form10q.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2010
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

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 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 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 Exchange Act).  Yes o    No x
 
Number of shares of common stock of the registrant:  Par value $0.01, authorized 20,000,000 shares; issued and outstanding 780,944 as of July 31, 2010.
 


 
 

 

FARMERS & MERCHANTS BANCORP

FORM 10-Q
TABLE OF CONTENTS
 

 
PART I. - FINANCIAL INFORMATION
Page
     
Item 1 -
 
     
 
3
     
 
4
     
 
5
     
 
6
     
 
7
     
 
8
     
Item 2 -
16
     
Item 3 -
33
     
Item 4 -
36
     
PART II. - OTHER INFORMATION
 
     
Item 1 -
37
     
Item 1A –
37
     
Item 2 -
37
     
Item 3 -
37
     
Item 4 –
 
     
Item 5 -
37
     
Item 6 -
37
     
38
     
38

 
2

 
PART I. - FINANCIAL INFORMATION

Item 1 -  Financial Statements

FARMERS & MERCHANTS BANCORP
Consolidated Balance Sheets (Unaudited)
 
(in thousands)
 
June 30,
   
December 31,
   
June 30,
 
Assets
 
2010
   
2009
   
2009
 
Cash and Cash Equivalents:
                 
Cash and Due From Banks
  $ 32,525     $ 32,660     $ 36,984  
Federal Funds Sold
    1,781       1,972       575  
Total Cash and Cash Equivalents
    34,306       34,632       37,559  
                         
Investment Securities:
                       
Available-for-Sale
    324,423       365,549       375,060  
Held-to-Maturity
    68,773       69,617       70,589  
Total Investment Securities
    393,196       435,166       445,649  
                         
Loans
    1,188,840       1,212,718       1,191,138  
Less: Allowance for Loan Losses
    31,403       29,813       25,454  
Loans, Net
    1,157,437       1,182,905       1,165,684  
Premises and Equipment, Net
    24,437       24,887       23,572  
Bank Owned Life Insurance
    44,663       43,759       42,873  
Interest Receivable and Other Assets
    68,659       59,665       45,687  
Total Assets
  $ 1,722,698     $ 1,781,014     $ 1,761,024  
                         
Liabilities
                       
Deposits:
                       
Demand
  $ 293,773     $ 324,073     $ 279,619  
Interest Bearing Transaction
    169,088       180,570       152,651  
Savings
    422,930       414,285       386,608  
Time
    564,493       579,196       687,529  
Total Deposits
    1,450,284       1,498,124       1,506,407  
                         
Securities Sold Under Agreement to Repurchase
    60,000       60,000       60,000  
Federal Home Loan Bank Advances
    4,821       20,149       676  
Subordinated Debentures
    10,310       10,310       10,310  
Interest Payable and Other Liabilities
    26,535       27,704       25,466  
Total Liabilities
    1,551,950       1,676,287       1,602,859  
                         
Shareholders' Equity
                       
Common Stock
    8       8       8  
Additional Paid-In Capital
    76,198       76,198       76,679  
Retained Earnings
    89,646       83,767       77,371  
Accumulated Other Comprehensive Income
    4,896       4,754       4,107  
Total Shareholders' Equity
    170,748       164,727       158,165  
Total Liabilities & Shareholders' Equity
  $ 1,722,698     $ 1,841,014     $ 1,761,024  

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


FARMERS & MERCHANTS BANCORP
Consolidated Statements of Income (Unaudited)
 
(in thousands except per share data)
 
Three Months
   
Six Months
 
   
Ended June 30,
   
Ended June 30,
 
   
2010
   
2009
   
2010
   
2009
 
Interest Income
                       
Interest and Fees on Loans
  $ 18,057     $ 18,646     $ 36,138     $ 37,307  
Interest on Federal Funds Sold and Securities Purchased
                               
Under Agreements to Resell
    16       35       36       68  
Interest on Investment Securities:
                               
Taxable
    2,151       3,470       4,812       6,961  
Tax-Exempt
    695       736       1,407       1,479  
Total Interest Income
    20,919       22,887       42,393       45,815  
Interest Expense
                               
Deposits
    1,739       4,041       3,715       8,272  
Borrowed Funds
    545       546       1,084       1,085  
Subordinated Debentures
    82       106       162       225  
Total Interest Expense
    2,366       4,693       4,961       9,582  
                                 
Net Interest Income
    18,553       18,194       37,432       36,233  
Provision for Loan Losses
    5,120       7,260       9,235       8,130  
Net Interest Income After Provision for Loan Losses
    13,433       10,934       28,197       28,103  
                                 
Non-Interest Income
                               
Service Charges on Deposit Accounts
    1,688       1,731       3,284       3,343  
Net Gain on Investment Securities
    7       1,452       2,853       2,472  
Increase in Cash Surrender Value of Life Insurance
    454       455       904       908  
Debit Card and ATM Fees
    651       573       1,250       1,077  
Net (Loss) Gain on Non-Qualified Deferred Compensation Plan Investments
    (730 )     458       (535 )     407  
Other
    472       420       1,029       1,040  
Total Non-Interest Income
    2,542       5,089       8,785       9,247  
                                 
Non-Interest Expense
                               
Salaries & Employee Benefits
    7,062       7,096       14,336       14,400  
Net (Gain) Loss on Non-Qualified Deferred Compensation Plan Investments
    (730 )     458       (535 )     407  
Occupancy
    660       670       1,300       1,379  
Equipment
    658       651       1,259       1,350  
ORE Holding Costs
    91       161       495       666  
FDIC Insurance
    507       675       1,308       1,801  
Other
    1,598       1,807       3,036       3,490  
Total Non-Interest Expense
    9,846       11,518       21,199       23,493  
                                 
Income Before Income Taxes
    6,129       4,505       15,783       13,857  
Provision for Income Taxes
    2,122       1,429       5,726       4,847  
Net Income
  $ 4,007     $ 3,076     $ 10,057     $ 9,010  
Earnings Per Share
  $ 5.13     $ 3.93     $ 12.88     $ 11.48  

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


FARMERS & MERCHANTS BANCORP
Consolidated Statements of Comprehensive Income (Loss) (Unaudited)
 
(in thousands)
 
Three Months
   
Six Months
 
   
Ended June 30,
   
Ended June 30,
 
   
2010
   
2009
   
2010
   
2009
 
Net Income
  $ 4,007     $ 3,076     $ 10,057     $ 9,010  
                                 
Other Comprehensive Income (Loss) -
                               
                                 
Unrealized Losses on Securities:
                               
Unrealized holding gains (losses) arising during the period, net of income tax benefit of $1,043 and $(1,018) for the quarters ended June 30, 2010 and 2009, respectively, and of $1,302 and $(87) for the six months ended June 30, 2010 and 2009, respectively.
    1,437       (1,403 )     1,795       (120 )
                                 
Less: Reclassification adjustment for realized gains included in net income, net of related income tax effects of $(3) and $(610) for the quarters ended June 30, 2010 and 2009, respectively, and of $(1,200) and $(1,039) for the six months ended June 30, 2010 and 2009, respectively.
    (4 )     (842 )     (1,653 )     (1,433 )
Total Other Comprehensive Income (Loss)
    1,433       (2,245 )     142       (1,553 )
                                 
Comprehensive Income
  $ 5,440     $ 831     $ 10,199     $ 7,457  

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


FARMERS & MERCHANTS BANCORP
Consolidated Statements of Changes in Shareholders' Equity (Unaudited)
 
(in thousands except share data)
                         
Accumulated
       
   
Common
         
Additional
         
Other
   
Total
 
   
Shares
   
Common
   
Paid-In
   
Retained
   
Comprehensive
   
Shareholders'
 
   
Outstanding
   
Stock
   
Capital
   
Earnings
   
Income (Loss)
   
Equity
 
Balance, December 31, 2008
    786,960     $ 8     $ 78,527     $ 72,350     $ 5,660     $ 156,545  
Net Income
            -       -       9,010       -       9,010  
Cash Dividends Declared on Common Stock
            -       -       (3,989 )     -       (3,989 )
Repurchase of Stock
    (4,805 )     -       (1,848 )     -       -       (1,848 )
Change in Net Unrealized Gain on Securities Available for Sale
            -       -       -       (1,553 )     (1,553 )
Balance, June 30, 2009
    782,155     $ 8     $ 76,679     $ 77,371     $ 4,107     $ 158,165  
                                                 
Balance, December 31, 2009
    780,944     $ 8     $ 76,198     $ 83,767     $ 4,754     $ 164,727  
Net Income
            -       -       10,057       -       10,057  
Cash Dividends Declared on Common Stock
            -       -       (4,178 )     -       (4,178 )
Change in Net Unrealized Gain on Securities Available for Sale
            -       -       -       142       142  
Balance, June 30, 2010
    780,944     $ 8     $ 76,198     $ 89,646     $ 4,896     $ 170,748  

