**UNITED
      STATES SECURITIES AND EXCHANGE COMMISSION**


**WASHINGTON,
      DC 20549**





**FORM
      10-Q**





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





For
      the
      quarterly period ended September 30, 2006





or





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





For
      the
      transition period from __________ to ____________.





000-50330


Commission
      File Number





EAST
      PENN FINANCIAL CORPORATION


(Exact
      name of registrant as specified in its charter)





Pennsylvania
            65-1172823(State
                or other jurisdiction of
            (IRS
                Employer Identificationincorporation
                or organization)
            Number)





731
      Chestnut Street, P.O. Box 869, Emmaus, Pennsylvania 18049


(Address
      of principal executive offices)





Registrant’s
      telephone number: 610-965-5959





Indicate
      by check mark whether the registrant: (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for such shorter period that the registrant was required
      to file such reports), and (2) has been subject to such filing requirements
      for
      the past 90 days.





YESý
            NO ̈





Indicate
      by check mark whether the Registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definition of “accelerated
      filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
      one):





Large
                Accelerated Filer ̈
            Accelerated
                Filer ̈
            Non-accelerated
                Filerý





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act).





YES ̈
            NOý





APPLICABLE
      ONLY TO CORPORATE ISSUERS:





Indicate
      the number of shares outstanding of each of the issuer’s classes of common
      stock, as of the latest practicable date.





6,304,262
      shares of common stock, par value $0.625 per share, outstanding as of October
      31, 2006.

















**EAST
      PENN FINANCIAL CORPORATION**





**INDEX**


**QUARTERLY
      REPORT ON FORM 10-Q**





**Page****Part
                I. FINANCIAL INFORMATION**Item
                1.
            Financial
                StatementsConsolidated
                Balance Sheets
            3September
                30, 2006 (unaudited) and December 31,
                2005Consolidated
                Statements of Income
                (unaudited)
            4Three
                and nine months ended September 30, 2006
                andSeptember
                30, 2005Consolidated
                Statements of Stockholders’ Equity
                (unaudited)
            5Nine
                months ended September 30, 2006 and September 30,
                2005Consolidated
                Statements of Cash Flows
                (unaudited)
            6Nine
                months ended September 30, 2006 and September 30,
                2005Notes
                to Interim Consolidated Financial Statements
                (unaudited)
            8Item
                2.
            Management’s
                Discussion and Analysis of Financial
                Condition
            13and
                Results of OperationsItem
                3.
            Quantitative
                and Qualitative Disclosures About Market
                Risk
            24Item
                4.
            Controls
                and Procedures
            24**Part
                II. OTHER INFORMATION**Item
                1.
            Legal
                Proceedings
            25Item
                1A.
            Risk
                Factors
            25Item
                2.
            Unregistered
                Sales of Equity Securities and Use of
                Proceeds
            25Item
                3.
            Defaults
                Upon Senior Securities
            25Item
                4.
            Submission
                of Matters to a Vote of Security
                Holders
            25Item
                5.
            Other
                Information
            25Item
                6.
            Exhibits
            25**SIGNATURES**
            27**EXHIBIT
                INDEX**
            28





*Index*











**Part
      I.**  **FINANCIAL
      INFORMATION**





**Item
      1.**  **FINANCIAL
      STATEMENTS**





**EAST
      PENN FINANCIAL CORPORATION**


**CONSOLIDATED
      BALANCE SHEETS**





September
                30,
            
            December
                31,(In
                thousands, except share data)
            
            2006
              (Unaudited)
            
            2005
              (Audited)**ASSETS**Cash
                and due from banks
            
            $
            6,634
            
            $
            10,609Interest
                bearing deposits
            
            
            1,381
            
            
            20Federal
                funds sold
            
            
            8,769
            
            
            -Cash
                and cash equivalents
            
            
            16,784
            
            
            10,629Interest
                bearing time deposits
            
            
            -
            
            
            500Securities
                available for sale
            
            
            69,213
            
            
            74,175Securities
                held to maturity
            
            
            -
            
            
            1,038Total
                securities
            
            
            69,213
            
            
            75,213Mortgages
                held for sale
            
            
            1,556
            
            
            1,077Loans,
                net of unearned income
            
            
            315,140
            
            
            293,387Less:
                allowance for loan losses
            
            
            (3,235
            )
            
            (3,072
            )Total
                net loans
            
            
            311,905
            
            
            290,315Bank
                premises and equipment, net
            
            
            10,010
            
            
            9,320Investment
                in restricted stock
            
            
            2,459
            
            
            3,115Other
                real estate owned
            
            
            -
            
            
            27Bank
                owned life insurance
            
            
            7,709
            
            
            7,506Accrued
                interest receivable and other assets
            
            
            6,309
            
            
            6,527**Total
                assets**
            
            $
            425,945
            
            $
            404,229**LIABILITIES
                AND STOCKHOLDERS’ EQUITY****LIABILITIES**Deposits:Noninterest
                bearing
            
            $
            45,577
            
            $
            44,257Interest
                bearing
            
            
            310,003
            
            
            280,049Total
                deposits
            
            
            355,580
            
            
            324,306Securities
                sold under agreements to repurchase
            
            
            6,183
            
            
            3,650Short-term
                borrowings
            
            
            -
            
            
            3,923Long-term
                debt
            
            
            30,000
            
            
            40,000Junior
                subordinated debentures
            
            
            8,248
            
            
            8,248Accrued
                interest payable and other liabilities
            
            
            1,890
            
            
            1,261**Total
                liabilities**
            
            
            401,901
            
            
            381,388**STOCKHOLDERS’
                EQUITY**Preferred
                stock, no par value; authorize16,000,000
                shares; none issued
            
            
            -
            
            
            -Common
                stock, par value $0.625 per share;authorized
                40,000,000 shares; issued6,612,554
                shares; outstanding 6,304,262 shares
            
            
            4,133
            
            
            4,133Surplus
            
            
            9,260
            
            
            9,246Retained
                earnings
            
            
            13,384
            
            
            12,192Accumulated
                other comprehensive loss
            
            
            (883
            )
            
            (880
            )Less:
                Treasury stock, at cost, 308,292 shares
            
            
            (1,850
            )
            
            (1,850
            )**Total
                stockholders’ equity**
            
            
            24,044
            
            
            22,841**Total
                liabilities and****stockholders’
                equity**
            
            $
            425,945
            
            $
            404,229








See
      Notes
      to Consolidated Financial Statements


Page
          3
 *Index*





**EAST
      PENN FINANCIAL CORPORATION**


**CONSOLIDATED
      STATEMENTS OF INCOME**


**Three
      Months and Nine Months Ended September 30, 2006 and 2005**


(Unaudited) ****





Three
                Months Ended
            
            Nine
                Months Ended(In
                thousands, except share data)
            
            2006
            
            2005
            
            2006
            
            2005**Interest
                income**Interest
                and fee income on loans
            
            $
            5,234
            
            $
            4,210
            
            $
            14,795
            
            $
            11,665Securities:Taxable
            
            
            565
            
            
            748
            
            
            1,838
            
            
            2,341Tax-exempt
            
            
            219
            
            
            157
            
            
            566
            
            
            459Other
            
            
            147
            
            
            79
            
            
            250
            
            
            140**Total
                interest income**
            
            
            6,165
            
            
            5,194
            
            
            17,449
            
            
            14,605**Interest
                expense**Deposits
            
            
            2,337
            
            
            1,454
            
            
            5,939
            
            
            3,665Federal
                funds purchased and securitiessold
                under agreements to repurchase
            
            
            33
            
            
            19
            
            
            198
            
            
            133Long-term
                debt
            
            
            274
            
            
            394
            
            
            891
            
            
            907Junior
                subordinated debentures
            
            
            136
            
            
            136
            
            
            408
            
            
            408**Total
                interest expense**
            
            
            2,780
            
            
            2,003
            
            
            7,436
            
            
            5,113**Net
                interest income**
            
            
            3,385
            
            
            3,191
            
            
            10,013
            
            
            9,492Provision
                for loan losses
            
            
            90
            
            
            84
            
            
            299
            
            
            336**Net
                interest income after****provision
                for loan losses**
            
            
            3,295
            
            
            3,107
            
            
            9,714
            
            
            9,156**Other
                income**Customer
                service fees
            
            
            412
            
            
            386
            
            
            1,189
            
            
            1,009Mortgage
                banking activities, net
            
            
            29
            
            
            86
            
            
            97
            
            
            299Income
                from investment in life insurance
            
            
            68
            
            
            70
            
            
            203
            
            
            211Net
                realized gains on sale of other real estate
            
            
            14
            
            
            -
            
            
            14
            
            
            16Other
                income
            
            
            76
            
            
            70
            
            
            306
            
            
            245**Total
                other income**
            
            
            599
            
            
            612
            
            
            1,809
            
            
            1,780**Other
                expense**Salaries
                and wages
            
            
            1,126
            
            
            1,004
            
            
            3,366
            
            
            2,930Employee
                benefits
            
            
            370
            
            
            343
            
            
            1,084
            
            
            1,000Occupancy
            
            
            279
            
            
            243
            
            
            842
            
            
            668Equipment
            
            
            218
            
            
            208
            
            
            655
            
            
            611Other
                operating expenses
            
            
            780
            
            
            761
            
            
            2,346
            
            
            2,239**Total
                other expense**
            
            
            2,773
            
            
            2,559
            
            
            8,293
            
            
            7,448**Income
                before income taxes**
            
            
            1,121
            
            
            1,160
            
            
            3,230
            
            
            3,488Federal
                income taxes
            
            
            221
            
            
            261
            
            
            651
            
            
            803**Net
                income**
            
            $
            900
            
            $
            899
            
            $
            2,579
            
            $
            2,685Basic
                earnings per share
            
            $
            0.14
            
            $
            0.14
            
            $
            0.41
            
            $
            0.43Diluted
                earnings per share
            
            $
            0.14
            
            $
            0.14
            
            $
            0.41
            
            $
            0.42Cash
                dividends per common share
            
            $
            0.11
            
            $
            0.10
            
            $
            0.22
            
            $
            0.19











See
      Notes
      to Consolidated Financial Statements


Page
          4
 *Index*





**EAST
      PENN FINANCIAL CORPORATION**


**CONSOLIDATED
      STATEMENTS OF STOCKHOLDERS’EQUITY**


**Nine
      Months Ended**


**September
      30, 2006 and 2005**


(Unaudited)







AccumulatedOtherCommon
            
            
            
            Retained
            
            Comprehensive
            
            Treasury(In
                thousands, except share data)
            Stock
            
            Surplus
            
            Earnings
            
            Income
                (Loss)
            
            Stock
            
            TotalBalance,
                December 31, 2004
            
            $
            4,131
            
            $
            9,225
            
            $
            9,887
            
            $
            274
            
            
            ($1,850
            )
            $
            21,667Comprehensive
                income:Net
                income
            
            
            -
            
            
            -
            
            
            2,685
            
            
            -
            
            
            -
            
            
            2,685Changes
                in net unrealized losseson
                securities available for sale,net
                of tax effect
            
