Edgar Filing: FARMERS & MERCHANTS BANCORP INC

Large accelerated filer

Accelerated filer

Non-accelerated filer

☐ (Do not check if a smaller reporting company)

Smaller reporting company

Form 10-Q

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

☒	Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period March 31, 2017

☐	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 0-14492

FARMERS & MERCHANTS BANCORP, INC.

(Exact name of registrant as specified in its charter)


OHIO		34-1469491
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification No.)

307 North Defiance Street, Archbold, Ohio		43502
(Address of principal executive offices)		(Zip Code)

(419) 446-2501

Registrant’s telephone number, including area code

(Former name, former address and former fiscal year, if changed since last report.)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or Section 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 ☒ No ☐

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

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 the definitions of “large accelerated filer”, “accelerated filer”, “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Emerging growth company ☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicated by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒

Indicate the number of shares of each of the issuers’ classes of common stock, as of the latest practicable date:


Common Stock, No Par Value		4,620,725
Class		Outstanding as of April 24, 2017

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10Q

FARMERS & MERCHANTS BANCORP, INC.

INDEX


Form 10-Q Items		Page
PART I.	FINANCIAL INFORMATION

Item 1.	Financial Statements (Unaudited)

	Condensed Consolidated Balance Sheets- March 31, 2017 and December 31, 2016	3

	Condensed Consolidated Statements of Income & Comprehensive Income - Three Months Ended March 31, 2017 and March 31, 2016	4

	Condensed Consolidated Statements of Cash Flows- Three Months Ended March 31, 2017 and March 31, 2016	5

	Notes to Condensed Consolidated Financial Statements	6-34

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	34-47

Item 3.	Qualitative and Quantitative Disclosures About Market Risk	47-48

Item 4.	Controls and Procedures	48

PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings	48

Item 1A.	Risk Factors	49

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	49

Item 3.	Defaults Upon Senior Securities	49

Item 4.	Mine Safety Disclosures	49

Item 5.	Other Information	49

Item 6.	Exhibits	49

Signatures		50

Exhibit 31.	Certifications Under Section 302	51-52

Exhibit 32.	Certifications Under Section 906	53-54

101.INS	XBRL Instance Document (1)
101.SCH	XBRL Taxonomy Extension Scheme Document (1)
101.CAL	XBRL Taxonomy Extension Calculation Linkbase Document (1)
101.DEF	XBRL Taxonomy Extension Definition Linkbase Document (1)
101.LAB	XBRL Taxonomy Extension Label Linkbase Document (1)
101.PRE	XBRL Taxonomy Extension Presentation Linkbase Document (1)

(1)

Pursuant to Rule 406T of Regulation S-T, the interactive Data Files in Exhibit 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.

ITEM 1

FINANCIAL STATEMENTS

FARMERS & MERCHANTS BANCORP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS


	(in thousands of dollars)
	March 31, 2017			December 31, 2016
	(Unaudited)
Assets
Cash and due from banks	$	38,842		$	27,348
Federal funds sold		1,052			974

Total cash and cash equivalents		39,894			28,322

Interest-bearing time deposits		1,845			1,915
Securities - available-for-sale		206,388			218,527
Other securities, at cost		3,717			3,717
Loans held for sale		1,067			2,055
Loans, net		764,356			751,310
Premises and equipment		21,222			21,457
Goodwill		4,074			4,074
Mortgage servicing rights		2,209			2,192
Other real estate owned		774			774
Bank Owned Life Insurance		14,452			14,376
Other assets		7,553			7,176

Total Assets	$	1,067,551		$	1,055,895

Liabilities and Stockholders’ Equity

Liabilities
Deposits
Noninterest-bearing	$	178,153		$	186,390
Interest-bearing
NOW accounts		292,364			230,446
Savings		236,230			226,537
Time		187,944			198,830

Total deposits		894,691			842,203

Federal Funds purchased and securities sold under agreements to repurchase		27,961			70,324
Federal Home Loan Bank (FHLB) advances		10,000			10,000
Dividend payable		1,053			1,053
Accrued expenses and other liabilities		6,129			6,738

Total liabilities		939,834			930,318

Commitments and Contingencies

Stockholders’ Equity
Common stock - No par value 10,000,000 shares authorized; issued and outstanding 5,200,000 shares 3/31/17 and 12/31/16		12,049			11,947
Treasury Stock - 579,125 shares 3/31/17, 579,125 shares 12/31/16		(12,267	)		(12,267	)
Retained earnings		129,655			127,869
Accumulated other comprehensive loss		(1,720	)		(1,972	)

Total stockholders’ equity		127,717			125,577

Total Liabilities and Stockholders’ Equity	$	1,067,551		$	1,055,895

See Notes to Condensed Consolidated Unaudited Financial Statements.

Note: The December 31, 2016, Condensed Consolidated Balance Sheet has been derived from the audited Consolidated Balance Sheet as of that date.

FARMERS & MERCHANTS BANCORP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME & COMPREHENSIVE INCOME

(Unaudited)


(in thousands of dollars, except per share data)
	Three Months Ended
	March 31, 2017			March 31, 2016
Interest Income
Loans, including fees	$	8,700		$	8,006
Debt securities:
U.S. Treasury and government agencies		642			580
Municipalities		315			369
Dividends		42			38
Other		22			11

Total interest income		9,721			9,004
Interest Expense
Deposits		1,030			854
Federal funds purchased and securities sold under agreements to repurchase		113			105
Borrowed funds		36			37

Total interest expense		1,179			996

Net Interest Income - Before Provision for Loan Losses		8,542			8,008
Provision for Loan Losses		73			277

Net Interest Income After Provision
For Loan Losses		8,469			7,731
Noninterest Income
Customer service fees		1,481			1,478
Other service charges and fees		871			910
Net gain on sale of loans		201			169
Net gain on sale of available for sale securities		31			113

Total noninterest income		2,584			2,670
Noninterest Expense
Salaries and Wages		3,001			2,840
Employee benefits		922			862
Net occupancy expense		413			378
Furniture and equipment		472			412
Data processing		311			411
Franchise taxes		225			214
Net loss on sale of other assets owned		—			45
FDIC Assessment		83			121
Mortgage servicing rights amortization		84			89
Other general and administrative		1,560			1,614

Total other operating expenses		7,071			6,986

Income Before Income Taxes		3,982			3,415
Income Taxes		1,143			934

Net Income		2,839			2,481

Other Comprehensive Income (Net of Tax):
Net unrealized gain on available for sale securities		412			1,945
Reclassification adjustment for gain on sale of available for sale securities		(31	)		(113	)

Net unrealized gain on available for sale securities		381			1,832
Tax expense		129			623

Other comprehensive income		252			1,209

Comprehensive Income	$	3,091		$	3,690

Earnings Per Share - Basic and Diluted	$	0.61		$	0.54

Dividends Declared	$	0.23		$	0.22

See Notes to Condensed Consolidated Unaudited Financial Statements

FARMERS & MERCHANTS BANCORP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)


	(in thousands of dollars)
	Three Months Ended
	March 31, 2017			March 31, 2016
Cash Flows from Operating Activities
Net income	$	2,839		$	2,481
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		455			367
Accretion and amortization of available for sale securities, net		293			274
Amortization of servicing rights		84			89
Amortization of core deposit intangible		81			81
Compensation expense related to stock awards		111			104
Provision for loan loss		73			277
Gain on sale of loans held for sale		(201	)		(169	)
Originations of loans held for sale		(14,404	)		(12,010	)
Proceeds from sale of loans held for sale		16,307			12,426
Loss on sale of other assets owned		—			45
Gain on sales of securities available for sale		(31	)		(113	)
Change in other assets and other liabilities, net		(193	)		(1,545	)

Net cash provided by operating activities		5,414			2,307

Cash Flows from Investing Activities
Activity in securities:
Maturities, prepayments and calls		7,712			4,230
Sales		5,577			17,453
Purchases		(1,031	)		(11,408	)
Change in interest-bearing time deposits		70			(1,960	)
Proceeds from sales of other assets owned		—			1
Additions to premises and equipment		(220	)		(653	)
Loan originations and principal collections, net		(15,022	)		(22,247	)

Net cash used in investing activities		(2,914	)		(14,584	)

Cash Flows from Financing Activities
Net change in deposits		52,488			26,793
Net change in federal funds purchased and securities sold under agreements to repurchase		(42,363	)		(9,425	)
Purchase of Treasury Stock		—			(194	)
Cash dividends paid on common stock		(1,053	)		(1,007	)

Net cash provided by financing activities		9,072			16,167

Net Increase in Cash and Cash Equivalents		11,572			3,890

Cash and cash equivalents - Beginning of year		28,322			22,018

Cash and cash equivalents - End of period	$	39,894		$	25,908

Supplemental Information
Cash paid during the year for:
Interest	$	1,193		$	958

Income taxes	$	—		$	146

Noncash investing activities:
Transfer of loans to other real estate owned	$	—		$	—

See Notes to Condensed Consolidated Unaudited Financial Statements.

ITEM1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS

NOTE 1 BASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions for Form 10Q and Rule 10-01 of Regulation S-X; accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2017 are not necessarily indicative of the results that are expected for the year ended December 31, 2017. The condensed consolidated balance sheet of the Company as of December 31, 2016, has been derived from the audited consolidated balance sheet of the Company as of that date. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2016.

NOTE 2 ASSET PURCHASES

The Company recognized core deposit intangible assets of $1.09 million with the purchase of the Hicksville office on July 9, 2010. These are being amortized over an estimated remaining economic useful life of the deposits of 7 years on a straight line basis.

An office was purchased on December 13, 2013 in Custar, Ohio. Core deposit intangible assets of $1.17 million were recognized and are being amortized over its remaining economic useful life of the deposits of 7 years on a straight line basis.

The amortization expense for the year ended December 31, 2016 was $323 thousand. Of the $245 thousand to be expensed in 2017, $81 thousand has been expensed for the three months ended March 31, 2017.


	Hicksville		Custar		Total
2017		78		167		245
2018		—		167		167
2019		—		167		167
2020		—		161		161

	$	78	$	662	$	740

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ITEM 1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 3 SECURITIES

The amortized cost and fair value of securities, with gross unrealized gains and losses at March 31, 2017 and December 31, 2016, follows:


	(In Thousands)
	March 31, 2017
			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value
Available-for-Sale:
U.S. Treasury	$	19,872	$	—	$	(137	)	$	19,735
U.S. Government agencies		84,252		—		(1,612	)		82,640
Mortgage-backed securities		46,728		181		(866	)		46,043
State and local governments		58,142		626		(798	)		57,970

Total available-for-sale securities	$	208,994	$	807	$	(3,413	)	$	206,388


	(In Thousands)
	December 31, 2016
			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value
Available-for-Sale:
U.S. Treasury	$	24,920	$	1	$	(146	)	$	24,775
U.S. Government agencies		84,266		3		(1,795	)		82,474
Mortgage-backed securities		49,155		185		(879	)		48,461
State and local governments		63,173		634		(990	)		62,817

Total available-for-sale securities	$	221,514	$	823	$	(3,810	)	$	218,527

Investment securities will at times depreciate to an unrealized loss position. The Company utilizes the following criteria to assess whether impairment is other than temporary. No one item by itself will necessarily signal that a security should be recognized as an other than temporary impairment.

1.	The fair value of the security has significantly declined from book value.

2.	A downgrade has occurred that lowered the credit rating to below investment grade (below Baa3 by Moody and BBB – by Standard and Poors.)

3.	Dividends have been reduced or eliminated or scheduled interest payments have not been made.

4.	The underwater security has longer than 10 years to maturity and the loss position had existed for more than 3 years.

5.	Management does not possess both the intent and ability to hold the security for a period of time sufficient to allow for any anticipated recovery in fair value.

If the impairment is judged to be other than temporary, the cost basis of the individual security shall be written down to fair value, thereby establishing a new cost basis. The new cost basis shall not be changed for subsequent recoveries in fair value. The amount of the write down shall be included in current earnings as a realized loss. The recovery in fair value, if any, shall be recognized in earnings when the security is sold. The table below is presented by category of security and length of time in a continuous loss position. The Company currently does not hold any securities with other than temporary impairment.

ITEM 1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 3 SECURITIES (Continued)

Information pertaining to securities with gross unrealized losses at March 31, 2017 and December 31, 2016, aggregated by investment category and length of time that individual securities have been in a continuous loss position follows:


	(In Thousands)
	March 31, 2017
	Less Than Twelve Months					Twelve Months & Over
	Gross Unrealized			Fair		Gross Unrealized			Fair
	Losses			Value		Losses			Value
U.S. Treasury	$	(137	)	$	15,721	$	—		$	—
U.S. Government agencies		(1,612	)		82,640		—			—
Mortgage-backed securities		(842	)		31,224		(24	)		3,772
State and local governments		(772	)		31,657		(26	)		1,003

Total available-for-sale securities	$	(3,363	)	$	161,242	$	(50	)	$	4,775


	(In Thousands)
	December 31, 2016
	Less Than Twelve Months					Twelve Months & Over
	Gross Unrealized			Fair		Gross Unrealized			Fair
	Losses			Value		Losses			Value
U.S. Treasury	$	(146	)	$	15,745	$	—		$	—
U.S. Government agencies		(1,795	)		77,471		—			—
Mortgage-backed securities		(879	)		36,474		—			—
State and local governments		(983	)		37,540		(7	)		526

Total available-for-sale securities	$	(3,803	)	$	167,230	$	(7	)	$	526

Unrealized losses on securities have not been recognized into income because the issuers’ bonds are of high credit quality, values have only been impacted by rate changes, and the Company has the intent and ability to hold the securities for the foreseeable future. Additionally, the decline in value is primarily due to changes in interest rates since the securities were purchased. The fair value is expected to recover as the bonds approach the maturity date.

