SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
DC  20549










FORM
10-Q








(Mark
One)




x
            QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934





For the
quarterly period ended June
30, 2009




OR




 ̈
              TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934





For the
transition period from ______________ to _____________





Commission
file number 0-17706




QNB Corp.


(Exact
Name of Registrant as Specified in Its Charter)




Pennsylvania
              23-2318082(State
      or Other Jurisdiction of Incorporation or Organization)
              (I.R.S.
      Employer Identification No.)
  15
      North Third Street, Quakertown, PA
              18951-9005(Address
      of Principal Executive Offices)
              (Zip
      Code)


Registrant's
Telephone Number, Including Area Code (215)
538-5600





Not
Applicable


Former
Name, Former Address and Former Fiscal Year, if Changed Since Last
Report.





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




Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such
files).  Yes oNo o




Indicate
by check mark whether the Registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
definition of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act.




Large
      accelerated filer o
              Accelerated
      filer oNon-accelerated
      filer o
              Smaller
      Reporting Company x






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


Yes oNo x





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




Class
            Outstanding
      at August 7, 2009Common
      Stock, par value $0.625
            3,089,382










QNB
CORP. AND SUBSIDIARY


FORM
10-Q


QUARTER
ENDED JUNE 30, 2009





INDEX




PAGEPART I - FINANCIAL INFORMATIONITEM
      1.
              
              CONSOLIDATED
      FINANCIAL STATEMENTS (Unaudited)Consolidated
      Balance Sheets at June 30, 2009 and
      December 31, 2008
              
              3Consolidated
      Statements of Income for the Three and Six Months
      Ended June 30, 2009 and 2008
              
              4Consolidated
      Statement of Shareholders’ Equity for the Six Months
      Ended June 30, 2009
              
              5Consolidated
      Statements of Cash Flows for the Six Months
      Ended June 30, 2009 and 2008
              
              6Notes
      to Consolidated Financial Statements
              
              7ITEM
      2.
              
              MANAGEMENT'S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
      AND RESULTS OF OPERATIONS
              
              31ITEM
      3.
              
              QUANTITATIVE
      AND QUALITATIVE DISCLOSURE ABOUT MARKET
      RISK
              
              64ITEM
      4.
              
              CONTROLS
      AND PROCEDURES
              
              64PART
      II - OTHER INFORMATIONITEM
      1.
              
              LEGAL
      PROCEEDINGS
              
              65ITEM
      1A.
              
              RISK
      FACTORS
              
              65ITEM
      2.
              
              UNREGISTERED
      SALES OF EQUITY SECURITIES AND USE
      OF PROCEEDS
              
              65ITEM
      3.
              
              DEFAULTS
      UPON SENIOR SECURITIES
              
              65ITEM
      4.
              
              SUBMISSIONS
      OF MATTERS TO A VOTE OF SECURITY HOLDERSITEM
      5.
              
              OTHER
      INFORMATION
              
              66ITEM
      6.
              
              EXHIBITS
              
              66SIGNATURES
              
              
              
              67CERTIFICATIONS




2
 
  QNB
Corp. and Subsidiary
 CONSOLIDATED
BALANCE SHEETS


(in
      thousands, except share data)(unaudited)June
      30,
                
                
                December
      31,2009
                
                
                2008AssetsCash
      and due from banks
                
                $
                11,872
                
                
                $
                10,634Interest-bearing
      deposits in banks
                
                
                8,227
                
                
                
                1,276Federal
      funds sold
                
                
                –
                
                
                
                4,541Total
      cash and cash equivalents
                
                
                20,099
                
                
                
                16,451Investment
      securitiesAvailable-for-sale
      (amortized cost $238,523 and $ 219,950)
                
                
                237,930
                
                
                
                219,597Held-to-maturity
      (fair value $3,446 and $ 3,683)
                
                
                3,347
                
                
                
                3,598Restricted
      investment in bank stocks
                
                
                2,291
                
                
                
                2,291Loans
      held-for-sale
                
                
                611
                
                
                
                120Loans
      receivable
                
                
                435,521
                
                
                
                403,579Allowance
      for loan losses
                
                
                (4,584
                )
                
                
                (3,836
                )Net
      loans
                
                
                430,937
                
                
                
                399,743Bank-owned
      life insurance
                
                
                8,927
                
                
                
                8,785Premises
      and equipment, net
                
                
                6,424
                
                
                
                6,661Accrued
      interest receivable
                
                
                2,766
                
                
                
                2,819Other
      assets
                
                
                4,403
                
                
                
                4,329Total
      assets
                
                $
                717,735
                
                
                $
                664,394LiabilitiesDepositsDemand,
      non-interest bearing
                
                $
                57,140
                
                
                $
                53,280Interest-bearing
      demand
                
                
                99,382
                
                
                
                95,630Money
      market
                
                
                63,513
                
                
                
                45,572Savings
                
                
                49,998
                
                
                
                44,006Time
                
                
                221,258
                
                
                
                206,336Time
      of $100,000 or more
                
                
                109,663
                
                
                
                104,966Total
      deposits
                
                
                600,954
                
                
                
                549,790Short-term
      borrowings
                
                
                22,843
                
                
                
                21,663Long-term
      debt
                
                
                35,000
                
                
                
                35,000Accrued
      interest payable
                
                
                3,198
                
                
                
                2,277Other
      liabilities
                
                
                1,932
                
                
                
                1,755Total
      liabilities
                
                
                663,927
                
                
                
                610,485Shareholders'
      EquityCommon
      stock, par value $0.625 per share;authorized
      10,000,000 shares; 3,253,951 shares and 3,245,159 shares
      issued;3,089,382
      and 3,131,815 shares outstanding
                
                
                2,034
                
                
                
                2,028Surplus
                
                
                10,142
                
                
                
                10,057Retained
      earnings
                
                
                44,500
                
                
                
                43,667Accumulated
      other comprehensive loss, net
                
                
                (392
                )
                
                
                (233
                )Treasury
      stock, at cost; 164,569 and 113,344 shares
                
                
                (2,476
                )
                
                
                (1,610
                )Total
      shareholders' equity
                
                
                53,808
                
                
                
                53,909Total
      liabilities and shareholders' equity
                
                $
                717,735
                
                
                $
                664,394
  The
accompanying notes are an integral part of the unaudited consolidated financial
statements.
 3
 
  QNB
      Corp. and SubsidiaryCONSOLIDATED
      STATEMENTS OF INCOME
 (in
      thousands, except share data) (unaudited)Three
      Months
                
                
                Six
      MonthsEnded
      June 30,
                
                
                Ended
      June 30,2009
                
                
                2008
                
                
                2009
                
                
                2008Interest
      IncomeInterest
      and fees on loans
                
                $
                6,149
                
                
                $
                6,221
                
                
                $
                12,062
                
                
                $
                12,394Interest
      and dividends on investment securities:Taxable
                
                
                2,178
                
                
                
                2,105
                
                
                
                4,380
                
                
                
                4,200Tax-exempt
                
                
                529
                
                
                
                457
                
                
                
                1,038
                
                
                
                919Interest
      on Federal funds sold
                
                
                1
                
                
                
                40
                
                
                
                2
                
                
                
                82Interest
      on interest-bearing balances and other interest income
                
                
                2
                
                
                
                15
                
                
                
                3
                
                
                
                33Total
      interest income
                
                
                8,859
                
                
                
                8,838
                
                
                
                17,485
                
                
                
                17,628Interest
      ExpenseInterest
      on depositsInterest-bearing
      demand
                
                
                173
                
                
                
                201
                
                
                
                327
                
                
                
                508Money
      market
                
                
                177
                
                
                
                204
                
                
                
                341
                
                
                
                495Savings
                
                
                31
                
                
                
                43
                
                
                
                59
                
                
                
                85Time
                
                
                1,819
                
                
                
                2,081
                
                
                
                3,668
                
                
                
                4,291Time
      of $100,000 or more
                
                
                910
                
                
                
                780
                
                
                
                1,830
                
                
                
                1,572Interest
      on short-term borrowings
                
                
                53
                
                
                
                95
                
                
                
                109
                
                
                
                266Interest
      on long-term debt
                
                
                376
                
                
                
                378
                
                
                
                750
                
                
                
                741Total
      interest expense
                
                
                3,539
                
                
                
                3,782
                
                
                
                7,084
                
                
                
                7,958Net
      interest income
                
                
                5,320
                
                
                
                5,056
                
                
                
                10,401
                
                
                
                9,670Provision
      for loan losses
                
                
                500
                
                
                
                200
                
                
                
                1,100
                
                
                
                425Net
      interest income after provision for loan losses
                
                
                4,820
                
                
                
                4,856
                
                
                
                9,301
                
                
                
                9,245Non-Interest
      IncomeTotal
      other-than-temporary impairment losses on investment
      securities
                
                
                (182
                )
                
                
                (198
                )
                
                
                (571
                )
                
                
                (198
                )Less:
      Portion of loss recognized in other comprehensive income (before
      taxes)
                
                
                48
                
                
                
                –
                
                
                
                48
                
                
                
                –Net
      other-than-temporary impairment losses on investment
      securities
                
                
                (134
                )
                
                
                (198
                )
                
                
                (523
                )
                
                
                (198
                )Net
      gain on sale of investment securities
                
                
                108
                
                
                
                80
                
                
                
                243
                
                
                
                302Net
      (loss) gain on investment securities
                
                
                (26
                )
                
                
                (118
                )
                
                
                (280
                )
                
                
                104Fees
      for services to customers
                
                
                423
                
                
                
                428
                
                
                
                818
                
                
                
                873ATM
      and debit card
                
                
                256
                
                
                
                242
                
                
                
                484
                
                
                
                461Bank-owned
      life insurance
                
                
                66
                
                
                
                64
                
                
                
                137
                
                
                
                170Mortgage
      servicing fees
                
                
                25
                
                
                
                21
                
                
                
                61
                
                
                
                41Net
      gain on sale of loans
                
                
                234
                
                
                
                40
                
                
                
                402
                
                
                
                72Other
                
                
                89
                
                
                
                152
                
                
                
                178
                
                
                
                492Total
      non-interest income
                
                
                1,067
                
                
                
                829
                
                
                
                1,800
                
                
                
                2,213Non-Interest
      ExpenseSalaries
      and employee benefits
                
                
                2,078
                
                
                
                1,955
                
                
                
                4,156
                
                
                
                3,926Net
      occupancy
                
                
                335
                
                
                
                333
                
                
                
                688
                
                
                
                673Furniture
      and equipment
                
                
                309
                
                
                
                286
                
                
                
                605
                
                
                
                575Marketing
                
                
                189
                
                
                
                172
                
                
                
                364
                
                
                
                325Third
      party services
                
                
                267
                
                
                
                205
                
                
                
                497
                
                
                
                393Telephone,
      postage and supplies
                
                
                156
                
                
                
                143
                
                
                
                305
                
                
                
                304State
      taxes
                
                
                133
                
                
                
                130
                
                
                
                268
                
                
                
                260FDIC
      insurance premiums
                
                
                539
                
                
                
                75
                
                
                
                732
                
                
                
                109Other
                
                
                378
                
                
                
                284
                
                
                
                698
                
                
                
                561Total
      non-interest expense
                
                
                4,384
                
                
                
                3,583
                
                
                
                8,313
                
                
                
                7,126Income
      before income taxes
                
                
                1,503
                
                
                
                2,102
                
                
                
                2,788
                
                
                
                4,332Provision
      for income taxes
                
                
                276
                
                
                
                496
                
                
                
                467
                
                
                
                1,016Net
      Income
                
                $
                1,227
                
                
                $
                1,606
                
                
                $
                2,321
                
                
                $
                3,316Earnings
      Per Share - Basic
                
                $
                0.40
                
                
                $
                0.51
                
                
                $
                0.75
                
                
                $
                1.06Earnings
      Per Share - Diluted
                
                $
                0.40
                
                
                $
                0.51
                
                
                $
                0.75
                
                
                $
                1.05Cash
      Dividends Per Share
                
                $
                0.24
                
                
                $
                0.23
                
                
                $
                0.48
                
                
                $
                0.46
 The
accompanying notes are an integral part of the unaudited consolidated financial
statements.
 4
  QNB
Corp. and Subsidiary
  CONSOLIDATED
STATEMENT OF SHAREHOLDERS' EQUITY
 AccumulatedOther(in
    thousands,
                
                Number
                
                
                Comprehensiveexcept
      share data)
                
                of
      Shares
                
                
                Income
                
                
                Common
                
                
                
                
                
                Retained
                
                
                Treasury(unaudited)
                
                Outstanding
                
                
                (Loss)
                
                
                Stock
                
                
                Surplus
                
                
                Earnings
                
                
                Stock
                
                
                TotalBalance,
      December 31, 2008
                
                
                3,131,815
                
                
                $
                (233
                )
                
                $
                2,028
                
                
                $
                10,057
                
                
                $
                43,667
                
                
                $
                (1,610
                )
                
                $
                53,909Comprehensive
      income (loss):Net
      Income
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                2,321
                
                
                
                –
                
                
                
                2,321Other
      comprehensive loss
                
                
                –
                
                
                
                (159
                )
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                (159
                )Total
      comprehensive income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                $
                2,162Cash
      dividends paid($0.48
      per share)
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                (1,488
                )
                
                
                –
                
                
                
                (1,488
                )Purchase
      of treasury stock
                
                
                (51,225
                )
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                (866
                )
                
                
                (866
                )Stock
      issued - Employee stock purchase plan
                
                
                2,630
                
                
                
                –
                
                
                
                2
                
                
                
                35
                
                
                
                –
                
                
                
                –
                
                
                
                37Stock
      issued for options exercised
                
                
                6,162
                
                
                
                –
                
                
                
                4
                
                
                
                15
                
                
                
                –
                
                
                
                –
                
                
                
                19Tax
      benefit from exercise of stock options
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                6
                
                
                
                –
                
                
                
                –
                
                
                
                6Stock-based
      compensation expense
                
                
                –
                
                
                
                –
                
                
                
                –
                
                
                
                29
                
                
                
                –
                
                
                
                –
                
                
                
                29Balance,
      June 30, 2009
                
                
                3,089,382
                
                
                $
                (392
                )
                
                $
                2,034
                
                
                $
                10,142
                
                
                $
                44,500
                
                
                $
                (2,476
                )
                
                $
                53,808
 The
accompanying notes are an integral part of the consolidated financial
statements.
 5
  QNB
      Corp. and SubsidiaryCONSOLIDATED
      STATEMENTS OF CASH FLOWS
 (in
      thousands)(unaudited)Six
      Months Ended June 30,
                
                2009
                
                
                2008Operating
      ActivitiesNet
      income
                
                $
                2,321
                
                
                $
                3,316Adjustments
      to reconcile net income to net cash provided by operating
      activitiesDepreciation
      and amortization
                
                
                445
                
                
                
                414Provision
      for loan losses
                
                
                1,100
                
                
                
                425Net
      loss (gains) on investment securities
                
                
                280
                
                
                
                (104
                )Gain
      on sale of equity investment
                
                
                –
                
                
                
                (175
                )Net
      loss (gain) on sale of repossessed assets
                
                
                101
                
                
                
                (40
                )Net
      gain on sale of loans
                
                
                (402
                )
                
                
                (72
                )Loss
      on disposal of premises and equipment
                
                
                –
                
                
                
                3Proceeds
      from sales of residential mortgages
                
                
                17,948
                
                
                
                7,048Originations
      of residential mortgages held-for-sale
                
                
                (18,037
                )
                
                
                (6,615
                )Income
      on bank-owned life insurance
                
                
                (137
                )
                
                
                (170
                )Life
      insurance premiums
                
                
                (5
                )
                
                
                (5
                )Stock-based
      compensation expense
                
                
                29
                
                
                
                30Deferred
      income tax benefit
                
                
                (313
                )
                
                
                (82
                )Net
      (decrease) increase in income taxes payable
                
                
                (126
                )
                
                
                123Net
      decrease in accrued interest receivable
                
                
                53
                
                
                
                86Amortization
      of mortgage servicing rights and change in valuation
    allowance
                
                
                30
                
                
                
                46Net
      amortization of premiums and discounts on investment
      securities
                
                
                (13
                )
                
                
                (140
                )Net
      increase in accrued interest payable
                
                
                921
                
                
                
                489Decrease
      (increase) in other assets
                
                
                351
                
                
                
                (426
                )Increase
      in other liabilities
                
                
                287
                
                
                
                15Net
      cash provided by operating activities
                
                
                4,833
                
                
                
                4,166Investing
      ActivitiesProceeds
      from maturities and calls of investment securitiesavailable-for-sale
                
                
                50,281
                
                
                
                21,299held-to-maturity
                
                
                250
                
                
                
                –Proceeds
      from sales of investment securitiesavailable-for-sale
                
                
                6,310
                
                
                
                3,752Purchase
      of investment securitiesavailable-for-sale
                
                
                (75,414
                )
                
                
                (38,985
                )Proceeds
      from sale of equity investment
                
                
                –
                
                
                
                175Proceeds
      from redemption of restricted bank stock
                
                
                –
                
                
                
                332Purchase
      of restricted bank stock
                
                
                –
                
                
                
                (534
                )Net
      increase in loans
                
                
                (32,771
                )
                
                
                (6,677
                )Net
      purchases of premises and equipment
                
                
                (208
                )
                
                
                (343
                )Redemption
      of bank owned life insurance investment
                
                
                –
                
                
                
                224Proceeds
      from sale of repossessed assets
                
                
                315
                
                
                
                198Net
      cash used by investing activities
                
                
                (51,237
                )
                
                
                (20,559
                )Financing
      ActivitiesNet
      increase in non-interest bearing deposits
                
                
                3,860
                
                
                
                6,421Net
      increase in interest-bearing non-maturity deposits
                
                
                27,685
                
                
                
                443Net
      increase in time deposits
                
                
                19,619
                
                
                
                19,628Proceeds
      from long-term debt
                
                
                –
                
                
                
                10,000Net
      increase (decrease) in short-term borrowings
                
                
                1,180
                
                
                
                (10,907
                )Tax
      benefit from employee stock transactions
                
                
                6
                
                
                
                –Cash
      dividends paid
                
                
                (1,488
                )
                
                
                (1,443
                )Purchase
      of treasury stock
                
                
                (866
                )
                
                
                –Proceeds
      from issuance of common stock
                
                
                56
                
                
                
                32Net
      cash provided by financing activities
                
                
                50,052
                
                
                
                24,174Increase
      in cash and cash equivalents
                
                
                3,648
                
                
                
                7,781Cash
      and cash equivalents at beginning of year
                
                
                16,451
                
                
                
                14,322Cash
      and cash equivalents at end of period
                
                $
                20,099
                
                
                $
                22,103Supplemental
      Cash Flow DisclosuresInterest
      paid
                
                $
                6,163
                
                
                $
                7,469Income
      taxes paid
                
                
                884
                
                
                
                975Non-Cash
      TransactionsTransfer
      of loans to repossessed assets
                
                
                477
                
                
                
                257Unsettled
      trades to purchase securities
                
                
                16
                
                
                
                1,001
 6
  QNB
CORP. AND SUBSIDIARY
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 AND 2008, AND DECEMBER 31, 2008
 (Unaudited)




1.
BASIS OF PRESENTATION





The
accompanying unaudited consolidated financial statements include the accounts of
QNB Corp. and its wholly-owned subsidiary, QNB Bank (the Bank). The consolidated
entity is referred to herein as “QNB” or the “Company”. All significant
intercompany accounts and transactions are eliminated in the consolidated
financial statements.





