or

      Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [X] Yes [  ] No

      Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K ([SECTION] 229.405 of this chapter) 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. [  ]

      Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). [X] Yes [  ] No

      The aggregate market value of the registrant's voting common stock held by non-affiliates was $100,800,242 as computed using the average bid and asked prices as reported on the NASDAQ, as of June 30, 2003.

The number of shares outstanding for each of the registrant's classes of common stock, as of March 1, 2004, is:
Class: Common stock, par value $.01 per share
Outstanding: 6,218,051 shares

DOCUMENTS INCORPORATED BY REFERENCE

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The following is a copy, except for the exhibits, of the Annual Report of Merchants Bancshares, Inc. and its wholly owned subsidiaries Merchants Bank and Merchants Properties, Inc; as well as Merchants Bank's wholly owned subsidiary Merchants Trust Company (collectively "Merchants") on Form 10-K for the year ended December 31, 2003, filed with the Securities and Exchange Commission (the "SEC").

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Except for the historical information contained herein, this Annual Report on Form 10-K of Merchants may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Investors are cautioned that forward-looking statements are inherently uncertain. Actual performance and results of operations may differ materially from those projected or suggested in the forward-looking statements due to certain risks and uncertainties, including, without limitation:

These factors, as well as general economic and market conditions in the United States, may materially and adversely affect the market price of shares of Merchants' common stock. Because of these and other factors, past financial performance should not be considered an indicator of future performance. The forward-looking statements contained herein represent Merchants' judgment as of the date of this Form 10-K, and Merchants cautions readers not to place undue reliance on such statements.

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Merchants Bancshares, Inc. is a bank holding company originally organized under Vermont law in 1983 (and subsequently reincorporated in Delaware) for the purposes of owning all of the outstanding capital stock of Merchants Bank and providing greater flexibility in helping Merchants achieve its business objectives. Merchants Bank, which is Merchants' primary subsidiary, is a Vermont commercial bank with 35 full-service banking offices.

The Merchants Bank was organized in 1849 and assumed a national bank charter in 1865, becoming The Merchants National Bank of Burlington, Vermont. On September 6, 1974, The Merchants National Bank of Burlington converted its national charter to a Vermont state commercial bank charter, adopting its current name, Merchants Bank. As of December 31, 2003, Merchants operated one of the largest commercial banking operations in Vermont, with deposits totaling $808 million, loans of $569 million, and total assets of $970 million. In September 2003 Merchants opened its new branch in White River Junction, Vermont. The branch is a free-standing, 1,850 square foot, full-service banking facility and is the model Merchants will use to implement its retail banking expansion strategy. Construction of Merchants' permanent location in St. Albans, Vermont began in the latter part of September 2003, and was completed and opened for business in January 2004. Merchants is in the process of negotiating a leas e for a location in Middlebury, Vermont.

Merchants Trust Company, a wholly owned subsidiary of Merchants Bank, is a Vermont corporation chartered in 1870 for the purpose of offering fiduciary services including trust management and administration, investment management and estate settlement services. As of December 31, 2003, Merchants Trust Company had fiduciary responsibility for assets having a market value in excess of $340 million, of which more than $230 million constituted managed assets. Total revenue of Merchants Trust Company for 2003 was $1.4 million; and total expenses were $1.1 million.

Merchants Properties, Inc., a wholly owned subsidiary of Merchants, was organized for the purpose of developing and owning affordable rental housing units throughout the state of Vermont. As of December 31, 2003, Merchants Properties, Inc. owned one development located in Enosburg, Vermont, consisting of a 24-unit low-income family rental housing project. Total assets of Merchants Properties, Inc. at December 31, 2003, were $1.1 million.

Merchants' products are designed to provide customers with a clear alternative to other local, regional and national financial service providers. Merchants' branded LYNX product line was developed to be simple for the customer to understand and for Merchants' staff to deliver. Merchants has consciously stayed away from business lines that are not strategic to its mission of providing value added financial products to value conscious consumers. Merchants' energies are focused on a very limited product offering, which allows its sales staff of over 150 employees to quickly become proficient in each of the products and their features. Merchants' compensation system is based on meeting high standards of product knowledge. Products that are easy to deliver are also easy for Merchants' customers to understand and use.

Merchants offers a variety of consumer financial products and services designed to satisfy the deposit and loan needs of its retail customers. Merchants' retail products include interest bearing and non interest bearing checking accounts, money market accounts, club accounts, and short-term and long-term certificates of deposit. Merchants also offers customary check collection services, wire transfers, safe deposit box rentals, and automated teller machine (ATM) cards and services. Credit programs include secured and unsecured installment lending, home equity lines of credit, and home mortgages.

Free Checking For Life^® is available to all applicants of "good standing" in Merchants' market area, and is free of monthly service charges for the life of the account. The only condition to holding the account is that the customer accept check truncation. The account pays interest at tiered levels beginning with the first dollar, and no minimum balance is required. Merchants opened just under 11,000 Free Checking For Life^® accounts during 2003.

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Free Checking For Life^® customers may choose either a Check Card or an ATM card. Customers who choose the Check Card can pay for purchases at locations that accept VISA^®. With expanded automated overdraft protection, customers can use a money market account and/or a home equity line of credit as overdraft protection for a checking account. The customer may choose either or both accounts to cover overdrafts.

Merchants' other major retail deposit product is its MoneyLYNX^® Money Market Account. MoneyLYNX^® pays interest at tiered levels beginning with the first dollar in the account, and fees are charged only under certain limited circumstances. Merchants' rates on this product remained competitive during the last year, but were not at the top of the market. New account activity and average deposit growth slowed during this period. At the beginning of 2004 the product was enhanced by lowering the minimum balance required to open an account and new account activity has increased.

Merchants' flexible TimeLYNX^® certificate of deposit allows multiple deposits and penalty free withdrawals within regulatory guidelines.

Merchants offers ATF (automatic transfer of funds) to cover overdrafts, EFT (electronic funds transfer) to automate transfers between accounts, and the PhoneLYNX^SM Telephone Banking system. Merchants offers eLYNX^®, a free online banking service as well as a free bill payment service delivered via the Internet, which has proven to be a popular addition.

Each of Merchants' 35 full-service branch offices is led by a branch president who has responsibility for the full range of retail and small business credit services. Merchants' semi-autonomous branch system is core to its strategy of providing one stop shopping to its customers. Currently almost all customer inquiries can be handled at any branch location. The branch serves as both a sales and a delivery outlet. Branch personnel can explain various deposit options and open new accounts online. Additionally, qualified branch staff have the ability to take loan applications, approve loans within defined approval limits, and to close consumer, mortgage and small business loans. Merchants also operates 41 ATMs throughout Vermont, and maintains a customer call center with expanded hours of operation.

