For Merchants Bancshares, last March was the darkest hour. Nonperforming assets had topped 10%, and several million in souring real estate loans were threatening to mortally wound the $700 million-asset bank in Burlington, Vt. Merchants was overloaded with costs, and the situation looked dire.

"We had serious doubts whether we could pull this thing off," said Joseph L. Boutin, president and chief executive.

But Merchants' future has brightened since Mr. Boutin instituted some wrenching changes designed to improve credit quality and operational efficiency.

Under Mr. Boutin, who joined the bank a year ago, Merchants downsized its asset base by $70 million, to $630 million, moved to cut its work force nearly in half, and undertook a four-month crash restructuring program, which is expected to be completed this month.

"I'm trying to eliminate every single expense that isn't critical," said Mr. Boutin. When financial health and stability are restored, he added, "then we can start investing in other things, the future. But today, I'm fully focused on the present, on getting our ship in order."

During this period, Mr. Boutin also concluded that in order to reach its efficiency and cost-cutting goals, Merchants could not postpone investing in new technology until the bottom line was healthier.

The bank, which operates 39 branches, recently opened a telephone customer service center and placed a "home page" on the Internet. It plans to introduce imaging systems for proof-of-deposit early next year.

Mr. Boutin was recruited to Merchants in October 1994 from a Burlington rival, the Howard Bank, a community bank unit of Banknorth Group Inc.

When he took the helm, Merchants was faced not only with poor asset quality - it was operating under a regulatory memorandum of understanding - but $35 million of the bank's trust assets were invested in a Piper Jaffray Inc. mutual fund that took a nosedive when the bond market went south. The day after he took the job, Merchants was served with a class action lawsuit.

"I thought the first priority was going to be credit," said Mr. Boutin, 48. "But I had to resolve Piper Jaffray. The exposure was too great to our reputation. If we didn't do anything, we had the risk of losing just about every customer in our trust department."

With the aid of some professional advisers, Merchants sold off its position within a month. The bank also decided to reimburse customers for their losses, calculating that the value of their investments would have depreciated 7% in less risky Ginnie Mae securities, compared to the 25% decline in the Piper Jaffray investments. Merchants made up the 18% difference.

"We took a $9 million hit to earnings," said Mr. Boutin. But by the end of 1994, the bank's insurer agreed to cover two-thirds of the loss. And Piper Jaffray later agreed to settle, although the amount has yet to be decided.

With the Piper Jaffray misfortune behind it, Merchants was still faced with a very troubled loan portfolio. Mr. Boutin, along with senior vice president Michael Tuttle, began to examine every single loan over $250,000. Initially, the task proved difficult because the bank lacked up-to-date information on customers' cash flow and current appraisals of real estate value.

"So I ordered new appraisals, got all of the financial information on it," recalled Mr. Boutin.

But in March of 1995, Mr. Boutin recalled, "There were some huge projects for us - $5 million to $7 million projects - that we just still didn't have enough information on. Fortunately, we got some additional information, and it was a little more encouraging."

Since those darkest days, the bank has charged off a total of about $36 million of bad loans. And as a result of two major additions to loan-loss reserves, along with a successful sale of nonperforming assets in July, the reserves stood at 62% of net nonperforming loans. The bank is adequately capitalized, and next year, the ratio of nonperforming assets is expected to be in the 3% range.

With nonperformers on their way to more normal levels, Mr. Boutin turned his attention to the next pressing problem: "We realized what we had was a bloated, bloated organization" he said.

In June, the bank's efficiency ratio, or noninterest expense per dollar of revenue, had ballooned to more than 78%, compared to a peer group average of 62.65% calculated by American Banker research.

To rein in expenses, Merchants sought the aid of a consulting firm, ultimately settling on Houston's John Floyd & Associates.

Initially, the firm suggested an 18-month restructuring program. But Mr. Boutin wanted to accomplish the task in just four months - a period that began in August.

"We don't normally try to accomplish this at this speed," said John M. Floyd, of the consulting firm. "He's helped keep the bank disciplined and on track."

"I want to be done at the end of December so we can start the beginning of the year as an organization that has been right-sized, reengineered," said Mr. Boutin.

One goal is to reduce noninterest expense to around $20 million next year, from $36 million in 1994.

To achieve those savings, the bank has been working to dramatically reduce layers of bureaucracy - which means drastic cuts in the work force. Of the eight managers that reported to Mr. Boutin when he came on board, only one remains at the bank.

The cuts will be most severe in the back room, where 200 of 300 positions will be eliminated. The item processing and customer accounting departments, for example, which each employed more than 50 people, will be downsized to 17 each. Data processing, once staffed by 21 people, will now be handled by six.

Earlier this year, Merchants said 150 jobs would be cut bankwide. But after a second round of 100 layoffs announced in October, half the jobs at the bank will have been eliminated.