These
consolidated financial statements should be read in conjunction with the audited
consolidated financial statements and notes thereto included in QNB's 2008
Annual Report incorporated in the Form 10-K.  Operating results for
the three- and six-month periods ended June 30, 2009 are not necessarily
indicative of the results that may be expected for the year ending December 31,
2009.





The
unaudited consolidated financial statements reflect all adjustments which, in
the opinion of management, are necessary for a fair presentation of the results
of operations for the interim periods and are of a normal and recurring
nature.  Certain items in the 2008 consolidated financial statements
have been reclassified to conform to the 2009 financial statement presentation
format.





Tabular
information, other than share and per share data, is presented in thousands of
dollars.





In
preparing the consolidated financial statements, management is required to make
estimates and assumptions that affect the reported amounts of assets and
liabilities at the dates of the consolidated financial statements and the
reported amounts of revenues and expenses during the reporting periods. Actual
results could differ from such estimates.





The
Company has evaluated events and transactions occurring subsequent to the
balance sheet date of June 30, 2009, for items that should potentially be
recognized or disclosed in these financial statements. The evaluation was
conducted through August 14, 2009, the date these financial statements were
issued.





2.
RECENT ACCOUNTING PRONOUNCEMENTS





Financial
Accounting Standards Board (FASB) Statement No. 141(R) Business Combinations was
issued in December of 2007. This Statement establishes principles and
requirements for how the acquirer of a business recognizes and measures in its
financial statements the identifiable assets acquired, the liabilities assumed,
and any non-controlling interest in the acquiree. The Statement also provides
guidance for recognizing and measuring the goodwill acquired in the business
combination and determines what information to disclose to enable users of the
financial statements to evaluate the nature and financial effects of the
business combination. This guidance became effective as of January 1, 2009 for
QNB and had no immediate impact. This new pronouncement will affect QNB’s
accounting for business combinations completed after January 1,
2009.





In
November 2008, the SEC released a proposed roadmap regarding the potential use
by U.S. issuers of financial statements prepared in accordance with
International Financial Reporting Standards (IFRS). IFRS is a comprehensive
series of accounting standards published by the International Accounting
Standards Board (“IASB”). Under the proposed roadmap, the Company may be
required to prepare financial statements in accordance with IFRS as early as
2014. The SEC will make a determination in 2011 regarding the mandatory adoption
of IFRS. The Company is currently assessing the impact that this potential
change would have on its consolidated financial statements, and it will continue
to monitor the development of the potential implementation of IFRS.




7




QNB
CORP. AND SUBSIDIARY
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 AND 2008, AND DECEMBER 31, 2008
 (Unaudited)


2.
RECENT ACCOUNTING PRONOUNCEMENTS (Continued)





In
June 2009, the FASB issued SFAS No. 165, Subsequent Events. This
standard establishes general standards of accounting for and disclosures of
events that occur after the balance sheet date but before financial statements
are issued or are available to be issued. It requires the disclosure of the date
through which an entity has evaluated subsequent events and the basis for that
date. SFAS 165 was effective for interim or annual financial periods ending
after June 15, 2009. The adoption of SFAS 165 did not have a material
impact on QNB’s financial condition or results of operations.





In June
2009, the FASB issued SFAS No. 166, Accounting for Transfers of
Financial Assets, an amendment of FASB Statement No. 140.This statement
prescribes the information that a reporting entity must provide in its financial
reports about a transfer of financial assets; the effects of a transfer on its
financial position, financial performance and cash flows; and a transferor’s
continuing involvement in transferred financial assets. Specifically, among
other aspects, SFAS 166 amends Statement of Financial Standard
No. 140, Accounting for
Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities (SFAS 140) by removing the concept of a qualifying
special-purpose entity from SFAS 140, removing the exception from applying
FIN 46(R) to variable interest entities that are qualifying special-purpose
entities, and modifying the financial-components approach used in SFAS 140.
SFAS 166 is effective for fiscal years beginning after November 15,
2009. QNB has not determined the effect that the adoption of SFAS 166
will have on our financial position or results of operations.





In June
2009, the FASB issued SFAS No. 167, Amendments to FASB Interpretation
No. 46(R).This statement amends
FASB Interpretation No. 46, Consolidation of Variable Interest
Entities (revised December 2003) — an interpretation of ARB
No. 51 (FIN 46(R)), to require an enterprise to determine
whether it’s variable interest or interests give it a controlling financial
interest in a variable interest entity. The primary beneficiary of a
variable interest entity is the enterprise that has both (1) the power to
direct the activities of a variable interest entity that most significantly
impact the entity’s economic performance and (2) the obligation to absorb
losses of the entity that could potentially be significant to the variable
interest entity or the right to receive benefits from the entity that could
potentially be significant to the variable interest entity. SFAS 167
also amends FIN 46(R) to require ongoing reassessments of whether an
enterprise is the primary beneficiary of a variable interest
entity. SFAS 167 is effective for fiscal years beginning after
November 15, 2009. We do not expect the adoption of this standard to have
an impact on our financial position or results of operations.





In June
2009, the FASB issued SFAS No. 168, The FASB Accounting Standards
Codification and the Hierarchy of Generally Accepted Accounting Principles, a
replacement of FASB Statement No. 162.SFAS 168 replaces
SFAS No. 162, The
Hierarchy of Generally Accepted Accounting Principles,to establish the
FASB Accounting Standards
Codificationas the source of authoritative accounting principles
recognized by the FASB to be applied by nongovernmental entities in preparation
of financial statements in conformity with generally accepted accounting
principles in the United States. SFAS 168 is effective for interim and
annual periods ending after September 15, 2009. We do not expect the
adoption of this standard to have an impact on our financial position or results
of operations.





In April
2009, FASB issued FASB Staff Position (FSP) No. FAS 157-4, Determining Fair Value When the
Volume and Level of Activity for the Asset or Liability Have Significantly
Decreased and Identifying Transactions That Are Not Orderly(FSP FAS
157-4). FASB Statement 157, Fair Value Measurements,
defines fair value as the price that would be received to sell the asset or
transfer the liability in an orderly transaction (that is, not a forced
liquidation or distressed sale) between market participants at the measurement
date under current market conditions. FSP FAS 157-4 provides additional guidance
on determining when the volume and level of activity for the asset or liability
has significantly decreased. The FSP also includes guidance on identifying
circumstances when a transaction may not be considered orderly.




8


QNB
CORP. AND SUBSIDIARY
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 AND 2008, AND DECEMBER 31, 2008
 (Unaudited)


2.
RECENT ACCOUNTING PRONOUNCEMENTS (Continued)





FSP FAS
157-4 provides a list of factors that a reporting entity should evaluate to
determine whether there has been a significant decrease in the volume and level
of activity for the asset or liability in relation to normal market activity for
the asset or liability. When the reporting entity concludes there has been a
significant decrease in the volume and level of activity for the asset or
liability, further analysis of the information from that market is needed and
significant adjustments to the related prices may be necessary to estimate fair
value in accordance with Statement 157.





This FSP
clarifies that when there has been a significant decrease in the volume and
level of activity for the asset or liability, some transactions may not be
orderly. In those situations, the entity must evaluate the weight of the
evidence to determine whether the transaction is orderly. The FSP provides a
list of circumstances that may indicate that a transaction is not orderly. A
transaction price that is not associated with an orderly transaction is given
little, if any, weight when estimating fair value.





This FSP
is effective for interim and annual reporting periods ending after June 15,
2009, with early adoption permitted for periods ending after March 15,
2009. The Company adopted this pronouncement for the period ended June 30, 2009
and has included the necessary disclosures.





In April
2009, the FASB issued FSP No. FAS 115-2 and FAS 124-2, Recognition and Presentation of
Other-Than-Temporary Impairments(FSP FAS 115-2 and FAS 124-2). FSP FAS
115-2 and FAS 124-2 clarifies the interaction of the factors that should be
considered when determining whether a debt security is other-than-temporarily
impaired. For debt securities, management must assess whether (a) it has
the intent to sell the security and (b) it is more likely than not that it
will be required to sell the security prior to its anticipated recovery. These
steps are done before assessing whether the entity will recover the cost basis
of the investment. Previously, this assessment required management to assert it
has both the intent and the ability to hold a security for a period of time
sufficient to allow for an anticipated recovery in fair value to avoid
recognizing an other-than-temporary impairment. This change does not affect the
need to forecast recovery of the value of the security through either cash flows
or market price.





In
instances when a determination is made that an other-than-temporary impairment
exists but the investor does not intend to sell the debt security and it is not
more likely than not that it will be required to sell the debt security prior to
its anticipated recovery, FSP FAS 115-2 and FAS 124-2 changes the presentation
and amount of the other-than-temporary impairment recognized in the income
statement. The other-than-temporary impairment is separated into (a) the
amount of the total other-than-temporary impairment related to a decrease in
cash flows expected to be collected from the debt security (the credit loss) and
(b) the amount of the total other-than-temporary impairment related to all
other factors. The amount of the total other-than-temporary impairment
related to the credit loss is recognized in earnings. The amount of the total
other-than-temporary impairment related to all other factors is recognized in
other comprehensive income.





This FSP
is effective for interim and annual reporting periods ending after June 15,
2009, with early adoption permitted for periods ending after March 15,
2009. The Company adopted this pronouncement for the period ended June 30,
2009 and has included the necessary disclosures.





In
April 2009, the Securities and Exchange Commission issued Staff Accounting
Bulletin No. 111 (SAB 111). SAB 111 amends Topic 5.M. in the Staff
Accounting Bulletin series entitled Other Than Temporary Impairment of
Certain Investments in Debt and Equity Securities. On April 9, 2009,
the FASB issued FASB Staff Position No. FAS 115-2 and FAS 124-2, Recognition and Presentation of
Other-Than-Temporary Impairments. SAB 111 maintains the previous views
related to equity securities and amends Topic 5.M. to exclude debt securities
from its scope.




9


QNB
CORP. AND SUBSIDIARY
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 AND 2008, AND DECEMBER 31, 2008
 (Unaudited)


2.
RECENT ACCOUNTING PRONOUNCEMENTS (Continued)





In April
2009, the FASB issued FSP No. FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value
of Financial Instruments(FSP FAS 107-1 and APB 28-1). FSP FAS 107-1
and APB 28-1 amends FASB Statement No. 107, Disclosures about Fair Value of
Financial Instruments, to require disclosures about fair value of
financial instruments for interim reporting periods of publicly traded companies
as well as in annual financial statements. This FSP also amends APB Opinion
No. 28, Interim Financial
Reporting, to require those disclosures in summarized financial
information at interim reporting periods.





This FSP
is effective for interim and annual reporting periods ending after June 15,
2009, with early adoption permitted for periods ending after March 15,
2009.The Company
adopted this pronouncement for the period ended June 30, 2009 and has included
the necessary disclosures.





3.
STOCK-BASED COMPENSATION AND SHAREHOLDERS’ EQUITY





QNB
sponsors stock-based compensation plans, administered by a committee, under
which both qualified and non-qualified stock options may be granted periodically
to certain employees. QNB accounts for all awards granted under stock-based
compensation plans in accordance with Financial Accounting Standards Board
(FASB) Statement No. 123R, Share-Based Payment(FASB No.
123R). Compensation cost has been measured using the fair value of an award on
the grant date and is recognized over the service period, which is usually the
vesting period.





Stock-based
compensation expense was approximately $16,000 and $17,000 for the three months
ended June 30, 2009 and 2008, respectively, and $29,000 and $30,000 for the six
months ended June 30, 2009 and 2008, respectively. As of June 30, 2009, there
was approximately $69,000 of unrecognized compensation cost related to unvested
share-based compensation awards granted that is expected to be recognized over
the next 30 months.





Options
are granted to certain employees at prices equal to the market value of the
stock on the date the options are granted. The 1998 Plan authorizes the issuance
of 220,500 shares. The time period during which any option is exercisable under
the Plan is determined by the committee but shall not commence before the
expiration of six months after the date of grant or continue beyond the
expiration of ten years after the date the option is awarded. The granted
options vest ratably over a three-year period. As of June 30, 2009, there
were 225,058 options granted, 12,198 options forfeited, 70,189 options exercised
and 142,671 options outstanding under this Plan. The 1998 Plan expired on March
10, 2008, therefore no further options can be granted under this
Plan





The 2005
Plan authorizes the issuance of 200,000 shares. The terms of the 2005 Plan
are identical to the 1998 Plan, except options expire five years after the grant
date. As of June 30, 2009, there were 63,700 options granted and outstanding
under this Plan. The 2005 Plan expires March 15, 2015.





The fair
value of each option is amortized into compensation expense on a straight-line
basis between the grant date for the option and each vesting date. QNB estimated
the fair value of stock options on the date of the grant using the Black-Scholes
option pricing model. The model requires the use of numerous assumptions, many
of which are highly subjective in nature.




10


QNB
CORP. AND SUBSIDIARY
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 AND 2008, AND DECEMBER 31, 2008
 (Unaudited)


3.
STOCK-BASED COMPENSATION AND SHAREHOLDERS’ EQUITY (Continued)





The
following assumptions were used in the option pricing model in determining the
fair value of options granted during the six months ended June 30:




Options
      granted
              
              2009
              
              
              2008Risk-free
      interest rate
              
              
              1.48
              %
              
              
              3.00
              %Dividend
      yield
              
              
              4.80
              
              
              
              3.64Volatility
              
              
              25.04
              
              
              
              18.46Expected
      life (years)
              
              
              5.00
              
              
              
              5.00


The
risk-free interest rate was selected based upon yields of U.S. Treasury issues
with a term equal to the expected life of the option being valued. Historical
information was the primary basis for the selection of the expected dividend
yield, expected volatility and expected lives of the options.





The fair
market value of options granted in 2009 and 2008 was $2.17 and $2.63,
respectively.





Stock
option activity during the six months ended June 30, 2009 is as
follows:





Number
      of
                Options
              
              
              Weighted
                Average
                Exercise
      Price
              
              
              Weighted
                Average
                Remaining
                Contractual
                Term
      (in yrs.)
              
              
              Aggregate
                Intrinsic
                ValueOutstanding
      at January 1, 2009
              
              
              221,323
              
              
              $
              20.60Exercised
              
              
              (32,748
              )
              
              
              15.08Expired
              
              
              (2,204
              )
              
              
              16.70Granted
              
              
              20,000
              
              
              
              17.15Outstanding
      at June 30, 2009
              
              
              206,371
              
              
              $
              21.18
              
              
              
              3.1
              
              
              $
              117Exercisable
      at June 30, 2009
              
              
              151,571
              
              
              $
              21.28
              
              
              
              3.0
              
              
              $
              117





4. SHARE REPURCHASE
PLAN





On
January 24, 2008, QNB announced that the Board of Directors authorized the
repurchase of up to 50,000 shares of its common stock in open market or
privately negotiated transactions. The repurchase authorization does not bear a
termination date. On February 9, 2009, the Board of Directors approved
increasing the authorization to 100,000 shares. As of June 30, 2009, 57,883
shares were repurchased under this authorization at an average price of $16.97
and a total cost of $982,000. As of June 30, 2008, QNB had not repurchased any
shares.




11


QNB
CORP. AND SUBSIDIARY
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 AND 2008, AND DECEMBER 31, 2008
 (Unaudited)


5.
EARNINGS PER SHARE





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




For
      the Three Months

                  Ended
      June 30,
              
              
              For
      the Six Months

                  Ended
      June 30,2009
              
              
              2008
              
              
              2009
              
              
              2008Numerator
      for basic and diluted earnings per share -net
      income
              
              $
              1,227
              
              
              $
              1,606
              
              
              $
              2,321
              
              
              $
              3,316Denominator
      for basic earnings per share - weightedaverage
      shares outstanding
              
              
              3,084,824
              
              
              
              3,135,214
              
              
              
              3,099,198
              
              
              
              3,134,959Effect
      of dilutive securities - employee stock options
              
              
              11,012
              
              
              
              28,595
              
              
              
              10,415
              
              
              
              30,465Denominator
      for diluted earnings per share - adjustedweighted
      average shares outstanding
              
              
              3,095,836
              
              
              
              3,163,809
              
              
              
              3,109,613
              
              
              
              3,165,424Earnings
      per share-basic
              
              $
              0.40
              
              
              $
              0.51
              
              
              $
              0.75
              
              
              $
              1.06Earnings
      per share-diluted
              
              $
              0.40
              
              
              $
              0.51
              
              
              $
              0.75
              
              
              $
              1.05


There
were 138,800 stock options that were anti-dilutive for the three- and six-month
periods ended June 30, 2009, respectively. There were 87,100 stock options that
were anti-dilutive for each of the three- and six-month periods ended June 30,
2008. These stock options were not included in the above
calculation.




12


QNB
CORP. AND SUBSIDIARY
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 AND 2008, AND DECEMBER 31, 2008
 (Unaudited)





6.
COMPREHENSIVE INCOME





For QNB,
the sole component of other comprehensive income (loss) is the unrealized
holding gains and losses on available-for-sale investment
securities.