In January 2003 Merchants launched a 10-year fully amortizing residential mortgage product, RealLYNX^®-10, which generated over 1,000 applications during 2003; and had $89.5 million in balances at an average rate of 4.86% at December 31, 2003. Additionally, financing is available for one-to-four-family residential mortgages, multifamily residential mortgages, residential construction, seasonal dwelling mortgages, and commercial real estate mortgages. Merchants offers both fixed rate and adjustable rate mortgages for residential properties. Merchants currently holds all originated mortgages in its loan portfolio.

Following the success of RealLYNX^®-10 in 2003, Merchants launched a new four-year closed end home equity line of credit in February 2004; and also enhanced its seven-year closed end home equity loan. Merchants offers a wide variety of consumer loans. Financing is provided for new or used automobiles, boats, airplanes, recreational vehicles and new mobile homes. Home improvement and home equity lines of credit and various personal loans are also available.

During 2003 Merchants continued to develop its capacity to service the small business market in Vermont. During the fourth quarter Merchants introduced QLYNX, a streamlined three-year, secured, term loan. The loans are priced attractively, documentation requirements are modest, and Merchants staff is able to turn them around quickly.

Branch presidents are trained for small business loan origination. Merchants' corporate sales staff services the majority of the commercial customers, which are primarily larger enterprises. The ten corporate banking officers and ten corporate banking administrators provide commercial credit services throughout Vermont to customers requiring business credit above the prescribed authorities of the branch presidents.

Financing is available for business inventory, accounts receivable, fixed assets, lines of credit for working capital, community development, irrevocable letters of credit, U.S. Small Business Administration guaranteed loans and USDA guaranteed loans. Merchants has increased the emphasis placed on small business loans originated in its branches.

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CommerceLYNX^® is a package of business banking services including a low cost business checking account, a CommerceLYNX^® Money Market Account, and a streamlined line of credit application. Merchants' philosophy of simplifying product offerings and minimizing fees has been applied to this program. Consistent with Merchants' goal of promoting electronic transactions, CommerceLYNX^® provides Internet banking, bill payment and debit and electronic services. Branch presidents are trained to offer this service leading with the introduction of small business financing options and the value of utilizing the efficient transaction accounts.

Merchants offers a variety of commercial checking accounts. Commercial checking uses an earnings credit rate to help offset service charges. Merchants offers the CommerceLYNX^® Money Market Account as the savings vehicle for businesses. The CommerceLYNX^® Money Market Account pays interest at tiered levels beginning with the first dollar in the account. Merchants' cash management services provide additional investment opportunities through the Cash Sweep Program. Other cash management services include funds concentration. Merchants offers eLYNX^® Online Banking, a commercial banking and bill payment service delivered via the Internet. These products allow businesses to view their account histories, print statements, view check images, order stop payments, transfer between accounts, transmit ACH batches, and order wire transfers. Other miscellaneous commercial banking services include night depository, coin and currency handling, and balance reporti ng services.

Like most financial institutions in America, Merchants competes with an ever increasing array of financial service providers. As the national economy moves further toward a concentration of service companies and the overall health of the financial service industry continues to be strong, competitive pressures will mount. Merchants competes in Vermont for deposit and loan business with numerous other commercial and savings banks, savings and loan associations, credit unions, and other non-bank financial providers. As of December 31, 2003, there were more than 20 state and national banking institutions operating in Vermont. In addition, the number of non-bank financial service providers competing in Vermont has increased dramatically. As a bank holding company and state-chartered commercial bank, Merchants is subject to extensive regulation and supervision, including, in many cases, regulation that limits the type and scope of its activities. The non-bank financial service providers that compete with Merchants may not be subject to such extensive regulation and supervision. Competition from nationwide banks, as well as local institutions, continues to be aggressive.

Merchants expects to see continued competitive pressure on its franchise. Merchants is the largest independent bank with offices exclusively in the state of Vermont. Aggressive and flexible direct marketing of core financial products continues to result in increased market share, even in mature market areas. In 2003, Merchants opened two de novo branches in St. Albans and White River Junction, Vermont. Several smaller community banks have made a commitment to increase their footprints in Merchants' markets. A small mutual savings bank headquartered in the central section of Vermont has moved into Chittenden County with three new retail locations. A small community bank based in the northeast section of Vermont has opened two new branches in the central part of the state. Several of the credit unions have also opened additional branch locations. The impact to Merchants of Bank of America's pending purchase of Fleet Bank remains to be seen. Bank of America will have branches in the three s tates that border Vermont; New Hampshire, Massachusetts and upstate New York; and they may choose to expand into Vermont. In a state that already has one of the nation's highest branch-to-population ratios it is necessary to have a very competitive product offering and exceptional service levels.

From a retail product standpoint, Merchants has seen a major change in the competitive landscape in the past few years. When Merchants' free checking product was introduced there was only one other competitor with a similar product offering. Since that time all but one of Merchants' largest competitors has introduced free checking products.

No material part of Merchants' business is dependent upon one, or a few, customers, or upon a particular industry segment, the loss of which would have a material adverse impact on the operations of Merchants.

As of December 31, 2003, Merchants Bancshares, Inc. had three officers: Joseph L. Boutin, President and Chief Executive Officer; Janet P. Spitler, Chief Financial Officer and Treasurer; and Rosemary Walker, Secretary. No officer of Merchants Bancshares, Inc. is on a salary basis.

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As of December 31, 2003, Merchants Bank employed 251 full-time and 59 part-time employees and Merchants Trust Company employed 12 full-time employees, representing a combined full time equivalent complement of 296 employees. Merchants Bank and Merchants Trust Company maintain comprehensive employee benefits programs for employees which provide major medical insurance, hospitalization, dental insurance, long-term and short-term disability insurance, life insurance and a 401(k) Plan. Merchants believes that relations with its employees are good.

As a bank holding company registered under the Bank Holding Company Act of 1956, as amended (the "BHCA"), Merchants is subject to extensive regulation and supervision by the Board of Governors of the Federal Reserve System. As a state-chartered commercial bank, Merchants Bank is subject to substantial regulation and supervision by the Federal Deposit Insurance Corporation (the "FDIC") and by applicable Vermont regulatory agencies. To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to those particular statutory provisions. Any change in applicable law or regulation may have a material effect on the business and prospects of Merchants.

