Farmers & Merchants Bancshares, Inc. - FORM 10-Q

Attached files

file	filename
EX-32 - EXHIBIT 32 - Farmers & Merchants Bancshares, Inc.	ex_120215.htm
EX-31.2 - EXHIBIT 31.2 - Farmers & Merchants Bancshares, Inc.	ex_120214.htm
EX-31.1 - EXHIBIT 31.1 - Farmers & Merchants Bancshares, Inc.	ex_120213.htm

UNITED STATES

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 quarterly period ended June 30, 2018

☐	TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT

For the transition period from _______________ to ________________

Commission file number 000-55756

Farmers and Merchants Bancshares, Inc.

(Exact name of registrant as specified in its charter)

Maryland

81-3605835

(State or other jurisdiction of

incorporation or organization)

(I. R. S. Employer Identification No.)

4510 Lower Beckleysville Road, Suite H, Hampstead, Maryland 21074

(Address of principal executive offices) (Zip Code)

(410) 374-1510

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter periods 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, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See definition of “large accelerated filer”, “accelerated filer”, “smaller reporting company”, and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer ☐	Accelerated filer ☐
Non-accelerated filer ☐ (Do not check if a smaller reporting company)	Smaller reporting company ☑
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. ☐

Indicate 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 outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 1,675,200 as of August 9, 2018.

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Table of Contents

Page

PART I – FINANCIAL INFORMATION		3
Item 1. Financial Statements		3
	Consolidated balance sheets at June 30, 2018 (unaudited) and December 31, 2017	3
	Consolidated statements of income (unaudited) for the three and six months ended June 30, 2018 and 2017	4
	Consolidated statements of comprehensive income (unaudited) for the three and six months Ended June 30, 2018 and 2017	5
	Consolidated statements of changes in stockholders’ equity (unaudited) for the six months ended June 30, 2018 and 2017	6
	Consolidated statements of cash flows (unaudited) for the six months ended June 30, 2018 and 2017	7
	Notes to financial statements (unaudited)	9
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		26
Item 3. Quantitative and Qualitative Disclosures About Market Risk		41
Item 4. Controls and Procedures		41

PART II – OTHER INFORMATION
Item 1. Legal Proceedings		42
Item 1A. Risk Factors		42
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		42
Item 3. Defaults upon Senior Securities		42
Item 4. Mine Safety Disclosures		42
Item 5. Other Information		42
Item 6. Exhibits		43

SIGNATURES		43

PART I – FINANCIAL INFORMATION

Item 1 – Financial Statements

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Consolidated Balance Sheets

	June 30,			December 31,
	2018			2017
	(Unaudited)
Assets

Cash and due from banks	$	6,564,122		$	6,235,186
Federal funds sold and other interest-bearing deposits		1,011,658			1,002,199
Cash and cash equivalents		7,575,780			7,237,385
Certificates of deposit in other banks		342,000			100,000
Securities available for sale		24,755,317			27,929,510
Securities held to maturity		18,215,244			18,204,182
Equity security at fair value		497,883			503,881
Federal Home Loan Bank stock, at cost		682,100			1,063,600
Mortgage loans held for sale		1,265,165			327,700
Loans, less allowance for loan losses of $2,731,955 and $2,458,911		343,874,046			332,533,706
Premises and equipment		5,176,739			5,206,271
Accrued interest receivable		1,038,809			1,020,256
Deferred income taxes		1,113,451			998,032
Other real estate owned		265,500			265,500
Bank owned life insurance		6,971,984			6,891,590
Other assets		649,327			622,856
	$	412,423,345		$	402,904,469

Liabilities and Stockholders' Equity

Deposits
Noninterest-bearing	$	62,921,659		$	64,403,133
Interest-bearing		277,354,227			255,393,291
Total deposits		340,275,886			319,796,424
Securities sold under repurchase agreements		18,521,862			21,768,507
Federal Home Loan Bank of Atlanta advances		7,500,000			17,000,000
Accrued interest payable		262,413			180,620
Other liabilities		2,551,252			2,359,986
		369,111,413			361,105,537
Stockholders' equity
Common stock, par value $.01 per share, authorized 5,000,000 shares; issued and outstanding 1,675,201 in 2018 and 1,667,813 shares in 2017		16,752			16,678
Additional paid-in capital		27,086,704			26,869,796
Retained earnings		16,896,247			15,306,625
Accumulated other comprehensive income		(687,771	)		(394,167	)
		43,311,932			41,798,932
	$	412,423,345		$	402,904,469

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

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Consolidated Statements of Income

(Unaudited)

	Three months ended June 30				Six months ended June 30
	2018		2017		2018		2017

Interest income
Loans, including fees	$	4,048,984	$	3,765,062	$	7,982,139	$	7,381,230
Investment securities - taxable		149,998		173,807		304,858		369,552
Investment securities - tax exempt		142,799		154,853		285,562		302,107
Federal funds sold and other interest earning assets		43,725		28,038		70,693		45,483
Total interest income		4,385,506		4,121,760		8,643,252		8,098,372

Interest expense
Deposits		499,916		332,879		938,326		643,684
Securities sold under repurchase agreements		35,012		37,772		69,401		84,287
Federal Home Loan Bank advances and other borrowings		45,985		41,967		108,947		70,360
Total interest expense		580,913		412,618		1,116,674		798,331
Net interest income		3,804,593		3,709,142		7,526,578		7,300,041

Provision for loan losses		75,000		75,000		125,000		125,000

Net interest income after provision for loan losses		3,729,593		3,634,142		7,401,578		7,175,041

Noninterest income
Service charges on deposit accounts		173,888		176,110		335,728		353,000
Mortgage banking income		60,468		50,952		114,661		108,733
Bank owned life insurance income		40,489		43,328		80,394		86,244
Gain on sale of loans		-		217,563		60,508		217,563
Other fees and commissions		15,651		33,785		40,320		59,242
Total noninterest income		290,496		521,738		631,611		824,782

Noninterest expense
Salaries		1,264,702		1,232,977		2,548,212		2,391,872
Employee benefits		322,568		323,626		690,022		679,167
Occupancy		189,156		167,618		366,689		351,421
Furniture and equipment		165,392		169,887		327,008		334,656
Other		687,062		680,879		1,326,239		1,321,139
Total noninterest expense		2,628,880		2,574,987		5,258,170		5,078,255

Income before income taxes		1,391,209		1,580,893		2,775,019		2,921,568
Income taxes		245,962		446,004		507,836		803,122
Net income	$	1,145,247	$	1,134,889	$	2,267,183	$	2,118,446

Earnings per share - basic and diluted	$	0.69	$	0.69	$	1.36	$	1.28

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

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Consolidated Statements of Comprehensive Income

(Unaudited)

	Three Months Ended June 30,					Six Months Ended June 30,
	2018			2017		2018			2017

Net income	$	1,145,247		$	1,134,889	$	2,267,183		$	2,118,446

Other comprehensive income (loss), net of income taxes:

Securities available for sale
Net unrealized gain (loss) arising during the period		(107,478	)		176,423		(419,439	)		182,869
Reclassification adjustment for realized gains and losses included in net income		-			-		-			-
Total unrealized gain (loss) on investment securities available for sale		(107,478	)		176,423		(419,439	)		182,869
Income tax expense (benefit) relating to investment securities available for sale		(29,576	)		69,590		(115,419	)		72,133
Total other comprehensive income (loss)		(77,902	)		106,833		(304,020	)		110,736

Total comprehensive income	$	1,067,345		$	1,241,722	$	1,963,163		$	2,229,182

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

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Consolidated Statements of Changes in Stockholders’ Equity

Six months ended June 30, 2018 and 2017

(Unaudited except for year-end amounts)

					Additional					Accumulated other			Total
	Common stock				paid-in		Retained			comprehensive			stockholders'
	Shares		Par value		capital		earnings			income			equity
Balance, December 31, 2016		1,656,390	$	16,564	$	26,562,919	$	12,713,099		$	(280,305	)	$	39,012,277

Net income		-		-		-		2,118,446			-			2,118,446
Unrealized gain on securities available for sale net of income tax expense of $72,133		-		-		-		-			110,736			110,736

Balance, June 30, 2017		1,656,390	$	16,564	$	26,562,919	$	14,831,545		$	(169,569	)	$	41,241,459


Balance, December 31, 2017		1,667,813	$	16,678	$	26,869,796	$	15,306,625		$	(394,167	)	$	41,798,932

Net income		-		-		-		2,267,183			-			2,267,183
Unrealized loss on securities available for sale net of income tax benefit of $115,419		-		-		-		-			(304,020	)		(304,020	)
Reclassification due to adoption of ASU No. 2016-01		-		-		-		(10,416	)		10,416			-
Cash dividends, $0.40 per share		-		-		-		(667,145	)		-			(667,145	)
Dividends reinvested		7,338		73		215,359		-			-			215,432
Shares issued		50		1		1,549		-			-			1,550

Balance, June 30, 2018		1,675,201	$	16,752	$	27,086,704	$	16,896,247		$	(687,771	)	$	43,311,932

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

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)

Six Months Ended June 30,	2018			2017

Cash flows from operating activities
Interest received	$	8,608,553		$	8,194,288
Fees and commissions received		502,188			520,975
Interest paid		(1,034,881	)		(753,271	)
Proceeds from sale of mortgage loans held for sale		4,785,472			5,244,483
Origination of mortgage loans held for sale		(5,722,937	)		(4,833,483	)
Cash paid to suppliers and employees		(4,751,554	)		(2,548,389	)
Income taxes paid, net of refunds received		(614,760	)		(767,251	)
		1,772,081			5,057,352

Cash flows from investing activities
Proceeds from maturity and call of securities
Available for sale		2,674,444			3,858,368
Held to maturity		-			1,054,308
Purchase of securities
Available for sale		-			(1,132,225	)
Held to maturity		-			(1,805,923	)
Purchase of certificate of deposit		(242,000	)		-
Loans made to customers, net of principal collected		(12,062,675	)		(31,504,240	)
Proceeds from sale of loans		668,508			2,752,563
(Purchase) redemption of stock in FHLB of Atlanta		381,500			(327,800	)
Purchases of premises, equipment and software		(136,117	)		(37,290	)
		(8,716,340	)		(27,142,239	)

Cash flows from financing activities
Net increase (decrease) in
Noninterest-bearing deposits		(1,481,474	)		(1,953,935	)
Interest-bearing deposits		21,960,936			17,081,711
Securities sold under repurchase agreements		(3,246,645	)		(6,222,299	)
Federal Home Loan Bank of Atlanta advances (repayments)		(9,500,000	)		9,000,000
Dividends paid, net of reinvestments		(451,713	)		-
Common stock issued		1,550			-

		7,282,654			17,905,477

Net increase (decrease) in cash and cash equivalents		338,395			(4,179,410	)

Cash and cash equivalents at beginning of period		7,237,385			13,312,915
Cash and cash equivalents at end of period	$	7,575,780		$	9,133,505

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

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)

Six Months Ended June 30,	2018			2017

Reconciliation of net income to net cash provided by operating activities
Net income	$	2,267,183		$	2,118,446
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation and amortization		194,595			216,767
Provision for loan losses		125,000			125,000
Mutual fund dividend reinvested		(5,481	)		(5,160	)
Mutual fund unrealized loss included in net income		11,479			-
Gain on sale of loans		(60,508	)		(217,563	)
Decrease (increase) in mortgage loans held for sale		(937,465	)		411,000
Amortization of premiums and accretion of discounts, net		69,248			65,503
Increase (decrease) in
Deferred loan fees		(10,665	)		86,760
Accrued interest payable		81,793			45,060
Other liabilities		191,266			366,777
Decrease (increase) in
Accrued interest receivable		(18,553	)		14,316
Bank owned life insurance cash surrender value		(80,394	)		(86,244	)
Other assets		(55,417	)		1,916,690
	$	1,772,081		$	5,057,352

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

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Unaudited)

1.	Principles of consolidation

The consolidated financial statements include the accounts of Farmers and Merchants Bancshares, Inc. and its wholly owned subsidiaries, Farmers and Merchants Bank (the “Bank”), and Series Protected Cell FCB-4 (the “Insurance Subsidiary”), and one indirect subsidiary, Reliable Community Financial Services, Inc. (collectively the “Company”, “we”, “us”, or “our”). The Insurance Subsidiary constitutes an investment in a series of membership interests, 100% owned by the Company, issued by First Community Bankers Insurance Co., LLC, a Tennessee “series” limited liability company and licensed property and casualty insurance company. Intercompany balances and transactions have been eliminated.

