**UNITED
STATES**
 **SECURITIES
AND EXCHANGE COMMISSION**
 **WASHINGTON,
D. C. 20549**
 **FORM
10-Q**
 
 **____________________________________**
 (Mark
One)
 
 [ x
      ]
    QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934 for the quarterly period ended **March 31,
      2005**OR[  
       ]
    TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF
      1934
 
 For the
transition period from ____________ to ____________
 
 **Commission
      File No. 000-50426**
 
 (Exact
      Name of Registrant as Specified in its
Charter)
 
 Pennsylvania
    
    38-3681905(State
      or Other Jurisdiction of Incorporation or Organization)
    
    (I.R.S.
      Employer Identification No.)
 
 **90
      Highland Avenue, Bethlehem, PA**
    
    **18017**(Address
      of Principal Executive Office)
    
    (Zip
      Code)
 
 Registrant’s
Telephone Number, Including Area Code:
**610-861-5000**
 
 Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.
 
 YES X
    NO
      _____
 
 Indicate
by check mark whether the registrant is an accelerated filer as defined in Rrule
12b-2 of the Exchange Act.
 
 YES X
    NO
      _____
 
 Indicate
the number of shares outstanding of each of the issuer’s classes of common stock
as of the latest practicable date: As of May 6, 2005,
30,791,761 shares of the Registrant’s common stock were
outstanding.
  
   **KNBT
BANCORP, INC. AND SUBSIDIARIES**
 
 
 **INDEX**
 
 
 Page
 
 **PART I - FINANCIAL
      INFORMATION**Item 1.
    Financial Statements
    1Consolidated Balance Sheets
    1Consolidated Statements of
Income
    2Consolidated Statement of Changes in
      Shareholders’ Equity
    3Consolidated Statements of Cash
      Flows
    4Notes to Interim Consolidated Financial
      Statements
    5Item 2.
    Management’s Discussion and Analysis of
      Financial Condition andResults of Operations
    15Item 3.
    Quantitative and Qualitative Disclosures about
      Market Risk
    25Item 4.
    Controls and Procedures
    25**PART II - OTHER
      INFORMATION**Item 1.
    Legal Proceedings
    25Item 2.
    Unregistered Sales of Equity Securities and
      Use of Proceeds
    26Item 3.
    Defaults Upon Senior Securities
    26Item 4.
    Submission of Matters to a Vote of Security
      Holders
    26Item 5.
    Other Information
    26Item 6.
    Exhibits and Reports on Form
8-K
    26**Signatures**
    27**Certifications**
    28
 
  
  **PART I.**
 
 **Item
1.****Financial
Statements**
 
 **KNBT
BANCORP, INC. AND SUBSIDIARIES**
 **CONSOLIDATED
BALANCE SHEETS**
 
 March
      31,
    
    December
      31,2005
    
    2004(unaudited)(dollars
      in thousands)ASSETSCash
      and due from banks
    
    $
    30,569
    
    $
    30,218Interest-bearing
      deposits with banks
    
    
    95,341
    
    
    56,002Cash
      and cash equivalents
    
    
    125,910
    
    
    86,220Investment
      securities available-for-sale
    
    
    1,008,145
    
    
    1,057,109Investment
      securities held to maturity
    
    
    54,999
    
    
    56,586(Fair
      value of $54,987 at March 31, 2005 and$57,034
      at December 31, 2004)Federal
      Home Loan Bank of Pittsburgh stock
    
    
    35,099
    
    
    36,456Mortgage
      loans held-for-sale
    
    
    954
    
    
    718Loans
    
    
    1,031,042
    
    
    1,013,202Less:
      Allowance for loan losses
    
    
    (10,450
    )
    
    (10,461
    )Net
      loans
    
    
    1,020,592
    
    
    1,002,741Bank
      owned life insurance
    
    
    61,153
    
    
    60,501Premises
      and equipment, net
    
    
    40,281
    
    
    40,790Accrued
      interest receivable
    
    
    9,398
    
    
    9,509Goodwill
      and other intangible assets
    
    
    52,798
    
    
    53,255Other
      assets
    
    
    9,251
    
    
    11,218TOTAL
      ASSETS
    
    $
    2,418,580
    
    $
    2,415,103LIABILITIESNon-interest-bearing
      deposits
    
    $
    129,354
    
    $
    128,498Interest-bearing
      deposits
    
    
    1,215,026
    
    
    1,194,555Total
      deposits
    
    
    1,344,380
    
    
    1,323,053Securities
      sold under agreements to repurchase
    
    
    24,496
    
    
    22,643Advances
      from the Federal Home Loan Bank
    
    
    646,852
    
    
    660,674Subordinated
      debt
    
    
    15,464
    
    
    15,464Accrued
      interest payable
    
    
    6,507
    
    
    5,811Other
      liabilities
    
    
    12,231
    
    
    10,104TOTAL
      LIABILITIES
    
    
    2,049,930
    
    
    2,037,749SHAREHOLDERS'
      EQUITYPreferred
      stock, par value $0.01 per shareAuthorized:
      20,000,000 shares, none issued
    
    
    -
    
    
    -Common
      stock, par value $0.01 a share
    
    
    297
    
    
    297Authorized:
      100,000,000 sharesIssued:30,664,861
      shares at March 31, 200530,656,840
      shares at December 31, 2004Additional
      paid-in capital
    
    
    296,433
    
    
    296,403Retained
      earnings
    
    
    117,122
    
    
    113,748Treasury
      stock, at cost; 964,000 and 650,000 shares atMarch
      31, 2005 and December 31, 2004, respectively
    
    
    (16,265
    )
    
    (11,179
    )Unallocated
      common stock heldby
      Employee Stock Ownership Plan
    
    
    (14,974
    )
    
    (15,176
    )Unearned
      common stock heldby
      Management Recognition and Retention Plan
    
    
    (8,576
    )
    
    (9,107
    )Accumulated
      other comprehensive income (loss) net
    
    
    (5,387
    )
    
    2,368TOTAL
      SHAREHOLDERS' EQUITY
    
    
    368,650
    
    
    377,354TOTAL
      LIABILITIES AND SHAREHOLDERS' EQUITY
    
    $
    2,418,580
    
    $
    2,415,103See
      accompanying notes to consolidated financial statements.
  1
  
 
 **KNBT BANCORP, INC. AND SUBSIDIARIES**
 **CONSOLIDATED
STATEMENTS OF INCOME**
  Three
      Months Ended March 31,2005
    
    2004(dollars
      in thousands, except per share data)(unaudited)INTEREST
      INCOMELoans,
      including fees
    
    $
    14,892
    
    $
    14,093Investment
      securities
    
    
    11,728
    
    
    8,116Other
      interest
    
    
    346
    
    
    142Total
      interest income
    
    
    26,966
    
    
    22,351INTEREST
      EXPENSEDeposits
    
    
    5,099
    
    
    4,535Securities
      sold under agreements to repurchase
    
    
    51
    
    
    35Advances
      from the Federal Home Loan Bank
    
    
    5,444
    
    
    2,124Subordinated
      debt
    
    
    233
    
    
    181Total
      interest expense
    
    
    10,827
    
    
    6,875NET
      INTEREST INCOME
    
    
    16,139
    
    
    15,476Provision
      for loan losses
    
    
    734
    
    
    1,500Net
      interest income after provisionfor
      loan losses
    
    
    15,405
    
    
    13,976NON-INTEREST
      INCOMETrust
      revenue
    
    
    398
    
    
    353Brokerage
      services revenue
    
    
    548
    
    
    160Deposit
      service charges
    
    
    1,105
    
    
    1,311Bank
      owned life insurance
    
    
    652
    
    
    667Net
      gains (losses) on sales of investment securities
    
    
    432
    
    
    (8
    )Net
      gains on sales of residential mortgage loans
    
    
    218
    
    
    159Net
      gains on sales of credit card loans
    
    
    -
    
    
    298Net
      (losses) on sale of assets
    
    
    (11
    )
    
    -Net
      gains (losses) on sale of other real estate owned
    
    
    (17
    )
    
    44Non-interest
      operating income
    
    
    1,117
    
    
    983Total
      non-interest income
    
    
    4,442
    
    
    3,967NON-INTEREST
      EXPENSESCompensation
      and employee benefits
    
    
    7,848
    
    
    7,245Net
      occupancy and equipment expense
    
    
    2,113
    
    
    1,825Professional
      fees
    
    
    427
    
    
    572Advertising
    
    
    222
    
    
    153Data
      processing
    
    
    433
    
    
    531Impairment
      of mortgage servicing rights
    
    
    84
    
    
    58Amortization
      of intangible assets
    
    
    547
    
    
    547Other
      operating expenses
    
    
    1,751
    
    
    1,574Total
      non-interest expenses
    
    
    13,425
    
    
    12,505Income
      before income taxes
    
    
    6,422
    
    
    5,438Income
      taxes
    
    
    1,592
    
    
    1,323NET
      INCOME
    
    $
    4,830
    
    $
    4,115PER
      SHARE DATANet
      income - basic
    
    $
    0.17
    
    $
    0.14Net
      income - diluted
    
    $
    0.17
    
    $
    0.14Cash
      dividends per common share
    
    $
    0.05
    
    $
    -See
      accompanying notes to consolidated financial statements.
   2
   
 **KNBT BANCORP, INC. AND SUBSIDIARIES**
 **CONSOLIDATED
STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY**
 
 
 Three
      Months Ended March 31, 2005 (unaudited)(dollars
      in thousands)Common
    
    Treasury
    
    
    
    
    
    
    
    
    
    
    
    AccumulatedStock
    
    Stock
    
    Common
    
    Add'l
    
    
    
    Unallocated
    
    Unearned
    
    OtherNumber
      of
    
    Number
      of
    
    Stock
    
    Paid
      In
    
    Retained
    
    ESOP
    
    Compensation
    
    Comprehensive
    
    TreasuryShares
    
    Shares
    
    Value
    
    Capital
    
    Earnings
    
    Shares
    
    MRRP
    
    Income
    
    Stock
    
    TotalBalance
      January 1, 2005
    
    
    29,764,319
    
    
    (650,000
    )
    $
    297
    
    $
    296,403
    
    $
    113,748
    
    
    ($15,176
    )
    
    ($9,107
    )
    $
    2,368
    
    
    ($11,179
    )
    $
    377,354Comprehensive
      income (loss)Net
      income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,830
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,830Other
      comprehensive loss net of taxesand
      reclassification adjustments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (7,755
    )
    
    
    
    
    (7,755
    )Total
      comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    ($2,925
    )Cash
      dividends
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,456
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,456
    )Unallocated
      ESOP shares committed to employees
    
    
    11,900
    
    
    
    
    
    
    
    
    (15
    )
    
    
    