The
following shows the components and activity of comprehensive income during the
periods ended June 30,
2009 and 2008:




For
      the Three Months

                  Ended
      June 30,
              
              
              For
      the Six Months

                  Ended
      June 30,2009
              
              
              2008
              
              
              2009
              
              
              2008Unrealized
      holding losses arising during the period
                on
      securities available-for-sale [net of tax
                benefit
      of $274, $1,594, $177 and $1,199,
                respectively]
              
              $
              (533
              )
              
              $
              (3,093
              )
              
              $
              (343
              )
              
              $
              (2,327
              )Reclassification
      adjustment for losses (gains)
                included
      in net income [net of (tax benefit)
                tax
      expense of $(9), $(40), $(96) and $35,
                respectively]
              
              
              17
              
              
              
              78
              
              
              
              184
              
              
              
              (69
              )Net
      change in unrealized losses during the
                period
              
              
              (516
              )
              
              
              (3,015
              )
              
              
              (159
              )
              
              
              (2,396
              )Accumulated
      other comprehensive income (loss),
                beginning
      of period
              
              
              124
              
              
              
              2,123
              
              
              
              (233
              )
              
              
              1,504Accumulated
      other comprehensive loss, end
                of
      period
              
              $
              (392
              )
              
              $
              (892
              )
              
              $
              (392
              )
              
              $
              (892
              )Net
      income
              
              $
              1,227
              
              
              $
              1,606
              
              
              $
              2,321
              
              
              $
              3,316Other
      comprehensive income, net of tax:Unrealized
      holding losses arising during the
                period
      [net of tax benefit of $265, $1,554,
                $81
      and $1,234, respectively]
              
              
              (516
              )
              
              
              (3,015
              )
              
              
              (159
              )
              
              
              (2,396
              )Comprehensive
      income (loss)
              
              $
              711
              
              
              $
              (1,409
              )
              
              $
              2,162
              
              
              $
              920


13





QNB
CORP. AND SUBSIDIARY
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 AND 2008, AND DECEMBER 31, 2008
 (Unaudited)


7.
INVESTMENT SECURITIES





The
amortized cost and estimated fair values of investment securities
available-for-sale at June 30, 2009 and December 31, 2008 were as
follows:




Available-for-Sale


June
      30, 2009
              
              
              December
      31, 2008Gross
              
              
              Gross
              
              
              
              
              
              
              
              
              Gross
              
              
              GrossAggregate
              
              
              unrealized
              
              
              unrealized
              
              
              
              
              
              Aggregate
              
              
              unrealized
              
              
              unrealizedfair
              
              
              holding
              
              
              holding
              
              
              Amortized
              
              
              fair
              
              
              holding
              
              
              holding
              
              
              Amortizedvalue
              
              
              gains
              
              
              losses
              
              
              cost
              
              
              value
              
              
              gains
              
              
              losses
              
              
              costU.S.
      Treasury
              
              $
              5,047
              
              
              $
              18
              
              
              $
              -
              
              
              $
              5,029
              
              
              $
              5,124
              
              
              $
              49
              
              
              
              -
              
              
              $
              5,075U.S.
      Government agencies
              
              
              48,944
              
              
              
              338
              
              
              
              184
              
              
              
              48,790
              
              
              
              44,194
              
              
              
              634
              
              
              $
              5
              
              
              
              43,565State
      and municipal securities
              
              
              46,510
              
              
              
              553
              
              
              
              638
              
              
              
              46,595
              
              
              
              42,300
              
              
              
              448
              
              
              
              512
              
              
              
              42,364Mortgage-backed
      securities
              
              
              74,399
              
              
              
              2,328
              
              
              
              16
              
              
              
              72,087
              
              
              
              67,347
              
              
              
              2,126
              
              
              
              -
              
              
              
              65,221Collateralized
      mortgage
                obligations
      (CMOs)
              
              
              58,478
              
              
              
              1,544
              
              
              
              371
              
              
              
              57,305
              
              
              
              49,067
              
              
              
              963
              
              
              
              591
              
              
              
              48,695Other
      debt securities
              
              
              1,348
              
              
              
              73
              
              
              
              4,316
              
              
              
              5,591
              
              
              
              8,476
              
              
              
              79
              
              
              
              3,171
              
              
              
              11,568Equity
      securities
              
              
              3,204
              
              
              
              211
              
              
              
              133
              
              
              
              3,126
              
              
              
              3,089
              
              
              
              9
              
              
              
              382
              
              
              
              3,462Total
      investment securitiesavailable-for-sale
              
              $
              237,930
              
              
              $
              5,065
              
              
              $
              5,658
              
              
              $
              238,523
              
              
              $
              219,597
              
              
              $
              4,308
              
              
              $
              4,661
              
              
              $
              219,950





The
amortized cost and estimated fair value of securities available-for-sale by
contractual maturity at June 30, 2009 are shown in the following table. Expected
maturities will differ from contractual maturities because borrowers may have
the right to call or prepay obligations with or without call or prepayment
penalties. Securities are assigned to categories based on contractual maturity
except for mortgage-backed securities and CMOs which are based on the estimated
average life of these securities.




Aggregate
              
              
              Amortizedfair
      value
              
              
              costDue
      in one year or less
              
              $
              10,105
              
              
              $
              9,943Due
      after one year through five years
              
              
              160,723
              
              
              
              156,999Due
      after five years through ten years
              
              
              36,445
              
              
              
              36,149Due
      after ten years
              
              
              27,453
              
              
              
              32,306Equity
      securities
              
              
              3,204
              
              
              
              3,126Total
      investment securities available-for-sale
              
              $
              237,930
              
              
              $
              238,523





Proceeds
from sales of investment securities available-for-sale were $6,310,000 and
$3,752,000 for the six months ended June 30, 2009 and 2008,
respectively.




14


QNB
CORP. AND SUBSIDIARY
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 AND 2008, AND DECEMBER 31, 2008
 (Unaudited)


7.
INVESTMENT SECURITIES (Continued)





The
following table presents information related to the Company’s gains and losses
on the sales of equity and debt securities, and losses recognized for the
other-than-temporary impairment of investments. Gains and losses on
available-for-sale securities are computed on the specific identification method
and included in non-interest income. Gross realized losses on equity and debt
securities are net of other-than-temporary impairment charges:




Other-than-Gross
              
              
              Gross
              
              
              temporaryRealized
              
              
              Realized
              
              
              impairment
              
              
              Net
      gainsSix months ended June 30,
    2009:
              
              Gains
              
              
              Losses
              
              
              losses
              
              
              (losses)Equity
      securities
              
              $
              107
              
              
              $
              -
              
              
              $
              (515
              )
              
              $
              (408
              )Debt
      securities
              
              
              136
              
              
              
              -
              
              
              
              (8
              )
              
              
              128Total
              
              $
              243
              
              
              $
              -
              
              
              $
              (523
              )
              
              $
              (280
              )


Other-than-Gross
              
              
              Gross
              
              
              temporaryRealized
              
              
              Realized
              
              
              impairment
              
              
              Net
      gainsSix months ended June 30,
    2008:
              
              Gains
              
              
              Losses
              
              
              losses
              
              
              (losses)Equity
      securities
              
              $
              235
              
              
              $
              -
              
              
              $
              (198
              )
              
              $
              37Debt
      securities
              
              
              67
              
              
              
              -
              
              
              
              -
              
              
              
              67Total
              
              $
              302
              
              
              $
              -
              
              
              $
              (198
              )
              
              $
              104





The
following table presents a summary of the cumulative credit related
other-than-temporary impairment charges recognized as components of earnings for
debt securities still held by the Company:





Three
      Months
                Ended
              
              
              Six
      Months
                EndedJune
      30, 2009
              
              
              June
      30, 2009Balance
      of cummulative credit losses on investment securities,beginning
      of period
              
              $
              -
              
              
              $
              -Additions
      of credit losses recorded which were not previouslyrecognized
      as components of earnings
              
              
              (8
              )
              
              
              (8
              )Ending
      balance of cummulative credit losses on investment
      securities,end
      of period
              
              $
              (8
              )
              
              $
              (8
              )




15


QNB
CORP. AND SUBSIDIARY
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 AND 2008, AND DECEMBER 31, 2008
 (Unaudited)




7.
INVESTMENT SECURITIES (Continued)





The
amortized cost and estimated fair values of investment securities
held-to-maturity at June 30, 2009 and December 31, 2008 were as
follows:




Held-To-Maturity


June
      30, 2009
              
              
              
              December
      31, 2008Gross
              
              
              
              Gross
              
              
              
              
              
              
              
              
              
              
              
              Gross
              
              
              
              Grossunrealized
              
              
              
              unrealized
              
              
              
              Aggregate
              
              
              
              
              
              
              
              unrealized
              
              
              
              unrealized
              
              
              
              AggregateAmortized
              
              
              
              holding
              
              
              
              holding
              
              
              
              fair
              
              
              
              Amortized
              
              
              
              holding
              
              
              
              holding
              
              
              
              faircost
              
              
              
              gains
              
              
              
              losses
              
              
              
              value
              
              
              
              cost
              
              
              
              gains
              
              
              
              losses
              
              
              
              valueState
      and municipal securities
              
              $
              3,347
              
              
              $
              102
              
              
              
              3
              
              
              $
              3,446
              
              
              $
              3,598
              
              
              $
              90
              
              
              $
              5
              
              
              $
              3,683


The
amortized cost and estimated fair value of securities held-to-maturity by
contractual maturity at June 30, 2009 are shown in the following table. Expected
maturities will differ from contractual maturities because borrowers may have
the right to call or prepay obligations with or without call or prepayment
penalties.




Aggregate
              
              
              Amortizedfair
      value
              
              
              costDue
      in one year or less
              
              
              -
              
              
              
              -Due
      after one year through five years
              
              
              -
              
              
              
              -Due
      after five years through ten years
              
              $
              3,446
              
              
              $
              3,347Due
      after ten years
              
              
              -
              
              
              
              -Total
      investment securities held-to-maturity
              
              $
              3,446
              
              
              $
              3,347





There
were no sales of investment securities classified as held-to-maturity during the
six months ended June 30, 2009 or 2008.





At June
30, 2009 and December 31, 2008, investment securities available-for-sale
totaling $101,849,000 and $101,302,000, respectively, were pledged as collateral
for repurchase agreements and deposits of public funds.





The
following table indicates the length of time individual securities have been in
a continuous unrealized loss position at June 30, 2009 and
December 31, 2008:




At
      June 30, 2009Less
      than 12 months
            
            
            12
      months or longer
            
            
            Total
            
            
            TotalNo.
      of
            
            
            Fair
            
            
            Unrealized
            
            
            Fair
            
            
            Unrealized
            
            
            Fair
            
            
            Unrealizedsecurities
            
            
            value
            
            
            losses
            
            
            value
            
            
            losses
            
            
            value
            
            
            lossesU.S.
      Government agencies
            
            
            18
            
            
            $
            19,823
            
            
            $
            184
            
            
            
            -
            
            
            
            -
            
            
            $
            19,823
            
            
            $
            184State
      and municipal securities
            
            
            42
            
            
            
            17,722
            
            
            
            579
            
            
            $
            762
            
            
            $
            62
            
            
            
            18,484
            
            
            
            641Mortgage-backed
      securities
            
            
            2
            
            
            
            3,245
            
            
            
            16
            
            
            
            -
            
            
            
            -
            
            
            
            3,245
            
            
            
            16Collateralized
      mortgage
              obligations
      (CMOs)
            
            
            7
            
            
            
            6,035
            
            
            
            55
            
            
            
            3,687
            
            
            
            316
            
            
            
            9,722
            
            
            
            371Other
      debt securities
            
            
            8
            
            
            
            -
            
            
            
            -
            
            
            
            829
            
            
            
            4,316
            
            
            
            829
            
            
            
            4,316Equity
      securities
            
            
            12
            
            
            
            1,349
            
            
            
            133
            
            
            
            -
            
            
            
            -
            
            
            
            1,349
            
            
            
            133Total
            
            
            89
            
            
            $
            48,174
            
            
            $
            967
            
            
            $
            5,278
            
            
            $
            4,694
            
            
            $
            53,452
            
            
            $
            5,661




16


QNB
CORP. AND SUBSIDIARY
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 AND 2008, AND DECEMBER 31, 2008
 (Unaudited)


7.
INVESTMENT SECURITIES (Continued)




At
      December 31, 2008Less
      than 12 months
              
              
              12
      months or longer
              
              
              Total
              
              
              TotalNo.
      of
              
              
              Fair
              
              
              Unrealized
              
              
              Fair
              
              
              Unrealized
              
              
              Fair
              
              
              Unrealizedsecurities
              
              
              value
              
              
              losses
              
              
              value
              
              
              losses
              
              
              value
              
              
              lossesU.S.
      Government agencies
              
              
              1
              
              
              $
              2,995
              
              
              $
              5
              
              
              
              -
              
              
              
              -
              
              
              $
              2,995
              
              
              $
              5State
      and municipal securities
              
              
              40
              
              
              
              15,975
              
              
              
              517
              
              
              
              -
              
              
              
              -
              
              
              
              15,975
              
              
              
              517Collateralized
      mortgage
                obligations
      (CMOs)
              
              
              5
              
              
              
              5,204
              
              
              
              591
              
              
              
              -
              
              
              
              -
              
              
              
              5,204
              
              
              
              591Other
      debt securities
              
              
              11
              
              
              
              2,978
              
              
              
              40
              
              
              $
              1,963
              
              
              $
              3,131
              
              
              
              4,941
              
              
              
              3,171Equity
      securities
              
              
              15
              
              
              
              1,715
              
              
              
              382
              
              
              
              -
              
              
              
              -
              
              
              
              1,715
              
              
              
              382Total
              
              
              72
              
              
              $
              28,867
              
              
              $
              1,535
              
              
              $
              1,963
              
              
              $
              3,131
              
              
              $
              30,830
              
              
              $
              4,666
  Management
evaluates debt securities, which are comprised of U.S. Government Agencies,
state and municipalities, mortgage-backed securities, CMOs and other issuers,
for other-than-temporary impairment and considers the current economic
conditions, the length of time and the extent to which the fair value has been
less than cost, interest rates and the bond rating of each security. The
unrealized losses in U.S. Government agency securities, state and municipal
securities and CMOs are primarily the result of purchases made when market
interest rates were lower than at June 30, 2009. As interest rates increase,
fixed-rate securities generally fall in market price to reflect the higher
market yield. If held to maturity, these bonds will mature at par, and QNB will
not realize a loss. The Company has the intent to hold the securities and does
not believe it will be required to sell the securities before recovery
occurs.





The
Company’s investment in marketable equity securities primarily consists of
investments in large cap stock companies. These equity securities are analyzed
for impairment on an ongoing basis. As a result of declines in equity values
during 2009, $515,000 of other-than-temporary impairment charges were taken
during the first six months of 2009. The severity and duration of the impairment
in the equity portfolio is consistent with current stock market developments.
Management believes these equity securities in an unrealized loss position will
recover in the foreseeable future. QNB evaluated the near-term prospects of the
issuers in relation to the severity and duration of the impairment. Based on
that evaluation and the Company’s ability and intent to hold those securities
and does not believe it will be required to sell the securities before recovery
occurs. The Company does not consider these equity securities to be
other-than-temporarily impaired.





All of
the securities in the other debt securities category with unrealized losses
greater than twelve months as of June 30, 2009 are pooled trust preferred
security issues. QNB holds eight of these securities with an amortized cost of
$5,145,000 and a fair value of $829,000. All of the trust preferred securities
are available-for-sale securities and are carried at fair value.




17


QNB
CORP. AND SUBSIDIARY
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 AND 2008, AND DECEMBER 31, 2008
 (Unaudited)


7.
INVESTMENT SECURITIES (Continued)





The
following table provides additional information related to pooled trust
preferred securities as of June 30, 2009:





Deal
              
              Class
              
              Book
                value
              
              
              Fair
                value
              
              
              Unrealized
                loss
              
              Moody's/
                Fitch
                ratings
              
              Current
                number
                of
      banks
              
              
              Current
                number
      of
                insurance
                companies
              
              
              Actual
      deferrals and defaults as a % of current collateral
              
              
              Excess
      subordin-ation as a % of current performing collateralPreTSL
      IV
              
              Mezzanine*
              
              $
              244
              
              
              $
              187
              
              
              $
              (57
              )
              Ca/B
              
              
              6
              
              
              
              -
              
              
              
              27.1
              %
              
              
              18.9
              %PreTSL
      V
              
              Mezzanine*
              
              
              275
              
              
              
              195
              
              
              
              (80
              )
              Ba3/A
              
              
              4
              
              
              
              -
              
              
              
              20.4
              %
              
              
              23.5
              %PreTSL
      VI
              
              Mezzanine*
              
              
              121
              
              
              
              87
              
              
              
              (34
              )
              Caa1/CCC
              
              
              5
              
              
              
              -
              
              
              
              61.4
              %
              
              
              0.0
              %PreTSL
      XVII
              
              Mezzanine
              
              
              982
              
              
              
              134
              
              
              
              (848
              )
              Ca/CC
              
              
              51
              
              
              
              8
              
              
              
              16.9
              %
              
              
              0.0
              %PreTSL
      XIX
              
              Mezzanine
              
              
              1,002
              
              
              
              83
              
              
              
              (919
              )
              Ca/CC
              
              
              60
              
              
              
              14
              
              
              
              13.7
              %
              
              
              0.0
              %PreTSL
      XXV
              
              Mezzanine
              
              
              1,010
              
              
              
              74
              
              
              
              (936
              )
              Ca/C
              
              
              64
              
              
              
              9
              
              
              
              20.3
              %
              
              
              0.0
              %PreTSL
      XXVI
              
              Mezzanine
              
              
              1,511
              
              
              
              69
              
              
              
              (1,442
              )
              Ca/C
              
              
              64
              
              
              
              10
              
              
              
              16.5
              %
              
              
              0.0
              %$
              5,145
              
              
              $
              829
              
              
              $
              (4,316
              )
  Mezzanine*
- only class of bonds still outstanding (represents the senior-most obligation
of the trust)


The
market for these securities at June 30, 2009 is not active and markets for
similar securities are also not active. The inactivity was evidenced first by a
significant widening of the bid-ask spread in the brokered markets in which
pooled trust preferred securities trade and then by a significant decrease in
the volume of trades relative to historical levels. The new issue market is also
inactive as no new pooled trust preferred notes have been issued since 2007. The
market values for these securities (and any securities other than those issued
or guaranteed by U.S. Government agencies) are depressed relative to historical
levels. In today’s market, a low market price for a particular bond may only
provide evidence of a recent widening of corporate spreads in general versus
being an indicator of credit problems with a particular issuer. Lack of
liquidity in the market for trust preferred collateralized debt obligations,
credit rating downgrades and market uncertainties related to the financial
industry are factors contributing to the temporary impairment of these
securities. Although these securities are classified as available-for-sale, the
Company has the intent to hold the securities and does not believe it will be
required to sell the securities before recovery occurs. These securities are
comprised mainly of securities issued by financial institutions, and to a lesser
degree, insurance companies. QNB owns either the senior or mezzanine tranches of
these securities. These securities are structured so that the senior and
mezzanine tranches are protected from defaults by both over-collateralization
and cash flow default protection provided by subordinated tranches.