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


FARMERS & MERCHANTS BANCORP
Consolidated Statements of Cash Flows (Unaudited)
 
Six Months Ended
 
(in thousands)
 
June 30,
   
June 30,
 
  
 
2010
   
2009
 
Operating Activities
           
Net Income
  $ 10,057     $ 9,010  
Adjustments to Reconcile Net Income to Net
               
Cash Provided by Operating Activities:
               
Provision for Loan Losses
    9,235       8,130  
Depreciation and Amortization
    954       932  
Net Accretion of Investment Security Discounts & Premium
    (291 )     (2,564 )
Net Gain on Investment Securities
    (2,853 )     (2,472 )
Net Gain on Sale of Property & Equipment
    (19 )     (10 )
Net Change in Operating Assets & Liabilities:
               
Net Increase in Interest Receivable and Other Assets
    (10,000 )     (6,483 )
Net (Decrease) Increase in Interest Payable and Other Liabilities
    (1,169 )     1,289  
Net Cash Provided by Operating Activities
    5,914       7,832  
                 
Investing Activities
               
Securities Available-for-Sale:
               
Purchased
    (135,949 )     (179,869 )
Sold, Matured or Called
    180,467       99,015  
Securities Held-to-Maturity:
               
Purchased
    -       (50 )
Matured or Called
    840       1,341  
Net Loans Paid, Originated or Acquired
    16,113       (16,603 )
Principal Collected on Loans Previously Charged Off
    120       119  
Additions to Premises and Equipment
    (506 )     (2,854 )
Proceeds from Disposition of Property & Equipment
    21       13  
Net Cash Provided by (Used in) Investing Activities
    61,106       (98,888 )
                 
Financing Activities
               
Net Decrease in Demand, Interest-Bearing Transaction, and Savings Accounts
    (33,137 )     (374 )
(Decrease) Increase in Time Deposits
    (14,703 )     74,079  
Net Decrease in Federal Home Loan Bank Advances
    (15,328 )     (27 )
Cash Dividends
    (4,178 )     (3,989 )
Stock Repurchases
    -       (1,848 )
Net Cash (Used in) Provided by Financing Activities
    (67,346 )     67,841  
Decrease in Cash and Cash Equivalents
    (326 )     (23,215 )
Cash and Cash Equivalents at Beginning of Period
    34,632       60,774  
Cash and Cash Equivalents at End of Period
  $ 34,306     $ 37,559  

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


FARMERS & MERCHANTS BANCORP
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

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-Q and Article 10 of Regulation S-X. All adjustments that, in the opinion of management, are necessary for a fair presentation for the periods presented have been reflected as required by Regulation S-X, Rule 10-01. All such adjustments are of a normal, recurring nature.

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

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

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

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.


2. Investment Securities

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

   
Amortized
   
Gross Unrealized
   
Fair/Book
 
June 30, 2010 (in thousands)
 
Cost
   
Gains
   
Losses
   
Value
 
Securities of U.S. Government Agencies
  $ 166,332     $ 585     $ -     $ 166,917  
Obligations of States and Political Subdivisions
    6,443       -       -       6,443  
Mortgage Backed Securities
    136,677       7,864       -       144,541  
FHLB Stock
    6,212       -       -       6,212  
Other
    310       -       -       310  
Total
  $ 315,974     $ 8,449     $ -     $ 324,423  
                                 
   
Amortized
   
Gross Unrealized
   
Fair/Book
 
December 31, 2009 (in thousands)
 
Cost
   
Gains
   
Losses
   
Value
 
Securities of U.S. Government Agencies
  $ 135,958     $ 277     $ 67     $ 136,168  
Obligations of States and Political Subdivisions
    8,362       3       -       8,365  
Mortgage Backed Securities
    207,335       8,142       150       215,327  
FHLB Stock
    5,379       -       -       5,379  
Other
    310       -       -       310  
Total
  $ 357,344     $ 8,422     $ 217     $ 365,549  

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

   
Book
   
Gross Unrealized
   
Fair
 
June 30, 2010 (in thousands)
 
Value
   
Gains
   
Losses
   
Value
 
Obligations of States and Political Subdivisions
  $ 63,897     $ 1,525     $ 39     $ 65,383  
Mortgage Backed Securities
    2,887       135       -       3,022  
Other
    1,989       -       -       1,989  
Total
  $ 68,773     $ 1,660     $ 39     $ 70,394  
                                 
   
Book
   
Gross Unrealized
   
Fair
 
December 31, 2009 (in thousands)
 
Value
   
Gains
   
Losses
   
Value
 
Obligations of States and Political Subdivisions
  $ 64,044     $ 1,437     $ 109     $ 65,372  
Mortgage Backed Securities
    3,583       65       -       3,648  
Other
    1,990       -       -       1,990  
Total
  $ 69,617     $ 1,502     $ 109     $ 71,010  

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

The remaining principal maturities of debt securities as of June 30, 2010 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.

 
Securities Available-for-Sale
June 30, 2010 (in thousands)
 
Within
1 Year
   
After 1
but
Within 5
   
After 5
but
Within 10
   
Over
10 years
   
Total
Fair
Value
 
Securities of U.S. Government Agencies
    -       161,822       5,095       -       166,917  
Obligations of States and Political Subdivisions
    -       -       -       6,443       6,443  
Mortgage Backed Securities
    -       -       18,098       126,443       144,541  
Other
    6,522       -       -       -       6,522  
Total
    6,522       161,822       23,193       132,886       324,423  
                                         
Securities Held-to-Maturity
June 30, 2010 (in thousands)
 
Within
1 Year
   
After 1
but
Within 5
   
After 5
but
Within 10
   
Over
10 years
   
Total
Book
Value
 
Obligations of States and Political Subdivisions
    1,122       5,921       44,114       12,740       63,897  
Mortgage Backed Securities
    -       2,887       -       -       2,887  
Other
    -       -       8       1,981       1,989  
Total
    1,122       8,808       44,122       14,721       68,773  

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
   
Total
 
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
 
June 30, 2010 (in thousands)
 
Value
   
Loss
   
Value
   
Loss
   
Value
   
Loss
 
Obligations of States and Political Subdivisions
    2,542       39       -       -       2,542       39  
Total
    2,542       39       -       -       2,542       39  

   
Less Than 12 Months
   
12 Months or More
   
Total
 
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
 
December 31, 2009 (in thousands)
 
Value
   
Loss
   
Value
   
Loss
   
Value
   
Loss
 
Securities of U.S. Government Agencies
  $ 39,926     $ 67     $ -     $ -     $ 39,926     $ 67  
Obligations of States and Political Subdivisions
    4,681       109       -       -       4,681       109  
Mortgage Backed Securities
    16,158       150       -       -       16,158       150  
Total
  $ 60,765     $ 326     $ -     $ -     $ 60,765     $ 326  

As of June 30, 2010, the Company held 196 investment securities of which 9 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.

As of June 30, 2010, securities carried at $290.0 million were pledged to secure public deposits, FHLB borrowings, and other government agency deposits as required by law.  This amount at December 31, 2009, was $282.8 million.


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 and obligations of states and political subdivisions were caused by interest rate increases. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the amortized cost of the investment. Because the Company 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 June 30, 2010.

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 June 30, 2010.

3. Fair Value Measurement

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 follows:

   
June 30, 2010
   
December 31, 2009
 
   
Carrying
   
Estimated
   
Carrying
   
Estimated
 
(in thousands)
 
Amount
   
Fair Value
   
Amount
   
Fair Value
 
ASSETS:
                       
Cash and Cash Equivalents
  $ 34,306     $ 34,306     $ 34,632     $ 34,632  
Investment Securities Held-to-Maturity
    68,773       69,791       69,617       71,010  
Investment Securities Available-for-Sale
    324,423       324,423       365,549       365,549  
Loans, Net of Deferred Loan Fees & Allowance
    1,157,437       1,183,228       1,182,905       1,200,036  
Bank Owned Life Insurance
    44,663       44,663       43,759       43,759  
Accrued Interest Receivable
    7,359       7,359       7,216       7,216  
LIABILITIES:
                               
Deposits:
                               
Non-Interest Bearing
    293,773       293,773       324,073       324,073  
Interest-Bearing
    1,156,511       1,157,987       1,174,051       1,175,619  
FHLB Advances & Securities Sold Under Agreement to  Repurchase
    64,821       69,559       80,149       81,931  
Subordinated Debentures
    10,310       4,807       10,310       4,061  
Accrued Interest Payable
    1,378       1,378       1,555       1,555  

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, 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.

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.

Fair value estimates presented herein are based on pertinent information available to management as of June 30, 2010. 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.

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 June 30, 2010, 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.

