UNITED STATES SECURITIES AND EXCHANGE COMMISSION


Washington, D.C.  20549





FORM 10-K





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


THE SECURITIES EXCHANGE ACT OF 1934





For the fiscal year ended December 31, 2009





OR





o 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 o  No x





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 o  No x





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 x   No o





Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes o   No o





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





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  o
Accelerated filer  x
Non-accelerated filer  o
Smaller Reporting Company o(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  o    No  x





The aggregate market value of the Registrant's common stock held by non-affiliates on June 30, 2009 (based on the last reported trade on June 30, 2009) was $308,951,225.





The number of shares of Common Stock outstanding as of February 26, 2010: 780,944





Documents Incorporated by Reference:


Portions of the definitive Proxy Statement for the 2010 Annual Meeting of Stockholders 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& MERCHANTS BANCORP


FORM 10-K





TABLE OF CONTENTS





PagePART IIntroduction
3Item  1.
Business
3Item 1A.
Risk Factors
14Item 1B.
Unresolved Staff Comments
20Item  2.
Properties
20Item  3.
Legal Proceedings
20Item 4.
ReservedPART IIItem  5.
Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
20Item  6.
Selected Financial Data
23Item  7.
Management's Discussion and Analysis of Financial Condition and Results of Operations
24Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
50Item  8.
Financial Statements and Supplementary Data
53Item  9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
82Item 9A.
Controls and Procedures
82Item 9A(T)
Controls and Procedures
83Item 9B.
Other Information
83PART IIIItem 10.
Directors, Executive Officers and Corporate Governance
84Item 11.
Executive Compensation
84Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
84Item 13.
Certain Relationships and Related Transactions, and Director Independence
85Item 14.
Principal Accountant Fees and Services
85PART IVItem 15.
Exhibits and Financial Statement Schedules
85Signatures
86Index to Exhibits
87


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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 Farmers & Merchants Bancorp’s (together with its subsidiaries, the “Company” or “we”) operations, future results, and prospects. These forward-looking statements are based upon current expectations and are subject to risks 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 current economic downturn and turmoil in financial markets and the response of federal and state regulators thereto; (ii) the effect of changing regional and national economic conditions including the housing market in the Central Valley of California; (iii) significant changes in interest rates and prepayment speeds; (iv) credit risks of lending and investment activities; (v) changes in federal and state banking laws or regulations; (vi) competitive pressure in the banking industry; (vii) changes in governmental fiscal or monetary policies; (viii) 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 (ix) 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.





PARTI





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. Farmers & Merchants’ first venture out of Lodi occurred when the Galt office was opened in 1948. Shortly thereafter branches were opened in Linden, Modesto and South Sacramento. In 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 branch in Elk Grove and a third office in Modesto. The year 2002 saw the opening of the Company’s first branch in the city of Stockton. In 2003, the Bank opened its fourth office in Modesto.





A second Galt office was opened in 2005 and a new full-service branch in downtown Sacramento was opened in early 2006. In late 2006, the Company opened its sixth Lodi office and its first commercial branch in Stockton. The downtown Turlock branch was relocated to a new facility in April 2008 and the Company’s first branch in Merced was opened in February 2009.





In addition to the preceding 22 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, the Company, pursuant to a reorganization, acquired all of the voting stock of Farmers & Merchants Bank of Central California (the “Bank”). The Company 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, 2009, consisted of 780,944 shares of common stock, $0.01 par value and no shares of preferred stock issued. The Bank is the Company’s principal asset.


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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 19 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 “Supervision and Regulation - Dividends and Other Transfer of Funds.”





The Bank’s deposit accounts are insured under the Federal Deposit Insurance Act up to applicable limits. See “Supervision and Regulation – Deposit Insurance.”





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 22 banking offices and two stand-along ATM’s. The area includes Sacramento, San Joaquin, Stanislaus and Merced Counties with branches in Sacramento, Elk Grove, Galt, Lodi, Stockton, Linden, Modesto, Turlock, Hilmar, and Merced.





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.





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.


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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, 2009, the Company employed a total of 307 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. 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 stockholders, 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. The impact that 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 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.





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 implemented regulations, would have on the financial condition or results of operations of the Company or any of its subsidiaries. See “Supervision and Regulation.”


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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 stockholders 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 BHCA. 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 “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.





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. 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 has not become a financial holding company.


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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 DFI and the FDIC. 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.





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.


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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 $34.0 million at December 31, 2009.





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 “Prompt Corrective Action and Other Enforcement Mechanisms.”





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 11 located in “Item 8. Financial Statements and Supplementary Data.”


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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, 2009, 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, 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.




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. The Company’s CRE portfolio may be viewed as falling within one or more of the foregoing categories, and accordingly may become subject to increased regulatory scrutiny because of the 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.


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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.





Deposit Insurance


The deposits of the Bank have historically been insured by the FDIC up to $100,000 per insured depositor, except certain types of retirement accounts, which are insured up to $250,000 per insured depositor. On October 3, 2008, the maximum amount insured under FDIC deposit insurance was temporarily increased from $100,000 to $250,000 per insured depositor through December 31, 2009. This increase was part of the Emergency Economic Stabilization Act of 2008.  On May 19, 2009, Congress extended the temporary $250,000 coverage through December 31, 2013.





Additionally, the Bank elected to participate in those provisions of the FDIC’s Transaction Account Guarantee (“TAG”) Program that provide additional insurance coverage on non-interest bearing deposit transaction accounts. Under this program, all non-interest bearing transaction accounts at the Bank with balances over $250,000 are also fully insured.  The TAG program was initially scheduled to terminate on December 31, 2009, however, on August 26, 2009, the FDIC extended the program through June 30, 2010, and the bank elected to continue its participation in the program.  The additional annualized cost to the Bank is 10 basis points per dollar over $250,000 through December 31, 2009.   After December 31, 2009, banks will be charged a higher annualized rate according to the institution’s risk category.  Banks in risk category I will pay 15 basis points; risk category II, 20 basis points; and risk categories III and IV, 25 basis points per dollar over $250,000.





Effective January 1, 2007, the FDIC adopted a rule for the insurance assessment on deposits based upon risk assessment classifications. Under the rule the charge for annual insurance deposit assessments ranged 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.   On February 27, 2009, the FDIC adopted a final rule modifying the risk-based assessment system and setting initial base assessment rates beginning April 1, 2009, at 12 to 45 basis points per $100 of insured deposits depending upon an institution’s risk category.  Insured institutions are not allowed to disclose their risk assessment classification and no assurance can be given as to what the future level of premiums will be. The Bank’s FDIC premiums (exclusive of special assessments – see below) were $1.70 million in 2009 compared to $532,000 in 2008.





On May 22, 2009, the FDIC adopted a final rule imposing a 5 basis point special assessment on each insured depository institution’s assets minus Tier 1 capital as of June 30, 2009.  The amount of the special assessment for any institution was not to exceed 10 basis points times the institution’s assessment base for the second quarter 2009.  This special assessment was collected by the FDIC on September 30, 2009, and resulted in an additional charge to the Bank of $798,000.


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On September 30, 2009, the FDIC adopted a rule that required insured institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012.  The prepaid assessment was collected December 30, 2009, and resulted in a prepayment by the Bank of $7,258,000.  The FDIC also adopted a uniform three-basis point increase in the assessment rates effective on January 1, 2011.





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, 2009, averaged 1.04 basis points of assessable deposits.





The FDIC has authority to increase insurance assessments and has used this authority over the past several years, resulting in a significant increase in the Bank’s deposit insurance premiums. See “Item 1A. Risk Factors.”  Additional increases in insurance premiums could have additional adverse effects 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 Bank’s primary regulator. Management of the Company is not aware of any practice, condition or violation that might lead to termination of the Company’s deposit insurance.





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, including but not limited to:




·
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;




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·
expanded disclosure of corporate operations and internal controls and certification of financial statements;
 
 ·
enhanced controls on, and reporting of, insider trading; and
 
 ·
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”). Compliance with the Act (the “Act”) did not 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.





Recent Governmental Actions in Response to the Financial Crises





Emergency Economic Stabilization Act


In response to the financial crisis affecting the banking system and financial markets, the Emergency Economic Stabilization Act (“EESA”) was signed into law on October 3, 2008, which among other things: (1) temporarily increased FDIC insurance coverage from $100,000 to $250,000 through December 31, 2009 (subsequently extended through December 31, 2013); and (2) established the Troubled Asset Relief Program (“TARP”). As part of TARP, the United States Department of the Treasury (“Treasury”) established the Capital Purchase Program (“CPP”) to provide up to $700 billion of funding to eligible financial institutions through the purchase of capital stock and other financial instruments for the purpose of stabilizing and providing liquidity to the U.S. financial markets. In connection with EESA, there have been numerous actions by the FRB, Congress, and the Treasury, the FDIC, the SEC and others to further the economic and banking industry stabilization efforts under EESA. It remains unclear at this time what further legislative and regulatory measures will be implemented under EESA affecting the Company.





The Company decided not to participate in the TARP CPP.





Temporary Liquidity Guarantee Program


On October 14, 2008, the FDIC announced the establishment of the Temporary Liquidity Guarantee Program (“TLGP”) to provide: (1) full deposit insurance on all non-interest bearing transaction account balances through December 31, 2009 (Transaction Account Guarantee Program); and (2) guarantees of certain newly issued senior unsecured debt issued by financial institutions and bank holding companies through June 30, 2012 (Debt Guarantee Program). The Bank elected to participate in the Transaction Account Guarantee Program, but not the Debt Guarantee Program..





Financial Stability Plan


On February 10, 2009, Treasury announced the Financial Stability Plan (“FSP”) which, among other things, established a new Capital Assistance Program (“CAP”) through which eligible banking institutions will have access to Treasury capital as a bridge to private capital until market conditions normalize, and extended the Debt Guarantee Program of the TLGP to October 31, 2009, and the Transaction Account Guarantee Program of the TLGP to June 30, 2010.  As a complement to CAP, a new Public-Private Investment Fund on an initial scale of up to $500 billion, which was later revised to be $30 billion, was announced to catalyze the removal of legacy assets from the balance sheets of financial institutions. This fund will combine public and private capital with government financing to help free up capital to support new lending. In addition, the existing Term Asset-Backed Securities Lending Facility (“TALF”) would be expanded (up to $1 trillion) in order to reduce credit spreads and restart the securitized credit markets that in recent years supported a substantial portion of lending to households, students, small businesses, and others. Furthermore, the FSP proposed a new framework of governance and oversight to help ensure that banks receiving funds are held responsible for appropriate use of those funds through stronger conditions on lending, dividends and executive compensation along with enhanced reporting to the public.





The Company is a participant in the Transaction Account Guarantee Program.


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American Recovery and Reinvestment Act of 2009


On February 17, 2009, the American Recovery and Reinvestment Act of 2009 (“ARRA”) was signed into law. ARRA is intended to provide tax breaks for individuals and businesses, direct aid to distressed states and individuals, and provide infrastructure spending. In addition, ARRA imposes new executive compensation and expenditure limits on all previous and future TARP CPP recipients and expands the class of employees to whom the limits and restrictions apply. ARRA also provides the opportunity for additional repayment flexibility for existing TARP CPP recipients. Among other things, ARRA prohibits the payment of bonuses, other incentive compensation and severance to certain highly paid employees (except in the form of restricted stock subject to specified limitations and conditions), and requires each TARP CPP recipient to comply with certain other executive compensation related requirements. These provisions modify the executive compensation provisions that were included in EESA, and in most instances apply retroactively for so long as any obligation arising from financial assistance provided to the recipient under TARP CPP remains outstanding.





In addition, ARRA directs the Treasury to review previously-paid bonuses, retention awards and other compensation paid to the senior executive officers and certain other highly-compensated employees of each TARP CPP recipient to determine whether any such payments were excessive, inconsistent with the purposes of ARRA or the TARP, or otherwise contrary to the public interest. If the Treasury determines that any such payments have been made by a TARP CPP recipient, the Treasury will seek to negotiate with the TARP CPP recipient and the subject employee for appropriate reimbursements to the U.S. government (not the TARP CPP recipient) with respect to any such compensation or bonuses. ARRA also permits the Treasury, subject to consultation with the appropriate federal banking agency, to allow a TARP CPP recipient to repay any assistance previously provided to such TARP CPP recipient under the TARP, without regard to whether the TARP CPP recipient has replaced such funds from any source, and without regard to any waiting period. Any TARP CPP recipient that repays its TARP assistance pursuant to this provision would no longer be subject to the executive compensation provisions under ARRA.





Since the Company elected not to participate in the TARP CPP, the preceding compensation limitations do not apply.





Homeowner Affordability and Stability Plan


On February 18, 2009, the Treasury announced the Homeowner Affordability and Stability Plan (“HASP”), which proposes to provide refinancing for certain homeowners, to support low mortgage rates by strengthening confidence in Fannie Mae and Freddie Mac, and to establish a Homeowner Stability Initiative to reach at-risk homeowners. Among other things, the Homeowner Stability Initiative would offer monetary incentive to mortgage servicers and mortgage holders for certain modifications of at-risk loans, and would establish an insurance fund designed to reduce foreclosures.





Future Legislation and Regulatory Initiatives


Various other legislative and regulatory initiatives, including proposals to overhaul the banking regulatory system are from time to time introduced in Congress and state legislatures, as well as regulatory agencies. Currently, the Congress is actively considering significant changes to the manner of regulating financial institutions including combining one or more of the FRB, FDIC, Comptroller of the Currency and the Office of Thrift Supervision and creating a new consumer protection agency for financial products. The current legislation being considered and other future legislation regarding financial institutions may change banking statutes and the operating environment of the Company and the Bank in substantial and unpredictable ways, and could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance depending upon 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 the Bank. The nature and extent of future legislative and regulatory changes affecting financial institutions is unpredictable at this time. The Company cannot determine the ultimate effect that such potential legislation, if enacted, would have upon its financial condition or operations.





Available Information





Company reports filed with the SEC 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 stockholders can be accessed through the Company’s web site at http://www.fmbonline.com. The link to the SEC is on the About Uspage.


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Item1A. Risk Factors





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





Recession And Changes In Domestic And Foreign Financial Markets May Have A Material Negative Impact On Our Results Of Operations And Financial Condition -Economic indices have shown that since the fourth quarter of 2007, the United States economy has been in a recession and the Central Valley of California, the Company’s primary market area, has been hit particularly hard. This has been reflected in significant business failures and job losses. In addition, over the past two years, the domestic and foreign financial markets, securities trading markets and economies generally have experienced significant turmoil including, without limitation, government takeovers of troubled institutions, government brokered mergers of such firms to avoid bankruptcy or failures, bankruptcies of securities trading firms and insurance companies, failures of financial institutions and securities brokerage firms, declines in real property values, and wide fluctuations in energy prices, all of which have contributed to reduced availability of credit for businesses and consumers, elevated foreclosures on residential and commercial properties, falling home prices, reduced liquidity and a lack of stability across the entire financial sector.





These recent events and the corresponding uncertainty in financial markets may continue for the foreseeable future.  The full extent of the repercussions to our nation’s economy in general and our business in particular; therefore, are not fully known at this time. Such events may have a negative effect on: (i) our ability to service our existing customers and attract new customers; (ii) the ability of our borrowers to operate their business as successfully as in the past; (iii) the financial security and net worth of our customers; and (iv) the ability of our customers to repay their loans with us in accordance with the terms thereof.





Recently Enacted Legislation And Other Measures Undertaken By The Treasury, The FRB And Other Governmental Agencies May Not Help Stabilize The U.S. Financial System Or Improve The Housing Market –Since 2008 the Federal Government has enacted many pieces of legislation designed to stabilize the economy and the financial system. See “Item 1 Business – Supervision and Regulation – Recent Government Actions in Response to the Financial Crises.”





The actual impact that any of this legislation and other related measures undertaken to alleviate the economic crises will have generally on the financial markets is still substantially unknown. The failure of such measures, or any future measures, to help stabilize the financial markets and a continuation or worsening of current financial market conditions could materially and adversely affect our business, financial condition, results of operations, access to credit or the trading price of our common stock.





Current Levels Of Market Volatility Are Unprecedented-The capital and credit markets have been experiencing volatility and disruption for more than two years. At times the volatility and disruption reached unprecedented levels.  In some cases, the markets have produced downward pressure on stock prices and credit availability for certain issuers without regard to those issuers’ underlying financial strength. If current levels of market disruption and volatility continue or worsen, there can be no assurance that we will not experience an adverse effect, which may be material, on our ability to access capital and on our business, financial condition and results of operations.


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Nonperforming Assets Take Significant Time To Resolve And Adversely Affect Our Company’s Results Of Operations And Financial Condition.Nonperforming assets adversely affect our net income in various ways. Until economic and market conditions improve, we expect to continue to incur additional losses relating to an increase in non-performing loans. We do not record interest income on non-accrual loans or other real estate owned, thereby adversely affecting our income and increasing our loan administration costs. When we take collateral in foreclosures and similar proceedings, we are required to mark the related loan to the then fair market value of the collateral, which may result in a loss. While we have tried to reduce our problem assets through workouts, restructurings and otherwise, decreases in the value of these assets, or the underlying collateral, or in these borrowers’ performance or financial conditions, whether or not due to economic and market conditions beyond our control, could adversely affect our business, results of operations and financial condition.  In addition, the resolution of nonperforming assets requires significant commitments of time from management, which can be detrimental to the performance of other responsibilities.  There can be no assurance that we will not experience further increases in nonperforming loans in the future.





Our Allowance For Loan Losses May Not Be Adequate To Cover Actual Losses.A significant source of risk arises from the possibility that losses could be sustained because borrowers, guarantors, and related parties may fail to perform in accordance with the terms of their loans and leases. The underwriting and credit monitoring policies and procedures that we have adopted to address this risk may not prevent unexpected losses that could have a material adverse effect on our business, financial condition, results of operations and cash flows. Unexpected losses may arise from a wide variety of specific or systemic factors, many of which are beyond our ability to predict, influence, or control.