The bank is attempting to minimize the blow to dislocated employees by offering severance packages and career counseling services.

Mr. Boutin said, "It is the hardest thing I've ever had to do, and it's the hardest thing that the employees have gone through."

Some may question whether the bank can operate effectively with such drastic staff cuts. Mr. Boutin said he is only bringing the bank in line with common industry practices. He noted that banks on average employ one person for every $2.3 million of assets. Merchants' employee-to-asset ratio had been $1.2 million to one.

He also said the bank does not plan to reduce the number of employees responsible for reviewing loans. This is part of an effort to build a stronger credit culture.

Mr. Boutin traced the bank's real estate loan problems to the previous management's lack of credit controls. He said that his predecessor, Dudley H. Davis, was personally responsible for a $180 million loan portfolio - in addition to handling his duties as chief executive.

"He was a brilliant individual who kept everything in his head (but) nothing in the file," said Mr. Boutin. "He could tell you what the amortized balance on a loan was that he made to someone five years ago without looking at the computer. Just a phenomenal memory."

But the management style became problematic as the bank grew, Mr. Boutin said. Mr. Davis declined to be interviewed for this story.

Mr. Boutin recalled that other banks in the state began to tighten their real estate and commercial lending in the late 1980s.

"Most of the developers went to the Merchants Bank for funding," said Mr. Boutin. Then, in 1993, Merchants bought a failed bank in eastern Vermont. "Hindsight would say that there were a lot more problems in that portfolio than we recognized in the front end," said Mr. Boutin.

A month later, regulators said Merchants had too large a concentration of commercial real estate loans and issued the memorandum of understanding. The bank will report a loss for 1995, its third straight down year.

The board of directors attempted to sell the bank but couldn't get the price they wanted. So they began to look for a new chief executive to engineer a turnaround. Mr. Boutin got the job.

In recent months, half the board has agreed to resign, although the departures will be staggered over several quarters.

"We had good board members," said Mr. Boutin. "These people are all in businesses that have seen really strong growth. The president of the company (Mr. Davis) helped each one of those individuals become successful."

Jack DuBrul 2d, who has served on the board for 18 years, said directors have been pleased with Mr. Boutin and the turnaround efforts thus far. "He's done an excellent job and surrounded himself with a lot of good people."

With the steps Merchants has taken this year, the bank hopes to post a return on assets of 1.5% in 1996.

To achieve this ROA in Vermont, a slow growth market, will mean taking market share from competitors - not an easy trick for a bank on the rebound.

As Mr. Boutin concedes, "I can't cut my price because I need the earnings. The shareholders are getting a little impatient, (after) three years of losses. And I can't reduce my credit quality. Our credit standards right now are a little tighter than any other bank in Burlington."

While Merchants is reducing fees to attract new business, its bid to distinguish itself from competitors will hinge on offering better service. Commercial lenders, whose compensation will now be incentive based, will spend all of their time in the field drumming up business and serving customers. "They are going to work out of their car with a portable PC, a cellular phone, and a pager," said Mr. Boutin.

And that's not the only Merchants initiative that will be dependent on technology for success. A new call center, which will handle customers' inquiries automatically 24 hours a day, will be manned with sales and service representatives from 7 a.m. to 9 p.m. The bank will also make better use of the 430 personal computers that were already installed when Mr. Boutin was hired. "The employees were not using them except for customer inquiries," he said. "We're now using it to do all document preparation."

"Merchants had bought a lot of the technology but not used it," a situation not uncommon at community banks, said Mr. Floyd.

The executive said the benefits of technology are clear cut. "The total cost to convert all of our documents onto imaging is $142,000 over the next three years," he said. "And we're going to save $212,000 in employee salaries alone."

Merchants is also erasing much of the customized computer code that had been written through the years. Mr. Floyd said it is very expensive to maintain and did little more than replicate how systems worked before new technology was installed.

Much of the cost of the restructuring will be charged against earnings for the third and fourth quarters. It will include hefty fees for the consultants.

Floyd & Associates will receive $1.5 million for the first $3 million in annual expenses that are cut. They are to be paid 15% of any additional savings identified. So if Merchants achieves its goal of reducing annual expenses by $16 million, the firm will reap more than $3 million.

While Mr. Boutin has had his moments of doubt over the last year, he appears to be reveling in his successes so far and in the challenges that lie ahead.

"It has been a chance to test every skill I had learned and if I could apply those skills to a turnaround situation," he said.

He's also clearly looking forward to seeing the benefits accrue in 1996.

"After six months, you don't accomplish much. I had to (resolve) Piper Jaffray. I was just getting to know the organization, where the skeletons were, what needed to be fixed, who I could depend on to help fix them," said Mr. Boutin. "In the last five or six months, I've really been trying to get that done."

"Next year," he added, "I think we'll be really rolling."

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