2.	Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and in accordance with the instructions to Form 10-Q and Rule 8-03 of Regulation S-X. Accordingly, they do not include all of the disclosures required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments necessary for a fair presentation of the results of operations for the interim periods have been made. Such adjustments were normal and recurring in nature. The results of operations for the three months and six months ended June 30, 2018 do not necessarily reflect the results that may be expected for the entire fiscal year ending December 31, 2018 or any future interim period. The consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes for the year ended December 31, 2017, which are included in Farmers and Merchants Bancshares, Inc.’s Annual Report on Form 10-K.

Recent Accounting Pronouncements

In January 2016, the Financial Accounting Standards Board (the “FASB”) issued Accounting Standards Update (“ASU”) 2016-01, “Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities.” The amendments in ASU 2016-01, among other things: (i) requires equity investments (except those accounted for under the equity method of accounting, or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income; (ii) requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset (i.e., securities or loans and receivables); and (iii) eliminates the requirement to disclose the fair value of financial instruments measured at amortized cost. The amendments within this ASU are effective for fiscal years beginning after December 15, 2017, and for interim periods within those fiscal years. The new guidance permits early adoption of the provision that exempts private companies and not-for-profit organizations from having to disclose at fair value information about financial instruments measured at amortized cost. The Company adopted the provisions of ASU 2016-01, effective January 1, 2018, by recording a $10,416 adjustment to retained earnings and reclassifying the Company’s ownership of a mutual fund, considered an equity security, to a separate line on the consolidated balance sheet as of December 31, 2017.

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Unaudited)

2. Basis of Presentation (continued)

In February 2016, the FASB issued ASU No. 2016-02, “Leases (Topic 841).” Among other things, ASU 2016-02 will require lessees to recognize the following for all leases (with the exception of short-term leases) at the commencement date: (i) a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis; and (ii) a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. Under the new guidance, lessor accounting is largely unchanged. Certain targeted improvements were made to align, where necessary, lessor accounting with the lessee accounting model and Topic 606, Revenue from Contracts with Customers. The amendments in this ASU are effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early application is permitted upon issuance. Lessees (for capital and operating leases) and lessors (for sales-type, direct financing, and operating leases) must apply a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The modified retrospective approach would not require any transition accounting for leases that expired before the earliest comparative period presented. Lessees and lessors may not apply a full retrospective transition approach. The Company anticipates that the impact of ASU 2016-02’s implementation will be an equal increase in assets and liabilities by approximately $1,500,000.

In June 2016, the FASB issued ASU 2016-13, “Financial Instruments – Credit Losses”. The ASU sets forth a “current expected credit loss” (CECL) model which requires the Company to measure all expected credit losses for financial instruments held at the reporting date based on historical experience, current conditions, and reasonable supportable forecasts. This replaces the existing incurred loss model and is applicable to the measurement of credit losses on financial assets measured at amortized cost and applies to some off-balance sheet credit exposures. This ASU is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. The Company is currently assessing the impact of the adoption of this ASU on its consolidated financial statements and has begun developing an implementation plan.

In March 2017, the FASB issued ASU 2017-08, “Receivables-Nonrefundable Fees and Other Costs (Subtopic 310-20) – Premium Amortization on Purchased Callable Debt Securities.” ASU 2017-08 shortens the amortization period for certain callable debt securities held at a premium. Specifically, the 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. ASU 2017-08 will be effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018 and is not expected to have a material impact on our financial statements.

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

(Unaudited)

3.	Investment Securities

Investments in debt securities are summarized as follows:

Amortized

Unrealized

Fair

June 30, 2018

cost

gains

losses

value

Available for sale

State and municipal

1,508,353

22,453

10,779

1,520,027

SBA pools

3,032,118

43,460

2,988,658

Mortgage-backed securities

21,163,725

917,093

20,246,632

25,704,196

22,453

971,332

24,755,317

Held to maturity

State and municipal

18,215,244

132,811

218,852

18,129,203

	Amortized		Unrealized		Unrealized		Fair
December 31, 2017	cost		gains		losses		value

Available for sale

State and municipal	$	1,510,848	$	38,494	$	10,135	$	1,539,207
SBA pools		3,212,771		75		13,000		3,199,846
Mortgage-backed securities		23,735,332		8,787		553,662		23,190,457
	$	28,458,951	$	47,356	$	576,797	$	27,929,510

Held to maturity

State and municipal	$	18,204,182	$	225,349	$	121,904	$	18,307,627

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(Unaudited)

3.	Investment Securities (continued)

Contractual maturities, shown below, will differ from actual maturities because borrowers and issuers may have the right to call or prepay obligations with or without call or prepayment penalties.

	Available for Sale				Held to Maturity
	Amortized		Fair		Amortized		Fair
June 30, 2018	cost		value		cost		value

Within one year	$	-	$	-	$	675,383	$	676,420
Over one to five years		261,799		251,020		1,101,989		1,116,837
Over five to ten years		870,695		888,142		1,461,581		1,493,790
Over ten years		375,859		380,865		14,976,291		14,842,156
		1,508,353		1,520,027		18,215,244		18,129,203
Mortgage-backed securities and SBA pools, due in monthly installments		24,195,843		23,235,290		-		-
	$	25,704,196	$	24,755,317	$	18,215,244	$	18,129,203

December 31, 2017

Within one year	$	-	$	-	$	165,677	$	168,260
Over one to five years		-		-		780,336		794,512
Over five to ten years		1,133,940		1,150,564		1,792,019		1,831,833
Over ten years		376,908		388,643		15,466,150		15,513,022
		1,510,848		1,539,207		18,204,182		18,307,627
Mortgage-backed securities and SBA pools, due in monthly installments		26,948,103		26,390,303		-		-
	$	28,458,951	$	27,929,510	$	18,204,182	$	18,307,627

Securities with a carrying value of $28,425,591 and $31,982,381 as of June 30, 2018 and December 31, 2017, respectively, were pledged as collateral for Federal Home Loan Bank advances, government deposits and securities sold under repurchase agreements.

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(Unaudited)

3.	Investment Securities (continued)

The following table sets forth the Company’s gross unrealized losses on a continuous basis for investments in debt securities, by category and length of time, at June 30, 2018 and December 31, 2017.

June 30, 2018	Less than 12 months				12 months or more				Total
Description of investments	Fair Value		Unrealized Loss		Fair Value		Unrealized Loss		Fair Value		Unrealized Loss

State and municipal	$	3,673,970	$	43,225	$	2,900,289	$	186,406	$	6,574,259	$	229,631
SBA pools		481,592		6,552		2,507,066		36,908		2,988,658		43,460
Mortgage-backed securities		2,661,167		90,365		17,585,465		826,728		20,246,632		917,093
Total	$	6,816,729	$	140,142	$	22,992,820	$	1,050,042	$	29,809,549	$	1,190,184

December 31, 2017	Less than 12 months				12 months or more				Total
			Unrealized				Unrealized				Unrealized
Description of investments	Fair value		losses		Fair value		losses		Fair value		losses

State and municipal	$	812,630	$	1,519	$	3,444,443	$	130,520	$	4,257,073	$	132,039
SBA pools		551,780		1,903		2,109,832		11,097		2,661,612		13,000
Mortgage-backed securities		2,871,597		41,413		19,571,511		512,249		22,443,108		553,662
Total	$	4,236,007	$	44,835	$	25,125,786	$	653,866	$	29,361,793	$	698,701

Management has the ability and intent to hold securities classified as held to maturity until they mature, at which time the Company should receive full value for the securities. As of June 30, 2018 and December 31, 2017, management did not have the intent to sell any of the held to maturity or available for sale securities with unrealized losses before a recovery of cost. The unrealized losses detailed in the table above were due to increases in market interest rates over the yields available at the time the underlying securities were purchased as well as other market conditions for each particular security based upon the structure and remaining principal balance. The fair values of the investment securities are expected to recover as the securities approach their maturity dates or repricing dates or if market yields for such investments decline. Based on the foregoing factors, as of June 30, 2018 and December 31, 2017, management believes that these unrealized losses are temporary and, accordingly, have not been recognized in the Company’s consolidated statement of income.

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(Unaudited)

Loans

Major categories of loans are as follows:

	June 30,		December 31,
	2018		2017

Real estate:
Commercial	$	242,116,569	$	234,026,574
Construction and land development		22,494,576		18,160,366
Residential		59,418,252		59,241,416
Commercial		22,675,755		23,613,543
Consumer		493,483		554,017
		347,198,635		335,595,916
Less: Allowance for loan losses		2,731,955		2,458,911
Deferred origination fees net of costs		592,634		603,299
	$	343,874,046	$	332,533,706

Non-accrual loans, segregated by class of loans, were as follows:

	June 30,		December 31,
	2018		2017

Commercial real estate	$	1,693,826	$	2,245,743

At June 30, 2018, the Company had two nonaccrual commercial real estate loans totaling $1,693,826. The loans were secured by real estate and business assets, and were personally guaranteed. Gross interest income of $0 and $34,259 would have been recorded for the three and six months ended June 30, 2018, respectively, if these nonaccrual loans had been current and performing in accordance with the original terms. The Company allocated $225,701 of its allowance for loan losses for these nonaccrual loans.

At December 31, 2017, the Company had one nonaccrual commercial real estate loan totaling $2,245,743. The loan was secured by real estate and business assets, and was personally guaranteed. Gross interest income of $82,070 would have been recorded in 2017 if this nonaccrual loan had been current and performing in accordance with the original terms. The Company allocated $127,213 of its allowance for loan losses for this nonaccrual loan. The balance of the nonaccrual loan was net of charge-offs of $275,000 at December 31, 2017.