            
            -
            
            
            -
            
            
            -
            
            
            (735
            )
            
            -
            
            
            (735
            )Total
                comprehensive income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            1,950Exercise
                of 3,652 common stockoptions
            
            
            2
            
            
            21
            
            
            -
            
            
            -
            
            
            -
            
            
            23Cash
                dividends ($0.19 per share)
            
            
            -
            
            
            -
            
            
            (1,198
            )
            
            -
            
            
            -
            
            
            (1,198
            )Balance,
                September 30, 2005
            
            $
            4,133
            
            $
            9,246
            
            $
            11,374
            
            
            ($461
            )
            
            ($1,850
            )
            $
            22,442Balance,
                December 31, 2005
            
            $
            4,133
            
            $
            9,246
            
            $
            12,192
            
            
            ($880
            )
            
            ($1,850
            )
            $
            22,841Comprehensive
                income:Net
                income
            
            
            -
            
            
            -
            
            
            2,579
            
            
            -
            
            
            -
            
            
            2,579Changes
                in net unrealized losseson
                securities availablefor
                sale, net of tax effect
            
            
            -
            
            
            -
            
            
            -
            
            
            (3
            )
            
            -
            
            
            (3
            )Total
                comprehensive income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            2,576Compensation
                expense related tostock
                options
            
            
            -
            
            
            14
            
            
            -
            
            
            -
            
            
            -
            
            
            14Cash
                dividends ($0.22 per share)
            
            
            -
            
            
            -
            
            
            (1,387
            )
            
            -
            
            
            -
            
            
            (1,387
            )Balance,
                September 30, 2006
            
            $
            4,133
            
            $
            9,260
            
            $
            13,384
            
            
            ($883
            )
            
            ($1,850
            )
            $
            24,044











See
      Notes
      to Consolidated Financial Statements





Page
          5
 *Index*





**EAST
      PENN FINANCIAL CORPORATION**


**CONSOLIDATEDSTATEMENTSOF CASH FLOWS**


**Nine
      Months Ended September 30, 2006 and 2005**


(Unaudited)


**Nine
                Months Ended September 30,**(In
                thousands)
            
            **2006**
            
            **2005****CASH
                FLOWS from OPERATING ACTIVITIES**Net
                income
            
            $
            2,579
            
            $
            2,685Adjustments
                to reconcile net income to net cashprovided
                by operating activities:Provision
                for loan losses
            
            
            299
            
            
            336Provision
                for depreciation and amortization
            
            
            658
            
            
            572Compensation
                expense for stock options
            
            
            14
            
            
            -Net
                amortization of securities premiums and discounts
            
            
            120
            
            
            179Net
                realized gain on sale of foreclosed real estate
            
            
            (14
            )
            
            (16
            )Net
                realized gain from the sale of held to maturity securities
            
            
            (38
            )
            
            -Proceeds
                from sale of mortgage loans
            
            
            7,213
            
            
            20,880Net
                gain on sale of loans
            
            
            (97
            )
            
            (299
            )Loans
                originated for sale
            
            
            (7,595
            )
            
            (23,033
            )Earnings
                on investment in life insurance
            
            
            (203
            )
            
            (211
            )(Increase)
                decrease in accrued interest receivableand
                other assets
            
            
            220
            
            
            (141
            )Increase
                in accrued interest payableand
                other liabilities
            
            
            629
            
            
            472**Net
                Cash Provided by Operating Activities**
            
            
            3,785
            
            
            2,424**CASH
                FLOWS from INVESTING ACTIVITIES****(**Increase)
                decrease in interest bearing time deposits
            
            
            500
            
            
            (500
            )Purchases
                of available for sale securities
            
            
            (7,223
            )
            
            (5,097
            )Proceeds
                from maturities of and principal repaymentson
                available for sale securities
            
            
            6,924
            
            
            10,171Proceeds
                from sale of available for sale securities
            
            
            5,136
            
            
            -Proceeds
                from maturities of and principal repaymentson
                held to maturity securities
            
            
            39
            
            
            2Proceeds
                from sale of held to maturity securities
            
            
            1,037
            
            
            -Proceeds
                from the sale of other real estate owned
            
            
            41
            
            
            31Net
                increase in loans
            
            
            (21,889
            )
            
            (31,120
            )Net
                (increase) decrease in restricted stock
            
            
            656
            
            
            (417
            )Purchases
                of bank premises and equipment
            
            
            (1,348
            )
            
            (1,981
            )Investment
                in Berkshire Bank
            
            
            -
            
            
            (287
            )**Net
                Cash Used in Investing Activities**
            
            
            (16,127
            )
            
            (29,198
            )**CASH
                FLOWS from FINANCING ACTIVITIES**Net
                increase in deposits
            
            
            31,274
            
            
            9,219Net
                increase (decrease) in federal funds purchased andsecurities
                sold under agreements to repurchase
            
            
            (1,390
            )
            
            2,967Increase
                in long-term borrowings
            
            
            -
            
            
            20,000Repayment
                of long-term borrowings
            
            
            (10,000
            )
            
            -Proceeds
                from the exercise of stock options
            
            
            -
            
            
            23Dividends
                paid
            
            
            (1,387
            )
            
            (1,198
            )**Net
                Cash Provided by Financing Activities**
            
            
            18,497
            
            
            31,011**Net
                Increase in Cash and Cash Equivalents**
            
            
            6,155
            
            
            4,237**Cash
                and cash equivalents -****Beginning**
            
            
            10,629
            
            
            8,782**Cash
                and cash equivalents -****Ending**
            
            $
            16,784
            
            $
            13,019








Page
          6
 *Index*























**SUPPLEMENTARY
                CASH FLOW INFORMATION**Interest
                paid
            
            $
            6,852
            
            $
            4,796Federal
                income taxes paid
            
            $
            540
            
            $
            850**SUPPLEMENTAL
                SCHEDULE of NON-CASH INVESTING****and
                FINANCING ACTIVITIES**Other
                real estate acquired in settlement of loans
            
            
            -
            
            $
            15



























See
      Notes
      to Consolidated Financial Statements




Page
            7
 *Index*








**EAST
      PENN FINANCIAL CORPORATION**


**NOTES
      TO INTERIM CONSOLIDATED FINANCIAL
      STATEMENTS**


**September
      30, 2006**


**(Unaudited)**





**1.**  **Basis
      of
      Presentation**





East
      Penn
      Financial Corporation (the “Company”) was incorporated on January 27, 2003 for
      the purpose of forming a bank holding company. On July 1, 2003, the Company
      completed the reorganization with East Penn Bank (the “Bank”) and its wholly
      owned subsidiary, East Penn Mortgage Company, into the holding company form
      of
      ownership. In the reorganization, the Bank became a wholly owned banking
      subsidiary of the Company. On July 31, 2003, the Company formed East Penn
      Statutory Trust I (the “Trust”), a Connecticut statutory business trust, for the
      purpose of issuing $8 million in capital pass-through securities to
      investors.





The
      consolidated financial statements include the accounts of the Company, and
      its
      wholly owned subsidiary, the Bank. All significant intercompany accounts and
      transactions have been eliminated.





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. Accordingly, they do not include
      all
      of the information and footnotes required by generally accepted accounting
      principles for complete financial statements. In the opinion of management,
      all
      adjustments considered necessary for fair presentation have been included.





Operating
      results for the nine-month period ended September 30, 2006, are not necessarily
      indicative of the results that may be expected for the year ended December
      31,
      2006. For further information, refer to the consolidated financial statements
      and footnotes thereto included in the Company’s Annual Report on Form 10-K for
      the year ended December 31, 2005.





**2.**
            **Investment
                in Bank**





On
      September 23, 2003, the Company made an initial purchase of 141,300 shares
      of
      common stock of a *de
      novo* bank,
      named Berkshire Bank, located in Wyomissing, Berks County, Pennsylvania. At
      the
      completion of Berkshire Bank’s initial stock offering, the Company purchased an
      additional 12,123 shares, which resulted in increasing the Company’s investment
      to $1,534,000 of Berkshire Bank’s outstanding common stock as of December 31,
      2003. In consideration of the Company’s and its director’s and officer’s
      combined ownership of Berkshire Bank common stock, the aggregate percentage
      ownership was 19.9% as of the 2003 year end, which is in accordance with the
      terms of a Stock Subscription and Purchase Agreement between the Company and
      Berkshire Bank. Under this agreement, the Company is also entitled to purchase
      from Berkshire Bank up to 5% of additional stock at any time beginning on the
      date of the warrant and for 10 years thereafter at an exercise price of $6.40
      per share, which is adjusted in consideration of three 5-for-4 stock splits.
      The
      total number of shares that are subject to purchase under all of the Company’s
      warrants, options or rights shall not exceed 25% of the total number of shares
      of Berkshire Bank common stock.





In
      August
      2003, the Company entered into a passive investment agreement (“Crown X
      agreement”) that was approved by the Federal Reserve Bank of Philadelphia in
      September 2003. The Crown X agreement imposes certain restrictions where the
      Company has agreed not to:





·
            solicit
                proxies with respect to any voting securities of Berkshire Bank or
                influence the manner in which any other shareholder of Berkshire
                Bank
                votes any voting securities of Berkshire
                Bank;


·
            cause
                any voting securities of Berkshire Bank to be subject to a voting
                trust;


·
            cause
                Berkshire Bank to become a subsidiary of the
                Company;


·
            have
                any designated representative serve or act as an officer, director,
                employee or agent of Berkshire
                Bank;


Page
          8
 *Index*





·
            propose
                any person for election as a director of Berkshire Bank;


·
            attempt
                to influence the dividend policies or practices of Berkshire Bank;
                the
                investment, loan or credit decision policies; the pricing of services;
                personnel decisions or operations
                activities;


·
            exercise
                or seek to exercise any controlling influence over the management
                of
                Berkshire Bank;


·
            enter
                into any banking or non-banking transactions with Berkshire Bank,
                except
                that the Company may establish and maintain deposit accounts with
                Berkshire Bank, provided the aggregate balance of all such accounts
                does
                not exceed $500,000 and that the accounts are maintained on substantially
                the same terms as those prevailing for comparable accounts of persons
                unaffiliated with Berkshire Bank.





During
      2004, Berkshire Bank announced a 5-for-4 stock split, effected in the form
      of a
      25% stock dividend, payable July 22, 2004, which resulted in the Company
      receiving an additional 38,355 shares. As part of a three-phase stock offering,
      which began on September 1, 2004 and was effective through March 31, 2005,
      the
      Company purchased an additional 57,119 shares of common stock. On July 21,
      2005,
      Berkshire Bank announced the payment of a 5-for-4 stock split, effected in
      the
      form of a 25% stock dividend, payable August 19, 2005, which resulted in an
      additional 62,224 shares.