Like all financial institutions, we maintain an allowance for loan losses to provide for loan defaults and non-performance. The allowance is funded from a provision for loan losses, which is a charge to our income statement.  Our allowance for loan losses may not be adequate to cover actual loan losses, and future provisions for loan losses could materially and adversely affect our business, financial condition, results of operations and cash flows. The allowance for loan losses reflects our estimate of the probable losses in our loan portfolio at the relevant balance sheet date.  Our allowance for loan losses is based on prior experience, as well as an evaluation of the known risks in the current portfolio, composition and growth of the loan portfolio and economic factors. The determination of an appropriate level of loan loss allowance is an inherently difficult process and is based on numerous assumptions. The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates, that may be beyond our control and these losses may exceed current estimates.





The process we use to estimate losses inherent in our credit exposure requires difficult, subjective and complex judgments, including forecasts of economic conditions and how these economic conditions might impair the ability of our borrowers to repay their loans. The level of uncertainty concerning current economic conditions may adversely affect the accuracy of our estimates, which may, in turn, impact the reliability of the allowance for loan losses.





While we believe that our allowance for loan losses is adequate to cover current losses, we cannot assure you that we will not increase the allowance for loan losses further or that regulators will not require us to increase this allowance. Either of these occurrences could materially adversely affect our business, financial condition, results of operations and cash flows.





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, 2009, real estate served as the principal source of collateral with respect to approximately 68% of our loan outstandings and 20% of loans outstanding 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.


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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.





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.”





Sustained low levels of 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. Beginning in September 2007 the FRB implemented a series of rate reductions in response to the current state of the national economy and housing market as well as the volatility of financial markets. 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 CRE 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 – Overview - Looking Forward: 2010 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 maintain or increase net interest margin;
  ·
inability to control non-interest expense, including, but not limited to, rising employee and healthcare costs;
  ·
inability to maintain or increase non-interest income; and
  ·
continuing ability to expand through de novo branching or otherwise.




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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 and this area has experienced a significant deterioration in real estate values. 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 as it is presently. 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 – Overview - Looking Forward: 2010 and Beyond.”





This Company’s service areas can be significantly impacted by the seasonal and cyclical operations of the agricultural industry. As a result, the Company’s financial results can be influenced by the banking needs of its agricultural customers (e.g., generally speaking 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 2009 approximately 36% of the Company’s loan balances were 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.





Our Ability To Access Markets For Funding And Acquire And Retain Customers Could Be Adversely Affected By The Deterioration Of Other Financial Institutions Or The Financial Service Industry’s Reputation.Reputation risk is the risk to liquidity, earnings and capital arising from negative publicity regarding the financial services industry.  The financial services industry continues to be featured in negative headlines about the global and national credit crisis and the resulting stabilization legislation enacted by the U.S. federal government.  These reports can be damaging to the industry’s image and potentially erode consumer confidence in insured financial institutions.  Recent bank failures in California and throughout the United States have also had a negative impact.  In addition, our ability to engage in routine funding and other transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, have led to market-wide liquidity problems, losses of depositor, creditor and counterparty confidence and could lead to losses or defaults by usor by other institutions.





We Face Strong Competition From Financial Service Companies And Other Companies That Offer Banking Services That Could Adversely Impact 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.


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Deposit Insurance Assessments Have Increased Substantially and May Continue to Increase, Which Will Adversely Affect Profits-FDIC deposit insurance expense for the year ended December 31, 2009 was $2.5 million, comprised of $1.70 million in regular assessments and a special assessment of $798,000.  This represents a $1.96 million increase over 2008.  Additionally, in December 2009 the FDIC required all banks to prepay three years of estimated insurance premiums, an amount that totaled $7.26 million for the Bank. Deposit insurance assessments may continue to increase in future years due to recent strains on the FDIC deposit insurance fund resulting from the cost of recent bank failures and an increase in the number of banks likely to fail over the next few years.





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.





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.


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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 Financial Performance - 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 stockholders. These regulations can sometimes impose significant limitations on our operations and increase our cost of doing 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, including EESA and the Stimulus Bill, 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. See “Item 1 Business – Supervision and Regulation – Recent Government Actions in Response to the Financial Crises.”





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:




·
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;
 
 ·
available investment liquidity in our market area since our stock is not listed on any exchange; 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.


19
 Table of Contents


Item1B. Unresolved Staff Comments





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





Item2. 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-two branch locations in the Company's service area. Of the twenty-two branches, sixteen are owned and six are leased. The expiration of these leases occurs between the years 2010 and 2016. See Note 16 located in “Item 8. Financial Statements and Supplementary Data.”





Item3. Legal Proceedings





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.





Item4. Reserved





PARTII





Item 5. Market for 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 2008. These figures are based on activity posted on the OTC Bulletin Board and on private transactions between individual stockholders that are reported to the Company.





Cash DividendsCalendar Quarter

High


Low


Close


Declared (Per Share)2009

Fourth quarter

$
425


$
325


$
380


$
5.90Third quarter


434



375



400



-Second quarter


475



325



395



5.10First quarter


475



310



390



-Cash DividendsCalendar Quarter

High


Low


Close


Declared (Per Share)2008

Fourth quarter

$
450


$
385


$
420


$
5.80Third quarter


475



425



450



-Second quarter


475



400



460



4.85First quarter


460



390



460



-


20
 Table of Contents


As of January 31, 2010, there were approximately 1,468 stockholders of record of the Company’s common stock.





The Company has paid cash dividends for the past 75 consecutive years.  There are limitations under Delaware corporate law as to the amounts of cash 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 cash dividends paid by the Bank to fund its cash 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.  This program was extended and expanded in both 2004 and 2006.   Most recently, on November 12, 2008, the Board of Directors approved increasing the funds available for the Company’s Common Stock Repurchase Program. The Board’s resolution authorized up to $20 million in repurchases over the four year period ending October 31, 2012.





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 the Company during the fourth quarter of 2009.





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 2009


-


$
-



-


$
16,812,510November 2009


461



410



461



16,623,500December 2009


-



-



-



16,623,500Total


461


$
410



461


$
16,623,500





All of the above shares were repurchased in private transactions.





On August 5, 2008, the Board of Directors approved a Share Purchase Rights Plan (the “Rights Plan”), pursuant to which the Company entered into a Rights Agreement dated August 5, 2008, with Registrar and Transfer Company, as Rights Agent, and the Company declared a dividend of a right to acquire one preferred share purchase right (a “Right”) for each outstanding share of the Company’s common stock, $0.01 par value per share, to stockholders of record at the close of business on August 15, 2008. Generally, the Rights are only triggered and become exercisable if a person or group (the “Acquiring Person”) acquires beneficial ownership of 10 percent or more of the Company’s common stock or announces a tender offer for 10 percent or more of the Company’s common stock.





The Rights Plan is similar to plans adopted by many other publicly-traded companies. The effect of the Rights Plan is to discourage any potential acquirer from triggering the Rights without first convincing the Company’s Board of Directors that the proposed acquisition is fair to, and in the best interest of, all of the stockholders of the Company. The provisions of the Plan will substantially dilute the equity and voting interest of any potential acquirer unless the Board of Directors approves of the proposed acquisition. Each Right, if and when exercisable, will entitle the registered holder to purchase from the Company one one-hundredth of a share of Series A Junior Participating Preferred Stock, no par value, at a purchase price of $1,200 for each one one-hundredth of a share, subject to adjustment. Each holder of a Right (except for the Acquiring Person, whose Rights will be null and void upon such event) shall thereafter have the right to receive, upon exercise, that number of common shares of the Company having a market value of two times the exercise price of the Right. At any time before a person becomes an Acquiring Person, the Rights can be redeemed, in whole, but not in part, by the Company’s Board of Directors at a price of $0.001 per Right. The Rights Plan will expire on August 5, 2018.


21
 Table of Contents


Performance Graphs











This graph shall not be deemed filed or incorporated by reference into any filing under the Securities Act of 1933


22
 Table of Contents


Item6. Selected Financial Data





Farmers & Merchants Bancorp


Five Year Financial Summary of Operations


(in thousands except per share data)





Summary of Income:

2009


2008


2007


2006


2005Total Interest Income

$
91,314


$
93,208


$
95,775


$
88,396


$
72,458Total Interest Expense


16,331



24,784



32,225



24,621



14,032Net Interest Income


74,983



68,424



63,550



63,775



58,426Provision for Loan Losses


15,420



7,998



1,495



275



425Net Interest Income After Provision for Loan Losses


59,563



60,426



62,055



63,500



58,001Total Non-Interest Income


18,194



16,064



15,455



12,063



11,274Total Non-Interest Expense


46,429



40,103



41,945



43,121



40,617Income Before Income Taxes


31,328



36,387



35,565



32,442



28,658Provision for Income Taxes


11,315



13,597



12,870



11,813



10,230Net Income

$
20,013


$
22,790


$
22,695


$
20,629


$
18,428Balance Sheet Data:Total Assets

$
1,781,014


$
1,684,437


$
1,519,172


$
1,411,233


$
1,352,989Loans


1,212,718



1,177,364



1,140,969



1,046,912



973,257Allowance for Loan Losses


29,813



20,034



18,483



18,099



17,860Investment Securities


435,166



363,729



247,637



243,867



267,940Deposits


1,498,124



1,432,702



1,310,790



1,198,528



1,103,340Federal Home Loan Bank Advances


20,149



703



28,954



47,532



98,847Shareholders' Equity


164,727



156,545



143,418



132,340



123,648Selected Ratios:Return on Average Assets


1.15
%


1.44
%


1.56
%


1.51
%


1.46
%Return on Average Equity


12.33
%


15.23
%


16.26
%


16.16
%


15.26
%Dividend Payout Ratio(1)


42.95
%


36.99
%


34.51
%


33.77
%


34.55
%Average Loans to Average Deposits


80.12
%


84.16
%


86.86
%


90.24
%


87.28
%Average Equity to Average Assets


9.34
%


9.46
%


9.60
%


9.38
%


9.58
%Period-end Shareholders' Equity to Total Assets


9.25
%


9.29
%


9.44
%


9.38
%


9.14
%Per Share Data:Net Income (2) (3)

$
25.57


$
28.69


$
28.05


$
25.25


$
22.24Cash Dividends Per Share (1)(3)

$
11.00


$
10.65


$
9.70


$
8.55


$
7.68





(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 782,754, 794,239, 809,057, 817,044, and  828,537 for the years ended December 31, 2009, 2008, 2007, 2006, and 2005, respectively.


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


23
 Table of Contents


Item7. Management's Discussion 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: 2005 through 2009


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





(in thousands, except per share data)


Financial Performance Indicator

2009


2008


2007


2006


2005Net Income

$
20,013


$
22,790


$
22,695


$
20,629


$
18,428Total Assets

$
1,781,014


$
1,684,437


$
1,519,172


$
1,411,233


$
1,352,989Total Loans

$
1,212,718


$
1,177,364


$
1,140,969


$
1,046,912


$
973,257Total Deposits

$
1,498,124


$
1,432,702


$
1,310,790


$
1,198,528


$
1,103,340Total Shareholders’ Equity

$
164,727


$
156,545


$
143,418


$
132,340


$
123,648Total Consolidated Risk-Based Capital Ratio


12.48
%


12.59
%


12.21
%


12.17
%


12.32
%Non-Performing Loans as a % of Total Loans


0.76
%


0.45
%


0.01
%


0.00
%


0.03
%Net Charge-Offs to Average Loans


0.48
%


0.57
%


0.10
%


0.00
%


0.03
%Loan Loss Allowance as a % of Total Loans


2.45
%


1.70
%


1.62
%


1.72
%


1.82
%Return on Average Assets


1.15
%


1.44
%


1.56
%


1.51
%


1.46
%Return on Average Equity


12.33
%


15.23
%


16.26
%


16.16
%


15.26
%Earnings Per Share (1)

$
25.57


$
28.69


$
28.05


$
25.25


$
22.24Cash Dividends Per Share (1) (2)

$
11.00


$
10.65


$
9.70


$
8.55


$
7.68Cash Dividends Declared (2)

$
8,596


$
8,430


$
7,831


$
6,966


$
6,366# Shares Repurchased During Year


6,016



13,152



11,821



11,718



8,066Average Share Price of Repurchased Shares

$
387


$
449


$
460


$
507


$
496High Stock Price – Fourth Quarter

$
425


$
450


$
460


$
557


$
500Low Stock Price – Fourth Quarter

$
325


$
385


$
381


$
505


$
465Closing Stock Price – Fourth Quarter

$
380


$
420


$
460


$
515


$
490


_______________________________________________________


(1) 2005 has  been restated for stock dividends issued.  No stock dividend was issued in 2006 through 2009.


(2) Not including cash paid in lieu of fractional shares related to stock dividends.  These payments totaled $290,000 in  2005.





The years 2005 through 2009 were comprised of two very distinct economic periods.  From 2005 through the first half of 2007 the economy was strong, the stock market rising and individuals and businesses doing well.  Then in October 2007, the financial markets started what would become a major adjustment and a prolonged economic recession began that continues even today. Despite what can only be described as a roller coaster ride, in management’s opinion the Company’s operating performance remained exceptionally strong even through the difficult years of 2008 and 2009:


24
 Table of Contents




·
Net income totaled $104.5 million over the five-year period and even during the difficult year of 2009, exceeded $20 million.





·
Return on Average Assets averaged 1.42%, and never dropped below 1.15% in any single year.





·
Total assets increased 45.2% to $1.8 billion.





·
Total loans increased 39.9% to $1.2 billion.





·
Total deposits increased 49.5% to $1.5 billion.





For many banks 2008 and 2009 were very difficult years when major credit quality problems surfaced that resulted in significant declines in profits or even losses.  Although the Company was not entirely immune to the pressures that a struggling economy brought to bear, record profits were reported in 2008 and in 2009, although profits declined, management believes that the Company’s performance compared very favorably to its peer banks.  During 2009:





·
The Company earned $20.0 million for a return on average assets of 1.15%. Importantly, these strong results were generated at the same time the Company: (1) strengthened its loan loss allowance by $9.8 million to $29.8 million or 2.45% of total loans; and (2) expensed FDIC premiums and special assessments of $2.5 million, a $1.96 million increase over 2008.





·
The Company increased its cash dividend per share by 3.3% over 2008 levels.





·
The Company’s risk based capital ratio was 12.48% at December 31, 2009, resulting in the highest regulatory classification of “well capitalized.”  See “Financial Condition – Capital.”





·
The Company’s asset quality remained very strong compared to peer banks at the present time, when measured by net charge-offs of 0.48% of average loans in 2009 and non-performing loans totaling 0.76% of total loans at December 31, 2009. See “Results of Operations – Provision and Allowance for Loan Losses” and “Financial Condition – Classified Loans and Non-Performing Assets.”





·
At December 31, 2009, the Bank’s “Texas Ratio” an industry measure that compares: (1) levels of non-performing assets to; (2) tangible equity capital plus loss reserves, was 8.6%, one of the best in California.





As a result of this strong earnings performance, capital position, and asset quality, stockholders have benefited well in excess of overall bank and bank holding company stock market returns over the past five years:





·
Cash Dividends per Share, restated for stock dividends issued, have increased 60.6% since 2004, and totaled $47.58 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 Company did not dilute existing common stockholders by participating in the Federal Government’s 2008 TARP Capital Purchase Program.  See “Item 1. Business – Supervision and Regulation - Recent Governmental Actions in Response to the Financial Crises.”




25
 Table of Contents





Looking Forward: 2010 and Beyond


In management’s opinion, the following key issues will influence the financial results of the Company in 2010 and future years:





·
The Company’s results can be significantly influenced by changes in the credit quality of its borrowers. Non-performing loans totaled $9.2 million or 0.76% of total loans at December 31, 2009. Management believes based on information currently available that these levels are adequately covered by the Company’s $29.8 million allowance for loan losses as of December 31, 2009. See “Results of Operations - Provision and Allowance for Loan Losses” and “Financial Condition – Classified Loans and Non-Performing Assets.” The Company’s provision for loan losses was $5.1 million in the fourth quarter of 2009 resulting in a total of $15.4 million for the full year, a significant increase from $8.0 million in 2008. Given the continued recessing economy in the United States, California, and particularly the Central Valley, an increasing number of the Company’s borrowers are feeling the impact of the recession. As a result, the Company anticipates that loan loss provisions at or above 2009 levels may be required throughout 2010 and possibly 2011. See “Item 1A. Risk Factors.”





·
FDIC deposit insurance assessments have increased substantially and may continue to increase, which will adversely affect profits.FDIC deposit insurance expense for the year ended December 31, 2009 was $2.5 million, comprised of $1.7 million in regular assessments and a special assessment of $798,000.  This represents a $1.9 million increase over 2008.  See “Results of Operations – Non-Interest Expense. Additionally, in December 2009 the FDIC required all banks to prepay three years of estimated insurance premiums, an amount that totaled $7.26 million for the Bank. Deposit insurance assessments may continue to increase in future years due to recent strains on the FDIC deposit insurance fund resulting from the cost of recent bank failures and an increase in the number of banks likely to fail over the next few years.





·
Congress and the Obama Administration have implemented, or are proposing, broad changes to consumer financial products regulation.  These changes could significantly affect the Company’s product offerings, pricing and profitability in areas such as credit cards, home mortgages and deposit services charges, particularly fees associated with the Company’s Overdraft Privilege Service. See “Results of Operations – Non-Interest Income.”





·
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 behind increases in loan rates, the Company’s net interest margin dropped by 48 basis points 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 4.82% for the fourth quarter of 2009.