Below are the gross realized gains and losses as of March 31 for each of the years presented.


	(In Thousands)
	2017		2016
Gross realized gains	$	31	$	123
Gross realized losses		—		(10	)

Net realized gains	$	31	$	113

Tax expense related to net realized gains	$	11	$	38

The net realized gain on sales and related tax expense is a reclassification out of accumulated other comprehensive income. The net realized gain is included in net gain on sale of available-for-sale securities and the related tax expense is included in income tax expense in the condensed consolidated statements of income and comprehensive income.

ITEM 1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 3 SECURITIES (Continued)

The amortized cost and fair value of debt securities at March 31, 2017, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.


	(In Thousands)
	Amortized
	Cost		Fair Value
One year or less	$	11,669	$	11,710
After one year through five years		85,477		85,266
After five years through ten years		61,298		59,700
After ten years		3,822		3,669

Total	$	162,266	$	160,345
Mortgage-backed securities		46,728		46,043

Total	$	208,994	$	206,388

Investments with a carrying value of $87.8 million and $129.4 million at March 31, 2017 and December 31, 2016, respectively, were pledged to secure public deposits and securities sold under repurchase agreements.

Other securities include Federal Home Loan Bank of Cincinnati and Farmer Mac stock as of March 31, 2017 and December 31, 2016.

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ITEM 1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS

Loan balances as of March 31, 2017 and December 31, 2016:


	(In Thousands)
Loans:	March 31, 2017			December 31, 2016
Consumer Real Estate	$	84,465		$	86,234
Agricultural Real Estate		62,840			62,375
Agricultural		86,950			84,563
Commercial Real Estate		382,758			377,481
Commercial and Industrial		115,415			109,256
Consumer		33,840			33,179
Industrial Development Bonds		5,667			5,732

		771,935			758,820
Less: Net deferred loan fees and costs		(729	)		(726	)

		771,206			758,094
Less: Allowance for loan losses		(6,850	)		(6,784	)

Loans - Net	$	764,356		$	751,310

The following is a maturity schedule by major category of loans as of March 31, 2017:


	(In Thousands)
	Within		After One Year Within		After
	One Year		Five Years		Five Years
Consumer Real Estate	$	1,766	$	12,975	$	69,724
Agricultural Real Estate		286		4,176		58,378
Agricultural		52,159		25,435		9,356
Commercial Real Estate		6,669		112,032		264,057
Commercial and Industrial		50,749		41,073		23,593
Consumer		5,372		20,950		7,518
Industrial Development Bonds		1,032		85		4,550

The distribution of fixed rate loans and variable rate loans by major loan category is as follows as of March 31, 2017.


	Rate		Rate
Consumer Real Estate	$	48,151	$	36,314
Agricultural Real Estate		46,507		16,333
Agricultural		38,916		48,034
Commercial Real Estate		264,121		118,637
Commercial and Industrial		47,189		68,226
Consumer		29,547		4,293
Industrial Development Bonds		5,667		—

ITEM 1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

As of March 31, 2017 and December 31, 2016 one to four family residential mortgage loans amounting to $17.8 and $17.9 million, respectively, have been pledged as security for future loans the Bank has received from the Federal Home Loan Bank.

Unless listed separately, Industrial Development Bonds are included in the Commercial and Industrial category for the remainder of the tables in this Note 4.

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ITEM 1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

The following table represents the contractual aging of the recorded investment (in thousands) in past due loans by portfolio classification of loans as of March 31, 2017 and December 31, 2016, net of deferred loan fees and costs:


March 31, 2017	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Financing Receivables		Recorded Investment > 90 Days and Accruing
Consumer Real Estate	$	502	$	10	$	472	$	984	$	83,097	$	84,081	$	—
Agricultural Real Estate		169		31		101		301		62,502		62,803		—
Agricultural		—		—		—		—		87,078		87,078		—
Commercial Real Estate		1,118		—		—		1,118		381,065		382,183		—
Commercial and Industrial		—		—		—		—		121,183		121,183		—
Consumer		37		13		7		57		33,821		33,878		—

Total	$	1,826	$	54	$	580	$	2,460	$	768,746	$	771,206	$	0


December 31, 2016	30-59 Days Past Due		60-89 Days Past Due		Greater Than 90 Days		Total Past Due		Current		Total Financing Receivables		Recorded Investment > 90 Days and Accruing
Consumer Real Estate	$	882	$	15	$	507	$	1,404	$	84,469	$	85,873	$	—
Agricultural Real Estate		12		—		132		144		62,192		62,336		—
Agricultural		101		—		—		101		84,591		84,692		—
Commercial Real Estate		60		—		—		60		376,827		376,887		—
Commercial and Industrial		—		—		—		—		115,093		115,093		—
Consumer		29		6		—		35		33,178		33,213		—

Total	$	1,084	$	21	$	639	$	1,744	$	756,350	$	758,094	$	0

ITEM 1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

The following table presents the recorded investment in nonaccrual loans by class of loans as of March 31, 2017 and December 31, 2016:


	(In Thousands)
	March 31 2017		December 31, 2016
Consumer Real Estate	$	1,154	$	1,091
Agricultural Real Estate		101		132
Agricultural		—		—
Commercial Real Estate		—		—
Commercial & Industrial		158		161
Consumer		17		—

Total	$	1,430	$	1,384

Following are the characteristics and underwriting criteria for each major type of loan the Bank offers:

Commercial Real Estate: Construction, purchase, and refinance of business purpose real estate. Risks include potential construction delays and overruns, vacancies, collateral value subject to market value fluctuations, interest rate, market demands, borrower’s ability to repay in orderly fashion, and others. The Bank does employ stress testing on higher balance loans to mitigate risk by ensuring the customer’s ability to repay in a changing rate environment before granting loan approval.

Agricultural Real Estate: Purchase of farm real estate or for permanent improvements to the farm real estate. Cash flow from the farm operation is the repayment source and is therefore subject to the financial success of the farm operation.

Consumer Real Estate: Purchase, refinance, or equity financing of one to four family owner occupied dwelling. Success in repayment is subject to borrower’s income, debt level, character in fulfilling payment obligations, employment, and others.

Commercial and Industrial: Loans to proprietorships, partnerships, or corporations to provide temporary working capital and seasonal loans as well as long term loans for capital asset acquisition. Risks include adequacy of cash flow, reasonableness of projections, financial leverage, economic trends, management ability and estimated capital expenditures during the fiscal year. The Bank does employ stress testing on higher balance loans to mitigate risk by ensuring the customer’s ability to repay in a changing rate environment before granting loan approval.

Agricultural: Loans for the production and housing of crops, fruits, vegetables, and livestock or to fund the purchase or re-finance of capital assets such as machinery and equipment and livestock. The production of crops and livestock is especially vulnerable to commodity prices and weather. The vulnerability to commodity prices is offset by the farmer’s ability to hedge their position by the use of the future contracts. The risk related to weather is often mitigated by requiring federal crop insurance.

Consumer: Funding for individual and family purposes. Success in repayment is subject to borrower’s income, debt level, character in fulfilling payment obligations, employment, and others.

Industrial Development Bonds (IDB): Funds for public improvements in the Bank’s service area. Repayment ability is based on the continuance of the taxation revenue as the source of repayment.

ITEM 1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

The Bank uses a nine tier risk rating system to grade its loans. The grade of a loan may change during the life of the loan.

The risk ratings are described as follows.

Zero (0) Unclassified. Any loan which has not been assigned a classification.

One (1) Excellent. Credit to premier customers having the highest credit rating based on an extremely strong financial condition, which compares favorably with industry standards (upper quartile of Risk Management Association ratios). Financial statements indicate a sound earnings and financial ratio trend for several years with satisfactory profit margins and excellent liquidity exhibited. Prime credits may also be borrowers with loans fully secured by highly liquid collateral such as traded stocks, bonds, certificates of deposit, savings account, etc. No credit or collateral exceptions exist and the loan adheres to the Bank’s loan policy in every respect. Financing alternatives would be readily available and would qualify for unsecured credit. This grade is summarized by high liquidity, minimum risk, strong ratios, and low handling costs.

Two (2) Good. Desirable loans of somewhat less stature than Grade 1, but with strong financial statements. Loan supported by financial statements containing strong balance sheets, generally with a leverage position less than 1.50, and a history of profitability. Probability of serious financial deterioration is unlikely. Possessing a sound repayment source (and a secondary source), which would allow repayment in a reasonable period of time. Individual loans backed by liquid personal assets, established history and unquestionable character.

Three (3) Satisfactory. Satisfactory loans of average or slightly above average risk – having some deficiency or vulnerability to changing economic conditions, but still fully collectible. Projects should normally demonstrate acceptable debt service coverage. Generally, customers should have a leverage position less than 2.00. May be some weakness but with offsetting features of other support readily available. Loans that are meeting the terms of repayment.

Loans may be graded 3 when there is no recent information on which to base a current risk evaluation and the following conditions apply:

At inception, the loan was properly underwritten and did not possess an unwarranted level of credit risk:

At inception, the loan was secured with collateral possessing a loan value adequate to protect the Bank from loss;

The loan exhibited two or more years of satisfactory repayment with a reasonable reduction of the principal balance;

During the period that the loan has been outstanding, there has been no evidence of any credit weakness. Some examples of weakness include slow payment, lack of cooperation by the borrower, breach of loan covenants, or the business is in an industry which is known to be experiencing problems. If any of the credit weaknesses is observed, a lower risk grade is warranted.

Four (4) Satisfactory / Monitored. A “4” (Satisfactory/Monitored) risk grade may be established for a loan considered satisfactory but which is of average credit risk due to financial weakness or uncertainty. The loans warrant a higher than average level of monitoring to ensure that weaknesses do not advance. The level of risk in Satisfactory/Monitored classification is considered acceptable and within normal underwriting guidelines, so long as the loan is given management supervision.

Five (5) Special Mention. Loans that possess some credit deficiency or potential weakness which deserves close attention, but which do not yet warrant substandard classification. Such loans pose unwarranted financial risk that, if not corrected, could weaken the loan and increase risk in the future. The key distinctions of a 5 (Special Mention) classification are that (1) it is indicative of an unwarranted level of risk, and (2) weaknesses are considered “potential”, versus “defined”, impairments to the primary source of loan repayment and collateral.

Six (6) Substandard. One or more of the following characteristics may be exhibited in loans classified substandard:

Loans, which possess a defined credit weakness and the likelihood that a loan will be paid from the primary source, are uncertain. Financial deterioration is underway and very close attention is warranted to ensure that the loan is collected without loss.

Loans are inadequately protected by the current net worth and paying capacity of the borrower.

ITEM 1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

The primary source of repayment is weakened, and the Bank is forced to rely on a secondary source of repayment such as collateral liquidation or guarantees.

Loans are characterized by the distinct possibility that the Bank will sustain some loss if deficiencies are not corrected.

Unusual courses of action are needed to maintain a high probability of repayment.

The borrower is not generating enough cash flow to repay loan principal; however, continues to make interest payments.

The lender is forced into a subordinate position or unsecured collateral position due to flaws in documentation.

Loans have been restructured so that payment schedules, terms and collateral represent concessions to the borrower when compared to the normal loan terms.

The lender is seriously contemplating foreclosure or legal action due to the apparent deterioration in the loan.

There is significant deterioration in the market conditions and the borrower is highly vulnerable to these conditions.

Seven (7) Doubtful. One or more of the following characteristics may be exhibited in loans classified Doubtful:

Loans have all of the weaknesses of those classified as Substandard. Additionally, however, these weaknesses make collection or liquidation in full based on existing conditions improbable.

The primary source of repayment is gone, and there is considerable doubt as to the quality of the secondary source of repayment.

The possibility of loss is high, but, because of certain important pending factors which may strengthen the loan, loss classification is deferred until its exact status is known. A Doubtful classification is established deferring the realization of the loss.

Eight (8) Loss. Loans are considered uncollectable and of such little value that continuing to carry them as assets on the institution’s financial statements is not feasible. Loans will be classified Loss when it is neither practical nor desirable to defer writing off or reserving all or a portion of a basically worthless asset, even though partial recovery may be possible at some time in the future.

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ITEM 1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

The following table represents the risk category of loans by portfolio class, net of deferred fees and costs, based on the most recent analysis performed as of March 31, 2017 and December 31, 2016:


	(In Thousands)
	Agricultural Real Estate		Agricultural		Commercial Real Estate		Commercial and Industrial		Industrial Development Bonds
March 31, 2017
1-2	$	3,719	$	4,064	$	877	$	9,857	$	—
3		15,901		33,151		25,899		18,131		2,609
4		41,594		48,278		340,854		85,740		3,058
5		1,365		1,424		11,993		1,062		—
6		224		161		2,560		611		—
7		—		—		—		115		—
8		—		—		—		—		—

Total	$	62,803	$	87,078	$	382,183	$	115,516	$	5,667


	Agricultural Real Estate		Agricultural		Commercial Real Estate		Commercial and Industrial		Industrial Development Bonds
December 31, 2016
1-2	$	4,399	$	7,334	$	677	$	10,060	$	—
3		16,660		31,397		27,858		14,064		2,640
4		39,808		44,560		333,523		83,100		3,092
5		1,209		1,234		8,321		1,379		—
6		260		167		6,508		641		—
7		—		—		—		117		—
8		—		—		—		—		—

Total	$	62,336	$	84,692	$	376,887	$	109,361	$	5,732

ITEM 1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

For consumer residential real estate, and other, the Company also evaluates credit quality based on the aging status of the loan, as was previously stated, and by payment activity. The following tables present the recorded investment in those classes based on payment activity and assigned risk grading as of March 31, 2017 and December 31, 2016.