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(Unaudited)

4.	Loans (continued)

An age analysis of past due loans, segregated by type of loan, is as follows:

					90 Days								Past Due 90
	30 - 59 Days		60 - 89 Days		or More		Total				Total		Days or More
	Past Due		Past Due		Past Due		Past Due		Current		Loans		and Accruing
June 30, 2018
Real estate:
Commercial	$	-	$	-	$	1,693,826	$	1,693,826	$	240,422,743	$	242,116,569	$	-
Construction and land development		-		-		-		-		22,494,576		22,494,576		-
Residential		-		-		45,816		45,816		59,372,436		59,418,252		45,816
Commercial		-		-		-		-		22,675,755		22,675,755		-
Consumer		-		-		-		-		493,483		493,483		-
Total	$	-	$	-	$	1,739,642	$	1,739,642	$	345,458,993	$	347,198,635	$	45,816

December 31, 2017
Real estate:
Commercial	$	-	$	-	$	2,245,743	$	2,245,743	$	231,780,831	$	234,026,574	$	-
Construction and land development		-		-		-		-		18,160,366		18,160,366		-
Residential		-		-		146,459		146,459		59,094,957		59,241,416		146,459
Commercial		-		-		-		-		23,613,543		23,613,543		-
Consumer		-		-		-		-		554,017		554,017		-
Total	$	-	$	-	$	2,392,202	$	2,392,202	$	333,203,714	$	335,595,916	$	146,459

Impaired loans, segregated by class of loans, are set forth in the following table:

Unpaid

Recorded

Contractual

Investment

Total

Average

Principal

With No

With

Recorded

Interest

Balance

Allowance

Investment

Allowance

Investment

Recognized

June 30, 2018

Commercial real estate

3,852,180

2,158,354

1,693,826

3,852,180

225,701

4,517,681

54,435

December 31, 2017

Commercial real estate

5,458,182

2,937,439

2,245,743

5,183,182

127,213

2,591,591

268,652

Impaired loans also include certain loans that have been modified in troubled debt restructurings (“TDRs”) where economic concessions have been granted to borrowers who have experienced or are expected to experience financial difficulties. These concessions typically result from the Company’s loss mitigation activities and could include reductions in the interest rate, payment extensions, forgiveness of principal, forbearance, or other actions. Certain TDRs are classified as nonperforming at the time of restructure and may only be returned to performing status after considering the borrower’s sustained repayment performance for a reasonable period, generally six months.

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(Unaudited)

4.	Loans (continued)

At June 30, 2018, the Company had three loans classified as a TDR. The loans are included in impaired loans above and are commercial real estate loans with an aggregate balance of $3,852,180. One of the loans totaling $2,158,354 is paying as agreed and the other two totaling $1,693,826 are more than 90 days delinquent.

At December 31, 2017, the Company had three commercial real estate loans totaling $2,937,439 classified as TDRs. Two loans totaling $774,274 were restructured as TDRs during 2017 and were paid off during the quarter ended June 30, 2018. All are included in impaired loans above. The remaining loan is paying as agreed. There have been no charge-offs or allowances associated with these three loans.

As part of our portfolio risk management, the Company assigns a risk grade to each loan. The factors used to determine the grade are the payment history of the loan and the borrower, the value of the collateral and net worth of the guarantor, and cash flow projections of the borrower. Excellent, Above Average, Average and Acceptable grades are assigned to loans with limited or no delinquent payments and more than sufficient collateral and/or cash flow.

A description of the general characteristics of loans characterized as watch list or classified is as follows:

Pass/Watch

Loans graded as Pass/Watch are secured by generally acceptable assets which reflect above-average risk. The loans warrant closer scrutiny by management than is routine, due to circumstances affecting the borrower, the borrower’s industry, or the overall economic environment. Borrowers may reflect weaknesses such as inconsistent or weak earnings, break even or moderately deficit cash flow, thin liquidity, minimal capacity to increase leverage, or volatile market fundamentals or other industry risks. Such loans are typically secured by acceptable collateral, at or near appropriate margins, with realizable liquidation values.

Special Mention

A special mention loan has potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the Company’s credit position at some future date. Special mention loans are not adversely classified and do not expose the Company to sufficient risk to warrant adverse classification.

Borrowers may exhibit poor liquidity and leverage positions resulting from generally negative cash flow or negative trends in earnings. Access to alternative financing may be limited to finance companies for business borrowers and may be unavailable for commercial real estate borrowers.

Substandard

A substandard loan is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Substandard loans have a well-defined weakness, or weaknesses, that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected.

Borrowers may exhibit recent or unexpected unprofitable operations, an inadequate debt service coverage ratio, or marginal liquidity and capitalization. These loans require more intense supervision by Company management.

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(Unaudited)

4.	Loans (continued)

Doubtful

A doubtful loan has all the weaknesses inherent in a substandard loan with the added characteristic that the weaknesses, based on currently existing facts, conditions, and values, make collection or liquidation in full highly questionable and improbable.

Loans by credit grade, segregated by loan type, are as follows:

Above

Pass

Special

June 30, 2018

Excellent

average

Average

Acceptable

watch

mention

Substandard

Doubtful

Total

Real estate:

Commercial

5,558,119

114,537,206

94,808,467

17,361,596

7,527,095

2,324,086

242,116,569

Construction and land development

1,222,941

7,310,422

9,438,403

4,522,810

22,494,576

Residential

40,075

1,337,672

30,523,560

23,430,988

3,442,182

643,775

59,418,252

Commercial

407,224

68,234

12,894,917

9,167,619

137,761

22,675,755

Consumer

90,521

313,676

57,817

2,040

29,429

493,483

447,299

8,277,487

165,579,781

136,903,294

25,464,349

7,527,095

2,969,901

29,429

347,198,635

			Above						Pass		Special
December 31, 2017	Excellent		average		Average		Acceptable		watch		mention		Substandard		Doubtful		Total

Real estate:
Commercial	$	-	$	6,115,925	$	127,639,361	$	79,619,726	$	9,041,882	$	5,391,589	$	3,972,348	$	2,245,743	$	234,026,574
Construction and land development		-		173,633		9,288,372		4,978,964		3,719,397		-		-		-		18,160,366
Residential		53,948		1,260,128		35,254,016		18,659,174		3,363,570		-		650,580		-		59,241,416
Commercial		1,581,878		121,919		16,225,350		5,545,562		138,834		-		-		-		23,613,543
Consumer		5,210		96,484		351,093		70,171		-		-		2,640		28,419		554,017
	$	1,641,036	$	7,768,089	$	188,758,192	$	108,873,597	$	16,263,683	$	5,391,589	$	4,625,568	$	2,274,162	$	335,595,916

The Company’s allowance for loan losses is based on management’s evaluation of the risks inherent in the Company’s loan portfolio and the general economy. The allowance for loan losses is maintained at the amount management considers adequate to cover estimated losses in loans receivable that are deemed probable based on information currently known to management. The allowance is based upon a number of factors, including current economic conditions, actual loss experience by pools of similar loans, diversification and size of the portfolio, adequacy of the collateral, the amount of non-performing loans and industry trends. In addition, various regulatory agencies, as an integral part of their examination processes, periodically review the Company’s allowance for loan losses. Such agencies may require the Company to make additional provisions for estimated loan losses based upon judgments different from those of management.

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(Unaudited)

4.	Loans (Continued)

The following table details activity in the allowance for loan losses by portfolio for the six months ended June 30, 2018 and 2017, and the year ended December 31, 2017. Allocation of a portion of the allowance to one category of loans does not preclude its availability to absorb losses in other categories.

Allowance for loan losses

Outstanding loan

Provision

ending balance evaluated

balances evaluated

Beginning

for loan

Charge

Ending

for impairment:

June 30, 2018

balance

losses

offs

Recoveries

balance

Individually

Collectively

Individually

Collectively

Real estate:

Commercial

1,867,397

39,796

154,500

2,061,693

225,701

1,835,992

3,852,180

238,264,389

Construction and land development

223,274

34,898

(10,622

)

247,550

22,494,576

Residential

247,953

7,914

255,867

59,418,252

Commercial

87,353

(7,632

)

4,166

83,887

22,675,755

Consumer

7,027

(173

)

6,854

493,483

Unallocated

25,907

50,197

76,104

2,458,911

125,000

(10,622

)

158,666

2,731,955

225,701

2,506,254

3,852,180

343,346,455

												Allowance for loan losses				Outstanding loan
			Provision									ending balance evaluated				balances evaluated
	Beginning		for loan			Charge				Ending		for impairment:				for impairment:
June 30, 2017	balance		losses			offs		Recoveries		balance		Individually		Collectively		Individually		Collectively

Real estate:
Commercial	$	1,717,749	$	120,972		$	-	$	1,780	$	1,840,501	$	-	$	1,840,501	$	3,136,252	$	229,552,790
Construction and land development		204,860		59,606			-		-		264,466		37,700		226,766		573,820		14,591,305
Residential		247,437		12,253			-		147		259,837		-		259,837		-		57,961,821
Commercial		125,260		(27,036	)		-		-		98,224		-		98,224		145,719		20,468,951
Consumer		8,826		(1,377	)		-		-		7,449		-		7,449		-		667,428
Unallocated		58,954		(39,418	)		-		-		19,536		-		19,536		-		-
	$	2,363,086	$	125,000		$	-	$	1,927	$	2,490,013	$	86,859	$	2,452,313	$	3,855,791	$	323,242,295

													Allowance for loan losses				Outstanding loan
			Provision										ending balance evaluated				balances evaluated
	Beginning		for loan			Charge					Ending		for impairment:				for impairment:
December 31, 2017	balance		losses			offs			Recoveries		balance		Individually		Collectively		Individually		Collectively

Real estate:
Commercial	$	1,717,749	$	419,868		$	(275,000	)	$	4,780	$	1,867,397	$	127,213	$	1,740,184	$	5,183,182	$	228,843,392
Construction and land development		204,860		65,850			(47,436	)		-		223,274		-		223,274		-		18,160,366
Residential		247,437		368			-			148		247,953		-		247,953		-		59,241,416
Commercial		125,260		(41,240	)		-			3,333		87,353		-		87,353		-		23,613,543
Consumer		8,826		(1,799	)		-			-		7,027		-		7,027		-		554,017
Unallocated		58,954		(33,047	)		-			-		25,907		-		25,907		-		-
	$	2,363,086	$	410,000		$	(322,436	)	$	8,261	$	2,458,911	$	127,213	$	2,331,698	$	5,183,182	$	330,412,734

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(Unaudited)

5.	Capital Standards

Farmers and Merchants Bancshares, Inc. and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possible additional, discretionary actions by the regulators that, if undertaken, could have a direct material effect on our financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. Our capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

The Basel III Capital Rules became effective for the Bank on January 1, 2015 (subject to a phase-in period for certain provisions). Quantitative measures established by the Basel III Capital Rules to ensure capital adequacy require the maintenance of minimum amounts and ratios (set forth in the table below) of Common Equity Tier 1 capital, Tier 1 capital, and Total capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital to adjusted quarterly average assets (as defined).