The Gramm-Leach-Bliley Act ("Gramm-Leach"), which significantly altered banking laws in the United States, was signed into law in 1999. Gramm-Leach enabled combinations among banks, securities firms and insurance companies beginning in 2000. As a result of Gramm-Leach, many of the depression-era laws which restricted these affiliations and other activities which may be engaged in by banks and bank holding companies were repealed. Under Gramm-Leach bank holding companies are permitted to offer their customers virtually any type of service that is financial in nature or incidental thereto, including banking, securities underwriting, insurance (both underwriting and agency), and merchant banking.

In order to engage in these new financial activities a bank holding company must qualify and register with the Federal Reserve Board as a "financial holding company" by demonstrating that each of its bank subsidiaries is "well capitalized," "well managed," and has at least a "satisfactory" rating under the Community Reinvestment Act of 1977 ("CRA").

These new financial activities authorized by Gramm-Leach may also be engaged in by a "financial subsidiary" of a national or state bank, except for insurance or annuity underwriting, insurance company portfolio investments, real estate investment and development, and merchant banking, which must be conducted in a financial holding company. In order for the new financial activities to be engaged in by a financial subsidiary of a national or state bank, Gramm-Leach requires the parent bank (and its sister-bank affiliates) to be "well capitalized" and "well managed"; the aggregate consolidated assets of all of that bank's financial subsidiaries may not exceed the lesser of 45% of its consolidated total assets or $50 billion; the bank must have at least a "satisfactory" CRA rating; and, if that bank is one of the 100 largest national banks, it must meet certain financial rating or other comparable requirements. Gramm-Leach establishes a system of functional regulation, under which the federal banking agencies will regulate the banking activities of financial holding companies and banks' financial subsidiaries, the U.S. Securities and Exchange Commission will regulate their securities activities and state insurance regulators will regulate their insurance activities. Gramm-Leach also provides new protections against the transfer and use by financial institutions of consumers' nonpublic, personal information.

Although Merchants believes that it meets the qualifications to become a financial holding company under Gramm-Leach, it has elected to retain its pre-Gramm-Leach status for the present time. This means that Merchants can engage in those activities which are closely related to banking. Merchants is required by the BHCA to file an annual report and additional reports required with the Federal Reserve Board. The Federal Reserve Board also makes periodic inspections of Merchants and its subsidiaries.

The BHCA requires every bank holding company to obtain the prior approval of the Federal Reserve Board before it may acquire substantially all of the assets of any bank, or ownership or control of any voting shares of a bank, if, after such acquisition, it would own or control, directly or indirectly, more than five percent of the voting shares of such

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bank. Additionally, as a bank holding company Merchants is prohibited from acquiring ownership or control of five percent or more of any class of voting securities of any company that is not a bank, or from engaging in activities other than banking or controlling banks except where the Federal Reserve Board has determined that such activities are so closely related to banking as to be a "proper incident thereto."

Merchants Bancshares, Inc. is a legal entity separate and distinct from Merchants Bank and its other non-bank subsidiary. The revenue of Merchants (on a parent company only basis) is derived primarily from interest and dividends paid to it by its subsidiaries. The right of Merchants, and consequently the right of shareholders of Merchants, to participate in any distribution of the assets or earnings of any subsidiary through the payment of such dividends or otherwise is necessarily subject to the prior claims of creditors of the subsidiary (including depositors, in the case of banking subsidiaries), except to the extent that certain claims of Merchants in a creditor capacity may be recognized.

The payment of dividends by Merchants is determined by its Board of Directors based on Merchants' consolidated liquidity, asset quality profile, capital adequacy, and recent earnings history, as well as economic conditions and other factors, including applicable government regulations and policies and the amount of dividends payable to Merchants by its subsidiaries.

It is the policy of the Federal Reserve Board that banks and bank holding companies, respectively, should pay dividends only out of current earnings and only if, after paying such dividends, the bank or bank holding company would remain adequately capitalized. Federal banking regulators also have authority to prohibit banks and bank holding companies from paying dividends if they deem such payment to be an unsafe or unsound practice. In addition, it is the position of the Federal Reserve Board that a bank holding company is expected to act as a source of financial strength to its subsidiary banks.

Vermont law requires the approval of state bank regulatory authorities if the dividends declared by state banks exceed prescribed limits. The payment of any dividends by Merchants' subsidiaries will be determined based on a number of factors, including the subsidiary's liquidity, asset quality profile, capital adequacy and recent earnings history.

Capital Guidelines. Under the uniform capital guidelines adopted by the Federal banking agencies, in order to be "well capitalized" a financial institution must have a minimum ratio of total capital to risk-adjusted assets of ten percent (including certain off-balance sheet items, such as standby letters of credit), a minimum ratio of Tier 1 capital to total risk-based assets of six percent (comprised of common equity, retained earnings, minority interests in the equity accounts of consolidated subsidiaries and a limited amount of noncumulative perpetual preferred stock, less deductible intangibles), and a minimum leverage ratio of five percent (Tier 1 capital to average quarterly assets, net of goodwill).

Under Federal banking laws, failure to meet the minimum regulatory capital requirements could subject a banking institution to a variety of enforcement remedies available to federal regulatory authorities, including the termination of deposit insurance by the FDIC and seizure of the institution.

Prompt Corrective Action. The Federal Deposit Insurance Corporation Improvement Act of 1991 (as amended), (the "FDICIA") provides the Federal banking agencies with broad powers to take prompt corrective action to resolve problems of insured depository institutions, depending upon a particular institution's level of capital. The FDICIA establishes five tiers of capital measurement for regulatory purposes ranging from "well capitalized" to "critically undercapitalized." A depository institution may be deemed to be in a capitalization category that is lower than is indicated by its actual capital position under certain circumstances. As of December 31, 2003, Merchants Bank was classified as "well capitalized" under the applicable prompt corrective action regulations.

Under the FDICIA a depository institution that is "well capitalized" may accept brokered deposits. A depository institution that is adequately capitalized may accept brokered deposits only if it obtains the approval of the FDIC, and may not offer interest rates on deposits "significantly higher" than the prevailing rate in its market. An "undercapitalized" depository institution may not accept brokered deposits. Merchants had no brokered deposits at December 31, 2003.

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Safety and Soundness Standards. The FDICIA, as amended, directs each Federal banking agency to prescribe safety and soundness standards for depository institutions relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation, asset-quality, earnings and stock valuation. The Community Development and Regulatory Improvement Act of 1994 amended the FDICIA by allowing Federal banking activities to publish guidelines rather than regulations concerning safety and soundness.

The FDICIA also contains a variety of other provisions that may affect Merchants' operations, including reporting requirements, regulatory guidelines for real estate lending, "truth in savings" provisions, and the requirement that a depository institution give 90 days prior notice to customers and regulatory authorities before closing any branch.