-
In addition to changes in market interest rates, the Company’s net interest margin has come under pressure from: (1) aggressive competitor pricing strategies for both loans and deposits to which the Company needs to respond 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.





In addition to the preceding issues, management has reviewed the Company’s existing branch delivery system, along with the availability and desirability of additional branch locations, and, beginning in 2003, initiated a branch expansion, relocation and renovation program. Between 2003 and 2006, five new branches were opened in Modesto, Galt, Sacramento, Lodi, and Stockton, and several other branches underwent major renovations. The downtown Turlock branch was relocated to a new facility in 2008. The Company’s first branch in Merced opened in February 2009. In management’s opinion, these moves are integral to the long-term strategic positioning of the Company. Although no other branch expansions are currently in process, the Company is always active in identifying areas of our branch system that could be expanded.




26
 Table of Contents


Capital expenditures associated with this multi-year branch program were approximately $15 million.  In addition, the increased staffing and other operating expenses associated with these new branches places pressure on the Company’s earnings over 24-36 months, the timeframe in which a branch is 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, 2009, 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 2009, 2008, and 2007. Average balance amounts for assets and liabilities are the computed average of daily balances.





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.”


27
 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 31,2009Assets

Balance


Interest


RateFederal Funds Sold and Securities Purchased Under Agreements to Resell

$
36,767


$
96



0.26
%Investment Securities Available-for-SaleU.S. Agencies


59,760



1,036



1.73
%Municipals - Non-Taxable


9,194



704



7.66
%Mortgage Backed Securities


243,280



12,100



4.97
%Other


8,312



42



0.51
%Total Investment Securities Available-for-Sale


320,546



13,882



4.33
%Investment Securities Held-to-MaturityU.S. Agencies


-



-



0.00
%Municipals - Non-Taxable


64,121



3,717



5.80
%Mortgage Backed Securities


4,365



167



3.83
%Other


1,991



51



2.56
%Total Investment Securities Held-to-Maturity


70,477



3,935



5.58
%LoansReal Estate


697,377



45,555



6.53
%Home Equity


65,802



3,984



6.05
%Agricultural


208,678



12,684



6.08
%Commercial


200,560



11,902



5.93
%Consumer


10,666



762



7.14
%Credit Card


-



-



0.00
%Municipal


1,077



14



1.30
%Total Loans


1,184,160



74,901



6.33
%Total Earning Assets


1,611,950


$
92,814



5.76
%Unrealized Gain on Securities Available-for-Sale


9,467Allowance for Loan Losses


(23,396
)Cash and Due From Banks


31,373All Other Assets


109,461Total Assets

$
1,738,855Liabilities & Shareholders' EquityInterest Bearing DepositsInterest Bearing DDA

$
155,000


$
308



0.20
%Savings


392,770



2,569



0.65
%Time Deposits


652,787



10,869



1.67
%Total Interest Bearing Deposits


1,200,557



13,746



1.14
%Securities Sold Under Agreement to Repurchase


60,000



2,148



3.58
%Other Borrowed Funds


1,817



40



2.20
%Subordinated Debt


10,310



397



3.85
%Total Interest Bearing Liabilities


1,272,684


$
16,331



1.28
%Interest Rate Spread










4.47
%Demand Deposits


277,398All Other Liabilities


26,414Total Liabilities


1,576,496Shareholders' Equity


162,359Total Liabilities & Shareholders' Equity

$
1,738,855Impact of Non-Interest Bearing Deposits and Other Liabilities










0.27
%Net Interest Income and Margin on Total Earning Assets






76,483



4.74
%Tax Equivalent Adjustment






(1,500
)Net Interest Income





$
74,983



4.65
%


Notes:  Yields on municipal securities have been calculated on a fully taxable equivalent basis.  Loan interest income includes fee income and unearned discount in the amount of $1.5 million for the year ended December 31, 2009. Non-accrual loans and lease financing receivables have been included in the average balances. Yields on securities available-for-sale are based on historical cost.


28
 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 31,2008Assets

Balance


Interest


RateFederal Funds Sold and Securities Purchased Under Agreements to Resell

$
16,642


$
424



2.55
%Investment Securities Available-for-SaleU.S. Agencies


601



23



3.83
%Municipals - Non-Taxable


9,277



703



7.57
%Mortgage Backed Securities


187,686



10,078



5.37
%Other


3,508



266



7.58
%Total Investment Securities Available-for-Sale


201,072



11,070



5.51
%Investment Securities Held-to-MaturityU.S. Agencies


27,567



1,154



4.19
%Municipals - Non-Taxable


66,538



3,879



5.83
%Mortgage Backed Securities


5,926



229



3.86
%Other


1,997



52



2.60
%Total Investment Securities Held-to-Maturity


102,028



5,314



5.21
%LoansReal Estate


663,336



45,781



6.90
%Home Equity


65,356



4,343



6.65
%Agricultural


183,644



12,988



7.07
%Commercial


202,001



13,574



6.72
%Consumer


12,328



958



7.77
%Credit Card


2,624



265



10.10
%Municipal


1,184



15



1.27
%Total Loans


1,130,473



77,924



6.89
%Total Earning Assets


1,450,215


$
94,732



6.53
%Unrealized Gain (Loss) on Securities Available-for-Sale


1,565Allowance for Loan Losses


(18,741
)Cash and Due From Banks


43,796All Other Assets


104,646Total Assets

$
1,581,481Liabilities & Shareholders' EquityInterest Bearing DepositsInterest Bearing DDA

$
132,686


$
125



0.09
%Savings


331,879



3,647



1.10
%Time Deposits


606,738



18,602



3.07
%Total Interest Bearing Deposits


1,071,303



22,374



2.09
%Securities Sold Under Agreement to Repurchase


43,607



1,528



3.50
%Other Borrowed Funds


8,329



245



2.94
%Subordinated Debt


10,310



637



6.18
%Total Interest Bearing Liabilities


1,133,549


$
24,784



2.19
%Interest Rate Spread










4.35
%Demand Deposits


271,994All Other Liabilities


26,347Total Liabilities


1,431,890Shareholders' Equity


149,591Total Liabilities & Shareholders' Equity

$
1,581,481Impact of Non-Interest Bearing Deposits and Other Liabilities










0.48
%Net Interest Income and Margin on Total Earning Assets






69,948



4.82
%Tax Equivalent Adjustment






(1,524
)Net Interest Income





$
68,424



4.72
%


Notes:  Yields on municipal securities have been calculated on a fully taxable equivalent basis.  Loan interest income includes fee income and unearned discount in the amount of $2.2 million for the year ended December 31, 2008. Non-accrual loans and lease financing receivables have been included in the average balances. Yields on securities available-for-sale are based on historical cost.


29
 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-SaleMunicipals - 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
%Municipal


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 Gain (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 in the amount of $2.2 million for the year ended December 31, 2007. Yields on securities available-for-sale are based on historical cost.


30
 Table of Contents


Farmers & Merchants Bancorp


Volume and Rate Analysis of Net Interest Revenue





(Interest and Rates on a Taxable Equivalent Basis)

2009 versus 2008(in thousands)

Amount of Increase(Decrease) Due to Change in:Interest Earning Assets

Volume


Rate


Net Chg.Federal Funds Sold

$
249


$
(577
)

$
(328
)Investment Securities Available-for-SaleU.S. Agencies


1,032



(19
)


1,013Municipals - Non-Taxable


(6
)


7



1Mortgage-backed Securities


2,809



(788
)


2,021Other


162



(386
)


(224
)Total Investment Securities Available-for-Sale


3,997



(1,186
)


2,811Investment Securities Held-to-MaturityU.S. Agencies


(577
)


(577
)


(1,154
)Municipals - Non-Taxable


(141
)


(21
)


(162
)Mortgage-backed Securities


(59
)


(3
)


(62
)Other


-



(1
)


(1
)Total Investment Securities Held-to-Maturity


(777
)


(602
)


(1,379
)Loans:Real Estate


2,287



(2,512
)


(225
)Home Equity


30



(389
)


(359
)Agricultural


1,647



(1,951
)


(304
)Commercial


(97
)


(1,575
)


(1,672
)Consumer


(122
)


(74
)


(196
)Credit Card


(132
)


(133
)


(265
)Other


(1
)


-



(1.00
)Total Loans


3,612



(6,634
)


(3,022
)Total Earning Assets


7,081



(8,999
)


(1,918
)Interest Bearing LiabilitiesInterest Bearing Deposits:Interest Bearing DDA


24



159



183Savings


585



(1,663
)


(1,078
)Time Deposits


1,320



(9,053
)


(7,733
)Total Interest Bearing Deposits


1,929



(10,557
)


(8,628
)Securities Sold Under Agreement to Repurchase


586



33



619Other Borrowed Funds


(156
)


(49
)


(205
)Subordinated Debt


-



(239
)


(239
)Total Interest Bearing Liabilities


2,359



(10,812
)


(8,453
)Total Change

$
4,722


$
1,813


$
6,535


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.


31
 Table of Contents


Farmers & Merchants Bancorp


Volume and Rate Analysis of Net Interest Revenue





(Interest and Rates on a Taxable Equivalent Basis)

2008 versus 2007(in thousands)

Amount of Increase(Decrease) Due to Change in:Interest Earning Assets

Volume


Rate


Net Chg.Federal Funds Sold

$
232


$
(346
)

$
(114
)Investment Securities Available-for-SaleU.S. Agencies


23



-



23Municipals - Non-Taxable


(133
)


50



(83
)Mortgage-backed Securities


3,899



184



4,083Other


(166
)


135



(31
)Total Investment Securities Available-for-Sale


3,623



369



3,992Investment Securities Held-to-MaturityU.S. Agencies


(122
)


5



(117
)Municipals - Non-Taxable


(143
)


17



(126
)Mortgage-backed Securities


(69
)


3



(66
)Other


(3
)


(6
)


(9
)Total Investment Securities Held-to-Maturity


(337
)


19



(318
)Loans:Real Estate


2,475



(2,611
)


(136
)Home Equity


(49
)


(796
)


(845
)Agricultural


(950
)


(2,479
)


(3,429
)Commercial


1,678



(2,927
)


(1,249
)Consumer


(98
)


(128
)


(226
)Credit Card


(284
)


12



(272
)Other


1



(1
)


-Total Loans


2,773



(8,930
)


(6,157
)Total Earning Assets


6,291



(8,888
)


(2,597
)Interest Bearing LiabilitiesInterest Bearing Deposits:Interest Bearing DDA


2



21



23Savings


564



(1,303
)


(739
)Time Deposits


2,204



(9,074
)


(6,870
)Total Interest Bearing Deposits


2,770



(10,356
)


(7,586
)Securities Sold Under Agreement to Repurchase


1,528



-



1,528Other Borrowed Funds


(699
)


(453
)


(1,152
)Subordinated Debt


-



(231
)


(231
)Total Interest Bearing Liabilities


3,599



(11,040
)


(7,441
)Total Change

$
2,692


$
2,152


$
4,844


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.


32
 Table of Contents


2009 Compared to 2008


Net interest income increased 9.6% to $74.9 million during 2009. On a fully tax equivalent basis, net interest income increased 9.3% and totaled $76.4 million during 2009 compared to $69.9 million for 2008. As more fully discussed below, the increase in net interest income was primarily due to an 11.2% increase in average earning assets.





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 2009, the Company’s net interest margin was 4.74% compared to 4.82% in 2008. 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: 2010 and Beyond” for a discussion of factors impacting the Company’s future net interest margin.





Loans, generally the Company’s highest earning assets, increased $35.3 million as of December 31, 2009, compared to December 31, 2008. See “Financial Condition – Loans” for further discussion of this increase. On an average balance basis, loans increased by $53.7 million for the year ended December 31, 2009. Loans decreased from 77.9% of average earning assets during 2008 to 73.5% in 2009. As a result of decreases in market interest rates from mid-September 2007 through December 2008 the year-to-date yield on the loan portfolio declined to 6.33% for the year ended December 31, 2009, compared to 6.89% for the year ended December 31, 2008. Even with the increase in loan balances, the decrease in yield resulted in interest revenue from loans decreasing 3.9% to $53.7 million for 2009. The Company has been experiencing aggressive competitor pricing for loans to which it may need to continue to respond in order to retain key customers. This, in conjunction with decreases in market interest rates by the FRB, could place even greater negative pressure on future loan yields and net interest margin.





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. Importantly, the Company never invested in the preferred stock or subordinated debt of Fannie Mae “FNMA” or Freddie Mac “FHLMC,” securities that caused many banks to incur losses in recent years.





Average investment securities increased $87.9 million in 2009 compared to the average balance during 2008.  As of year-end 2009 investment securities were $71.4 million greater than at year-end 2008. See “Financial Condition – Investment Securities” for a discussion of the Company’s investment strategy in 2009. Interest income on securities increased $1.4 million to $17.8 million for the year ended December 31, 2009, compared to $16.4 million for the year ended December 31, 2008. The average yield, on a tax equivalent basis, in the investment portfolio was 4.5% in 2009 compared to 5.4% in 2008. Net interest income on the Schedule of Year-to-Date Average Balances and Interest Rates is shown on a tax equivalent basis, which is higher than net interest income as reflected on the Consolidated Statements 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 $139.1 million or 12.3% during 2009. Of that increase, securities sold under agreement to repurchase, a new borrowing added during the first quarter of 2008 to manage the Company’s interest rate risk, increased $16.4 million, interest-bearing deposits increased $129.2 million, and other borrowed funds decreased $6.5 million.





During 2009, the Company was able to grow average interest bearing deposits by $129.2 million. See “Financial Condition – Deposits” for a discussion of trends in the Company’s deposit base. Total interest expense on deposits was $13.7 million in 2009 as compared to $22.4 million in 2008. The average rate paid on interest-bearing deposits was 1.1% in 2009 and 2.1% in 2008. Since September 2007 the FRB has been lowering market rates. The Company has begun to feel this beneficial impact as the average rate paid on interest-bearing liabilities declined to 1.3% in December 2009. The Company anticipates that this decline in deposit rates will continue into 2010.  See “Overview – Looking Forward: 2010 and Beyond” for a discussion of factors impacting the Company’s future deposit rates and their impact on net interest margin.


33
 Table of Contents


2008 Compared to 2007


Net interest income increased 7.7% to $68.4 million during 2008. During 2007 net interest income was $63.6 million, representing a decrease of 0.4% from 2006. On a fully tax equivalent basis, net interest income increased 7.4% and totaled $69.9 million during 2008 compared to $65.1 million for 2007. As more fully discussed below, the increase in net interest income was primarily due to an 8.0% increase in average earning assets.





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 2008, the Company’s net interest margin was 4.82% compared to 4.85% in 2007.





Loans, generally the Company’s highest earning assets, increased $36.4 million as of December 31, 2008, compared to December 31, 2007. On an average balance basis, loans increased by $40.5 million for the year ended December 31, 2008. Loans decreased from 81.2% of average earning assets during 2007 to 77.9% in 2008. As a result of decreases in market interest rates from mid-September 2007 through December 2008 the year-to-date yield on the loan portfolio declined to 6.89% for the year ended December 31, 2008, compared to 7.71% for the year ended December 31, 2007. Even with the increase in loan balances, the decrease in yield resulted in interest revenue from loans decreasing 7.3% to $77.9 million for 2008.





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 increased $61.4 million in 2008 compared to the average balance during 2007.  As of year-end 2008 investment securities were $116.1 million greater than at year-end 2007. Interest income on securities increased $3.7 million to $16.4 million for the year ended December 31, 2008, compared to $12.7 million for the year ended December 31, 2007. The average yield, on a tax equivalent basis, in the investment portfolio was 5.4% in 2008 compared to 5.3% in 2007.





Average interest-bearing sources of funds increased $120.5 million or 11.9% during 2008. Of that increase, securities sold under agreement to repurchase, a new borrowing added during the first quarter of 2008 to manage the Company’s interest rate risk, increased $43.6 million, and interest-bearing deposits increased $95.0 million.





During 2008 the Company was able to grow average interest bearing deposits by $95.0 million. The increase was primarily in time and savings deposits, which grew $93.1 million, as lower cost interest bearing DDA increased by $1.9 million. Total interest expense on deposits was $22.4 million in 2008 as compared to $30.0 million in 2007. The average rate paid on interest-bearing deposits was 2.1% in 2008 and 3.1% in 2007.





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 best 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.


34
 Table of Contents


Changes in the provision for loan losses between years are the result of management’s evaluation, based upon information currently available, 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. The Central Valley of California has been one of the hardest hit areas in the country during this recession.  Housing prices in many areas are down over 60% and the economic stress has spread from residential real estate to other industry segments such as autos and commercial real estate.  Unemployment levels are well above 10% in many areas. Although, in management’s opinion, the Company’s levels of net charge-offs and non-performing assets as of December 31, 2009, compare very favorably to our peers at the present time, we believe that it is prudent to be prepared for the possibility that any significant recovery in our local markets will not occur until the second half of 2010 or later and this may result in additional borrower stress in the coming quarters.  Accordingly, beginning in the second quarter of 2009, management and the Board of Directors significantly increased the Company’s level of loan loss allowance and as of December 31, 2009, the balance was $29.8 million or 2.45% of total loans.  This represents a $9.8 million or 48.8% increase over December 31, 2008, with $9.3 million of this increase allocated to the Company’s commercial real estate portfolio, an area of the local economy that has experience increasing stress in 2009.  The allowance allocated to the Company’s commercial real estate portfolio has increased from 1.3% to 4.4% of commercial real estate loans outstanding over the past year (see allowance allocation table).