In connection with the adoption of the Basel III Capital Rules, the Bank elected to opt-out of the requirement to include accumulated other comprehensive income in Common Equity Tier 1 capital. Common Equity Tier 1 capital for the Bank is reduced by goodwill and other intangible assets, net of associated deferred tax liabilities and subject to transition provisions.

Under the revised prompt corrective action requirements, as of January 1, 2015, insured depository institutions are required to meet the following in order to qualify as “well capitalized”: (i) a common equity Tier 1 risk-based capital ratio of 6.5%; (ii) a Tier 1 risk-based capital ratio of 8%; (iii) a total risk-based capital ratio of 10%; and (iv) a Tier 1 leverage ratio of 5%. Management believes that, as of June 30, 2018, the Bank met all capital adequacy requirements under the Basel III Capital Rules on a fully phased-in basis as if such requirements were fully in effect.

The implementation of the capital conservation buffer began on January 1, 2016, at the 0.625% level and will be phased in over a four-year period (increasing by that amount on each subsequent January 1, until it reaches 2.5% on January 1, 2019). The Basel III Capital Rules also provide for a “countercyclical capital buffer” that is applicable to only certain covered institutions and does not have current applicability to the Bank. Management believes that, as of June 30, 2018, the Bank met all capital adequacy requirements under the Basel III Capital Rules on a fully phased-in basis as if such requirements were currently in effect.

The aforementioned capital conservation buffer is designed to absorb losses during periods of economic stress. Banking institutions with a ratio of Common Equity Tier 1 capital to risk-weighted assets above the minimum but below the conservation buffer (or below the combined capital conservation buffer and countercyclical capital buffer, when the latter is applied) will face constraints on dividends, equity repurchases, and compensation based on the amount of the shortfall.

The following table presents actual and required capital ratios as of June 30, 2018 and December 31, 2017, for the Bank under the Basel III Capital Rules. The minimum required capital amounts presented include the minimum required capital levels as of June 30, 2018 and December 31, 2017 based on the phase-in provisions of the Basel III Capital Rules. Capital levels required to be considered well capitalized are based upon prompt corrective action regulations, as amended to reflect the changes under the Basel III Capital Rules. Capital ratios of the Company are substantially the same as the Bank’s.

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(Unaudited)

5.	Capital Standards (continued)

Minimum

Capital Adequacy

To Be Well

(Dollars in thousands)

Actual

Phase-In Schedule

Capitalized

June 30, 2018

Amount

Ratio

Amount

Ratio

Amount

Ratio

Total capital (to risk-weighted assets)

45,577

12.61

35,698

9.88

36,150

10.00

Tier 1 capital (to risk-weighted assets)

42,845

11.85

28,468

7.88

28,920

8.00

Common equity tier 1 (to risk- weighted assets)

42,845

11.85

23,046

6.38

23,497

6.50

Tier 1 leverage (to average assets)

42,845

10.35

16,565

4.00

20,706

5.00

						Minimum
						Capital Adequacy					To Be Well
(Dollars in thousands)	Actual					Phase-In Schedule					Capitalized
December 31, 2017	Amount		Ratio			Amount		Ratio			Amount		Ratio

Total capital (to risk-weighted assets)	$	44,039		12.54	%	$	32,477		9.25	%	$	35,110		10.00	%
Tier 1 capital (to risk-weighted assets)		41,580		11.84	%		25,455		7.25	%		28,088		8.00	%
Common equity tier 1 (to risk- weighted assets)		41,580		11.84	%		20,188		5.75	%		22,822		6.50	%
Tier 1 leverage (to average assets)		41,580		10.31	%		16,135		4.00	%		20,169		5.00	%

As of June 30, 2018, the most recent notification from the FDIC has categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain ratios as set forth in the table. There have been no conditions or events since that notification that management believes have changed the Bank’s category.

The FDIC, through formal or informal agreement, has the authority to require an institution to maintain higher capital ratios than those provided by statute, to be categorized as well capitalized under the regulatory framework for prompt corrective action.

6. Fair Value

Accounting standards define fair value as the price that would be received upon the sale of an asset or paid upon the transfer of a liability in an orderly transaction between market participants. The price in the principal market used to measure the fair value of the asset or liability is not adjusted for transaction costs. Market participants are buyers and sellers in the principal market that are (i) independent, (ii) knowledgeable, (iii) able to transact and (iv) willing to transact.

The standards require the use of valuation techniques that are consistent with the market approach, the income approach and/or the cost approach. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets and liabilities. The income approach uses valuation techniques to convert future amounts, such as cash flows or earnings, to a single present amount on a discounted basis. The cost approach is based on the amount that currently would be required to replace the service capacity of an asset (replacement cost). Valuation techniques should be consistently applied. Inputs to valuation techniques refer to the assumptions that market participants would use in pricing the asset or liability. The standards establish a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs.

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(Unaudited)

6. Fair Value (continued)

The fair value hierarchy is as follows:

●

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

●

Level 2: Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.

●

Level 3: Significant unobservable inputs that reflect the Company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The Company uses the following methods and significant assumptions to estimate the fair values of the following assets:

●

Securities available for sale: The fair values of securities available for sale are determined by obtaining quoted prices from a nationally recognized securities pricing agent. If quoted market prices are not available, fair value is determined using quoted market prices for similar securities.

●

Other real estate owned (“OREO”): Nonrecurring fair value adjustments to OREO reflect full or partial write-downs that are based on the OREO’s observable market price or current appraised value of the real estate. Since the market for OREO is not active, OREO subjected to nonrecurring fair value adjustments based on the current appraised value of the real estate are classified as Level 3. The appraised value is obtained annually from an independent third party appraiser and is reduced by expected sales costs, which has historically been 10% of the appraised value.

●

Impaired loans: Nonrecurring fair value adjustments to impaired loans reflect full or partial write-downs and reserves that are based on the impaired loan’s observable market price or current appraised value of the collateral. Since the market for impaired loans is not active, such loans subjected to nonrecurring fair value adjustments based on the current appraised value of the collateral are classified as Level 3. The appraised value is obtained annually from an independent third party appraiser and is reduced by expected sales costs, which has historically been 10% of the appraised value.

The following table summarizes financial assets measured at fair value on a recurring and nonrecurring basis as of June 30, 2018 and December 31, 2017, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(Unaudited)

6. Fair Value (continued)

	Carrying Value:
	Level 1		Level 2		Level 3		Total
June 30, 2018

Recurring
Available for sale securities
State and municipal	$	-	$	1,520,027	$	-	$	1,520,027
SBA pools		-		2,988,658		-		2,988,658
Mortgage-backed securities		-		20,246,632		-		20,246,632
	$	-	$	24,755,317	$	-	$	24,755,317

Equity security at fair value
Mutual fund	$	497,883	$	-	$	-	$	497,883

Nonrecurring
Other real estate owned	$	-	$	-	$	265,500	$	265,500
Impaired loans		-		-		3,626,479		3,626,479

December 31, 2017

Recurring
Available for sale securities
State and municipal	$	-	$	1,539,207	$	-	$	1,539,207
SBA pools		-		3,199,846		-		3,199,846
Mortgage-backed securities		-		23,190,457		-		23,190,457
	$	-	$	27,929,510	$	-	$	27,929,510

Equity security at fair value
Mutual fund	$	503,881	$	-	$	-	$	503,881

Nonrecurring
Other real estate owned	$	-	$	-	$	265,500	$	265,500
Impaired loans		-		-		5,055,969		5,055,969

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(Unaudited)

6. Fair Value (continued)

The estimated fair value of financial instruments that are reported at amortized cost in the Company’s consolidated balance sheets, segregated by the level of the valuation inputs were as follows:

June 30, 2018

December 31, 2017

Carrying

Estimated

Carrying

Estimated

Amount

Fair Value

Amount

Fair Value

Financial assets

Level 1 inputs

Cash and cash equivalents

7,575,780

7,237,385

Level 2 inputs

Securities held to maturity

18,215,244

18,129,203

18,204,182

18,307,627

Mortgage loans held for sale

1,265,165

1,279,388

327,700

332,558

Federal Home Loan Bank stock

682,100

1,063,600

Level 3 inputs

Loans, net

343,874,046

340,906,635

332,533,706

332,689,848

Financial liabilities

Level 1 inputs

Noninterest-bearing deposits

62,921,659

64,403,133

Securities sold under repurchase agreements

18,521,862

21,768,507

Level 2 inputs

Interest-bearing deposits

277,354,227

260,584,227

255,393,291

244,403,281

Federal Home Loan Bank advances

7,500,000

7,454,000

17,000,000

16,957,000

The fair value of mortgage loans held for sale is determined by the expected sales price. Beginning in the first quarter 2018 the fair value of loans were determined using an exit price methodology as prescribed by ASU 2016-01, which became effective in the first quarter of 2018. The exit price estimation of fair value is based on the present value of the expected cash flows. The projected cash flows are based on the contractual terms of the loans, adjusted for prepayments and use of a discount rate based on the relative risk of the cash flows, taking into account the loan type, maturity of the loan, liquidity risk, servicing costs, and a required return on debt and capital (Level 3). In addition, an incremental liquidity discount is applied to certain loans, using historical sales of loans during periods of similar economic conditions as a benchmark. In comparison, loan fair values as of December 31, 2017 were estimated based on an entrance price methodology. As a result, the fair value adjustments as of June 30, 2018 and December 31, 2017 are not comparable.

The fair values of interest-bearing checking, savings, and money market deposit accounts are equal to their carrying amounts. The fair values of fixed-maturity time deposits are estimated based on interest rates currently offered for deposits of similar remaining maturities.

The fair value of credit commitments are considered to be the same as the contractual amounts, and are not included in the table above. These commitments generate fees that approximate those currently charged to originate similar commitments.

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(Unaudited)

7.	Earnings per Share

Basic earnings per share is determined by dividing net income available to stockholders by the weighted-average number of shares of common stock outstanding during the period and does not include the effect of any potentially dilutive common stock equivalents, giving retroactive effect to stock dividends declared during the period. Diluted earnings per share is determined in the same manner, except that the weighted-average number of shares of common stock outstanding is adjusted for the dilutive effect of outstanding common stock equivalents. The following table sets forth the calculation of basic and diluted earnings per share for the six-and three-month periods ended June 30, 2018 and 2017. There were no common stock equivalents outstanding for the six-and three-month periods ended June 30, 2018 or 2017.

