholders which will be filed pursuant to Regulation
14A.





PART IV





Item 15. Exhibitsand Financial Statement Schedules





(a)(1)
      Financial Statements. Incorporated herein by reference, are listed in Item
      8 hereof.


(2)
Financial Statement Schedules. None





(b)
            See
      "Index to Exhibits"





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 Table of Contents





SIGNATURES





Pursuant
to the requirements of Section 13 or 15(d) 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.





Farmers
      & Merchants Bancorp(Registrant)By
            /s/
      Stephen W. Haley_________________________Dated:  March
      7, 2008
            
            Stephen
      W. HaleyExecutive
      Vice President &Chief
      Financial Officer





Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the registrant and in the
capacities indicated on March 7, 2008.








/s/
      Kent A. Steinwert______________________________
            President
      and Chief Executive OfficerKent
      A. Steinwert
            (Principal
      Executive Officer)/s/
      Stephen W. Haley_____________________________
            Executive
      Vice President & Chief Financial OfficerStephen
      W. Haley
            (Principal
      Financial and Accounting  Officer)/s/
      Ole R. Mettler
            /s/
      James E. Podesta_____________________________
            ______________________________Ole
      R. Mettler, Chairman
            James
      E. Podesta, Director/s/
      Stewart C. Adams, Jr.
            /s/
      Kevin Sanguinetti____________________________
            ______________________________Stewart
      C. Adams, Jr., Director
            Kevin
      Sanguinetti, Director/s/
      Ralph Burlington
            /s/
      Carl Wishek, Jr.____________________________
            ______________________________Ralph
      Burlington, Director
            Carl
      Wishek, Jr., Director/s/
      Edward Corum, Jr.
            /s/
      Calvin Suess____________________________
            ______________________________Edward
      Corum, Jr., Director
            Calvin
      Suess, Director





75
 Table of Contents





Index to
Exhibits





Exhibit
      No.
            
            Description3.1
            
            Amended
      Certificate of Incorporation (incorporated by reference to Appendices 1
      and 2 to the Registrant's Definitive Proxy Statement on Schedule 14A for
      its 2007 Annual Meeting of Stockholders and Exhibit 3(i) to the
      Registrant's Current Report on Form 8-K dated April 30,
    1999).3.2
            
            Amended
      By-Laws (incorporated by reference to Appendix 3 to the Registrant's
      Definitive Proxy Statement on Schedule 14A for its 2007 Annual Meeting of
      Stockholders, Exhibit 3.1 to the Registrant's Current Report on Form 8-K
      dated June 7, 2005, and Exhibit 3(ii) to the Registrant's Current Report
      on Form 8-K dated April 30, 1999).10.1
            
            Employment
      Agreement dated January 1, 2005, between Farmers & Merchants Bank of
      Central California and Kent A. Steinwert, filed on Registrant’s Form 10-K
      for the year ended December 31, 2004, is incorporated herein by
      reference.10.3
            
            Employment
      Agreement dated January 1, 2005, between Farmers & Merchants Bank of
      Central California and Deborah E. Hodkin, filed on Registrant’s Form 10-K
      for the year ended December 31, 2004, is incorporated herein by
      reference.10.4
            
            Employment
      Agreement dated January 1, 2005, between Farmers & Merchants Bank of
      Central California and Kenneth W. Smith, filed on Registrant’s Form 10-K
      for the year ended December 31, 2004, is incorporated herein by
      reference.10.5
            
            Employment
      Agreement dated January 1, 2005, between Farmers & Merchants Bank of
      Central California and Richard S. Erichson, filed on Registrant’s Form
      10-K for the year ended December 31, 2004, is incorporated herein by
      reference.10.6
            
            Employment
      Agreement dated January 1, 2005, between Farmers & Merchants Bank of
      Central California and Stephen W. Haley, filed on Registrant’s Form 10-K
      for the year ended December 31, 2004, is incorporated herein by
      reference.10.15
            
            2005
      Deferred Bonus Plan of Farmers & Merchants Bank of Central California
      executed May 3, 2005, filed on Registrant’s Form 10-Q for the quarter
      ended March 31, 2005, is incorporated herein by
  reference.10.16
            
            Executive
      Retention Plan of Farmers & Merchants Bank of Central California
      executed May 3, 2005, filed on Registrant’s Form 10-Q for the quarter
      ended March 31, 2005, is incorporated herein by
  reference.10.17
            
            Amended
      and Restated Indexed Retirement Plan of Farmers & Merchants Bank of
      Central California adopted as of March 7, 2006, filed on Registrant’s Form
      10-K for the year ended December 31, 2005, is incorporated herein by
      reference.10.18
            
            Deferred
      Compensation Plan of Farmers & Merchants Bank of Central California,
      executed October 17, 2006, filed on the Registrants Form 10-Q for the
      quarter ended September 30, 2006, is incorporated herein by
      reference.14
            
            Code
      of Conduct of Farmers & Merchants Bancorp, filed on Registrant’s Form
      10-K for the year ended December 31, 2003, is incorporated herein by
      reference.21
            
            Subsidiaries
      of the Registrant, filed on Registrant’s Form 10-K for the year ended
      December 31, 2003, is incorporated herein by reference.31(a)
            
            Certification
      of the Chief Executive Officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002.31(b)
            
            Certification
      of the Chief Financial Officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002.32
            
            Certification
      of the Chief Executive Officer and Chief Financial Officer pursuant to 18
      U.S.C. Section 1350, as adopted pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002.







76