On a
quarterly basis we evaluate our debt securities for other-than-temporary
impairment (OTTI). In the second quarter of 2009, $8,000 in other-than-temporary
impairment charges were recognized on our pooled trust preferred collateralized
debt obligations. When evaluating these investments we determine a credit
related portion and a non-credit related portion of OTTI. The credit related
portion is recognized in earnings and represents the expected shortfall in
future cash flows. The non-credit related portion is recognized in other
comprehensive income and represents the difference between the fair value of the
security and the amount of credit related impairment. A discounted cash flow
analysis provides the best estimate of credit related OTTI for these securities.
Additional information related to this analysis follows:




18


QNB
CORP. AND SUBSIDIARY
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 AND 2008, AND DECEMBER 31, 2008
 (Unaudited)




7.
INVESTMENT SECURITIES (Continued)




All of
the pooled trust preferred collateralized debt obligations held by QNB are rated
lower than AA and are measured for OTTI within the scope of EITF 99-20, Recognition of Interest Income and
Impairment on Purchased Beneficial Interests and Beneficial Interests That
Continue to be Held by a Transferor in Securitized Financial Assets, and
FSP EITF 99-20-1, Amendments
to the Impairment Guidance of EITF Issue No. 99-20, by determining
whether it is probable that an adverse change in estimated cash flows has
occurred. Determining whether there has been an adverse change in estimated cash
flows from the cash flows previously projected involves comparing the present
value of remaining cash flows previously projected against the present value of
the cash flows estimated at June 30, 2009. The discounted cash flow analysis is
considered to be the primary evidence when determining whether credit related
other-than-temporary impairment exists.




Results
of a discounted cash flow test are significantly affected by other variables
such as the estimate of future cash flows, credit worthiness of the underlying
banks and insurance companies and determination of probability of default of the
underlying collateral. The following provides additional information for each of
these variables:




·
              Estimate
      of Future Cash Flows – Cash flows are constructed in an INTEX cash flow
      model. INTEX is a proprietary cash flow model recognized as the industry
      standard for analyzing all types of structured debt products. It includes
      each deal’s structural features updated with trustee information,
      including asset-by-asset detail, as it becomes available. The modeled cash
      flows are then used to determine if all the scheduled principal and
      interest payments of the investments will be
  returned.




·
              Credit
      Analysis – A quarterly credit evaluation is performed for the companies
      comprising the collateral across the various pooled trust preferred
      securities. This credit evaluation considers all available evidence and
      focuses on profitability, return on assets, shareholders’ equity, credit
      quality ratios and capital
adequacy.




·
              Probability
      of Default – Asset default rates are primarily base on historical default
      rates and the impact of current economic conditions on these historical
      default rates.




In
addition to the above factors, the evaluation of impairment also includes a
stress test analysis which provides an estimate of excess subordination for each
tranche. This stressed breakpoint is then compared to the level of assets with
credit concerns in each tranche. This comparison allows management to identify
those pools that are at a greater risk for a future adverse change in cash flows
so that we can monitor the asset quality in those pools more closely for
potential deterioration of credit quality.





Based
upon the analysis performed by management as of June 30, 2009, it is probable
that we will collect all contractual principal and interest payments on all of
our pooled trust preferred securities, except for PreTSL VI. The expected
principal shortfall on this security resulted in an $8,000 credit related
other-than-temporary impairment charge in the second quarter of
2009.




19


QNB
CORP. AND SUBSIDIARY
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 AND 2008, AND DECEMBER 31, 2008
 (Unaudited)




8.
LOANS & ALLOWANCE FOR LOAN LOSSES





The
following table presents loans by category as of June 30, 2009 and December 31,
2008:




June
      30,
              
              
              December
      31,2009
              
              
              2008Commercial
      and industrial
              
              $
              102,488
              
              
              $
              97,238Construction
              
              
              28,254
              
              
              
              21,894Real
      estate-commercial
              
              
              159,973
              
              
              
              142,499Real
      estate-residential
              
              
              128,463
              
              
              
              124,538Consumer
              
              
              3,785
              
              
              
              4,483Indirect
      lease financing
              
              
              12,513
              
              
              
              12,762Total
      loans
              
              
              435,476
              
              
              
              403,414Net
      unearned (fees) costs
              
              
              45
              
              
              
              165Loans
      receivable
              
              $
              435,521
              
              
              $
              403,579





Activity
in the allowance for loan losses is shown below:





Three
      Months Ended

                  June
      30,
              
              
              Six
      Months Ended

                  June
      30,2009
              
              
              2008
              
              
              2009
              
              
              2008Balance
      at beginning of period
              
              $
              4,220
              
              
              $
              3,411
              
              
              $
              3,836
              
              
              $
              3,279Charge-offs
              
              
              (164
              )
              
              
              (151
              )
              
              
              (407
              )
              
              
              (272
              )Recoveries
              
              
              28
              
              
              
              13
              
              
              
              55
              
              
              
              41Net
      charge-offs
              
              
              (136
              )
              
              
              (138
              )
              
              
              (352
              )
              
              
              (231
              )Provision
      for loan losses
              
              
              500
              
              
              
              200
              
              
              
              1,100
              
              
              
              425Balance
      at end of period
              
              $
              4,584
              
              
              $
              3,473
              
              
              $
              4,584
              
              
              $
              3,473





Information
with respect to loans that are considered to be impaired under Statement of
Financial Accounting Standards (SFAS) No. 114, Accounting by Creditors for
Impairment of a Loan at June 30, 2009 and December 31, 2008 is as
follows:




At
      June 30, 2009
              
              
              At
      December 31, 2008Balance
              
              
              Specific
                reserve
              
              
              Balance
              
              
              Specific
                reserveRecorded
      investment in impaired loans at period-end
                subject
      to a specific reserve for loan losses and
                corresponding
      specific reserve
              
              $
              567
              
              
              $
              151
              
              
              $
              586
              
              
              $
              188Recorded
      investment in impaired loans at period-end
                requiring
      no specific reserve for loan losses
              
              
              3,084
              
              
              
              
              
              
              
              238Recorded
      investment in impaired loans at period-end
              
              $
              3,651
              
              
              
              
              
              
              $
              824Recorded
      investment in non-accrual and
                restructured
      loans
              
              $
              3,923
              
              
              
              
              
              
              $
              830




20


QNB
CORP. AND SUBSIDIARY
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 AND 2008, AND DECEMBER 31, 2008
 (Unaudited)




9.
INTANGIBLE ASSETS & SERVICING





Loans
serviced for others are not included in the accompanying consolidated balance
sheets. The unpaid principal balances of mortgage loans serviced for others were
$77,622,000 and $67,412,000 at June 30, 2009 and December 31, 2008,
respectively.





The
following table reflects the activity of mortgage servicing rights for the
periods indicated:





Six
      Months Ended
              
              
              Year
      EndedJune
      30,
              
              
              December
      31,2009
              
              
              2008Mortgage
      servicing rights beginning balance
              
              $
              402
              
              
              $
              451Mortgage
      servicing rights capitalized
              
              
              134
              
              
              
              60Mortgage
      servicing rights amortized
              
              
              (59
              )
              
              
              (77
              )Fair
      market value adjustments
              
              
              29
              
              
              
              (32
              )Mortgage
      servicing rights ending balance
              
              $
              506
              
              
              $
              402


The
balance of these mortgage servicing assets are included in other assets at June
30, 2009 and December
31, 2008. The fair value of these rights was $648,000 and $440,000,
respectively. The fair value of servicing rights was determined using a 9.0%
discount rate for both periods presented above.





The
annual estimated amortization expense of intangible assets for each of the five
succeeding fiscal years is as follows:





2009
              
              $
              1162010
              
              
              1042011
              
              
              832012
              
              
              632013
              
              
              48





10.
FAIR VALUE MEASUREMENTS





Management
uses its best judgment in estimating the fair value of the Company’s financial
instruments; however, there are inherent weaknesses in any estimation technique.
Therefore, for substantially all financial instruments, the fair value estimates
herein are not necessarily indicative of the amounts the Company could have
realized in a sales transaction on the dates indicated. The estimated fair value
amounts have been measured as of the respective period ends and have not been
re-evaluated or updated for purposes of these financial statements subsequent to
those respective dates. As such, the estimated fair values of these financial
instruments subsequent to the respective reporting dates may be different than
the amounts reported at each period end.




21




QNB
CORP. AND SUBSIDIARY
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 AND 2008, AND DECEMBER 31, 2008
 (Unaudited)


10.
FAIR VALUE MEASUREMENTS (Continued)





In
September 2006, the Financial Accounting Standards Board (“FASB”) issued
Statement No. 157, Fair Value Measurements (“SFAS 157”), which defines fair
value, establishes a framework for measuring fair value under GAAP, and expands
disclosures about fair value measurements. SFAS 157 applies to other accounting
pronouncements that require or permit fair value measurements. The Bank adopted
SFAS 157 effective for its fiscal year beginning January 1, 2007.





In
December 2007, the FASB issued FASB Staff Position 157-2, Effective Date of FASB Statement No.
157(“FSP 157-2”). FSP 157-2 delays the effective date of SFAS 157 for
all non-financial assets and liabilities, except those that are recognized or
disclosed at fair value on a recurring basis (at least annually) to fiscal years
beginning after November 15, 2008 and interim periods within those fiscal years.
As such, the Company only partially adopted the provisions of SFAS 157 as of
December 31, 2008, and began to account and report for non-financial assets and
liabilities in 2009. In October 2008, the FASB issued FASB Staff Position
157-3, Determining the Fair
Value of a Financial Asset When the Market for that Asset is Not Active(“FSP 157-3”), to clarify the application of the provisions of SFAS 157
in an inactive market and how an entity would determine fair value in an
inactive market. FSP 157-3 was effective immediately and QNB has applied the
provisions of FSP 157-3 to its financial statements as of and for the periods
ended June 30, 2009 and as of and for the year-ended December 31, 2008. At June
30, 2009, the Company determined that no active market existed for pooled trust
preferred securities with an amortized cost of $5,145,000 and an estimated fair
value of $829,000. At December 31, 2008, the Company determined that no active
market existed for pooled trust preferred securities with an amortized cost of
$5,094,000 and an estimated fair value of $1,963,000.





SFAS 157
establishes a fair value hierarchy that prioritizes the inputs to valuation
methods used to measure fair value. The hierarchy gives the highest priority to
unadjusted quoted prices in active markets for identical assets or liabilities
(Level 1 measurements) and the lowest priority to unobservable inputs (Level 3
measurements). The three levels of the fair value hierarchy under SFAS 157 are
as follows:





Level
      1:
              Unadjusted
      quoted prices in active markets that are accessible at the measurement
      date for identical, unrestricted assets or
  liabilities.


Level
      2:
              Quoted
      prices in markets that are not active, or inputs that are observable
      either directly or indirectly, for substantially the full term of the
      asset or liability.


Level
      3:
              Prices
      or valuation techniques that require inputs that are both significant to
      the fair value measurement and unobservable (i.e., supported with little
      or no market activity).





An
asset’s or liability’s level within the fair value hierarchy is based on the
lowest level of input that is significant to the fair value
measurement.





The
measurement of fair value should be consistent with one of the following
valuation techniques: market approach, income approach, and/or cost approach.
The market approach uses prices and other relevant information generated by
market transactions involving identical or comparable assets or liabilities
(including a business). For example, valuation techniques consistent with the
market approach often use market multiples derived from a set of comparables.
Multiples might lie in ranges with a different multiple for each comparable. The
selection of where within the range the appropriate multiple falls requires
judgment, considering factors specific to the measurement (qualitative and
quantitative). Valuation techniques consistent with the market approach include
matrix pricing. Matrix pricing is a mathematical technique used principally to
value debt securities without relying exclusively on quoted prices for the
specific securities, but rather by relying on the security’s relationship to
other benchmark quoted securities.




22


QNB
CORP. AND SUBSIDIARY
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 AND 2008, AND DECEMBER 31, 2008
 (Unaudited)




10.
FAIR VALUE MEASUREMENTS (Continued)





QNB used
the following methods and significant assumptions to estimate fair value of each
type of financial instrument and non-financial asset.





Investment
securitiesavailable for sale (carried at fair value)and held-to-maturity
(carried at amortized cost): The fair value of
securities are determined by obtaining quoted market prices on nationally
recognized securities exchanges (Level 1), or matrix pricing (Level 2), which is
a mathematical technique used widely in the industry to value debt securities
without relying exclusively on quoted market prices for the specific securities
but rather by relying on the securities’ relationship to other benchmark quoted
prices. For certain securities which are not traded in active markets or are
subject to transfer restrictions, valuations are adjusted to reflect illiquidity
and/or non-transferability, and such adjustments are generally based on
available market evidence (Level 3). In the absence of such evidence,
management’s best estimate is used. Management’s best estimate consists of both
internal and external support on certain Level 3 investments. Cash flow models
using a present value formula that includes assumptions market participants
would use along with indicative exit pricing obtained from broker/dealers (where
available) were used to support fair values of certain Level 3
investments.





Impaired Loans (generallycarried atfairvalue): Impaired loans
are those that are accounted for under FASB Statement No. 114, Accounting by Creditors for
Impairment of a Loan(“SFAS 114”), in which the Bank has measured
impairment generally based on the fair value of the loan’s collateral. Fair
value is generally determined based upon independent third-party appraisals of
the properties, or discounted cash flows based upon the expected proceeds. These
assets are included as Level 3 fair values, based upon the lowest level of input
that is significant to the fair value measurements. The fair value of impaired
loans as of June 30, 2009 consists of the loan balances of $567,000, net of a
valuation allowance of $151,000.





Mortgage Servicing Rights
(carried atlower ofcost orfairvalue): The fair value
of mortgage servicing rights is based on a valuation model that calculates the
present value of estimated net servicing income. After stratifying the rights
into tranches based on predominant characteristics, such as interest rate, loan
type and investor type. The valuation incorporates assumptions that market
participants would use in estimating future net servicing income.





Certain
tranches of mortgage servicing rights, which are carried at lower of cost or
fair value, were written down to fair value during the quarter. The ending
valuation allowance is $4,000 at June 30, 2009. Income of $2,000 was included in
earnings for the period which was composed of a $1,000 charge for two tranches
that required a valuation allowance for the quarter, offset by $3,000 of the
valuation allowance that existed at March 31, 2009 that was no longer required
and consequently reversed.





Foreclosed assets (other
real estate owned and repossessed assets): Foreclosed
assets are the only non-financial assets valued on a non-recurring basis which
are held by the Company at fair value, less cost to sell. At foreclosure or
repossession, if the fair value, less estimated costs to sell, of the collateral
acquired (real estate, vehicles, equipment) is less than the Company’s recorded
investment in the related loan, a write-down is recognized through a charge to
the allowance for loan losses. Additionally, valuations are periodically
performed by management and any subsequent reduction in value is recognized
by a charge to income. The fair value of foreclosed assets held-for-sale is
estimated using Level 3 inputs based on observable market data.




23


QNB
CORP. AND SUBSIDIARY
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 AND 2008, AND DECEMBER 31, 2008
 (Unaudited)




10.
FAIR VALUE MEASUREMENTS (Continued)





For
financial assets measured at fair value on a recurring basis, the fair value
measurements by level within the fair value hierarchy used were as
follows:





Quoted
      Prices in Active Markets for Identical Assets
                (Level
      1)
              
              
              Significant
      Other Observable Input
                (Level
      2)
              
              
              Significant
      Unobservable Inputs
                (Level
      3)
              
              
              Balance
      at End of PeriodJune
      30, 2009Securities
      available-for-sale
              
              $
              8,251
              
              
              $
              228,850
              
              
              $
              829
              
              
              $
              237,930December
      31, 2008Securities
      available-for-sale
              
              $
              8,213
              
              
              $
              209,421
              
              
              $
              1,963
              
              
              $
              219,597


The
following table presents additional information about the securities
available-for-sale measured at fair value on a recurring basis and for which QNB
utilized significant unobservable inputs (Level 3 inputs) to determine fair
value:




For
      the Three Months Ended June 30, 2009Balance
      at
                March
      31,
                2009
              
              Total
                Unrealized
                Gains
      or
                (Losses)
              
              Total
                Realized
                Gains
      or
                (Losses)
              
              Purchases
                (Sales
      or
                Paydowns)
              
              Balance
      at
                June
      30,
                2009Securities
      available-for-sale
              
              $
              712
              
              
              $
              122
              
              
              $
              (8
              )
              
              $
              3
              
              
              $
              829


For
      the Six Months Ended June 30, 2009Balance
      at
                December
      31,
                2008
              
              Total
                Unrealized
                Gains
      or
                (Losses)
              
              Total
                Realized
                Gains
      or
                (Losses)
              
              Purchases
                (Sales
      or
                Paydowns)
              
              Balance
      at
                June
      30,
                2009Securities
      available-for-sale
              
              $
              1,963
              
              
              $
              (1,130
              )
              
              $
              (8
              )
              
              $
              4
              
              
              $
              829


QNB owns
eight collateralized debt obligation securities that are backed by trust
preferred securities issued by banks, thrifts, and insurance companies (TRUP
CDOs). The market for these securities at June 30, 2009 is not active and
markets for similar securities are also not active. The inactivity was evidenced
first by a significant widening of the bid-ask spread in the brokered markets in
which TRUP CDOs trade and then by a significant decrease in the volume of trades
relative to historical levels. The new issue market is also inactive as no new
TRUP CDOs have been issued since 2007. There are currently very few market
participants who are willing and or able to transact for these
securities.




24




QNB
CORP. AND SUBSIDIARY
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 AND 2008, AND DECEMBER 31, 2008
 (Unaudited)


10.
FAIR VALUE MEASUREMENTS (Continued)





The
market values for these securities (and any securities other than those issued
or guaranteed by the U.S. Treasury) are very depressed relative to historical
levels. For example, the yield spreads for the broad market of investment grade
and high yield corporate bonds reached all time wide levels versus Treasuries at
the end of November 2008 and remain near those levels. Thus in the current
market, a low market price for a particular bond may only provide evidence of
stress in the credit markets in general versus being an indicator of credit
problems with a particular issuer.





Given
conditions in the debt markets today and the absence of observable transactions
in the secondary and new issue markets, we determined:




·
              The
      few observable transactions and market quotations that are available are
      not reliable for purposes of determining fair value at June 30,
      2009,


·
              An
      income valuation approach technique (present value technique) that
      maximizes the use of relevant observable inputs and minimizes the use of
      unobservable inputs will be equally or more representative of fair value
      than the market approach valuation technique used at prior measurement
      dates and


·
              TRUP
      CDOs will be classified within Level 3 of the fair value hierarchy because
      significant adjustments are required to determine fair value at the
      measurement date.





Our TRUP
CDO valuations were prepared by an independent third party. Their approach in
determining fair value involved these steps:




·
              The
      credit quality of the collateral is estimated using average risk-neutral
      probability of default values for each industry (i.e. banks and insurance
      companies are evaluated separately).


·
            Asset
      defaults are then generated taking into account both the probability of
      default of the asset and an assumed level of correlation among the
      assets.


·
            A
      higher level of correlation is assumed among assets from the same industry
      (e.g. banks with other banks) than among those from different
      industries.


·
            The
      loss given default was assumed to be 95% (i.e. a 5 %
      recovery).


·
            The
      cash flows were forecast for the underlying collateral and applied to each
      CDO tranche to determine the resulting distribution among the
      securities.