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 June 30, 2010, Using
 
(in thousands)
 
Fair Value
Total
   
Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
   
Other
 Observable
Inputs
(Level 2)
   
Significant
Unobservable
Inputs
(Level 3)
 
Available-for-Sale Securities
  $ 324,423     $ -     $ 324,423     $ -  
Total Assets Measured at Fair Value On a Recurring Basis
  $ 324,423     $ -     $ 324,423     $ -  

         
Fair Value Measurements
At June 30, 2009, Using
 
(in thousands)
 
Fair Value
Total
   
Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
   
Other
 Observable
Inputs
(Level 2)
   
Significant
Unobservable
Inputs
(Level 3)
 
Available-for-Sale Securities
  $ 375,060     $ -     $ 375,060     $ -  
Total Assets Measured at Fair Value On a Recurring Basis
  $ 375,060     $ -     $ 375,060     $ -  

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 June 30, 2010, Using
       
 (in thousands)
 
Fair Value
Total
   
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
  $ 1,473     $ -     $ 1,473     $ -     $ (674 )
Other Real Estate
    9,677       -       9,677       -       -  
Total Assets Measured at Fair Value On a Non-Recurring Basis
  $ 11,150     $ -     $ 11,150     $ -     $ (674 )

Impaired loans where an allowance was established were $2.6 million with an allowance for loan losses of $1.1 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 $674,000 represent charge-offs and reserve for loan loss related to impaired loans recognized during the quarter ended June 30, 2010.


ORE was $12.9 million with a valuation allowance of $3.2 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. There were no impairment losses charged to the Consolidated Statements of Income during the quarter ended June 30, 2010.

         
Fair Value Measurements
At June 30, 2009, Using
       
(in thousands)
 
Fair Value
Total
   
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
  $ 7,573     $ -     $ 7,573     $ -     $ (1,223 )
Other Real Estate
    4,322       -       4,322       -       (55 )
Total Assets Measured at Fair Value On a Non-Recurring Basis
  $ 11,895     $ -     $ 11,895     $ -     $ (1,278 )
 
 
Impaired loans where an allowance was established were $9.0 million with an allowance for loan losses of $1.5 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 $1.2 million represent charge-offs and reserve for loan loss related to impaired loans recognized during the quarter ended June 30, 2009.

ORE was $6.9 million with a valuation allowance of $2.6 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 $55,000 represent the impairment charged to the Consolidated Statements of Income during the quarter ended June 30, 2009.

4. Dividends and Earnings Per Share

Farmers & Merchants Bancorp common stock is not traded on any exchange.  The shares are primarily held by local residents and are not actively traded.  On May 12, 2010, the Board of Directors of Farmers & Merchants Bancorp declared a mid-year cash dividend of $5.35 per share, a 5.0% increase over the $5.10 per share paid on July 1, 2009. The cash dividend was paid on July 1, 2010, to shareholders of record on June 11, 2010.
 
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 three and six months ended June 30, 2010 and 2009.

   
Three Months
   
Six Months
 
   
Ended June 30,
   
Ended June 30,
 
(net income in thousands)
 
2010
   
2009
   
2010
   
2009
 
Net Income
  $ 4,007     $ 3,076     $ 10,057     $ 9,010  
Average Number of Common Shares Outstanding
    780,944       782,403       780,944       784,020  
Per Share Amount
  $ 5.13     $ 3.93     $ 12.88     $ 11.48  


5. Recent Accounting Pronouncements

In January 2010, the FASB issued ASU 2010-06, Fair Value Measurements and Disclosures (“Topic 820”): Improving Disclosures about Fair Value Measurements (“ASU 10-06”). ASU 10-06 revises two disclosure requirements concerning fair value measurements and clarifies two others. It requires separate presentation of significant transfers into and out of Levels 1 and 2 of the fair value hierarchy and disclosure of the reasons for such transfers. It will also require the presentation of purchases, sales, issuances and settlements within Level 3 on a gross basis rather than a net basis. The amendments also clarify that disclosures should be disaggregated by class of asset or liability and that disclosures about inputs and valuation techniques should be provided for both recurring and non-recurring fair value measurements. The Company’s disclosures about fair value measurements are presented in Note 2. Fair Value Measurement. These new disclosure requirements were adopted by the Company during the current period, with the exception of the requirement concerning gross presentation of Level 3 activity, which is effective for fiscal years beginning after December 15, 2010.  With respect to the portions of this ASU that were adopted during the first quarter of 2010, the adoption of this standard did not have a material impacted on the Company’s financial position, results of operations, cash flows, or disclosures.  Management does not believe that the adoption of the remaining portion of this ASU will have a material impact on the Company’s financial position, results of operation, cash flows, or disclosures. 

In June 2009, the FASB issued ASC Topic 860 (previously SFAS No. 166), Accounting for Transfers of Financial Assets, an amendment of SFAS No. 140.  This standard amends the derecognition accounting and disclosure guidance included in previously issued standards.  This standard eliminates the exemption from consolidation for qualifying special-purpose entities (SPEs) and also requires a transferor to evaluate all existing qualifying SPEs to determine whether they must be consolidated in accordance with ASC Topic 810.  This standard also provides more stringent requirements for derecognition of a portion of a financial asset and establishes new conditions for reporting the transfer of a portion of a financial asset as a sale.  This standard is effective as of the beginning of the first annual reporting period that begins after November 15, 2009.  This standard was adopted January 1, 2010 and did not have a material impact on the Company’s financial position, results of operation, cash flows, or disclosures. 

In December 2009, the FASB issued Accounting Standards Update (ASU) No. 2009-16, Transfers and Servicing (ASC Topic 860): Accounting for Transfers of Financial Assets, which updates the derecognition guidance in ASC Topic 860 for previously issued SFAS No. 166.  This update reflects the Board's response to issues entities have encountered when applying ASC 860, including: (1) requires that all arrangements made in connection with a transfer of financial assets be considered in the derecognition analysis, (2) clarifies when a transferred asset is considered legally isolated from the transferor, (3) modifies the requirements related to a transferee's ability to freely pledge or exchange transferred financial assets, and (4) provides guidance on when a portion of a financial asset can be derecognized.  This update is effective for financial asset transfers occurring after the beginning of an entity's first fiscal year that begins after November 15, 2009.  This standard was adopted January 1, 2010 and did not have a material impact on the Company’s financial position, results of operation, cash flows, or disclosures. 

In June 2009, the FASB issued ASC Topic 810 (previously SFAS No. 167), Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities.  This standard amends the consolidation guidance applicable to variable interest entities. The amendments to the consolidation guidance affect all entities currently within the scope of ASC Topic 810, as well as qualifying special-purpose entities that are currently excluded from the scope of ASC Topic 810. This standard is effective as of the beginning of the first annual reporting period that begins after November 15, 2009.  This standard was adopted January 1, 2010 and did not have a material impact on the Company’s financial position, results of operation, cash flows, or disclosures. 

In July 2010, Financial Accounting Standards Board (the “FASB”) issued Accounting Standards Update 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses.  This standard expands disclosures about credit quality of financing receivables and the allowance for loan and lease losses.  The standard will require the Company to expand disclosures about the credit quality of our loans and leases and the related reserves against them.  The extra disclosures will include disaggregated matters related to our past due loans, credit quality indicators, and modifications of loans and leases.  The Company will adopt the standard beginning with our December 31, 2010 financial statements. Management does not believe that the adoption of this standard will have a material impact on the Company’s financial position, results of operation, or cash flows.   


Item 2. Management’s Discussion And Analysis Of Financial Condition And Results Of Operations

The following is management’s discussion and analysis of the major factors that influenced our financial performance for the three and six months ended June 30, 2010.  This analysis should be read in conjunction with our 2009 Annual Report to Shareholders on Form 10-K, and with the unaudited financial statements and notes as set forth in this report.

Forward–Looking Statements

This Form 10-Q contains various forward-looking statements, usually containing the words “estimate,” “project,” “expect,” “objective,” “goal,” or similar expressions and includes assumptions concerning the Company’s operations, future results, and prospects. These forward-looking statements are based upon current expectations and are subject to 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 located in the Company’s 2009 Annual Report on Form 10-K.

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.

Introduction

Farmers & Merchants Bancorp, or the Company, is a bank holding company formed March 10, 1999. Its subsidiary, Farmers & Merchants Bank of Central California, or the Bank, is a California state-chartered bank formed in 1916. The Bank serves the northern Central Valley of California through twenty-two banking offices and two stand-alone ATM’s. The service area includes Sacramento, San Joaquin, Stanislaus and Merced Counties with branches in Sacramento, Elk Grove, Galt, Lodi, Stockton, Linden, Modesto, Turlock, Hilmar, and Merced. Substantially all of the Company’s business activities are conducted within its market area.