Pursuant to the CRA and similar provisions of Vermont law, regulatory authorities review the performance of Merchants in meeting the credit needs of the communities it serves. The applicable regulatory authorities consider compliance with this law in connection with the applications for, among other things, approval for de novo branches, branch relocations and acquisitions of banks and bank holding companies. Merchants received a "satisfactory" rating at its most recent CRA examination.

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, as amended (the "Interstate Banking Act"), generally permits bank holding companies to acquire banks in any state, and preempts all state laws restricting the ownership by a bank holding company of banks in more than one state. The Interstate Banking Act also permits a bank to merge with an out-of-state bank and convert any offices into branches of the resulting bank if both states have not opted out of interstate branching; permits a bank to acquire branches from an out-of-state bank if the law of the state where the branches are located permits the interstate branch acquisition; and permits banks to establish and operate de novo interstate branches whenever the host state opts-in to de novo branching. Bank holding companies and banks seeking to engage in transactions authorized by the Interstate Banking Act must be adequately capitalized and managed.

Under Title III of the USA Patriot Act, also known as the "International Money Laundering Abatement and Anti-Terrorism Financing Act of 2001," all financial institutions are required in general to identify their customers, adopt formal and comprehensive anti-money laundering programs, scrutinize or prohibit altogether certain transactions of special concern, and be prepared to respond to inquiries from U.S. law enforcement agencies concerning their customers and their transactions. Additional information-sharing among financial institutions, regulators, and law enforcement authorities is encouraged by the presence of an exemption from the privacy provisions of Gramm-Leach for financial institutions that comply with this provision and the authorization of the Secretary of the Treasury to adopt rules to further encourage cooperation and information-sharing. The effectiveness of a financial institution in combating money laundering activities is a factor to be considered in any applicatio n submitted by the financial institution under the Bank Merger Act and Bank Holding Company Act.

The Sarbanes-Oxley Act of 2002, signed into law July 30, 2002, addresses, among other issues, corporate governance, auditor independence and accounting standards, executive compensation, insider loans, whistleblower protection and enhanced and timely disclosure of corporate information. The Securities Exchange Commission (the "SEC") has adopted a substantial number of implementing rules, and the New York Stock Exchange and the National Association of Securities Dealers, Inc. have adopted corporate governance rules that have been approved by the SEC. The changes are intended to allow shareholders to monitor more effectively the performance of companies and management.

Effective August 29, 2002, as directed by Section 302(a) of the Sarbanes-Oxley Act of 2002, Merchants' chief executive officer and chief financial officer are each required to certify that Merchants' quarterly and annual reports do not contain any untrue statement of a material fact. This requirement has several parts, including certification that these officers are responsible for establishing, maintaining and regularly evaluating the effectiveness of Merchants' internal controls; that they have made certain disclosures to Merchants' auditors and the Audit Committee of the board of

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directors about Merchants' internal controls and that they have included information in Merchants' quarterly and annual reports about their evaluation of Merchants' internal controls, and whether there have been significant changes in Merchants' internal controls or in other factors that could significantly affect internal controls.

Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350, Merchants' chief executive officer and chief financial officer are each required to certify that Merchants' quarterly and annual reports fully comply with the requirements of Sections 13(a) or 15(d) of the Securities Exchange Act and that the information contained in the report fairly presents, in all material respects, Merchants' financial condition and results of operations.

Other legislative and regulatory proposals regarding changes in banking, the regulation of banks and other financial institutions, and public companies generally, are regularly considered by the executive branch of the Federal government, Congress and various state governments, including Vermont, and state and federal regulatory authorities. It cannot be predicted what additional legislative and/or regulatory proposals, if any, will be considered in the future, whether any such proposals will be adopted or, if adopted, how any such proposals would affect Merchants.

Merchants files annual, quarterly, and current reports, proxy statements, and other documents with the SEC under the Securities Exchange Act of 1934 (the "Exchange Act"). The public may read and copy any materials that Merchants has filed with the SEC at the SEC's Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Also, the SEC maintains an Internet website that contains reports, proxy and information statements, and other information regarding issuers, including Merchants that file electronically with the SEC. The public can obtain any documents that Merchants, has filed with the SEC at http://www.sec.gov.

Merchants also makes available free of charge on or through its Internet website (http://www.mbvt.com) its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and, if applicable, amendments to those reports filed or furnished pursuant to Section 13(a) of the Exchange Act, as soon as reasonably practicable after Merchants electronically files such materials with or furnishes them to, the SEC. Merchants also makes all filed insider transactions available through its website free of charge. In addition, Merchants' Audit Committee and Nominating and Governance Committee Charters as well as its Code of Ethics for Senior Financial Officers are available free of charge on its website.

As of December 31, 2003, Merchants operated 35 full-service banking offices, and 41 ATMs throughout the state of Vermont. Merchants' headquarters are located in Merchants' service center at 275 Kennedy Drive, South Burlington, Vermont, which also houses Merchants' administrative offices, the operations data processing center and Merchants Trust Company.

Merchants leases certain premises from third parties under current market terms and conditions. The offices of all subsidiaries are in good physical condition with modern equipment and facilities considered adequate to meet the banking needs of customers in the communities served. Additional information relating to Merchants' properties is set forth in Note 4 to the consolidated financial statements included in Item 8 of this 2003 Annual Report on Form 10-K.

Merchants and certain of its subsidiaries have been named as defendants in various legal proceedings arising from their normal business activities. Although the amount of any ultimate liability with respect to such proceedings cannot be determined, in the opinion of management, based upon the opinion of counsel on the outcome of such proceedings, any such liability will not have a material effect on the consolidated financial position of Merchants and its subsidiaries.

During the fourth quarter of calendar year 2003 no matters were submitted to a vote of security holders through a solicitation of proxies or otherwise.

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The common stock of Merchants is traded on the NASDAQ National Stock Market under the trading symbol MBVT. On December 31, 2003, the 4:00 close bid and ask prices were $30.45 and $30.53 respectively. Quarterly stock prices and dividends paid for each quarterly period during the last two years were as follows:

High and low stock prices are based upon quotations as provided by the National Association of Securities Dealers, Inc. Prices of transactions between private parties may vary from the ranges quoted above.

In January 2001 Merchants' Board of Directors approved a stock repurchase program. In January 2004 the Board of Directors voted to extend the program until January 2005. Under the program Merchants is authorized to repurchase up to 300,000 shares of its own common stock. As of December 31, 2003, Merchants had purchased 178 thousand shares of its own common stock on the open market under the program at an average per share price of $21.52.