The provision for loan losses totaled $15.4 million in 2009 compared to $8.0 million in 2008 and $1.5 million in 2007.  Net charge-offs during 2009 were $5.6 million compared to $6.4 million in 2008 and $1.1 million in 2007.  Net charge-offs represented 0.48% of average loans during 2009, a level that in management’s opinion compares very favorably to the Company’s peers at the present time.  See “Overview – Looking Forward: 2010 and Beyond”, “Critical Accounting Policies and Estimates – Allowance for Loan Losses” and “Item 7A. Quantitative and Qualitative Disclosures About Market Risk-Credit Risk.”





As of December 31, 2009, the allowance for loan losses was $29.8 million, which represented 2.45% of the total loan balance. At December 31, 2008, the allowance for loan losses was $20.0 million or 1.70% of the total loan balance. After reviewing all factors above, based upon information currently available, management concluded that the allowance for loan losses as of December 31, 2009, was adequate.


35
 Table of Contents


The following tables summarize the activity and the allocation of the allowance for losses for the years indicated.





(in thousands)

2009


2008


2007


2006


2005Allowance for Loan Losses Beginning of Year

$
20,034


$
18,483


$
18,099


$
17,860


$
17,727Provision Charged to Expense


15,420



7,998



1,495



275



425Charge Offs:Commercial Real Estate


-



-



-



-



-Agricultural Real Estate


-



-



-



-



-Real Estate Construction


641



4,648



-



-



-Residential 1st Mortgages


749



192



-



-



-Home Equity Lines and Loans


391



-



-



-



-Agricultural


123



209



254



333



199Commercial


3,868



1,405



722



121



442Consumer


159



98



52



41



26Credit Card


-



124



202



284



200Other


-



101



143



60



-Total Charge Offs


5,931



6,777



1,373



839



867Recoveries:Commercial Real Estate


-



-



-



-



-Agricultural Real Estate


-



-



-



-



-Real Estate Construction


-



-



-



-



-Residential 1st Mortgages


3



-



-



-



-Home Equity Lines and Loans


1



-



-



-



-Agricultural


50



60



79



75



376Commercial


104



143



30



624



134Consumer


132



9



11



37



19Credit Card


-



27



42



26



46Other


-



91



100



41



-Total Recoveries


290



330



262



803



575Net Charge-Offs


(5,641
)


(6,447
)


(1,111
)


(36
)


(292
)Total Allowance for Loan Losses

$
29,813


$
20,034


$
18,483


$
18,099


$
17,860Ratios:Allowance for Loan Losses to:Total Loans at Year End


2.45
%


1.70
%


1.62
%


1.72
%


1.83
%Average Loans


2.52
%


1.77
%


1.70
%


1.81
%


1.98
%Consolidated Net Charge-Offs to:Loans at Year End


0.46
%


0.55
%


0.10
%


0.00
%


0.03
%Average Loans


0.48
%


0.57
%


0.10
%


0.00
%


0.03
%


36
 Table of Contents


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." The table below discloses a breakdown of the allowance for loan losses and the allowance percentage allocated to each loan category.





Allowance Allocation at December 31,2009


2008


2007


2006


2005(in thousands)

Amount


Percent


Amount


Percent


Amount


Percent


Amount


Percent


Amount


PercentCommercial Real Estate

$
12,845



4.4
%

$
3,547



1.3
%

$
2,527



0.6
%

$
4,175



1.0
%

$
3,974



1.2
%Agricultural Real Estate*


1,099



0.4
%


1,683



0.7
%Real Estate Construction


4,089



5.7
%


1,514



2.0
%


2,896



3.6
%


880



0.9
%


1,088



1.0
%Residential 1st Mortgages


552



0.5
%


992



0.9
%


1,652



1.5
%


1,373



1.3
%


1,370



1.3
%Home Equity Lines and Loans


1,349



2.1
%


1,781



2.7
%


836



1.3
%


436



0.6
%


416



0.6
%Agricultural


2,298



1.1
%


4,432



2.0
%


5,335



2.5
%


3,564



1.9
%


1,786



1.0
%Commercial


6,449



3.4
%


4,933



2.4
%


3,923



2.0
%


6,007



3.6
%


8,317



4.8
%Consumer


67



0.7
%


698



5.8
%


346



2.7
%


92



0.7
%


89



0.7
%Other


258



14.3
%


228



14.2
%


815



11.1
%


1,199



16.5
%


543



8.6
%Unallocated


807







226







153







373







277Total

$
29,813



2.5
%

$
20,034



1.7
%

$
18,483



1.6
%

$
18,099



1.7
%

$
17,860



1.8
%





* Prior to 2008 the allowance related to Agricultural Real Estate was included with Commercial Real Estate





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) Debit Card and 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; (7) gains and losses on the sale of loans and/or other business assets; and (8) fees from other miscellaneous business services.





2009 Compared to 2008


Non-interest income totaled $18.2 million, an increase of $2.1 million or 13.3% from non-interest income of $16.1 million for 2008.





Service charges on deposit accounts totaled $6.9 million, a decrease of $188,000 or 2.6% from service charges on deposit accounts of $7.1 million in 2008. This was due primarily to a decrease in fees related to the Company’s Overdraft Privilege Service.





Net gain on investment securities was $3.5 million in 2009 compared to a gain of $1.5 million for 2008. During 2009 the Company sold mortgage-backed securities at a gain and, in anticipation of rising rates, invested the funds primarily in shorter-term agency securities.  See “Financial Condition-Investment Securities” for a discussion of the Company’s investment strategy.





During the second quarter of 2008 the Company determined that providing credit card and merchant processing services through third party strategic partners would result in a stronger, more competitive set of products with the potential for increased growth in future earnings. The sale of the credit card portfolio resulted in a gain of $1.0 million and the merchant portfolio $1.9 million in 2008. The sale of the merchant portfolio also resulted in a decrease in Credit Card Merchants Fees in the amount of $1.1 million from 2008, with a corresponding decrease in Credit Card Merchant Expense. See “Non-Interest Expense.”


37
 Table of Contents


Debit Card and ATM fees totaled $2.2 million, an increase of $194,000 or 9.5% over fees in 2008. These are: (1) fees earned by the Company when non-customers use our ATM’s; and (2) fees paid to the Company by VISA merchants when the Company’s VISA Money Card holders use their card to complete a purchase.





Gain on deferred compensation investments were $1.8 million in 2009 compared to losses of $2.7 million in 2008. The Company allows executives who participate in non-qualified deferred compensation plans to self-direct the investment of their vested balances. See Note 13. located in “Item 8. Financial Statements and Supplementary Data” for a description of these plans. Market value gains/losses on these plan balances fluctuate depending on the type of investments held and market trends in interest rates and stock prices. Although Generally Accepted Accounting Principles require these investment gains/losses be recorded in non-interest income, an offsetting entry is also required to be made to non-interest expense resulting in no effect on the Company’s net income.





Other non-interest income totaled $1.8 million in 2009, a decrease of $373,000 or 16.9% from 2008. This decrease was primarily due to the reduction of certain fees the Company no longer generates since the sale of the Credit Card and Merchant Card portfolios in June 2008.





2008 Compared to 2007


Non-interest income totaled $16.1 million, an increase of $609,000 or 3.9% from non-interest income of $15.4 million for 2007.





Service charges on deposit accounts totaled $7.1 million, a decrease of $143,000 or 1.9% from service charges on deposit accounts of $7.3 million in 2007. This decrease was due primarily to fees related to the Company’s Overdraft Privilege Service.





Net gain on investment securities was $1.5 million in 2008 compared to a loss of $1.7 million for 2007. During 2007 the Company recognized an impairment loss on investment securities. In both the second and fourth quarter of 2008 the Company sold selected investment securities, which resulted in the net a gain of $1.5 million.





During the second quarter of 2008 the Company determined that providing credit card and merchant processing services through third party strategic partners would result in a stronger, more competitive set of products with the potential for increased growth in future earnings. The sale of the credit card portfolio resulted in a gain of $1.0 million and the merchant portfolio $1.9 million. The sale of the merchant portfolio also resulted in a corresponding decrease in Credit Card Merchants Fees in the amount of $1.1 million or 49.1% from 2007, with a corresponding decrease in Credit Card Merchant Expense.





Debit Card and ATM fees totaled $2.1 million, an increase of $65,000 or 3.3% over fees in 2007. These are: (1) fees earned by the Company when non-customers use our ATM’s; and (2) fees paid to the Company by VISA merchants when the Company’s VISA Money Card holders use their card to complete a purchase.





Losses on deferred compensation investments were $2.7 million in 2008 compared to a gain of $1.0 million in 2007. The Company allows executives who participate in non-qualified deferred compensation plans to self-direct the investment of their vested balances. Market value gains/losses on these plan balances fluctuate depending on the type of investments held and market trends in interest rates and stock prices. Although Generally Accepted Accounting Principles require these investment gains/losses be recorded in non-interest income, an offsetting entry is also required to be made to non-interest expense resulting in no effect on the Company’s net income.





Other non-interest income totaled $2.2 million in 2008, a decrease of $723,000 or 24.7% from 2007. This decrease was primarily due to the receipt in 2007 of an $869,000 liquidating dividend from the Company’s partial ownership in WESBA, a credit card processing company whose operating assets were sold during 2006 and subsequently liquidated in 2007.





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.


38
 Table of Contents


2009 Compared to 2008


Overall, non-interest expense totaled $46.4 million, an increase of $6.3 million or 15.8% for the year ended December 31, 2009.





Salaries and employee benefits increased $1.7 million or 6.4% primarily due to officer salary increases, which took place in April 2009.





Gain on deferred compensation investments were $1.8 million in 2009 compared to losses of $2.7 million in 2008. The Company allows executives who participate in non-qualified deferred compensation plans to self-direct the investment of their vested balances. See Note 13. located in “Item 8. Financial Statements and Supplementary Data” for a description of these plans. Market value gains/losses on these plan balances fluctuate depending on the type of investments held and market trends in interest rates and stock prices. Although Generally Accepted Accounting Principles require these investment gains/losses be recorded in non-interest expense, an offsetting entry is also required to be made to non-interest income resulting in no effect on the Company’s net income.





Equipment expense in 2009 totaled $2.4 million, a decrease of $241,000 or 9.1% from 2008. In 2009, the Company converted its item processing, check imaging, and report generation systems from Wausau, Inc. to Summit Software, resulting in the elimination of the large annual maintenance contract payment to Wausau.





Credit Card Merchant Expense was zero in 2009. This was due to the sale of the merchant card portfolio during the second quarter of 2008.





ORE holding costs totaled $1.5 million in 2009 as compared to $2.2 in 2008. Due to the economic climate over the past two years the Company has acquired $8.4 million of other real estate, which includes a mix of raw land, residential finished lots and commercial buildings. See “Financial Condition – Classified Loans and Non-Performing Assets.” Included in the $1.5 million is $1.0 million related to the establishment of a reserve for ORE valuation adjustments.





Company’s total FDIC insurance costs exceeded the same period in 2008 by $1.9 million, a 369.2% increase. The FDIC continued to increase rates in 2009 and levy special assessments on all banks. See “Supervision and Regulation – Deposit Insurance” for further discussion of the Company’s deposit insurance.





Other non-interest expense declined $117,000, or 1.7%, to $6.7 million in 2009 compared to $6.8 million in 2008. This decrease was due to: (1) the elimination of certain costs associated with the Company’s credit card portfolio, which was sold in June 2008; and (2) the decrease or elimination of other expenses that were determined not to be necessary for the successful operation of the Company.





2008 Compared to 2007


Overall, non-interest expense totaled $40.1 million, a decrease of $1.8 million or 4.4% for the year ended December 31, 2008.





Salaries and employee benefits increased $722,000 or 2.7% primarily due to an increase in staff levels and overall salaries.





Losses on deferred compensation investments were $2.7 million in 2008 compared to a gain of $1.0 million in 2007. The Company allows executives who participate in non-qualified deferred compensation plans to self-direct the investment of their vested balances. Market value gains/losses on these plan balances fluctuate depending on the type of investments held and market trends in interest rates and stock prices. Although Generally Accepted Accounting Principles require these investment gains/losses be recorded in non-interest expense, an offsetting entry is also required to be made to non-interest income resulting in no effect on the Company’s net income.





Equipment expense in 2008 totaled $2.6 million, a decrease of $217,000 or 7.5% from 2007. During 2007 some Company owned automobiles and ATM machines were fully depreciated which reduced depreciation expense for 2008 when compared to 2007.


39
 Table of Contents


Credit Card Merchant Expense decreased $812,000 or 49.5% in 2008. This was due to the sale of the merchant card portfolio during the second quarter of 2008.





ORE holding costs totaled $2.2 million in 2008 as compared to $0 in 2007.The Company acquired $4.8 million of other real estate in 2008, most of which was raw land. Included in the $2.2 million was $2.1 million related to the establishment of a reserve for ORE valuation adjustments.





The Company’s total FDIC insurance costs totaled $532,000 for 2008, an increase of $388,000 or 269.4% from 2007. During 2008 the FDIC began increasing deposit insurance rates (see “Item 1. Business - Supervision and Regulation – Deposit Insurance”).





Other non-interest expense declined $671,000, or 8.9%, to $6.8 million in 2008 compared to $7.5 million in 2007. This decrease was due to: (1) the elimination of certain costs associated with the Company’s credit card portfolio, which was sold in June 2008; and (2) the decrease or elimination of other expenses that were determined not to be necessary for the successful operation of the Company.





Income Taxes


The provision for income taxes decreased $2.3 million during 2009. The effective tax rate in 2009 was 36.1% compared to 37.4% in 2008 and 36.2% in 2007. 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.





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: (1) the restrictions on the deductibility of loan losses; (2) deductibility of pension and other long-term employee benefits only when paid; and (3) 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 debt securities in the Company’s investment portfolio have historically been comprised primarily of Mortgage-backed securities issued by federal government-sponsored entities, U.S. Government Agencies and high grade bank-qualified municipals.  Importantly, the Company never invested in the preferred stock or subordinated debt of Fannie Mae “FNMA” or Freddie Mac “FHLMC”, classes of securities that resulted in losses for many banks in recent years.





The Company’s investment portfolio at the end of 2009 was $435.2 million, an increase of $71.4 million or 19.6% from 2008. Since the beginning of 2009 the Company has generated a significant amount of excess liquidity because interest rates have been low and perceived market risks high, causing customers to move funds from the stock market and other investment vehicles to FDIC insured bank deposits. Additionally, given the drop in mortgage rates during the first nine months of 2009, many of our higher coupon mortgage-backed securities were prepaying quickly, and their market value gains disappearing. As a result, during 2009 the Company sold, for a gain of $3.52 million, approximately $74.3 million of primarily mortgage-backed securities.  This further increased our excess cash position.





The Company’s 2009 reinvestment strategy for the cash generated from security sales and deposit inflows was: (1) during the first quarter forego higher yields in order to reduce current credit risk exposure by maintaining excess liquidity at the FRB; and (2) beginning during the second quarter increase yields by moving out of cash, but: (i) limit future interest rate risk exposure; and (ii) provide cash for future loan growth when economic conditions in the Company’s market improve by investing primarily in adjustable rate short-to-medium term agency mortgage-backed securities and callable agency debt securities.





The Company’s investment portfolio at the end of 2008 was $363.7 million, an increase of $116.1 million or 46.9% from 2007.  This increase was primarily due to the Company’s strategy during the first three quarters of 2008 of growing available-for-sale agency mortgage backed-backed securities as part of a leveraging strategy to manage interest rate risk.  This asset growth was funded primarily through Repurchase Agreements.


40
 Table of Contents


Not included in the investment portfolio are overnight investments in Federal Funds Sold.  In 2009 average Federal Funds Sold on a year to date basis was $36.7 million compared to $16.6 million in 2008. Overnight investments in Federal Funds Sold are an additional earning asset available to the Company. Historically, in order to earn interest on excess cash balances banks had to “sell” these balances (called “Federal Funds Sold”) on an overnight basis to other banks. However, in late 2008 the FRB began paying interest on the deposits that banks maintained in their FRB accounts (which are also classified as Federal Funds Sold on the Company’s balance sheets) providing an essentially risk-free alternative for earning interest on overnight cash balances. These balances earn interest at the Fed Funds rate, which has been 0.25% since December, 2008.  Since significant uncertainty/risk existed in the credit markets in early 2009, the Company elected to maintain much of its excess cash at the FRB during the first nine months of 2009, despite the fact that it was earning a very low rate of interest.The Company’s peak Federal Funds Sold position occurred on April 3, 2009 when $134.0 million was maintained overnight at the FRB.  By late April, 2009 the Company determined that the overall risk in the credit markets had returned to acceptable levels, and by June 30, 2009 the Company had moved most of its Federal Funds Sold balances into higher-yielding short- and medium-term investment securities.





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, 2009 and 2008, 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.


41
 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)

2009





2008


2007U. S. Agency

$
136,168


$
-


$
-


$
-


$
-


$
30,435Municipal


8,365



64,044



10,231



64,765



9,979



66,375Mortgage-backed Securities


215,327



3,583



276,176



5,133



126,144



6,731Other


5,689



1,990



5,432



1,992



5,920



2,053Total Book Value

$
365,549


$
69,617


$
291,839


$
71,890


$
142,043


$
105,594Fair Value

$
365,549


$
71,010


$
291,839


$
71,538


$
142,043


$
106,253





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, 2009. Non-taxable municipal securities have been calculated on a fully taxable equivalent basis.