	Three months ended June 30,				Six months ended June 30,
	2018		2017		2018		2017

Net income	$	1,145,247	$	1,134,889	$	2,267,183	$	2,118,446

Weighted average shares outstanding		1,667,943		1,656,390		1,667,889		1,656,390

Earnings per share - basic and diluted	$	0.69	$	0.69	$	1.36	$	1.28

8.	Retirement Plans

The Company has a profit sharing plan qualifying under Section 401(k) of the Internal Revenue Code. All employees age 21 or more with six months of service are eligible for participation in the plan. The Company matches employee contributions up to 4% of total compensation and may make additional discretionary contributions. Employee and employer contributions are 100% vested when made. The Company’s contributions to this plan were $39,334 and $36,286 for the three months ended June 30, 2018 and 2017, respectively, and $87,988 and $79,746 for the six months ended June 30, 2018 and 2017, respectively.

The Company has entered into agreements with 12 employees to provide certain life insurance benefits payable in connection with policies of life insurance on those employees that are owned by the Company. Each of the agreements provides for the amount of death insurance benefits to be paid to beneficiaries of the insured. For this plan, the Company expensed $1,419 and $1,307 for the three months ended June 30, 2018 and 2017, respectively, and $2,837 and $2,614 for the six months ended June 30, 2018 and 2017, respectively.

In 2010 and 2015, the Company adopted supplemental executive retirement plans for three of its executives. The plans provide cash compensation to the executive officers under certain circumstances, including a separation of service. The benefits vest over the period from adoption to a specified age for each executive. The Company recorded expenses, including interest, of $60,000 and $63,600 for the three months ended June 30, 2018 and 2017, respectively, and $120,000 and $127,200 for the six months ended June 30, 2018 and 2017, respectively, for these plans.

Retirement plan expenses are included in employee benefits on the consolidated statements of income.

Farmers and Merchants Bancshares, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Continued)

(Unaudited)

9. Subsequent Events

The Company has evaluated subsequent events for potential recognition and/or disclosure through the date the consolidated financial statements were issued. No significant subsequent events were identified which would affect the presentation of the financial statements.

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

Introduction

The following discussion and analysis is intended as a review of material changes in and significant factors affecting the financial condition and results of operations of Farmers and Merchants Bancshares, Inc. and its consolidated subsidiaries for the periods indicated. This discussion and analysis should be read in conjunction with the unaudited consolidated financial statements and the notes thereto contained in Item 1 of Part I of this report. References in this report to “us”, “we”, “our”, and “the Company” are to Farmers and Merchants Bancshares, Inc. and, unless the context clearly suggests otherwise, its consolidated subsidiaries.

Forward-Looking Statements

This report may contain forward-looking statements within the meaning of The Private Securities Litigation Reform Act of 1995. Readers of this report should be aware of the speculative nature of “forward-looking statements.” Statements that are not historical in nature, including those that include the words “intend”, “believe”, “estimate”, “predict”, “potential”, or “continue” or the negative of those words and other comparable words, are based on current expectations, estimates and projections about, among other things, the industry and the markets in which we operate, and they are not guarantees of future performance. Whether actual results will conform to expectations and predictions is subject to known and unknown risks and uncertainties, including risks and uncertainties discussed in this report; general economic, market, or business conditions; changes in interest rates, deposit flow, the cost of funds, and demand for loan products and financial services; changes in our competitive position or competitive actions by other companies; changes in the quality or composition of our loan and investment portfolios; our ability to manage growth; changes in laws or regulations or policies of federal and state regulators and agencies; and other circumstances beyond our control. Consequently, all of the forward-looking statements made in this report are qualified by these cautionary statements, and there can be no assurance that the actual results anticipated will be realized, or if substantially realized, will have the expected consequences on our business or operations. These and other risks are discussed in detail in the registration statements and periodic reports that Farmers and Merchants Bancshares, Inc. files with the Securities and Exchange Commission (the “SEC”) (see Item 1A of Part II of this report for further information). Except as required by applicable laws, we do not intend to publish updates or revisions of any forward-looking statements we make to reflect new information, future events or otherwise.

Farmers and Merchants Bancshares, Inc.

Farmers and Merchants Bancshares, Inc. is a Maryland corporation and a financial holding company registered with the Board of Governors of the Federal Reserve System (the “FRB”) under the Bank Holding Company Act of 1956, as amended. The Company was incorporated on August 8, 2016 for the purpose of becoming the holding company of Farmers and Merchants Bank (the “Bank”) in a share exchange transaction that was intended to constitute a tax-free exchange under Section 351 of the Internal Revenue Code of 1986, as amended (the “Reorganization”). The Reorganization was consummated on November 1, 2016, at which time the Bank became a wholly-owned subsidiary of the Company and all of the Bank’s stockholders became stockholders of the Company by virtue of the conversion of their shares of common stock of the Bank into an equal number of shares of common stock of the Company.

The Company’s primary business activities are serving as the parent company of the Bank and holding a series investment in First Community Bankers Insurance Co., LLC, a Tennessee “series” limited liability company and licensed protected cell captive insurance company (“FCBI”). The Company owns 100% of one series of membership interests issued by FCBI, which series is deemed a “protected cell” under Tennessee law and has been designated “Series Protected Cell FCB-4” (such series investment is hereinafter referred to as the “Insurance Subsidiary”).

The Bank is a Maryland commercial bank chartered on October 24, 1919 that is engaged in a general commercial and retail banking business. The Bank has had one inactive subsidiary, Reliable Community Financial Services, Inc., a Maryland corporation that was incorporated in April 1992 to facilitate the sale of fixed rate annuity products and later positioned to sell a full array of investment and insurance products.

The Insurance Subsidiary represents one protected cell of a protected cell captive insurance company (FCBI) that was formed on November 9, 2016 to better manage our risk programs, provide insurance efficiencies, and add operating income by both keeping insurance premiums paid with respect to such risks within our affiliated group of entities and realizing certain tax benefits that are unique to captive insurance companies. The Company’s investment in the Insurance Subsidiary represents one series of membership interests in FCBI. As a “series” limited liability company, FCBI is authorized by state law and its governing instruments to issue one or more series of membership interests, each of which, for all purposes under state law, is deemed to be a legal entity separate and apart from FCBI and its other series.

The Company maintains an Internet site at www.fmb1919.com on which it makes available, free of charge, its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to the foregoing as soon as reasonably practicable after these reports are electronically filed with, or furnished to, the SEC.

Estimates and Critical Accounting Policies

This discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent liabilities. See Note 1 of the Notes to the audited consolidated financial statements as of and for the year ended December 31, 2017, which were included in Item 8 of Part II of Farmers and Merchants Bancshares, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2017. On an on-going basis, management evaluates estimates, including those related to loan losses and intangible assets, other-than-temporary impairment (“OTTI”) of investment securities, income taxes, and fair value of investments. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Management believes the following critical accounting policies affect our more significant judgments and estimates used in the preparation of the consolidated financial statements.

The allowance for loan losses represents management’s estimate of probable loan losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the balance sheet.

Management does not believe that any material changes in our critical accounting policies have occurred since December 31, 2017.

Financial Condition

Total assets increased by $9,518,876 or 2.4% during the first half of 2018 to $412,423,345 at June 30, 2018 from $402,904,469 at December 31, 2017. The increase in total assets was due primarily to increases of $11,340,340 in loans and $937,465 in loans held for sale, offset by a decrease of $3,174,193 in securities available for sale.

Total liabilities increased $8,005,876 or 2.2% during the first half of 2018 to $369,111,413 at June 30, 2018 from $361,105,537 at December 31, 2017. The increase was due primarily to an increase of $20,479,462 in deposits, offset by reductions of $9,500,000 in advances from the Federal Home Loan Bank of Atlanta (“FHLB”) and $3,246,645 in securities sold under repurchase agreements.

Stockholders’ equity increased by $1,513,000 during the first half of 2018 to $43,311,932 at June 30, 2018 from $41,798,932 at December 31, 2017. The increase was due primarily to net income for the period of $2,267,183, offset by dividends paid, net of reinvestments, of $451,713 and a decrease of $293,604 in accumulated other comprehensive income.

Loans

Major categories of loans at June 30, 2018 and December 31, 2017 are as follows:

	June 30,				December 31,
	2018				2017

Real estate:
Commercial	$	242,116,569	70	%	$	234,026,574	70	%
Construction/Land development		22,494,576	6	%		18,160,366	5	%
Residential		59,418,252	17	%		59,241,416	18	%
Commercial		22,675,755	7	%		23,613,543	7	%
Consumer		493,483	0	%		554,017	0	%
		347,198,635	100	%		335,595,916	100	%
Less: Allowance for loan losses		2,731,955				2,458,911
Deferred origination fees net of costs		592,634				603,299
	$	343,874,046			$	332,533,706

Loans increased by $11,340,340 or 3.4% to $343,874,046 at June 30, 2018 from $332,533,706 at December 31, 2017. The growth was due primarily to an $8,089,995 increase in commercial real estate loans and a $4,334,210 increase in construction/land development loans, offset by a reduction in commercial loans of $937,788. The allowance for loan losses increased $273,044 to $2,731,955 at June 30, 2018, compared to $2,458,911 at December 31, 2017.

The Company has adopted policies and procedures that seek to mitigate credit risk and to maintain the quality of the loan portfolio. These policies include underwriting standards for new credits as well as the continuous monitoring and reporting of asset quality and the adequacy of the allowance for loan losses. These policies, coupled with continuous training efforts, have provided effective checks and balances for the risk associated with the lending process. Lending authority is based on the level of risk, size of the loan, and the experience of the lending officer. The Company’s policy is to make the majority of its loan commitments in the market area it serves. Management believes that this tends to reduce risk because management is familiar with the credit histories of loan applicants and has in-depth knowledge of the risk to which a given credit is subject. Although the loan portfolio is diversified, its performance will be influenced by the economy of the region.

An age analysis of past due loans, segregated by class of loans, as of June 30, 2018 and December 31, 2017, is as follows:

					90 Days								Past Due 90
	30 - 59 Days		60 - 89 Days		or more		Total				Total		Days or More
	Past Due		Past Due		Past Due		Past Due		Current		Loans		and Accruing
June 30, 2018
Real estate:
Commerical	$	-	$	-	$	1,693,826	$	1,693,826	$	240,422,743	$	242,116,569	$	-
Construction/Land development		-		-		-		-		22,494,576		22,494,576		-
Residential		-		-		45,816		45,816		59,372,436		59,418,252		45,816
Commercial		-		-		-		-		22,675,755		22,675,755		-
Consumer		-		-		-		-		493,483		493,483		-

Total	$	-	$	-	$	1,739,642	$	1,739,642	$	345,458,993	$	347,198,635	$	45,816

					90 Days								Past Due 90
	30 - 59 Days		60 - 89 Days		or more		Total				Total		Days or More
	Past Due		Past Due		Past Due		Past Due		Current		Loans		and Accruing
December 31, 2017
Real estate:
Commerical	$	-	$	-	$	2,245,743	$	2,245,743	$	231,780,831	$	234,026,574	$	-
Construction/Land development		-		-		-		-		18,160,366		18,160,366		-
Residential		-		-		146,459		146,459		59,094,957		59,241,416		146,459
Commercial		-		-		-		-		23,613,543		23,613,543		-
Consumer		-		-		-		-		554,017		554,017		-

Total	$	-	$	-	$	2,392,202	$	2,392,202	$	333,203,714	$	335,595,916	$	146,459

It is the Company’s policy to place a loan in nonaccrual status whenever there is substantial doubt about the ability of the borrower to pay principal or interest on any outstanding credit. Management considers such factors as payment history, the nature of the collateral securing the loan, and the overall economic situation of the borrower when making a nonaccrual decision. Management closely monitors nonaccrual loans. The Company returns a nonaccrual loan to accruing status when (i) the loan is brought current with the full payment of all principal and interest arrearages, (ii) all contractual payments are thereafter made on a timely basis for at least six months, and (iii) management determines, based on a credit review, that it is reasonable to expect that future payments will be made as and when required by the contract.