·
            The
      calculations were modeled in several thousand scenarios using a Monte
      Carlo engine.


·
            The
      expected cash flows for each scenario were discounted at the risk-free
      rate plus 200 basis points (for illiquidity) to calculate the present
      value of the security.


·
            The
      average price was used for valuation purposes. The overall discount rates
      are highly dependent upon the credit quality of the collateral, the
      relative position of the tranche in the capital structure of the CDO and
      the prepayment assumptions.





25


QNB
CORP. AND SUBSIDIARY
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 AND 2008, AND DECEMBER 31, 2008
 (Unaudited)


10.
FAIR VALUE MEASUREMENTS (Continued)





For
assets measured at fair value on a non-recurring basis, the fair value
measurements by level within the fair value hierarchy are as
follows:




Quoted
      Prices in Active Markets for Identical Assets
                (Level
      1)
              
              
              Significant
      Other Observable Input
                (Level
      2)
              
              
              Significant
      Unobservable Inputs
                (Level
      3)
              
              
              Balance
      at End of PeriodJune
      30, 2009Mortgage
      servicing rights
              
              $
              -
              
              
              $
              -
              
              
              $
              506
              
              
              $
              506Impaired
      loans
              
              $
              -
              
              
              $
              -
              
              
              $
              416
              
              
              $
              416Foreclosed
      assets
              
              $
              -
              
              
              $
              -
              
              
              $
              380
              
              
              $
              380December
      31, 2008Mortgage
      servicing rights
              
              $
              -
              
              
              $
              -
              
              
              $
              402
              
              
              $
              402Impaired
      loans
              
              $
              -
              
              
              $
              -
              
              
              $
              398
              
              
              $
              398





The
following information should not be interpreted as an estimate of the fair value
of the entire Company since a fair value calculation is only provided for a
limited portion of QNB’s assets and liabilities. Due to a wide range of
valuation techniques and the degree of subjectivity used in making the
estimates, comparisons between QNB’s disclosures and those of other companies
may not be meaningful. The following methods and assumptions were used to
estimate the fair values of each major classification of financial instrument at
June 30, 2009 and December 31, 2008:





Cash and due from banks,
interest-bearing deposits in banks, Federal funds sold, accrued interest
receivable and accrued interest payable (carried at cost): The carrying
amounts reported in the balance sheet approximate those assets’ fair
value.





Restricted investment in
bank stocks (carried at cost): The fair value of stock in Atlantic
Central Bankers Bank and the Federal Home Loan Bank is the carrying amount,
based on redemption provisions, and considers the limited marketability of such
securities.





Loans Held for Sale (carried
at lower of cost or fair value): The fair value of loans held for sale is
determined, when possible, using quoted secondary market prices. If no such
quoted prices exist, the fair value of a loan is determined using quoted prices
for a similar loan or loans, adjusted for the specific attributes of that
loan.





Loans Receivable (carried at
cost): The fair values of loans are estimated using discounted cash flow
analyses, using market rates at the balance sheet date that reflect the credit
and interest rate-risk inherent in the loans. Projected future cash flows are
calculated based upon contractual maturity or call dates, projected repayments
and prepayments of principal. Generally, for variable rate loans that reprice
frequently and with no significant change in credit risk, fair values are based
on carrying values.




26


QNB
CORP. AND SUBSIDIARY
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 AND 2008, AND DECEMBER 31, 2008
 (Unaudited)
  10.
FAIR VALUE MEASUREMENTS (Continued)


Deposit liabilities (carried
at cost): The fair value of deposits with no stated maturity (e.g. demand
deposits, interest-bearing demand accounts, money market accounts and savings
accounts) are by definition, equal to the amount payable on demand at the
reporting date (i.e. their carrying amounts). This approach to estimating fair
value excludes the significant benefit that results from the low-cost funding
provided by such deposit liabilities, as compared to alternative sources of
funding. Deposits with a stated maturity (time deposits) have been valued using
the present value of cash flows discounted at rates approximating the current
market for similar deposits.





Short-term borrowings
(carried at cost): The carrying amount of short-term borrowings
approximates their fair values.





Long-term debt (carried at
cost): The fair values of FHLB advances and securities sold under
agreements to repurchase are estimated using discounted cash flow analysis,
based on quoted prices for new long-term debt with similar credit risk
characteristics, terms and remaining maturity. These prices obtained from this
active market represent a fair value that is deemed to represent the transfer
price if the liability were assumed by a third party.





Off-balance-sheet
instruments (disclosed at cost): The fair values for the Bank’s
off-balance sheet instruments (lending commitments and letters of credit) are
based on fees currently charged in the market to enter into similar agreements,
taking into account, the remaining terms of the agreements and the
counterparties’ credit standing.





The
estimated fair values and carrying amounts are summarized as
follows:





June
      30, 2009
              
              
              December
      31, 2008Carrying
              
              
              Estimated
              
              
              Carrying
              
              
              EstimatedAmount
              
              
              Fair
      Value
              
              
              Amount
              
              
              Fair
      ValueFinancial
      AssetsCash
      and due from banks
              
              $
              11,872
              
              
              $
              11,872
              
              
              $
              10,634
              
              
              $
              10,634Interest-bearing
      deposits in banks
              
              
              8,227
              
              
              
              8,227
              
              
              
              1,276
              
              
              
              1,276Federal
      funds sold
              
              
              -
              
              
              
              -
              
              
              
              4,541
              
              
              
              4,541Investment
      securities available-for-sale
              
              
              237,930
              
              
              
              237,930
              
              
              
              219,597
              
              
              
              219,597Investment
      securities held-to-maturity
              
              
              3,347
              
              
              
              3,446
              
              
              
              3,598
              
              
              
              3,683Restricted
      investment in bank stocks
              
              
              2,291
              
              
              
              2,291
              
              
              
              2,291
              
              
              
              2,291Loans
      held-for-sale
              
              
              611
              
              
              
              612
              
              
              
              120
              
              
              
              124Net
      loans
              
              
              430,937
              
              
              
              418,013
              
              
              
              399,743
              
              
              
              397,232Mortgage
      servicing rights
              
              
              506
              
              
              
              648
              
              
              
              402
              
              
              
              440Accrued
      interest receivable
              
              
              2,766
              
              
              
              2,766
              
              
              
              2,819
              
              
              
              2,819Financial
      LiabilitiesDeposits
      with no stated maturities
              
              
              270,033
              
              
              
              270,033
              
              
              
              238,488
              
              
              
              238,488Deposits
      with stated maturities
              
              
              330,921
              
              
              
              334,190
              
              
              
              311,302
              
              
              
              316,239Short-term
      borrowings
              
              
              22,843
              
              
              
              22,843
              
              
              
              21,663
              
              
              
              21,663Long-term
      debt
              
              
              35,000
              
              
              
              36,894
              
              
              
              35,000
              
              
              
              37,352Accrued
      interest payable
              
              
              3,198
              
              
              
              3,198
              
              
              
              2,277
              
              
              
              2,277




27


QNB
CORP. AND SUBSIDIARY
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 AND 2008, AND DECEMBER 31, 2008
 (Unaudited)


10.
FAIR VALUE MEASUREMENTS (Continued)





The
estimated fair value of QNB’s off-balance sheet financial instruments is as
follows:





June
      30, 2009
              
              
              December
      31, 2008Notional
              
              
              Estimated
              
              
              Notional
              
              
              EstimatedAmount
              
              
              Fair
      Value
              
              
              Amount
              
              
              Fair
      ValueCommitments
      to extend credit
              
              $
              97,089
              
              
              $
              -
              
              
              $
              87,227
              
              
              $
              -Standby
      letters of credit
              
              
              12,667
              
              
              
              -
              
              
              
              12,051
              
              
              
              -


11.
OFF-BALANCE-SHEET FINANCIAL INSTRUMENTS AND GUARANTEES





In the
normal course of business there are various legal proceedings, commitments, and
contingent liabilities which are not reflected in the financial statements.
Management does not anticipate any material losses as a result of these
transactions and activities. They include, among other things, commitments to
extend credit and standby letters of credit. The maximum exposure to credit
loss, which represents the possibility of sustaining a loss due to the failure
of the other parties to a financial instrument to perform according to the terms
of the contract, is represented by the contractual amount of these instruments.
QNB uses the same lending standards and policies in making credit commitments as
it does for on-balance sheet instruments. The activity is controlled through
credit approvals, control limits, and monitoring procedures.





A summary
of the Bank's financial instrument commitments is as follows:





June
      30,
              
              
              December
      31,2009
              
              
              2008Commitments
      to extend credit and unused lines of credit
              
              $
              97,089
              
              
              $
              87,227Standby
      letters of credit
              
              
              12,667
              
              
              
              12,051$
              109,756
              
              
              $
              99,278


Commitments
to extend credit are agreements to lend to a customer as long as there is no
violation of any condition established in the contract. Commitments generally
have fixed expiration dates or other termination clauses and may require the
payment of a fee. Since many of the commitments are expected to expire without
being drawn upon, the total commitment amounts do not necessarily represent
future cash requirements. QNB evaluates each customer’s creditworthiness on a
case-by-case basis.





Standby
letters of credit are conditional commitments issued by the Bank to guarantee
the financial or performance obligation of a customer to a third party. QNB’s
exposure to credit loss in the event of nonperformance by the other party to the
financial instrument for standby letters of credit is represented by the
contractual amount of those instruments. The Bank uses the same credit policies
in making conditional obligations as it does for on-balance sheet instruments.
These standby letters of credit expire within three years. The credit risk
involved in issuing letters of credit is essentially the same as that involved
in extending other loan commitments. The Bank requires collateral and personal
guarantees supporting these letters of credit as deemed necessary. Management
believes that the proceeds obtained through a liquidation of such collateral and
the enforcement of personal guarantees would be sufficient to cover the maximum
potential amount of future payments required under the corresponding guarantees.
The amount of the liability as of June 30, 2009 and December 31, 2008 for
guarantees under standby letters of credit issued is not material.




28




QNB
CORP. AND SUBSIDIARY
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 AND 2008, AND DECEMBER 31, 2008
 (Unaudited)


11.
OFF-BALANCE-SHEET FINANCIAL INSTRUMENTS AND GUARANTEES (Continued)





The
amount of collateral obtained for letters of credit and commitments to extend
credit is based on management’s credit evaluation of the customer. Collateral
varies, but may include real estate, accounts receivable, marketable securities,
pledged deposits, inventory or equipment.




12.
REGULATORY RESTRICTIONS





Dividends
payable by the Company and the Bank are subject to various limitations imposed
by statutes, regulations and policies adopted by bank regulatory agencies. Under
Pennsylvania banking law, the Bank is subject to certain restrictions on the
amount of dividends that it may declare without prior regulatory approval. Under
Federal Reserve regulations, the Bank is limited as to the amount it may lend
affiliates, including the Company, unless such loans are collateralized by
specific obligations.





Both the
Company and the Bank are subject to regulatory capital requirements administered
by Federal banking agencies. Failure to meet minimum capital requirements can
initiate actions by regulators that could have an effect on the financial
statements. Under the framework for prompt corrective action, both the Company
and the Bank must meet capital guidelines that involve quantitative measures of
their assets, liabilities, and certain off-balance-sheet items. The capital
amounts and classification are also subject to qualitative judgments by the
regulators. Management believes, as of June 30, 2009, that the Company and the
Bank met capital adequacy requirements to which they were subject.





As of the
most recent notification, the primary regulator of the Bank considered it to be
“well capitalized” under the regulatory framework. There are no conditions or
events since that notification that management believes have changed the
classification. To be categorized as well capitalized, the Company and the Bank
must maintain minimum ratios as set forth in the table below. The Company and
the Bank’s actual capital amounts and ratios are presented as
follows:





Capital
      LevelsActual
              
              
              Adequately
      Capitalized
              
              
              Well
      CapitalizedAs
      of June 30, 2009
              
              Amount
              
              
              Ratio
              
              
              Amount
              
              
              Ratio
              
              
              Amount
              
              
              RatioTotal
      Risk-Based Capital (to Risk Weighted Assets)Consolidated
              
              $
              58,819
              
              
              
              11.29
              %
              
              $
              41,692
              
              
              
              8.00
              %
              
              
              N/A
              
              
              
              N/ABank
              
              
              55,012
              
              
              
              10.63
              %
              
              
              41,389
              
              
              
              8.00
              %
              
              $
              51,737
              
              
              
              10.00
              %Tier
      I Capital (to Risk Weighted Assets)Consolidated
              
              
              54,200
              
              
              
              10.40
              %
              
              
              20,846
              
              
              
              4.00
              %
              
              
              N/A
              
              
              
              N/ABank
              
              
              50,428
              
              
              
              9.75
              %
              
              
              20,695
              
              
              
              4.00
              %
              
              
              31,042
              
              
              
              6.00
              %Tier
      I Capital (to Average Assets)Consolidated
              
              
              54,200
              
              
              
              7.71
              %
              
              
              28,107
              
              
              
              4.00
              %
              
              
              N/A
              
              
              
              N/ABank
              
              
              50,428
              
              
              
              7.22
              %
              
              
              27,957
              
              
              
              4.00
              %
              
              
              34,946
              
              
              
              5.00
              %




29


QNB
CORP. AND SUBSIDIARY
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 JUNE
30, 2009 AND 2008, AND DECEMBER 31, 2008
 (Unaudited)


12.
REGULATORY RESTRICTIONS (Continued)




Capital
      LevelsActual
              
              
              Adequately
      Capitalized
              
              
              Well
      CapitalizedAs
      of December 31, 2008
              
              Amount
              
              
              Ratio
              
              
              Amount
              
              
              Ratio
              
              
              Amount
              
              
              RatioTotal
      Risk-Based Capital (to Risk Weighted Assets)Consolidated
              
              $
              57,732
              
              
              
              12.37
              %
              
              $
              37,338
              
              
              
              8.00
              %
              
              
              N/A
              
              
              
              N/ABank
              
              
              54,022
              
              
              
              11.67
              %
              
              
              37,043
              
              
              
              8.00
              %
              
              $
              46,304
              
              
              
              10.00
              %Tier
      I Capital (to Risk Weighted Assets)Consolidated
              
              
              53,896
              
              
              
              11.55
              %
              
              
              18,669
              
              
              
              4.00
              %
              
              
              N/A
              
              
              
              N/ABank
              
              
              50,186
              
              
              
              10.84
              %
              
              
              18,522
              
              
              
              4.00
              %
              
              
              27,783
              
              
              
              6.00
              %Tier
      I Capital (to Average Assets)Consolidated
              
              
              53,896
              
              
              
              8.32
              %
              
              
              25,924
              
              
              
              4.00
              %
              
              
              N/A
              
              
              
              N/ABank
              
              
              50,186
              
              
              
              7.79
              %
              
              
              25,754
              
              
              
              4.00
              %
              
              
              32,192
              
              
              
              5.00
              %




30
 
 QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS


ITEM
      2.
              MANAGEMENT'S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS





QNB Corp.
(the Company) is a bank holding company headquartered in Quakertown,
Pennsylvania. The Company, through its wholly-owned subsidiary, QNB Bank (the
Bank), has been serving the residents and businesses of upper Bucks, northern
Montgomery and southern Lehigh counties in Pennsylvania since 1877. The Bank is
a locally managed community bank that provides a full range of commercial and
retail banking and retail brokerage services. The consolidated entity is
referred to herein as “QNB”.





Tabular
information presented throughout management’s discussion and analysis, other
than share and per share data, is presented in thousands of
dollars.





FORWARD-LOOKING
STATEMENTS





In
addition to historical information, this document contains forward-looking
statements. Forward-looking statements are typically identified by words or
phrases such as “believe,” “expect,” “anticipate,” “intend,” “estimate,”
“project” and variations of such words and similar expressions, or future or
conditional verbs such as “will,” “would,” “should,” “could,” “may” or similar
expressions. The U.S. Private Securities Litigation Reform Act of 1995 provides
safe harbor in regard to the inclusion of forward-looking statements in this
document and documents incorporated by reference.





Shareholders
should note that many factors, some of which are discussed elsewhere in this
document and in the documents that are incorporated by reference, and including
the risk factors identified in Item 1A of QNB’s 2008 Form 10-K, could affect the
future financial results of the Company and its subsidiary and could cause those
results to differ materially from those expressed in the forward-looking
statements contained or incorporated by reference in this document. These
factors include, but are not limited, to the following:




·
              Volatility
      in interest rates and shape of the yield curve;


·
            Credit
      risk;


·
            Liquidity
      risk;


·
            Operating,
      legal and regulatory risks;


·
            Economic,
      political and competitive forces affecting the Company’s line of
      business;


·
            The
      risk that the Federal Deposit Insurance Corporation (FDIC) could levy
      additional insurance assessments on all insured institutions in order to
      replenish the Deposit Insurance Fund based on the level of bank failures
      in the future; and


·
            The
      risk that the analysis of these risks and forces could be incorrect,
      and/or that the strategies developed to address them could be
      unsuccessful.





QNB
cautions that these forward-looking statements are subject to numerous
assumptions, risks and uncertainties, all of which change over time, and QNB
assumes no duty to update forward-looking statements. Management cautions
readers not to place undue reliance on any forward-looking statements. These
statements speak only as of the date of this report on Form 10-Q, even if
subsequently made available by QNB on its website or otherwise, and they advise
readers that various factors, including those described above, could affect
QNB’s financial performance and could cause actual results or circumstances for
future periods to differ materially from those anticipated or projected. Except
as required by law, QNB does not undertake, and specifically disclaims any
obligation, to publicly release any revisions to any forward-looking
statements to reflect the occurrence of anticipated or unanticipated events
or circumstances after the date of such statements.




31


QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS


CRITICAL
ACCOUNTING POLICIES AND ESTIMATES





The
discussion and analysis of the financial condition and results of operations are
based on the consolidated financial statements of QNB, which are prepared in
accordance with U.S. generally accepted accounting principles (GAAP) and
predominant practices within the banking industry. The preparation of these
consolidated financial statements requires QNB to make estimates and judgments
that affect the reported amounts of assets, liabilities, revenues and expenses,
and related disclosure of contingent assets and liabilities. QNB evaluates
estimates on an on-going basis, including those related to other-than-temporary
impairments on investment securities, the determination of impairment of
restricted bank stocks, the determination of the allowance for loan losses, the
determination of the valuation of foreclosed assets, stock-based compensation
and income taxes. QNB bases its estimates on historical experience and various
other factors and assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. Actual results may differ from these estimates under different
assumptions or conditions.