	(In Thousands)
	Consumer Real Estate		Consumer Real Estate
	March 31, 2017		December 31, 2016
Grade
Pass	$	83,560	$	85,322
Special Mention (5)		25		25
Substandard (6)		338		368
Doubtful (7)		158		158

Total	$	84,081	$	85,873


	(In Thousands)
	Consumer - Credit				Consumer - Other
	March 31, 2017		December 31, 2016		March 31, 2017		December 31, 2016
Performing	$	3,762	$	4,061	$	30,094	$	29,120
Nonperforming		—		—		22		32

Total	$	3,762	$	4,061	$	30,116	$	29,152

Information about impaired loans as of March 31, 2017, December 31, 2016 and March 31, 2016 are as follows:


	(In Thousands)
	March 31, 2017		December 31, 2016		March 31, 2016
Impaired loans without a valuation allowance	$	1,099	$	1,141	$	1,042

Impaired loans with a valuation allowance		694		711		1,169

Total impaired loans	$	1,793	$	1,852	$	2,211

Valuation allowance related to impaired loans	$	117	$	135	$	426

Total non-accrual loans	$	1,430	$	1,384	$	2,003

Total loans past-due ninety days or more and still accruing	$	—	$	—	$	—

Quarter ended average investment in impaired loans	$	1,832	$	1,684	$	2,130

Year to date average investment in impaired loans	$	1,832	$	1,802	$	2,130

No additional funds are committed to be advanced in connection with impaired loans.

ITEM 1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

The Bank had approximately $551 thousand of its impaired loans classified as troubled debt restructured (TDR) as of March 31, 2017, $0.7 million as of December 31, 2016 and $1.1 million as of March 31, 2016. During the year-to-date 2017, there were no new loans considered TDR.

The following table represents three months ended March 31, 2017.

Three Months

March 31, 2017

Troubled Debt Restructurings

Number of
Contracts
Modified in the
Last 3 Months

Pre-
Modification
Outstanding
Recorded
Investment

Post-
Modification
Outstanding
Recorded
Investment

Commercial Real Estate

—

Commercial and Industrial

—

Consumer Real Estate

—

The following table represents three months ended March 31, 2016.


Three Months March 31, 2016 Troubled Debt Restructurings	Number of Contracts Modified in the Last 3 Months		Pre- Modification Outstanding Recorded Investment		Post- Modification Outstanding Recorded Investment
Commercial Real Estate		—	$	—	$	—
Commercial and Industrial		—		—		—
Consumer Real Estate		1		138		138

For the three month period ended March 31, 2017 and 2016, there were no TDRs that subsequently defaulted after modification.

For the majority of the Bank’s impaired loans, the Bank will apply the fair value of collateral or use a measurement incorporating the present value of expected future cash flows discounted at the loan’s effective rate of interest. To determine fair value of collateral, collateral asset values securing an impaired loan are periodically evaluated. Maximum time of re-evaluation is every 12 months for chattels and titled vehicles and every two years for real estate. In this process, third party evaluations are obtained. Until such time that updated appraisals are received, the Bank may discount the collateral value used.

The Bank uses the following guidelines as stated in policy to determine when to realize a charge-off, whether a partial or full loan balance. A charge-off in whole or in part is realized when unsecured consumer loans, credit card credits and overdraft lines of credit reach 90 days delinquency. At 120 days delinquent, secured consumer loans are charged down to the value of the collateral, if repossession of the collateral is assured and/or in the process of repossession. Consumer mortgage loan deficiencies are charged down upon the sale of the collateral or sooner upon the recognition of collateral deficiency. Commercial and agricultural credits are charged down at 120 days delinquency, unless an established and approved work-out plan is in place or litigation of the credit will likely result in recovery of the loan balance. Upon notification of bankruptcy, unsecured debt is charged off. Additional charge-off may be realized as further unsecured positions are recognized.

ITEM 1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

The following tables present loans individually evaluated for impairment by class of loans for three months ended March 31, 2017 and March 31, 2016.


	(In Thousands)
											QTD
							QTD		QTD		Interest
Three Months Ended March 31, 2017			Unpaid				Average		Interest		Income
	Recorded		Principal		Related		Recorded		Income		Recognized
	Investment		Balance		Allowance		Investment		Recognized		Cash Basis
With no related allowance recorded:
Consumer Real Estate	$	998	$	998	$	—	$	1,003	$	8	$	6
Agricultural Real Estate		101		101		—		121		—		—
Agricultural		—		—		—		—		—		—
Commercial Real Estate		—		—		—		—		—		—
Commercial and Industrial		—		—		—		—		—		—
Consumer		—		—		—		—		—		—
With a specific allowance recorded:
Consumer Real Estate		83		83		23		94		—		—
Agricultural Real Estate		—		—		—		—		—		—
Agricultural		—		—		—		—		—		—
Commercial Real Estate		496		496		61		498		5		—
Commercial and Industrial		115		115		33		116		—		—
Consumer		—		—		—		—		—		—

Totals:
Consumer Real Estate	$	1,081	$	1,081	$	23	$	1,097	$	8	$	6

Agricultural Real Estate	$	101	$	101	$	—	$	121	$	—	$	—

Agricultural	$	—	$	—	$	—	$	—	$	—	$	—

Commercial Real Estate	$	496	$	496	$	61	$	498	$	5	$	—

Commercial and Industrial	$	115	$	115	$	33	$	116	$	—	$	—

Consumer	$	—	$	—	$	—	$	—	$	—	$	—

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ITEM 1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)


	(In Thousands)
											QTD
							QTD		QTD		Interest
Three Months Ended March 31, 2016			Unpaid				Average		Interest		Income
	Recorded		Principal		Related		Recorded		Income		Recognized
	Investment		Balance		Allowance		Investment		Recognized		Cash Basis
With no related allowance recorded:
Consumer Real Estate	$	365	$	365	$	—	$	156	$	3	$	3
Agricultural Real Estate		162		162		—		162		—		—
Agricultural		—		—		—		—		—		—
Commercial Real Estate		515		515		—		409		8		7
Commercial and Industrial		—		—		—		454		6		—
Consumer		—		—		—		—		—		—
With a specific allowance recorded:
Consumer Real Estate		509		628		104		307		1		—
Agricultural Real Estate		57		57		57		38		1		—
Agricultural		—		—		—		—		—		—
Commercial Real Estate		422		422		152		422		—		—
Commercial and Industrial		181		239		113		182		—		—
Consumer		—		—		—		—		—		—

Totals:
Consumer Real Estate	$	874	$	993	$	104	$	463	$	4	$	3

Agricultural Real Estate	$	219	$	219	$	57	$	200	$	1	$	—

Agricultural	$	—	$	—	$	—	$	—	$	—	$	—

Commercial Real Estate	$	937	$	937	$	152	$	831	$	8	$	7

Commercial and Industrial	$	181	$	239	$	113	$	636	$	6	$	—

Consumer	$	—	$	—	$	—	$	—	$	—	$	—

[Remainder of this page intentionally left blank]

ITEM 1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

As of March 31, 2017, the Company had $169 thousand of foreclosed residential real estate property obtained by physical possession and $190 thousand of consumer mortgage loans secured by residential real estate properties for which foreclosure proceedings are in process according to local jurisdictions. As of March 31, 2016, the Company had $456 thousand of foreclosed residential real estate property obtained by physical possession and $568 thousand of consumer mortgage loans secured by residential real estate properties for which foreclosure proceedings are in process according to local jurisdictions.

The Allowance for Loan and Lease Losses (ALLL) has a direct impact on the provision expense. An increase in the ALLL is funded through recoveries and provision expense. The following tables summarize the activities in the allowance for credit losses.


	(In Thousands)
	Three Months Ended			Twelve Months Ended
	March 31, 2017			December 31, 2016
Allowance for Loan & Lease Losses
Balance at beginning of year	$	6,784		$	6,057
Provision for loan loss		73			1,121
Loans charged off		(44	)		(550	)
Recoveries		37			156

Allowance for Loan & Lease Losses		6,850			6,784

Allowance for Unfunded Loan Commitments &
Letters of Credit	$	219		$	217

Total Allowance for Credit Losses	$	7,069		$	7,001

The Company segregates its ALLL into two reserves: The ALLL and the Allowance for Unfunded Loan Commitments and Letters of Credit (AULC). When combined, these reserves constitute the total Allowance for Credit Losses (ACL).

The AULC is reported within other liabilities on the balance sheet while the ALLL is netted within the loans, net asset line. The ACL presented above represents the full amount of reserves available to absorb possible credit losses.

[Remainder of this page intentionally left blank]

ITEM 1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)

The following table breaks down the activity within ACL for each loan portfolio classification and shows the contribution provided by both the recoveries and the provision along with the reduction of the allowance caused by charge-offs.

Additional analysis, presented in thousands, related to the allowance for credit losses for three months ended March 31, 2017 and March 31, 2016 is as follows:


	Consumer Real Estate			Agricultural Real Estate		Agricultural		Commercial Real Estate			Commercial and Industrial			Consumer			Unfunded Loan Commitment & Letters of Credit		Unallocated		Total
Three Months Ended March 31, 2017
ALLOWANCE FOR CREDIT LOSSES:
Beginning balance	$	316		$	241	$	616	$	3,250		$	1,318		$	394		$	217	$	649	$	7,001
Charge Offs		—			—		—		—			—			(44	)		—		—		(44	)
Recoveries		10			—		1		2			3			21			—		—		37
Provision (Credit)		(49	)		3		17		(244	)		(22	)		26			—		342		73
Other Non-interest expense related to unfunded		—			—		—		—			—			—			2		—		2

Ending Balance	$	277		$	244	$	634	$	3,008		$	1,299		$	397		$	219	$	991	$	7,069

Ending balance: individually evaluated for impairment	$	23		$	—	$	—	$	61		$	33		$	—		$	—	$	—	$	117

Ending balance: collectively evaluated for impairment	$	254		$	244	$	634	$	2,947		$	1,266		$	397		$	219	$	991	$	6,952

Ending balance: loans acquired with deteriorated credit quality	$	—			—		—		—			—			—			—		—	$	—

FINANCING RECEIVABLES:
Ending balance	$	84,081		$	62,803	$	87,078	$	382,183		$	121,183		$	33,878		$	—	$	—	$	771,206

Ending balance: individually evaluated for impairment	$	1,081		$	101	$	—	$	496		$	115		$	—		$	—	$	—	$	1,793

Ending balance: collectively evaluated for impairment	$	83,000		$	62,702	$	87,078	$	381,687		$	121,068		$	33,878		$	—	$	—	$	769,413

Ending balance: loans acquired with deteriorated credit quality	$	198		$	—	$	—	$	—		$	—		$	—		$	—	$	—	$	198

ITEM 1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 4 LOANS (Continued)


	Consumer Real Estate		Agricultural Real Estate		Agricultural			Commercial Real Estate			Commercial and Industrial			Consumer			Unfunded Loan Commitment & Letters of Credit		Unallocated			Total
Three Months Ended March 31, 2016
ALLOWANCE FOR CREDIT LOSSES:
Beginning balance	$	338	$	211	$	582		$	2,516		$	1,229		$	337		$	208	$	844		$	6,265
Charge Offs		—		—		—			(3	)		(20	)		(61	)		—		—			(84	)
Recoveries		2		—		4			1			3			25			—		—			35
Provision (Credit)		117		61		(38	)		164			39			34			—		(100	)		277
Other Non-interest expense related to unfunded		—		—		—			—			—			—			12		—			12

Ending Balance	$	457	$	272	$	548		$	2,678		$	1,251		$	335		$	220	$	744		$	6,505

Ending balance: individually evaluated for impairment	$	104	$	57	$	—		$	152		$	113		$	—		$	—	$	—		$	426

Ending balance: collectively evaluated for impairment	$	353	$	215	$	548		$	2,526		$	1,138		$	335		$	220	$	744		$	6,079

Ending balance: loans acquired with deteriorated credit quality	$	1		—		—			—			—			—			—		—		$	1

FINANCING RECEIVABLES:
Ending balance	$	88,097	$	59,479	$	78,021		$	344,661		$	109,386		$	28,016		$	—	$	—		$	707,660

Ending balance: individually evaluated for impairment	$	874	$	219	$	—		$	937		$	181		$	—		$	—	$	—		$	2,211

Ending balance: collectively evaluated for impairment	$	87,223	$	59,260	$	78,021		$	343,724		$	109,205		$	28,016		$	—	$	—		$	705,449

Ending balance: loans acquired with deteriorated credit quality	$	502	$	—	$	—		$	—		$	—		$	—		$	—	$	—		$	502

ITEM 1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 5 EARNINGS PER SHARE

Basic earnings per share are calculated using the two-class method. The two-class method is an earnings allocation formula under which earnings per share is calculated from common stock and participating securities according to dividends declared and participation rights in undistributed earnings. Under this method, all earnings distributed and undistributed, are allocated to participating securities and common shares based on their respective rights to receive dividends. Unvested share-based payment awards that contain non-forfeitable rights to dividends are considered participating securities (i.e. unvested restricted stock), not subject to performance based measures. Basic earnings per share is calculated by dividing net income available to common shareholders by the weighted average number of common shares outstanding. Application of the two-class method for participating securities results a more dilutive basic earnings per share as the participating securities are allocated the same amount of income as if they are outstanding for purposes of basic earnings per share. There is no additional potential dilution in calculating diluted earnings per share, therefore basic and diluted earnings per share are the same amounts. Other than the restricted stock plan, the Company has no other stock based compensation plans.