Fair


AverageDecember 31, 2009(in thousands)

Value


YieldU.S. AgencyAfter one year through five years

$
131,077



1.72
%After five years through ten years


5,091



2.50
%Total U.S. Agency Securities


136,168



1.75
%Municipal - Non-TaxableOne year or less


1,017



4.59
%After ten years


7,348



5.14
%Total Non-Taxable Municipal Securities


8,365



5.07
%Mortgage-backed SecuritiesAfter five years through ten years


20,443



4.72
%After ten years


194,884



4.58
%Total Mortgage-backed Securities


215,327



4.60
%FHLBOne year or less


5,379



0.21
%Total FHLB Securities


5,379



0.21
%OtherOne year or less


310



3.92
%Total Other Securities


310



3.92
%Total Investment Securities Available-for-Sale

$
365,549



3.48
%





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, 2009. Non-taxable municipal securities have been calculated on a fully taxable equivalent basis.





Book


AverageDecember 31, 2009(in thousands)

Value


YieldMunicipal - Non-TaxableOne year or less

$
371



3.11
%After one year through five years


5,816



5.02
%After five years through ten years


42,141



3.99
%After ten years


15,716



5.36
%Total Non-Taxable Municipal Securities


64,044



4.42
%Mortgage-backed SecuritiesAfter one year through five years


3,583



3.87
%Total Mortgage-Backed Securities


3,583



3.87
%OtherAfter five years through ten years


9



4.11
%After ten years


1,981



2.55
%Total Other Securities


1,990



2.56
%Total Investment Securities Held-to-Maturity

$
69,617



4.34
%


42
 Table of Contents


Loans


The Company's loan portfolio at December 31, 2009, increased $35.4 million or 3.0% from December 31, 2008. Most of the current year’s growth occurred in commercial and agricultural real estate loans, market segments where the Company believes that current market rates and/or credit risks are more reasonable than in other loan segments. Growth in commercial real estate was carefully focused on owner-occupied buildings or investment properties with reasonable LTV’s and borrower personal guarantees.





Beginning in late 2006 and continuing through 2009, 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 $53.7 million or 4.7%. In 2008 average balances increased 3.7% or $40.5 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.





2009


2008


2007


2006


2005Amount


Percent


Amount


Percent


Amount


Percent


Amount


Percent


Amount


PercentCommercial Real Estate

$
290,473



23.9
%

$
271,856



23.0
%

$
245,926



21.5
%

$
242,033



23.1
%

$
222,323



22.8
%Agricultural Real Estate


260,000



21.4
%


227,166



19.3
%


207,889



18.2
%


168,425



16.1
%


102,286



10.5
%Real Estate Construction


71,647



5.9
%


75,472



6.4
%


80,651



7.1
%


95,378



9.1
%


110,235



11.3
%Residential 1st Mortgages


105,850



8.7
%


105,980



9.0
%


109,764



9.6
%


106,148



10.1
%


107,769



11.0
%Home Equity Lines and Loans


65,541



5.4
%


66,159



5.6
%


65,953



5.8
%


67,132



6.4
%


69,013



7.1
%Agricultural


217,989



17.9
%


216,610



18.4
%


215,798



18.9
%


183,589



17.5
%


170,657



17.5
%Commercial


191,949



15.8
%


202,636



17.2
%


197,108



17.2
%


165,412



15.8
%


174,530



17.9
%Consumer


9,599



0.8
%


12,004



1.0
%


12,706



1.1
%


13,949



1.3
%


12,653



1.3
%Credit Card


-



0.0
%


-



0.0
%


5,499



0.5
%


5,543



0.5
%


5,353



0.5
%Other


1,801



0.1
%


1,608



0.1
%


1,856



0.2
%


1,730



0.2
%


952



0.1
%Total Gross Loans


1,214,849



100.0
%


1,179,491



100.0
%


1,143,150



100.0
%


1,049,339



100.0
%


975,771



100.0
%Less:Unearned Income


2,131







2,127







2,181







2,427







2,514Allowance for Loan Losses


29,813







20,034







18,483







18,099







17,860Loans, Net

$
1,182,905






$
1,157,330






$
1,122,486






$
1,028,813






$
955,397


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.


43
 Table of Contents


The following table shows the maturity distribution and interest rate sensitivity of the loan portfolio of the Company on December 31, 2009.


Over OneYear to


OverOne Year


Five


Five(in thousands)

or Less


Years


Years


TotalCommercial Real Estate

$
4,392


$
78,585


$
207,496


$
290,473Agricultural Real Estate


11,256



30,893



217,851



260,000Real Estate Construction


53,126



14,946



3,575



71,647Residential 1st Mortgages


698



10,226



94,926



105,850Home Equity Lines and Loans


213



915



64,413



65,541Agricultural


110,970



88,858



18,161



217,989Commercial


91,237



76,394



24,318



191,949Consumer, Credit Card & Other


3,492



6,999



909



11,400Total

$
275,384


$
307,816


$
631,649


$
1,214,849Rate Sensitivity:Fixed Rate

$
42,174


$
142,193


$
217,041


$
401,408Variable Rate


233,210



165,623



414,608



813,441Total

$
275,384


$
307,816


$
631,649


$
1,214,849Percent


22.67
%


25.34
%


51.99
%


100.00
%





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, 2009, the Company had entered into loan commitments amounting to $315.2 million compared to $355.2 million at December 31, 2008. In addition, letters of credit issued by the Company to guarantee the performance of a customer to a third party at December 31, 2009, and December 31, 2008, were $9.2 million and $7.9 million, respectively.





Classified Loans and Non-Performing Assets


All loans are assigned a credit risk grade using grading standards developed by bank regulatory agencies. The Company utilizes the services of a third-party independent loan review firm to perform evaluations of individual loans and review the credit risk grades the Company places on loans. Loans that are judged to exhibit a higher risk profile are referred to as “classified loans”, and these loans receive increased management attention. As of December 31, 2009, classified loans totaled $62.9 million.  As of December 31, 2009, classified loans included multiple loans to one borrower totaling $32.7 million, all of which were current in their payments.





Also included in classified loans are seven restructured residential mortgage loans with balances totaling $556,000 at December 31, 2009. During 2009, the Company restructured these loans by taking partial principal charge-offs totaling $111,000 due to rate reductions and/or maturity extensions. All of these loans were current in their payments when they were restructured and remained on accrual at December 31, 2009. These loans have no commitments to lend additional funds.





Classified loans with higher levels of credit risk can be further designated as “non-accrual” loans, and the accrual of interest discontinued. 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.





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


44
 Table of Contents


The following table sets forth the amount of the Company's non-performing loans and ORE as of the dates indicated. These balances are reported net of guarantees of the U.S. Government, including its agencies and its government-sponsored agencies, in the amounts of $0, $473,000, $134,000, $27,000 and $314,000, respectively:





December 31,(in thousands)

2009


2008


2007


2006


2005Non-Accrual LoansCommercial Real Estate

$
1,294


$
3,635


$
-


$
3


$
-Agricultural Real Estate


2,589



-



-



-



-Real Estate Construction


1,225



400



-



-



-Residential 1st Mortgages


-



176



-



-



-Home Equity Lines and Loans


325



191



-



-



94Agricultural


1,080



-



-



-



93Commercial


2,696



55



45



9



104Consumer


-



-



6



-



-Credit Card


-



-



-



-



-Other


-



41



1



-



-Total Non-Accrual Loans


9,209



4,498



52



12



291Accruing Loans Past Due 90 Days or MoreCommercial Real Estate


-



769



-



-



17Agricultural Real Estate


-



-



-



-



-Real Estate Construction


-



-



-



-



-Residential 1st Mortgages


-



-



-



-



-Home Equity Lines and Loans


-



-



-



-



-Agricultural


-



-



-



-



-Commercial


-



-



-



-



-Consumer


-



-



-



-



-Credit Card


-



-



17



15



22Other


-



-



-



-



-Total Accruing Loans Past Due 90 Days or More


-



769



17



15



39Total Non-Performing Loans

$
9,209


$
5,267


$
69


$
27


$
330Other Real Estate Owned

$
8,418


$
4,817


$
251


$
-


$
-Non-Performing Loans as a Percent of Total Loans


0.76
%


0.45
%


0.01
%


0.00
%


0.03
%Allowance for Loan Losses as a Percent of Total Non-Performing Loans


323.74
%


380.37
%


26786.96
%


67033.33
%


5412.12
%





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 and/or collateral values will not result in future credit losses. Specific reserves of $1.0 million and $1.2 million have been established for non-performing loans at December 31, 2009 and 2008, respectively.





The Company reported $8.4 million of ORE at December 31, 2009, and $4.8 million at December 31, 2008. The increase in ORE during 2009 was primarily a result of the Company resolving a problem loan to one of the Bank’s commercial real estate borrowers.  The December 31, 2009, carrying value of $8.4 million is net of a $3.0 million reserve for ORE valuation adjustments.  ORE at December 31, 2009  includes a mix of raw land, residential finished lots and commercial buildings





Except for those classified and non-performing loans discussed above, the Company’s management is not aware of any loans as of December 31, 2009, for which known financial problems of the borrower would cause serious doubts as to the ability of these borrowers to materially comply with their present loan repayment terms, or any known events that would result in the loan being designated as non-performing at some future date.  However, the Central Valley of California has been one of the hardest hit areas in the country during this recession.  Housing prices in many areas are down over 60% and the economic stress has spread from residential real estate to other industry segments such as autos and commercial real estate.  Unemployment levels are well above 10% in many areas.  As a result of this combination of: (1) real estate values having declined significantly over the past 24 months; and (2) continuing deterioration in general economic conditions leading to increased unemployment and business failures; borrowers who up until this time have been able to keep current in their payments may experience continuing deterioration in their overall financial condition, significantly increasing the potential of default. See “Part I, Item 1A. Risk Factors.”


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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 following table sets forth, by time remaining to maturity, the Company’s time deposits in amounts of $100,000 or more at December 31, 2009.





(in thousands)Time Deposits of $100,000 or MoreThree Months or Less

$
203,159Over Three Months Through Six Months


120,860Over Six Months Through Twelve Months


57,147Over Twelve Months


15,499Total Time Deposits of $100,000 or More

$
396,665


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





At December 31, 2009, deposits totaled $1.5 billion.  This represents an increase of 4.6% or $65.4 million from December 31, 2008. Core deposits (exclusive of Public Time deposits) increased 4.6% over the same period.  Public Time Deposits totaled $162.8 million at December 31, 2009, an increase of $6.8 million since December 31, 2008. In addition to the Company’s ongoing business development activities for deposits, the following factors positively impacted year-over-year deposit growth: (1) interest rates were low and perceived market risks high, causing customers to move funds from the stock market and other investment vehicles to bank deposits; (2) the Federal government’s decision to increase FDIC deposit insurance limits from $100,000 to $250,000 per depositor (unlimited for non-interest bearing transaction accounts); and (3) the Company’s strong financial results and position and F&M Bank’s reputation as one of the most safe and sound banks in its market territory. The Company expects that the impact of the first two factors may mitigate during 2010, particularly if funds move back into the stock market. This could impact future deposit growth.





The primary area of deposit growth in 2009 has been in Interest Bearing Transaction and Savings (which includes money market deposits) deposits. These deposit types grew $94.9 million or 19.0% from December 31, 2008. Overall, Demand deposits grew $4.7 million or 1.5%, Interest Bearing Transaction deposits grew $33.7 million or 22.9%, and Savings deposits grew $61.2 million or 17.3%.





Non-Public time deposits declined $43.3 million or 10.4% during 2009.  This decline was the result of an explicit pricing strategy adopted by the Company beginning in the second quarter based upon the recognition that market CD rates were greater than the yields that the Company could obtain reinvesting these funds in short-term agency securities or overnight Fed Funds.  As a result: (1) the Company could not effectively invest funds at a profit without incurring excessive interest rate risk; and (2) significant growth in our overall balance sheet, without any resulting profit, would only place pressures on the Company’s capital ratios.  In the first quarter of 2009, non-public time deposits had increased approximately $75 million or 18% as depositors aggressively sought out the safety of banks for their funds.  Beginning in April 2009 management carefully reviewed time deposit customers and reduced our deposit rates to customers that did not also have transaction and savings balances with us (i.e., depositors who were not “relationship customers”).  This resulted in non-public time deposit balances dropping approximately $118 million over the last nine months of 2009.  Given the Company’s strong deposit growth in transaction and savings accounts, this time deposit decline did not present any liquidity issues and it significantly enhanced the Company’s net interest margin and earnings.


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In December 2008, the Bank elected to participate in the provisions of the FDIC’s Temporary Liquidity Guarantee Program that provides full FDIC deposit insurance on all non-interest bearing transaction accounts even if they exceed the deposit insurance limit of $250,000 on other types of deposit accounts.  When the program was extended through June 30, 2010 we elected to continue our participation.   See “Part I, Item 1. Business – Supervision and Regulation.”





Federal Home Loan Bank Advances and Federal Reserve Bank Borrowings


Lines of Credit with the Federal Reserve Bank and Federal Home Loan Bank are other key sources of funds to support earning assets. These sources of funds are also used to manage the Bank’s interest rate risk exposure; and, as opportunities arise, to borrow and invest the proceeds at a positive spread through the investment portfolio. FHLB advances as of December 31, 2009, were $20.1 million compared to $703,000 as of December 31, 2008.  The average rate on FHLB advances during 2009 was 2.2% compared to 2.9% in 2008. There were no Federal Funds purchased or advances from the FRB at December 31, 2009.





Securities Sold Under Agreement to Repurchase


Securities Sold Under Agreement to Repurchase are used as secured borrowing alternatives to FHLB Advances or FRB Borrowings, and totaled $60 million at December 31, 2009 and December 31, 2008.





On March 13, 2008, the Bank entered into a $40 million medium term repurchase agreement with Citigroup as part of a leveraging strategy (see “Investment Securities”) in response to the FRB’s continued interest rate cuts.  The repurchase agreement pricing rate is 3.20% with an embedded 3 year cap tied to 3 month Libor with a strike price of 3.3675%.  The repurchase agreement matures March 13, 2013, putable only on March 13, 2011, and is secured by investments in Agency pass through securities.





On May 30, 2008, the Company entered into a $20 million medium term repurchase agreement with Citigroup as part of a leveraging strategy (see “Investment Securities”).  The repurchase agreement pricing rate is 4.19% with an embedded 3 year cap tied to 3 month Libor with a strike price of 3.17%.  The repurchase agreement matures June 5, 2013, putable only on June 5, 2011, and is secured by investments in Agency pass through securities.





Subordinated Debentures


On December 17, 2003, the Company raised $10 million through an offering of trust preferred securities. See Note 19 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, 2010) and the rate was 3.1% as of December 31, 2009. The average rate paid for these securities in 2009 was 3.8% compared to 6.2% in 2008. 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.





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 $164.7 million at December 31, 2009, and $156.5 million at the end of 2008.





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 actions by regulators that, if undertaken, could have a 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.


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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 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, 2009, 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. There are no conditions or events since that notification that management believes have changed the Bank’s category. For further information on the Company’s and the Bank’s risk-based capital ratios, see Note 11 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 19 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 was to be effective March 31, 2009. However, on March 17, 2009, the FRB adopted a rule that delayed the effective date of the new limits until March 31, 2011. 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 the “Consolidation” topic of the FASB Accounting Standards Codification (“ASC”), 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.  This program was extended and expanded in both 2004 and 2006. Most recently, on November 12, 2008, the Board of Directors approved increasing the funds available for the Company’s Common Stock Repurchase Program. The Board’s resolution authorized up to $20 million in repurchases over the four year period ending October 31, 2012. See “Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.”





During 2009 the Company repurchased 6,016 shares at an average share price of $387 per share. In 2008 the Company repurchased 13,152 shares at an average share price of $449. Since the second share repurchase program was expanded in 2006 the Company has repurchased over 39,000 shares for total consideration of $17.9 million.





On August 5, 2008, the Board of Directors approved a Share Purchase Rights Plan (the “Rights Plan”), pursuant to which the Company entered into a Rights Agreement dated August 5, 2008, with Registrar and Transfer Company as Rights Agent. See “Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” for further explanation.





Based upon the Company’s strong capital position and continued earnings strength, the Company elected not to participate in the Federal Government’s 2008 TARP capital purchase program. See “Item 1A. Risk Factors.”





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 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 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.




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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 4 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 Notes 14 and 15 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.





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.





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 19 located in “Item 8. Financial Statements and Supplementary Data”); (2) obligations under guarantee contracts such as financial and performance standby letters of credit for our credit customers (see Note 16 located in “Item 8. Financial Statements and Supplementary Data”); (3) unfunded commitments to lend (see Note 16 located in “Item 8. Financial Statements and Supplementary Data”); and (4) lease contracts (see Note 16 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, 2009, 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 discounts, hedge basis adjustments, or other similar carrying value adjustments. For further information on the nature of each obligation type, see applicable note disclosures located in “Item 8. Financial Statements and Supplementary Data.”


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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

$
2,003


$
459


$
666


$
567


$
311FHLB Advances


20,149



19,500



-



-



649Long-Term Subordinated Debentures


10,310



-



-



-



10,310Deferred Compensation (1)


17,030



171



535



519



15,805Total

$
49,492


$
20,130


$
1,201


$
1,086


$
27,075





(1) These amounts represent payments to participants under the Company's non-qualified deferred compensation and supplemental retirement plans. See Note 13 located in “Item 8. Financial Statements and Supplementary Data.”





Item7A. Quantitative and Qualitative Disclosures About Market Risk





Risk Management


The Company has adopted risk management policies and procedures, which aim to ensure the proper control and management of all risk factors inherent in the operation of the Company, most importantly credit risk, interest rate risk and liquidity risk.  These 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.





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 parts.





Part 1:  includes a detailed analysis of the loan portfolio in two phases. The first phase is conducted in accordance with the “Receivables” topic of the FASB ASC. 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 of the analysis of the loan portfolio is the 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.  Risk ratings are reviewed by both the Company’s independent third-party credit examiners and bank examiners from the DFI and FDIC.


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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 that the loan is impaired and there is a probability 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 the “Contingency” topic of the FASB ASC. In this second phase, groups of loans with similar characteristics are reviewed and the appropriate allowance factor is applied based on the five-year average charge-off rate for each particular group of loans.





Part 2: considers qualitative 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 historical 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:





§
general economic and business conditions affecting the key lending areas of the Company;


§
credit quality trends (including trends in collateral values, delinquencies and non-performing loans);


§
loan volumes, growth rates and concentrations;


§
loan portfolio seasoning;


§
specific industry and crop conditions;


§
recent loss experience; and


§
duration of the current business cycle.





Management reviews these conditions in discussion with the Company’s senior credit officers. To the extent that any of these conditions is evidenced by a specifically identifiable impaired 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 impaired 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 of the allowance.





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, 2009, was adequate to provide for both recognized probable 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.


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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 100 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, 2009, 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 2.63% if rates increase by 200 basis points and an increase in net interest income of 0.36% if rates decline 100 basis points.





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 Company’s principal operating sources of liquidity include (see “Item 8. Financial Statements and Supplementary Data – Consolidated Statements of Cash Flows”) cash and cash equivalents, cash provided by operating activities, principal payments on loans, proceeds from the maturity or sale of investments, and growth in deposits. To supplement these operating sources of funds the Company maintains Federal Funds credit lines of $56 million and repurchase lines of $1.4 million with major brokers.  In addition, as of December 31, 2009 the Company has available borrowing capacity of $165.3 million at the Federal Home Loan Bank and $209 million at the Federal Reserve Bank.


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At December 31, 2009, the Company had available sources of liquidity, which included cash and cash equivalents and unpledged investment securities of approximately $163.3 million, which represents 9.3% of total assets.





Item8. Financial Statements and Supplementary Data





INDEX TO CONSOLIDATED FINANCIAL STATEMENTS


AND FINANCIAL STATEMENT SCHEDULES


PageReport of Management on Internal Control Over Financial Reporting
54Reports of Independent Registered Public Accounting Firms
55Consolidated Financial StatementsConsolidated Statements of Income – Years ended December 31, 2009, 2008 and 2007
57Consolidated Balance Sheets – December 31, 2009, and 2008
58Consolidated Statements of Changes in Shareholders' Equity – Years ended December 31, 2009, 2008 and 2007
59Consolidated Statements of Comprehensive Income
60Consolidated Statements of Cash Flows - Years Ended December 31, 2009, 2008 and 2007
61Notes to Consolidated Financial Statements
62


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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, 2009, 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, 2009.
 
 Perry-Smith LLP, the independent registered public accounting firm that audited the financial statements included in this Annual Report, was engaged to express an opinion as to the fairness of presentation of such financial statements. Perry-Smith LLP was also engaged to assess the effectiveness of the Company’s internal control over financial reporting. The report of Perry-Smith LLP follows this report.


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


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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, 2009 and 2008, 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, 2009.  We also have audited the Company's internal control over financial reporting as of December 31, 2009, 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.


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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, 2009 and 2008, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2009 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, 2009, based on the COSO criteria.





/s/ Perry-Smith LLP





Sacramento, California


March 2, 2010


56
 Table of Contents


Farmers & Merchants Bancorp


Consolidated Statements of Income(in thousands except per share data)Year Ended December 31,2009


2008


2007Interest IncomeInterest and Fees on Loans

$
74,901


$
77,924


$
84,081Interest on Federal Funds Sold and Securities PurchasedUnder Agreements to Resell


96



424



538Interest on Investment Securities:Taxable


13,396



11,801



7,920Exempt from Federal Tax


2,921



3,059



3,236Total Interest Income


91,314



93,208



95,775Interest ExpenseDeposits


13,746



22,374



29,960Borrowed Funds


2,188



1,773



1,397Subordinated Debentures


397



637



868Total Interest Expense


16,331



24,784



32,225Net Interest Income


74,983



68,424



63,550Provision for Loan Losses


15,420



7,998



1,495Net Interest Income After Provision for Loan Losses


59,563



60,426



62,055Non-Interest IncomeService Charges on Deposit Accounts


6,956



7,144



7,287Net Gain (Loss) on Investment Securities


3,524



1,503



(1,707
)Credit Card Merchant Fees


-



1,109



2,181Gain on Sale of Merchant Card Business


-



1,905



-Gain on Sale of Credit Card Loan Portfolio


-



1,030



-Increase in Cash Surrender Value of Bank Owned Life Insurance


1,794



1,785



1,737Debit Card and ATM Fees


2,245



2,051



1,986Net Gain (Loss) on Deferred Compensation Investments


1,847



(2,664
)


1,047Other


1,828



2,201



2,924Total Non-Interest Income


18,194



16,064



15,455Non-Interest ExpenseSalaries and Employee Benefits


28,771



27,039



26,317Net Gain (Loss) on Deferred Compensation Investments


1,847



(2,664
)


1,047Occupancy


2,715



2,651



2,559Equipment


2,417



2,658



2,875Credit Card Merchant Expense


-



828



1,640OREO Holding Costs


1,464



2,223



-FDIC Insurance


2,496



532



144Other


6,719



6,836



7,363Total Non-Interest Expense


46,429



40,103



41,945Income Before Income Taxes


31,328



36,387



35,565Provision for Income Taxes


11,315



13,597



12,870Net Income

$
20,013


$
22,790


$
22,695Earnings Per Share

$
25.57


$
28.69


$
28.05


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


57
 Table of Contents


Farmers & Merchants Bancorp


Consolidated Balance Sheets(in thousands except share data)December 31,Assets

2009


2008Cash and Cash Equivalents:Cash and Due from Banks

$
32,660


$
46,774Federal Funds Sold and Securities Purchased Under Agreements to Resell


1,972



14,000Total Cash and Cash Equivalents


34,632



60,774Investment Securities:Available-for-Sale


365,549



291,839Held-to-Maturity


69,617



71,890Total Investment Securities


435,166



363,729Loans:


1,212,718



1,177,364Less: Allowance for Loan Losses


29,813



20,034Loans, Net


1,182,905



1,157,330Premises and Equipment, Net


24,887



21,653Bank Owned Life Insurance


43,759



41,965Interest Receivable and Other Assets


59,665



38,986Total Assets

$
1,781,014


$
1,684,437LiabilitiesDeposits:Demand

$
324,073


$
319,318Interest-Bearing Transaction


180,570



146,879Savings


414,285



353,055Time


579,196



613,450Total Deposits


1,498,124



1,432,702Securities Sold Under Agreement to Repurchase


60,000



60,000Federal Home Loan Bank Advances


20,149



703Subordinated Debentures


10,310



10,310Interest Payable and Other Liabilities


27,704



24,177Total Liabilities


1,616,287



1,527,892Commitments & Contingencies (See Note 16)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, 780,944 and 786,960 Issued and Outstanding at December 31, 2009 and 2008, respectively


8



8Additional Paid-In Capital


76,198



78,527Retained Earnings


83,767



72,350Accumulated Other Comprehensive Gain


4,754



5,660Total Shareholders' Equity


164,727



156,545Total Liabilities and Shareholders' Equity

$
1,781,014


$
1,684,437


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


58
 Table of Contents


Farmers & Merchants Bancorp


Consolidated Statements 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, 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 on Securities Available-for-Sale


















1,701



1,701Balance, December 31, 2007


800,112



8



84,437



57,990



983



143,418Net Income














22,790







22,790Cash Dividends Declared on Common Stock ($10.65 per share)














(8,430
)






(8,430
)Repurchase of Stock


(13,152
)






(5,910
)










(5,910
)Change in Net Unrealized Gain on Securities Available-for-Sale


















4,677



4,677Balance, December 31, 2008


786,960



8



78,527



72,350



5,660



156,545Net Income














20,013







20,013Cash Dividends Declared on Common Stock ($11.00 per share)














(8,596
)






(8,596
)Repurchase of Stock


(6,016
)






(2,329
)










(2,329
)Change in Net Unrealized Gain on Securities Available-for-Sale


















(906
)


(906
)Balance, December 31, 2009


780,944


$
8


$
76,198


$
83,767


$
4,754


$
164,727


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


59
 Table of Contents


Farmers & Merchants Bancorp


Consolidated Statements of Comprehensive Income(in thousands)Year Ended December 31,2009


2008


2007Net Income

$
20,013


$
22,790


$
22,695Other Comprehensive IncomeUnrealized Gains on Derivative Instruments:Reclassification adjustment for realized gains included in net income, net of related income tax effects of $0, $0 and $1 for the years ended December 31, 2009, 2008 and 2007, respectively.


-



-



2Unrealized Gains on Securities:Unrealized holding gains arising during the period, net of income tax effects of $824, $4,026 and  $517 for the years ended December 31, 2009, 2008 and 2007, respectively.


1,136



5,548



712Less: Reclassification adjustment for realized (gains) losses included in net income, net of related income tax effects of $(1,482), $(632), and $718 for the years ended December 31, 2009, 2008 and 2007, respectively.


(2,042
)


(871
)


989Total Other Comprehensive (Loss) Income


(906
)


4,677



1,703Comprehensive Income

$
19,107


$
27,467


$
24,398


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


60
 Table of Contents


Farmers & Merchants Bancorp


Consolidated Statements of Cash Flows(in thousands)Year Ended December 31,2009


2008


2007Operating ActivitiesNet Income

$
20,013


$
22,790


$
22,695Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities:Provision for Loan Losses


15,420



7,998



1,495Depreciation and Amortization


1,894



1,878



1,933Provision for Deferred Income Taxes


(7,412
)


(995
)


(2,316
)Net (Accretion) Amortization of Investment Security Premium & Discounts


(2,719
)


301



213Net (Gain) Loss on Investment Securities


(3,524
)


(1,503
)


1,707Net Gain on Sale of Property & Equipment


(11
)


(15
)


(12
)Net Change in Operating Assets & Liabilities:Net Increase in Interest Receivable and Other Assets


(14,405
)


(5,879
)


(5,338
)Net Increase (Decrease) in Interest Payable and Other Liabilities


3,527



(1,523
)


3,177Net Cash Provided by Operating Activities


12,783



23,052



23,554Investing ActivitiesSecurities Available-for-Sale:Purchased


(271,757
)


(240,063
)


(43,577
)Sold, Matured or Called


202,742



99,268



35,254Securities Held-to-Maturity:Purchased


(1,870
)


(4,500
)


(2,424
)Sold, Matured or Called


4,129



38,476



7,994Net Loans Originated or Acquired


(41,285
)


(43,172
)


(95,430
)Principal Collected on Loans Previously Charged Off


290



330



262Net Additions to Premises and Equipment


(5,133
)


(3,349
)


(1,625
)Proceeds from Sale of Property & Equipment


16



21



12Net Cash Used by Investing Activities


(112,868
)


(152,989
)


(99,534
)Financing ActivitiesNet Increase in Demand, Interest-Bearing Transactionand Savings Deposits


99,676



71,610



48,606Net (Decrease) Increase in Time Deposits


(34,254
)


50,302



63,656Securities Sold Under Agreement to Repurchase


-



60,000



-Net Increase (Decrease) in Federal Home Loan Bank Advances


19,446



(28,251
)


(18,578
)Stock Repurchases


(2,329
)


(5,910
)


(5,489
)Cash Dividends


(8,596
)


(8,430
)


(7,831
)Net Cash Provided by Financing Activities


73,943



139,321



80,364(Decrease) Increase in Cash and Cash Equivalents


(26,142
)


9,384



4,384Cash and Cash Equivalents at Beginning of Year


60,774



51,390



47,006Cash and Cash Equivalents at End of Year

$
34,632


$
60,774


$
51,390Supplementary DataLoans Transferred to Foreclosed Assets (ORE)

$
5,571


$
7,342


$
251Cash Payments Made for Income Taxes

$
15,950


$
16,100


$
14,995Interest Paid

$
17,843


$
26,552


$
31,287


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


61
 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 and notes thereto 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.





In May 2009, the FASB issued ASC 855 (formerly Statement No. 165), “Subsequent Events”.  ASC 855 establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or available to be issued.  ASC 855 is effective for interim or annual periods ending after June 15, 2009.  The Company adopted the provisions of ASC 855 and has evaluated subsequent events for potential recognition and/or disclosure through the date the consolidated financial statements were issued or March 16, 2010. The Company does not believe any subsequent events have occurred that would require further disclosure or adjustment to the financial statements.





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 Statements 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.


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 Table of Contents


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.





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 and we do not intend to sell the security or it is more likely than not that we will not be required to sell the security before recovery, only the portion of the impairment loss representing credit exposure is recognized as a charge to earnings, with the balance recognized as a charge to other comprehensive income.  If management intends to sell the security or it is more likely than not that we will be required to sell the security before recovering its forecasted cost, the entire impairment loss is recognized as a charge to earnings.





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. Additionally, cash would be applied to principal if all principal was not expected to be collected. 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.


63
 Table of Contents


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 concentrations, 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.





The allowance also incorporates the results of measuring impaired loans in accordance with the “Receivables” topic of the FASB ASC. These accounting standards prescribe the measurement methods, income recognition and disclosures related to impaired loans, which are discussed more fully in Note 4 and Note 15 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 expected to be sold and 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.





The Company follows the standards set forth in the “Income Taxes” topic of  the FASB ASC, which clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements. This standard 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.  It also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.


64
 Table of Contents


The Company evaluated 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.





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


The Company’s common stock is not traded on any exchange. The shares are primarily held by local residents and are not actively traded. Earnings per share amounts are computed by dividing net income by the weighted average number of common shares outstanding for the period. See Note 12.





Segment Reporting


The “Segment Reporting” topic of the FASB ASC 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


The “Derivatives and Hedging” topic of the FASB ASC 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.





From time to time, 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, 2009 and December 31, 2008.


65
 Table of Contents


Comprehensive Income


The “Comprehensive Income” topic of the FASB ASC establishes standards for the reporting and display of comprehensive income and its components in the financial statements. Other comprehensive income (loss) 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 includes net income and changes in fair value of its available-for-sale investment securities 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, 2009

Cost


Gains


Losses


ValueSecurities of U.S. Government Agencies

$
135,958


$
277


$
67


$
136,168Obligations of States and Political Subdivisions


8,362



3



-



8,365Mortgage Backed Securities


207,335



8,142



150



215,327FHLB Stock


5,379



-



-



5,379Other


310



-



-



310Total

$
357,344


$
8,422


$
217


$
365,549





Amortized


Gross Unrealized


Fair/BookDecember 31, 2008

Cost


Gains


Losses


ValueSecurities of U.S. Government Agencies

$
-


$
-


$
-


$
-Obligations of States and Political Subdivisions


10,224



7



-



10,231Mortgage Backed Securities


266,416



9,761



1



276,176FHLB Stock


5,122



-



-



5,122Other


310



-



-



310Total

$
282,072


$
9,768


$
1


$
291,839





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, 2009

Value


Gains


Losses


ValueObligations of States and Political Subdivisions

$
64,044


$
1,437


$
109


$
65,372Mortgage Backed Securities


3,583



65



-



3,648Other


1,990



-



-



1,990Total

$
69,617


$
1,502


$
109


$
71,010





Book


Gross Unrealized


FairDecember 31, 2008

Value


Gains


Losses


ValueObligations of States and Political Subdivisions

$
64,765


$
529


$
988


$
64,306Mortgage Backed Securities


5,133



107



-



5,240Other


1,992



-



-



1,992Total

$
71,890


$
636


$
988


$
71,538





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.


66
 Table of Contents


In November 2008 the Company sold approximately $35 million of held-to-maturity Agency securities for a gain of $722,000 as a result of increasing concerns regarding the failure of the U.S. Government to back this agency debt with its “full faith and credit” after the Agencies were placed into conservatorship during September 2008.  The Company took this action under the provisions of the “Investment” topic of the FASB ASC, which allow for the sale of held-to-maturity securities where “there is evidence of a significant deterioration in the issuer’s creditworthiness.”





The remaining principal maturities of debt securities as of December 31, 2009, and 2008 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, 2009 (in thousands)

1 Year


Within 5


Within 10


10 years


ValueSecurities of U.S. Government Agencies

$
-


$
131,077


$
5,091


$
-


$
136,168Obligations of States and Political Subdivisions


1,017



-



-



7,348



8,365Mortgage Backed Securities


-



-



20,443



194,884



215,327Other


5,689



-



-



-



5,689Total

$
6,706


$
131,077


$
25,534


$
202,232


$
365,5492008 Totals

$
7,170


$
1,017


$
12,026


$
271,626


$
291,839After 1


After 5






TotalSecurities Held-to-Maturity

Within


but


but


Over


FairDecember 31, 2009 (in thousands)

1 Year


Within 5


Within 10


10 years


ValueObligations of States and Political Subdivisions

$
371


$
5,816


$
42,141


$
15,716


$
64,044Mortgage Backed Securities


-



3,583



-



-



3,583Other


-



-



9



1,981



1,990Total

$
371


$
9,399


$
42,150


$
17,697


$
69,6172008 Totals

$
1,570


$
4,571


$
29,830


$
35,919


$
71,890





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, 2009

Fair


Unrealized


Fair


Unrealized


Fair


Unrealized(in thousands)

Value


Loss


Value


Loss


Value


LossSecurities of U.S. Government Agencies

$
39,926


$
67


$
-


$
-


$
39,926


$
67Obligations of States and Political Subdivisions


4,681



109



-



-



4,681



109Mortgage Backed Securities


16,158



150



-



-



16,158



150Total

$
60,765


$
326


$
-


$
-


$
60,765


$
326Less Than 12 Months


12 Months or More


TotalDecember 31, 2008

Fair


Unrealized


Fair


Unrealized


Fair


Unrealized(in thousands)

Value


Loss


Value


Loss


Value


LossObligations of States and Political Subdivisions

$
24,092


$
988


$
-


$
-


$
24,092


$
988Mortgage Backed Securities


9,858



1



-



-



9,858



1Total

$
33,950


$
989


$
-


$
-


$
33,950


$
989





As of December 31, 2009, the Company held 180 investment securities of which 23 were in a loss position for less than twelve months. No securities were 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.