Other-than-Temporary
Investment Security Impairment


Securities
are evaluated periodically to determine whether a decline in their value is
other-than-temporary. Management utilizes criteria such as the magnitude and
duration of the decline, in addition to the reasons underlying the decline, to
determine whether the loss in value is other-than-temporary. The term
“other-than-temporary” is not intended to indicate that the decline is
permanent, but indicates that the prospect for a near-term recovery of value is
not necessarily favorable, or that there is a lack of evidence to support a
realizable value equal to or greater than the carrying value of the investment.
Once a decline in value is determined to be other-than-temporary, the value of
the security is reduced and a corresponding charge to earnings is recognized. As
a result of declines in the equity markets, QNB recorded an other-than-temporary
impairment charge of $115,000 in the second quarter of 2009 and $515,000 for the
six-month period ended June 30, 2009 related to several equity securities held
by the Company. In addition, during the second quarter of 2009 an
other-than-temporary impairment charge of $8,000 was taken on one pooled trust
preferred security.





Impairment
of Restricted Investment in Bank Stocks


Restricted
bank stock is comprised of restricted stock of the Federal Home Loan Bank of
Pittsburgh (FHLB) and the Atlantic Central Bankers Bank. Federal law requires a
member institution of the FHLB to hold stock of its district bank according to a
predetermined formula.





In
December 2008, the FHLB of Pittsburgh notified member banks that it was
suspending dividend payments and the repurchase of capital stock to preserve
capital. Management evaluates the restricted stock for impairment in accordance
with Statement of Position (SOP) 01-6, Accounting by Certain Entities (Including
Entities With Trade Receivables) That Lend to or Finance the Activities of
Others. Management’s determination of whether these investments are impaired is
based on their assessment of the ultimate recoverability of their cost rather
than by recognizing temporary declines in value. The determination of whether a
decline affects the ultimate recoverability of their cost is influenced by
criteria such as (1) the significance of the decline in net assets of the FHLB
as compared to the capital stock amount for the FHLB and the length of time this
situation has persisted, (2) commitments by the FHLB to make payments required
by law or regulation and the level of such payments in relation to the operating
performance of the FHLB, and (3) the impact of legislative and regulatory
changes on institutions and, accordingly, on the customer base of the FHLB.
Management believes no impairment charge is necessary related to the restricted
stock as of June 30, 2009.




32


QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS


CRITICAL
ACCOUNTING POLICIES AND ESTIMATES (Continued)





Allowance
for Loan Losses


QNB
considers that the determination of the allowance for loan losses involves a
higher degree of judgment and complexity than its other significant accounting
policies. The allowance for loan losses is calculated with the objective of
maintaining a level believed by management to be sufficient to absorb probable,
known and inherent losses in the outstanding loan portfolio. The allowance is
reduced by actual credit losses and is increased by the provision for loan
losses and recoveries of previous losses. The provisions for loan losses are
charged to earnings to bring the total allowance for loan losses to a level
considered appropriate by management.





The
allowance for loan losses is based on management’s continuous review and
evaluation of the loan portfolio. The level of the allowance is determined by
assigning specific reserves to individually identified problem credits and
general reserves to all other loans. The portion of the allowance that is
allocated to impaired loans is determined by estimating the inherent loss on
each credit after giving consideration to the value of underlying collateral.
The general reserves are based on the composition and risk characteristics of
the loan portfolio, including the nature of the loan portfolio, credit
concentration trends, historic and anticipated delinquency and loss experience,
as well as other qualitative factors such as current economic
trends.





Management
emphasizes loan quality and close monitoring of potential problem credits.
Credit risk identification and review processes are utilized in order to assess
and monitor the degree of risk in the loan portfolio. QNB’s lending and loan
administration staff are charged with reviewing the loan portfolio and
identifying changes in the economy or in a borrower’s circumstances which may
affect the ability to repay debt or the value of pledged collateral. A loan
classification and review system exists that identifies those loans with a
higher than normal risk of uncollectibility. Each commercial loan is assigned a
grade based upon an assessment of the borrower’s financial capacity to service
the debt and the presence and value of collateral for the loan. An independent
loan review group tests risk assessments and evaluates the adequacy of the
allowance for loan losses. Management meets monthly to review the credit quality
of the loan portfolio and quarterly to review the allowance for loan
losses.





In
addition, various regulatory agencies, as an integral part of their examination
process, periodically review QNB’s allowance for loan losses. Such agencies may
require QNB to recognize additions to the allowance based on their judgments
about information available to them at the time of their
examination.





Management
believes that it uses the best information available to make determinations
about the adequacy of the allowance and that it has established its existing
allowance for loan losses in accordance with GAAP. If circumstances differ
substantially from the assumptions used in making determinations, future
adjustments to the allowance for loan losses may be necessary and results of
operations could be affected. Because future events affecting borrowers and
collateral cannot be predicted with certainty, increases to the allowance may be
necessary should the quality of any loans deteriorate as a result of the factors
discussed above.





Foreclosed
Assets


Assets
acquired through, or in lieu of, loan foreclosure are held-for-sale and are
initially recorded at fair value less cost to sell at the date of foreclosure,
establishing a new cost basis. Subsequent to foreclosure, valuations are
periodically performed by management and the assets are carried at the lower of
carrying amount or fair value less cost to sell. Revenue and expenses from
operations and changes in the valuation allowance are included in net expenses
from foreclosed assets.




33


QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS


CRITICAL
ACCOUNTING POLICIES AND ESTIMATES (Continued)





Stock-Based
Compensation


QNB
sponsors stock-based compensation plans, administered by a board committee,
under which both qualified and non-qualified stock options may be granted
periodically to certain employees. QNB accounts for all awards granted under
stock-based compensation plans in accordance with FASB Statement No. 123
(revised 2004), Share-Based Payment (FASB No. 123R). Compensation cost has been
measured using the fair value of an award on the grant date and is recognized
over the service period, which is usually the vesting period. The fair value of
each option is amortized into compensation expense on a straight-line basis
between the grant date for the option and each vesting date. QNB estimates the
fair value of stock options on the date of the grant using the Black-Scholes
option pricing model. The model requires the use of numerous assumptions, many
of which are highly subjective in nature.





Income
Taxes


QNB
accounts for income taxes under the asset/liability method. Deferred tax assets
and liabilities are recognized for the future tax consequences attributable to
differences between the financial statement carrying amounts of existing assets
and liabilities and their respective tax bases, as well as operating loss and
tax credit carryforwards. Deferred tax assets and liabilities are measured using
enacted tax rates expected to apply to taxable income in the years in which
those temporary differences are expected to be recovered or settled. The effect
on deferred tax assets and liabilities of a change in tax rates is recognized in
income in the period that includes the enactment date. A valuation allowance is
established against deferred tax assets when, in the judgment of management, it
is more likely than not that such deferred tax assets will not become available.
Because the judgment about the level of future taxable income is dependent to a
great extent on matters that may, at least in part, be beyond QNB’s control, it
is at least reasonably possible that management’s judgment about the need for a
valuation allowance for deferred taxes could change in the near
term.





RESULTS
OF OPERATIONS - OVERVIEW





QNB Corp.
earns its net income primarily through its subsidiary, QNB Bank. Net interest
income, or the spread between the interest, dividends and fees earned on loans
and investment securities and the expense incurred on deposits and other
interest-bearing liabilities, is the primary source of operating income for QNB.
QNB seeks to achieve sustainable and consistent earnings growth while
maintaining adequate levels of capital and liquidity and limiting its exposure
to credit and interest rate risk to levels approved by the Board of Directors.
Due to its limited geographic area, comprised principally of upper Bucks,
southern Lehigh and northern Montgomery counties, growth is pursued through
expansion of existing customer relationships and building new relationships by
stressing a consistently high level of service at all points of
contact.





QNB
reported net income for the second quarter of 2009 of $1,227,000, or $0.40 per
share on a diluted basis. This compares to $1,606,000, or $0.51 per share on a
diluted basis, for the same period in 2008. For the six month period ended June
30, 2009, QNB reported net income of $2,321,000, or $0.75 per share on a diluted
basis. This compares to net income of $3,316,000, or $1.05 per shared on a
diluted basis, for the six month period ended June 30, 2008.





The core
functions of the Bank, gathering deposits and making loans, continued to show
strength and contributed positively to the results for both the three and six
month periods ended June 30, 2009. However, the challenging economic environment
and the continued uncertainty in the financial markets negatively impacted QNB’s
earnings performance during these same periods as QNB had to increase its
provision for loan losses and recognize further declines in the value of the
equity securities portfolio. In addition, results for these periods were
impacted by higher industry-wide
FDIC insurance premiums plus a special industry-wide FDIC assessment. This
special assessment impacted the results for both periods by $219,000 ($332,000
pretax), or $0.07 per diluted share. These FDIC actions were a result of bank
failures which have significantly impacted the level of the Deposit Insurance
Fund.




34


QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS
  RESULTS
OF OPERATIONS – OVERVIEW (Continued)


Net
interest income increased $264,000, or 5.2%, to $5,320,000 for the second
quarter of 2009 compared to the second quarter of 2008 and $239,000, or 4.7%
compared to the first quarter of 2009. Included in net interest income in the
second quarter of 2008 was the recognition of $156,000 in non-recurring income
resulting from the collection of a prepayment penalty on a commercial loan and
the recovery of interest and fees on a non-accrual loan that was repaid.
Adjusting 2008 for these non-recurring items, net interest income for the second
quarter of 2009 increased $420,000, or 8.6%, compared to the second quarter of
2008. The improvement in net interest income comparing the three-month periods
ending June 30, 2009 and 2008 is a result of 13.5% growth in average earning
assets. Comparing the second quarter of 2009 to the same period in 2008, average
loans increased $40,142,000, or 10.4%, and average investment securities
increased $43,571,000, or 21.8%. The growth in the loan portfolio was primarily
in commercial loans secured by commercial and residential real estate, while the
growth in the investment portfolio was primarily in high-quality U.S. Government
agency and agency mortgage-backed securities.





On the
funding side average total deposits increased $79,021,000, or 15.4%, to
$591,111,000 comparing the second quarter of 2009 to the same period in 2008. In
comparison to prior periods, the current growth reflects increases in both
lower-cost core deposits, including checking, savings and money market accounts,
as well as higher-cost time deposits. Comparing the two quarters, average
transaction account balances increased 8.4% while average time deposit balances
increased 21.6%.





The net
interest margin was 3.40% for the second quarter of 2009 compared to 3.67% for
the second quarter of 2008 and 3.48% for the first quarter of 2009. Excluding
the non-recurring items in the second quarter of 2008 the net interest margin
would have been 3.56%. The decline in the net interest margin from the second
quarter of 2008 and the first quarter of 2009 is mainly the result of the yield
earned on loans and investment securities declining to a greater degree than the
cost of deposits as well as a small change in the mix of earning assets, from
higher yielding loans to lower yielding investment securities, and the mix of
deposits from lower-cost transaction accounts to higher-cost time deposits. The
reduction in treasury rates and the prime lending rate over the past year has
had a greater impact on the rates earned on loans and investment securities than
it has had on the rates paid on deposits.





Net
interest income increased $731,000, or 7.6%, to $10,401,000 comparing the first
six months of 2009 and 2008 and $887,000, or 9.3%, excluding the non-recurring
items recorded in 2008. Over this time period, average loans and investment
securities increased 9.6% and 18.5%, respectively, and average total deposits
increased 13.8%. The net interest margin for the first half of 2009 was 3.44%
compared to 3.57% for the first half of 2008, and 3.51% excluding the
non-recurring items.





As a
result of the significant growth in loans, an increase in net charge-offs and
non-performing loans and current economic conditions, QNB recorded a provision
for loan losses of $500,000 in the second quarter of 2009 and $1,100,000 for the
first half of 2009. This compares to a provision of $200,000 for the second
quarter of 2008 and $425,000 for the first half 2008. Net loan charge-offs were
$352,000 for the first half of 2009 compared with $231,000 for the first half of
2008.




35


QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS


RESULTS
OF OPERATIONS – OVERVIEW (Continued)





Total
non-interest income was $1,067,000 for the second quarter of 2009, an increase
of $238,000 compared with the same period in 2008. Gains on the sale of
residential mortgages increased $194,000 comparing these same periods, as the
low interest rate environment has resulted in an increase in mortgage
refinancing activity. Net losses on other real estate owned and repossessed
assets increased $97,000, while losses recognized in the equity securities
portfolio decreased $92,000 comparing the three-month periods.





Total
non-interest income for the six month periods ended June 30, 2009 and 2008 was
$1,800,000 and $2,213,000, respectively. Positively impacting non-interest
income for the first half of 2008 was the recognition of $230,000 of income as a
result of the Visa initial public offering and $48,000 from the proceeds of life
insurance. For the six-month period, gains on the sale of residential mortgages
increased $330,000 while net losses on other real estate owned and repossessed
assets increased $141,000.





Net
investment securities losses were $280,000 for the six months ended June 30,
2009. This compares to $104,000 of net securities gains in the first half of
2008. The net securities losses for 2009 include a $515,000 charge related to
other-than-temporary impairment (OTTI) in the carrying value of holdings in the
equity investment portfolio and an $8,000 OTTI charge on one of the Company’s
pooled trust preferred securities.





Total
non-interest expense was $4,384,000 for the second quarter of 2009, an increase
of $801,000 from the second quarter of 2008. The largest contributing factor to
the increase in non-interest expense was FDIC insurance premium expense which
increased $464,000 to $539,000, comparing the second quarter of 2009 to 2008.
The higher expense is a result of the special assessment mentioned previously
and an increased assessment rate which were both levied on all insured
institutions by the FDIC in order to replenish the Deposit Insurance Fund.
Salary and benefit expense increased $123,000, or 6.3%, to $2,078,000 for the
second quarter of 2009. Additional commercial lending personnel and the staffing
of the Wescosville branch, opened in November 2008, account for the majority of
the increase.





Total
non-interest expense was $8,313,000 for the six month period ended June 30,
2009. This represents an increase of $1,187,000 from the same period in 2008.
Higher FDIC premiums account for $623,000 of this increase and higher salary and
benefit expense contributed $230,000.





QNB
operates in an attractive market for financial services but also in a market
with intense competition from other local community banks and regional and
national financial institutions. QNB has been able to compete effectively with
other financial institutions by emphasizing technology, including
internet-banking and electronic bill pay, and customer service, including local
decision-making on loans, the establishment of long-term customer relationships
and loyalty, and products and services designed to address the specific needs of
our customers.





These
items noted in the foregoing overview, as well as others, will be discussed and
analyzed more thoroughly in the next sections.




36




QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS




Three
      Months EndedJune
      30, 2009
              
              
              June
      30, 2008Average
              
              
              Average
              
              
              
              
              
              Average
              
              
              AverageBalance
              
              
              Rate
              
              
              Interest
              
              
              Balance
              
              
              Rate
              
              
              InterestAssetsFederal
      funds sold
              
              $
              2,497
              
              
              
              0.13
              %
              
              $
              1
              
              
              $
              7,734
              
              
              
              2.07
              %
              
              $
              40Investment
      securities:U.S.
      Treasury
              
              
              5,040
              
              
              
              1.60
              %
              
              
              20
              
              
              
              5,024
              
              
              
              3.60
              %
              
              
              45U.S.
      Government agencies
              
              
              45,474
              
              
              
              4.36
              %
              
              
              496
              
              
              
              30,376
              
              
              
              5.30
              %
              
              
              402State
      and municipal
              
              
              48,561
              
              
              
              6.60
              %
              
              
              802
              
              
              
              42,386
              
              
              
              6.54
              %
              
              
              693Mortgage-backed
      and CMOs
              
              
              128,372
              
              
              
              4.94
              %
              
              
              1,584
              
              
              
              104,072
              
              
              
              5.50
              %
              
              
              1,431Corporate
      bonds (fixed and variable)
              
              
              5,566
              
              
              
              3.42
              %
              
              
              47
              
              
              
              13,736
              
              
              
              6.04
              %
              
              
              207Money
      market mutual funds
              
              
              7,314
              
              
              
              0.64
              %
              
              
              12
              
              
              
              -
              
              
              
              0.00
              %
              
              
              -Equities
              
              
              3,160
              
              
              
              3.23
              %
              
              
              25
              
              
              
              4,322
              
              
              
              2.56
              %
              
              
              28Total
      investment securities
              
              
              243,487
              
              
              
              4.91
              %
              
              
              2,986
              
              
              
              199,916
              
              
              
              5.61
              %
              
              
              2,806Loans:Commercial
      real estate
              
              
              217,305
              
              
              
              6.15
              %
              
              
              3,334
              
              
              
              181,903
              
              
              
              6.98
              %
              
              
              3,157Residential
      real estate
              
              
              24,738
              
              
              
              5.92
              %
              
              
              366
              
              
              
              21,839
              
              
              
              6.15
              %
              
              
              336Home
      equity loans
              
              
              65,112
              
              
              
              5.11
              %
              
              
              830
              
              
              
              68,147
              
              
              
              5.82
              %
              
              
              986Commercial
      and industrial
              
              
              74,192
              
              
              
              5.11
              %
              
              
              945
              
              
              
              71,129
              
              
              
              5.98
              %
              
              
              1,058Indirect
      lease financing
              
              
              14,651
              
              
              
              9.05
              %
              
              
              331
              
              
              
              12,768
              
              
              
              9.73
              %
              
              
              311Consumer
      loans
              
              
              3,946
              
              
              
              10.10
              %
              
              
              99
              
              
              
              4,425
              
              
              
              11.94
              %
              
              
              131Tax-exempt
      loans
              
              
              24,750
              
              
              
              6.00
              %
              
              
              370
              
              
              
              24,341
              
              
              
              6.04
              %
              
              
              366Total
      loans, net of unearned income*
              
              
              424,694
              
              
              
              5.93
              %
              
              
              6,275
              
              
              
              384,552
              
              
              
              6.64
              %
              
              
              6,345Other
      earning assets
              
              
              4,522
              
              
              
              0.11
              %
              
              
              2
              
              
              
              2,488
              
              
              
              2.38
              %
              
              
              15Total
      earning assets
              
              
              675,200
              
              
              
              5.50
              %
              
              
              9,264
              
              
              
              594,690
              
              
              
              6.23
              %
              
              
              9,206Cash
      and due from banks
              
              
              9,442
              
              
              
              
              
              
              
              
              
              
              
              10,247Allowance
      for loan losses
              
              
              (4,384
              )
              
              
              
              
              
              
              
              
              
              
              (3,429
              )Other
      assets
              
              
              22,407
              
              
              
              
              
              
              
              
              
              
              
              21,885Total
      assets
              
              $
              702,665
              
              
              
              
              
              
              
              
              
              
              $
              623,393Liabilities
      and Shareholders' EquityInterest-bearing
      deposits:Interest-bearing
      demand
              
              $
              69,888
              
              
              
              0.52
              %
              
              
              90
              
              
              $
              56,729
              
              
              
              0.16
              %
              
              
              22Municipals
              
              
              28,772
              
              
              
              1.15
              %
              
              
              83
              
              
              
              37,897
              
              
              
              1.90
              %
              
              
              179Money
      market
              
              
              56,864
              
              
              
              1.25
              %
              
              
              177
              
              
              
              48,495
              
              
              
              1.69
              %
              
              
              204Savings
              
              
              49,269
              
              
              
              0.25
              %
              
              
              31
              
              
              
              44,815
              
              
              
              0.39
              %
              
              
              43Time
              
              
              222,081
              
              
              
              3.28
              %
              
              
              1,819
              
              
              
              199,094
              
              
              
              4.20
              %
              
              
              2,081Time
      of $100,000 or more
              
              
              109,115
              
              
              
              3.35
              %
              
              
              910
              
              
              
              73,162
              
              
              
              4.29
              %
              
              
              780Total
      interest-bearing deposits
              
              
              535,989
              
              
              
              2.33
              %
              
              
              3,110
              
              
              
              460,192
              
              
              
              2.89
              %
              
              
              3,309Short-term
      borrowings
              
              
              17,244
              
              
              
              1.24
              %
              
              
              53
              
              
              
              18,604
              
              
              
              2.05
              %
              
              
              95Long-term
      debt
              
              
              35,000
              
              
              
              4.26
              %
              
              
              376
              
              
              
              35,000
              
              
              
              4.26
              %
              
              
              378Total
      interest-bearing liabilities
              
              
              588,233
              
              
              
              2.41
              %
              
              
              3,539
              
              
              
              513,796
              
              
              
              2.96
              %
              
              
              3,782Non-interest-bearing
      deposits
              
              
              55,122
              
              
              
              
              
              
              
              
              
              
              
              51,898Other
      liabilities
              
              
              4,869
              
              
              
              
              
              
              
              
              
              
              
              4,558Shareholders'
      equity
              
              
              54,441
              
              
              
              
              
              
              
              
              
              
              
              53,141Total
      liabilities andshareholders'
      equity
              
              $
              702,665
              
              
              
              
              
              
              
              
              
              
              $
              623,393Net
      interest rate spread
              
              
              
              
              
              
              3.09
              %
              
              
              
              
              
              
              
              
              
              
              3.27
              %Margin/net
      interest income
              
              
              
              
              
              
              3.40
              %
              
              $
              5,725
              
              
              
              
              
              
              
              3.67
              %
              
              $
              5,424
 
 Tax-exempt
securities and loans were adjusted to a tax-equivalent basis and are based on
the marginal Federal corporate tax rate of 34
percent.
 
