**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 THEFISCAL YEAR ENDED DECEMBER 31, 2007**

 

**COMMISSIONFILE NUMBER 333-90273**

 

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

 

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

 

**BLAKELYAND DRINKER STREETS**

**DUNMORE,PENNSYLVANIA  18512**

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

 

SECURITIESREGISTERED UNDER SECTION 12(b) OF THE ACT:**None**

 

SECURITIESREGISTERED UNDER SECTION 12(g) OF THE ACT:**Common Stock, without par value**

 

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act.  Yes o  No x

 

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act.  Yes o  No x

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days.  Yes x  No o

 

Indicate by check mark ifdisclosure 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. o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer or a smaller reporting company.  See definition of “large accelerated filer,” “acceleratedfiler” and “smaller reporting 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) |   |                              |

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12B-2 of theAct).  Yes o  No x

 

Aggregate market value ofthe voting common stock held by non-affiliates of the registrant equals$54,750,683, as of June 30, 2007, based on a market priceof $32.10.  The number of shares ofcommon stock outstanding as of February 29, 2008, was 2,075,182.

 

**DOCUMENTS INCORPORATED BYREFERENCE**

 

Excerpts from the Registrant’s 2007 Annual Report toShareholders are incorporated herein by reference in response to Part I.Portions of the Registrant’s definitive Proxy Statement to be used inconnection with the 2008 Annual Meeting of Shareholders are incorporated hereinby reference in partial response to Part II and Part III.

 

 

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**FidelityD & D Bancorp, Inc.2007 Annual Report on Form 10-KTable of Contents**

 
| **Part I.**   |   |                                                                                                                |   |   |
|--------------------|--------|---------------------------------------------------------------------------------------------------------------------|--------|--------|
|               |   |                                                                                                                |   |   |
| Item 1.            |   | Business                                                                                                            |   | 3      |
| Item  1A.          |   | Risk  Factors                                                                                                       |   | 4      |
| Item 1B.           |   | Unresolved Staff  Comments                                                                                          |   | 10     |
| Item  2.           |   | Properties                                                                                                          |   | 10     |
| Item  3.           |   | Legal  Proceedings                                                                                                  |   | 11     |
| Item 4.            |   | Submission of  Matters to a Vote of Security Holders                                                                |   | 11     |
|               |   |                                                                                                                |   |   |
| **Part II.**  |   |                                                                                                                |   |   |
|               |   |                                                                                                                |   |   |
| Item 5.            |   | Market for  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases  of Equity Securities |   | 11     |
| Item 6.            |   | Selected Financial Data                                                                                             |   | 14     |
| Item 7.            |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         |   | 15     |
| Item 7A.           |   | Quantitative  and Qualitative Disclosures About Market Risk                                                         |   | 44     |
| Item 8.            |   | Financial  Statements and Supplementary Data                                                                        |   | 45     |
| Item 9.            |   | Changes in and  Disagreements with Accountants on Accounting and Financial Disclosure                               |   | 74     |
| Item 9A.           |   | Controls and  Procedures                                                                                            |   | 74     |
| Item  9B.          |   | Other  Information                                                                                                  |   | 75     |
|               |   |                                                                                                                |   |   |
| **Part III.** |   |                                                                                                                |   |   |
|               |   |                                                                                                                |   |   |
| Item 10.           |   | Directors,  Executive Officers and Corporate Governance                                                             |   | 75     |
| Item 11.           |   | Executive  Compensation                                                                                             |   | 75     |
| Item 12.           |   | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                    |   | 76     |
| Item 13.           |   | Certain  Relationships and Related Transactions, and Director Independence                                          |   | 76     |
| Item 14.           |   | Principal  Accountant Fees and Services                                                                             |   | 76     |
|               |   |                                                                                                                |   |   |
| **Part IV.**  |   |                                                                                                                |   |   |
|               |   |                                                                                                                |   |   |
| Item 15.           |   | Exhibits,  Financial Statement Schedules                                                                            |   | 76     |
|               |   |                                                                                                                |   |   |
| Signatures         |   | 79                                                                                                                  |
| Exhibit Index |   | 80                                                                                                                  |
| Certifications     |   | 84                                                                                                                  |

 

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** **

**FIDELITYD & D BANCORP, INC.**

 

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

######  

# ***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 is headquartered at Blakely andDrinker Streets in Dunmore, Pennsylvania.

 

The Bank has offered afull range of traditional banking services since it commenced operations in1903.  The Bank has a personal andcorporate trust department and also provides alternative financial andinsurance products with asset management services.  A complete list of services provided by theBank is detailed in the section entitled “Products and Services” containedwithin the 2007 Annual Report to Shareholders, incorporated by reference.  The service area is comprised of the Boroughof Dunmore and the surrounding communities within Lackawanna and Luzernecounties.

 

The banking business ishighly competitive, and the profitability of the Company depends principallyupon the Company’s ability to compete in its market area.  The Company competes with, among othersources, 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.  These efforts enabled the Bank to establishlong-term customer relationships and build customer loyalty by providingproducts and services designed to address the specific needs of its customers.

 

There are noconcentrations of loans that, if lost, would have a materially adverse effecton the continued business of the Bank. The Bank’s loan portfolio does not have a material concentration withina single industry or group of related industries that are vulnerable to therisk of a near-term severe impact. However, the Company’s success is dependent, to a significant degree, oneconomic conditions in Northeastern Pennsylvania, especially in Lackawanna andLuzerne counties, which the Company defines as its primary market area.  The banking industry is affected by generaleconomic conditions including the effects of inflation, recession,unemployment, real estate values, trends in national and global economies andother factors beyond the Company’s control. An economic recession or a delayed economic recovery over a prolongedperiod of time in the Company’s primary market area could cause an increase inthe level of the Bank’s non-performing assets and loan losses, and therebycause operating losses, impairment of liquidity and erosion of capital.  We cannot assure you that adverse changes inthe local economy would not have a material effect on the Company’s futureconsolidated financial condition, results of operations and cash flows.

 

The Company had 188 full-time equivalent employees on December 31,2007, 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 issubject to, among others, the regulations of the Securities and ExchangeCommission (the SEC) and the Federal Reserve Board (the FRB) and the Bank issubject to, among others, the regulations of the Pennsylvania Department ofBanking and the Federal Deposit Insurance Corporation (the FDIC).  Refer to Part II, Item 7 “Supervisionand Regulation” 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 only and 

 

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are qualified in their entirety by reference to suchstatutes and regulations. Applicable regulations relate to, among other things:

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

 

Annually, the Bank isexamined by the Pennsylvania Department of Banking and/or the FDIC.  The last examination was conducted by theFDIC as of December 31, 2006. During the preparation and prior to the filing of this Form 10-K,the Bank was in the process of being examined by the Pennsylvania Department ofBanking as of December 31, 2007.

 

The Company’s websiteaddress is http://www.bankatfidelity.com. The Company makes available through this website the annual reports on Form 10-K,quarterly reports on Form 10-Q and current reports on Form 8-K andamendments to those reports as soon as reasonably practical after filing withthe 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.  Youmay obtain information on the operation of the Public Reference Room bycalling the SEC at (202) 551-8090.  TheSEC also maintains an internet site that contains reports, proxy andinformation statements 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 “Critical Accounting Policies,”which are incorporated by reference in Part II, Item 7.

 

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

 

An investment in theCompany’s common stock is subject to risks inherent to the Company’sbusiness.  The material risks anduncertainties that management believes affect the Company are describedbelow.  Before making an investmentdecision, you should carefully consider the risks and uncertainties describedbelow together with all of the other information included or incorporated byreference in this report.  The risks anduncertainties described below are not the only ones facing the Company.  Additional risks and uncertainties thatmanagement is not aware of or focused on or that management currently deemsimmaterial may also impair the Company’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 theCompany’s common stock could decline significantly, and you could lose all orpart 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.  TheCompany’s earnings and cash flows are largely dependent upon its net interestincome.  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.  Asprevailing interest rates change, net interest spreads are affected by thedifference between the maturities and re-pricing characteristics ofinterest-earning assets and interest-bearing liabilities.  In addition, loan volume and yields areaffected by market interest rates on loans, and rising interest rates generallyare associated with a lower volume of loan originations.  An increase in the general level of interestrates may also adversely affect the ability of certain borrowers to pay theinterest on and principal of their obligations. Accordingly, changes in levels of market interest rates could materiallyadversely affect the Company’s net interest spread, asset quality, loanorigination volume and overall profitability.

 

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*TheCompany is subject to lending risk.*

 

There are inherent risksassociated with the Company’s lending activities.  These risks include, among other things, theimpact of changes in interest rates and changes in the economic conditions inthe markets where the Company operates as well as those across the Commonwealthof Pennsylvania and the United States. Increases in interest rates and/or weakening economic conditions couldadversely impact the ability of borrowers to repay outstanding loans or thevalue of the collateral securing these loans. The Company is also subject to various laws and regulations that affectits lending activities.  Failure tocomply with applicable laws and regulations could subject the Company toregulatory enforcement action that could result in the assessment ofsignificant civil money penalties against the Company.

 

As of December 31,2007, approximately 51% of the Company’s loan portfolio consisted ofcommercial, commercial real estate and real estate construction loans.  These types of loans are generally viewed ashaving more risk of default than residential real estate loans or consumerloans.  These types of loans are alsotypically larger than residential real estate loans and consumer loans.  Because the Company’s loan portfolio containsa significant number of commercial, commercial real estate and constructionloans with relatively large balances, the deterioration of one or a few ofthese loans could cause a significant increase in non-performing loans.  An increase in non-performing loans couldresult in a net loss of earnings from these loans, an increase in the provisionfor possible loan losses and an increase in loan charge-offs, all of whichcould have a material adverse effect on the Company’s financial condition andresults 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.  Theallowance, in the judgment of management, is necessary to reserve for estimatedloan losses and risks inherent in the loan portfolio.  The level of the allowance reflectsmanagement’s continuing evaluation of industry concentrations; specific creditrisks; loan loss experience; current loan portfolio quality; present economic,political and regulatory conditions and unidentified losses inherent in thecurrent loan portfolio.  Thedetermination of the appropriate level of the allowance for possible loanlosses inherently involves a high degree of subjectivity and requires theCompany to make significant estimates of current credit risks and futuretrends, all of which may undergo material changes.  Changes in economic conditions affectingborrowers, new information regarding existing loans, identification ofadditional problem loans and other factors, both within and outside of theCompany’s control, may require an increase in the allowance for possible loanlosses.  In addition, bank regulatoryagencies periodically review the Company’s allowance for loan losses and mayrequire an increase in the provision for possible loan losses or therecognition of further loan charge-offs, based on judgments different thanthose of management.  In addition, ifcharge-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 inthe allowance for loan losses will result in a decrease in net income andcapital and may have a material adverse effect on the Company’s financialcondition 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 ordinary course of business, theCompany may foreclose on and take title to properties securing certainloans.  In doing so, there is a risk thathazardous or toxic substances could be found on these properties.  If hazardous or toxic substances are found,the Company may be liable for remediation costs, as well as for personal injuryand property damage.  Environmental lawsmay require the Company to incur substantial expenses and may materially reducethe affected property’s value or limit the Company’s ability to use or sell theaffected property.  In addition, futurelaws or more stringent interpretations or enforcement policies with respect toexisting laws may increase the Company’s exposure to environmentalliability.  Although the Company haspolicies and procedures to perform an environmental review before initiatingany foreclosure action on real property, these reviews may not be sufficient todetect all potential environmental hazards. 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.  Unlike larger national or other regionalbanks that are more geographically diversified, the Company provides bankingand financial services to customers primarily in Lackawanna and LuzerneCounties.  The local economic conditionsin these areas have a significant impact on the demand for the Company’s 

 

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products and services aswell as the ability of the Company’s customers to repay loans, the value of thecollateral securing loans and the stability of the Company’s deposit fundingsources.  A significant decline ingeneral economic conditions, caused by inflation, recession, acts of terrorism,an outbreak of hostilities or other international or domestic occurrences,unemployment, changes in securities markets or other factors could impact theselocal economic conditions and, in turn, have a material adverse effect on theCompany’s financial condition and results of operations.

 

*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 havesubstantially greater resources than the Company does, and operate under lessstringent regulatory environments.  Thedifferences in resources and regulations may make it more difficult for theCompany to compete profitably, reduce the rates that it can earn on loans andinvestments, increase the rates it must offer on deposits and other funds, andadversely 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 primarily intended to protect depositors’ funds,federal deposit insurance funds and the banking system as a whole, notshareholders.  These regulations affectthe Company’s lending practices, capital structure, investment practices,dividend policy and growth, among other things.  Federal or commonwealth regulatory agenciescontinually review banking laws, regulations and policies for possiblechanges.  Changes to statutes,regulations or regulatory policies, including changes in interpretation orimplementation of statutes, regulations or policies, could affect the Companyin substantial and unpredictable ways. Such changes could subject the Company to additional costs, limit thetypes of financial services and products the Company may offer and/or increasethe ability of non-banks to offer competing financial services and products,among other things.  Failure to complywith laws, regulations or policies could result in sanctions by regulatoryagencies, civil money penalties and/or reputation damage, which could have amaterial adverse effect on the Company’s business, financial condition andresults of operations.  While the Companyhas policies and procedures designed to prevent any such violations, there canbe no assurance 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 of controls, however well designedand operated, is based in part on certain assumptions and can provide onlyreasonable, not absolute, assurances that the objectives of the system aremet.  Any failure or circumvention of theCompany’s controls and procedures or failure to comply with regulations relatedto controls 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.  Thereare substantial risks and uncertainties associated with these efforts, particularlyin instances where the markets are not fully developed.  In developing and marketing new lines ofbusiness and/or new products and services the Company may invest significanttime and resources.  Initial timetablesfor the introduction and development of new lines of business and/or newproducts or services may not be achieved and price and profitability targetsmay not prove feasible.  Externalfactors, such as compliance with regulations, competitive alternatives, andshifting market preferences, may also impact the successful implementation of anew line of business or a new product or service.  Furthermore, any new line of business and/ornew product or service could have a significant impact on the effectiveness ofthe Company’s system of internal controls. Failure to successfully manage these risks in the development andimplementation of new lines of business or new products or services could havea material adverse effect on the Company’s business, results of operations andfinancial condition.

 

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*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 ability to pay dividends depends on itsreceipt of dividends from its subsidiary. Dividend payments from its banking subsidiary are subject to legal andregulatory limitations, generally based on net profits and retained earnings,imposed by the 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 its subsidiary will be able to pay dividendsin the future or that the Company will generate adequate cash flow to paydividends 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.

 

*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 other companies or makeinvestments in banks and other complementary businesses in the future.  The Company may issue additional shares ofcommon stock to pay for future acquisitions, which would dilute your ownershipinterest in the Company.  Future businessacquisitions could be material to the Company, and the degree of successachieved in acquiring and integrating these businesses into the Company couldhave a material effect on the value of the Company’s common stock.  In addition, any acquisition could require itto use substantial cash or other 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.  Competition for the best people in mostactivities engaged in by the Company can be intense and the Company may not beable to hire people or to retain them. The unexpected loss of services of one or more of the Company’s keypersonnel could have a material adverse impact on the Company’s businessbecause of their skills, knowledge of the Company’s market, years of industryexperience and the difficulty of promptly finding qualified replacementpersonnel.  The Company has an employmentagreement 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.  Any failure, interruption or breach insecurity of these systems could result in failures or disruptions in theCompany’s customer relationship management, general ledger, deposit, loan andother systems.  While the Company haspolicies and 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.  The occurrence of any failures, interruptionsor security breaches of the Company’s information systems could damage theCompany’s reputation, result in a loss of customer business, subject theCompany to additional regulatory scrutiny, or expose the Company to civil litigationand possible financial liability, any of which could have a material adverseeffect on the Company’s financial condition and 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 use of technology increasesefficiency and enables financial institutions to better serve customers and toreduce costs.  The Company’s futuresuccess depends, in part, upon its ability to address the needs of itscustomers by using technology to provide products and services that willsatisfy customer demands, as well as to create additional efficiencies in theCompany’s operations.  Many of theCompany’s competitors have substantially greater resources to invest intechnological improvements.  The Companymay not be able to effectively implement new technology-driven products andservices or be successful in marketing these products and services to itscustomers.  Failure to successfully keeppace with technological change affecting the financial services industry couldhave a material adverse impact on the Company’s business and, in turn, theCompany’s financial condition and results of operations.

 

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*TheCompany is subject to claims and litigation pertaining to fiduciaryresponsibility.*

 

From time-to-time,customers make claims and take legal action pertaining to the Company’s performanceof its fiduciary responsibilities. Whether customer claims and legal action related to the Company’sperformance of its fiduciary responsibilities are founded or unfounded, if suchclaims and legal actions are not resolved in a manner favorable to the Companythey may result in significant financial liability and/or adversely affect themarket perception of the Company and its products and services as well asimpact customer demand for 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.  Such events could affect the stability of theCompany’s deposit base, impair the ability of borrowers to repay outstandingloans, impair the value of collateral securing loans, cause significantproperty damage, result in loss of revenue and/or cause the Company to incuradditional expenses.  Severe weather ornatural disasters, acts of war or terrorism or other adverse external eventsmay occur in the future.  Althoughmanagement has established disaster recovery policies and procedures, theoccurrence of any such event could have a material adverse effect on theCompany’s business, which, in turn, could have a material adverse effect on theCompany’s financial condition and results of operations.

 

**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.  TheCompany’s stock price can fluctuate significantly in response to a variety offactors including, among other things:

 

·            Actual or anticipated variations inquarterly results of operations.

·            Recommendations by securities analysts.

·            Operating and stock price performance ofother companies that investors deem comparable to the Company.

·            News reports relating to trends, concernsand other issues in the financial services industry.

·            Perceptions in the marketplace regardingthe Company and/or its competitors.

·            New technology used, or services offered,by competitors.

·            Significant acquisitions or businesscombinations, strategic partnerships, joint ventures or capital commitments byor involving the Company or its competitors.

·            Failure to integrate acquisitions orrealize anticipated benefits from acquisitions.

·            Changes in government regulations.

·            Geopolitical conditions such as acts orthreats 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 markethaving the desired characteristics of depth, liquidity and orderliness dependson the presence in the marketplace of willing buyers and sellers of the Company’scommon 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 lower trading volume of the Company’scommon stock, significant sales of the Company’s common stock, or theexpectation of these sales, could cause the Company’s stock price to fall.

 

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*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’scommon stock is inherently risky for the reasons described in this “RiskFactors” section and elsewhere in this report and is subject to the same marketforces that affect the price of common stock in any company.  As a result, if you acquire the Company’scommon stock, you may lose 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, includingregulatory approval requirements, could make it more difficult for a thirdparty to acquire the Company, even if doing so would be perceived to bebeneficial to the Company’s shareholders. The combination of these provisions effectively inhibits anon-negotiated merger or other business combination, which, in turn, couldadversely 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 is subject tovarious regulations and examinations by various regulatory authorities.  In general, statutes establish the corporategovernance and eligible business activities for the Company, certainacquisition and merger restrictions, limitations on inter-company transactionssuch as loans and dividends, capital adequacy requirements, requirements foranti-money laundering programs and other compliance matters, among otherregulations.  The Company is extensivelyregulated under federal and state banking laws and regulations that areintended primarily for the protection of depositors, federal deposit insurancefunds and the banking system as a whole. Compliance with these statutes and regulations is important to itsability to engage in new 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 cannotpredict whether any of these changes may adversely and materially affectit.  Federal and state banking regulatorsalso possess broad powers to take supervisory actions as they deemappropriate.  These supervisory actionsmay result in higher capital requirements, higher insurance premiums andlimitations on the Company’s activities that could have a material adverseeffect on its business and profitability. While these statutes are generally designed to minimize potential lossto depositors and the FDIC insurance funds, they do not eliminate risk, andcompliance with such statutes increases the Company’s expense, requiresmanagement’s attention and can be a disadvantage from a competitive standpointwith respect to non-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.  Theseconditions include short-term and long-term interest rates, inflation, moneysupply, political issues, legislative and regulatory changes, fluctuations inboth debt and equity capital markets, broad trends in industry and finance, andthe strength of the U.S. economy and the local economies in which the Companyoperates, all of which are beyond the Company’s control.  Deterioration in economic conditions couldresult in an increase in loan delinquencies and non-performing assets,decreases in loan collateral values and a decrease in demand for the Company’sproducts and services, among other things, any of which could have a materialadverse impact on 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 financialinformation.  The Company may also relyon representations of those customers, counterparties or other third parties,such as independent auditors, as to the accuracy and completeness of thatinformation.  Reliance on inaccurate ormisleading financial statements, credit reports or other financial informationcould have a material adverse impact on the Company’s business and, in turn,the Company’s financial condition and results of operations.

 

9

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*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 fundsthat would have historically been held as bank deposits in brokerage accountsor mutual funds.  Consumers can alsocomplete transactions such as paying bills and/or transferring funds directlywithout the assistance of banks.  Theprocess of eliminating banks as intermediaries, known as “disintermediation,”could result in the loss of fee income, as well as the loss of customerdeposits and the related income generated from those deposits.  The loss of these revenue streams and thelower cost deposits as a source of funds could have a material adverse effecton the Company’s financial condition and results of operations.

 

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

 

None

 

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

 

As of December 31,2007, the Bank operated 12 full-service banking offices, of which three wereowned and nine were leased.  None of thelessors of the properties leased by the Bank are affiliated with the Company orthe 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 following tableprovides information with respect to the principal properties from which theBank conducts business:

 
| **Location**                                   | ** ** | **Owned/leased*** | ** ** | **Type of use**                  | ** ** | **Full service** | ** ** | **Drive-thru** | ** ** | **ATM** |
|------------------------------------------------|------------|-------------------|------------|----------------------------------|------------|------------------|------------|----------------|------------|---------|
| Drinker & Blakely Sts.,   Dunmore, PA |       | Owned             |       | Main Branch (1)                  |       | 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       |
|                                           |       |              |       |                             |       |             |       |           |       |    |
| 403 Kennedy Blvd.,   Pittston, PA              |       | Leased            |       | Pittston Branch                  |       | 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       |

 

----

*Allof the owned properties are free of encumbrances

 

(1) Executive andadministrative, commercial lending, trust and asset management services arelocated at this facility.  This officehas two automated teller machines (ATMs).

 

(2) This office has two ATMs.

 

10

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(3) In addition,there is a banking facility located in the Clarks Summit State Hospital.  The office is leased from the hospital undera lease-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 inthis building.  A portion of the buildingis leased to a non-related entity.  The Companyalso owned an adjacent attached building which was leased to a non-relatedentity.  The Company sold this buildingin 2007.

 

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

 

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

·                  Marywood University, 2300 Adams Ave., Nazareth Hall,Scranton

·                  Snö Mountain Ski Resort, 1000 Montage Mountain Rd.,Moosic

·                  Convenient Food Mart, 100 Highland Ave., Clarks Summit

·                  Ice Box Sports Complex, 3 West Olive St., Scranton

·                  Shops at Montage, 1035 Shoppes Blvd., Moosic

 

The Company also owned acommercial facility located at 116—118 N. Blakely Street, Dunmore, PA which wasleased to a non-related entity.  TheCompany sold this facility in 2007.

 

The Company also ownsproperty located at Luzerne Street and South Main Avenue, Scranton.  This property is currently under constructionand will be the site of our West Scranton Branch scheduled to open for businessin 2008.

 

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 OFSECURITY HOLDERS***

 

No matter was submittedduring the quarter ended December 31, 2007 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

 

11

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The following table liststhe quarterly cash dividends paid per share and the range of sales prices forthe Company’s common stock.  Suchover-the-counter prices do not include retail mark-ups, markdowns orcommissions:

 
| ** **  | ** ** | **2007**   | ** ** | ** **    | ** ** | **2006**   | ** ** | ** **    |
|-------------|------------|------------|------------|---------------|------------|------------|------------|---------------|
| ** **  | ** ** | **Prices** | ** ** | **Dividends** | ** ** | **Prices** | ** ** | **Dividends** |
| ** **  | ** ** | **High**   | ** ** | **Low**       | ** ** | **paid**   | ** ** | **High**      | ** ** | **Low** | ** ** | **paid** |
| 1st Quarter |       | $          | 40.00      |          | $          | 32.50      |       | $             | 0.22 |   | $ | 42.50 |   | $ | 36.36 |   | $ | 0.22 |
| 2nd Quarter |       | $          | 37.75      |          | $          | 32.00      |       | $             | 0.22 |   | $ | 38.00 |   | $ | 32.50 |   | $ | 0.22 |
| 3rd Quarter |       | $          | 34.00      |          | $          | 27.10      |       | $             | 0.24 |   | $ | 35.00 |   | $ | 32.10 |   | $ | 0.22 |
| 4th Quarter |       | $          | 34.00      |          | $          | 27.00      |       | $             | 0.25 |   | $ | 35.50 |   | $ | 31.25 |   | $ | 0.22 |

 

Dividends are determinedand declared by the Board of Directors of the Company.  On January 17, 2006, the Board ofDirectors declared a 10% stock dividend. The new shares were distributed on February 15, 2006 toshareholders of record at the close of business on January 30, 2006.  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 orshares that are available in the open market.

 

The Company hadapproximately 1,335 shareholders at February 29, 2008 and approximately1,338 at December 31, 2007.  Thenumber of shareholders is the actual number of individual shareholders ofrecord.  Each security depository isconsidered a single shareholder for purposes of determining the approximatenumber of shareholders.

 

***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 2008 AnnualMeeting of Shareholders to be filed with the SEC.

 

***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 1,2003, and ending December 31, 2007. The graph illustrates the cumulative investment return to shareholders,based on the assumption that a $100 investment was made on December 31,2002, 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:

 

12

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| ** **                                 | ** ** | **Period ending** | ** ** |
|--------------------------------------------|------------|------------------------|------------|
| **Index**                                  | ** ** | **12/31/02**           | ** ** | **12/31/03** | ** ** | **12/31/04** | ** ** | **12/31/05** | ** ** | **12/31/06** | ** ** | **12/31/07** | ** ** |
| Fidelity D & D Bancorp, Inc. |       | 100.00                 |       | 99.07 |   | 93.07 |   | 116.78 |   | 106.30 |   | 93.11 |   |
| NASDAQ Composite                           |       | 100.00                 |       | 150.01 |   | 162.89 |   | 165.13 |   | 180.85 |   | 198.60 |   |
| SNL > $500M OTC-BB and Pink Sheet Banks |       | 100.00                 |       | 139.37 |   | 163.02 |   | 173.49 |   | 190.35 |   | 175.39 |   |

 

 

13

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***ITEM6:  SELECTED FINANCIAL DATA***

 

Set forth below are our selected consolidated financial and otherdata.  This financial data is derived inpart from, and should be read in conjunction with, the Company’s consolidatedfinancial statements and related footnotes:

 
| ** **                                                    | ** ** | **2007**    | ** **  | **2006**    | ** ** | **2005**    | ** ** | **2004**    | ** **  | **2003**    | ** ** |
|---------------------------------------------------------------|------------|-------------|-------------|-------------|------------|-------------|------------|-------------|-------------|-------------|------------|
| **Balance sheet data:**                                       | ** ** | ** **  | ** **  | ** **  | ** ** | ** **  | ** ** | ** **  | ** **  | ** **  | ** ** |
| Total assets                                                  |       | $           | 587,412,555 |        | $          | 562,317,988 |       | $           | 544,060,698 |        | $          | 536,675,138 |   | $ | 575,215,466 |   |
| Total investment  securities                                  |       | 122,984,160 |        | 100,410,736 |       | 97,678,573  |       | 115,668,818 |        | 139,654,074 |       |
| Net loans                                                     |       | 421,424,379 |        | 417,199,048 |       | 403,144,095 |       | 381,546,375 |        | 366,981,640 |       |
| Loans  available-for-sale                                     |       | 827,250     |        | 122,000     |       | 428,584     |       | 576,378     |        | 19,863,577  |       |
| Total deposits                                                |       | 425,708,361 |        | 410,334,595 |       | 379,498,640 |       | 365,615,335 |        | 401,442,546 |       |
| Short-term  borrowings                                        |       | 39,656,354  |        | 33,656,150  |       | 28,772,997  |       | 50,534,046  |        | 54,756,978  |       |
| Long-term debt                                                |       | 62,708,677  |        | 62,536,210  |       | 83,704,188  |       | 71,119,188  |        | 71,876,034  |       |
| Total  shareholders’ equity                              |       | 55,191,294  |        | 51,611,863  |       | 48,846,029  |       | 46,366,760  |        | 43,931,899  |       |
|                                                          |       |        |        |        |       |        |       |        |        |        |       |
| **Operating data for the year ended:**                        | ** ** | ** **  | ** **  | ** **  | ** ** | ** **  | ** ** | ** **  | ** **  | ** **  | ** ** |
| Total interest  income                                        |       | $           | 35,279,357  |        | $          | 33,529,710  |       | $           | 29,020,261  |        | $          | 27,395,491 |   | $ | 28,462,093 |   |
| Total interest  expense                                       |       | 17,660,075  |        | 16,361,109  |       | 11,720,986  |       | 11,180,135  |        | 14,237,129  |       |
| Net interest  income                                          |       | 17,619,282  |        | 17,168,601  |       | 17,299,275  |       | 16,215,356  |        | 14,224,964  |       |
| (Credit)  provision for loan losses                           |       | (60,000     | )           | 325,000     |       | 830,000     |       | 2,150,000   |        | 3,715,000   |       |
|                                                          |       |        |        |        |       |        |       |        |        |        |       |
| Net interest  income after (credit) provision for loan losses |       | 17,679,282  |        | 16,843,601  |       | 16,469,275  |       | 14,065,356  |        | 10,509,964  |       |
| Other income                                                  |       | 5,205,215   |        | 4,522,138   |       | 4,150,502   |       | 4,153,277   |        | 4,182,739   |       |
| Other operating  expense                                      |       | 16,636,760  |        | 15,878,376  |       | 14,561,968  |       | 13,818,565  |        | 12,902,963  |       |
|                                                          |       |        |        |        |       |        |       |        |        |        |       |
| Income before  provision for income taxes                     |       | 6,247,737   |        | 5,487,363   |       | 6,057,809   |       | 4,400,068   |        | 1,789,740   |       |
| Provision for  income taxes                                   |       | 1,636,165   |        | 1,362,080   |       | 1,466,112   |       | 1,035,594   |        | 146,492     |       |
| Net Income                                                    |       | $           | 4,611,572   |        | $          | 4,125,283   |       | $           | 4,591,697   |        | $          | 3,364,474 |   | $ | 1,643,248 |   |
|                                                          |       |        |        |        |       |        |       |        |        |        |       |
| **Per share data:**                                           | ** ** | ** **  | ** **  | ** **  | ** ** | ** **  | ** ** | ** **  | ** **  | ** **  | ** ** |
| Net income per  share, basic                                  |       | $           | 2.23        |        | $          | 2.01        |       | $           | 2.26        |        | $          | 1.67 |   | $ | 0.82 |   |
| Net income per  share, diluted                                |       | $           | 2.23        |        | $          | 2.01        |       | $           | 2.25        |        | $          | 1.67 |   | $ | 0.82 |   |
| Dividends  declared                                           |       | $           | 1,921,533   |        | $          | 1,801,361   |       | $           | 1,624,263   |        | $          | 1,610,423 |   | $ | 1,601,898 |   |
| Dividends per  share                                          |       | $           | 0.93        |        | $          | 0.88        |       | $           | 0.80        |        | $          | 0.80 |   | $ | 0.80 |   |
| Book value per  share                                         |       | $           | 26.62       |        | $          | 25.09       |       | $           | 23.95       |        | $          | 22.92 |   | $ | 21.91 |   |
| Weighted-average  number of shares outstanding*               |       | 2,066,683   |        | 2,047,975   |       | 2,031,211   |       | 2,013,798   |        | 2,002,443   |       |
| Number of shares  outstanding at year-end*               |       | 2,072,929   |        | 2,057,433   |       | 2,039,639   |       | 2,023,529   |        | 2,005,347   |       |
|                                                          |       |        |        |        |       |        |       |        |        |        |       |
| **Ratios:**                                                   | ** ** | ** **  | ** **  | ** **  | ** ** | ** **  | ** ** | ** **  | ** **  | ** **  | ** ** |
| Return on  average assets                                     |       | 0.80        | %           | 0.73        | %          | 0.86        | %          | 0.61        | %           | 0.29        | %          |
| Return on  average equity                                     |       | 8.65        | %           | 8.31        | %          | 9.64        | %          | 7.51        | %           | 3.63        | %          |
| Net interest  margin                                          |       | 3.34        | %           | 3.31        | %          | 3.51        | %          | 3.20        | %           | 2.74        | %          |
| Efficiency ratio                                              |       | 71.61       | %           | 71.67       | %          | 65.99       | %          | 64.45       | %           | 72.32       | %          |
| Expense ratio                                                 |       | 2.01        | %           | 2.02        | %          | 1.93        | %          | 1.69        | %           | 1.68        | %          |
| Allowance for  loan losses to total loans                |       | 1.13        | %           | 1.29        | %          | 1.46        | %          | 1.54        | %           | 1.28        | %          |
| Dividend payout  ratio                                        |       | 41.67       | %           | 43.67       | %          | 35.37       | %          | 47.87       | %           | 97.48       | %          |
| Equity to assets                                              |       | 9.40        | %           | 9.18        | %          | 8.98        | %          | 8.64        | %           | 7.64        | %          |
| Equity to  deposits                                           |       | 12.96       | %           | 12.58       | %          | 12.87       | %          | 12.68       | %           | 10.94       | %          |

 

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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 the 10% stock dividend paid on February 15,2006.

 

14

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

 

***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.  These statements may be identified by the useof the words “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,”“outlook,” “plan,” “potential,” “predict,” “project,” “should,” “will,” “would”and similar terms and phrases, including references 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 not guarantees of futureperformance and are subject to risks, uncertainties and other factors (many ofwhich are beyond our control) that could cause actual results to differmaterially from future results expressed or implied by such forward-lookingstatements.  These factors include,without limitation, the following:

 

·                  the timing and occurrence or non-occurrence of eventsmay be subject to circumstances beyond our control;

 

·                  there may be increases in competitive pressure amongfinancial institutions or from non-financial institutions;

 

·                  changes in the interest rate environment may reduceinterest margins;

 

·                  changes in deposit flows, loan demand or real estatevalues may adversely affect our business;

 

·                  changes in accounting principles, policies orguidelines may cause our financial condition to be perceived differently;

 

·                  general economic conditions, either nationally orlocally in some or all areas in which we do business, or conditions in thesecurities markets or the banking industry may be less favorable than wecurrently anticipate;

 

·                  legislative or regulatory changes may adversely affectour business;

 

·                  technological changes may be more rapid, difficult orexpensive than we anticipate;

 

·                  success or consummation of new business initiativesmay be more difficult or expensive than we anticipate;

 

·                  acts of war or terrorism; or

 

·                  natural disaster.

 

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 to update anyforward-looking statements to reflect events or circumstances after the date ofthis document.

 

Readers should review therisk factors described in Item 1A, above, and in other documents that we file,from time-to-time with the SEC, including quarterly reports on Form 10-Qand any current reports on Form 8-K.

 

# ***Critical accounting policies***

#  

The presentation offinancial 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 31,2007 is adequate and reasonable.  Giventhe subjective nature of identifying and valuing loan losses, it is likely thatwell-informed individuals could make different 

 

15

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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.  The Company receives estimated fair values ofinvestment securities from an independent valuation service.  In developing these fair values, thevaluation service uses estimates of cash flows, based on historical performanceof similar instruments in similar interest rate environments.  Based on experience, management is aware thatestimated fair values of investment securities tend to vary among valuationservices.  Accordingly, when sellinginvestment securities, management may obtain price quotes from more than onesource.  As described in Notes 1 and 3 ofthe consolidated financial statements, the large majority of the Company’sinvestment securities are classified as available-for-sale (AFS).  AFS securities are carried at fair value onthe consolidated balance sheet, with unrealized gains and losses, net of incometax, reported separately within shareholders’ equity through accumulated othercomprehensive income (loss).

 

The fair value ofresidential mortgage loans, classified as AFS, is obtained from the FederalNational Mortgage Association (FNMA).  Todetermine the fair value of student loans, classified as AFS, the Bank uses thepricing obtained from the most recent student loans sold from its AFSportfolio.  The market to which the Banksells mortgage and other loans is restricted and price quotes from othersources are not typically obtained.  Fora further discussion on the accounting treatment of AFS loans, see the sectionentitled “Loans available-for-sale,” contained within management’s discussionand analysis.  As of December 31,2007, loans classified 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, 2007 and December 31,2006 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, 2007***

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

 

***FinancialCondition***

 

***Overview***

 

Compared to 2006, theinterest rate environment improved during 2007. The yield curve, which continues to steepen, should help widen theinterest-rate spreads, bolster margins and improve the operating performance ofthe Bank.  This, in conjunction with oursuccessful deposit gathering tactics, improved credit quality and hedgingstrategy should continue to help position the Bank to optimize net interestincome during this downward, challenging yet improving interest rateenvironment.  The Bank will continue tomonitor cash inflows from prepayments of interest-earning assets, which tend toaccelerate during down interest rate cycles. We are proactively seeking means by which to redeploy excess fundsshould this occur, including but not limited to debt reduction, loan fundingand structured investment strategies.

 

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

 

16

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The following table is a comparison of condensed balance sheet accountsand percentage to total assets at December 31, 2007, 2006 and 2005(thousands of dollars):

 
| ** **                                       | ** ** | **2007**   | ** ** | **2006**    | ** ** | **2005**   | ** ** |
|--------------------------------------------------|------------|------------|------------|-------------|------------|------------|------------|
| ** **                                       | ** ** | **Amount** | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **                                       | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Assets:**                                      | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash equivalents                        |       | $          | 10,409     |        | 1.8        | %          | $          | 13,801 |   | 2.4 | % | $ | 12,594 |   | 2.3 | % |
| Investment securities                            |       | 122,984    |       | 20.9        |       | 100,411    |       | 17.9 |   | 97,679 |   | 18.0 |   |
| Federal Home Loan Bank Stock                     |       | 3,303      |       | 0.6         |       | 3,795      |       | 0.7 |   | 4,628 |   | 0.8 |   |
| Loans and leases, net                            |       | 422,252    |       | 71.9        |       | 417,321    |       | 74.2 |   | 403,573 |   | 74.2 |   |
| Bank premises and equipment                      |       | 12,965     |       | 2.2         |       | 11,324     |       | 2.0 |   | 11,683 |   | 2.2 |   |
| Life insurance cash surrender value              |       | 8,489      |       | 1.4         |       | 8,178      |       | 1.5 |   | 7,892 |   | 1.4 |   |
| Other assets                                     |       | 7,011      |       | 1.2         |       | 7,488      |       | 1.3 |   | 6,012 |   | 1.1 |   |
| Total assets                                     |       | $          | 587,413    |        | 100.0      | %          | $          | 562,318 |   | 100.0 | % | $ | 544,061 |   | 100.0 | % |
| ** **                                       | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Liabilities:**                                 | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total deposits                                   |       | $          | 425,708    |        | 72.5       | %          | $          | 410,335 |   | 73.0 | % | $ | 379,499 |   | 69.7 | % |
| Short-term borrowings                            |       | 39,656     |       | 6.7         |       | 33,656     |       | 6.0 |   | 28,773 |   | 5.3 |   |
| Long-term debt                                   |       | 62,709     |       | 10.7        |       | 62,536     |       | 11.1 |   | 83,704 |   | 15.4 |   |
| Other liabilities                                |       | 4,149      |       | 0.7         |       | 4,179      |       | 0.7 |   | 3,239 |   | 0.6 |   |
| Total  liabilities                               |       | 532,222    |       | 90.6        |       | 510,706    |       | 90.8 |   | 495,215 |   | 91.0 |   |
| Shareholders’ equity                        |       | 55,191     |       | 9.4         |       | 51,612     |       | 9.2 |   | 48,846 |   | 9.0 |   |
| Total liabilities  and shareholders’ equity |       | $          | 587,413    |        | 100.0      | %          | $          | 562,318 |   | 100.0 | % | $ | 544,061 |   | 100.0 | % |

 

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

 
| ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** **            | ** ** | ** ** | ** ** | ** **   | ** ** | ** ** | ** ** | ** **                 | ** ** | ** ** | ** ** | ** **            | ** ** | ** ** | ** ** |
|------------|------------|-------------|------------|------------|------------|-----------------------|------------|------------|------------|--------------|------------|------------|------------|----------------------------|------------|------------|------------|-----------------------|------------|------------|------------|
| ** ** | ** ** | **Assets**  | ** ** | **%**      | ** ** | **Earning  assets *** | ** ** | **%**      | ** ** | **Deposits** | ** ** | **%**      | ** ** | **Short-term  borrowings** | ** ** | **%**      | ** ** | **Other  borrowings** | ** ** | **%**      | ** ** |
| 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)        |       |
| 2003       |       | (2,777,850  | )          | (1)        |       | (3,007,038            | )          | (1)        |       | (12,345,630  | )          | (3)        |       | 3,543,964                  |       | 7          |       | 8,876,034             |       | 14         |       |
|            |            |             |            |            |            |                       |            |            |            |              |            |            |            |                            |            |            |            |                       |            |            |            |  |  |  |  |  |

 

----

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

 

***Deposits***

 

The Bank is acommunity-based, commercial financial institution that offers a variety ofdeposit accounts with a range of interest rates and terms.  Deposit products include savings accounts,interest-bearing checking (NOW), money market, non-interest bearing deposits(DDAs) and certificate of deposit accounts. Certificate of deposit accounts, or CDs, are deposits with statedmaturities ranging from seven days to five years.  The flow of deposits is significantlyinfluenced by general economic conditions, changes in prevailing interestrates, pricing and competition.  Most ofthe Bank’s deposits are obtained from the communities surrounding its 12 branchoffices.  We attempt to attract andretain deposit customers via sales and marketing efforts with new products,quality service, competitive rates and maintaining long-standing customerrelationships.  To determine depositproduct interest rates, the Bank considers local competition, market yields andthe rates charged for alternative sources of funding such as borrowings.  Though we continue to experience intensecompetition for deposits, we set deposit rates based on liquidity needs,balance sheet structure and cost effective strategies that takes intoconsideration the current interest rate environment.

 

17

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The following tablerepresents the components of total deposits as of December 31, 2007 and2006 (thousands of dollars):

 
| ** **              | ** ** | **2007**   | ** ** | **2006**    | ** ** |
|-------------------------|------------|------------|------------|-------------|------------|
| ** **              | ** ** | **Amount** | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **              | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Money market            |       | $          | 87,892     |        | 20.6       | % | $ | 72,359 |   | 17.6 | % |
| NOW                     |       | 54,695     |       | 12.9        |       | 65,122 |   | 15.9 |   |
| Savings and clubs       |       | 40,125     |       | 9.4         |       | 45,301 |   | 11.0 |   |
| Certificates of deposit |       | 178,200    |       | 41.9        |       | 153,811 |   | 37.5 |   |
| Total  interest-bearing |       | 360,912    |       | 84.8        |       | 336,593 |   | 82.0 |   |
| Non-interest-bearing    |       | 64,796     |       | 15.2        |       | 73,742 |   | 18.0 |   |
| Total deposits          |       | $          | 425,708    |        | 100.0      | % | $ | 410,335 |   | 100.0 | % |

 

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 continue togrow as customers are locking in rates during the current declining interestrate environment.  The ongoing increasein money market accounts, net of the decline in savings and club accounts, isfrom success in our deposit-gathering strategies in conjunction withpromotional interest rates tailored to depositors’ needs.  DDAs decreased 12% compared to December 31,2006; however, management believes this outflow to be related to customertransaction timing and therefore temporary rather than permanent.  Management continues to monitor the activityin this account and will develop strategies and implement campaigns to attractand retain this important source of cost-lowering funds.

 

The maturity distributionof certificate of deposit accounts at December 31, 2007 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   |       | $                     | 28,196,901 |                       | $          | 6,108,435                   |       | $                      | 23,724,159 |       | $          | 22,827,030 |   | $ | 80,856,525 |   |
| CDs of less than $100,000 |       | 11,748,231            |       | 8,898,664                  |       | 35,234,358                  |       | 41,462,764             |       | 97,344,017 |       |
| Total CDs                 |       | $                     | 39,945,132 |                       | $          | 15,007,099                  |       | $                      | 58,958,517 |       | $          | 64,289,794 |   | $ | 178,200,542 |   |

 

Approximately 64% ofthese CDs are scheduled to mature in one year. Renewing CDs may re-price to higher or lower 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 preferencefor alternative products.  To help reducethe financial 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 given tocustomer retention.

 

***Short-term borrowings***

 

In addition to deposits,other funding sources available to the Bank are overnight funds purchased fromthe Federal Home Loan Bank of Pittsburgh (FHLB), fed funds purchased fromcorrespondent banks and repurchase agreements with individuals, businesses andpublic entities.  The Bank uses overnightfunding for asset growth, deposit run-off and short-term liquidity needs.  Investment security pre-refunding strategiesand late-year deposit outflow resulted in an increase in overnight borrowingsof $8,555,000 as of December 31, 2007 compared to December 31, 2006.

 

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, theseaccounts tend to be more volatile than the fixed-term product because the dailysweep is dependent 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 2007 declined to $20,504,000 from $22,224,000 at December 31,2006.  At December 31, 2007 and2006, sweep accounts represented 62% and 70%, respectively, of total repurchaseagreements.

 

Overnightborrowings and repurchase agreements are included with short-term borrowings onthe consolidated balance sheet.  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.

 

18

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***Long-term debt***

 

Long-termdebt consists of borrowings from the FHLB. The weighted-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 currently fixedbut will adjust quarterly should market rates increase beyond the issues’original or strike rates.  As of December 31,2007, the weighted-average rate on this convertible debt was 5.35%.  Significant prepayment penalties attached tothe borrowings are a disincentive from paying off the high cost advances.  However, in the event underlying market ratesdrift 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.  Tohelp reduce the Bank’s reliance on overnight funding, during 2007 $16,000,000of advances that had matured or converted, and carried a weighted-averageinterest rate of 4.78%, were replaced with fixed- and capped floating-rateadvances.  The new advances  aggregated of $20,000,000 that mature in 2009and carried an initial weighted-average interest rate of 5.40%.  As of December 31, 2007, theweighted-average interest rate on these advances amounted to 5.13%.

 

At December 31,2007, the Bank had the ability to borrow an additional $122,133,000 from theFHLB by utilizing the numerous funding products available at a variety ofterms.

 

***Investments***

 

The Bank’s investment policy is designed to complementits lending activities, generate a favorable return without incurring undueinterest rate and credit risk, manage interest rate sensitivity, providemonthly cash flow and manage liquidity at acceptable levels.  In establishing investment strategies, theBank considers its business, growth or restructuring plans, the economicenvironment, the interest rate sensitivity position, the types of securitiesheld, permissible purchases, credit quality, maturity and re-pricing terms,call or average-life intervals and investment concentrations.  The policy prescribes permissible investmentcategories that meet the policy standards and management is responsible forstructuring and 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 structuringstrategies.  Investment securitypurchases provide a way to quickly invest excess liquidity in order to generateadditional earnings.  The Bank generallyearns a positive interest spread by assuming interest rate risk and usingdeposits and/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 HTMare carried at amortized cost and represent debt securities that the Companyhas the ability and intent to hold until maturity.  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, net of 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.

 

19

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

 
| ** **                               | ** ** | **2007**   | ** **  | **2006**    | ** ** | **2005**   | ** ** |
|------------------------------------------|------------|------------|-------------|-------------|------------|------------|------------|
| ** **                               | ** ** | **Amount** | ** **  | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| U.S. government agencies                 |       | $          | 35,243,890  |        | 28.7       | %          | $          | 33,891,985 |   | 33.8 | % | $ | 31,125,909 |   | 31.9 | % |
| Mortgage-backed securities               |       | 58,767,109 |        | 47.8        |       | 42,900,005 |       | 42.7 |   | 42,615,197 |   | 43.6 |   |
| State & municipal  subdivisions |       | 12,133,443 |        | 9.8         |       | 12,576,684 |       | 12.5 |   | 13,401,874 |   | 13.7 |   |
| Preferred term securities                |       | 16,335,486 |        | 13.3        |       | 10,570,993 |       | 10.5 |   | 10,083,084 |   | 10.3 |   |
| Equity securities                        |       | 504,232    |        | 0.4         |       | 471,069    |       | 0.5 |   | 452,509 |   | 0.5 |   |
| Total                                    |       | $          | 122,984,160 |        | 100.0      | %          | $          | 100,410,736 |   | 100.0 | % | $ | 97,678,573 |   | 100.0 | % |

 

The distribution of debt securities by stated maturitydate at December 31, 2007 is as follows:

 
| ** **                               | ** ** | **One year** | ** ** | **One through** | ** ** | **Five through** | ** ** | **More than** | ** ** | ** ** | ** ** |
|------------------------------------------|------------|-------------------|------------|----------------------|------------|-----------------------|------------|--------------------|------------|------------|------------|
| ** **                               | ** ** | **or less**  | ** ** | **five years**  | ** ** | **ten years**    | ** ** | **ten years** | ** ** | **Total**  | ** ** |
| U.S. government agencies                 |       | $                 | 997,5000   |                 | $          | 5,012,356             |       | $                  | 16,076,875 |       | $          | 13,157,159 |   | $ | 35,243,890 |   |
| Mortgage-backed securities               |       | 18,120            |       | 3,315,644            |       | 6,272,027             |       | 49,161,318         |       | 58,767,109 |       |
| State & municipal  subdivisions |       | —            |       | —               |       | 1,292,533             |       | 10,840,910         |       | 12,133,443 |       |
| Preferred term securities                |       | —            |       | —               |       | —                |       | 16,335,486         |       | 16,335,486 |       |
| Total debt securities                    |       | $                 | 1,015,620  |                 | $          | 8,328,000             |       | $                  | 23,641,435 |       | $          | 89,494,873 |   | $ | 122,479,928 |   |

 

AFS securities are stated net of unrealized gains andlosses.  As of December 31, 2007,AFS debt securities were recorded with a net unrealized loss in the amount of$1,663,000.  At December 31, 2007,AFS equity securities were recorded at $505,000 including an unrealized gain of$176,000.

 

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       | %          |

 

----

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.

 

***Loansand leases***

 

Gross loans and leasesincreased $3,606,000, or 1%, from $422,643,000 at December 31, 2006, to $426,249,000at December 31, 2007.  Gross loansrepresented 73% and 75% of total assets at December 31, 2007 and December 31,2006, respectively.

 

In 2007, the Bankoriginated $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 Bank originatedlines of credit in the amounts of $18,564,000 for commercial borrowers 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.  With the recent steepening of the yield curveand the hiring of a new senior lender, management anticipates growth in allsectors of the loan portfolio during 2008. During 2008, the Company will channel efforts to develop total bankingrelationships with new customers and strengthen relationships with our existingbase of loyal customers.

 

20

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*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 has recently hired a new senior lender and has restructuredits existing team of commercial loan officers to better serve our existingcustomer base and strategically penetrate the markets for new businessrelationships.

 

*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.  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 the same terms as the residential or the commercial constructionloans.  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.

 

A comparison of domesticloans at December 31, for the five previous periods is as follows:

 
| ** **                | ** ** | **2007**    | ** **  | **2006**    | ** ** | **2005**    | ** ** | **2004**    | ** **  | **2003**    | ** ** |
|---------------------------|------------|-------------|-------------|-------------|------------|-------------|------------|-------------|-------------|-------------|------------|
| Commercial and CRE        |       | $           | 216,057,882 |        | $          | 218,213,216 |       | $           | 216,288,597 |        | $          | 221,968,137 |   | $ | 221,275,922 |   |
| Residential real estate   |       | 116,978,378 |        | 112,742,692 |       | 103,920,613 |       | 91,294,401  |        | 77,077,315  |       |
| Consumer                  |       | 81,998,093  |        | 77,729,520  |       | 74,070,328  |       | 61,487,608  |        | 62,919,070  |       |
| Real estate construction  |       | 10,703,249  |        | 13,369,712  |       | 14,198,858  |       | 10,620,472  |        | 7,267,616   |       |
| Direct financing leases   |       | 511,178     |        | 588,211     |       | 650,348     |       | 2,211,978   |        | 3,685,802   |       |
| Gross loans               |       | 426,248,780 |        | 422,643,351 |       | 409,128,744 |       | 387,582,596 |        | 372,225,725 |       |
| Less:                     |       |        |        |        |       |        |       |        |        |        |       |
| Unearned discount         |       | —      |        | —      |       | —      |       | 48,423      |        | 247,119     |       |
| Allowance for loan losses |       | 4,824,401   |        | 5,444,303   |       | 5,984,649   |       | 5,987,798   |        | 4,996,966   |       |
| Net loans                 |       | $           | 421,424,379 |        | $          | 417,199,048 |       | $           | 403,144,095 |        | $          | 381,546,375 |   | $ | 366,981,640 |   |
|                      |       |        |        |        |       |        |       |        |        |        |       |
| Loans available-for-sale  |       | $           | 827,250     |        | $          | 122,000     |       | $           | 428,584     |        | $          | 576,378 |   | $ | 19,863,577 |   |

 

21

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

 
| ** **               | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Commercial and CRE       |       | 50.7     | %          | 51.6     | %          | 52.9     | %          | 57.3     | %          | 59.5     | %          |
| Residential real estate  |       | 27.5     |       | 26.7     |       | 25.4     |       | 23.5     |       | 20.7     |       |
| Consumer                 |       | 19.2     |       | 18.4     |       | 18.1     |       | 15.9     |       | 16.9     |       |
| Real estate construction |       | 2.5      |       | 3.2      |       | 3.5      |       | 2.7      |       | 1.9      |       |
| Direct financing leases  |       | 0.1      |       | 0.1      |       | 0.1      |       | 0.6      |       | 1.0      |       |
| Gross loans              |       | 100.0    | %          | 100.0    | %          | 100.0    | %          | 100.0    | %          | 100.0    | %          |

 

The following table sets forth the maturitydistribution of select components of the loan portfolio at December 31,2007.  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       |       | $                | 35,289     |                      | $          | 72,576              |       | $          | 108,193    |   | $ | 216,058 |   |
| Real estate construction |       | 10,703           |       | —                    |       | —              |       | 10,703     |       |
| Total                    |       | $                | 45,992     |                      | $          | 72,576              |       | $          | 108,193    |   | $ | 226,761 |   |

 

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, 2007(dollars in thousands):

 
| ** **             | ** ** | **One to five** | ** ** | **More than**  | ** ** | ** ** | ** ** |
|------------------------|------------|---------------------------|------------|---------------------|------------|------------|------------|
| ** **             | ** ** | **years**                 | ** ** | **five years** | ** ** | **Total**  | ** ** |
| Fixed interest rate    |       | $                         | 36,571     |                | $          | 29,561     |       | $ | 66,132 |   |
| Variable interest rate |       | 26,721                    |       | 9,340               |       | 36,061     |       |
| Total                  |       | $                         | 63,292     |                | $          | 38,901     |       | $ | 102,193 |   |

 

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, iflost, would have a material adverse effect on the business of the Bank.  The Bank’s loan portfolio does not have amaterial concentration within a single industry or group of related industriesthat is vulnerable to the risk of a near-term severe negative business impact.

 

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

 

Generally, uponorigination, certain residential mortgages, the guaranteed portions of SBAloans and student loans are classified as AFS. Should market rates increase, fixed-rate loans and loans not immediatelyscheduled to re-price would no longer produce yields consistent with thecurrent market.  In a declining interestrate environment, the Bank would be exposed to prepayment risk and, as rates onadjustable rate loans decrease, interest income would be negativelyaffected.  Consideration is given to thecurrent 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 these loans 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 31,2007, were $827,000, with a corresponding fair value of $843,000 compared to $122,000and $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 $159,000were recognized.  There were no sold SBAloans during 2007.

 

22

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The Bank retains mortgage servicing rights (MSRs) onloans sold into the secondary market. MSRs are retained so that the Bank can continue the personalrelationship developed with its customers. At December 31, 2007 and 2006, the servicing portfolio balance ofsold residential mortgage loans was $61,023,000 and $53,112,000, respectively.

 

***Allowance for loan losses***

 

Management continually evaluatesthe credit quality of the Bank’s loan portfolio and performs a formal review ofthe adequacy of the allowance for loan losses (the allowance) on a quarterlybasis.  The allowance reflects management’sbest estimate of the amount of credit losses in the loan portfolio.  Management’s judgment is based on theevaluation of individual loans, past experience, the assessment of currenteconomic conditions and other relevant factors including the amounts and timingof 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:

 

·                  identification of specific impaired loans by loancategory;

·                  calculation of specific allowances where required forthe impaired loans based on collateral and other objective and quantifiableevidence;

·                  determination of homogenous pools by loan category andeliminating the impaired loans;

·                  application of historical loss percentages (five-yearaverage) to pools to determine the allowance allocation; and

·                  application of qualitative factor adjustmentpercentages to historical losses for trends or changes in the loan portfolio.

 

Allocation of theallowance for different categories of loans is based on the methodology asexplained above.  A key element of themethodology to determine the allowance is the Company’s credit risk evaluationprocess, which includes credit risk grading of individual commercialloans.  Commercial loans are assignedcredit risk grades based on the Company’s assessment of conditions that affectthe borrower’s ability to meet its contractual obligations under the loanagreement.  That process includesreviewing borrowers’ current financial information, historical paymentexperience, credit documentation, public information and other informationspecific to each individual borrower. The changes in allocations in the commercial loan portfolio from periodto period are based upon the credit risk grading system and from periodicreviews of the loan and lease 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 ofall loans on a non-accruing basis as well as a review of certain loans to whichthe lenders or the Company’s Credit Administration function have assigned acriticized or classified risk rating.

 

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.  For further discussion onthe provision for loan losses, see the “Provision for loan losses,” located inthe results of operations section of management’s discussion and analysiscontained 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, and incorporated herein byreference.

 

23

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Management believes thatthe current balance in the allowance for loan losses of $4,824,000 is sufficientto withstand the identified potential credit quality issues that may arise andothers unidentified but are inherent to the portfolio.  Currently, management is unaware of anypotential 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 nor past due 90 days or more.  However, there could be certain instanceswhich become identified over the upcoming year that may require additionalcharge-offs and/or increases to the allowance. The ratio of allowance for loan losses to total loans was 1.13% at December 31,2007 compared to 1.29% at December 31, 2006.

 

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

 
| ** **                                                                | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
|                                                                      |       |     |       |     |       |     |       |     |       |     |       |
| Balance at beginning of period                                            |       | $        | 5,444      |     | $          | 5,985    |       | $        | 5,988      |     | $          | 4,997 |   | $ | 3,900 |   |
|                                                                      |       |     |       |     |       |     |       |     |       |     |       |
| Charge-offs:                                                              |       |     |       |     |       |     |       |     |       |     |       |
| Commercial and all other                                                  |       | 376      |       | 661      |       | 1,077    |       | 775      |       | 1,334    |       |
| Real estate                                                               |       | 90       |       | 109      |       | 21       |       | 266      |       | 503      |       |
| Consumer                                                                  |       | 256      |       | 285      |       | 288      |       | 480      |       | 1,167    |       |
| Lease financing                                                           |       | —   |       | —   |       | 8        |       | 85       |       | 92       |       |
| Total                                                                     |       | 722      |       | 1,055    |       | 1,394    |       | 1,606    |       | 3,096    |       |
|                                                                      |       |     |       |     |       |     |       |     |       |     |       |
| Recoveries:                                                               |       |     |       |     |       |     |       |     |       |     |       |
| Commercial and all other                                                  |       | 18       |       | 64       |       | 395      |       | 226      |       | 204      |       |
| Real estate                                                               |       | 125      |       | 1        |       | 11       |       | 20       |       | 34       |       |
| Consumer                                                                  |       | 19       |       | 124      |       | 155      |       | 178      |       | 230      |       |
| Lease financing                                                           |       | —   |       | —   |       | —   |       | 23       |       | 10       |       |
| Total                                                                     |       | 162      |       | 189      |       | 561      |       | 447      |       | 478      |       |
| Net charge-offs                                                           |       | 560      |       | 866      |       | 833      |       | 1,159    |       | 2,618    |       |
| (Credit) provision for loan losses                                        |       | (60      | )          | 325      |       | 830      |       | 2,150    |       | 3,715    |       |
| Balance at end of period                                                  |       | $        | 4,824      |     | $          | 5,444    |       | $        | 5,985      |     | $          | 5,988 |   | $ | 4,997 |   |
|                                                                      |       |     |       |     |       |     |       |     |       |     |       |
| Net charge-offs to average net loans outstanding                          |       | 0.13     | %          | 0.21     | %          | 0.22     | %          | 0.30     | %          | 0.68     | %          |
| Allowance for loan losses to net charge-offs                              |       | 8.62     | x          | 6.29     | x          | 7.18     | x          | 5.17     | x          | 1.91     | x          |
| Allowance for loan losses to total loans                                  |       | 1.13     | %          | 1.29     | %          | 1.46     | %          | 1.54     | %          | 1.28     | %          |
| Loans 30 - 89 days past due and accruing                                  |       | $        | 4,698      |     | $          | 2,571    |       | $        | 1,609      |     | $          | 4,317 |   | $ | 3,975 |   |
| Loans 90 days or more past due and accruing                               |       | $        | 26         |     | $          | 81       |       | $        | 197        |     | $          | 557 |   | $ | 958 |   |
| Non-accruing loans                                                        |       | $        | 3,811      |     | $          | 3,358    |       | $        | 9,453      |     | $          | 9,904 |   | $ | 7,323 |   |
| Allowance for  loan losses to loans 90 days or more past due and accruing |       | 189.41   | x          | 67.54    | x          | 30.39    | x          | 10.75    | x          | 5.22     | x          |
| Allowance for loan losses to non-accruing loans                           |       | 1.27     | x          | 1.62     | x          | 0.63     | x          | 0.60     | x          | 0.68     | x          |
| Allowance for loan losses to non-performing loans                         |       | 1.58     | x          | 1.58     | x          | 0.62     | x          | 0.57     | x          | 0.60     | x          |
| Average net loans                                                         |       | $        | 419,586    |     | $          | 412,523  |       | $        | 385,800    |     | $          | 381,366 |   | $ | 383,226 |   |

 

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 the Bank,as previously explained.  The changes inthe allocations from year-to-year are based upon year-end reviews of the loanand lease portfolios.

 

24

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Allocation of theallowance among major categories of loans for the past five years is summarizedbelow.  This table should not beinterpreted as an indication that charge-offs in future periods will occur inthese amounts or proportions, or that the allocation indicates futurecharge-off trends.  The portion of theallowance designated as unallocated is within the Company’s policy guidelines.

 
| ** **                            | ** ** | **2007**  | ** ** | **%**  | ** ** | **2006**  | ** ** | **%**     | ** ** | **2005**  | ** ** | **%**  | ** ** | **2004**  | ** ** | **%**  | ** ** | **2003**  | ** ** | **%**  | ** ** |
|---------------------------------------|------------|-----------|------------|--------|------------|-----------|------------|-----------|------------|-----------|------------|--------|------------|-----------|------------|--------|------------|-----------|------------|--------|------------|
| Category                              |       |      |       |   |       |      |       |      |       |      |       |   |       |      |       |   |       |      |       |   |       |
| Residential real estate               |       | $         | 636,899    |   | 13.2       |      | $          | 578,117   |       | 10.6      |       | $      | 595,092    |      | 9.9        |   | $          | 451,349   |       | 7.5    |       | $ | 354,207 |   | 7.1 |   |
| Consumer                              |       | 960,505   |       | 19.9   |       | 1,157,091 |       | 21.2      |       | 1,180,175 |       | 19.7   |       | 966,081   |       | 16.1   |       | 884,689   |       | 17.7   |       |
| Commercial and commercial real estate |       | 2,979,372 |       | 61.7   |       | 3,549,870 |       | 65.2      |       | 4,035,950 |       | 67.4   |       | 4,330,285 |       | 72.3   |       | 3,699,488 |       | 74.0   |       |
| Direct financing leases               |       | 9,355     |       | 0.2    |       | 14,058    |       | 0.3       |       | 14,828    |       | 0.3    |       | 40,891    |       | 0.7    |       | 42,706    |       | 0.9    |       |
| Real estate construction              |       | 52,634    |       | 1.1    |       | 59,617    |       | 1.1       |       | 59,953    |       | 1.0    |       | 46,465    |       | 0.8    |       | 15,876    |       | 0.3    |       |
| Unallocated                           |       | 185,636   |       | 3.9    |       | 85,550    |       | 1.6       |       | 98,651    |       | 1.7    |       | 152,727   |       | 2.6    |       | —    |       | — |       |
| Total                                 |       | $         | 4,824,401  |   | 100.0      | %         | $          | 5,444,303 |       | 100.0     | %          | $      | 5,984,649  |      | 100.0      | %      | $          | 5,987,798 |       | 100.0  | %          | $ | 4,996,966 |   | 100.0 | % |

 

The allocation of theallowance for the commercial loan portfolio comprised 62%, or $2,979,000, ofthe total allowance for loan losses at December 31, 2007, of whichapproximately 18% is reserved for non-performing commercial loanrelationships.  Collateral values wereprudently valued to provide a conservative and realistic value of thecollateral supporting these loans.  Theallocations to the other categories of loans are adequate compared to theactual three-year historical net charge-offs.

 

***Non-performing assets***

 

The Bank 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, 2007,non-performing assets represented 0.67% of total assets compared to 0.65% at December 31,2006.

 

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

 
| ** **                                                                         | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Net loans, including loans available-for-sale                                      |       | $        | 422,252    |     | $          | 417,321  |       | $        | 403,573    |     | $          | 382,123 |   | $ | 386,846 |   |
|                                                                               |       |     |       |     |       |     |       |     |       |     |       |
| Loans past due 90 days or more and accruing                                        |       | $        | 26         |     | $          | 81       |       | $        | 197        |     | $          | 557 |   | $ | 958 |   |
| Non-accrual loans                                                                  |       | 3,811    |       | 3,358    |       | 9,453    |       | 9,904    |       | 7,323    |       |
| Total  non-performing loans                                                        |       | 3,837    |       | 3,439    |       | 9,650    |       | 10,461   |       | 8,281    |       |
| Restructured loans                                                                 |       | —   |       | —   |       | —   |       | —   |       | —   |       |
| Other real estate owned                                                            |       | 107      |       | 197      |       | —   |       | 163      |       | 394      |       |
| Repossessed assets                                                                 |       | —   |       | —   |       | 19       |       | 50       |       | 73       |       |
| Total  non-performing assets                                                       |       | $        | 3,944      |     | $          | 3,636    |       | $        | 9,669      |     | $          | 10,674 |   | $ | 8,748 |   |
|                                                                               |       |     |       |     |       |     |       |     |       |     |       |
| Non-accrual loans to net loans                                                     |       | 0.90     | %          | 0.80     | %          | 2.34     | %          | 2.59     | %          | 1.89     | %          |
| Non-performing  assets to net loans, foreclosed real estate and repossessed assets |       | 0.93     | %          | 0.87     | %          | 2.40     | %          | 2.79     | %          | 2.26     | %          |
| Non-performing assets to total assets                                              |       | 0.67     | %          | 0.65     | %          | 1.78     | %          | 1.99     | %          | 1.52     | %          |
| Non-performing loans to net loans                                                  |       | 0.91     | %          | 0.82     | %          | 2.39     | %          | 2.74     | %          | 2.14     | %          |

 

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 Bank’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 

 

25

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Assets Department haddeveloped specific action plans for each of the Company’s non-performing loans.  During 2007, many of those plans came to aconclusion resulting in repayments of non-performing loans.  The non-accrual loans aggregated $3,811,000at December 31, 2007, an increase of $453,000 from year-end 2006.  During 2007 approximately $3,075,000 of loanswere placed in non-accrual status.  Thesewere partially offset by payoffs or pay-downs of $1,888,000, charge-offs of$236,000, $352,000 in transfers to ORE and $146,000 of loans that returned toperforming status.  Loans past due 90days or more and accruing declined 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.

 

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 Bank terminated its automobile leasingbusiness in 2005.

 

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.  During2007, the Bank collected $93,000 of interest income recognized on the cashbasis.  If the non-accrual loans thatwere outstanding as of December 31, 2007 had been performing in accordancewith their original terms, the Bank 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 Bank purchased ortransferred from construction in process, a component of other assets in theconsolidated balance sheet, approximately $3,293,000 compared to $852,000 in2006.  The increase was principally fromthe completion of the Company’s Green Ridge branch relocation constructionproject.

 

***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.

 

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

 

***The Bank maintains bank owned life insurance (BOLI) for achosen group of employees, namely its officers, where the Bank is the owner andsole beneficiary of the policies.  BOLIis classified as a non-interest earning asset. Increases in the cash surrender value are recorded as non-interestincome.  The BOLI is profitable from theappreciation of the cash surrender values of the pool of insurance and itstax-free advantage to the Bank.  Thisprofitability is used to offset a portion of current and future employeebenefit costs.  The BOLI can beliquidated, if necessary, with associated tax costs.  However, the Bank intends to hold this poolof insurance, because it provides income that enhances the Bank’s capitalposition.  Therefore, the Bank has notprovided for deferred income taxes on the earnings from the increase in cash surrendervalue.***

*** ***

***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 Bank’s branch expansion and other projects and a decrease in the net deferredtax asset, partially offset by an increase in the market value of the Bank’sderivative contract.  See Note 10, “IncomeTaxes,” for an analysis of the net deferred tax asset.  For a further discussion on the Bank’sderivative contract, 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.***

*** ***

***26***

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***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 theliabilities that 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 loan and deposit products, trust and assetmanagement service fees, increases in the cash surrender value of the BOLI, netgains or losses from the sales of loans and securities AFS and from the salesof ORE.  Non-interest expense consists ofcompensation and related employee benefit expenses, occupancy, equipment, dataprocessing, advertising, marketing, professional fees, insurance and otheroperating overhead.

 

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 value ofthe 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, 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 return on average assets (ROA) and return on averageshareholders’ equity (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.

 

27

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***Netinterest income***

 

The following table setsforth a comparison of average balances of assets and liabilities and theirrelated net tax equivalent yields and rates for 2007, 2006 and 2005 (dollars inthousands):

 
| ** **                             | ** ** | **2007**    | ** ** | **2006**     | ** ** | **2005**   | ** ** |
|----------------------------------------|------------|-------------|------------|--------------|------------|------------|------------|
| ** **                             | ** ** | **Average** | ** ** | ** **   | ** ** | **Yield/** | ** ** | **Average** | ** ** | ** ** | ** ** | **Yield/** | ** ** | **Average** | ** ** | ** ** | ** ** | **Yield/** | ** ** |
| ** **                             | ** ** | **balance** | ** ** | **Interest** | ** ** | **rate**   | ** ** | **balance** | ** ** | **Interest** | ** ** | **rate** | ** ** | **balance** | ** ** | **Interest** | ** ** | **rate** | ** ** |
| Interest-earning  assets               |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                                   |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing deposits              |       | $           | 184        |         | $          | 9          |       | 4.81 | % | $ | 240 |   | $ | 9 |   | 3.82 | % | $ | 540 |   | $ | 14 |   | 2.67 | % |
|                                   |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Investments:                           |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. government agencies               |       | 34,682      |       | 1,724        |       | 4.97       |       | 43,299 |   | 1,795 |   | 4.15 |   | 31,976 |   | 1,171 |   | 3.66 |   |
| Mortgage-backed securities             |       | 51,781      |       | 2,540        |       | 4.91       |       | 42,999 |   | 1,944 |   | 4.52 |   | 54,257 |   | 2,328 |   | 4.29 |   |
| State and municipal                    |       | 12,267      |       | 780          |       | 6.36       |       | 14,485 |   | 927 |   | 6.40 |   | 13,203 |   | 837 |   | 6.34 |   |
| Other                                  |       | 17,487      |       | 1,175        |       | 6.72       |       | 14,536 |   | 946 |   | 6.50 |   | 14,126 |   | 643 |   | 4.55 |   |
| Total investments                      |       | 116,217     |       | 6,219        |       | 5.35       |       | 115,319 |   | 5,612 |   | 4.87 |   | 113,562 |   | 4,979 |   | 4.38 |   |
|                                   |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans:                                 |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial                             |       | 220,968     |       | 16,458       |       | 7.45       |       | 219,482 |   | 16,018 |   | 7.30 |   | 216,385 |   | 13,646 |   | 6.31 |   |
| Consumer                               |       | 68,395      |       | 4,625        |       | 6.76       |       | 65,011 |   | 4,200 |   | 6.46 |   | 53,675 |   | 3,548 |   | 6.61 |   |
| Real estate                            |       | 134,869     |       | 8,360        |       | 6.20       |       | 133,279 |   | 8,101 |   | 6.08 |   | 120,407 |   | 7,237 |   | 6.01 |   |
| Direct financing leases                |       | 549         |       | 34           |       | 6.16       |       | 618 |   | 38 |   | 6.18 |   | 1,387 |   | 83 |   | 6.01 |   |
| Total loans                            |       | 424,781     |       | 29,477       |       | 6.94       |       | 418,390 |   | 28,357 |   | 6.78 |   | 391,854 |   | 24,514 |   | 6.26 |   |
|                                   |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Federal funds sold                     |       | 1,948       |       | 103          |       | 5.28       |       | 2,479 |   | 123 |   | 4.97 |   | 1,866 |   | 49 |   | 2.60 |   |
|                                   |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total earning  assets                  |       | $           | 543,130    |         | $          | 35,808     |       | 6.59 | % | $ | 536,428 |   | $ | 34,101 |   | 6.36 | % | $ | 507,822 |   | $ | 29,556 |   | 5.82 | % |
|                                   |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  liabilities          |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                                   |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Deposits:                              |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Savings                                |       | $           | 41,055     |         | $          | 511        |       | 1.24 | % | $ | 46,422 |   | $ | 620 |   | 1.34 | % | $ | 48,273 |   | $ | 450 |   | 0.93 | % |
| NOW                                    |       | 67,489      |       | 1,837        |       | 2.72       |       | 69,138 |   | 1,880 |   | 2.72 |   | 52,244 |   | 666 |   | 1.28 |   |
| MMDA                                   |       | 84,000      |       | 3,658        |       | 4.35       |       | 68,476 |   | 2,948 |   | 4.30 |   | 24,183 |   | 438 |   | 1.81 |   |
| CDs < $100,000                      |       | 94,420      |       | 4,173        |       | 4.42       |       | 87,345 |   | 3,235 |   | 3.70 |   | 85,612 |   | 2,534 |   | 2.96 |   |
| CDs > $100,000                      |       | 66,998      |       | 3,168        |       | 4.73       |       | 67,129 |   | 2,791 |   | 4.16 |   | 89,076 |   | 2,821 |   | 3.17 |   |
| Clubs                                  |       | 1,908       |       | 23           |       | 1.21       |       | 1,750 |   | 19 |   | 1.08 |   | 1,781 |   | 19 |   | 1.07 |   |
| Total deposits                         |       | 355,870     |       | 13,370       |       | 3.76       |       | 340,260 |   | 11,493 |   | 3.38 |   | 301,169 |   | 6,928 |   | 2.30 |   |
|                                   |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Repurchase agreements                  |       | 19,580      |       | 465          |       | 2.38       |       | 23,391 |   | 624 |   | 2.67 |   | 35,106 |   | 634 |   | 1.81 |   |
|                                   |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Borrowed funds                         |       | 71,573      |       | 3,825        |       | 5.34       |       | 79,627 |   | 4,244 |   | 5.33 |   | 82,114 |   | 4,159 |   | 5.06 |   |
|                                   |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total  interest-bearing liabilities    |       | $           | 447,023    |         | $          | 17,660     |       | 3.95 | % | $ | 443,278 |   | $ | 16,361 |   | 3.69 | % | $ | 418,389 |   | $ | 11,721 |   | 2.80 | % |
|                                   |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income                    |       |        |       | $            | 18,148     |       |       |   |   |   | $ | 17,740 |   |   |   |   |   | $ | 17,835 |   |   |   |
|                                   |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest spread                    |       |        |       |         |       | 2.64       | %          |   |   |   |   | 2.67 | % |   |   |   |   | 3.02 | % |
|                                   |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest margin                    |       |        |       |         |       | 3.34       | %          |   |   |   |   | 3.31 | % |   |   |   |   | 3.51 | % |
|                                   |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total average assets                   |       | $           | 575,458    |         |       |       |       |   | $ | 564,923 |   |   |   |   |   | $ | 536,262 |   |   |   |   |   |
|                                   |       |        |       |         |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Average  non-interest-bearing deposits |       | $           | 70,606     |         |       |       |       |   | $ | 68,224 |   |   |   |   |   | $ | 67,093 |   |   |   |   |   |

 

----

Inthe above table, interest income was adjusted to a tax-equivalent basis, usingthe corporate federal tax rate of 34%, to recognize the income from tax-exemptinterest-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.  Within consumer loans,direct financing leases are presented net of unearned interest.  Average balances are based on amortized costand do not reflect unrealized gains or losses. Net interest rate spread represents the difference between the averageyield on average interest-earning assets and the average cost of averageinterest-bearing liabilities.  Netinterest margin represents net interest income divided by total averageinterest-earning assets.

 

28

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Changes in net interestincome are a function of both changes in interest rates and changes in volumeof 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 Bank’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,**   | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                               | ** ** | **2007 compared to 2006**      | ** ** | **2006 compared to 2005** | ** ** |
| ** **                                                               | ** ** | **Increase (decrease) due to** | ** ** | **Increase (decrease) due to** | ** ** |
| ** **                                                               | ** ** | **Volume**                                    | ** ** | **Rate** | ** ** | **Total** | ** ** | **Volume** | ** ** | **Rate** | ** ** | **Total** | ** ** |
| Interest income:                                                         |       |                                          |       |   |   |   |   |   |   |   |   |   |   |
| Loans and leases:                                                        |       |                                          |       |   |   |   |   |   |   |   |   |   |   |
| Mortgage                                                                 |       | $                                             | 97         |   | $ | 163 |   | $ | 260 |   | $ | 781 |   | $ | 82 |   | $ | 863 |   |
| Commercial                                                               |       | 108                                           |       | 318 |   | 426 |   | 194 |   | 2,180 |   | 2,374 |   |
| Consumer                                                                 |       | 219                                           |       | 203 |   | 422 |   | 682 |   | (73 | ) | 609 |   |
| Total loans and  leases                                                  |       | 424                                           |       | 684 |   | 1,108 |   | 1,657 |   | 2,189 |   | 3,846 |   |
| Investment  securities, interest-bearing deposits and federal funds sold |       | 14                                            |       | 628 |   | 642 |   | 86 |   | 577 |   | 663 |   |
| Total interest income                                                    |       | 438                                           |       | 1,312 |   | 1,750 |   | 1,743 |   | 2,766 |   | 4,509 |   |
|                                                                     |       |                                          |       |   |   |   |   |   |   |   |   |   |   |
| Interest expense:                                                        |       |                                          |       |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                                                |       |                                          |       |   |   |   |   |   |   |   |   |   |   |
| Certificates of deposit greater than $100,000                            |       | (5                                            | )          | 382 |   | 377 |   | (793 | ) | 754 |   | (39 | ) |
| Other                                                                    |       | 520                                           |       | 980 |   | 1,500 |   | 1,414 |   | 3,190 |   | 4,604 |   |
| Total deposits                                                           |       | 515                                           |       | 1,362 |   | 1,877 |   | 621 |   | 3,944 |   | 4,565 |   |
| Other interest-bearing liabilities                                       |       | (558                                          | )          | (20 | ) | (578 | ) | (620 | ) | 695 |   | 75 |   |
| Total interest  expense                                                  |       | (43                                           | )          | 1,342 |   | 1,299 |   | 1 |   | 4,639 |   | 4,640 |   |
| Net interest  income                                                     |       | $                                             | 481        |   | $ | (30 | ) | $ | 451 |   | $ | 1,742 |   | $ | (1,873 | ) | $ | (131 | ) |

 

The slope of the yield curve, which became inverted,or negatively sloped in 2006, has 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 Federal Open Market Committee (FOMC)reduced short-term interest rates three times during the second half of2007.  In response to these actions,national prime also decreased during 2007. National prime, the benchmark rate banks use to set rates on variouslending and other interest sensitive products, also decreased three times for atotal 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 has become more positivelysloped thereby providing opportunities for the Bank to bolster its net interestmargin.

 

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 the 2007 consisted of marketrates that 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.  During2008, the FOMC has already reduced short-term rates two times, by 125 basispoints in January.  The Bank’s assetliability committee meets regularly to combat the rapidly downward adjustmentsin order to minimize the effect rate changes will have on net interest incomeduring what appears to be the beginning of a period of rate easing and the Bankwill, no doubt, operate in a relatively lower interest rate environment in 2008than what existed during 2006 and most of 2007.

 

As market rates fallalong with national prime, loan originations, renewing commercial andresidential loans and lines of credit should price below the average 2007portfolio yields.  In addition, thedecrease in the Treasury yields and other capital market rates could have an unfavorableimpact on the Bank’s total investment portfolio by decreasing yields, which hadbeen on the rise during 2005 and continued through 2007.  As expected, the relative and predominantlyhigher interest rate environment during 2007 continued to have a positiveinfluence on the Bank’s interest-earning assets.  Total interest income increased 5%, from$33,530,000 in 2006 to $35,279,000 in 2007 and further, caused thetax-equivalent yield on earning assets to increase 23 basis points.  The Bank should begin a period of yielddecline on its interest-earning assets during the current interest rateenvironment.

 

29

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Interest expenseincreased $1,299,000, or 8%, from $16,361,000 in 2006 to $17,660,000 in2007.  The cost of interest-bearingliabilities increased 26 basis points in 2007. The higher interest rate environment that was prevalent throughout mostof 2007, in conjunction with higher average interest-bearing deposit balances,necessitated the need for the Bank to increase offering rates on its depositproducts.  As a result, interest expenseon deposits increased $1,877,000 during 2007, of which approximately $1,362,000was caused by a 38 basis point rise in average rates.  Average balances in interest-bearing depositsincreased by $15,610,000 during 2007, resulting in an additional $515,000 inexpense.  Interest expense on borrowings,including repurchase agreements, declined $578,000 during 2007, due almostentirely to lower average balances.

 

As a result of the mix ofthe Bank’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***

 

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 the Bank’sloan portfolio.  Loans and leasesdetermined to be uncollectible are charged-off against the allowance for loanlosses.  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 Bank’s Special Asset Committee meetsperiodically to review problem loans and leases.  The committee is comprised of Bankmanagement, including the chief risk officer, loan workout officers andcollection personnel.  The committeereports quarterly to the Credit Administration Committee of the Board ofDirectors.

 

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 loans that could have loss potential;

·                  levels of and trends in delinquencies and non-accrualloans;

·                  levels of and trends in charge-offs and recoveries;

·                  trends in volume and terms of loans;

·                  changes in risk selection and underwriting standards;

·                  changes in lending policies, procedures and practices;

·                  experience, ability and depth of lending management;

·                  national and local economic trends and conditions; and

·                  changes in credit concentrations.

 

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 loanswhich were either upgraded in rating due to credit improvement or wererepaid.  The allowance for loan losseswas $4,824,000 at December 31, 2007, compared to $5,444,000 at December 31,2006.  The reduced level of the allowancethis year was due to the improved quality of the portfolio mentionedpreviously.

 

***Other income***

 

Other (non-interest) income consists of service charges or feescollected on the Bank’s various deposit and loan products, fees from trust,asset management and other financial services, net mortgage servicing revenue,the increase in the cash surrender value of the BOLI, the net realized gainsand losses from the sales of investment securities, loans and foreclosed assetsheld-for-sale and other various classifications of non-interest related 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 

 

30

----

 

$62,000 more of gainscompared to 2006; increases in BOLI earnings; higher revenue from financialservices activities; and the disposal of premises and equipment that producednet gains of $98,000 in 2007 compared to net losses of $20,000 in 2006.  Included in 2007 were the sales of twocommercial facilities previously leased 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 of the Company’sGreen Ridge branch office.  Otherexpenses increased $225,000, or 6%, in 2007 compared to 2006 caused byincreased professional services, ATM expense and other branch related operatingcosts.

 

The ratio of non-interest expense less non-interestincome (expense ratio) to average assets at December 31, 2007 and 2006 was2.01% and 2.02%, respectively.  Theoverhead expense ratio of the Company remains 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 was 26.2%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.

 

***Comparisonof Financial Condition as of December 31, 2006***

***and2005 and Results of Operations for each of the Years then Ended***

 

***FinancialCondition***

 

***Overview***

 

Consolidated assetsincreased $18,257,000, or 3%, during the year ended December 31, 2006 to$562,318,000.  The increase resulted fromincreases in total deposits of $30,836,000 and total shareholders’ equity of$2,766,000, partially offset by a net decrease in total borrowings of$16,285,000.  During 2006, the carryingvalues of total loans and total securities increased $13,748,000 and$2,732,000, respectively, while cash and cash equivalents increased $1,206,000.

 

***Deposits***

 

Total deposits increased$30,836,000, or 8%, during 2006 to $410,335,000.  The growth was principally due to increasesin money market and NOW accounts of $20,775,000 and $15,074,000, or 40% and30%, respectively.  The positiverelationships we have garnered with our customers in the public sectorcontinued to strengthen our position in NOW accounts.  The increase in money market accounts was dueto continued success in the implementation of deposit-gathering strategies inconjunction with increased short-term promotional interest rates and transfersfrom less attractive longer-term certificates of deposit.  Though the Bank has introduced some promotionalstrategies for shorter-term certificates of deposit, management did notaggressively pursue CDs; rather, most of the efforts were targeted to attracttransactional core deposits such as NOW and money market accounts.  Certificate of deposit accounts continued toshrink with a sustaining shift of depositor sentiment toward more attractiveinterest-bearing core deposits. Certificate of deposit accounts represented 38% of total deposits with asignificant portion scheduled to mature in 2007.  DDAs increased 5% compared to December 31,2005 and the Bank continues to experience growth from both its personal andnon-personal relationship customers.

 

***Short-term borrowings***

 

At December 31,2006 and 2005, sweep accounts represented 70% and 66%, respectively, of totalrepurchase agreements.  Customerliquidity and investment needs and changes in interest rates caused a netdecrease in repurchase agreements from $26,913,000, at December 31, 2005,to $22,224,000 at December 31, 2006. This variance included a shift from repurchase agreements to NOW andmoney market deposit accounts.

 

 

31

----

 

A combination of loandemand, investment in branch expansion projects and a desire to strategicallyreduce dependency on long-term financing has resulted in an increase inovernight borrowings of $9,626,000 at December 31, 2006 compared to December 31,2005.

 

***Long-term debt***

 

Theweighted-average rate in effect on funds borrowed at December 31, 2006,was 5.15% compared to 5.16% as of December 31, 2005.  The 2006 weighted-average rate was 121 basispoints below the tax-equivalent yield of 6.36% on average earning assets forthe year ended December 31, 2006. During the third quarter of 2006, the Bank refinanced a portion of itslong-term debt with the FHLB in order to reduce interest expense.  The Bank repaid a $16,000,000 convertibleselect 6.22% advance scheduled to mature in 2010.  Simultaneously, the Bank entered into a newFHLB $16,000,000 convertible select 5.26% advance with a scheduled maturity in2016.  The immediate effect of the 96basis point decrease in rate was to reduce interest expense by approximately$154,000 per annum.

 

Long-term debt decreased$21,168,000, or 25%, during 2006, to $62,536,000.  The decrease was the result of increaseddeposit generation that was used to repay FHLB advances during the second andthird quarters of 2006 and the Bank’s desire to reduce its dependency on thislong-term funding source.

 

***Accrued expenses and otherliabilities***

 

Netincreases in interest-bearing liabilities along with higher interest ratescaused an increase in accrued interest payable which was the primarycontributor to an increase in accrued expenses and other liabilities of$940,000, or 29%, from December 31, 2005 to December 31, 2006.

 

***Investments***

 

Total investments increased $2,732,000, net of$221,000 appreciation in the market value of AFS investments.  Throughout 2006, tactics were undertaken tore-position the portfolio to meet earnings and liquidity objectives.  These measures contributed to the increase inthe yield of the portfolio 49 basis points in 2006 compared to 2005.  The carrying value of investment securities,at December 31, 2006, was $100,411,000, or 18%, of total assets comparedto $97,679,000, or 18%, as of December 31, 2005.  Mortgage-backed securities continued todominate the composition of the total investment portfolio representing 43% at December 31,2006, essentially unchanged from 44% at December 31, 2005.

 

During 2006, interest rates throughout the yield curvecontinued to increase with the most significant increase at the short-end andthe least significant at the long-end, basically resulting in a continuedperiod of yield curve inversion.  Thisenvironment continued to preclude structured growth strategies, especially forearning assets that are market driven, such as the investment portfolio, due tothe lack of investments that produced adequate interest rate spreads to theBank’s funding sources.  Because of thisunusual interest rate environment, the Bank used cash flows from its investmentportfolio to repay borrowings and fund growth in the loan portfolio.

 

AFS securities are stated net of unrealized gains andlosses.  As of December 31, 2006,AFS debt securities were recorded with a net unrealized loss in the amount of$1,656,000.  At December 31, 2006AFS equity securities were recorded at $471,000 including an unrealized gain of$192,000.

 

The tax-equivalent yieldon debt securities by stated maturity date at December 31, 2006, was asfollows:

 
| ** **                              | ** ** | **One year** | ** ** | **One through** | ** ** | **Five through** | ** ** | **More than** | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|-------------------|------------|----------------------|------------|-----------------------|------------|--------------------|------------|------------|------------|
| ** **                              | ** ** | **or less**  | ** ** | **five years**  | ** ** | **ten years**    | ** ** | **ten years** | ** ** | **Total**  | ** ** |
| U.S. government agencies                |       | —            | %          | 4.35                 | %          | 4.38                  | %          | 5.64               | %          | 4.65       | %          |
| Mortgage-backed securities              |       | —            |       | 3.78                 |       | 3.82                  |       | 5.01               |       | 4.69       |       |
| State & municipal subdivisions |       | —            |       | —               |       | 5.77                  |       | 5.71               |       | 5.71       |       |
| Preferred term securities               |       | —            |       | —               |       | —                |       | 7.02               |       | 7.02       |       |
| Total debt  securities                  |       | —            | %          | 4.11                 | %          | 4.27                  | %          | 5.56               | %          | 5.04       | %          |

 

 

32

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***Loansand leases***

 

Gross loans and leasesincreased $13,514,000, or 3%, from $409,129,000 at December 31, 2005, to$422,643,000 at December 31, 2006. Gross loans represented 75% of total assets at December 31, 2006and December 31, 2005.

 

In 2006, the Bankoriginated $17,152,000 of commercial loans, $21,431,000 of mortgage loans and$29,565,000 of consumer loans.  Thiscompares to $27,030,000, $39,398,000 and $38,763,000, respectively, in2005.  Included in mortgage loans was$11,111,000 of real estate construction lines in 2006 and $18,128,000 in 2005.  In addition for 2006, the Bank originatedlines of credit in the amounts of $29,389,000 for commercial borrowers and$6,768,000 in home equity and other consumer lines of credit.

 

Though loan originationswere down in 2006 compared to 2005, payoffs and pay-downs subsided resulting ina net increase in the loan portfolio.

 

*Commercialand Commercial Real Estate Loans**:*

 

Net of scheduledprincipal curtailments, loan participation sales and pre-payments, commercialloans increased $1,924,000 to $218,213,000 from $216,289,000, or almost 1%during 2006.

 

*ResidentialReal Estate Loans*:

 

Residential real estateloans increased $8,822,000, or 8%, to $112,743,000.  Due to the interest rate environment, andlower amounts of pay-downs and payoffs growth was primarily from convertedconstruction loans and to a lesser extent, sales campaigns.

 

*ConsumerLoans**:*

 

Consumer loans increased$3,659,000, or 5%, during 2006.  Successin the spring and fall sales campaigns, with added advertising and marketing,along with less pay-downs, helped boost the home equity installment program bymore than $8,000,000.  These campaignsmore than offset declines in home equity lines of credit, during a period of arising prime rate.

 

*RealEstate Construction Loans**:*

 

Real estate constructionloans decreased by $829,000, or 6%, at December 31, 2006 compared to December 31,2005.  The commercial construction loansdid not quite offset the decline in the residential construction loan balancebut both categories remained strong.

 

*DirectFinancing Leases**:*

 

The balance representstax-free leasing arrangements provided to municipal customers.  For 2006, the activity represented scheduledannual run-off.  In years prior to 2005,the balance also consisted of automobile lease financing.

 

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

 

Loans AFS, at December 31,2006, were $122,000, with a corresponding fair value of $123,000, compared to$429,000 and $434,000, respectively, at December 31, 2005.  During 2006, residential mortgages andstudent loans with principal balances of $11,792,000 and $707,000,respectively, were sold into the secondary market and gains of approximately$98,000 were recognized.

 

At December 31, 2006and 2005, the servicing portfolio balance of sold residential mortgage loanswas $53,112,000 and $47,835,000, respectively.

 

***Allowance for loan losses***

 

Total charge-offs, net ofrecoveries, for the year ended December 31, 2006 were $866,000, comparedto $833,000 in 2005.  Combined consumerloan and lease financing net charge-offs increased slightly from $141,000 at December 31,2005 to $161,000 through December 31, 2006.  Commercial loan net charge-offs were $597,000for the year 2006 compared to 

 

33

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$682,000 for 2005.  Mortgage loan net charge-offs were $108,000in 2006 compared to $10,000 in 2005.  Theratio of allowance for loan losses to total loans was 1.29% at December 31,2006 compared to 1.46% at December 31, 2005.

 

***Non-performing assets***

 

In 2006, non-performingloans were reduced by $6,211,000, or 64%, to $3,439,000.  There were no repossessed assets at December 31,2006 compared to $19,000 in 2005.  Atyear-end 2006 ORE totaled $197,000. There was no ORE at year-end 2005. Five residential properties were owned at year-end 2006, four of whichwere under agreements to be sold.  TheSpecial Assets Department had developed specific action plans for each of theCompany’s non-performing loans.  During2006, several of those plans came to a conclusion resulting in a substantialreduction of non-performing loans.  Thenon-accrual loans were $3,358,000 at December 31, 2006, a reduction of$6,095,000, or 64%, from year-end 2005. During 2006 approximately $1,583,000 of loans were placed in non-accrualstatus.  This was more than offset bypayoffs or pay-downs of $2,485,000, charge-offs of $909,000, $240,000 intransfers to foreclosed assets and $4,045,000 of loans that returned toperforming status.  Loans past due 90days or more and accruing declined by 59%, to $81,000, at December 31,2006.  As a result, the percentage ofnon-performing assets to total assets declined to 0.65% at December 31,2006, compared to 1.78% for the prior year-end and non-performing loans to netloans declined to 0.82% at December 31, 2006, from 2.39% at December 31,2005.

 

During 2006, the Bankcollected $279,000 of interest income recognized on the cash basis.  If the non-accrual loans that wereoutstanding as of December 31, 2006 had been performing in accordance withtheir original terms, the Bank would have recognized interest income, withrespect to such loans, of $332,000 for the year ended December 31, 2006.

 

***Bankpremises and equipment, net***

 

The Bank’s premises andequipment decreased $359,000, net of accumulated depreciation.  During 2006, the Bank purchased ortransferred from construction in process, a component of other assets,approximately $852,000, net of disposals compared to $1,724,000 in 2005.

 

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

 

*Other Real Estate Owned*

 

ORE was $197,000.  Five residential properties were owned atyear end 2006, four of which were under agreements to be sold.  There were no foreclosed real estateproperties owned at December 31, 2005.

 

*Repossessed Assets*

 

Improvement in theturn-around time on sales of repossessed vehicles and the termination of theBank’s automobile leasing business in 2005 reduced the repossessed asset balancefrom $19,000 at December 31, 2005 to $0 as of December 31, 2006.

 

***Terminatedlease assets held-for-sale***

 

At the end of 2005, theBank’s vehicle lease program terminated. Terminated lease assets were vehicles that were lease-financed by theCompany with contractual terms fulfilled. Pursuant to the lease agreement, the vehicles were returned to theCompany and recorded on the books in other assets at the residual value.  These vehicles were subsequently sold as soonas practicable.  The difference betweensales price and residual value, if any, was charged against currentearnings.  Simultaneously, a claim wassubmitted to the Company’s residual insurance carrier for payment.  Receipt of any residual insurance proceedswas then credited to current earnings. All vehicles which were returned to the Bank were subsequently soldprior to December 31, 2005.  During2006, the Bank received $15,000 from residual insurance claims for vehiclesthat were sold at the end of 2005.

 

***Accruedinterest receivable and other assets***

 

The increase in accruedinterest receivable of $543,000, or 28%, from December 31, 2005 to December 31,2006 was principally due to higher average balances of interest-earning assetsas well as an increase in the number of days in the accrual compared to theprior year.  The increase in other assetsof $755,000, or 19%, for the same period, was due mostly to capitalized interimconstruction costs for the Bank’s Green Ridge branch expansion and otherprojects and the purchase of an 

 

34

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interest rate floorderivative contract.  These increaseswere partially offset by a cumulative effect adjustment related to the Bank’sinvestment in a limited partnership.

 

***Resultsof Operations***

 

***EarningsSummary***

 

Net income for the yearended December 31, 2006 was $4,125,000, compared to $4,592,000 for theyear ended December 31, 2005. During the same periods, diluted earnings per common share was $2.01 and$2.25, respectively.  For the year ended December 31,2006, the Company’s return on average assets (ROA) and return on averageshareholders’ equity (ROE) were 0.73% and 8.31%, respectively, compared to0.86% and 9.64% for the year ended December 31, 2005.  The decline in net income was causedprimarily by a 9% increase in non-interest expenses.  The provision for loan losses declined by$505,000 and non-interest income increased by $372,000, or 9%, while netinterest income was down marginally; less than 1% for the year ended December 31,2006 compared to year end 2005.  Thedecrease in ROA and ROE was primarily due to the variance in net income.

 

***Netinterest income***

 

The slope of the yield curve, which flattened in 2004and continued to flatten in 2005 became inverted, or negatively sloped in2006.  An inverted yield curve presentschallenges to all banks because short-term rates are higher than long-termrates.  This situation is unusual andtends to squeeze net interest income because deposit and borrowing terms aregenerally shorter than investment and loan terms.  The FOMC increased short-term interest ratesfour times in the first half of 2006.  Inresponse to these actions, national prime also increased during 2006.  National prime, the benchmark rate banks useto set rates on various lending and other interest-sensitive products, alsoincreased four times for a total increase of 100 basis points from 7.25% at December 31,2005 to 8.25% at December 31, 2006.

 

As expected, the relativeand predominantly higher interest rate environment during 2006 continued to havea positive influence on the Bank’s interest-earning assets.  Total interest income increased 15.5%, from$29,020,000 in 2005 to $33,530,000 in 2006 and further, caused thetax-equivalent yield on earning assets to increase 54 basis points.

 

Interest expenseincreased $4,640,000, or 39.6%, from $11,721,000 in 2005 to $16,361,000 in2006.  The cost of interest-bearingliabilities increased 89 basis points in 2006. The increased interest rate environment, in particular at the short- tomid-term range of the yield curve, in conjunction with deposit gatheringstrategies, required the Bank to increase offering rates on its depositproducts.  The bulk of the rate increasesimpacted the Bank’s interest expense on customer deposits, which increased$4,565,000 during 2006 of which over $3,944,000 was caused by a 108 basis pointrise in rates.  Average balances indeposits increased by more than $39,000,000 during 2006, with growth in mostall categories, resulting in additional interest expense of $621,000 during2006.

 

The weighted-averageinterest rate paid on borrowed funds increased 27 basis points in 2006 comparedto 2005 largely due to higher rates paid on overnight borrowings.  During the third quarter of 2006, the Bankrefinanced a portion of its long-term debt with the FHLB in order to reduceinterest expense.  The immediate impactof the refinance was a reduction of interest expense by approximately $154,000per annum.

 

As a result of the mix ofthe Bank’s interest-sensitive assets and liabilities and the varying effectsthat the slope of the interest rate yield curve had during 2006, net interestincome decreased $131,000, or 0.8%, from $17,299,000 in 2005 to $17,168,000 in2006.  On a tax-equivalent basis, the netinterest rate spread declined 35 basis points from 3.02% to 2.67% and thetax-equivalent margin declined 20 basis points, from 3.51% in 2005 to 3.31% in2006, respectively.

 

***Provisionfor loan losses***

 

The provision for loanlosses was $325,000 for the year ended December 31, 2006, compared to $830,000in 2005.  As a result, the allowance forloan losses was $5,444,000 at December 31, 2006, compared to $5,985,000 atDecember 31, 2005.  The significantreduction in the provision was due to the improved quality of the portfoliocoupled with a decline in loans migrating to non-performing status.  Non-performing loans declined $6,211,000, or64%, to $3,439,000 at December 31, 2006, from $9,650,000, at December 31,2005.  The reduction was both innon-accrual loans which declined by $6,095,000 to $3,358,000 at December 31,2006, and a decline of $116,000 in loans past due 90 days or more and stillaccruing.  The Bank continued to giveheightened attention to the collection of sub-performing loans which resultedin lower levels of delinquencies and non-accruing loans for 2006.

 

35

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*** ***

***Otherincome***

 

For the year ended December 31,2006, other income was $4,522,000, an increase of $372,000, or 9.0%, from$4,150,000 for the year ended December 31, 2005.  The primary cause of the increase was thelack of losses incurred from the sales of terminated and previously leasedautomobiles.  During 2005, the Companyrecognized $335,000 in losses from these vehicle sales compared to residualinsurance claims of $15,000 in 2006.  Theautomobile leasing program expired in 2005. In addition, the strategy to sell more loans into the secondary marketresulted in gains of $98,000 in 2006 compared to $10,000 in 2005.  During 2005, the gains recognized onforeclosed assets included proceeds from an insurance claim resulting in a gainof $57,000, compared to a minor loss in 2006.

 

***Otherexpense***

 

For the twelve monthsended December 31, 2006, other operating expenses were $15,878,000 or$1,316,000 more than the $14,562,000 recorded in the same period of 2005.  Salary and employee benefit costs increased$1,235,000, or 17.4%, for the twelve months ended December 31, 2006compared to the same period in 2005.  Theincrease was due to pay increases, increased number of full-time equivalentemployees due to staffing needs, one-time voluntary separation benefit paymentsand stock-based compensation expense.

 

Premises and equipmentincreased $190,000, or 6.4%, in 2006 compared to 2005.  Equipment maintenance increased byapproximately $58,000 due to more repairs, rental and maintenance in 2006.  Occupancy related expense increases werecaused by increased property insurance, facility maintenance and increased rentdue to activities related to the branch expansion project.

 

Advertising and marketingrelated expenses were down $81,000, or 13.0%, during the year ended 2006compared to the year ended 2005.  Thedecrease was related to expense savings tactics implemented during the fourthquarter of 2006 caused by expense overruns in some of the other strategicfunctional areas.  As a result, some ofthe advertising programs, use of mass media, direct mail, community events andsponsorships, slated for the fourth quarter of 2006, were either cancelled ordeferred to 2007 where the primary focus would be branch opening projects.

 

The ratio of non-interest expense less non-interestincome (expense ratio) to average assets at December 31, 2006 and 2005 was2.02% and 1.93%, respectively.  Theincrease was caused predominantly by higher overhead expenses and wascomparative to the Uniform Bank Performance Report peer comparison grouppercentage.

 

***Provision for income taxes***

 

Income before provisionfor income taxes in 2006 decreased $570,000 from 2005.  The effective federal income tax rate was24.8% and 24.2% for the years ending December 31, 2006 and 2005,respectively.  The minor increase in theeffective tax rate was attributed to an increase in temporary differences thatgave rise to an increase in pre-tax income.

 

36

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***Off-Balance Sheet Arrangements and Contractual Obligations***

 

The Company is a party to financial instruments with off-balance sheetrisk in the normal course of business in order to meet the financing needs ofits customers and in connection with the overall interest rate managementstrategy.  These instruments involve, toa varying degree, elements of credit, interest rate and liquidity risk.  In accordance with GAAP, these instrumentsare either not recorded in the consolidated financial statements or arerecorded in amounts that differ from the notional amounts.  Such instruments primarily include lendingcommitments, lease obligations and derivative instruments.  For a further discussion on the Bank’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, 2007, 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):

 
| ** **               | ** ** | ** **        | ** ** | **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  |       | $                 | 113,911    |                  | $          | 61,542                 |       | $                   | 2,514      |       | $          | 234 |   | $ | 178,201 |   |
| Long-term debt           |       | 709               |       | 41,000                |       | —                 |       | 21,000              |       | 62,709     |       |
| Repurchase agreements    |       | 19,711            |       | 793                   |       | —                 |       | —              |       | 20,504     |       |
| Operating leases         |       | 375               |       | 693                   |       | 698                    |       | 4,262               |       | 6,028      |       |
|                     |       |              |       |                  |       |                   |       |                |       |       |       |
| Significant commitments: |       |              |       |                  |       |                   |       |                |       |       |       |
| Letters of credit        |       | 2,661             |       | 725                   |       | —                 |       | 2,564               |       | 5,950      |       |
| Loan commitments*        |       | 15,103            |       | —                |       | —                 |       | —              |       | 15,103     |       |
|                     |       |              |       |                  |       |                   |       |                |       |       |       |
| Total                    |       | $                 | 152,470    |                  | $          | 104,753                |       | $                   | 3,212      |       | $          | 28,060 |   | $ | 288,495 |   |

 

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| * | Available  credit to borrowers in the amount of $68,276 is excluded from the above table  since, by its nature, the borrowers may not have the need for additional  funding, and, therefore, the credit may or may not be disbursed by the Bank. |
|---|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

In addition to the itemsabove, in 2008 the Company expects to complete the construction of a new branchoffice in West Scranton.  As of December 31,2007, the Company expects to incur approximately $2,000,000 of additionalcapital expenditures, representing outstanding construction commitments, andthe cost for design, furniture and equipment to complete the project.

 

***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.

 

37

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***Impactof Inflation and Changing Prices***

 

The consolidatedfinancial statements and notes thereto presented herein have been prepared inaccordance with GAAP, which requires measurement of our financial condition andresults of operations in terms of historical dollars without considering thechanges in the relative purchasing power of money over time due toinflation.  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 $3,579,000 increase in shareholders’ equity(capital) during 2007 was primarily attributable to net income of $4,612,000,an increase in common stock from the Company’s dividend reinvestment, stockpurchase and stock option plans for a total of $521,000 and an increase inother comprehensive income (loss) of $369,000 due to the increased intrinsicvalue of the Company’s cash flow hedge. These items were partially offset by the declaration of cash dividendsof $1,922,000.

 

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 involve quantitativemeasures 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 regulators aboutcomponents, risk-weightings and other factors.

 

Under these guidelines,assets and certain off-balance sheet items are assigned to broad riskcategories, each with appropriate weights. The resulting capital ratios represent capital as a percentage of totalrisk-weighted assets and certain off-balance sheet items.  The guidelines require all banks and bankholding companies to maintain a minimum ratio of total risk-based capital tototal risk-weighted assets (Total Risk Adjusted Capital) of 8%, including TierI capital to total risk-weighted assets (Tier I Capital) of 4% and Tier Icapital to average total assets (Leverage Ratio) of at least 4%.  Additional information with respect tocapital requirements is contained in Note 14, “Regulatory matters,” within thenotes to the consolidated financial statements, and incorporated by referencein Part II, Item 8.

 

The Company’s major source of capital during theprevious five years has been from the retention of equity in undistributedearnings of the Bank, as reflected below:

 
| ** ** | ** ** | **Net**    | ** ** | **Cash dividends** | ** ** | **Earnings** | ** ** |
|------------|------------|------------|------------|-------------------------|------------|--------------|------------|
| ** ** | ** ** | **Income** | ** ** | **declared**            | ** ** | **retained** | ** ** |
|       |       |       |       |                    |       |         |       |
| 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    |       |
| 2003       |       | 1,643,248  |       | 1,601,898               |       | 41,350       |       |
|            |            |            |            |                         |            |              |            |  |  |  |  |

 

At December 31,2007, the Bank reported a net unrealized loss of $982,000 on AFS securitiescompared to a net unrealized loss of $966,000 as of December 31, 2006, ora minor deterioration of less than 2%. Fluctuations in the capital markets may cause frequent changes in thefair value of AFS securities.  Furtherdeclines in value of the Bank’s AFS securities should not be construed as aweakness in the capital position of the Company.  The Company monitors market conditionsclosely and is prepared to take remedial action when appropriate.

 

***Liquidity***

 

Liquidity managementensures that adequate funds will be available to meet customers’ needs forborrowings, deposit withdrawals and maturities and normal operating expenses ofthe Bank.  Current sources of liquidityare cash and cash equivalents, asset maturities and pay-downs within one year,loans and investments AFS, growth of core deposits, growth of repurchaseagreements, increases of other borrowed funds from correspondent banks andissuance 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 

 

38

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conditions and the levelof interest rates.  During a declininginterest rate environment, prepayments from interest-sensitive assets tend toaccelerate and provide significant liquidity which will then be re-invested atthe lower market rates.  Conversely, in aperiod of rising interest rates, prepayment speeds from interest-sensitiveassets tend to decelerate.  Depositinflow may accelerate and will then be invested at higher market interestrates.  The Company closely monitorsactivity in the capital markets and takes appropriate action to ensure that theliquidity levels are adequate for funding, investing and operating activities.

 

At December 31, 2007, the Company had $10,409,000 in cash and cashequivalents.  In addition, the Companyhad $827,000 of loans AFS and $121,837,000 in investments AFS.  This combined total of $133,073,000 represented23% of total assets at December 31, 2007. Management believes this level of liquidity to be strong and adequate tosupport current operations.  For adiscussion on the Bank’s significant determinable contractual obligations andsignificant commitments, see “Off-balance sheet arrangements and contractualobligations,” above.

 

The Company considers itsprimary source of liquidity to be its core deposit base consisting of depositsfrom customers throughout the branch network. The Company will continue to promote the acquisition of deposits throughits branch offices and marketing efforts. At December 31, 2007, approximately 72% of the Company’s assetswere funded by deposits, which increased 4% during 2007, and an additional 9%of the assets were funded by the Company’s equity, which increased 7% during2007.  The Company expects to continue togrow these two components, which provide a substantial and steady source offunds.

 

As detailed in thestatement of cash flows, incorporated by reference, total cash and cashequivalents declined $3,392,000 during 2007. Cash from operations of $4,563,000, was supported by healthyearnings.  The $20,130,000 provided byfinancing was mostly due to increased deposits. The Bank invested $28,085,000 from these two sources and $3,392,000 ofcash on hand as of December 31, 2006, in interest-sensitive assets andpremises and equipment, the latter mostly due to branch expansion projects.

 

At December 31,2007, the Bank had approximately $138,836,000 in unused sources of borrowedfunds available to meet liquidity requirements, if needed.  The sources were the approximate borrowingcapacity at the Federal Reserve Bank of Philadelphia of $5,652,000, availablefunding at the FHLB of $122,134,000 and $11,050,000 from correspondent banks.

 

***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 affectingmarket values of all interest-earning assets and interest-bearing liabilities,except for those assets or liabilities with a short term remaining tomaturity.  Interest rate risk managementis an integral part of the asset/liability management process.  The Company has instituted certain proceduresand policy guidelines to manage the interest rate risk position.  Those internal policies enable the Company toreact to changes in market rates to protect net interest income fromsignificant fluctuations.  The primaryobjective in managing interest rate risk is to minimize the adverse impact ofchanges in interest rates on net interest income along with creating anasset/liability structure that maximizes earnings.

 

*Asset/Liability Management*. One major objective of the Company when managing the rate sensitivity ofits assets and liabilities is to stabilize net interest income.  The management of and authority to assumeinterest rate risk is the responsibility of the Company’s Asset/LiabilityCommittee (ALCO), which is comprised of senior management and members of theboard of directors.  ALCO meets quarterlyto monitor the relationship of interest sensitive assets to interest sensitiveliabilities.  The process to reviewinterest 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. *Interest rate risk is monitored throughthe use of three complementary measures: static gap analysis, earnings at risksimulation and economic value at risk simulation.  While each of the interest rate riskmeasurements has limitations, taken together they represent a reasonablycomprehensive view of the magnitude of interest rate risk in the Company andthe distribution of risk along the yield curve, the level of risk through timeand the amount of exposure to changes in certain interest rate relationships.

 

*Static Gap*. The ratio between assets and liabilities re-pricing in specific timeintervals is referred to as an interest rate sensitivity gap.  Interest rate sensitivity gaps can be managedto take advantage of the slope of the yield curve as well as forecasted changesin the level of interest rate changes.

 

39

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To manage this interest ratesensitivity gap position, an asset/liability model commonly known as cumulativegap analysis is used to monitor the difference in the volume of the Company’sinterest sensitive assets and liabilities that mature or re-price within giventime intervals.  A positive gap (assetsensitive) indicates that more assets will re-price during a given periodcompared to liabilities, while a negative gap (liability sensitive) has theopposite 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 31,2007 the Bank maintained a one-year cumulative gap of negative $27.5 million,or negative 4.7%, of total assets.  Theeffect of this negative gap position provided a mismatch of assets andliabilities which may expose the Bank to interest rate risk during periods ofincreasing interest rates.  Conversely,in a declining interest rate environment, net interest income could bepositively impacted because more liabilities than assets will re-price downwardduring the one-year period.

 

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 mayreact in 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 behindchanges in market interest rates. Certain assets, such as adjustable-rate mortgages, have features whichrestrict changes in interest rates on a short-term basis and over the life ofthe asset.  In the event of a change ininterest rates, prepayment and early withdrawal levels may deviatesignificantly from those assumed in calculating the table.  The ability of many borrowers to servicetheir adjustable-rate debt may decrease in the event of an interest rateincrease.

 

The following tablereflects the re-pricing of the balance sheet or “gap” position at December 31,2007 (dollars in thousands):

 
| ** **                                     | ** ** | **Interest sensitivity gap at December 31, 2007** | ** ** |                                      |
|------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|-------------------------------------------|
| ** **                                     | ** ** | **Three months**

**or less**                                         | ** ** | **Three to**

**twelve months** | ** ** | **One to**

**three years** | ** ** | **Over**

**three years** | ** ** | **Total** | ** ** |
| Cash and cash equivalents                      |       | $                                                                               | 378        |                                      | $ | — |   | $ | — |   | $ | 10,031 |   | $ | 10,409 |   |
| Investment securities (1)(2)                   |       | 21,658                                                                          |       | 13,705                                    |   | 28,406 |   | 62,518 |   | 126,287 |   |
| Loans (2)                                      |       | 121,338                                                                         |       | 66,967                                    |   | 107,793 |   | 126,154 |   | 422,252 |   |
| Fixed and other assets                         |       | —                                                                          |       | 8,489                                     |   | — |   | 19,976 |   | 28,465 |   |
| Total assets                                   |       | $                                                                               | 143,374    |                                      | $ | 89,161 |   | $ | 136,199 |   | $ | 218,679 |   | $ | 587,413 |   |
| Total cumulative  assets                       |       | $                                                                               | 143,374    |                                      | $ | 232,535 |   | $ | 368,734 |   | $ | 587,413 |   |   |   |
|                                           |       |                                                                            |       |                                      |   |   |   |   |   |   |   |
| Non-interest-bearing  transaction deposits (3) |       | $                                                                               | —     |                                      | $ | 6,480 |   | $ | 17,819 |   | $ | 40,497 |   | $ | 64,796 |   |
| Interest-bearing transaction deposits (3)      |       | 89,289                                                                          |       | —                                    |   | 37,024 |   | 56,399 |   | 182,712 |   |
| Certificates of Deposit                        |       | 39,941                                                                          |       | 73,966                                    |   | 61,542 |   | 2,751 |   | 178,200 |   |
| Repurchase agreements                          |       | 20,504                                                                          |       | —                                    |   | — |   | — |   | 20,504 |   |
| Short-term borrowings                          |       | 19,152                                                                          |       | —                                    |   | — |   | — |   | 19,152 |   |
| Long-term debt                                 |       | 10,213                                                                          |       | 496                                       |   | 31,000 |   | 21,000 |   | 62,709 |   |
| Other liabilities                              |       | —                                                                          |       | —                                    |   | — |   | 4,149 |   | 4,149 |   |
| Total  liabilities                             |       | $                                                                               | 179,099    |                                      | $ | 80,942 |   | $ | 147,385 |   | $ | 124,796 |   | $ | 532,222 |   |
| Total cumulative  liabilities                  |       | $                                                                               | 179,099    |                                      | $ | 260,041 |   | $ | 407,426 |   | $ | 532,222 |   |   |   |
|                                           |       |                                                                            |       |                                      |   |   |   |   |   |   |   |
| Interest sensitivity gap                       |       | $                                                                               | (35,725    | )                                         | $ | 8,219 |   | $ | (11,186 | ) | $ | 93,883 |   |   |   |
| Cumulative gap                                 |       | $                                                                               | (35,725    | )                                         | $ | (27,506 | ) | $ | (38,692 | ) | $ | 55,191 |   |   |   |
|                                           |       |                                                                            |       |                                      |   |   |   |   |   |   |   |
| Cumulative gap to total assets                 |       | (6.1                                                                            | )%         | (4.7                                      | )% | (6.6 | )% | 9.4 | % |   |   |
|                                                |            |                                                                                 |            |                                           |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

| (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  Bank’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 |
|-----|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

40

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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 thatmore sophisticated tools exist for measuring the interest rate risk in thebalance sheet that extend beyond static re-pricing gap analysis.  Although it will continue to measure itsre-pricing gap position, the Company utilizes additional modeling for identifyingand measuring the interest rate risk in the overall balance sheet.  The ALCO is responsible for focusing on “earningsat risk” and “economic value at risk”, and how both relate to the risk-basedcapital position when analyzing the interest rate risk.

 

*Earnings at Risk*. Earnings at risk simulation measures the change in net interest incomeand net income should interest rates rise and fall.  The simulation recognizes that not all assetsand liabilities re-price one-for-one with market rates (e.g., savingsrate).  The ALCO looks at “earnings atrisk” to determine income changes from a base case scenario under an increaseand 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.  Economicvalue (or portfolio equity) at risk measures the long-term risk by finding thenet present value of the future cash flows from the Company’s existing assetsand liabilities.  The ALCO examines thisratio quarterly utilizing an increase and decrease of 200 basis points ininterest rate simulation models.  TheALCO recognizes that, in some instances, this ratio may contradict the “earningsat risk” ratio.

 

The following tableillustrates the simulated impact of an immediate 200 basis points upward or downwardmovement in interest rates on net interest income, net income and the change inthe economic value (portfolio equity). This analysis assumed that interest-earning asset and interest-bearingliability levels at December 31, 2007 remained constant.  The impact of the rate movements was developedby simulating the effect of the rate change over a twelve-month period from theDecember 31, 2007 levels:

 
| ** **                                             | ** ** | **Rates +200** | ** ** | **Rates -200** | ** ** |
|--------------------------------------------------------|------------|---------------------|------------|---------------------|------------|
|                                                   |       |                |       |                |       |
| Earnings at risk:                                      |       |                |       |                |       |
| Percent change  in:                                    |       |                |       |                |       |
| Net interest  income                                   |       | (3.5                | )%         | (3.2                | )%         |
| Net income                                             |       | (9.8                | )          | (9.7                | )          |
|                                                   |       |                |       |                |       |
| Economic value at risk:                                |       |                |       |                |       |
| Percent change  in:                                    |       |                |       |                |       |
| Economic value  of equity                              |       | (23.4               | )          | (5.3                | )          |
| Economic value  of equity as a percent of total assets |       | (2.5                | )          | (0.6                | )          |

 

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 31,2007, 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, 2008, 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                           |       | $                             | 17,864     |            | $          | (641            | )          | (3.5 | )% |
| +100 basis points                           |       | 18,158                        |       | (347            | )          | (1.9            | )          |
| Flat rate                                   |       | 18,505                        |       | —          |       | —          |       |
| -100 basis points                           |       | 18,490                        |       | (15             | )          | (0.1            | )          |
| -200 basis points                           |       | 17,920                        |       | (585            | )          | (3.2            | )          |
|                                             |            |                               |            |                 |            |                 |            |  |  |

 

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 investment securities, the Bank uses athird-party service to provide cash flow estimates in the various rateenvironments.  Savings, money market andinterest-bearing checking accounts do not have a stated maturity or re-pricingterm and can be withdrawn or re-price at any time.  This may impact the margin if more expensivealternative sources of deposits are required 

 

41

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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 FinancialInstruments. *As part of the Bank’s overall interestrate risk strategy, the Company has adopted a policy whereby the Bank mayperiodically use derivative instruments to minimize significant fluctuations inearnings caused by interest rate volatility. This interest rate risk management strategy entails the use of interestrate floors, caps and swaps.  In October 2006,the Bank entered into an interest rate floor derivative agreement on$20,000,000 notional value of its prime-based loan portfolio.  The purpose of the hedge is to help protectthe Bank’s interest income in the event interest rates decline below a pre-determinedcontractual interest rate.  The strategyis reflected in the scenarios for earnings and economic value at risk and thenet interest income in the two immediately preceding tables.  For a further discussion on the Bank’sderivative contract, 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.

 

***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.***** **Thisfederal act amends several federal banking laws to reduce redundant and costlyregulatory burden.  Among its manyprovisions, the act allows the payment of interest on certain reserve balancesof depository institutions that are held at the Federal Reserve beginning inyear 2011, requires banking regulatory agencies to streamline reports ofcondition and clarifies the authority of home and host state regulators withrespect to supervision of interstate branches. The act was signed into law in October 2006.

 

***Federal DepositInsurance Reform Act of 2005 and the Federal Deposit Insurance ReformConforming Amendments Act of 2005.***** **Thesefederal acts were signed into law in February 2006 to amend the FederalDeposit Insurance Act.  These laws enactFDIC and banking industry deposit insurance reform proposals by amendmentsincluding: increasing the coverage for retirement accounts to $250,000 andindexing the coverage limit for retirement accounts to inflation as with thegeneral deposit insurance coverage limit; merging the Bank Insurance Fund (BIF)and the Savings Association Insurance Fund (SAIF) into a new fund, the DepositInsurance Fund (DIF); establishing a percentage range within which the FDICBoard of Directors may set the FDIC’s Designated Reserve Ratio (DRR); allowingthe FDIC to manage the pace at which the DRR varies within this range;eliminating the restrictions on premium rates based on the DRR and granting theFDIC Board the discretion to price deposit insurance according to risk for allinsured institutions 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.

 

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 the 

 

42

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accounting profession,and to state corporate law such as the relationship between a board ofdirectors and management and between a board of directors and its committees.

 

***USA PATRIOT Actof 2001.***  The Uniting and Strengthening America by ProvidingAppropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (USAPATRIOT Act) was signed into law in October 2001.  The USA PATRIOT Act broadened the applicationof anti-money laundering regulations to apply to additional types of financialinstitutions, such as broker-dealers, and strengthened the ability of the U.S.government to detect and prosecute international money laundering and thefinancing of terrorism.  The principalprovisions of Title III of the USA PATRIOT Act require that regulated financialinstitutions, including banks: (1) establish an anti-money launderingprogram that includes training and audit components; (2) comply withregulations regarding the verification of the identity of any person seeking toopen an account; (3) take additional required precautions with regard tonon-U.S. owned accounts; and (4) perform certain verification andcertification of money laundering risk for their foreign correspondent bankingrelationships. The USA PATRIOT Act also expanded the conditions under whichfunds in a U.S. inter-bank account may be subject to forfeiture and increasedthe penalties for violation of anti-money laundering regulations.  Failure of a financial institution to complywith the USA PATRIOT Acts requirements could have serious legal andreputational consequences for the institution. The Bank has adopted policies, procedures and controls to addresscompliance with the requirements of the USA PATRIOT Act under the existingregulations and will continue to revise and update its policies, procedures andcontrols to reflect changes required by the USA PATRIOT Act and implementingregulations.

 

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 suspicioustransactions, respond to requests for information by federal banking regulatoryauthorities and law enforcement agencies, and share information with otherfinancial institutions.  The Secretary ofthe Treasury has adopted several regulations to implement theseprovisions.  The Bank is also barred fromdealing with foreign “shell” banks.  Inaddition, the IML Act expands the circumstances under which funds in a bankaccount may be forfeited.  The IML Actalso amended the Bank Holding Company Act and the Bank Merger Act to requirethe federal banking regulatory authorities to consider the effectiveness of afinancial institution’s anti-money laundering activities when reviewing anapplication to expand operations.  TheBank has in place a Bank Secrecy Act compliance program.

 

***Gramm-Leach-BlileyAct of 1999***.  This law authorized cross-industryaffiliations between banks, securities firms, insurance companies and otherfinancial service providers.  This waslandmark legislation that repealed the Glass-Steagall Act which since the 1930’shad prohibited such affiliations.  Amongother provisions, the Act provided new authority for banks and created arevised framework for regulating 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.

 

43

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***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.

 

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.

 

***FutureOutlook***

 

Based upon the current uncertain economic outlook andinability to predict when interest rate changes will occur, the Companyrecognizes that there are challenges ahead. The Company is prepared to meet the challenges and effects of a changinginterest rate environment.  Managementbelieves that a significant impact on earnings depends on its ability to reactto changes in interest 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 remaining 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 will continue.  These steps are designed to provide theCompany with stability and the wherewithal to provide customer service andincrease shareholder value.

 

***Item 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT 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.

 

44

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

 

### **Report Of Independent RegisteredPublic Accounting Firm**

###  

Board of Directors and Shareholders

Fidelity D & D Bancorp, Inc.:

 

We have audited theaccompanying consolidated balance sheets of Fidelity D & D Bancorp, Inc.and Subsidiary as of December 31, 2007 and 2006 and the relatedconsolidated statements of income, changes in shareholders’ equity and cashflows for each of the years in the three-year period ended December 31,2007. 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 ofmaterial misstatement. The Company is not required to have, nor were we engagedto perform, an audit of its internal control over financial reporting.  Our audit included consideration of internalcontrol over financial reporting as a basis for designing audit procedures thatare appropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the Company’s internal control over financialreporting. Accordingly, we express no such opinion. An audit also includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation. We believe that our audit provides areasonable basis for our opinion.

 

In our opinion, the consolidatedfinancial statements referred to above present fairly, in all materialrespects, the financial position of Fidelity D & D Bancorp, Inc.and Subsidiary as of December 31, 2007 and 2006, and the results of theiroperations and their cash flows for each of the years in the three-year periodended December 31, 2007 in conformity with accounting principles generallyaccepted in the United States of America.

 

 

Scranton, Pennsylvania

March 12, 2008

 

45

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

 

Consolidated Balance Sheets

As of December 31, 2007 and 2006

 
| ** **                                                                                                                                | ** ** | **2007**    | ** **  | **2006**    | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------|-------------|-------------|------------|
|                                                                                                                                      |       |        |        |        |       |
| Assets:                                                                                                                                   |       |        |        |        |       |
| Cash and due from banks                                                                                                                   |       | $           | 10,204,714  |        | $          | 13,732,137 |   |
| Interest-bearing  deposits with financial institutions                                                                                    |       | 204,102     |        | 68,711      |       |
|                                                                                                                                      |       |        |        |        |       |
| Total cash and cash  equivalents                                                                                                          |       | 10,408,816  |        | 13,800,848  |       |
|                                                                                                                                      |       |        |        |        |       |
| Available-for-sale  securities                                                                                                            |       | 121,836,851 |        | 98,841,364  |       |
| Held-to-maturity  securities                                                                                                              |       | 1,147,309   |        | 1,569,372   |       |
| Federal Home Loan Bank  Stock                                                                                                             |       | 3,302,900   |        | 3,795,100   |       |
| Loans and leases, net  (allowance for loan losses of $4,824,401 in 2007; $5,444,303  in 2006)                                        |       | 421,424,379 |        | 417,199,048 |       |
| Loans  available-for-sale (fair value $842,923 in 2007; $123,156 in 2006)                                                                 |       | 827,250     |        | 122,000     |       |
| Bank premises and  equipment, net                                                                                                         |       | 12,964,932  |        | 11,324,465  |       |
| Cash surrender value of  bank owned life insurance                                                                                        |       | 8,488,663   |        | 8,177,961   |       |
| Other assets                                                                                                                              |       | 4,403,723   |        | 4,788,105   |       |
| Accrued interest  receivable                                                                                                              |       | 2,500,696   |        | 2,502,576   |       |
| Foreclosed assets  held-for-sale                                                                                                          |       | 107,036     |        | 197,149     |       |
|                                                                                                                                      |       |        |        |        |       |
| Total assets                                                                                                                              |       | $           | 587,412,555 |        | $          | 562,317,988 |   |
|                                                                                                                                      |       |        |        |        |       |
| Liabilities:                                                                                                                              |       |        |        |        |       |
| Deposits:                                                                                                                                 |       |        |        |        |       |
| Interest-bearing                                                                                                                          |       | $           | 360,912,740 |        | $          | 336,592,620 |   |
| Non-interest-bearing                                                                                                                      |       | 64,795,621  |        | 73,741,975  |       |
|                                                                                                                                      |       |        |        |        |       |
| Total deposits                                                                                                                            |       | 425,708,361 |        | 410,334,595 |       |
|                                                                                                                                      |       |        |        |        |       |
| Accrued interest  payable and other liabilities                                                                                           |       | 4,147,869   |        | 4,179,170   |       |
| Short-term borrowings                                                                                                                     |       | 39,656,354  |        | 33,656,150  |       |
| Long-term debt                                                                                                                            |       | 62,708,677  |        | 62,536,210  |       |
|                                                                                                                                      |       |        |        |        |       |
| Total liabilities                                                                                                                         |       | 532,221,261 |        | 510,706,125 |       |
|                                                                                                                                      |       |        |        |        |       |
| Shareholders’ equity:                                                                                                                |       |        |        |        |       |
| Preferred stock  authorized 5,000,000 shares with no par value; none issued                                                               |       | —      |        | —      |       |
| Capital stock  authorized 10,000,000 shares with no par value; issued and  outstanding 2,072,929 shares in 2007; 2,057,433 shares in 2006 |       | 19,223,363  |        | 18,702,537  |       |
|                                                                                                                                      |       |        |        |        |       |
| Retained earnings                                                                                                                         |       | 36,564,157  |        | 33,874,118  |       |
| Accumulated other comprehensive loss                                                                                                      |       | (596,226)   |        | (964,792)   |       |
|                                                                                                                                      |       |        |        |        |       |
| Total shareholders’  equity                                                                                                          |       | 55,191,294  |        | 51,611,863  |       |
|                                                                                                                                      |       |        |        |        |       |
| Total liabilities and  shareholders’ equity                                                                                          |       | $           | 587,412,555 |        | $          | 562,317,988 |   |

 

See notes to consolidatedfinancial statements

 

46

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

 

Consolidated Statements ofIncomeFor the years ended December 31, 2007, 2006 and 2005

 
| ** **                                                   | ** ** | **2007**   | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|--------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
|                                                         |       |       |       |       |       |       |       |
| Interest income:                                             |       |       |       |       |       |       |       |
| Loans and leases:                                            |       |       |       |       |       |       |       |
| Taxable                                                      |       | $          | 28,765,640 |       | $          | 27,681,779 |       | $ | 23,829,470 |   |
| Nontaxable                                                   |       | 469,389    |       | 445,527    |       | 451,590    |       |
| Interest-bearing deposits with financial institutions        |       | 8,865      |       | 9,166      |       | 14,440     |       |
| Investment securities:                                       |       |       |       |       |       |       |       |
| U.S. Government agency  and corporations                     |       | 4,264,152  |       | 3,738,995  |       | 3,498,419  |       |
| States and political  subdivisions (nontaxable)              |       | 498,335    |       | 590,558    |       | 539,004    |       |
| Other securities                                             |       | 1,170,063  |       | 940,467    |       | 638,738    |       |
| Federal funds sold                                           |       | 102,913    |       | 123,218    |       | 48,600     |       |
|                                                         |       |       |       |       |       |       |       |
| Total interest income                                        |       | 35,279,357 |       | 33,529,710 |       | 29,020,261 |       |
|                                                         |       |       |       |       |       |       |       |
| Interest expense:                                            |       |       |       |       |       |       |       |
| Deposits                                                     |       | 13,369,992 |       | 11,492,827 |       | 6,928,000  |       |
| Securities sold under  repurchase agreements                 |       | 465,391    |       | 623,902    |       | 633,942    |       |
| Other short-term  borrowings and other                       |       | 504,972    |       | 377,958    |       | 328,857    |       |
| Long-term debt                                               |       | 3,319,720  |       | 3,866,422  |       | 3,830,187  |       |
|                                                         |       |       |       |       |       |       |       |
| Total interest expense                                       |       | 17,660,075 |       | 16,361,109 |       | 11,720,986 |       |
|                                                         |       |       |       |       |       |       |       |
| Net interest income                                          |       | 17,619,282 |       | 17,168,601 |       | 17,299,275 |       |
|                                                         |       |       |       |       |       |       |       |
| (Credit) provision for loan losses                           |       | (60,000)   |       | 325,000    |       | 830,000    |       |
|                                                         |       |       |       |       |       |       |       |
| Net interest income after (credit) provision for loan losses |       | 17,679,282 |       | 16,843,601 |       | 16,469,275 |       |
|                                                         |       |       |       |       |       |       |       |
| Other income:                                                |       |       |       |       |       |       |       |
| Service charges on  deposit accounts                         |       | 3,007,365  |       | 2,631,859  |       | 2,660,723  |       |
| Gain (loss) on sale of:                                      |       |       |       |       |       |       |       |
| Loans                                                        |       | 159,441    |       | 97,848     |       | 9,937      |       |
| Investment securities                                        |       | 79         |       | 1,200      |       | 4,696      |       |
| Premises and equipment                                       |       | 97,518     |       | (19,654)   |       | (14,779)   |       |
| Foreclosed assets  held-for-sale                             |       | 143,559    |       | (3,390)    |       | 56,516     |       |
| Leased assets                                                |       | —     |       | 15,154     |       | (334,663)  |       |
| Fees and other service  charges                              |       | 1,797,253  |       | 1,799,121  |       | 1,768,072  |       |
|                                                         |       |       |       |       |       |       |       |
| Total other income                                           |       | 5,205,215  |       | 4,522,138  |       | 4,150,502  |       |
|                                                         |       |       |       |       |       |       |       |
| Other expenses:                                              |       |       |       |       |       |       |       |
| Salaries and employee  benefits                              |       | 8,705,698  |       | 8,328,407  |       | 7,093,427  |       |
| Premises and equipment                                       |       | 3,156,372  |       | 3,144,669  |       | 2,954,205  |       |
| Advertising                                                  |       | 684,732    |       | 540,543    |       | 621,103    |       |
| Other                                                        |       | 4,089,958  |       | 3,864,757  |       | 3,893,233  |       |
|                                                         |       |       |       |       |       |       |       |
| Total other expenses                                         |       | 16,636,760 |       | 15,878,376 |       | 14,561,968 |       |
|                                                         |       |       |       |       |       |       |       |
| Income before provision for income taxes                     |       | 6,247,737  |       | 5,487,363  |       | 6,057,809  |       |
|                                                         |       |       |       |       |       |       |       |
| Provision for income taxes                                   |       | 1,636,165  |       | 1,362,080  |       | 1,466,112  |       |
|                                                         |       |       |       |       |       |       |       |
| Net income                                                   |       | $          | 4,611,572  |       | $          | 4,125,283  |       | $ | 4,591,697 |   |
|                                                         |       |       |       |       |       |       |       |
| Per share data:                                              |       |       |       |       |       |       |       |
| Net income—basic                                        |       | $          | 2.23       |       | $          | 2.01       |       | $ | 2.26 |   |
| Net income—diluted                                      |       | $          | 2.23       |       | $          | 2.01       |       | $ | 2.25 |   |
| Dividends                                                    |       | $          | 0.93       |       | $          | 0.88       |       | $ | 0.80 |   |

 

See notes toconsolidated financial statements

 

47

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** **

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

 

Consolidated Statements of Changes in Shareholders’ EquityFor the years ended December 31, 2007, 2006 and 2005

 
| ** **                                                                                                                     | ** ** | ** **             | ** ** | ** **   | ** ** | ** **        | ** ** | **Accumulated**        | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|--------------|------------|-------------------|------------|------------------------|------------|------------|------------|
| ** **                                                                                                                     | ** ** | ** **             | ** ** | ** **   | ** ** | ** **        | ** ** | **other**              | ** ** | ** ** | ** ** |
| ** **                                                                                                                     | ** ** | **Capital stock** | ** ** | **Retained** | ** ** | **comprehensive** | ** ** | ** **             | ** ** |
| ** **                                                                                                                     | ** ** | **Shares**             | ** ** | **Amount**   | ** ** | **earnings**      | ** ** | **income (loss)** | ** ** | **Total**  | ** ** |
|                                                                                                                           |       |                   |       |         |       |              |       |                   |       |       |       |
| Balance, December 31, 2004                                                                                                |       | 1,839,572              |       | $            | 10,072,134 |              | $          | 36,396,027             |       | $          | (101,401   | ) | $ | 46,366,760 |   |
| Total comprehensive income:                                                                                                    |       |                   |       |         |       |              |       |                   |       |       |       |
| Net income                                                                                                                     |       |                   |       |         |       | 4,591,697         |       |                   |       | 4,591,697  |       |
| Change in net  unrealized holding losses on available-for-sale securities, net of  reclassification adjustment and tax effects |       |                   |       |         |       |              |       | (1,010,932             | )          | (1,010,932 | )          |
| Comprehensive  income                                                                                                          |       |                   |       |         |       |              |       |                   |       | 3,580,765  |       |
| Issuance of  common stock through Employee Stock Purchase Plan                                                                 |       | 1,031                  |       | 31,671       |       |              |       |                   |       | 31,671     |       |
| Dividends  reinvested through Dividend Reinvestment Plan                                                                       |       | 13,614                 |       | 491,096      |       |              |       |                   |       | 491,096    |       |
| Cash dividends declared                                                                                                        |       |                   |       |         |       | (1,624,263        | )          |                   |       | (1,624,263 | )          |
|                                                                                                                           |       |                   |       |         |       |              |       |                   |       |       |       |
| 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 |   |
|                                                                                                                                |            |                        |            |              |            |                   |            |                        |            |            |            |  |  |  |  |  |  |  |

 

 

Seenotes to consolidated financial statements

 

48

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

 

Consolidated Statementsof Cash Flows

For the years ended December 31,2007, 2006 and 2005

 
| ** **                                                                         | ** ** | **2007**    | ** ** | **2006**    | ** ** | **2005**    | ** ** |
|------------------------------------------------------------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|
| Cash flows from operating activities:                                              |       |        |       |        |       |        |       |
| Net income                                                                         |       | $           | 4,611,572  |        | $          | 4,125,283   |       | $ | 4,591,697 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |        |       |        |       |        |       |
| Depreciation,  amortization and accretion                                          |       | 1,130,274   |       | 1,349,990   |       | 1,493,621   |       |
| (Credit)  provision for loan losses                                                |       | (60,000     | )          | 325,000     |       | 830,000     |       |
| Deferred income  tax expense (benefit)                                             |       | 78,838      |       | (75,003     | )          | (318,948    | )          |
| Stock-based  compensation expense                                                  |       | 15,861      |       | 28,744      |       | —      |       |
| Loss from  investment in limited partnership                                       |       | 80,400      |       | 80,000      |       | 90,000      |       |
| Proceeds from  sale of loans available-for-sale                                    |       | 16,399,530  |       | 12,573,745  |       | 2,337,108   |       |
| Originations of  loans available-for-sale                                          |       | (16,945,339 | )          | (12,169,313 | )          | (2,179,377  | )          |
| Write-down of  foreclosed assets held-for-sale                                     |       | —      |       | —      |       | 63,569      |       |
| Increase in cash  surrender value of life insurance                                |       | (310,702    | )          | (286,063    | )          | (278,461    | )          |
| Net gain on sale  of loans                                                         |       | (159,441    | )          | (97,848     | )          | (9,937      | )          |
| Net gain on sale  of investment securities                                         |       | (79         | )          | (1,200      | )          | (4,696      | )          |
| Net (gain) loss  on sale of foreclosed assets held-for-sale                        |       | (143,559    | )          | 3,390       |       | (56,516     | )          |
| Net loss on sale  of leased assets                                                 |       | —      |       | —      |       | 334,663     |       |
| Net (gain) loss  on disposal of equipment                                          |       | (97,518     | )          | 19,654      |       | 14,779      |       |
| Change in:                                                                         |       |        |       |        |       |        |       |
| Accrued interest  receivable                                                       |       | 1,880       |       | (542,750    | )          | (236,976    | )          |
| Other assets                                                                       |       | (8,933      | )          | (385,141    | )          | (172,882    | )          |
| Accrued interest  payable and other liabilities                                    |       | (29,680     | )          | 922,747     |       | 200,655     |       |
|                                                                               |       |        |       |        |       |        |       |
| Net cash  provided by operating activities                                         |       | 4,563,104   |       | 5,871,235   |       | 6,698,299   |       |
|                                                                               |       |        |       |        |       |        |       |
| Cash flows from investing activities:                                              |       |        |       |        |       |        |       |
| Held-to-maturity  securities:                                                      |       |        |       |        |       |        |       |
| Proceeds from  maturities, calls and principal pay-downs                           |       | 421,096     |       | 424,880     |       | 1,053,978   |       |
| Available-for-sale  securities:                                                    |       |        |       |        |       |        |       |
| Proceeds from  sales                                                               |       | 3,818,914   |       | 19,554,141  |       | 25,283,946  |       |
| Proceeds from  maturities, calls and principal pay-downs                           |       | 12,001,895  |       | 24,445,735  |       | 14,121,713  |       |
| Purchases                                                                          |       | (38,399,150 | )          | (46,996,118 | )          | (24,207,221 | )          |
| Net decrease  (increase) FHLB stock                                                |       | 492,200     |       | 833,100     |       | (59,500     | )          |
| Net increase in  loans and leases                                                  |       | (4,517,367  | )          | (14,619,300 | )          | (24,026,568 | )          |
| Proceeds from  sale of leased assets                                               |       | —      |       | —      |       | 1,021,403   |       |
| Acquisition of  bank premises and equipment                                        |       | (2,939,866  | )          | (1,723,928  | )          | (1,676,465  | )          |
| Proceeds from  sale of bank premises and equipment                                 |       | 453,186     |       | 1,560       |       | 15,845      |       |
| Proceeds from  sale of foreclosed assets held-for-sale                             |       | 584,088     |       | 55,890      |       | 546,956     |       |
|                                                                               |       |        |       |        |       |        |       |
| Net cash used in  investing activities                                             |       | (28,085,004 | )          | (18,024,040 | )          | (7,925,913  | )          |
|                                                                               |       |        |       |        |       |        |       |
| Cash flows from financing activities:                                              |       |        |       |        |       |        |       |
| Net increase in  deposits                                                          |       | 15,373,765  |       | 30,835,955  |       | 13,883,305  |       |
| Net increase  (decrease) in short-term borrowings                                  |       | 6,000,204   |       | 4,883,153   |       | (21,761,049 | )          |
| Proceeds from  issuance of long-term debt                                          |       | 20,000,000  |       | 16,000,000  |       | 15,000,000  |       |
| Repayments of  long-term debt                                                      |       | (19,827,533 | )          | (37,167,978 | )          | (2,415,000  | )          |
| Proceeds from  employee stock purchase plan                                        |       | 67,820      |       | 48,151      |       | 31,671      |       |
| Dividends paid,  net of dividends reinvested                                       |       | (1,484,388  | )          | (1,232,720  | )          | (1,133,167  | )          |
| Cash payments in  lieu of fractional shares on stock dividend                      |       | —      |       | (7,448      | )          | —      |       |
|                                                                               |       |        |       |        |       |        |       |
| Net cash  provided by financing activities                                         |       | 20,129,868  |       | 13,359,113  |       | 3,605,760   |       |
|                                                                               |       |        |       |        |       |        |       |
| Net (decrease) increase in cash and cash equivalents                               |       | (3,392,032  | )          | 1,206,308   |       | 2,378,146   |       |
|                                                                               |       |        |       |        |       |        |       |
| Cash and cash equivalents, beginning                                               |       | 13,800,848  |       | 12,594,540  |       | 10,216,394  |       |
|                                                                               |       |        |       |        |       |        |       |
| Cash and cash equivalents, ending                                                  |       | $           | 10,408,816 |        | $          | 13,800,848  |       | $ | 12,594,540 |   |

 

Seenotes to consolidated financial statements

 

49

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**FIDELITYD & D BANCORP, INC.**

**AND SUBSIDIARY**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

**1.****             ****NATUREOF OPERATIONS AND SUMMARY OF 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 and the valuation of real estate acquired inconnection with foreclosures or in satisfaction of loans.  In connection with the determination ofallowance for losses on loans and foreclosed real estate, management obtainsindependent appraisals for properties.

 

**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.  TheCompany did not have any investment securities held for trading purposes during2007, 2006 or 2005.

 

 

50

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**AVAILABLE-FOR-SALESECURITIES**

 

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.  Unrealized holding gains and losses on AFSsecurities are reported as a separate component of shareholders’ equity, net ofdeferred income taxes, until realized. These net unrealized holding gains and losses are a component ofaccumulated other comprehensive (loss) income. Gains and losses from sales of securities AFS are determined using thespecific identification method.

 

**FEDERALHOME LOAN 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 to the extent of previous write-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.

 

51

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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, “Accountingby Creditors for Impairment of a Loan,” (SFAS 114) for loans specificallyidentified to be individually evaluated for impairment and the requirements ofSFAS 5, “Accounting for Contingencies,” for large groups of homogeneous loansto 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 been allotted. SFAS 5 allowances include a portionbased on historical charge-off experience and a portion based on evaluation ofqualitative factors.

 

**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 PREMISES AND 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 of bankowned life insurance (BOLI) policies on certain employees.  The earnings from the BOLI are recognized asa component of other income.  The BOLI isan asset that can be liquidated, ifnecessary, 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 tosell.  Losses from the acquisition ofproperty in full 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 replaces SFAS 123, *Accounting for Stock-Based Compensation*,and supersedes Accounting Principles Bulletin (APB) Opinion 25, *Accounting for Stock Issued to Employees*.  SFAS 123R requires that the cost ofshare-based payment transactions (including those with employees andnon-employees) be recognized in the financial statements.

 

52

----

 

Prior to 2006, theCompany accounted for these plans under the recognition and measurementprinciples of APB 25, and related Interpretations.  Prior to 2006, no stock-based employeecompensation cost is reflected in net income, as all options granted underthese plans had an exercise price equal to the fair value of the underlyingcommon stock on the date of grant.  Thefollowing table illustrates the effect on net income and earnings per share ifthe Company had applied the fair value recognition provisions of Statement SFASNo. 123R, to stock-based employee compensation for the year ended December 31,2005 (dollars in thousands except for per share data):

 

| ** **                                                                                                                  | ** ** | **2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
|                                                                                                                        |       |     |       |
| Net income, as reported                                                                                                     |       | $        | 4,592      |   |
| Less: total  stock-based employee compensation expense determined under fair value based  method for all awards, net of tax |       | —   |       |
|                                                                                                                        |       |     |       |
| Pro forma net income                                                                                                        |       | $        | 4,592      |   |
| Earnings per  share:                                                                                                        |       |     |       |
| Basic — as  reported                                                                                                   |       | $        | 2.26       |   |
| Basic — pro  forma                                                                                                     |       | $        | 2.26       |   |
|                                                                                                                        |       |     |       |
| Diluted — as  reported                                                                                                 |       | $        | 2.25       |   |
| Diluted — pro  forma                                                                                                   |       | $        | 2.25       |   |

 

The Company did not grantstock options in 2005.

 

**TRUST AND FINANCIAL SERVICE FEES**

 

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

 

**ADVERTISINGCOSTS**

 

Advertisingcosts are charged to expense as incurred. For the years ended December 31, 2007, 2006 and 2005, advertisingcosts amounted to approximately $685,000, $541,000 and $621,000, respectively.

 

**FAIRVALUE OF FINANCIAL INSTRUMENTS**

 

**Cash andshort-term instruments:**  The carrying amounts of cashand short-term instruments approximate their fair value.

 

**Securities:** Fair values for securities are based on bid prices received fromsecurities dealers.  Federal Home LoanBank Stock is carried at cost, which approximates fair value.

 

**Loansreceivable:**  The fair value of all loans is estimated bythe net present value of the future expected cash flows.

 

**Loansavailable-for-sale:**  For loans available-for-sale, the fair valueis estimated using rates currently offered for similar loans.

 

**Depositliabilities:**  The fair values of deposits with no statedmaturity such as demand, NOW, savings and money market deposit accounts, areequal to the amount payable on demand which are their carrying values.  The fair values of certificate of depositaccounts are based on discounted cash flows using rates which approximate therates we offer for deposits of similar maturities.

 

**Short-termborrowings:**  For short-term borrowings, the fair value isestimated using the rates currently offered for similar borrowings.

 

**Long-termdebt:**  For other borrowed funds, the fair value isestimated using the rates currently offered for similar borrowings.

 

53

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**Accruedinterest:** The carrying amounts of accrued interestapproximate their fair values.

 

**Derivativefinancial instruments:**  The carrying amount of interestrate contracts are based on proprietary models from independent third-partysources that consider size, lack of a quoted market for the instrument and thecustom tailored nature of the transaction.

 

**Off-balance-sheetinstruments:**  Commitments to extend credit and unused linesof credit are priced to market.  Therates on standby letters of credit are priced on prime.  Therefore, the estimated fair value of thesefinancial 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.

 

For the years ended December 31,2007, 2006, and 2005, the Company paid interest of $18,306,000, $15,318,000 and$11,367,000, respectively.  For the yearsended December 31, 2007, 2006, and 2005, the Company paid cash for incometaxes of $1,500,000, $1,480,000 and $1,800,000, respectively.

 

Transfers from loans toforeclosed assets held-for-sale amounted to $352,000, $258,000 and $322,000 in2007, 2006, and 2005, respectively.  Expendituresfor construction in process, a component of other assets in the consolidatedbalance sheets, are included in acquisition of premises and equipment.

 

54

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**OTHERCOMPREHENSIVE INCOME (LOSS)**

 

Thecomponents of other comprehensive income (loss) and related tax effects are asfollows:

 
| ** **                                                          | ** ** | **2007** | ** ** | **2006** | ** ** | **2005**   | ** ** |
|---------------------------------------------------------------------|------------|----------|------------|----------|------------|------------|------------|
|                                                                |       |     |       |     |       |       |       |
| Unrealized  holding (losses) gains on available-for-sale securities |       | $        | (24,554    | )        | $          | 223,358    |       | $ | (1,527,019 | ) |
|                                                                |       |     |       |     |       |       |       |
| Less  reclassification adjustment for gains realized in income      |       | (79      | )          | (1,200   | )          | (4,696     | )          |
|                                                                |       |     |       |     |       |       |       |
| Net unrealized (losses) gains                                       |       | (24,633  | )          | 222,158  |       | (1,531,715 | )          |
|                                                                |       |     |       |     |       |       |       |
| Change in cash flow hedge intrinsic value                           |       | 384,824  |       | 917      |       | —     |       |
|                                                                |       |     |       |     |       |       |       |
| Subtotal                                                            |       | 360,191  |       | 223,075  |       | (1,531,715 | )          |
|                                                                |       |     |       |     |       |       |       |
| Tax effect                                                          |       | 8,375    |       | (75,534  | )          | 520,783    |       |
|                                                                |       |     |       |     |       |       |       |
| Net of tax amount                                                   |       | $        | 368,566    |     | $          | 147,541    |       | $ | (1,010,932 | ) |

 

The components ofaccumulated other comprehensive loss consisted of:

 
| ** **                                                  | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                        |       |     |       |     |       |     |       |
| Unrealized  holding losses on available-for-sale securities |       | $        | (981,967   | )        | $          | (965,709 | )          | $ | (1,112,333 | ) |
|                                                        |       |     |       |     |       |     |       |
| Change in cash  flow hedge intrinsic value                  |       | 385,741  |       | 917      |       | —   |       |
|                                                        |       |     |       |     |       |     |       |
| Accumulated  other comprehensive loss                       |       | $        | (596,226   | )        | $          | (964,792 | )          | $ | (1,112,333 | ) |
|                                                             |            |          |            |          |            |          |            |  |  |  |  |

 

**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, 2007 and 2006 were $702,000 and$714,000, respectively.

 

Deposits with any onefinancial institution are insured up to $100,000.  From time-to-time, the Company maintains cashand cash equivalents with certain other financial institutions in excess of theinsured amount.

 

55

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

 

Amortized cost and fairvalue of investment securities at December 31, 2007 and 2006 are asfollows (in thousands):

 
| ** **                                        | ** ** | **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 |   |

 
| ** **                                        | ** ** | **2006**            | ** ** |
|---------------------------------------------------|------------|---------------------|------------|
| ** **                                        | ** ** | **Amortized  cost** | ** ** | **Gross  unrealized  gains** | ** ** | **Gross  unrealized  losses** | ** ** | **Fair  value** | ** ** |
|                                              |       |                |       |   |   |   |   |   |   |
| Held-to-maturity securities:                      |       |                |       |   |   |   |   |   |   |
| Mortgage-backed  securities                       |       | $                   | 1,569      |   | $ | 29 |   | $ | — |   | $ | 1,598 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| Available-for-sale securities:                    |       |                |       |   |   |   |   |   |   |
| U.S. government  agencies and corporations        |       | $                   | 34,604     |   | $ | — |   | $ | 712 |   | $ | 33,892 |   |
| Obligations of  states and political subdivisions |       | 12,560              |       | 49 |   | 33 |   | 12,576 |   |
| Corporate bonds                                   |       | 10,530              |       | 52 |   | 11 |   | 10,571 |   |
| Mortgage-backed  securities                       |       | 42,332              |       | 1 |   | 1,002 |   | 41,331 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| Total debt  securities                            |       | 100,026             |       | 102 |   | 1,758 |   | 98,370 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| Equity  securities                                |       | 279                 |       | 192 |   | — |   | 471 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| Total  available-for-sale securities              |       | $                   | 100,305    |   | $ | 294 |   | $ | 1,758 |   | $ | 98,841 |   |

 

Most of the Company’s debtand 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.

 

56

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The amortized cost andfair value of debt securities at December 31, 2007 by contractual maturityare shown below (in thousands):

 
| ** **                                | ** ** | **Amortized  cost** | ** ** | **Fair  value** | ** ** |
|-------------------------------------------|------------|---------------------|------------|-----------------|------------|
|                                      |       |                |       |            |       |
| Held-to-maturity securities:              |       |                |       |            |       |
| Mortgage-backed  securities               |       | $                   | 1,147      |            | $          | 1,180 |   |
|                                      |       |                |       |            |       |
| Available-for-sale securities:            |       |                |       |            |       |
| Debt securities:                          |       |                |       |            |       |
| Due in one year  or less                  |       | $                   | 1,000      |            | $          | 997 |   |
| Due after one  year through five years    |       | 4,999               |       | 5,012           |       |
| Due after five  years through ten years   |       | 17,283              |       | 17,369          |       |
| Due after ten  years                      |       | 41,783              |       | 40,334          |       |
|                                      |       |                |       |            |       |
| Total debt  securities                    |       | 65,065              |       | 63,712          |       |
|                                      |       |                |       |            |       |
| Mortgage-backed  securities               |       | 57,930              |       | 57,620          |       |
|                                      |       |                |       |            |       |
| Total  available-for-sale debt securities |       | $                   | 122,995    |            | $          | 121,332 |   |

 

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.

 

57

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The following tablepresents the fair value and gross unrealized losses of investments aggregatedby investment category and length of time and the number of securities thatindividual securities have been in a continuous unrealized loss position at December 31,2007 and 2006 (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, 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 |   |   |   |
|                                              |       |                                   |         |                                 |       |            |       |   |   |   |   |   |   |
| December 31, 2006:                           |       |                                   |         |                                 |       |            |       |   |   |   |   |   |   |
|                                              |       |                                   |         |                                 |       |            |       |   |   |   |   |   |   |
| U.S. government  agencies and corporations        |       | $                                      |  12,421 |                                 | $          |  183       |       | $ |  21,471 |   | $ |  529 |   | $ |  33,892 |   | $ |  712 |   |
| Obligations of  states and political subdivisions |       | 4,820                                  |         | 30                                   |       | 203             |       | 3 |   | 5,023 |   | 33 |   |
| Mortgage-backed  securities                       |       | 6,839                                  |         | 45                                   |       | 34,435          |       | 957 |   | 41,274 |   | 1,002 |   |
| Corporate bonds                                   |       | 3,514                                  |         | 11                                   |       | —          |       | — |   | 3,514 |   | 11 |   |
|                                              |       |                                   |         |                                 |       |            |       |   |   |   |   |   |   |
| Subtotal, debt  securities                        |       | 27,594                                 |         | 269                                  |       | 56,109          |       | 1,489 |   | 83,703 |   | 1,758 |   |
|                                              |       |                                   |         |                                 |       |            |       |   |   |   |   |   |   |
| Equity  securities                                |       | —                                 |         | —                               |       | —          |       | — |   | — |   | — |   |
|                                              |       |                                   |         |                                 |       |            |       |   |   |   |   |   |   |
| Total  temporarily impaired securities            |       | $                                      |  27,594 |                                 | $          |  269       |       | $ |  56,109 |   | $ |  1,489 |   | $ |  83,703 |   | $ |  1,758 |   |
| Number of  securities                             |       | 22                                     |         |                                 |       | 32              |       |   |   | 54 |   |   |   |

 

Management evaluatessecurities for other-than-temporary impairment on a quarterly basis or morefrequently when economic conditions or market conditions warrant suchevaluation.  Consideration is given to (1) thelength of time and the extent to which the fair value has been less than cost, (2) thefinancial condition and near-term prospects of the issuer, and (3) theintent and ability of the Company to retain its investment in the issuer for aperiod of time sufficient to allow for any anticipated recovery in fair value.

 

58

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At December 31, 2007 the debt securities withunrealized losses have depreciated 2.4% from the Company’s amortized costbasis.  Management believes that thecause of the unrealized losses is directly related to changes in interest ratesand not credit quality, which is consistent with its experience.  In general, as interest rates rise, the fairvalue of fixed rate securities will decrease; as interest rates fall, their fairvalue will increase. Nearly all of the securities in the portfolio have fixedrates or have predetermined scheduled rate changes, and many have call featuresthat allow the issuer to call the security at par before its stated maturitywithout penalty.

 

Management views theunrealized losses to be temporary based on the impact of interest rates, andtheir high credit quality. In addition, the Company has the ability and intentto hold its investments for a period of time sufficient for the fair value ofthe securities to recover, which may be at maturity. Management evaluates thesecurities for other-than-temporary impairment at least on a quarterly basis,and more frequently when economic or market concerns warrant such evaluation.There were no other-than-temporary impairment write-downs recorded in 2007,2006 or 2005.

 

Gross realized gains andlosses on sales of available-for-sale securities, determined using specificidentification of the securities were as follows:

 
| ** **          | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------|------------|----------|------------|----------|------------|----------|------------|
|                |       |     |       |     |       |     |       |
| Gross realized gain |       | $        | 18,853     |     | $          | 71,201   |       | $ | 127,414 |   |
| Gross realized loss |       | 18,774   |       | 70,001   |       | 122,718  |       |
| Net gain            |       | $        | 79         |     | $          | 1,200    |       | $ | 4,696 |   |

 

**4.****             ****LOANSAND LEASES**

 

The major classificationsof loans and leases at December 31, 2007 and 2006 are summarized asfollows:

 
| ** **                 | ** **             | **2007**    | ** **  | **2006**    | ** ** |
|----------------------------|------------------------|-------------|-------------|-------------|------------|
|                       |                   |        |        |        |       |
| Commercial and CRE         |                   | $           | 216,057,882 |        | $          | 218,213,216 |   |
| Residential real estate    |                   | 116,978,378 |        | 112,742,692 |       |
| Consumer                   |                   | 81,998,093  |        | 77,729,520  |       |
| Real estate construction   |                   | 10,703,249  |        | 13,369,712  |       |
| Direct financing leases    |                   | 511,178     |        | 588,211     |       |
|                       |                   |        |        |        |       |
| Total                      |                   | 426,248,780 |        | 422,643,351 |       |
|                       |                   |        |        |        |       |
| Less:                      |                   |        |        |        |       |
| Allowance for  loan losses |                   | 4,824,401   |        | 5,444,303   |       |
|                       |                   |        |        |        |       |
|                       | Loans and  leases, net |        | $           | 421,424,379 |       | $ | 417,199,048 |   |
|                            |                        |             |             |             |            |  |  |  |

 

Net deferred loan costsof $722,000 and $618,000 have been added to the carrying value of loans at December 31,2007 and 2006, respectively.

 

59

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

 
| ** **                                                                   | ** ** | **2007**  | ** ** | **2006**  | ** ** |
|------------------------------------------------------------------------------|------------|-----------|------------|-----------|------------|
| At December 31:                                                         |       |      |       |      |       |
| Non-accrual  loans                                                           |       | $         | 3,811,205  |      | $          | 3,357,718 |   |
| Other impaired  loans                                                        |       | 2,283,501 |       | —    |       |
| Total impaired  loans                                                        |       | $         | 6,094,706  |      | $          | 3,357,718 |   |
|                                                                         |       |      |       |      |       |
| Amount of  impaired loans that have a specific allowance                     |       | $         | 5,038,972  |      | $          | 1,393,660 |   |
| Amount of  impaired loans with no specific allowance                         |       | 1,055,734 |       | 1,964,058 |       |
| Allowance for  impaired loans                                                |       | 1,143,203 |       | 278,153   |       |
|                                                                         |       |      |       |      |       |
| Accruing loans  that are contractually past due as to principal or interest: |       |      |       |      |       |
| Past due 90 days  or more                                                    |       | 25,470    |       | 80,603    |       |
| Past due 30-89  days                                                         |       | 4,697,953 |       | 2,570,825 |       |
|                                                                         |       |      |       |      |       |
| During the year ended December 31:                                      |       |      |       |      |       |
| Average  investment in impaired loans                                        |       | 5,214,365 |       | 8,146,755 |       |
| Interest income  recognized on impaired loans                                |       | 109,889   |       | 390,127   |       |
| Interest income  recognized on impaired loans (cash basis)                   |       | 93,426    |       | 278,570   |       |

 

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

 
| ** **                         | ** ** | **2007** | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|------------------------------------|------------|----------|------------|------------|------------|------------|------------|
|                               |       |     |       |       |       |       |       |
| Balance, beginning                 |       | $        | 5,444,303  |       | $          | 5,984,649  |       | $ | 5,987,798 |   |
| Recoveries                         |       | 161,861  |       | 189,668    |       | 560,496    |       |
| (Credit) provision for loan losses |       | (60,000  | )          | 325,000    |       | 830,000    |       |
| Losses charged to allowance        |       | (721,763 | )          | (1,055,014 | )          | (1,393,645 | )          |
|                               |       |     |       |       |       |       |       |
| Balance, ending                    |       | $        | 4,824,401  |       | $          | 5,444,303  |       | $ | 5,984,649 |   |

 

The Company services real estate loans for investors in the secondarymortgage market which are not included in the accompanying consolidated balancesheet.  The approximate amount ofmortgages serviced amounted to $61,023,000 at December 31, 2007 and$53,112,000 at December 31, 2006.

 

**5.****             ****BANKPREMISES AND EQUIPMENT**

 

Components of bankpremises and equipment at December 31, 2007 and 2006 are summarized asfollows:

 
| ** **                                     | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|------------------------------------------------|------------|------------|------------|------------|------------|
|                                           |       |       |       |       |       |
| Land                                           |       | $          | 2,072,048  |       | $          | 2,072,048 |   |
| Bank premises                                  |       | 7,171,328  |       | 7,492,231  |       |
| Furniture, fixtures and equipment              |       | 8,603,310  |       | 8,148,040  |       |
| Leasehold improvements                         |       | 5,102,308  |       | 3,021,602  |       |
|                                           |       |       |       |       |       |
| Total                                          |       | 22,948,994 |       | 20,733,921 |       |
|                                           |       |       |       |       |       |
| Less accumulated depreciation and amortization |       | 9,984,062  |       | 9,409,456  |       |
|                                           |       |       |       |       |       |
| Bank premises  and equipment, net              |       | $          | 12,964,932 |       | $          | 11,324,465 |   |

 

Depreciation expense, which includes amortization of leaseholdimprovements, was $1,297,000, $1,191,000 and $1,189,000 for the years ended December 31,2007, 2006 and 2005, respectively.

 

During 2008, the Company expects to complete the construction of a newbranch office in West Scranton.  As of December 31,2007, approximately $2,000,000 of additional capital expenditures representingoutstanding 

 

60

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construction commitments, design, furniture and equipment will beincurred before the entire cost of the project will be reclassified fromconstruction in process, a component of other assets on the consolidatedbalance sheets, to bank premises and equipment.

 

The Company leases its Green Ridge, Scranton, Pittston, West Pittston,Moosic, Kingston, Peckville, Clarks Summit and Eynon branches under the terms ofoperating leases.  Rental expense was$435,000 for 2007, $428,000 for 2006 and $380,000 for 2005.  The future minimum rental payments at December 31,2007 under these leases are as follows:

 
| **Year ending December 31** | ** ** | **Amount** | ** ** |
|--------------------------------------------|------------|------------|------------|
|                                       |       |       |       |
| 2008                                       |       | $          | 375,225    |   |
| 2009                                       |       | 347,962    |       |
| 2010                                       |       | 345,484    |       |
| 2011                                       |       | 347,151    |       |
| 2012                                       |       | 350,484    |       |
| 2013 and  thereafter                       |       | 4,261,752  |       |
|                                       |       |       |       |
| Total                                      |       | $          | 6,028,058  |   |

 

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

 

At December 31,2007, the scheduled maturities of certificates of deposit are as follows:

 
| 2008                |   | $113,910,750 |   | 63.9   | %      |
|---------------------|--------|--------------|--------|--------|--------|
| 2009                |   | 53,147,973   |   | 29.8   |   |
| 2010                |   | 8,394,364    |   | 4.7    |   |
| 2011                |   | 1,392,190    |   | 0.8    |   |
| 2012                |   | 1,121,297    |   | 0.7    |   |
| 2013 and thereafter |   | 233,968      |   | 0.1    |   |
|                |   |         |   |   |   |
|                |   | $178,200,542 |   | 100.0  | %      |

 

Certificate of deposit accounts of $100,000 or more aggregated$80,857,000 and $63,020,000 at December 31, 2007 and 2006, respectively.

 

Investment securities with a fair value of $63,505,000 and letters ofcredit with a notional amount of $10,563,000 as of December 31, 2007 werepledged as collateral to secure public deposits and trust funds.

 

**7.****             ****SHORT-TERMBORROWINGS**

 

Short-term borrowings are as follows at December 31, 2007, 2006and 2005:

 
| ** **                                  | ** ** | **2007**   | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|---------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
|                                        |       |       |       |       |       |       |       |
| Securities sold under repurchase agreements |       | $          | 20,504,408 |       | $          | 22,224,445 |       | $ | 26,912,700 |   |
| Demand note, U.S. Treasury                  |       | 201,946    |       | 1,036,705  |       | 1,091,297  |       |
| Overnight borrowings                        |       | 18,950,000 |       | 10,395,000 |       | 769,000    |       |
|                                        |       |       |       |       |       |       |       |
| Total                                       |       | $          | 39,656,354 |       | $          | 33,656,150 |       | $ | 28,772,997 |   |

 

61

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The maximum and average amounts of short-term borrowings outstandingand related interest rates for the years ended December 31, 2007, 2006 and2005 are as follows:

 
| ** **                 | ** ** | **Maximum  outstanding  at any  month end** | ** ** | **Average  outstanding** | ** ** | **Weighted-  average  rate during  the year** | ** ** | **Rate at  year end** | ** ** |
|----------------------------|------------|-------------------------------------------------------|------------|--------------------------|------------|---------------------------------------------------------|------------|---------------------------------|------------|
| ** **                 | ** ** | ** **                                            | ** ** | ** **               | ** ** | ** **                                              | ** ** | ** **                      | ** ** |
| 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                                              |       |                            |       |   |   |
|                       |       |                                                  |       |                     |       |                                                    |       |                            |       |
| 2005                       |       |                                                  |       |                     |       |                                                    |       |                            |       |
|                       |       |                                                  |       |                     |       |                                                    |       |                            |       |
| Overnight borrowings       |       | $                                                     | 15,850,000 |                     | $          | 8,002,896                                               |       | 3.59%                           |       | 4.22% |   |
| Repurchase agreements      |       | 56,137,013                                            |       | 35,105,825               |       | 1.81%                                                   |       | 1.89%                           |       |
| Demand note, U.S. Treasury |       | 1,091,297                                             |       | 685,572                  |       | 3.35%                                                   |       | 3.96%                           |       |
|                       |       |                                                  |       |                     |       |                                                    |       |                            |       |
| Total                      |       | $                                                     | 73,078,310 |                     | $          | 43,794,293                                              |       |                            |       |   |   |

 

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 qualifiedinvestment securities of the Company. Repurchase agreements are reflected at the amount of cash received inconnection with the transaction.  Thecarrying value of the underlying qualified investment securities wasapproximately $22,000,000, $25,000,000 and $27,000,000 at December 31,2007, 2006 and 2005, respectively.  TheCompany may be required to provide additional collateral based on the fairvalue of the underlying securities.  TheU. S. Treasury demand note is generally repaid within 1 to 90 days.

 

At December 31,2007, the Company had approximately $122,134,000 available to borrow from theFHLB, $11,050,000 from correspondent banks and approximately $5,652,000 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, 2007, 2006or 2005.

 

**8.****             ****LONG-TERMDEBT**

 

Long-termdebt consists of advances from the FHLB with interest rates ranging from 2.98%to 6.14% at December 31, 2007. These advances are secured by unencumbered U.S. government agencysecurities, mortgage-backed securities, certain residential mortgages and otherreal estate collateralized loans with a combined fair value of $206,000,000 at December 31,2007.

 

62

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At December 31,2007, the maturities and weighted-average interest rates of long-term debt areas follows:

 
| **Year ending December 31,** | ** ** | **Amount** | ** ** | **Rate** | ** ** |
|---------------------------------------------|------------|------------|------------|----------|------------|
|                                        |       |       |       |     |       |
| 2008                                        |       | $          | 708,677    |     | 2.98       | % |
| 2009                                        |       | 20,000,000 |       | 5.13     |       |
| 2010                                        |       | 21,000,000 |       | 5.84     |       |
| 2013                                        |       | 5,000,000  |       | 3.61     |       |
| 2016                                        |       | 16,000,000 |       | 5.26     |       |
|                                        |       |       |       |     |       |
| Total                                       |       | $          | 62,708,677 |     | 5.26       | % |

 

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 ratesdrift 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 31,2007 the weighted-average interest rate on these convertible select advances was5.35% with maturity dates ranging from 2010 to 2016.

 

**9.****             ****STOCKPLANS**

 

The Company uses the fair value method of accounting for stock-basedcompensation provided under SFAS 123R, Share Based Payment.  SFAS 123R requires that the cost ofshare-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 wereshareholder-approved and permit the grant of share-based compensation awards toits directors, key officers and certain other employees.  The Company believes that these stock optionplans better align the interest of its directors, key officers and employeeswith the interest of its shareholders. The Company further believes that the granting of share-based awards,under the provisions of the stock option plans, is necessary to retain theknowledge base, continuity and expertise of its directors, key officers andcertain employees.  During the fourthquarter of 2007, various amendment provisions to the stock option plansconcerning their administration are intended to qualify the plans for exemptionfrom the application of Section 409A of the Internal Revenue Code, ascontemplated by the recently released final Treasury Regulations under theCode.  Other amendments to the stockoption plans are described more fully below.

 

The Company establishedthe 2000 Independent Directors Stock Option Plan (the Directors Plan) andreserved 55,000 shares of its un-issued capital stock for issuance under theplan.  In addition to the amendment tothe Directors’ Plan noted above, the Directors Plan was also amended to removeautomatic stock option granting in January of each year and allow thegrant of stock options at any time at the discretion of the Company’s Board ofDirectors.  This plan was further amendedto add a six-month vesting period for options granted.  During 2007, 17,500 stock options weregranted under the Directors’ Plan.  Nostock options were awarded during each of the years ended December 31,2006 and 2005 due to the directors’ voluntary election to forego theaward.  As of December 31, 2007,there were 32,350 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 under the plan.  In addition to the amendment to the IncentivePlan noted above, the Incentive Plan was also amended to provide that noqualified incentive stock options will be granted after the date of theamendments.  Under 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 2007 and 2006, 5,000 non-qualified shares and 2,200 qualifiedincentive shares, respectively, were granted under the Incentive Plan.  No stock options were granted during the yearended December 31, 2005.  As of December 31,2007, there were 10,830 unexercised stock options outstanding under this plan.

 

63

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A summary of the statusof the Company’s stock option plans as of December 31, 2007, December 31,2006 and December 31, 2005 and changes during the periods is presented inthe following table:

 
| ** **                                           | ** ** | **Options** | ** ** | **Weighted-  average  exercise price** | ** ** | **Weighted-  average  remaining   contractual  term (yrs)** | ** ** |
|------------------------------------------------------|------------|-------------|------------|---------------------------------------------|------------|-----------------------------------------------------------------------|------------|
|                                                 |       |        |       |                                        |       |                                                                  |       |
| Outstanding and  exercisable, December 31, 2004 |       | 20,570      |       | $                                           | 32.29      |                                                                  | 5.7        |   |
| Granted                                              |       | —      |       | —                                      |       |                                                                  |       |
| Exercised                                            |       | —      |       | —                                      |       |                                                                  |       |
| Forfeited                                            |       | (440        | )          | 34.09                                       |       |                                                                  |       |
|                                                 |       |        |       |                                        |       |                                                                  |       |
| 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, December 31,  2007                 |       | 43,180      |       | 30.69                                       |       | 6.8                                                                   |       |
| Exercisable, December 31,  2007                 |       | 20,680      |       | $                                           | 32.64      |                                                                  |       |   |

 

----

In the above table, the weighted-averageexercise price includes options with exercise prices ranging from $28.18 to$36.59.  Also, in the above table, onlyoptions that are fully vested are included in the amounts that are exercisableas of the date indicated.

 

As of December 31, 2007and 2006, the intrinsic value (stock options with fair values that exceededtheir exercise or strike price) aggregated approximately $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 2007 and 2006, themodel incorporated the assumptions noted in the following table:

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

 

The expectedvolatility was determined based on the daily five-year historical volatility ofthe Company’s stock.  Management believesthe five-year historical volatility measurement closely resembles thefluctuation of 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 todetermine the 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.

 

64

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The followingtable summarizes the per share weighted-average fair value of options granted:

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

 

Approximately$8,900 and $13,700 of stock-based compensation expense was recorded during thetwelve months ended 2007 and 2006, respectively, and is included as a componentof salaries and employee benefits in the consolidated income statement.  As of December 31, 2007, there were22,500 non-vested shares with a grant-date fair value of $5.57 per share.  In addition, as of December 31, 2007,there was approximately $114,000 of unrecognized compensation expense relatedto these non-vested shares granted under the stock option plans.  The non-vested shares are expected to befully vested and the related unrecognized compensation is expected to be fullyrecognized during the first half of 2008.

 

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 may have automatic payroll deductions to purchase the Company’scapital stock at a discounted price based at the fair market value of theCompany’s capital stock on either the commencement date or terminationdate.  At December 31, 2007, 8,317shares have been issued under the ESPP. The ESPP is considered a compensatory plan and, as such, is required tocomply with the provisions of SFAS 123R. The Company recognizes compensation expense on its ESPP on the date theshares are purchased.  For the year endedDecember 31, 2007 and 2006, compensation expense related to the ESPPapproximated $7,000 and $15,000, respectively and is included as a component ofsalaries and employee benefits in the consolidated income statement.  For the year ended December 31, 2008,the Company expects to issue approximately 2,300 shares and recognizecompensation expense of $3,000 under the ESPP.

 

Also, as of December 31,2007, the Company has reserved 110,000 shares of its un-issued capital stockfor issuance under a dividend reinvestment plan (the DRP).  Reserved shares issued under the DRP arevalued at fair value as of the dividend payment date.  At December 31, 2007, 29,330 shares areavailable for future issuance.

 

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

 

The Companyadopted FASB Interpretation No. 48, Accounting for Uncertainty in IncomeTaxes—an interpretation of FASB Statement No. 109 (FIN 48) during thefirst quarter of 2007 and has evaluated its material tax positions as of December 31,2007.  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, 2007, 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 31,2007, there were no unrecognized tax benefits that, if recognized, wouldsignificantly affect the Company’s effective tax rate.  Also, as of December 31, 2007, 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 twelve months.

 

65

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The following temporarydifferences gave rise to the deferred tax asset (liability) at December 31,2007 and 2006:

 
| ** **                                          | ** ** | **2007**  | ** ** | **2006**  | ** ** |
|-----------------------------------------------------|------------|-----------|------------|-----------|------------|
| Deferred tax assets:                                |       |      |       |      |       |
| Allowance for  loan losses                          |       | $         | 1,640,296  |      | $          | 1,851,063 |   |
| Unrealized  losses on available-for-sale securities |       | 505,861   |       | 497,486   |       |
| Deferred  interest from non-accrual loans           |       | 297,482   |       | 163,593   |       |
| Deferred  compensation                              |       | 24,479    |       | 43,702    |       |
| Retirement  settlement reserve                      |       | 39,714    |       | 46,918    |       |
| Other                                               |       | 111,228   |       | 87,755    |       |
|                                                |       |      |       |      |       |
| Total                                               |       | 2,619,060 |       | 2,690,517 |       |
|                                                |       |      |       |      |       |
| Deferred tax liabilities:                           |       |      |       |      |       |
| Depreciation                                        |       | (251,475  | )          | (328,321  | )          |
| Loan fees and  costs                                |       | (469,892  | )          | (396,355  | )          |
| Other                                               |       | (108,168  | )          | (105,853  | )          |
|                                                |       |      |       |      |       |
| Total                                               |       | (829,535  | )          | (830,529  | )          |
|                                                |       |      |       |      |       |
| Deferred tax  asset, net                            |       | $         | 1,789,525  |      | $          | 1,859,988 |   |

 

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

 
| ** **      | ** ** | **2007** | ** ** | **2006** | ** ** | **2005**  | ** ** |
|-----------------|------------|----------|------------|----------|------------|-----------|------------|
|            |       |     |       |     |       |      |       |
| Current         |       | $        | 1,557,327  |     | $          | 1,437,083 |       | $ | 1,785,060 |   |
| Deferred        |       | 78,838   |       | (75,003  | )          | (318,948  | )          |
|            |       |     |       |     |       |      |       |
| Total provision |       | $        | 1,636,165  |     | $          | 1,362,080 |       | $ | 1,466,112 |   |

 

Thereconciliation between the expected statutory income tax and the actualprovision for income taxes is as follows:

 
| ** **                                  | ** ** | **2007** | ** ** | **2006** | ** ** | **2005**  | ** ** |
|---------------------------------------------|------------|----------|------------|----------|------------|-----------|------------|
|                                        |       |     |       |     |       |      |       |
| Expected provision at the statutory rate    |       | $        | 2,124,231  |     | $          | 1,865,703 |       | $ | 2,059,655 |   |
| Tax-exempt income                           |       | (348,903 | )          | (376,906 | )          | (353,559  | )          |
| Nondeductible interest expense              |       | 47,385   |       | 54,670   |       | 43,296    |       |
| Bank owned life insurance                   |       | (105,639 | )          | (97,261  | )          | (94,677   | )          |
| Nondeductible other expenses and other, net |       | 36,792   |       | 33,575   |       | (68,489   | )          |
| Low income housing tax credits              |       | (117,701 | )          | (117,701 | )          | (120,114  | )          |
|                                        |       |     |       |     |       |      |       |
| Actual provision  for income taxes          |       | $        | 1,636,165  |     | $          | 1,362,080 |       | $ | 1,466,112 |   |

 

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

 

The Company has a definedcontribution profit sharing 401(k) plan covering substantially all of itsemployees.  The plan is subject to theprovisions of the Employee Retirement Income Security Act of 1974 (ERISA).  Contributions to the plan were approximately$292,000 in 2007, $242,000 in 2006 and $214,000 in 2005.

 

66

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**12.****      ****FAIRVALUE OF FINANCIAL INSTRUMENTS AND DERIVATIVES**

 

The following table represents the carrying amount and estimated fairvalue of the Company’s financial instruments as of December 31 (inthousands):

 
| ** **                              | ** ** | **2007**             | ** ** | **2006**                       | ** ** |
|-----------------------------------------|------------|----------------------|------------|--------------------------------|------------|
| ** **                              | ** ** | **Carrying  amount** | ** ** | **Estimated  fair value** | ** ** | **Carrying  amount** | ** ** | **Estimated  fair value** | ** ** |
|                                    |       |                 |       |                           |       |   |   |   |   |
| Financial assets:                       |       |                 |       |                           |       |   |   |   |   |
| Cash and cash  equivalents              |       | $                    | 10,409     |                           | $          | 10,409 |   | $ | 13,801 |   | $ | 13,801 |   |
| Held-to-maturity  securities            |       | 1,147                |       | 1,180                          |       | 1,569 |   | 1,598 |   |
| Available-for-sale  securities          |       | 121,837              |       | 121,837                        |       | 98,841 |   | 98,841 |   |
| FHLB Stock                              |       | 3,303                |       | 3,303                          |       | 3,795 |   | 3,795 |   |
| Loans and leases                        |       | 421,424              |       | 423,219                        |       | 417,199 |   | 410,412 |   |
| Loans  available-for-sale               |       | 827                  |       | 843                            |       | 122 |   | 123 |   |
| Accrued interest                        |       | 2,501                |       | 2,501                          |       | 2,503 |   | 2,503 |   |
|                                    |       |                 |       |                           |       |   |   |   |   |
| Financial liabilities:                  |       |                 |       |                           |       |   |   |   |   |
| Deposit  liabilities                    |       | 425,708              |       | 426,357                        |       | 410,335 |   | 408,903 |   |
| Short-term  borrowings                  |       | 39,656               |       | 39,656                         |       | 33,656 |   | 33,658 |   |
| Long-term debt                          |       | 62,709               |       | 65,514                         |       | 62,536 |   | 63,663 |   |
| Accrued interest                        |       | 1,736                |       | 1,736                          |       | 2,382 |   | 2,382 |   |
|                                    |       |                 |       |                           |       |   |   |   |   |
| On-balance sheet derivative instrument: |       |                 |       |                           |       |   |   |   |   |
| Cash flow hedge                         |       | 441                  |       | 441                            |       | 225 |   | 225 |   |
|                                         |            |                      |            |                                |            |  |  |  |  |  |  |  |  |

** **

**Financial Instruments withOff-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 31,2007 and 2006, the notional amount and estimated fair values of the Company’sfinancial instruments with off-balance sheet risk were as follows (inthousands):

 

| ** **                               | ** ** | **2007**     | ** ** | **2006**            | ** ** |
|------------------------------------------|------------|--------------|------------|---------------------|------------|
| ** **                               | ** ** | **Notional** | ** ** | **Estimated**       | ** ** | **Notional** | ** ** | **Estimated** | ** ** |
| ** **                               | ** ** | **amount**   | ** ** | **fair value** | ** ** | **amount** | ** ** | **fair value** | ** ** |
| Off-balance sheet financial instruments: |       |         |       |                |       |   |   |   |   |
| Commitments to  extend credit            |       | $            | 83,379     |                | $          | 83,379 |   | $ | 71,277 |   | $ | 71,277 |   |
| Standby letters  of credit               |       | 5,950        |       | 5,950               |       | 5,535 |   | 5,535 |   |
| Cash flow hedge                          |       | 20,000       |       | 441                 |       | 20,000 |   | 225 |   |
|                                          |            |              |            |                     |            |  |  |  |  |  |  |  |  |

 

----

In the above table, theestimated fair value of the cash flow hedge is an on-balance sheet item.

 

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

 

The Company’s exposure to credit loss from nonperformance by the otherparty to the financial instruments for commitments to extend credit and standbyletters of credit is represented by the contractual amount of thoseinstruments.  The Company uses the samecredit policies in making commitments and conditional obligations as it doesfor on-balance-sheet instruments.

 

67

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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.

 

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 does not have any recourseprovisions or hold any assets that would enable it to recover from thirdparties any of the amounts paid under the guarantee.  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, 2007(in thousands):

 
| ** **            | ** ** | **Less than   one year** | ** ** | **One to five  years** | ** ** | **Over five   years** | ** ** | **Total** | ** ** |
|-----------------------|------------|------------------------------------|------------|----------------------------------|------------|----------------------------|------------|-----------|------------|
| Secured by:           |       |                               |       |                             |       |                       |       |      |       |
| Collateral            |       | $                                  | 1,570      |                             | $          | 720                        |       | $         | 2,564      |   | $ | 4,854 |   |
| Guarantees            |       | 88                                 |       | —                           |       | —                     |       | 88        |       |
| Bank lines of  credit |       | 934                                |       | —                           |       | —                     |       | 934       |       |
|                  |       |                               |       |                             |       |                       |       |      |       |
|                  |       | 2,592                              |       | 720                              |       | 2,564                      |       | 5,876     |       |
|                  |       |                               |       |                             |       |                       |       |      |       |
| Unsecured             |       | 69                                 |       | 5                                |       | —                     |       | 74        |       |
|                  |       |                               |       |                             |       |                       |       |      |       |
| Total                 |       | $                                  | 2,661      |                             | $          | 725                        |       | $         | 2,564      |   | $ | 5,950 |   |

 

The Company has notincurred any losses on its commitments in 2007, 2006 or 2005.

 

**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, theCompany entered into a three-year interest rate floor derivative agreement on$20,000,000 notional value of its prime-based loan portfolio.  The transaction required the payment of a premiumby the Company to the seller for the right to receive payments in the eventnational 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$385,000 in 2007 and $900 in 2006, is recorded as a component of OCI in theconsolidated statement of changes in shareholders’ equity and the portion ofthe change in fair value related to the time value expiration, or approximately$169,000 and $22,000 for the years ended December 31, 2007 and 2006,respectively, is recorded in the consolidated statement of income as areduction of interest income.  No gain orloss has been recognized in earnings due to hedge ineffectiveness as of December 31,2007.  As of December 31, 2007, theCompany does not expect to reclassify any amount from OCI to earnings over thenext twelve months and no hedge has been discontinued.  As of December 31, 2007 and 2006, thefair value of the derivative contract approximated $441,000 and $225,000,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 Company controlsthe credit risk associated with the derivative instrument by engagingcounterparties with high credit ratings, establishing counterparty exposurelimits and monitoring procedures.

 

68

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

 

Basic earnings pershare (EPS) is computed by dividing income available to common shareholders bythe weighted-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 shares.  Generally, dilution wouldoccur if Company-issued stock options were exercised and converted into commonstock.

 

In the computationof diluted 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, 2007, 2006 and 2005:  The number of shares and per-share data hasbeen adjusted, for all periods, to reflect a 10% stock dividend paid on February 15,2006:

 
| ** **                                                                | ** ** | **2007**  | ** ** | **2006**  | ** ** | **2005**  | ** ** |
|---------------------------------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
|                                                                      |       |      |       |      |       |      |       |
| Basic EPS:                                                                |       |      |       |      |       |      |       |
|                                                                      |       |      |       |      |       |      |       |
| Net income available to common shareholders                               |       | $         | 4,611,572  |      | $          | 4,125,283 |       | $ | 4,591,697 |   |
|                                                                      |       |      |       |      |       |      |       |
| Weighted-average common shares outstanding                                |       | 2,066,683 |       | 2,047,975 |       | 2,031,211 |       |
|                                                                      |       |      |       |      |       |      |       |
| Basic EPS                                                                 |       | $         | 2.23       |      | $          | 2.01      |       | $ | 2.26 |   |
|                                                                      |       |      |       |      |       |      |       |
| Diluted EPS:                                                              |       |      |       |      |       |      |       |
|                                                                      |       |      |       |      |       |      |       |
| Net income available to common shareholders                               |       | $         | 4,611,572  |      | $          | 4,125,283 |       | $ | 4,591,697 |   |
|                                                                      |       |      |       |      |       |      |       |
| Weighted-average common shares outstanding                                |       | 2,066,683 |       | 2,047,975 |       | 2,031,211 |       |
| Diluted potential common shares                                           |       | 386       |       | 1,172     |       | 2,924     |       |
| Weighted-average  common shares and dilutive potential shares outstanding |       | 2,067,069 |       | 2,049,147 |       | 2,034,135 |       |
|                                                                      |       |      |       |      |       |      |       |
| Diluted EPS                                                               |       | $         | 2.23       |      | $          | 2.01      |       | $ | 2.25 |   |

 

**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 and classificationare also subject to qualitative judgments by the regulators about components,risk-weightings and other factors. Prompt corrective action provisions are not applicable to bank holdingcompanies.

 

69

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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, 2007,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 2007 or 2006.

 
| ** **                                | ** ** | **Actual** | ** ** | **For capital  adequacy purposes** | ** ** | **To be well capitalized  under prompt corrective  action provisions** | ** **        |
|-------------------------------------------|------------|------------|------------|----------------------------------------------|------------|------------------------------------------------------------------------------------------------------|-------------------|
| ** **                                | ** ** | **Amount** | ** ** | **Ratio**                                    | ** ** | **Amount**                                                                                           | ** **        | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
|                                      |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| 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% |   |
|                                      |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| As of  December 31, 2006:            |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| Total capital  (to risk-weighted assets)  |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| Consolidated                              |       | $          | 57,777,905 |                                         | 14.0%      |                                                                                                 | 3$32,913,690 |   | 38.0% |   | N/A |   | N/A |   |
| Bank                                      |       | $          | 57,476,581 |                                         | 14.0%      |                                                                                                 | 3$32,908,004 |   | 38.0% |   | 3$41,135,005 |   | 310.0% |   |
|                                      |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| Tier I capital  (to risk-weighted assets) |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| Consolidated                              |       | $          | 52,544,818 |                                         | 12.8%      |                                                                                                 | 3$16,456,845 |   | 34.0% |   | N/A |   | N/A |   |
| Bank                                      |       | $          | 52,322,924 |                                         | 12.7%      |                                                                                                 | 3$16,454,002 |   | 34.0% |   | 3$24,681,003 |   | 36.0% |   |
|                                      |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| Tier I capital  (to average assets)       |       |       |       |                                         |       |                                                                                                 |              |   |   |   |   |   |   |
| Consolidated                              |       | $          | 52,544,818 |                                         | 9.3%       |                                                                                                 | 3$22,533,961 |   | 34.0% |   | N/A |   | N/A |   |
| Bank                                      |       | $          | 52,322,924 |                                         | 9.3%       |                                                                                                 | 3$22,518,803 |   | 34.0% |   | 3$28,148,504 |   | 35.0% |   |

 

The Bank can paydividends to the Company equal to the Bank’s retained earnings whichapproximated $46,720,000 at December 31, 2007.  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:

 

70

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| ** **                                                                                                       | ** ** | **2007**   | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
|                                                                                                             |       |       |       |       |       |       |       |
| Balance, beginning                                                                                               |       | $          | 9,028,873  |       | $          | 9,165,554  |       | $ | 9,243,286 |   |
| Adjustments for  loans to individuals no longer officers, directors, associates or greater  than 5% shareholders |       | (1,254,485 | )          | —     |       | (1,100     | )          |
| Additions                                                                                                        |       | 1,261,950  |       | 1,600,137  |       | 1,560,469  |       |
| Collections                                                                                                      |       | (1,370,628 | )          | (1,736,818 | )          | (1,637,101 | )          |
|                                                                                                             |       |       |       |       |       |       |       |
| Balance, ending                                                                                                  |       | $          | 7,665,710  |       | $          | 9,028,873  |       | $ | 9,165,554 |   |

 

Aggregate loans to directors and associates exceeding2.5% of shareholders’ equity included in the table above are as follows:

 
| ** **                                        | ** ** | **2007** | ** ** | **2006**   | ** ** | **2005**  | ** ** |
|---------------------------------------------------|------------|----------|------------|------------|------------|-----------|------------|
|                                              |       |     |       |       |       |      |       |
| Number of persons                                 |       | 2        |       | 2          |       | 2         |       |
|                                              |       |     |       |       |       |      |       |
| Balance, beginning                                |       | $        | 7,349,167  |       | $          | 7,446,933 |       | $ | 7,890,075 |   |
| Additions                                         |       | 793,049  |       | 2,312,295  |       | 334,734   |       |
| Collections                                       |       | (946,137 | )          | (1,203,870 | )          | (777,876  | )          |
| Prior loan balances no longer exceeding threshold |       | —   |       | (1,206,191 | )          | —    |       |
|                                              |       |     |       |       |       |      |       |
| Balance, ending                                   |       | $        | 7,196,079  |       | $          | 7,349,167 |       | $ | 7,446,933 |   |

 

As of December 31,2007, 2006 and 2005, deposits from executive officers, directors and associatesof such persons approximated $8,100,000, $7,876,000 and $5,405,000,respectively.

 

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

 

The following is asummary of quarterly results of operations for the years ended December 31,2007, 2006 and 2005 (in thousands, except per share data):

 
| **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 |   |

 

71

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| **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 |   |

 
| **2005**                               | ** ** | **First  quarter** | ** ** | **Second  quarter** | ** ** | **Third  quarter** | ** ** | **Fourth  quarter** | ** ** | **Total** | ** ** |
|----------------------------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|-----------|------------|
|                                   |       |               |       |                |       |               |       |                |       |      |       |
| Interest income                        |       | $                  | 6,974      |                | $          | 7,103              |       | $                   | 7,324      |      | $          | 7,619 |   | $ | 29,020 |   |
| Interest expense                       |       | (2,698             | )          | (2,785              | )          | (2,962             | )          | (3,276              | )          | (11,721   | )          |
|                                   |       |               |       |                |       |               |       |                |       |      |       |
| Net interest income                    |       | 4,276              |       | 4,318               |       | 4,362              |       | 4,343               |       | 17,299    |       |
| Provision for loan losses              |       | (80                | )          | (300                | )          | (300               | )          | (150                | )          | (830      | )          |
| Gain on sale of investment  securities |       | —             |       | 3                   |       | —             |       | 2                   |       | 5         |       |
| Other income                           |       | 747                |       | 1,123               |       | 1,228              |       | 1,047               |       | 4,145     |       |
| Other expenses                         |       | (3,565             | )          | (3,611              | )          | (3,591             | )          | (3,794              | )          | (14,561   | )          |
|                                   |       |               |       |                |       |               |       |                |       |      |       |
| Income before income taxes             |       | 1,378              |       | 1,533               |       | 1,699              |       | 1,448               |       | 6,058     |       |
| Provision for income taxes             |       | (358               | )          | (397                | )          | (405               | )          | (306                | )          | (1,466    | )          |
|                                   |       |               |       |                |       |               |       |                |       |      |       |
| Net income                             |       | $                  | 1,020      |                | $          | 1,136              |       | $                   | 1,294      |      | $          | 1,142 |   | $ | 4,592 |   |
|                                   |       |               |       |                |       |               |       |                |       |      |       |
| Net income per share                   |       | $                  | 0.50       |                | $          | 0.56               |       | $                   | 0.64       |      | $          | 0.56 |   | $ | 2.26 |   |

 

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

 

Thenature of the Company’s business generates some litigation involving mattersarising in 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 September 2006,the FASB issued SFAS No. 157, *Fair Value Measurements*(SFAS 157).  SFAS 157 defines fair value,establishes a framework for measuring fair value in accounting principlesgenerally accepted in the United States of America, and expands disclosureabout fair value measurements.  SFAS 157applies to other accounting standards that require or permit fair valuemeasurements.  Accordingly, it does notrequire any new fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15,2007 and interim periods within those fiscal years.  The Company does not expect the adoption ofthis pronouncement to have a material effect on its consolidated financialstatements.

 

72

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In February 2007,FASB issued SFAS 159, *The Fair Value Option forFinancial Assets and Financial Liabilities,* which permits entitiesto choose to measure at fair value eligible financial instruments and certainother items that are not currently required to be measured at fair value.  SFAS 159 requires that unrealized gains andlosses on items for which the fair value option has been elected be reported inearnings at each reporting date.  SFAS159 is effective for fiscal years beginning after November 15, 2007.  The Company does not expect the adoption ofthis pronouncement to have a material effect on its consolidated financialstatements.

 

In November 2007,the SEC staff issued Staff Accounting Bulletin (SAB) No. 109, *Written Loan Commitments Recorded at Fair Value Through Earnings.*SAB109 requires entities to include the expected net future cash flows related tothe associated servicing of the loan in the measurement of its written loancommitments that are accounted for at fair value through earnings. Theprovisions of SAB 109 are applicable on a prospective basis to written loan commitmentsrecorded at fair value under GAAP that are issued or modified in fiscalquarters beginning after December 15, 2007. The Company does not expectthe adoption of this pronouncement to have a material impact on itsconsolidated financial statements.

 

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

 

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

 

**CondensedBalance Sheets**

 
| ** **                                 | ** ** | **December 31,** | ** ** |
|--------------------------------------------|------------|-----------------------|------------|
| ** **                                 | ** ** | **2007**              | ** ** | **2006** | ** ** |
|                                       |       |                  |       |   |   |
| Assets:                                    |       |                  |       |   |   |
| Cash                                       |       | $                     | 2          |   | $ | 17 |   |
| Investment in  subsidiary                  |       | 54,812                |       | 51,275 |   |
| Securities  available-for-sale             |       | 489                   |       | 447 |   |
|                                       |       |                  |       |   |   |
| Total                                      |       | $                     | 55,303     |   | $ | 51,739 |   |
|                                       |       |                  |       |   |   |
| Liabilities and shareholders’ equity: |       |                  |       |   |   |
| Liabilities                                |       | $                     | 112        |   | $ | 127 |   |
| Shareholders’  equity                 |       | 55,191                |       | 51,612 |   |
|                                       |       |                  |       |   |   |
| Total                                      |       | $                     | 55,303     |   | $ | 51,739 |   |

 

**Condensed Income Statements**

 
| ** **                                      | ** ** | **Years ended December 31,** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                      | ** ** | **2007**                                    | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                            |       |                                        |       |   |   |   |   |
| Income:                                         |       |                                        |       |   |   |   |   |
| Equity in  undistributed earnings of subsidiary |       | $                                           | 3,163      |   | $ | 2,972 |   | $ | 3,504 |   |
| Dividends from  subsidiary                      |       | 1,613                                       |       | 1,253 |   | 1,167 |   |
| Other income                                    |       | 13                                          |       | 14 |   | 12 |   |
|                                            |       |                                        |       |   |   |   |   |
| Total income                                    |       | 4,789                                       |       | 4,239 |   | 4,683 |   |
|                                            |       |                                        |       |   |   |   |   |
| Operating expenses                              |       | 267                                         |       | 163 |   | 136 |   |
|                                            |       |                                        |       |   |   |   |   |
| Income before income taxes                      |       | 4,522                                       |       | 4,076 |   | 4,547 |   |
|                                            |       |                                        |       |   |   |   |   |
| Credit for income taxes                         |       | 90                                          |       | 49 |   | 45 |   |
|                                            |       |                                        |       |   |   |   |   |
| Net income                                      |       | $                                           | 4,612      |   | $ | 4,125 |   | $ | 4,592 |   |

 

73

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** **

**CondensedStatements of Cash Flows**

 
| *** ***                                                         | ** ** | **Years ended December 31,** | ** ** |
|----------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                           | ** ** | **2007**                                    | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                 |       |                                        |       |   |   |   |   |
| Cash flows from operating activities:                                |       |                                        |       |   |   |   |   |
| Net income                                                           |       | $                                           | 4,612      |   | $ | 4,125 |   | $ | 4,592 |   |
| Adjustments to  reconcile net income to net cash used in operations: |       |                                        |       |   |   |   |   |
| Equity in  earnings of subsidiary                                    |       | (4,777                                      | )          | (4,225 | ) | (4,671 | ) |
| Stock-based  compensation expense                                    |       | 16                                          |       | 29 |   | — |   |
| Deferred income  tax benefit                                         |       | (3                                          | )          | — |   | — |   |
| Changes in other  assets and liabilities, net                        |       | (10                                         | )          | 19 |   | 16 |   |
|                                                                 |       |                                        |       |   |   |   |   |
| Net cash used in  operating activities                               |       | (162                                        | )          | (52 | ) | (63 | ) |
|                                                                 |       |                                        |       |   |   |   |   |
| Cash flows  provided by investing activities:                        |       |                                        |       |   |   |   |   |
| Dividends  received from subsidiary                                  |       | 1,613                                       |       | 1,253 |   | 1,167 |   |
| Purchases of  securities available for sale                          |       | (50                                         | )          | — |   | — |   |
|                                                                 |       |                                        |       |   |   |   |   |
| Net cash  provided by investing activities                           |       | 1,563                                       |       | 1,253 |   | 1,167 |   |
|                                                                 |       |                                        |       |   |   |   |   |
| Cash flows from  financing activities:                               |       |                                        |       |   |   |   |   |
| Dividends paid,  net of dividend reinvestment                        |       | (1,484                                      | )          | (1,240 | ) | (1,133 | ) |
| Exercise of  stock options                                           |       | —                                      |       | — |   | — |   |
| Withholdings to  purchase capital stock                              |       | 68                                          |       | 48 |   | 32 |   |
|                                                                 |       |                                        |       |   |   |   |   |
| Net cash used in  financing activities                               |       | (1,416                                      | )          | (1,192 | ) | (1,101 | ) |
|                                                                 |       |                                        |       |   |   |   |   |
| Net (decrease)  increase in cash                                     |       | (15                                         | )          | 9 |   | 3 |   |
|                                                                 |       |                                        |       |   |   |   |   |
| Cash, beginning                                                      |       | 17                                          |       | 8 |   | 5 |   |
|                                                                 |       |                                        |       |   |   |   |   |
| Cash, ending                                                         |       | $                                           | 2          |   | $ | 17 |   | $ | 8 |   |

*** ***

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

*** ***

None.

 

***Item 9A:******                  ******CONTROLS AND PROCEDURES***

 

As of the end of the period covered by this Annual Report onForm 10-K, an evaluation was carried out by the Company’s management, withthe participation of its Chief Executive Officer and Chief Financial Officer,of the effectiveness of the Company’s disclosure controls and procedures, asdefined in Rule 13a-15(e) under the Securities Exchange Act of1934.  Based on such evaluation, theChief Executive Officer and Chief Financial Officer concluded that the Company’sdisclosure controls and procedures are designed to ensure that informationrequired to be disclosed in the reports the Company files or furnishes underthe Securities Exchange Act of 1934 is recorded, processed, summarized andreported within the time periods specified in the SEC’s rules andregulations, and are operating in aneffective manner.  In addition, the SEChas proposed to extend the deadline for non-accelerated filers, such as theCompany, for an auditor attestation on internal control over financialreporting for one additional year from fiscal years ending after December 15,2008 to fiscal years ending after December 15, 2009.  Furthermore, the Company made no significantchanges in its internal controls over financial reporting or in other factorsthat materially affected, or are reasonably likely to materially affect, thesecontrols during the last fiscal quarter ended December 31, 2007.

 

74

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

 

Management of the Company is responsible for establishingand maintaining adequate internal control over financial reporting.  The Company’s internal control over financialreporting is a process designed under the supervision of the Company’s ChiefExecutive Officer and Chief Financial Officer, and implemented in conjunctionwith management and other personnel, to provide reasonable assurance regardingthe reliability of financial reporting and the preparation of the Company’sconsolidated financial statements for external purposes in accordance withgenerally accepted accountingprinciples.

 

There are inherentlimitations in the effectiveness of any internal control, including thepossibility 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.

 

Management assessed theeffectiveness of the Company’s internal control over financial reporting as of December 31,2007.  This assessment was based oncriteria for effective internal control over financial reporting described in “InternalControl — Integrated Framework,” issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO).  Based on this assessment, managementdetermined that, as of December 31, 2007, the Company maintained effectiveinternal control over financial reporting.

 

This annual report doesnot include an attestation report of the Company’s registered public accountingfirm regarding internal control over financial reporting.  Management’s report was not subject toattestation by the Company’s registered public accounting firm pursuant totemporary rules of the SEC that permit the Company to provide onlymanagement’s report in this annual report.

 

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

 

None.

 

### ***PART III***

###  

***Item 10:***  DIRECTORS AND EXECUTIVE OFFICERS AND CORPORATEGOVERNANCE

*** ***

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 2008 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 2008 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 is availableon our investor relations website at http://www.the-fidelity.com under theheading “Corporate Governance” of the Investor Relations link.  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 2008definitive Proxy Statement.

 

75

----

 

#### ***Item12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT******AND RELATED STOCKHOLDER MATTERS***

####  

The information requiredby this Item is incorporated by reference herein, to the information presentedin the Company’s 2008 definitive Proxy Statement.

 

##### ***Item 13: CERTAIN RELATIONSHIPS ANDRELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE***

#####  

The information requiredby this Item, relating to transactions with management and others, certain businessrelationships and indebtedness of management, is set forth above in Item 8 “FinancialStatements and Supplementary Data” and is incorporated by reference herein tothe information presented in the Company’s 2008 definitive Proxy Statement.

 

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

 

The information requiredby this Item is incorporated by reference herein, to the information presentedin the Company’s 2008 definitive Proxy Statement.

 

***PART IV***

 

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

 

***(a) (1) Financial Statements*** - The following financial statements areincluded by reference in Part II, Item 8 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 byreference to Exhibit 3(ii) to Registrant’s Form 8-K filed withthe SEC on November 21, 2007.

 

****10.1 1998 Independent Directors Stock Option Plan of The FidelityDeposit and Discount Bank, as assumed by Registrant.*** 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.

 

76

----

 

****10.3 Form of Deferred Compensation Plan of The Fidelity Depositand Discount Bank. ***Incorporated by reference to Exhibit 10.3to Registrant’s Registration Statement No. 333-45668 on Form S-1,filed with the SEC on September 12, 2000.

 

****10.4 Registrant’s 2000 Dividend Reinvestment Plan. ***Incorporated by reference to Exhibit 4 toRegistrant’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 and by Post-EffectiveAmendment No. 2 on July 7, 2005.

 

****10.5 Registrant’s 2000 Independent Directors Stock Option Plan. ***Incorporated by reference to Exhibit 4.3 toRegistrant’s Registration Statement No. 333-64356 on Form S-8 filedwith the SEC on July 2, 2001.

 

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

 

****10.7 Registrant’s 2000 Stock Incentive Plan. ***Incorporated by reference to Exhibit 4.4 toRegistrant’s Registration Statement No. 333-64356 on Form S-8 filedwith the SEC on July 2, 2001.

 

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

 

****10.9 Registrant’s 2002 Employee Stock Purchase Plan. ***Incorporated by reference to Exhibit 4.5 toRegistrant’s Registration Statement No. 333-113339 on Form S-8 filedwith the SEC on March 5, 2004.

 

****10.10 Employment Agreement between Fidelity D & D Bancorp, Inc.,The Fidelity Deposit and Discount Bank******and Steven C. Ackmann,dated June 21, 2004. ***Incorporatedby reference to Exhibit 99.1 to Registrant’s Current Report on Form 8-Kfiled with the SEC on June 24, 2004.

 

****10.11 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 99.1to Registrant’s Current Report on Form 8-K filed with the SEC on August 10,2004.

 

****10.12 Change of Control and Severance Agreement between James T.Gorman, Registrant and The Fidelity Deposit and Discount Bank, dated September 19,2005. ***Incorporated by reference to Exhibit 99.1to Registrant’s Current Report on Form 8-K filed with the SEC on September 22,2005.

 

****10.13 Amendment and Termination of the Deferred Compensation Agreementwith Joseph J. Earyes, Daniel Santaniello, Registrant and The Fidelity Depositand Discount Bank, dated November 1, 2005. ***Incorporatedby reference to Exhibits 99.1 and 99.2 to Registrant’s Current Report on Form 8-Kfiled with the SEC on November 3, 2005.

 

****10.14 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 reference to****Exhibit 99.1to Registrant’s Current Report on Form 8-K filed with the SEC on November 9,2005.

 

****10.15 Change of Control Agreements with Daniel J. Santaniello,Salvatore R. DeFrancesco, James T. Gorman, Registrant and The Fidelity Depositand Discount Bank, dated March 21, 2006. ***Incorporatedby reference to Exhibit 99.1, 99.2 and 99.3, respectively, to Registrant’sCurrent Report on Form 8-K filed with the SEC on March 27, 2006.

 

****10.16 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 reference to Exhibit 10.1 toRegistrant’s Current Report on Form 8-K filed with the SEC on July 13,2007.

 

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

 

77

----

 

****10.18 Executive Employment Agreement between Fidelity D & DBancorp, Inc., The Fidelity Deposit and Discount Bank******and Daniel J. Santaniello,dated February 28, 2008. ***Incorporatedby reference 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 Note 13 “Earnings per Share,”contained within the notes to consolidated financial statements, andincorporated herein by reference.

 

***12Statement regarding computation of ratios. ***Includedherein in Item 6, “Selected Financial Data.”

 

***13Annual Report to Shareholders. ***Incorporated by reference to the 2007Annual 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.***

 

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

 

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

 

***(b)******                                ******Theexhibits required to be filed by this Item are listed under Item 15(a) 3,above.***

 

***(c)******                                 ******Notapplicable.***

 

----

* Management contract or compensatory plan or arrangement.

 

78

----

 

**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 dulyauthorized.

 
|                      | **FIDELITY D & D BANCORP, INC.** |
|---------------------------|-------------------------------------------|
|                      | (Registrant)                              |
|                      |                                      |   |
|                      |                                      |   |
|                      | By:                                       | /s/ STEVEN C. ACKMANN |
| Date: March 12, 2008 |                                      | Steven C. Ackmann, |
|                      |                                      | President and Chief Executive Officer |
|                      |                                      |   |
|                      |                                      |   |
|                      | By:                                       | /s/ SALVATORE R. DEFRANCESCO, JR. |
| Date: March 12, 2008 |                                      | 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 12, 2008 |   |
|   | Steven C. Ackmann, President and              |     |                |
|   | Chief Executive Officer                       |     |                |
|   |                                          |     |                |
| By:    | /s/ SALVATORE R. DEFRANCESCO, JR.             |     | March 12, 2008 |   |
|   | Salvatore R. DeFrancesco, Jr., Treasurer |     |                |
|   | and Chief Financial Officer                   |     |                |
|   |                                          |     |                |
| By:    | /s/ SAMUEL C. CALI                            |     | March 12, 2008 |   |
|   | Samuel C. Cali, Chairman Emeritus             |     |                |
|   | and Director                                  |     |                |
|   |                                          |     |                |
| By:    | /s/ PATRICK J. DEMPSEY                        |     | March 12, 2008 |   |
|   | Patrick J. Dempsey, Chairman                  |     |                |
|   | of the Board of Directors and Directord       |     |                |
|   |                                          |     |                |
| By:    | /s/ JOHN T. COGNETTI                          |     | March 12, 2008 |   |
|   | John T. Cognetti, Assistant Secretary         |     |                |
|   | and Director                                  |     |                |
|   |                                          |     |                |
| By:    | /s/ MICHAEL J. MCDONALD                       |     | March 12, 2008 |   |
|   | Michael J. McDonald, Vice Chairman            |     |                |
|   | of the Board of Directors and Director        |     |                |
|   |                                          |     |                |
| By:    | /s/ DAVID L. TRESSLER                         |     | March 12, 2008      |   |
|   | David L. Tressler, Director                   |     |                |
|   |                                          |     |                |
| By:    | /s/ Mary E.  McDonald                         |     | March 12, 2008      |   |
|   | Mary E. McDonald, Director                    |     |                |
|   |                                          |     |                |
| By:    | /s/ BRIAN J. CALI                             |     | March 12, 2008 |   |
|   | Brian J. Cali, Director                       |     |                |

 

79

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|                                                                                                                                                                                                                                                                                                                                                                                                                                                       |   |     |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------|
| **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 Form of Deferred  Compensation Plan of The Fidelity Deposit and Discount Bank.*** Incorporated by reference to  Exhibit 10.3 to Registrant’s Registration Statement No. 333-45668  on Form S-1, filed with the SEC on September 12, 2000.                                                                                                                                                                            |   | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                       |   |     |
| ***10.4 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 and by Post-Effective Amendment No. 2 on  July 7, 2005. |   | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                       |   |     |
| ***10.5 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.                                                                                                                                                                                                       |   | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                       |   |     |
| ***10.6 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.                                                                                                                                                                                                 |   | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                       |   |     |
| ***10.7 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.                                                                                                                                                                                                                          |   | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                       |   |     |
| ***10.8 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.                                                                                                                                                                                                                     |   | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                       |   |     |
| ***10.9 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.                                                                                                                                                                                                                |   | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                       |   |     |
| ***10.10 Employment Agreement  between Fidelity D & D Bancorp, Inc., The Fidelity Deposit and  Discount Bank and Steven C. Ackmann, dated June 21, 2004.*** Incorporated by reference to  Exhibit 99.1 to Registrant’s Current Report on Form 8-K filed with  the SEC on June 24, 2004.                                                                                                                             |   | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                       |   |     |
| ***10.11 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.                                                                                                                            |   | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                       |   |     |
| ***10.12 Change of Control and  Severance Agreement between James T. Gorman, Registrant and the Fidelity  Deposit and Discount Bank, dated September 19, 2005.*** Incorporated by reference to  Exhibit 99.1 to Registrant’s Current Report on Form 8-K filed with  the SEC on September 22, 2005.                                                                                                                                |   | *        |

 

80

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| ***10.13 Amendment and Termination  of the Deferred Compensation Agreement with Joseph J. Earyes, Daniel  Santaniello, Registrant and The Fidelity Deposit and Discount Bank, dated  November 1, 2005.*** Incorporated by reference to Exhibits 99.1 and 99.2  to Registrant’s Current Report on Form 8-K filed with the SEC on  November 3, 2005.              |   | *      |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
|                                                                                                                                                                                                                                                                                                                                                                                |   |   |
| ***10.14 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.                               |   | *      |
| *** ***                                                                                                                                                                                                                                                                                                                                                                        |   |   |
| ***10.15 Change of Control  Agreements with Daniel J. Santaniello, Salvatore R. DeFrancesco, James T.  Gorman, Registrant and The Fidelity Deposit and Discount Bank, dated  March 21, 2006.*** Incorporated by reference to Exhibit 99.1,  99.2 and 99.3, respectively, to Registrant’s Current Report on Form 8-K  filed with the SEC on March 27, 2006. |   | *      |
|                                                                                                                                                                                                                                                                                                                                                                                |   |   |
| ***10.16 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.                      |   | *      |
|                                                                                                                                                                                                                                                                                                                                                                                |   |   |
| ***10.17 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.                                 |   | *      |
|                                                                                                                                                                                                                                                                                                                                                                                |   |   |
| ***10.18 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.                                                                                                                                                  |   | 69     |
|                                                                                                                                                                                                                                                                                                                                                                                |   |   |
| ***12 Statement regarding  computation of ratios.*** Included herein in Item 6, “Selected Financial  Data”.                                                                                                                                                                                                                                                               |   | 14     |
|                                                                                                                                                                                                                                                                                                                                                                                |   |   |
| ***13 Annual Report to  Shareholders.***  Incorporated by reference to the 2007 Annual Report to Shareholders filed  with the SEC on Form ARS.                                                                                                                                                                                                                                 |   | *      |
|                                                                                                                                                                                                                                                                                                                                                                                |   |   |
| 1***4 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.***                                                                                                                                                                                                                                                                                                                                           |   | 82     |
|                                                                                                                                                                                                                                                                                                                                                                                |   |   |
| ***23 Consent of Independent  Registered Public Accounting Firm.***                                                                                                                                                                                                                                                                                                                 |   | 83     |
|                                                                                                                                                                                                                                                                                                                                                                                |   |   |
| ***31.1  Rule 13a-14(a) Certification of Principal Executive Officer.***                                                                                                                                                                                                                                                                                                  |   | 84     |
|                                                                                                                                                                                                                                                                                                                                                                                |   |   |
| ***31.2  Rule 13a-14(a) Certification of Principal Financial Officer.***                                                                                                                                                                                                                                                                                                  |   | 85     |
|                                                                                                                                                                                                                                                                                                                                                                                |   |   |
| ***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.***                                                                                                                                                                                                       |   | 86     |
|                                                                                                                                                                                                                                                                                                                                                                                |   |   |
| ***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.***                                                                                                                                                                                                       |   | 87     |

 

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*Incorporated by Reference

 

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