	In Thousands Three Months Ended
	March 31			March 31
Earnings per share	2017			2016
Net income	$	2,839		$	2,481
Less: distributed earnings allocated to participating securities		(10	)		(8	)
Less: undistributed earnings allocated to participating securities		(17	)		(13	)

Net earnings available to common shareholders	$	2,812		$	2,460

Weighted average common shares outstanding including participating securities		4,620,875			4,609,226
Less: average unvested restricted shares		(43,150	)		(38,670	)

Weighted average common shares outstanding		4,577,725			4,570,556

Basic earnings and diluted per share	$	0.61		$	0.54

NOTE 6 FAIR VALUE OF INSTRUMENTS

FAIR VALUE OF FINANCIAL INSTRUMENTS

Fair values of financial instruments are management’s estimate of the values at which the instruments could be exchanged in a transaction between willing parties. These estimates are subjective and may vary significantly from amounts that would be realized in actual transactions. In addition, other significant assets are not considered financial assets including deferred tax assets, premises, equipment and intangibles. Further, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on the fair value estimates and have not been considered in any of the estimates.

The following assumptions and methods were used in estimating the fair value for financial instruments:

Cash and Cash Equivalents

The carrying amounts reported in the balance sheet for cash, cash equivalents and federal funds sold approximate their fair values. Also included in this line item are the carrying amounts of interest-bearing deposits maturing within ninety days which approximate their fair values. Fair values of other interest-bearing deposits are estimated using discounted cash flow analyses based on current rates for similar types of deposits.

ITEM 1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 6 FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)

Interest Bearing Time Deposits

Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow analysis that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits.

Securities – Available-for-sale

Fair values for securities, excluding Federal Home Loan Bank and Farmer Mac stock, are based on quoted market price, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments.

Other Securities

The carrying value of Federal Home Loan Bank and Farmer Mac stock, listed as “other securities”, approximates fair value based on the redemption provisions of the Federal Home Loan Bank.

Loans Held for Sale

The carrying amount approximates fair value due to insignificant amount of time between origination and date of sale.

Loans, net

For those variable-rate loans that re-price frequently, and with no significant change in credit risk, fair values are based on carrying values. The fair values of the fixed rate and all other loans are estimated using discounted cash flow analysis, using interest rates currently being offered for loans with similar terms to borrowers with similar credit quality.

Deposits

The fair values disclosed for deposits with no defined maturities are equal to their carrying amounts, which represent the amount payable on demand. The carrying amounts for variable-rate, fixed term money market accounts and certificates of deposit approximate their fair value at the reporting date. Fair value for fixed-rate certificates of deposit are estimated using a discounted cash flow analysis that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits.

Federal Funds Purchased and Securities Sold Under Agreements to Repurchase

The carrying value of federal funds purchased and securities sold under agreements to repurchase approximates fair values.

Accrued Interest Receivable and Payable

The carrying amounts of accrued interest approximate their fair values.

Off Balance Sheet Financial Instruments

Fair values for off-balance sheet, credit related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counter-parties’ credit standing.

FHLB Advances

Fair values or FHLB advances are estimated using discounted cash flow analysis based on the Company’s current incremental borrowing rates for similar types or borrowing arrangements.

ITEM 1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 6 FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)

The estimated fair values, and related carrying or notional amounts, for on and off-balance sheet financial instruments as of March 31, 2017 and December 31, 2016 are reflected below.


	(In Thousands)
	March 31, 2017
	Carrying		Fair
	Amount		Value		Level 1		Level 2		Level 3
Financial Assets:
Cash and Cash Equivalents	$	39,894	$	39,894	$	39,894	$	—	$	—
Interest-bearing time deposits		1,845		1,845		—		1,845		—
Securities - available-for-sale		206,388		206,388		19,735		185,239		1,414
Other Securities		3,717		3,717		—		—		3,717
Loans held for sale		1,067		1,067		—		—		1,067
Loans, net		764,356		765,974		—		—		765,974
Interest receivable		4,192		4,192		—		—		4,192

Financial Liabilities:
Interest bearing Deposits	$	528,594	$	528,664	$	—	$	—	$	528,664
Non-interest bearing Deposits		178,153		178,153		—		178,153		—
Time Deposits		187,944		187,868		—		—		187,868

Total Deposits	$	894,691	$	894,685	$	—	$	178,153	$	716,532

Federal Funds Purchased and Securities Sold Under Agreement to Repurchase	$	27,961	$	27,961	$	—	$	—	$	27,961
Federal Home Loan Bank advances		10,000		10,041		—		—		10,041
Interest payable		241		241		—		—		241

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ITEM 1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 6 FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)


	(In Thousands)
	December 31, 2016
	Carrying		Fair
	Amount		Value		Level 1		Level 2		Level 3
Financial Assets:
Cash and Cash Equivalents	$	28,322	$	28,322	$	28,322	$	—	$	—
Interest-bearing time deposits		1,915		1,918		—		1,918		—
Securities - available-for-sale		218,527		218,527		24,775		192,334		1,418
Other Securities		3,717		3,717		—		—		3,717
Loans held for sale		2,055		2,055		—		—		2,055
Loans, net		751,310		753,357		—		—		753,357
Interest receivable		3,880		3,880		—		—		3,880

Financial Liabilities:
Interest bearing Deposits	$	456,983	$	456,983	$	—	$	—	$	456,983
Non-interest bearing Deposits		186,390		186,390		—		186,390		—
Time Deposits		198,830		199,658		—		—		199,658

Total Deposits	$	842,203	$	843,031	$	—	$	186,390	$	656,641

Federal Funds Purchased and Securities Sold Under Agreement to Repurchase	$	70,324	$	70,324	$	—	$	—	$	70,324
Federal Home Loan Bank advances		10,000		10,041		—		—		10,041
Interest payable		256		256		—		—		256

Fair Value Measurements

In general, fair values determined by Level 1 inputs use quoted prices in active markets for identical assets or liabilities in active markets that the Company has the ability to access.

Available-for-sale securities, when quoted prices are available in an active market, securities are valued using the quoted price and are classified as Level 1.

Fair values determined by Level 2 inputs use other inputs that are observable, either directly or indirectly. These Level 2 inputs include quoted prices for similar assets and liabilities in active markets, and other inputs such as interest rates and yield curves that are observable at commonly quoted intervals.

Available-for-sale securities classified as Level 2 are valued using the prices obtained from an independent pricing service. The prices are not adjusted. Securities of obligations of state and political subdivisions are valued using a type of matrix, or grid, pricing in which securities are benchmarked against the treasury rate based on credit rating. Substantially all assumptions used by the independent pricing service are observable in the marketplace, can be derived from observable data, or are supported by observable levels at which transactions are executed in the marketplace.

Level 3 inputs are unobservable inputs, including inputs that are available in situations where there is little, if any, market activity for the related asset or liability. The Bank holds some local municipals that the Bank evaluates based on the credit strength of the underlying project. The fair value is determined by valuing similar credit payment streams at similar rates.

In instances where inputs used to measure fair value fall into different levels in the above fair value hierarchy, fair value measurements in their entirety are categorized based on the lowest level input that is significant to the valuation. The Company’s assessment of the significance of particular inputs to these fair value measurements requires judgment and considers factors specific to each asset.

ITEM 1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 6 FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)

The following summarizes financial assets measured at fair value on a recurring basis as of March 31, 2017 and December 31, 2016, segregated by level or the valuation inputs within the fair value hierarchy utilized to measure fair value:


Assets and Liabilities Measured at Fair Value on a Recurring Basis (In Thousands)
	Quoted Prices in		Significant		Significant
	Active Markets		Observable		Observable
	for Identical		Inputs		Inputs
March 31, 2017	Assets (Level 1)		(Level 2)		(Level 3)
Assets - (Securities Available-for-Sale)
U.S. Treasury	$	19,735	$	—	$	—
U.S. Government agencies		—		82,640		—
Mortgage-backed securities		—		46,043		—
State and local governments		—		56,556		1,414

Total Securities Available-for-Sale	$	19,735	$	185,239	$	1,414


	Quoted Prices in		Significant		Significant
	Active Markets		Observable		Observable
	for Identical		Inputs		Inputs
December 31, 2016	Assets (Level 1)		(Level 2)		(Level 3)
Assets - (Securities Available-for-Sale)
U.S. Treasury	$	24,775	$	—	$	—
U.S. Government agencies		—		82,474		—
Mortgage-backed securities		—		48,461		—
State and local governments		—		61,399		1,418

Total Securities Available-for-Sale	$	24,775	$	192,334	$	1,418

ITEM 1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 6 FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)

The following table represents the changes in the Level 3 fair-value category of which unobservable inputs are relied upon as of March 31, 2017 and March 31, 2016.


	(In Thousands)
	Fair Value Measurements Using Significant
	Unobservable Inputs (Level 3)
	State and Local Governments Tax-Exempt			State and Local Governments Taxable			State and Local Governments Total
Balance at January 1, 2017	$	—		$	1,418		$	1,418
Change in Market Value		—			(4	)		(4	)
Payments & Maturities		—			—			—

Balance at March 31, 2017	$	—		$	1,414		$	1,414


	(In Thousands)
	Fair Value Measurements Using Significant
	Unobservable Inputs (Level 3)
	State and Local Governments Tax-Exempt			State and Local Governments Taxable			State and Local Governments Total
Balance at January 1, 2016	$	5,904		$	1,448		$	7,352
Change in Market Value		—			33			33
Payments & Maturities		(270	)		—			(270	)

Balance at March 31, 2016	$	5,634		$	1,481		$	7,115

Most of the Company’s available-for-sale securities, including any bonds issued by local municipalities, have CUSIP numbers or have similar characteristics of those in the municipal markets, making them marketable and comparable as Level 2.

The Company also has assets that, under certain conditions, are subject to measurement at fair value on a non-recurring basis. At March 31, 2017 and December 31, 2016, such assets consist primarily of collateral dependent impaired loans. Collateral dependent impaired loans categorized as Level 3 assets consist of non-homogeneous loans that are considered impaired. The Company estimates the fair value of the loans based on the present value of expected future cash flows using management’s best estimate of key assumptions. These assumptions include future payment ability, timing of payment streams, and estimated realizable values of available collateral (typically based on outside appraisals.)

ITEM 1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 6 FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)

At March 31, 2017 and December 31, 2016, fair value of collateral dependent impaired loans categorized as Level 3 was $577 and $576 thousand, respectively. The specific allocation for impaired loans was $117 and $135 thousand as of March 31, 2017 and December 31, 2016, respectively, which are accounted for in the allowance for loan losses (see Note 4).

Other real estate is reported at either the lower of the fair value of the real estate minus the estimated costs to sell the asset or the cost of the asset. The determination of fair value of the real estate relies primarily on appraisals from third parties. If the fair value of the real estate, minus the estimated costs to sell the asset, is less than the asset’s cost, the deficiency is recognized as a valuation allowance against the asset through a charge to expense. The valuation allowance is therefore increased or decreased, through charges or credits to expense, for changes in the asset’s fair value or estimated selling costs.

The following table presents quantitative information about unobservable inputs used in recurring and nonrecurring Level 3 fair value measurements:


	Fair Value at March 31, 2017		Valuation Technique	Unobservable Inputs	Range (Weighted Average)
State and local government	$	1,414	Discounted Cash Flow	Credit strength of underlying project or entity / Discount rate	0-5% (3.92%)
Collateral dependent Impaired Loans		577	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability	0-50% (16.95%)
Other real estate owned - residential		144	Appraisals	Discount to reflect current market	0-20% (0.0%)

	Fair Value at December 31, 2016		Valuation Technique	Unobservable Inputs	Range (Weighted Average)
State and local government	$	1,418	Discounted Cash Flow	Credit strength of underlying project or entity / Discount rate	0-5% (3.92%)
Collateral dependent Impaired Loans		576	Collateral based measurements	Discount to reflect current market conditions and ultimate collectability	0-50% (18.92%)
Other real estate owned - residential		144	Appraisals	Discount to reflect current market	0-20% (0.51%)

ITEM 1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 6 FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)

The following table presents impaired loans and other real estate owned as recorded at fair value on March 31, 2017 and December 31, 2016:


	Assets Measured at Fair Value on a Nonrecurring Basis at March 31, 2017
(In Thousands)	Balance at March 31, 2017		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Collateral dependent impaired loans	$	577	$	—	$	—	$	577
Other real estate owned - residential	$	144	$	—	$	—	$	144

Total change in fair value							$	721


	Assets Measured at Fair Value on a Nonrecurring Basis at December 31, 2016
(In Thousands)	Balance at December 31, 2016		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Collateral dependent impaired loans	$	576	$	—	$	—	$	576
Other real estate owned - residential	$	144	$	—	$	—	$	144

Total change in fair value							$	720

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ITEM 1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 7 FEDERAL FUNDS PURCHASED AND SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE

The Company had $0 and $17 million in Federal Funds Purchased as of March 31, 2017, and December 31, 2016, respectively. During the same time periods the company also had $28 million and $53 million in securities sold under agreement to repurchase.