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

Overview

The Company’s primary service area encompasses the northern Central Valley of California, a region that can be significantly impacted by the seasonal and cyclical operations of the agricultural industry.  Accordingly, discussion of the Company’s Financial Condition and Results of Operations 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 planting of crops. Correspondingly, deposit balances are replenished and loans repaid in fall and winter as crops are harvested and sold).


For the three and six months ended June 30, 2010, Farmers & Merchants Bancorp reported net income of $4,007,000 and $10,057,000, earnings per share of $5.13 and $12.88 and return on average assets of 0.93% and 1.15%, respectively.  Return on average shareholders’ equity was 9.32% and 11.87% for the three and six months ended June 30, 2010.

For the three and six months ended June 30, 2009, Farmers & Merchants Bancorp reported net income of $3,076,000 and $9,010,000, earnings per share of $3.93 and $11.48 and return on average assets of 0.71% and 1.06%, respectively.  Return on average shareholders’ equity was 7.55% and 11.23% for the three and six months ended June 30, 2009.
 
Factors impacting the Company’s earnings performance in the first six months of 2010 as compared to the same period last year were: (1) a $1.2 million increase in net interest income due to a 1.8% increase in average earnings assets and a 6 basis point increase in net interest margin; (2) a $493,000 decrease in FDIC insurance expense; and (3) a $381,000 increase in gain on investment securities. These factors were partially offset by a $1.1 million increase in the provision for loan losses.

The following is a summary of the financial results for the six month period ended June 30, 2010 compared to June 30, 2009.

·
Net income increased 11.6% to $10.1 million from $9.0 million.

·
Earnings per share increased 12.2% to $12.88 from $11.48.

·
Total assets decreased 2.2% to $1.7 billion.

·
Total loans decreased 0.2% to $1.2 billion.

·
Allowance for loan losses increased 23.4% to $31.4 million.

·
Total deposits decreased 3.7% to $1.5 billion.

Results of Operations

This section discusses material changes in the Company’s income statement for the three and six month periods ended June 30, 2010 as compared to the three and six month periods ended June 30, 2009.

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 three and six month periods ended June 30, 2010 and 2009.

The average yields on earning assets and average rates paid on interest-bearing liabilities have been computed on an annualized basis for purposes of comparability with full year data.  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 liabilities.  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 “taxable equivalent” 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 3. “Quantitative and Qualitative Disclosures about Market Risk: Market Risk – Interest Rate Risk”).


Farmers & Merchants Bancorp
Quarterly Average Balances and Interest Rates
(Interest and Rates on a Taxable Equivalent Basis)
(in thousands)
   
Three Months Ended
June 30,
   
Three Months Ended
June 30,
 
   
2010
   
2009
 
Assets
 
Balance
   
Interest
   
Rate
   
Balance
   
Interest
   
Rate
 
Federal Funds Sold
  $ 25,195     $ 16       0.25 %   $ 57,085     $ 35       0.25 %
Investment Securities Available-for-Sale:
                                               
U.S. Agencies
    163,187       626       1.53 %     23,387       96       1.64 %
Municipals - Non-Taxable
    6,714       127       7.57 %     9,673       183       7.56 %
Mortgage Backed Securities
    142,522       1,477       4.15 %     264,012       3,310       5.01 %
Other
    4,237       6       0.57 %     10,736       5       0.19 %
Total Investment Securities Available-for-Sale
    316,660       2,236       2.82 %     307,808       3,594       4.67 %
                                                 
Investment Securities Held-to-Maturity:
                                               
Municipals - Non-Taxable
    63,960       925       5.78 %     64,253       921       5.74 %
Mortgage Backed Securities
    3,061       30       3.92 %     4,549       43       3.78 %
Other
    1,989       13       2.61 %     1,991       15       3.01 %
Total Investment Securities Held-to-Maturity
    69,010       968       5.61 %     70,793       979       5.53 %
                                                 
Loans:
                                               
Real Estate
    720,257       11,296       6.29 %     687,081       11,157       6.51 %
Home Equity
    64,298       948       5.91 %     65,896       991       6.03 %
Agricultural
    212,654       3,153       5.95 %     211,364       3,223       6.12 %
Commercial
    175,346       2,518       5.76 %     200,341       3,073       6.15 %
Consumer
    8,777       138       6.31 %     10,862       199       7.35 %
Municipal
    951       4       1.69 %     1,075       3       1.12 %
Total Loans
    1,182,283       18,057       6.13 %     1,176,619       18,646       6.36 %
Total Earning Assets
    1,593,148     $ 21,277       5.36 %     1,612,305     $ 23,254       5.79 %
                                                 
Unrealized Gain/(Loss) on Securities Available-for-Sale
    6,930                       10,318                  
Allowance for Loan Losses
    (33,558 )                     (20,833 )                
Cash and Due From Banks
    28,174                       31,719                  
All Other Assets
    132,672                       103,702                  
Total Assets
  $ 1,727,366                     $ 1,737,211                  
                                                 
Liabilities & Shareholders' Equity
                                               
Interest Bearing Deposits:
                                               
Interest Bearing DDA
  $ 172,127     $ 52       0.12 %   $ 149,413     $ 87       0.23 %
Savings
    434,828       469       0.43 %     368,048       660       0.72 %
Time Deposits
    563,801       1,218       0.87 %     694,724       3,295       1.90 %
Total Interest Bearing Deposits
    1,170,756       1,739       0.60 %     1,212,185       4,042       1.34 %
Securities Sold Under Agreement to Repurchase
    60,000       535       3.58 %     60,000       535       3.58 %
Other Borrowed Funds
    2,011       10       1.99 %     1,660       10       2.42 %
Subordinated Debentures
    10,310       82       3.19 %     10,310       106       4.12 %
Total Interest Bearing Liabilities
    1,243,077     $ 2,366       0.76 %     1,284,155     $ 4,693       1.47 %
Interest Rate Spread
                    4.59 %                     4.32 %
Demand Deposits (Non-Interest Bearing)
    285,783                       265,466                  
All Other Liabilities
    26,510                       24,543                  
Total Liabilities
    1,555,370                       1,574,164                  
                                                 
Shareholders' Equity
    171,996                       163,047                  
Total Liabilities & Shareholders' Equity
  $ 1,727,366                     $ 1,737,211                  
Impact of Non-Interest Bearing Deposits and Other Liabilities
                    0.17 %                     0.30 %
Net Interest Income and Margin on Total Earning Assets
            18,911       4.76 %             18,561       4.62 %
Tax Equivalent Adjustment
            (358 )                     (367 )        
Net Interest Income
          $ 18,553       4.67 %           $ 18,194       4.53 %

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 $152,000 and $446,000 for the quarters ended June 30, 2010 and 2009, respectively. Yields on securities available-for-sale are based on historical cost.


Farmers & Merchants Bancorp
Year-to-Date Average Balances and Interest Rates
(Interest and Rates on a Taxable Equivalent Basis)
(in thousands)
   
Six Months Ended
June 30,
   
Six Months Ended
June 30,
 
   
2010
   
2009
 
Assets
 
Balance
   
Interest
   
Rate
   
Balance
   
Interest
   
Rate
 
Federal Funds Sold
  $ 32,245     $ 36       0.23 %   $ 54,700     $ 68       0.25 %
Investment Securities Available-for-Sale:
                                               
U.S. Agencies
    152,472       1,205       1.58 %     11,758       96       1.63 %
Municipals - Non-Taxable
    7,198       272       7.57 %     9,940       373       7.51 %
Mortgage Backed Securities
    161,879       3,507       4.33 %     256,795       6,737       5.25 %
Other
    3,830       12       0.63 %     7,167       9       0.25 %
Total Investment Securities Available-for-Sale
    325,379       4,996       3.07 %     285,660       7,215       5.05 %
                                                 
Investment Securities Held-to-Maturity:
                                               
Municipals - Non-Taxable
    63,994       1,857       5.80 %     64,420       1,843       5.72 %
Mortgage Backed Securities
    3,236       62       3.83 %     4,755       91       3.83 %
Other
    1,989       26       2.61 %     1,991       28       2.81 %
Total Investment Securities Held-to-Maturity
    69,219       1,945       5.62 %     71,166       1,962       5.51 %
                                                 
Loans:
                                               
Real Estate
    720,846       22,667       6.34 %     681,745       22,399       6.63 %
Home Equity
    64,730       1,897       5.91 %     66,031       1,997       6.10 %
Agricultural
    205,971       6,139       6.01 %     206,503       6,331       6.18 %
Commercial
    180,638       5,142       5.74 %     202,957       6,177       6.14 %
Consumer
    9,055       286       6.37 %     11,027       396       7.24 %
Municipal
    990       7       1.43 %     1,063       7       1.33 %
Total Loans
    1,182,230       36,138       6.16 %     1,169,326       37,307       6.43 %
Total Earning Assets
    1,609,073     $ 43,116       5.40 %     1,580,852     $ 46,552       5.94 %
                                                 
Unrealized Gain/(Loss) on Securities Available-for-Sale
    7,474                       9,897                  
Allowance for Loan Losses
    (32,380 )                     (20,748 )                
Cash and Due From Banks
    28,549                       32,543                  
All Other Assets
    130,381                       104,419                  
Total Assets
  $ 1,743,097                     $ 1,706,963                  
                                                 
Liabilities & Shareholders' Equity
                                               
Interest Bearing Deposits:
                                               
Interest Bearing DDA
  $ 174,808     $ 124       0.14 %   $ 145,024     $ 136       0.19 %
Savings
    438,781       1,030       0.47 %     366,927       1,416       0.78 %
Time Deposits
    571,927       2,561       0.90 %     671,481       6,720       2.02 %
Total Interest Bearing Deposits
    1,185,516       3,715       0.63 %     1,183,432       8,272       1.41 %
Securities Sold Under Agreement to Repurchase
    60,000       1,065       3.58 %     60,000       1,065       3.58 %
Other Borrowed Funds
    1,847       19       2.07 %     1,182       20       3.41 %
Subordinated Debentures
    10,310       162       3.17 %     10,310       225       4.40 %
Total Interest Bearing Liabilities
    1,257,673     $ 4,961       0.80 %     1,254,924     $ 9,582       1.54 %
Interest Rate Spread
                    4.61 %                     4.40 %
Demand Deposits (Non-Interest Bearing)
    288,567                       267,891                  
All Other Liabilities
    27,432                       23,623                  
Total Liabilities
    1,573,672                       1,546,438                  
                                                 
Shareholders' Equity
    169,425                       160,525                  
Total Liabilities & Shareholders' Equity
  $ 1,743,097                     $ 1,706,963                  
Impact of Non-Interest Bearing Deposits and Other Liabilities
                    0.17 %                     0.32 %
Net Interest Income and Margin on Total Earning Assets
            38,155       4.78 %             36,970       4.72 %
Tax Equivalent Adjustment
            (723 )                     (737 )        
Net Interest Income
          $ 37,432       4.69 %           $ 36,233       4.62 %

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 $398,000 and $861,000 for the six months ended June 30, 2010 and 2009, respectively. Yields on securities available-for-sale are based on historical cost.


Farmers & Merchants Bancorp
Volume and Rate Analysis of Net Interest Revenue
(Rates on a Taxable Equivalent Basis)
(in thousands)
 
Three Months Ended
   
Six Months Ended
 
   
June 30, 2010 compared to June 30, 2009
   
June 30, 2010 compared to June 30, 2009
 
Interest Earning Assets
 
Volume
   
Rate
   
Net Chg.
   
Volume
   
Rate
   
Net Chg.
 
Federal Funds Sold
  $ (20 )   $ 1     $ (19 )   $ (25 )   $ (7 )   $ (32 )
Investment Securities Available for Sale
                                               
U.S. Agencies
    537       (7 )     530       1,112       (3 )     1,109  
Municipals - Non-Taxable
    (56 )     -       (56 )     (104 )     3       (101 )
Mortgage Backed Securities
    (1,331 )     (502 )     (1,833 )     (2,195 )     (1,035 )     (3,230 )
Other
    (4 )     5       1       (5 )     8       3  
Total Investment Securities Available for Sale
    (854 )     (504 )     (1,358 )     (1,192 )     (1,027 )     (2,219 )
                                                 
Investment Securities Held to Maturity
                                               
Municipals - Non-Taxable
    (4 )     7       3       (12 )     26       14  
Mortgage Backed Securities
    (14 )     1       (13 )     (29 )     -       (29 )
Other
    -       (2 )     (2 )     (1 )     (1 )     (2 )
Total Investment Securities Held to Maturity
    (18 )     6       (12 )     (42 )     25       (17 )
                                                 
Loans:
                                               
Real Estate
    529       (390 )     139       1,262       (994 )     268  
Home Equity
    (24 )     (19 )     (43 )     (39 )     (61 )     (100 )
Agricultural
    20       (90 )     (70 )     (16 )     (176 )     (192 )
Commercial
    (367 )     (188 )     (555 )     (652 )     (383 )     (1,035 )
Consumer
    (35 )     (26 )     (61 )     (65 )     (45 )     (110 )
Total Loans
    123       (711 )     (589 )     490       (1,658 )     (1,169 )
Total Earning Assets
    (769 )     (1,208 )     (1,978 )     (769 )     (2,667 )     (3,437 )
                                                 
Interest Bearing Liabilities
                                               
Interest Bearing Deposits:
                                               
Transaction
    11       (46 )     (35 )     25       (37 )     (12 )
Savings
    105       (296 )     (191 )     245       (631 )     (386 )
Time Deposits
    (534 )     (1,543 )     (2,077 )     (880 )     (3,279 )     (4,159 )
Total Interest Bearing Deposits
    (418 )     (1,885 )     (2,303 )     (610 )     (3,947 )     (4,557 )
Other Borrowed Funds
    2       (2 )     -       8       (9 )     (1 )
Subordinated Debentures
    -       (25 )     (25 )     -       (64 )     (64 )
Total Interest Bearing Liabilities
    (416 )     (1,912 )     (2,328 )     (602 )     (4,020 )     (4,622 )
Total Change on a Tax Equivalent Basis
  $ (353 )   $ 704     $ 350     $ (167 )   $ 1,353     $ 1,185  

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.


2nd Quarter 2010 vs. 2nd Quarter 2009
Net interest income for the second quarter of 2010 increased 2.0% or $359,000 to $18.6 million.  On a fully taxable equivalent basis, net interest income increased 1.9% and totaled $18.9 million for the second quarter of 2010.  As more fully discussed below, the increase in net interest income was primarily due to an increase in the net interest margin.

Net interest income on a taxable equivalent basis, expressed as a percentage of average total earning assets, is referred to as the net interest margin. For the quarter ended June 30, 2010, the Company’s net interest margin was 4.76% compared to 4.62% for the quarter ended June 30, 2009.  This increase was a result of rates paid on interest bearing liabilities declining faster than the yield on earning assets.

Loans, generally the Company’s highest earning assets, decreased $2.3 million as of June 30, 2010 compared to June 30, 2009. See “Financial Condition – Loans” for further discussion on this decrease. On an average balance basis, loans increased by $5.7 million for the quarter ended June 30, 2010. Loans increased from 73.0% of average earning assets at June 30, 2009 to 74.2% at June 30, 2010. As a result of decreases in market interest rates from September 2007 through December 2008, and the continuing low rate environment since then, the year-to-date yield on the loan portfolio declined to 6.13% for the quarter ended June 30, 2010, compared to 6.36% for the quarter ended June 30, 2009. Even with the increase in average loan balances, the decrease in yield resulted in interest revenue from loans decreasing 3.2% to $18.1 million for quarter ended June 30, 2010. 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 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. Since the risk factor for investments is typically lower than that of loans, the yield earned on investments is generally less than that of loans.  Average investment securities totaled $385.6 million for the quarter ended June 30, 2010, an increase of $7.1 million compared to the average balance for the quarter ended June 30, 2009. Interest income on securities decreased $1.4 million to $3.2 million for the quarter ended June 30, 2010, compared to $4.6 million for the quarter ended June 30, 2009. The average investment portfolio yield, on a tax equivalent basis, was 3.3% for the quarter ended June 30, 2010, compared to 4.8% for the quarter ended June 30, 2009. This decrease in yield was primarily due to the sale of higher yielding mortgage-backed securities and the Company’s decision to shorten the maturities of new investment purchases to protect against future increases in market interest rates. See “Financial Condition – Investment Securities” for a discussion of the Company’s investment strategy in 2010.  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 Statement of Income because of adjustments that relate to income on securities that are exempt from federal income taxes.

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 balances sheet) 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. Average Federal Funds Sold (which includes interest earning balances at the FRB) for the quarter ended June 30, 2010, was $25.2 million, a decrease of $31.9 million compared to the average balance for the quarter ended June 30, 2009. See “Financial Condition – Investment Securities” for a discussion of the Company’s investment strategy in 2010.

Average interest-bearing liabilities decreased $41.1 million or 3.2% during the second quarter of 2010 as compared to the second quarter of 2009. Of that decrease: (1) interest-bearing deposits decreased $41.4 million; (2) securities sold under agreement to repurchase remained unchanged (see “Financial Condition - Securities Sold Under Agreement to Repurchase”); (3) Federal Home Loan Bank (“FHLB”) Advances increased $351,000 (see “Financial Condition – Federal Home Loan Bank Advances and Federal Reserve Bank Borrowings”); and (4) subordinated debt remained unchanged.


The $41.4 million decrease in average interest-bearing deposits was primarily in time deposits, which declined $130.1 million since the second quarter of 2009, as lower cost interest bearing DDA and Savings increased by $89.5 million. See “Financial Condition – Deposits” for a discussion of trends in the Company’s deposit base. Total interest expense on deposits was $1.7 million for the second quarter of 2010 as compared to $4.0 million for the second quarter of 2009. From September 2007 through December 2008, the FRB lowered market rates by 5.00%, and as a result the average rate paid on interest-bearing deposits declined to 0.6% for the second quarter of 2010 from 1.3% for the second quarter of 2009. The Company anticipates that this decline in deposit rates, if any, will be much more modest in the second half of 2010.

Six Months Ending June 30, 2010 vs. Six Months Ending June 30, 2009
During the first six months of 2010, net interest income increased 3.3% to $37.4 million, compared to $36.2 million at June 30, 2009.  On a fully taxable equivalent basis, net interest income increased 3.2% and totaled $38.2 million at June 30, 2010, compared to $36.9 million at June 30, 2009. The increase in net interest income was due to an increase in earning assets as well as an increase in the net interest margin.

For the six months ended June 30, 2010, the Company’s net interest margin was 4.78% compared to 4.72% for the same period in 2009.

The average balance of loans increased by $12.9 million for the six months ended June 30, 2010 compared to the six months ended June 30, 2009.  The yield on the loan portfolio decreased 27 basis points to 6.16% for the six months ended June 30, 2010 compared to 6.43% for the six months ended June 30, 2009.  This decrease in yield, partially offset by an increase in average balances, resulted in interest income from loans decreasing 3.1% or $1.2 million for the first six months of 2010.

Average investment securities were $394.6 million for the six months ended June 30, 2010 compared to $356.8 million for the same period in 2009.  The average yield (TE) for the six months ended June 30, 2010 was 3.52% compared to 5.14% for the six months ended June 30, 2009 a decrease in interest income of $2.2 million or 24.4%, for the six months ended June 30, 2010.

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 balances sheet) 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. Average Federal Funds Sold (which includes interest earning balances at the FRB) for the six months ended June 30, 2010, was $32.2 million, a decrease of $22.5 million compared to the average balance for the six months ended June 30, 2009. See “Financial Condition – Investment Securities” for a discussion of the Company’s investment strategy in 2010.

Average interest-bearing liabilities increased $2.7 million or 0.22% during the six months ended June 30, 2010 as compared to the six months ended June 30, 2009. Of that increase: (1) interest-bearing deposits increased $2.1 million; (2) FHLB Advances increased $665,000; and (3) securities sold under agreement to repurchase and subordinated debt remained unchanged.

The $2.1 million increase in average interest-bearing deposits was primarily in interest bearing DDA and savings deposits, which grew $101.6 million since June 30, 2009, while time deposits decreased by $99.5 million. See “Financial Condition – Deposits” for a discussion of trends in the Company’s deposit base. Total interest expense on deposits was $3.7 million for the first six months of 2010 as compared to $8.3 million for the first six months of 2009. The average rate paid on interest-bearing deposits was 0.63% in the first six months of 2010 and 1.41% in the first six months of 2009. In September 2007 the FRB began lowering short-term market interest rates and has continued to keep these rates very low. Since most of the Company’s interest bearing deposits are priced off of short-term market rates, the Company is benefiting from the impact of these lower market rates. The Company anticipates that this decline in deposit rates, if any, will be much more modest in the second half of 2010.


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” in the Company’s 2009 Annual Report on Form 10-K. 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.

Changes in the provision for loan losses between periods 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 June 30, 2010, 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, during the second quarter of 2009, management and the Board of Directors began significantly increasing the Company’s loan loss allowance and, as of June 30, 2010, the balance was $31.4 million or 2.64% of total loans. This represents a $5.9 million or 23.4% increase over June 30, 2009. The majority of the increase in the allowance has been allocated to Commercial Real Estate Loans. See the Allowance Allocation table located in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of the Company’s 2009 Annual Report on Form 10-K.

The provision for loan losses totaled $9.2 million for the first half quarter of 2010 compared to $8.1 million for the first half of 2009. Net charge-offs during the first half of 2010 were $7.6 million compared to $2.7 million in the first half of 2009. The increase in net charge-offs was primarily related to two restructured loans. See “Financial Condition – Classified Loans and Non-Performing Assets.” Net charge-offs represented 0.65% of average loans at June 30, 2010, a level that, in management’s opinion, compares favorably to most of 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” located in the Company’s 2009 Annual Report on Form 10-K.

The allowance for loan losses was $31.4 million or 2.64% of total loan balances at June 30, 2010 compared to $25.5 million or 2.13% of total loan balances at June 30, 2009. As of December 31, 2009, the allowance for loan losses was $29.8 million, which represented 2.45% of the total loan balance. After reviewing all factors above, management concluded that the allowance for loan losses as of June 30, 2010 was adequate. See the following table for allowance for loan loss activity for the periods indicated.

 
   
Three Months Ended
June 30,
   
Six Months Ended
June 30,
 
(in thousands)
 
2010
   
2009
   
2010
   
2009
 
Balance at Beginning of Period
  $ 33,192     $ 20,500     $ 29,813     $ 20,034  
Provision Charged to Expense
    5,120       7,260       9,235       8,130  
Recoveries of Loans Previously Charged Off
    90       35       120       119  
Loans Charged Off
    (6,999 )     (2,341 )     (7,765 )     (2,829 )
Balance at End of Period
  $ 31,403     $ 25,454     $ 31,403     $ 25,454  

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

2nd Quarter 2010 vs. 2nd Quarter 2009
Non-interest income decreased $2.5 million or 50.0% for the three months ended June 30, 2010, compared to the same period of 2009. This decrease was primarily comprised of: (1) a $1.4 million decrease in gain on investment securities for the second quarter of 2010 when compared to the second quarter of 2009; and (2) a $730,000 loss on deferred compensation investments during the second quarter of 2010 as compared to a $458,000 gain during the second quarter of 2009. These decreases were partially offset by a $78,000 increase in debit card and ATM fees.

The Company allows executives who participate in non-qualified deferred compensation plans to self direct the investment of their vested balances.  See “Note 13 of the Notes to Consolidated Financial Statements” in the Company’s 2009 Annual Report on Form 10-K. 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.

Six Months Ending June 30, 2010 vs. Six Months Ending June 30, 2009
Non-interest income decreased $462,000 or 5.0% for the six months ended June 30, 2010 compared to the same period of 2009. This decrease was primarily comprised of a $535,000 loss on deferred compensation investments during the second half of 2010 as compared to a $407,000 gain during the same period in 2009. This decrease was partially offset by: (1) gain on investment securities in the amount of $381,000; and (2) a $173,000 increase in debit card and ATM fees.

The Company allows executives who participate in non-qualified deferred compensation plans to self direct the investment of their vested balances.  See “Note 13 of the Notes to Consolidated Financial Statements” in the Company’s 2009 Annual Report on Form 10-K. 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.

Non-Interest Expense
Non-interest expense for the Company includes expenses for: (1) salaries and employee benefits; (2) net gains and losses on non-qualified deferred compensation plan investments; (3) occupancy; (4) equipment; (5) supplies; (6) legal fees; (7) professional services; (8) data processing; (9) marketing; (10) deposit insurance; and (11) other miscellaneous expenses.


2nd Quarter 2010 vs. 2nd Quarter 2009
Non-interest expense decreased $1.7 million or 14.5% for the three months ended June 30, 2010, compared to the same period of 2009.  This decrease was primarily comprised of: (1) a $730,000 loss on deferred compensation investments during the second quarter of 2010 as compared to a $458,000 gain during the second quarter of 2009; (2) a $168,000 decrease in FDIC insurance premiums; and (3) a $209,000 decrease in other non-interest expense primarily related to reduced advertising expenses.

The Company allows executives who participate in non-qualified deferred compensation plans to self-direct the investment of their vested balances. See “Note 13 of the Notes to Consolidated Financial Statements” in the Company’s 2009 Annual Report on Form 10-K. 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.

Six Months Ending June 30, 2010 vs. Six Months Ending June 30, 2009
Non-interest expense decreased $2.3 million or 9.8% for the six months ended June 30, 2010, compared to the same period of 2009.  This decrease was primarily comprised of: (1) a $535,000 loss on deferred compensation investments during the second half of 2010 as compared to a $407,000 gain during the same period in 2009; (2) a $171,000 decrease in ORE holding costs; (3) a $493,000 decrease in FDIC insurance premiums; and (4) a $454,000 decrease in other non-interest expense primarily related to reduced advertising expenses.

The Company allows executives who participate in non-qualified deferred compensation plans to self-direct the investment of their vested balances. See “Note 13 of the Notes to Consolidated Financial Statements” in the Company’s 2009 Annual Report on Form 10-K. 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.

Income Taxes
The provision for income taxes increased 48.5% to $2.1 million for the second quarter of 2010.  The Company’s effective tax rate increased for the second quarter of 2010 and was 34.6% compared to 31.7% for the same period in 2009.

The provision for income taxes increased 18.1% to $5.7 million for the first six months of 2010.  The Company’s effective tax rate increased for the first six months of 2010 and was 36.3% compared to 35.0% for the same period in 2009.

The Company’s effective tax rate fluctuates from quarter to quarter due primarily to changes in the mix of taxable and tax-exempt earning sources. 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 retirement 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

This section discusses material changes in the Company’s balance sheet for the six month period ending June 30, 2010 as compared to the year ended December 31, 2009 and to the six month period ending June 30, 2009. As previously discussed (see “Overview”) the Company’s financial condition is influenced by the seasonal banking needs of its agricultural customers.


Investment Securities and Federal Funds Sold
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.

The Company’s investment portfolio at June 30, 2010 was $393.2 million, a decrease of $42.0 million since December 31, 2009 and $52.4 million since June 30, 2009.

Beginning in the 2nd quarter of 2009 the Company realized that the yields that could be obtained investing in short-term agency securities or Fed Funds was below the marginal rate that local banks were paying on time deposits.  Accordingly, in order to improve our net interest margin, the Company adopted an explicit strategy to reduce the rate paid on non-relationship time deposits and use the cash flow being generated from the investment portfolio to help fund the resulting time deposit outflow.  See “Deposits” for additional details regarding this strategy.

The mix of the investment portfolio has also changed over the past year. To protect against anticipated increases in market interest rates, the Company has reduced the weighted average maturity on its investment portfolio by selling mortgage-backed securities and reinvesting in lower yielding, shorter term U.S. agency securities.

The Company's total investment portfolio currently represents 22.8% of the Company’s total assets as compared to 24.4% at December 31, 2009 and 25.3% at June 30, 2009.

Not included in the investment portfolio are overnight investments in Federal Funds Sold. In late 2008, the FRB began paying interest on the deposits that banks maintained in their FRB accounts, whereas historically banks had to sell these Federal Funds to other banks in order to earn interest.  Since balances at the FRB are effectively risk free, the Company elected to maintain its excess cash at the FRB during the first half of 2010. Average Federal Funds Sold (including interest earning balances at the FRB) for the six-months ended June 30, 2010, was $32.2 million compared to $54.7 million for the six-months ended June 30, 2009.

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 June 30, 2010, December 31, 2009 and June 30, 2009 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.

Loans
The Company's loan portfolio at June 30, 2010 decreased $2.3 million or 0.2% from June 30, 2009 and $23.9 million or 2.0% from December 31, 2009, largely a reflection of the continuing slowdown in the overall economy which affected commercial and real estate construction loan balances.  The following table sets forth the distribution of the loan portfolio by type and percent as of the periods indicated.



Loan Portfolio
 
June 30, 2010
   
December 31, 2009
   
June 30, 2009
 
(in thousands)
  $       %     $       %     $       %  
Commercial Real Estate
  $ 287,326       24.1 %   $ 290,473       23.9 %   $ 278,145       23.3 %
Agricultural Real Estate
    257,688       21.6 %     260,000       21.4 %     236,204       19.8 %
Real Estate Construction
    63,793       5.4 %     71,647       5.9 %     77,306       6.5 %
Residential 1st Mortgages
    105,322       8.8 %     105,850       8.7 %     101,479       8.5 %
Home Equity Lines and Loans
    63,849       5.4 %     65,541       5.4 %     65,141       5.5 %
Agricultural
    226,279       19.0 %     217,989       17.9 %     221,622       18.6 %
Commercial
    177,351       14.9 %     191,949       15.8 %     201,870       16.9 %
Consumer
    9,300       0.8 %     11,400       0.9 %     11,320       0.9 %
Total Loans
    1,190,908       100.0 %     1,214,849       100.0 %     1,193,087       100.0 %
Less:
                                               
Unearned Income
    2,068               2,131               1,949          
Allowance for Loan Losses
    31,403               29,813               25,454          
Net Loans
  $ 1,157,437             $ 1,182,905             $ 1,165,684          

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 June 30, 2010, classified loans totaled $48.9 million compared to $62.8 million at December 31, 2009 and $72.1 million at June 30, 2009.

Classified Assets include $32.7 million comprised of multiple loans to two borrowers.  During the second quarter of 2010, several of the loans to these borrowers were restructured resulting in the creation of a multiple note (i.e., A/B Note) structure. Charge-offs of $6.6 million were taken on the “B” notes.  All of these loans were current as to interest and principal at the time the Company agreed to restructure them, and the Company’s current credit assessment of the restructured (“A” Notes) loans documents reasonable prospects for future payment performance and reasonable collateral coverage.  Accordingly, consistent with the guidance provided in the Interagency Statement on Prudent Commercial Real Estate Loan Workouts issued in October of 2009, the “A” notes have been maintained on accrual status.

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.


The following table sets forth the amount of the Company's non-performing loans and ORE as of the dates indicated.

Non-Performing Assets
(in thousands)
 
June 30,
2010
   
Dec. 31,
2009
   
June 30,
2009
 
Non-Performing Loans
  $ 3,881     $ 9,209     $ 11,439  
Other Real Estate
    9,677       8,418       4,322  
Total
  $ 13,558     $ 17,627     $ 15,761  
                         
Non-Performing Loans as a % of Total Loans
    0.33 %     0.76 %     0.96 %
Allowance for Loan Losses as a % of Non-Performing Loans
    809.1 %     323.7 %     222.5 %
Non-Performing Assets as a % of Total Assets
    0.79 %     0.99 %     0.89 %

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 $1.1 million , $1.0 million, and $1.5 million have been established for non-performing loans at June 30, 2010, December 31, 2009 and June 30, 2009, respectively.

Foregone interest income on non-accrual loans which would have been recognized , if all such loans had been current in accordance with their original terms, totaled $136,000 for the six months ended June 30, 2010, $618,000 for the twelve months ended December 31, 2009, and $507,000 for the six months ended June 30, 2009.

The Company reported $9.7 million of ORE at June 30, 2010, $8.4 million at December 31, 2009, and $4.3 million at June 30, 2009. The June 30, 2010, carrying value of $9.7 million is net of a $3.2 million reserve for ORE valuation adjustments. The December 31, 2009 carrying value of $8.4 million is net of a $3.0 million reserve for ORE valuation adjustments and the June 30, 2009 carrying value of $4.3 million is net of a $2.6 million reserve for ORE valuation adjustments.

Except for those classified and non-performing loans discussed above, the Company’s management is not aware of any loans as of June 30, 2010, 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 continues to be 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 30 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” in the Company’s 2009 Annual Report on Form 10-K.

Deposits
One of the key sources of funds to support earning assets (loans and investments) is the generation of deposits from the Company’s customer base.  The ability to grow the customer base and subsequently deposits is a significant element in the performance of the Company.
 
The Company's deposit balances at June 30, 2010 have decreased $56.1 million or 3.7% compared to June 30, 2009.


Although total deposits have decreased 3.7% since June 30, 2009, the Company’s focus on increasing low cost transaction and savings accounts has resulted in significant growth in these deposit types:

·
Demand and Interest-Bearing transaction accounts increased $30.6 million or 7.1% since June 30, 2009.

·
Savings accounts have increased $36.3 million or 9.4% since June 30, 2009.

·
Time deposit accounts have decreased $123.0 million or 17.9% since June 30, 2009. This decline was the result of an explicit pricing strategy adopted by the Company beginning in the second quarter of 2009 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 $77.8 million or 18% from December 2008, 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”). Given the Company’s strong deposit growth in transaction and savings accounts, supplemented by investment portfolio maturities and sales, this time deposit decline did not result in any liquidity issues and it significantly enhanced the Company’s net interest margin and earnings.

In addition to the Company’s ongoing business development activities for deposits, the following factors positively impacted transaction and savings deposit growth since June 30, 2009: (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; 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 in the future, particularly if funds move back into the stock market. This could impact future deposit growth.

The Company's deposit balances at June 30, 2010 have declined $47.8 million or 3.2% compared to December 31, 2009. Most of this decline is due to normal seasonal cycles for the Company’s agricultural customers but may also reflect the continuing economic stresses felt by some of the Company’s depositors. Demand and Interest-Bearing transaction accounts decreased $41.7 million or 8.3% since December 31, 2009. Savings accounts have increased $8.6 or 2.1% since December 31, 2009. Time deposit accounts have decreased $14.7 million or 2.5% since December 31, 2009.
 
Beginning in December 2008, the Bank elected to participate in the FDIC’s Transaction Account 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 (See “Item 1. Business – Supervision and Regulation – Deposit Insurance” of the Company’s 2009 Annual Report on Form 10-K). On April 13, 2010, the FDIC announced that it had approved the second extension of the Transaction Account Guarantee for six months, beginning July 1, 2010, with the possibility of extending the program an additional 12 months. The FDIC provided each participant bank the opportunity to “opt-out” of the program as of July 1, 2010. Accordingly, the Company decided not to remain in the program after June 30, 2010.

Federal Home Loan Bank Advances and Federal Reserve Bank Borrowings
Lines of credit with the Federal Reserve Bank and the Federal Home Loan Bank are other key sources of funds to support earning assets (see “Item 3. Quantitative and Qualitative Disclosures About Market Risk and Liquidity Risk”). These sources of funds are also used to manage the Company’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 June 30, 2010 were $4.8 million compared to $20.1 million at December 31, 2009 and $676,000 at June 30, 2009. The average rate on FHLB advances during the first half of 2010 was 2.1% compared to 3.4% during the first half of 2009.

There were no amounts outstanding on the Company’s line of credit with the FRB as of June 30, 2010.

As of June 30, 2010 the Company has additional borrowing capacity of $171.7 million with the Federal Home Loan Bank and $238.4 million with the Federal Reserve Bank.  Any borrowings under these lines would be collateralized with loans that have been accepted for pledging at the FHLB and FRB.

Securities Sold Under Agreement to Repurchase
Securities Sold Under Agreement to Repurchase totaled $60 million at June 30, 2010, December 31, 2009, and June 30, 2009.

On March 13, 2008, the Bank entered into a $40 million term repurchase agreement with Citigroup.  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 term repurchase agreement with Citigroup.  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.  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 and were 3.39% as of June 30, 2010, 3.10% at December 31, 2009 and 3.46% at June 30, 2009. The average rate paid for these securities for the first half of 2010 was 3.17% compared to 4.40% for the first half of 2009. 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 $170.7 million at June 30, 2010, $164.7 million at December 31, 2009, and $158.2 million at June 30, 2009.

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’s and the Bank's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company’s and the Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios set forth in the table below of Total and Tier 1 capital to risk-weighted assets and of Tier 1 capital to average assets (all terms as defined in the regulations). Management believes, as of June 30, 2010, that the Company and the Bank meet all capital adequacy requirements to which they are subject.


In its most recent notification from the FDIC the Bank was categorized 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 table below. There are no conditions or events since that notification that management believes have changed the institution’s categories.
 
(in thousands)
 
Actual
   
Regulatory Capital Requirements
   
To Be Well Capitalized Under Prompt Corrective Action Provisions
 
The Company:
 
Amount
   
Ratio
   
Amount
   
Ratio
   
Amount
   
Ratio
 
As of June 30, 2010
                                   
Total Capital to Risk Weighted Assets
  $ 194,423       13.20 %   $ 117,819       8.0 %     N/A       N/A  
Tier 1 Capital to Risk Weighted Assets
    175,852       11.94 %     58,910       4.0 %     N/A       N/A  
Tier 1 Capital to Average Assets
    175,852       10.16 %     69,245       4.0 %     N/A       N/A  

 (in thousands)
 
Actual
   
Regulatory Capital Requirements
   
To Be Well Capitalized Under Prompt Corrective Action Provisions
 
The Bank:
 
Amount
   
Ratio
   
Amount
   
Ratio
   
Amount
   
Ratio
 
As of June 30, 2010
                                   
Total Capital to Risk Weighted Assets
  $ 194,328       13.20 %   $ 117,815       8.0 %   $ 147,269       10.0 %
Tier 1 Capital to Risk Weighted Assets
    175,757       11.93 %     58,908       4.0 %     88,362       6.0 %
Tier 1 Capital to Average Assets
    175,757       10.16 %     69,185       4.0 %     86,481       5.0 %

As previously discussed (see Long-term Subordinated Debentures), in order to supplement its regulatory capital base, during December 2003 the Company issued $10 million of trust preferred securities.  On March 1, 2005, the Federal Reserve Board issued its final rule effective April 11, 2005, concerning the regulatory capital treatment of trust preferred securities (“TPS”) by bank holding companies (“BHCs”).  Under the final rule BHCs may include TPS in Tier 1 capital in an amount equal to 25% of the sum of core capital net of goodwill.  The quantitative limitation concerning goodwill will not be effective until March 31, 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.

During the second quarter of 2010 the Company did not repurchase any shares. During the second quarter of 2009 the Company repurchased 410 shares at an average share price of $390. 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, 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 only are 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 Farmers & Merchants Bancorp’s Board of Directors that the proposed acquisition is fair to, and in the best interest of, all of the shareholders 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 Farmers and Merchants Bancorp’s Board of Directors at a price of $0.001 per Right. The Rights Plan will expire on August 5, 2018.

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 “Part I, Item 1A. Risk Factors” in the Company’s 2009 Annual Report on Form 10-K.

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.  These judgments govern areas such as the allowance for loan losses, the fair value of financial instruments and accounting for income taxes.

For a full discussion of the Company’s critical accounting policies and estimates see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the Company’s 2009 Annual Report on Form 10-K.

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 the Company 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.

In the ordinary course of business, the Company enters into commitments to extend credit to its customers. As of June 30, 2010, the Company had entered into commitments with certain customers amounting to $291.5 million compared to $315.2 million at December 31, 2009 and $329.7 million at June 30, 2009.  Letters of credit at June 30, 2010, December 31, 2009 and June 30, 2009, were $9.4 million, $9.2 million and $7.4 million, respectively. These commitments are not reflected in the accompanying consolidated financial statements and do not significantly impact operating results.

ITEM 3. 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.

In order to control credit risk in the loan portfolio 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. However, 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.

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.

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 historical average charge-off rate for each particular group of loans.


Part 2: considers qualitative internal and external factors that may affect a loan’s collectability, 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.

Management believes that based upon the preceding methodology, and using information currently available, the allowance for loan losses at June 30, 2010 was adequate. 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 require increases in the provision for loan losses and thereby adversely affect the results of operations.

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

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

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

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

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


The simulation model estimates the impact of changing interest rates on interest income from all interest earning assets and the interest expense paid on all interest bearing liabilities reflected on the Company’s balance sheet. This sensitivity analysis is compared to policy limits, which specify a maximum tolerance level for net interest income exposure over a one-year horizon assuming no balance sheet growth, given a 200 basis point upward and a 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 June 30, 2010, 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 2.56% if rates increase by 200 basis points and an increase in net interest income of 0.05% if rates decline 100 basis points. Comparatively, 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. All results are within the Company’s policy limits.

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 $84.0 million and repurchase lines of $1.6 million with major banks.  In addition, as of June 30, 2010 the Company has available borrowing capacity of $171.7 million at the Federal Home Loan Bank and $238.4 million at the Federal Reserve Bank.

ITEM 4. CONTROLS AND PROCEDURES

The Company maintains disclosure controls and procedures designed to ensure that 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 designing these controls and procedures, management recognizes that they can only provide reasonable assurance of achieving the desired control objectives. Management also evaluated the cost-benefit relationship of possible controls and procedures.

As of the end of the period covered by this report, the Company carried out an evaluation of the effectiveness of Company’s disclosure controls and procedures under the supervision and with the participation of the Chief Executive Officer, the Chief Financial Officer and other senior management of the Company. The evaluation was based, in part, upon reports and affidavits provided by a number of executives. Based on the foregoing, the Company’s Chief Executive Officer and the Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective.

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


PART II.  OTHER INFORMATION

ITEM 1. 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.

ITEM 1A. Risk Factors

See “Item 1A. Risk Factors” in the Company’s 2009 Annual Report on Form 10-K. In management’s opinion, there have been no material changes in risk factors since the filing of the 2009 Form 10-K.

ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds

There were no shares repurchased by Farmers & Merchants Bancorp during the second quarter of 2010. The remaining dollar value of shares that may yet be purchased under the Company’s Stock Repurchase Plan is approximately $16.6 million.

The common stock of Farmers & Merchants Bancorp is not widely held nor 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.

ITEM 3. Defaults Upon Senior Securities

Not applicable

ITEM 4. (Removed and Reserved)

ITEM 5. Other Information

None

ITEM 6. Exhibits

See Exhibit Index on Page 38.


SIGNATURES

Pursuant to the requirement 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
   
Date:  August 5, 2010
/s/ Kent A. Steinwert
     
 
Kent A. Steinwert
 
President and
 
Chief Executive Officer
 
(Principal Executive Officer)
   
Date:  August 5, 2010
/s/ Stephen W. Haley
     
 
Stephen W. Haley
 
Executive Vice President and
 
Chief Financial Officer
 
(Principal Accounting Officer)

Index to Exhibits

Exhibit No.
Description

Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
Certifications 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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