As of January 31, 2004, Merchants had 920 registered shareholders. Merchants declared and distributed dividends totaling $1.04 per share during 2003. In January 2004 Merchants declared a dividend of $0.27 per share, which was paid on February 19, 2004, to shareholders of record as of February 5, 2004. Future dividends will depend upon the financial condition and earnings of Merchants and its subsidiaries, its need for funds and other factors, including applicable government regulations.

American Stock Transfer & Trust Company provides transfer agent services for Merchants. Inquires may be directed to: American Stock Transfer & Trust Company, 59 Maiden Lane, New York, New York, 10038, telephone: 1-800-426-5523, Internet address: http://www.amstock.com, or email: [email protected].

The supplementary financial data presented in the following tables contain information highlighting certain significant trends in Merchants' financial condition and results of operations over an extended period of time.

The following information should be analyzed in conjunction with Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations and with the audited consolidated financial statements included in this 2003 Annual Report on Form 10-K.

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Management's discussion and analysis of Merchants' financial condition is based on the consolidated financial statements which are prepared in accordance with accounting principles generally accepted in the United States. The preparation of such consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Management evaluates its estimates on an ongoing basis. Management bases its estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis in making judgments about financial statement amounts. Actual results could differ from the amount derived from management's estimates and assumptions under different assumptions or conditions.

Merchants' significant accounting policies are described in more detail in Note 1 to the consolidated financial statements included in Item 8 of this Form 10-K. Management believes the following accounting policies are the most critical to the preparation of the consolidated financial statements.

Allowance for Loan Losses: The allowance for loan losses, which is established through the provision for loan losses, is based on management's evaluation of the level of the allowance for loan losses required in relation to the estimated loss exposure in the loan portfolio. Management believes the allowance for loan losses is a significant estimate and therefore evaluates it for adequacy each quarter. Management considers factors such as previous loss experience, the size and composition of the loan portfolio, current economic and real estate market conditions, the performance of individual loans in relation to contract terms, and estimated fair value of collateral that secures the loans. The use of different estimates or assumptions could produce a different allowance for loan losses.

Income Taxes: Merchants estimates its income taxes for each period for which a statement of operations is presented. This involves estimating Merchants' actual current tax exposure, as well as assessing temporary differences resulting from differing timing of recognition of expenses, income and tax credits, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in Merchants consolidated balance sheets. Merchants must also assess the likelihood that any deferred tax assets will be recovered from future taxable income and to the extent that recovery is not likely a valuation allowance must be established. Significant management judgement is required in determining income tax expense, and deferred tax assets and liabilities. As of December 31, 2003, there was no valuation allowance for deferred tax assets.

Interest Income Recognition on Loans: Interest on loans is included in income as earned based upon the unpaid principal balance of the loan. Merchants' policy is to discontinue the accrual of interest, and to reverse any uncollected interest recorded on loans, when scheduled payments become contractually past due in excess of 90 days unless the ultimate collectibility of principal and interest is assured.

The following discussion and analysis of financial condition and results of operations of Merchants and its subsidiaries for the three years ended December 31, 2003, should be read in conjunction with the Consolidated Financial Statements and Notes thereto and selected statistical information appearing elsewhere in this Form 10-K. The information about asset yields, interest rate spreads and net interest margins is discussed on a fully taxable equivalent basis. The financial condition and operating results of Merchants essentially reflect the operations of its principal subsidiary, Merchants Bank. Certain statements contained in this section constitute "Forward Looking Statements" and are subject to certain risks and uncertainties described in this 10-K under the heading "Forward Looking Statements".

Reflecting trends in the national economy, Merchants' market area generally witnessed an increase in economic growth toward the end of 2003, although job gains have not reflected the same trend. Business spending increased in the fourth quarter, and if it continues, may lead to additional job growth as businesses hire to stay competitive. Vermont's season-

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ally adjusted unemployment rate closed the year at 4.7%, and changed little throughout 2003. The national unemployment rate at the end of 2003 was 5.7%. There was little inflation pressure during 2003 and the Federal Reserve Board kept rates low for most of 2003 as the economy slowly picked up steam. Historically low interest rate levels during 2003 led to a boom in the refinancing market, but also led to compression in Merchants' net interest margin throughout the year. The economies and real estate markets in Merchants' primary market areas will continue to be significant determinants of the quality of Merchants' assets in future periods and, thus, its results of operations, liquidity and financial condition. Merchants believes future economic activity will depend on consumer confidence, business expenditures for new capital equipment and personal consumption expenditures. For a description of other factors which could affect Merchants' financial performance and that of its common sto ck, see "Forward-Looking Statements" at the beginning of this report.

Merchants realized net income of $11.59 million, $12.62 million and $12.16 million for the years ended December 31, 2003, 2002 and 2001, respectively. Basic earnings per share were $1.87, $2.05 and $1.99 and diluted earnings per share were $1.86, $2.02 and $1.98 for the years ended December 31, 2003, 2002 and 2001, respectively. Merchants declared and distributed total dividends of $1.04, $0.96 and $0.88 per share during 2003, 2002 and 2001, respectively. In January 2004 Merchants declared a dividend of $.27 per share, which was paid on February 19, 2004, to shareholders of record as of February 5, 2004.

Net income as a percentage of average equity capital was 13.75%, 15.73% and 17.06% for 2003, 2002 and 2001, respectively. Net income as a percentage of average assets was 1.28%, 1.54% and 1.59%, in 2003, 2002 and 2001, respectively.

Net interest income, on a fully taxable equivalent basis, increased $270 thousand from 2002 to 2003, in spite of a 43 basis point decrease in the net interest margin. Merchants grew its average interest earning assets $80.48 million, or 10%, to $849.37 million from $768.89 million over the course of 2003. The average loan portfolio increased $56.84 million, or 12%, to $536.10 million from $479.25 million; and the average investment portfolio increased $40.02 million, or 15%, to $304.75 million from $264.73 million during 2003. Merchants' larger base of interest earning assets helped to mitigate the effect of the decrease in the net interest margin, and protect Merchants' overall net interest income. As shown in the schedule on page 18, increased volumes of interest bearing assets were offset by lower interest rates on those assets, while the cost of increased volumes of interest bearing liabilities was offset by decreases in rates on those liabilities.