	March 31, 2017
	Remaining Contratual Maturity of the Agreements (In Thousands)
	Overnight & Continuous		Up to 30 days		30-90 days		Greater Than 90 days		Total
Federal funds purchased	$	—	$	—	$	—	$	—	$	—
Repurchase Agreements;
US Treasury & agency securities	$	7,352	$	—	$	—	$	20,609	$	27,961

	$	7,352	$	—	$	—	$	20,609	$	27,961


	December 31, 2016
	Remaining Contratual Maturity of the Agreements (In Thousands)
	Overnight & Continuous		Up to 30 days		30-90 days		Greater Than 90 days		Total
Federal funds purchased	$	17,000	$	—	$	—	$	—	$	17,000
Repurchase Agreements;
US Treasury & agency securities	$	32,814	$	—	$	—	$	20,510	$	53,324

	$	49,814	$	—	$	—	$	20,510	$	70,324

NOTE 8 RECENT ACCOUNTING PRONOUNCEMENTS

In January 2016, the Financial Accounting Standards Board (FASB) issued ASU No. 2016-01 “Financial Instruments - Overall (Subtopic 825-10) - Recognition and Measurement of Financial Assets and Financial Liabilities.” ASU 2016-01 is intended to improve the recognition and measurement of financial instruments by requiring equity investments to be measured at fair value with changes in fair value recognized in net income; requiring public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; requiring separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or the accompanying notes to the financial statements; eliminating the requirement for public business entities to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured and amortized at cost on the balance sheet; and requiring a reporting organization to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the organization has elected to measure the liability at fair value in a accordance with the fair value option for financial instruments. ASU 2016-01 is effective for annual periods and interim periods within those annual periods, beginning after December 15, 2017. The amendments should be applied by means of a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. The amendments related to equity securities without readily determinable fair values (including disclosure requirements) should be applied prospectively to equity investments that exist as of the date of adoption. The Company is assessing the impact of ASU 2016-01 on its accounting and disclosures. While it would be preferred to run fair value adjustment through other comprehensive income, the Company would choose to limit any further fair value presentation on the financial statements.

ITEM 1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 8 RECENT ACCOUNTING PRONOUNCEMENTS (Continued)

In February 2016, the FASB issued ASU No. 2016-02 “Leases (Topic 842).” ASU 2016-02 establishes a right of use model that requires a lessee to record a right of use asset and a lease liability for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. For lessors, the guidance modifies the classification criteria and the accounting for sales-type and direct financing leases. A lease will be treated as sale if it transfers all of the risks and rewards, as well as control of the underlying asset, to the lessee. If risks and rewards are conveyed without the transfer of control, the lease is treated as a financing. If the lessor doesn’t convey risks and rewards or control, an operating lease results. The amendments are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years for public business entities. Entities are required to use a modified retrospective approach for leases that exist or are entered into after the beginning of the earliest comparative period in the financial statements, with certain practical expedients available. Early adoption is permitted. The Company is assessing the impact of ASU 2016-02 on its accounting and disclosures and currently has very limited exposure to the rule.

In March 2016, the FASB issued ASU No. 2016-09 “Compensation - Stock Compensation (Topic 718) - Improvements to Employee Share-Based Payment Accounting.” ASU 2016-09 requires all income tax effects of awards to be recognized in the income statement when the awards vest or are settled. It also allows an employer to repurchase more of an employee’s shares than it can today for tax withholding purposes without triggering liability accounting and to make a policy election for forfeitures as they occur. The guidance is effective for public business entities for fiscal years beginning after December 15, 2016, and interim periods within those years. Early adoption is permitted. The Company adopted ASU 2016-09 on January 1, 2017. ASU 2016-09 also requires that companies make an accounting policy election regarding forfeitures, to either estimate the number of awards that are expected to vest or account for them when they occur. The impact of this change and that of the remaining provisions of ASU 2016-09 did not have a significant impact on our financial statements.

In June 2016, FASB issued 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The ASU requires the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations will now use forward-looking information to better inform their credit loss estimates. Many of the loss estimation techniques applied today will still be permitted, although the inputs to those techniques will change to reflect the full amount of expected credit losses. Organizations will continue to use judgment to determine which loss estimation method is appropriate for their circumstances. The ASU requires enhanced disclosures to help investors and other financial statement users better understand significant estimates and judgments used in estimating credit losses, as well as the credit quality and underwriting standards of an organization’s portfolio. These disclosures include qualitative and quantitative requirements that provide additional information about the amounts recorded in the financial statements. In addition, the ASU amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration.

The ASU is effective for SEC filers for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019 (i.e., January 1, 2020, for calendar year entities). Early application will be permitted for all organizations for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company is currently gathering information, reviewing possible vendors and has formed a committee to formulate the methodology to be used. Most importantly, the Company is gathering as much data as possible to enable review scenarios and determine which calculations will produce the most reliable results.

In January 2017, the FASB issued ASU No. 2017-04 “Intangibles – Goodwill and other (Topic 350) – Simplifying the Test for Goodwill Impairment” These amendments eliminate Step 2 from the goodwill impairment test. The amendments also eliminate the requirements for any reporting unit with a zero or negative carrying amount to perform a qualitative assessment and, if it fails that qualitative test, to perform Step 2 of the goodwill impairment test. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. The guidance is effective for annual or any interim goodwill impairment tests in fiscal years beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment test performed on testing dates after January 1, 2017. ASU 2017-04 should be adopted on a prospective basis. The Company does not expect ASU 2017-04 to have a material impact on its accounting disclosures, as goodwill testing has been completed annually without any impairment concerns.

In March 2017, the FASB issued Accounting Standards Update (ASU) No. 2017-08 “Receivables – Nonrefundable Fees and Other Cost (Subtopic 310-20), Premium Amortization on Purchased Callable Debit Securities.” These amendments shorten the amortization period for certain callable debit securities held at a premium. Specifically, the

ITEM 1

NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)

NOTE 8 RECENT ACCOUNTING PRONOUNCEMENTS (Continued)

amendments require the premium to be amortized to the earliest call date. The amendments do not require an accounting change for securities held at a discount; the discount continues to be amortized to maturity. The guidance is effective for public business entities for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. Early adoption is permitted including adoption in an interim period. If an entity early adopts in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes the interim period. The amendments should be applied on a modified retrospective basis, with a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. The Company does have exposure and is assessing the impact of ASU 2017-08 and may choose early adoption. Overall, the Company does not expect it to have a material impact on it accounting.

ITEM 2

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

The Company continued to emphasize the importance of loan growth to overall profitability for the new year. First quarter performance for 2017 was stronger than the previous first quarter 2016. It represented a continuation of 2016’s milestone year. The increase in rate by the Federal Reserve in December 2016 and March 2017 of 25 basis points each provided the stimulus for the prime lending rate to be increased by similar amounts. Many of the Bank’s variable loans have now had spread adjustments raising the base rates equivalent to their floors or above. This has resulted in improved asset yield when coupled with loan growth.

A mild winter and higher than normal temperatures through the Company’s market area has area farmers preparing the fields with some planting. A breakeven to modest performance in 2016 did not harm the agricultural customers though some operating loans have been utilized to fund inputs for 2017. The Bank is not overly concerned as borrowers remain well capitalized and land values have only decreased slightly.

Consumer loans slowed during the first quarter while residential mortgage loans increased. Unemployment rates remain low though slight increases were evident in the Company’s most mature markets.

Manufacturing activity remains similar to last year. Low gas prices continue to help the local economies. Commercial lending remains firm with the growth in the portfolio dominated by market share increases. The Company’s growth has been largely attributable to expanding relationships with newer customers and acquiring customers from our competitors.

Loan growth drove the improvement in net interest income as compared to last year. Net income after taxes ended the first quarter 2017 14.4% above first quarter 2016. The 9.5% increase in net interest income after provision for loan losses resulted in a 13.0% increase in earnings per share for the 2017 first quarter as compared to 2016’s first quarter.

NATURE OF ACTIVITIES

Farmers & Merchants Bancorp, Inc. (the “Company”) is a financial holding company incorporated under the laws of Ohio in 1985. Our subsidiaries are, The Farmers & Merchants State Bank (the “Bank”), a community bank operating in Northwest Ohio since 1897 and Farmers & Merchants Risk Management, Inc., a captive insurance company formed in December 2014 and is located in Nevada. We report our financial condition and net income on a consolidated basis and we have only one segment.

Our executive offices are located at 307 North Defiance Street, Archbold, Ohio 43502, and our telephone number is (419) 446-2501.

The Bank opened an additional office during April of 2016 in Fort Wayne, Indiana and the office is located within the corporation limits of Huntertown, with a Fort Wayne address. The Bank has continued its expansion strategy and the new office is expected to provide new growth opportunities.

The Bank opened its twenty-fourth location in Bowling Green, Ohio in the fourth quarter 2016. It is the second leased office and was renovated to meet the Bank’s needs before opening.

ITEM 2

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

NATURE OF ACTIVITIES (Continued)

The Farmers & Merchants State Bank engages in general commercial banking and savings business including commercial, agricultural and residential mortgage, consumer and credit card lending activities. The largest segment of the lending business relates to commercial, both real estate and non-real estate. The type of commercial business ranges from small business to multi-million dollar companies. The loans are a reflection of business located within the Banks’ market area. Because the Bank’s offices are located in Northwest Ohio and Northeast Indiana, a substantial amount of the loan portfolio is comprised of loans made to customers in the farming industry for such items as farm land, farm equipment, livestock and operating loans for seed, fertilizer, and feed. Other types of lending activities include loans for home improvements, and loans for the purchase of autos, trucks, recreational vehicles, motorcycles, and other consumer goods.

The Bank also provides checking account services, as well as savings and time deposit services such as certificates of deposits. In addition, Automated Teller Machines (ATMs) are provided at most branch locations along with other independent locations such as major employers and hospitals in the market area. The Bank has custodial services for

Individual Retirement Accounts (IRAs) and Health Savings Accounts (HSAs). The Bank provides on-line banking access for consumer and business customers. For consumers, this includes bill-pay, on-line statement opportunities and mobile banking. For business customers, it provides the option of electronic transaction origination such as wire and Automated Clearing House (ACH) file transmittal. In addition, the Bank offers remote deposit capture or electronic deposit processing and merchant credit card services. Mobile banking was added in 2012 and has been widely accepted and used by consumers. Over the past couple of years, the Bank has updated its consumer offerings with “Secure” and “Pure” checking in 2014 and with KASASA Cash Back in 2015. Upgrades to our digital products and services continue to occur in both retail and business lines.

The Bank has established underwriting policies and procedures which facilitate operating in a safe and sound manner in accordance with supervisory and regulatory guidance. Within this sphere of safety and soundness, the Bank’s practice has been to not promote innovative, unproven credit products which may not be in the best interest of the Bank or its customers. The Bank does offer a hybrid mortgage loan. Hybrid loans are loans that start out as a fixed rate mortgage but after a set number of years automatically adjust to an adjustable rate mortgage. The Bank offers a three year fixed rate mortgage after which the interest rate will adjust annually. The majority of the Bank’s adjustable rate mortgages are of this type. In order to offer longer term fixed rate mortgages, the Bank does participate in the Freddie Mac, Farmer Mac and Small Business Lending programs. The Bank also normally retains the servicing rights on these partially or 100% sold loans. In order for the customer to participate in these programs they must meet the requirements established by those agencies. In addition, the Bank does sell some of its longer term fixed rate agricultural mortgages into the secondary market with the aid of a broker.

The Bank does not have a program to fund sub-prime loans. Sub-prime loans are characterized as a lending program or strategy that targets borrowers who pose a significantly higher risk of default than traditional retail banking customers.

All loan requests are reviewed as to credit worthiness and are subject to the Bank’s underwriting guidelines as to secured versus unsecured credit. Secured loans are in turn subject to loan to value (LTV) requirements based on collateral types as set forth in the Bank’s Loan Policy. In addition, credit scores of principal borrowers are reviewed and an approved exception from an additional officer is required should a credit score not meet the Bank’s Loan Policy guidelines.

Consumer Loans:

•

Maximum loan to value (LTV) for cars, trucks and light trucks vary from 90% to 110% depending on whether direct or indirect.

•

Loans above 100% are generally due to additional charges for extended warranties and/or insurance coverage periods for wage or death.

•

Boats, campers, motorcycles, RV’s and Motor Coaches range from 80%-90% based on age of vehicle.

•

1st or 2nd mortgages on 1-4 family homes range from 75%-90% with “in-house” first real estate mortgages requiring private mortgage insurance on those exceeding 80% LTV.

•

Raw land LTV maximum ranges from 65%-75% depending on whether or not the property has been improved.

ITEM 2

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

NATURE OF ACTIVITIES (Continued)

Commercial/Agriculture/Real Estate:

•

Maximum LTVs range from 70%-80% depending on type.

•

Accounts Receivable: Up to 80% LTV less retainages and greater than 90 days.

Inventory:

•

Agriculture:

Livestock and grain up to 80% LTV, crops (insured) up to 75% and Warehouse Receipts up to 87%.

•

Commercial:

Maximum LTV of 50% on raw and finished goods.

•

Floor plan:

•

New/used vehicles to 100% of wholesale.

•

New/Used recreational vehicles and manufactured homes to 80% of wholesale.

Equipment:

•

New not to exceed 80% of invoice, used NTE 50% of listed book or 75% of appraised value.

•

Restaurant equipment up to 35% of market value.

•

Heavy trucks, titled trailers up to NTE 75% LTV and aircraft up to 75% of appraised value.

F&M Investment Services, the brokerage department of the Bank, opened for business in April, 1999. Securities are offered through Raymond James Financial Services, Inc.

In December of 2014, the Company became a financial holding company within the meaning of the Bank Holding Company Act of 1956 as amended (the “Act”), in order to provide the flexibility to take advantage of the expanded powers available to a financial holding company under the Act. Our subsidiary bank is in turn regulated and examined by the Ohio Division of Financial Institutions and the Federal Deposit Insurance Corporation. The activities of our bank subsidiary are also subject to other federal and state laws and regulations. The Company also formed a captive insurance company (the “captive”) in December 2014 which is located in Nevada and regulated by the State of Nevada Division of Insurance.