Pursuant
      to a Plan of Reorganization and a Plan of Merger (the “Plan”) that was approved
      by Berkshire Bank’s shareholders on April 18, 2006, a holding company named
      Berkshire Bancorp, Inc. was formed and was effective September 1, 2006. As
      part
      of the reorganization, Berkshire Bank became a wholly owned banking subsidiary
      of Berkshire Bancorp, Inc. The Plan further provided for the one-for-one
      exchange of shares of common stock of Berkshire Bank for shares of common stock
      of Berkshire Bancorp, Inc. In accordance with its equivalent 19.9% ownership,
      the Company exchanged one-for-one the common stock shares of Berkshire Bank
      for
      the common stock shares of Berkshire Bancorp, Inc. In addition, the Company
      executed a Crown X agreement that was amended to reflect the Company’s
      acquisition of Berkshire Bancorp, Inc. common stock. Other than this revision,
      the Crown X agreement, which was approved by the Federal Reserve Bank of
      Philadelphia in July 2006, remained substantially unchanged from the original
      agreement approved by the Federal Reserve Bank in September 2003.





Subsequently,
      Berkshire Bancorp, Inc. announced a 5-for-4 stock split effected in the form
      of
      a stock dividend as of the record date of September 14, 2006, which resulted
      in
      the issuance of 77,780 additional shares of common stock. As of September 30,
      2006, the Company’s total investment in Berkshire Bancorp, Inc. was $2,147,000,
      represented by 388,901 shares, resulting in a 19.9% aggregate ownership in
      consideration of the combined ownership of the Company, its directors and its
      officers. The investment is carried at cost and is included in the other assets
      category on the consolidated balance sheet. Based upon the limitations imposed
      by the Crown X agreement, the Company is considered to be a passive investor.




**3.**  **Earnings
      per Share**





The
      following table sets forth the computation of basic and diluted earnings per
      share:





Nine
                Months Ended
            
            Three
                Months EndedSeptember
                30
            
            September
                30,2006
            
            2005
            
            2006
            
            2005Net
                income applicable to common stock
            
            $
            2,579,000
            
            $
            2,685,000
            
            $
            900,000
            
            $
            899,000Weighted-average
                common shares outstanding
            
            
            6,304,262
            
            
            6,302,452
            
            
            6,304,262
            
            
            6,303,560Effect
                of dilutive securities, stock options
            
            
            18,613
            
            
            20,073
            
            
            16,350
            
            
            19,288Weighted-average
                common shares outstandingused
                to calculate diluted earnings per share
            
            
            6,322,875
            
            
            6,322,525
            
            
            6,320,612
            
            
            6,322,848Basic
                earnings per share
            
            $
            0.41
            
            $
            0.43
            
            $
            0.14
            
            $
            0.14Diluted
                earnings per share
            
            $
            0.41
            
            $
            0.42
            
            $
            0.14
            
            $
            0.14





Page
          9
 *Index*








**4.**  **Comprehensive
      Income**





The
      components of other comprehensive income (loss) and related tax effects for
      the
      three and nine months ended September 30, 2006 and 2005 are as
      follows:





Nine
                Months Ended
            
            Three
                Months EndedSeptember
                30,
            
            September
                30,(In
                thousands)****
            
            2006
            
            2005
            
            2006
            
            2005Unrealized
                holding gains (losses) onavailable
                for sale securities
            
            
            ($5
            )
            
            ($1,114
            )
            $
            1,473
            
            
            ($898
            )Less
                reclassification adjustments forloss
                included in net income
            
            
            -
            
            
            -
            
            
            -
            
            
            -Net
                unrealized gains (losses)
            
            
            (5
            )
            
            (1,114
            )
            
            1,473
            
            
            (898
            )Tax
                effect
            
            
            2
            
            
            379
            
            
            (500
            )
            
            302Net
                of tax amount
            
            
            ($3
            )
            
            ($735
            )
            $
            973
            
            
            ($593
            )





**5.**  **Stock-Based
      Compensation**





Prior
      to
      January 1, 2006, the Company’s stock option plan was accounted for under the
      recognition and measurement provisions of APB Opinion No. 25 (Opinion 25), *Accounting
      for Stock Issued to Employees* ,
      and
      related Interpretations, as permitted by FASB Statement No. 123, *Accounting
      for Stock Based Compensation* (as
      amended by SFAS No. 148, *Accounting
      for Stock-Based Compensation Transition and Disclosure* )
      (collectively SFAS 123). No stock-based employee compensation cost was
      recognized in the Company’s consolidated statements of income through December
      31, 2005, as all options granted under the plan had an exercise price equal
      to
      the market value of the underlying common stock on the date of grant. Effective
      January 1, 2006, the Company adopted the fair value recognition provisions
      of
      FASB Statement No. 123(R), Share-Based Payment (SFAS 123(R)), using the
      modified-prospective transition method. Under this transition method,
      compensation cost recognized in 2006 includes: (a) compensation cost for all
      share-based payments granted prior to, but not yet vested as of January 1,
      2006
      based on the grant date fair value calculated in accordance with the original
      provisions of SFAS 123, and (b) compensation cost for all share-based payments
      granted subsequent to December 31, 2005, based on a grant-date fair value
      estimated in accordance with the provisions of SFAS 123(R). As of December
      31,
      2005, there were no unvested options. However, on May 18, 2006, 13,000 options
      to purchase common stock were granted to directors. Since the options have
      a
      six-month vesting period, the Company had 13,000 stock options not fully vested
      as of September 30, 2006 with related compensation costs totaling $19,000.
      The
      cost is expected to be recognized monthly on a straight-line basis through
      November 18, 2006, which is the end of the six-month vesting period.





As
      a
      result of adopting SFAS 123(R) on January 1, 2006, the Company’s earnings before
      income taxes for the three and nine months ended September 30, 2006, were
      $10,000 and $13,000, respectively, lower than if the granting of options had
      continued to be accounted for as share-based compensation under Opinion 25.





The
      table
      below illustrates the effect on net income and earnings per share if the Company
      had applied the fair value recognition provisions of SFAS 123 to options granted
      under the Company’s stock option plan for the three and nine months ended
      September 30, 2005. For purposes of this *pro
      forma* disclosure, the value of the options is estimated using the Black-Scholes
      option-pricing model and is being amortized to expense over the options’ vesting
      periods.





Page
          10
 *Index*





Nine Months Ended
            
            Three Months EndedSeptember
                30,
            
            September
                30,2005
            
            2005(In
                thousands, except share data)Net
                income as reported
            
            $
            2,685
            
            $
            899Total
                stock-based compensation cost, net of tax,that
                would have been included in thedetermination
                of net income if the fairvalue
                based method had been appliedto
                all awards
            
            
            84
            
            
            6*Pro
                forma*net income
            
            $
            2,601
            
            $
            893Basic
                earnings per share:As
                reported
            
            $
            0.43
            
            $
            0.14*Pro
                forma*
            
            $
            0.41
            
            $
            0.14Diluted
                earnings per share:As
                reported
            
            $
            0.42
            
            $
            0.14*Pro
                forma*
            
            $
            0.41
            
            $
            0.14





**6.**  **Guarantees**





The
      Company does not issue any guarantees that would require liability recognition
      or disclosure, other than its standby letters of credit. Standby letters of
      credit that are written are conditional commitments issued by the Bank to
      guarantee the performance of a customer to a third party. Generally, all letters
      of credit, when issued, have expiration dates within one year. The credit risk
      involved in issuing letters of credit is essentially the same as those that
      are
      involved in extending loan facilities to customers. The Bank, generally, holds
      collateral and/or personal guarantees supporting these commitments. The Bank
      had
      $2,671,000 in standby letters of credit as of September 30, 2006. Management
      believes that the proceeds obtained through liquidation of collateral and the
      enforcement of guarantees would be sufficient to cover the potential amount
      of
      future payments required under the corresponding guarantees. The current amount
      of the liability as of September 30, 2006 for guarantees under standby letters
      of credit is not material.





**7.**  **New
      Accounting Standards**





In
      February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid
      Financial Instruments” (“SFAS No. 155”).   SFAS No. 155 amends FASB
      Statement No. 133 and FASB Statement No. 140, and improves the financial
      reporting of certain hybrid financial instruments by requiring more consistent
      accounting that eliminates exemptions and provides a means to simplify the
      accounting for these instruments.  Specifically, SFAS No. 155 allows
      financial instruments that have embedded derivatives to be accounted for as
      a
      whole (eliminating the need to bifurcate the derivative from its host) if the
      holder elects to account for the whole instrument on a fair value basis. 
SFAS No. 155 is effective for all financial instruments acquired or issued
      after
      the beginning of an entity's first fiscal year that begins after September
      15,
      2006. The Company is required to adopt the provisions of SFAS No. 155, as
      applicable, beginning in fiscal year 2007. Management does not believe the
      adoption of SFAS No. 155 will have a material impact on the Company’s
      consolidated financial position and results of operations.





In
      March
      2006, the FASB issued SFAS No. 156, “Accounting for Servicing of
      Financial Assets — An Amendment of FASB Statement No. 140”
(“SFAS 156”). SFAS 156 requires that all separately recognized
      servicing assets and servicing liabilities be initially measured at fair value,
      if practicable. The statement permits, but does not require, the subsequent
      measurement of servicing assets and servicing liabilities at fair value.
      SFAS 156 is effective as of the beginning of an entity’s first fiscal year
      that begins after September 15, 2006, which for the Company will be as of
      the beginning of fiscal 2007. The Company does not believe that the adoption
      of
      SFAS 156 will have a significant effect on its consolidated financial
      statements.





In
      February 2006, the FASB issued Staff Position No. FAS 123(R)-4, “Classification
      of Options and Similar Instruments Issued as Employee Compensation That Allow
      for Cash


Page
          11
 *Index*


Settlement
      upon the Occurrence of a Contingent Event”. This position amends SFAS 123(R) to
      incorporate that a cash settlement feature that can be exercised only upon
      the
      occurrence of a contingent event that is outside the employee’s control does not
      meet certain conditions in SFAS 123(R) until it becomes probable that the event
      will occur. The guidance in this FASB Staff Position shall be applied upon
      initial adoption of Statement 123(R). The adoption of SFAS 123(R) did not have
      an impact on the Company’s consolidated financial statements.




In
      July
      2006, the FASB issued FASB Interpretation No. 48, "Accounting for Uncertainty
      in
      Income Taxes”. The interpretation clarifies the accounting for uncertainty in
      income taxes recognized in a company's financial statements in accordance with
      Statement of Financial Accounting Standards No. 109, "Accounting for Income
      Taxes”. Specifically, the pronouncement prescribes a recognition threshold and a
      measurement attribute for the financial statement recognition and measurement
      of
      a tax position taken or expected to be taken in a tax return. The interpretation
      also provides guidance on the related derecognition, classification, interest
      and penalties, accounting for interim periods, disclosure and transition of
      uncertain tax positions. The interpretation is effective for fiscal years
      beginning after December 15, 2006. The Company is evaluating the impact of
      this
      new pronouncement on its consolidated financial statements.




In
      September 2006, the FASB issued FASB Statement No. 157, Fair Value Measurements,
      which defines fair value, establishes a framework for measuring fair value
      under
      GAAP, and expands disclosures about fair value measurements. FASB Statement
      No.
      157 applies to other accounting pronouncements that require or permit fair
      value
      measurements. The new guidance is effective for financial statements issued
      for
      fiscal years beginning after November 15, 2007, and for interim periods within
      those fiscal years. We are currently evaluating the potential impact, if any,
      of
      the adoption of FASB Statement No. 157 on our consolidated financial position,
      results of operations and cash flows.




On
      September 13, 2006, the Securities and Exchange Commission “SEC” issued Staff
      Accounting Bulletin No. 108 (“SAB 108”). SAB 108 provides interpretive guidance
      on how the effects of the carryover or reversal of prior year misstatements
      should be considered in quantifying a potential current year misstatement.
      Prior
      to SAB 108, companies might evaluate the materiality of financial statement
      misstatements using either the income statement or balance sheet approach,
      with
      the income statement approach focusing on new misstatements added in the current
      year, and the balance sheet approach focusing on the cumulative amount of
      misstatement present in a company’s balance sheet. Misstatements that would be
      material under one approach could be viewed as immaterial under another
      approach, and not be corrected. SAB 108 now requires that companies view
      financial statement misstatements as material if they are material according
      to
      either the income statement or balance sheet approach. The Company has analyzed
      SAB 108 and determined that upon adoption, it will have no impact on the
      reported results of operations or financial conditions.




In
      September 2006, the FASB issued FASB Staff Position AUG AIR-1’ “Accounting for
      Planned Major Maintenance Activities”, which is effective for fiscal years
      beginning after December 15, 2006. This position statement eliminates the
      accrue-in-advance-method of accounting for planned major maintenance activities.
      We do not expect this pronouncement to have a significant impact on the
      determination or reporting of our financial results.







Page
          12
 *Index*




**Item
      2.**





**MANAGEMENT’S
      DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND**


**RESULTS
      OF OPERATIONS**


**September
      30, 2006**





The
      following is management’s discussion and analysis of the significant changes in
      the consolidated financial condition, results of operations, capital resources
      and liquidity presented in the accompanying unaudited consolidated financial
      statements for the Company. This discussion should be read in conjunction with
      the preceding consolidated financial statements and related footnotes, as well
      as, the Company's December 31, 2005 Annual Report on Form 10-K. Current
      performance does not guarantee and may not be indicative of similar performance
      in the future.





In
      addition to historical information, this quarterly report on Form 10-Q contains
      forward-looking statements. The forward-looking statements contained in this
      report are subject to certain risks, assumptions and uncertainties. Because
      of
      the possibility of change in the underlying assumptions, actual results could
      differ materially from those projected in the forward-looking statements.
      Additional factors that might cause actual results to differ materially from
      those expressed in the forward-looking statements include, but are not limited
      to:





-
            operating,
                legal and regulatory risks,


-
            economic,
                political and competitive forces affecting the Company’s services,
                and


-
            the
                risk that management’s analyses of these risks could be incorrect and/or
                that the strategies developed to address them could be
                unsuccessful.





The
      Company’s forward-looking statements are relevant only as of the date on which
      the statements are made. By making forward-looking statements, the Company
      assumes no duty to update them to reflect new, changing or unanticipated events
      or circumstances. Readers should carefully review the risk factors described
      in
      other periodic reports and public documents that the Company files from time
      to
      time with the Securities and Exchange Commission.





**CRITICAL
      ACCOUNTING POLICIES**





Disclosure
      of the Company’s significant accounting policies is included in Note 1 to the
      consolidated financial statements of the Company’s Annual Report on Form 10-K
      for the year ended December 31, 2005. Some of these policies are particularly
      sensitive requiring significant judgments, estimates and assumptions to be
      made
      by management. Additional information is contained on pages 15 and 18 herein
      of
      this report for the provision and allowance for loan losses.




**OVERVIEW**





Net
      income for the nine months ended September 30, 2006 was $2,579,000 as compared
      with net income of $2,685,000 for the nine months ended September 30, 2005.
      The
      $106,000, or 3.9% decline in earnings is attributable to an increase in the
      Company’s operating expenses resulting from its expansion and growth as well as
      the decline in the Company’s net interest margin. On a dilutive earnings per
      share basis, net income for the nine months ended September 30, 2006 was $0.41
      per share as compared with $0.42 per share for the same period in 2005. Net
      income as a percentage of average assets on an annualized basis, also known
      as
      return on average assets, decreased to 0.84% for the first nine months of 2006
      from 0.95% for the first nine months of 2005. This decline was the result of
      a
      decrease in net income in comparison with asset growth of 7.6% from the end
      of
      the third quarter of 2005 to the end of the third quarter of 2006. Net income
      as
      a percentage of total average stockholders’ equity on an annualized basis, also
      known as return on average equity, was 15.21% and 16.40% for the first nine
      months of 2006 and 2005, respectively. The decrease in this ratio is
      attributable to the decline in net income in contrast to the increased level
      of
      stockholders’ equity.




During
      the first nine months of 2006, the Company’s assets increased $21,716,000, or
      5.4%, to $425,945,000 as of September 30, 2006 as compared with $404,229,000
      as
      of the year ended December 31,


Page
          13
 *Index*


2005.
      The
      increase in assets since the 2005 year end is attributable to the increase
      in
      cash and cash equivalents and loans. Loans, which increased to $315,140,000
      as
      of September 30, 2006 from $293,387,000 as of December 31, 2005, were funded
      from cash flow generated from the investment portfolio, which declined
      $6,000,000 and the proceeds of deposit growth, which increased $31,274,000
      to
      $355,580,000 at the end of the third quarter of 2006 from $324,306,000 as of
      December 31, 2005. This compares to deposit growth of $9,219,000, or 3.1%,
      to
      $307,484,000 at September 30, 2005 from $298,265,000 as of December 31, 2004.
      The growth in total deposits during the first nine months of 2006 was higher
      than that of the same period in 2005 as a result of increased interest bearing
      deposits driven by the Bank’s continued efforts to offer competitive interest
      rates and provide quality customer service.





**RESULTS
      OF OPERATIONS**





**Net
      Interest Income**





For
      the
      three months ended September 30, 2006, total interest income increased $971,000,
      or 18.7%, to $6,165,000 as compared with $5,194,000 for the three months ended
      September 30, 2005. This increase is primarily due to loan volume growth, which
      is the Company’s highest yielding asset, and increased yields on interest
      earning assets impacted by  six 25 basis point prime rate increases that
      occurred since the third quarter of 2005.




Total
      interest expense increased by $777,000, or 38.8%, to $2,780,000 for the three
      months ended September 30, 2006 from $2,003,000 for the three months ended
      September 30, 2005. This increase is primarily attributable to deposit growth
      and the increased costs associated with attracting and maintaining deposits
      during a period of rising short-term interest rates.





Net
      interest income increased by $194,000, or 6.1%, to $3,385,000 for the three
      months ended September 30, 2006 from $3,191,000 for the three months ended
      September 30, 2005.





For
      the
      nine months ended September 30, 2006, total interest income increased
      $2,844,000, or 19.5%, to $17,449,000, as compared with $14,605,000 for the
      nine
      months ended September 30, 2005. This increase was supported by the yield from
      interest earning assets, which increased to 6.30% (on a fully tax equivalent
      basis) during the first nine months of 2006 from 5.77% during the first nine
      months of 2005 as a result of prime rate increases, which contributed to the
      better than anticipated yields. In addition, average interest-earning assets
      increased 9.4% to $383,423,000 for the first nine months of 2006, from
      $350,369,000 for the first nine months of 2005. The growth in average interest
      earning assets was primarily attributable to increased loan volume, which was
      funded from the cash flow generated from the investment securities portfolio
      and
      deposit growth.





Total
      interest expense increased $2,323,000, or 45.4%, to $7,436,000 for the nine
      months ended September 30, 2006, from $5,113,000 for the nine months ended
      September 30, 2005. This increase was attributable to the 9.3% growth in average
      interest bearing liabilities, which increased $29,131,000 to $341,407,000 for
      the first nine months of 2006 from $312,276,000 for the first nine months of
      2005. The need to increase interest rates to maintain and attract deposits
      affected the Bank’s cost of funds, which increased to 2.91% for the nine months
      ended September 30, 2006 from 2.19% for the same period in 2005.





Net
      interest income increased by $521,000, or 5.5%, to $10,013,000 for the nine
      months ended September 30, 2006 from $9,492,000 for the nine months ended
      September 30, 2005. This increase was attributable to the growth of interest
      sensitive assets, in particular loans, and prime rate increases, which helped
      to
      offset and to a certain degree, minimize the impact of increased costs
      associated with funding sources. The composition of the Company’s interest
      sensitive assets shifted, where the balance of the investment portfolio
      decreased due to reinvesting the cash flow in loans, which are higher yielding.
      In addition, the proceeds from the deposit growth were not only used to fund
      loans, but were used to reduce the Bank’s borrowings, which are a more costly
      funding source as compared with deposits. This strategy helped to minimize
      further compression of the Bank’s net interest rate spread and margin. For the
      first nine months of 2006, the net interest spread (on a fully tax equivalent
      basis) decreased to 3.39% from 3.58% for the first nine months in 2005, while
      the net interest margin (on a fully tax equivalent basis) decreased to 3.71%
      for
      the nine-month period ending September 30, 2006 from 3.82% for the nine-month
      period ending


Page
          14
 *Index*


September
      30, 2005.





**Provision
      for Loan Losses**





The
      provision for loan losses was $90,000 for the three months ended September
      30,
      2006 compared with $84,000 for the three months ended September 30,
      2005.





For
      the
      nine months ended September 30, 2006, the provision for loan losses was
      $299,000, a decrease of $37,000, or 11.0%, compared with $336,000 for the nine
      months ended September 30, 2005. The decrease in the provision is attributable
      to management’s consistent efforts to ensure the high quality of the loan
      portfolio, as represented by a lower percentage of non-performing assets and
      loans subject to review or regulatory classification.





The
      allowance for loans losses represented 1.03% of total loans at September 30,
      2006, compared with 1.05% as of December 31, 2005 and 1.12% as of September
      30,
      2005. Management performs ongoing assessments of the loan loss reserve in
      relation to loan portfolio growth, credit exposure to individual borrowers,
      overall trends in the loan portfolio and other relevant factors. Based upon
      these factors, management believes that as of September 30, 2006, the reserve
      is
      reasonable and sufficient to support the increased loan growth in light of
      the
      strong asset quality as supported by the ratios reflected in Table 2 on page
      19.





**Other
      Income**





For
      the
      three months ended September 30, 2006, other income was $599,000, a decrease
      of
      $13,000, or 2.1%, compared with other income of $612,000 for the three months
      ended September 30, 2005. The decline was primarily due to a $57,000 decrease
      in
      fee income from mortgage banking activities resulting from lower mortgage
      origination volume and $2,000 in less income from its investment in life
      insurance. Offsetting these declines were a $26,000 increase in customer service
      fees, a $14,000 gain from the sale of other real estate owned and a $6,000
      increase in other miscellaneous income.





Other
      income for the nine months ended September 30, 2006 increased $29,000, or 1.6%,
      to $1,809,000 from $1,780,000 for the first nine months ended September 30,
      2005. This increase was due to an $180,000 increase in customer service fees
      attributable to increased core deposit activity and fees earned on an overdraft
      privilege product. Further impacting other income was an increase of $61,000
      in
      other miscellaneous income, which was primarily attributable to a one-time
      gain
      of $62,000 from the exchange of one asset to another. Offsetting these increases
      was a $202,000 decline in income from mortgage banking activities because of
      lower mortgage origination volume during the first nine months of 2006 as
      compared with 2005. In addition, there was an $8,000 decline in income
      associated with a decrease in the cash surrender value of the Bank’s investment
      in life insurance and a decline of $2,000 from the gain on sale of other real
      estate owned in 2006 as compared with 2005.




**Other
      Expenses**





Other
      expenses, which include salary, occupancy, equipment and all other expenses
      incidental to the operation of the Company, increased to $2,773,000 for the
      third quarter of 2006 from $2,559,000 for the third quarter of 2005. The
      $214,000, or 8.4%, increase is not only due to the Company’s continued growth,
      but is attributable to increased salary, occupancy and equipment costs
      associated with the opening of a new branch located at 4510 Bath Pike,
      Bethlehem, Pennsylvania, the completion and opening of a new branch building
      located at 502 State Avenue, Emmaus, Pennsylvania and the completed renovation
      and full utilization of a 3-story brick building to house administrative,
      operational and executive offices.




Salaries
      and employee benefit expenses, which make up the largest component of other
      expenses, increased $149,000, or 11.1%, to $1,496,000 for the third quarter
      of
      2006 from $1,347,000 for the third quarter in 2005. The increase is primarily
      attributable to additions to staff the new branches and the increase in normal
      salary and benefit costs.


Page
          15
 *Index*





Occupancy
      expenses increased $36,000, or 14.8%, to $279,000 for the three months ended
      September 30, 2006 from $243,000 for the three months ended September 30, 2005.
      The increase is due to the costs associated with the two branches opened since
      the third quarter of 2005.





Equipment
      expense increased $10,000, or 4.8%, to $218,000 for the three months ended
      September 30, 2006 from $208,000 for the three months ended September 30, 2005.
      This increase is the result of additional costs and depreciation associated
      with
      equipment purchased to accommodate the Company’s expansion.





Other
      operating expenses during the third quarter of 2006 increased $19,000, or 2.5%,
      to $780,000 from $761,000 during the third quarter of 2005. The increase is
      primarily associated with the growth of the Company.





Salaries
      and employee benefit expenses, which make up the largest component of other
      expenses, increased $520,000, or 13.2%, to $4,450,000 for the first nine months
      of 2006 from $3,930,000 for the first nine months of 2005. The increase is
      attributable to staff additions to support the expansion of the Company and
      increases in normal salary and benefit related expenses.





Occupancy
      expenses increased $174,000, or 26.0%, to $842,000 for the nine months ended
      September 30, 2006 from $668,000 for the nine months ended September 30, 2005.
      The increase resulted from the increased depreciation of real property
      associated with the 3-story brick building to accommodate administrative,
      operational and executive offices, and the costs related to the opening of
      a new
      branch in Bethlehem, Pennsylvania and the completed construction of a new branch
      building that opened in Emmaus, Pennsylvania.





Equipment
      expense increased $44,000, or 7.2%, to $655,000 for the nine months ended
      September 30, 2006 from $611,000 for the nine months ended September 30, 2005.
      This increase is the result of additional costs and depreciation associated
      with
      equipment purchased to accommodate the Company’s growth.





Other
      operating expenses increased $107,000, or 4.8%, to $2,346,000 for the nine
      months ended September 30, 2006 from $2,239,000 for the nine months ended
      September 30, 2005. This increase was primarily the result of the Company’s
      growth and increased transactional volume, which impacted certain volume driven
      expenses.





**Income
      Taxes**





Income
      tax expense was $221,000 for the three months ended September 30, 2006, a
      decrease of $40,000, or 15.3%, compared with $261,000 for the three months
      ended
      September 30, 2005. The decline in the tax expense was attributable to realizing
      3.4% in less net income before taxes in the third quarter of 2006 as compared
      with 2005 in addition to an increased level of tax exempt income.





For
      the
      nine months ended September 30, 2006, the tax provision was $651,000 compared
      with $803,000 for the nine months ended September 30, 2005. This decrease of
      $152,000, or 18.9%, is the result of achieving lower pre-tax net income for
      the
      nine months ended September 30, 2006 as compared with the same period in 2005
      while increasing the amount of tax-exempt income. Income tax expense as a
      percentage of pretax income was 20.2% for the nine months ended September 30,
      2006 as compared with 23.0% for the same period in 2005.





**Net
      Income**





Net
      income for the three months ended September 30, 2006 was $900,000, an increase
      of $1,000, or 0.1%, compared with $899,000 for the three months ended September
      30, 2005. The increase in net income is the result of an increase of $194,000
      in
      net interest income and a decline of $40,000 in taxes. This is offset by a
      decrease of $13,000 in other income, an increase of $214,000 in other expenses,
      and an increase of $6,000 in the provision for loan losses. Basic and diluted
      earnings per share for the three


Page
          16
 *Index*


months
      ended September 30, 2006 was $0.14 per share, which was the same as the per
      share earnings for the three months ended September 30, 2005.





Net
      income for the nine months ended September 30, 2006 was $2,579,000, a decrease
      of $106,000, or 3.9%, compared with $2,685,000 for the nine months ended
      September 30, 2005. The decrease in net income was attributable to an increase
      of $845,000 in other expenses, which was offset by an increase of $521,000
      in
      net interest income, a decrease of $37,000 in the provision for loan losses,
      an
      increase of $29,000 in other income and a decrease of $152,000 in taxes. Basic
      and diluted earnings per share for the nine months ended September 30, 2006
      were
      respectively $0.41 per share, as compared with the nine months ended September
      30, 2005 where basic earnings per share was $0.43 per share and diluted earnings
      per share was $0.42 per share.




**FINANCIAL
      CONDITION**





**Securities**





The
      Company’s securities portfolio is comprised of securities that not only provide
      interest income, including tax-exempt income, but also provide a source of
      liquidity, diversify the earning assets portfolio, allow for the management
      of
      risk and tax liability, and provide collateral for repurchase agreements and
      public fund deposits. Policies are in place to address various aspects of
      managing the portfolio, which include but are not limited to, concentrations,
      liquidity, credit quality, interest rate sensitivity and regulatory guidelines.
      Adherence to these policies is monitored by the Company’s Asset/Liability
      Committee on a monthly basis.





The
      Company generally intends to hold its investment securities to maturity. As
      of
      September 30, 2006 all of the securities in the portfolio are classified as
      available for sale, with new purchases generally placed in this category. As
      part of the Company’s strategy to reduce some of the future risk inherent within
      the investment portfolio, the Company sold, during the second quarter of 2006,
      the balance of its held to maturity securities, which totaled $1,026,000, at
      a
      gain of $38,000. Securities in the available for sale category are accounted
      for
      at fair value with unrealized appreciation or depreciation, net of tax, reported
      as a separate component of stockholders’ equity. The Company periodically
      evaluates the securities portfolio to determine if any declines in the fair
      values of securities are other than temporary. If such a decline were deemed
      to
      be other than temporary, the Company would write down the security to its fair
      value through a charge to current period operations. As of September 30, 2006,
      there were no securities in the portfolio whose values were deemed to be other
      than temporarily impaired. Prior to September 30, 2006, any securities in the
      held to maturity category were accounted for at amortized cost. The Company
      invests in securities for the yield they produce and not to profit from trading.
      The Company holds no trading securities in its portfolio, and the securities
      portfolio contained no high-risk securities or derivatives as of September
      30,
      2006.





The
      securities portfolio at September 30, 2006 was $69,213,000, compared to
      $75,213,000 at December 31, 2005, a decrease of $6,000,000, or 8.0%. The decline
      is attributable to repayments of principal, which were reinvested by funding
      the
      Company’s loan growth of 7.4% since year end 2005. Securities available for sale
      decreased to $69,213,000 at September 30, 2006 from $74,175,000 at December
      31,
      2005, while there were no securities held to maturity at September 30, 2006
      as
      compared with $1,038,000 at December 31, 2005.





The
      carrying value of the available for sale portion of the portfolio at September
      30 2006 includes an unrealized loss of ($1,338,000) (reflected as an accumulated
      other comprehensive loss of ($883,000) in stockholders’ equity, net of a
      deferred income tax asset of ($455,000)). This compares with an unrealized
      loss
      at December 31, 2005 of ($1,336,000) (reflected as an accumulated other
      comprehensive loss of ($880,000) in stockholders’ equity, net of a deferred
      income tax asset of ($456,000)).





**Loans**





The
      loan
      portfolio comprises the major component of the Company’s earning assets and
      generally is the highest yielding asset category. Gross loans receivable, net
      of
      unearned fees and origination costs,


Page
          17
 *Index*


increased
      $21,753,000, or 7.4%, to $315,140,000 at September 30, 2006 from $293,387,000
      at
      December 31, 2005. In comparing the third quarter of 2006 with the third quarter
      of 2005, gross loans increased 16.0%. Gross loans represented 88.6% of total
      deposits at September 30, 2006 as compared with 90.5% at December 31, 2005.
      Loan
      growth was significant in the commercial sector, consisting of commercial real
      estate and commercial and industrial loans. The Bank’s general business
      development program and specific focus on municipal/tax-free lending continue
      to
      lead this effort in the commercial lending sector. Outstanding retail loans
      have
      grown as well, although to a lesser extent than commercial loans. While
      residential mortgage lending activity remains active, it is not as robust as
      it
      was a year ago primarily due to the increase in mortgage interest rates during
      the period.





**Credit
      Risk and Loan Quality**





The
      Company continues to be prudent in its efforts to minimize credit risk. The
      Bank’s written lending policy requires underwriting, loan documentation and
      credit analysis standards to be met prior to the approval and funding of any
      loan. In accordance with that policy, the internal loan review process monitors
      the loan portfolio on an ongoing basis. The Credit Administration area then
      prepares an analysis of the allowance for loan losses on a quarterly basis,
      which is then submitted to the Board of Directors for its assessment as to
      the
      adequacy of the allowance.





The
      allowance for loan losses at September 30, 2006 and December 31, 2005 was
      $3,235,000 and $3,072,000, respectively, compared to $3,055,000 at September
      30,
      2005. Although less of a provision for loan losses was recorded in the first
      nine months of 2006 as compared with the same period in 2005, there was an
      increase in the allowance for loan losses as of September 30, 2006 compared
      to
      December 31, 2005 due to the provision for loan losses exceeding net
      charge-offs. At September 30, 2006, the allowance for loan losses represented
      1.03% **** of
      the
      gross loan portfolio, compared with 1.05% at December 31, 2005. This compares
      to
      1.12% at September 30, 2005. At September 30, 2006, in consideration of the
      strong asset quality, management believes that the allowance for loan loss
      reserve is reasonable and adequate to address any potential losses.





**Table
      1 - “Analysis of Allowance for Loan Losses”** -
      details the activity, which occurred in the allowance over the first nine months
      of 2006 and 2005.





**Table
      1 - Analysis of Allowance for Loan Losses** (1)




(dollars
                in thousands)******2006**
            
            ******2005**Balance,
                beginning of year
            
            $
            3,072
            
            $
            2,838Provision
                charged to operating expense
            
            
            299
            
            
            336Charge-offs:Commercial
            
            
            -
            
            
            (8
            )Real
                estate
            
            
            (90
            )
            
            (36
            )Consumer
            
            
            (70
            )
            
            (90
            )Total
                charge-offs
            
            
            (160
            )
            
            (134
            )Recoveries:Commercial
            
            
            3
            
            
            0Real
                estate
            
            
            1
            
            
            3Consumer
            
            
            20
            
            
            12Total
                recoveries
            
            
            24
            
            
            15Net
                (charge-offs)
            
            
            (136
            )
            
            (119
            )$
            3,235
            
            $
            3,055Net
                (charge-offs) recoveries to average net loans
            
            
            (0.06
            )%
            
            (0.05
            )%(1)
                Bank’s loan portfolio is entirely domestic




The
      Bank’s lending policy is executed through the assignment of tiered loan limit
      authorities to individual officers of the Bank, the Officer’s Loan Committee,
      the Board Loan Committee and the Board of Directors. Although the Bank believes
      it maintains sound credit policies, certain loans may deteriorate for a variety
      of reasons. The Bank’s policy is to place all loans on a non-accrual status upon
      becoming 90 days delinquent in their payments, unless there is a documented
      and
      reasonable expectation of the collection of


Page
          18
 *Index*


the
      delinquent amount. Loans are reviewed monthly as to their status, and on a
      quarterly basis, a Watch List of potentially troubled loans is prepared and
      presented to the Board of Directors. Management is not aware of any materially
      potential loan problems that have not been disclosed in this
      report.





**Table
      2 - “Asset Quality Ratios”** -
      summarizes pertinent asset quality ratios at September 30, 2006 and December
      31,
      2005.




**Table
                2 -Asset Quality Ratios********9/30/06**
            
            ******12/31/05**Non-accrual
                loans/Total loans
            
            
            0.16
            %
            
            0.21
            %Non-performing
                assets (1) /Total loans
            
            
            0.33
            %
            
            0.22
            %Net
                charge-offs/Average loans
            
            
            0.06
            %
            
            0.07
            %Allowance/Total
                loans
            
            
            1.03
            %
            
            1.05
            %Allowance/Non-accrual
                loans
            
            
            638.07
            %
            
            503.61
            %Allowance/Non-performing
                loans (1)
            
            
            310.76
            %
            
            488.39
            %(1)
                - Includes non-accrual loans.


At
      September 30, 2006, the Company did not have any real estate in-substance
      foreclosure as compared with $27,000 that was outstanding at December 31, 2005.
      Since year end, the Company was able to dispose of the one property and
      recognized a $14,000 gain from the sale, which is included in other income.





Loan
      concentrations are considered to exist when the total amount of loans to any
      one
      or a multiple number of borrowers engaged in similar activities or having
      similar characteristics exceeds 10% of loans outstanding in any one category.
      The majority of the Bank’s lending is made within its primary market area, which
      includes Emmaus and other adjacent communities in Lehigh County, Pennsylvania.
      Two portfolio segments represent possible concentrations: commercial real estate
      loans and consumer loans secured by residential real estate. While the Bank
      does
      not have a concentration of credit risk with any single borrower, repayments
      on
      loans in these portfolios can be negatively influenced by decreases in real
      estate values. Management mitigates this risk through stringent underwriting
      policies and procedures.





**Bank
      Owned Life Insurance**





During
      2000, the Bank invested $4,500,000 in Bank Owned Life Insurance (“BOLI”) for a
      chosen group of employees, namely officers. In 2001, the Bank made a subsequent
      BOLI investment, resulting in a total investment of $6,000,000. Under the terms
      of the BOLI, the Bank is the owner and beneficiary of the policies. The Bank’s
      BOLI was funded from the proceeds of deposit growth and from the sale of
      investment securities. Earnings from the BOLI are recognized as other income.
      The BOLI is profitable from the appreciation of the cash surrender values of
      the
      pool of insurance, and provides a tax advantage to the Company. This
      profitability is used to offset a portion of current and future employee benefit
      costs and a Nonqualified Supplemental Executive Retirement Plan for the
      Company’s Chief Executive Officer.





The
      Company had $7,709,000 and $7,506,000 in BOLI as of September 30, 2006 and
      December 31, 2005, respectively. Although the BOLI is an asset that may be
      liquidated, it is the Company’s intention to hold this pool of insurance because
      it provides tax-exempt income that lowers the Company’s tax liability, while
      enhancing its overall capital position.





**Investment
      in Bank**





On
      September 23, 2003, the Company purchased 141,300 shares of common stock
      outstanding for $1,413,000 in a *de
      novo* bank,
      named Berkshire Bank, located in Wyomissing, Berks County, Pennsylvania. On
      October 22, 2003, the Company purchased an additional 12,123 shares of common
      stock for $121,000, which resulted in increasing the Company’s investment to
      $1,534,000, or 18.3%, of Berkshire Bank’s








Page
            19
 *Index*




outstanding
      common stock as of December 31, 2003. The aggregate ownership percentage of
      the
      Company and its directors and officers as dictated within the terms of the
      Stock
      Subscription and Purchase Agreement between the Company and Berkshire Bancorp,
      Inc. was 19.9%.





During
      2004, Berkshire Bank announced a 5-for-4 stock split, effected in the form
      of a
      25% stock dividend, payable July 22, 2004, which resulted in the Company
      receiving an additional 38,355 shares. On September 1, 2004, Berkshire Bank
      commenced a three-phase common stock offering effective through March 31, 2005.
      In order to maintain its level of investment in Berkshire Bank, the Company
      purchased an additional 57,119 shares. On July 21, 2005, Berkshire Bank
      announced the payment of a 5-for-4 stock split, effected in the form of a 25%
      stock dividend, payable August 19, 2005, which resulted in an additional 62,224
      shares.




Pursuant
      to a Plan of Reorganization and a Plan of Merger (the “Plan”) that was approved
      by Berkshire Bank’s shareholders on April 18, 2006, a holding company named
      Berkshire Bancorp, Inc. was formed and was effective September 1, 2006. As
      part
      of the reorganization, Berkshire Bank became a wholly owned banking subsidiary
      of Berkshire Bancorp, Inc. The Plan further provided for the one-for-one
      exchange of shares of common stock of Berkshire Bank for shares of common stock
      of Berkshire Bancorp, Inc. In accordance with its equivalent 19.9% ownership,
      the Company exchanged one-for-one the common stock shares of Berkshire Bank
      for
      the common stock shares of Berkshire Bancorp, Inc.





Berkshire
      Bancorp, Inc. announced a 5-for-4 stock split effected in the form of a stock
      dividend as of the record date of September 14, 2006, which resulted in the
      issuance of 77,780 additional shares of common stock. As of September 30, 2006,
      the Company’s total investment in Berkshire Bancorp, Inc. was $2,147,000,
      represented by 388,901 shares, resulting in a 19.9% aggregate ownership in
      consideration of the combined ownership of the Company, its directors and its
      officers.





While
      the
      Company is considered to be a passive investor, it regards this to be a viable
      investment. The investment is carried at cost and is included in the other
      assets category on the consolidated balance sheet. The Company uses the best
      information that is available to assess the reasonableness of the value of
      this
      asset. The financial condition of Berkshire Bancorp, Inc. and the stability
      of
      its stock price have proven to be reliable valuation sources. No indicators
      of
      impairment were noted as part of the Company’s latest evaluation.




**Deposits**





Deposits
      are the major source of the Company’s funds for lending and investment purposes.
      Total deposits at September 30, 2006 were $355,580,000, an increase of
      $31,274,000, or 9.6%, from total deposits of $324,306,000 at December 31, 2005.
      The growth in deposits was primarily due to an increase of $45,228,000, or
      37.1%, in time deposits. There was a shift between deposit categories where
      customers invested fewer dollars in money market accounts and other interest
      bearing demand deposits and placed more funds in term deposits since time
      deposit term products generally paid a higher interest rate than savings
      accounts and demand deposits. Interest rate increases were influenced by prime
      rate increases and competitive pressures. The fact that we had more deposits
      placed in products that carried a higher cost impacted the cost of deposits,
      which increased to 2.72% as of September 30, 2006 from 1.99% as of December
      31,
      2005 and 1.88% as of September 30, 2005.





**Securities
      Sold under Agreements to Repurchase**





Securities
      sold under agreements to repurchase increased $2,533,000, or 69.4%, to
      $6,183,000 at September 30, 2006 from $3,650,000 at December 31, 2005 due to
      an
      increase in the interest rate paid on this product, which attracted additional
      investors. Securities sold under agreements to repurchase generally mature
      in
      one business day and roll over under a continuing contract.





**Short-Term
      Borrowings**





There
      were no outstanding short-term borrowings in the form of overnight federal
      funds
      purchased as of September 30, 2006 as compared with $3,923,000 at December
      31,
      2005. Since the cost of


Page
          20
 *Index*


borrowings
      has been higher than the cost of raising deposits, the Bank has been proactive
      in minimizing the use of such a funding source. The Bank has a $5,000,000
      federal funds line of credit with its main correspondent bank, Atlantic Central
      Bankers Bank, Camp Hill, Pennsylvania (“ACBB”) as well as a short-term/overnight
      line of credit of $35 million with the Federal Home Loan Bank of Pittsburgh
      (“FHLB”), which is part of its overall maximum borrowing capacity of
      $156,896,000.





**Long-Term
      Debt and Borrowing Capacity**





There
      were $30 million outstanding in fixed rate term loans with the FHLB at September
      30, 2006, a decrease of $10 million as compared with the $40 million that was
      outstanding at December 31, 2005. The $30 million borrowing is comprised of
      the
      following fixed rate borrowings (dollars in thousands):





Maturity
            
            Amount
            
            RateNovember
                28, 2006
            
            $
            6,000
            
            
            2.80
            %May
                7, 2007
            
            
            5,000
            
            
            3.89
            %November
                28, 2007
            
            
            7,000
            
            
            3.43
            %May
                5, 2008
            
            
            5,000
            
            
            4.03
            %November
                28, 2008
            
            
            7,000
            
            
            3.78
            %Total
            
            $
            30,000
            
            
            3.57
            %weighted average


The
      Bank
      has used long-term borrowings to fund growth. This strategy has helped the
      Bank
      to manage its cost of funds by allowing it to lock into fixed rates, at a time
      when interest rates were at their historic lowest levels.





The
      Bank
      has a total maximum borrowing capacity for both short and long-term borrowings
      of approximately $156,896,000 with the FHLB, out of which $30 million represents
      fixed rate term loans that were outstanding at September 30, 2006, and resulted
      in an unused borrowing capacity of $126,896,000.





**Mandatory
      Redeemable Capital and Junior Subordinated Debentures**




As
      of
      September 30, 2006, the Company had $8,248,000 outstanding in junior
      subordinated debentures, which were issued on July 31, 2003 to investors as
      capital trust pass-through securities by East Penn Statutory Trust I (“Trust”),
      a Connecticut statutory business trust and non-consolidated wholly owned
      subsidiary of the Company. The securities have a fixed rate of 6.80% through
      September 17, 2008. The capital securities are redeemable by the Company on
      or
      after September 17, 2008, at par, or earlier, if the deduction of related
      interest for federal income taxes is prohibited, classification as Tier I
      Capital is no longer allowed, or certain other contingencies arise. The capital
      securities must be redeemed upon final maturity of the subordinated debentures
      on September 17, 2033. Proceeds totaling $4.3 million were contributed to the
      capital at the Bank. The remaining proceeds in the amount of $3.9 million were
      used to invest in Berkshire Bank, a *de* novo
      bank, and the repurchase of the Company’s common stock. The Company chose to
      utilize the multi-issuer trust preferred alternative, which proved to be a
      less
      expensive and more flexible resource of regulatory capital.





**Asset/Liability
      Management**





Interest
      rate risk is the risk to interest income that is attributed to the repricing
      characteristics of interest sensitive assets and liabilities. An interest
      sensitive asset or liability is one that experiences changes in cash flows
      as a
      direct result of changes in market interest rates. The management of interest
      rate risk involves analyzing the maturity and repricing of interest sensitive
      assets and liabilities at specific points in time. The imbalance between
      interest sensitive assets and liabilities is commonly referred to as the
      interest rate gap. The interest rate gap is one way of assessing the risk
      inherent in the existing balance sheet as it relates to potential changes in
      net
      interest income.





The
      Company manages its balance sheet with the intent of maximizing net interest
      income, while maintaining an acceptable level of risk to minimize the impact
      that changing interest rates may have on its


Page
          21
 *Index*


net
      income and changes in the economic value of its equity. The overall interest
      rate risk position and strategies for the management of interest rate risk
      are
      reviewed by senior management and the Asset/ Liability Committee (“ALCO”) of the
      Board of Directors on an ongoing basis. The Company utilizes a variety of
      methodologies and resources to measure its interest rate risk. It also has
      the
      ability to implement strategies to manage interest rate risk, which include,
      but
      are not limited to, selling newly originated residential mortgage loans,
      controlling the volume mix of fixed/variable rate commercial loans and
      securities, increasing/ decreasing deposits via interest rate changes, borrowing
      from the FHLB, and buying/selling securities. Adjustments to the mix of interest
      sensitive assets and liabilities are made periodically in an effort to give
      the
      Company dependable and steady growth in net interest income, while at the same
      time, managing the related risks.





**Liquidity**





Liquidity
      refers to the Company’s ability to generate adequate amounts of cash to meet
      financial obligations to its customers and shareholders in order to fund loans,
      to respond to deposit outflows and to cover operating expenses. Maintaining
      a
      level of liquid funds through asset/liability management seeks to ensure that
      these needs are met at a reasonable cost. Liquidity is essential to compensate
      for fluctuations in the balance sheet and provide funds for growth and normal
      operating expenditures. Sources of funds include scheduled amortization of
      loans, loan prepayments, scheduled maturities of investments, and cash flows
      from mortgage-backed securities. Liquidity needs may also be met by converting
      assets into cash or obtaining sources of additional funding, whether through
      deposit growth or borrowings under lines of credit with correspondent banks.





Liquidity
      from asset categories is provided through cash, amounts due from banks,
      interest-bearing deposits with banks and federal funds sold, which were
      $16,784,000 at September 30, 2006, compared to $11,129,000 at December 31,
      2005.
      This increased liquidity was the result of the influx of funds from the growth
      in deposits. Additional asset liquidity sources include principal and interest
      payments from securities in the Company’s investment portfolio and cash flow
      from its amortizing loan portfolio. Longer-term liquidity needs may be met
      by
      selling securities available for sale, selling loans or raising additional
      capital. At September 30, 2006, there was $44,514,000 in liquid securities
      as
      compared with $54,746,000 at December 31, 2005. Liquid securities decreased
      by
      $10,232,000 since year-end as a result of reinvesting the cash flow generated
      from the investment securities portfolio into loans and the need to pledge
      additional securities to collateralize the increase in securities sold under
      agreements to repurchase and public fund deposits.





Liability
      liquidity sources include attracting deposits at competitive rates. Deposits
      at
      September 30, 2006 were $355,580,000, compared to $324,306,000 at December
      31,
      2005. In addition, the Bank has lines of credit with its main correspondent
      bank, ACBB, and with the FHLB, which are reliable sources for short and
      long-term funds.





The
      Company’s consolidated financial statements do not reflect various off-balance
      sheet commitments that are made in the normal course of business, which may
      involve some liquidity risk. Off-balance sheet arrangements are discussed in
      detail below.





Management
      is of the opinion that its liquidity position at September 30, 2006 is adequate
      to respond to fluctuations “on” and “off” the balance sheet. In addition,
      management knows of no trends, demands, commitments, events or uncertainties
      that may result in, or that are reasonably likely to result in the Company’s
      inability to meet anticipated or unexpected liquidity needs.





**Contractual
      Obligations**





The
      Company has various financial obligations that may require future cash payments.
      These obligations include the payment of liabilities recorded on the
      consolidated balance sheet as well as contractual obligations for purchase
      commitments and operating leases. The following table represents the Company’s
      contractual obligations, by type, that are fixed and determined at September
      30,
      2006.


Page
          22
 *Index*


**CONTRACTUAL
      OBLIGATIONS**





**September
                30, 2006****Less
                Than**
            
            
            
            
            
            **Over****1
                Year**
            
            **1
                - 3 Years**
            
            **3
                - 5 Years**
            
            **5
                Years**
            
            **Total****(in
                thousands)**Time
                deposits
            
            **$**
            **133,197**
            
            **$**
            **30,543**
            
            **$**
            **3,127**
            
            **$**
            **181**
            
            **$**
            **167,048**Long-term
                debt
            
            
            **11,000**
            
            
            **19,000**
            
            
            **-**
            
            
            **-**
            
            
            **30,000**Junior
                subordinateddebentures****
            
            
            **-**
            
            
            **8,248**
            
            
            **-**
            
            
            **-**
            
            
            **8,248**Nonqualified
                supplementalexecutive
                retirement plan
            
            
            **117**
            
            
            **162**
            
            
            **71**
            
            
            **232**
            
            
            **582**Premises
                commitments
            
            
            **850**
            
            
            **-**
            
            
            **-**
            
            
            **-**
            
            
            **850**Operating
                leases
            
            
            **260**
            
            
            **492**
            
            
            **407**
            
            
            **920**
            
            
            **2,079**Total
            
            **$**
            **145,424**
            
            **$**
            **58,445**
            
            **$**
            **3,605**
            
            **$**
            **1,333**
            
            **$**
            **208,807**


**Off-Balance
      Sheet Arrangements**





The
      Company’s consolidated financial statements do not reflect various off-balance
      sheet arrangements that are made in the normal course of business. These
      commitments consist mainly of loans approved but not yet funded, unused lines
      of
      credit and letters of credit made in accordance with the same standards as
      on-balance sheet instruments. Unused commitments at September 30, 2006 were
      $84,464,000, which consisted of $55,725,000 in unfunded commitments to existing
      loans, $14,321,000 to grant new loans, $11,747,000 in unused lines for overdraft
      privilege and $2,671,000 in letters of credit. Because these instruments have
      fixed maturity dates, and many of them will expire without being drawn upon,
      they do not present a liquidity risk to the Company. Management believes that
      any amounts actually drawn upon can be funded in the normal course of
      operations. The Company has no investment in or financial relationship with
      any
      unconsolidated entities that are reasonably likely to have a material effect
      on
      liquidity or the availability of capital resources.





**Capital**





The
      following **Table
      3** presents
      the risk-based and leverage capital amounts and ratios at September 30, 2006
      for
      the Company and the Bank.


**Actual**
              
              **For
                  Capital Adequacy**
                **Purposes**
              
              **To
                  be Well Capitalized**
                **under
                  Prompt**
                **Corrective
                  Action**
                **Provisions****Amount**
              
              **Ratio**
              
              **Amount**
              
              **Ratio**
              
              **Amount**
              
              **Ratio****(Dollars
                  in thousands)****As
                  of September 30, 2006:**Total
                  capital (to risk-weighted assets):Company
              
              **$**
              **36,151**
              
              
              **10.9**
              **%**
              
              **3****$26,535**
              
              
              **38.0**
              **%**
              
              **N/A**
              
              
              **N/A**
              **%**Bank
              
              
              **33,433**
              
              
              **10.2**
              
              
              **3****26,319**
              
              
              **3****8.0**
              
              
              **3****$32,899**
              
              
              **3****10.0**Tier
                  1 capital (to risk-weighted assets):Company
              
              
              **32,916**
              
              
              **9.9**
              
              
              **3****13,268**
              
              
              **3****4.0**
              
              
              **N/A**
              
              
              **N/A**Bank
              
              
              **30,198**
              
              
              **9.2**
              
              
              **3****13,160**
              
              
              **3****4.0**
              
              
              **3****19,740**
              
              
              **3****6.0**Tier
                  1 capital (to average assets):Company
              
              
              **32,916**
              
              
              **7.7**
              
              
              **3****17,058**
              
              
              **3****4.0**
              
              
              **N/A**
              
              
              **N/A**Bank
              
              
              **30,198**
              
              
              **7.1**
              
              
              **3****16,941**
              
              
              **3****4.0**
              
              
              **3****21,176**
              
              
              **3****5.0**




Page
          23
 *Index*


All
      of
      the capital ratios presented continue to remain at levels, which are considered
      to be “well- capitalized” as defined by regulatory guidelines. However, one of
      the three capital ratios represented by total capital as a percentage of
      risk-weighted assets of the Company and the Bank, which are 10.9% and 10.2%,
      respectively, has declined to a level that is very close to the regulatory
“well
      capitalized” threshold of 10%. This ratio has declined because capital growth,
      through the retention of earnings alone, has not kept up with the robust asset
      growth experienced by the Company in recent years. Management continues to
      closely monitor this ratio in an attempt to mitigate further deterioration
      below
      the 10% well capitalized regulatory threshold. This effort has resulted in
      this
      ratio remaining the same as was reported as of the end of the second quarter
      of
      2006.





Banking
      laws and regulations limit the amount of cash dividends that may be paid without
      prior approval from the Company’s regulatory agencies. In abidance with such
      requirements, on January 19, 2006, the Board of Directors authorized and
      declared a semi-annual cash dividend for 2006 in the amount of $0.11 per share,
      payable on February 28, 2006 to all shareholders of record as of February 3,
      2006. On July 20, 2006, the Board of Directors authorized and declared a cash
      dividend for the second half of 2006 for $0.11 per share of common stock,
      payable on August 31, 2006 to all shareholders of record as of August 11, 2006.
      The payment of these semi-annual cash dividends decreased retained earnings
      by
      $1,387,000.





Restrictions
      under the Section 202e of the Pennsylvania Banking Code of 1965 are placed
      on
      the size of a Bank’s investment in fixed assets as a percentage of equity.
      Presently, the Bank exceeds the allowable limit of 25% of equity, as defined
      by
      the Pennsylvania Department of Banking. The Bank’s fixed assets as a percentage
      of equity increased to 40.16% at September 30, 2006, as compared with 38.94%
      at
      September 30, 2005. This increase is due to the increase in fixed assets
      primarily associated with the completed construction of a new branch building,
      the opening of two branches and the Bank’s newly renovated and fully occupied
      administrative and operational office space and a new branch. Generally, the
      Bank contacts the Department of Banking to obtain the Department’s approval
      before acquiring a fixed asset that is of a material dollar amount. On March
      30,
      2006, the Bank received an authorization from the Department of Banking to
      exceed the fixed asset limitation as a result of filing an application to open
      a
      new branch. Compliance with the allowable fixed asset limit of this section
      of
      the Banking Code is expected to occur through normal depreciation adjustments
      and retention of earnings.





**Item
      3.**





**Quantitative
      and Qualitative Disclosures About Market Risk**





In
      the
      normal course of conducting business activities, the Company is exposed to
      market risk, principally interest risk. Interest risk arises from market driven
      fluctuations in interest rates that affect cash flows, income, expense and
      values of financial instruments. The Asset/Liability Committee, using policies
      and procedures approved by the Board of Directors, is responsible for managing
      the rate sensitivity position.





No
      material changes in the market risk strategy occurred during the current period.
      No material changes have been noted in the Company’s equity value at risk. A
      detailed discussion of market risk is provided in the Form 10-K for the year
      ended December 31, 2005.





**Item4.**





**Controls
      and Procedures**









(a) Evaluation
      of disclosure controls and procedures





As
      of
      September 30, 2006, the Company carried out an evaluation, under the supervision
      and with the participation of the Company’s management, including the Company’s
      Chief Executive Officer and Chief Financial Officer, of the effectiveness of
      the
      design and operation of the Company’s disclosure controls and procedures
      pursuant to Exchange Act Rule 13a-15(e). Based upon that evaluation, the Chief
      Executive Officer and Chief Financial Officer concluded that the Company’s
      disclosure controls and procedures are effective in timely alerting them to
      material information relating to the Company (including its consolidated
      subsidiary) required to be included in the Company’s periodic
      filings.


Page
          24
 *Index*





(b) Changes
      in internal control over financial reporting





The
      Company made no significant changes in its internal control over financial
      reporting or in other factors that have materially affected, or is reasonably
      likely to materially affect, the Company’s internal control over financial
      reporting.








**Part
      II - OTHER INFORMATION**





**Item1.** **Legal
      Proceedings**





In
      the
      opinion of the Company, after review with legal counsel, there are no
      proceedings pending to which the Company is a party or to which its property
      is
      subject, which, if determined adversely to the Company, would be material in
      relation to the Company’s consolidated financial condition. There are no
      proceedings pending other than ordinary, routine litigation incident to the
      business of the Company. In addition, no material proceedings are pending or
      are
      known to be threatened or contemplated against the Company by governmental
      authorities.





**Item1A.** **Risk
      Factors**





No
      material changes from those disclosed in the Form 10-K for the year ended
      December 31, 2005.





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





Nothing
      to report.





**Item
      3.** **Defaults
      upon Senior Securities**





Nothing
      to report.





**Item
      4.** **Submission
      of Matters to a Vote of Security Holders**





Nothing
      to report.





**Item
      5.** **Other
      Information**





Nothing
      to report.





**Item
      6.** **Exhibits**





3(i)
            Registrant’s
                Articles of Incorporation, as amended, are incorporated herein by
                reference to Annex B to the Registrant’s Registration Statement on Form
                S-4 (Registration No. 333-103673) as filed with the Securities and
                Exchange Commission on March 7, 2003.





3(ii)
            Registrant’s
                By-Laws are incorporated herein by reference to Annex C to the
                Registrant’s Registration Statement on Form S-4 (Registration No.
                333-103673) as filed with the Securities and Exchange Commission
                on March
                7, 2003.




10.1
            East
                Penn Financial Corporation’s 1999 Stock Incentive Plan for the benefit of
                officers and key employees is incorporated by reference to Exhibit
                10.2 to
                the Registrant’s Registration Statement on Form S-4 (Registration No.
                333-103673) as filed with the Securities and Exchange Commission
                on March
                7, 2003.


Page
          25
 *Index*





10.2
            East
                Penn Financial Corporation’s 1999 Independent Directors Stock Option Plan
                for the benefit of non-employee directors is incorporated by reference
                to
                Exhibit 10.1 to the Registrant’s Registration Statement on Form S-4
                (Registration No. 333-103673) as filed with the Securities and Exchange
                Commission on March 7, 2003.




10.3
            Executive
                Employment Agreement between East Penn Bank and Brent L. Peters,
                dated
                April 12, 2001, is incorporated by reference to Exhibit 10.3 to the
                Registrant’s Registration Statement on Form S-4 (Registration No.
                333-103673) as filed with the Securities and Exchange Commission
                on March
                7, 2003.





10.4
            The
                Supplemental Executive Retirement Plan (“SERP”) between East Penn Bank and
                Brent L. Peters, dated May 31, 2001, is incorporated herein by reference
                to Exhibit 10.4 to the Registrant’s Registration Statement on Form S-4
                (Registration No. 333-103673) as filed with the Securities and Exchange
                Commission on March 7, 2003.





10.5
            East
                Penn Financial Corporation’s Dividend Reinvestment and Stock Purchase Plan
                is incorporated by reference to the Registrant’s Registration Statement on
                Form S-3 (Registration No. 333-116754) as filed with the Securities
                and
                Exchange Commission on June 23, 2004.





10.6
            Agreement
                of sale between East Penn Bank and WAWA, Inc. dated November 10,
                2005.





10.7
            Amendment
                to Supplemental Executive Retirement Plan (“SERP”) between East Penn Bank
                and Brent L. Peters, dated July 21, 2006, is incorporated by reference
                to
                Exhibit 10.2 of Registrant’s Form 8-K filed August 1,
                2006.





10.8
            Amendment
                to Executive Employment Agreement between East Penn Bank and Brent
                L.
                Peters, dated July 21, 2006, is incorporated by reference to Exhibit
                10.1
                of Registrant’s Form 8-K filed August 1, 2006.





11
            Statement
                re: Computation of per share earnings is incorporated by reference
                herein
                to Note 3 on page 9 of this Form
                10-Q.





31.1
            Certification
                of Chief Executive Officer pursuant to Rule
                13a-15(e)/15d-15(e).





31.2
            Certification
                of Chief Financial Officer pursuant to Rule
                13a-15(e)/15d-15(e).





32.1
            Certification
                of Chief Executive Officer pursuant to Section 1350 of the Sarbanes
                Oxley
                Act of 2002.





32.2
            Certification
                of Chief Financial Officer pursuant to Section1350
                of the Sarbanes Oxley Act of
                2002.


Page
          26
 *Index*







**SIGNATURES**





Pursuant
      to the requirements of Section 12 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.








EAST
                PENN FINANCIAL CORPORATION(Registrant)By:
            /s/
                Brent L. PetersBrent
                L. PetersChairman
                of the Board, President andChief
                Executive Officer(Principal
                Executive Officer)Date:
            November
                10, 2006By:
            /s/
                Theresa M. WaskoTheresa
                M. WaskoTreasurer
                and Chief Financial Officer(Principal
                Financial and Accounting Officer)Date:
            November
                10, 2006



















Page
          27
 *Index*








**Exhibit
      Index**





3(i)
            Registrant’s
                Articles of Incorporation, as amended, are incorporated by reference
                to
                Annex B to the Registrant’s Registration Statement on Form S-4
                (Registration No. 333-103673) as filed with the Securities and Exchange
                Commission on March 7, 2003.





3(ii)
            Registrant’s
                By-Laws are incorporated by reference to Annex C to the Registrant’s
                Registration Statement on Form S-4 (Registration No. 333-103673)
                as filed
                with the Securities and Exchange Commission on March 7,
                2003.





10.1
            East
                Penn Financial Corporation’s 1999 Stock Incentive Plan for the benefit of
                officers and key employees is incorporated by reference to Exhibit
                10.3 to
                the Registrant’s Registration Statement on Form S-4 (Registration No.
                333-103673) as filed with the Securities and Exchange Commission
                on March
                7, 2003.





10.2
            East
                Penn Financial Corporation’s 1999 Independent Directors Stock Option Plan
                for the benefit of non-employee directors is incorporated by reference
                to
                Exhibit 10.2 to the Registrant’s Registration Statement on Form S-4
                (Registration No. 333-103673) as filed with the Securities and Exchange
                Commission on March 7, 2003.





10.3
            Executive
                Employment Agreement between East Penn Bank and Brent L. Peters,
                dated
                April 12, 2001, is incorporated by reference to Exhibit 10.1 to the
                Registrant’s Registration Statement on Form S-4 (Registration No.
                333-103673) as filed with the Securities and Exchange Commission
                on March
                7, 2003.





10.4
            Supplemental
                Executive Retirement Plan (“SERP”) between East Penn Bank and Brent L.
                Peters, dated May 31, 2001, is incorporated by reference to Exhibit
                10.4
                to the Registrant’s Registration Statement on Form S-4 (Registration No.
                333-103673) as filed with the Securities and Exchange Commission
                on March
                7, 2003.





10.5
            East
                Penn Financial Corporation’s Dividend Reinvestment and Stock Purchase Plan
                is incorporated by reference to the Registrant’s Registration Statement on
                Form S-3 (Registration No. 333-116754) as filed with the Securities
                and
                Exchange Commission on June 23, 2004.





10.6
            Agreement
                of sale between East Penn Bank and WAWA, Inc. dated November 10,
                2005.





10.7
            Amendment
                to Supplemental Executive Retirement Plan (“SERP”) between East Penn Bank
                and Brent L. Peters, dated July 21, 2006, is incorporated by reference
                to
                Exhibit 10.2 of Registrant’s Form 8-K filed August 1,
                2006.





10.8
            Amendment
                to Executive Employment Agreement between East Penn Bank and Brent
                L.
                Peters, dated July 21, 2006, is incorporated by reference to Exhibit
                10.1
                of Registrant’s Form 8-K filed August 1, 2006.





11
            Statement
                re: Computation of per share earnings is incorporated by reference
                herein
                to Note 3 on page 9 of this Form
                10-Q.





31.1
            Certification
                of Chief Executive Officer pursuant to Rule
                13a-15(e)/15d-15(e).





31.2
            Certification
                of Chief Financial Officer pursuant to Rule
                13a-15(e)/15d-15(e).





32.1
            Certification
                of Chief Executive Officer pursuant to Section 1350 of the Sarbanes
                Oxley
                Act of 2002.





32.2
            Certification
                of Chief Financial Officer pursuant to Section1350
                of the Sarbanes Oxley Act of 2002.


Page
      28