The decrease in the net interest margin for 2003 reflects the overall low interest rate environment that began in 2001 and continued throughout 2002 and 2003; interest rates hit historic lows in 2003. During 2003 the average yield on interest earning assets decreased 92 basis points to 5.37 % from 6.29%; at the same time the cost of interest bearing liabilities decreased 60 basis points to 1.12% from 1.72% leading to an overall decrease in interest rate spread of 32 basis points. The average rate earned on Merchants' loan portfolio decreased to 6.07% for 2003 from 7.13% for 2002. As mentioned above, Merchants' experienced a 12% increase in its average loan portfolio over the course of 2003, which helped to generate additional interest revenue and mitigate the effect of decreases in loan yields during 2003. The decrease in rates on the overall loan portfolio was driven by several factors. Merchants' year-end residential real estate loan portfolio grew $57 million as borrowers looked to t ake advantage of historically low interest rates. The average rate on the residential real estate portfolio at December 31, 2003, was 5.60%, a 1.12% decrease from the average rate at the end of 2002 of 6.72%. At the same time much of the overall growth in the commercial and commercial real estate portfolios was in variable rate products. As a result more assets were priced at the short end of the yield curve, the lowest point, and further decreased margins. The migration in the commercial and commercial real estate portfolios from fixed rates to lower yielding variable rates that occurred during 2002 continued, although at a slower pace, into 2003; and new commercial originations were primarily in the variable rate category. Variable rate commercial and commercial real estate loans increased $31.9 million, or 16%, to $231.6 million from $199.7 million during 2003.

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The average interest rate earned on the investment portfolio decreased by 99 basis points to 4.23% from 5.22%. As mentioned above, the average investment portfolio grew 15% during 2003. Merchants' average short-term borrowing position increased $21 million over the course of the year, and was $57 million at year-end 2003 as Merchants leveraged its balance sheet to generate additional net interest income.

Over the course of 2003 Merchants' average interest bearing liabilities increased $71.0 million, or 11%, to $711.0 million from $640.0 million. The average rate on all interest bearing liabilities decreased 60 basis points to 1.12% from 1.72% during the year. The average rate paid on savings, NOW and money market deposits decreased 55 basis points and the average rate on time deposits decreased 84 basis points.

Merchants entered into a $25 million, three year, interest rate swap early in the second quarter of 2002. Merchants received a fixed interest rate and paid prime under the swap. Merchants terminated the swap and received proceeds of $1.3 million during October 2002. This gain on swap termination is being accreted into interest income monthly, using the effective yield method, through April 2005.

Although taxable equivalent net interest income increased $1.8 million (5.1%) from 2001 to 2002, the net interest margin decreased year over year. Total interest and dividend income decreased $5.7 million (10.5%), and total interest expense decreased $7.5 million (40.4%) from 2001 levels. The rate on interest earning assets decreased 124 basis points over the course of the year, from 7.53% for 2001 to 6.29% for 2002; and the rate on average interest bearing liabilities decreased 136 basis points during the same period from 3.08% for 2001 to 1.72% for 2002. These changes resulted in an increase in the interest rate spread of 10 basis points and a decrease in the overall net interest margin for 2002 of 10 basis points to 4.86%, down from 4.96% for 2001.

This decrease in Merchants' margin reflected the continuing effect of the low interest rate environment. Although the average balances of the loan portfolio increased $201 thousand in 2002, the average interest rate earned on the loan portfolio decreased from 8.33% in 2001 to 7.13% in 2002. This decrease was primarily a result of a shift in the makeup of Merchants' loan portfolio from fixed rates to lower yielding variable rates during 2002.

The commercial and commercial real estate loan portfolios experienced a substantial shift from fixed rate to variable rate loans during 2002. From year-end 2001 to 2002 Merchants' commercial real estate portfolio, which comprises approximately 36% of Merchants' loan portfolio, shifted from approximately 70% fixed rate to approximately 70% variable rate. The fixed rate commercial real estate portfolio, with a December 31, 2002, yield of approximately 8.34%, decreased by approximately $51 million during 2002, while the variable rate commercial real estate portfolio, with a December 31, 2002, yield of approximately 4.72%, increased by over $59 million. Merchants' commercial loan portfolio had a similar shift. The commercial loan portfolio shifted from approximately 50% fixed rate to approximately 70% variable rate.

The average interest rate on the investment portfolio decreased from 6.38% in 2001 to 5.22% in 2002, and the average balance increased $62.8 million (31.1%) to $264.7 million. Merchants' average federal funds sold and securities purchased under agreements to resell position decreased by $11.8 million during 2002, from $36.7 million to $24.9 million, as management redeployed excess funds into the investment portfolio.

Average interest bearing deposits increased by $39.4 million during 2002 and the average rate on those deposits decreased 135 basis points, from 3.07% to 1.72%. The decrease in rates paid on deposits was attributable to the continued decrease in short-term interest rates over the course of 2002. Over 72% of Merchants' interest bearing deposits were in Savings, Money Market and NOW accounts during 2002. These accounts generated the bulk of the deposit growth during 2002, and tend to be much less expensive than time deposits. Average balances in Savings, Money Market and NOW accounts increased by $26.5 million (6.1%), at an average interest rate for 2002 of 1.15%, while average balances in higher cost time deposits increased $12.9 million (7.9%), at an average interest rate of 3.18% for 2002.

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The following table presents the condensed annual average balance sheets for 2003, 2002 and 2001. The total dollar amount of interest income from assets and the related yields are calculated on a taxable equivalent basis:

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The following table presents the extent to which changes in interest rates and changes in the volume of earning assets and interest bearing liabilities have affected interest income and interest expense during the periods indicated. Information is presented in each category with respect to: (i) changes attributable to changes in volume (changes in volume multiplied by prior rate), (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume) and (iii) changes in volume/rate (change in volume multiplied by change in rate).

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The Allowance for Loan Losses ("Allowance") is reviewed by management at least quarterly and continues to be deemed adequate under current market conditions. At December 31, 2003, the Allowance stood at $7.95 million, 1.40% of total loans and 360% of nonperforming loans, compared to $8.50 million, 1.71% of total loans and 230% of nonperforming loans at December 31, 2002. Merchants recorded charge-offs of $1.08 million and recoveries of $539 thousand during 2003. For 2001 and 2002, Merchants recorded a negative loan loss provision. Merchants discontinued this practice during 2003 as a result of increased net loan losses during 2003. The amount of the negative provision during 2002 was $945 thousand and was $1.0 million for 2001. There was no provision for loan losses during 2003. Merchants expects that, as the loan portfolio continues to grow, additions to the Allowance in the form of provisions for loan losses will be necessary. For a more detailed discussion of Merchants' Al lowance, see "Credit Quality and Allowance for Loan Losses".