The Bank’s primary market includes communities located in the Ohio counties of Defiance, Fulton, Henry, Lucas, Williams, Wood and in the Indiana counties of DeKalb and Steuben. In the second quarter of 2016 the Bank added the Indiana county of Allen to its service area with the opening of its newly constructed office in Fort Wayne. In third quarter 2016, the Bank opened its 25^th office in Bowling Green, Ohio. The new office is located next to Kroger. Bowling Green is home to Bowling Green State University and its nearly 17,000 students and more than 2,000 faculty members. Bowling Green is an exciting market supported by compelling demographics, a strong economic anchor and expanded our presence in Wood County, Ohio. The commercial banking business in this market is highly competitive, with approximately 17 other depository institutions currently doing business in the Bank’s primary market. In our banking activities, we compete directly with other commercial banks, credit unions, farm credit services, and savings and loan institutions in each of our operating localities. In a number of our locations, we compete against entities which are much larger than us. The primary factors in competing for loans and deposits are the rates charged as well as location and quality of the services provided.

At March 31, 2017, we had 272 full time equivalent employees. The employees are not represented by a collective bargaining unit. We provide our employees with a comprehensive benefit program, some of which are contributory. We consider our employee relations to be good.

REGULATORY DEVELOPMENTS

The Bank remains attentive to the current regulatory environment in light of the risk-based approach regulatory agencies use to conduct examinations. The degree of regulatory changes and the complexity of the recent new rules, which lack clarity or guidance on various provisions, and have resulted in uncertainties regarding liability, pose an increased overall risk of noncompliance. Various significant mortgage rules require ongoing monitoring by means of testing, validation of results, additional training, and further research or consultation to assist with ensuring compliance.

ITEM 2

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

REGULATORY DEVELOPMENTS (Continued)

The Bank is subject to numerous laws, rules, regulations and guidance which include to the following significant matters, yet are not limited solely to these matters, deposit insurance coverage, equal credit opportunity, fair lending; community reinvestment; anti-money laundering; suspicious activity reporting; identity theft identification and prevention; protections for military members and their dependents; flood disaster protection; mortgage servicing rights; legal lending limits; electronic fund transfers; and consumer privacy. Extensive training and training resources are necessary to develop and maintain expertise on the various regulatory matters.

Implementation of the new Military Lending Act (MLA) requirements was conducted to meet the mandatory compliance date in October 2016. Coverage of credit card accounts becomes effective on October 3, 2017. The MLA is intended to protect active duty military service members and their dependents from potentially abusive lending practices. New requirements resulted in expanded coverage of more types of loans. Safe harbor methods to identify covered borrowers who are military service members or their dependents were implemented, along with required disclosures. Training on MLA requirements was provided.

The Company has implemented Basel III capital rules which began to be phased in for the Company on January 1, 2015. These rules may impact the ability of some financial institutions to pay dividends, though the Company believes itself to be able to maintain its strong capital position and not be limited in that regard.

With regard to all regulatory matters, the Bank remains committed in making good faith efforts to comply with technical requirements of the laws, rules, regulations, and guidance from both federal and state agencies which govern its activities.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America, and the Company follows general practices within the financial services industry in which it operates. At times the application of these principles requires management to make assumptions, estimates and judgments that affect the amounts reported in the financial statements and accompanying notes.

These assumptions, estimates and judgments are based on information available as of the date of the financial statements. As this information changes, the financial statements could reflect different assumptions, estimates and judgments. Certain policies inherently have a greater reliance on assumptions, estimates and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Examples of critical assumptions, estimates and judgments are when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not required to be recorded at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability must be recorded contingent upon a future event. These policies, along with the disclosures presented in the notes to the condensed consolidated financial statements and in the management discussion and analysis of the financial condition and results of operations, provide information on how significant assets and liabilities are valued and how those values are determined for the financial statements. Based on the valuation techniques used and the sensitivity of financial statement amounts to assumptions, estimates, and judgments underlying those amounts, management has identified the determination of the ALLL, the valuation of its Mortgage Servicing Rights and the valuation of reals estate acquired through or in lieu of; loan foreclosures (“OREO Property”) as the accounting areas that require the most subjective or complex judgments, and as such could be the most subject to revision as new information becomes available.

OREO Property held for sale and is initially recorded at fair value at the date of foreclosure. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of cost or fair value minus estimated costs to sell.

Costs of holding foreclosed real estate are charged to expense in the current period, except for significant property improvements, which are capitalized. Valuations are periodically performed by management and a write-down is recorded by a charge to non-interest expense if the carrying value exceeds the fair value minus estimated costs to sell. The net income from operations of foreclosed real estate held for sale is reported either in non-interest income or non-interest expense depending upon whether the property is in a gain or loss position overall. At March 31, 2017 and December 31, 2016 OREO Property holdings were $774 thousand. OREO totaled $1.1 million as of March 31, 2016.

ITEM 2

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

CRITICAL ACCOUNTING POLICIES AND ESTIMATES (Continued)

The ALLL and ACL represents management’s estimate of probable credit losses inherent in the Bank’s loan portfolio, unfunded loan commitments, and letters of credit at the report date. The ALLL methodology is regularly reviewed for its appropriateness and is approved annually by the Board of Directors. This written methodology is consistent with Generally Accepted Accounting Principles which provides for a consistently applied analysis.

The Bank’s methodology provides an estimate of the probable credit losses either by calculating a specific loss per credit or by applying a composite of historical factors over a relevant period of time with current internal and external factors which may affect credit collectability. Such factors which may influence estimated losses are the conditions of the local and national economy, local unemployment trends, and abilities of lending staff, valuation trends of fixed assets, and trends in credit delinquency, classified credits, and credit losses.

Inherent in most estimates is imprecision. The Bank’s ALLL provides a margin for imprecision with an unallocated portion. Bank regulatory agencies and external auditors periodically review the Bank’s methodology and adequacy of the ALLL. Any required changes in the ALLL or loan charge-offs by these agencies or auditors may have a material effect on the ALLL.

The Bank is required to estimate the value of its Mortgage Servicing Rights. The Bank recognizes as separate assets rights to service fixed rate single-family mortgage loans that it has sold without recourse but services for others for a fee. Mortgage servicing assets are initially recorded at cost, based upon pricing multiples as determined by the purchaser, when the loans are sold. Mortgage servicing assets are carried at the lower of the initial carrying value, adjusted for amortization, or estimated fair value. Amortization is determined in proportion to and over the period of estimated net servicing income using the level yield method. For purposes of determining impairment, the mortgage servicing assets are stratified into like groups based on loan type, term, new versus seasoned and interest rate. The valuation is completed by an independent third party.

The expected and actual rates of mortgage loan prepayments are the most significant factors driving the potential for the impairment of the value of mortgage servicing assets. Increases in mortgage loan prepayments reduce estimated future net servicing cash flows because the life of the underlying loan is reduced.

The Bank’s mortgage servicing rights relating to loans serviced for others represent an asset. This asset is initially capitalized and included in other assets on the Company’s consolidated balance sheet. The mortgage servicing rights are then amortized against noninterest income in proportion to, and over the period of the estimated future net servicing income of the underlying mortgage servicing rights. The amortization thereof is recorded in non-interest expense. There are a number of factors, however, that can affect the ultimate value of the mortgage servicing rights to the Bank, including the estimated prepayment speed of the loan and the discount rate used to present value the servicing right. For example, if the mortgage loan is prepaid, the Bank will receive fewer servicing fees, meaning that the present value of the mortgage servicing rights is less than the carrying value of those rights on the Bank’s balance sheet. Therefore, in an attempt to reflect an accurate expected value to the Bank of the mortgage servicing rights, the Bank receives a valuation of its mortgage servicing rights from an independent third party. The independent third party’s valuation of the mortgage servicing rights is based on relevant characteristics of the Bank’s loan servicing portfolio, such as loan terms, interest rates and recent national prepayment experience, as well as current national market interest rate levels, market forecasts and other economic conditions. Management, with the advice from its third party valuation firm, reviewed the assumptions related to prepayment speeds, discount rates, and capitalized mortgage servicing income on a quarterly basis. Changes are reflected in the following quarter’s analysis related to the mortgage servicing asset. In addition, based upon the independent third party’s valuation of the Bank’s mortgage servicing rights, management then establishes a valuation allowance by each strata, if necessary, to quantify the likely impairment of the value of the mortgage servicing rights to the Bank. The estimates of prepayment speeds and discount rates are inherently uncertain, and different estimates could have a material impact on the Bank’s net income and results of operations. The valuation allowance is evaluated and adjusted quarterly by management to reflect changes in the fair value of the underlying mortgage servicing rights based on market conditions. The accuracy of these estimates and assumptions by management and its third party valuation specialist can be directly tied back to the fact that management has only been required to record minor valuation allowances through its income statement over time based upon the valuation of each stratum of servicing rights. For more information regarding the estimates and calculations used to establish the ALLL and the value of Mortgage Servicing Rights, please see Note 1 to the consolidated financial statements provided herewith.

ITEM 2

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

For more information regarding the estimates and calculations used to establish the ALLL and the value of Mortgage Servicing Rights, please see Note 1 to the consolidated financial statements provided herewith.

Servicing Rights, please see Note 1 to the consolidated financial statements provided herewith.

MATERIAL CHANGES IN FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES

The Company plans to continue in its growth mode in 2017 led by loan growth from within our newer markets. The Bank is focused on funding the loan growth with deposit growth. The Bank was able to grow deposits in the last quarter of 2016 and continued to do so in the first quarter of 2017. The Bank also decreased the level of pledged securities by offering the Insured Cash Sweep, “ICS” product accessed through the Promontory network of financial institutions. This coupled with higher cash and cash equivalent balances has improved the liquidity position of the Company.

Liquidity in terms of cash and cash equivalents ended almost $11.6 million higher as of March 31, 2017 than it was at yearend December 31, 2016. A decreased in securities held along with increased deposits funded the $13.0 million increase in net loans since yearend 2016. The largest loan growth occurred in commercial real estate and commercial and industrial portfolios. Agricultural portfolios also experienced an increase. The largest decline was in consumer real estate which was due to sales into the secondary market outpacing new originations.

In comparing to the same prior year period, the March 31, 2017 (net of deferred fees and including loans held for sale) loan balances of $772.3 million accounted for a $64.6 million or 9.1% increase when compared to 2016’s $707.7 million. The year over year improvement was made up of a 12.2% increase in commercial and industrial loans, a 10.9% increase in commercial real estate loans, a 20.9% increase in consumer loans and lastly a combined 18.5% increase in agricultural related loans (comprised of a 6.9% increase in agricultural real estate loans and 11.6% increase in non-real estate agricultural loans). Consumer real estate loans decreased by 4.2% while Industrial Development Bonds (“IDB’s”) decreased 11.7%. While the last percentage seems high, the decrease in dollars was only $753 thousand. The Company credits the growth to a strong team of lenders focused on providing customers valuable localized services and thereby increasing our market share.

The chart below shows the breakdown of the loan portfolio by category as of March 31 for the last three years, net of deferred fees and costs and including loans held for sale.


	(In Thousands)
	March-17		March-16		March-15
	Amount		Amount		Amount
Consumer Real Estate	$	84,379	$	88,097	$	97,019
Agricultural Real Estate		63,572		59,479		51,396
Agricultural		87,078		78,021		71,571
Commercial Real Estate		382,183		344,661		271,201
Commercial and Industrial		115,516		102,966		95,222
Consumer		33,878		28,016		23,627
Industrial Development Bonds		5,667		6,420		4,673

Total Loans, net	$	772,273	$	707,660	$	614,709

While the security portfolio has been utilized to fund loan growth for the last three years, additional sources have been cultivated during 2016 and 2017. The security portfolio decreased $12.1 million in the first three months 2017 from yearend 2016. The amount of pledged investment securities decreased significantly by $41.6 million as compared to yearend and $109.3 million as compared to March 31, 2016. This was accomplished by utilizing Promontory’s Insured Cash Sweep, “ICS”, product to protect Ohio public fund depositors and commercial sweep customers with FDIC coverage rather than pledge securities. This in turn improves liquidity with the additional option of selling unpledged investment securities. As of March 31, 2017, pledged investment securities totaled $87.8 million. The current portfolio is in a net unrealized loss position of $2.6 million. With the exception of stock, which is shown as other securities, all of the Company’s security portfolio is categorized as “available for sale” and as such is recorded at fair value.

ITEM 2

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

MATERIAL CHANGES IN FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES (Continued)

Management feels confident that liquidity needs for future growth can be met through additional maturities and/or sales from the security portfolio, increased deposits and additional borrowings. For short term needs, the Bank has $106.5 million of unsecured borrowing capacity through its correspondent banks.

Overall assets grew 1.1% since yearend 2016 and 5.8% since March 31, 2016. The largest growth was in the loan portfolios.

Deposits accounted for the largest growth within liabilities, up 6.2% or $52.5 million since yearend and 12.1% or $96.6 million over March 31, 2016 balances. Core deposits continue to drive the increase which provide the greatest benefit for both lower cost of funds and the opportunity to generate additional noninterest income. Compared to previous year and last quarter, a movement of funds from securities sold under agreement to repurchase into interest bearing NOW accounts occurred due to utilization of the ICS product previously mentioned. Overall, deposits grew $10.1 million since the yearend 2016 and $55.1 million as compared to a year ago March 31, 2016 excluding the movement of funds from the sweep products. This growth aided the increased liquidity position and funded the loan growth for the periods.