    
    202
    
    
    
    
    
    
    
    
    
    
    
    187Shares
      issued upon exercise of stock options
    
    
    8,021
    
    
    
    
    
    
    
    
    45
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    45Purchases
      of treasury stock
    
    
    
    
    
    (314,000
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (5,086
    )
    
    (5,086
    )Amortization
      of compensation related toManagement
      Recognition and Retention Plan ("MRRP")
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    531
    
    
    
    
    
    
    
    
    531Balance
      at March 31, 2005
    
    
    29,784,240
    
    
    (964,000
    )
    $
    297
    
    $
    296,433
    
    $
    117,122
    
    
    ($14,974
    )
    
    ($8,576
    )
    
    ($5,387
    )
    
    ($16,265
    )
    $
    368,650
 
 
   3
  **KNBT BANCORP, INC. AND SUBSIDIARIES**
 **CONSOLIDATED
STATEMENTS OF CASH FLOWS** ****
  Three
      months endedMarch
      31, 2005
    
    March
      31, 2004(dollars
      in thousands)**OPERATING
      ACTIVITIES:**Net
      income
    
    $
    4,830
    
    $
    4,115Adjustments
      to reconcile net income to net cashProvided
      by operating activities:Provision
      for possible loan losses
    
    
    734
    
    
    1,500Depreciation
      and amortization
    
    
    1,782
    
    
    1,182Compensation
      expense stock option plan
    
    
    6
    
    
    -Management
      Recognition and Retention Plan expense
    
    
    525
    
    
    -ESOP
      expense
    
    
    187
    
    
    326Amortization
      and accretion of securities premiums and discounts, net
    
    
    551
    
    
    608(Gain)
      Loss on sale of other real estate owned
    
    
    17
    
    
    (44
    )Net
      (Gain) loss on sales of investment securities
    
    
    (432
    )
    
    8Gain
      on sale of credit card portfolio
    
    
    -
    
    
    (298
    )Loss
      on sale of other assets
    
    
    11
    
    
    -Gain
      on sale of mortgage loans
    
    
    (218
    )
    
    (159
    )Mortgage
      loans originated for sale
    
    
    (13,336
    )
    
    (1,255
    )Mortgage
      loan sales
    
    
    13,790
    
    
    2,715Changes
      in assets and liabilities:Increase
      in Bank Owned Life Insurance
    
    
    (652
    )
    
    (667
    )Decrease
      (Increase) in accrued interest receivable
    
    
    111
    
    
    (1,629
    )Decrease
      in other assets
    
    
    5,157
    
    
    2,449Increase
      (Decrease) in other liabilities and accrued interest
    payable
    
    
    2,823
    
    
    (4,173
    )Net
      cash provided by operating activities
    
    
    15,886
    
    
    4,678**INVESTING
      ACTIVITIES:**Proceeds
      from calls and maturities of securities available-for-sale
    
    
    39,067
    
    
    32,573Proceeds
      from calls and maturities of securities held-to maturity
    
    
    1,774
    
    
    -Proceeds
      from sales of securities available-for-sale
    
    
    22,334
    
    
    249Purchase
      of securities available-for-sale
    
    
    (24,374
    )
    
    (160,343
    )Purchase
      of securities held to maturity
    
    
    (148
    )
    
    -Purchase
      of Federal Home Loan Bank of Pittsburgh stock
    
    
    (89
    )
    
    (4,248
    )Redemption
      of Federal Home Loan Bank of Pittsburgh stock
    
    
    1,446
    
    
    -Proceeds
      from the sale of credit card loans
    
    
    -
    
    
    1,831Net
      (Increase) in loans
    
    
    (18,585
    )
    
    (34,323
    )Purchase
      of premises & equipment
    
    
    (642
    )
    
    (2,902
    )Proceeds
      from the sale of other assets
    
    
    57
    
    
    -Proceeds
      from the sale of other real estate owned
    
    
    103
    
    
    161Net
      cash provided by (used in) investing activities
    
    
    20,943
    
    
    (167,002
    )**FINANCING
      ACTIVITIES:**Net
      increase in deposits
    
    
    21,327
    
    
    4,805Net
      increase in repurchase agreements
    
    
    1,853
    
    
    3,843Proceeds
      from long -term debt
    
    
    22,000
    
    
    109,562Payments
      on long -term debt
    
    
    (35,822
    )
    
    (8,175
    )Purchase
      of treasury stock
    
    
    (5,086
    )
    
    -Proceeds
      from the exercise of stock options
    
    
    45
    
    
    564Cash
      dividends paid
    
    
    (1,456
    )
    
    -Net
      cash provided by financing activities
    
    
    2,861
    
    
    110,599Increase
      (Decrease) in cash and cash equivalents
    
    
    39,690
    
    
    (51,725
    )Cash
      and cash equivalents January 1,
    
    
    86,220
    
    
    138,977Cash
      and cash equivalents March 31,
    
    $
    125,910
    
    $
    87,252Supplemental
      disclosure of cash flow informationCash
      paid during the period forIncome
      taxes
    
    $
    1,100,000
    
    $
    -Interest
      on deposits, advances and other borrowed money
    
    $
    10,131
    
    $
    6,454Supplemental
      disclosure of non-cash activitiesReclassification
      of loans receivable to other real estate owned
    
    $
    765
    
    $
    97See
      accompanying notes to consolidated financial statements.
   4
 
 **KNBT BANCORP, INC. AND SUBSIDIARIES**
 **NOTES
TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS** (unaudited)
  **NOTE
A - BASIS OF PRESENTATION**
 
 KNBT
Bancorp, Inc. (“KNBT” or the “Company”) is a Pennsylvania corporation and
registered bank holding company organized in 2003. KNBT’s business consists
primarily of being the parent holding company for Keystone Nazareth Bank &
Trust Company, a Pennsylvania chartered savings bank. Keystone Nazareth Bank
& Trust Company (the “Bank”) is the stock-form successor to Keystone Savings
Bank upon the mutual-to-stock conversion of Keystone Savings Bank, which was
completed on October 31, 2003. Concurrently with the mutual-to-stock conversion,
KNBT acquired, through a merger, First Colonial Group, Inc. (“First Colonial”),
the parent bank holding company for Nazareth National Bank and Trust Company
(“Nazareth National Bank”) which was merged with and into the Bank in connection
with the acquisition of First Colonial.
 
 
 **NOTE
B - BASIS OF CONSOLIDATION**
 
 The
accompanying consolidated financial statements were prepared in accordance with
instructions to Form 10-Q, and therefore, do not include information or
footnotes necessary for a complete presentation of financial position, results
of operations and cash flows in conformity with generally accepted accounting
principles (“GAAP”). However, all normal, recurring adjustments that, in the
opinion of management, are necessary for a fair presentation of these financial
statements have been included. These financial statements should be read in
conjunction with the audited financial statements and the notes thereto for the
Company for the year ended December 31, 2004, which are included in the
Company’s Annual Report on Form 10-K for the year ended December 31, 2004. The
results for the interim periods presented are not necessarily indicative of the
results that may be expected for the year ending December 31, 2005.
 
 The
financial information presented herein is unaudited; however, in the opinion of
management, all adjustments (which include normal recurring adjustments)
necessary to present fairly the unaudited financial information have been made.
The Company has prepared its accompanying consolidated financial statements in
accordance with GAAP as applicable to the banking industry. Certain amounts in
prior years are reclassified for comparability to the current year’s
presentation. Such reclassifications, when applicable have no effect on net
income. The consolidated financial statements include the balances of the
Company and its wholly owned subsidiaries. All material intercompany balances
and transactions have been eliminated in consolidation. References to the
Company include the Bank unless otherwise noted.
 
 In
preparing the consolidated financial statements, the Company is required to make
estimates and assumptions that affect the reported amounts of assets and
liabilities as of the date of the statement of financial condition and revenue
and expense for the period. Actual results could differ significantly from those
estimates. A material estimate that is particularly susceptible to significant
changes in the near-term is the determination of the allowance for loan
losses.
 
 In
addition to the Bank, KNBT’s subsidiaries include KNBT Inv. I, Inc. and KNBT
Inv. II, Inc. The Bank has four wholly owned subsidiaries, KLV, Inc., KLVI,
Inc., Traditions Settlement Services LLC and KNBT Securities. KLV, Inc. is
inactive.
 5
 **NOTE
C - CONVERSION AND ACQUISITIONS**
 
 
 **Oakwood
Financial Corp.**
 
 On
November 11, 2004, the Bank acquired Oakwood Financial Corp. (“Oakwood”), a
full-service securities brokerage firm based in Allentown, Pennsylvania, for
$650,000. The Bank acquired $121,000 in assets and recorded $531,000 of
goodwill. The merger transaction was accounted for under the purchase method of
accounting. KNBT’s results of operations include the operations acquired from
Oakwood since the date of acquisition on November 11, 2004.
 
 Oakwood
provides a full menu of securities brokerage, insurance and investment advisory
products and services. Oakwood now operates as KNBT Securities Inc. and is a
wholly owned subsidiary of the Bank.
 
 **Caruso
Benefits Group, Inc.**
 
 On
April 1, 2005, the Bank acquired Caruso Benefits Group, Inc.
(“Caruso”)  ,
a benefits management firm based in Bethlehem, Pennsylvania. Since the date of
acquisition on April 1, 2005, Caruso has been operating as a wholly owned
subsidiary of the Bank.
 
 Caruso
specializes in benefits management with an emphasis on group medical, life and
disability. Under the terms of the definitive agreement, the Bank acquired all
of the capital stock of Caruso for a purchase price of $28 million in cash of
which $20 million was paid at time of closing and $8 million will be payable
over a three-year period, subject to Caruso maintaining certain levels of
profitability.
 
 **Northeast
Pennsylvania Financial Corp.**
 
 On
December 9, 2004, KNBT announced entering into an Agreement and Plan of Merger
dated December 8, 2004 (the “Merger Agreement”) with Northeast Pennsylvania
Financial Corp., a Delaware corporation (“NEPF”), which sets forth the terms and
conditions under which NEPF will merge with and into KNBT (the “Merger”). The
total cost of the acquisition is expected to be approximately $98.0
million.
 
 Under
the terms of the Merger Agreement, NEPF’s shareholders may elect to receive
either $23.00 of KNBT common stock or $23.00 in cash in exchange for their
shares of NEPF common stock, subject to an overall requirement that 50% of the
total outstanding NEPF common stock be exchanged for KNBT common stock and 50%
for cash. The stock component of the merger consideration will be valued at
$23.00 per share based on the average market price of KNBT common stock during
the 20-trading day period ending on the fifth business day prior to the Merger.
 
 All
required regulatory approvals have been obtained and the transaction was
approved by stockholders of NEPF at their special meeting held on April 14,
2005. KNBT expects the transaction to close during the middle of the second
quarter of 2005.
 
 6
 
 **NOTE
D - EARNINGS PER SHARE**
 
 The
Company calculates earnings per share as provided by the provisions of Statement
of Financial Accounting Standards No. 128, “Earnings Per Share (SFAS 128)”.
Basic and diluted earnings per share for the three months ended March 31, 2005
and 2004 were calculated as follows:


Net
    
    AverageIncome
    
    Shares
    
    Per
      Share(numerator)
    
    (denominator)
    
    AmountFor
      the Three Months Ended March 31, 2005
    
    (dollars
      in thousands, except per share amounts)Basic
      earnings per shareIncome
      available to common shareholders
    
    $
    4,830
    
    
    28,226,025
    
    $
    0.17Effect
      of dilutive securitiesStock
      options
    
    
    
    
    
    217,581
    
    
    -Management
      Recognition and Retention Plan
    
    
    
    
    
    94,162
    
    
    -Total
      effect of dilutive securities
    
    
    
    
    
    311,743
    
    
    -Diluted
      earnings per shareIncome
      available to common shareholdersplus
      assumed exercise of options
    
    $
    4,830
    
    
    28,537,768
    
    $
    0.17For
      the Three Months Ended March 31, 2004Basic
      earnings per shareIncome
      available to common shareholders
    
    $
    4,115
    
    
    29,555,238
    
    $
    0.14Effect
      of dilutive securitiesStock
      options
    
    
    
    
    
    456,026
    
    
    -Diluted
      earnings per share
    
    
    
    
    
    
    
    
    -Income
      available to common shareholdersplus
      assumed exercise of options
    
    $
    4,115
    
    
    30,011,264
    
    $
    0.14


KNBT
also had outstanding stock options for the three months ended March 31, 2005,
equal to 1,108,500 shares of common stock at an exercise price per share of
$16.50. These options were not included in the computation of diluted earnings
per share for the three months ended March 31, 2005, because the option exercise
price was greater than the average market price. There were no anti-dilutive
securities as of March 31, 2004.
 
 Common
stock outstanding for the purpose of calculating basic earnings per share does
not include 880,620 and 928,222 unallocated shares held by the Employee Stock
Ownership Pan (“ESOP”) at March 31, 2005 and March 31, 2004 respectively. The
exclusion of these unallocated shares held by the ESOP is in accordance with the
provision of Statement of Position (“SOP”) 93-6, “Employer’s Accounting for
Employee Stock Ownership Plans”, issued by the Accounting Standards Division of
the American Institute of Certified Public Accountants (“AICPA”).
 
 Unearned
and uncommitted Management Recognition and Retention Plan (“MRRP”) shares to be
released are not considered to be outstanding for basic earnings per share
calculations. At March 31, 2005, unearned MRRP shares totaled 629,500 and
uncommitted MRRP shares totaled 178,547.





7





**NOTE
E - INVESTMENT SECURITIES**
****
The
amortized cost, unrealized gains and losses and fair value of KNBT’s investment
securities held-to-maturity and available-for-sale at March 31, 2005 (unaudited)
and December 31, 2004 are as follows:


At
      March 31, 2005 (unaudited)Gross
    
    GrossAmortized
    
    Unrealized
    
    Unrealized
    
    FairCost
    
    Gains
    
    Losses
    
    Value(dollars
      in thousands)Held
      to maturity:U.S.
      Government and agencies
    
    $
    149
    
    $
    -
    
    $
    (1
    )
    $
    148Obligations
      of states and politicalsubdivisions
    
    
    5,507
    
    
    19
    
    
    (6
    )
    
    5,520Mortgage-backed
      securitiesFNMA
    
    
    25,211
    
    
    -
    
    
    (57
    )
    
    25,154CMOs
    
    
    24,132
    
    
    83
    
    
    (50
    )
    
    24,165Total
      mortgage-backed securities
    
    
    49,343
    
    
    83
    
    
    (107
    )
    
    49,319Total
      held to maturity
    
    
    54,999
    
    
    102
    
    
    (114
    )
    
    54,987Available
      for sale:U.S.
      Government and agencies
    
    
    158,394
    
    
    310
    
    
    (1,920
    )
    
    156,784Obligations
      of states and politicalsubdivisions
    
    
    101,638
    
    
    1,703
    
    
    (421
    )
    
    102,920Asset-managed
      funds
    
    
    4,904
    
    
    -
    
    
    (108
    )
    
    4,796Federated
      liquid cash trust
    
    
    36
    
    
    -
    
    
    -
    
    
    36Mortgage-backed
      securitiesGNMA
    
    
    1,293
    
    
    35
    
    
    -
    
    
    1,328FHLMC
    
    
    99,129
    
    
    112
    
    
    (1,168
    )
    
    98,073FNMA
    
    
    300,792
    
    
    1,064
    
    
    (3,798
    )
    
    298,058CMOs
    
    
    261,079
    
    
    3
    
    
    (4,630
    )
    
    256,452Total
      mortgage-backed securities
    
    
    662,293
    
    
    1,214
    
    
    (9,596
    )
    
    653,911Corporate
      and other debt securities
    
    
    75,231
    
    
    398
    
    
    (55
    )
    
    75,574Equity
      securities
    
    
    13,810
    
    
    745
    
    
    (431
    )
    
    14,124Total
      available for sale
    
    
    1,016,306
    
    
    4,370
    
    
    (12,531
    )
    
    1,008,145Total
      investment securities
    
    $
    1,071,305
    
    $
    4,472
    
    $
    (12,645
    )
    $
    1,063,132





8







At
      December 31, 2004Gross
    
    GrossAmortized
    
    Unrealized
    
    Unrealized
    
    FairCost
    
    Gains
    
    Losses
    
    Value(dollars
      in thousands)Held
      to maturity:Obligations
      of states and politicalsubdivisions
    
    $
    5,510
    
    $
    39
    
    $
    (4
    )
    $
    5,545Mortgage-backed
      securitiesFNMA
    
    
    25,893
    
    
    100
    
    
    -
    
    
    25,993CMOs
    
    
    25,183
    
    
    313
    
    
    
    
    
    25,496Total
      mortgage-backed securities
    
    
    51,076
    
    
    413
    
    
    -
    
    
    51,489Total
      held to maturity
    
    
    56,586
    
    
    452
    
    
    (4
    )
    
    57,034Available
      for sale:U.S.
      Government and agencies
    
    
    174,864
    
    
    1,562
    
    
    (777
    )
    
    175,649Obligations
      of states and politicalsubdivisions
    
    
    104,476
    
    
    2,249
    
    
    (151
    )
    
    106,574Asset-managed
      funds
    
    
    4,904
    
    
    -
    
    
    (93
    )
    
    4,811Federated
      Liquid Cash Trust
    
    
    35
    
    
    -
    
    
    -
    
    
    35Mortgage-backed
      securitiesGNMA
    
    
    1,416
    
    
    44
    
    
    -
    
    
    1,460FHLMC
    
    
    104,476
    
    
    524
    
    
    (346
    )
    
    104,654FNMA
    
    
    308,923
    
    
    2,975
    
    
    (1,257
    )
    
    310,641CMOs
    
    
    277,485
    
    
    522
    
    
    (2,125
    )
    
    275,882Total
      mortgage-backed securities
    
    
    692,300
    
    
    4,065
    
    
    (3,728
    )
    
    692,637Corporate
      and other debt securities
    
    
    9,029
    
    
    168
    
    
    -
    
    
    9,197Equity
      securities
    
    
    67,914
    
    
    1,093
    
    
    (801
    )
    
    68,206Total
      available for sale
    
    
    1,053,522
    
    
    9,137
    
    
    (5,550
    )
    
    1,057,109Total
      investment securities
    
    $
    1,110,108
    
    $
    9,589
    
    $
    (5,554
    )
    $
    1,114,143




**NOTE
F - STOCK BASED COMPENSATION**
 
 Stock
Option Plans
 
 KNBT
maintains the 2004 Stock Option Plan adopted by its stockholders at the 2004
annual meeting, as well as the stock option plans previously maintained by First
Colonial acquired as a part of the acquisition of First Colonial in October
2003. KNBT’s stock option plans are accounted for under Statement of Financial
Accounting Standards No. 123 (SFAS No. 123), “Accounting for Stock-Based
Compensation.” This standard contains a fair value-based method for valuing
stock-based compensation, which measures compensation cost at the grant date
based on the fair value of the award. Compensation is then recognized over the
service period, which is usually the vesting period. Alternatively, through
December 31, 2005, the standard permits entities to continue accounting for
employee stock options and similar instruments under the intrinsic value method
of APB Opinion No. 25. Entities that continue to account for stock options using
APB Opinion No. 25 are required to make pro forma disclosures of net income and
earnings per share, as if the fair value-based method of accounting defined in
SFAS No. 123 had been applied. The Company has elected to account for options,
except as discussed below, in accordance with APB Opinion No. 25.





9





The
Company accounts for stock-based compensation on awards granted pursuant to the
former First Colonial option plans and to directors, officers and employees
under KNBT’s 2004 Stock Option Plan using the intrinsic value method, except as
discussed below. Since each option granted had an exercise price per share equal
to the fair market value of one share of the Company’s stock on the date of the
grant, no compensation cost at date of grant has been recognized.
 
 The
following table illustrates the effect on net income and earnings per share if
KNBT had applied the fair value recognition provisions of SFAS No. 123 to
stock-based employee compensation.


For
      the three months endedMarch
      31, 2005(in
      thousands, except per share amounts)
  Net
      IncomeAs
      reported
    
    $
    4,830Add:
      Stock-based employee compensation expenseincluded
      in reported net income, netof
      related tax effects
    
    
    6Less:
      Stock-based compensation cost determinedunder
      fair value method for all awards, netof
      related tax effects
    
    
    167Pro-forma
    
    $
    4,669Earnings
      per share (Diluted)As
      reported
    
    $
    0.17Pro-forma
    
    $
    0.16Earnings
      per share (Basic)As
      reported
    
    $
    0.17Pro-forma
    
    $
    0.17
 KNBT
granted options for 214,650 and 1,132,000 shares in the first three months of
2005 and 2004, respectively. The fair value of each option grant is estimated on
the date of grant using the Black-Scholes options-pricing model with the
following weighted average assumptions used for grants in 2005 and 2004,
respectively: dividend yield of 2% for each period; expected volatility of
26.75% and 25.00%; risk-free interest rates for each plan of 3.95% and 3.91%;
and expected lives of 7.33 years and 6.67 years. The weighted average fair value
of each option grant under KNBT’s 2004 Stock Option Plan is $4.64 in 2005 and
$4.69 in 2004.
 
 In
May 2004, KNBT granted 22,500 options to purchase shares of the Company’s common
stock at $16.50 to KNBT’s advisory directors. The Company recognizes
compensation expense in accordance with the fair value-based method of
accounting described in SFAS No. 123 with respect to options granted to advisory
directors. The fair value of each option is expensed over its vesting period.
Compensation expense of $6,000 was recognized for the three months ended March
31, 2005 for options granted to advisory directors.
 
 On
December 16, 2004, FASB issued Statement No. 123 (revised 2004), “Share-Based
Payment.” Statement 123(R) replaces FASB Statement No.123, “Accounting for
Stock-Based Compensation” and supersedes APB Opinion No. 25, Accounting for
Stock Issued to Employees. Statement 123(R) establishes standards for which an
entity exchanges its equity instruments for goods or services. It also addresses
transactions in which an entity incurs liabilities in exchange for good and
services that are based on the fair value of the entity’s equity instruments or
that may be settled by the issuance of those equity instruments.








10








Under
Statement 123(R), all forms of share-based payments to employees, including
stock options, will be treated the same as other forms of compensation by
recognizing the related cost in the income statement. The expense of the award
requires the entity to measure the cost of employee services received in
exchange for an award of equity instruments based on the grant-date fair value
of the award. That cost will be recognized over the period during which an
employee is required to provide service in exchange for the award (vesting
period). Fair value of that award will be re-measured subsequently at each
reporting date through the settlement date. The grant-date fair value of
employee share options and similar instruments will be estimated using
option-pricing models adjusted for the unique characteristics of those
instruments.

All
public entities that use the fair-value based method for either recognition or
disclosure under Statement 123(R) will apply this Statement using a modified
version of prospective application. Under the transition method, compensation
cost is recognized on or after the required effective date for the portion of
outstanding awards for which the requisite service has not yet been rendered,
based on the grant-date fair value of those awards calculated under Statement
123(R) for either recognition or pro forma disclosure. For periods before the
required effective date, those entities may elect to apply a modified version of
retrospective application under which the financial statements for prior periods
are adjusted on a basis consistent with the pro forma disclosures required for
those periods by Statement 123(R).

Staff
Accounting Bulletin No. 107, “Share-Based Payment,” (SAB 107), issued March 29,
2005, expresses views of the SEC staff regarding the application of Statement
123(R). Among other things, SAB 107 provides interpretive guidance related to
the interaction between Statement 123(R) and certain SEC rules and regulations,
as well as provides the staff’s views regarding the valuation of share-based
payment arrangements, for public companies. On April 14, 2005, the SEC adopted a
new rule amending the effective dates of Statement 123(R) for public companies
by issuing Release 33-8568. The new rule allows registrants to implement
Statement 123(R) at the beginning of their*next
fiscal year*,
instead of the next interim period, that begins after June 15, 2005. Statement
123(R) will therefore be effective for the Company beginning the first quarter
of 2006. The anticipated annual impact on the Company is expected to be similar
to the amounts disclosed in this Footnote.This Statement applies to all awards granted after the required effective date
including existing awards not vested, modified, repurchased, or canceled after
that date. KNBT is currently evaluating the impact Statement 123(R) will have on
its financial statements.

Management
Recognition and Retention Plan

The
MRRP, which is a stock-based incentive plan, provides the ability to award up to
808,047 shares of the Company’s common stock, subject to adjustment, which may
be granted as restricted shares to the Company’s directors, advisory directors,
officers and employees. Shares awarded to date by the MRRP are earned by the
participants at the rate of 20% per year. On May 6, 2004, 638,000 restricted
shares were awarded leaving 170,047 shares available for future grants.
Compensation expense for this plan is being recorded over the 60-month vesting
period and is based on the market value of the Company’s stock as of the date
the awards were made. KNBT, for the benefit of the MRRP Trust, purchased 808,047
shares of KNBT common stock at an average price of $16.44 per share, which is
shown as reduction of additional paid-in-capital. The remaining unamortized cost
of the MRRP shares acquired to date is reflected as a reduction in shareholders’
equity. Expense under this plan for the three months ended March 31, 2005 was
$525,000.








11






**NOTE
G - LOANS**
 
 A
summary of KNBT’s loans receivable at March 31, 2005 (unaudited) and December
31, 2004 is as follows:


March
      31,
    
    December
      31,2005
    
    2004(unaudited)(dollars
      in thousands)Real
      EstateResidential
    
    $
    327,668
    
    $
    326,552Construction
    
    
    104,966
    
    
    106,361Commercial
    
    
    244,307
    
    
    231,132Total
      real estate
    
    
    676,941
    
    
    664,045Consumer
      loans
    
    
    299,390
    
    
    297,935Commercial
      (non-real estate)
    
    
    54,370
    
    
    50,691States
      and political subdivisions
    
    
    1,103
    
    
    1,170Total
      gross loans
    
    
    1,031,804
    
    
    1,013,841Less:Mortgage
      loans held-for-sale
    
    
    (954
    )
    
    (718
    )Deferred
      fees
    
    
    192
    
    
    79Total
      loans
    
    
    1,031,042
    
    
    1,013,202Less:
      Allowance for loan losses
    
    
    (10,450
    )
    
    (10,461
    )Total
      net loans
    
    $
    1,020,592
    
    $
    1,002,741




The
following table shows the amounts of KNBT’s non-performing assets, defined as
non-accruing loans, accruing loans 90 days or more past due and other real
estate owned at March 31, 2005 and December 31, 2004.
  At
      Mar. 31,
    
    At
      Dec. 31,2005
    
    2004(unaudited)(dollars
      in thousands)Non-accrual
      loans
    
    $
    3,768
    
    $
    4,544Accruing
      loans 90 days or more past due
    
    
    292
    
    
    511Total
      non-performing loans
    
    
    4,060
    
    
    5,055Other
      real estate owned
    
    
    -
    
    
    71Total
      non-performing assets
    
    $
    4,060
    
    $
    5,126Total
      non-performing loansas
      a percentage of loans, net
    
    
    0.40
    %
    
    0.50
    %Total
      non-performing loansas
      a percentage of total assets
    
    
    0.17
    %
    
    0.21
    %Total
      non-performing assetsas
      a percentage of total assets
    
    
    0.17
    %
    
    0.21
    %Interest
      on non-accrual loans which would have beenrecorded
      at the original rate
    
    $
    38
    
    $
    125Interest
      on non-accrual loans that was reflected in income
    
    
    -
    
    
    -Net
      decrease in interest income
    
    $
    (38
    )
    $
    (125
    )
   12
  
 
 
 KNBT’s
recorded investment in impaired loans was $288,000 at March 31, 2005 and
$424,000 at December 31, 2004. The valuation allowance for loan losses related
to impaired loans is a part of the allowance for loan losses and was $87,000 at
March 31, 2005 and $61,000 at December 31, 2004. The average impaired loan
balance for the three months ended March 31, 2005 was $325,000. During the
quarter ended March 31, 2005, the Bank received principal payments of $149,000
on impaired loans, which payments are recognized on a cash basis. The Bank
recognized no income on impaired loans in the three-month period ended March 31,
2005. For the three months ended March 31, 2005, KNBT received principal
payments of $38,000 on impaired loans and recognized no income.
 
 The
following table shows the activity in KNBT’s allowance for loan losses during
the periods indicated:
 At
      or for theThree
      Months Ended March 31,(unaudited)2005
    
    2004(dollars
      in thousands)Balance,
      beginning of period
    
    $
    10,461
    
    $
    7,910Provision
      charged to operations
    
    
    734
    
    
    1,500Charge-offs:One-to-four
      family residential
    
    
    (15
    )
    
    -Multi-family
    
    
    -
    
    
    -Commercial
      real estate
    
    
    -
    
    
    -Construction
      and land development
    
    
    -
    
    
    -Commercial
      business
    
    
    -
    
    
    -Consumer
    
    
    (748
    )
    
    (491
    )Total
      charge offs
    
    
    (763
    )
    
    (491
    )Recoveries
      of loans previously charged off:One-to-four
      family residential
    
    
    1
    
    
    26Commercial
      business
    
    
    2
    
    
    1Consumer
    
    
    15
    
    
    54Total
      recoveries
    
    
    18
    
    
    81Net
      loans charged-off
    
    
    (745
    )
    
    (410
    )Balance,
      end of period
    
    $
    10,450
    
    $
    9,000
 **NOTE
H - RETIREMENT PLANS**
 
 *1.*
    *Defined
      Benefit Plans*
 KNBT
participates in a multiple employer defined benefit pension plan, which covers
substantially all employees with 1,000 hours of service during plan years prior
to October 2003. In October 2003, KNBT froze the future accrual of benefits
under this plan. KNBT continues to contribute to this plan for benefits accrued
prior to October 2003. KNBT’s contribution to this plan in the three months
ended March 31, 2005 was $248,000. During the three months ended March 31, 2004,
the contribution to this plan amounted to $215,000. KNBT currently expects to
contribute approximately $77,000 to this plan during the remainder of 2005.
 13
   *2.*
    *Directors’
      Deferred Plan.*
 KNBT,
as a part of the merger with First Colonial, assumed the deferred compensation
plan for certain former directors of First Colonial. The plan requires defined
annual payments for five to fifteen years beginning at age 65 or death. The
annual benefit is based upon the amount deferred plus interest. KNBT has
recorded the deferred compensation liabilities using the present value method.
The net periodic defined benefit expense for the three months ended March 31,
2005 and March 31, 2004 was as follows:
 March
      31,
    
    March
      31,2005
    
    2004(dollars
      in thousands)Service
      cost
    
    $
    -
    
    $
    -Interest
      cost
    
    
    19
    
    
    6Expected
      return on plan assets
    
    
    -
    
    
    -Amortization
      of unrecognized nettransition
      asset or obligation
    
    
    -
    
    
    -Amortization
      of Unrecognized Prior Service Cost
    
    
    -
    
    
    -Amortization
      of Unrecognized Net Gain or Loss
    
    
    -
    
    
    -Total
      Net Periodic Pension Cost for the Quarter
    
    $
    19
    
    $
    6
 KNBT
currently expects to contribute a total of approximately $19,000 to this plan in
the year ended December 31, 2005.
 ****
 **NOTE
I - NEW ACCOUNTING PRONOUNCEMENTS**
 
 
 In
October 2003, the AICPA issued SOP 03-3, “Accounting for Loans or Certain Debt
Securities Acquired in a Transfer”. SOP 03-3 applies to a loan with the evidence
of deterioration of credit quality since origination acquired by completion of a
transfer for which it is probable at acquisition, that KNBT will be unable to
collect all contractually required payments receivable. SOP 03-3 is effective
for loans acquired in fiscal years beginning after December 31, 2004. Management
is currently evaluating the provisions of SOP 03-3 with respect to loans being
acquired from the NEPF acquisition.
 
 
 **NOTE
J - RECLASSIFICATIONS**
 
 Certain
reclassifications of prior years’ amounts have been made to conform to the March
31, 2005 presentation.
 14
  
 **Item 2.****Management's
Discussion and Analysis of****Financial
Condition and** **Results
of Operations**
 
 
 **CAUTIONARY
STATEMENT REGARDING FORWARD LOOKING INFORMATION**
 
 The
information contained in this Form 10-Q may contain forward-looking statements
(as defined in the Securities Exchange Act of 1934 and the regulations
thereunder) which are not historical facts or as to KNBT Bancorp, Inc. (“KNBT”
or “Holding Company”) management's intentions, plans, beliefs, expectations or
opinions or with respect to the acquisition of the Caruso Benefits Group, Inc.
(“Caruso”) or the pending acquisition of Northeast Pennsylvania Financial Corp.
(“NEPF”). These statements include, but are not limited to, financial
projections and estimates and their underlying assumptions; statements regarding
plans, objectives and expectations with respect to future operations, products
and services; and statements regarding future performance. Such statements are
subject to certain risks and uncertainties, many of which are difficult to
predict and generally beyond the control of KNBT and its management, that could
cause actual results to differ materially from those expressed in, or implied or
projected by, the forward-looking information and statements. The following
factors, among others, could cause actual results to differ materially from the
anticipated results or other expectations expressed in the forward-looking
statements: (1) economic and competitive conditions which could affect the
volume of loan originations, deposit flows and real estate values; (2) the
levels of non-interest income and expense and the amount of loan losses; (3)
estimated cost savings from the acquisition of NEPF cannot be fully realized
within the expected time frame; (4) revenues following the acquisitions of
Caruso and NEPF are lower than expected; (5) competitive pressure among
depository institutions increases significantly; (6) costs or difficulties
related to the integration of the businesses of KNBT, NEPF and Caruso are
greater than expected; (7) changes in the interest rate environment may reduce
interest margins; (8) general economic conditions, either nationally or in the
markets in which KNBT is or will be doing business, are less favorable than
expected; (9) legislation or changes in regulatory requirements adversely affect
the business in which KNBT would be engaged; or (10) factors which result in a
condition to the acquisition of NEPF not being met as well as other factors
discussed in the documents filed by KNBT with the Securities and Exchange
Commission ("SEC") from time to time. Copies of these documents may be obtained
from KNBT upon request and without charge (except for the exhibits thereto) or
can be accessed at the website maintained by the SEC at http://www.sec.gov .
KNBT undertakes no obligation to update these forward-looking statements to
reflect events or circumstances that occur after the date on which such
statements were made.
 
 **Critical
Accounting Policies, Judgments and Estimates**
 
 The
accounting and reporting policies of KNBT conform with accounting principles
generally accepted in the United States of America and general practices within
the financial services industry. The preparation of financial statements in
conformity with accounting principles generally accepted in the United States
requires management to make estimates and assumptions that affect the amounts
reported in the financial statements and the accompanying notes. Actual results
could differ from those estimates.
 
 
 15
 
 KNBT
considers that the determination of the allowance for loan losses involves a
higher degree of judgment and complexity than its other significant accounting
policies. The allowance for loan losses is calculated with the objective of
maintaining a reserve level believed by management to be sufficient to absorb
estimated probable credit losses. Management’s determination of the adequacy of
the allowance is based on periodic evaluations of the loan portfolio and other
relevant factors. However, this evaluation is inherently subjective as it
requires material estimates, including, among others, expected default
probabilities, loss given default, expected commitment usage, the amounts and
timing of expected future cash flows on impaired loans, mortgages, and general
amounts for historical loss experience. The process also considers economic
conditions, uncertainties in estimating losses and inherent risks in the loan
portfolio. All of these factors may be susceptible to significant change. To the
extent actual outcomes differ from management estimates, additional provisions
for loan losses may be required that would adversely impact earnings in future
periods.
 
 KNBT
recognizes deferred tax assets and liabilities for future tax effects of
temporary differences, net operating loss carry forwards and tax credits.
Deferred tax assets are subject to management’s judgment based upon available
evidence that future realization is more likely than not. If management
determines that KNBT may be unable to realize all or part of net deferred tax
assets in the future, a direct charge to income tax expense may be required to
reduce the recorded value of the net deferred tax asset to the expected
realizable amount.
 
 Goodwill,
under SFAS No. 142, is subject to impairment testing at least annually to
determine whether write-downs of the recorded balance is necessary. KNBT tests
for impairment based on the goodwill maintained at each defined reporting unit.
A fair value is determined for each reporting unit based on at least one of
three various market valuation methodologies. If the fair values of the
reporting units exceed their book values, no write-down of recorded goodwill is
necessary. If the fair value of the reporting unit is less, an expense may be
required on KNBT’s books to write down the related goodwill to the proper
carrying value. KNBT recorded goodwill and other identifiable intangible assets
as a result of the acquisition of First Colonial in October 2003 and Oakwood
Securities in November 2004.
 
 **Comparison
of Financial Condition as of March 31, 2005 and December 31,
2004**
 
 **Assets.** KNBT’s
total assets were $2.4 billion at both March 31, 2005 and December 31, 2004.
KNBT’s total loans receivable were $1.03 billion at March 31, 2005, an increase
of $17.8 million or 1.8% over the $1.01 billion reported for December 31, 2004.
The growth in loans receivable was primarily due to an increase of $13.2 million
or 5.7% in commercial real estate loans, $3.7 million or 7.3% in other
commercial loans and $1.5 million or 0.5% in consumer loans **.** Single-family
residential loans increased $1.1 million or 0.3% while construction loans
decreased $1.4 million or 1.3%. KNBT sold $13.8 million of single-family
residential loans during the three month period ended March 31, 2005. KNBT
believes that rising interest rates reduced the level of activity in both the
single-family residential and construction loan categories during the quarter
ended March 31, 2005. Total investment securities decreased $50.6 million or
4.5% to $1.06 billion as compared with $1.11 billion at December 31, 2004.
During the quarter ended March 31, 2005, there was a decrease in both the
available-for-sale and held-to-maturity investments. The available-for-sale
category decreased $49.0 million or 4.6% while the held to maturity category
decreased $1.6 million or 2.8%. This decrease in the investment portfolio will
continue to be used to fund the growth in the loan portfolio, maturing Federal
Home Loan Bank (“FHLB”) advances, common stock purchases made through the stock
repurchase program and for payment in part, of the cash portion of the NEPF
acquisition anticipated to be consummated in the second quarter of 2005. Cash
and cash equivalents increased $39.7 million or 46.0% chiefly as a result of
reduction in investment securities.
 
 
 
 16
 
  **Non-Performing
Assets.** On
loans where the collection of principal or interest payments is doubtful, the
accrual of interest income ceases (“non-accrual” loans). On loans 90 days or
more past due as to principal and interest payments, KNBT’s policy, with certain
limited exceptions, is to discontinue accruing additional interest and reverse
any interest currently accrued. On occasion, this action may be taken earlier if
the financial condition of the borrower raises significant concern with regard
to the borrower’s ability to service the debt in accordance with the terms of
the loan agreement. Interest income is not accrued on these loans until the
borrower’s financial condition and payment record demonstrate an ability to
service the debt. Real estate that is acquired as a result of foreclosure is
classified as other real estate owned. Other real estate owned is recorded at
the lower of cost or fair value less estimated selling costs. Costs associated
with acquiring and improving a foreclosed property are usually capitalized to
the extent that the carrying values does not exceed fair value less estimated
selling costs. Holding costs are charged to expense. Gains and losses on the
sale of other real estate owned are credited or charged to operations, as
incurred.
 
 ****   Non-performing
loans decreased $995,000 or 19.7% to $4.1 million at March 31, 2005 as compared
with $5.1 million at December 31, 2004. The decrease was principally due to an
$811,000 or 25.6% decline in non-performing residential mortgage loans, and a
$136,000 or 32.1% decrease in non-performing commercial loans. Non-performing
consumer loan levels were relatively unchanged at March 31, 2005 compared to
December 31, 2004. Indirect vehicle non-performing levels were $879,000 at March
31, 2005 compared with $864,000 at December 31, 2004. During
the fourth quarter of 2004, KNBT instituted policies limiting vehicle collateral
advance levels based on key credit criteria which management believes will yield
improved portfolio non-accrual and charge-off results. Total non-performing loans as a percentage of net loans improved to 0.40% at
March 31, 2005 compared with 0.50% at December 31, 2004.
 **Allowance
for Loan Losses.** KNBT’s
allowance for loan losses decreased $11,000 or .1% during the first three months
of 2005. The
allowance for loan losses is established through a provision for loan losses.
KNBT maintains the allowance at a level believed, to the best of management’s
knowledge, to cover all known and inherent losses in the portfolio that are both
probable and reasonable to estimate at each reporting date. Management reviews
all loans that are delinquent 60 days or more on a monthly basis and performs
regular reviews of the allowance no less than quarterly in order to identify
those inherent losses and assesses the overall collection probability for the
loan portfolio. Such reviews consist of a quantitative analysis by loan
category, using historical loss experience and consideration of a series of
qualitative loss factors. KNBT’s evaluation process includes, among other
things, an analysis of delinquency trends, non-performing loan trends, the level
of charge-offs and recoveries, prior loss experience, total loans outstanding,
the volume of loan originations, the type, size and geographic concentration of
its loans, the value of collateral securing the loan, the borrower’s ability to
repay and repayment performance, the number of loans requiring heightened
management oversight, local economic conditions and industry experience. In
addition, in establishing the allowance for loan losses, KNBT’s management
considers a ten point internal rating system for all loans originated by the
Commercial Lending department. At the time of origination, each commercial loan
is assigned a rating based on the assumed risk elements of the loan. Such risk
ratings are periodically reviewed by management and revised as deemed
appropriate.
 
 KNBT
will continue to monitor and modify its allowance for loan losses as conditions
dictate. No assurances can be given that its level of allowance for loan losses
will cover all of the inherent losses on its loans or that future adjustments to
the allowance for loan losses will not be necessary if economic and other
conditions differ substantially from the economic and other conditions used by
management to determine the current level of the allowance for loan losses.
KNBT’s allowance for loan losses was 1.02% and 1.03% of total loans receivable
at March 31, 2005 and December 31, 2004, respectively. See “Comparison of
Operating Results for the three months ended March 31, 2005 and 2004 - Provision
for Loan Losses.”
 
 
 
 17
 
 **Liabilities.** KNBT’s
total liabilities equaled $2.05 billion at March 31, 2005, an increase of $12.2
million or .6% compared to total liabilities of $2.04 billion at December 31,
2004. Total deposits increased $21.3 million or 1.6% to $1.34 billion at March
31, 2005 compared to $1.32 billion at December 31, 2004. This increase
reflected, in part, KNBT’s continuing efforts to boost the level of checking
accounts and other core deposits. Core deposits consists of all deposits other
than certificates of deposit. Also, contributing to the increase in deposits in
the first quarter of 2005 was the increased market penetration of branches
opened in 2003 and KNBT’s marketing efforts. FHLB advances declined $13.8
million or 2.1% to $646.9 million at March 31, 2005 compared to $660.7 million
at December 31, 2004. Maturing advances was the primary reason for the
decline.
 
 **Shareholders’
Equity.** Shareholders’
equity totaled $368.7 million at March 31, 2005 compared to $377.4 million at
December 31, 2004, a decrease of $8.7 million or 2.3%. The decrease in
shareholders’ equity was primarily the result of the repurchase of KNBT common
stock through the Company’s stock repurchase program. A total of 314,000 shares
were repurchased during the three months ended, March 31, 2005, at an average
price of $16.20 per share. A total of 964,000 shares have been repurchased at an
average price of $16.65 since the program was approved in the third quarter of
2004. Also contributing to the decline in shareholders’ equity was a decrease in
accumulated other comprehensive income of $7.8 million relating to a decline in
unrealized gains on investment securities available-for-sale. KNBT also declared
and paid a cash dividend of $.05 per share during the quarter ended March 31,
2005. This resulted in a decrease in retained earnings of $1.5 million. Net
income for the three months ended March 31, 2005 was $4.8 million.  KNBT committed to release 11,900 shares of the Company’s common stock during the
three months ended March 31, 2005 pursuant to the ESOP for a value of $187,000
and issued 8,021 common shares upon the exercise of stock options for proceeds
of $45,000. Regulatory capital for KNBT and the Bank at March 31, 2005 and
December 31, 2004 are shown in the following tables.




At
      March 31, 2005Required
    
    To
      Be Well CapitalizedFor
      Capital
    
    Under
      Prompt CorrectiveActual
    
    Adequacy
      Purposes
    
    Action
      ProvisionsAmount
    
    Ratio
    
    Amount
    
    Ratio
    
    Amount
    
    RatioTotal
      Capital
    
    (dollars
      in thousands)(To
      risk-weighted assets)Company
      (consolidated)
    
    $
    348,064
    
    
    24.69
    %
    $
    112,764
    
    
    8.00
    %
    
    N/A
    
    
    N/ABank
    
    $
    262,742
    
    
    18.79
    %
    $
    111,878
    
    
    8.00
    %
    $
    139,848
    
    
    10.00
    %Tier
      I Capital(To
      risk-weighted assets)Company
      (consolidated)
    
    $
    337,614
    
    
    23.95
    %
    $
    56,382
    
    
    4.00
    %
    
    N/A
    
    
    N/ABank
    
    $
    252,292
    
    
    18.04
    %
    $
    55,939
    
    
    4.00
    %
    $
    83,909
    
    
    6.00
    %Tier
      I Capital(To
      average assets, leverage)Company
      (consolidated)
    
    $
    337,614
    
    
    14.29
    %
    $
    56,382
    
    
    4.00
    %
    
    N/A
    
    
    N/ABank
    
    $
    252,292
    
    
    10.85
    %
    $
    55,939
    
    
    4.00
    %
    $
    69,924
    
    
    5.00
    %
    At
      December 31, 2004Required
    
    To
      Be Well CapitalizedFor
      Capital
    
    Under
      Prompt CorrectiveActual
    
    Adequacy
      Purposes
    
    Action
      ProvisionsAmount
    
    Ratio
    
    Amount
    
    Ratio
    
    Amount
    
    RatioTotal
      Capital
    
    (dollars
      in thousands)(To
      risk-weighted assets)Company
      (consolidated)
    
    $
    355,857
    
    
    25.64
    %
    $
    111,042
    
    
    8.00
    %
    
    N/A
    
    
    N/ABank
    
    $
    264,159
    
    
    19.17
    %
    $
    110,233
    
    
    8.00
    %
    $
    137,792
    
    
    10.00
    %Tier
      I Capital(To
      risk-weighted assets)Company
      (consolidated)
    
    $
    345,396
    
    
    24.88
    %
    $
    55,521
    
    
    4.00
    %
    
    N/A
    
    
    N/ABank
    
    $
    253,698
    
    
    18.41
    %
    $
    55,117
    
    
    4.00
    %
    $
    82,675
    
    
    6.00
    %Tier
      I Capital(To
      average assets, leverage)Company
      (consolidated)
    
    $
    345,396
    
    
    14.66
    %
    $
    55,521
    
    
    4.00
    %
    
    N/A
    
    
    N/ABank
    
    $
    253,698
    
    
    12.17
    %
    $
    55,117
    
    
    4.00
    %
    $
    68,896
    
    
    5.00
    %


18
 
 
 
 **Liquidity.**KNBT’s
primary sources of funds are from deposits, amortization of loans, loan
prepayments and the maturity of loans, mortgage-backed securities and other
investments, and other funds provided from operations. While scheduled payments
from the amortization of loans and mortgage-backed securities and maturing
investment securities are relatively predictable sources of funds, deposit flows
and loan prepayments can be greatly influenced by general interest rates,
economic conditions and competition. KNBT also maintains excess funds in
short-term, interest-bearing assets that provide additional liquidity and also
utilizes outside borrowings, primarily from the FHLB, as an additional funding
source.KNBT
uses its liquidity to fund existing and future loan commitments, to fund
maturing certificates of deposit and demand deposit withdrawals, to invest in
other interest-earning assets, and to meet operating expenses. In addition to
cash flow from loan and securities payments and prepayments as well as from
sales of available-for-sale securities and mortgage loans, KNBT has significant
borrowing capacity available to fund liquidity needs. KNBT has increased its
utilization of FHLB borrowings in recent years as a cost efficient addition to
deposits as a source of funds. The average balance of FHLB borrowings was $651.9
million and $248.5 million for the three months ended March 31, 2005 and March
31, 2004, respectively.
 
 **“GAP”
Analysis.** The
following interest rate sensitivity “GAP” table sets forth the amounts of KNBT’s
interest-earning assets and interest-bearing liabilities outstanding at March
31, 2005, which are expected, based upon certain assumptions, to reprice or
mature in each of the future time periods shown. Except as stated below, the
amount of assets and liabilities shown which reprice or mature during a
particular period were determined in accordance with the earlier of term to
repricing or the contractual maturity of the asset or liability. The table sets
forth an approximation of the projected repricing of assets and liabilities at
March 31, 2005, on the basis of contractual maturities, anticipated prepayments,
and scheduled rate adjustments within a three-month period and subsequent
selected time intervals. The loan amounts in the table reflect principal
balances expected to be repaid and/or repriced as a result of contractual
amortization and anticipated prepayments of adjustable-rate loans and fixed-rate
loans, and as a result of contractual rate adjustments on adjustable-rate loans.
Annual prepayment rates for adjustable-rate and fixed-rate single-family and
multi-family mortgage loans are assumed to range from 14% to 32%. The annual
prepayment rate for mortgage-backed securities is assumed to range from 14% to
32%. Money market deposit accounts, savings accounts and interest-bearing
checking accounts are assumed to have annual rates of withdrawal, or “decay
rates,” of 30%, 8% and 10%, respectively.
 
 19
 
 At
      March 31, 2005More
      than
    
    More
      than
    
    More
      than
    
    More
      than3
      Months
    
    3
      Months
    
    6
      Months
    
    1
      Year
    
    3
      Years
    
    More
      thanor
      Less
    
    to
      6 Months
    
    to
      1 Year
    
    to
      3 Years
    
    to
      5 Years
    
    5
      Years
    
    Total(dollars
      in thousands)Interest-earning
      assets (1):Deposits
      at other institutions
    
    $
    95,341
    
    $
    -
    
    $
    -
    
    $
    -
    
    $
    -
    
    $
    -
    
    $
    95,341Loans
      receivable (2)
    
    
    177,945
    
    
    68,031
    
    
    114,647
    
    
    319,770
    
    
    197,229
    
    
    153,419
    
    
    1,031,042Investment
      securities, debt
    
    
    107,983
    
    
    36,000
    
    
    72,001
    
    
    333,525
    
    
    208,481
    
    
    299,603
    
    
    1,057,593Investment
      securities, equity
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    40,650
    
    
    40,650Total
      interest-earningassets
    
    $
    381,270
    
    $
    104,032
    
    $
    186,648
    
    $
    653,295
    
    $
    405,710
    
    $
    493,672
    
    $
    2,224,626Cumulative
      total interest-earning
      assets
    
    $
    381,270
    
    $
    485,301
    
    $
    671,949
    
    $
    1,325,244
    
    $
    1,730,954
    
    $
    2,224,626
    
    $
    2,224,626Interest-bearingliabilities:Savings
      deposits
    
    $
    -
    
    $
    8,449
    
    $
    8,449
    
    $
    11,229
    
    $
    14,118
    
    $
    168,984
    
    $
    211,230Interest-bearing
      checking deposits
    
    
    -
    
    
    10,817
    
    
    7,210
    
    
    7,210
    
    
    3,605
    
    
    151,414
    
    
    180,257Money
      market deposits
    
    
    25,416
    
    
    30,498
    
    
    20,332
    
    
    33,887
    
    
    16,944
    
    
    127,077
    
    
    254,154Certificates
      of deposit
    
    
    81,216
    
    
    60,462
    
    
    100,093
    
    
    285,957
    
    
    40,913
    
    
    743
    
    
    569,385FHLB
      advances and otherborrowings
    
    
    127,672
    
    
    16,163
    
    
    59,375
    
    
    262,370
    
    
    159,369
    
    
    61,863
    
    
    686,812Total
      interest-bearingliabilities
    
    $
    234,305
    
    $
    126,389
    
    $
    195,460
    
    $
    600,653
    
    $
    234,949
    
    $
    510,081
    
    $
    1,901,837Cumulative
      total interest-bearing
      liabilities
    
    $
    234,305
    
    $
    360,694
    
    $
    556,154
    
    $
    1,156,807
    
    $
    1,391,756
    
    $
    1,901,837
    
    $
    1,901,837Interest-earning
      assetsless
      interest-bearingliabilities
    
    $
    146,965
    
    $
    (22,357
    )
    $
    (8,812
    )
    $
    52,641
    
    $
    170,761
    
    $
    (16,409
    )
    $
    322,789Cumulative
      interest-ratesensitivity
      gap (3)
    
    $
    146,965
    
    $
    124,607
    
    $
    115,795
    
    $
    168,437
    
    $
    339,198
    
    $
    322,789Cumulative
      interest-rate gap as apercentage
      of total assets atMarch
      31, 2005
    
    
    6.08
    %
    
    5.15
    %
    
    4.79
    %
    
    6.96
    %
    
    14.02
    %
    
    13.35
    %Cumulative
      interest-earning assetsas
      a percentage ofcumulative
      interest-bearingliabilities
      at March 31, 2005
    
    
    162.72
    %
    
    134.55
    %
    
    120.82
    %
    
    114.56
    %
    
    124.37
    %
    
    116.97
    %
 (1)
    Interest-earning
      assets are included in the period in which the balances are expected to be
      redeployed and/or repriced as a
      result of anticipated prepayments, scheduled rate adjustment or
      contractual maturity.(2)
    For
      purposes of the gap analysis, loans receivable includes non-performing
      loans, gross of the allowance for loan losses, undisbursed
      loan funds and deferred loan fees.(3)
    Interest-rate sensitivity gap represents the difference between net
      interest-earning assets and interest-bearing
liabilities.
  20
 ****
 **Comparison
of Operating Results for the Three Months Ended March 31, 2005 and
2004**
 
 **General.** KNBT’s net income increased by $715,000, or 17.4% to $4.8 million for the three
months ended March 31, 2005 compared to $4.1 million for the three months ended
March 31, 2004. Net income increased during 2005 due to higher levels of net
interest income and non-interest income in addition to a lower loan loss
provision. These increases were partially offset by increases in non-interest
expense. The increase in net interest income primarily reflects increased
interest income in the 2005 period due to an increase in the average balance of
interest-earning assets. Earning assets increased as a result of the growth of
the investment portfolio, due to the implementation of a leverage strategy
during 2004, as well as growth of the loan portfolio. KNBT made efforts to
control the growth of non-interest expense while growing non-interest income. As
result, for the three-month period ended March 31, 2005 compared to the
three-month period ended March 31, 2004, non-interest income increased by 12.0%
while non-interest expense increased by 7.4%.
 
 **Analysis
of**  **Net
Interest Income.** For the three months ended March 31, 2005, KNBT’s net interest income was $16.1
million, a $663,000 or 4.3% increase compared to $15.5 million for the three
months ended March 31, 2004. KNBT’s average interest-earning assets totaled $2.2
billion for the three months ended March 31, 2005 as compared to $1.8 billion
for the three months ended March 31, 2004. Growth in earning assets was
primarily the result of an increase in both the investment securities and loan
portfolios. During the first three months of 2005, the average balance of the
investment portfolio grew $311.0 million or 38.1% and the average balance of the
loan portfolio (gross loans) increased $110.0 million or 12.1%. Growth in
interest-bearing liabilities in the first quarter of 2005 compared to the first
quarter of 2004 was primarily focused on the increase in FHLB advances to fund
the leverage strategy and support the loan growth. For the three months ended
March 31, 2005, the average balance of FHLB advances increased by $403.4 million
or 162.4% compared to the same period in 2004. Total interest income increased
$4.6 million or 20.6% to $27.0 million for the three months ended March 31, 2005
as compared with $22.4 million for the three months ended March 31, 2004. For
the three months ended March 31, 2005, total interest expense increased $4.0
million or 57.5% to $10.8 million as compared with $6.9 million for the three
months ended March 31, 2004. The major factors in the increase in both interest
income and interest expense were the increased average balances of
interest-earning assets and interest-bearing liabilities.
 
 Net
interest margin, a measure of net interest income performance, is determined by
dividing net interest income by the average balance of total interest-earning
assets. The Company’s net interest margin was 2.94% for the three months ended
March 31, 2005 as compared with 3.53% for the same period in 2004. The net
interest margin on a tax equivalent basis was 3.05% for the three months ended
March 31, 2005 compared to 3.68% for the prior year comparable period. Net
interest spread on a tax equivalent basis was 2.72% three months ended March 31,
2005 compared to 3.36% for the prior year. The lower interest margin and
interest spread in the 2005 periods was the result of the rates paid on
interest-bearing liabilities increasing by 42 basis points while interest rates
on earning assets declined 22 basis points.
 **Average
Balances, Net Interest Income, and Yields Earned and Rates
Paid.** The following table shows for the periods indicated the total dollar amount of
interest from average interest-earning assets and the resulting yields, as well
as the interest expense on average interest-bearing liabilities, expressed both
in dollars and rates, and the net interest margin. The table includes
information adjusted to a tax equivalent basis for the Company’s tax-exempt
investment securities. The presentation on a tax-equivalent basis may be
considered to include non-GAAP information. Management believes that it is a
common industry practice in the banking industry to present such information on
a fully tax equivalent basis and that such information is useful to investors in
making peer comparisons. The tax-exempt adjustments and comparable GAAP
information also is included in the table.
 
 
 
 
 21
  For
      the Three Months Ended March 31,2005
    
    2004Interest
    
    Average
    
    
    
    Interest
    
    AverageAverage
    
    Income/
    
    Yield/
    
    Average
    
    Income/
    
    Yield/Balance
    
    Expense
    
    Rate
    
    Balance
    
    Expense
    
    RateAssets
    
    (dollars
      in thousands)Interest-earning
      assetsInterest-bearing
      balances with banks
    
    $
    60,543
    
    $
    346
    
    
    2.29
    %
    $
    36,390
    
    $
    142
    
    
    1.56
    %Investment
      securitiesTaxable
      (1)
    
    
    1,017,927
    
    
    10,566
    
    
    4.15
    %
    
    699,329
    
    
    6,871
    
    
    3.93
    %Non-taxable
      (2)
    
    
    108,544
    
    
    1,759
    
    
    6.48
    %
    
    116,178
    
    
    1,886
    
    
    6.49
    %Loans
      receivable (2) (3)
    
    
    1,021,335
    
    
    14,920
    
    
    5.84
    %
    
    911,362
    
    
    14,104
    
    
    6.19
    %Allowance
      for loan losses
    
    
    (10,393
    )
    
    
    
    
    
    
    
    (8,079
    )Net
      loans
    
    
    1,010,942
    
    
    14,920
    
    
    5.90
    %
    
    903,283
    
    
    14,104
    
    
    6.25
    %Total
      interest-earning assets
    
    
    2,197,956
    
    
    27,591
    
    
    5.02
    %
    
    1,755,180
    
    
    23,003
    
    
    5.24
    %Non-interest-earning
      assets
    
    
    202,307
    
    
    -
    
    
    
    
    
    224,006
    
    
    -Total
      assets, interest income
    
    $
    2,400,263
    
    
    27,591
    
    
    
    
    $
    1,979,186
    
    
    23,003LiabilitiesInterest-bearing
      liabilitiesInterest-bearing
      depositsDemand
      deposits
    
    $
    176,622
    
    
    71
    
    
    0.16
    %
    $
    178,104
    
    
    64
    
    
    0.14
    %Money
      market deposits
    
    
    247,648
    
    
    792
    
    
    1.28
    %
    
    238,371
    
    
    542
    
    
    0.91
    %Savings
      deposits
    
    
    209,538
    
    
    249
    
    
    0.48
    %
    
    224,034
    
    
    263
    
    
    0.47
    %Certificates
      of deposit
    
    
    564,659
    
    
    3,987
    
    
    2.82
    %
    
    536,535
    
    
    3,666
    
    
    2.73
    %Total
      interest-bearing deposits
    
    
    1,198,467
    
    
    5,099
    
    
    1.70
    %
    
    1,177,044
    
    
    4,535
    
    
    1.54
    %Securities
      sold under agreementsto
      repurchase
    
    
    18,732
    
    
    51
    
    
    1.09
    %
    
    23,296
    
    
    35
    
    
    0.60
    %FHLB
      advances
    
    
    651,901
    
    
    5,444
    
    
    3.34
    %
    
    248,470
    
    
    2,124
    
    
    3.42
    %Other
      debt
    
    
    15,464
    
    
    233
    
    
    6.03
    %
    
    15,464
    
    
    181
    
    
    4.68
    %Total
      interest-bearing liabilities
    
    
    1,884,564
    
    
    10,827
    
    
    2.30
    %
    
    1,464,274
    
    
    6,875
    
    
    1.88
    %Non-interest-bearing
      liabilitiesNon-interest-bearing
      deposits
    
    
    123,805
    
    
    -
    
    
    -
    
    
    115,925
    
    
    -
    
    
    -Other
      liabilities
    
    
    13,969
    
    
    -
    
    
    -
    
    
    5,594
    
    
    -
    
    
    -Total
      liabilities
    
    
    2,022,338
    
    
    10,827
    
    
    
    
    
    1,585,793
    
    
    6,875Shareholders'
      equity /retained earnings
    
    
    377,925
    
    
    -
    
    
    -
    
    
    393,393
    
    
    -
    
    
    -Total
      liabilities and shareholders'equity,
      interest expense
    
    $
    2,400,263
    
    
    10,827
    
    
    
    
    $
    1,979,186
    
    
    6,875Net
      interest income on tax equivalent basis (2)
    
    
    
    
    
    16,764
    
    
    
    
    
    
    
    
    16,128Net
      interest spread ontax
      equivalent basis (4)
    
    
    
    
    
    
    
    
    2.72
    %
    
    
    
    
    
    
    
    3.36
    %Effect
      of interest-free sourcesused
      to fund earning assets
    
    
    
    
    
    
    
    
    0.11
    %
    
    
    
    
    
    
    
    0.15
    %Net
      interest margintax
      equivalent basis (5)
    
    
    
    
    
    
    
    
    3.05
    %
    
    
    
    
    
    
    
    3.68
    %Tax-exempt
      adjustment
    
    
    
    
    
    (625
    )
    
    
    
    
    
    
    
    (652
    )Net
      interest income and margin (4)
    
    
    
    
    $
    16,139
    
    
    2.94
    %
    
    
    
    $
    15,476
    
    
    3.53
    %Average
      interest-earning assetsto
      average interest-bearing liabilities
    
    
    
    
    
    
    
    
    116.63
    %
    
    
    
    
    
    
    
    119.87
    %
  (1)
    Includes Federal Home Loan Bank stock.(2)
    The indicated interest income and average yields are presented on a
      taxable equivalent basis. The taxable equivalent adjustments
      included above are $625,000 and $652,000 for the three months ended March
      31, 2005 and 2004, respectively. The
      effective tax rate used for the taxable equivalent adjustment was
      34%.(3)
    Loan (expenses) fees of $(24,041) and $(34,000) for the three
      months ended March 31, 2005 and 2004, respectively, are included
      in interest income. Average loan balances include non-accruing loans of
      $3.8 million and $2.1 million and
      average
      loans held-for-sale of $1.4 million and $3.3 million for the three months
      ended March 31, 2005 and 2004,
  respectively.(4)
    Net interest spread is the arithmatic difference between yield on
      interest-earning assets and the rate paid on interest-bearing
      liabilities.(5)
    Net interest margin is computed by dividing net interest income by
      average interest-earning assets.
 
 22
 ****


****


**Rate
Volume Analysis.**The
following table shows the extent to which changes in interest rates and changes
in volume of interest-earning assets and interest-bearing liabilities affected
KNBT’s interest income and expense during the periods indicated. For each
category of interest-earning assets and interest-bearing liabilities,
information is provided on changes attributable to (1) changes in rate, which is
the change in rate multiplied by prior year volume, and (2) changes in volume,
which is the change in volume multiplied by prior year rate. The combined effect
of changes in both rate and volume has been allocated proportionately to the
change due to rate and the change due to volume.

Three
      Months Ended March 31, 2005Compared
      to Three Months Ended March 31, 2004Increase
      (Decrease)
    
    TotalDue
      to
    
    IncreaseRate
    
    Volume
    
    (Decrease)(Dollars
      in Thousands)Interest
      Income:Cash
      and cash equivalents
    
    $
    110
    
    $
    94
    
    $
    204Investment
      securities
    
    
    229
    
    
    3,339
    
    
    3,568Loans
      receivable, net
    
    
    (886
    )
    
    1,702
    
    
    816Total
      interest-earning assets
    
    
    (547
    )
    
    5,135
    
    
    4,588Interest
      Expense:Demand
      deposits
    
    
    8
    
    
    (1
    )
    
    7Money
      market deposits
    
    
    229
    
    
    21
    
    
    250Savings
      deposits
    
    
    3
    
    
    (17
    )
    
    (14
    )Certificates
      of deposit
    
    
    129
    
    
    192
    
    
    321Total
      interest-bearing deposits
    
    
    369
    
    
    195
    
    
    564Securities
      sold under agreementsto
      repurchase
    
    
    23
    
    
    (7
    )
    
    16FHLB
      advances and other borrowings
    
    
    (128
    )
    
    3,448
    
    
    3,320Other
      debt
    
    
    52
    
    
    -
    
    
    52Total
      interest-bearing liabilities
    
    
    316
    
    
    3,636
    
    
    3,952Increase
      (decrease) in netinterest
      income
    
    $
    (863
    )
    $
    1,499
    
    $
    636


**Provision
for Loan Losses.** The
provision for loan losses is determined by management’s review and analysis of
the loan portfolio. This evaluation process includes, among other things, an
analysis of delinquent and non-performing loans, the level of charge-offs and
recoveries, the value of collateral securing the loan, the borrower’s ability to
repay, repayment performance and local economic conditions. The valuation also
takes into consideration performing loans that may have certain weaknesses as
identified by management in its review of loans.








23





KNBT **** made
a provision for loan losses of $734,000 for the three months ended March 31,
2005 as compared to $1.5 million for the three months ended March 31, 2004. KNBT
believes that it has made provisions to its allowance for loan loss in amounts
which are consistent with the reasonably estimable losses in its loan portfolio.
During the twelve-month period ending December 31, 2004, KNBT increased the
provision for loan loss to $4.3 million; a $1.3 million or 46.0% increase as
compared to a provision of $3.0 million for twelve months ending December 31,
2003. The allowance for loan loss to loans at period end increased to 1.03% from
..89% over the same period. A primary factor in the increased provision over the
comparable 2004 periods over 2003 was the acquisition of $271.2 million of net
loans from the First Colonial acquisition of which commercial loans totaled
$61.5 million. Commercial loans and commercial real estate loans are deemed to
have higher levels of known and inherent losses than one to four-family
residential loans due to, among other things, the nature of the collateral and
the dependency on economic conditions for successful completion or operation of
the project. KNBT has made provisions in order to maintain the allowance for
loan losses at a level, we believe, to the best of our knowledge, covers all
known and inherent losses in the portfolio that are both probable and reasonable
to estimate at this time. During the three months ended March 31, 2005, most
charge-offs were primarily related to consumer loans. Non-performing loans
totaled $4.1 million, and $5.1 million at March 31, 2005, and December 31, 2004,
respectively. **** At
March 31, 2005, KNBT’s allowance for loan losses equaled 257.4% of
non-performing loans as compared to 206.9% at December 31, 2004. The Company’s
allowance for loan losses as a percentage of loans at period end was 1.01% and
1.03% at March 31, 2005 and December 31, 2004, respectively.





**Non-Interest
Income.** Non-interest
income increased $475,000 or 12.0% to $4.4 million for the three months ended
March 31, 2005 as compared to $4.0 million for the three months ended March 31,
2004. The primary reasons for the increase were increased brokerage service
revenues of $388,000 as a result of the acquisition of Oakwood Securities and
the hiring of additional, experienced sales professionals, and increased trust
revenues from the Company’s Trust Department of $45,000. Non-interest operating
income increased $134,000 during the three months ended March 31, 2005 compared
to the three months ended March 31, 2004, principally because of a $70,000
increase in check card interchange fees. The increase in non-interest operating
income helped offset a $206,000 decline in deposit service charge revenue in the
2005 period. During the three months ended March 31, 2005, KNBT’s net gain on
sale of residential mortgage loans increased $59,000 to $218,000 and net gain on
sales of investment securities was $432,000 as compared to a net loss of $8,000
for three months ended March 31, 2004.





**Non-Interest
Expense.** Non-interest expense increased by $920,000, or 7.4%, to $13.4 million for the
three months ended March 31, 2005 as compared to $12.5 million for the three
months ended March 31, 2004. This was the result of higher compensation and
benefit costs and higher occupancy and equipment expenses. Compensation and
benefit expenses increased $603,000 or 8.3% to $7.8 million for the three months
ended March 31, 2005 as compared with $7.2 million for the same period in 2004.
The increase reflects the addition of staff members from the fourth quarter 2004
acquisition of Oakwood Securities, amortization of the Management Recognition
and Retention Plan, and merit increases. Net occupancy and equipment costs
increased $288,000 or 15.8% to $2.1 million for the three months ended March 31,
2005. Building maintenance costs increased $200,000 or 249.9% during the three
months ended March 31, 2005 compared to the three months ended March 31, 2004,
due to preventive maintenance measures performed on KNBT’s buildings and costs
associated with weather. Depreciation expense on equipment increased $446,000 or
211.6% to $846,000 for the three months ended March 31, 2005. This increase
reflects costs associated with the addition of equipment and systems
necessitated by KNBT’s core system conversion and integration completed during
March 2004. KNBT’s core system is now internally operated instead of contracted
with a third-party service bureau provider.








24





**Income
Tax Expense.** KNBT’s income tax expense was $1.6 million for the three months ended March 31,
2005 compared with $1.3 million for the three months ended March 31, 2004. The
effective income tax rate for the three months ended March 31, 2005 was 24.8% as
compared to 24.3% for the three-month period ended March 31, 2004.








**Item 3.****Quantitative
and Qualitative Disclosures About Market Risk**





For
a discussion of KNBT’s asset and liability management policies as well as the
methods used to manage its exposure to the risk of loss from adverse changes in
market prices and interest rates see “Management’s Discussion and Analysis of
Financial Condition and Results of Operations - Market Risk and Interest Rate
Sensitivity” in KNBT’s annual report on Form 10-K for the year ended December
31, 2004. There have been no material changes in KNBT’s assessment of its
sensitivity to market risk since December 31, 2004.








**Item 4.****Controls
and Procedures**





**Evaluation
of Disclosure Controls and Procedures.** KNBT’s
management evaluated, with the participation of its Chief Executive Officer and
Chief Financial Officer, the effectiveness of its disclosure controls and
procedures (as defined in Rule 13a-15(e) or 15d-15(e) under the Securities
Exchange Act of 1934) as of the end of the period covered by this report. Based
on such evaluation, KNBT’s Chief Executive Officer and Chief Financial Officer
have concluded that its disclosure controls and procedures are designed to
ensure that information required to be disclosed in the reports that it files or
submits under the Securities Exchange Act of 1934 is recorded, processed,
summarized and reported within the time periods specified in the SEC’s rules and
regulations and are operating in an effective manner.


**Changes
in Internal Control Over Financial Reporting.** No change in KNBT’s internal control over financial reporting (as defined in
Rules 13a-15(f) or 15d-15(f) under the Securities Exchange Act of 1934, as
amended) occurred during the quarter ended March 31, 2005 that has materially
affected or is reasonably likely to materially affect, KNBT’s internal control
over financial reporting.








**PART
II -**  **OTHER INFORMATION**





**Item 1.****Legal
Proceedings**


There
are no matters required to be reported under this item.





25





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





The
following table sets forth information regarding KNBT’s repurchases of its
common stock during the quarter ended March 31, 2005.





Period
    
    Total
      Number of Shares Purchased
    
    Average
      Price Paid
      Per
      Share
    
    Total
      Number of Shares Purchased as Part of Publicly Announced Plans or
      Programs
    
    Maximum
      Number of Shares that may yet be Purchased Under the Plan or Program(s)
      (1)January
      1 - 31, 2005
    
    -
    
    -
    
    -
    
    2,412,486
      (2)February
      1 - 28, 2005
    
    -
    
    -
    
    -
    
    2,412,486
      (2)March
      1 - 31, 2005
    
    314,000
    
    $16.20
    
    964,000
    
    2,098,486
      (2)Total
    
    314,000
    
    $16.20
    
    964,000
    
    N/A


(1)
    On
      October 27, 2004, the Board of Directors authorized the repurchase of up
      to 3,062,486 shares or approximately 10% of KNBT's outstanding
      shares. Repurchases will be made from time to time, during the next 12
      months or longer if necessary a(2)
    The 2004
      Management Recognition and Retention Plan and Trust Agreement ("MRRP") was
      adopted by the Board of Directors
      and
      approved by KNBT stockholders at their Annual Meeting on May 6, 2004. The
      MRRP is a stock-based plan that provides
for


**Item 3.****Defaults
Upon Senior Securities**





There
are no matters required to be reported under this item.








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


Not
applicable.





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


There
are no matters required to be reported under this item.


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





(a)
    List
      of exhibits:31.1
    Section
      302 Certification of the Chief Executive Officer31.2
    Section
      302 Certification of the Chief Financial Officer32.1
    Certification
      Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of
      the Sarbanes-Oxley Act of 2002.








26





**SIGNATURES**








Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized.








**KNBT
      BANCORP, INC.****DATE:****May
      10, 2005**
    **BY:**
    **/S/
      Scott V. Fainor****Scott
      V. Fainor****President
      and Chief Executive Officer****DATE:****May
      10, 2005**
    **BY:**
    **/S/
      Eugene T. Sobol****Eugene
      T. Sobol****Senior
      Executive Vice President,****Chief
      Operating Officer and****Chief
      Financial Officer**










27