Total noninterest income increased $916 thousand to $9.57 million for the year 2003 from $8.65 million for the year 2002. Net gains on sales of investments totaled $1.42 million for 2003 and $610 thousand for 2002. During the third quarter of 2002 Merchants recognized a $272 thousand gain on the sale of a branch building and $449 thousand related to the settlement of certain litigation. Excluding these items (see table below) total noninterest income increased $827 thousand (11%) to $8.15 million for 2003 from $7.32 million for 2002.

The category Service Charges on Deposits increased $351 thousand from 2002 to 2003. The principal components of service charges on deposits are overdraft fee income and monthly service charge revenue. Net overdraft fee income increased $317 thousand to $2.93 million for 2003 from $2.61 million for 2002. The increase in overdraft fee income was due primarily to an overall larger deposit base, as well as general increased overdraft activity. Revenue from monthly service charges on deposits, a component of noninterest income that had been decreasing over the last few years, was flat from 2002 to 2003. The category Other noninterest income increased by $391 thousand from 2002 to 2003. This increase is primarily a result of increases in ATM and debit card fee income, which, net of expenses, increased $220 thousand to $1.21 million for 2003 from $991 thousand for 2002. Merchants has had success in transitioning more of its customers' activity to electronic transactions, which has produced increased fee income levels and allowed for level staffing in its back office. The average number of checks written on Merchants' transaction accounts has decreased to 9.5 per month, a 27% reduction from 1999 levels of 13 per month.

Net gains on sales of securities totaled $1.42 million for 2003, an increase of $810 thousand over 2002. Merchants engaged a new investment advisory firm during 2003 to help it manage its investment portfolio. During 2003 some repositioning of the investment portfolio occurred resulting in larger than usual gains.

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Total noninterest income increased $139 thousand for 2002 compared to 2001. Net gains (losses) on sales of investments totaled $610 thousand for 2002 and were $(224) thousand for 2001. Additionally, during 2001 Merchants recognized gains related to the sales of loans of $616 thousand, income related to the resolution of certain ongoing litigation of $312 thousand and received interest income of $199 thousand related to a Vermont franchise tax refund. As shown in the table above, after excluding the non-recurring items for 2002 and 2001, total noninterest income decreased $289 thousand to $7.32 million in 2002 from $7.61 million in 2001. The category Service Charges on Deposits, comprised primarily of monthly service charges on deposits and overdraft fee income, increased $160 thousand from 2001 to 2002. Merchants continued to offer its highly successful Free Checking for Life® account, which generally charges no monthly fees, and offers free Internet banking. As a result, Me rchants' monthly service charge revenue generally decreased over the last several years. Merchants' monthly service charge revenue decreased by $79 thousand during 2002. The decrease in monthly service charge revenue was offset by increases in overdraft income of $179 thousand from $2.43 million in 2001 to $2.61 million in 2002; this increase was primarily a result of increased volumes of accounts. During 2002 the number of customers signed up for Internet banking increased from 2,100 to almost 8,000. As a result of this increased Internet usage Merchants gained efficiencies in many areas, such as item processing and our customer call center.

Other noninterest income decreased $337 thousand during 2002. The decrease in other noninterest income when comparing 2002 to 2001 is due primarily to several one-time events that occurred during the two years. As shown in the table above, Merchants recorded a gain on the sale of a branch building totaling $272 thousand during 2002 and received interest income of $199 thousand related to a Vermont franchise tax refund during 2001. During 2001 Merchants booked gains related to the sales of merchant credit card services portfolio totaling $81 thousand and during 2002 experienced decreases in its net merchant credit card servicing income of $188 thousand during 2002 due to the sale.

Gains on sales of loans totaled $616 thousand during 2001, which consisted of a gain on the sale of Merchants credit card portfolio of $563 thousand and gains related to the sales of loan servicing rights of $53 thousand. There were no gains on sales of loans during 2002.

Noninterest expense increased $1.74 million to $31.23 million for 2003 compared to $29.50 million for 2002, a 5.88% increase. Salaries and Wages increased $238 thousand to $11.57 million for 2003 compared to 2002, a 2.1% increase. Merchants' salary administration plan, begun in 2001, is now fully implemented, and average salary increases for 2003 were just under 6%. The salary administration program was designed to ensure that Merchants' base wage levels were competitive and would allow Merchants to attract and retain highly skilled staff. The first phase of the project, which focused on sales staff, was completed in late 2002; the second phase of the project, covering the Service Center staff was completed during the third quarter of 2003. Merchants continued its incentive program, designed to compensate employees based on their individual performance, as well as the performance of their division and Merchants, during 2003. The program for 2003 focused entirely on profitabili ty for Service Center staff, and on increased sales with a quality control component in the branches and corporate banking division. Incentive compensation decreased $689 thousand to $694 thousand for 2003 from $1.38 million in 2002 as a result of decreased profitability; and as a percentage of payroll decreased to approximately 7% during 2003 from approximately 14% for 2002. This decrease served to partially offset an $809 thousand increase in base salaries and wages which increased to $10.45 million for 2003 from $9.64 million in 2002. Employee benefit costs have increased $222 thousand, or 6.6%, to $3.57 million for 2003 from $3.35 million for 2002. The primary component of this is an increase in Merchants' pension plan expense. Although the pension plan was curtailed in 1995, decreases in the market value of pension plan assets have caused increased expense recognition. Pension plan expense for 2003 increased to $330 thousand from $102 thousand for 2002. Pension plan expense for 2004 is projected t o be somewhat lower than 2003 because the market value of plan assets increased over the course of 2003.

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Occupancy expenses increased $202 thousand, or 7.8% for 2003 over 2002. This increase is primarily a result of new de novo branch rental contracts, as well as normal increases in building maintenance and rental expenses. Equipment expenses increased $140 thousand, or 5.6% for 2003 over 2002. Merchants began a network server infrastructure and desktop computer upgrade during 2003 which is expected to be completed by the third quarter of 2004. The total estimated cost of the project is approximately $2.09 million; approximately $1.95 million of these costs will be capitalized and depreciated over three to five years. The remaining $137 thousand of the total costs are being directly expensed as incurred. Merchants recorded $66 thousand in direct expenses for this project during 2003 and expects to expense $71 thousand during 2004.

Merchants marketing expenses increased $353 thousand, or 29.9%, to $1.53 million for 2003 from $1.18 million for 2002 as Merchants opened, or prepared to open, its two new offices. Additionally, Merchants launched its RealLYNX^®-10 10-year mortgage campaign, and continued to actively market its Free Checking for Life^® account during 2003.