Non-accrual loans as of June 30, 2018 and December 31, 2017, segregated by class of loans, were as follows:

	June 30,		December 31,
	2018		2017

Commercial real estate	$	1,693,826	$	2,245,743

At June 30, 2018, the Company had two nonaccrual commercial real estate loans totaling $1,693,826. The loans were secured by real estate and business assets, and were personally guaranteed. Gross interest income of $0 and $34,259 would have been recorded for the three and six months ended June 30, 2018, respectively, if these nonaccrual loans had been current and performing in accordance with their original terms. The Company allocated $225,701 of its allowance for loan losses for these nonaccrual loans.

At June 30, 2018, the Company had one loan totaling $45,816 that was delinquent 90 days or greater other than the nonaccrual loans discussed above. The loan was secured by residential real estate.

Impaired loans as of June 30, 2018 and December 31, 2017 are set forth in the following table:

	June 30,		December 31,
	2018		2017

Impaired loans with no valuation allowance	$	2,158,354	$	2,937,439
Impaired loans with a valuation allowance		1,693,826		2,245,743
Total impaired loans	$	3,852,180	$	5,183,182

At June 30, 2018, the Company had three loans classified as a TDR. The loans are included in impaired loans above and are commercial real estate loans with a balance of $3,852,180. One of the loans totaling $2,158,354 is paying as agreed and the other two totaling $1,693,826 are more than 90 days delinquent.

At December 31, 2017, the Company had three commercial real estate loans totaling $2,937,439 classified as TDRs. Two loans totaling $774,274 were restructured as TDRs during 2017 and were paid off during the quarter ended March 31, 2018. All are included in impaired loans above. The remaining loan is paying as agreed. There have been no charge-offs or allowances associated with these three loans.

	June 30,		December 31,
	2018		2017

Restructured loans (TDRs):
Performing as agreed	$	2,158,354	$	2,937,439
Not performing as agreed		1,693,826		-
Total TDRs	$	3,852,180	$	2,937,439

The allowance for loan losses is a reserve established through a provision for loan losses charged to expense. The allowance for loan losses represents an amount which, in management’s judgment, will be adequate to absorb probable losses on existing loans and other extensions of credit that may become uncollectible. The Company’s allowance for loan loss methodology includes allowance allocations calculated in accordance with Accounting Standards Codification (“ASC”) Topic 310, “Receivables” and allowance allocations calculated in accordance with ASC Topic 450, “Contingencies.” Accordingly, the methodology is based on historical loss experience by type of credit and internal risk grade, specific homogeneous risk pools and specific loss allocations, with adjustments for current events and conditions.

The Company’s process for determining the appropriate level of the allowance for loan losses is designed to account for credit deterioration as it occurs. The provision for loan losses reflects loan quality trends, including the levels of and trends related to non-accrual loans, past due loans, potential problem loans, classified and criticized loans and net charge-offs or recoveries, among other factors.

Although management believes that, based on information currently available, the Company’s allowance for loan losses is sufficient to cover losses inherent in its loan portfolio at this time, no assurances can be given that the Company’s level of allowance for loan losses will be sufficient to cover future loan losses incurred by the Company or that future adjustments to the allowance for loan losses will not be necessary if economic and other conditions differ substantially from the economic and other conditions at the time management determined the current level of the allowance for loan losses.

													Allowance for loan losses				Outstanding loan
			Provision										ending balance evaluated				balances evaluated
	Beginning		for loan			Charge					Ending		for impairment:				for impairment:
June 30, 2018	balance		losses			offs			Recoveries		balance		Individually		Collectively		Individually		Collectively

Real estate:
Commercial	$	1,867,397	$	39,796		$	-		$	154,500	$	2,061,693	$	225,701	$	1,835,992	$	3,852,180	$	238,264,389
Construction and land development		223,274		34,898			(10,622	)		-		247,550		-		247,550		-		22,494,576
Residential		247,953		7,914			-			-		255,867		-		255,867		-		59,418,252
Commercial		87,353		(7,633	)		-			4,166		83,887		-		83,887		-		22,675,755
Consumer		7,027		(173	)		-			-		6,854		-		6,854		-		493,483
Unallocated		25,907		50,197			-			-		76,104		-		76,104		-		-
	$	2,458,911	$	125,000		$	(10,622	)	$	158,666	$	2,731,955	$	225,701	$	2,506,254	$	3,852,180	$	343,346,455

												Allowance for loan losses				Outstanding loan
			Provision									ending balance evaluated				balances evaluated
	Beginning		for loan			Charge				Ending		for impairment:				for impairment:
June 30, 2017	balance		losses			offs		Recoveries		balance		Individually		Collectively		Individually		Collectively

Real estate:
Commercial	$	1,717,749	$	120,972		$	-	$	1,780	$	1,840,501	$	-	$	1,840,501	$	3,136,252	$	229,552,790
Construction and land development		204,860		59,606			-		-		264,466		37,700		226,766		573,820		14,591,305
Residential		247,437		12,253			-		147		259,837		-		259,837		-		57,961,821
Commercial		125,260		(27,036	)		-		-		98,224		-		98,224		145,719		20,468,951
Consumer		8,826		(1,377	)		-		-		7,449		-		7,449		-		667,428
Unallocated		58,954		(39,418	)		-		-		19,536		-		19,536		-		-
	$	2,363,086	$	125,000		$	-	$	1,927	$	2,490,013	$	37,700	$	2,452,313	$	3,855,791	$	323,242,295

													Allowance for loan losses				Outstanding loan
			Provision										ending balance evaluated				balances evaluated
	Beginning		for loan			Charge					Ending		for impairment:				for impairment:
December 31, 2017	balance		losses			offs			Recoveries		balance		Individually		Collectively		Individually		Collectively

Real estate:
Commercial	$	1,717,749	$	419,868		$	(275,000	)	$	4,780	$	1,867,397	$	127,213	$	1,740,184	$	5,183,182	$	228,843,392
Construction and land development		204,860		65,850			(47,436	)		-		223,274		-		223,274		-		18,160,366
Residential		247,437		368			-			148		247,953		-		247,953		-		59,241,416
Commercial		125,260		(41,240	)		-			3,333		87,353		-		87,353		-		23,613,543
Consumer		8,826		(1,799	)		-			-		7,027		-		7,027		-		554,017
Unallocated		58,954		(33,047	)		-			-		25,907		-		25,907		-		-
	$	2,363,086	$	410,000		$	(322,436	)	$	8,261	$	2,458,911	$	127,213	$	2,331,698	$	5,183,182	$	330,412,734

The provision for loan losses for the six months ended June 30, 2018 and 2017 was $125,000.

During the six months ended June 30, 2018, the Company had loan charge-offs of $10,622 and had recoveries of $158,666 from loans written off in prior periods. During the six months ended June 30, 2017, the Company had no loan charge-offs and had recoveries of $1,927 from loans written off in prior periods.

As of June 30, 2018, the Company had $6,690,632 of loans on a watch list, other than impaired loans, for which the borrowers have the potential for experiencing financial difficulties. As of December 31, 2017, the Company had $7,079,718 of such loans. These loans are subject to ongoing management attention and their classifications are reviewed regularly.

Investment Securities

Investments in debt securities decreased $3,163,131 or 6.9% to $42,970,561 at June 30, 2018 from $46,133,692 at December 31, 2017. At June 30, 2018 and December 31, 2017, the Company had classified 58% and 61%, respectively, of the investment portfolio as available for sale. The balance of the portfolio was classified as held to maturity.

Securities classified as available for sale are held for an indefinite period of time and may be sold in response to changing market and interest rate conditions as part of the Company’s asset/liability management strategy. Available for sale debt securities are carried at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders’ equity, net of income taxes. Securities classified as held to maturity, which management has both the positive intent and ability to hold to maturity, are reported at amortized cost. Effective January 1, 2018, the Company began recording unrealized gains and losses on equity securities in earnings. The Company does not currently follow a strategy of making security purchases with a view to near-term sales, and, therefore, does not own trading securities. The Company manages the investment portfolio within policies that seek to achieve desired levels of liquidity, manage interest rate sensitivity, meet earnings objectives, and provide required collateral for deposit and borrowing activities.

The following table sets forth the carrying value of investments in debt securities at June 30, 2018 and December 31, 2017:

	June 30,		December 31,
	2018		2017
Available for sale
State and municipal	$	1,520,027	$	1,539,207
SBA pools		2,988,658		3,199,846
Mortgage-backed securities		20,246,632		23,190,457
	$	24,755,317	$	27,929,510

Held to maturity
State and municipal	$	18,215,244	$	18,204,182

The following table sets forth the scheduled maturities of investments in debt securities at June 30, 2018:

	Available for Sale				Held to Maturity
	Amortized Cost		Fair Value		Amortized Cost		Fair Value

Within 1 year	$	-	$	-	$	675,383	$	676,420
Over 1 to 5 years		261,799		251,020		1,101,989		1,116,837
Over 5 to 10 years		870,695		888,142		1,461,581		1,493,790
Over 10 years		375,859		380,865		14,976,291		14,842,156
		1,508,353		1,520,027		18,215,244		18,129,203
SBA Pools		3,032,118		2,988,658		-		-
Mortgage-backed securities		21,163,725		20,246,632		-		-
	$	25,704,196	$	24,755,317	$	18,215,244	$	18,129,203

SBA pools and mortgage-backed securities are due in monthly installments.

Other Real Estate Owned

Other real estate owned at June 30, 2018 and December 31, 2017 included one property with a carrying value of $265,500. The property is land in Cecil County, Maryland and was acquired through foreclosure in 2007. The property consists of 10.43 acres which is being sub-divided into four lots that will be marketed for sale in 2018.

Deposits

Total deposits increased by $20,479,462 or 6.4% during the first half of 2018 to $340,275,886 at June 30, 2018 from $319,796,424 at December 31, 2017. The increase in deposits was due to a $3,082,382 increase in interest bearing checking accounts, an $878,966 increase in savings accounts, and a $21,163,226 increase in time deposits, offset by a $3,163,638 decrease in money market accounts and a $1,481,474 decrease in noninterest-bearing accounts.