Time deposits decreased during the first quarter due to the runoff of short term deposits from the Promontory Network. The Promontory Network has been used by the Bank for many years to provide additional FDIC insurance coverage to the Bank’s depositors having deposits with the Bank in excess of the FDIC’s insurance limits by using Promontory’s CDARS product. When the Bank, as a member of the network, places a customer’s deposit using the CDARS service, the deposit is divided into amounts under the standard FDIC insurance maximum and placed with other Network member banks in exchange for certificates of deposit. This makes the full amount placed by the Bank eligible for FDIC coverage. The Bank used the CDARS product in a reciprocal manner previously and expanded into a “one-way” usage whereby the Bank can place or receive time deposits during the last half of 2016. The time deposits utilized were for six months or less and as they matured were not replaced.

As of March 31, 2017, the Bank had balances of $449.5 thousand in the one-way receipt of funds from the network though not due to the Bank’s usage. Rather it was due to reciprocal balance customers redeeming their time deposit early. This was the main factor in the decreased time deposits. The Bank will continue to explore additional sources of funds to supplement deposit growth and provide a base for future loan growth when necessary.

Shareholder’s equity increased by $2.1 million as of the first quarter of 2017 compared to yearend 2016, as earnings exceeded dividend declarations. Accumulated other comprehensive income decreased in loss position $252 thousand which encompassed the shift of $31 thousand from unrealized gain to realized gain with the sale of securities since yearend 2016. Dividends paid for the quarter matched the previous quarter. Compared to March 31, 2016, shareholders’ equity increased $5.0 million. Record profits during 2016 were offset by a change in accumulated other comprehensive income related to the available for sale securities portfolio from a gain of $1.4 million to a loss position of $1.7 million as of March 31, 2017. The difference in dividend payments for each of the first quarters 2016 and 2017 was just $46 thousand with 2017 the higher amount.

Basel III regulatory capital requirements became effective in 2016. The Bank and Company include a capital conservation buffer as a part of the transition provision. For calendar year 2016, the applicable required capital conservation buffer percentage of 0.625% is the base above which institutions avoid limitations on distributions and certain discretionary bonus payments. For the calendar 2017, the applicable required capital conservation buffer percentage is 1.25%. The total buffer requirement will increase to 2.5% for calendar year 2019. As of March 31, 2017, the Company and the Bank are both positioned well above the 2019 requirement.

ITEM 2

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Continued)

The Company continues to be well-capitalized in accordance with Federal regulatory capital requirements as the capital ratios below show:


Tier I Leverage Ratio	11.81	%
Risk Based Capital Tier I	14.88	%
Total Risk Based Capital	15.73	%
Stockholders’ Equity/Total Assets	12.26	%
Capital Conservation Buffer	7.73	%

MATERIAL CHANGES IN RESULTS OF OPERATIONS

Comparison of Results of Operation for three month periods ended March 31, 2017, 2016 and December 31, 2016.

When comparing first quarter 2017 to first quarter 2016, average loan balances grew $69.5 million. This represented a strong 10.0% increase in a one year time period. Interest income on loan balances also experienced an increase of $694 thousand as compared to the quarter ended March 31, 2016.

In terms of comparison to fourth quarter 2016, loan interest income was almost equivalent to first quarter 2017, just $6 thousand higher in fourth quarter 2016. The three months of fourth quarter 2016 had more days at 92 than 2017’s first quarter had with 90.

The higher levels of loan interest income helped to offset the available-for-sale securities portfolio, which decreased in average balances, whether comparing to last quarter or the previous year. The decreased balances were expected as available for sale securities were used as a source of funds for loan growth. The income associated with the security portfolio decreased by $22 thousand in comparison to fourth quarter 2016 and increased just $8 thousand in comparison to the same first quarter 2016 even though balances had decreased. The benefit of the increase in interest income from loans was well above the loss of interest income from the smaller security portfolio.

Overall, interest income for the quarter comparisons was higher for first quarter 2017 by 8.0% or $717 thousand as to first quarter 2016 and lower by 3% or $25 thousand as to last quarter 2016.

In terms of annualized yield, for the quarter ended March 31, 2017, it was 3.99% which compares to last quarter’s 4.00% and a year ago first quarter ended March 31, 2016 of 3.97%. The following chart demonstrates the value of increased loan balances in the balance sheet mix, even if offset by lower balances in other interest bearing assets. The yields on tax-exempt securities and the portion of the tax-exempt IDB loans included in loans have been tax adjusted based on a 34% tax rate in the charts to follow.

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ITEM 2

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

MATERIAL CHANGES IN RESULTS OF OPERATIONS (Continued)


	(In Thousands)
	Quarter to Date Ended March 31, 2017				Yield/Rate
	Average Balance		Interest/Dividends		March 31, 2017			March 31, 2016
Interest Earning Assets:
Loans	$	762,126	$	8,700		4.57	%		4.63	%
Taxable Investment Securities		165,528		725		1.75	%		1.60	%
Tax-exempt Investment Securities		53,623		274		3.10	%		3.43	%
Fed Funds Sold & Interest Bearing Deposits		7,921		22		1.11	%		0.50	%

Total Interest Earning Assets	$	989,198	$	9,721		3.99	%		3.97	%

Change in Quarter to Date March 31, 2017 Interest Income Compared to March 31, 2016 (In Thousands)


				Due to
	Change			Volume			Due to Rate
Interest Earning Assets:
Loans	$	694		$	794		$	(100	)
Taxable Investment Securities		55			(10	)		65
Tax-exempt Investment Securities		(43	)		(18	)		(25	)
Fed Funds Sold & Interest Bearing Deposits		11			(3	)		14

Total Interest Earning Assets	$	717		$	763		$	(46	)

Offsetting some of the increase in interest income for the quarter was the increase in cost of funds in 2016. First quarter 2017 was higher by $183 thousand than first quarter 2016. Since 2016, average interest-bearing deposit balances have increased $78 million and resulted in $176 thousand more in interest expense for the most recent quarter. Additionally, interest expense on Fed Funds Purchased, Securities Sold Under Agreement to Repurchase and FHLB borrowings was up $7 thousand in the first quarter 2017 over the same time frame in 2016.


	(In Thousands)
	Quarter to Date Ended March 31, 2017				Yield/Rate
	Average Balance		Interest/Dividends		March 31, 2017			March 31, 2016
Interest Bearing Liabilities:
Savings Deposits	$	495,556	$	491		0.40	%		0.38	%
Other Time Deposits		193,789		539		1.11	%		0.97	%
Other Borrowed Money		10,000		36		1.44	%		1.48	%
Fed Funds Purchased & Securities Sold under Agreement to Repurch.		31,409		113		1.44	%		0.63	%

Total Interest Bearing Liabilities	$	730,754	$	1,179		0.65	%		0.58	%

Change in Quarter to Date March 31, 2017 Interest Expense Compared to March 31, 2016 (In Thousands)


				Due to
	Change			Volume			Due to Rate
Interest Bearing Liabilities:
Savings Deposits	$	81		$	68		$	13
Other Time Deposits		95			28			67
Other Borrowed Money		(1	)		—			(1	)
Fed Funds Purchased & Securities Sold under Agreement to Repurch.		8			(127	)		135

Total Interest Bearing Liabilities	$	183		$	(31	)	$	214

Overall, net interest spread and net interest margin figures for the first quarter 2017 are lower than last year and down from last quarter. As the chart below illustrates, higher yields on interest and dividend income did not offset the higher interest expense in the most recent quarter when comparing to the same period a year ago or reach the levels of the previous quarter. Interest expense for the quarter as compared to last quarter increased more than the improvement to the asset yield, some of which can be attributed to a higher number of days in the last quarter compared to current quarter.

ITEM 2

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

MATERIAL CHANGES IN RESULTS OF OPERATIONS (Continued)

Fourth quarter 2016 recorded an asset yield of 4.05% for the quarter with cost of funds at 0.55%. Net interest spread and margin for fourth quarter 2016 were higher at 3.49% and 3.61% respectively as compared to current quarter shown below.


	3/31/2017			3/31/2016			3/31/2015
Interest/Dividend income/yield		3.99	%		3.97	%		3.85	%
Interest Expense / yield		0.65	%		0.58	%		0.53	%

Net Interest Spread		3.34	%		3.39	%		3.32	%

Net Interest Margin		3.51	%		3.54	%		3.45	%

Net interest income was up $534 thousand for the first quarter 2017 over the same time frame in 2016 due to the increase in loan interest income and partially offset by higher interest expense, as previously mentioned. There has also been a $123 thousand decrease in net interest income under fourth quarter 2016. As the new loans added in 2016 and 2017 generate more income, management expects the benefits of the Company’s strategy of repositioning the balance sheet to continue to widen this margin as measured in dollars.

The discussion will now be separated into two distinct quarter discussions – first quarter comparisons and the two most recent quarter comparisons.

Comparison of Noninterest Results of Operations – First Quarter 2017 to First Quarter 2016

Provision Expense

The ALLL has a direct impact on the provision expense. The increase in the ALLL is funded through recoveries and provision expense. The following tables both deal with the allowance for credit losses. The first table breaks down the activity within ALLL for each loan portfolio class and shows the contribution provided by both the recoveries and the provision along with the reduction of the allowance caused by charge-offs. The second table discloses how much of the

ALLL is attributed to each class of the loan portfolio, as well as the percent that each particular class of the loan portfolio represents to the entire loan portfolio in the aggregate. The consumer and consumer real estate loan portfolio accounted for the largest component of charge-offs and recoveries through third quarter of 2016. As was mentioned in previous discussion, the commercial real estate portfolio is currently creating a large impact on the ALLL due to the loan growth.

Total provision for loan losses was $204 thousand lower for the first quarter 2017 as compared to the same quarter 2016. Management continues to monitor asset quality, making adjustments to the provision as necessary. Loan charge-offs were $40 thousand higher in first quarter 2016 than the same quarter 2017, recoveries were lower by $2 thousand also. Combined net charge-offs were $42 thousand lower in first quarter 2017 than same time period 2016. Past due loans increased $378 thousand from March 31, 2016 to March 31, 2017, the bulk of which came from the commercial real estate portfolio but was in the 30-59 days bucket.

The following table breaks down the activity within the ALLL for each loan portfolio class and shows the contribution provided by both recoveries and the provision, along with the reduction of the allowance caused by charge-offs. The time period covered is for three months ended March 31, 2017, 2016, and 2015.

ITEM 2

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

MATERIAL CHANGES IN RESULTS OF OPERATIONS (Continued)


	(In Thousands)
	Three Months Ended March-17			Three Months Ended March-16			Three Months Ended March-15
Loans, including held for sale	$	772,273		$	707,660		$	614,709

Daily average of outstanding loans	$	762,126		$	692,638		$	610,798

Allowance for Loan & Lease Losses - January 1	$	6,784		$	6,057		$	5,905
Loans Charged off:
Consumer Real Estate		—			—			—
Agricultural Real Estate		—			—			—
Agricultural		—			—			—
Commercial Real Estate		—			3			—
Commercial and Industrial		—			20			—
Consumer		44			61			92

		44			84			92

Loan Recoveries
Consumer Real Estate		10			2			2
Agricultural Real Estate		—			—			—
Agricultural		1			4			1
Commercial Real Estate		2			1			1
Commercial and Industrial		3			3			5
Consumer		21			25			41

		37			35			50

Net Charge Offs		7			49			42
Provision for loan loss		73			277			114

Allowance for Loan & Lease Losses - March 31	$	6,850		$	6,285		$	5,977
Allowance for Unfunded Loan Commitments & Letters of Credit - March 31		219			220			202

Total Allowance for Credit Losses - March 31	$	7,069		$	6,505		$	6,179

Ratio of net charge-offs to average Loans outstanding		0.00	%		0.01	%		0.01	%

Ratio of Allowance for Loan Loss to Nonperforming Loans		478.96	%		310.50	%		246.56	%

*	Nonperforming loans are defined as all loans on nonaccrual, plus any loans past 90 days not on nonaccrual.

The Bank uses the following guidelines as stated in policy to determine when to realize a charge-off of a loan, whether partial loan balance or full loan balance. A charge down in whole or in part is realized when unsecured consumer loans, credit card credits and overdraft lines of credit reach 90 days delinquency. At 120 days delinquent, secured consumer loans are charged down to the value of the collateral, if repossession of the collateral is assured and/or in the process of repossession. Consumer mortgage loan deficiencies are charged down upon the sale of the collateral or sooner upon the recognition of collateral deficiency. Commercial and agricultural credits are charged down at 120 days delinquency, unless an established and approved work-out plan is in place or litigation of the credit will likely result in recovery of the loan balance. Upon notification of bankruptcy, unsecured debt is charged off. Additional charge-offs may be realized as further unsecured positions are recognized.

Loans classified as nonaccrual were significantly lower as of March 31, 2017 at $1.4 million compared to $2.0 million as of March 31, 2016.

In determining the allocation for impaired loans the Bank applies the appraised market value of the collateral securing the asset, reduced by applying a discount for estimated costs of collateral liquidation. In some instances where the discounted market value is less than the loan amount, a specific impairment allocation is assigned, which may be reduced or eliminated by the write down of the credit’s active principal outstanding balance.

ITEM 2

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

MATERIAL CHANGES IN RESULTS OF OPERATIONS (Continued)

For the majority of the Bank’s impaired loans, including all collateral dependent loans, the Bank will apply the appraised market value methodology. However, the Bank may also utilize a measurement incorporating the present value of expected future cash flows discounted at the loan’s effective rate of interest. To determine appraised market value, collateral asset values securing an impaired loan are periodically evaluated. Maximum time of re-evaluation is every 12 months for chattels and titled vehicles and every two years for real estate. In this process, third party evaluations are obtained and heavily relied upon. Until such time that updated appraisals are received, the Bank may discount the collateral value used.

The following table presents the balances for allowance of loan losses by loan type for three months ended March 31, 2017 and March 31, 2016.


	(In Thousands)				(In Thousands)
	March-2017				March-2016
	Amount		% of Loan Category		Amount		% of Loan Category
Balance at End of Period Applicable To:
Consumer Real Estate	$	277		10.93	$	457		12.45
Agricultural Real Estate		244		8.23		272		8.41
Agricultural		634		11.28		548		11.03
Commercial Real Estate		3,008		49.48		2,678		48.69
Commercial and Industrial		1,299		15.69		1,251		15.46
Consumer		397		4.39		335		3.96
Unallocated		991		0.00		744		0.00

Allowance for Loan & Lease Losses		6,850				6,285
Off Balance Sheet Commitments		219				220

Total Allowance for Credit Losses	$	7,069			$	6,505

Noninterest Income

Noninterest income was down $86 thousand for the first quarter 2017 over the same time frame in 2016. The Company has seen an increase in its mortgage production volume, and as such the gain on the sale of these loans was $32 thousand higher for the first quarter 2017 over the same period in 2016. Loan originations on loans held for sale for the first quarter were $14.4 million with proceeds from sale at $16.3 million for 2017 which well exceeded 2016’s first quarter activity of $12.0 million in originations and $12.4 million in sales. The net result of the activity was 2017 had $32 thousand more revenue on gain of sale. The Company was able to better take advantage of market fluctuations in its available-for-sale portfolio and sales on securities in first quarter 2016 than first quarter 2017. The gain was $82 thousand lower in the most recent quarter than the same quarter prior year. The next largest fluctuation in noninterest income was in the combined service fee lines, which was $36 thousand under same quarter last year.

The impact of mortgage servicing rights, both to income and expense, is shown in the following table which reconciles the value of mortgage servicing rights. The capitalization runs through non-interest income while the amortization thereof is included in non-interest expense. For the first quarter of 2017, mortgage servicing rights caused a net $18 thousand in income, in comparison to $52 thousand for the first quarter of 2016. The lower capitalized additions for 2017 are attributed to a lower mortgage servicing rights value being applied to the originations in 2017 as compared to 2016. For loans of 15 years and less, the value was .647% in the first quarter 2017 versus .748% in first quarter 2016. For loans over 15 years, the value was .929% versus 1.257% for the same periods respectively. The carrying value is well below the market value of $2.9 million which indicates any large expense to fund the valuation allowance to be unlikely in 2017.

ITEM 2

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

MATERIAL CHANGES IN RESULTS OF OPERATIONS (Continued)


	(In Thousands)
	2017			2016
Beginning Balance, January 1	$	2,192		$	2,056
Capitalized Additions		101			141
Amortization		(84	)		(89	)

Ending Balance, March 31		2,209			2,108
Valuation Allowance		—			—

Mortgage Servicing Rights, net March 31	$	2,209		$	2,108

Noninterest Expense

For the first quarter 2017, noninterest expenses were $85 thousand higher than for the same quarter in 2016. Salaries, wages, and employee benefits increased $221 thousand, with the addition of the Huntertown and Bowling Green offices, and normal merit increases. Data processing charges decreased $100 thousand for first quarter 2017 under the first quarter 2016. Two reasons for the improvement was the negotiation of an extended contract with our core processor and 2016 had the additional cost of upgrading Bank customer debit cards to incorporate EMV chip card technology. Both already better align with our future strategies while controlling costs.

Results overall, net income in the first quarter of 2017 was up $358 thousand as compared to the same quarter last year. The Company has done an exceptional job of growing loans while keeping past dues low. The Company remains strong, stable, and well capitalized and has the capacity to continue to cover the increased costs of expansion and doing business in a less than robust economy.

Comparison of Noninterest Results of Operations – First Quarter 2017 to Fourth Quarter 2016

Provision Expense

Total provision for loan losses was $124 thousand lower for first quarter 2017 than for fourth quarter 2016. While loan growth continued in first quarter, strong asset quality continued also. The strong asset quality and lower net charge-offs offset any need for additional provision above the $73 thousand that was expensed.

Noninterest Income

Since the fourth quarter 2016, past due loans have increased by $716 thousand. Though, net charge-offs were higher at $25 thousand for fourth quarter 2016 compared to first quarter 2017’s $7 thousand.

Noninterest income for the first quarter 2017 also was below the fourth quarter by $315 thousand. The increased number of business days in the fourth quarter 2016 as compared to first quarter 2017, provided more opportunity to transact business and generate noninterest income. All line items in fourth quarter 2016 were higher than first quarter 2017.

Noninterest Expense

Through the first quarter 2017, noninterest expenses were $205 thousand higher than in fourth quarter 2016. The effect of an increase of $42 thousand in salaries and wages was combined with an increase of $25 thousand in employee benefits. The increase in employee benefits was derived from higher costs related to medical claims for the period offset by lower pension costs due to a lower accrual for 2017 than what was paid in 2016 due to the record year and a higher profit sharing component being paid.

Data processing fees were $34 thousand higher than last quarter due to the increased number of customers, accounts and updated services. The seven year contract extension signed in the third quarter of 2016 is expected to help lower the increases while adding new products and services to better align with our customers’ expectations in the coming years. We have already added additional products in 2017, mainly focused on mobile services.

ITEM 2

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

MATERIAL CHANGES IN RESULTS OF OPERATIONS (Continued)

The next largest increase for 2017 was in other general and administrative. This line item on the income statement was up by $43 thousand over fourth quarter. As the amount is not large, it is made up of many varying activities of which no single one is notable.

Net Income

Overall, net income through the first quarter of 2017 was down $355 thousand as compared to the last quarter of 2016. The last quarter of the year tends to be a strong performance while the first quarter tends to lack. This is unchanged from last year. The more favorable result is the first quarter to first quarter comparison which shows 2017 off to a more profitable start by $358 thousand. The Company has done an exceptional job of growing loans while keeping past dues low. The growth in loans has spurred the large increase in net interest income that has flowed through to the bottom line. The opening of the new offices may create a slight drag in the short run; however, the Company remains focused on the long term.

The Company continues to look for new opportunities to generate and protect revenue and provide additional channels through which to serve our customers and maintain our high level of customer satisfaction.

FORWARD LOOKING STATEMENTS

Statements contained in this portion of the Company’s report may be forward-looking statements, as that term is defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements may be identified by the use of words such as “intend,” “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” and “potential.” Such forward-looking statements are based on current expectations, but actual results may differ materially from those currently anticipated due to a number of factors, which include, but are not limited to, factors discussed in documents filed by the Company with the Securities and Exchange Commission from time to time. Other factors which could have a material adverse effect on the operations of the Company and its subsidiaries include, but are not limited to, changes in interest rates, general economic conditions, legislative and regulatory changes, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality and composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Bank’s market area, changes in relevant accounting principles and guidelines and other factors over which management has no control. The forward-looking statements are made as of the date of this report, and the Company assumes no obligation to update the forward-looking statements or to update the reasons why actual results differ from those projected in the forward-looking statements.

ITEM 3

QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk is the exposure to loss resulting from changes in interest rates and equity prices. The primary market risk to which the Company is subject is interest rate risk. The majority of our interest rate risk arises from the instruments, positions and transactions entered into for purposes other than trading such as loans, available for sale securities, interest bearing deposits, short term borrowings and long term borrowings. Interest rate risk occurs when interest bearing assets and liabilities re-price at different times as market interest rates change. For example, if fixed rate assets are funded with variable rate debt, the spread between asset and liability rates will decline or turn negative if rates increase.

Interest rate risk is managed within an overall asset/liability framework. The principal objectives of asset/liability management are to manage sensitivity of net interest spreads and net income to potential changes in interest rates.

Funding positions are kept within predetermined limits designed to ensure that risk-taking is not excessive and that liquidity is properly managed. In the event that our asset/liabilities management strategies are unsuccessful, our profitably may be adversely affected. The Company employs a sensitivity analysis utilizing interest rate shocks to help in this analysis.

ITEM 3

QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK (Continued)

The shocks presented below assume an immediate change of rate in the percentages and directions shown covering a twelve month period:


Net Interest Margin (Ratio)	% Change to Flat Rate			Rate Direction	Rate Changes by			Cumulative Total ($000)		% Change to Flat Rate
3.16%		-0.30	%	Rising		3.00	%		32,696		2.94	%
3.18%		0.58	%	Rising		2.00	%		32,566		2.53	%
3.21%		1.33	%	Rising		1.00	%		32,439		2.13	%
3.17%		0.00	%	Flat		0.00	%		31,763		0.00	%
3.31%		4.65	%	Falling		-1.00	%		32,790		3.23	%
3.08%		-2.63	%	Falling		-2.00	%		31,085		-2.13	%
2.84%		-10.18	%	Falling		-3.00	%		29,336		-7.64	%

The net interest margin represents the forecasted twelve month margin. The Company also reviews shocks with a 4.0% fluctuation with a delayed time frame of 10 months and over a 24 month time frame. It also shows what effect rate changes will have on both the margin and net interest income. The goal of the Company is to lengthen some of the liabilities or sources of funds to decrease the exposure to a rising rate environment. Of course, customer desires also drive the ability to capture longer term deposits. Currently, the majority of customers look for terms twelve months and under while the Bank would prefer 24 months and longer. Some movement into the longer term time deposits has occurred. Compared to five years ago, what the Bank has experienced over the years is a decrease in the time balances of our deposit portfolio, therefore a loss of term funding.

The shock chart currently shows a slight tightening in net interest margin over the next twelve months in an increasing rate environment with an even lower tightening in a falling rate environment beginning at the 200 basis point shock level 3% with the Federal Reserve having raised its rates, the Company has room for widening should rates fall 1%. The model does not predict expansion of net interest income in any falling category below the 1%. Cost of funds are below 0.70% so at even the lowest shock of 100 basis points, the Bank cannot take full advantage and reprice funds to match the level of shock. Since the average duration of the majority of the assets is outside the 12 month shock period, the rising rate environment only shows minor improvement. The majority of the newer loans added to the commercial real estate portfolio begin with an initial fixed rate period of three to five years whose variable adjustment is outside of the current shock time frame. The Bank enhanced its use of the software model during 2012 by including decay rates and key rate ties on certain deposit accounts and continues to review and modify those rates as updated data is compiled. Both enhancements were based on historical performance data of the Bank. Both directional changes are within risk exposure guidelines at all levels. The effect of the rate shocks may be mitigated to the extent that not all lines of business are directly tied to an external index and actual balance sheet composition may differ from prediction.

Overall, what the chart shows is that the Company must concentrate on increasing loan spreads on variable loans and extend the duration on cost of funds where possible. Changes in portfolio and/or balance sheet composition are needed for the margin to improve regardless of any rate shock.

ITEM 4

CONTROLS AND PROCEDURES

As of March 31, 2017, an evaluation was performed under the supervision and with the participation of the Company’s management including the CEO and CFO, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on that evaluation, the Company’s management, including the CEO and CFO, concluded that the Company’s disclosure controls and procedures were effective as of March 31, 1027. There have been no changes in the Company’s internal control over financial reporting that occurred during the quarter ended March 31, 2017 that have materially affected, or are reasonably likely to materially affect, the registrant’s internal control over financial reporting.

PART II

OTHER INFORMATION

ITEM 1

LEGAL PROCEEDINGS

None

ITEM 4

CONTROLS AND PROCEDURES (continued)

ITEM 1A

RISK FACTORS

There have been no material changes in the risk factors disclosed by Registrant in its Report on Form 10-K for the fiscal year ended December 31, 2016.

ITEM 2

UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Treasury stock repurchased the quarter ended March 31, 2017 ⁽¹⁾.


Period	(a) Total Number of Shares Purchased		(b) Average Price Paid per Share		(c) Total Number of Shares Purchased as Part of Publicly Announced Plan or Programs		(d) Maximum Number of Shares that may yet be purchased under the Plans or Programs
1/1/2017 to		—		—		—		200,000
1/31/2017
2/1/2017 to		—		—		—		200,000
2/28/2017
3/1/2017 to		—		—		—		200,000
3/31/2017

Total		—		—		—		200,000

(1)	From time to time, the Company purchases shares in the market pursuant to a stock repurchase program publicly announced on January 20, 2017. On that date, the Board of Directors authorized the repurchase of 200,000 common shares between January 20, 2017 and December 31, 2017.

ITEM 3

DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4

MINE SAFETY DISCLOSURES

Not applicable

ITEM 5

OTHER INFORMATION

ITEM 6

EXHIBITS


3.1		Amended Articles of Incorporation of the Registrant (incorporated by reference to Registrant’s Quarterly Report on Form 10-Q filed with the Commission on July 27, 2016)

3.2		Code of Regulations of the Registrant (incorporated by reference to Registrant’s Quarterly Report on Form 10-Q filed with the Commission on May 10, 2004)

31.1		Rule 13-a-14(a) Certification -CEO

31.2		Rule 13-a-14(a) Certification -CFO

32.1		Section 1350 Certification - CEO

32.2		Section 1350 Certification - CFO

101.INS		XBRL Instance Document (1)

101.SCH		XBRL Taxonomy Extension Schem Document (1)

101.CAL		XBRL Taxonomy Extension Calculation Linkbase Document (1)

101.DEF		XBRL Taxonomy Extension Definition Linkbase Document (1)

101.LAB		XBRL Taxonomy Extension Label Linkbase Document (1)

101.PRE		XBRL Taxonomy Extension Presentation Linkbase Document (1)

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.


		Farmers & Merchants Bancorp, Inc.,

Date: April 26, 2017	By:	/s/ Paul S. Siebenmorgen
		Paul S. Siebenmorgen
		President and CEO

Date: April 26, 2017	By:	/s/ Barbara J. Britenriker
		Barbara J. Britenriker
		Exec. Vice-President and CFO