67
 Table of Contents


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


The unrealized losses on the Company's investments in securities of U.S. government agencies andobligations 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 does not intend to sell the securities and it is more likely than not that the Company will not have to sell the securities before recovery of their cost basis, the Company does not consider these investments to be other-than-temporarily impaired at December 31, 2009.





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 does not intend to sell the securities and it is more likely than not that the Company will not have to sell the securities before recovery of their cost basis, the Company does not consider these investments to be other-than-temporarily impaired at December 31, 2009.





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


(in thousands)


Gross


Gross


GrossProceeds


Gains


Losses2009

$
112,765


$
3,524


$
-2008


71,255



933



2162007


2,006



1



11





As of December 31, 2009, securities carried at $282,773,000 were pledged to secure public deposits, FHLB borrowings, and other government agency deposits as required by law. This amount at December 31, 2008, was $295,898,000.





3.  Federal Home Loan Bank Of San Francisco Stock





Federal Home Loan Bank of San Francisco (“FHLB”) stock represents the Company’s required investment in the common stock of a correspondent bank and is carried at cost as of December 31, 2009 and December 31, 2008.





Management evaluates the FHLB stock for impairment in accordance with the “Investments” topic of the FASB ASC.Management’s determination of whether this investment is impaired is based on their assessment of the ultimate recoverability of their cost rather than by recognizing temporary declines in value.  The determination of whether a decline affects the ultimate recoverability of their cost is influenced by criteria such as: (1) the significance of the decline in net assets of the FHLB as compared to the capital stock amount for the FHLB and the length of time this situation has persisted; (2) commitments by the FHLB to make payments required by law or regulation and the level of such payments in relation to the operating performance of the FHLB; and (3) the impact of legislative and regulatory changes on institutions and, accordingly, on the customer base of the FHLB.





Management believes no impairment charge is necessary related to the FHLB stock as of December 31, 2009.


68
 Table of Contents


4. Loans and Allowance for Loan Losses





Loans as of December 31 consisted of the following:


(in thousands)

2009


2008Commercial Real Estate

$
290,473


$
271,856Agricultural Real Estate


260,000



227,166Real Estate Construction


71,647



75,472Residential 1st Mortgages


105,850



105,980Home Equity Lines and Loans


65,541



66,159Agricultural


217,989



216,610Commercial


191,949



202,636Consumer and Other


11,400



13,612Subtotal


1,214,849



1,179,491Deferred Loan Origination Fees, Net


(2,131
)


(2,127
)Allowance for Loan Losses


(29,813
)


(20,034
)Net Loans

$
1,182,905


$
1,157,330





At December 31, 2009, the portion of loans that were approved for pledging as collateral on borrowing lines with the Federal Home Loan Bank (“FHLB”) and the Federal Reserve Bank (“FRB”) were $332.8 million and $452.2 million, respectively. The borrowing capacity on these loans was $184.5 million from FHLB and $208.8 million from the FRB. There were no outstanding borrowings against these loans from the FRB and there were $19.5 million in outstanding borrowings against these loans from the FHLB at December 31, 2009, respectively.





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


(in thousands)

2009


2008


2007Balance, January 1

$
20,034


$
18,483


$
18,099Provision Charged to Operating Expense


15,420



7,998



1,495Recoveries of Loans Previously Charged Off


290



330



262Loans Charged Off


(5,931
)


(6,777
)


(1,373
)Balance, December 31

$
29,813


$
20,034


$
18,483





All impaired loans have been assigned a related allowance for loan losses. As of December 31, 2009 and 2008, the total recorded investment in impaired loans was $9.2 million and $4.9 million, respectively. The related allowance for impaired loans was $1.0 million and $1.2 million for the years ended 2009 and 2008, respectively. The average balance of impaired loans was $8.5 million, $3.5 million, and $427,000 for the years ended 2009, 2008, and 2007, respectively. Interest income reported on impaired loans in 2009 was $0, $1,000 in 2008, and none in 2007. Non-accrual loans at December 31, 2009 and 2008 were $9.2 million and $4.5 million, respectively. Interest income forgone on loans placed on non-accrual status was $618,000, $261,000, and $31,000 for the years ended December 31, 2009, 2008, and 2007, respectively.





At December 31, 2009, the Company had seven restructured residential mortgage loans with balances totaling $556,000. During 2009, the Company restructured these loans by taking partial principal charge-offs totaling $111,000 due to rate reductions and/or maturity extensions. All of these loans were current in their payments when they were restructured and remained on accrual at December 31, 2009. These loans have no commitments to lend additional funds.


69
 Table of Contents


5. Premises and Equipment





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


(in thousands)

2009


2008Land and Buildings

$
31,691


$
27,839Furniture, Fixtures, and Equipment


15,702



17,985Leasehold Improvements


2,044



2,044Subtotal


49,437



47,868Less:  Accumulated Depreciation and Amortization


24,550



26,215Total

$
24,887


$
21,653





Depreciation and amortization on premises and equipment included in occupancy and equipment expense amounted to $1,894,000, $1,878,000, and $1,933,000 for the years ended December 31, 2009, 2008, and 2007, respectively. Total rental expense for premises was $379,000, $359,000, and $496,000 for the years ended December 31, 2009, 2008, and 2007, respectively. Rental income was $178,000, $181,000, and $153,000 for the years ended December 31, 2009, 2008, and 2007, respectively.





6. Other Real Estate





The Bank reported $8.4 million in other real estate at December 31, 2009, and $4.8 million in 2008. 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. Other real estate is reported in Interest Receivable and Other Assets on the Company’s Consolidated Balance Sheets.





7. Time Deposits





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


(in thousands)

2009


2008Balance

$
396,665


$
389,318





At December 31, 2009, the scheduled maturities of time deposits were as follows:





(in thousands)

ScheduledMaturities2010

$
547,5832011


26,9592012


4,654Total

$
579,196


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 Table of Contents


8. Income Taxes





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





(in thousands)

2009


2008


2007CurrentFederal

$
13,815


$
10,591


$
11,340State


4,912



4,001



3,984Total Current


18,727



14,592



15,324DeferredFederal


(5,666
)


(780
)


(1,963
)State


(1,746
)


(215
)


(491
)Total Deferred


(7,412
)


(995
)


(2,454
)Total Provision for Taxes

$
11,315


$
13,597


$
12,870





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


(in thousands)


2009





2008





2007Amount


Rate


Amount


Rate


Amount


RateTax Provision at Federal Statutory Rate

$
10,965



35.0
%

$
12,735



35.0
%

$
12,448



35.0
%Interest on Obligations of States and Political Subdivisions Exempt from Federal Taxation


(980
)


(3.1
)%


(994
)


(2.7
)%


(1,014
)


(2.9
)%State and Local Income Taxes,Net of Federal Income Tax Benefit


2,058



6.5
%


2,461



6.8
%


2,331



6.6
%Bank Owned Life Insurance


(656
)


(2.1
)%


(610
)


(1.7
)%


(640
)


(1.8
)%Other, Net


(72
)


(0.2
)%


5



0.0
%


(255
)


(0.7
)%Total Provision for Taxes

$
11,315



36.1
%

$
13,597



37.4
%

$
12,870



36.2
%





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


(in thousands)

2009


2008Deferred Tax AssetsAllowance for Loan Losses

$
12,595


$
8,483Accrued Liabilities


3,856



2,710Deferred Compensation


4,959



3,904State Franchise Tax


1,719



1,400Capital Loss Carry Forward


298



298Interest on Non-Accrual Loans


260



110Restructured Loan Interest


-



3ORE Writedown and Holding Costs


1,377



872Total Deferred Tax Assets

$
25,064


$
17,780Deferred Tax LiabilitiesPremises and Equipment

$
(286
)

$
(434
)Securities Accretion (zero coupon securities)


(644
)


(696
)Unrealized Gain on Securities Available-for-Sale


(3,450
)


(4,107
)Other


(593
)


(521
)Total Deferred Tax Liabilities


(4,973
)


(5,758
)Net Deferred Tax Assets

$
20,091


$
12,022


71
 Table of Contents


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 2004.





9. Short Term Borrowings





As of December 31, 2009 and 2008, the Company had unused lines of credit available for short term liquidity purposes of $432 million and  $629 million, respectively.  Federal Funds purchased and advances are generally issued on an overnight basis.  There were $19.5 million in advances from the FHLB at December 31, 2009.  There were no Federal Funds purchased or advances from the FRB at December 31, 2009.





10. 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)

2009


20085.60% amortizing note, interest and principal payable monthly with final maturity of September 25, 2018.

$
649


$
703.03% fixed rate credit advance, interest payable daily with a maturity of January 4, 2010


19,500



-Total

$
20,149


$
703





In accordance with the Collateral Pledge and Security Agreement, advances are secured by all FHLB stock held by the Company and by agency and mortgage-backed securities with carrying values of $1million.  At December 31, 2009, $332.8 million in loans were approved for pledging as collateral on borrowing lines with the FHLB. The borrowing capacity on these loans was $184.5 million. There were $19.5 million in outstanding borrowings against these loans at December 31, 2009.





11. Shareholders' Equity





In 1998, the Board approved the Company’s first stock repurchase program.  This program was extended and expanded in both 2004 and 2006.   Most recently, on November 12, 2008, the Board of Directors approved increasing the funds available for the Company’s Common Stock Repurchase Program. The Board’s resolution authorized up to $20 million in repurchases over the four year period ending October 31, 2012.





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 the Company 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, 2009, the Bank could declare dividends of $34,028,000 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 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.


72
 Table of Contents


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, 2009, 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.





The Federal Government passed the Emergency Economic Stabilization Act of 2008, which, among other measures, authorized the Treasury Department to create a capital purchase program, pursuant to which it provides access to Tier 1 capital through a standardized program to acquire preferred stock (accompanied by warrants) from eligible financial institutions. Based upon the Company’s strong capital position and continued earnings strength, the Company elected not to participate in the capital purchase program.





Well CapitalizedRegulatory Capital


Under Prompt(in thousands)

Actual


Requirements


Corrective ActionDecember 31, 2009

Amount


Ratio


Amount


Ratio


Amount


RatioTotal Bank Capital to Risk Weighted Assets

$
188,925



12.47
%

$
121,170



8.0
%

$
151,462



10.0
%Total Consolidated Capital to Risk Weighted Assets

$
189,042



12.48
%

$
121,174



8.0
%


N/A



N/ATier 1 Bank Capital to Risk Weighted Assets

$
169,856



11.21
%

$
60,585



4.0
%

$
90,877



6.0
%Tier 1 Consolidated Capital to Risk Weighted Assets

$
169,872



11.22
%

$
60,587



4.0
%


N/A



N/ATier 1 Bank Capital to Average Assets

$
169,856



9.60
%

$
70,742



4.0
%

$
88,427



5.0
%Tier 1 Consolidated Capital to Average Assets

$
169,972



9.60
%

$
70,818



4.0
%


N/A



N/A





Well CapitalizedRegulatory Capital


Under Prompt(in thousands)

Actual


Requirements


Corrective ActionDecember 31, 2008

Amount


Ratio


Amount


Ratio


Amount


RatioTotal Bank Capital to Risk Weighted Assets

$
178,814



12.61
%

$
113,485



8.0
%

$
141,856



10.0
%Total Consolidated Capital to Risk Weighted Assets

$
178,648



12.59
%

$
113,489



8.0
%


N/A



N/ATier 1 Bank Capital to Risk Weighted Assets

$
161,052



11.35
%

$
56,742



4.0
%

$
85,114



6.0
%Tier 1 Consolidated Capital to Risk Weighted Assets

$
160,885



11.34
%

$
56,744



4.0
%


N/A



N/ATier 1 Bank Capital to Average Assets

$
161,052



9.76
%

$
65,985



4.0
%

$
82,482



5.0
%Tier 1 Consolidated Capital to Average Assets

$
160,885



9.73
%

$
66,134



4.0
%


N/A



N/A


73
 Table of Contents


12. Dividends and Earnings Per Share





Total cash dividends during 2009 were $8,596,000 or $11.00 per share of common stock, an increase of 3.3% from $8,430,000 or $10.65 per share in 2008. In 2007, cash dividends totaled $7,831,000 or $9.70 per share.





Earnings per share amounts are computed by dividing net income by the weighted average number of common shares outstanding for the period. The following table calculates the earnings per share for the periods indicated.





(net income in thousands)

2009


2008


2007Net Income

$
20,013


$
22,790


$
22,695Average Number of Common Shares Outstanding


782,754



794,239



809,057Per Share Amount

$
25.57


$
28.69


$
28.05





13. Employee Benefit Plans





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 $700,000, $790,000, and $780,000 for the years ended December 31, 2009, 2008, and 2007, respectively. The mandatory contributions to the Profit Sharing Plan are made according to a predetermined set of criteria. Mandatory contributions totaled $885,000, $800,000, and $780,000 for the years ended December 31, 2009, 2008, and 2007, 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.





Executive Retirement Plan and Life Insurance Arrangements


The Company, through the Bank, sponsors an Executive Retirement Plan for certain employees. The Executive Retirement Plan is a non-qualified defined contribution plan and was developed to supplement the Company’s Profit Sharing Plan, which, as a qualified retirement plan, has a ceiling on benefits as set by the Internal Revenue Service. The  Plan is comprised of: (1) a Performance Component which makes contributions based upon long-term cumulative profitability and increase in market value of the Company, and vests 0% during the first year of participation and 25% per full year of service thereafter; (2) a Retention Component applicable to participants employed by the Company as of January 1, 2005, which makes contributions based upon years of service, and vests 10% per year beginning in 2005; and (3) a Salary Component which makes contributions based upon participant salary levels and cliff vests after five years of service.





The Company made contributions to the Executive Retirement Plan of $1.6 million for each of the years ended December 31, 2009, 2008 and 2007. The Company’s total accrued liability under the Executive Retirement Plan was $10.9 million and $8.3 million as of December 31, 2009, and 2008, respectively.





The Company has purchased single premium life insurance policies on the lives of the Executive 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 Executive 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.


74
 Table of Contents


The Company earned tax exempt interest on the life insurance policies of $1.8 million for the years ended December 31, 2009, and 2008, and $1.7 million for the year ended December 31, 2007. As of December 31, 2009 and 2008, the total cash surrender value of the insurance policies was $43.8 million and $42.0 million, respectively.





14. Fair Value of Financial Instruments





Generally accepted accounting principles require disclosure of fair value information about financial instruments, whether or not recognized on the balance sheet, for which it is practical to estimate that value. 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 summarizes the book value and estimated fair value of financial instruments as of December 31:


2009


2008(in thousands)

Carrying


Estimated


Carrying


EstimatedASSETS:

Amount


Fair Value


Amount


Fair ValueCash and Cash Equivalents

$
34,632


$
34,632


$
60,774


$
60,774Investment Securities Held-to-Maturity


69,617



71,010



71,890



71,454Investment Securities Available-for-Sale


365,549



365,549



291,839



291,839Loans, Net of Deferred Loan Origination Fees


1,212,718



1,229,849



1,177,364



1,192,946Bank Owned Life Insurance


43,759



43,759



41,965



41,965Accrued Interest Receivable


7,216



7,216



7,250



7,250LIABILITIES:Deposits:Non-Interest Bearing


324,073



324,073



319,318



319,318Interest-Bearing


1,174,051



1,175,619



1,113,384



1,116,389FHLB Advances & Securities Sold Under Agreement to  Repurchase


80,149



81,931



60,703



62,434Subordinated Debentures


10,310



4,061



10,310



7,441Accrued Interest Payable


1,555



1,555



3,067



3,067





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.





Bank Owned Life Insurance: 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.


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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 advances 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, 2009, and 2008. 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.





15. Fair Value Measurements





The Company follows the “Fair Value Measurement and Disclosures” topic of the FASB ASC, which establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. This standard 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, The standard establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The fair value hierarchy is as follows:





Level 1 inputs – Unadjusted quoted prices in active markets for identical assets or liabilities that the entity has the ability to access at the measurement date.





Level 2 inputs - Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets and liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals.





Level 3 inputs - Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.





Securities classified as available-for-sale are reported at fair value on a recurring basis utilizing Level 2 inputs. For these securities, the Company obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond's terms and conditions, among other things.





The Company does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Once a loan is identified as individually impaired, management measures impairment in accordance with the “Receivable” topic of the FASB ASC. The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value, and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At December 31, 2009, substantially all impaired loans were evaluated based on the fair value of the collateral. Impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value which uses observable data, the Company records the impaired loan as nonrecurring Level 2. Otherwise, the Company records the impaired loan as nonrecurring Level 3.





Other Real Estate (“ORE”) is reported at fair value on a non-recurring basis. When the fair value of the ORE is based on an observable market price or a current appraised value which uses observable data, the Company records the ORE as nonrecurring Level 2. Otherwise, the Company records the ORE as nonrecurring Level 3. Other real estate is reported in Interest Receivable and Other Assets on the Company’s Consolidated Balance Sheets.


