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**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-K**

 
| **x** | **ANNUAL  REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934** |
|-------|------------------------------------------------------------------------------------------------|

 

**FOR THE FISCAL YEAR ENDED DECEMBER 31, 2008**

 

**COMMISSION FILE NUMBER 333-90273**

 

**FIDELITYD & D BANCORP, INC.**

 

COMMONWEALTH OF PENNSYLVANIA I.R.S. EMPLOYER IDENTIFICATION NO: **23-3017653**

 

**BLAKELY AND DRINKER STREETS**

**DUNMORE, PENNSYLVANIA 18512**

**TELEPHONE NUMBER (570) 342-8281**

 

SECURITIES REGISTERED UNDER SECTION 12(b) OF THE ACT:

**None**

 

SECURITIES REGISTERED UNDER SECTION 12(g) OF THE ACT:

**Common Stock, without par value**

 

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act.  Yes o  No x

 

Indicateby check mark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Act.  Yeso No x

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter period thatthe registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past90 days.  Yes x  No o

 

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to thebest of the registrant’s knowledge, in definitive proxy or informationstatements incorporated by references in Part III of this Form 10-Kor any amendment to this Form 10-K. x

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer or a smaller reporting company. Seedefinition of “large accelerated filer,” “accelerated filer” and “smallerreporting company” in Rule 12b-2 of the Exchange Act. (Check One)

 
| Large  accelerated filer o                |   | Accelerated  filer o         |
|------------------------------------------------|--------|-----------------------------------|
|                                           |   |                              |
| Non-accelerated  filer o                  |   | Smaller  reporting company x |
| (Do  not check if a smaller reporting company) |   |                              |

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12B-2of the Act).  Yes o  No x

 

Aggregatemarket value of the voting common stock held by non-affiliates of theregistrant equals $49,429,783, as of June 30, 2008, based on a marketprice of $29.25. The number of shares of common stock outstanding as of February 28,2009, was 2,062,128.

 

**DOCUMENTSINCORPORATED BY REFERENCE**

 

Excerpts from the Registrant’s2008 Annual Report to Shareholders are incorporated herein by reference inresponse to Part I. Portions of the Registrant’s definitive ProxyStatement to be used in connection with the 2009 Annual Meeting of Shareholdersare incorporated herein by reference in partial response to Part II and Part III.

 

 

 

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**FidelityD & D Bancorp, Inc.**

**2008Annual Report on Form 10-K**

**Table of Contents**

 
| **Part I.**   | ** **               | ** **                                                                                                          | ** ** |
|--------------------|--------------------------|---------------------------------------------------------------------------------------------------------------------|------------|
|               |                     |                                                                                                                |       |
| Item 1.            |                     | Business                                                                                                            | 3          |
| Item 1A.           |                     | Risk Factors                                                                                                        | 5          |
| Item 1B.           |                     | Unresolved Staff  Comments                                                                                          | 11         |
| Item  2.           |                     | Properties                                                                                                          | 11         |
| Item 3.            |                     | Legal Proceedings                                                                                                   | 12         |
| Item 4.            |                     | Submission  of Matters to a Vote of Security Holders                                                                | 12         |
|               |                     |                                                                                                                |       |
| **Part II.**  | ** **               | ** **                                                                                                          | ** ** |
|               |                     |                                                                                                                |       |
| Item 5.            |                     | Market for  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases  of Equity Securities | 12         |
| Item 6.            |                     | Selected Financial  Data                                                                                            | 15         |
| Item 7.            |                     | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         | 16         |
| Item 7A.           |                     | Quantitative  and Qualitative Disclosures About Market Risk                                                         | 47         |
| Item 8.            |                     | Financial  Statements and Supplementary Data                                                                        | 48         |
| Item 9.            |                     | Changes in  and Disagreements with Accountants on Accounting and Financial Disclosure                               | 81         |
| Item 9A (T).       | Controls and  Procedures | 81                                                                                                                  |
| Item 9B.           |                     | Other Information                                                                                                   | 82         |
|               |                     |                                                                                                                |       |
| **Part III.** | ** **               | ** **                                                                                                          | ** ** |
|               |                     |                                                                                                                |       |
| Item 10.           |                     | Directors,  Executive Officers and Corporate Governance                                                             | 82         |
| Item 11.           |                     | Executive  Compensation                                                                                             | 82         |
| Item 12.           |                     | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                    | 82         |
| Item 13.           |                     | Certain  Relationships and Related Transactions, and Director Independence                                          | 82         |
| Item 14.           |                     | Principal  Accountant Fees and Services                                                                             | 83         |
|               |                     |                                                                                                                |       |
| **Part IV.**  | ** **               | ** **                                                                                                          | ** ** |
|               |                     |                                                                                                                |       |
| Item 15.           |                     | Exhibits,  Financial Statement Schedules                                                                            | 83         |
|               |                     |                                                                                                                |       |
| Signatures         |                     | 86                                                                                                                  |
| Exhibit Index |                     | 87                                                                                                                  |
| Certifications     |                     | 91                                                                                                                  |

 

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**FIDELITYD & D BANCORP, INC.**

 

###### ***PART I***

######  

***Forward-Looking Statements***

 

This Annual Report on Form 10-Kcontains a number of forward-looking statements within the meaning of Section 27Aof the Securities Act of 1933, as amended, or the Securities Act, and Section 21Eof the Securities Exchange Act of 1934, as amended, or the Exchange Act. Thesestatements may be identified by the use of the words “anticipate,” “believe,” “could,”“estimate,” “expect,” “intend,” “may,” “outlook,” “plan,” “potential,” “predict,”“project,” “should,” “will,” “would” and similar terms and phrases, includingreferences to assumptions. Forward-looking statements include risks anduncertainties.

 

Forward-lookingstatements are based on various assumptions and analyses made by us in light ofmanagement’s experience and its perception of historical trends, currentconditions and expected future developments, as well as other factors itbelieves are appropriate under the circumstances. These statements are notguarantees of future performance and are subject to risks, uncertainties andother factors (many of which are beyond our control) that could cause actualresults to differ materially from future results expressed or implied by suchforward-looking statements. These factors include, without limitation, thefollowing:

 

·                  the timing andoccurrence or non-occurrence of events may be subject to circumstances beyondour control;

 

·                  there may beincreases in competitive pressure among financial institutions or fromnon-financial institutions;

 

·                  changes in theinterest rate environment may reduce interest margins;

 

·                  changes indeposit flows, loan demand or real estate and investment securities values mayadversely affect our business;

 

·                  changes inaccounting principles, policies or guidelines may cause our financial conditionto be perceived differently;

 

·                  general economicconditions, either nationally or locally in some or all areas in which we dobusiness, or conditions in the securities markets or the banking industry maybe less favorable than we currently anticipate;

 

·                  legislative orregulatory changes may adversely affect our business;

 

·                  technologicalchanges may be more rapid, difficult or expensive than we anticipate;

 

·                  success orconsummation of new business initiatives may be more difficult or expensivethan we anticipate;

 

·                  acts of war orterrorism; or

 

·                  naturaldisaster.

 

Management cautionsreaders not to place undue reliance on forward-looking statements, whichreflect analyses only as of the date of this report. We have no obligation toupdate any forward-looking statements to reflect events or circumstances afterthe date of this document.

 

# Readers should review the risk factors described in Item 1A, above, andin other documents that we file, from time-to-time with the SEC, includingquarterly reports on Form 10-Q and any current reports on Form 8-K.

#  

# ***ITEM 1:*        *BUSINESS***

#  

Fidelity D & DBancorp, Inc. (the Company) was incorporated in the Commonwealth ofPennsylvania, on August 10, 1999, and is a bank holding company, whosewholly-owned state chartered commercial bank is The Fidelity Deposit andDiscount Bank (the Bank) (collectively, the Company). The Company isheadquartered at Blakely and Drinker Streets in Dunmore, Pennsylvania.

 

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The Bank has offered afull range of traditional banking services since it commenced operations in1903. The Bank has a personal and corporate trust department and also providesalternative financial and insurance products with asset management services. Afull list of services provided by the Bank is detailed in the section entitled “Productsand Services” contained within the 2008 Annual Report to Shareholders,incorporated by reference. The service area is comprised of the Borough ofDunmore and the surrounding communities within Lackawanna and Luzerne countiesin Northeastern Pennsylvania.

 

The banking business ishighly competitive, and the profitability of the Company depends principally uponthe Company’s ability to compete in its market area. Competition includes,among other sources, the following:

 
|   | · | local community banks     | · | insurance companies                |
|--------|--------|---------------------------|--------|------------------------------------|
|   |   |                      |   |                               |
|   | · | savings banks             | · | money market funds                 |
|   |   |                      |   |                               |
|   | · | regional banks            | · | mutual funds                       |
|   |   |                      |   |                               |
|   | · | credit unions             | · | small loan companies               |
|   |   |                      |   |                               |
|   | · | savings &  loans | · | other financial service  companies |

 

The Company has been ableto compete effectively with other financial institutions by emphasizingtechnology and customer service, including local decision making on loans. Theseefforts enabled the Company to establish long-term customer relationships andbuild customer loyalty by providing products and services designed to addresstheir specific needs.

 

There are noconcentrations of loans that, if lost, would have a materially adverse effecton the continued business of the Company. The Company’s loan portfolio does nothave a material concentration within a single industry or group of relatedindustries that are vulnerable to the risk of a near-term severe impact. However,the Company’s success is dependent, to a significant degree, on economicconditions in Northeastern Pennsylvania, especially Lackawanna and Luzernecounties which the Company defines as its primary market area. The bankingindustry is affected by general economic conditions including the effects ofinflation, recession, unemployment, real estate values, trends in national andglobal economies and other factors beyond the Company’s control. An economicrecession or a delayed economic recovery over a prolonged period of time in theCompany’s primary market area could cause an increase in the level of theCompany’s non-performing assets and loan losses, and thereby cause operatinglosses, impairment of liquidity and erosion of capital. We cannot assure youthat adverse changes in the local economy would not have a material effect onthe Company’s future consolidated financial condition, results of operationsand cash flows. Refer to Item 1A, “Risk Factors” for material risks anduncertainties that management believes affect the Company.

 

The Company had 196 full-time equivalent employees on December 31,2008, which includes exempt officers and part-time employees.

 

Federal and state banking laws contain numerousprovisions that affect various aspects of the business and operations of theCompany and the Bank. The Company is subject to, among others, the regulationsof the Securities and Exchange Commission (the SEC) and the Federal ReserveBoard (the FRB) and the Bank is subject to, among others, the regulations ofthe Pennsylvania Department of Banking and the Federal Deposit InsuranceCorporation (the FDIC). Refer to Part II, Item 7 “Supervision andRegulation” for descriptions of and references to applicable statutes andregulations which are not intended to be complete descriptions of theseprovisions or their effects on the Company or the Bank. They are summaries onlyand are qualified in their entirety by reference to such statutes andregulations. Applicable regulations relate to, among other things:

 
|        | · | operations          | · |  consolidation        |
|--------|--------|---------------------|--------|----------------------------|
|   |   |                |   |                       |
|   | · | securities          | · |  reserves             |
|   |   |                |   |                       |
|   | · | risk management     | · |  dividends            |
|   |   |                |   |                       |
|   | · | consumer compliance | · |  branches             |
|   |   |                |   |                       |
|   | · | mergers             | · | ** **capital adequacy |

 

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Annually, the Bank isexamined by the Pennsylvania Department of Banking and/or the FDIC. The lastexamination was conducted by the Pennsylvania Department of Banking as of December 31,2007.

 

The Company’s websiteaddress is http://www.bankatfidelity.com. The Company makes available throughthis website the annual reports on Form 10-K, quarterly reports on Form 10-Qand current reports on Form 8-K and amendments to those reports as soon asreasonably practical after filing with the SEC. You may read and copy anymaterials filed with the SEC at the SEC’s Public Reference Room at 100 FStreet, NE, Washington, DC 20549. You may obtain information on the operationof the Public Reference Room by calling the SEC at (202) 551-8090. The SECalso maintains an internet site that contains reports, proxy and informationstatements and other information about the Company at http://www.sec.gov.

 

The Company’s accountingpolicies and procedures are designed to comply with accounting principlesgenerally accepted in the United States of America (GAAP). Refer to “CriticalAccounting Policies,” which are incorporated by reference in Part II, Item7.

 

***ITEM1A:******RISK FACTORS***

 

An investment in theCompany’s common stock is subject to risks inherent to the Company’s business. Thematerial risks and uncertainties that management believes affect the Companyare described below. Before making an investment decision, you should carefullyconsider the risks and uncertainties described below together with all of theother information included or incorporated by reference in this report. Therisks and uncertainties described below are not the only ones facing theCompany. Additional risks and uncertainties that management is not aware of orfocused on or that management currently deems immaterial may also impair theCompany’s business operations. This report is qualified in its entirety bythese risk factors.

 

If any of the followingrisks actually occur, the Company’s financial condition and results ofoperations could be materially and adversely affected. If this were to happen,the value of the Company’s common stock could decline significantly, and youcould lose all or part of your investment.

 

**RisksRelated to the Company’s Business**

 

*The Company’s business is subjectto interest rate risk and variations in interest rates may negatively affectits financial performance.*

 

Changes in the interestrate environment may reduce profits. The Company’s earnings and cash flows arelargely dependent upon its net interest income. Net interest income is thedifference between the interest earned on loans, securities and otherinterest-earning assets, and interest paid on deposits, borrowings and otherinterest-bearing liabilities. As prevailing interest rates change, net interestspreads are affected by the difference between the maturities and re-pricingcharacteristics of interest-earning assets and interest-bearing liabilities. Inaddition, loan volume and yields are affected by market interest rates onloans, and rising interest rates generally are associated with a lower volumeof loan originations. An increase in the general level of interest rates mayalso adversely affect the ability of certain borrowers to pay the interest onand principal of their obligations. Accordingly, changes in levels of marketinterest rates could materially adversely affect the Company’s net interestspread, asset quality, loan origination volume and overall profitability.

 

*TheCompany is subject to lending risk.*

 

There are inherent risksassociated with the Company’s lending activities. These risks include, amongother things, the impact of changes in interest rates and changes in theeconomic conditions in the markets where the Company operates as well as thoseacross the Commonwealth of Pennsylvania and the United States. Increases ininterest rates and/or weakening economic conditions could adversely impact theability of borrowers to repay outstanding loans or the value of the collateralsecuring these loans. The Company is also subject to various laws andregulations that affect its lending activities. Failure to comply withapplicable laws and regulations could subject the Company to regulatoryenforcement action that could result in the assessment of significant civilmoney penalties against the Company.

 

As of December 31,2008, approximately 56% of the Company’s loan portfolio consisted ofcommercial, commercial real estate and real estate construction loans. Thesetypes of loans are generally viewed as having more risk of default thanresidential real estate loans or consumer loans. These types of loans are alsotypically larger than residential real estate loans and consumer loans. Becausethe Company’s loan portfolio contains a significant number of commercial,commercial real estate and construction loans with relatively large balances,the deterioration of one or a few of these loans could cause a significantincrease in non-performing loans. An increase in non-performing loans couldresult in a net loss of earnings from

 

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these loans, an increasein the provision for possible loan losses and an increase in loan charge-offs,all of which could have a material adverse effect on the Company’s financialcondition and results of operations.

 

*TheCompany’s allowance for possible loan losses may be insufficient.*

 

The Company maintains anallowance for possible loan losses, which is a reserve established through aprovision for possible loan losses charged to expense, that representsmanagement’s best estimate of probable losses that have been incurred withinthe existing portfolio of loans. The allowance, in the judgment of management,is necessary to reserve for estimated loan losses and risks inherent in theloan portfolio. The level of the allowance reflects management’s continuingevaluation of industry concentrations; specific credit risks; loan lossexperience; current loan portfolio quality; present economic, political andregulatory conditions and unidentified losses inherent in the current loanportfolio. The determination of the appropriate level of the allowance forpossible loan losses inherently involves a high degree of subjectivity andrequires the Company to make significant estimates of current credit risks andfuture trends, all of which may undergo material changes. Changes in economicconditions affecting borrowers, new information regarding existing loans,identification of additional problem loans and other factors, both within andoutside of the Company’s control, may require an increase in the allowance forpossible loan losses. In addition, bank regulatory agencies periodically reviewthe Company’s allowance for loan losses and may require an increase in theprovision for possible loan losses or the recognition of further loancharge-offs, based on judgments different than those of management. In addition,if charge-offs in future periods exceed the allowance for possible loan losses,the Company will need additional provisions to increase the allowance forpossible loan losses. Any increases in the allowance for loan losses willresult in a decrease in net income and capital and may have a material adverseeffect on the Company’s financial condition and results of operations.

 

*TheCompany is subject to environmental liability risk associated with lendingactivities.*

 

A significant portion ofthe Company’s loan portfolio is secured by real property. During the ordinarycourse of business, the Company may foreclose on and take title to propertiessecuring certain loans. In doing so, there is a risk that hazardous or toxicsubstances could be found on these properties. If hazardous or toxic substancesare found, the Company may be liable for remediation costs, as well as forpersonal injury and property damage. Environmental laws may require the Companyto incur substantial expenses and may materially reduce the affected property’svalue or limit the Company’s ability to use or sell the affected property. Inaddition, future laws or more stringent interpretations or enforcement policieswith respect to existing laws may increase the Company’s exposure to environmentalliability. Although the Company has policies and procedures to perform anenvironmental review before initiating any foreclosure action on real property,these reviews may not be sufficient to detect all potential environmentalhazards. The remediation costs and any other financial liabilities associatedwith an environmental hazard could have a material adverse effect on theCompany’s financial condition and results of operations.

 

*TheCompany’s profitability depends significantly on economic conditions in theCommonwealth of Pennsylvania and the local region in which it conductsbusiness.*

 

The Company’s successdepends primarily on the general economic conditions of the Commonwealth ofPennsylvania and the specific local markets in which the Company operates. Unlikelarger national or other regional banks that are more geographicallydiversified, the Company provides banking and financial services to customersprimarily in Lackawanna and Luzerne Counties. The local economic conditions inthese areas have a significant impact on the demand for the Company’s productsand services as well as the ability of the Company’s customers to repay loans,the value of the collateral securing loans and the stability of the Company’sdeposit funding sources. A significant decline in general economic conditions,caused by inflation, recession, acts of terrorism, an outbreak of hostilitiesor other international or domestic occurrences, unemployment, changes insecurities markets or other factors could impact these local economicconditions and, in turn, have a material adverse effect on the Company’sfinancial condition and results of operations. Currently, our Country is in arecession. The severity, depth and length of this recession is indeterminable. Joblayoffs and eliminations continue to be announced throughout the United States,as well as locally. Reductions in the levels of income of both businesses andindividual consumers could have a material impact on their ability to meettheir loan payment obligations. This in turn could have a material adverseimpact on the companies overall financial condition and earnings.

 

*There is no assurance that theCompany will be able to successfully compete with others for business.*

 

The Company competes forloans, deposits and investment dollars with numerous regional and nationalbanks and other community banking institutions, as well as other kinds offinancial institutions and enterprises, such as securities firms, insurancecompanies, savings associations, credit unions, mortgage brokers and privatelenders. Many competitors have substantially greater resources than the Companydoes, and operate under less stringent regulatory environments. The differencesin resources and regulations may make it more difficult for the Company tocompete profitably, reduce the rates

 

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that it can earn on loansand investments, increase the rates it must offer on deposits and other funds,and adversely affect its overall financial condition and earnings.

 

*TheCompany is subject to extensive government regulation and supervision.*

 

The Company, primarilythrough the Bank**,**is subject to extensive federaland state regulation and supervision. Banking regulations are primarilyintended to protect depositors’ funds, federal deposit insurance funds and thebanking system as a whole, not shareholders. These regulations affect theCompany’s lending practices, capital structure, investment practices, dividendpolicy and growth, among other things. Federal or commonwealth regulatoryagencies continually review banking laws, regulations and policies for possiblechanges. Changes to statutes, regulations or regulatory policies, includingchanges in interpretation or implementation of statutes, regulations orpolicies, could affect the Company in substantial and unpredictable ways. Suchchanges could subject the Company to additional costs, limit the types of financialservices and products the Company may offer and/or increase the ability ofnon-banks to offer competing financial services and products, among otherthings. Failure to comply with laws, regulations or policies could result insanctions by regulatory agencies, civil money penalties and/or reputationdamage, which could have a material adverse effect on the Company’s business,financial condition and results of operations. While the Company has policiesand procedures designed to prevent any such violations, there can be noassurance that such violations will not occur.

 

*TheCompany’s controls and procedures may fail or be circumvented.*

 

Management regularlyreviews and updates the Company’s internal controls, disclosure controls andprocedures, and corporate governance policies and procedures. Any system ofcontrols, however well designed and operated, is based in part on certainassumptions and can provide only reasonable, not absolute, assurances that theobjectives of the system are met. Any failure or circumvention of the Company’scontrols and procedures or failure to comply with regulations related tocontrols and procedures could have a material adverse effect on the Company’sbusiness, results of operations and financial condition.

 

*New lines of business or newproducts and services may subject the Company to additional risks.*

 

From time-to-time, theCompany may implement new lines of business or offer new products and serviceswithin existing lines of business. There are substantial risks and uncertaintiesassociated with these efforts, particularly in instances where the markets arenot fully developed. In developing and marketing new lines of business and/ornew products and services the Company may invest significant time andresources. Initial timetables for the introduction and development of new linesof business and/or new products or services may not be achieved and price andprofitability targets may not prove feasible. External factors, such ascompliance with regulations, competitive alternatives, and shifting marketpreferences, may also impact the successful implementation of a new line ofbusiness or a new product or service. Furthermore, any new line of businessand/or new product or service could have a significant impact on the effectivenessof the Company’s system of internal controls. Failure to successfully managethese risks in the development and implementation of new lines of business ornew products or services could have a material adverse effect on the Company’sbusiness, results of operations and financial condition.

 

*The Company’s ability to paydividends depends primarily on dividends from its banking subsidiary, which issubject to regulatory limits.*

 

The Company is a bankholding company and its operations are conducted by its subsidiary. Its abilityto pay dividends depends on its receipt of dividends from its subsidiary. Dividendpayments from its banking subsidiary are subject to legal and regulatorylimitations, generally based on net profits and retained earnings, imposed bythe various banking regulatory agencies. The ability of its subsidiary to paydividends is also subject to its profitability, financial condition, capitalexpenditures and other cash flow requirements. There is no assurance that itssubsidiary will be able to pay dividends in the future or that the Company willgenerate adequate cash flow to pay dividends in the future. The Company’sfailure to pay dividends on its common stock could have a material adverseeffect on the market price of its common stock.

 

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*The Company’s future acquisitions could dilute yourownership and may cause it to become more susceptible to adverse economicevents.*

 

The Company may use its common stock to acquire othercompanies or make investments in banks and other complementary businesses inthe future. The Company may issue additional shares of common stock to pay forfuture acquisitions, which would dilute your ownership interest in the Company.Future business acquisitions could be material to the Company, and the degreeof success achieved in acquiring and integrating these businesses into theCompany could have a material effect on the value of the Company’s commonstock. In addition, any acquisition could require it to use substantial cash orother liquid assets or to incur debt. In those events, it could become moresusceptible to economic downturns and competitive pressures.

 

*TheCompany may not be able to attract and retain skilled people.*

 

The Company’s successdepends, in large part, on its ability to attract and retain key people. Competitionfor the best people in most activities engaged in by the Company can be intenseand the Company may not be able to hire people or to retain them. Theunexpected loss of services of one or more of the Company’s key personnel couldhave a material adverse impact on the Company’s business because of theirskills, knowledge of the Company’s market, years of industry experience and thedifficulty of promptly finding qualified replacement personnel. The Company hasan employment agreement with its President and Chief Executive Officer.

 

*TheCompany’s information systems may experience an interruption or breach insecurity.*

 

The Company reliesheavily on communications and information systems to conduct its business. Anyfailure, interruption or breach in security of these systems could result infailures or disruptions in the Company’s customer relationship management,general ledger, deposit, loan and other systems. While the Company has policiesand procedures designed to prevent or limit the effect of the failure,interruption or security breach of its information systems, there can be noassurance that any such failures, interruptions or security breaches will notoccur or, if they do occur, that they will be adequately addressed. Theoccurrence of any failures, interruptions or security breaches of the Company’sinformation systems could damage the Company’s reputation, result in a loss ofcustomer business, subject the Company to additional regulatory scrutiny, orexpose the Company to civil litigation and possible financial liability, any ofwhich could have a material adverse effect on the Company’s financial conditionand results of operations.

 

*TheCompany continually encounters technological change.*

 

The financial servicesindustry is continually undergoing rapid technological change with frequentintroductions of new technology-driven products and services. The effective useof technology increases efficiency and enables financial institutions to betterserve customers and to reduce costs. The Company’s future success depends, inpart, upon its ability to address the needs of its customers by usingtechnology to provide products and services that will satisfy customer demands,as well as to create additional efficiencies in the Company’s operations. Manyof the Company’s competitors have substantially greater resources to invest intechnological improvements. The Company may not be able to effectivelyimplement new technology-driven products and services or be successful inmarketing these products and services to its customers. Failure to successfullykeep pace with technological change affecting the financial services industrycould have a material adverse impact on the Company’s business and, in turn,the Company’s financial condition and results of operations.

 

*TheCompany is subject to claims and litigation pertaining to fiduciary responsibility.*

 

From time-to-time,customers make claims and take legal action pertaining to the Company’sperformance of its fiduciary responsibilities. Whether customer claims andlegal action related to the Company’s performance of its fiduciaryresponsibilities are founded or unfounded, if such claims and legal actions arenot resolved in a manner favorable to the Company they may result insignificant financial liability and/or adversely affect the market perceptionof the Company and its products and services as well as impact customer demandfor those products and services. Any financial liability or reputation damagecould have a material adverse effect on the Company’s business, which, in turn,could have a material adverse effect on the Company’s financial condition andresults of operations.

 

*Severeweather, natural disasters, acts of war or terrorism and other external eventscould significantly impact the Company’s business.*

 

Severe weather, naturaldisasters, acts of war or terrorism and other adverse external events couldhave a significant impact on the Company’s ability to conduct business. Suchevents could affect the stability of the Company’s deposit base, impair theability of borrowers to repay outstanding loans, impair the value of collateralsecuring loans, cause significant property damage, result in loss of revenueand/or cause the Company to incur additional expenses. Severe weather ornatural disasters, acts of war or terrorism or other adverse external eventsmay occur in the future. Although management has

 

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established disasterrecovery policies and procedures, the occurrence of any such event could have amaterial adverse effect on the Company’s business, which, in turn, could have amaterial adverse effect on the Company’s financial condition and results ofoperations.

 

**RisksAssociated with the Company’s Common Stock**

 

*TheCompany’s stock price can be volatile.*

 

Stock price volatilitymay make it more difficult for you to resell your common stock when you wantand at prices you find attractive. The Company’s stock price can fluctuatesignificantly in response to a variety of factors including, among otherthings:

 

·                  Actual oranticipated variations in quarterly results of operations.

·                  Recommendationsby securities analysts.

·                  Operating andstock price performance of other companies that investors deem comparable tothe Company.

·                  News reportsrelating to trends, concerns and other issues in the financial servicesindustry.

·                  Perceptions inthe marketplace regarding the Company and/or its competitors.

·                  New technologyused, or services offered, by competitors.

·                  Significantacquisitions or business combinations, strategic partnerships, joint venturesor capital commitments by or involving   the Company or itscompetitors.

·                  Failure tointegrate acquisitions or realize anticipated benefits from acquisitions.

·                  Changes ingovernment regulations.

·                  Geopoliticalconditions such as acts or threats of terrorism or military conflicts.

 

General marketfluctuations, industry factors and general economic and political conditionsand events, such as economic slowdowns or recessions, interest rate changes orcredit loss trends, could also cause the Company’s stock price to decreaseregardless of operating results.

 

*Thetrading volume in the Company’s common stock is less than that of other largerfinancial services companies.*

 

The Company’s commonstock is listed for trading on the over-the-counter bulletin board; the tradingvolume in its common stock is less than that of other larger financial servicescompanies. A public trading market having the desired characteristics of depth,liquidity and orderliness depends on the presence in the marketplace of willingbuyers and sellers of the Company’s common stock at any given time. Thispresence depends on the individual decisions of investors and general economicand market conditions over which the Company has no control. Given the lowertrading volume of the Company’s common stock, significant sales of the Company’scommon stock, or the expectation of these sales, could cause the Company’sstock price to fall.

 

*Aninvestment in the Company’s common stock is not an insured deposit.*

 

The Company’s commonstock is not a bank deposit and, therefore, is not insured against loss by theFDIC, any other deposit insurance fund or by any other public or privateentity. Investment in the Company’s common stock is inherently risky for thereasons described in this “Risk Factors” section and elsewhere in this reportand is subject to the same market forces that affect the price of common stockin any company. As a result, if you acquire the Company’s common stock, you maylose some or all of your investment.

 

*TheCompany’s articles of incorporation and by-laws, as well as certainbanking laws, may have an anti-takeover effect.*

 

Provisions of the Company’sarticles of incorporation and by-laws, federal banking laws, including regulatoryapproval requirements, could make it more difficult for a third party toacquire the Company, even if doing so would be perceived to be beneficial tothe Company’s shareholders. The combination of these provisions effectivelyinhibits a non-negotiated merger or other business combination, which, in turn,could adversely affect the market price of the Company’s common stock.

 

**RisksAssociated with the Company’s Industry**

 

*Future governmental regulationand legislation could limit the Company’s future growth.*

 

The Company is aregistered bank holding company, and its subsidiary bank is a depositoryinstitution whose deposits are insured by the FDIC. As a result, the Company issubject to various regulations and examinations by various regulatoryauthorities. In general, statutes establish the corporate governance andeligible business activities for the Company, certain

 

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acquisition and mergerrestrictions, limitations on inter-company transactions such as loans anddividends, capital adequacy requirements, requirements for anti-moneylaundering programs and other compliance matters, among other regulations. TheCompany is extensively regulated under federal and state banking laws andregulations that are intended primarily for the protection of depositors,federal deposit insurance funds and the banking system as a whole. Compliancewith these statutes and regulations is important to its ability to engage innew activities and to consummate additional acquisitions.

 

In addition, the Companyis subject to changes in federal and state tax laws as well as changes inbanking and credit regulations, accounting principles and governmental economicand monetary policies. The Company cannot predict whether any of these changesmay adversely and materially affect it. Federal and state banking regulatorsalso possess broad powers to take supervisory actions as they deem appropriate.These supervisory actions may result in higher capital requirements, higherinsurance premiums and limitations on the Company’s activities that could havea material adverse effect on its business and profitability. While thesestatutes are generally designed to minimize potential loss to depositors andthe FDIC insurance funds, they do not eliminate risk, and compliance with suchstatutes increases the Company’s expense, requires management’s attention andcan be a disadvantage from a competitive standpoint with respect tonon-regulated competitors.

 

*Theearnings of financial services companies are significantly affected by generalbusiness and economic conditions.*

 

The Company’s operationsand profitability are impacted by general business and economic conditions inthe United States and abroad. These conditions include short-term and long-terminterest rates, inflation, money supply, political issues, legislative andregulatory changes, fluctuations in both debt and equity capital markets, broadtrends in industry and finance, and the strength of the U.S. economy andthe local economies in which the Company operates, all of which are beyond theCompany’s control. Deterioration in economic conditions could result in anincrease in loan delinquencies and non-performing assets, decreases in loancollateral values and a decrease in demand for the Company’s products andservices, among other things, any of which could have a material adverse impacton the Company’s financial condition and results of operations.

 

*Financialservices companies depend on the accuracy and completeness of information aboutcustomers and counterparties.*

 

In deciding whether toextend credit or enter into other transactions, the Company may rely oninformation furnished by or on behalf of customers and counterparties,including financial statements, credit reports and other financial information.The Company may also rely on representations of those customers, counterpartiesor other third parties, such as independent auditors, as to the accuracy andcompleteness of that information. Reliance on inaccurate or misleadingfinancial statements, credit reports or other financial information could havea material adverse impact on the Company’s business and, in turn, the Company’sfinancial condition and results of operations.

 

*Consumersmay decide not to use banks to complete their financial transactions.*

 

Technology and otherchanges are allowing parties to complete financial transactions thathistorically have involved banks through alternative methods. For example,consumers can now maintain funds that would have historically been held as bankdeposits in brokerage accounts or mutual funds. Consumers can also completetransactions such as paying bills and/or transferring funds directly withoutthe assistance of banks. The process of eliminating banks as intermediaries,known as “disintermediation,” could result in the loss of fee income, as wellas the loss of customer deposits and the related income generated from thosedeposits. The loss of these revenue streams and the lower cost deposits as asource of funds could have a material adverse effect on the Company’s financialcondition and results of operations.

 

***Thecapital and credit markets have experienced unprecedented levels of volatility***.

*** ***

During 2008 the capitaland credit markets experienced severe volatility and disruption. In the thirdand fourth quarters of 2008, the volatility and disruption reachedunprecedented levels. This has continued into 2009 and the Country is presentlyin a recession. Reflecting concern about the stability of the financial marketsgenerally and the strength of counterparties, many lenders and institutionalinvestors have reduced, and in some cases ceased to provide, funding toborrowers, including other financial institutions. Although to date we have notsuffered liquidity problems, we are part of the financial system and a systemiclack of available credit, a lack of confidence in the financial sector,increased volatility in the financial markets and reduced business activitycould materially and adversely affect our business, financial condition andresults of operations.

 

In response to theturmoil in the banking system and financial markets, the U.S. government hastaken unprecedented actions, including the U.S. Treasury’s plan to injectcapital and to purchase mortgage loans and mortgage-backed and other securitiesfrom financial institutions for the purpose of stabilizing the financialmarkets generally or particular financial institutions. There is no assurancethat these government actions will achieve their purpose.

 

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The failure to helpstabilize the financial markets and a continuation or worsening of the currentfinancial market conditions could have a material adverse affect on ourbusiness, our financial condition, the financial condition of our customers,our common stock trading price, as well as our ability to access credit.

 

***ITEM1B:***  ***UNRESOLVED STAFF COMMENTS***

 

None

 

***ITEM2:***  ***PROPERTIES***

 

As of December 31,2008, the Company operated 12 full-service banking offices, of which four wereowned and eight were leased.  None of thelessors of the properties leased by the Company are affiliated with the Companyor the Bank and all of the properties are located in the Commonwealth ofPennsylvania.  The Company isheadquartered at its owner occupied main branch located on the corner ofBlakely and Drinker Streets in Dunmore, PA.

 

The followingtable provides information with respect to the principal properties from whichthe Bank conducts business:

 
| **Location**                                   | ** ** | **Owned / leased*** | ** ** | **Type of use**        | ** ** | **Full service** | ** ** | **Drive-thru** | ** ** | **ATM** |
|------------------------------------------------|------------|-------------------------------|------------|----------------------------------|------------|-----------------------|------------|----------------|------------|---------|
| Drinker &  Blakely Sts.,  Dunmore, PA |       | Owned                         |       | Main  Branch (1) (2)        |       | x                     |       | x              |       | x       |
|                                           |       |                          |       |                             |       |                  |       |           |       |    |
| 111 Green Ridge  St.,  Scranton, PA            |       | Leased                        |       | Green  Ridge Branch (2)          |       | x                     |       | x              |       | x       |
|                                           |       |                          |       |                             |       |                  |       |           |       |    |
| 139 Wyoming  Ave.,  Scranton, PA               |       | Leased                        |       | Scranton  Branch                 |       | x                     |       |           |       | x       |
|                                           |       |                          |       |                             |       |                  |       |           |       |    |
| 1311 Morgan  Hwy.,  Clarks Summit, PA          |       | Leased                        |       | Abington  Branch (3)             |       | x                     |       | x              |       | x       |
|                                           |       |                          |       |                             |       |                  |       |           |       |    |
| Industrial Park  Rd.,  Dunmore, PA             |       | Owned                         |       | Keystone  Industrial Park Branch |       | x                     |       | x              |       | x       |
|                                           |       |                          |       |                             |       |                  |       |           |       |    |
| 338 North  Washington Ave.,  Scranton, PA      |       | Owned                         |       | Financial Center  Branch (4)     |       | x                     |       |           |       | x       |
|                                           |       |                          |       |                             |       |                  |       |           |       |    |
| 4010 Birney  Ave.,  Moosic, PA                 |       | Leased                        |       | Moosic Branch                    |       | x                     |       | x              |       | x       |
|                                           |       |                          |       |                             |       |                  |       |           |       |    |
| 801 Wyoming  Ave.,  West Pittston, PA          |       | Leased                        |       | West Pittston  Branch            |       | x                     |       |           |       | x       |
|                                           |       |                          |       |                             |       |                  |       |           |       |    |
| 1598 Main St.,  Peckville, PA                  |       | Leased                        |       | Peckville Branch                 |       | x                     |       | x              |       | x       |
|                                           |       |                          |       |                             |       |                  |       |           |       |    |
| 247 Wyoming  Ave.,  Kingston, PA               |       | Leased                        |       | Kingston Branch                  |       | x                     |       | x              |       | x       |
|                                           |       |                          |       |                             |       |                  |       |           |       |    |
| 511  Scranton-Carbondale Hwy., Eynon, PA       |       | Leased                        |       | Eynon Branch                     |       | x                     |       | x              |       | x       |
|                                           |       |                          |       |                             |       |                  |       |           |       |    |
| 400 S. Main St.,  Scranton, PA                 |       | Owned                         |       | West Scranton  Branch(2)         |       | x                     |       | x              |       | x       |

 

----

*Allof the owned properties are free of encumbrances

 

(1) Executive and administrative, commerciallending, trust and asset management services are located at this facility.

 

(2) This office has two automated teller machines (ATMs).

 

(3) In addition, there is a banking facilitylocated in the Clarks Summit State Hospital. The office is leased from the hospital under alease-for-service-provided agreement with service limited to employees andpatients of the hospital.

 

(4) Executive, mortgage and consumer lending,finance and operational offices are located in this building.  A portion of the building is leased to anon-related entity.

 

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The Bank maintainsseveral free-standing 24-hour ATMs located at the following locations inPennsylvania:

 

·                  U.S. Mini Marts, Inc.,511 Main St., Childs

·                  MarywoodUniversity, 2300 Adams Ave., Nazareth and Regina Halls, Scranton

·                  Snö Mountain SkiResort, 1000 Montage Mountain Rd., Moosic

·                  Shoppes atMontage, 1035 Shoppes Blvd., Moosic

 

During 2008, the Companyclosed its Pittston branch office located at 403 Kennedy Blvd., Pittston.

 

Other real estate ownedincludes all foreclosed properties listed for sale.  Upon possession, foreclosed properties arerecorded on the Company’s balance sheet at the lower of cost or fair value.

 

***ITEM3:****  **LEGAL PROCEEDINGS***

 

The nature of the Company’sbusiness generates some litigation involving matters arising in the ordinarycourse of business.  However, in theopinion of the Company after consulting with legal counsel, no legalproceedings are pending, which, if determined adversely to the Company or theBank, would have a material effect on the Company’s undivided profits orfinancial condition.  No legalproceedings are pending other than ordinary routine litigation incidental tothe business of the Company and the Bank. In addition, to management’s knowledge, no governmental authorities haveinitiated or contemplated any material legal actions against the Company or theBank.

 

***ITEM4:****  **SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS***

 

No matter was submittedduring the quarter ended December 31, 2008 to a vote of our securityholders through solicitation of proxies or otherwise.

 

###### ***PART II***

######  

***ITEM 5:***  ***MARKET FOR REGISTRANT’S COMMON EQUITY, RELATEDSTOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES***

 

The common stock of theCompany is traded on the over-the-counter bulletin board under the symbol “FDBC.”  Shareholders requesting information about theCompany’s common stock may contact Salvatore R. DeFrancesco, Jr., Treasurer.  Requests may be mailed to:

 

Fidelity D & DBancorp, Inc.

Blakely and Drinker St.

Dunmore, PA 18512

(570) 342-8281

 

The following table liststhe quarterly cash dividends paid per share and the range of high and low bidprices for the Company’s common stock. Such over-the-counter prices do not include retail mark-ups, markdownsor commissions:

 
| ** **       | ** ** | **2008**   | ** ** | ** **    | ** ** | **2007**   | ** ** | ** **    | ** ** |
|------------------|------------|------------|------------|---------------|------------|------------|------------|---------------|------------|
| ** **       | ** ** | **Prices** | ** ** | **Dividends** | ** ** | **Prices** | ** ** | **Dividends** | ** ** |
| ** **       | ** ** | **High**   | ** ** | **Low**       | ** ** | **paid**   | ** ** | **High**      | ** ** | **Low** | ** ** | **paid** | ** ** |
| 1st Quarter |       | $          | 31.00      |          | $          | 25.20      |       | $             | 0.25       |   | $ | 40.00 |   | $ | 32.50 |   | $ | 0.22 |   |
| 2nd Quarter |       | $          | 30.00      |          | $          | 27.00      |       | $             | 0.25       |   | $ | 37.75 |   | $ | 32.00 |   | $ | 0.22 |   |
| 3rd Quarter |       | $          | 33.50      |          | $          | 29.00      |       | $             | 0.25       |   | $ | 34.00 |   | $ | 27.10 |   | $ | 0.24 |   |
| 4th Quarter |       | $          | 28.75      |          | $          | 21.75      |       | $             | 0.25       |   | $ | 34.00 |   | $ | 27.00 |   | $ | 0.25 |   |

 

Dividends are determinedand declared by the Board of Directors of the Company.  The Company expects to continue to pay cashdividends in the future; however, future dividends are dependent upon earnings,financial condition, capital needs and other factors of the Company.  For a further discussion of regulatorycapital requirements see Note 14, “Regulatory matters,” contained within thenotes to the consolidated financial statements.

 

The Company hasestablished a dividend reinvestment plan (DRP) for its shareholders.  The plan is designed to make the Company’sstock available at no transactional cost to our shareholders.  Cash dividends, paid to shareholders who areenrolled in the DRP, are used to purchase shares directly from the Company orfrom shares that are available in the open market.

 

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The Company hadapproximately 1,323 shareholders at February 28, 2009 and also at December 31,2008.  The number of shareholders is theactual number of individual shareholders of record.  Each security depository is considered asingle shareholder for purposes of determining the approximate number ofshareholders.

 

***Securities authorized for issuance under equity compensation plans***

 

The information requiredunder this section is incorporated by reference herein, to the informationpresented in the Company’s definitive Proxy Statement for its 2009 AnnualMeeting of Shareholders to be filed with the SEC.

 

***Purchases of equity securities by the issuer and affiliated purchasers***

 

Thefollowing table summarizes the activity in the Company’s stock repurchaseprogram during the fourth quarter of 2008:

 
| ** **                                         | ** ** | **(a)**                                 | ** ** | **(b)**                                | ** ** | **(c)**                                 | ** ** | **(d)**                                            | ** ** |
|----------------------------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|-----------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                         | ** ** | ** **                              | ** ** | ** **                             | ** ** | **Total number of**           | ** ** | ** **                                         | ** ** |
| ** **                                         | ** ** | ** **                              | ** ** | ** **                             | ** ** | **shares (or units)**         | ** ** | **Maximum number of**                    | ** ** |
| ** **                                         | ** ** | **Total Number**                   | ** ** | ** **                             | ** ** | **purchased as part as** | ** ** | **shares (or units) that may** | ** ** |
| ** **                                         | ** ** | **of shares (or units)** | ** ** | **Average price paid**       | ** ** | **publicly announced plans**  | ** ** | **yet be purchased under the** | ** ** |
| **Period**                                         | ** ** | **purchased**                           | ** ** | **per share (or unit)** | ** ** | **or programs**                    | ** ** | **plans or programs**                    | ** ** |
| October 1, 2008  to  October 31, 2008    |       | —                                  |       | $                                      | —     |                                    | —     |                                               | 37,000     |   |
| November 1, 2008  to  November 30, 2008  |       | 2,000                                   |       | 25.31                                  |       | 2,000                                   |       | 35,000                                             |       |
| December  1, 2008  to  December 31, 2008 |       | —                                  |       | —                                 |       | —                                  |       | 35,000                                             |       |
| Total                                              |       | 2,000                                   |       | $                                      | 25.31      |                                    | 2,000      |                                               | 35,000     |   |

 

Inthe second quarter of 2008 the Company’s Board of Directors approved andpublicly announced its intent to initiate a capital stock repurchase programcovering up to 50,000 shares, or approximately 2.4% of its outstanding capitalstock as of May 31, 2008.  TheCompany has not made any purchases of its shares of capital that has not beenpublicly announced.  Neither anexpiration date nor a maximum dollar amount has been fixed to the program.  The repurchases will be made fromtime-to-time in open-market transactions, subject to availability.  The repurchased shares would become treasurystock and could be available for issuance under the Company’s variousstock-based compensation, employee stock purchase and dividend reinvestmentplans and for general corporate purposes. No repurchase program has expired or has been subject to a determinationto terminate during the period covered by the above table.  In December 2008, 2,745 shares werereissued by the Company to participants in the dividend reinvestment plan at are-issue price of $26.81 per share.

 

***Performance graph***

 

The following graph andtable compare the cumulative total shareholder return on the Company’s commonstock against the cumulative total return of the NASDAQ Composite and the SNLindex of greater than $500 million in-asset banks traded on the OTC-BB and PinkSheet (the SNL index) for the period of five fiscal years commencing January 1,2004, and ending December 31, 2008. The graph illustrates the cumulative investment return to shareholders,based on the assumption that a $100 investment was made on December 31,2003, in each of: the Company’s common stock, the NASDAQ Composite and the SNLindex.  All cumulative total returns arecomputed assuming the reinvestment of dividends into the applicablesecurities.  The shareholder return shownon the graph and table below is not necessarily indicative of futureperformance:

 

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| ** **                                  | ** ** | **Period ending** | ** ** |
|---------------------------------------------|------------|------------------------|------------|
| **Index**                                   | ** ** | **12/31/03**           | ** ** | **12/31/04** | ** ** | **12/31/05** | ** ** | **12/31/06** | ** ** | **12/31/07** | ** ** | **12/31/08** | ** ** |
| Fidelity  D & D Bancorp, Inc. |       | 100.00                 |       | 93.95 |   | 117.87 |   | 107.30 |   | 93.99 |   | 90.64 |   |
| NASDAQ Composite                            |       | 100.00                 |       | 108.59 |   | 110.08 |   | 120.56 |   | 132.39 |   | 78.72 |   |
| SNL > $500M  OTC-BB and Pink Sheet Banks |       | 100.00                 |       | 116.97 |   | 124.48 |   | 136.58 |   | 125.85 |   | 91.32 |   |

 

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***ITEM6:***  ***SELECTED FINANCIAL DATA***

 

Set forth below are our selected consolidatedfinancial and other data.  This financialdata is derived in part from, and should be read in conjunction with, theCompany’s consolidated financial statements and related footnotes:

 
| ** **                                                    | ** ** | **2008**    | ** **  | **2007**    | ** ** | **2006**    | ** ** | **2005**    | ** **  | **2004**    | ** ** |
|---------------------------------------------------------------|------------|-------------|-------------|-------------|------------|-------------|------------|-------------|-------------|-------------|------------|
| **Balance  sheet data:**                                      | ** ** | ** **  | ** **  | ** **  | ** ** | ** **  | ** ** | ** **  | ** **  | ** **  | ** ** |
| Total assets                                                  |       | $           | 575,718,997 |        | $          | 587,412,555 |       | $           | 562,317,988 |        | $          | 544,060,698 |   | $ | 536,675,138 |   |
| Total investment  securities                                  |       | 84,187,579  |        | 122,984,160 |       | 100,410,736 |       | 97,678,573  |        | 115,668,818 |       |
| Net loans                                                     |       | 436,207,460 |        | 421,424,379 |       | 417,199,048 |       | 403,144,095 |        | 381,546,375 |       |
| Loans  available-for-sale                                     |       | 84,000      |        | 827,250     |       | 122,000     |       | 428,584     |        | 576,378     |       |
| Total deposits                                                |       | 433,311,932 |        | 425,708,361 |       | 410,334,595 |       | 379,498,640 |        | 365,615,335 |       |
| Short-term  borrowings                                        |       | 38,129,704  |        | 39,656,354  |       | 33,656,150  |       | 28,772,997  |        | 50,534,046  |       |
| Long-term debt                                                |       | 52,000,000  |        | 62,708,677  |       | 62,536,210  |       | 83,704,188  |        | 71,119,188  |       |
| Total  shareholders’ equity                              |       | 48,960,651  |        | 55,191,294  |       | 51,611,863  |       | 48,846,029  |        | 46,366,760  |       |
|                                                          |       |        |        |        |       |        |       |        |        |        |       |
| **Operating  data for the year ended:**                       | ** ** | ** **  | ** **  | ** **  | ** ** | ** **  | ** ** | ** **  | ** **  | ** **  | ** ** |
| Total interest  income                                        |       | $           | 33,961,434  |        | $          | 35,279,357  |       | $           | 33,529,710  |        | $          | 29,020,261 |   | $ | 27,395,491 |   |
| Total interest  expense                                       |       | 14,684,133  |        | 17,660,075  |       | 16,361,109  |       | 11,720,986  |        | 11,180,135  |       |
| Net interest  income                                          |       | 19,277,301  |        | 17,619,282  |       | 17,168,601  |       | 17,299,275  |        | 16,215,356  |       |
| Provision  (credit) for loan losses                           |       | 940,000     |        | (60,000     | )          | 325,000     |       | 830,000     |        | 2,150,000   |       |
|                                                          |       |        |        |        |       |        |       |        |        |        |       |
| Net interest  income after provision (credit) for loan losses |       | 18,337,301  |        | 17,679,282  |       | 16,843,601  |       | 16,469,275  |        | 14,065,356  |       |
| Other income                                                  |       | 4,578,301   |        | 5,205,215   |       | 4,522,138   |       | 4,150,502   |        | 4,153,277   |       |
| Other operating  expense                                      |       | 18,210,683  |        | 16,636,760  |       | 15,878,376  |       | 14,561,968  |        | 13,818,565  |       |
|                                                          |       |        |        |        |       |        |       |        |        |        |       |
| Income before  provision for income taxes                     |       | 4,704,919   |        | 6,247,737   |       | 5,487,363   |       | 6,057,809   |        | 4,400,068   |       |
| Provision for  income taxes                                   |       | 1,068,971   |        | 1,636,165   |       | 1,362,080   |       | 1,466,112   |        | 1,035,594   |       |
| Net Income                                                    |       | $           | 3,635,948   |        | $          | 4,611,572   |       | $           | 4,125,283   |        | $          | 4,591,697 |   | $ | 3,364,474 |   |
|                                                          |       |        |        |        |       |        |       |        |        |        |       |
| **Per  share data:**                                          | ** ** | ** **  | ** **  | ** **  | ** ** | ** **  | ** ** | ** **  | ** **  | ** **  | ** ** |
| Net income per  share, basic                                  |       | $           | 1.76        |        | $          | 2.23        |       | $           | 2.01        |        | $          | 2.26 |   | $ | 1.67 |   |
| Net income per  share, diluted                                |       | $           | 1.76        |        | $          | 2.23        |       | $           | 2.01        |        | $          | 2.25 |   | $ | 1.67 |   |
| Dividends  declared                                           |       | $           | 2,068,680   |        | $          | 1,921,533   |       | $           | 1,801,361   |        | $          | 1,624,263 |   | $ | 1,610,423 |   |
| Dividends per  share                                          |       | $           | 1.00        |        | $          | 0.93        |       | $           | 0.88        |        | $          | 0.80 |   | $ | 0.80 |   |
| Book value per  share                                         |       | $           | 23.73       |        | $          | 26.62       |       | $           | 25.09       |        | $          | 23.95 |   | $ | 22.92 |   |
| Weighted-average  number of shares outstanding *              |       | 2,068,851   |        | 2,066,683   |       | 2,047,975   |       | 2,031,211   |        | 2,013,798   |       |
| Number of shares  outstanding at year-end *              |       | 2,062,927   |        | 2,072,929   |       | 2,057,433   |       | 2,039,639   |        | 2,023,529   |       |
|                                                          |       |        |        |        |       |        |       |        |        |        |       |
| **Ratios:**                                                   | ** ** | ** **  | ** **  | ** **  | ** ** | ** **  | ** ** | ** **  | ** **  | ** **  | ** ** |
| Return on  average assets                                     |       | 0.62        | %           | 0.80        | %          | 0.73        | %          | 0.86        | %           | 0.61        | %          |
| Return on  average equity                                     |       | 6.81        | %           | 8.65        | %          | 8.31        | %          | 9.64        | %           | 7.51        | %          |
| Net interest  margin                                          |       | 3.60        | %           | 3.34        | %          | 3.31        | %          | 3.51        | %           | 3.20        | %          |
| Efficiency ratio                                              |       | 72.98       | %           | 71.61       | %          | 71.67       | %          | 65.99       | %           | 64.45       | %          |
| Expense ratio                                                 |       | 2.25        | %           | 2.01        | %          | 2.02        | %          | 1.93        | %           | 1.69        | %          |
| Allowance for  loan losses to total loans                |       | 1.08        | %           | 1.13        | %          | 1.29        | %          | 1.46        | %           | 1.54        | %          |
| Dividend payout  ratio                                        |       | 56.90       | %           | 41.67       | %          | 43.67       | %          | 35.37       | %           | 47.87       | %          |
| Equity to assets                                              |       | 8.50        | %           | 9.40        | %          | 9.18        | %          | 8.98        | %           | 8.64        | %          |
| Equity to  deposits                                           |       | 11.30       | %           | 12.96       | %          | 12.58       | %          | 12.87       | %           | 12.68       | %          |

 

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* The number of shares andthe weighted-average number of shares outstanding prior to 2006, have beenadjusted to reflect the effect of a 10% stock dividend paid on February 15,2006.

 

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***ITEM 7:****  **MANAGEMENT’S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION AND******RESULTS OF OPERATIONS***

 

# ***Criticalaccounting policies***

#  

The presentationof financial statements in conformity with GAAP requires management to makeestimates and assumptions that affect many of the reported amounts anddisclosures.  Actual results could differfrom these estimates.

 

A material estimate thatis particularly susceptible to significant change relates to the determinationof the allowance for loan losses. Management believes that the allowance for loan losses at December 31,2008 is adequate and reasonable.  Giventhe subjective nature of identifying and valuing loan losses, it is likely thatwell-informed individuals could make different assumptions, and could,therefore calculate a materially different allowance value.  While management uses available informationto recognize losses on loans, changes in economic conditions may necessitaterevisions in the future.  In addition,various regulatory agencies, as an integral part of their examination process,periodically review the Company’s allowance for loan losses.  Such agencies may require the Company torecognize adjustments to the allowance based on their judgment of informationavailable to them at the time of their examination.

 

Another material estimateis the calculation of fair values of the Company’s investment securities.  Except for the Company’s investment incorporate bonds, consisting of preferred term securities, market values on theother investment securities are determined by prices provided by a third-partyvendor, who is a provider of financial market data, analytics and relatedservices to financial institutions.  Forthe trust preferred term securities, management was unable to obtain readilyattainable and realistic pricing from market traders due to lack of activemarket participants and therefore management has determined that the market forthese securities is currently inactive. In order to determine the market value of the preferred term securities,management relied on the use of an income valuation approach (present valuetechnique) that maximizes the use of relevant observable inputs and minimizesthe use of unobservable inputs the results of which are more representative offair value than the market approach valuation technique used for the otherinvestment securities.

 

Based on experience,management is aware that estimated fair values of investment securities tend tovary among valuation services. Accordingly, when selling investment securities, management may obtainprice quotes from more than one source. As described in Notes 1 and 3 of the consolidated financial statements,the large majority of the Company’s investment securities are classified asavailable-for-sale (AFS).  AFS securitiesare carried at fair value on the consolidated balance sheet, with unrealizedgains and losses, net of income tax, reported separately within shareholders’equity through accumulated other comprehensive income (loss).

 

The fair value ofresidential mortgage loans, classified as AFS, is obtained from the FederalNational Mortgage Association (FNMA) or the Federal Home Loan Bank (FHLB).  Generally, the market to which the Companysells mortgages it originates for sale is restricted and price quotes fromother sources are not typically obtained. On occasion, the Company may transfer loans from the loan and leaseportfolio to loans AFS.  Under these rarecircumstances, pricing may be obtained from other entities and the loans aretransferred at the lower of cost or market value and simultaneously sold.  For a further discussion on the accountingtreatment of AFS loans, see the section entitled “Loans available-for-sale,”contained within management’s discussion and analysis.  As of December 31, 2008 and 2007, loansclassified as AFS consisted of residential mortgages.

 

All significantaccounting policies are contained in Note 1, “Nature of operations and summaryof significant accounting policies,” within the notes to consolidated financialstatements and incorporated by reference in Part II, Item 8.

 

The following discussionand analysis presents the significant changes in the financial condition and inthe results of operations of the Company as of December 31, 2008 and December 31,2007 and for each of the years then ended. This discussion should be read in conjunction with the consolidatedfinancial statements and notes included in Part II, Item 8 of this report.

 

***Comparisonof Financial Condition as of December 31, 2008***

***and2007 and Results of Operations for each of the Years then Ended***

 

***FinancialCondition***

 

***Overview***

 

The national economy continued to falter withparticular emphasis on the deterioration of the housing and real estatemarkets. The current economy has been marked by contractions in theavailability of commercial and consumer credit, falling home 

 

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prices, increasing home foreclosures and risingunemployment. In response, the Federal Open Market Committee (FOMC), reducedthe federal funds rates seven times during 2008 to unprecedented levels,approaching zero and has resulted in a much more positively sloped yield curveduring the current year.  The shape ofthe yield curve will present opportunities, however the local economy is notinsulated from the disruptions and volatility that continues to plague the nationaleconomy thereby requiring the Company to operate in a very difficult interestrate environment, the likes of which have been unseen for many decades.  The management team of the Company is poisedto address the issues at hand and will implement strategies to navigate throughthese uncertain times.

 

Consolidated assetsdecreased $11,694,000, or 2%, during the year ended December 31, 2008 to$575,719,000.  The decline was the resultof decreases in total borrowings of $12,235,000, or 12%, and a decrease intotal shareholders’ equity of $6,231,000 partially offset by a 2%, or$7,604,000  increase in deposits.  The decline in shareholders’ equity wasprimarily from increased unrealized net losses in the securities AFS portfolio,the declaration of cash dividends and the repurchase of the Company’s capitalstock (treasury stock).  During 2008, thecarrying amount of the investment portfolios declined by $38,797,000, or 32%,while the loan portfolios increased $14,040,000, or 3% to $436,291,000 as of December 31,2008.  Other increases included premisesand equipment, the net deferred tax asset, bank owned life insurance, FHLBstock, the carrying value of the derivative contract and prepaid expenses.  Cash increased $2,362,000 since 2007.

 

The following table is a comparison of condensedbalance sheet accounts and percentage to total assets at December 31,2008, 2007 and 2006 (thousands of dollars):

 
| ** **                                       | ** ** | **2008**   | ** ** | **2007**    | ** ** | **2006**   | ** ** |
|--------------------------------------------------|------------|------------|------------|-------------|------------|------------|------------|
| ** **                                       | ** ** | **Amount** | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **                                       | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Assets:**                                      |       |       |       |        |       |       |       |   |   |   |   |   |   |   |   |   |
| Cash and cash  equivalents                       |       | $          | 12,771     |        | 2.2        | %          |       | $ | 10,409 |   | 1.8 | % |   | $ | 13,801 |   | 2.4 | % |   |
| Investment  securities                           |       | 84,188     |       | 14.6        |       |       | 122,984    |   | 20.9 |   |   | 100,411 |   | 17.9 |   |   |
| Federal Home  Loan Bank Stock                    |       | 4,781      |       | 0.8         |       |       | 3,303      |   | 0.6 |   |   | 3,795 |   | 0.7 |   |   |
| Loans and leases,  net                           |       | 436,291    |       | 75.8        |       |       | 422,252    |   | 71.9 |   |   | 417,321 |   | 74.2 |   |   |
| Bank premises  and equipment                     |       | 16,056     |       | 2.8         |       |       | 12,965     |   | 2.2 |   |   | 11,324 |   | 2.0 |   |   |
| Life insurance  cash surrender value             |       | 8,808      |       | 1.5         |       |       | 8,489      |   | 1.4 |   |   | 8,178 |   | 1.5 |   |   |
| Other assets                                     |       | 12,824     |       | 2.3         |       |       | 7,011      |   | 1.2 |   |   | 7,488 |   | 1.3 |   |   |
| Total assets                                     |       | $          | 575,719    |        | 100.0      | %          |       | $ | 587,413 |   | 100.0 | % |   | $ | 562,318 |   | 100.0 | % |   |
| ** **                                       | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Liabilities:**                                 |       |       |       |        |       |       |       |   |   |   |   |   |   |   |   |
| Total deposits                                   |       | $          | 433,312    |        | 75.3       | %          |       | $ | 425,708 |   | 72.5 | % |   | $ | 410,335 |   | 73.0 | % |   |
| Short-term  borrowings                           |       | 38,130     |       | 6.6         |       |       | 39,656     |   | 6.7 |   |   | 33,656 |   | 6.0 |   |   |
| Long-term debt                                   |       | 52,000     |       | 9.0         |       |       | 62,709     |   | 10.7 |   |   | 62,536 |   | 11.1 |   |   |
| Other  liabilities                               |       | 3,316      |       | 0.6         |       |       | 4,149      |   | 0.7 |   |   | 4,179 |   | 0.7 |   |   |
| Total  liabilities                               |       | 526,758    |       | 91.5        |       |       | 532,222    |   | 90.6 |   |   | 510,706 |   | 90.8 |   |   |
| Shareholders’  equity                       |       | 48,961     |       | 8.5         |       |       | 55,191     |   | 9.4 |   |   | 51,612 |   | 9.2 |   |   |
| Total  liabilities and shareholders’ equity |       | $          | 575,719    |        | 100.0      | %          |       | $ | 587,413 |   | 100.0 | % |   | $ | 562,318 |   | 100.0 | % |   |

 

A comparison of netchanges in selected balance sheet categories as of December 31, are asfollows:

 
| ** ** | ** ** | ** **  | ** **  | ** ** | ** ** | **Earning**       | ** ** | ** **  | ** ** | ** **   | ** ** | ** ** | ** ** | **Short-term** | ** ** | ** ** | ** ** | **Other**      | ** ** | ** ** | ** ** |
|------------|------------|-------------|-------------|------------|------------|-------------------|------------|-------------|------------|--------------|------------|------------|------------|----------------|------------|------------|------------|----------------|------------|------------|------------|
| ** ** | ** ** | **Assets**  | ** **  | **%**      | ** ** | **assets *** | ** ** | **%**       | ** ** | **Deposits** | ** ** | **%**      | ** ** | **borrowings** | ** ** | **%**      | ** ** | **borrowings** | ** ** | **%**      | ** ** |
| 2008       |       | $           | (11,693,558 | )          | (2)        |              | $          | (22,808,541 | )          | (4)          |       | $          | 7,603,571  |           | 2          |       | $          | (1,526,650     | )          | (4)        |       | $ | (10,708,677 | ) | (17) |   |
| 2007       |       | 25,094,567  |        | 4          |       | 26,073,807        |       | 5           |       | 15,373,766   |       | 4          |       | 6,000,204      |       | 18         |       | 172,467        |       | —     |       |
| 2006       |       | 18,257,290  |        | 3          |       | 21,202,050        |       | 4           |       | 30,835,955   |       | 8          |       | 4,883,153      |       | 17         |       | (21,167,978    | )          | (25)       |       |
| 2005       |       | 7,385,560   |        | 1          |       | 2,784,580         |       | 1           |       | 13,883,305   |       | 4          |       | (21,761,049    | )          | (43)       |       | 12,585,000     |       | 18         |       |
| 2004       |       | (38,540,328 | )           | (7)        |       | (35,884,098       | )          | (7)         |       | (35,827,211  | )          | (9)        |       | (4,222,932     | )          | (8)        |       | (756,846       | )          | (1)        |       |
|            |            |             |             |            |            |                   |            |             |            |              |            |            |            |                |            |            |            |                |            |            |            |  |  |  |  |  |

 

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*Earning assets exclude loans placed on non-accrual status.

 

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***Deposits***

 

The Bank is acommunity-based commercial financial institution, member FDIC, which offers avariety of deposit accounts with varying ranges of interest rates andterms.  Deposit products include savingsaccounts, interest-bearing checking (NOW), money market, non-interest bearingchecking (DDAs) and certificates of deposit accounts.  Certificates of deposit accounts, or CDs, aredeposits with stated maturities ranging from seven days to ten years.  The flow of deposits is significantlyinfluenced by general economic conditions, changes in prevailing interestrates, pricing and competition.  Most ofthe Company’s deposits are obtained from the communities surrounding its 12branch offices and all deposits are insured by the FDIC up to the full extentpermitted by law.  The Bank attempts toattract and retain deposit customers via sales and marketing efforts, newproducts, quality service, competitive rates and maintaining long-standingcustomer relationships.  To determine depositproduct interest rates, the Company considers local competition, market yieldsand the rates charged for alternative sources of funding such as short- andlong-term borrowings.  Though we tend toexperience intense competition for deposits, our interest rate setting strategyincludes consideration of the Company’s liquidity needs, balance sheetstructure and cost effective strategies that are mindful of the currentinterest rate environment.

 

The followingtable represents the components of total deposits as of December 31, 2008and 2007 (thousands of dollars):

 
| ** **               | ** ** | **2008**   | ** ** | **2007**    | ** ** |
|--------------------------|------------|------------|------------|-------------|------------|
| ** **               | ** ** | **Amount** | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **               | ** ** | ** ** | ** ** |        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Money market             |       | $          | 96,738     |        | 22.3       | % |   | $ | 87,892 |   | 20.6 | % |   |
| NOW                      |       | 50,124     |       | 11.6        |       |   | 54,695 |   | 12.9 |   |   |
| Savings and  clubs       |       | 41,326     |       | 9.5         |       |   | 40,125 |   | 9.4 |   |   |
| Certificates of  deposit |       | 173,681    |       | 40.1        |       |   | 178,200 |   | 41.9 |   |   |
| Total  interest-bearing  |       | 361,869    |       | 83.5        |       |   | 360,912 |   | 84.8 |   |   |
| Non-interest-bearing     |       | 71,443     |       | 16.5        |       |   | 64,796 |   | 15.2 |   |   |
| Total deposits           |       | $          | 433,312    |        | 100.0      | % |   | $ | 425,708 |   | 100.0 | % |   |

 

Total deposits increased$7,604,000, or 2%, during 2008 to $433,312,000. The growth in deposits was mostly from increases in money markets$8,846,000 and DDAs of $6,647,000, or 10% each, partially offset by declines inNOW and certificates of deposit accounts of $4,571,000 and $4,519,000,respectively.  The majority of theincrease in DDAs was from a temporary deposit from a corporate trust accountwhich has since been withdrawn.  The newWest Scranton branch office that opened during the third quarter of  2008 and the related bank-wide promotions,superior customer service, increased deposit business from our existing and newcommercial customers all contributed to the net increase in deposits.  The continued increases in money marketaccounts that the Company has experienced is from success in ourdeposit-gathering strategies in conjunction with promotional interest ratestailored to depositors’ needs.  Weattribute the decline in certificate of deposit accounts to the lower andhighly volatile interest rate environment that exists today compared to a yearago.

 

The maturity distributionof certificate of deposit accounts at December 31, 2008 is as follows:

 
| ** **                | ** ** | **Three months** | ** ** | **Three to six** | ** ** | **Six to twelve** | ** ** | **Over**               | ** ** | ** ** | ** ** |
|---------------------------|------------|-----------------------|------------|----------------------------|------------|-----------------------------|------------|------------------------|------------|------------|------------|
| ** **                | ** ** | **or less**      | ** ** | **Months**                 | ** ** | **months**                  | ** ** | **twelve months** | ** ** | **Total**  | ** ** |
| CDs of $100,000 or more   |       | $                     | 20,438,339 |                       | $          | 10,989,353                  |       | $                      | 29,534,467 |       | $          | 13,288,607 |   | $ | 74,250,766 |   |
| CDs of less than $100,000 |       | 13,641,073            |       | 14,907,570                 |       | 49,896,837                  |       | 20,984,669             |       | 99,430,149 |       |
| Total CDs                 |       | $                     | 34,079,412 |                       | $          | 25,896,923                  |       | $                      | 79,431,304 |       | $          | 34,273,276 |   | $ | 173,680,915 |   |

 

Approximately 80% of theCDs are scheduled to mature within one year. Renewing CDs may re-price to lower or higher market rates depending onthe direction of interest rate movements, the shape of the yield curve, competition,the rate profile of the maturing accounts and depositor preference foralternative products.  To help reduce thefinancial impact of the unpredictable and highly volatile interest rateenvironment, management intends to continue to deploy strategies that willdiversify the deposit mix across the entire spectrum of products offered.  As always, consideration will be afforded tocustomer retention and new customer relationships.

 

***Short-term borrowings***

 

In addition to deposits,other funding sources available to the Company are overnight funds purchasedfrom the Federal Home Loan Bank of Pittsburgh (FHLB), fed funds purchased fromcorrespondent banks and repurchase agreements with 

 

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individuals, businessesand public entities.  The Company usesovernight funding for asset growth, deposit run-off and short-term liquidityneeds.

 

Repurchaseagreements are offered in both sweep and fixed-term products.  These agreements are non-insuredinterest-bearing liabilities that have a security interest in qualified pledgedinvestments of the Bank.  A sweep accountis designed to ensure that on a daily basis, an attached DDA is adequatelyfunded and excess DDA funds are transferred, or swept, into an interest-bearingovernight repurchase agreement account. In addition, the sweep is designed to transfer funds to the DDA asnecessary to cover checks presented for payment.  Due to the nature of the sweep product, theytend to be more volatile than the fixed-term product because the daily sweep isdependent on the level of available funds in depositor accounts.  Customer liquidity and investment needs andchanges in interest rates are the typical causes for variances in repurchaseagreements, which during 2008 declined $11,412,000 from $20,504,000 at December 31,2007.  At December 31, 2008 and2007, sweep accounts represented 93% and 62%, respectively, of total repurchaseagreements.  The low interest rateenvironment has caused our customers to seek higher rates in alternativeproducts and as such the balances in the term-repurchase agreement declined byabout 91%.

 

Overnightborrowings and repurchase agreements are included with short-term borrowings onthe consolidated balance sheets.  For afurther discussion on short-term borrowings, see Note 7, “Short-termborrowings,” contained in the notes to consolidated financial statements in Part II,Item 8.

 

***Long-term debt***

 

Long-termdebt consists of borrowings from the FHLB. The weighted-average rate in effect on funds borrowed at December 31,2008 was 5.35% compared to 5.26% as of December 31, 2007.  The 2008 weighted-average rate was 92 basispoints below the tax-equivalent yield of 6.27% on the Company’s portfolio ofaverage interest-earning assets for the year ended December 31, 2008.  Rates on $42,000,000 of the total long-termadvances are currently fixed but are designed to adjust quarterly should marketrates increase beyond the issues’ original or strike rates.  Significant prepayment penalties are attachedto the borrowings thereby creating a significant disincentive from paying offthe relatively high cost advances. However, in the event underlying market rates drift above the ratescurrently paid on these borrowings, the FHLB rate will convert to a floatingrate and the Company has the option, at that time, to repay or to renegotiatethe converted advance rate.  During December 2008,a $10,000,000 capped floating-rate long-term advance was paid off early.  During February 2009, a $10,000,000,5.32% fixed-rate advance was also paid off early.  Whether or not the advance will be renewedwill be predicated on the interest rate environment, demand for liquidity andrelative cash-flows of deposits, demand for loan funding and prepayments ofinterest-earning assets.

 

At December 31,2008, the Company had the ability to borrow an additional $117,348,000 from theFHLB, from their array of numerous funding products that are available at a varyingterms and conditions.

 

***Investments***

 

The Company’s investment policy is designed tocomplement its lending activities, generate a favorable return withoutincurring undue interest rate and credit risk, manage interest ratesensitivity, provide monthly cash flow and manage liquidity at acceptablelevels.  In establishing investmentstrategies, the Company considers its business, growth or restructuring plans,the economic environment, the interest rate sensitivity position, the types ofsecurities held, permissible purchases, credit quality, maturity and re-pricingterms, call or average-life intervals and investment concentrations.  The policy prescribes permissible investmentcategories that meet the policy standards and management is responsible for structuringand executing the specific investment purchases within these policyparameters.  Management buys and sellsinvestment securities from time-to-time depending on market conditions,business trends, liquidity needs, capital levels and structuring strategies.  Investment security purchases provide a wayto quickly invest excess liquidity in order to generate additionalearnings.  The Company generally earns apositive interest spread by assuming interest rate risk and using depositsand/or borrowings to purchase securities with longer maturities.

 

At the time of purchase, management classifiesinvestment securities into one of three categories: trading, AFS orheld-to-maturity (HTM).  To date,management has not purchased any securities for trading purposes.  Most of the securities purchased areclassified as AFS even though there is no immediate intent to sell them.  The AFS designation affords management theflexibility to sell securities and position the balance sheet in response tocapital levels, liquidity needs or changes in market conditions.  Securities AFS are carried at net fair valuesin the consolidated balance sheet with an adjustment to shareholders’ equity,net of tax, presented under the caption “Accumulated other comprehensive income(loss).”  Securities designated as HTMrepresent debt securities that the Company has the ability and intent to holduntil maturity and are carried at amortized cost.  As of December 31, 2008 and December 31,2007, the aggregate fair value of 

 

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securities HTM exceeded their respective aggregateamortized cost by $31,000 and $33,000, respectively.

 

Total investments decreased $38,797,000, including an$11,893,000 decline in the market value of AFS investments.  During 2008, the Company sold approximately$48.4 million of mortgage-backed and agency securities, the proceeds of whichwere used to pay-down long-term debt, fund loan growth and fund the expansionof the Company’s branch network.  Thecarrying value of investment securities, at December 31, 2008, was$84,188,000, or 15% of total assets compared to $122,984,000, or 21%, as of December 31,2007.

 

The market values for corporate investment securitiesare very depressed relative to historical levels.  For example, the yield spreads for the broadmarket of investment grade and high yield corporate bonds reached all time widelevels compared to treasury securities at the end of 2008 and remain near thoselevels today.  Thus in today’s market, alow market price for a particular bond may only provide evidence of stress inthe credit markets in general versus being an indicator of credit problems witha particular issuer.

 

As of December 31, 2008 thedebt securities with unrealized losses have depreciated 27.4% compared to 2.4%at December 31, 2007.   Managementbelieves that the cause of the unrealized losses is related to changes ininterest rates, instability in the capital markets or the limited tradingactivity due to recent debt market illiquid conditions and is not directlyrelated to credit quality, which is consistent with its past experience.  Nearly all of the securities in the portfoliohave fixed rates or have predetermined scheduled rate changes, and many havecall features that allow the issuer to call the security at par before itsstated maturity without penalty.

 

Management performs a review of the investment portfolio quarterly todetermine the cause of declines in the fair value of each security.  The Company uses inputs provided by anindependent third party to determine the fair values of its investmentsecurities portfolio.  Inputs provided bythe third party are reviewed and corroborated by management.  Evaluations of the causes of the unrealizedlosses are performed to determine whether impairment, if any, is temporary orother-than-temporary.  Considerationssuch as the Company’s intent and ability to hold the securities to maturity,recoverability of the invested amounts over the intended holding period,severity in pricing decline, the interest rate environment, receipts of amountscontractually due and whether or not there is an active market for thesecurity, for example, are applied in determining whether a security isother-than-temporarily impaired.  If adecline in value is deemed to be other-than-temporary, the amortized cost ofthe security is reduced by the impairment amount and a corresponding charge toearnings is recognized.  If at the timeof sale, call or maturity the proceeds exceed the security’s amortized cost,the impairment charge may be fully or partially recovered and recorded as again on sale of investment securities.

 

At December 31, 2008, the securities with the most significantreductions in fair value and associated estimated unrealized losses were in theCompany’s corporate bond portfolio consisting of collateralized debt obligation(CDO) securities that are backed by pooled trust preferred term securities(preferred term securities) issued by banks, thrifts and insurance companies.

 

The Company owns 13issues of preferred term securities.  Themarket for these securities at December 31, 2008 was not active andmarkets for similar securities are also not active. The inactivity wasevidenced first by a significant widening of the bid-ask spread in the brokeredmarkets in which preferred term securities trade and then by a significantdecrease in the volume of trades relative to historical levels. The new issuemarket is also inactive as no new preferred term securities have been issuedsince 2007.  There are currently very fewmarket participants who are willing and or able to transact for thesesecurities.  Given conditions in the debtmarkets today and the absence of observable transactions in the secondary andnew issue markets, fair value of the preferred term securities was determinedas explained in Note 3, “Securities Investments,” contained within the notes tothe consolidated financial statements in Part II, Item 8.

 

Based on the techniquedescribed in Note 3, the Company determined that as of December 31, 2008,the fair value of one of its preferred term securities had declined $430,000below its cost basis and has been deemed to be other-than-temporarilyimpaired.  Accordingly, this amount hasbeen recorded as an impairment charge and is included as a component of otherincome in the consolidated income statements for the year ended December 31,2008.  The market value of the Company’sinvestment in preferred term securities has declined by $9,958,000 since December 31,2007.  The Company intends to closelymonitor the preferred term securities market and perform collateral sufficiencyand cash flow analyses on at least a quarterly basis.  Future analyses could yield results that mayindicate further impairment has occurred and therefore require additionalwrite-downs and corresponding other-than-temporary charges to currentearnings.  In addition to the impairmentcharge on the preferred term securities portfolio, the Company had an equityposition in FNMA common stock whose fair value declined below its cost basis by$6,000 and has also been deemed to be other-than-temporarily impaired andwritten down as of December 31, 2008. There were no other-than-temporary impairment write-downs recorded in2007 or 2006.

 

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A comparison ofinvestments at December 31, for the three previous years is as follows:

 
| ** **                              | ** ** | **2008**   | ** ** | **2007**    | ** ** | **2006**   | ** ** |
|-----------------------------------------|------------|------------|------------|-------------|------------|------------|------------|
| ** **                              | ** ** | **Amount** | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| U.S. government agencies                |       | $          | 43,507,359 |        | 51.7       | %          |       | $ | 35,243,890 |   | 28.7 | % |   | $ | 33,891,985 |   | 33.8 | % |   |
| Mortgage-backed securities              |       | 12,438,721 |       | 14.8        |       |       | 58,767,109 |   | 47.8 |   |   | 42,900,005 |   | 42.7 |   |   |
| State & municipal subdivisions |       | 17,552,729 |       | 20.8        |       |       | 12,133,443 |   | 9.8 |   |   | 12,576,684 |   | 12.5 |   |   |
| Preferred term securities               |       | 10,260,196 |       | 12.2        |       |       | 16,335,486 |   | 13.3 |   |   | 10,570,993 |   | 10.5 |   |   |
| Equity securities                       |       | 428,574    |       | 0.5         |       |       | 504,232    |   | 0.4 |   |   | 471,069 |   | 0.5 |   |   |
| Total                                   |       | $          | 84,187,579 |        | 100.0      | %          |       | $ | 122,984,160 |   | 100.0 | % |   | $ | 100,410,736 |   | 100.0 | % |   |

 

The distribution of debt securities by stated maturitydate at December 31, 2008 is as follows:

 
| ** **                              | ** ** | **One year** | ** ** | **One through** | ** ** | **Five through** | ** ** | **More than** | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|-------------------|------------|----------------------|------------|-----------------------|------------|--------------------|------------|------------|------------|
| ** **                              | ** ** | **or less**  | ** ** | **five years**  | ** ** | **ten years**    | ** ** | **ten years** | ** ** | **Total**  | ** ** |
| U.S. government agencies                |       | $                 | —     |                 | $          | —                |       | $                  | 7,917,994  |       | $          | 35,589,365 |   | $ | 43,507,359 |   |
| Mortgage-backed securities              |       | —            |       | —               |       | 381,537               |       | 12,057,184         |       | 12,438,721 |       |
| State & municipal subdivisions |       | —            |       | —               |       | 2,788,460             |       | 14,764,269         |       | 17,552,729 |       |
| Preferred term securities               |       | —            |       | —               |       | —                |       | 10,260,196         |       | 10,260,196 |       |
| Total debt securities                   |       | $                 | —     |                 | $          | —                |       | $                  | 11,087,991 |       | $          | 72,671,014 |   | $ | 83,759,005 |   |

 

AFS securities are stated net of unrealized gains andlosses.  As of December 31, 2008,AFS debt securities were recorded with a net unrealized loss in the amount of$13,486,000.  At December 31, 2008,AFS equity securities were recorded at $428,000 which included a net unrealizedgain of $106,000.

 

The tax-equivalent yieldon debt securities by stated maturity date at December 31, 2008, is asfollows:

 
| ** **                              | ** ** | **One year**         | ** ** | **One through**      | ** ** | **Five through** | ** ** | **More than** | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|---------------------------|------------|---------------------------|------------|-----------------------|------------|--------------------|------------|------------|------------|
| ** **                              | ** ** | **or less**          | ** ** | **five years**       | ** ** | **ten years**    | ** ** | **ten years** | ** ** | **Total**  | ** ** |
| U.S. government agencies                |       |    —% |       |    —% |       | 5.07                  | %          |               | 5.87       | %          |       | 5.74 | % |   |
| Mortgage-backed securities              |       | —                    |       | —                    |       | 6.01                  |       |               | 5.44       |       |       | 5.45 |   |   |
| State & municipal subdivisions |       | —                    |       | —                    |       | 5.47                  |       |               | 5.90       |       |       | 5.83 |   |   |
| Preferred term securities               |       | —                    |       | —                    |       | —                |       |               | 4.00       |       |       | 4.00 |   |   |
| Total debt securities                   |       |    —% |       |    —% |       | 5.21                  | %          |               | 5.35       | %          |       | 5.34 | % |   |

 

----

Inthe above table, the book yields on state & municipal subdivisionswere adjusted to a tax-equivalent basis using the corporate federal tax rate of34%.  In addition, average yields onsecurities AFS are based on amortized cost and do not reflect unrealized gainsor losses.

 

***FederalHome Loan Bank Stock***

 

Investment in FHLB stockis required for membership in the organization and is carried at cost sincethere is no market value available.  Theamount the Company is required to invest is dependent upon the relative size ofoutstanding borrowings the Company has with the FHLB.  Excess stock is typically repurchased fromthe Company at par if the level of borrowings declines to a predeterminedlevel.  In addition, the Company normallyearns a return or dividend on the amount invested.  In late December, the FHLB announced that ithas suspended payment of dividends and the repurchase of excess capital stockto preserve its capital level.  Thatdecision was based on FHLB’s analysis and consideration of certain negativemarket trends and the impact those trends will have on their financialcondition.  Based on the financialresults of the FHLB for the year-ended December 31, 2008, managementbelieves that the suspension of both the dividend payments and excess capitalstock repurchase is temporary in nature. The Company will continue to monitor the financial condition of the FHLBand assess its ability to resume these activities in the future.

 

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***Loansand leases***

 

Gross loans andleases increased $14,704,000, or 3%, from $426,249,000 at December 31,2007, to $440,953,000 at December 31, 2008.  Gross loans represented 77% and 73% of totalassets at December 31, 2008 and December 31, 2007, respectively.

 

In 2008, the Companyoriginated $47,864,000 of commercial loans, $23,111,000 of residential mortgageloans and $21,354,000 of consumer loans. This compares to $32,919,000, $24,032,000 and $28,062,000, respectively,in 2007.  Included in mortgage loans is$9,476,000 of real estate construction lines in 2008 and $12,515,000 in2007.  In addition for 2008, the Companyoriginated lines of credit in the amounts of $50,664,000 for commercialborrowers and $11,866,000 in home equity and other consumer lines of credit.

 

The Company’s originationactivity increased 9% in 2008 over 2007 despite operating in a very difficulteconomy.  Only the residential realestate portfolio recorded a decline compared to 2007 and was more than offsetby growth in commercial lending.  Thehiring of a new senior lender has enabled the Company to grow its commercialand CRE portfolio.  During 2009, theCompany will continue to channel efforts to develop total banking relationshipswith new customers and strengthen relationships with our existing base of loyalcustomers.

 

*Commercialand Commercial Real Estate Loans**:*

 

Originations incommercial and commercial real estate (CRE) were relatively strong, as theyfully exceeded scheduled principal curtailments and pre-payments therebyresulting in a commercial loan increase of $29,422,000 to $245,480,000 from$216,058,000, or 14% during 2008.  Duringmost of 2008, the Company bolstered the origination activities in thecommercial loan business.  Commerciallending successfully restructured its team of commercial loan officers led bythe experienced newly hired senior lender. This team has effectively penetrated our markets and successfullydeveloped new business relationships and re-kindled relationships with ourexisting commercial customer base.

 

*ResidentialReal Estate Loans*:

 

Residential real estate loansdeclined $18,468,000, or 16%, to $98,511,000 in 2008.  In the beginning of 2008, the Companytransferred approximately $28,103,000 to the loans AFS portfolio.  The loans were subsequently sold.  From time-to-time, management will evaluatethe composition of the residential loan portfolio and based upon liquidityneeds, interest rate risk and other considerations may transfer loans to theavailable-for-sale portfolio, at the lower of cost or market value, andsimultaneously sell them.  Excluding thistransfer, the residential real estate loan portfolio would have grown$6,900,000 as origination activity exceeded maturities and pay-downs.  Operating in a lower interest rateenvironment throughout most of 2008 with expectations of a continued period oflow rates into 2009, the Company expects higher levels of prepayment andrefinance activity in 2009.

 

*ConsumerLoans**:*

 

Though consumer loanoriginations were lower in 2008 compared to 2007, this sector  increased $3,093,000, or 4%, during theyear.  The increase was mainly from lowerprincipal pay-downs and  increased drawactivity from customers accessing their home equity available credit.  While interest rates remain low, the Companyexpects the home equity business to continue to increase into 2009.  During 2008, the Company established a newrelationship with a local automobile dealership which should provide increasedorigination activity in consumer lending in the years ahead.

 

*RealEstate Construction Loans**:*

 

Real estate constructionloans increased $724,000, or 7%, at December 31, 2008 compared to December 31,2007.  These loans fund residential andcommercial construction projects and then convert to a residential mortgage orto a commercial real estate loan usually within one year from the originationdate.  Generally, the converted loanswill bear similar terms as the terms during the construction period.  The increase in 2008 was caused by morecommercial construction projects that had not yet converted to permanentfinancing.

 

*DirectFinancing Leases**:*

 

The balance representstax-free leasing arrangements provided to municipal customers.  For 2008, the activity represents scheduledrun-off.

 

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A comparison ofdomestic loans at December 31, for the five previous periods is asfollows:

 
| ** **                | ** ** | **2008**    | ** **  | **2007**    | ** ** | **2006**    | ** ** | **2005**    | ** **  | **2004**    | ** ** |
|---------------------------|------------|-------------|-------------|-------------|------------|-------------|------------|-------------|-------------|-------------|------------|
| Commercial and CRE        |       | $           | 245,479,992 |        | $          | 216,057,882 |       | $           | 218,213,216 |        | $          | 216,288,597 |   | $ | 221,968,137 |   |
| Residential real estate   |       | 98,510,562  |        | 116,978,378 |       | 112,742,692 |       | 103,920,613 |        | 91,294,401  |       |
| Consumer                  |       | 85,091,205  |        | 81,998,093  |       | 77,729,520  |       | 74,070,328  |        | 61,487,608  |       |
| Real estate construction  |       | 11,426,978  |        | 10,703,249  |       | 13,369,712  |       | 14,198,858  |        | 10,620,472  |       |
| Direct financing leases   |       | 443,957     |        | 511,178     |       | 588,211     |       | 650,348     |        | 2,211,978   |       |
| Gross loans               |       | 440,952,694 |        | 426,248,780 |       | 422,643,351 |       | 409,128,744 |        | 387,582,596 |       |
| Less:                     |       |        |        |        |       |        |       |        |        |        |       |
| Unearned discount         |       | —      |        | —      |       | —      |       | —      |        | 48,423      |       |
| Allowance for loan losses |       | 4,745,234   |        | 4,824,401   |       | 5,444,303   |       | 5,984,649   |        | 5,987,798   |       |
| Net loans                 |       | $           | 436,207,460 |        | $          | 421,424,379 |       | $           | 417,199,048 |        | $          | 403,144,095 |   | $ | 381,546,375 |   |
|                      |       |        |        |        |       |        |       |        |        |        |       |
| Loans available-for-sale  |       | $           | 84,000      |        | $          | 827,250     |       | $           | 122,000     |        | $          | 428,584 |   | $ | 576,378 |   |

 

A comparison of grossloans by percent at year-end for the five previous periods is as follows:

 
| ** **               | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Commercial and CRE       |       | 55.7     | %          |     | 50.7       | %        |       | 51.6     | %          |     | 52.9       | % |   | 57.3 | % |   |
| Residential real estate  |       | 22.3     |       |     | 27.5       |     |       | 26.7     |       |     | 25.4       |   |   | 23.5 |   |   |
| Consumer                 |       | 19.3     |       |     | 19.2       |     |       | 18.4     |       |     | 18.1       |   |   | 15.9 |   |   |
| Real estate construction |       | 2.6      |       |     | 2.5        |     |       | 3.2      |       |     | 3.5        |   |   | 2.7 |   |   |
| Direct financing leases  |       | 0.1      |       |     | 0.1        |     |       | 0.1      |       |     | 0.1        |   |   | 0.6 |   |   |
| Gross loans              |       | 100.0    | %          |     | 100.0      | %        |       | 100.0    | %          |     | 100.0      | % |   | 100.0 | % |   |

 

The following table setsforth the maturity distribution of select components of the loan portfolio at December 31,2008.  Excluded from the table areresidential real estate loans, consumer loans and direct financing leases(dollars in thousands):

 
| ** **               | ** ** | **One-year**     | ** ** | **One to five** | ** ** | **More than**  | ** ** | ** ** | ** ** |
|--------------------------|------------|------------------|------------|---------------------------|------------|---------------------|------------|------------|------------|
| ** **               | ** ** | **or less** | ** ** | **Years**                 | ** ** | **five years** | ** ** | **Total**  | ** ** |
| ** **               | ** ** | ** **       | ** ** | ** **                | ** ** | ** **          | ** ** | ** ** | ** ** |
| Commercial and CRE       |       | $                | 20,276     |                      | $          | 57,026              |       | $          | 168,178    |   | $ | 245,480 |   |
| Real estate construction |       | 11,427           |       | —                    |       | —              |       | 11,427     |       |
| Total                    |       | $                | 31,703     |                      | $          | 57,026              |       | $          | 168,178    |   | $ | 256,907 |   |

 

Real estate construction loans are included in theone-year or less category since, by their nature, these loans are convertedinto residential and CRE loans within one year from the date the real estateconstruction loan was consummated.  Uponconversion, the residential and CRE loans would normally mature after fiveyears.

 

The following table sets forth the sensitivity changesin interest rates for commercial and CRE loans at December 31, 2008(dollars in thousands):

 
| ** **             | ** ** | **One to five** | ** ** | **More than**  | ** ** | ** ** | ** ** |
|------------------------|------------|---------------------------|------------|---------------------|------------|------------|------------|
| ** **             | ** ** | **Years**                 | ** ** | **five years** | ** ** | **Total**  | ** ** |
| Fixed interest rate    |       | $                         | 38,807     |                | $          | 46,121     |       | $ | 84,928 |   |
| Variable interest rate |       | 64,070                    |       | 56,801              |       | 120,871    |       |
| Total                  |       | $                         | 102,877    |                | $          | 102,922    |       | $ | 205,799 |   |

 

Non-refundable fees orcosts associated with all loan originations are deferred.  Using the principal reduction method, thedeferral is released as charges or credits to loan interest income over thelife of the loan.

 

There are no concentrations of loans to a number ofborrowers engaged in similar activities exceeding 10% of total loans that arenot otherwise disclosed as a category in the tables above.  There are no concentrations of loans that, ifresulted in a loss, would have a material adverse effect on the business of theCompany.  The Company’s loan portfoliodoes not have a material concentration within a single industry or group ofrelated industries that is vulnerable to the risk of a near-term severenegative business impact.

 

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***Loans available-for-sale***

 

Generally, uponorigination, certain residential mortgages are classified as AFS.  In the event market rates increase,fixed-rate loans and adjustable-rate loans not immediately scheduled tore-price would no longer produce yields consistent with the currentmarket.  In a declining interest rateenvironment, the Company would be exposed to prepayment risk and, as rates onadjustable-rate loans decrease, interest income would be negatively affected.  Consideration is given to the Company’scurrent liquidity position and projected future liquidity needs.  To better manage interest rate and prepaymentrisk, loans meeting these conditions may be classified as AFS.  The carrying value of loans AFS is at thelower of cost or estimated fair value. If the fair values of loans AFS fall below their original cost, thedifference is written down and charged to current earnings.  Any subsequent appreciation in the portfoliois credited to current earnings but only to the extent of previous write-downs.

 

Loans AFS at December 31,2008 were $84,000 with a corresponding fair value of $85,000 compared to$827,000 and $843,000, respectively, at December 31, 2007.  During 2008, residential mortgages with principalbalances of $46,969,000 were sold into the secondary market and recognized netgains of approximately $261,000. Included in the sale was $28,103,000 of residential loans transferredfrom the loan and lease portfolio.

 

The Company retains mortgage servicing rights (MSRs)on loans sold into the secondary market. MSRs are retained so that the Company can continue the personalrelationships they have established with their customers.  At December 31, 2008 and 2007, theservicing portfolio balance of sold residential mortgage loans was $95,856,000and $61,023,000, respectively.

 

***Allowance for loan losses***

 

Management continuallyevaluates the credit quality of the Company’s loan portfolio and performs aformal review of the adequacy of the allowance for loan losses (the allowance)on a quarterly basis.  The allowancereflects management’s best estimate of the amount of credit losses in the loanportfolio.  Management’s judgment isbased on the evaluation of individual loans, past experience, the assessment ofcurrent economic conditions and other relevant factors including the amountsand timing of cash flows expected to be received on impaired loans.  Those estimates may be susceptible tosignificant change.  The provision forloan losses represents the amount necessary to maintain an appropriateallowance.  Loan losses are chargeddirectly against the allowance when loans are deemed to be uncollectible.  Recoveries from previously charged-off loansare added to the allowance when received.

 

Management applies twoprimary components during the loan review process to determine proper allowancelevels.  The two components are aspecific loan loss allocation for loans that are deemed impaired and a generalloan loss allocation for those loans not specifically allocated.  The methodology to analyze the adequacy ofthe allowance for loan losses is as follows:

 

·                  identificationof specific impaired loans by loan category;

·                  calculation ofspecific allowances where required for the impaired loans based on collateral andother objective and quantifiable evidence;

·                  determination ofhomogenous pools by loan category and eliminating the impaired loans;

·                  application ofhistorical loss percentages (five-year average) to pools to determine theallowance allocation; and

·                  application ofqualitative factor adjustment percentages to historical losses for trends orchanges in the loan portfolio.

 

Allocation of theallowance for different categories of loans is based on the methodology asexplained above.  A key element of the methodologyto determine the allowance is the Company’s credit risk evaluation process,which includes credit risk grading of individual commercial loans.  Commercial loans are assigned credit riskgrades based on the Company’s assessment of conditions that affect the borrower’sability to meet its contractual obligations under the loan agreement.  That process includes reviewing borrowers’current financial information, historical payment experience, creditdocumentation, public information and other information specific to eachindividual borrower.  The changes inallocations in the commercial loan portfolio from period to period are basedupon the credit risk grading system and from periodic reviews of the loan andlease portfolios.

 

Each quarter, managementperforms an assessment of the allowance and the provision for loan losses.  The Company’s Special Assets Committee meetsquarterly and the applicable lenders discuss each relationship under review andreach a consensus on the appropriate estimated loss amount based on Statementof Financial Accounting Standards No. 114, “Accounting by Creditors forImpairment of a Loan,” (SFAS 114).  TheSpecial Assets Committee’s focus is on ensuring the pertinent facts areconsidered and the SFAS 114 reserve amounts are reasonable.  The assessment process includes the review 

 

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of all loans on anon-accruing basis as well as a review of certain loans to which the lenders orthe Company’s Credit Administration function have assigned a criticized orclassified risk rating.

 

Total charge-offs, net ofrecoveries, for the year ended December 31, 2008, were $1,019,000,compared to $560,000 in 2007. The majority of the increase occurred in thecommercial portfolio and was attributable to non-performing loan dispositionsand write-downs before transfers to ORE.

 

Combined consumer loanand lease financing net charge-offs increased from $237,000 at December 31,2007 to $320,000 through December 31, 2008.  Commercial loan net charge-offs were $358,000for the year 2007 compared to $654,000 for 2008.  Mortgage loans showed net Charge-offs of$45,000 in 2008 compared to net recoveries of $35,000 in 2007.  For a discussion on the provision for loanlosses, see the “Provision for loan losses,” located in the results ofoperations section of management’s discussion and analysis contained herein.

 

For a further discussionof delinquencies and net charge-offs, see the section entitled “Non-performingassets.”  Additional discussion is inNote 1, “Nature of operations and summary of significant accounting policies —Allowance for loan losses,” and Note 4, “Loans and leases,” contained in thenotes to consolidated financial statements, incorporated herein by reference.

 

Management believes thatthe current balance in the allowance for loan losses of $4,745,000 issufficient to withstand the identified potential credit quality issues that mayarise and others unidentified but are inherent to the portfolio.  At December 31, 2008, management wasunaware of any potential problem loans that have not been reviewed.  Potential problem loans are those where thereis known information that leads management to believe repayment of principaland/or interest is in jeopardy and the loans are currently neither onnon-accrual status or past due 90 days or more. However, there could be certain instances which become identified over theupcoming year that may require additional charge-offs and/or increases to theallowance.  The ratio of allowance forloan losses to total loans was 1.08% at December 31, 2008 compared to1.13% at December 31, 2007.

 

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The following table setsforth the activity in the allowance for loan losses and certain key ratios forthe periods indicated (dollars in thousands):

 
| ** **                                                                | ** ** | **2008**   | ** ** | **2007**   | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|---------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balance at  beginning of period                                           |       | $          | 4,824      |       | $          | 5,444      |       | $          | 5,985      |       | $          | 5,988 |   | $ | 4,997 |   |
|                                                                      |       |       |       |       |       |       |       |       |       |       |       |
| Charge-offs:                                                              |       |       |       |       |       |       |       |       |       |       |       |
| Commercial and  all other                                                 |       | 733        |       | 376        |       | 661        |       | 1,077      |       | 775        |       |
| Real estate                                                               |       | 45         |       | 90         |       | 109        |       | 21         |       | 266        |       |
| Consumer                                                                  |       | 351        |       | 256        |       | 285        |       | 288        |       | 480        |       |
| Lease financing                                                           |       | —     |       | —     |       | —     |       | 8          |       | 85         |       |
| Total                                                                     |       | 1,129      |       | 722        |       | 1,055      |       | 1,394      |       | 1,606      |       |
|                                                                      |       |       |       |       |       |       |       |       |       |       |       |
| Recoveries:                                                               |       |       |       |       |       |       |       |       |       |       |       |
| Commercial and  all other                                                 |       | 79         |       | 18         |       | 64         |       | 395        |       | 226        |       |
| Real estate                                                               |       | —     |       | 125        |       | 1          |       | 11         |       | 20         |       |
| Consumer                                                                  |       | 31         |       | 19         |       | 124        |       | 155        |       | 178        |       |
| Lease financing                                                           |       | —     |       | —     |       | —     |       | —     |       | 23         |       |
| Total                                                                     |       | 110        |       | 162        |       | 189        |       | 561        |       | 447        |       |
| Net charge-offs                                                           |       | 1,019      |       | 560        |       | 866        |       | 833        |       | 1,159      |       |
| Provision  (credit) for loan losses                                       |       | 940        |       | (60        | )          | 325        |       | 830        |       | 2,150      |       |
| Balance at end  of period                                                 |       | $          | 4,745      |       | $          | 4,824      |       | $          | 5,444      |       | $          | 5,985 |   | $ | 5,988 |   |
|                                                                      |       |       |       |       |       |       |       |       |       |       |       |
| Net charge-offs  to average net loans outstanding                         |       | 0.24       | %          | 0.13       | %          | 0.21       | %          | 0.22       | %          | 0.30       | %          |
| Allowance for  loan losses to net charge-offs                             |       | 4.66       | x          | 8.62       | x          | 6.29       | x          | 7.18       | x          | 5.17       | x          |
| Allowance for  loan losses to total loans                                 |       | 1.08       | %          | 1.13       | %          | 1.29       | %          | 1.46       | %          | 1.54       | %          |
| Loans 30 - 89  days past due and accruing                                 |       | $          | 1,858      |       | $          | 4,698      |       | $          | 2,571      |       | $          | 1,609 |   | $ | 4,317 |   |
| Loans 90 days or  more past due and accruing                              |       | $          | 604        |       | $          | 26         |       | $          | 81         |       | $          | 197 |   | $ | 557 |   |
| Non-accruing loans                                                        |       | $          | 3,493      |       | $          | 3,811      |       | $          | 3,358      |       | $          | 9,453 |   | $ | 9,904 |   |
| Allowance for  loan losses to loans 90 days or more past due and accruing |       | 7.85       | x          | 189.41     | x          | 67.54      | x          | 30.39      | x          | 10.75      | x          |
| Allowance for  loan losses to non-accruing loans                          |       | 1.36       | x          | 1.27       | x          | 1.62       | x          | 0.63       | x          | 0.60       | x          |
| Allowance for  loan losses to non-performing loans                        |       | 1.16       | x          | 1.26       | x          | 1.58       | x          | 0.62       | x          | 0.57       | x          |
| Average net  loans                                                        |       | $          | 416,438    |       | $          | 419,586    |       | $          | 412,523    |       | $          | 385,800 |   | $ | 381,366 |   |

 

The allowance for loanlosses can generally absorb losses throughout the loan and leaseportfolios.  However, in some instancesan allocation is made for specific loans or groups of loans.  Allocation of the allowance for loan lossesfor different categories of loans is based on the methodology used by theCompany, as previously explained.  Thechanges in the allocations from year-to-year are based upon year-end reviews ofthe loan and lease portfolios.

 

Allocation of theallowance among major categories of loans for the past five years is summarizedin the following table.  This tableshould not be interpreted as an indication that charge-offs in future periodswill occur in these amounts or proportions, or that the allocation indicatesfuture charge-off trends.  The portion ofthe allowance designated as unallocated is within the Company’s policyguidelines.

 

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| ** **                             | ** ** | **2008**  | ** ** | **%**                 | ** **       | **2007**  | ** ** | **%**                 | ** ** | **2006**   | ** ** | **%**           | ** ** | **2005**  | ** ** | **%**                 | ** ** | **2004**  | ** ** | **%**                  | ** ** |
|----------------------------------------|------------|-----------|------------|-----------------------|------------------|-----------|------------|-----------------------|------------|------------|------------|-----------------|------------|-----------|------------|-----------------------|------------|-----------|------------|------------------------|------------|
| Category                               |       |      |       |                  |             |      |       |                  |       |       |       |            |       |      |       |                  |       |      |       |                   |       |
| Residential real estate                |       | $         | 710,981    |                  |   15.0 |      | $          | 636,899               |       |  13.2 |       | $               | 578,117    |      |  10.6 |                  | $          | 595,092   |       |    9.9  |       | $ | 451,349 |   |   7.5 |   |
| Consumer                               |       | 973,356   |       |   20.5      |             | 960,505   |       |  19.9            |       | 1,157,091  |       |  21.2      |       | 1,180,175 |       |   19.7      |       | 966,081   |       |   16.1       |       |
| Commercial and  commercial real estate |       | 2,860,059 |       |   60.3      |             | 2,979,372 |       |  61.7            |       | 3,549,870  |       |  65.2      |       | 4,035,950 |       |   67.4      |       | 4,330,285 |       |    72.3 |       |
| Direct financing leases                |       | 6,837     |       |    0.1 |             | 9,355     |       |    0.2 |       | 14,058     |       |   0.3 |       | 14,828    |       |    0.3 |       | 40,891    |       |    0.7  |       |
| Real estate construction               |       | 67,141    |       |    1.4 |             | 52,634    |       |    1.1 |       | 59,617     |       |   1.1 |       | 59,953    |       |    1.0 |       | 46,465    |       |    0.8  |       |
| Unallocated                            |       | 126,860   |       |    2.7 |             | 185,636   |       |    3.9 |       | 85,550     |       |   1.6 |       | 98,651    |       |    1.7 |       | 152,727   |       |    2.6  |       |
| Total                                  |       | $         | 4,745,234  |                  | 100.0            | %         | $          | 4,824,401             |       | 100.0      | %          | $               | 5,444,303  |      | 100.0      | %                     | $          | 5,984,649 |       | 100.0                  | %          | $ | 5,987,798 |   | 100.0 | % |

 

The allocation of theallowance for the commercial loan portfolio comprised 60%, or $2,860,000, ofthe total allowance for loan losses at December 31, 2008, of whichapproximately 10% is reserved for specifically identified non-performingcommercial loan relationships. Collateral values were prudently valued to provide a conservative andrealistic value of the collateral supporting these loans.  The allocations to the other categories ofloans are adequate compared to the actual three-year historical netcharge-offs.

 

***Non-performing assets***

 

The Company definesnon-performing assets as accruing loans past due 90 days or more, non-accrualloans, restructured loans, other real estate owned (ORE) and repossessedassets.  As of December 31, 2008,non-performing assets represented 0.96% of total assets compared to 0.67% at December 31,2007.

 

The following table setsforth non-performing assets at December 31 (dollars in thousands):

 
| ** **                                                                         | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Net loans, including loans available-for-sale                                      |       | $        | 436,291    |     | $          | 422,252  |       | $        | 417,321    |     | $          | 403,573 |   | $ | 382,123 |   |
|                                                                               |       |     |       |     |       |     |       |     |       |     |       |
| Loans past due 90 days or more and accruing                                        |       | $        | 604        |     | $          | 26       |       | $        | 81         |     | $          | 197 |   | $ | 557 |   |
| Non-accrual loans                                                                  |       | 3,493    |       | 3,811    |       | 3,358    |       | 9,453    |       | 9,904    |       |
| Total non-performing loans                                                         |       | 4,097    |       | 3,837    |       | 3,439    |       | 9,650    |       | 10,461   |       |
| Restructured loans                                                                 |       | —   |       | —   |       | —   |       | —   |       | —   |       |
| Other real estate owned                                                            |       | 1,451    |       | 107      |       | 197      |       | —   |       | 163      |       |
| Repossessed assets                                                                 |       | —   |       | —   |       | —   |       | 19       |       | 50       |       |
| Total non-performing assets                                                        |       | $        | 5,548      |     | $          | 3,944    |       | $        | 3,636      |     | $          | 9,669 |   | $ | 10,674 |   |
|                                                                               |       |     |       |     |       |     |       |     |       |     |       |
| Non-accrual loans to net loans                                                     |       | 0.80     | %          | 0.90     | %          | 0.80     | %          | 2.34     | %          | 2.59     | %          |
| Non-performing assets to net loans, foreclosed real estate  and repossessed assets |       | 1.27     | %          | 0.93     | %          | 0.87     | %          | 2.40     | %          | 2.79     | %          |
| Non-performing assets to total assets                                              |       | 0.96     | %          | 0.67     | %          | 0.65     | %          | 1.78     | %          | 1.99     | %          |
| Non-performing loans to net loans                                                  |       | 0.94     | %          | 0.91     | %          | 0.82     | %          | 2.39     | %          | 2.74     | %          |

 

In the review of loansfor both delinquency and collateral sufficiency, management concluded thatthere were a number of loans that lacked the ability to repay in accordancewith contractual terms.  The decision toplace loans or leases on a non-accrual status is made on an individual basisafter considering factors pertaining to each specific loan.

 

The majority ofnon-performing assets for the period is attributed to non-accruing commercialbusiness loans and non-accruing real estate loans in the process offoreclosure.  Most of these loans arecollateralized, thereby mitigating the Company’s potential for loss.  In 2007, non-performing loans were $3,837,000compared to $4,097,000 at year-end 2008. There were no repossessed assets at December 31, 2008 or 2007.  ORE at December 31, 2008 consisted offour properties of which one had an agreement to sell pending at thattime.  ORE at year-end 2007, consisted ofone property which was subsequently sold. The Special Assets Department had developed specific action plans foreach of the Company’s non-performing loans. During 2008, several of those plans were brought to a conclusionresulting in repayments of non-performing loans.  The non-accrual loans aggregated $3,493,000at December 31, 2008, a reduction of $318,000 from year-end 2007.  During 2008, approximately $4,946,000 ofloans were placed in non-accrual status. These were partially offset by reductions or payoffs of $2,426,000,charge-offs of $916,000, $1,562,000 of transfers to ORE and $360,000 of loansthat 

 

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returned to performingstatus.  Loans past due 90 days or moreand accruing totaled $604,000 at December 31, 2008 compared to $26,000, atDecember 31, 2007.   The majority ofthe increase was attributable to one residential mortgage migrating to the over90 day category.  Non-accrual loans werereduced by 8% to $3,493,000.  The OREbalance rose from $107,000 to $1,450,000. This sizeable increase is a result of the collections process as thecollateral securing non-accruing loans are taken in the foreclosureprocess.  These three items comprise thenon-performing assets of $5,548,000 at December 31, 2008.  The percentage of non-performing assets tototal assets was 0.96% at December 31, 2008, an increase from 0.67% at December 31,2007, primarily due to the aforementioned ORE increase.  Non-performing loans to net loans were 0.94%at December 31, 2008, and 0.91% at December 31, 2007.  The 30-89 day past due loans at December 31,2008 were $1,858,000 reduced from $4,698,000 at December 31, 2007.  Contributing to the reduction was therepayment of previously delinquent loans and others which had been broughtcurrent.

 

During the latter part ofJanuary 2009 the Company was notified by a customer of a significantadverse business event causing management to place the customer’s $3,300,000loan relationship on non-accruing status. Management does not expect this will have a material impact on incomegoing forward.

 

Repossessed assetsconsist of previously financed vehicles held-for-sale.  Subsequent to the loan or lease maturity, theborrower or lessee defaulted on their contract and the Company repossessed theunit.  Repossessed assets are soldthrough either a private or public sale and any deficiency balance from thesale of the asset is charged to the allowance for loan losses.  The Company terminated its automobile leasingbusiness in 2005.  There were norepossessed assets or restructured loans at December 31, 2007 or December 31,2008.

 

Payments received onnon-accrual loans are recognized on a cash basis.  Payments are first applied against theoutstanding principal balance, then to the recovery of any charged-off loanamounts.  Any excess is treated as arecovery of interest income.  During2008, the Company collected approximately $311,000 of interest incomerecognized on the cash basis.  If thenon-accrual loans that were outstanding as of December 31, 2008 had beenperforming in accordance with their original terms, the Company would haverecognized interest income with respect to such loans of $250,000 for the yearended December 31, 2008.

 

***Bankpremises and equipment, net***

 

Net of accumulateddepreciation and disposals, premises and equipment increased $3,091,000.  The Company purchased fixed assets ortransferred assets from construction in process, a component of other assets inthe consolidated balance sheet, of approximately $4,489,000 during 2008compared to $3,293,000 in 2007.  Theincrease was principally from the construction and completion of the Company’sWest Scranton branch expansion project.

 

***Foreclosed******assets held-for-sale***

 

*Other Real Estate Owned*

 

ORE was $1,451,000 at December 31,2008 consisting of four properties, one of which was under an agreement to besold. The remaining three properties were listed for sale with a realtor.  The one ORE property which had been owned atyear end December 31, 2007 was sold.

 

***Cashsurrender value of bank owned life insurance***

 

***The Company maintains bank owned life insurance (BOLI) for achosen group of employees, namely its officers, where the Company is the ownerand sole beneficiary of the policies. BOLI is classified as a non-interest earning asset.  Increases in the cash surrender value arerecorded as components of non-interest income. The BOLI is profitable from the appreciation of the cash surrendervalues of the pool of insurance and its tax-free advantage to the Company.  This profitability is used to offset aportion of current and future employee benefit costs.  The BOLI can be liquidated if necessary withassociated tax costs.  However, theCompany intends to hold this pool of insurance, because it provides income thatenhances the Company’s capital position. Therefore, the Company has not provided for deferred income taxes on theearnings from the increase in cash surrender value.***

*** ***

***Other assets***

*** ***

***Other assets more than doubled in 2008 to $8,930,000compared to 2007.  The increase wascaused predominately by the increase in the net deferred tax asst of  $4,046,000 as a result of additional unrealizedlosses in the securities AFS portfolio. See Note 10, “Income Taxes,” for an analysis of the net deferred taxasset.  Also contributing to the increasein other assets was an increase in the fair value of the Company’s derivativecontract which is more fully explained in Note 1, “Nature of***

 

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***operations and summary of significant accounting policies,”and Note 12, “Fair value of financial instruments and derivatives,” containedwithin the notes to consolidated financial statements in Part II, Item 8.***

*** ***

***Resultsof Operations***

 

***EarningsSummary***

 

The Company’s results ofoperations depend primarily on net interest income.  Net interest income is the difference betweeninterest income and interest expense. Interest income is generated from yields on interest-earning assets,which consist principally of loans and investment securities.  Interest expense is incurred from rates paidon interest-bearing liabilities, which consist of deposits and borrowings.  Net interest income is determined by theCompany’s interest rate spread (i.e., the difference between the yields earnedon its interest-earning assets and the rates paid on its interest-bearingliabilities) and the relative amounts of interest-earning assets andinterest-bearing liabilities.  Theinterest rate spread is significantly impacted by: changes in interest ratesand market yield curves and their related impact on cash flows; the compositionand characteristics of interest-earning assets and interest-bearingliabilities; differences in the maturity and re-pricing characteristics ofassets compared to the maturity and re-pricing characteristics of the liabilitiesthat fund them and by the competition in our marketplace.

 

The Company’sprofitability is also affected by the level of its non-interest income andexpenses, provision for loan losses and provision for income taxes.  Non-interest income consists mostly ofservice charges on the Bank’s deposit and loan products, trust and assetmanagement service fees, increases in the cash surrender value of the bankowned life insurance (BOLI), net gains or losses from the sales of loans andsecurities AFS, sales of other real estate (ORE) properties and fromother-than-temporary impairment (OTTI) charges from investment securities.  Non-interest expense consists of compensationand related employee benefit expenses, occupancy, equipment, data processing,advertising, marketing, professional fees, insurance and other operatingoverhead.

 

The Company’sprofitability is significantly affected by general economic and competitiveconditions, changes in market interest rates, government policies and actionsof regulatory authorities.  The Company’sloan portfolio is comprised principally of commercial and commercial realestate loans.  The properties underlyingthe Company’s mortgages are concentrated in Northeastern Pennsylvania.  Credit risk, which represents the possibilityof the Company not recovering amounts due from its borrowers, is significantlyrelated to local economic conditions in the areas where the properties arelocated as well as the Company’s underwriting standards.  Economic conditions affect the market valueof the underlying collateral as well as the levels of adequate cash flow andrevenue generation from income-producing commercial properties.

 

***Overview***

 

Net income for the yearended December 31, 2008 was $3,636,000, compared to $4,612,000 for theyear ended December 31, 2007. During the same periods, diluted earnings per common share was $1.76 and$2.23, respectively.  For the year ended December 31,2008, the Company’s return on average assets (ROA) and return on averageshareholders’ equity (ROE) were 0.62% and 6.81% compared to 0.80% and 8.65%,respectively, for the year ended December 31, 2007.  The current year included a non-operating,non-cash, after-tax charge of $288,000 related to an other-than-temporaryimpairment (OTTI) in the Company’s security AFS portfolio that did not occur in2007.  In addition, during 2008, theCompany recorded a provision for loan losses in the amount of $940,000 comparedto a credit for loan losses of $60,000 in 2007. The provision for loan losses in 2008 was recorded in anticipation ofcredit quality deterioration ensuing from accelerated declines in economicconditions during the fourth quarter of 2008, in addition to growth in thecommercial loan portfolio.  Furthercontributing to the lower net income were lower non-interest interest incomeand higher non-interest expenses.  Theseitems were partially offset by an improvement in net interest income of$1,658,000, or  9%, to $19,277,000 in 2008compared to $17,619,000 in 2007.  Thedecline in ROA and ROE was caused by the decrease in net income.

 

The following tablereconciles net income, as reported to pro forma net operating income for theyears indicated:

 
| ** **              | ** ** | **2008**   | ** ** | **2007**           | ** ** |
|-------------------------|------------|------------|------------|--------------------|------------|
| ** **              | ** ** | **Amount** | ** ** | **Per share** | ** ** | **Amount** | ** ** | **Per share** | ** ** |
| Net income, as reported |       | $          | 3,635,948  |               | $          | 1.76 |   | $ | 4,611,572 |   | $ | 2.23 |   |
| OTTI                    |       | 435,665    |       | 0.21               |       | — |   | — |   |
| Tax effect              |       | (148,126   | )          | (0.07              | )          | — |   | — |   |
| Net operating earnings  |       | $          | 3,923,487  |               | $          | 1.90 |   | $ | 4,611,572 |   | $ | 2.23 |   |

 

29

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***Netinterest income***

 

The followingtable sets forth a comparison of average balances of assets and liabilities andtheir related net tax equivalent yields and rates for 2008, 2007 and 2006(dollars in thousands):

 
| ** **                                          | ** ** | **2008**    | ** ** | **2007**     | ** ** | **2006**   | ** ** |
|-----------------------------------------------------|------------|-------------|------------|--------------|------------|------------|------------|
| ** **                                          | ** ** | **Average** | ** ** | ** **   | ** ** | **Yield/** | ** ** | **Average** | ** ** | ** ** | ** ** | **Yield/** | ** ** | **Average** | ** ** | ** ** | ** ** | **Yield/** | ** ** |
| ** **                                          | ** ** | **balance** | ** ** | **Interest** | ** ** | **rate**   | ** ** | **balance** | ** ** | **Interest** | ** ** | **rate** | ** ** | **balance** | ** ** | **Interest** | ** ** | **rate** | ** ** |
| **Assets**                                          |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-earning assets                             |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Interest-bearing deposits**                       |       | $           | 233        |         | $          | 3          |       | 1.36 | % | $ | 184 |   | $ | 9 |   | 4.81 | % | $ | 240 |   | $ | 9 |   | 3.82 | % |
|                                                |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Investments:**                                    |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. government agencies                            |       | 49,034      |       | 2,576        |       | 5.25       |       | 34,682 |   | 1,724 |   | 4.97 |   | 43,299 |   | 1,795 |   | 4.15 |   |
| Mortgage-backed securities                          |       | 35,294      |       | 1,833        |       | 5.19       |       | 51,781 |   | 2,540 |   | 4.91 |   | 42,999 |   | 1,944 |   | 4.52 |   |
| State and municipal                                 |       | 15,813      |       | 1,014        |       | 6.41       |       | 12,267 |   | 780 |   | 6.36 |   | 14,485 |   | 927 |   | 6.40 |   |
| Other                                               |       | 25,967      |       | 1,252        |       | 4.82       |       | 17,487 |   | 1,175 |   | 6.72 |   | 14,536 |   | 946 |   | 6.50 |   |
| **Total investments**                               |       | 126,108     |       | 6,675        |       | 5.29       |       | 116,217 |   | 6,219 |   | 5.35 |   | 115,319 |   | 5,612 |   | 4.87 |   |
|                                                |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Loans:**                                          |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial                                          |       | 231,721     |       | 15,869       |       | 6.85       |       | 220,968 |   | 16,458 |   | 7.45 |   | 219,482 |   | 16,018 |   | 7.30 |   |
| Consumer                                            |       | 71,089      |       | 4,872        |       | 6.85       |       | 68,395 |   | 4,625 |   | 6.76 |   | 65,011 |   | 4,200 |   | 6.46 |   |
| Real estate                                         |       | 117,547     |       | 6,985        |       | 5.94       |       | 134,869 |   | 8,360 |   | 6.20 |   | 133,279 |   | 8,101 |   | 6.08 |   |
| Direct financing leases                             |       | 477         |       | 29           |       | 6.15       |       | 549 |   | 34 |   | 6.16 |   | 618 |   | 38 |   | 6.18 |   |
| **Total loans**                                     |       | 420,834     |       | 27,755       |       | 6.60       |       | 424,781 |   | 29,477 |   | 6.94 |   | 418,390 |   | 28,357 |   | 6.78 |   |
|                                                |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Federal funds sold**                              |       | 3,342       |       | 91           |       | 2.73       |       | 1,948 |   | 103 |   | 5.28 |   | 2,479 |   | 123 |   | 4.97 |   |
|                                                |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total interest-earning assets                       |       | 550,517     |       | 34,524       |       | 6.27       | %          | 543,130 |   | 35,808 |   | 6.59 | % | 536,428 |   | 34,101 |   | 6.36 | % |
|                                                |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Non-interest earning assets                         |       | 33,301      |       |         |       |       |       | 32,328 |   |   |   |   |   | 28,495 |   |   |   |   |   |
|                                                |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Total Assets**                                    |       | $           | 583,818    |         |       |       |       |   | $ | 575,458 |   |   |   |   |   | $ | 564,923 |   |   |   |   |   |
|                                                |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Liabilities and shareholders’ equity**       |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities                        |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Deposits:**                                       |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings                                             |       | $           | 38,425     |         | $          | 331        |       | 0.86 | % | $ | 41,055 |   | $ | 511 |   | 1.24 | % | $ | 46,422 |   | $ | 620 |   | 1.34 | % |
| NOW                                                 |       | 59,130      |       | 616          |       | 1.04       |       | 67,489 |   | 1,837 |   | 2.72 |   | 69,138 |   | 1,880 |   | 2.72 |   |
| MMDA                                                |       | 93,465      |       | 2,460        |       | 2.63       |       | 84,000 |   | 3,658 |   | 4.35 |   | 68,476 |   | 2,948 |   | 4.30 |   |
| CDs < $100,000                                   |       | 98,410      |       | 4,052        |       | 4.12       |       | 94,420 |   | 4,173 |   | 4.42 |   | 87,345 |   | 3,235 |   | 3.70 |   |
| CDs > $100,000                                   |       | 80,389      |       | 3,638        |       | 4.53       |       | 66,998 |   | 3,168 |   | 4.73 |   | 67,129 |   | 2,791 |   | 4.16 |   |
| Clubs                                               |       | 1,764       |       | 21           |       | 1.19       |       | 1,908 |   | 23 |   | 1.21 |   | 1,750 |   | 19 |   | 1.08 |   |
| **Total deposits**                                  |       | 371,583     |       | 11,118       |       | 2.99       |       | 355,870 |   | 13,370 |   | 3.76 |   | 340,260 |   | 11,493 |   | 3.38 |   |
|                                                |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Repurchase agreements**                           |       | 12,074      |       | 103          |       | 0.85       |       | 19,580 |   | 465 |   | 2.38 |   | 23,391 |   | 624 |   | 2.67 |   |
|                                                |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Borrowed funds**                                  |       | 74,530      |       | 3,463        |       | 4.65       |       | 71,573 |   | 3,825 |   | 5.34 |   | 79,627 |   | 4,244 |   | 5.33 |   |
|                                                |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total interest-bearing liabilities                  |       | 458,187     |       | 14,684       |       | 3.20       | %          | 447,023 |   | 17,660 |   | 3.95 | % | 443,278 |   | 16,361 |   | 3.69 | % |
|                                                |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Non-interest bearing deposits                       |       | 67,717      |       |         |       |       |       | 70,606 |   |   |   |   |   | 68,224 |   |   |   |   |   |
|                                                |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Non-interest bearing liabilities                    |       | 4,503       |       |         |       |       |       | 4,499 |   |   |   |   |   | 3,771 |   |   |   |   |   |
|                                                |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total liabilities                                   |       | 530,407     |       |         |       |       |       | 522,128 |   |   |   |   |   | 515,273 |   |   |   |   |   |
|                                                |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Shareholders’ equity                           |       | 53,411      |       |         |       |       |       | 53,330 |   |   |   |   |   | 49,650 |   |   |   |   |   |
|                                                |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Total liabilities and shareholders’ equity** |       | $           | 583,818    |         |       |       |       |   | $ | 575,458 |   |   |   |   |   | $ | 564,923 |   |   |   |   |   |
| Net interest income                                 |       |        |       | $            | 19,840     |       |       |   |   |   | $ | 18,148 |   |   |   |   |   | $ | 17,740 |   |   |   |
|                                                |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest spread                                 |       |        |       |         |       | 3.07       | %          |   |   |   |   | 2.64 | % |   |   |   |   | 2.67 | % |
|                                                |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest margin                                 |       |        |       |         |       | 3.60       | %          |   |   |   |   | 3.34 | % |   |   |   |   | 3.31 | % |

 

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Inthe preceding table, interest income was adjusted to a tax-equivalent basis,using the corporate federal tax rate of 34%, to recognize the income fromtax-exempt interest-earning assets as if the interest was taxable.  This treatment allows a uniform comparisonbetween yields on interest-earning assets. Loans include loans AFS and non-accrual loans but exclude the allowancefor loan losses.  Average balances arebased on amortized cost and do not reflect unrealized gains or losses.  Net interest margin represents net interestincome divided by total average interest-earning assets.

 

Changes in netinterest income are a function of both changes in interest rates and changes involume of interest-earning assets and interest-bearing liabilities.  The following table presents the extent towhich changes in interest rates and changes in volumes of interest-earningassets and interest-bearing liabilities have affected the Company’s interestincome and interest expense during the periods indicated.  Information is provided in each category withrespect to (1) the changes attributable to changes in volume (changes involume multiplied by the prior period rate), (2) the changes attributableto changes in interest rates (changes in rates multiplied by prior periodvolume) and (3) the net change.  Thecombined effect of changes in both volume and rate has been allocatedproportionately to the change due to volume and the change due to rate.  Tax-exempt income was not converted to atax-equivalent basis on the rate/volume analysis (dollars in thousands):

 
| ** **                                                               | ** ** | **Years ended December 31,**   | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                               | ** ** | **2008 compared to 2007**      | ** ** | **2007 compared to 2006** | ** ** |
| ** **                                                               | ** ** | **Increase (decrease) due to** | ** ** |
| ** **                                                               | ** ** | **Volume**                                    | ** ** | **Rate** | ** ** | **Total** | ** ** | **Volume** | ** ** | **Rate** | ** ** | **Total** | ** ** |
| Interest income:                                                         |       |                                          |       |   |   |   |   |   |   |   |   |   |   |
| Loans and  leases:                                                       |       |                                          |       |   |   |   |   |   |   |   |   |   |   |
| Mortgage                                                                 |       | $                                             | (1,040     | ) | $ | (336 | ) | $ | (1,376 | ) | $ | 97 |   | $ | 163 |   | $ | 260 |   |
| Commercial                                                               |       | 766                                           |       | (1,305 | ) | (539 | ) | 108 |   | 318 |   | 426 |   |
| Consumer                                                                 |       | 178                                           |       | 66 |   | 244 |   | 219 |   | 203 |   | 422 |   |
| Total loans and  leases                                                  |       | (96                                           | )          | (1,575 | ) | (1,671 | ) | 424 |   | 684 |   | 1,108 |   |
| Investment  securities, interest-bearing deposits and federal funds sold |       | 564                                           |       | (211 | ) | 353 |   | 14 |   | 628 |   | 642 |   |
| Total interest  income                                                   |       | 468                                           |       | (1,786 | ) | (1,318 | ) | 438 |   | 1,312 |   | 1,750 |   |
|                                                                     |       |                                          |       |   |   |   |   |   |   |   |   |   |   |
| Interest  expense:                                                       |       |                                          |       |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                                                |       |                                          |       |   |   |   |   |   |   |   |   |   |   |
| Certificates of  deposit greater than $100,000                           |       | 611                                           |       | (141 | ) | 470 |   | (5 | ) | 382 |   | 377 |   |
| Other                                                                    |       | 81                                            |       | (2,803 | ) | (2,722 | ) | 520 |   | 980 |   | 1,500 |   |
| Total deposits                                                           |       | 692                                           |       | (2,944 | ) | (2,252 | ) | 515 |   | 1,362 |   | 1,877 |   |
| Other  interest-bearing liabilities                                      |       | (206                                          | )          | (518 | ) | (724 | ) | (558 | ) | (20 | ) | (578 | ) |
| Total interest  expense                                                  |       | 486                                           |       | (3,462 | ) | (2,976 | ) | (43 | ) | 1,342 |   | 1,299 |   |
| Net interest  income                                                     |       | $                                             | (18        | ) | $ | 1,676 |   | $ | 1,658 |   | $ | 481 |   | $ | (30 | ) | $ | 451 |   |

 

The slope of the yield curve has returned to a morenormal, positive slope in 2008 compared to 2007, but at unprecedented lowlevels.  In several efforts to stimulatea recessing economy, the FOMC reduced short-term interest rates seven timesduring 2008, in intervals ranging from 25 to 75 basis points, sometimesoccurring twice in a single month.  Inresponse to these actions, the national prime rate also decreased during2008.  National prime, the benchmark ratebanks use to set rates on various lending and other interest sensitiveproducts, decreased seven times for a total decrease of 400 basis points from7.25% at December 31, 2007 to 3.25% at December 31, 2008.  As a result of the short-term ratereductions, the yield curve has become positively sloped thereby resulting inopportunities for the Company to improve its net interest margin.  However, operating in a very low, highlyvolatile interest rate environment will also present challenges in the comingyear.

 

While national prime decreased 400 basis points, theweighted-average national prime rate decreased to 5.09% in 2008 compared to8.05% in 2007.  The effect of thisaverage decrease has been to exert extreme downward pressure on yields of theCompany’s interest-earning assets.  Withrate cutting beginning in January 2008, this pressure existed withincreasing momentum throughout all of 2008. The Company was able to more than offset this pressure by periodicallyadjusting rates on its interest-bearing deposits.  In response to the swift downward shift inrates, the Company’s asset liability committee assessed, among otherthings,  the impact the interest ratemovements have had on its earning assets. Where necessary, rate adjustments to interest-bearing deposit andrepurchase agreements were implemented and wholesale funding sources wereutilized, all which helped minimize the effect rate changes  have had on net interest income.  The committee meets frequently and hassuccessfully implemented rate setting strategies to mitigate the interest raterisk inherent in the balance sheet and has been able to preserve its netinterest margin while always mindful of our customers’ needs.

 

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As market rates fallalong with national prime, loan originations, renewing commercial andresidential loans and lines of credit should price below the average 2008portfolio yields.  In addition, thedecrease in the Treasury yields and other capital market rates, which largelybegan during the second half of 2008, could continue to have an unfavorableimpact on the Company’s total 2009 investment portfolio yield.  The relative and predominantly lower interestrate environment of 2008 continued to have a negative impact on the Company’sinterest-earning assets.  Total interestincome declined 4%, or $1,318,000 from $35,279,000 in 2007 to $33,961,000in2008 and further caused the tax-equivalent yield on earning assets to decrease32 basis points.  The Company shouldcontinue to experience a period of sliding yields on its interest-earningassets during 2009, and in what appears to be a prolonged low interest rateenvironment.

 

Interest expensedecreased $2,976,000, or 17%, from $17,660,000 in 2007 to $14,684,000 in2008.  The fast-falling, lower interestrate environment that was prevalent throughout most of 2008, required theCompany to periodically reduce offering rates on both  its deposit and repurchase agreementproducts.  Though the Company recorded anet increase in average interest-bearing liabilities, due to deposit growth,interest expense on deposits declined by almost $3,000,000 in 2008 compared to2007 caused by a 77 basis point decline on rates paid.  The effect of the $15,713,000 increase inaverage interest-bearing deposits was an additional $692,000 in interestexpense.  In an effort to maintainreasonable interest rate spreads to its earning-assets, throughout 2008 theCompany’s asset / liability committee has reduced rates paid on CDs as well asrates paid on transactional deposits. Rates on CD’s should naturally price lower as they mature. However,whether or not the Company can continue to reduce rates on transaction depositsthat are currently priced at unprecedented low levels to maintain its interestrate spread will be predicated on the interest rate environment, liquidityposition and competition.  Interestexpense on borrowings, including repurchase agreements, declined $724,000during 2008, mostly from lower rates.

 

The resulting performanceof the mix of the Company’s interest-sensitive assets and liabilities and thevarying effects the severity of the yield curve slope has had during 2008, netinterest income increased $1,658,000, or 9%, from $17,619,000 in 2007 to$19,277,000 in 2008.  On a tax-equivalentbasis, the net interest rate spread increased 43 basis points from 2.64% to3.07% and the tax-equivalent margin improved 26 basis points, from 3.34% in2007 to 3.60% in 2008, respectively.  Theimprovement in spread and margin were due largely to lower rates paid oninterest-bearing liabilities and more net interest income.

 

***Provisionfor loan losses***

 

The provision for loanlosses represents the necessary amount to charge against current earnings, thepurpose of which is to increase the allowance for loan losses to a level thatrepresents management’s best estimate of known and inherent losses in theCompany’s loan portfolio.  Loans andleases determined to be uncollectible are charged-off against the allowance forloan losses.  The required amount of theprovision for loan losses, based upon the adequate level of the allowance forloan losses, is subject to ongoing analysis of the loan portfolio.  The Company’s Special Asset Committee meetsperiodically to review problem loans and leases.  The committee is comprised of management,including the chief risk officer, loan workout officers and collectionpersonnel.  The committee reportsquarterly to the Credit Administration Committee of the Board of Directors.

 

Management continuouslyreviews the risks inherent in the loan and lease portfolio.  Specific factors used to evaluate theadequacy of the loan loss provision during the formal process include:

 

·                  specific loansthat could have loss potential;

·                  levels of andtrends in delinquencies and non-accrual loans;

·                  levels of andtrends in charge-offs and recoveries;

·                  trends in volumeand terms of loans;

·                  changes in riskselection and underwriting standards;

·                  changes inlending policies, procedures and practices;

·                  experience,ability and depth of lending management;

·                  national andlocal economic trends and conditions; and

·                  changes incredit concentrations.

 

Provisions for loanlosses of $940,000 were made for the year ended December 31, 2008.  In 2007, the Company did not need to makeprovisions and reduced the allowance for loan losses due to a reduced level ofinternally criticized and classified loans. The $940,000 provision for loan losses was recorded for anticipatedcredit quality deterioration, ensuing from accelerated declines in economicconditions during the fourth quarter of 2008, together with providing for over$30 million of loan growth throughout 2008. The provision increase occurred to reinforce and fund the allowance forloan losses balance as of December 31, 2008 to safeguard against possiblefuture losses.  The allowance for loanlosses was $4,745,000 at December 31, 2008, and was $4,824,000 at December 31,2007.

 

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***Other income***

 

For the year ended December 31,2008, total other income was $4,578,000, $627,000, or 12% less than the$5,205,000 recorded during the year ended December 31, 2007.  In 2008, a non-cash OTTI charge of $436,000was recorded.  There was no similarcharge in 2007.  The OTTI charge isrelated to the Company’s investment in a pooled preferred term security and acommon stock equity position in FNMA. The carrying values of these securities were written down to their fairvalues during the third and fourth quarters as management has deemed theimpairment to be other-than-temporary. Service charges on deposit related accounts declined $106,000, or 4%, in2008 compared to 2007.  Most of thisdecline was the result of lower volumes of overdraft transactions.  During 2008, the Company recorded net losses fromthe disposal of premises and equipment of $36,000 compared to net gains of$98,000 recorded in 2007, or an adverse impact of approximately $134,000.  The loss in 2008 was from the disposal ofunused, obsolete capital equipment while in 2007 gains included the sales oftwo commercial facilities previously leased to non-related third parties.  Further contributing to the non-interestincome decline in 2008 were the gains recorded form the sale of foreclosedproperties in 2007 of $144,000 compared to $43,000 in 2008.  Partially offsetting these adverse changes innon-interest income were: $101,000 more gains from the sales of residentialmortgages into the secondary market; fees earned from the Company’s trustservices business and an increase in the cash surrender value of BOLI.

 

In 2009, the Companyprojects continued decline in service fees from deposit accounts, which in 2008declined by nearly 4% from 2007, as the expectation there will be an even lowervolume of overdraft transactions.  In thecurrent environment, it is difficult to determine whether this trend willcontinue.

 

***Otherexpenses***

 

For the year ended December 31,2008, other operating expenses grew $1,574,000, or 9%, from $16,637,000 for theyear ended December 31, 2007.  Meritand performance-based incentive increases, branch expansion and the relatedemployee benefits, health care, and wider participation in the Company’s 401(k) plancaused salaries and employee benefit costs to rise $1,164,000, or 13%, for thetwelve months ended December 31, 2008 compared to the same period in2007.  Higher occupancy related expenses,a component of premises and equipment, increased $95,000, or 3%, due to a fullyear of depreciation and amortization on the Green Ridge branch relocation andthe 2008 opening of the West Scranton branch. Branch expansion activities also included more advertising andmarketing, up $33,000, or 5%, and other increased overhead including: officesupplies, postage, data processing and FDIC premiums.  Other expenses also increased by highercollection and ORE expenses associated with more legal and foreclosure costs.

 

As the Company enters2009, management expects certain expenses to rise over and above normalexpected inflationary increases. In 2009, the West Scranton branch will reflecta full year of operational expenses.  Forexample occupancy related costs could amount to $230,000 more in 2009 than in2008.  The Company’s FDIC premium, whichgrew 1.5 times the 2007 level, will significantly increase even further, byincreased premiums and also from the Company’s decision to voluntarilyparticipate in the Temporary Liquidity Guarantee Program (TLGP).  The Company anticipates up to $300,000 ofadditional premiums, but cannot quantify the effect of the TLGP premium impactas it will be determined by depositor sentiment for mitigating their personalrisk.

 

In late February 2009,the FDIC voted to impose a special assessment of 20 basis points on allFDIC-insured banks to be collected on September 30, 2009.  The Company anticipates that the specialassessment will adversely affect earning by approximately $900,000 based on ourcurrent federally-insured deposit amounts. Furthermore, the FDIC has the authority, after June 30, 2009, toimpose an additional 10 basis point emergency special assessment on allFDIC-insured banks if it estimates the reserve ratio of the Deposit InsuranceFund will fall to a level that it believes would adversely affect publicconfidence or to a level which would be close to zero or negative at the end ofa calendar quarter.  At this time wecannot estimate the probability of this event; however, any additional FDICassessment and/or premium would be adverse to our 2009 earnings.

 

The ratio of non-interest expense less non-interestincome (expense ratio) to average assets at December 31, 2008 and 2007 was2.25% and 2.01%, respectively.  Theoverhead expense ratio of the Company drifted upward due to higher non-interestexpenses.

 

***Provision for income taxes***

 

Income before provisionfor income taxes in 2008 decreased $1,543,000 from 2007.  The effective federal income tax rate was22.7% and 26.2% for the years ending December 31, 2008 and 2007,respectively.  The decrease in theeffective tax rate is attributable to the decrease in pre-tax income.

 

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***Comparisonof Financial Condition as of December 31, 2007***

***and2006 and Results of Operations for each of the Years then Ended***

 

***FinancialCondition***

 

***Overview***

 

Consolidated assetsincreased $25,095,000, or 4%, during the year ended December 31, 2007 to$587,413,000.  The increase resulted fromincreases in total deposits of $15,374,000, total borrowings of $6,173,000 andtotal shareholders’ equity of $3,579,000. During 2007, the carrying values of the investment and loan portfoliosincreased $22,573,000 and $4,931,000, respectively, while premises andequipment, net plus construction in process, a component of other assets in theconsolidated balance sheet, increased $1,287,000.  Cash decreased $3,392,000 since December 31,2006.

 

***Deposits***

 

Total deposits increased$15,373,000, or 4%, during 2007 to $425,708,000.  The growth in deposits was from increases inmoney market and certificate of deposit accounts of $15,533,000 and$24,389,000, or 21% and 16%, respectively, partially offset by declines in NOW,savings and DDAs of $10,427,000, $5,176,000 and $8,946,000, respectively.  Certificate of deposit accounts continued togrow as customers locked in rates during the declining interest rateenvironment.  The increase in moneymarket accounts, net of the decline in savings and club accounts, was fromsuccess in our deposit-gathering strategies in conjunction with promotionalinterest rates tailored to depositors’ needs. DDAs decreased 12% compared to December 31, 2006; however,management believed this outflow was related to customer transaction timing andtherefore temporary rather than permanent.

 

***Short-term borrowings***

 

During 2007, repurchaseagreements declined to $20,504,000 from $22,224,000 at December 31, 2006.  At December 31, 2007 and 2006, sweepaccounts represented 62% and 70%, respectively, of total repurchaseagreements.  Investment securitypre-refunding strategies and late-year deposit outflow resulted in an increasein overnight borrowings of $8,555,000 as of December 31, 2007 compared to December 31,2006.

 

***Long-term debt***

 

Theweighted-average rate in effect on funds borrowed at December 31, 2007,was 5.26% compared to 5.15% as of December 31, 2006.  The 2007 weighted-average rate was 133 basispoints below the tax-equivalent yield of 6.59% on average earning assets forthe year ended December 31, 2007. Rates on $42,000,000 of the total long-term advances are fixed but willadjust quarterly should market rates increase beyond the issues’ original or strikerates.  As of December 31, 2007, theweighted-average rate on this convertible debt was 5.35%.  To help reduce the Company’s reliance onovernight funding, during 2007 $16,000,000 of advances that had matured orconverted, and carried a weighted-average interest rate of 4.78%, were replacedwith fixed- and capped floating-rate advances. The new advances  aggregated$20,000,000 that mature in 2009 and carried an initial weighted-averageinterest rate of 5.40%.  As of December 31,2007, the weighted-average interest rate on these advances amounted to 5.13%.

 

***Investments***

 

As of December 31, 2007 and December 31,2006, the aggregate fair value of securities HTM exceeded their respectiveaggregate amortized cost by $33,000 and $29,000, respectively.  Total investments increased $22,574,000, netof a $23,000 decline in the market value of AFS investments.  The increase in the investment portfolioduring 2007 was the result of investing excess liquidity stemming from depositinflows and late-year overnight borrowings used as a pre-refundingstrategy.  The carrying value ofinvestment securities, at December 31, 2007, was $122,984,000, or 21%, oftotal assets compared to $100,411,000, or 18%, as of December 31,2006.  Mortgage-backed securities, whichamortize and provide monthly cash flow, continue to dominate the composition ofthe total investment portfolio representing 48% at December 31, 2007,compared to 43% at December 31, 2006.

 

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The tax-equivalent yieldon debt securities by stated maturity date at December 31, 2007, is asfollows:

 
| ** **                              | ** ** | **One year** | ** ** | **One through** | ** ** | **Five through** | ** ** | **More than** | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|-------------------|------------|----------------------|------------|-----------------------|------------|--------------------|------------|------------|------------|
| ** **                              | ** ** | **or less**  | ** ** | **five years**  | ** ** | **ten years**    | ** ** | **ten years** | ** ** | **Total**  | ** ** |
| U.S. government agencies                |       | 3.00              | %          |                 | 4.83       | %                     |       | 4.90               | %          |       | 5.99       | % |   | 5.25 | % |   |
| Mortgage-backed securities              |       | 6.00              |       |                 | 4.11       |                  |       | 4.32               |       |       | 5.22       |   |   | 5.06 |   |   |
| State & municipal subdivisions |       | —            |       |                 | —     |                  |       | 5.55               |       |       | 5.71       |   |   | 5.69 |   |   |
| Preferred term securities               |       | —            |       |                 | —     |                  |       | —             |       |       | 6.25       |   |   | 6.25 |   |   |
| Total debt securities                   |       | 3.05              | %          |                 | 4.54       | %                     |       | 4.78               | %          |       | 5.59       | % |   | 5.34 | % |   |

 

***Loansand leases***

 

Gross loans andleases increased $3,606,000, or 1%, from $422,643,000 at December 31,2006, to $426,249,000 at December 31, 2007.  Gross loans represented 73% and 75% of totalassets at December 31, 2007 and December 31, 2006, respectively.

 

In 2007, the Companyoriginated $32,919,000 of commercial loans, $24,032,000 of residential mortgageloans and $28,062,000 of consumer loans. This compares to $17,152,000, $21,431,000 and $29,565,000, respectively,in 2006.  Included in mortgage loans is$12,515,000 of real estate construction lines in 2007 and $11,111,000 in2006.  In addition for 2007, the Companyoriginated lines of credit in the amounts of $18,564,000 for commercialborrowers and $6,296,000 in home equity and other consumer lines of credit.

 

Though loan originationsincreased in 2007 compared to 2006, and despite operating in an overall higherinterest rate environment, payoffs and pay-downs were high in 2007 almostoffsetting the originations.  As aresult, there was only a subtle increase in the loan portfolio.

 

*Commercialand Commercial Real Estate Loans**:*

 

Though commercial andcommercial real estate (CRE) originations were relatively strong, they werefully offset by scheduled principal curtailments and pre-payments, therebyresulting in a commercial loan decline of $2,155,000 to $216,058,000 from$218,213,000, or almost 1% during 2007. The Company hired a new senior lender and had restructured its existingteam of commercial loan officers to better serve our existing customer base andstrategically penetrate the markets for new business relationships.

 

*ResidentialReal Estate Loans*:

 

Residential real estateloans increased $4,235,000, or 4%, to $116,978,000 in 2007.  Though operating in a higher interest rateenvironment, which tends to reduce the level of prepayment and refinanceactivity, the Company was able to continue to grow its residential real estateloan portfolio on the strength of its very dedicated staff of loan originatorsand transfers of construction loans to permanent financing.

 

*ConsumerLoans**:*

 

Consumer loans increased$4,269,000, or 6%, during 2007.  Theincrease in this sector is mainly from less refinance and payoff activitycaused by a relatively higher interest rate environment.  This enabled the portfolio to grow despite aminor decline in loan originations.

 

*RealEstate Construction Loans**:*

 

Real estate constructionloans decreased by $2,666,000, or 20%, at December 31, 2007 compared to December 31,2006.  The decline in 2007 was caused bymore residential construction loans converting to permanent mortgage loans;however, both categories remain strong.

 

*DirectFinancing Leases**:*

 

The balance representstax-free leasing arrangements provided to municipal customers.  For 2007, the activity represents scheduledrun-off.

 

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***Loans available-for-sale***

 

Loans AFS at December 31,2007, were $827,000, with a corresponding fair value of $843,000 compared to$122,000 and $123,000, respectively, at December 31, 2006.  During 2007, residential mortgages andstudent loans with principal balances of $16,210,000 and $57,000, respectively,were sold into the secondary market and combined gains of approximately$159,000 were recognized.  There were nosold SBA loans during 2007.

 

At December 31, 2007 and 2006, the servicingportfolio balance of sold residential mortgage loans was $61,023,000 and$53,112,000, respectively.

 

***Allowance for loan losses***

 

Total charge-offs, net ofrecoveries, for the year ended December 31, 2007, were $560,000, comparedto $865,000 in 2006.  Combined consumerloan and lease financing net charge-offs increased slightly from $161,000 at December 31,2006 to $237,000 through December 31, 2007.  Commercial loan net charge-offs were $597,000for the year 2006 compared to $357,000 for 2007.  Mortgage loans showed net recoveries of$35,000 in 2007 compared to net charge-offs of $108,000 in 2006.  This reversal from net mortgage charge-offsin 2006 to net recoveries in 2007 was the result of recording one largemortgage loan recovery of $107,000 on a loan which had been charged-off in aprior year.

 

***Non-performing assets***

 

The majority ofnon-performing assets for the period was attributed to non-accruing commercialbusiness loans and non-accruing real estate loans in the process offoreclosure.  Most of these loans werecollateralized, thereby mitigating the Company’s potential for loss.  In 2006, non-performing loans were $3,439,000compared to $3,837,000 at year-end 2007. There were no repossessed assets at December 31, 2007 or 2006.  ORE at December 31, 2007 consisted ofone property which had an agreement to sell pending.  At year-end 2006, five residential propertieswere owned, all of which were sold.  TheSpecial Assets Department had developed specific action plans for each of theCompany’s non-performing loans.  During2007, many of those plans came to a conclusion resulting in repayments ofnon-performing loans.  The non-accrualloans aggregated $3,811,000 at December 31, 2007, an increase of $453,000from year-end 2006.  During 2007approximately $3,075,000 of loans were placed in non-accrual status.  These were partially offset by payoffs orpay-downs of $1,888,000, charge-offs of $236,000, $352,000 in transfers to OREand $146,000 of loans that returned to performing status.  Loans past due 90 days or more and accruingdeclined 68%, to $26,000, at December 31, 2007.  The non-accrual loans rose by 14 % to$3,811,000 and ORE declined by 46 % to $107,000.  These three items comprise the non-performingassets of $3,944,000.  The percentage ofnon-performing assets to total assets was 0.67% at December 31, 2007, aminor change from 0.65% at December 31, 2006.  Non-performing loans to net loans were 0.91%at December 31, 2007, and 0.82% at December 31, 2006.

 

During 2007, the Companycollected $93,000 of interest income recognized on the cash basis.  If the non-accrual loans that wereoutstanding as of December 31, 2007 had been performing in accordance withtheir original terms, the Company would have recognized interest income withrespect to such loans of $391,000 for the year ended December 31, 2007.

 

***Bankpremises and equipment, net***

 

Net of accumulateddepreciation and disposals, premises and equipment increased $1,640,467.  During 2007, the Company purchased ortransferred from construction in process approximately $3,293,000 compared to$852,000 in 2006.  The increase wasprincipally from the completion of the Company’s Green Ridge branch relocationconstruction project.

 

***Foreclosed******assets held-for-sale***

 

*Other Real Estate Owned*

 

ORE was $107,000 at December 31,2007 consisting of one property, the sale of which is pending.  The five residential properties which wereowned at year end 2006 have all been sold.

 

***Other assets***

*** ***

***The decrease in other assets of $384,000, or 8%, from December 31,2006 was due mostly to the reduction of capitalized interim construction costsfor the Company’s branch expansion and other projects and a decrease in the netdeferred tax asset, partially offset by an increase in the market value of theCompany’s derivative contract.  See Note10, “Income Taxes,” for an analysis of the net deferred tax asset.  For a further discussion on the Company’sderivative contract, see Note 1, “Nature***

 

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***of operations and summary of significant accountingpolicies,” and Note 12, “Fair value of financial instruments and derivatives,”contained within the notes to consolidated financial statements in Part II,Item 8.***

 

***Resultsof Operations***

 

***EarningsSummary***

 

Net income for the yearended December 31, 2007 was $4,612,000, compared to $4,125,000 for theyear ended December 31, 2006. During the same periods, diluted earnings per common share was $2.23 and$2.01, respectively.  For the year ended December 31,2007, the Company’s ROA and ROE were 0.80% and 8.65%, respectively, compared to0.73% and 8.31% for the year ended December 31, 2006.  The improvement in net income was primarilyfrom a 3%, or $451,000, increase in net interest income, a 15%, or $683,000,rise in non-interest income, partially offset be a 5%, or $758,000, increase inoperating expenses.  Also contributing tothe improvement was a credit for loan losses of $60,000 during the twelvemonths ended December 31, 2007 compared to a provision of $325,000 in2006.  The improvement in ROA and ROE waslargely due to the improvement in net income.

 

***Netinterest income***

 

The slope of the yield curve, which became inverted,or negatively sloped in 2006, had returned to a more normal, positive slope in2007.  An inverted yield curve presentschallenges to banks because short-term rates are higher than long-term rateswhich tends to compress net interest income because deposit and borrowing termsare generally shorter than investment and loan terms.  The FOMC reduced short-term interest ratesthree times during the second half of 2007. In response to these actions, national prime also decreased during 2007.  National prime also decreased three times fora total decrease of 100 basis points from 8.25% at December 31, 2006 to7.25% at December 31, 2007.  As aresult of the rate reductions, the yield curve had become more positivelysloped thereby provided opportunities for the Company to bolster its netinterest margin.

 

Though national prime decreased 100 basis points, theweighted-average national prime rate increased to 8.05% in 2007 compared to7.96% in 2006.  This phenomenon wascaused by the first rate reduction occurring well into the third quarter.  Thus, most of 2007 consisted of market ratesthat existed at the year-end 2006 level. The effect of this average increase pressured rates paid oninterest-bearing liabilities and was only marginally offset by the effect rateshad on interest earning-assets.

 

As expected, the relative and predominantly higherinterest rate environment during 2007 continued to have a positive influence onthe Company’s interest-earning assets. Total interest income increased 5%, from $33,530,000 in 2006 to$35,279,000 in 2007 and further, caused the tax-equivalent yield on earningassets to increase 23 basis points. Interest expense increased $1,299,000, or 8%, from $16,361,000 in 2006to $17,660,000 in 2007.  The cost ofinterest-bearing liabilities increased 26 basis points in 2007.  The higher interest rate environment that wasprevalent throughout most of 2007, in conjunction with higher averageinterest-bearing deposit balances, necessitated the need for the Company toincrease offering rates on its deposit products.  As a result, interest expense on depositsincreased $1,877,000 during 2007, of which approximately $1,362,000 was causedby a 38 basis point rise in average rates. Average balances in interest-bearing deposits increased by $15,610,000during 2007, resulting in an additional $515,000 in expense.  Interest expense on borrowings, includingrepurchase agreements, declined $578,000 during 2007, due almost entirely tolower average balances.

 

As a result of the mix ofthe Company’s interest-sensitive assets and liabilities and the varying effectsthe slope of the interest rate yield curve has had during 2007, net interestincome increased $451,000, or 3%, from $17,168,000 in 2006 to $17,619,000 in2007.  On a tax-equivalent basis, the netinterest rate spread declined 3 basis points from 2.67% to 2.64% and thetax-equivalent margin improved 3 basis points, from 3.31% in 2006 to 3.34% in2007, respectively.  The decrease inspread was due to a larger increase in rates paid on interest-bearingliabilities than the increase in yields from interest-earning assets.  The margin improvement was from more netinterest income in 2007 compared to 2006.

 

***Provisionfor loan losses***

 

A credit for loan lossesof $60,000 was made to the allowance during 2007 compared to a provision forloan losses of $325,000 for the year ended December 31, 2006.  In 2007, the Company did not need to makeprovisions and reduced the allowance for loan losses due to a reduced level ofinternally criticized and classified loans. These reductions occurred as a result of some adversely rated loans whichwere either upgraded in rating due to credit improvement or were repaid.  The allowance for loan losses was $4,824,000at December 31, 2007, compared to $5,444,000 at December 31,2006.  The reduced level of the allowancewas due to the improved quality of the portfolio.

 

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***Other income***

 

For the year ended December 31,2007, total other income was $5,205,000, an increase of $683,000, or 15%, fromthe $4,522,000 recorded during 2006.  In2007, the Company experienced growth in service charges on deposit accounts of$376,000, or 14%, and also recognized net gains of $144,000 from sales offoreclosed properties held-for-sale.  Anincrease in overdraft charges was the principal reason for growth in depositservice charges.  The significant gainfrom the sale of foreclosed properties was the result of excess collateralvalue compared to the carrying value. Further contributing to the increase in non-interest income were:increased sales activities of residential mortgages into the secondary marketresulting in $62,000 more of gains compared to 2006; increases in BOLIearnings; higher revenue from financial services activities; and the disposalof premises and equipment that produced net gains of $98,000 in 2007 comparedto net losses of $20,000 in 2006. Included in 2007 were the sales of two commercial facilities previouslyleased to non-related third parties.

 

***Otherexpense***

 

For the twelve monthsended December 31, 2007, other operating expenses were $16,637,000compared to $15,878,000 for the twelve months ended December 31, 2006, a$758,000 or 5% increase.  Merit andperformance-based incentive increases caused salary and employee benefit coststo rise $377,000, or 5%, for the twelve months ended December 31, 2007compared to the same period in 2006. Advertising and marketing related expenses were up $144,000, or 27%, dueto activities associated with the grand opening and relocation project ofCompany’s Green Ridge branch office. Other expenses increased $225,000, or 6%, in 2007 compared to 2006caused by increased professional services, ATM expense and other branch relatedoperating costs.

 

The expense ratio at December 31, 2007 and 2006was 2.01% and 2.02%, respectively.  Theoverhead expense ratio of the Company remained comparable to the Uniform BankPerformance Report peer comparison group ratio.

 

***Provision for income taxes***

 

Income before provisionfor income taxes in 2007 increased $760,000 from 2006.  The effective federal income tax rate was26.2% and 24.8% for the years ending December 31, 2007 and 2006,respectively.  The increase in theeffective tax rate is attributed to an increase in pre-tax income and adecrease in tax-free income.

 

***Off-Balance Sheet Arrangementsand Contractual Obligations***

 

The Company is a party to financial instruments withoff-balance sheet risk in the normal course of business in order to meet thefinancing needs of its customers and in connection with the overall interestrate management strategy.  Theseinstruments involve, to a varying degree, elements of credit, interest rate andliquidity risk.  In accordance with GAAP,these instruments are either not recorded in the consolidated financialstatements or are recorded in amounts that differ from the notionalamounts.  Such instruments primarilyinclude lending commitments, lease obligations and derivative instruments.  For a further discussion on the Company’sderivative instrument, see Note 1, “Nature of operations and summary ofsignificant accounting policies,” and Note 12, “Fair value of financialinstruments and derivatives,” contained within the notes to consolidatedfinancial statements in Part II, Item 8.

 

Lending commitmentsinclude commitments to originate loans and commitments to fund unused lines ofcredit.  Commitments to extend credit areagreements to lend to a customer as long as there is no violation of anycondition established in the contract. Commitments generally have fixed expiration dates or other terminationclauses and may require payment of a fee. Since some of the commitments are expected to expire without being drawnupon, the total commitment amounts do not necessarily represent future cashrequirements.

 

In addition to lendingcommitments, the Company has contractual obligations related to operating leasecommitments.  Operating lease commitmentsare obligations under various non-cancelable operating leases on buildings andland used for office space and banking purposes.

 

The following tablepresents, as of December 31, 2008, the Company’s significant determinablecontractual obligations and significant commitments by payment date.  The payment amounts represent those amountscontractually due to the recipient, excluding interest (dollars in thousands):

 

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| ** **                | ** ** | ** **        | ** ** | **Over one**     | ** ** | **Over three**    | ** ** | ** **          | ** ** | ** ** | ** ** |
|---------------------------|------------|-------------------|------------|-----------------------|------------|------------------------|------------|---------------------|------------|------------|------------|
| ** **                | ** ** | **One year** | ** ** | **year through** | ** ** | **years through** | ** ** | **Over**            | ** ** | ** ** | ** ** |
| ** **                | ** ** | **or less**  | ** ** | **three years**  | ** ** | **five years**    | ** ** | **five years** | ** ** | **Total**  | ** ** |
|                      |       |              |       |                  |       |                   |       |                |       |       |       |
| Contractual  obligations: |       |              |       |                  |       |                   |       |                |       |       |       |
| Certificates of  deposit  |       | $                 | 138,896    |                  | $          | 29,544                 |       | $                   | 4,433      |       | $          | 808 |   | $ | 173,681 |   |
| Long-term debt            |       | 10,000            |       | 21,000                |       | 5,000                  |       | 16,000              |       | 52,000     |       |
| Repurchase  agreements    |       | 11,412            |       | —                |       | —                 |       | —              |       | 11,412     |       |
| Operating leases          |       | 368               |       | 666                   |       | 682                    |       | 3,844               |       | 5,560      |       |
|                      |       |              |       |                  |       |                   |       |                |       |       |       |
| Significant  commitments: |       |              |       |                  |       |                   |       |                |       |       |       |
| Letters of  credit        |       | 2,053             |       | 1,190                 |       | —                 |       | 725                 |       | 3,968      |       |
| Loan commitments*         |       | 25,613            |       | —                |       | —                 |       | —              |       | 25,613     |       |
|                      |       |              |       |                  |       |                   |       |                |       |       |       |
| Total                     |       | $                 | 188,342    |                  | $          | 52,400                 |       | $                   | 10,115     |       | $          | 21,377 |   | $ | 272,234 |   |

 

----

*Available credit to borrowers in the amount of$68,379 is excluded from the above table since, by its nature, the borrowersmay not have the need for additional funding, and, therefore, the credit may ormay not be disbursed by the Company.

 

***RelatedParty Transactions***

 

Information with respectto related parties is contained in Note 15, “Related party transactions,”within the notes to the consolidated financial statements, and incorporated byreference in Part II, Item 8.

 

***Impactof Accounting Standards and Interpretations***

 

Information with respectto the impact of accounting standards is contained in Note 18, “Recentaccounting pronouncements,” within the notes to the consolidated financialstatements, and incorporated by reference in Part II, Item 8.

 

***Impactof Inflation and Changing Prices***

 

The consolidatedfinancial statements and notes thereto presented herein have been prepared inaccordance with GAAP, which requires the measurement of the Company’s financialcondition and results of operations in terms of historical dollars withoutconsidering the changes in the relative purchasing power of money over time dueto inflation.  The impact of inflation isreflected in the increased cost of our operations.  Unlike industrial businesses, most all of theCompany’s assets and liabilities are monetary in nature.  As a result, interest rates have a greaterimpact on our performance than do the effects of general levels of inflation asinterest rates do not necessarily move in the same direction or, to the sameextent, as the price of goods and services.

 

***CapitalResources***

 

The Company is subject to various regulatory capitalrequirements administered by the federal banking agencies.  Failure to meet minimum capital requirementscan initiate certain mandatory and possible additional discretionary actions byregulators that, if undertaken, could have a direct material effect on theCompany’s financial statements.  Undercapital adequacy guidelines and the regulatory framework for prompt correctiveaction, the Company must meet specific capital guidelines that involvequantitative measures of the Company’s assets, liabilities and certain off-balance-sheetitems as calculated under regulatory accounting practices.  The Company’s capital amounts andclassification are also subject to qualitative judgments by the regulatorsabout components, risk-weightings and other factors.

 

Under these guidelines,assets and certain off-balance sheet items are assigned to broad riskcategories, each with prescribed risk weightings.  The resulting capital ratios representcapital as a percentage of total risk-weighted assets and certain off-balancesheet items.  The guidelines require allbanks and bank holding companies to maintain a minimum ratio of totalrisk-based capital to total risk-weighted assets (Total Risk Adjusted Capital)of 8%, including Tier I capital to total risk-weighted assets (Tier I Capital)of 4% and Tier I capital to average total assets (Leverage Ratio) of at least4%.  Additional information with respectto capital requirements is contained in Note 14, “Regulatory matters,” withinthe notes to the consolidated financial statements, and incorporated byreference in Part II, Item 8.

 

In October 2008, the U.S. Department of Treasury(Treasury), the Board of Governors of the Federal Reserve System (FRB) and theFDIC issued a joint statement announcing a voluntary capital purchase program where the Treasury will purchase 

 

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senior preferred stock of certain financialinstitutions.  The Treasury had allocated$250 billion under the Troubled Asset Relief Program (TARP) created under theEconomic Stabilization Act of 2008 (ESSA) to purchase senior preferred stock inbanks through the Capital Purchase Program. The Company received preliminary approval from the U.S. TreasuryDepartment to participate in the TARP, however because of the Company’s strong capital position, the Companyhas decided not to participate as the effect of accepting the program wasdetermined to not be in the best interest of the Company’s shareholders.  At December 31, 2008, the Company’stotal risk-based capital ratio was 13.6%, Tier 1 risk-based ratio was 12.6% andits leverage ratio was 9.9%.  The Companycurrently exceeds the regulatory guidelines with the Company’s capital adequacylevels above the “well-capitalized” regulatory requirements.

 

During the second quarterof 2008 the Company’s Board of Directors announced its intent to initiate acapital stock repurchase program covering up to 50,000 shares of itsoutstanding capital stock.  Therepurchased shares would become treasury stock and could be available forissuance under the Company’s various stock-based compensation, employee stockpurchase and dividend reinvestment (DRP) plans and for general corporatepurposes.  The repurchases will be madefrom time-to-time in open-market transactions, subject to availability,pursuant to safe harbor rule 10b-18 under the Securities Exchange Act of1934.  Currently, the Company reacquired12,255 shares, net of reissued shares to participants in the Company’s DRP, ata weighted-average cost of $28.70 per share. For a further discussion about this program, see  “Unregistered Sales of Equity Securities andUse of Proceeds” included in Part II, Item 5, “Market for Registrant’sCommon Equity, Related Stockholder Matters and Issue Purchases on EquitySecurities,” above.

 

During the year-ended December 31, 2008, totalshareholders’ equity decreased $6,231,000, or 11%, due principally fromincreased unrealized net losses in the securities AFS portfolio, thedeclaration of cash dividends and the repurchase of the Company’s capital stock(treasury stock).  Conversely,shareholders’ equity was enhanced by current year earnings, stock issued fromthe Company’s Employee Stock Purchase and Dividend Reinvestment Plans, and anincrease in the intrinsic value of the Company’s cash flow hedgeinstrument.  The Company’s primary sourceof capital during the previous five years has been from the retention of equityin undistributed earnings of the Bank, as reflected below:

 
| ** ** | ** ** | **Net**    | ** ** | **Cash dividends** | ** ** | **Earnings** | ** ** |
|------------|------------|------------|------------|-------------------------|------------|--------------|------------|
| ** ** | ** ** | **Income** | ** ** | **declared**            | ** ** | **Retained** | ** ** |
|       |       |       |       |                    |       |         |       |
| 2008       |       | $          | 3,635,948  |                    | $          | 2,068,680    |       | $ | 1,567,268 |   |
| 2007       |       | 4,611,572  |       | 1,921,533               |       | 2,690,039    |       |
| 2006       |       | 4,125,283  |       | 1,801,361               |       | 2,323,922    |       |
| 2005       |       | 4,591,697  |       | 1,624,263               |       | 2,967,434    |       |
| 2004       |       | 3,364,474  |       | 1,610,423               |       | 1,754,051    |       |
|            |            |            |            |                         |            |              |            |  |  |  |

 

At December 31,2008, the Company reported a net unrealized loss of  $8,831,000 from the securities AFS portfoliocompared to a net unrealized loss of $982,000 as of December 31, 2007, ornearly nine times greater at the end of 2008. The large decrease in 2008 wascaused by a faltering economy which has created uncertainty and in certaincircumstances illiquidity in the financial and capital markets and has had amomentous impact on the volatility in fair value estimates and determinationfor securities in banks investment portfolios. Management believes these changes are due mainly to liquidity problemsin the financial markets and to a lesser extent the deterioration in thecreditworthiness of the issuers. Additional information with respect to the investment portfolio and adiscussion on the related decline in fair value, is contained in Note 3, “InvestmentSecurities,” within the notes to the consolidated financial statements, andincorporated by reference in Part II, Item 8.

 

***Liquidity***

 

Liquidity managementensures that adequate funds will be available to meet customers’ needs forborrowings, deposit withdrawals and maturities and normal operating expenses ofthe Company.  Current sources ofliquidity are cash and cash equivalents, asset maturities and pay-downs withinone year, loans and investments AFS, growth of core deposits, growth ofrepurchase agreements, increases of other borrowed funds from correspondentbanks and issuance of capital stock.  Althoughregularly scheduled investment and loan payments are a dependable source ofdaily funds, the sales of both loans and investments AFS, deposit activity andinvestment and loan prepayments are significantly influenced by generaleconomic conditions and the level of interest rates.  During a declining interest rate environment,prepayments from interest-sensitive assets tend to accelerate and providesignificant liquidity which can be used to invest in other interest-earningassets but at lower market rates. Conversely, in a period of rising interest rates, prepayment frominterest-sensitive assets tend to decelerate causing cash flow from mortgageloans and mortgage-backed securities portfolio to decrease.  Deposit inflow may accelerate and be investedat higher market interest rates.  TheCompany closely monitors activity in the capital markets and takes appropriateaction to ensure that the liquidity levels are adequate for funding, investingand operating activities.

 

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During the year ended December 31,2008, the Company generated approximately $2.4 million of cash.  During this period, the Company’s operationsprovided approximately $35.8 million primarily from the sales of mortgages AFSnet of originations.  Included in thesesales were approximately $28.1 million of residential mortgage loans that weretransferred to the loan AFS portfolio. This was partially offset by cash used for investing and financing of$33.4 million net, for loan growth, purchases of investment securities,facility expansion, the repayment of debt and shareholder dividends.  In addition to operations, the Company’sprimary sources of funds used for investing and financing was from the proceedsfrom the sales, calls and maturities of investment securities and  from deposit generation.

 

As of December 31,2008, the Company maintained $12,771,000 in cash and cash equivalents and$83,362,000 of investments and loans AFS. In addition, as of December 31, 2008, the Company had approximately$117,348,000 available to borrow from the FHLB, $19,700,000 available from other correspondent banks and $2,250,000 fromthe Discount Window from the Federal Reserve Bank of Philadelphia.  This combined total of $235,431,000represented 41% of total assets at December 31, 2008.  Management believes this level of liquidityto be strong and adequate to support current operations.  For a discussion on the Company’s significantdeterminable contractual obligations and significant commitments, see “Off-balancesheet arrangements and contractual obligations,” above.  During the third quarter of 2008, the Companyterminated its relationship with a correspondent bank, due to inactivity, thatpreviously provided access to $10,000,000 of liquidity in the form ofshort-term overnight borrowings.  TheCompany is currently analyzing replacement correspondent banks to provideaccess to similar funding levels, if needed. The termination of the relationship does not have a significant effecton the Company’s liquidity position.

 

In October 2008, the FDIC announced the TemporaryLiquidity Guarantee Program (TLGP) to strengthen confidence and encourageliquidity in the banking system.  Amongother things, this new program will provide full deposit insurance coverage fornon-interest bearing deposit transaction accounts in FDIC-insured institutionsregardless of the dollar amount.  Toprotect its depositors, the Company is participating in the TLGP.  Under the TLGP, all depositors who hold fundsin non-interest bearing accounts, or interest-bearing accounts with an interestrate of 0.50% or less, including the Lawyers Trust Accounts, will have atemporary unlimited guarantee from the FDIC until December 31, 2009.  The coverage of the TLGP is in addition toand separate from coverage available under the FDIC’s general deposit insurancerules, which insures accounts up to $250,000 until the end of 2009 unlessextended.

 

***Managementof interest rate risk and market risk analysis***

 

The Company is subject tothe interest rate risks inherent in its lending, investing and financingactivities.  Fluctuations of interestrates will impact interest income and interest expense along with affecting marketvalues of all interest-earning assets and interest-bearing liabilities, exceptfor those assets or liabilities with a short term remaining to maturity.  Interest rate risk management is an integralpart of the asset/liability management process. The Company has instituted certain procedures and policy guidelines tomanage the interest rate risk position. Those internal policies enable the Company to react to changes in marketrates to protect net interest income from significant fluctuations.  The primary objective in managing interestrate risk is to minimize the adverse impact of changes in interest rates on netinterest income along with creating an asset/liability structure that maximizesearnings.

 

*Asset/Liability Management*.  One major objective of the Company whenmanaging the rate sensitivity of its assets and liabilities is to stabilize netinterest income.  The management of andauthority to assume interest rate risk is the responsibility of the Company’sAsset/Liability Committee (ALCO), which is comprised of senior management andmembers of the board of directors.  ALCOmeets quarterly to monitor the relationship of interest sensitive assets tointerest sensitive liabilities.  Theprocess to review interest rate risk is a regular part of managing the Company.  Consistent policies and practices ofmeasuring and reporting interest rate risk exposure, particularly regarding thetreatment of non-contractual assets and liabilities, are in effect.  In addition, there is an annual process toreview the interest rate risk policy with the board of directors which includeslimits on the impact to earnings from shifts in interest rates.

 

*Interest Rate RiskMeasurement. *Interestrate risk is monitored through the use of three complementary measures: staticgap analysis, earnings at risk simulation and economic value at risksimulation.  While each of the interestrate risk measurements has limitations, taken together they represent areasonably comprehensive view of the magnitude of interest rate risk in theCompany and the distribution of risk along the yield curve, the level of riskthrough time and the amount of exposure to changes in certain interest raterelationships.

 

*Static Gap*.  The ratio between assets and liabilitiesre-pricing in specific time intervals is referred to as an interest ratesensitivity gap.  Interest ratesensitivity gaps can be managed to take advantage of the slope of the yieldcurve as well as forecasted changes in the level of interest rate changes.

 

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To manage this interestrate sensitivity gap position, an asset/liability model commonly known ascumulative gap analysis is used to monitor the difference in the volume of theCompany’s interest sensitive assets and liabilities that mature or re-pricewithin given time intervals.  A positivegap (asset sensitive) indicates that more assets will re-price during a givenperiod compared to liabilities, while a negative gap (liability sensitive) hasthe opposite effect.  The Company employscomputerized net interest income simulation modeling to assist in quantifyinginterest rate risk exposure.  Thisprocess measures and quantifies the impact on net interest income throughvarying interest rate changes and balance sheet compositions.  The use of this model assists the ALCO togauge the effects of the interest rate changes on interest-sensitive assets andliabilities in order to determine what impact these rate changes will have uponthe net interest spread.  At December 31,2008 the Company maintained a one-year cumulative gap of positive $6.8 million,or 1.2%, of total assets.  The effect ofthis gap position provided a mismatch of assets and liabilities which mayexpose the Company to interest rate risk during periods of falling interestrates.  Conversely, in an increasinginterest rate environment, net interest income could be positively impactedbecause more assets than liabilities will re-price upward during the one-yearperiod.

 

Certain shortcomings areinherent in the method of analysis discussed above and presented in the nexttable.  Although certain assets andliabilities may have similar maturities or periods of re-pricing, they may reactin different degrees to changes in market interest rates.  The interest rates on certain types of assetsand liabilities may fluctuate in advance of changes in market interest rates,while interest rates on other types of assets and liabilities may lag behind changesin market interest rates.  Certainassets, such as adjustable-rate mortgages, have features which restrict changesin interest rates on a short-term basis and over the life of the asset.  In the event of a change in interest rates,prepayment and early withdrawal levels may deviate significantly from thoseassumed in calculating the table.  Theability of many borrowers to service their adjustable-rate debt may decrease inthe event of an interest rate increase.

 

The followingtable reflects the re-pricing of the balance sheet or “gap” position at December 31,2008 (dollars in thousands):

 
| ** **                                     | ** ** | **Three months  or less** | ** ** | **Three to  twelve months** | ** ** | **One to  three years** | ** ** | **Over  three years** | ** ** | **Total** | ** ** |
|------------------------------------------------|------------|-------------------------------------|------------|---------------------------------------|------------|-----------------------------------|------------|----------------------------|------------|-----------|------------|
| Cash and cash  equivalents                     |       | $                                   | 176        |                                  | $          | —                            |       | $                          | —     |      | $          | 12,595 |   | $ | 12,771 |   |
| Investment  securities (1)(2)                  |       | 41,429                              |       | 30,169                                |       | 6,517                             |       | 10,854                     |       | 88,969    |       |
| Loans (2)                                      |       | 120,778                             |       | 55,961                                |       | 113,196                           |       | 146,356                    |       | 436,291   |       |
| Fixed and other  assets                        |       | —                              |       | 8,808                                 |       | —                            |       | 28,880                     |       | 37,688    |       |
| Total assets                                   |       | $                                   | 162,383    |                                  | $          | 94,938                            |       | $                          | 119,713    |      | $          | 198,685 |   | $ | 575,719 |   |
| Total cumulative  assets                       |       | $                                   | 162,383    |                                  | $          | 257,321                           |       | $                          | 377,034    |      | $          | 575,719 |   |   |   |
|                                           |       |                                |       |                                  |       |                              |       |                       |       |      |       |
| Non-interest-bearing  transaction deposits (3) |       | $                                   | —     |                                  | $          | 7,146                             |       | $                          | 19,646     |      | $          | 44,651 |   | $ | 71,443 |   |
| Interest-bearing  transaction deposits (3)     |       | 56,325                              |       | —                                |       | 50,504                            |       | 81,363                     |       | 188,192   |       |
| Certificates of  Deposit                       |       | 33,464                              |       | 105,430                               |       | 29,597                            |       | 5,186                      |       | 173,677   |       |
| Repurchase  agreements                         |       | 11,412                              |       | —                                |       | —                            |       | —                     |       | 11,412    |       |
| Short-term  borrowings                         |       | 26,718                              |       | —                                |       | —                            |       | —                     |       | 26,718    |       |
| Long-term debt                                 |       | —                              |       | 10,000                                |       | 21,000                            |       | 21,000                     |       | 52,000    |       |
| Other  liabilities                             |       | —                              |       | —                                |       | —                            |       | 3,316                      |       | 3,316     |       |
| Total  liabilities                             |       | $                                   | 127,919    |                                  | $          | 122,576                           |       | $                          | 120,747    |      | $          | 155,516 |   | $ | 526,758 |   |
| Total cumulative  liabilities                  |       | $                                   | 127,919    |                                  | $          | 250,495                           |       | $                          | 371,242    |      | $          | 526,758 |   |   |   |
|                                           |       |                                |       |                                  |       |                              |       |                       |       |      |       |
| Interest sensitivity  gap                      |       | $                                   | 34,464     |                                  | $          | (27,638                           | )          | $                          | (1,034     | )         | $          | 43,169 |   |   |   |
| Cumulative gap                                 |       | $                                   | 34,464     |                                  | $          | 6,826                             |       | $                          | 5,792      |      | $          | 48,961 |   |   |   |
|                                           |       |                                |       |                                  |       |                              |       |                       |       |      |       |
| Cumulative gap  to total assets                |       | 6.0                                 | %          | 1.2                                   | %          | 1.0                               | %          | 8.5                        | %          |      |       |

 

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| (1)    | Includes  FHLB stock and the net unrealized gains/losses on available-for-sale  securities.                                                                                                                                                                                                                                                                                                                                                                                                       |
|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| (2)    | Investments  and loans are included in the earlier of the period in which interest rates  were next scheduled to adjust or the period in which they are due. In  addition, loans were included in the periods in which they are scheduled to  be repaid based on scheduled amortization. For amortizing loans and  mortgage-backed securities, annual prepayment rates are assumed reflecting  historical experience as well as management’s knowledge and experience of its  loan products. |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| (3)    | The  Company’s demand and savings accounts were generally subject to immediate  withdrawal. However, management considers a certain amount of such accounts  to be core accounts having significantly longer effective maturities based on  the retention                                                                                                                                                                                                                                    |

 

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|   | experiences  of such deposits in changing interest rate environments.  The effective maturities presented are the  recommended maturity distribution limits for non-maturing deposits based on  historical deposit studies. |
|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

*Earnings at Risk and EconomicValue at Risk Simulations*. The Company recognizes that more sophisticated tools exist for measuringthe interest rate risk in the balance sheet that extend beyond staticre-pricing gap analysis.  Although itwill continue to measure its re-pricing gap position, the Company utilizesadditional modeling for identifying and measuring the interest rate risk in theoverall balance sheet.  The ALCO isresponsible for focusing on “earnings at risk” and “economic value at risk”,and how both relate to the risk-based capital position when analyzing theinterest rate risk.

 

*Earnings at Risk*.  Earnings at risk simulation measures thechange in net interest income and net income should interest rates rise andfall.  The simulation recognizes that notall assets and liabilities re-price one-for-one with market rates (e.g.,savings rate).  The ALCO looks at “earningsat risk” to determine income changes from a base case scenario under anincrease and decrease of 200 basis points in interest rate simulation models.

 

*Economic Value at Risk.* Earnings at risk simulation measures theshort-term risk in the balance sheet. Economic value (or portfolio equity) at risk measures the long-term riskby finding the net present value of the future cash flows from the Company’sexisting assets and liabilities.  TheALCO examines this ratio quarterly utilizing an increase and decrease of 200 basispoints in interest rate simulation models. The ALCO recognizes that, in some instances, this ratio may contradictthe “earnings at risk” ratio.

 

The following tableillustrates the simulated impact of an immediate 200 basis points upward ordownward movement in interest rates on net interest income, net income and thechange in the economic value (portfolio equity).  This analysis assumed that interest-earningasset and interest-bearing liability levels at December 31, 2008 remainedconstant.  The impact of the ratemovements was developed by simulating the effect of the rate change over atwelve-month period from the December 31, 2008 levels:

 
| ** **                                             | ** ** | **Rates +200** | ** ** | **Rates -200** | ** ** |
|--------------------------------------------------------|------------|---------------------|------------|---------------------|------------|
|                                                   |       |                |       |                |       |
| Earnings at  risk:                                     |       |                |       |                |       |
| Percent change  in:                                    |       |                |       |                |       |
| Net interest  income                                   |       | 1.3                 | %          | 5.1                 | %          |
| Net income                                             |       | 6.1                 |       | 19.7                |       |
|                                                   |       |                |       |                |       |
| Economic value  at risk:                               |       |                |       |                |       |
| Percent change  in:                                    |       |                |       |                |       |
| Economic value  of equity                              |       | (7.8                | )          | (8.3                | )          |
| Economic value  of equity as a percent of total assets |       | (0.6                | )          | (0.7                | )          |

 

Economic value has themost meaning when viewed within the context of risk-based capital.  Therefore, the economic value may normallychange beyond the Company’s policy guideline for a short period of time as longas the risk-based capital ratio (after adjusting for the excess equity exposure)is greater than 10%.  At December 31,2008, the Company’s risk-based capital ratio was 13.6%.

 

The table belowsummarizes estimated changes in net interest income over a twelve-month periodbeginning January 1, 2009, under alternate interest rate scenarios usingthe income simulation model described above (dollars in thousands):

 
| **Change in interest rates** | ** ** | **Net interest  income** | ** ** | **$  variance** | ** ** | **%  variance** | ** ** |
|---------------------------------------------|------------|-------------------------------|------------|-----------------|------------|-----------------|------------|
|                                        |       |                          |       |            |       |            |       |
| +200 basis  points                          |       | $                             | 19,729     |            | $          | 259             |       | 1.3 | % |
| +100 basis  points                          |       | 19,791                        |       | 321             |       | 1.6             |       |
| Flat rate                                   |       | 19,470                        |       | —          |       | —          |       |
| -100 basis  points                          |       | 20,067                        |       | 597             |       | 3.1             |       |
| -200 basis  points                          |       | 20,454                        |       | 984             |       | 5.1             |       |
|                                             |            |                               |            |                 |            |                 |            |  |  |

 

Simulation models requireassumptions about certain categories of assets and liabilities.  The models schedule existing assets andliabilities by their contractual maturity, estimated likely call date orearliest re-pricing opportunity. Mortgage-backed securities and amortizing loans are scheduled based ontheir anticipated cash flow including estimated prepayments.  For 

 

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investment securities,the Company uses a third-party service to provide cash flow estimates in thevarious rate environments.  Savings, moneymarket and interest-bearing checking accounts do not have a stated maturity orre-pricing term and can be withdrawn or re-price at any time.  This may impact the margin if more expensivealternative sources of deposits are required to fund loans or depositrunoff.  Management projects there-pricing characteristics of these accounts based on historical performanceand assumptions that it believes reflect their rate sensitivity.  The model reinvests all maturities,repayments and prepayments for each type of asset or liability into the sameproduct for a new like term at current product interest rates provided bymanagement.  As a result, the mix ofinterest-earning assets and interest bearing-liabilities is held constant.

 

*Derivative Financial Instruments. *As part of the Company’soverall interest rate risk strategy, the Company has adopted a policy wherebythe Company may periodically use derivative instruments to minimize significantfluctuations in earnings caused by interest rate volatility.  This interest rate risk management strategyentails the use of interest rate floors, caps and swaps.  In October 2006, the Company enteredinto an interest rate floor derivative agreement on $20,000,000 notional valueof its prime-based loan portfolio.  Thepurpose of the hedge is to help protect the Company’s interest income in theevent interest rates decline below a pre-determined contractual interestrate.  The strategy is reflected in thescenarios for earnings and economic value at risk and the net interest incomein the two immediately preceding tables. For a further discussion on the Company’s derivative contract, see Note1, “Nature of operations and summary of significant accounting policies,” andNote 12, “Fair value of financial instruments and derivatives,” containedwithin the notes to consolidated financial statements in Part II, Item 8.

 

***Supervision and Regulation***

 

The following is a briefsummary of the regulatory environment in which the Company and the Bank operateand is not designed to be a complete discussion of all statutes and regulationsaffecting such operations, including those statutes and regulationsspecifically mentioned herein.  Changesin the laws and regulations applicable to the Company and the Bank can affectthe operating environment in substantial and unpredictable ways.  We cannot accurately predict whetherlegislation will ultimately be enacted, and if enacted, the ultimate effectthat legislation or implementing regulations would have on our financialcondition or results of operations. While banking regulations are material to the operations of the Companyand the Bank, it should be noted that supervision, regulation and examinationof the Company and the Bank are intended primarily for the protection ofdepositors, not shareholders.

 

***RecentLegislation***

 

***FinancialServices Regulatory Relief Act of 2006.* **This federal act amends several federalbanking laws to reduce redundant and costly regulatory burden.  Among its many provisions, the act allows thepayment of interest on certain reserve balances of depository institutions thatare held at the Federal Reserve beginning in year 2011, requires bankingregulatory agencies to streamline reports of condition and clarifies theauthority of home and host state regulators with respect to supervision ofinterstate branches.  The act was signedinto law in October 2006.

 

***Federal DepositInsurance Reform Act of 2005 and the Federal Deposit Insurance ReformConforming Amendments Act of 2005.* **These federal acts were signed into lawin February 2006 to amend the Federal Deposit Insurance Act.  These laws enact FDIC and banking industrydeposit insurance reform proposals by amendments including: increasing thecoverage for retirement accounts to $250,000 and indexing the coverage limitfor retirement accounts to inflation as with the general deposit insurancecoverage limit; merging the Bank Insurance Fund (BIF) and the SavingsAssociation Insurance Fund (SAIF) into a new fund, the Deposit Insurance Fund(DIF); establishing a percentage range within which the FDIC Board of Directorsmay set the FDIC’s Designated Reserve Ratio (DRR); allowing the FDIC to managethe pace at which the DRR varies within this range; eliminating therestrictions on premium rates based on the DRR and granting the FDIC Board thediscretion to price deposit insurance according to risk for all insuredinstitutions at all times.

 

***Sarbanes-OxleyAct of 2002.****** ***InJuly, 2002, the Sarbanes-Oxley Act of 2002 was enacted.  The stated goals of the Act are to increasecorporate responsibility, to provide for enhanced penalties for accounting andauditing improprieties at publicly traded companies, and to protect investorsby improving the accuracy and reliability of corporate disclosures pursuant tothe securities laws.

 

The Act is the mostfar-reaching U.S. securities legislation enacted in decades.  The Act generally applies to all companies,both U.S. and non-U.S., that file or are required to file periodic reports withthe Securities and Exchange Commission under the Securities Exchange Act of1934.

 

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The Act includes veryspecific additional disclosure requirements and corporate governance rules,requires the SEC and securities exchanges to adopt extensive additionaldisclosure, corporate governance and other related rules and mandatesfurther studies of certain issues by the SEC. The Act adds new obligations and restrictions on directors and seniorexecutives of public companies, such as requiring certification of financialstatements, and new audit committee procedures. The Act represents significant federal involvement in matterstraditionally left to state regulatory systems such as the regulation of theaccounting profession, and to state corporate law such as the relationshipbetween a board of directors and management and between a board of directorsand its committees.

 

***USA PATRIOT Actof 2001.***  TheUniting and Strengthening America by Providing Appropriate Tools Required toIntercept and Obstruct Terrorism Act of 2001 (USA PATRIOT Act) was signed intolaw in October 2001.  The USAPATRIOT Act broadened the application of anti-money laundering regulations toapply to additional types of financial institutions, such as broker-dealers,and strengthened the ability of the U.S. government to detect and prosecuteinternational money laundering and the financing of terrorism.  The principal provisions of Title III of theUSA PATRIOT Act require that regulated financial institutions, including banks:(1) establish an anti-money laundering program that includes training andaudit components; (2) comply with regulations regarding the verificationof the identity of any person seeking to open an account; (3) takeadditional required precautions with regard to non-U.S. owned accounts; and (4) performcertain verification and certification of money laundering risk for theirforeign correspondent banking relationships. The USA PATRIOT Act also expandedthe conditions under which funds in a U.S. inter-bank account may be subject toforfeiture and increased the penalties for violation of anti-money launderingregulations.  Failure of a financialinstitution to comply with the USA PATRIOT Acts requirements could have seriouslegal and reputational consequences for the institution.  The Bank has adopted policies, procedures andcontrols to address compliance with the requirements of the USA PATRIOT Actunder the existing regulations and will continue to revise and update itspolicies, procedures and controls to reflect changes required by the USAPATRIOT Act and implementing regulations.

 

As part of the USAPATRIOT Act, Congress adopted the International Money Laundering Abatement andFinancial Anti-Terrorism Act of 2001 (IML Act). The IML Act amended the Bank Secrecy Act and adopted certain additionalmeasures that increase the obligation of financial institutions, including theBank, to identify their customers, watch for and report upon suspicious transactions,respond to requests for information by federal banking regulatory authoritiesand law enforcement agencies, and share information with other financialinstitutions.  The Secretary of theTreasury has adopted several regulations to implement these provisions.  The Bank is also barred from dealing withforeign “shell” banks.  In addition, theIML Act expands the circumstances under which funds in a bank account may beforfeited.  The IML Act also amended theBank Holding Company Act and the Bank Merger Act to require the federal bankingregulatory authorities to consider the effectiveness of a financial institution’santi-money laundering activities when reviewing an application to expandoperations.  The Bank has in place a BankSecrecy Act compliance program.

 

***Gramm-Leach-BlileyAct of 1999***.  Thislaw authorized cross-industry affiliations between banks, securities firms,insurance companies and other financial service providers.  This was landmark legislation that repealedthe Glass-Steagall Act which since the 1930’s had prohibited suchaffiliations.  Among other provisions,the Act provided new authority for banks and created a revised framework forregulating affiliated financial services institutions.

 

***Regulation W.****** ***Transactionsbetween a bank and its “affiliates” are quantitatively and qualitativelyrestricted under the Federal Reserve Act. The Federal Deposit Insurance Act applies Sections 23A and 23B toinsured nonmember banks in the same manner and to the same extent as if theywere members of the Federal Reserve System. In 2002, the Federal Reserve Board issued Regulation W, whichbecame effective in 2003.  Regulation Wcodifies prior regulations under Sections 23A and 23B of the FederalReserve Act and interpretative guidance with respect to affiliate transactions.

 

Regulation Wincorporates the exemption from the affiliate transaction rules butexpands the exemption to cover the purchase of any type of loan or extension ofcredit from an affiliate.  Affiliates ofa bank include, among other entities, the Bank’s holding company and companiesthat are under common control with the Bank. The Company is considered to be an affiliate of the Bank.

 

***Federal and State Legislation***

 

From time-to-time, various types of federal and state legislation havebeen proposed that could result in additional regulations and restrictions onthe business of the Company and the Bank. We cannot predict whether legislation will be adopted, or if adopted,how the new laws would affect our business. As a consequence, we are susceptible to legislation that may increasethe cost of doing business.  Managementbelieves that the effect of any current legislative proposals on the liquidity,capital resources and the results of operations of the Company and the Bankwill be minimal.

 

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It is possible that therewill be regulatory proposals which, if implemented, could have a materialeffect upon our liquidity, capital resources and results of operations.  In addition, the general cost of compliancewith numerous federal and state laws does have, and in the future may have, anegative impact on our results of operations. As with other banks, the status of the financial services industry canaffect the Bank.  Consolidations ofinstitutions are expected to continue as the financial services industry seeksgreater efficiencies and market share. Bank management believes that such consolidations may enhance the Bank’scompetitive position as a community bank.

 

***Recent Developments***

 

The global and U.S.economies are experiencing significantly reduced business activity as a resultof, among other factors, disruptions in the financial system during the pastyear. Dramatic declines in the housing market during the past year, withfalling home prices and increasing foreclosures and unemployment, have resultedin significant write-downs of asset values by financial institutions, includinggovernment-sponsored entities and major commercial and investment banks. Thesewrite-downs, initially of mortgage-backed securities but spreading to creditdefault swaps and other derivative securities have caused many financialinstitutions to seek additional capital, to merge with larger and strongerinstitutions and, in some cases, to fail.

 

Reflecting concern aboutthe stability of the financial markets generally and the strength ofcounterparties, many lenders and institutional investors have reduced, and in somecases, ceased to provide funding to borrowers, including other financialinstitutions. The availability of credit, confidence in the financial sector,and level of volatility in the financial markets have been significantlyadversely affected as a result. In recent weeks, volatility and disruption inthe capital and credit markets has reached unprecedented levels. In some cases,the markets have produced downward pressure on stock prices and credit capacityfor certain issuers without regard to those issuers’ underlying financialstrength.

 

In response to thefinancial crises affecting the banking system and financial markets and goingconcern threats to investment banks and other financial institutions, on October 3,2008, the Emergency Economic Stabilization Act of 2008 (the “EESA”) was signedinto law. Pursuant to the EESA, the U.S. Treasury will have the authority to,among other things, purchase up to $700 billion of mortgages, mortgage-backedsecurities and certain other financial instruments from financial institutionsfor the purpose of stabilizing and providing liquidity to the U.S. financialmarkets.  The EESA included a provisionfor a temporary increase in FDIC insurance from $100,000 to $250,000 per depositorthrough December 31, 2009.

 

On October 14, 2008,Secretary Paulson, after consulting with the Federal Reserve and the FDIC,announced that the Department of the Treasury will purchase equity stakes in awide variety of banks and thrifts. Under this program, known as the TroubledAsset Relief Program (“TARP”) Capital Purchase Program, from the $700 billionauthorized by the EESA, the Treasury will make $250 billion of capitalavailable to U.S. financial institutions in the form of preferred stock. Inconjunction with the purchase of preferred stock, the Treasury will receivewarrants to purchase common stock with an aggregate market price equal to 15%of the preferred investment. Participating financial institutions will berequired to adopt the Treasury’s standards for executive compensation andcorporate governance for the period during which the Treasury holds equityissued under TARP Capital Purchase Program.

 

Also on October 14,2008, after receiving a recommendation from the boards of the FDIC and theFederal Reserve, and consulting with the President, Secretary Paulson signedthe systemic risk exception to the FDIC Act, enabling the FDIC to temporarilyprovide a 100% guarantee of the senior debt of all FDIC-insured institutionsand their holding companies, as well as deposits in non-interest bearingtransaction deposit accounts under a Temporary Liquidity Guarantee Program.Coverage under the Temporary Liquidity Guarantee Program is available until November 12,2008 without charge and thereafter at a cost of 75 basis points per annum forsenior unsecured debt and 10 basis points per annum for non-interest bearingtransaction deposits.

 

It is not clear at thistime what impact the EESA, TARP Capital Purchase Program, the TemporaryLiquidity Guarantee Program, other liquidity and funding initiatives of theFederal Reserve and other agencies that have been previously announced, and anyadditional programs that may be initiated in the future will have on thefinancial markets and the other difficulties described above, including theextreme levels of volatility and limited credit availability currently beingexperienced, or on the U.S. banking and financial industries and the broaderU.S. and global economies. Further adverse effects could have an adverse effecton the Corporation and its business.

 

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***FutureOutlook***

 

Based upon the current uncertain economic outlook andinability to predict when and by how much interest rates will change andwhether rates will continue to fall or rise, the Company recognizes that thereare challenges ahead.  The Company isprepared to meet the challenges and effects of a volatile interest rateenvironment.  Management believes that asignificant impact on earnings depends on its ability to react to changes ininterest rates.

 

The Company will continue to monitor interest ratesensitivity of its interest-earning assets and interest-bearing liabilities tominimize any adverse effects on future earnings.  The Company’s commitment to remain acommunity based organization is very strong. Our intention is to recognize a steady disciplined growth in the loanportfolios while increasing our base of core deposits.  Review and implementation of policies andprocedures along with adding innovative products and services willcontinue.  These steps are designed toprovide the Company with stability and the means to provide customer serviceand increase shareholder value.

 

***Item 7A:QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK***

 

# The informationrequired by 7A is set forth at Item 7, under “Liquidity” and “Management ofinterest rate risk and market risk analysis,” contained within management’sdiscussion and analysis of financial condition and results of operations andincorporated herein by reference.

 

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## ***Item 8:  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA***

##  

 

### **Report Of Independent Registered Public Accounting Firm**

###  

Board of Directors andShareholders

Fidelity D & DBancorp, Inc.:

 

Wehave audited the accompanying consolidated balance sheets of Fidelity D &D Bancorp, Inc. and Subsidiary as of December 31, 2008 and 2007 andthe related consolidated statements of income, changes in shareholders’ equityand cash flows for each of the years in the three-year period ended December 31,2008. These financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financialstatements based on our audits.

 

We conducted our audit inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free of materialmisstatement. The Company is not required to have, nor were we engaged toperform, an audit of its internal control over financial reporting. Our auditincluded consideration of internal control over financial reporting as a basisfor designing audit procedures that are appropriate in the circumstances, butnot for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting. Accordingly, we express nosuch opinion. An audit also includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements, assessingthe accounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audit provides a reasonable basis for our opinion.

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Fidelity D & D Bancorp, Inc.and Subsidiary as of December 31, 2008 and 2007, and the results of theiroperations and their cash flows for each of the years in the three-year periodended December 31, 2008 in conformity with accounting principles generallyaccepted in the United States of America.

 

****

 

Scranton, Pennsylvania

March 6, 2009

 

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**FIDELITYD & D BANCORP, INC. AND SUBSIDIARY**

 

ConsolidatedBalance Sheets

As of December 31, 2008and 2007

 
| ** **                                                                                                                                                                           | ** ** | **2008**    | ** **  | **2007**    | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------|-------------|-------------|------------|
|                                                                                                                                                                                 |       |        |        |        |       |
| Assets:                                                                                                                                                                              |       |        |        |        |       |
| Cash and due  from banks                                                                                                                                                             |       | $           | 12,335,905  |        | $          | 10,204,714 |   |
| Interest-bearing  deposits with financial institutions                                                                                                                               |       | 435,242     |        | 204,102     |       |
|                                                                                                                                                                                 |       |        |        |        |       |
| Total cash and  cash equivalents                                                                                                                                                     |       | 12,771,147  |        | 10,408,816  |       |
|                                                                                                                                                                                 |       |        |        |        |       |
| Available-for-sale  securities                                                                                                                                                       |       | 83,278,132  |        | 121,836,851 |       |
| Held-to-maturity  securities                                                                                                                                                         |       | 909,447     |        | 1,147,309   |       |
| Federal Home  Loan Bank Stock                                                                                                                                                        |       | 4,781,100   |        | 3,302,900   |       |
| Loans and  leases, net (allowance for loan losses of $4,745,234 in 2008; $4,824,401in  2007)                                                                                         |       | 436,207,460 |        | 421,424,379 |       |
| Loans  available-for-sale (fair value $85,312 in 2008; $842,923 in 2007)                                                                                                             |       | 84,000      |        | 827,250     |       |
| Bank premises  and equipment, net                                                                                                                                                    |       | 16,056,362  |        | 12,964,932  |       |
| Cash surrender  value of bank owned life insurance                                                                                                                                   |       | 8,807,784   |        | 8,488,663   |       |
| Other assets                                                                                                                                                                         |       | 8,929,917   |        | 4,403,723   |       |
| Accrued interest  receivable                                                                                                                                                         |       | 2,443,141   |        | 2,500,696   |       |
| Foreclosed  assets held-for-sale                                                                                                                                                     |       | 1,450,507   |        | 107,036     |       |
|                                                                                                                                                                                 |       |        |        |        |       |
| Total assets                                                                                                                                                                         |       | $           | 575,718,997 |        | $          | 587,412,555 |   |
|                                                                                                                                                                                 |       |        |        |        |       |
| Liabilities:                                                                                                                                                                         |       |        |        |        |       |
| Deposits:                                                                                                                                                                            |       |        |        |        |       |
| Interest-bearing                                                                                                                                                                     |       | $           | 361,869,281 |        | $          | 360,912,740 |   |
| Non-interest-bearing                                                                                                                                                                 |       | 71,442,651  |        | 64,795,621  |       |
|                                                                                                                                                                                 |       |        |        |        |       |
| Total deposits                                                                                                                                                                       |       | 433,311,932 |        | 425,708,361 |       |
|                                                                                                                                                                                 |       |        |        |        |       |
| Accrued interest  payable and other liabilities                                                                                                                                      |       | 3,316,710   |        | 4,147,869   |       |
| Short-term  borrowings                                                                                                                                                               |       | 38,129,704  |        | 39,656,354  |       |
| Long-term debt                                                                                                                                                                       |       | 52,000,000  |        | 62,708,677  |       |
|                                                                                                                                                                                 |       |        |        |        |       |
| Total  liabilities                                                                                                                                                                   |       | 526,758,346 |        | 532,221,261 |       |
|                                                                                                                                                                                 |       |        |        |        |       |
| Shareholders’  equity:                                                                                                                                                          |       |        |        |        |       |
| Preferred stock  authorized 5,000,000 shares with no par value; none issued                                                                                                          |       | —      |        | —      |       |
| Capital stock,  no par value (10,000,000 shares authorized; 2,075,182 shares issued and  2,062,927 shares outstanding in 2008; 2,072,929 shares issued and  outstanding in 2007 |       | 19,410,306  |        | 19,223,363  |       |
| Treasury stock,  at cost (12,255 shares in 2008, none in 2007)                                                                                                                       |       | (351,665    | )           | —      |       |
| Retained  earnings                                                                                                                                                                   |       | 38,126,250  |        | 36,564,157  |       |
| Accumulated  other comprehensive loss                                                                                                                                                |       | (8,224,240  | )           | (596,226    | )          |
|                                                                                                                                                                                 |       |        |        |        |       |
| Total  shareholders’ equity                                                                                                                                                     |       | 48,960,651  |        | 55,191,294  |       |
|                                                                                                                                                                                 |       |        |        |        |       |
| Total liabilities  and shareholders’ equity                                                                                                                                     |       | $           | 575,718,997 |        | $          | 587,412,555 |   |

 

See notes to consolidatedfinancial statements

 

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**FIDELITY D & D BANCORP, INC.AND SUBSIDIARY**

 

Consolidated Statements ofIncome

For the years ended December 31, 2008,2007 and 2006

 
| ** **                                                    | ** ** | **2008**   | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|---------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
|                                                          |       |       |       |       |       |       |       |
| Interest income:                                              |       |       |       |       |       |       |       |
| Loans and  leases:                                            |       |       |       |       |       |       |       |
| Taxable                                                       |       | $          | 27,194,191 |       | $          | 28,765,640 |       | $ | 27,681,779 |   |
| Nontaxable                                                    |       | 370,097    |       | 469,389    |       | 445,527    |       |
| Interest-bearing  deposits with financial institutions        |       | 3,173      |       | 8,865      |       | 9,166      |       |
| Investment  securities:                                       |       |       |       |       |       |       |       |
| U.S. government  agency and corporations                      |       | 4,408,437  |       | 4,264,152  |       | 3,738,995  |       |
| States and  political subdivisions (nontaxable)               |       | 648,000    |       | 498,335    |       | 590,558    |       |
| Other securities                                              |       | 1,246,403  |       | 1,170,063  |       | 940,467    |       |
| Federal funds  sold                                           |       | 91,133     |       | 102,913    |       | 123,218    |       |
|                                                          |       |       |       |       |       |       |       |
| Total interest  income                                        |       | 33,961,434 |       | 35,279,357 |       | 33,529,710 |       |
|                                                          |       |       |       |       |       |       |       |
| Interest  expense:                                            |       |       |       |       |       |       |       |
| Deposits                                                      |       | 11,118,194 |       | 13,369,992 |       | 11,492,827 |       |
| Securities sold  under repurchase agreements                  |       | 102,577    |       | 465,391    |       | 623,902    |       |
| Other short-term  borrowings and other                        |       | 276,407    |       | 504,972    |       | 377,958    |       |
| Long-term debt                                                |       | 3,186,955  |       | 3,319,720  |       | 3,866,422  |       |
|                                                          |       |       |       |       |       |       |       |
| Total interest  expense                                       |       | 14,684,133 |       | 17,660,075 |       | 16,361,109 |       |
|                                                          |       |       |       |       |       |       |       |
| Net interest  income                                          |       | 19,277,301 |       | 17,619,282 |       | 17,168,601 |       |
|                                                          |       |       |       |       |       |       |       |
| Provision  (credit) for loan losses                           |       | 940,000    |       | (60,000    | )          | 325,000    |       |
|                                                          |       |       |       |       |       |       |       |
| Net interest  income after provision (credit) for loan losses |       | 18,337,301 |       | 17,679,282 |       | 16,843,601 |       |
|                                                          |       |       |       |       |       |       |       |
| Other income:                                                 |       |       |       |       |       |       |       |
| Service charges  on deposit accounts                          |       | 2,901,156  |       | 3,007,365  |       | 2,631,859  |       |
| Gain (loss) on  sale or disposal of:                          |       |       |       |       |       |       |       |
| Loans                                                         |       | 260,940    |       | 159,441    |       | 97,848     |       |
| Investment  securities                                        |       | 25,428     |       | 79         |       | 1,200      |       |
| Premises and  equipment                                       |       | (35,658    | )          | 97,518     |       | (19,654    | )          |
| Foreclosed  assets held-for-sale                              |       | 43,199     |       | 143,559    |       | (3,390     | )          |
| Leased assets                                                 |       | —     |       | —     |       | 15,154     |       |
| Other-than-temporary  impairment on securities                |       | (435,665   | )          | —     |       | —     |       |
| Fees and other  service charges                               |       | 1,818,901  |       | 1,797,253  |       | 1,799,121  |       |
|                                                          |       |       |       |       |       |       |       |
| Total other  income                                           |       | 4,578,301  |       | 5,205,215  |       | 4,522,138  |       |
|                                                          |       |       |       |       |       |       |       |
| Other expenses:                                               |       |       |       |       |       |       |       |
| Salaries and  employee benefits                               |       | 9,869,866  |       | 8,705,698  |       | 8,328,407  |       |
| Premises and  equipment                                       |       | 3,251,453  |       | 3,156,372  |       | 3,144,669  |       |
| Advertising                                                   |       | 717,685    |       | 684,732    |       | 540,543    |       |
| Other                                                         |       | 4,371,679  |       | 4,089,958  |       | 3,864,757  |       |
|                                                          |       |       |       |       |       |       |       |
| Total other  expenses                                         |       | 18,210,683 |       | 16,636,760 |       | 15,878,376 |       |
|                                                          |       |       |       |       |       |       |       |
| Income before  provision for income taxes                     |       | 4,704,919  |       | 6,247,737  |       | 5,487,363  |       |
|                                                          |       |       |       |       |       |       |       |
| Provision for  income taxes                                   |       | 1,068,971  |       | 1,636,165  |       | 1,362,080  |       |
|                                                          |       |       |       |       |       |       |       |
| Net income                                                    |       | $          | 3,635,948  |       | $          | 4,611,572  |       | $ | 4,125,283 |   |
|                                                          |       |       |       |       |       |       |       |
| Per share data:                                               |       |       |       |       |       |       |       |
| Net income—basic                                         |       | $          | 1.76       |       | $          | 2.23       |       | $ | 2.01 |   |
| Net  income—diluted                                      |       | $          | 1.76       |       | $          | 2.23       |       | $ | 2.01 |   |
| Dividends                                                     |       | $          | 1.00       |       | $          | 0.93       |       | $ | 0.88 |   |

 

See notes toconsolidated financial statements

 

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**FIDELITYD & D BANCORP, INC. AND SUBSIDIARY**

 

Consolidated Statements of Changes in Shareholders’ Equity

Forthe years ended December 31, 2008, 2007 and 2006

 
| ** **                                                                                                                     | ** ** | ** **             | ** ** | ** **              | ** ** | ** **   | ** ** | ** **        | ** ** | ** **   | ** ** | **Accumulated**        | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-------------------------|------------|--------------|------------|-------------------|------------|--------------|------------|------------------------|------------|------------|------------|
| ** **                                                                                                                     | ** ** | ** **             | ** ** | ** **              | ** ** | ** **   | ** ** | ** **        | ** ** | ** **   | ** ** | **other**              | ** ** | ** ** | ** ** |
| ** **                                                                                                                     | ** ** | **Capital stock** | ** ** | **Treasury stock** | ** ** | **Retained** | ** ** | **comprehensive** | ** ** | ** **   | ** ** |
| ** **                                                                                                                     | ** ** | **Shares**             | ** ** | **Amount**              | ** ** | **Shares**   | ** ** | **Amount**        | ** ** | **earnings** | ** ** | **income (loss)** | ** ** | **Total**  | ** ** |
|                                                                                                                           |       |                   |       |                    |       |         |       |              |       |         |       |                   |       |       |       |
| Balance,  December 31, 2005                                                                                               |       | 1,854,217              |       | $                       | 10,594,901 |         | —     |              | $          | —       |       | $                      | 39,363,461 |       | $          | (1,112,333 | ) | $ | 48,846,029 |   |
| Cumulative effect  adjustments                                                                                                 |       |                   |       |                    |       |         |       |              |       | (343,717     | )          |                   |       | (343,717   | )          |
| Total  comprehensive income:                                                                                                   |       |                   |       |                    |       |         |       |              |       |         |       |                   |       |       |       |
| Net income                                                                                                                     |       |                   |       |                    |       |         |       |              |       | 4,125,283    |       |                   |       | 4,125,283  |       |
| Change in net  unrealized holding losses on available-for-sale securities, net of  reclassification adjustment and tax effects |       |                   |       |                    |       |         |       |              |       |         |       | 146,624                |       | 146,624    |       |
| Change in cash  flow hedge intrinsic value                                                                                     |       |                   |       |                    |       |         |       |              |       |         |       | 917                    |       | 917        |       |
| Comprehensive  income                                                                                                          |       |                   |       |                    |       |         |       |              |       |         |       |                   |       | 4,272,824  |       |
| Issuance of  common stock through Employee Stock Purchase Plan                                                                 |       | 1,571                  |       | 48,151                  |       |         |       |              |       |         |       |                   |       | 48,151     |       |
| Dividends  reinvested through Dividend Reinvestment Plan                                                                       |       | 16,251                 |       | 568,641                 |       |         |       |              |       |         |       |                   |       | 568,641    |       |
| Stock-based  compensation expense                                                                                              |       |                   |       | 28,744                  |       |         |       |              |       |         |       |                   |       | 28,744     |       |
| Cash dividends  declared                                                                                                       |       |                   |       |                    |       |         |       |              |       | (1,801,361   | )          |                   |       | (1,801,361 | )          |
| Stock dividend  declared                                                                                                       |       | 185,394                |       | 7,462,100               |       |         |       |              |       | (7,469,548   | )          |                   |       | (7,448     | )          |
|                                                                                                                           |       |                   |       |                    |       |         |       |              |       |         |       |                   |       |       |       |
| Balance,  December 31, 2006                                                                                               |       | 2,057,433              |       | 18,702,537              |       | —       |       | —            |       | 33,874,118   |       | (964,792               | )          | 51,611,863 |       |
| Total  comprehensive income:                                                                                                   |       |                   |       |                    |       |         |       |              |       |         |       |                   |       |       |       |
| Net income                                                                                                                     |       |                   |       |                    |       |         |       |              |       | 4,611,572    |       |                   |       | 4,611,572  |       |
| Change in net  unrealized holding losses on available-for-sale securities, net of  reclassification adjustment and tax effects |       |                   |       |                    |       |         |       |              |       |         |       | (16,258                | )          | (16,258    | )          |
| Change in cash  flow hedge intrinsic value                                                                                     |       |                   |       |                    |       |         |       |              |       |         |       | 384,824                |       | 384,824    |       |
| Comprehensive  income                                                                                                          |       |                   |       |                    |       |         |       |              |       |         |       |                   |       | 4,980,138  |       |
| Issuance of  common stock through Employee Stock Purchase Plan                                                                 |       | 2,266                  |       | 67,820                  |       |         |       |              |       |         |       |                   |       | 67,820     |       |
| Dividends  reinvested through Dividend Reinvestment Plan                                                                       |       | 13,230                 |       | 437,145                 |       |         |       |              |       |         |       |                   |       | 437,145    |       |
| Stock-based  compensation expense                                                                                              |       |                   |       | 15,861                  |       |         |       |              |       |         |       |                   |       | 15,861     |       |
| Cash dividends  declared                                                                                                       |       |                   |       |                    |       |         |       |              |       | (1,921,533   | )          |                   |       | (1,921,533 | )          |
|                                                                                                                           |       |                   |       |                    |       |         |       |              |       |         |       |                   |       |       |       |
| Balance,  December 31, 2007                                                                                               |       | 2,072,929              |       | 19,223,363              |       | —       |       | —            |       | 36,564,157   |       | (596,226               | )          | 55,191,294 |       |
| Total  comprehensive loss:                                                                                                     |       |                   |       |                    |       |         |       |              |       |         |       |                   |       |       |       |
| Net income                                                                                                                     |       |                   |       |                    |       |         |       |              |       | 3,635,948    |       |                   |       | 3,635,948  |       |
| Change in net  unrealized holding losses on available-for-sale securities, net of  reclassification adjustment and tax effects |       |                   |       |                    |       |         |       |              |       |         |       | (7,848,766             | )          | (7,848,766 | )          |
| Change in cash  flow hedge intrinsic value                                                                                     |       |                   |       |                    |       |         |       |              |       |         |       | 220,752                |       | 220,752    |       |
| Comprehensive  loss                                                                                                            |       |                   |       |                    |       |         |       |              |       |         |       |                   |       | (3,992,066 | )          |
| Issuance of  common stock through Employee Stock Purchase Plan                                                                 |       | 2,253                  |       | 57,891                  |       |         |       |              |       |         |       |                   |       | 57,891     |       |
| Dividends  reinvested through Dividend Reinvestment Plan                                                                       |       |                   |       |                    |       | 2,745        |       | 78,770            |       | (5,175       | )          |                   |       | 73,595     |       |
| Stock-based  compensation expense                                                                                              |       |                   |       | 129,052                 |       |         |       |              |       |         |       |                   |       | 129,052    |       |
| Purchase of  treasury stock                                                                                                    |       |                   |       |                    |       | (15,000      | )          | (430,435          | )          |         |       |                   |       | (430,435   | )          |
| Cash dividends  declared                                                                                                       |       |                   |       |                    |       |         |       |              |       | (2,068,680   | )          |                   |       | (2,068,680 | )          |
| Balance,  December 31, 2008                                                                                               |       | 2,075,182              |       | $                       | 19,410,306 |         | (12,255    | )                 | $          | (351,665     | )          | $                      | 38,126,250 |       | $          | (8,224,240 | ) | $ | 48,960,651 |   |

 

Seenotes to consolidated financial statements

 

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**FIDELITYDEPOSIT & DISCOUNT BANCORP, INC. AND SUBSIDIARY**

 

ConsolidatedStatements of Cash Flows

For the yearsended December 31, 2008, 2007 and 2006

 
| ** **                                                                         | ** ** | **2008**    | ** ** | **2007**    | ** ** | **2006**    | ** ** |
|------------------------------------------------------------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|
| Cash flows from  operating activities:                                             |       |        |       |        |       |        |       |
| Net income                                                                         |       | $           | 3,635,948  |        | $          | 4,611,572   |       | $ | 4,125,283 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |        |       |        |       |        |       |
| Depreciation,  amortization and accretion                                          |       | 611,429     |       | 1,130,274   |       | 1,349,990   |       |
| Provision  (credit) for loan losses                                                |       | 940,000     |       | (60,000     | )          | 325,000     |       |
| Deferred income tax  (benefit) expense                                             |       | (2,941      | )          | 78,838      |       | (75,003     | )          |
| Stock-based  compensation expense                                                  |       | 129,052     |       | 15,861      |       | 28,744      |       |
| Loss from  investment in limited partnership                                       |       | 80,400      |       | 80,400      |       | 80,000      |       |
| Proceeds from  sale of loans available-for-sale                                    |       | 47,230,437  |       | 16,399,530  |       | 12,573,745  |       |
| Originations of  loans available-for-sale                                          |       | (14,754,219 | )          | (16,945,339 | )          | (12,169,313 | )          |
| Increase in cash  surrender value of life insurance                                |       | (319,121    | )          | (310,702    | )          | (286,063    | )          |
| Net gain on sale  of loans                                                         |       | (260,940    | )          | (159,441    | )          | (97,848     | )          |
| Net gain on sale  of investment securities                                         |       | (25,428     | )          | (79         | )          | (1,200      | )          |
| Net (gain) loss  on sale of foreclosed assets held-for-sale                        |       | (43,199     | )          | (143,559    | )          | 3,390       |       |
| Net loss (gain)  on disposal of equipment                                          |       | 35,658      |       | (97,518     | )          | 19,654      |       |
| Other-than-temporary  impairment on securities                                     |       | 435,665     |       | —      |       | —      |       |
| Change in:                                                                         |       |        |       |        |       |        |       |
| Accrued interest  receivable                                                       |       | 48,394      |       | 1,880       |       | (542,750    | )          |
| Other assets                                                                       |       | (1,122,487  | )          | (8,933      | )          | (385,141    | )          |
| Accrued interest  payable and other liabilities                                    |       | (829,539    | )          | (29,680     | )          | 922,747     |       |
|                                                                               |       |        |       |        |       |        |       |
| Net cash  provided by operating activities                                         |       | 35,789,109  |       | 4,563,104   |       | 5,871,235   |       |
|                                                                               |       |        |       |        |       |        |       |
| Cash flows from  investing activities:                                             |       |        |       |        |       |        |       |
| Held-to-maturity  securities:                                                      |       |        |       |        |       |        |       |
| Proceeds from  maturities, calls and principal pay-downs                           |       | 237,303     |       | 421,096     |       | 424,880     |       |
| Available-for-sale  securities:                                                    |       |        |       |        |       |        |       |
| Proceeds from  sales                                                               |       | 48,402,457  |       | 3,818,914   |       | 19,554,141  |       |
| Proceeds from  maturities, calls and principal pay-downs                           |       | 31,969,469  |       | 12,001,895  |       | 24,445,735  |       |
| Purchases                                                                          |       | (53,111,087 | )          | (38,399,150 | )          | (46,996,118 | )          |
| Net (increase)  decrease in FHLB stock                                             |       | (1,478,200  | )          | 492,200     |       | 833,100     |       |
| Net increase in  loans and leases                                                  |       | (48,759,407 | )          | (4,517,367  | )          | (14,619,300 | )          |
| Acquisition of  bank premises and equipment                                        |       | (3,950,934  | )          | (2,939,866  | )          | (1,723,928  | )          |
| Proceeds from  sale of bank premises and equipment                                 |       | 600         |       | 453,186     |       | 1,560       |       |
| Proceeds from  sale of foreclosed assets held-for-sale                             |       | 262,406     |       | 584,088     |       | 55,890      |       |
|                                                                               |       |        |       |        |       |        |       |
| Net cash used in  investing activities                                             |       | (26,427,393 | )          | (28,085,004 | )          | (18,024,040 | )          |
|                                                                               |       |        |       |        |       |        |       |
| Cash flows from  financing activities:                                             |       |        |       |        |       |        |       |
| Net increase in  deposits                                                          |       | 7,603,571   |       | 15,373,765  |       | 30,835,955  |       |
| Net (decrease)  increase in short-term borrowings                                  |       | (1,526,650  | )          | 6,000,204   |       | 4,883,153   |       |
| Proceeds from  long-term debt advances                                             |       | —      |       | 20,000,000  |       | 16,000,000  |       |
| Repayments of  long-term debt                                                      |       | (10,708,677 | )          | (19,827,533 | )          | (37,167,978 | )          |
| Proceeds from  employee stock purchase plan                                        |       | 57,891      |       | 67,820      |       | 48,151      |       |
| Dividends paid,  net of dividends reinvested                                       |       | (1,995,085  | )          | (1,484,388  | )          | (1,232,720  | )          |
| Purchase of treasury  stock                                                        |       | (430,435    | )          | —      |       | —      |       |
| Cash payments in  lieu of fractional shares on stock dividend                      |       | —      |       | —      |       | (7,448      | )          |
|                                                                               |       |        |       |        |       |        |       |
| Net cash (used  in) provided by financing activities                               |       | (6,999,385  | )          | 20,129,868  |       | 13,359,113  |       |
|                                                                               |       |        |       |        |       |        |       |
| Net increase  (decrease) in cash and cash equivalents                              |       | 2,362,331   |       | (3,392,032  | )          | 1,206,308   |       |
|                                                                               |       |        |       |        |       |        |       |
| Cash and cash  equivalents, beginning                                              |       | 10,408,816  |       | 13,800,848  |       | 12,594,540  |       |
|                                                                               |       |        |       |        |       |        |       |
| Cash and cash  equivalents, ending                                                 |       | $           | 12,771,147 |        | $          | 10,408,816  |       | $ | 13,800,848 |   |

 

Seenotes to consolidated financial statements

 

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**FIDELITY D & D BANCORP, INC.**

**AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

**1.****             ****NATURE OF OPERATIONS AND SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES**

# ** **

# **PRINCIPLESOF CONSOLIDATION**

 

The accompanyingconsolidated financial statements include the accounts of Fidelity D &D Bancorp, Inc. and its wholly-owned subsidiary, The Fidelity Deposit andDiscount Bank (the Bank) (collectively, the Company).  All significant inter-company balances andtransactions have been eliminated in consolidation.

 

**NATURE OFOPERATIONS**

 

The Company provides avariety of financial services to individuals and corporate customers inLackawanna and Luzerne Counties, Pennsylvania. This region has a diversified and fairly stable economy.  The Company’s primary deposit products arechecking accounts, savings accounts, NOW accounts, money market depositaccounts and certificates of deposit accounts. Its primary lending products are single-family residential loans,secured consumer loans and secured loans to businesses.  In addition to these traditional bankingservices, the Company also provides asset management, investment and trustservices.

 

Although the Company hasa diversified loan portfolio, a substantial portion of its debtors’ ability tohonor their contracts is dependent on the economic sector in which the Companyoperates.  While management usesavailable information to recognize losses on loans, leases and foreclosedassets, future additions to the allowance for loan losses and foreclosed assetsmay be necessary based on changes in local economic conditions.  In addition, regulatory agencies, as anintegral part of their examination process, periodically review the Company’sallowance.  Such agencies may require theCompany to recognize additions to the allowance based on their judgments aboutinformation available to them at the time of their examination.  Because of these factors, it is reasonablypossible that the allowance for loan losses and foreclosed assets may changematerially in the near future.

 

# **USE OFESTIMATES**

 

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period.  Actual results coulddiffer from those estimates.

 

Material estimates thatare particularly susceptible to significant change relate to the determinationof the allowance for loan losses, the valuation of real estate acquired inconnection with foreclosures or in satisfaction of loans and fair value pricingof the investment securities portfolio. In connection with the determination of allowance for losses on loansand foreclosed real estate, management obtains independent appraisals forproperties.

 

**HELD-TO-MATURITYSECURITIES**

 

Debt securities, forwhich the Company has the positive intent and ability to hold to maturity, arereported at cost.  Premiums and discountsare amortized or accreted, as a component of interest income, over the life ofthe related security as an adjustment to yield using the interest method.

 

**TRADINGSECURITIES**

 

Debt and equitysecurities held principally for resale in the near-term are recorded at theirfair values.  Unrealized gains and lossesare included in other income.  The Companydid not have any investment securities held for trading purposes during 2008,2007 or 2006.

 

**AVAILABLE-FOR-SALE SECURITIES**

 

Available-for-sale(AFS) securities consist of debt and equity securities not classified as eitherheld-to-maturity securities or trading securities and are reported at fairvalue.  Premiums and discounts areamortized or accreted as a component of interest income over the life of therelated security as an adjustment to yield using the interest method.  

 

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Unrealizedholding gains and losses on AFS securities are reported as a separate componentof shareholders’ equity, net of deferred income taxes, until realized.  The net unrealized holding gains and lossesare a component of accumulated other comprehensive (loss) income.  Gains and losses from sales of securities AFSare determined using the specific identification method.

 

**FEDERAL HOMELOAN BANK STOCK**

 

Investment in FederalHome Loan Bank stock is required for membership in the organization and iscarried at cost since there is no market value available.  The Company is required to maintain aninvestment in the stock based upon the level of its outstanding borrowings.

 

**LOANS**

 

Loansthat management has the intent and ability to hold for the foreseeable futureor until maturity or payoff are stated at face value, net of unamortized loanfees and costs and the allowance for loan losses.  Interest on residential real estate loans isrecorded on an amortized schedule. Commercial loan interest is accrued on the principal balance on anactual day basis.  Interest on consumerloans is determined using the simple interest method.

 

Loansare generally placed on non-accrual status when principal or interest is pastdue 90 days or more.  When a loan isplaced on non-accrual status, all interest previously accrued but not collectedis charged against current income.  Anypayments received on non-accrual loans are applied, first to the outstandingloan amounts, then to the recovery of any charged-off loan amounts.  Any excess is treated as a recovery of lostinterest.

 

**LOANSAVAILABLE-FOR-SALE**

 

Loansoriginated and intended for sale in the secondary market are carried at thelower of cost or estimated fair value in the aggregate.  Net unrealized losses are recognized througha valuation allowance by charges to income. Unrealized gains are recognized but only to the extent of previouswrite-downs.

 

**ALLOWANCEFOR LOAN LOSSES**

 

The allowance for loanlosses is established through a provision for loan losses.  The allowance represents an amount which, inmanagement’s judgment, will be adequate to absorb losses on existing loans andleases that may become uncollectible. Management’s judgment in determining the adequacy of the allowance isbased on evaluations of the collectability of the loans.  These evaluations take into considerationsuch factors as changes in the nature and volume of the loan portfolio, currenteconomic conditions that may affect the borrower’s ability to pay, collateralvalue, overall portfolio quality and review of specific loans forimpairment.  Loans considereduncollectible are charged against the allowance.  Recoveries on loans previously charged offare added to the allowance.

 

A loanis considered impaired when, based on current information and events, it isprobable that the Company will be unable to collect the scheduled payments inaccordance with the contractual terms of the loan.  Factors considered in determining impairmentinclude payment status, collateral value and the probability of collectingpayments when due.  The significance ofpayment delays and/or shortfalls is determined on a case by case basis.  All circumstances surrounding the loan aretaken into account.  Such factors includethe length of the delinquency, the underlying reasons and the borrower’s priorpayment record.  Impairment is measuredon these loans on a loan by loan basis.

 

The Company currentlyemploys the Federal Financial Institutions Examination Council InteragencyPolicy Statement, as amended December 13, 2006, following GAAP inassessing the adequacy of the allowance. Under GAAP, the adequacy of the allowance is determined based on theprovisions of Statement of Financial Accounting Standards No. 114, *“Accounting by Creditors for Impairment of a Loan,”* (SFAS114) for loans specifically identified to be individually evaluated forimpairment and the requirements of SFAS 5, *“Accounting for Contingencies,”*for large groups of homogeneous loans to be collectively evaluated.

 

Allowances for impairedloans under SFAS 114 are determined based on collateral values or the presentvalue of estimated cash flows.  All loansplaced on a non-accruing status are considered impaired loans as well as otherspecific loans which, based upon all the pertinent facts known at the time,were deemed to be impaired and to which a specific allowance has beenallotted.  SFAS 5 allowances include aportion based on historical charge-off experience and a portion based onevaluation of qualitative factors.

 

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**LEASES**

 

Financing of equipmentwas provided to municipal customers under lease arrangements accounted for asdirect financing leases.  Income earnedis based on a constant periodic return on the net investment in the lease.

 

**LOAN FEES**

 

Nonrefundable loanorigination fees and certain direct loan origination costs are recognized as acomponent of interest income over the life of the related loans as anadjustment to yield.  The unamortizedbalance of these fees and costs are included as part of the loan balance towhich it relates.

 

**BANK PREMISESAND EQUIPMENT**

 

Land is carried at cost.  Bank premises and equipment are stated atcost less accumulated depreciation. Depreciation is computed on the straight-line method over the estimateduseful lives of the assets.  Leaseholdimprovements are amortized over the shorter of the term of the lease or theestimated useful lives of the improved property.

 

**BANK OWNED LIFE INSURANCE**

 

The Company is the owner and sole beneficiary ofbank owned life insurance (BOLI) policies on certain employees.  The earnings from the BOLI are recognized asa component of other income in the consolidated statements of income.  The BOLI is an asset that can be liquidated,if necessary, with tax costs associated. However, the Company intends to hold these policies and, accordingly,the Company has not provided for deferred income taxes on the earnings from theincrease in cash surrender value.

 

**FORECLOSEDASSETS HELD-FOR-SALE**

 

Foreclosed assetsheld-for-sale are carried at the lower of cost or fair value less cost to sell.  Losses from the acquisition of property infull and partial satisfaction of debt are treated as credit losses.  Routine holding costs are included in otheroperating expenses.  Write-downs forsubsequent declines in value are recorded in other income as a component ofgain or loss on sale of foreclosed assets held-for-sale.  Gains or losses are recorded when theproperties are sold.

 

**STOCKOPTIONS**

 

The Company has twostock-based compensation plans, which are described more fully in Note 9.  The Company accounts for these plans underthe recognition and measurement principles of SFAS No. 123R, *Share-Based Payment,* which requires the cost of share-basedpayment transactions (including those with employees and non-employees) berecognized in the financial statements.

 

**TRUST AND FINANCIAL SERVICE FEES**

 

Trustand financial service fees are recorded on the cash basis, which is notmaterially different from the accrual basis.

 

**ADVERTISING COSTS**

 

Advertisingcosts are charged to expense as incurred.

 

**FAIR VALUE OF FINANCIAL INSTRUMENTS**

** **

**Cash andshort-term instruments:** The carrying amounts of cash and short-term instruments approximatetheir fair value.

 

**Securities:**  With the exception of preferred termsecurities, fair values on the other investment securities are determined byprices provided by a third-party vendor, who is a provider of financial marketdata, analytics and related services to financial institutions.  Federal Home Loan Bank Stock is carried atcost, which approximates fair value.  Thefair values of preferred term securities is determined based on a present valuetechnique (income valuation) which is fully described in Note 3, “SecurityInvestments.”

 

**Loansreceivable:**  The fairvalue of all loans is estimated by the net present value of the future expectedcash flows discounted at the current offering rates.

 

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**Loansavailable-for-sale:** For loans available-for-sale, the fair value is estimated using ratescurrently offered for similar loans and is typically obtained from the FNMA orthe FHLB.

 

**Depositliabilities:**  The fairvalues of deposits with no stated maturity such as demand, NOW, savings andmoney market deposit accounts, are equal to the amount payable on demand whichare their carrying values.  The fairvalues of certificate of deposit accounts are based on discounted cash flowsusing rates which approximate the rates we offer for deposits of similarmaturities.

 

**Short-termborrowings:**  Forshort-term borrowings, the fair value is estimated using the rates currentlyoffered for similar borrowings.

 

**Long-termdebt:**  For otherborrowed funds, the fair value is estimated using the rates currently offeredfor similar borrowings.

 

**Accruedinterest:** The carryingamounts of accrued interest approximate their fair values.

 

**Derivativefinancial instruments**: The carrying amount of interest rate contracts are based on pricingprovided by a third party who considers observable interest rates, forwardyield curves at commonly quoted intervals and volatility.

 

**Off-balance-sheetinstruments:** Commitments to extend credit and unused lines of credit are priced tomarket.  The rates on standby letters ofcredit are priced on prime.  Therefore,the estimated fair value of these financial instruments is face value.

 

**INCOME TAXES**

 

Deferredtax assets and liabilities are reflected at currently enacted income tax ratesapplicable to the period in which the deferred tax assets or liabilities areexpected to be realized or settled.  Aschanges in tax laws or rates are enacted, deferred tax assets and liabilitiesare adjusted through the provision for income taxes.

 

**DERIVATIVE INSTRUMENTS**

 

Aspart of our asset/liability management program, the Company will utilize, fromtime-to-time, interest rate floors, caps or swaps to reduce its sensitivity tointerest rate fluctuations.  These arederivative instruments which are recorded as assets or liabilities in theconsolidated balance sheets at fair value. Changes in the fair values of derivatives are reported in theconsolidated income statements or other comprehensive income (OCI) depending onthe use of the derivative and whether the instrument qualifies for hedgeaccounting.  The key criterion for hedgeaccounting is that the hedged relationship must be highly effective inachieving offsetting changes in those cash flows that are attributable to thehedged risk, both at inception of the hedge and on an ongoing basis.

 

Derivatives that qualifyfor hedge accounting treatment are designated as either: a hedge of the fairvalue of a recognized asset or liability or of an unrecognized firm commitment(a fair value hedge) or a hedge of a forecasted transaction or the variabilityof cash flows to be received or paid related to a recognized asset or liability(a cash flow hedge).  To date, theCompany has only entered into a cash flow hedge.  For cash flow hedges, changes in the fairvalues of the derivative instruments are reported in OCI to the extent thehedge is effective.  The gains and losseson derivative instruments that are reported in OCI are reflected in theconsolidated income statements in the periods in which the results ofoperations are impacted by the variability of the cash flows of the hedgeditem.  Generally, net interest income isincreased or decreased by amounts receivable or payable with respect to thederivatives which qualify for hedge accounting. At inception of the hedge, the Company establishes the method it usesfor assessing the effectiveness of the hedging derivative and the measurementapproach for determining the ineffective aspect of the hedge.  The ineffective portion of the hedge, if any,is recognized currently in the consolidated statements of income.  The Company excludes the time valueexpiration of the hedge when measuring ineffectiveness.

 

**CASHFLOWS**

 

For purposes of reportingcash flows, cash and cash equivalents includes cash on hand, amounts due frombanks and interest-bearing deposits with financial institutions.

 

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For the years ended December 31,2008, 2007, and 2006, the Company paid interest of $15,030,000, $18,306,000 and$15,318,000, respectively.  For the yearsended December 31, 2008, 2007, and 2006, the Company paid income taxes of$1,250,000, $1,500,000 and $1,480,000, respectively.

 

Transfers from loans toforeclosed assets held-for-sale amounted to $1,564,000, $352,000 and $258,000in 2008, 2007, and 2006, respectively. Transfers from loans to loans available-for-sale amounted to $28,103,000in 2008.  There were no transfers fromloans to loans available-for-sale in 2007 or 2006.  Expenditures for construction in process, acomponent of other assets in the consolidated balance sheets, are included inacquisition of premises and equipment.

 

**OTHER COMPREHENSIVE INCOME (LOSS)**

 

The components of other comprehensive income (loss)and related tax effects are as follows:

 
| ** **                                                          | ** ** | **2008**    | ** **  | **2007** | ** ** | **2006** | ** ** |
|---------------------------------------------------------------------|------------|-------------|-------------|----------|------------|----------|------------|
|                                                                |       |        |        |     |       |     |       |
| Unrealized  holding (losses) gains on available-for-sale securities |       | $           | (11,866,642 | )        | $          | (24,554  | )          | $ | 223,358 |   |
|                                                                |       |        |        |     |       |     |       |
| Less  reclassification adjustment for gains realized in income      |       | (25,428     | )           | (79      | )          | (1,200   | )          |
|                                                                |       |        |        |     |       |     |       |
| Net unrealized  (losses) gains                                      |       | (11,892,070 | )           | (24,633  | )          | 222,158  |       |
|                                                                |       |        |        |     |       |     |       |
| Tax effect                                                          |       | 4,043,304   |        | 8,375    |       | (75,534  | )          |
|                                                                |       |        |        |     |       |     |       |
| Net of tax  amount                                                  |       | (7,848,766  | )           | (16,258  | )          | 146,624  |       |
|                                                                |       |        |        |     |       |     |       |
| Change in cash  flow hedge intrinsic value                          |       | 220,752     |        | 384,824  |       | 917      |       |
|                                                                |       |        |        |     |       |     |       |
| Total                                                               |       | $           | (7,628,014  | )        | $          | 368,566  |       | $ | 147,541 |   |

 

The components ofaccumulated other comprehensive loss consisted of:

 
| ** **                                                  | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                        |       |     |       |     |       |     |       |
| Unrealized  holding losses on available-for-sale securities |       | $        | (8,830,733 | )        | $          | (981,967 | )          | $ | (965,709 | ) |
|                                                        |       |     |       |     |       |     |       |
| Cash flow hedge  intrinsic value                            |       | 606,493  |       | 385,741  |       | 917      |       |
|                                                        |       |     |       |     |       |     |       |
| Accumulated  other comprehensive loss                       |       | $        | (8,224,240 | )        | $          | (596,226 | )          | $ | (964,792 | ) |

 

**2.****             ****CASH**

 

The Company is requiredby the Federal Reserve Bank to maintain average reserve balances based on apercentage of deposits.  The amounts ofthose reserve requirements on December 31, 2008 and 2007 were $594,000and  $702,000, respectively.

 

Deposits with any onefinancial institution are insured up to $250,000.  From time-to-time, the Company maintains cashand cash equivalents with certain other financial institutions in excess of theinsured amount.

 

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**3.****             ****INVESTMENT SECURITIES**

 

Amortized cost and fairvalue of investment securities at December 31, 2008 and 2007 are asfollows (in thousands):

 
| ** **                                        | ** ** | **2008**            | ** ** |
|---------------------------------------------------|------------|---------------------|------------|
| ** **                                        | ** ** | **Amortized  cost** | ** ** | **Gross  unrealized  gains** | ** ** | **Gross  unrealized  losses** | ** ** | **Fair  value** | ** ** |
|                                              |       |                |       |   |   |   |   |   |   |
| Held-to-maturity  securities:                     |       |                |       |   |   |   |   |   |   |
| Mortgage-backed  securities                       |       | $                   | 909        |   | $ | 31 |   | $ | — |   | $ | 940 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| Available-for-sale  securities:                   |       |                |       |   |   |   |   |   |   |
| U.S. government  agencies and corporations        |       | $                   | 45,824     |   | $ | 134 |   | $ | 2,451 |   | $ | 43,507 |   |
| Obligations of  states and political subdivisions |       | 18,009              |       | 97 |   | 553 |   | 17,553 |   |
| Corporate bonds                                   |       | 21,415              |       | — |   | 11,155 |   | 10,260 |   |
| Mortgage-backed  securities                       |       | 11,088              |       | 442 |   | — |   | 11,530 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| Total debt  securities                            |       | 96,336              |       | 673 |   | 14,159 |   | 82,850 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| Equity  securities                                |       | 322                 |       | 122 |   | 16 |   | 428 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| Total  available-for-sale securities              |       | $                   | 96,658     |   | $ | 795 |   | $ | 14,175 |   | $ | 83,278 |   |

 
| ** **                                        | ** ** | **2007**            | ** ** |
|---------------------------------------------------|------------|---------------------|------------|
| ** **                                        | ** ** | **Amortized  cost** | ** ** | **Gross  unrealized  gains** | ** ** | **Gross  unrealized  losses** | ** ** | **Fair  value** | ** ** |
|                                              |       |                |       |   |   |   |   |   |   |
| Held-to-maturity  securities:                     |       |                |       |   |   |   |   |   |   |
| Mortgage-backed  securities                       |       | $                   | 1,147      |   | $ | 33 |   | $ | — |   | $ | 1,180 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| Available-for-sale  securities:                   |       |                |       |   |   |   |   |   |   |
| U.S. government  agencies and corporations        |       | $                   | 35,406     |   | $ | 101 |   | $ | 263 |   | $ | 35,244 |   |
| Obligations of  states and political subdivisions |       | 12,127              |       | 63 |   | 57 |   | 12,133 |   |
| Corporate bonds                                   |       | 17,532              |       | — |   | 1,197 |   | 16,335 |   |
| Mortgage-backed  securities                       |       | 57,930              |       | 70 |   | 380 |   | 57,620 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| Total debt  securities                            |       | 122,995             |       | 234 |   | 1,897 |   | 121,332 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| Equity  securities                                |       | 329                 |       | 183 |   | 7 |   | 505 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| Total  available-for-sale securities              |       | $                   | 123,324    |   | $ | 417 |   | $ | 1,904 |   | $ | 121,837 |   |

 

Most of the Company’sdebt and equity securities are pledged to secure trust funds, public deposits,repurchase agreements, other short-term borrowings, Federal Home Loan Bank ofPittsburgh (FHLB) borrowings, Federal Reserve Bank of Philadelphia DiscountWindow borrowings and certain other deposits as required by law.  U.S. government securities pledged onrepurchase agreements are under the Company’s control.

 

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The amortized cost andfair value of debt securities at December 31, 2008 by contractual maturityare shown below (in thousands):

 
| ** **                                | ** ** | **Amortized  cost** | ** ** | **Fair  value** | ** ** |
|-------------------------------------------|------------|---------------------|------------|-----------------|------------|
|                                      |       |                |       |            |       |
| Held-to-maturity  securities:             |       |                |       |            |       |
| Mortgage-backed  securities               |       | $                   | 909        |            | $          | 940 |   |
|                                      |       |                |       |            |       |
| Available-for-sale  securities:           |       |                |       |            |       |
| Debt securities:                          |       |                |       |            |       |
| Due in one year  or less                  |       | $                   | —     |            | $          | — |   |
| Due after one  year through five years    |       | —              |       | —          |       |
| Due after five  years through ten years   |       | 10,649              |       | 10,706          |       |
| Due after ten  years                      |       | 74,599              |       | 60,614          |       |
|                                      |       |                |       |            |       |
| Total debt  securities                    |       | 85,248              |       | 71,320          |       |
|                                      |       |                |       |            |       |
| Mortgage-backed  securities               |       | 11,088              |       | 11,530          |       |
|                                      |       |                |       |            |       |
| Total  available-for-sale debt securities |       | $                   | 96,336     |            | $          | 82,850 |   |

 

Expected maturities will differ from contractual maturities becauseissuers and borrowers may have the right to call or repay obligations with orwithout call or prepayment penalty. Federal agency and municipal securities are included based on theiroriginal stated maturity. Mortgage-backed securities, which are based on weighted-average livesand subject to monthly principal pay-downs, are listed in total.

 

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The following table presents the fair value and gross unrealized lossesof investments aggregated by investment type, the length of time and the numberof securities that have been in a continuous unrealized loss position at December 31,2008 and 2007 (in thousands):

 
| ** **                                        | ** ** | **Less than 12 months** | ** ** | **12 months or more** | ** ** | **Total**       | ** ** |
|---------------------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|-----------------|------------|
| ** **                                        | ** ** | **Fair  value**                        | ** ** | **Unrealized  losses**               | ** ** | **Fair  value** | ** ** | **Unrealized  losses** | ** ** | **Fair  value** | ** ** | **Unrealized  losses** | ** ** |
|                                              |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
| **December 31,  2008:**                      |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
|                                              |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
| U.S. government  agencies and corporations        |       | $                                      | 12,506     |                                 | $          | 1,878           |       | $ | 5,145 |   | $ | 573 |   | $ | 17,651 |   | $ | 2,451 |   |
| Obligations of states  and political subdivisions |       | 8,154                                  |       | 496                                  |       | 1,455           |       | 57 |   | 9,609 |   | 553 |   |
| Mortgage-backed  securities                       |       | 17                                     |       | —                               |       | —          |       | — |   | 17 |   | — |   |
| Corporate bonds                                   |       | 2,235                                  |       | 2,352                                |       | 8,025           |       | 8,803 |   | 10,260 |   | 11,155 |   |
|                                              |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
| Subtotal, debt  securities                        |       | 22,912                                 |       | 4,726                                |       | 14,625          |       | 9,433 |   | 37,537 |   | 14,159 |   |
|                                              |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
| Equity  securities                                |       | —                                 |       | —                               |       | 60              |       | 16 |   | 60 |   | 16 |   |
|                                              |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
| Total  temporarily impaired securities            |       | $                                      | 22,912     |                                 | $          | 4,726           |       | $ | 14,685 |   | $ | 9,449 |   | $ | 37,597 |   | $ | 14,175 |   |
| Number of  securities                             |       | 20                                     |       |                                 |       | 22              |       |   |   | 42 |   |   |   |
|                                              |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
| **December 31,  2007:**                      |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
|                                              |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
| U.S. government  agencies and corporations        |       | $                                      | 5,311      |                                 | $          | 126             |       | $ | 11,827 |   | $ | 137 |   | $ | 17,138 |   | $ | 263 |   |
| Obligations of  states and political subdivisions |       | 5,177                                  |       | 55                                   |       | 204             |       | 2 |   | 5,381 |   | 57 |   |
| Mortgage-backed  securities                       |       | 12,809                                 |       | 16                                   |       | 26,603          |       | 364 |   | 39,412 |   | 380 |   |
| Corporate bonds                                   |       | 14,076                                 |       | 954                                  |       | 2,260           |       | 243 |   | 16,336 |   | 1,197 |   |
|                                              |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
| Subtotal, debt  securities                        |       | 37,373                                 |       | 1,151                                |       | 40,894          |       | 746 |   | 78,267 |   | 1,897 |   |
|                                              |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
| Equity  securities                                |       | 69                                     |       | 7                                    |       | —          |       | — |   | 69 |   | 7 |   |
|                                              |       |                                   |       |                                 |       |            |       |   |   |   |   |   |   |
| Total  temporarily impaired securities            |       | $                                      | 37,442     |                                 | $          | 1,158           |       | $ | 40,894 |   | $ | 746 |   | $ | 78,336 |   | $ | 1,904 |   |
| Number of  securities                             |       | 33                                     |       |                                 |       | 22              |       |   |   | 55 |   |   |   |

 

As of December 31, 2008 thedebt securities with unrealized losses have depreciated 27.4% compared to 2.4%at December 31, 2007.   Managementbelieves that the cause of the unrealized losses is related tochanges in interest rates, instability in the capital markets or the limitedtrading activity due to recent debt market illiquid conditions and is notdirectly related to credit quality, which is consistent with its pastexperience.  Nearly all of the securities in theportfolio have fixed rates or have predetermined scheduled rate changes, andmany have call features that allow the issuer to call the security at parbefore its stated maturity without penalty.

 

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Management performs a review of the investmentportfolio quarterly to determine the cause of declines in the fair value ofeach security.  The Company uses inputsprovided by independent third parties to determine the fair value of itsinvestment securities portfolio.  Inputsprovided by the third party are reviewed and corroborated by management.  Evaluations of the causes of the unrealizedlosses are performed to determine whether impairment, if any, is temporary orother-than-temporary.  Considerationssuch as the Company’s intent and ability to hold the securities to maturity,recoverability of the invested amounts over the intended holding period, thelength of time and the severity in pricing decline below cost, the interestrate environment, receipts of amounts contractually due and whether or notthere is an active market for the security, for example are applied, along withthe financial condition of the issuer for management to make a realisticjudgment of the probability that the Company will be unable to collect allamounts (principal and interest) due in determining whether a security isother-than-temporarily impaired.  If adecline in value is deemed to be other-than-temporary, the amortized cost ofthe security is reduced by the impairment amount and a corresponding charge toearnings is recognized.  If at the timeof sale, call or maturity the proceeds exceed the security’s amortized cost,the impairment charge may be fully or partially recovered.

 

During 2008, uncertainty in the financial marketsincreased the volatility in fair value estimates for the securities in ourinvestment portfolio.  Compared toyear-end 2007, the fair values of securities have declined.  Management believes these changes were duemainly to liquidity problems in the financial markets, not deterioration in thecreditworthiness of the issuers.

 

At December 31, 2008, the securities with themost significant reductions in fair value and associated estimated unrealizedlosses were in the Company’s corporate bond portfolio consisting ofcollateralized debt obligation (CDO) securities that are backed by pooled trustpreferred term securities (preferred term securities) issued by banks, thriftsand insurance companies.

 

Except for preferred term securities, market values onthe other investment securities are determined by prices provided by athird-party vendor, who is a provider of financial market data, analytics andrelated services to financial institutions. For the trust preferred term securities portfolio, management was unableto obtain readily attainable and realistic pricing from market traders due tolack of active market participants and therefore management has determined thatthe market for these securities is currently inactive.

 

The Company owns 13issues of preferred term securities.  Themarket for these securities at December 31, 2008 is not active and marketsfor similar securities are also not active. The inactivity was evidenced firstby a significant widening of the bid-ask spread in the brokered markets inwhich preferred term securities trade and then by a significant decrease in thevolume of trades relative to historical levels. The new issue market is alsoinactive as no new preferred term securities have been issued since 2007.  There are currently very few marketparticipants who are willing and or able to transact for these securities.  Given conditions in the debt markets todayand the absence of observable transactions in the secondary and new issuemarkets, we determined:

 

·                  The fewobservable transactions and market quotations that are available are notreliable for purposes of determining fair value at December 31, 2008,

 

·                  An incomevaluation approach technique (present value technique) that maximizes the useof relevant observable inputs and minimizes the use of unobservable inputs willbe equally or more representative of fair value than the market approachvaluation technique used at prior measurement dates and

 

·                  Our preferredterm securities will be classified within Level 3 of the fair value hierarchybecause we determined that significant adjustments are required to determinefair value at the measurement date.  Ourpreferred term securities valuations were prepared by an independent thirdparty.  Their approach to determiningfair value involved the following:

 

·                  Data about theissue structure as defined in the indenture and the underlying collateral werecollected.

 

·                  The creditquality of the collateral is estimated using average probability of defaultvalues for each issuer (adjusted for rating levels and stressed to reflect thecurrent environment),

 

·                  The defaultprobabilities also considered the potential for correlation among issuerswithin the same industry (e.g. banks with other banks),

 

·                  The loss givendefault was assumed to be 95%,

 

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·                  The cash flowswere forecast for the underlying collateral and applied to each CDO tranche todetermine the resulting distribution among the securities,

 

·                  The expectedcash flows were discounted to calculate the present value of the security,

 

·                  The effectivediscount rates on an overall basis range from 5.04% to 14.19% and are highlydependent upon the credit quality of the collateral, the relative position ofthe tranche in the capital structure of the CDO and the prepayment assumptions,

 

·                  The calculationswere modeled in several thousand scenarios using a Monte Carlo engine toestablish a distribution of intrinsic values and the average was used forvaluation purposes.

 

Based on the techniquedescribed, the Company determined that as of December 31, 2008, the fairvalue of one preferred term security had declined $430,000 below its amortizedcost and has deemed this security to be other-than-temporarily impaired.  Accordingly, this amount has been recorded asan impairment charge and is included as a component of other income in theconsolidated income statements for the year ended December 31, 2008.  The market value of the Company’s investmentin preferred term securities has declined by $9,958,000 since December 31,2007.  The Company closely monitors thepreferred term securities market and performs collateral sufficiency and cashflow analyses on at least a quarterly basis. Future analyses could yield results that may indicate further impairmenthas occurred and therefore require additional write-downs and correspondingother-than-temporary charges to current earnings.  In addition to the impairment charge on thepreferred term securities portfolio, the Company had an equity position in FNMAcommon stock whose fair value declined below its cost basis by $6,000 and has alsobeen deemed to be other-than-temporarily impaired and written down as of December 31,2008.  There were no other-than-temporaryimpairment write-downs recorded in 2007 or 2006.

 

For a further discussion on the fair value of the Company’s financialinstruments, see Note 12, “Fair value of financial instruments and derivatives.”

 

As of December 31, 2008, the AFS debt securities portfolio wascarried at a net unrealized loss of $13,486,000 compared to a net unrealizedloss of $1,663,000 at December 31, 2007. Management believes the cause of the unrealized losses is related tochanges in interest rates or the limited trading activity due to recent debtmarket illiquid conditions and is not directly related to credit quality, whichis consistent with its past experience. In addition, the Company has the ability and intent to hold itsinvestments for a period of time sufficient for the fair value of thesecurities to recover, which may be at maturity.

 

Gross realized gains and losses on sales of available-for-salesecurities, determined using specific identification of the securities were asfollows:

 
| ** **           | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|----------------------|------------|----------|------------|----------|------------|----------|------------|
|                 |       |     |       |     |       |     |       |
| Gross realized  gain |       | $        | 113,070    |     | $          | 18,853   |       | $ | 71,201 |   |
| Gross realized  loss |       | 87,642   |       | 18,774   |       | 70,001   |       |
| Net gain             |       | $        | 25,428     |     | $          | 79       |       | $ | 1,200 |   |

 

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**4.             LOANS AND LEASES**

 

The major classificationsof loans and leases at December 31, 2008 and 2007 are summarized asfollows:

 
| ** **                 | ** ** | **2008**    | ** **  | **2007**    | ** ** |
|----------------------------|------------|-------------|-------------|-------------|------------|
|                       |       |        |        |        |       |
| Commercial and  CRE        |       | $           | 245,479,992 |        | $          | 216,057,882 |   |
| Residential real  estate   |       | 98,510,562  |        | 116,978,378 |       |
| Consumer                   |       | 85,091,205  |        | 81,998,093  |       |
| Real estate  construction  |       | 11,426,978  |        | 10,703,249  |       |
| Direct financing  leases   |       | 443,957     |        | 511,178     |       |
|                       |       |        |        |        |       |
| Total                      |       | 440,952,694 |        | 426,248,780 |       |
|                       |       |        |        |        |       |
| Less:                      |       |        |        |        |       |
| Allowance for  loan losses |       | 4,745,234   |        | 4,824,401   |       |
|                       |       |        |        |        |       |
| Loans and  leases, net     |       | $           | 436,207,460 |        | $          | 421,424,379 |   |

 

Net deferred loan costsof $629,000 and $722,000 have been added to the carrying values of loans at December 31,2008 and 2007, respectively.

 

The Company services real estate loans for investorsin the secondary mortgage market which are not included in the accompanyingconsolidated balance sheet.  Theapproximate amount of mortgages serviced amounted to $95,856,000 as of December 31,2008 and $61,023,000 as of  December 31,2007.

 

Information related toimpaired and past due loans as of December 31 is as follows:

 
| ** **                                                                   | ** ** | **2008**  | ** ** | **2007**  | ** ** |
|------------------------------------------------------------------------------|------------|-----------|------------|-----------|------------|
| At December 31:                                                         |       |      |       |      |       |
| Non-accrual  loans                                                           |       | $         | 3,493,169  |      | $          | 3,811,205 |   |
| Other impaired  loans                                                        |       | 186,774   |       | 2,283,501 |       |
| Total impaired  loans                                                        |       | $         | 3,679,943  |      | $          | 6,094,706 |   |
|                                                                         |       |      |       |      |       |
| Amount of  impaired loans that have a specific allowance                     |       | $         | 2,571,851  |      | $          | 5,038,972 |   |
| Amount of  impaired loans with no specific allowance                         |       | 1,108,092 |       | 1,055,734 |       |
| Allowance for  impaired loans                                                |       | 630,093   |       | 1,143,203 |       |
|                                                                         |       |      |       |      |       |
| Accruing loans  that are contractually past due as to principal or interest: |       |      |       |      |       |
| Past due 90 days  or more                                                    |       | 604,140   |       | 25,470    |       |
| Past due 30-89  days                                                         |       | 1,858,481 |       | 4,697,953 |       |
|                                                                         |       |      |       |      |       |
| During the year  ended December 31:                                     |       |      |       |      |       |
| Average  investment in impaired loans                                        |       | 4,372,742 |       | 5,214,365 |       |
| Interest income  recognized on impaired loans                                |       | 327,063   |       | 109,889   |       |
| Interest income  recognized on impaired loans (cash basis)                   |       | 310,899   |       | 93,426    |       |

 

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Information related tothe changes in the allowance for loan losses as of December 31 is asfollows:

 
| ** **                          | ** ** | **2008**   | ** ** | **2007** | ** ** | **2006**   | ** ** |
|-------------------------------------|------------|------------|------------|----------|------------|------------|------------|
|                                |       |       |       |     |       |       |       |
| Balance,  beginning                 |       | $          | 4,824,401  |     | $          | 5,444,303  |       | $ | 5,984,649 |   |
| Recoveries                          |       | 109,703    |       | 161,861  |       | 189,668    |       |
| Provision  (credit) for loan losses |       | 940,000    |       | (60,000  | )          | 325,000    |       |
| Losses charged  to allowance        |       | (1,128,870 | )          | (721,763 | )          | (1,055,014 | )          |
|                                |       |       |       |     |       |       |       |
| Balance, ending                     |       | $          | 4,745,234  |     | $          | 4,824,401  |       | $ | 5,444,303 |   |

 

**5.****             ****BANK PREMISES AND EQUIPMENT**

 

Components of bankpremises and equipment at December 31, 2008 and 2007 are summarized asfollows:

 
| ** **                                      | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|-------------------------------------------------|------------|------------|------------|------------|------------|
|                                            |       |       |       |       |       |
| Land                                            |       | $          | 2,072,048  |       | $          | 2,072,048 |   |
| Bank premises                                   |       | 9,683,614  |       | 7,171,328  |       |
| Furniture,  fixtures and equipment              |       | 10,096,550 |       | 8,603,310  |       |
| Leasehold  improvements                         |       | 4,820,202  |       | 5,102,308  |       |
|                                            |       |       |       |       |       |
| Total                                           |       | 26,672,414 |       | 22,948,994 |       |
|                                            |       |       |       |       |       |
| Less accumulated  depreciation and amortization |       | 10,616,052 |       | 9,984,062  |       |
|                                            |       |       |       |       |       |
| Bank premises  and equipment, net               |       | $          | 16,056,362 |       | $          | 12,964,932 |   |

 

Depreciation expense, which includes amortization ofleasehold improvements, was $1,362,000, $1,297,000 and $1,191,000 for the yearsended December 31, 2008, 2007 and 2006, respectively.

 

The Company leases its Green Ridge, Scranton, WestPittston, Moosic, Kingston, Peckville, Clarks Summit and Eynon branches underthe terms of operating leases.  Rentalexpense was $392,000 in 2008, $435,000 in 2007 and $428,000 in 2006.  In 2008, the Company closed its Pittstonbranch.  The future minimum rentalpayments at December 31, 2008 under these leases are as follows:

 
| **Year ending December 31** | ** ** | **Amount** | ** ** |
|--------------------------------------------|------------|------------|------------|
|                                       |       |       |       |
| 2009                                       |       | $          | 368,143    |   |
| 2010                                       |       | 331,927    |       |
| 2011                                       |       | 333,594    |       |
| 2012                                       |       | 339,665    |       |
| 2013                                       |       | 342,402    |       |
| 2014 and  thereafter                       |       | 3,844,309  |       |
|                                       |       |       |       |
| Total                                      |       | $          | 5,560,040  |   |

 

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**6.****             ****DEPOSITS**

 

At December 31,2008, the scheduled maturities of certificates of deposit are as follows:

 
| 2009                 |   | $          | 138,895,533 |   | 80.0   | % |
|----------------------|--------|------------|-------------|--------|--------|---|
| 2010                 |   | 26,519,078 |        | 15.3   |   |
| 2011                 |   | 3,024,673  |        | 1.7    |   |
| 2012                 |   | 1,386,305  |        | 0.8    |   |
| 2013                 |   | 3,047,070  |        | 1.8    |   |
| 2014 and  thereafter |   | 808,255    |        | 0.4    |   |
|                 |   |       |        |   |   |
|                 |   | $          | 173,680,914 |   | 100.0  | % |

 

Certificate of deposit accounts of $100,000 or moreaggregated $74,250,000 and $80,857,000 at December 31, 2008 and 2007,respectively.  Certificate of depositaccounts of $250,000 or more aggregated $35,108,000 at December 31, 2008.

 

Investment securities with a fair value of $51,388,000and letters of credit with a notional amount of $4,350,000 as of December 31,2008 were pledged as collateral to secure public deposits and trust funds.

 

**7.****             ****SHORT-TERM BORROWINGS**

 

Short-term borrowings are as follows at December 31,2008, 2007 and 2006:

 
| ** **                                   | ** ** | **2008**   | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|----------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
|                                         |       |       |       |       |       |       |       |
| Overnight  borrowings                        |       | $          | 25,668,000 |       | $          | 18,950,000 |       | $ | 10,395,000 |   |
| Securities sold  under repurchase agreements |       | 11,411,939 |       | 20,504,408 |       | 22,224,445 |       |
| Demand note,  U.S. Treasury                  |       | 1,049,765  |       | 201,946    |       | 1,036,705  |       |
| Total                                        |       | $          | 38,129,704 |       | $          | 39,656,354 |       | $ | 33,656,150 |   |

 

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The maximum and averageamounts of short-term borrowings outstanding and related interest rates for theyears ended December 31, 2008, 2007 and 2006 are as follows:

 
| ** **                  | ** ** | **Maximum  outstanding  at any  month end** | ** ** | **Average  outstanding** | ** ** | **Weighted-  average  rate during  the year** | ** ** | **Rate at  year end** | ** ** |
|-----------------------------|------------|-------------------------------------------------------|------------|--------------------------|------------|---------------------------------------------------------|------------|---------------------------------|------------|
| ** **                  | ** ** | ** **                                            | ** ** | ** **               | ** ** | ** **                                              | ** ** | ** **                      | ** ** |
| 2008                        |       |                                                  |       |                     |       |                                                    |       |                            |       |
|                        |       |                                                  |       |                     |       |                                                    |       |                            |       |
| Overnight  borrowings       |       | $                                                     | 29,960,000 |                     | $          | 12,314,584                                              |       | 2.13%                           |       | 0.62% |   |
| Repurchase  agreements      |       | 17,210,316                                            |       | 12,074,345               |       | 0.85%                                                   |       | 0.33%                           |       |
| Demand note,  U.S. Treasury |       | 1,049,765                                             |       | 509,715                  |       | 1.85%                                                   |       | 0.00%                           |       |
|                        |       |                                                  |       |                     |       |                                                    |       |                            |       |
| Total                       |       | $                                                     | 48,220,081 |                     | $          | 24,898,644                                              |       |                            |       |   |   |
|                        |       |                                                  |       |                     |       |                                                    |       |                            |       |
| 2007                        |       |                                                  |       |                     |       |                                                    |       |                            |       |
|                        |       |                                                  |       |                     |       |                                                    |       |                            |       |
| Overnight  borrowings       |       | $                                                     | 30,795,000 |                     | $          | 8,781,767                                               |       | 5.17%                           |       | 4.24% |   |
| Repurchase  agreements      |       | 21,678,303                                            |       | 19,579,632               |       | 2.38%                                                   |       | 1.94%                           |       |
| Demand note,  U.S. Treasury |       | 1,057,677                                             |       | 523,018                  |       | 6.19%                                                   |       | 3.60%                           |       |
|                        |       |                                                  |       |                     |       |                                                    |       |                            |       |
| Total                       |       | $                                                     | 53,530,980 |                     | $          | 28,884,417                                              |       |                            |       |   |   |
|                        |       |                                                  |       |                     |       |                                                    |       |                            |       |
| 2006                        |       |                                                  |       |                     |       |                                                    |       |                            |       |
|                        |       |                                                  |       |                     |       |                                                    |       |                            |       |
| Overnight  borrowings       |       | $                                                     | 13,308,000 |                     | $          | 6,110,115                                               |       | 5.21%                           |       | 5.36% |   |
| Repurchase  agreements      |       | 24,917,518                                            |       | 23,390,881               |       | 2.67%                                                   |       | 2.80%                           |       |
| Demand note,  U.S. Treasury |       | 1,081,822                                             |       | 500,907                  |       | 6.11%                                                   |       | 5.06%                           |       |
|                        |       |                                                  |       |                     |       |                                                    |       |                            |       |
| Total                       |       | $                                                     | 39,307,340 |                     | $          | 30,001,903                                              |       |                            |       |   |   |

 

Overnight borrowings mayinclude both Fed funds purchased with correspondent banks and open repurchaseagreements with the FHLB.  Securitiessold under agreements to repurchase (repurchase agreements) are non-insuredinterest-bearing liabilities that have a security interest in qualified investmentsecurities of the Company.  Repurchaseagreements are reflected at the amount of cash received in connection with thetransaction.  The carrying value of theunderlying qualified investment securities was approximately $11,866,000,$22,000,000 and $25,000,000 at December 31, 2008, 2007 and 2006,respectively.  The Company may berequired to provide additional collateral based on the fair value of theunderlying securities.  The U. S.Treasury demand note is generally repaid within 1 to 90 days.

 

At December 31,2008, the Company had approximately $117,348,000 available to borrow from theFHLB, $19,700,000 from correspondent banks and approximately $2,250,000 that itcould borrow at the Discount Window from the Federal Reserve Bank ofPhiladelphia.  There were no borrowingsfrom the Federal Reserve Bank Discount Window at December 31, 2008, 2007or 2006.

 

**8.****             ****LONG-TERM DEBT**

 

Long-term debt consists of advances from the FHLB withinterest rates ranging from 3.61% to 6.14% at December 31, 2008.  These advances are secured by unencumberedU.S. government agency securities, mortgage-backed securities, certainresidential mortgages and other real estate collateralized loans with acombined fair value of $170,000,000 as of September 30, 2008 that was ineffect as of December 31, 2008.

 

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At December 31,2008, the maturities and weighted-average interest rates of long-term debt areas follows:

 
| **Year ending December 31,** | ** ** | **Amount** | ** ** | **Rate** | ** ** |
|---------------------------------------------|------------|------------|------------|----------|------------|
|                                        |       |       |       |     |       |
| 2009                                        |       | $          | 10,000,000 |     | 5.32       | % |
| 2010                                        |       | 21,000,000 |       | 5.84     |       |
| 2013                                        |       | 5,000,000  |       | 3.61     |       |
| 2016                                        |       | 16,000,000 |       | 5.26     |       |
|                                        |       |       |       |     |       |
| Total                                       |       | $          | 52,000,000 |     | 5.35       | % |

 

Rates on $42,000,000 ofconvertible select FHLB advances are fixed but may adjust quarterly, shouldmarket rates increase beyond the issues’ original or strike rates.  Significant prepayment penalties attached tothe borrowings is a deterrent from paying off the high cost advances.  However, in the event underlying market ratesrise above the rates currently paid on these borrowings, the FHLB rate willconvert to floating and the Bank has the option at that time, to repay or torenegotiate the converted advance.  As of December 31, 2008 theweighted-average interest rate on these convertible select advances was 5.35%with maturity dates ranging from 2010 to 2016.

 

**9.****             ****STOCK PLANS**

 

The Company uses the fair value method of accountingfor stock-based compensation provided under SFAS 123R, Share BasedPayment.  SFAS 123R requires that thecost of share-based payment transactions (including those with employees andnon-employees) be recognized in the financial statements.  SFAS 123R applies to all share-based paymenttransactions in which an entity acquires goods or services by issuing (oroffering to issue) its shares, share options, or other equity instruments(except for those held by an ESOP) or by incurring liabilities (1) inamounts based (even in part) on the price of the entity’s shares or otherequity instruments, or (2) that require (or may require) settlement by theissuance of an entity’s shares or other equity instruments.

 

The Company has twostock-based compensation plans (the stock option plans).  The stock option plans were shareholder-approvedand permit the grant of share-based compensation awards to its directors, keyofficers and certain other employees. The Company believes that these stock option plans better align theinterest of its directors, key officers and employees with the interest of itsshareholders.  The Company furtherbelieves that the granting of share-based awards under the provisions of thestock option plans is necessary to retain the knowledge base, continuity and expertiseof its directors, key officers and employees.

 

The Company establishedthe 2000 Independent Directors Stock Option Plan (the Directors Plan) andreserved 55,000 shares of its un-issued capital stock for issuance.  In the Directors Plan, no stock options wereawarded during 2008 or 2006 and 17,500 options were awarded in 2007.  As of December 31, 2008, there were30,150 unexercised stock options outstanding under this plan.

 

The Company has alsoestablished the 2000 Stock Incentive Plan (the Incentive Plan) and reserved55,000 shares of its un-issued capital stock for issuance.  In 2007, the Incentive Plan was amended toprovide that no qualified incentive stock options will be granted after theamendment date.  In the Incentive Plan asamended, key officers and certain other employees are eligible to be awardednon-qualified stock options to purchase the Company’s common stock at the fairmarket value on the date of grant. During 2008, 2007 and 2006, 2,000 and 5,000 non-qualified options and2,200 qualified options, respectively, were granted.  As of December 31, 2008, there were12,830 unexercised stock options outstanding under this plan.

 

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A summary of the status of the Company’s stock option plans as of December 31,2008, December 31, 2007 and December 31, 2006 and changes during theperiods is presented in the following table:

 
| ** **                                           | ** ** | **Options** | ** ** | **Weighted-  average  exercise price** | ** ** | **Weighted-  average  remaining  contractual  term (yrs)** | ** ** |
|------------------------------------------------------|------------|-------------|------------|---------------------------------------------|------------|-----------------------------------------------------------------|------------|
|                                                 |       |        |       |                                        |       |                                                            |       |
| Outstanding and  exercisable, December 31, 2005 |       | 20,130      |       | $                                           | 32.25      |                                                            | 4.7        |   |
| Granted                                              |       | 2,200       |       | 36.59                                       |       |                                                            |       |
| Exercised                                            |       | —      |       | —                                      |       |                                                            |       |
| Forfeited                                            |       | (1,650      | )          | 33.07                                       |       |                                                            |       |
|                                                 |       |        |       |                                        |       |                                                            |       |
| Outstanding and  exercisable, December 31, 2006 |       | 20,680      |       | 32.64                                       |       | 4.3                                                             |       |
| Granted                                              |       | 22,500      |       | 28.90                                       |       |                                                            |       |
| Exercised                                            |       | —      |       | —                                      |       |                                                            |       |
| Forfeited                                            |       | —      |       | —                                      |       |                                                            |       |
|                                                 |       |        |       |                                        |       |                                                            |       |
| Outstanding and  exercisable, December 31, 2007 |       | 43,180      |       | 30.69                                       |       | 6.8                                                             |       |
| Granted                                              |       | 2,000       |       | 26.90                                       |       |                                                            |       |
| Exercised                                            |       | —      |       | —                                      |       |                                                            |       |
| Forfeited                                            |       | (2,200      | )          | 31.85                                       |       |                                                            |       |
|                                                 |       |        |       |                                        |       |                                                            |       |
| Outstanding,  December 31, 2008                 |       | 42,980      |       | $                                           | 30.46      |                                                            | 6.1        |   |
| Exercisable,  December 31, 2008                 |       | 42,980      |       | $                                           | 30.46      |                                                            |       |   |

 

----

In the above table, the weighted-averageexercise price includes options with exercise prices ranging from $26.05 to$36.59.  Also in the above table, optionsthat are fully vested are included in the amounts that are exercisable as of December 31,2008.

 

As of December 31,2008, 2007 and 2006, the intrinsic value (stock options with fair values thatexceeded their exercise or strike price) aggregated $0 and $1,200 and $28,000,respectively.

 

Under the stock optionplans, options are granted with an exercise price equal to the market price ofthe Company’s stock at the date of grant. The awards vest based on six months of continuous service from the dateof grant and have 10-year contractual terms. Generally, all shares that are granted become fully vested.

 

The Company does not havestock options that are traded on organized capital exchanges.  As such, the estimated fair value of optionsawarded under its stock option plans is determined, on the date of grant, usingthe Black-Scholes Option Pricing Valuation Model (the model).  For the options granted in 2008, 2007 and2006, the model incorporated the following assumptions:

 
| ** **               | ** ** | **2008** | ** **  | **2007** | ** **  | **2006** | ** **  |
|--------------------------|------------|----------|-------------|----------|-------------|----------|-------------|
| Expected  volatility     |       | 26.31    | %           | 25.36    | %           | 16.00    | %           |
| Expected  dividend       |       | 3.72     | %           | 3.46     | %           | 2.41     | %           |
| Risk-free  interest rate |       | 2.77     | %           | 3.57     | %           | 4.35     | %           |
| Expected term            |       | 5.25     |  years | 5.25     |  years | 5.25     |  years |

 

The expected volatilitywas determined based on the daily five-year historical volatility of theCompany’s stock.  Management believes thefive-year historical volatility measurement closely resembles the fluctuationof its stock value under most economic conditions and cycles.  Because of the relatively short vestingperiod, the model assumes that all options granted will fully vest.  The risk-free rate is for the period withinthe expected term of the options based on the U.S. Treasury yield curve.  The Company used the simplified method to determinethe term in which options are expected to be outstanding.  The Company does not have sufficienthistorical share option exercise experience upon which to estimate expectedterm and therefore used the simplified method.

 

The following tablesillustrate stock-based compensation expense recognized during the years ended December 31,2008, 2007 and 2006 and the unrecognized stock-based compensation expense as ofDecember 31 of the same years. 

 

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Stock-based compensationexpense is a component of salaries and employee benefits in the consolidatedincome statements.

 
| ** **                                  | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|---------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Stock-based compensation expense: |       |     |       |     |       |     |       |
| Director’s Plan                        |       | $        | 90,550     |     | $          | 6,925    |       | $ | — |   |
| Incentive Plan                              |       | 35,562   |       | 1,978    |       | 13,662   |       |
| Total                                       |       | $        | 126,112    |     | $          | 8,903    |       | $ | 13,662 |   |

 
| ** **                                      | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Unrecognized  stock-based compensation expense: |       |     |       |     |       |     |       |
| Director’s Plan                            |       | $        | —     |     | $          | 90,550   |       | $ | — |   |
| Incentive Plan                                  |       | —   |       | 25,872   |       | —   |       |
| Total                                           |       | $        | —     |     | $          | 116,422  |       | $ | — |   |

 

The following tablesummarizes the per share weighted-average fair value of options granted:

 
| ** **           | ** ** | **2008**             | ** ** | **2007**                                                     | ** ** | **2006**             | ** ** |
|----------------------|------------|----------------------|------------|--------------------------------------------------------------|------------|----------------------|------------|
| ** **           | ** ** | **Options  granted** | ** ** | **Weighted-  average grant  date fair value** | ** ** | **Options  granted** | ** ** | **Weighted-  average grant  date fair value** | ** ** | **Options  granted** | ** ** | **Weighted-  average grant  date fair value** | ** ** |
| Director’s Plan |       | —               |       | $                                                            | —     |                 | 17,500     |   | $ | 5.57 |   | — |   | $ | — |   |
| Incentive Plan       |       | 2,000                |       | 4.85                                                         |       | 5,000                |       | 5.57 |   | 2,200 |   | 6.21 |   |
| Total                |       | 2,000                |       | $                                                            | 4.85       |                 | 22,500     |   | $ | 5.57 |   | 2,200 |   | $ | 6.21 |   |

 

As of December 31,2008, there were no unvested options compared to 22,500 unvested options with agrant-date weighted-average fair value of $5.57 per share as of December 31,2007.

 

In addition to the twostock option plans, the Company has established the 2002 Employee StockPurchase Plan (the ESPP) and has reserved 110,000 shares of its un-issuedcapital stock for issuance under the plan. The plan was designed to promote broad-based employee ownership of theCompany’s stock.  Under the ESPP,employees have automatic payroll withholding purchase the Company’s capitalstock at a discounted price based at the fair market value of the capital stockon either the commencement date or termination date.  At December 31, 2008, 10,570 shares havebeen issued under the ESPP.  The ESPP isconsidered a compensatory plan and as such, is required to comply with theprovisions of SFAS 123R.  The Company recognizescompensation expense on its ESPP on the date the shares are purchased.  For the year ended December 31, 2008,2007 and 2006, compensation expense related to the ESPP approximated $3,000,$7,000 and $15,000, respectively and is included as a component of salaries andemployee benefits in the consolidated income statements.  For the year ended December 31, 2009,the Company expects to issue approximately 1,700 shares and recognizecompensation expense of $5,000.

 

The Company alsoestablished the dividend reinvestment plan (DRP) for its shareholders.  The plan is designed to avail the Company’sstock at no transactional cost to its shareholders.  Cash dividends paid to shareholders who areenrolled in the DRP plus voluntary cash deposits received are used to purchaseshares either directly from the Company, from shares that become available inthe open market or from the Company’s previously acquired treasury stock.  The Company has reserved 110,000 shares ofits un-issued capital stock for issuance under the DRP.  Reserved shares under the DRP are issued atfair value as of the dividend payment date. As of  December 31, 2008,there are 29,330 shares are available for future issuance.

 

**10.****      ****INCOME TAXES**

 

The Company adopted FASBInterpretation No. 48, Accounting for Uncertainty in Income Taxes—aninterpretation of FASB Statement No. 109 (FIN 48) during the first quarterof 2007 and has evaluated its material tax positions as 

 

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of December 31, 2008and 2007.  The adoption of FIN 48 had noeffect on its consolidated financial statements.  Under the “more-likely-than-not” thresholdguidelines, the Company believes no significant uncertain tax positions exist,either individually or in the aggregate, that would give rise to thenon-recognition of an existing tax benefit. In periods subsequent to December 31, 2008, determinations ofpotentially adverse material tax positions will be evaluated to determinewhether an uncertain tax position may have previously existed or has beenoriginated.  In the event an adverse taxposition is determined to exist, penalty and interest will be accrued, inaccordance with the Internal Revenue Service guidelines, and recorded as acomponent of other expenses in the Company’s consolidated statements of income.

 

As of December 31,2008, there were no unrecognized tax benefits that, if recognized, wouldsignificantly affect the Company’s effective tax rate.  Also, as of December 31, 2008, therewere no penalties and interest recognized in the consolidated statements ofincome as a result of the adoption of FIN 48, nor does the Company foresee achange in its material tax positions that would give rise to thenon-recognition of an existing tax benefit during the forthcoming twelvemonths.  Tax returns filed with theInternal Revenue Service are subject to review by law under a three-yearstatute of limitations.  The Company hasnot received notification from the IRS regarding adverse tax issues from taxreturns filed for tax years 2005, 2006 or 2007. The Company has not yet filed its income tax return for the year ended December 31,2008.

 

The following temporarydifferences gave rise to the deferred tax asset (liability) at December 31,2008 and 2007:

 
| ** **                                                        | ** ** | **2008**  | ** ** | **2007**  | ** ** |
|-------------------------------------------------------------------|------------|-----------|------------|-----------|------------|
| Deferred tax  assets:                                             |       |      |       |      |       |
| Allowance for  loan losses                                        |       | $         | 1,613,380  |      | $          | 1,640,296 |   |
| Unrealized  losses on available-for-sale securities               |       | 4,549,165 |       | 505,861   |       |
| Deferred  interest from non-accrual loans                         |       | 269,278   |       | 297,482   |       |
| Other-than-temporary  impairment on available-for-sale securities |       | 148,126   |       | —    |       |
| Stock-based  compensation                                         |       | 45,905    |       | 3,027     |       |
| Deferred  compensation                                            |       | —    |       | 24,479    |       |
| Retirement  settlement reserve                                    |       | 32,365    |       | 39,714    |       |
| Other                                                             |       | 121,013   |       | 108,201   |       |
|                                                              |       |      |       |      |       |
| Total                                                             |       | 6,779,232 |       | 2,619,060 |       |
|                                                              |       |      |       |      |       |
| Deferred tax  liabilities:                                        |       |      |       |      |       |
| Depreciation                                                      |       | (272,108  | )          | (251,475  | )          |
| Loan fees and  costs                                              |       | (510,858  | )          | (469,892  | )          |
| Other                                                             |       | (160,496  | )          | (108,168  | )          |
|                                                              |       |      |       |      |       |
| Total                                                             |       | (943,462  | )          | (829,535  | )          |
|                                                              |       |      |       |      |       |
| Deferred tax  asset, net                                          |       | $         | 5,835,770  |      | $          | 1,789,525 |   |

 

The provision for income taxes for the years ended December 31are as follows:

 
| ** **      | ** ** | **2008** | ** ** | **2007** | ** ** | **2006**  | ** ** |
|-----------------|------------|----------|------------|----------|------------|-----------|------------|
|            |       |     |       |     |       |      |       |
| Current         |       | $        | 1,071,912  |     | $          | 1,557,327 |       | $ | 1,437,083 |   |
| Deferred        |       | (2,941   | )          | 78,838   |       | (75,003   | )          |
|            |       |     |       |     |       |      |       |
| Total provision |       | $        | 1,068,971  |     | $          | 1,636,165 |       | $ | 1,362,080 |   |

 

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The reconciliation between the expected statutoryincome tax and the actual provision for income taxes is as follows:

 
| ** **                                   | ** ** | **2008** | ** ** | **2007** | ** ** | **2006**  | ** ** |
|----------------------------------------------|------------|----------|------------|----------|------------|-----------|------------|
|                                         |       |     |       |     |       |      |       |
| Expected provision  at the statutory rate    |       | $        | 1,599,672  |     | $          | 2,124,231 |       | $ | 1,865,703 |   |
| Tax-exempt  income                           |       | (371,360 | )          | (348,903 | )          | (376,906  | )          |
| Nondeductible  interest expense              |       | 41,542   |       | 47,385   |       | 54,670    |       |
| Bank owned life  insurance                   |       | (108,501 | )          | (105,639 | )          | (97,261   | )          |
| Nondeductible  other expenses and other, net |       | 25,319   |       | 36,792   |       | 33,575    |       |
| Low income  housing tax credits              |       | (117,701 | )          | (117,701 | )          | (117,701  | )          |
|                                         |       |     |       |     |       |      |       |
| Actual provision  for income taxes           |       | $        | 1,068,971  |     | $          | 1,636,165 |       | $ | 1,362,080 |   |

 

**11.****      ****RETIREMENT PLAN**

 

TheCompany has a defined contribution profit sharing 401(k) plan coveringsubstantially all of its employees.  Theplan is subject to the provisions of the Employee Retirement Income SecurityAct of 1974 (ERISA).  Contributions tothe plan were approximately $351,000 in 2008, $292,000 in 2007 and $242,000 in2006.

 

**12.****      ****FAIR VALUE OF FINANCIAL INSTRUMENTS AND DERIVATIVES**

 

The following table represents the carrying amount andestimated fair value of the Company’s financial instruments as of December 31(in thousands):

 
| ** **                               | ** ** | **2008**             | ** ** | **2007**                       | ** ** |
|------------------------------------------|------------|----------------------|------------|--------------------------------|------------|
| ** **                               | ** ** | **Carrying  amount** | ** ** | **Estimated  fair value** | ** ** | **Carrying  amount** | ** ** | **Estimated  fair value** | ** ** |
|                                     |       |                 |       |                           |       |   |   |   |   |
| Financial  assets:                       |       |                 |       |                           |       |   |   |   |   |
| Cash and cash  equivalents               |       | $                    | 12,771     |                           | $          | 12,771 |   | $ | 10,409 |   | $ | 10,409 |   |
| Held-to-maturity  securities             |       | 910                  |       | 940                            |       | 1,147 |   | 1,180 |   |
| Available-for-sale  securities           |       | 83,278               |       | 83,278                         |       | 121,837 |   | 121,837 |   |
| FHLB Stock                               |       | 4,781                |       | 4,781                          |       | 3,303 |   | 3,303 |   |
| Loans and leases                         |       | 436,207              |       | 438,838                        |       | 421,424 |   | 423,219 |   |
| Loans  available-for-sale                |       | 84                   |       | 85                             |       | 827 |   | 843 |   |
| Accrued interest                         |       | 2,443                |       | 2,443                          |       | 2,501 |   | 2,501 |   |
|                                     |       |                 |       |                           |       |   |   |   |   |
| Financial  liabilities:                  |       |                 |       |                           |       |   |   |   |   |
| Deposit  liabilities                     |       | 433,312              |       | 436,011                        |       | 425,708 |   | 426,357 |   |
| Short-term  borrowings                   |       | 38,130               |       | 38,130                         |       | 39,656 |   | 39,656 |   |
| Long-term debt                           |       | 52,000               |       | 57,230                         |       | 62,709 |   | 65,514 |   |
| Accrued interest                         |       | 1,390                |       | 1,390                          |       | 1,736 |   | 1,736 |   |
|                                     |       |                 |       |                           |       |   |   |   |   |
| On-balance sheet  derivative instrument: |       |                 |       |                           |       |   |   |   |   |
| Cash flow hedge                          |       | 636                  |       | 636                            |       | 441 |   | 441 |   |
|                                          |            |                      |            |                                |            |  |  |  |  |  |  |  |  |

 

On January 1,2008, the Company adopted SFAS 157, Fair Value Measurements.  SFAS 157 defines fair value, establishes aframework for measuring fair value and enhances disclosures about fair valuemeasurements required under other accounting pronouncements, but does notchange existing guidance as to whether or not an instrument is carried at fairvalue.  SFAS 157 establishes a valuationhierarchy for disclosure of the inputs used to measure fair value.  This hierarchy prioritizes the inputs intothree broad levels as follows.  Level 1inputs are quoted prices (unadjusted) in active markets for identical assets orliabilities.  Level 2 inputs are quotedprices for similar assets and liabilities in active markets; quoted prices foridentical or similar assets or liabilities in markets that are not active; orinputs that are observable for the asset or liability, either directly orindirectly through market corroboration, for substantially the full term of thefinancial instrument.  Level 3 inputs areunobservable inputs based on our own assumptions to measure assets andliabilities at fair value.  Level 3pricing for securities may also include unobservable inputs based uponbroker-traded transactions.  A financialasset or liability’s 

 

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classificationwithin the hierarchy is determined based on the lowest level input that issignificant to the fair value measurement. The adoption of this statement had no effect on the Company’s financialcondition, results of operations and cash flows.

 

In February 2008the Financial Accounting Standards Board (FASB) issued FASB Staff Position(FSP) 157-2, Effective Date of FASB Statement No. 157, which delays theeffective date of SFAS 157 to fiscal years beginning after November 15,2008 for non-financial assets and non-financial liabilities that are notrecognized or disclosed at fair value in the financial statements on arecurring basis.  In October 2008,FASB issued FSP 157-3, Determining the Fair Value of a Financial Asset When theMarket for that Asset is not Active, which clarifies the application of FAS 157in a market that is not active and provides an example to illustrate keyconsiderations in determining the fair value of a financial asset when themarket for that financial asset is not active.

 

The following table illustrates the financialinstruments measured at fair value on a recurring basis segregated by hierarchyfair value levels (in thousands):

 
| ** **                     | ** ** | **Fair value measurement at December 31, 2008** | ** ** |
|--------------------------------|------------|-------------------------------------------------------------------------------|------------|
| ** **                     | ** ** | **Total carrying value  at December 31,  2008**           | ** ** | **Quoted prices  in active  markets  (Level 1)** | ** ** | **Significant other  observable inputs  (Level 2)** | ** ** | **Significant other  unobservable  inputs (Level 3)** | ** ** |
|                           |       |                                                                          |       |   |   |   |   |   |   |
| Available-for-sale  securities |       | $                                                                             | 83,278     |   | $ | 428 |   | $ | 72,590 |   | $ | 10,260 |   |
| Loans  available-for-sale      |       | 84                                                                            |       | — |   | 84 |   | — |   |
| Derivative  instrument         |       | 636                                                                           |       | — |   | 636 |   | — |   |
|                           |       |                                                                          |       |   |   |   |   |   |   |
| Total                          |       | $                                                                             | 83,998     |   | $ | 428 |   | $ | 73,310 |   | $ | 10,260 |   |

 

Equity securities in theavailable-for-sale securities portfolio are measured at fair value using quotedmarket prices for identical assets and are classified within Level 1of thevaluation hierarchy.  Other than theCompany’s investment in corporate bonds, all other debt securities in theavailable-for-sale securities portfolio are measured at fair value using pricesprovided by a third-party vendor, who is a provider of financial market data,analytics and related services to financial institutions.  The Company’s investment grade preferred termsecurities, classified under corporate bonds, include both observable andunobservable inputs to determine fair value as described above and, therefore,are considered Level 3 inputs.  Once themarket activity, including new issues, begins to occur, and the unobservablesubjective inputs are replaced by market activity, these securities may betransferred out of Level 3 into a Level 2 classification by management.  For a further discussion on the fair valuedetermination of the Company’s preferred term securities, see Note 3, “InvestmentSecurities.”  Loans available-for-saleare measured at fair value from quotes received through secondary marketsources, i.e., FNMA or FHLB, who provide pricing for similar assets withsimilar terms in actively traded markets. The derivative instrument, included in other assets, is measured at fairvalue from pricing provided by a third party who considers observable interestrates, forward yield curves at commonly quoted intervals and volatility.

 

The following tableillustrates the changes in Level 3 financial instruments measured at fair valueon a recurring basis for the year ended December 31, 2008 (in thousands):

 
| Balance at  beginning of period                                               |   | $      | 16,335 |   |
|-------------------------------------------------------------------------------|--------|--------|--------|--------|
|                                                                          |   |   |   |
| Realized /  unrealized gains losses:                                          |   |   |   |
| In earnings                                                                   |   | (430   | )      |
| In comprehensive  income                                                      |   | (9,958 | )      |
| Purchases,  sales, issuances and settlements, amortization and accretion, net |   | 4,313  |   |
|                                                                          |   |   |   |
| Transfers into  (out of) Level 3                                              |   | — |   |
| Balance at end  of period                                                     |   | $      | 10,260 |   |

 

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The following table illustrates the financialinstruments measured at fair value on a nonrecurring basis segregated byhierarchy fair value levels (in thousands):

 
| ** **     | ** ** | **Fair value measurement at December 31, 2008** | ** ** |
|----------------|------------|-------------------------------------------------------------------------------|------------|
| ** **     | ** ** | **Total carrying value  at December 31,  2008**           | ** ** | **Quoted prices  in active  markets  (Level 1****)** | ** ** | **Significant other  observable inputs  (Level 2****)** | ** ** | **Significant other  unobservable  inputs (Level 3)** | ** ** |
| ** **     | ** ** | ** **                                                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Impaired loans |       | $                                                                             | 1,942      |   | $ | 12 |   | $ | 1,136 |   | $ | 794 |   |
|                |            |                                                                               |            |  |  |  |  |  |  |  |  |  |  |

 

Impaired loans that arecollateral dependent are written down to fair value through the establishmentof specific reserves.  Techniques used tovalue the collateral that secures the impaired loan include: quoted marketprices for identical assets classified as Level 1 inputs; observable inputs,employed by certified appraisers, for similar assets classified as Level 2inputs.  In cases where valuationtechniques included inputs that are unobservable or are based on estimates andassumptions developed by management, with significant adjustments from the bestinformation available under each circumstance, the asset valuation isclassified as Level 3 inputs.

 

**FinancialInstruments with Off-Balance Sheet Risk**

 

The Company is a party tofinancial instruments with off-balance sheet risk in the normal course ofbusiness to meet the financing needs of its customers and to manage itsexposure to interest rate risk.  Interestrate risk includes the possibility that the Company’s net interest income willbe adversely affected as a result of changes in interest rates.  These financial instruments includecommitments to extend credit, standby letters of credit and interest ratefloors.  Those instruments involve, tovarying degrees, elements of credit and interest rate risk in excess of theamount recognized in the balance sheet. The contract or notional amounts of those instruments reflect the extentof the Company’s involvement in particular classes of financial instruments.

 

As of December 31, 2008 and 2007, the notionalamount and estimated fair values of the Company’s financial instruments withoff-balance sheet risk were as follows (in thousands):

 
| ** **                                | ** ** | **2008**     | ** ** | **2007**            | ** ** |
|-------------------------------------------|------------|--------------|------------|---------------------|------------|
| ** **                                | ** ** | **Notional** | ** ** | **Estimated**       | ** ** | **Notional** | ** ** | **Estimated** | ** ** |
| ** **                                | ** ** | **amount**   | ** ** | **fair value** | ** ** | **amount** | ** ** | **fair value** | ** ** |
| Off-balance sheet  financial instruments: |       |         |       |                |       |   |   |   |   |
| Commitments to  extend credit             |       | $            | 93,992     |                | $          | 93,992 |   | $ | 83,379 |   | $ | 83,379 |   |
| Standby letters  of credit                |       | 3,968        |       | 3,968               |       | 5,950 |   | 5,950 |   |
| Cash flow hedge                           |       | 20,000       |       | 636                 |       | 20,000 |   | 441 |   |
|                                           |            |              |            |                     |            |  |  |  |  |  |  |  |  |

 

----

In the above table, the estimated fair valueof the cash flow hedge is an on-balance sheet item included as a component ofother assets in the consolidated balance sheets.

 

**Commitments to Extend Credit and Standby Lettersof Credit**

 

The Company’s exposure tocredit loss from nonperformance by the other party to the financial instrumentsfor commitments to extend credit and standby letters of credit is representedby the contractual amount of those instruments. The Company uses the same credit policies in making commitments andconditional obligations as it does for on-balance sheet instruments.

 

Commitments to extendcredit are legally binding agreements to lend to customers.  Commitments generally have fixed expirationdates or other termination clauses and may require payment of fees.  Since commitments may expire without beingdrawn upon, the total commitment amounts do not necessarily represent futureliquidity requirements.  The Companyevaluates each customer’s credit-worthiness on a case-by-case basis.  The amount of collateral obtained, ifconsidered necessary by the Company on extension of credit, is based onmanagement’s credit assessment of the customer.

 

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Financial standby lettersof credit are conditional commitments issued by the Company to guaranteeperformance of a customer to a third party. Those guarantees are issued primarily to support public and private borrowingarrangements, including commercial paper, bond financing, and similartransactions.  The Company’s performanceunder the guarantee is required upon presentation by the beneficiary of thefinancial standby letter of credit.  Thecredit risk involved in issuing letters of credit is essentially the same asthat involved in extending loan facilities to customers.  The Company was not required to recognize anyliability in connection with the issuance of these financial standby letters ofcredit.

 

The following tablesummarizes outstanding financial letters of credit as of December 31, 2008(in thousands):

 
| ** **            | ** ** | **Less than** | ** ** | **One to five** | ** ** | **Over five** | ** ** | ** ** | ** ** |
|-----------------------|------------|--------------------|------------|---------------------------|------------|--------------------|------------|------------|------------|
| ** **            | ** ** | **one year**  | ** ** | **years**                 | ** ** | **years**          | ** ** | **Total**  | ** ** |
| Secured by:           |       |               |       |                      |       |               |       |       |       |
| Collateral            |       | $                  | 1,938      |                      | $          | 1,000              |       | $          | 725        |   | $ | 3,663 |   |
| Bank lines of  credit |       | 44                 |       | 95                        |       | —             |       | 139        |       |
|                  |       |               |       |                      |       |               |       |       |       |
|                  |       | 1,982              |       | 1,095                     |       | 725                |       | 3,802      |       |
|                  |       |               |       |                      |       |               |       |       |       |
| Unsecured             |       | 71                 |       | 95                        |       | —             |       | 166        |       |
|                  |       |               |       |                      |       |               |       |       |       |
| Total                 |       | $                  | 2,053      |                      | $          | 1,190              |       | $          | 725        |   | $ | 3,968 |   |

 

The Company has notincurred any losses on its commitments in 2008, 2007 or 2006.

 

**Interest Rate Floors, Caps and Swaps**

 

As part of the Company’soverall interest rate risk management strategy, the Company has adopted apolicy whereby it may periodically use derivative instruments to minimizesignificant fluctuations in earnings caused by interest rate volatility.  This interest rate risk management strategyentails the use of interest rate floors, caps and swaps.  During the fourth quarter of 2006, the Companyentered into a three-year interest rate floor derivative agreement on $20,000,000notional value of its prime-based loan portfolio.  The transaction required the payment of apremium by the Company to the seller for the right to receive payments in theevent national prime drops below a pre-determined level (strike rate), essentiallyconverting floating rate loans to fixed rate loans when prime drops below thecontractual strike rate.  When purchased,the Company recorded an asset representing the fair value of the hedge at thetime of purchase.  The Company hasdesignated this agreement as a cash flow hedge pursuant to SFAS No. 133.  Accordingly, the change in the fair value ofthe instrument related to the hedge’s intrinsic value, or approximately$221,000 in 2008, $385,000 in 2007 and $900 in 2006 is recorded as a componentof OCI in the consolidated statement of changes in shareholders’ equity and theportion of the change in fair value related to the time value expiration, orapproximately $25,000, $169,000 and $22,000 for the years ended December 31,2008, 2007 and 2006 respectively, is recorded in the consolidated incomestatements as a reduction of interest income. No gain or loss has been recognized in earnings due to hedgeineffectiveness as of December 31, 2008, 2007 and 2006.  As of December 31, 2008, the Companydoes not expect to reclassify any amount from OCI to earnings over the nexttwelve months and no hedge has been discontinued.  As of December 31, 2008 and 2007, thefair value of the derivative contract approximated $636,000 and $441,000,respectively, and is recorded as a component of other assets in theconsolidated balance sheets.

 

The use of derivativeinstruments exposes the Company to credit risk in the event of non-performanceby the agreement’s counterparty to the derivative instrument.  In the event of default by the counterparty,the Company would be subject to an economic loss that corresponds to the costto replace the agreement.  The Companycontrols the credit risk associated with the derivative instrument by engagingcounterparties with high credit ratings, establishing counterparty exposurelimits and monitoring procedures.

 

**13.****      ****EARNINGS PER SHARE**

 

Basic earnings per share(EPS) is computed by dividing income available to common shareholders by theweighted-average number of common shares outstanding for the period.  Diluted EPS is computed in the same manner asbasic EPS but reflects the potential dilution that could occur if stock optionsto issue additional common stock were exercised, which would then result inadditional stock outstanding to share in or dilute the earnings of theCompany.  The Company maintains twoshare-based compensation plans that may generate additional potential dilutivecommon 

 

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shares.  Generally, dilution would occur ifCompany-issued stock options were exercised and converted into common stock.

 

In the computation ofdiluted EPS, the Company uses the treasury stock method to determine thedilutive effect of its granted but unexercised stock options.  Under this method, the assumed proceedsreceived from shares issued, in a hypothetical stock option exercise, areassumed to be used to purchase treasury stock. Pursuant to the guidance of SFAS No. 128, *Earnings PerShare*, proceeds include: proceeds from the exercise of outstandingstock options; compensation cost for future service that the Company has notyet recognized; and any “windfall” tax benefits that would be credited directlyto shareholders’ equity when the grant generates a tax deduction (or areduction in proceeds if there is a charge to equity).  For a further discussion on the Company’sstock plans, see note 9, above.

 

The following dataillustrates the data used in computing earnings per share and the effects onincome and the weighted-average number of shares of potentially dilutive commonstock for the years ended December 31, 2008, 2007 and 2006:

 
| ** **                                                                | ** ** | **2008**  | ** ** | **2007**  | ** ** | **2006**  | ** ** |
|---------------------------------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
|                                                                      |       |      |       |      |       |      |       |
| Basic EPS:                                                                |       |      |       |      |       |      |       |
|                                                                      |       |      |       |      |       |      |       |
| Net income  available to common shareholders                              |       | $         | 3,635,948  |      | $          | 4,611,572 |       | $ | 4,125,283 |   |
|                                                                      |       |      |       |      |       |      |       |
| Weighted-average  common shares outstanding                               |       | 2,068,851 |       | 2,066,683 |       | 2,047,975 |       |
|                                                                      |       |      |       |      |       |      |       |
| Basic EPS                                                                 |       | $         | 1.76       |      | $          | 2.23      |       | $ | 2.01 |   |
|                                                                      |       |      |       |      |       |      |       |
| Diluted EPS:                                                              |       |      |       |      |       |      |       |
|                                                                      |       |      |       |      |       |      |       |
| Net income  available to common shareholders                              |       | $         | 3,635,948  |      | $          | 4,611,572 |       | $ | 4,125,283 |   |
|                                                                      |       |      |       |      |       |      |       |
| Weighted-average  common shares outstanding                               |       | 2,068,851 |       | 2,066,683 |       | 2,047,975 |       |
| Diluted  potential common shares                                          |       | 20        |       | 386       |       | 1,172     |       |
| Weighted-average  common shares and dilutive potential shares outstanding |       | 2,068,871 |       | 2,067,069 |       | 2,049,147 |       |
|                                                                      |       |      |       |      |       |      |       |
| Diluted EPS                                                               |       | $         | 1.76       |      | $          | 2.23      |       | $ | 2.01 |   |

 

**14.****      ****REGULATORY MATTERS**

 

The Company (on aconsolidated basis) and the Bank are subject to various regulatory capitalrequirements administered by the federal banking agencies.  Failure to meet minimum capital requirementscan initiate certain mandatory and possible additional discretionary actions byregulators that, if undertaken, could have a direct material effect on theCompany’s and the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework forprompt corrective action, the Company and the Bank must meet specific capitalguidelines that involve quantitative measures of their assets, liabilities andcertain off-balance-sheet items as calculated under regulatory accountingpractices.  The capital amounts andclassification are also subject to qualitative judgments by the regulatorsabout components, risk-weightings and other factors.  Prompt corrective action provisions are notapplicable to bank holding companies.

 

Quantitative measures,established by regulation to ensure capital adequacy, require the Company andthe Bank to maintain minimum amounts and ratios (set forth in the table below)of total and Tier I capital (as defined in the regulations) to risk-weightedassets (as defined), and of Tier I capital (as defined) to average assets (asdefined).  As of December 31, 2008,the Company and the Bank met all capital adequacy requirements to which theyare subject.

 

To be categorized as wellcapitalized, the Company and the Bank must maintain minimum total risk-based,Tier I risk-based and Tier I leverage ratios as set forth in the followingtable.  The Company’s and the Bank’sactual capital amounts and ratios are also presented in the table.  No amounts were deducted from capital forinterest-rate risk in either 2008 or 2007.

 

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| ** **                                | ** ** | **Actual** | ** ** | **For capital  adequacy purposes** | ** ** | **To be well capitalized  under prompt corrective  action provisions** | ** **        |
|-------------------------------------------|------------|------------|------------|----------------------------------------------|------------|------------------------------------------------------------------------------------------------------|-------------------|
| ** **                                | ** ** | **Amount** | ** ** | **Ratio**                                    | ** ** | **Amount**                                                                                           | ** **        | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
|                                      |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| As of  December 31, 2008:            |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| Total capital  (to risk-weighted assets)  |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| Consolidated                              |       | $          | 61,929,662 |                                         | 13.6%      |                                                                                                 | 3$36,323,088 |   | 38.0% |   | N/A |   | N/A |   |
| Bank                                      |       | $          | 61,552,250 |                                         | 13.6%      |                                                                                                 | 3$36,313,495 |   | 38.0% |   | 3$45,391,868 |   | 310.0% |   |
|                                      |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| Tier I capital  (to risk-weighted assets) |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| Consolidated                              |       | $          | 57,136,680 |                                         | 12.6%      |                                                                                                 | 3$18,161,544 |   | 34.0% |   | N/A |   | N/A |   |
| Bank                                      |       | $          | 56,806,892 |                                         | 12.5%      |                                                                                                 | 3$18,156,747 |   | 34.0% |   | 3$27,235,121 |   | 36.0% |   |
|                                      |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| Tier I capital  (to average assets)       |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| Consolidated                              |       | $          | 57,136,680 |                                         | 10.0%      |                                                                                                 | 3$22,934,915 |   | 34.0% |   | N/A |   | N/A |   |
| Bank                                      |       | $          | 56,806,892 |                                         |  9.9% |                                                                                                 | 3$22,918,851 |   | 34.0% |   | 3$28,648,563 |   | 35.0% |   |
|                                      |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| As of  December 31, 2007:            |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| Total capital  (to risk-weighted assets)  |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| Consolidated                              |       | $          | 60,657,888 |                                         | 13.6%      |                                                                                                 | 3$35,593,844 |   | 38.0% |   | N/A |   | N/A |   |
| Bank                                      |       | $          | 60,313,618 |                                         | 13.6%      |                                                                                                 | 3$35,587,244 |   | 38.0% |   | 3$44,484,055 |   | 310.0% |   |
|                                      |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| Tier I capital  (to risk-weighted assets) |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| Consolidated                              |       | $          | 55,754,463 |                                         | 12.5%      |                                                                                                 | 3$17,796,922 |   | 34.0% |   | N/A |   | N/A |   |
| Bank                                      |       | $          | 55,485,085 |                                         | 12.5%      |                                                                                                 | 3$17,793,622 |   | 34.0% |   | 3$26,690,433 |   | 36.0% |   |
|                                      |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| Tier I capital  (to average assets)       |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| Consolidated                              |       | $          | 55,754,463 |                                         |  9.5% |                                                                                                 | 3$23,573,565 |   | 34.0% |   | N/A |   | N/A |   |
| Bank                                      |       | $          | 55,485,085 |                                         |  9.4% |                                                                                                 | 3$23,557,576 |   | 34.0% |   | 3$29,446,969 |   | 35.0% |   |

 

The Bank can paydividends to the Company equal to the Bank’s retained earnings whichapproximated $48,057,000 at December 31, 2008.  However, such dividends are limited due tothe capital requirements discussed above.

 

**15.****      ****RELATED PARTY TRANSACTIONS**

 

During the ordinarycourse of business, loans are made to executive officers, directors, greaterthan 5% shareholders and associates of such persons.  These transactions are executed onsubstantially the same terms and at the rates prevailing at the time forcomparable transactions with others. These loans do not involve more than the normal risk of collectibilityor present other unfavorable features.  Asummary of loan activity with officers, directors, associates of such personsand shareholders who own more than 5% of the Company’s outstanding shares is asfollows:

 
| ** **                                                                                                       | ** ** | **2008**   | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
|                                                                                                             |       |       |       |       |       |       |       |
| Balance,  beginning                                                                                              |       | $          | 7,665,710  |       | $          | 9,028,873  |       | $ | 9,165,554 |   |
| Adjustments for  loans to individuals no longer officers, directors, associates or greater  than 5% shareholders |       | —     |       | (1,254,485 | )          | —     |       |
| Additions                                                                                                        |       | 1,696,194  |       | 1,261,950  |       | 1,600,137  |       |
| Collections                                                                                                      |       | (1,308,300 | )          | (1,370,628 | )          | (1,736,818 | )          |
|                                                                                                             |       |       |       |       |       |       |       |
| Balance, ending                                                                                                  |       | $          | 8,053,604  |       | $          | 7,665,710  |       | $ | 9,028,873 |   |

 

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Aggregateloans to directors and associates exceeding 2.5% of shareholders’ equityincluded in the table above are as follows:

 
| ** **                                         | ** ** | **2007**  | ** ** | **2006** | ** ** | **2005**   | ** ** |
|----------------------------------------------------|------------|-----------|------------|----------|------------|------------|------------|
|                                               |       |      |       |     |       |       |       |
| Number of  persons                                 |       | 2         |       | 2        |       | 2          |       |
|                                               |       |      |       |     |       |       |       |
| Balance,  beginning                                |       | $         | 7,196,079  |     | $          | 7,349,167  |       | $ | 7,446,933 |   |
| Additions                                          |       | 1,090,044 |       | 793,049  |       | 2,312,295  |       |
| Collections                                        |       | (707,961  | )          | (946,137 | )          | (1,203,870 | )          |
| Prior loan  balances no longer exceeding threshold |       | —    |       | —   |       | (1,206,191 | )          |
|                                               |       |      |       |     |       |       |       |
| Balance, ending                                    |       | $         | 7,578,162  |     | $          | 7,196,079  |       | $ | 7,349,167 |   |

 

As of December 31,2008, 2007 and 2006, deposits from executive officers, directors and associatesof such persons approximated $9,000,000, $8,100,000 and $7,876,000,respectively.

 

**16.****      ****QUARTERLY FINANCIAL INFORMATION (UNAUDITED)**

 

The following is asummary of quarterly results of operations for the years ended December 31,2008, 2007 and 2006 (in thousands, except per share data):

 
| **2008**                               | ** ** | **First  quarter** | ** ** | **Second  quarter** | ** ** | **Third  quarter** | ** ** | **Fourth  quarter** | ** ** | **Total** | ** ** |
|----------------------------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|-----------|------------|
|                                   |       |               |       |                |       |               |       |                |       |      |       |
| Interest income                        |       | $                  | 8,745      |                | $          | 8,613              |       | $                   | 8,419      |      | $          | 8,184 |   | $ | 33,961 |   |
| Interest expense                       |       | (4,198             | )          | (3,670              | )          | (3,540             | )          | (3,276              | )          | (14,684   | )          |
|                                   |       |               |       |                |       |               |       |                |       |      |       |
| Net interest  income                   |       | 4,547              |       | 4,943               |       | 4,879              |       | 4,908               |       | 19,277    |       |
| Provision for  loan losses             |       | —             |       | (125                | )          | (130               | )          | (685                | )          | (940      | )          |
| Gain on sale of  investment securities |       | 1                  |       | 7                   |       | 17                 |       | —              |       | 25        |       |
| Other-than-temporary  impairment       |       | —             |       | —              |       | (403               | )          | (33                 | )          | (436      | )          |
| Other income                           |       | 1,295              |       | 1,259               |       | 1,231              |       | 1,204               |       | 4,989     |       |
| Other expenses                         |       | (4,393             | )          | (4,445              | )          | (4,673             | )          | (4,699              | )          | (18,210   | )          |
|                                   |       |               |       |                |       |               |       |                |       |      |       |
| Income before  income taxes            |       | 1,450              |       | 1,639               |       | 921                |       | 695                 |       | 4,705     |       |
| Provision for  income taxes            |       | (361               | )          | (435                | )          | (180               | )          | (93                 | )          | (1,069    | )          |
|                                   |       |               |       |                |       |               |       |                |       |      |       |
| Net income                             |       | $                  | 1,089      |                | $          | 1,204              |       | $                   | 741        |      | $          | 602 |   | $ | 3,636 |   |
|                                   |       |               |       |                |       |               |       |                |       |      |       |
| Net income per  share                  |       | $                  | 0.52       |                | $          | 0.59               |       | $                   | 0.35       |      | $          | 0.30 |   | $ | 1.76 |   |

 

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| **2007**                    | ** ** | **First  quarter** | ** ** | **Second  quarter** | ** ** | **Third  quarter** | ** ** | **Fourth  quarter** | ** ** | **Total** | ** ** |
|-----------------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|-----------|------------|
|                        |       |               |       |                |       |               |       |                |       |      |       |
| Interest income             |       | $                  | 8,632      |                | $          | 8,684              |       | $                   | 8,892      |      | $          | 9,071 |   | $ | 35,279 |   |
| Interest expense            |       | (4,328             | )          | (4,362              | )          | (4,470             | )          | (4,500              | )          | (17,660   | )          |
|                        |       |               |       |                |       |               |       |                |       |      |       |
| Net interest  income        |       | 4,304              |       | 4,322               |       | 4,422              |       | 4,571               |       | 17,619    |       |
| Credit for loan  losses     |       | —             |       | —              |       | 60                 |       | —              |       | 60        |       |
| Other income                |       | 1,214              |       | 1,329               |       | 1,309              |       | 1,354               |       | 5,206     |       |
| Other expenses              |       | (4,113             | )          | (4,087              | )          | (4,189             | )          | (4,248              | )          | (16,637   | )          |
|                        |       |               |       |                |       |               |       |                |       |      |       |
| Income before  income taxes |       | 1,405              |       | 1,564               |       | 1,602              |       | 1,677               |       | 6,248     |       |
| Provision for  income taxes |       | (361               | )          | (405                | )          | (424               | )          | (446                | )          | (1,636    | )          |
|                        |       |               |       |                |       |               |       |                |       |      |       |
| Net income                  |       | $                  | 1,044      |                | $          | 1,159              |       | $                   | 1,178      |      | $          | 1,231 |   | $ | 4,612 |   |
|                        |       |               |       |                |       |               |       |                |       |      |       |
| Net income per  share       |       | $                  | 0.51       |                | $          | 0.56               |       | $                   | 0.57       |      | $          | 0.59 |   | $ | 2.23 |   |

 
| **2006**                               | ** ** | **First  quarter** | ** ** | **Second  quarter** | ** ** | **Third  quarter** | ** ** | **Fourth  quarter** | ** ** | **Total** | ** ** |
|----------------------------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|-----------|------------|
|                                   |       |               |       |                |       |               |       |                |       |      |       |
| Interest income                        |       | $                  | 7,893      |                | $          | 8,371              |       | $                   | 8,595      |      | $          | 8,671 |   | $ | 33,530 |   |
| Interest expense                       |       | (3,663             | )          | (4,106              | )          | (4,281             | )          | (4,311              | )          | (16,361   | )          |
|                                   |       |               |       |                |       |               |       |                |       |      |       |
| Net interest  income                   |       | 4,230              |       | 4,265               |       | 4,314              |       | 4,360               |       | 17,169    |       |
| Provision for  loan losses             |       | (75                | )          | (175                | )          | (75                | )          | —              |       | (325      | )          |
| Gain on sale of  investment securities |       | —             |       | —              |       | —             |       | 1                   |       | 1         |       |
| Other income                           |       | 1,129              |       | 1,084               |       | 1,136              |       | 1,172               |       | 4,521     |       |
| Other expenses                         |       | (3,923             | )          | (3,948              | )          | (3,996             | )          | (4,012              | )          | (15,879   | )          |
|                                   |       |               |       |                |       |               |       |                |       |      |       |
| Income before  income taxes            |       | 1,361              |       | 1,226               |       | 1,379              |       | 1,521               |       | 5,487     |       |
| Provision for  income taxes            |       | (329               | )          | (288                | )          | (349               | )          | (396                | )          | (1,362    | )          |
|                                   |       |               |       |                |       |               |       |                |       |      |       |
| Net income                             |       | $                  | 1,032      |                | $          | 938                |       | $                   | 1,030      |      | $          | 1,125 |   | $ | 4,125 |   |
|                                   |       |               |       |                |       |               |       |                |       |      |       |
| Net income per  share                  |       | $                  | 0.51       |                | $          | 0.45               |       | $                   | 0.51       |      | $          | 0.54 |   | $ | 2.01 |   |

 

**17.****      ****CONTINGENCIES**

 

Thenature of the Company’s business generates litigation involving matters arisingin the ordinary course of business. However, in the opinion of management of the Company after consultingwith the Company’s legal counsel, no legal proceedings are pending, which, ifdetermined adversely to the Company or the Bank, would have a material effecton the Company’s shareholders’ equity or results of operations.  No legal proceedings are pending other thanordinary routine litigation incident to the business of the Company and theBank.  In addition, to management’sknowledge, no government authorities have initiated or contemplated anymaterial legal actions against the Company or the Bank.

 

**18.****       ****RECENT ACCOUNTING PRONOUNCEMENTS**

 

In April 2008,the Financial Accounting Standards Board (FASB) posted FASB Staff Position(FSP) No. 142-3, *Determination of theUseful Life of Intangible Assets*, (FSP 142-3).  FSP 142-3 amends the factors that should beconsidered in developing renewal or extension assumptions used to determine theuseful life of a recognized intangible asset under FASB Statement No. 142,*Goodwill and Other Intangible Assets*.  The intent of FSP 142-3 is to improve theconsistency between the useful life of a recognized intangible asset and theperiod of expected cash flows, particularly as used to measure fair value inbusiness combinations.  FSP 142-3 iseffective for fiscal years beginning after December 15, 2008, and is notexpected to have a material effect on the Company’s consolidated financialstatements.

 

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In June 2008,the FASB issued FSP Emerging Issues Task Force (EITF) 03-6-1*, Determining Whether Instruments Granted in Share-Based TransactionsAre Participating Securities,* (FSP EITF 03-6-1).  The FASB determined in FSP EITF 03-6-1, thatall outstanding unvested share-based payment awards that containnon-forfeitable rights to dividends are considered participating securities andshall be included in the computation of earning per share pursuant to thetwo-class method.  FSP EITF 03-6-1 iseffective for fiscal years beginning after December 15, 2008.  The Company will adopt FSP EITF 03-6-1at the beginning of 2009 as required, with no expected impact on the Company’sconsolidated financial statements.

 

In February 2008,the FASB issued FSP 157-2, *Effective Date of FASB 157*,(FSP 157-2) which delays the effective date of FAS 157, *Fair Value Measurements*, for nonfinancial assets andnonfinancial liabilities, except for items that are recognized or disclosed atfair value in the financial statements on a recurring basis (at leastannually).  The provisions ofFSP 157-2 are effective for the Company on January 1, 2009.  The Company is currently evaluating theimpact that the adoption of FAS 157, as it pertains to nonfinancial assetsand nonfinancial liabilities, will have on its consolidated financialstatements.

 

In October 2008,the FASB issued FSP 157-3, *Determining the Fair Valueof a Financial Asset When the Market For That Asset Is Not Active*(FSP 157-3). FSP 157-3 clarifies how management’s internal assumptions andobservable market information should be considered when measuring fair value inan inactive market and how market quotes should be considered when assessingthe relevance of observable available data in measuring fair value.  The adoption of FSP No. 157-3 did nothave a material impact on the Company’s consolidated financial statements.

 

In January 2009,the FASB issued FSP EITF 99-20-1, *Amendments to theImpairment Guidance of EITF Issue No. 99-20* (FSP EITF99-20-1).  While FSP EITF 99-20-1 retainsfair value as the measurement attribute for those other-than-temporarilyimpaired beneficial interests, the Company is not permitted to use marketparticipant assumptions regarding future cash flows to assessother-than-temporary impairment.  FSPEITF 99-20-1 requires the Company to update our interest income recognition anytime it is probable that there is a favorable change in the estimated cashflows or an adverse change in estimated cash flows resulting in another-than-temporary impairment.  FSPEITF 99-20-1 would be applied prospectively to interim and annual reportingperiods ending after December 15, 2008. The adoption of FSP EITF 99-20-1 will not have a material impact on ourconsolidated financial statements.

 

In November 2008,the FASB ratified the consensus reached by the EITF on Issue 08-6, *Equity Method Investment Accounting Considerations* (Issue08-6).  Under Issue 08-6, an entity shallmeasure its equity method investment initially at cost in accordance withFinancial Accounting Standard (FAS) 141(R), *Business Combinations*.  Any other-than-temporary impairment of anequity method investment should be recognized in accordance with AccountingPrincipal Board Opinion 18, *The Equity Method ofAccounting for Investments in Common Stock*.  An equity method investor shall notseparately test an investee’s underlying assets for impairment.  Share issuance by an investee shall beaccounted for as if the equity method investor had sold a proportionate shareof its investment, with gain or loss recognized in earnings.  Issue 08-6 is effective for the Company  on January 1, 2009, and is not expectedto have a material impact on the Company’s consolidated financial statements.

 

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**19.****      ****PARENT COMPANY ONLY**

 

Thefollowing is the condensed financial information for Fidelity D & DBancorp, Inc. on a parent company only basis (in thousands):

 

**Condensed Balance Sheets**

 
| ** **                                  | ** ** | **December 31,** | ** ** |
|---------------------------------------------|------------|-----------------------|------------|
| ** **                                  | ** ** | **2008**              | ** ** | **2007** | ** ** |
|                                        |       |                  |       |   |   |
| Assets:                                     |       |                  |       |   |   |
| Cash                                        |       | $                     | 2          |   | $ | 2 |   |
| Investment in  subsidiary                   |       | 48,561                |       | 54,812 |   |
| Securities  available-for-sale              |       | 428                   |       | 489 |   |
| Other assets                                |       | 10                    |       | — |   |
|                                        |       |                  |       |   |   |
| Total                                       |       | $                     | 49,001     |   | $ | 55,303 |   |
|                                        |       |                  |       |   |   |
| Liabilities and  shareholders’ equity: |       |                  |       |   |   |
| Liabilities                                 |       | $                     | 40         |   | $ | 112 |   |
| Shareholders’  equity                  |       | 48,961                |       | 55,191 |   |
|                                        |       |                  |       |   |   |
| Total                                       |       | $                     | 49,001     |   | $ | 55,303 |   |

** **

**CondensedIncome Statements**

 
| ** **                                      | ** ** | **Years ended December 31,** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                      | ** ** | **2008**                                    | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                            |       |                                        |       |   |   |   |   |
| Income:                                         |       |                                        |       |   |   |   |   |
| Equity in  undistributed earnings of subsidiary |       | $                                           | 1,337      |   | $ | 3,163 |   | $ | 2,972 |   |
| Dividends from  subsidiary                      |       | 2,580                                       |       | 1,613 |   | 1,253 |   |
| Other income                                    |       | 16                                          |       | 13 |   | 14 |   |
|                                            |       |                                        |       |   |   |   |   |
| Total income                                    |       | 3,933                                       |       | 4,789 |   | 4,239 |   |
|                                            |       |                                        |       |   |   |   |   |
| Operating  expenses                             |       | 446                                         |       | 267 |   | 163 |   |
|                                            |       |                                        |       |   |   |   |   |
| Income before  income taxes                     |       | 3,487                                       |       | 4,522 |   | 4,076 |   |
|                                            |       |                                        |       |   |   |   |   |
| Credit for  income taxes                        |       | 149                                         |       | 90 |   | 49 |   |
|                                            |       |                                        |       |   |   |   |   |
| Net income                                      |       | $                                           | 3,636      |   | $ | 4,612 |   | $ | 4,125 |   |

 

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**Condensed Statements ofCash Flows**

 
| ** **                                                           | ** ** | **Years ended December 31,** | ** ** |
|----------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                           | ** ** | **2008**                                    | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                                 |       |                                        |       |   |   |   |   |
| Cash flows from  operating activities:                               |       |                                        |       |   |   |   |   |
| Net income                                                           |       | $                                           | 3,636      |   | $ | 4,612 |   | $ | 4,125 |   |
| Adjustments to  reconcile net income to net cash used in operations: |       |                                        |       |   |   |   |   |
| Equity in  earnings of subsidiary                                    |       | (3,917                                      | )          | (4,777 | ) | (4,225 | ) |
| Stock-based  compensation expense                                    |       | 129                                         |       | 16 |   | 29 |   |
| Deferred income  tax benefit                                         |       | (17                                         | )          | (3 | ) | — |   |
| Changes in other  assets and liabilities, net                        |       | (43                                         | )          | (10 | ) | 19 |   |
|                                                                 |       |                                        |       |   |   |   |   |
| Net cash used in  operating activities                               |       | (212                                        | )          | (162 | ) | (52 | ) |
|                                                                 |       |                                        |       |   |   |   |   |
| Cash flows  provided by investing activities:                        |       |                                        |       |   |   |   |   |
| Dividends  received from subsidiary                                  |       | 2,580                                       |       | 1,613 |   | 1,253 |   |
| Purchases of  securities available for sale                          |       | —                                      |       | (50 | ) | — |   |
|                                                                 |       |                                        |       |   |   |   |   |
| Net cash  provided by investing activities                           |       | 2,580                                       |       | 1,563 |   | 1,253 |   |
|                                                                 |       |                                        |       |   |   |   |   |
| Cash flows from  financing activities:                               |       |                                        |       |   |   |   |   |
| Dividends paid,  net of dividend reinvestment                        |       | (1,995                                      | )          | (1,484 | ) | (1,240 | ) |
| Purchase of  treasury stock                                          |       | (430                                        | )          | — |   | — |   |
| Withholdings to  purchase capital stock                              |       | 57                                          |       | 68 |   | 48 |   |
|                                                                 |       |                                        |       |   |   |   |   |
| Net cash used in  financing activities                               |       | (2,368                                      | )          | (1,416 | ) | (1,192 | ) |
|                                                                 |       |                                        |       |   |   |   |   |
| Net (decrease)  increase in cash                                     |       | —                                      |       | (15 | ) | 9 |   |
|                                                                 |       |                                        |       |   |   |   |   |
| Cash, beginning                                                      |       | 2                                           |       | 17 |   | 8 |   |
|                                                                 |       |                                        |       |   |   |   |   |
| Cash, ending                                                         |       | $                                           | 2          |   | $ | 2 |   | $ | 17 |   |

 

***Item9:  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING ANDFINANCIAL DISCLOSURE***

 

None.

 

***Item 9A(T):******  ******CONTROLS AND PROCEDURES***

 

As of the end of the period coveredby this Annual Report on Form 10-K, an evaluation was carried out by theCompany’s management, with the participation of its Chief Executive Officer andChief Financial Officer, of the effectiveness of the Company’s disclosure controlsand procedures, as defined in Rule 13a-15(e) under the SecuritiesExchange Act of 1934.  Based on suchevaluation, the Chief Executive Officer and Chief Financial Officer concludedthat the Company’s disclosure controls and procedures are designed to ensurethat information required to be disclosed in the reports the Company files orfurnishes under the Securities Exchange Act of 1934 is recorded, processed,summarized and reported within the time periods specified in the SEC’s rules andregulations, and are operating inan effective manner.  In addition, theSEC has extended the deadline for non-accelerated filers, such as the Company,for an auditor attestation on internal control over financial reporting tofiscal years ending after December 15, 2009.  Furthermore, the Company made no changes inits internal controls over financial reporting or in other factors thatmaterially affected, or are reasonably likely to materially affect, thesecontrols during the last fiscal quarter ended December 31, 2008.

 

**Management’s Report on Internal Control Over Financial Reporting**

 

Management of the Company isresponsible for establishing and maintaining adequate internal control overfinancial reporting.  The Company’sinternal control over financial reporting is a process designed under thesupervision of the 

 

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Company’s Chief Executive Officerand Chief Financial Officer, and implemented in conjunction with management andother personnel, to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of the Company’s consolidated financialstatements for external purposes in accordance with generally acceptedaccounting principles.

 

Thereare inherent limitations in the effectiveness of any internal control,including the possibility of human error and the circumvention or overriding ofcontrols.  Accordingly, even effectiveinternal control can provide only reasonable assurance with respect tofinancial statement preparation. Further, because of changes in conditions, the effectiveness of internalcontrol may vary over time.

 

Managementassessed the effectiveness of the Company’s internal control over financialreporting as of December 31, 2008. This assessment was based on criteria for effective internal controlover financial reporting described in “Internal Control — Integrated Framework,”issued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO).  Based on this assessment,management determined that, as of December 31, 2008, the Companymaintained effective internal control over financial reporting.

 

Thisannual report does not include an attestation report of the Company’sregistered public accounting firm regarding internal control over financialreporting.  Management’s report was notsubject to attestation by the Company’s registered public accounting firmpursuant to temporary rules of the SEC that permit the Company to provideonly management’s report in this annual report.

 

***Item 9B:*****                  *****OTHER INFORMATION***

 

None.

 

### ***PART III***

###  

***Item 10:***  DIRECTORS, EXECUTIVE OFFICERSAND CORPORATE GOVERNANCE

*** ***

The information requiredunder Items 401 and 407(c)(3), (d)(4) and (d)(5) of Regulation S-K isincorporated by reference herein, to the information presented in the Company’sdefinitive Proxy Statement for its 2009 Annual Meeting of Shareholders to befiled with the SEC.

 

***Section 16(a) BeneficialOwnership Reporting Compliance***

 

The information requiredunder this section is incorporated by reference herein, to the informationpresented in the Company’s definitive Proxy Statement for its 2009 AnnualMeeting of Shareholders to be filed with the SEC.

 

#### ***Code of Ethics***

####  

The Company adopted awritten code of ethics that applies to our directors, officers and employees,including our chief executive officer and chief financial officer, which isavailable on our website at http://www.bankatfidelity.com through the InvestorRelations link and then under the heading “Governance Documents.”  In addition, copies of our code of ethicswill be provided to shareholders upon written request to Fidelity D &D Bancorp, Inc., Blakely and Drinker Streets, Dunmore, PA 18512 at nocharge.

 

***Item 11:***  EXECUTIVE COMPENSATION

*** ***

The information required by this Item is incorporatedby reference herein, to the information presented in the Company’s definitiveProxy Statement for its 2009 annual meeting of shareholders to be filed withthe SEC.

 

#### ***Item 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS ANDMANAGEMENT******ANDRELATED STOCKHOLDER MATTERS***

####  

The information requiredby this Item is incorporated by reference herein, to the information presentedin the Company’s definitive Proxy Statement for its 2009 annual meeting ofshareholders to be filed with the SEC.

 

##### ***Item 13: CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE***

#####  

The information requiredby this Item, relating to transactions with management and others, certainbusiness relationships and indebtedness of management, is set forth above inFootnote No. 15 “Related Part Transactions,” of  

 

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Part II, Item 8 “FinancialStatements and Supplementary Data,” and is also incorporated by referenceherein to the information presented in the Company’s definitive Proxy Statementfor its 2009 annual meeting of shareholders to be filed with the SEC.

 

***Item 14:******PRINCIPAL ACCOUNTANT FEES AND SERVICES***

 

The information requiredby this Item is incorporated by reference herein, to the information presentedin the Company’s definitive Proxy Statement for its 2009 annual meeting ofshareholders to be filed with the SEC.

 

***PART IV***

 

***Item15: EXHIBITS AND FINANCIAL STATEMENT SCHEDULES***

 

***(a) (1) Financial Statements*** - Thefollowing financial statements are included by reference in Part II, Item8 hereof:

 
|        | Report of Independent Registered Public Accounting  Firm.         |
|--------|-------------------------------------------------------------------|
|   | Consolidated Balance Sheets.                                      |
|   | Consolidated Statements of Income.                                |
|   | Consolidated Statements of Changes in Shareholders’  Equity. |
|   | Consolidated Statements of Cash Flows.                            |
|   | Notes to Consolidated Financial Statements.                       |

 

***(2) Financial Statement Schedules***

 

Financial StatementSchedules are omitted because the required information is either notapplicable, the data is not significant or the required information is shown inthe respective financial statements or in the notes thereto or elsewhereherein.

* *

***(3) Exhibits***

 

The following exhibitsare filed herewith or incorporated by reference as a part of this Form 10-K:

 

***3(i) Amendedand Restated Articles of Incorporation of Registrant.*** Incorporated by reference to Annex B of theProxy Statement/Prospectus included in Registrant’s Amendment 4 to itsRegistration Statement No. 333-90273 on Form S-4, filed with the SECon April 6, 2000.

 

***3(ii) Amendedand Restated Bylaws of Registrant.*** Incorporated by reference to Exhibit 3(ii) toRegistrant’s Form 8-K filed with the SEC on November 21, 2007.

 

****10.1 1998 Independent Directors Stock Option Plan of The FidelityDeposit and Discount Bank, as assumed  byRegistrant.*** Incorporated by reference to Exhibit 10.1to Registrant’s Registration Statement No. 333-90273 on Form S-4,filed with the SEC on November 3, 1999.

 

****10.21998 Stock Incentive Plan of The Fidelity Deposit and Discount Bank, as assumedby Registrant.*** Incorporated by reference to Exhibit 10.2of Registrant’s Registration Statement No. 333-90273 on Form S-4,filed with the SEC on November 3, 1999.

 

****10.3 Registrant’s 2000 Dividend Reinvestment Plan. ***Incorporated byreference to Exhibit 4 to Registrant’s Registration Statement No. 333-45668on Form S-1, filed with the SEC on September 12, 2000 and as amendedby Pre-Effective Amendment No. 1 on October 11, 2000, byPost-Effective Amendment No. 1 on May 30, 2001, by Post-EffectiveAmendment No. 2 on July 7, 2005 and by Registration Statement No.  333-152806on Form S-3 filed on August 6, 2008.

 

****10.4 Registrant’s 2000 Independent Directors Stock Option Plan. ***Incorporated byreference to Exhibit 4.3 to Registrant’s Registration Statement No. 333-64356on Form S-8 filed with the SEC on July 2, 2001.

 

****10.5 Amendment, dated October 2, 2007, to the Registrant’s 2000Independent Directors Stock Option Plan. ***Incorporated by reference to Exhibit 10.2to Registrant’s Form 8-K filed with the SEC on October 4, 2007.

 

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****10.6 Registrant’s 2000 Stock Incentive Plan. ***Incorporated byreference to Exhibit 4.4 to Registrant’s Registration Statement No. 333-64356on Form S-8 filed with the SEC on July 2, 2001.

 

****10.7 Amendment, dated October 2, 2007, to the Registrant’s 2000Stock Incentive Plan. ***Incorporatedby reference to Exhibit 10.1 to Registrant’s Form 8-K filed with theSEC on October 4, 2007.

 

****10.8 Registrant’s 2002 Employee Stock Purchase Plan. ***Incorporated byreference to Exhibit 4.5 to Registrant’s Registration Statement No. 333-113339on Form S-8 filed with the SEC on March 5, 2004.

 

****10.9 Complete Settlement Agreement and General Release between MichaelF. Marranca, Registrant and The Fidelity Deposit and Discount Bank, dated July 30,2004***. Incorporated by reference to Exhibit 99.1 to Registrant’s CurrentReport on Form 8-K filed with the SEC on August 10, 2004.

 

****10.10 Amendment to the Complete Settlement Agreement and GeneralRelease between Michael F. Marranca, Registrant and The Fidelity Deposit andDiscount Bank, dated November 4, 2005*. **Incorporated by referenceto****Exhibit 99.1 to Registrant’sCurrent Report on Form 8-K filed with the SEC on November 9, 2005.

 

****10.11 Change of Control Agreements with Salvatore R. DeFrancesco, Registrant and The Fidelity Deposit andDiscount Bank, dated March 21, 2006. ***Incorporated by reference to Exhibit 99.2to Registrant’s Current Report on Form 8-K filed with the SEC on March 27,2006.

 

****10.12 Amended and Restated Executive Employment Agreement betweenFidelity D & D Bancorp, Inc., The Fidelity Deposit and DiscountBank and Steven C. Ackmann, dated July 11, 2007.* **Incorporated by referenceto Exhibit 10.1 to Registrant’s Current Report on Form 8-K filed withthe SEC on July 13, 2007.

 

****10.13 Executive Employment Agreement between Fidelity D & DBancorp, Inc., The Fidelity Deposit and Discount Bank******and Timothy P. O’Brien, dated January 3, 2008. ***Incorporated by reference to Exhibit 10.1to Registrant’s Current Report on Form 8-K filed with the SEC on January 10,2008.

 

****10.14 Executive Employment Agreement between Fidelity D & DBancorp, Inc., The Fidelity Deposit and Discount Bank******and Daniel J. Santaniello, dated February 28,2008. ***Incorporated byreference to Exhibit 10.1 to Registrant’s Current Report on Form 8-Kfiled with the SEC on March 3, 2008.

 

***11Statement regarding computation of earnings per share. ***Included herein in Note13 “Earnings per Share,” contained within the notes to consolidated financialstatements, and incorporated herein by reference.

 

***12Statement regarding computation of ratios. ***Included herein in Item 6, “Selected FinancialData.”

 

***13Annual Report to Shareholders. ***Incorporatedby reference to the 2008 Annual Report to Shareholders filed with the SEC on Form ARS.

 

***14Code of Ethics.*** Incorporated by reference to the 2003 AnnualReport to Shareholders on Form 10-K filed with the SEC on March 29,2004.

 

***21Subsidiaries of the Registrant.***

 

***23Consent of Independent Registered Public Accounting Firm.***

 

***31.1 Rule 13a-14(a) Certificationof Principal Executive Officer, filed herewith.***

 

***31.2 Rule 13a-14(a) Certificationof Principal Financial Officer, filed herewith.***

 

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***32.1Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350,******as adopted pursuant to Section 906 of theSarbanes-Oxley Act of 2002, filed herewith.***

 

***32.2Certification of Principal Financial Officer pursuant to 18 U.S.C. Section 1350,******as adopted pursuant to Section 906 of theSarbanes-Oxley Act of 2002, filed herewith.***

 

***(b)******                                ******The exhibits required to be filedby this Item are listed under Item 15(a) 3, above.***

 

***(c)******                                 ******Not applicable.***

 

----

* Management contract or compensatory plan or arrangement.

 

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities and Exchange Act of 1934, the registrant has duly caused thisreport to be signed on its behalf by the undersigned, thereunto duly authorized.

 
|                          | **FIDELITY D & D BANCORP, INC.** |
|--------------------------|-------------------------------------------|
|                     | (Registrant)                              |
|                     |                                      |   |
|                     |                                      |   |
| Date: March 6, 2009 | By:                                       | /s/ STEVEN C. ACKMANN |
|                     |                                      |      Steven  C. Ackmann, |
|                     |                                      |       President  and Chief Executive Officer |
|                     |                                      |   |
|                     |                                      |   |
| Date: March 6, 2009 | By:                                       | /s/ SALVATORE R. DEFRANCESCO, JR. |
|                     |                                      |      Salvatore  R. DeFrancesco, Jr., |
|                     |                                      |      Treasurer  and Chief Financial Officer |

 

Pursuant to the requirements of the Securities andExchange Act of 1934, this report has been signed below by the following personon behalf of the registrant and in the capacities and on the dates indicated.

 
|        | ** **                                          | ** ** | **DATE**           | ** ** |
|--------|-----------------------------------------------------|------------|--------------------|------------|
|   |                                                |       |               |       |
| By:    | /s/ STEVEN C. ACKMANN                               |       | March 6, 2009 |       |
|   | Steven C. Ackmann, President and                    |       |               |       |
|   | Chief Executive Officer                             |       |               |       |
|   |                                                |       |               |       |
| By:    | /s/ SALVATORE R. DEFRANCESCO, JR.                   |       | March 6, 2009 |       |
|   | Salvatore R. DeFrancesco, Jr., Treasurer       |       |               |       |
|   | and Chief Financial Officer                         |       |               |       |
|   |                                                |       |               |       |
| By:    | /s/ SAMUEL C. CALI                                  |       | March 6, 2009 |       |
|   | Samuel C. Cali, Chairman Emeritus                   |       |               |       |
|   | and Director                                        |       |               |       |
|   |                                                |       |               |       |
| By:    | /s/ PATRICK J. DEMPSEY                              |       | March 6, 2009 |       |
|   | Patrick J. Dempsey, Chairman                        |       |               |       |
|   | of the Board of Directors and Director              |       |               |       |
|   |                                                |       |               |       |
| By:    | /s/ JOHN T. COGNETTI                                |       | March 6, 2009 |       |
|   | John T. Cognetti, Secretary and Director            |       |               |       |
|   |                                                |       |               |       |
| By:    | /s/ MICHAEL J. MCDONALD                             |       | March 6, 2009 |       |
|   | Michael J. McDonald, Vice Chairman                  |       |               |       |
|   | of the Board of Directors and Director              |       |               |       |
|   |                                                |       |               |       |
| By:    | /s/ DAVID L. TRESSLER                               |       | March 6, 2009 |       |
|   | David L. Tressler, Director                         |       |               |       |
|   |                                                |       |               |       |
| By:    | /s/ MARY E. MCDONALD                                |       | March 6, 2009 |       |
|   | Mary E. McDonald, Assistant Secretary  and Director |       |               |       |
|   |                                                |       |               |       |
| By:    | /s/ BRIAN J. CALI                                   |       | March 6, 2009 |       |
|   | Brian J. Cali, Director                             |       |               |       |

 

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Tableof Contents

 
| Exhibit Index                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | ** **   | **Page** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------|----------|
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |         |     |
| ***3(i) Amended  and Restated Articles of Incorporation of Registrant.***Incorporated  by reference to Annex B of the Proxy Statement/Prospectus included in  Registrant’s Amendment 4 to its Registration Statement No. 333-90273 on  Form S-4, filed with the SEC on April 6, 2000.                                                                                                                                                                                                                                                      |         | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |         |     |
| ***3(ii) Amended  and Restated Bylaws of Registrant.***Incorporated by  reference to Exhibit 3(ii) to Registrant’s Form 8-K filed with  the SEC on November 21, 2007.                                                                                                                                                                                                                                                                                                                                                                 | *** *** | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |         |     |
| ***10.1  1998 Independent Directors Stock Option Plan of The Fidelity Deposit and Discount  Bank, as assumed by Registrant.***Incorporated by  reference to Exhibit 10.1 to Registrant’s Registration Statement  No. 333-90273 on Form S-4, filed with the SEC on November 3,  1999.                                                                                                                                                                                                                                                       | *** *** | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |         |     |
| ***10.2  1998 Stock Incentive Plan of The Fidelity Deposit and Discount Bank, as  assumed by Registrant.***Incorporated by reference to  Exhibit 10.2 of Registrant’s Registration Statement No. 333-90273  on Form S-4, filed with the SEC on November 3, 1999.                                                                                                                                                                                                                                                                           | *** *** | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |         |     |
| ***10.3  Registrant’s 2000 Dividend Reinvestment Plan.***Incorporated  by reference to Exhibit 4 to Registrant’s Registration Statement  No. 333-45668 on Form S-1, filed with the SEC on September 12,  2000 and as amended by Pre-Effective Amendment No. 1 on October 11,  2000, by Post-Effective Amendment No. 1 on May 30, 2001, by  Post-Effective Amendment No. 2 on July 7, 2005 and by Registration  Statement No.  333-152806 on Form S-3 filed on  August 6, 2008. | *** *** | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |         |     |
| ***10.4  Registrant’s 2000 Independent Directors Stock Option Plan.***Incorporated  by reference to Exhibit 4.3 to Registrant’s Registration Statement  No. 333-64356 on Form S-8 filed with the SEC on July 2, 2001.                                                                                                                                                                                                                                                                                                                 | *** *** | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |         |     |
| ***10.5  Amendment, dated October 2, 2007, to the Registrant’s 2000 Independent  Directors Stock Option Plan.***Incorporated by reference  to Exhibit 10.2 to Registrant’s Form 8-K filed with the SEC on  October 4, 2007.                                                                                                                                                                                                                                                                                                           | *** *** | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |         |     |
| ***10.6  Registrant’s 2000 Stock Incentive Plan.***Incorporated by  reference to Exhibit 4.4 to Registrant’s Registration Statement  No. 333-64356 on Form S-8 filed with the SEC on July 2, 2001.                                                                                                                                                                                                                                                                                                                                    | *** *** | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |         |     |
| ***10.7  Amendment, dated October 2, 2007, to the Registrant’s 2000 Stock  Incentive Plan.***Incorporated by reference to  Exhibit 10.1 to Registrant’s Form 8-K filed with the SEC on  October 4, 2007.                                                                                                                                                                                                                                                                                                                              | *** *** | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |         |     |
| ***10.8  Registrant’s 2002 Employee Stock Purchase Plan.***Incorporated  by reference to Exhibit 4.5 to Registrant’s Registration Statement  No. 333-113339 on Form S-8 filed with the SEC on March 5,  2004.                                                                                                                                                                                                                                                                                                                         | *** *** | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |         |     |
| ***10.9  Complete Settlement Agreement and General Release between Michael F.  Marranca, Registrant and The Fidelity Deposit and Discount Bank, dated  July 30, 2004.***Incorporated by reference to  Exhibit 99.1 to Registrant’s Current Report on Form 8-K filed with  the SEC on August 10, 2004.                                                                                                                                                                                                                                      | *** *** | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |         |     |
| ***10.10 Amendment to the Complete  Settlement Agreement and General Release between Michael F. Marranca,  Registrant and The Fidelity Deposit and Discount Bank, dated November 4,  2005.***Incorporated by reference to Exhibit 99.1 to  Registrant’s Current Report on Form 8-K filed with the SEC on  November 9, 2005.                                                                                                                                                                                                                | *** *** | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |         |     |
| ***10.11 Change of Control  Agreements with Salvatore R. DeFrancesco, Registrant and The Fidelity Deposit  and Discount Bank, dated March 21, 2006.***Incorporated  by reference to Exhibit 99.2 to Registrant’s Current Report on  Form 8-K filed with the SEC on March 27, 2006.                                                                                                                                                                                                                                                         | *** *** | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |         |     |
| ***10.12 Amended and Restated  Executive Employment Agreement between Fidelity D & D  Bancorp, Inc., The Fidelity Deposit and Discount Bank and Steven C.  Ackmann, dated July 11, 2007.***Incorporated by  reference to Exhibit 10.1 to Registrant’s Current Report on  Form 8-K filed with the SEC on July 13, 2007.                                                                                                                                                                                                       | *** *** | *        |

 

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| ***10.13 Executive Employment Agreement between  Fidelity D & D Bancorp, Inc., The Fidelity Deposit and Discount  Bank and Timothy P. O’Brien, dated January 3, 2008.***Incorporated  by reference to Exhibit 10.1 to Registrant’s Current Report on  Form 8-K filed with the SEC on January 10, 2008. | *** *** | *            |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------|--------------|
| *** ***                                                                                                                                                                                                                                                                                                                                       | *** *** | *** *** |
| ***10.14  Executive Employment Agreement between Fidelity D & D  Bancorp, Inc., The Fidelity Deposit and Discount Bank and Daniel J.  Santaniello, dated February 28, 2008.***Incorporated  by reference to Exhibit 10.1 to Registrant’s Current Report on  Form 8-K filed with the SEC on March 3, 2008.   | *** *** | *            |
| *** ***                                                                                                                                                                                                                                                                                                                                       | *** *** | *** *** |
| ***11  Statement regarding computation of earnings per share.***Included  herein Note 13, “Earnings per Share,” contained within the Notes to  Consolidated Financial Statements, and incorporated herein by reference.                                                                                                                  | *** *** | 74           |
| *** ***                                                                                                                                                                                                                                                                                                                                       | *** *** | *** *** |
| ***12  Statement regarding computation of ratios.***Included  herein in Item 6, “Selected Financial Data”.                                                                                                                                                                                                                               | *** *** | 15           |
| *** ***                                                                                                                                                                                                                                                                                                                                       | *** *** | *** *** |
| ***13  Annual Report to Shareholders.***Incorporated by  reference to the 2008 Annual Report to Shareholders filed with the SEC on  Form ARS.                                                                                                                                                                                                 | *** *** | *            |
| *** ***                                                                                                                                                                                                                                                                                                                                       | *** *** | *** *** |
| ***14  Code of Ethics.***Incorporated by reference to the 2003  Annual Report to Shareholders on Form 10-K filed with the SEC on  March 29, 2004.                                                                                                                                                                                        | *** *** | *            |
| *** ***                                                                                                                                                                                                                                                                                                                                       | *** *** | *** *** |
| ***21  Subsidiaries of the Registrant.***                                                                                                                                                                                                                                                                                                          | *** *** | 89           |
|                                                                                                                                                                                                                                                                                                                                               |         |         |
| ***23  Consent of Independent Registered Public Accounting Firm.***                                                                                                                                                                                                                                                                                | *** *** | 90           |
| *** ***                                                                                                                                                                                                                                                                                                                                       | *** *** | *** *** |
| ***31.1  Rule 13a-14(a) Certification of Principal Executive Officer.***                                                                                                                                                                                                                                                                 | *** *** | 91           |
| *** ***                                                                                                                                                                                                                                                                                                                                       | *** *** | *** *** |
| ***31.2  Rule 13a-14(a) Certification of Principal Financial Officer.***                                                                                                                                                                                                                                                                 | *** *** | 92           |
| *** ***                                                                                                                                                                                                                                                                                                                                       | *** *** | *** *** |
| ***32.1  Certification of Principal Executive Officer pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.***                                                                                                                                                                     | *** *** | 93           |
| *** ***                                                                                                                                                                                                                                                                                                                                       | *** *** | *** *** |
| ***32.2 Certification of Principal  Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.***                                                                                                                                                                      | *** *** | 94           |

 

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*Incorporated byReference

 

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