 Non-accrual
loans are included in earning assets.
 
 *
Includes loans held-for-sale
  37
  QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS
 Average
      Balances, Rate, and Interest Income and Expense Summary (Tax-Equivalent
      Basis)
 
 Six
      Months EndedJune
      30, 2009
                
                
                June
      30, 2008Average
                
                
                Average
                
                
                
                
                
                Average
                
                
                AverageBalance
                
                
                Rate
                
                
                Interest
                
                
                Balance
                
                
                Rate
                
                
                InterestAssetsFederal
      funds sold
                
                $
                1,999
                
                
                
                0.15
                %
                
                $
                2
                
                
                $
                6,783
                
                
                
                2.43
                %
                
                $
                82Investment
      securities:U.S.
      Treasury
                
                
                5,052
                
                
                
                1.60
                %
                
                
                40
                
                
                
                5,075
                
                
                
                3.86
                %
                
                
                97U.S.
      Government agencies
                
                
                41,302
                
                
                
                4.54
                %
                
                
                938
                
                
                
                29,796
                
                
                
                5.42
                %
                
                
                807State
      and municipal
                
                
                48,149
                
                
                
                6.53
                %
                
                
                1,573
                
                
                
                42,506
                
                
                
                6.55
                %
                
                
                1,393Mortgage-backed
      and CMOs
                
                
                123,760
                
                
                
                5.19
                %
                
                
                3,209
                
                
                
                101,672
                
                
                
                5.54
                %
                
                
                2,818Corporate
      bonds (fixed and variable)
                
                
                6,521
                
                
                
                4.14
                %
                
                
                135
                
                
                
                13,797
                
                
                
                6.33
                %
                
                
                437Money
      market mutual funds
                
                
                5,367
                
                
                
                0.76
                %
                
                
                20
                
                
                
                -
                
                
                
                0.00
                %
                
                
                -Equities
                
                
                3,312
                
                
                
                3.13
                %
                
                
                51
                
                
                
                4,236
                
                
                
                2.65
                %
                
                
                56Total
      investment securities
                
                
                233,463
                
                
                
                5.11
                %
                
                
                5,966
                
                
                
                197,082
                
                
                
                5.69
                %
                
                
                5,608Loans:Commercial
      real estate
                
                
                209,396
                
                
                
                6.21
                %
                
                
                6,450
                
                
                
                179,900
                
                
                
                6.87
                %
                
                
                6,147Residential
      real estate
                
                
                24,464
                
                
                
                5.98
                %
                
                
                731
                
                
                
                21,878
                
                
                
                6.17
                %
                
                
                675Home
      equity loans
                
                
                66,337
                
                
                
                5.18
                %
                
                
                1,705
                
                
                
                68,224
                
                
                
                5.98
                %
                
                
                2,028Commercial
      and industrial
                
                
                73,114
                
                
                
                5.02
                %
                
                
                1,822
                
                
                
                69,322
                
                
                
                6.30
                %
                
                
                2,171Indirect
      lease financing
                
                
                14,941
                
                
                
                8.74
                %
                
                
                653
                
                
                
                12,902
                
                
                
                9.91
                %
                
                
                639Consumer
      loans
                
                
                4,109
                
                
                
                10.23
                %
                
                
                208
                
                
                
                4,393
                
                
                
                11.29
                %
                
                
                247Tax-exempt
      loans
                
                
                25,086
                
                
                
                6.00
                %
                
                
                747
                
                
                
                24,376
                
                
                
                6.09
                %
                
                
                738Total
      loans, net of unearned income*
                
                
                417,447
                
                
                
                5.95
                %
                
                
                12,316
                
                
                
                380,995
                
                
                
                6.67
                %
                
                
                12,645Other
      earning assets
                
                
                4,021
                
                
                
                0.13
                %
                
                
                3
                
                
                
                2,262
                
                
                
                2.97
                %
                
                
                33Total
      earning assets
                
                
                656,930
                
                
                
                5.61
                %
                
                
                18,287
                
                
                
                587,122
                
                
                
                6.29
                %
                
                
                18,368Cash
      and due from banks
                
                
                9,627
                
                
                
                
                
                
                
                
                
                
                
                10,120Allowance
      for loan losses
                
                
                (4,156
                )
                
                
                
                
                
                
                
                
                
                
                (3,360
                )Other
      assets
                
                
                22,053
                
                
                
                
                
                
                
                
                
                
                
                21,750Total
      assets
                
                $
                684,454
                
                
                
                
                
                
                
                
                
                
                $
                615,632Liabilities
      and Shareholders' EquityInterest-bearing
      deposits:Interest-bearing
      demand
                
                $
                67,210
                
                
                
                0.50
                %
                
                
                168
                
                
                $
                55,821
                
                
                
                0.16
                %
                
                
                44Municipals
                
                
                27,200
                
                
                
                1.18
                %
                
                
                159
                
                
                
                37,159
                
                
                
                2.51
                %
                
                
                464Money
      market
                
                
                52,489
                
                
                
                1.31
                %
                
                
                341
                
                
                
                49,147
                
                
                
                2.03
                %
                
                
                495Savings
                
                
                47,042
                
                
                
                0.25
                %
                
                
                59
                
                
                
                43,705
                
                
                
                0.39
                %
                
                
                85Time
                
                
                218,608
                
                
                
                3.38
                %
                
                
                3,668
                
                
                
                197,002
                
                
                
                4.38
                %
                
                
                4,291Time
      of $100,000 or more
                
                
                107,176
                
                
                
                3.44
                %
                
                
                1,830
                
                
                
                70,594
                
                
                
                4.48
                %
                
                
                1,572Total
      interest-bearing deposits
                
                
                519,725
                
                
                
                2.42
                %
                
                
                6,225
                
                
                
                453,428
                
                
                
                3.08
                %
                
                
                6,951Short-term
      borrowings
                
                
                17,862
                
                
                
                1.23
                %
                
                
                109
                
                
                
                21,276
                
                
                
                2.51
                %
                
                
                266Long-term
      debt
                
                
                35,000
                
                
                
                4.27
                %
                
                
                750
                
                
                
                34,066
                
                
                
                4.30
                %
                
                
                741Total
      interest-bearing liabilities
                
                
                572,587
                
                
                
                2.49
                %
                
                
                7,084
                
                
                
                508,770
                
                
                
                3.15
                %
                
                
                7,958Non-interest-bearing
      deposits
                
                
                52,862
                
                
                
                
                
                
                
                
                
                
                
                49,869Other
      liabilities
                
                
                4,583
                
                
                
                
                
                
                
                
                
                
                
                4,415Shareholders'
      equity
                
                
                54,422
                
                
                
                
                
                
                
                
                
                
                
                52,578Total
      liabilities andshareholders'
      equity
                
                $
                684,454
                
                
                
                
                
                
                
                
                
                
                $
                615,632Net
      interest rate spread
                
                
                
                
                
                
                3.12
                %
                
                
                
                
                
                
                
                
                
                
                3.14
                %Margin/net
      interest income
                
                
                
                
                
                
                3.44
                %
                
                $
                11,203
                
                
                
                
                
                
                
                3.57
                %
                
                $
                10,410
 
 Tax-exempt
securities and loans were adjusted to a tax-equivalent basis and are based on
the marginal Federal corporate tax rate of 34
percent.
 Non-accrual
loans are included in earning assets.
  *
Includes loans held-for-sale
  38
 QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS


Rate/Volume Analysis. The
following table shows the fully taxable equivalent effect of changes in volumes
and rates on interest income and interest expense. Changes in net interest
income that could not be specifically identified as either a rate or volume
change were allocated to changes in volume.





Three
      Months Ended
              
              
              Six
      Months EndedJune
      30, 2009 compared
              
              
              June
      30, 2009 comparedto
      June 30, 2008
              
              
              to
      June 30, 2008Total
              
              
              Due
      to change in:
              
              
              Total
              
              
              Due
      to change in:Change
              
              
              Volume
              
              
              Rate
              
              
              Change
              
              
              Volume
              
              
              RateInterest
      income:Federal
      funds sold
              
              $
              (39
              )
              
              $
              (27
              )
              
              $
              (12
              )
              
              $
              (80
              )
              
              $
              (57
              )
              
              $
              (23
              )Investment
      securities:U.S.
      Treasury
              
              
              (25
              )
              
              
              -
              
              
              
              (25
              )
              
              
              (57
              )
              
              
              -
              
              
              
              (57
              )U.S.
      Government agencies
              
              
              94
              
              
              
              200
              
              
              
              (106
              )
              
              
              131
              
              
              
              312
              
              
              
              (181
              )State
      and municipal
              
              
              109
              
              
              
              101
              
              
              
              8
              
              
              
              180
              
              
              
              184
              
              
              
              (4
              )Mortgage-backed
      and CMOs
              
              
              153
              
              
              
              334
              
              
              
              (181
              )
              
              
              391
              
              
              
              612
              
              
              
              (221
              )Corporate
      bonds (fixed and variable)
              
              
              (160
              )
              
              
              (124
              )
              
              
              (36
              )
              
              
              (302
              )
              
              
              (230
              )
              
              
              (72
              )Money
      market mutual funds
              
              
              12
              
              
              
              12
              
              
              
              -
              
              
              
              20
              
              
              
              20
              
              
              
              -Equities
              
              
              (3
              )
              
              
              (8
              )
              
              
              5
              
              
              
              (5
              )
              
              
              (13
              )
              
              
              8Loans:Commercial
      real estate
              
              
              177
              
              
              
              625
              
              
              
              (448
              )
              
              
              303
              
              
              
              987
              
              
              
              (684
              )Residential
      real estate
              
              
              30
              
              
              
              45
              
              
              
              (15
              )
              
              
              56
              
              
              
              79
              
              
              
              (23
              )Home
      equity loans
              
              
              (156
              )
              
              
              (41
              )
              
              
              (115
              )
              
              
              (323
              )
              
              
              (61
              )
              
              
              (262
              )Commercial
      and industrial
              
              
              (113
              )
              
              
              49
              
              
              
              (162
              )
              
              
              (349
              )
              
              
              113
              
              
              
              (462
              )Indirect
      lease financing
              
              
              20
              
              
              
              45
              
              
              
              (25
              )
              
              
              14
              
              
              
              101
              
              
              
              (87
              )Consumer
      loans
              
              
              (32
              )
              
              
              (14
              )
              
              
              (18
              )
              
              
              (39
              )
              
              
              (17
              )
              
              
              (22
              )Tax-exempt
      loans
              
              
              4
              
              
              
              7
              
              
              
              (3
              )
              
              
              9
              
              
              
              20
              
              
              
              (11
              )Other
      earning assets
              
              
              (13
              )
              
              
              13
              
              
              
              (26
              )
              
              
              (30
              )
              
              
              27
              
              
              
              (57
              )Total
      interest income
              
              
              58
              
              
              
              1,217
              
              
              
              (1,159
              )
              
              
              (81
              )
              
              
              2,077
              
              
              
              (2,158
              )Interest
      expense:Interest-bearing
      demand
              
              
              68
              
              
              
              6
              
              
              
              62
              
              
              
              124
              
              
              
              9
              
              
              
              115Municipals
              
              
              (96
              )
              
              
              (43
              )
              
              
              (53
              )
              
              
              (305
              )
              
              
              (125
              )
              
              
              (180
              )Money
      market
              
              
              (27
              )
              
              
              35
              
              
              
              (62
              )
              
              
              (154
              )
              
              
              33
              
              
              
              (187
              )Savings
              
              
              (12
              )
              
              
              5
              
              
              
              (17
              )
              
              
              (26
              )
              
              
              7
              
              
              
              (33
              )Time
              
              
              (262
              )
              
              
              247
              
              
              
              (509
              )
              
              
              (623
              )
              
              
              457
              
              
              
              (1,080
              )Time
      of $100,000 or more
              
              
              130
              
              
              
              386
              
              
              
              (256
              )
              
              
              258
              
              
              
              807
              
              
              
              (549
              )Short-term
      borrowings
              
              
              (42
              )
              
              
              (7
              )
              
              
              (35
              )
              
              
              (157
              )
              
              
              (44
              )
              
              
              (113
              )Long-term
      debt
              
              
              (2
              )
              
              
              (1
              )
              
              
              (1
              )
              
              
              9
              
              
              
              15
              
              
              
              (6
              )Total
      interest expense
              
              
              (243
              )
              
              
              628
              
              
              
              (871
              )
              
              
              (874
              )
              
              
              1,159
              
              
              
              (2,033
              )Net
      interest income
              
              $
              301
              
              
              $
              589
              
              
              $
              (288
              )
              
              $
              793
              
              
              $
              918
              
              
              $
              (125
              )




39


QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS


NET
INTEREST INCOME





The
following table presents the adjustment to convert net interest income to net
interest income on a fully taxable-equivalent basis for the three- and six-month
periods ended June 30, 2009 and 2008.





For
      the Three Months
              
              
              For
      the Six MonthsEnded
      June 30,
              
              
              Ended
      June 30,2009
              
              
              2008
              
              
              2009
              
              
              2008Total
      interest income
              
              $
              8,859
              
              
              $
              8,838
              
              
              $
              17,485
              
              
              $
              17,628Total
      interest expense
              
              
              3,539
              
              
              
              3,782
              
              
              
              7,084
              
              
              
              7,958Net
      interest income
              
              
              5,320
              
              
              
              5,056
              
              
              
              10,401
              
              
              
              9,670Tax-equivalent
      adjustment
              
              
              405
              
              
              
              368
              
              
              
              802
              
              
              
              740Net
      interest income (fully taxable-equivalent)
              
              $
              5,725
              
              
              $
              5,424
              
              
              $
              11,203
              
              
              $
              10,410





Net
interest income is the primary source of operating income for QNB. Net interest
income is interest income, dividends, and fees on earning assets, less interest
expense incurred for funding sources. Earning assets primarily include loans,
investment securities and Federal funds sold. Sources used to fund these assets
include deposits and borrowed funds. Net interest income is affected by changes
in interest rates, the volume and mix of earning assets and interest-bearing
liabilities, and the amount of earning assets funded by non-interest bearing
deposits.





For
purposes of this discussion, interest income and the average yield earned on
loans and investment securities are adjusted to a tax-equivalent basis as
detailed in the tables that appear on pages 37 and 38. This adjustment to
interest income is made for analysis purposes only. Interest income is increased
by the amount of savings of Federal income taxes, which QNB realizes by
investing in certain tax-exempt state and municipal securities and by making
loans to certain tax-exempt organizations. In this way, the ultimate economic
impact of earnings from various assets can be more easily compared.





The net
interest rate spread is the difference between average rates received on earning
assets and average rates paid on interest-bearing liabilities, while the net
interest rate margin, which includes interest-free sources of funds, is net
interest income expressed as a percentage of average interest-earning
assets.





Net
interest income increased $264,000, or 5.2%, to $5,320,000 for the quarter ended
June 30, 2009 as compared to the quarter ended June 30, 2008. On a
tax-equivalent basis, net interest income increased by 5.5% from $5,424,000 for
the three months ended June 30, 2008 to $5,725,000 for the same period ended
June 30, 2009. Included in net interest income for the second quarter of 2008
was the recognition of $156,000 in non-recurring income resulting from the
collection of a prepayment penalty on a commercial loan that paid off early as
well as the recovery of interest and fees on a non-accrual loan that was repaid.
Adjusting 2008 for these non-recurring items, net interest income on a
tax-equivalent basis for the second quarter of 2009 increased $457,000, or 8.7%,
compared to the second quarter of 2008.





Strong
growth in deposits and the deployment of these deposits into loans and
investment securities was the primary contributor to the growth in net interest
income. Total average deposits increased $79,021,000, or 15.4%, to $591,111,000
when comparing the three months ended June 30, 2009 and June 30, 2008. Over this
same time period total average loans increased $40,142,000, or 10.4%, and total
average investment securities increased $43,571,000, or 21.8%. Partially
offsetting the positive impact on net interest income of this strong growth was
a decrease in the net interest
margin. The net interest margin was 3.40% for the second quarter of 2009
compared to 3.67% for the second quarter of 2008 and 3.48% for the first quarter
of 2009. Excluding the non-recurring items in the second quarter of 2008 the net
interest margin would have been 3.56%.