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The following tables present information about the Company’s assets and liabilities measured at fair value on a recurring basis and indicate the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value for the years indicated


Fair Value Measurements

At December 31, 2009, Using(in thousands)

Fair Value

December 31, 2009


Quoted Prices in

Active Markets for

Identical Assets

(Level 1)


Other

Observable

Inputs

(Level 2)


Significant

Unobservable

Inputs

(Level 3)Available-for-Sale Securities

$
365,549


$
-


$
365,549


$
-Total Assets Measured at Fair Value On a Recurring Basis

$
365,549


$
-


$
365,549


$
-





Fair Value Measurements

At December 31, 2008, Using(in thousands)

Fair Value

December 31, 2008


Quoted Prices in

Active Markets for

Identical Assets

(Level 1)


Other

Observable

Inputs

(Level 2)


Significant

Unobservable

Inputs

(Level 3)Available-for-Sale Securities

$
291,839


$
-


$
291,839


$
-Total Assets Measured at Fair Value On a Recurring Basis

$
291,839


$
-


$
291,839


$
-





The following tables present information about the Company’s assets and liabilities measured at fair value on a non-recurring basis and indicate the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value for the years indicated.




Fair Value Measurements

At December 31, 2009, Using(in thousands)

Fair Value

December 31, 2009


Quoted Prices in

Active Markets for

Identical Assets

(Level 1)


Other

Observable

Inputs

(Level 2)


Significant

Unobservable

Inputs

(Level 3)


Total

Gains

(Losses)Impaired Loans

$
1,419


$
-


$
1,419


$
-


$
(1,368
)Other Real Estate


8,418



-



8,418



-



(1,034
)Total Assets Measured at Fair Value On a Non-Recurring Basis

$
9,837


$
-


$
9,837


$
-


$
(2,402
)





Impaired loans where an allowance was established were $2.4 million with an allowance for loan losses of $1.0 million. Impaired loans are collateral dependent and have been adjusted to fair value based on the estimated fair value of the underlying collateral, less estimated selling costs. If the Company determines that the value of an impaired loan is less than the recorded investment in the loan, the carrying value is adjusted through a charge-off recorded through the allowance for loan losses.  Total losses of $1.4 million represent charge-offs and reserve for loan loss related to impaired loans recognized during the year ended December 31, 2009.





ORE was $11.4 million with a valuation allowance of $3.0 million. ORE has been adjusted to estimated fair value, less estimated selling costs. At the time of foreclosure, foreclosed assets are recorded at the lower of the carrying amount of the loan or the estimated fair value less estimated selling costs. Any write-downs based on the asset’s fair value at the date of acquisition are charged to the allowance for loan losses. After foreclosure, management periodically obtains updated valuations of the foreclosed assets and, if additional impairments are deemed necessary, the impairment is recorded in non-interest expense on the Consolidated Statements of Income.  Total losses of $1.03 million represent the impairment charged to the Consolidated Statements of Income during the year ended December 31, 2009.


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Fair Value Measurements

At December 31, 2008, Using(in thousands)

Fair Value

December 31, 2008


Quoted Prices in

Active Markets for

Identical Assets

(Level 1)


Other

Observable

Inputs

(Level 2)


Significant

Unobservable

Inputs

(Level 3)Impaired Loans

$
3,736


$
-


$
3,736


$
-Other Real Estate


4,817



-



4,817



-Total Assets Measured at Fair Value On a Non-Recurring Basis

$
8,553


$
-


$
8,553


$
-





Impaired loans and ORE are measured for impairment using the fair value of the collateral because the loans/ORE are considered to be collateral dependent. Impaired loans were $4.9 million with an allowance for loan losses of $1.2 million and ORE was $6.9 million with a valuation allowance of $2.1 million.





16. 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 $9,173,000 at December 31, 2009, and $7,902,000 at December 31, 2008. Outstanding standby letters of credit have maturity dates ranging from 1 to 17 months with final expiration in May 2011. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Undisbursed loan commitments totaled $315,186,000 and $355,209,000 as of December 31, 2009 and 2008, 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, 2009, were $459,000, $384,000, $282,000, $278,000, and $289,000 for the years 2010 through 2014 and $311,000 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 2009 or 2008.


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17. Recent Accounting Developments





FASB Accounting Standards CodificationTM(ASC or Codification):  In June 2009, the FASB issued Accounting Standards Update (ASU) No. 2009-01 (formerly Statement No. 168), “Topic 105 - Generally Accepted Accounting Principles - FASB Accounting Standards CodificationTMand the Hierarchy of Generally Accepted Accounting Principles.”The Codification is the single source of authoritative nongovernmental U.S. generally accepted accounting principles (GAAP).  The Codification does not change current GAAP, but is intended to simplify user access to all authoritative GAAP by providing all the authoritative literature related to a particular topic in one place.  All existing accounting standard documents are superseded and all other accounting literature not included in the Codification is considered nonauthoritative.  The Codification is effective for interim or annual reporting periods ending after September 15, 2009.  The Company has made the appropriate changes to GAAP references in the financial statements.





Measuring Liabilities at Fair Value:  In August 2009, the FASB issued ASU No. 2009-05, “Fair Value Measurements and Disclosures (Topic 820) – Measuring Liabilities at Fair Value”.  This ASU provides amendments for fair value measurements of liabilities.  It provides clarification that in circumstances in which a quoted price in an active market for the identical liability is not available, a reporting entity is required to measure fair value using one or more techniques.  ASU 2009-05 also clarifies that when estimating a fair value of a liability, a reporting entity is not required to include a separate input or adjustment to other inputs relating to the existence of a restriction that prevents the transfer of the liability.  ASU 2009-05 is effective for the first reporting period (including interim periods) beginning after issuance or fourth quarter 2009.  The provisions of this update were adopted on October 1, 2009 and they did not have a material impact on the Company’s financial condition or results of operations.





FASB Amends Disclosures about Fair Value of Financial Instruments:  In April 2009, the FASB issued ASC 825 (formerly FASB Staff Position (FSP) 107-1 and APB 28-1), “Interim Disclosures about Fair Value of Financial Instruments.”ASC 825 requires a public entity to provide disclosures about fair value of financial instruments in interim financial information.  ASC 825 is effective for interim and annual financial periods ending after June 15, 2009.  The Company adopted the provisions of ASC 825 on April 1, 2009 and the disclosure is more fully presented in Note 14. Fair Value of Financial Instruments.





FASB Clarifies Other-Than-Temporary Impairment:  In April 2009, the FASB issued ASC 320 (formerly FSP FAS 115-2, FAS124-2 and EITF 99-20-2), “Recognition and Presentation of Other-Than-Temporary-Impairment.”ASC 320 (i) changes existing guidance for determining whether an impairment is other than temporary to debt securities and (ii) replaces the existing requirement that the entity’s management assert it has both the intent and ability to hold an impaired security until recovery with a requirement that management assert: (a) it does not have the intent to sell the security; and (b) it is more likely than not it will not have to sell the security before recovery of its cost basis.  Under ASC 320, declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses to the extent the impairment is related to credit losses.  The amount of impairment related to other factors is recognized in other comprehensive income.  ASC 320 is effective for interim and annual periods ending after June 15, 2009.   The Company adopted the provisions of ASC 320 on April 1, 2009 and the disclosure is more fully presented in Note 2. Investment Securities. The provisions of ASC 320 did not have an impact on the Company’s financial condition and results of operations.





FASB Clarifies Application of Fair Value Accounting:  In April 2009, the FASB issued ASC 820 (formerly FSP FAS 157-4), “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly.”ASC 820 affirms the objective of fair value when a market is not active, clarifies and includes additional factors for determining whether there has been a significant decrease in market activity, eliminates the presumption that all transactions are distressed unless proven otherwise, and requires an entity to disclose a change in valuation technique.  ASC 820 is effective for interim and annual periods ending after June 15, 2009.  The Company adopted the provisions of ASC 820 on April 1, 2009.  The provisions of ASC 820 did not have a material impact on the Company’s financial condition and results of operations.


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Business Combinations:  In December 2007, the FASB issued ASC 805 (formerly Statement  No. 141R), “Business Combinations”.  ASC 805 broadens the guidance and , extends its applicability to all transactions and other events in which one entity obtains control over one or more other businesses.  It broadens the fair value measurement and recognition of assets acquired, liabilities assumed, and interests transferred as a result of business combinations.  ASC 805 expands on required disclosures to improve the statement users’ abilities to evaluate the nature and financial effects of business combinations.  ASC 805 is effective for the first annual reporting period beginning on or after December 15, 2008.  In April 2009, the FASB amended the guidance in ASC 805 and is effective for the first annual reporting period beginning on or after December 15, 2008.  The provisions of ASC 805 will only impact the Company if we are party to a business combination closing on or after January 1, 2009.





18. Parent Company Financial Information





The following financial information is presented as of December 31, 2009 and December 31, 2008.





Farmers & Merchants BancorpCondensed Balance Sheets(in thousands)

2009


2008Cash

$
341


$
57Investment in Farmers & Merchants Bank of Central California


174,610



166,712Investment Securities


310



310Capital Leases


1



1Other Assets


48



48Total Assets

$
175,310


$
167,128Subordinated Debentures

$
10,310


$
10,310Liabilities


273



273Shareholders' Equity


164,727



156,545Total Liabilities and Shareholders' Equity

$
175,310


$
167,128





Farmers & Merchants BancorpCondensed Statements of IncomeYear Ended December 31,(in thousands)

2009


2008


2007Equity in Undistributed Earnings in Farmers & Merchants Bank of Central California

$
8,804


$
13,000


$
12,224Dividends from Subsidiary


12,050



10,900



12,430Interest Income


12



20



79Other Expenses, Net


(1,463
)


(1,935
)


(3,459
)Tax Benefit


610



805



1,421Net Income

$
20,013


$
22,790


$
22,695


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Farmers & Merchants Bancorp


Condensed Statements of Cash FlowsYear Ended December 31,(in thousands)

2009


2008


2007Cash Flows from Operating Activities:Net Income

$
20,013


$
22,790


$
22,695Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities:Equity in Undistributed Net Earnings from Subsidiary


(8,804
)


(13,000
)


(12,224
)Net Loss on Sale of Securities


-



216



1,707Net Decrease (Increase) in Other Assets


-



3,644



(1,402
)Net Increase (Decrease) in Liabilities


-



40



(37
)Net Cash Provided by Operating Activities


11,209



13,690



10,739Investing Activities:Securities Purchased


-



-



-Securities Sold or Matured


-



533



1,544Change in Capital Leases


-



-



825Net Cash Provided by Investing Activities


-



533



2,369Financing Activities:Stock Repurchased


(2,329
)


(5,910
)


(5,489
)Cash Dividends


(8,596
)


(8,430
)


(7,831
)Net Cash Used by Financing Activities


(10,925
)


(14,340
)


(13,320
)Increase (Decrease) in Cash and Cash Equivalents


284



(117
)


(212
)Cash and Cash Equivalents at Beginning of Year


57



174



386Cash and Cash Equivalents at End of Year

$
341


$
57


$
174





19.  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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20. Quarterly Financial Information (Unaudited)





2009

First


Second


Third


Fourth(in thousands except per share data)

Quarter


Quarter


Quarter


Quarter


TotalTotal Interest Income

$
22,928


$
22,887


$
23,075


$
22,424


$
91,314Total Interest Expense


4,889



4,693



3,806



2,943



16,331Net Interest Income


18,039



18,194



19,269



19,481



74,983Provision for Loan Losses


870



7,260



2,215



5,075



15,420Net Interest Income AfterProvision for Loan Losses


17,169



10,934



17,054



14,406



59,563Total Non-Interest Income


4,158



5,089



4,529



4,418



18,194Total Non-Interest Expense


11,975



11,518



11,677



11,259



46,429Income Before Income Taxes


9,352



4,505



9,906



7,565



31,328Provision for Income Taxes


3,418



1,429



3,728



2,740



11,315Net Income

$
5,934


$
3,076


$
6,178


$
4,825


$
20,013Earnings Per Share

$
7.55


$
3.93


$
7.90


$
6.19


$
25.57





2008

First


Second


Third


Fourth(in thousands except per share data)

Quarter


Quarter


Quarter


Quarter


TotalTotal Interest Income

$
23,757


$
22,678


$
23,310


$
23,463


$
93,208Total Interest Expense


7,168



6,033



6,050



5,533



24,784Net Interest Income


16,589



16,645



17,260



17,930



68,424Provision for Loan Losses


570



4,035



765



2,628



7,998Net Interest Income AfterProvision for Loan Losses


16,019



12,610



16,495



15,302



60,426Total Non-Interest Income


2,977



7,850



2,463



2,774



16,064Total Non-Interest Expense


9,766



10,874



9,295



10,168



40,103Income Before Income Taxes


9,230



9,586



9,663



7,908



36,387Provision for Income Taxes


3,466



3,624



3,606



2,901



13,597Net Income

$
5,764


$
5,962


$
6,057


$
5,007


$
22,790Earnings Per Share

$
7.21


$
7.50


$
7.63


$
6.35


$
28.69





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 2009, 2008, and 2007 ranged from $535.00 to $310.00 per share.





Item9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure





None





Item9A. Controls and 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, 2009, 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, 2009.


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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 in “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 financial statements included in this Annual Report, was engaged to assess the effectiveness of the Company’s internal control over financial reporting. The report of Perry-Smith LLP, which is set forth in “Item 8. Financial Statements and Supplementary Data,” is incorporated herein by reference.





Item9A(T). Controls and Procedures





Not Applicable





Item9B. Other Information





None


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PARTIII





Item 10. Directors, Executive Officers and Corporate Governance





Set forth below is certain information regarding the Named 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
57
President & Chief Executive Officer of the Company and Bank.Richard S. Erichson

Executive Vice President

& Senior Credit Officer

of the Company and Bank
62
Executive Vice President & Senior Credit Officer of the Company and Bank.Deborah E. Hodkin

Executive Vice President & Chief Administrative Officer of the Bank
47
Executive Vice President & Chief Administrative Officer of the Bank.Stephen W. Haley

Executive Vice President

& Chief Financial Officer & Secretary of the Company and

Bank
56
Executive Vice President & Chief Financial Officer of the Company and Bank.Kenneth W. Smith

Executive Vice President & Head of Business Markets of the Bank
50
Executive Vice President & Head of Business Markets 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 2010 Annual Meeting of Stockholders which will be filed with the SEC and which is incorporated herein by reference.  During 2009 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 SEC. 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 on the About Us page. The Company’s website address is www.fmbonline.com.





Item11. Executive Compensation





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 2010 Annual Meeting of Stockholders, which will be filed pursuant to Regulation 14A.





Item12. Security Ownership 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 2010 Annual Meeting of Stockholders, 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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Item13. Certain Relationships 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 2010 Annual Meeting of Stockholders, which will be filed pursuant to Regulation 14A.





Item14. Principal Accounting 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 2010 Annual Meeting of Stockholders, which will be filed pursuant to Regulation 14A.





PART IV





Item 15. Exhibits and 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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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. HaleyDated:  March 10, 2010Stephen 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 10, 2010.




/s/ Kent A. SteinwertPresident and Chief Executive OfficerKent A. Steinwert

(Principal Executive Officer)/s/ Stephen W. HaleyExecutive Vice President & Chief Financial OfficerStephen W. Haley

(Principal Financial and Accounting  Officer)/s/ Ole R. Mettler

/s/ James E. PodestaOle R. Mettler, Chairman

James E. Podesta, Director/s/ Stewart C. Adams, Jr.

/s/ Kevin SanguinettiStewart C. Adams, Jr., Director

Kevin Sanguinetti, Director/s/ Edward Corum, Jr.

/s/ Carl Wishek, Jr.Edward Corum, Jr., Director

Carl Wishek, Jr., Director/s/ Calvin SuessCalvin Suess, Director


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Indexto Exhibit


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 the Registrant’s Current Report on Form 8-K dated September 19, 2008, 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).3.3
Certificate of Designation for the Series A Junior Participating Preferred Stock (included as Exhibit A to the Rights Agreement between Farmers & Merchants Bancorp and Registrar and Transfer Company, dated as of August 5, 2008, filed as Exhibit 4.1 below), filed on the Registrant’s Form 10-Q for the quarter ended June 30, 2008, is incorporated herein by reference.4.1
Rights Agreement between Farmers & Merchants Bancorp and Registrar and Transfer Company, dated as of August 5, 2008, including Form of Right Certificate attached thereto as Exhibit B, filed on the Registrant’s Form 10-Q for the quarter ended June 30, 2008,  is incorporated herein by reference.10.1
Amended and Restated Employment Agreement dated April 1, 2009, between Farmers & Merchants Bank of Central California and Kent A. Steinwert, filed on Registrant’s Form 10-K for the year ended December 31, 2008, is incorporated herein by reference.10.3
Amended and Restated Employment Agreement dated April 1, 2009, between Farmers & Merchants Bank of Central California and Deborah E. Hodkin, filed on Registrant’s Form 10-K for the year ended December 31, 2008, is incorporated herein by reference.10.4
Amended and Restated Employment Agreement dated April 1, 2009, between Farmers & Merchants Bank of Central California and Kenneth W. Smith, filed on Registrant’s Form 10-K for the year ended December 31, 2008, is incorporated herein by reference.10.5
Amended and Restated Employment Agreement dated April 1, 2009, between Farmers & Merchants Bank of Central California and Richard S. Erichson, filed on Registrant’s Form 10-K for the year ended December 31, 2008, is incorporated herein by reference.10.6
Amended and Restated Employment Agreement dated April 1, 2009, between Farmers & Merchants Bank of Central California and Stephen W. Haley, filed on Registrant’s Form 10-K for the year ended December 31, 2008, is incorporated herein by reference.10.15
Executive Retirement Plan – Performance Component (amending and renaming the 2005 Deferred Bonus Plan of Farmers & Merchants Bank of Central California), as amended on March 10, 2010.10.16
Executive Retirement Plan – Retention Component (amending and renaming the Executive Retention Plan of Farmers & Merchants Bank of Central California), as amended on March 10, 2010.10.17
Executive Retirement Plan – Salary Component (amending and renaming the Indexed Retirement Plan of Farmers & Merchants Bank of Central California), as amended on March 10, 2010.10.18
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.






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