The following table shows the average balances and average costs of deposits for the six months ended June 30, 2018 and 2017:

	June 30, 2018					June 30, 2017
	Average					Average
	Balance		Cost			Balance		Cost

Noninterest bearing demand deposits	$	61,541,369		0.00	%	$	59,316,396		0.00	%
Interest bearing demand deposits		44,916,486		0.14	%		41,836,281		0.13	%
Savings and money market deposits		96,296,850		0.22	%		105,643,475		0.23	%
Time deposits		126,954,931		1.50	%		104,109,381		0.95	%
	$	329,709,636		0.66	%	$	310,905,533		0.41	%

Liquidity Management

Liquidity describes our ability to meet financial obligations that arise out of the ordinary course of business. Liquidity is primarily needed to meet depositor withdrawal requirements, to fund loans, and to fund our other debts and obligations as they come due in the normal course of business. We maintain our asset liquidity position internally through short-term investments, the maturity distribution of the investment portfolio, loan repayments, and income from earning assets. On the liability side of the balance sheet, liquidity is affected by the timing of maturing liabilities and the ability to generate new deposits or borrowings as needed. The Bank is approved to borrow 75% of eligible pledged single family residential loans and 50% of eligible pledged commercial loans as well as investment securities, or approximately $50.7 million under a secured line of credit with the FHLB. The Bank also has a facility with the Federal Reserve Bank of Richmond (the “Reserve Bank”) under which the Bank can borrow approximately $31.1 million. Finally, the Bank has an $11,000,000 ($2,000,000 unsecured and $9,000,000 secured) overnight federal funds line of credit available from a commercial bank. FHLB advances of $7,500,000 and $17,000,000 were outstanding as of June 30, 2018 and December 31, 2017, respectively. There were no borrowings from the Reserve Bank or our commercial bank lender at June 30, 2018 and December 31, 2017. Management believes that we have adequate liquidity sources to meet all anticipated liquidity needs over the next 12 months. Management knows of no trend or event which is likely to have a material impact on our ability to maintain liquidity at satisfactory levels.

Borrowings and Other Contractual Obligations

The Company’s contractual obligations consist primarily of borrowings and operating leases for various facilities.

Securities sold under agreements to repurchase represent overnight borrowings from customers. Securities owned by the Company which are used as collateral for these borrowings are primarily U.S. government agency securities.

Specific information about the Company’s borrowings and contractual obligations is set forth in the following table:

		June 30,			December 31,
		2018			2017
Amount oustanding at period-end:
Securities sold under repurchase agreements		$	18,521,862		$	21,768,507
Federal Home Loan Bank advances			7,500,000			17,000,000
Federal Home Loan Bank advances mature in:
	2018		4,500,000			14,000,000
	2019		3,000,000			3,000,000
Weighted average rate paid at period-end:
Securites sold under repurchase agreements			0.69	%		0.66	%
Federal Home Loan Bank advances			1.54	%		1.20	%

Capital Resources and Adequacy

The Company and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possible additional, discretionary actions by the regulators that, if undertaken, could have a direct material effect on our financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices.

Additional information regarding the capital requirements that apply to us can be found in Item 1 of Part I of Farmers and Merchants Bancshares, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2017 under the heading, “Supervision and Regulation – Capital Requirements”.

The following table presents actual and required capital ratios as of June 30, 2018 and December 31, 2017 for the Bank under the Basel III Capital Rules. The minimum required capital amounts presented include the minimum required capital levels as of June 30, 2018 and December 31, 2017, based on the phase-in provisions of the Basel III Capital Rules. Capital levels required to be considered well capitalized are based upon prompt corrective action regulations, as amended to reflect the changes under the Basel III Capital Rules.

						Minimum
						Capital Adequacy					To Be Well
(Dollars in thousands)	Actual					Phased In Schedule					Capitalized
June 30, 2018	Amount		Ratio			Amount		Ratio			Amount		Ratio

Total capital (to risk-weighted assets)	$	45,577		12.61	%	$	35,698		9.88	%	$	36,150		10.00	%
Tier 1 capital (to risk-weighted assets)		42,845		11.85	%		28,468		7.88	%		28,920		8.00	%
Common equity tier 1 (to risk- weighted assets)		42,845		11.85	%		23,046		6.38	%		23,497		6.50	%
Tier 1 leverage (to average assets)		42,845		10.35	%		16,565		4.00	%		20,706		5.00	%

December 31, 2017

Total capital (to risk-weighted assets)	$	44,039		12.54	%	$	32,477		9.25	%	$	35,110		10.00	%
Tier 1 capital (to risk-weighted assets)		41,580		11.84	%		25,455		7.25	%		28,088		8.00	%
Common equity tier 1 (to risk- weighted assets)		41,580		11.84	%		20,188		5.75	%		22,822		6.50	%
Tier 1 leverage (to average assets)		41,580		10.31	%		16,135		4.00	%		20,169		5.00	%

The Company intends to fund future growth primarily with cash, federal funds, maturities of investment securities and deposit growth. Management knows of no other trend or event that will have a material impact on capital.

Off-Balance Sheet Arrangements

In the normal course of business, the Bank makes commitments to extend credit and issues standby letters of credit. Outstanding loan commitments, unused lines of credit, and letters of credit as of June 30, 2018 and December 31, 2017 are as follows:

	June 30,		December 31,
	2018		2017

Loan commitments
Construction and land development	$	1,425,200	$	-
Commercial		903,614		1,295,000
Commercial real estate		11,777,322		7,478,500
Residential		2,199,000		660,000
	$	16,305,136	$	9,433,500

Unused lines of credit
Home-equity lines	$	3,590,375	$	3,390,515
Commercial lines		27,194,634		36,614,548
	$	30,785,009	$	40,005,063

Letters of credit	$	1,899,183	$	1,827,513

Loan commitments and lines of credit are agreements to lend to a customer as long as there is no violation of any condition to the contract. Loan commitments generally have interest rates at current market amounts, fixed expiration dates, and may require payment of a fee. Lines of credit generally have variable interest rates. Such lines do not represent future cash requirements because it is unlikely that all customers will draw upon their lines in full at any time. Letters of credit are commitments issued to guarantee the performance of a customer to a third party.

The maximum exposure to credit loss in the event of nonperformance by the customer is the contractual amount of the commitment. Loan commitments, lines of credit and letters of credit are made on the same terms, including collateral, as outstanding loans. Management is not aware of any accounting loss that is likely to be incurred as a result of funding its credit commitments.

RESULTS OF OPERATIONS

Comparison of Operating Results for the Six Months Ended June 30, 2018 and 2017

General

Net income for the six months ended June 30, 2018 was $2,267,183, compared to $2,118,446 for the same period of 2017. The increase of $148,737 or 7.02% was due to a $226,537 increase in net interest income and a $295,286 decrease in income taxes, offset by a $179,915 increase in noninterest expense and a $193,171 decrease in noninterest income.

Net Interest Income

Net interest income, which is the difference between interest income on loans and investments and interest expense on deposits and borrowings, was $7,526,578 for the six months ended June 30, 2018, compared to $7,300,041 for the same period of 2017.

Total interest income for the six months ended June 30, 2018 was $8,643,252, compared to $8,098,372 for the same period of 2017, an increase of $544,880 or 6.73%.

Total interest income on loans for the six months ended June 30, 2018 increased $600,909 over the same period of 2017 due to a $29 million higher average loan balance for the first six months of 2018 when compared to the same period of 2017, offset by a lower loan yield of 4.68% for the first six months of 2018 versus 4.73% for the same period of 2017. Investment income for the first six months of 2018 decreased by $81,239 or 12.1% when compared to the same period of 2017 due to a $6.5 million lower average investment balance and a decrease in fully-taxable equivalent yield to 2.94% for six months ended June 30, 2018, compared to 3.21% for the same period of 2017. The fully-taxable equivalent yield on total interest-earning assets decreased 2 basis points to 4.44% for the six months ended June 30, 2018, compared to 4.46% for the same period of 2017. The average balance of total interest-earning assets increased by $22.4 million to $393 million for the six months ended June 30, 2018, compared to $371 million for the same period of 2017.

Total interest expense for the six months ended June 30, 2018 was $1,116,674, compared to $798,331 for the same period of 2017, an increase of $318,343 or 39.9%. The increase was due to a higher overall cost of funds of 0.74% for the six months ended June 30, 2018, compared to 0.55% for the same period of 2017, and a $13.1 million increase in the average balance of interest-bearing liabilities to $302.7 million in the first six months of 2018, compared to $289.6 million in the same period of 2017. Cost of funds for time deposits increased to 1.26% for the six months ended June 30, 2018 from 0.95% for the same period of 2017. Securities sold under repurchase agreements cost of funds also increased to 0.69% for the first six months of 2018 from 0.65% for the first six months of 2017. FHLB advances cost of funds also increased to 1.50% for the first six months of 2018 from 1.16% for the first six months of 2017.

Average noninterest-earning assets decreased by $2.8 million to $16.5 million in the first six months of 2018, compared to $19.3 million in the same period of 2017. Average noninterest-bearing deposits increased by $2.2 million to $61.5 million during the first six months of 2018, compared to $59.3 million in the same period of 2017. The average balance in stockholders’ equity increased by $3.5 million for the six months ended June 30, 2018, when compared with the same period of 2017.

The FRB has raised rates six times over the last 24 months. The cost of deposits and borrowings has increased over that time. However, the yields on loans continue to decline as those with higher rates mature or payoff and are replaced by lower yielding loans and investments. Management anticipates that the FRB will continue to raise rates over the next few years. Management will closely monitor its asset-liability position so that it can respond to any future changes in interest rates and/or changes to the Bank’s interest rate spread.

The following table sets forth information regarding the average balances of interest-earning assets and interest-bearing liabilities, the amount of interest income and interest expense and the resulting yields on average interest-earning assets and rates paid on average interest-bearing liabilities for the six-month periods ended June 30, 2018 and 2017. Average balances are also provided for noninterest-earning assets and noninterest-bearing liabilities.

	Six Months Ended June 30, 2018							Six Months Ended June 30, 2017
	Average							Average
	Balance		Interest		Yield			Balance		Interest		Yield
Assets:
Loans	$	341,034,018	$	7,982,139		4.68	%	$	312,050,387	$	7,381,230		4.73	%
Securities, taxable		27,640,502		308,009		2.23	%		33,682,115		372,187		2.21	%
Securities, tax exempt		17,700,079		358,563		4.05	%		18,177,304		459,603		5.06	%
Federal funds sold and other interest-earning assets		6,665,463		75,202		2.26	%		6,776,653		47,979		1.42	%
Total interest-earning assets		393,040,062		8,723,913		4.44	%		370,686,459		8,260,999		4.46	%
Noninterest-earning assets		16,523,171							19,343,666
Total assets	$	409,563,233						$	390,030,125

Liabilities and Stockholders’ Equity:
NOW, savings, and money market	$	141,213,336		137,403		0.19	%	$	147,479,756		148,681		0.20	%
Certificates of deposit		126,954,931		800,923		1.26	%		104,109,381		495,003		0.95	%
Securities sold under repurchase agreements		20,026,582		69,401		0.69	%		25,844,306		84,287		0.65	%
FHLB advances and other borrowings		14,493,923		108,947		1.50	%		12,176,796		70,360		1.16	%
Total interest-bearing liabilities		302,688,772		1,116,674		0.74	%		289,610,239		798,331		0.55	%

Noninterest-bearing deposits		61,541,369							59,316,396
Noninterest-bearing liabilities		2,455,963							1,684,081
Total liabilities		366,686,104							350,610,716
Stockholders' equity		42,877,129							39,419,409
Total liabilities and stockholders' equity	$	409,563,233						$	390,030,125

Net interest income			$	7,607,239						$	7,462,668

Interest rate spread						3.70	%						3.91	%

Net yield on interest-earning assets						3.87	%						4.03	%

Ratio of average interest-earning assets to Average interest-bearing liabilities						129.85	%						127.99	%

Interest on tax-exempt securities and other tax-exempt investments are reported on fully taxable equivalent basis.