Merchants' equity in losses of Real Estate Limited Partnerships increased $298 thousand to $1.62 million during the year as Merchants continued to invest in community based low-income housing partnerships. Merchants accounts for its investment in these partnerships using the equity method. Losses generated by the partnerships are recorded as a reduction in Merchants' investments in the Consolidated Balance Sheets and as an expense in the Consolidated Statements of Operations. Tax credits generated by the partnerships are recorded as a reduction in the income tax provision. Merchants finds these investments attractive because they provide an internal rate of return of approximately 12%, and provide an opportunity to invest in affordable housing in the communities in which Merchants does business. Other noninterest expense increased $387 thousand, or 7.9% to $5.29 million during 2003. There were a number of small (less than $100 thousand) expense increases that contributed to this overall la rger increase.

Noninterest expense increased $725 thousand (2.5%) for 2002. Salaries and wages increased $124 thousand from $11.20 million to $11.33 million as Merchants continued its salary administration program. Employee benefits increased $350 thousand (11.7%). Merchants recognized pension expense totaling $102 thousand for 2002 compared to income of $209 thousand for 2001 due to significant declines in the market value of plan assets.

Occupancy expenses increased slightly from 2001 to 2002, primarily a result of increases in depreciation expenses and ongoing maintenance and repair of various premises. Equipment expenses were flat year over year. Legal and professional fees decreased $338 thousand (18.0%) primarily due to the timing of expenses as Merchants defended itself or settled certain ongoing litigation. Marketing expenses were down $475 thousand from 2001 to 2002, as Merchants repositioned its marketing efforts in anticipation of the opening of two new branches. Merchants experienced a $678 thousand increase in Vermont franchise taxes from 2001 to 2002, primarily a result of a $622 thousand Vermont franchise tax refund received in 2001.

Merchants equity in losses of Real Estate Limited Partnerships increased $504 thousand to $1.3 million during 2002 as Merchants continued to invest in community-based affordable housing limited partnerships. Other noninterest expense decreased by $237 thousand, which is primarily a result of decreases in expenses related to other real estate owned ("OREO"). OREO expense decreased from $268 thousand in 2001 to $116 thousand in 2002.

Merchants recognized $1.32 million, $1.38 million and $1.39 million, respectively during 2003, 2002 and 2001 in low-income housing tax credits as a reduction in the provision for income taxes; this resulted in an effective tax rate of 27%, 28% and 24% for 2003, 2002 and 2001, respectively. As of December 31, 2003, Merchants has net deferred tax assets of approximately $1.22 million arising from temporary differences between Merchants' book and tax reporting. These net deferred tax assets are included in Other Assets in the Consolidated Balance Sheet.

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Merchants' year-end total assets increased $115.4 million, or 13.5%, to $969.9 million from $854.5 million during 2003, while Merchants' average earning assets increased by $80.5 million, or 10.5%, to $849.4 million from $768.9 million. Merchants experienced a significant increase in loan demand during 2003 and the year-end loan portfolio increased $73.4 million, or 14.8%, from $495.6 million to $569.0 million during the year. The composition of Merchants' loan portfolio is shown in the following table:

During 2003 most of the growth in Merchants' loan portfolio was in the residential real estate and commercial real estate portfolios. Residential mortgage activity was very high, as mortgage rates dropped to their lowest level in 40 years. Merchants has had great success with its new 10-year fully amortizing mortgage product RealLYNX^®-10, introduced in January 2003. This product was originally introduced at a 4.95% rate, and was lowered to 4.65% for the months of June and July. Year-end balances in this product were $89.5 million at an average rate of 4.86%. The increase in the commercial real estate portfolio is primarily a result of property owners taking advantage of the low interest rate environment to refinance existing loans. An active calling effort presented several opportunities to finance new property acquisitions and to refinance existing loans. Line of credit utilization by mortgage banking customers dropped $9.0 million from December 31, 2002 to December 31 , 2003; this decrease was the primary component of the decrease in commercial loans. Absent the fluctuations in mortgage banking balances the originations in the commercial loan portfolio served to cover amortization and pay downs in the existing portfolio. Efforts to grow the commercial portfolio were hampered by soft demand in business spending throughout 2003.

The decrease in installment loans during 2001 resulted from the sale of Merchants $5.5 million credit card portfolio during October 2001.

At December 31, 2003, Merchants serviced $20.20 million in residential mortgage loans for investors such as Federal government agencies (FNMA and FHLMC) and financial investors such as insurance companies and pension funds located outside Vermont. This servicing portfolio has decreased from $193.3 million at year end 1997. Servicing revenue is not expected to be a significant revenue source in the future.

The following table presents the distribution of the varying contractual maturities or repricing opportunities of the loan portfolio at December 31, 2003.

Loans maturing or repricing after one year which have predetermined interest rates totaled $286.2 million. Loans maturing or repricing after one year which have floating or adjustable interest rates totaled $2.9 million.

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The investment portfolio is used to generate interest income, manage liquidity and mitigate interest rate sensitivity. The composition of Merchants' investment portfolio at carrying amounts, (excluding trading securities) is shown in the following table:

Merchants engaged a new investment advisory firm in early 2003. The firm specializes in stable value and fixed income portfolios, and has a staff of investment professionals who research and track each bond. During the year Merchants increased the investment portfolio $70.2 million (26.1%) to $339.6 million from $269.4 million. The average investment portfolio increased $40.02 million (15.1%) to $304.75 million from $264.73 million during the year. At the same time Merchants increased its average FHLB short term borrowing position to $22.2 million from zero over the course of 2003. Year-end FHLB short-term borrowings were $55.0 million. As mentioned in the earlier discussion on net interest income, this leverage has helped Merchants mitigate the effect of 2003's margin compression on its net interest income during the year. Merchants' Asset Liability Committee ("ALCO") manages the investment portfolio. As the portfolio has grown, the ALCO has used portfolio diversification as a way to mitigate the risk of being too heavily invested in any single asset class. Over the course of 2003, with the advice of its investment advisor, the ALCO has repositioned the investment portfolio, increasing its position in several different sectors.

Bank Premises and Equipment, Net increased to $13.06 million at year-end 2003 from $11.40 million at year-end 2002 as Merchants invested $1.70 million in its new branches in White River Junction and St. Albans, Vermont. Additionally, Merchants invested $869 thousand in its network server infrastructure and desktop computer upgrade. Investment in Real Estate Limited Partnerships increased to $5.47 million from $3.55 million during 2003. This increase represents continued investments by Merchants in affordable housing partnerships. These partnerships provide affordable housing in the communities in which Merchants does business, and provide Merchants with an acceptable level of return on its investment.

Merchants' year-end deposit balances increased $52.8 million (7.0%) to $808.1 million at year-end 2003 from $755.3 million at year-end 2002. The composition of Merchants' deposit balances is shown in the following table: