10-Q 1 k80665e10vq.txt QUARTERLY REPORT FOR PERIOD ENDED 09/30/03 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 September 30, 2003 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ___________ to __________ COMMISSION FILE NUMBER: 0-49771 MERCHANTS BANCORP, INC. (Exact name of registrant as specified in its charter) Ohio 31-1467303 (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 100 North High Street, Hillsboro, Ohio 45133 (Address of principal executive offices) (Zip Code) (937) 393-1993 (Registrant's telephone number, including area code) 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 [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act.) Yes [ ] No [X] Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Common stock - 2,945,000 shares outstanding at November 13, 2003 1 PART I - FINANCIAL INFORMATION ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS The accompanying information has not been audited by independent public accountants; however, in the opinion of management such information reflects all adjustments necessary for a fair presentation of the results for the interim period. All such adjustments are of a normal and recurring nature. The accompanying financial statements are presented in accordance with the requirements of Form 10-Q and consequently do not include all of the disclosures normally required by accounting principles generally accepted in the United States of America or those made in the Registrant's Form 10-K. Accordingly, the reader of the Form 10-Q should refer to the Registrant's Form 10-K for the year ended December 31, 2002 for further information in this regard. 2 SEPTEMBER 30, 2003 AND DECEMBER 31, 2002 (IN THOUSANDS EXCEPT SHARE DATA)

See notes to condensed consolidated financial statements. 3 MERCHANTS BANCORP, INC. AND SUBSIDIARY CONDENSED CONSOLIDATED STATEMENTS OF INCOME (IN THOUSANDS EXCEPT PER SHARE DATA)

See notes to condensed consolidated financial statements. 4

SUPPLEMENTAL DISCLOSURE OF NONCASH FINANCING ACTIVITY: In connection with the Redemption Agreement to purchase treasury stock, the company recorded $5,845 in other liabilities. See notes to condensed consolidated financial statements. 5 MERCHANTS BANCORP, INC. AND SUBSIDIARY NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002 -------------------------------------------------------------------------------- 1. SUMMARY OF SIGNIFICANT ACCOUNTING AND REPORTING POLICIES The unaudited condensed consolidated financial statements include the accounts of Merchants Bancorp, Inc. and its wholly-owned subsidiary, Merchants National Bank (collectively, the "Company"). All significant intercompany balances and transactions have been eliminated in consolidation. In the opinion of management, these condensed consolidated financial statements include all adjustments (which consist of normal recurring accruals) necessary to present the condensed consolidated financial position as of September 30, 2003, the results of operations for the three and nine months ended September 30, 2003 and 2002, and of cash flows for the nine-months ended September 30, 2003 and 2002. These condensed consolidated financial statements have been prepared in accordance with instructions to Form 10-Q, and therefore do not include all information and footnote disclosures necessary for a fair presentation of financial position, results of operations and cash flows in conformity with accounting principles generally accepted in the United States of America. Financial information as of December 31, 2002 has been derived from the audited consolidated financial statements of Merchants Bancorp, Inc. and subsidiary. The results of operations for the three and nine months ended September 30, 2003 and 2002 and cash flows for the nine months ended September 30, 2003 and 2002 are not necessarily indicative of the results to be expected for the full year. For further information, refer to the consolidated financial statements and footnotes thereto for the year ended December 31, 2002, included in the Company's Form 10-K. Earnings per Share -- Basic earnings per share is computed using the weighted average number of shares of common stock outstanding during the period. For the three and nine months ended September 30, 2003, the weighted average number of shares outstanding were 2,985,054 shares and 2,994,963 shares, respectively. For the three and nine months ended September 30, 2002, the weighted average number of shares outstanding were 3,000,000. There were no common stock equivalents or potentially diluted securities outstanding during the respective periods. New Accounting Pronouncements -- In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." This Statement amends and clarifies financial accounting and reporting for derivative instruments, including certain embedded derivatives, and for hedging activities under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." This Statement amends SFAS No. 133 to reflect the decisions made as part of the Derivatives Implementation Group (DIG) and in other FASB projects or deliberations. SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. Adoption of this standard is not expected to have a material effect on the Company's Consolidated Financial Statements. In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity." This Statement establishes standards for how an entity classifies and measures certain financial instruments with characteristics of both liabilities and equity. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. Adoption of this standard did not have a material effect on the Company's Consolidated Financial Statements. 6 2. LOANS Major classifications of loans are summarized as follows (in thousands):

========= ========= The Company did not have any loans held for sale at September 30, 2003 or December 31, 2002. 7 3. FHLB BORROWINGS All stock in the Federal Home Loan Bank ("FHLB") and qualifying first mortgage residential loans are pledged as collateral on FHLB borrowings. Maturities and interest rates of advances from the FHLB at September 30, 2003 are as follows (in thousands):

The maximum amount available to the Company under FHLB borrowings was approximately $75.7 million and $57.8 million as of September 30, 2003 and December 31, 2002, respectively. 4. TREASURY STOCK On August 28, 2003 Merchants Bancorp entered into a stock redemption agreement with 3 shareholders of the Company. Collectively the three shareholders owned 351,349.994 common shares of the Company 8 or 11.71% of outstanding shares. They desired to sell 333,349.994 of such shares (referred to herein as the "shares") to the Company. The Company retained Austin Associates, LLC to determine a "fair value" and issued a "fairness opinion" to the Company dated July 30, 2003. The purchase is to be made in two separate settlements. The first settlement was for 55,000 shares and a total of $1,155,000 and occurred on September 5, 2003. The second settlement will occur on January 5, 2004 for the 278,349.994 remaining shares. The dollar value of this settlement is $5,845,349.87 and is recorded in other liabilities on the September 30, 2003 financial statements. The total value of the transaction is $7,000,349.87. 9 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW Merchants Bancorp, Inc. (the "Company") is a bank holding company and sole shareholder of Merchants National Bank (the "Bank"), headquartered in Hillsboro, Ohio. At September 30, 2003, the Company had total assets of approximately $354.0 million and total shareholders' equity of approximately $28.1 million. The Company, through its banking affiliate, offers a broad range of banking services to the commercial, industrial and consumer market segments which it serves. The primary business of the Bank consists of accepting deposits through various consumer and commercial deposit products, and using such deposits to fund various loan products. The Bank's primary loan products are as follows: (1) loans secured by residential real estate, including loans for the purchase of one to four family residences which are secured by 1st and 2nd mortgages and home equity loans; (2) consumer loans, including new and used automobile loans, loans for the purchase of mobile homes and debt consolidation loans; (3) agricultural loans, including loans for the purchase of real estate used in connection with agricultural purposes, operating loans and loans for the purchase of equipment; and (4) commercial loans, including loans for the purchase of real estate used in connection with office or retail activities, loans for the purchase of equipment and loans for the purchase of inventory. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires the appropriate application of certain accounting policies, many of which require us to make estimates and assumptions about future events and their impact on amounts reported in our financial statements and related notes. Since future events and their impact cannot be determined with certainty, the actual results will inevitably differ from our estimates. Such differences could be material to the financial statements. The Company believes the application of accounting policies and the estimates required therein are reasonable. These accounting policies and estimates are constantly reevaluated, and adjustments are made when facts and circumstances dictate a change. Historically, the Company has found its application of accounting policies to be appropriate, and actual results have not differed materially from those determined using necessary estimates. The Company's accounting policies are more fully described in Note 1 to the condensed consolidated financial statements. Management believes that the determination of the allowance for loan losses represents a critical accounting policy. The Company maintains an allowance for loan losses to absorb probable loan losses inherent in the portfolio. The allowance for loan losses is maintained at a level management considers to be adequate to absorb probable loan losses inherent in the portfolio, based on evaluations of the collectibility and historical loss experience of loans. Credit losses are charged and recoveries are credited to the allowance. Provisions for loan losses are based on management's review of the historical loan loss experience and such factors which, in management's judgment, deserve consideration under existing economic conditions in estimating probable credit losses. The allowance is based on ongoing assessments of the probable estimated losses inherent in the loan portfolio. The Company's methodology for assessing the appropriate allowance level consists of several key elements, as described below. 10 Larger commercial loans that exhibit probable or observed credit weaknesses are subject to individual review. Where appropriate, reserves are allocated to individual loans based on management's estimate of the borrower's ability to repay the loan given the availability of collateral, other sources of cash flow and available legal options. Included in the review of individual loans are those that are impaired as provided in Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan," as amended. Any specific reserves for impaired loans are measured based on the fair value of the underlying collateral. The Company evaluates the collectibility of both principal and interest when assessing the need for a specific reserve. Historical loss rates are applied to other commercial loans not subject to specific reserve allocations. Homogenous loans, such as consumer installment and residential mortgage loans, are not individually reviewed by management. Reserves are established for each pool of loans based on the expected net charge-offs. Loss rates are based on the average five-year net charge-off history by loan category. Historical loss rates for commercial and consumer loans may be adjusted for significant factors that, in management's judgment, reflect the impact of any current conditions on loss recognition. Factors which management considers in the analysis include the effects of the local economy, trends in the nature and volume of loans (delinquencies, charge-offs, nonaccrual and problem loans), changes in the internal lending policies and credit standards, collection practices, and examination results from bank regulatory agencies and the Company's internal credit review function. An unallocated reserve is maintained to recognize the imprecision in estimating and measuring loss when evaluating reserves for individual loans or pools of loans. Specific reserves on individual loans and historical loss rates are reviewed throughout the year and adjusted as necessary based on changing borrower and/or collateral conditions and actual collection and charge-off experience. The Company has not substantively changed any aspect of its overall approach in the determination of the allowance for loan losses since January 1, 2003. There have been no material changes in assumptions or estimation techniques as compared to prior years that impacted the determination of the current year allowance. COMPARISON OF OPERATING RESULTS FOR THE THREE MONTHS ENDED, SEPTEMBER 2003 AND 2002 The Company reported net income of $485,000 and $1,255,000 for the three months ended September 30, 2003 and 2002, respectively. During the same periods, basic and diluted earnings per share were $.16 and $.42, respectively. On an annualized basis, return on average assets was .57% and return on average equity was 5.93% for the three months ended September 30, 2003, compared to 1.63% and 15.76%, respectively, for the comparable period in 2002. The income was substantially less for the three quarters in 2003 due to an accrual of $1.5 million to the loan loss reserve. The provision was made when management became aware of a probable credit loss to a large borrower. The credit loss is discussed further in the "Loans and Allowance for Loan Losses" section of this report. Net interest income for the three months ended September 30, 2003, was $3,570,000, an increase of $87,000, or 2.50%, compared to net interest income of $3,483,000 for the comparable period in 2002. Net interest margin was 4.44% for the three months ended September 30, 2003, compared to 4.83% for the comparable period in 2002. The average annualized yield on earning assets decreased to 6.52% for the three months ended September 30, 2003, from 7.45% for the comparable period in 2002. The average cost of interest-bearing funds was 2.40% for the three months ended September 30, 2003, a decrease from 3.10% for the comparable period in 2002. Management attributes the decrease in net interest margin to the contractual 11 repricing of one, three and five year adjustable rate mortgages in the loan portfolio. Management has also implemented a fixed rate 1-4 family lending program to maintain and grow the loan portfolio. The loans are funded by FHLB borrowings and are priced to net approximately 2% spread over borrowings. This spread is slightly lower than our usual spread to cost of funds but is necessary due to competition. The provision for loan losses was $1,785,000 and $138,000 for the three months ended September 30, 2003 and 2002, respectively, representing an increase of 1,193.5%. Net charge-offs for the three months ended September 30, 2003 were $1,706,000, compared to $38,000 experienced during the three months ended September 30, 2002. Management increased the provision for loan losses during the three month period ending September 30, 2003 to reflect the increased estimate of probable loan losses in 2003, primarily related to a certain commercial borrower, which was identified by management on July 23, 2003. The Company assessed the collateral situation and believes the collateral to be inadequate. In July 2003, the Company provided $1.5 million in the loan loss reserve to cover the estimated losses. In September 2003, the company charged off $1.5 million against the loan loss reserve relating to this credit loss. Upon further review of the borrower's loans, the company estimated additional loss potential and made an additional allowance in the loan loss reserve for $80,000 in September 2003. The remaining collateral will be liquidated over time to cover the remaining balance of the loans. The collateral to be liquidated includes 4 residential properties, a commercial property, chattels and rolling stock. Additionally, throughout the year, the Company has made additional provisions to the loan loss reserve for certain agricultural credits. Drought conditions, reduced government program payments, and average to below-average grain prices have affected the repayment opportunities for borrowers. Management has conducted a review of its agricultural lending approval process and made modifications where necessary to strengthen its underwriting process of agricultural operating loans. Management believes its review process has adequately identified problem loans within its portfolio. Total noninterest income was $384,000 for the three months ended September 30, 2003, a decrease of $16,000, or 4.0%, from $400,000 for the comparable period in 2002. The decrease is due to a recording of a gain on sale of Other Real Estate Owned in third quarter 2002 for $22,000. Total noninterest expense was $1,665,000 for the three months ended September 30, 2003, a decrease of $222,000, or 11.8%, from $1,887,000 for the comparable period in 2002. Salaries and benefits expense comprises the largest component of noninterest expense, with totals of $747,000 and $938,000 for the three months ended September 30, 2003 and 2002, respectively. The net decrease in salaries and benefits expense is primarily attributable to the reduction in profit sharing bonus accrual which is based on return on equity. For the three months ended September 2003 the expense was negative $100,000 as a result of the reversal of the accrual compared to $150,000 expense for three months ended September 2002. The reduction in expense is a result of the large credit loss recorded during July 2003 as described above. This decrease is offset by an increase in salaries and benefits expense primarily attributable to the additional employees at the new branch opened during 2002 and the hiring of an additional mortgage loan officer. COMPARISON OF OPERATING RESULTS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002 The Company reported net income of $2,713,000 and $3,428,000 for the nine months ended September 30, 2003 and 2002, respectively. During each of the same periods, basic and diluted earnings per share were $.90 and $1.14, respectively. On an annualized basis, return on average assets was 1.08% and return on average equity was 10.83% for the nine months ended September 30, 2003, compared to 1.50% and 14.36%, respectively, for the comparable period in 2002. Net interest income for the nine months ended September 30, 2003, was $10,655,000, an increase of $950,000, or 9.8%, compared to net interest income of $9,705,000 for the comparable period in 2002. Net interest margin was 4.45% for the nine months ended September 30, 2003, compared to 4.48% for the 12 comparable period in 2002. The average annualized yield on earning assets decreased to 6.55% for the nine months ended September 30, 2003, from 7.29% for the comparable period in 2002. The average cost of interest-bearing funds was 2.48% for the nine months ended September 30, 2003, a decrease from 3.34% for the comparable period in 2002. The net interest margin has remained relatively consistent over the comparable time periods due to the correlation of the decreasing yield on interest earning assets and decreasing cost of funds. The provision for loan losses was $2,451,000 and $367,000 for the nine months ended September 30, 2003 and 2002, respectively, representing an increase of 567.9%. Net charge-offs for the nine months ended September 30, 2003 were $2,183,000, compared to $165,000 experienced during the nine months ended September 30, 2002. Management increased the provision for loan losses during the nine month period ending September 30, 2003 to reflect the increased estimate of probable loan losses in 2003, primarily related to a certain commercial borrower, which was identified by management on July 23, 2003. The Company assessed the collateral situation and believes the collateral to be inadequate. In July 2003, the Company provided $1.5 million in the loan loss reserve to cover the estimated losses. In September 2003, the company charged off $1.5 million against the loan loss reserve relating to this credit loss. Upon further review of the borrower's loans, the company estimated additional loss potential and made an additional allowance in the loan loss reserve for $80,000 in September 2003. The remaining collateral will be liquidated over time to cover the remaining balance of the loans. The collateral to be liquidated includes 4 residential properties, a commercial property, chattels and rolling stock. The additional charge offs in the first nine months of 2003 were primarily within the agricultural portfolio. Drought conditions, reduced government program payments, and average to below-average grain prices have affected the repayment opportunities for these certain borrowers. Management has conducted a review of its agricultural lending approval process and made modifications where necessary to strengthen its underwriting process of agricultural operating loans. Management believes its review process has adequately identified problem loans within its portfolio on a timely basis. Total noninterest income was $1,125,000 for the nine months ended September 30, 2003, a decrease of $6,000, or .53%, from $1,131,000 for the comparable period in 2002. The increase is due to service charges on customers' deposit account transactions. Total noninterest expense was $5,556,000 for the nine months ended September 30, 2003, an increase of $137,000, or 2.5%, from $5,419,000 for the comparable period in 2002. Salaries and benefits expense comprises the largest component of noninterest expense, with totals of $2,778,000 and $2,684,000 for the nine months ended September 30, 2003 and 2002, respectively. The net increase in salaries and benefits expense is primarily attributable to the additional employees at the new branch opened during 2002 and the hiring of an additional mortgage loan officer offset by the reduction in profit sharing bonus accrual totaling $197,000 during the nine months ended September 30, 2003 compared to $440,000 for the nine months ended 2002. The reduction is expense is a result of the large credit loss recorded during July 2003 as described above. FINANCIAL CONDITION The Company's total assets increased to $354.0 million as of September 30, 2003 from $318.8 million as of December 31, 2002, an increase of 11.0%. The majority of the asset growth came from $37.9 million in loan growth. The loan growth was funded by an increase of $26.5 million in FHLB borrowings and an increase of $9.8 million is deposits. The loan growth was partially driven by increases in the residential mortgage portfolio due to the continued historically low interest rates. LOANS AND ALLOWANCE FOR LOAN LOSSES 13 The Company reported total loans of $286.2 million as of September 30, 2003 and $248.3 million as of December 31, 2002, an increase of $37.9 million, or 15.3%. The portfolio composition has remained consistent during the period. Federal regulations and generally accepted accounting principles require the Company establish prudent allowances for loan losses. The Company maintains an allowance for loan losses to absorb probable loan losses inherent in the portfolio, based on evaluations of the collectability and historical loss experience of loans. Loan losses are charged and recoveries are credited to the allowance. Provisions for loan losses are based on management's review of the historical loan loss experience and such factors which, in management's judgment, deserve consideration under existing economic conditions in estimating probable loan losses. The allowance is based on ongoing assessments of the probable estimated losses inherent in the loan portfolio. The Company has not substantively changed any aspect of its overall approach in the determination of the allowance for loan losses during 2003. There have been no material changes in assumptions or estimation techniques as compared to prior years that impacted the determination of the current year allowance. The allowance for loan losses was 0.83% of total loans as of September 30, 2003 and 0.85% as of December 31, 2002. As a percentage of the allowance for loan losses, total nonaccrual loans and loans past due 90 days or more were 173.7% as of September 30, 2003, 145.8% as of June 30, 2003, and 76.4% as of December 31, 2002. The amount of nonaccrual loans increased to $1,309,000 as of September 30, 2003, compared to $573,000 as of June 30, 2003, and $476,000 at December 31, 2002. As a percentage of total loans, nonaccrual loans represented 0.46% as of September 30, 2003, 0.21% as of June 30, 2003, and 0.19% as of December 31, 2002. The increase in nonaccrual loans is due to a single commercial borrower whose nonaccrual borrowings total $933,000. These loans are secured with 4 residences, a commercial property, chattels, and rolling stock, all of which will be liquidated to repay these borrowings. Management will closely monitor the liquidation of collateral to assure adequate proceeds are available to fully repay the associated loans. The category of accruing loans which are past due 90 days or more was $2,814,000 as of September 30, 2003, $2,772,000 as of June 30, 2003, and $1,133,000 as of December 31, 2002. As a percentage of total loans, loans past due 90 days and still accruing interest represented .98% as of September 30, 2003, 1.00% as of June 30, 2003, and 0.46% as of December 31, 2002. Nine borrowers represent approximately $2 million of the past due loans 90 days or over. A commercial borrower representing $539,000 is expected to be liquidating the business and inventories in November 2003. The loan may need to be restructured after the sale but no loss is anticipated. Two customers with balances of approximately $303,000 have 90% FSA loan guarantees. The bank expects to receive full payment on both loans through either regular payments or liquidation. No losses are anticipated on these loans. A customer with an approximate loan balance of $150,000 has filed chapter 7 bankruptcy. The Company is receiving sporadic payments from the bankruptcy plan. Management believes liquidation of the underlying collateral will be sufficient to mitigate any significant losses on the loan should foreclosure become necessary. The bank believes it has sufficient collateral of the remaining 5 customers to cover the balance of the loans if forced to liquidate. Of the five remaining loans, one loan with a loan balance of $150,000 paid off their loan in October 2003. As a percentage of the allowance for loan losses, total nonaccrual loans and loans past due 90 days or more were 173.7% as of September 30, 2003, 145.8% as of June 30, 2003, and 76.4% as of December 31, 2002. DEPOSITS Deposits totaled $272.5 million as of September 30, 2003, an increase of $9.8 million, or 3.7%, from $262.7 million as of December 31, 2002. Deposit areas showing the most significant growth are in savings, insured 14 money markets, and supernow accounts. Certificate of Deposit balances remain flat from December 31, 2002. . FHLB BORROWINGS Federal Home Loan Bank borrowings increased $26.5 million to $44.0 million as of September 30, 2003 from $17.5 million as of December 31, 2002. The additional borrowings were primarily used to fund the lending of 1-4 family fixed rate loans made and held by the bank for additional loan funding. LIQUIDITY AND CAPITAL RESOURCES The declaration and payment of dividends by the Company are subject to the discretion of the Board of Directors and to the earnings and financial condition of the Company and applicable laws and regulations. The Company paid $960,000 and $840,000 in dividends during the nine months ended September 30, 2003 and 2002, respectively. At September 30, 2003, consolidated Tier 1 risk based capital was 10.30%, and total risk-based capital was 11.19%. The minimum Tier 1 and total risk-based capital ratios required by the Board of Governors of the Federal Reserve are 4% and 8%, respectively. Effective liquidity management ensures that the cash flow requirements of depositors and borrowers, as well as company cash needs, are met. The Company manages liquidity on both the asset and liability sides of the balance sheet. Community bank liquidity management currently involves the challenge of attracting deposits while maintaining positive loan growth at a reasonable interest rate spread. The loan to deposit ratio at September 30, 2003 was 105.0% compared to 94.5% as of December 31, 2002. Loans to total assets were 80.8% at September 30, 2003 compared to 77.9% at the end of 2002. The securities portfolio is available for sale and consists of securities that are readily marketable. Approximately 73% of the available for sale portfolio is pledged to secure public deposits, short-term and long-term borrowings and for other purposes as required by law. The balance of the available for sale securities could be sold if necessary for liquidity purposes. Also, a stable deposit base, consisting of 88.1% core deposits, makes the Company less susceptible to large fluctuations in funding needs. The Company also has both short- and long-term borrowings capacity available through FHLB with unused available credit of approximately $12.7 million as of September 30, 2003. The Company has the ability to obtain deposits in the brokered certificate of deposit market to help provide liquidity to fund loan growth, if necessary. Generally, the Company uses short-term borrowings to fund overnight and short-term funding needs in the Company's balance sheet. Longer-term borrowings have been primarily used to fund mortgage-loan originations. This has occurred when FHLB longer-term rates are a more economical source of funding than traditional deposit gathering activities. Additionally, the Company occasionally uses FHLB borrowings to fund larger commercial loans. As of September 30, 2003, management is not aware of any current recommendations by banking regulatory authorities which, if they were to be implemented, would have, or would be reasonably likely to have, a material adverse impact on the Company's liquidity, capital resources, or operations. On August 28, 2003 Merchants Bancorp entered into a stock redemption agreement with 3 shareholders of the Company. Collectively the three shareholders owned 351,349.994 common shares of the Company or 11.71% of outstanding shares. They desired to sell 333,349.994 of such shares (referred to herein as the "shares") to the Company. The Company retained Austin Associates, LLC to determine a "fair value" and issued a "fairness opinion" to the Company dated July 30, 2003 confirming that the payment of $21.00 per share is fair to both the Company and remaining shareholders. The purchase is to be made in two separate settlements. The first settlement was for 55,000 shares and a total of $1,155,000 and occurred on September 5, 2003. The second settlement will occur on January 5, 2004 for the 278,349.994 remaining shares. The dollar value of this settlement is $5,845,349.87 and is recorded in other liabilities on the September 30, 2003 15 financial statements. The total value of the transaction will be $7,000,349.87. The Company and its subsidiary bank Merchants National Bank will be "well capitalized" both before and after consummation of the stock transaction. CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS The Company has certain obligations and commitments to make future payments under contracts. At September 30, 2003, the aggregate contractual obligations and commercial commitments are:

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to variations in interest rates, exchange rates, equity price risk and commodity prices. The Company does not maintain a trading account for any class of financial instrument, and is not currently subject to currency exchange rate risk, equity price risk or commodity price risk. The Company's market risk is composed primarily of interest rate risk. The major source of the Company's interest rate risk is the difference in the maturity and repricing characteristics between the Company's core banking assets and liabilities -- loans and deposits. This difference, or mismatch, poses a risk to net interest income. Most significantly, the Company's core banking assets and liabilities are mismatched with respect to repricing frequency, maturity and/or index. Most of the Company's commercial loans, for example, reprice rapidly in response to changes in short-term interest rates. In contrast, many of the Company's consumer deposits reprice slowly, if at all, in response to changes in market interest rates. The Company's Senior Management is responsible for reviewing the interest rate sensitivity position of the Company and establishing policies to monitor and limit exposure to interest rate risk. The guidelines established by senior management are approved by the Company's Board of Directors. The primary goal of the asset/liability management function is to maximize net interest income within the interest rate risk limits set by approved guidelines. Techniques used include both interest rate gap management and simulation 16 modeling that measures the effect of rate changes on net interest income and market value of equity under different rate scenarios. In the Company's simulation models, each asset and liability balance is projected over a time horizon. Net interest income is then projected based on expected cash flows and projected interest rates under a stable rate scenario and analyzed. The results of this analysis are factored into decisions made concerning pricing strategies for loan and deposits, balance sheet mix, securities portfolio strategies, liquidity and capital adequacy. Simulation models are also performed under an instantaneous parallel 200 basis point increase or decrease in interest rates. The model includes assumptions as to repricing and expected prepayments, anticipated calls, and expected decay rates of transaction accounts under the different rate scenarios. The results of these simulations include changes in both net interest income and market value of equity. The Company's rate shock simulation models provide results in extreme interest rate environments and results are used accordingly. Reacting to changes in economic conditions, interest rates and market forces, the Company has been able to alter the mix of short and long-term loans and investments, and increase or decrease the emphasis on fixed and variable rate products in response to changing market conditions. By managing the interest rate sensitivity of its asset composition in this manner, the Company has been able to maintain a fairly stable flow of net interest income. Complicating management's efforts to control non-trading exposure to interest rate risk is the fundamental uncertainty of the maturity, repricing, and/or runoff characteristics of some of the Company's core banking assets and liabilities. This uncertainty often reflects options embedded in these financial instruments. The most important embedded options are contained in consumer deposits and loans. For example, many of the Company's interest bearing retail deposit products (e.g., interest checking, savings and money market deposits) have no contractual maturity. Customers have the right to withdraw funds from these deposit accounts freely. Deposit balances may therefore run off unexpectedly due to changes in competitive or market conditions. To forestall such runoff, rates on interest bearing deposits may have to be increased more (or reduced less) than expected. Such repricing may not be highly correlated with the repricing of prime rate-based or U.S. Treasury-based loans. Finally, balances that leave the banking franchise may have to be replaced with other more expensive retail or wholesale deposits. Given the uncertainties surrounding deposit runoff and repricing, the interest rate sensitivity of core bank liabilities cannot be determined precisely. Management believes as of September 30, 2003, there have been no material changes in the Company's interest rate sensitive instruments which would cause a material change in the market risk exposures which affect the quantitative and qualitative risk disclosures as presented in the Company's Form 10-K filed for the period ended December 31, 2002. ITEM 4. CONTROLS AND PROCEDURES The Company carried out an evaluation, under the supervision and with the participation of the Company's management, including the Company's Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures as of September 30, 2003, pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures were effective as of September 30, 2003, in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company's periodic SEC filings. 17 There was no change in the Company's internal control over financial reporting that occurred during the Company's fiscal quarter ended September 30, 2003, that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. FORWARD-LOOKING STATEMENTS Certain of the statements contained herein that are not historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act. Economic circumstances, the Company's operation and the Company's actual results could differ significantly from those discussed in the forward-looking statements. Forward-looking statements are typically identified by words or phrases such as "believe," "expect," "anticipate," "intend," "estimate," "may increase," "may fluctuate," and similar expressions or future or conditional verbs such as "will," "should," "would" and "could." These forward-looking statements involve risks and uncertainties including, but not limited to, economic conditions, portfolio growth, the credit performance of the portfolios, including bankruptcies, and seasonal factors; changes in general economic conditions including the performance of financial markets, the prices of crops, prevailing inflation and interest rates, and losses on lending activities; results of various investment activities; the effects of competitors' pricing policies, of changes in laws and regulations on competition and of demographic changes on target market populations' savings and financial planning needs; industry changes in information technology systems on which we are dependent; and the resolution of legal proceedings and related matters. In addition, the policies and regulations of the various regulatory authorities could affect the Company's results. These statements are representative only on the date hereof, and the Company undertakes no obligation to update any forward-looking statements made. PART II - OTHER INFORMATION ITEM 5. OTHER INFORMATION On August 28, 2003 Merchants Bancorp entered into a stock redemption agreement with 3 shareholders of the Company. Collectively the three shareholders owned 351,349.994 common shares of the Company or 11.71% of outstanding shares. They desired to sell 333,349.994 of such shares (referred to herein as the "shares") to the Company. The Company retained Austin Associates, LLC to determine a "fair value" and issued a "fairness opinion" to the Company dated July 30, 2003. The purchase is to be made in 2 separate settlements. The first settlement was for 55,000 shares and a total of $1,155,000 and occurred on September 5, 2003. The second settlement will occur on January 5, 2004 for the 278,349.994 remaining shares. The dollar value of this settlement is $5,845,349.87. The total value of the transaction will be $7,000,349.87. The Company and its subsidiary bank Merchants National Bank will be "well capitalized" both before and after consummation of the stock transaction. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K. (a) EXHIBITS - The following exhibits are filed as a part of this report: Exhibit No. Exhibit 3.1 Amended and Restated Articles of Incorporation of Merchants Bancorp, Inc. (Incorporated by reference to the Registration Statement on Form 10 filed on April 30, 2002.) 3.2 Code of Regulations of Merchants Bancorp, Inc. (Incorporated by reference to the Registration Statement on Form 10 filed on April 30, 2002.) 18 4. Instruments Defining the Rights of Security Holders. (See Exhibit 3.) 10. Stock Redemption Agreement entered into August 28, 2003 (Incorporated by reference to Exhibit 10 to the current report on Form 8-K filed with the Commission by the Registrant on September 5, 2003). 31.1 Certification of Principal Executive and Financial Officer Pursuant to Section 302 of the Sarbanes- Oxley Act of 2002. 32.1 Certification pursuant to 18 U.S.C. section 1350, as enacted pursuant to section 906 of the Sarbanes- Oxley Act of 2002. (b) REPORTS ON FORM 8-K DURING THE QUARTER ENDED SEPTEMBER 30, 2003: o The Registrant filed a report on Form 8-K on September 5, 2003 announcing the stock redemption agreement dated as of August 28, 2003 executed by and among the Registrant and Janet F. Daniel, Mary Jane Mallory and Sara Fling West. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. MERCHANTS BANCORP, INC. Date: November 14, 2003 By: /s/ Paul W. Pence, Jr. ----------------------- Paul W. Pence, Jr., President and Principal Financial Officer 19 EXHIBIT INDEX Exhibit No. Description ----------- ----------- 3.1 Amended and Restated Articles of Incorporation of Merchants Bancorp, Inc. (Incorporated by reference to the Registration Statement on Form 10 filed on April 30, 2002.) 3.2 Code of Regulations of Merchants Bancorp, Inc. (Incorporated by reference to the Registration Statement on Form 10 filed on April 30, 2002.) 4. Instruments Defining the Rights of Security Holders. (See Exhibit 3.) 10. Stock Redemption Agreement entered into August 28, 2003 (Incorporated by reference to Exhibit 10 to the current report on Form 8-K filed with the Commission by the Registrant on September 5, 2003). 31.1 Certification of Principal Executive and Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certification pursuant to 18 U.S.C. section 1350, as enacted pursuant to section 906 of the Sarbanes-Oxley Act of 2002. 20

MERCHANTS BANCORP INC/OH 10-Q