Noninterest Income

Noninterest income for the six months ended June 30, 2018 was $631,611, compared to $824,782 for the same period of 2017, a decrease of $193,171 or 23.42%. A decrease in net gain on sale of loans of $157,055 drove the decrease, along with a decrease in service charges on deposit accounts of $17,272, and an unrealized loss of $11,479 on equity securities recorded at fair value.

Noninterest Expense

Noninterest expenses for the six months ended June 30, 2018 totaled $5,258,170, compared to $5,078,255 for the same period of 2017, an increase of $179,915 or 3.5%. The increase was due primarily to increases in salaries and benefits of $167,195.

Income Tax Expense

Income tax expense for the six months ended June 30, 2018 was $507,836, compared to $803,122 for the same period of 2017. The effective tax rate was 18.3% for the six months ended June 30, 2018, compared to 27.5% for the same period of 2017. The decreases in both income tax expense and the effective tax rate resulted from the reduction of the statutory federal rate applicable to C corporations from 34% to 21% as a result of the Tax Cuts and Jobs Act enacted in December 2017.

Comparison of Operating Results for the Three Months Ended June 30, 2018 and 2017

Net income for the three months ended June 30, 2018 was $1,145,247, compared to $1,134,889 for the same period of 2017. The increase of $10,358 or 0.91% was due to a $95,451 increase in net interest income and a $200,042 decrease in income taxes, offset by a $53,893 increase in noninterest expense and a $231,242 decrease in noninterest income.

Net Interest Income

Net interest income was $3,804,593 for the three months ended June 30, 2018, compared to $3,709,142 for the same period of 2017.

Total interest income for the three months ended June 30, 2018 was $4,385,506, compared to $4,121,760 for the same period of 2017, an increase of $263,746 or 6.4%.

Total interest income on loans for the three months ended June 30, 2018 increased $283,922 over the same period of 2017 due to a $27.9 million higher average loan balance for the three months ended June 30, 2018 when compared to the same period of 2017, offset by a lower loan yield of 4.70% for the three months ended June 30, 2018 versus 4.75% for the same period of 2017. Investment income for the three months ended June 30, 2018 decreased by $35,863 or 10.91% when compared to the same period of 2017 due to a $7.1 million lower average investment balance and a decrease in fully-taxable equivalent yield to 2.97% for three months ended June 30, 2018, compared to 3.13% for the same period of 2017. The fully-taxable equivalent yield on total interest-earning assets was 4.46% for the three months ended June 30, 2018 and 2017. The average balance of total interest-earning assets increased by $20.9 million to $397.7 million for the three months ended June 30, 2018, compared to $376.8 million for the same period of 2017.

Total interest expense for the three months ended June 30, 2018 was $580,913, compared to $412,618 for the same period of 2017, an increase of $168,295 or 40.8%. The increase was due to a higher overall cost of funds of 0.76% for the three months ended June 30, 2018, compared to 0.56% for the same period of 2017, and a $11.4 million increase in the average balance of interest-bearing liabilities to $305 million in the three months ended June 30, 2018, compared to $293.7 million in the same period of 2017. Cost of funds for time deposits increased to 1.32% for the three months ended June 30, 2018 from 0.96% for the same period of 2017. Securities sold under repurchase agreements cost of funds also increased to 0.72% for the three months ended June 30, 2018 from 0.66% for the same period of 2017. FHLB advances cost of funds increased to 1.56% for the three months ended June 30, 2018 from 1.17% for the same period of 2017.

Average noninterest-earning assets decreased by $3.2 million to $15.4 million for the three months ended June 30, 2018, compared to $18.6 million in the same period of 2017. Average noninterest-bearing deposits increased by $2.6 million to $62.2 million during the three months ended June 30, 2018, compared to $59.6 million in the same period of 2017. The average balance in stockholders’ equity increased by $3.2 million for the three months ended June 30, 2018 when compared with the same period of 2017.

The following table sets forth information regarding the average balances of interest-earning assets and interest-bearing liabilities, the amount of interest income and interest expense and the resulting yields on average interest-earning assets and rates paid on average interest-bearing liabilities for the three-month periods ended June 30, 2018 and 2017. Average balances are also provided for noninterest-earning assets and noninterest-bearing liabilities.

	Three Months Ended June 30, 2018							Three Months Ended June 30, 2017
	Average							Average
	Balance		Interest		Yield			Balance		Interest		Yield
Assets:
Loans	$	344,844,889	$	4,048,984		4.70	%	$	316,936,352	$	3,765,062		4.75	%
Securities, taxable		26,968,356		151,576		2.25	%		33,353,651		175,124		2.10	%
Securities, tax exempt		17,702,843		180,068		4.07	%		18,449,733		229,675		4.98	%
Federal funds sold and other interest-earning assets		8,178,822		46,685		2.28	%		8,011,113		29,687		1.48	%
Total interest-earning assets		397,694,910		4,427,313		4.46	%		376,750,849		4,199,548		4.46	%
Noninterest-earning assets		15,381,884							18,626,127
Total assets	$	413,076,794						$	395,376,976

Liabilities and Stockholders’ Equity:
NOW, savings, and money market	$	143,245,471		70,200		0.20	%	$	149,220,473		75,322		0.20	%
Certificates of deposit		130,577,083		429,716		1.32	%		107,241,134		257,557		0.96	%
Securities sold under repurchase agreements		19,453,450		35,012		0.72	%		22,867,851		37,772		0.66	%
FHLB advances and other borrowings		11,769,231		45,985		1.56	%		14,362,637		41,967		1.17	%
Total interest-bearing liabilities		305,045,235		580,913		0.76	%		293,692,095		412,618		0.56	%

Noninterest-bearing deposits		62,212,060							59,571,704
Noninterest-bearing liabilities		2,487,567							1,986,241
Total liabilities		369,744,862							355,250,040
Stockholders' equity		43,331,932							40,126,936
Total liabilities and stockholders' equity	$	413,076,794						$	395,376,976

Net interest income			$	3,846,400						$	3,786,930

Interest rate spread						3.70	%						3.90	%

Net yield on interest-earning assets						3.87	%						4.02	%

Ratio of average interest-earning assets to Average interest-bearing liabilities						130.37	%						128.28	%

Interest on tax-exempt securities and other tax-exempt investments are reported on fully taxable equivalent basis.

Noninterest Income

Noninterest income for the three months ended June 30, 2018 was $290,496, compared to $521,738 for the same period of 2017, a decrease of $231,242 or 44.32%. A decrease in net gain on sale of loans of $217,563 drove the decrease, along with an unrealized loss of $11,479 on equity securities recorded at fair value.

Noninterest Expense

Noninterest expenses for the three months ended June 30, 2018 totaled $2,628,880, compared to $2,574,987 for the same period of 2017, an increase of $53,893 or 2.1%. The increase was due primarily to increases in salaries of $31,725 and occupancy expenses of $21,538. The salary increase was attributable to several new positions and annual salary increases.

Income Tax Expense

Income tax expense for the three months ended June 30, 2018 was $245,962, compared to $446,004 for the same period of 2017. The effective tax rate was 17.7% for the three months ended June 30, 2018, compared to 28.2% for the same period of 2017. The decreases in both income tax expense and the effective tax rate resulted from the reduction of the statutory federal rate applicable to C corporations from 34% to 21% as a result of the Tax Cuts and Jobs Act enacted in December 2017.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Our primary market risk is interest rate fluctuation and we have procedures in place to evaluate and mitigate this risk. This market risk and our procedures are described in Item 7 of Part II of Farmers and Merchants Bancshares, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2017 under the heading, “Interest Rate Risk”, which provides information as of December 31, 2017. Management believes that no material changes in market risk or our procedures used to evaluate and mitigate these risks have occurred since December 31, 2017.

Item 4. Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed under the Exchange Act with the SEC, such as this Quarterly Report, is recorded, processed, summarized and reported within the periods specified in those rules and forms, and that such information is accumulated and communicated to our management, including Farmers and Merchants Bancshares, Inc.’s principal executive officer (“PEO”) and the principal financial officer (“PFO”), as appropriate, to allow for timely decisions regarding required disclosure. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.

An evaluation of the effectiveness of these disclosure controls as of June 30, 2018 was carried out under the supervision and with the participation of management, including the PEO and the PFO. Based on that evaluation, management, including the PEO and the PFO, has concluded that our disclosure controls and procedures are, in fact, effective at the reasonable assurance level.

During the quarter ended June 30, 2018, there was no change in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Part II – OTHER INFORMATION

Item 1. Legal Proceedings

None.

Item 1A. Risk Factors

The risks and uncertainties to which our financial condition and operations are subject are discussed in detail in Item 1A of Part of Farmers and Merchants Bancshares, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2017 and in Item 1A of Part II of its Quarterly Report on Form 10-Q for the quarter ended March 31, 2018. Management does not believe that any material changes in our risk factors have occurred since they were last disclosed.

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

None.

Item 3. Defaults upon Senior Securities

None.

Item 4. Mine Safety Disclosures

Not Applicable.

Item 5. Other Information

None.

Item 6. Exhibits

The exhibits filed or furnished with this quarterly report are listed in the following Exhibit Index:

Exhibit	Description

31.1	Certifications of the Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act (filed herewith)

31.2	Certifications of the Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act (filed herewith)

32	Certification of the Principal Executive Officer and the Principal Financial Office pursuant to Section 906 of the Sarbanes-Oxley Act (furnished herewith)

101	Interactive Data Files pursuant to Rule 405 of Regulation S-T (filed herewith)

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 AND MERCHANTS BANCSHARES, INC.


Date: August 10, 2018	/s/ James R. Bosley, Jr.
	James R. Bosley, Jr. President and Chief Executive Officer (Principal Executive Officer)


Date August 10, 2018	/s/ Mark C. Krebs
	Mark C. Krebs, Treasurer and Chief Financial Officer (Principal Financial Officer & Principal Accounting Officer)

Farmers & Merchants Bancshares, Inc. - FORM 10-Q - August 10, 2018

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Farmers & Merchants Bancshares, Inc. Reports