40


QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS


NET
INTEREST INCOME (Continued)
  During
2008, in response to liquidity issues in the world’s financial markets, a
nationwide housing slowdown and the impact of the deepening recession on
economic growth and unemployment the Federal Reserve Bank’s Open Market
Committee (Fed) picked up the pace of reducing the Federal funds target rate.
The Fed cut its key interest rate, the Federal funds target rate, seven times in
2008 in an attempt to boost the economy. The rate dropped from 4.25% at the
start of the year to the last cut in December setting the target rate at a range
of 0% to 0.25%, a historic low. The prime lending rate followed in step and was
at 3.25% as of December 31, 2008. The short end of the Treasury yield curve
declined significantly as liquidity and financial market strains caused a flight
to quality and the U.S. T-bill became the safe haven. During the fourth quarter
of 2008, short-term T-bill rates hit 0% and the 10-year Treasury yield hit
historic lows. While coming off these historic lows, interest rates remained at
low levels during the first half of 2009. At the end of 2008, the three-month
T-bill rate was 0.11%, a decline of 325 basis points from the prior year, the
two-year note yielded 0.76%, down 229 basis points from December 31, 2007 and
the ten-year note yielded 2.25%, a decline of 179 basis points. In comparison,
as of June 30, 2009 and 2008, the three-month T-bill rate was 0.19% and 1.90%,
the two-year note yield was 1.11% and 2.63%, and the ten-year note yield was
3.53% and 3.99%, respectively. During the first half of 2009, the yield on the
ten-year note was volatile as the Federal Government, in an effort to stimulate
residential mortgage activity, was purchasing mortgage-backed securities which
had the impact of lowering the ten-year note yield while concerns over the
amount of Government stimulus and its longer-term impact on the economy had the
effect of increasing the yield on the ten-year note.





QNB’s
interest sensitivity position as well as a small change in the mix of earning
assets, from higher yielding loans to lower yielding investment securities, and
the mix of deposits from lower-cost transaction accounts to higher-cost time
deposits also impacted net interest income and the net interest margin. For
the majority of 2008, QNB’s interest sensitivity position reflected a negative
gap position in a one-year time frame. A negative sensitivity position results
when the amount of interest rate sensitive liabilities (deposits and debt)
exceeds interest rate sensitive assets (loans and investment securities). As a
result of this position, QNB’s cost of interest-bearing liabilities initially
declined to a greater degree than the yield on its earnings assets, resulting in
both increasing net interest income and net interest margin throughout 2008.
However, since year-end 2008, QNB has been in a positive gap position in a
one-year time frame with the amount of rate sensitive assets exceeding rate
sensitive liabilities. This position, combined with the inability to reduce
rates on some deposit products any further and the change in the mix of earning
assets and deposits described above has resulted in the decrease in the net
interest margin when comparing the second quarter of 2009 to the same period in
2008 and also when comparing the second quarter of 2009 to the first quarter of
2009.





The yield
on earning assets on a tax-equivalent basis decreased 73 basis points from 6.23%
for the second quarter of 2008 to 5.50% for the second quarter of 2009 and
decreased 23 basis points when compared to 5.73% reported in the first quarter
of 2009. Excluding the $156,000 in non-recurring income mentioned previously the
yield on earning assets would have been 6.12% for the second quarter of 2008 or
62 basis points higher than the second quarter of 2009. In comparison, the rate
paid on interest-bearing liabilities decreased 55 basis points from 2.96% for
the second quarter of 2008 to 2.41% for the second quarter of 2009 and decreased
17 basis points when compared to 2.58% reported in the first quarter of
2009.




41


QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS





NET
INTEREST INCOME (Continued)





Interest
income on investment securities increased $180,000 when comparing the two
quarters as the increase in average balances offset the 70 basis point decline
in the average yield of the portfolio. The average yield on the investment
portfolio was 4.91% for the second quarter of 2009 compared with 5.61% for the
second quarter of 2008 and 5.34% for the first quarter of 2009. The decline in
the yield on the investment portfolio is primarily the result of an increase in
liquidity resulting from deposit growth and a significant increase in cash flow
from the investment portfolio as prepayments speeds on mortgage-backed
securities and CMOs ramped-up as did the amount of calls of agency securities.
The reinvestment of these funds were generally in securities that had lower
yields than what they replaced. The growth in the investment portfolio was
primarily in high quality U.S. Government agency and agency mortgage-backed and
CMO securities and tax-exempt State and municipal bonds. Interest income on
mortgage-backed securities and CMOs increased $153,000 with growth in the
portfolio contributing $334,000. This was partially offset by a $181,000
decrease in interest income resulting from a 56 basis point decline in yield.
The yield on the mortgage-backed portfolio decreased from 5.50% to 4.94% when
comparing the second quarter of 2008 and 2009. It also represents a decline of
52 basis points from the first quarter 2009 yield of 5.46%. Income on Government
agency securities increased by $94,000 as the 49.7% growth in average balances
was offset by a 94 basis point decline in yield from 5.30% for the second
quarter of 2008 to 4.36% for the same period in 2009. The yield on agency bonds
was 4.77% for the first quarter of 2009. Most of the bonds in the agency
portfolio have call features ranging from three months to five years, many of
which were exercised as a result of the significant decline in interest rates.
Interest on tax-exempt municipal securities increased $109,000 with higher
balances accounting for $101,000 of additional income. The yield on the state
and municipal portfolio increased from 6.54% for the second quarter of 2008 to
6.60% for the second quarter of 2009. Credit concerns in the municipal market
arising from issues with the insurance companies that insure the bonds resulted
in yields on municipal bonds remaining high despite the significant decline in
treasury market rates. This is known as spread widening. Interest on corporate
bonds declined by $160,000, with lower balances accounting for $124,000 of the
decline and lower rates accounting for $36,000 of the decline. The yield on the
corporate portfolio was 6.04% for the second quarter of 2008 compared to 3.42%
for the second quarter of 2009. To reduce credit risk in the portfolio, in
June 2008, QNB sold approximately $2,000,000 of Lehman Brothers bonds, which had
a yield of 7.25%, at a slight gain. In January 2009, QNB sold another
$6,000,000 in corporate bonds issued by financial institutions at a gain of
$136,000. The bonds sold in 2009 had an average yield of 6.89%. In addition,
some of the bonds in the corporate portfolio reprice quarterly based on
three-month LIBOR. The yield on these securities declined as interest rates
declined. The yield on the investment portfolio is anticipated to continue to
decline as cash flow from the portfolio is reinvested at current market rates
which are below the portfolio yield at June 30, 2009 of 4.77%.





Income on
loans decreased $70,000 to $6,275,000 when comparing the second quarters of
2009 and 2008 as the impact of declining interest rates could not be
overcome by higher balances. Average loans increased $40,142,000, or 10.4%, and
contributed an additional $716,000 in interest income. The yield on loans
decreased 71 basis points, to 5.93% when comparing the same periods, resulting
in a reduction in interest income of $786,000. Excluding the non-recurring items
the yield on loans would have been 6.47% for the second quarter of 2008, or 54
basis points higher than the second quarter of 2009. The decline in the yield on
the loan portfolio reflects the impact of lower interest rates, primarily loans
indexed to the prime lending rate such as commercial loans and home equity
lines of credit. Reducing the impact of the decline in interest rates on loan
yields is the structure of the loan portfolio, which has a significant portion
of fixed-rate and adjustable-rate loans with fixed-rate terms for three to ten
years. The rate of decline of the loan portfolio yield has slowed with the
second quarter 2009 yield of 5.93% representing only a 4 basis points decline
from the 5.97% yield recorded in the first quarter of 2009. Also helping to
stabilize the yield was the implementation of interest rate floors on some
variable rate commercial loans and home equity lines of credit.




42


QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS




NET
INTEREST INCOME (Continued)





Income on
commercial real estate loans increased $177,000, with average balances
increasing $35,402,000, or 19.5%. The yield on commercial real estate loans was
6.15% for the second quarter of 2009, a decline of 83 basis points from the
6.98% reported for the second quarter of 2008. The $156,000 in non-recurring
income was in the commercial real estate loan category. Excluding this income
the yield for the second quarter of 2008 in this category would have been 6.64%,
or 49 basis points higher than the second quarter of 2009. Interest on
commercial and industrial loans decreased $113,000 with the impact of the
increase in average balances being offset by the impact of the decline in yield.
Average commercial and industrial loans increased $3,063,000, or 4.3%, when
comparing the two periods, contributing an additional $49,000 in interest
income. The average yield on these loans decreased 87 basis points to 5.11%
resulting in a reduction in interest income of $162,000. The commercial and
industrial loan category was impacted significantly by the action by the Fed to
lower interest rates since a large portion of this category of loans is indexed
to the prime rate.





Residential
mortgage loan activity, which was slow for most of 2008, picked up significantly
during the first half of 2009 as mortgage rates declined in response to actions
by the Federal Government. Income on residential real estate loans increased by
$30,000 when comparing the two quarters, as the increase in balances offset the
slight decline in yield. The average balance of residential mortgages increased
$2,899,000, or 13.3%, when comparing the two quarters while the average yield
decreased by 23 basis points. QNB sells most of the fixed rate loans it
originates, especially in the current low rate environment. Included in the
increase in average balances was an increase of $1,387,000 in residential
mortgages held-for-sale.





Income on
home equity loans declined by $156,000 when comparing the two quarters.
Over this same time period average home equity loans decreased 4.5%, to
$65,112,000, while the yield on the home equity portfolio decreased 71 basis
points to 5.11%. The demand for home equity loans has declined as home
values have stabilized or fallen and some homeowners have already borrowed
against the equity in their homes. Included in the home equity portfolio are
floating rate home equity lines tied to the prime lending rate. The average
balance of these loans increased by $7,354,000, or 51.7%, to $21,587,000 for the
second quarter of 2009. In contrast, average fixed rate loans declined by
$10,389,000, or 19.3%, to $43,525,000. The movement from fixed rate to floating
rate loans reflects the significant decline in the prime rate to 3.25% and the
introduction of the Equity Choice product during 2008. This product is a
variable rate line of credit indexed to the prime rate that allows the borrower
to carve out portions of the variable rate balance and to fix the rate on that
portion based on the term and rate at that time. As the fixed rate portion is
paid down, the available amount under the line increases. As with commercial and
industrial loans tied to the prime rate, QNB has begun to institute a rate floor
on these prime based loans.





Interest
income on Federal funds sold decreased $39,000 when comparing the two quarters,
a result of both a 194 basis point decline in rate and a $5,237,000 decrease in
average balances. The average yield on Federal funds sold decreased from 2.07%
for the second quarter of 2008 to 0.13% for the second quarter of 2009,
reflecting the actions by the Fed to reduce the Federal funds target rate.
Impacting the volume of Federal funds sold was the decision by management to
invest some of the short-term excess funds in AAA rated money market mutual
funds which were yielding approximately 50 basis points more than Federal
funds.





Income on
other earning assets is comprised of interest on deposits in banks and dividends
on restricted investments in bank stocks, primarily the Federal Home Loan Bank
of Pittsburgh (FHLB). Income on other earning assets declined from $15,000 for
the second quarter of 2008 to $2,000 for the second quarter of 2009. In December
2008, the FHLB notified member banks that it was suspending dividend payments to
preserve capital. FHLB dividend income was $9,000 for the second quarter of
2008.




43


QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS




NET
INTEREST INCOME (Continued)





For the
most part, earning assets are funded by deposits, which increased on average by
$79,021,000, or 15.4%, to $591,111,000, when comparing the second quarters of
2009 and 2008. It appears that customers are looking for the safety of FDIC
insured deposits and the stability of a strong local community bank as opposed
to the volatility of the equity markets and the uncertainty of the larger
regional and national banks. On October 3, 2008, in response to the ongoing
economic crisis affecting the financial services industry, the Emergency
Economic Stabilization Act of 2008 was enacted which temporarily raised the
basic limit on FDIC coverage from $100,000 to $250,000 per depositor until
December 31, 2009. However, legislation was passed during the second quarter of
2009 that extended the higher coverage through December 31, 2013. On October 13,
2008, the FDIC established a program under which the FDIC will fully guarantee
all non-interest bearing transaction accounts until December 31, 2009 (the
“Transaction Liquidity Guarantee Program”). All eligible institutions
participated in the program without cost for the first 30 days of the program.
After November 12, 2008, institutions are assessed at the rate of ten basis
points for transaction account balances in excess of $250,000. QNB is
participating in the Transaction Account Guarantee Program.





Most of
the increase in average deposits was time deposits which increased $58,940,000,
or 21.6%, to $331,196,000 for the second quarter of 2009. Included in this total
was $109,115,000 of time deposits of $100,000 or more, an increase of
$35,953,000 from the $73,162,000 reported for the second quarter of 2008. Higher
yields relative to alternative investments, including other bank deposits, and
the increase in FDIC coverage, as discussed above, appear to be the impetus
behind this growth. In addition, the opening of the Wescosville branch in
November 2008 has been extremely successful. Average time deposit balances at
this location were $36,086,000 for the second quarter of 2009.





Average
non-interest bearing and interest-bearing demand accounts increased $3,224,000,
or 6.2%, and $13,159,000 or 23.2%, respectively when comparing the second
quarters of 2009 and 2008. Average money market accounts increased $8,369,000,
or 17.3%, to $56,864,000 while average savings account balances increased
$4,454,000, or 9.9%, to $49,269,000 when comparing the same periods. Partially
offsetting these increases were lower average balances in municipal
interest-bearing demand accounts which decreased $9,125,000 to $28,772,000 for
the second quarter of 2009.





While
total income on earning assets on a tax-equivalent basis increased $58,000 when
comparing the second quarter of 2009 to the second quarter of 2008, total
interest expense declined $243,000. Interest expense on total deposits decreased
$199,000 while interest expense on borrowed funds decreased $44,000 when
comparing the two quarters. The rate paid on interest-bearing liabilities
decreased 55 basis points from 2.96% for the second quarter of 2008 to 2.41% for
the second quarter of 2009. During this same period, the rate paid on
interest-bearing deposits decreased 56 basis points from 2.89% to
2.33%.





Interest
expense on interest-bearing demand accounts increased $68,000, to $90,000, when
comparing the two quarters. Average interest-bearing demand accounts increased
$13,159,000, or 23.2%, when comparing the second quarters of 2009 and 2008.
During the third quarter of 2008 QNB introduced eRewards checking, a high rate
checking account paying 4.01% interest on balances up to $25,000. As of April 1,
2009, the rate paid on balances up to $25,000 was reduced to 3.25%. In order to
receive the high rate a customer must receive an electronic statement, have one
direct deposit or other ACH transaction and perform at least 12 check card
transactions per statement cycle. For the quarter, the average balance in the
product was $12,621,000 and the related interest expense was $82,000 for an
average yield of 2.61%. This lower rate than the 3.25% reflects the lower rate
paid on accounts that don’t meet the qualifications or on balances in excess of
$25,000. This account was the primary contributor to the increase in rate on
total interest-bearing demand accounts from 0.16% for the second quarter of 2008
to 0.52% for the second quarter of 2009. It is anticipated that this product
will result in the movement of balances
from lower yielding deposit accounts to this product, but will also result in
obtaining new customers and additional deposits of existing customers. This
product also generates fee income through the use of the check
card.




44




QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS




NET
INTEREST INCOME (Continued)


Interest
expense on municipal interest-bearing demand accounts decreased from $179,000
for the second quarter of 2008 to $83,000 for the same period in 2009. The
decrease in interest expense was the result of both volume and rate declines.
The average balance of municipal interest-bearing demand accounts decreased
$9,125,000, or 24.1%, while the average interest rate paid on these accounts
decreased from 1.90% for the second quarter of 2008 to 1.15% for the second
quarter of 2009. The decline in average balances accounted for $43,000 of the
decrease in interest expense while the decline in the average rate paid
contributed $53,000. Most of these accounts are tied directly to the Federal
funds rate with some having rate floors of 1.00%. It is anticipated that
the balance of municipal accounts will increase during the third quarter as
school taxes are received.





Interest
expense on money market accounts declined $27,000 to $177,000 for the second
quarter of 2009 compared to the second quarter of 2008. Interest expense related
to the increase in average balances was $35,000 while the decline in the rate
paid had the impact of decreasing interest expense by $62,000. The average
interest rate paid on money market accounts was 1.69% for the second quarter of
2008 and 1.25% for the second quarter of 2009, a decline of 44 basis points.
Included in total money market balances is the Select money market account, a
higher yielding money market product that pays a tiered rate based on account
balances. With the sharp decline in short-term interest rates, the rates paid on
the Select money market account have declined as well.





When
comparing the second quarter of 2009 to the second quarter of 2008, interest
expense on time deposits decreased $132,000. Similar to fixed-rate loans and
investment securities, time deposits reprice over time and, therefore, have less
of an immediate impact on costs in either a rising or falling rate environment.
Unlike loans and investment securities, however, the maturity and repricing
characteristics of time deposits tend to be shorter. Over the course of 2008 and
the first half of 2009 a significant amount of time deposits have repriced lower
as rates have declined. The average rate paid on time deposits decreased from
4.23% to 3.30% when comparing the three-month periods and as a result interest
expense declined by $765,000. Partially offsetting the impact of lower rates was
$633,000 in additional expense related to the 21.6% increase in average
balances.





Approximately
$251,369,000, or 76.0%, of time deposits at June 30, 2009 will reprice or mature
over the next 12 months. The average rate paid on these time deposits is
approximately 3.13%. Given the short-term nature of QNB’s time deposit portfolio
and the current rates being offered, it is likely that the average rate paid on
time deposits should continue to decline as higher costing time deposits are
repriced lower. There are still a few competitors who are offering above market
rates on time deposits which could have an impact on the rate QNB needs to pay
to retain these deposits. To date QNB has been extremely successful in retaining
and growing these balances.





Contributing
to the decrease in total interest expense was a reduction in interest expense on
short-term borrowings of $42,000. The average rate paid on short-term borrowings
declined from 2.05% for thesecond
quarter of 2008 to 1.24% for the second quarter of 2009. Short-term borrowings
are primarily comprised of repurchase agreements (a sweep product for commercial
customers). While not directly indexed to the Federal funds rate, the rate paid
on these accounts moves closely with the Federal funds rate and as a result
declined when comparing the two periods. The average balance of short-term
borrowings decreased from $18,604,000 for the second quarter of 2008 to
$17,244,000 for the second quarter of 2009.




45


QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS


NET
INTEREST INCOME (Continued)





For the
six-month period ended June 30, 2009 tax-equivalent net interest income
increased $793,000, or 7.6%. Excluding the non-recurring items recorded in 2008
of $156,000, tax-equivalent net interest income increased 9.3% compared with the
first six months of 2008. Average earning assets increased $69,808,000, or
11.9%, to $656,930,000 with average loans and investment securities increasing
9.6% and 18.5%, respectively. Average total deposits increased $69,290,000, or
13.8%, to $572,587,000 for the six month period ended June 30, 2009 compared to
the same period in 2008. The net interest margin on a tax-equivalent basis was
3.44% for the six-month period ended June 30, 2009 compared with 3.57% for the
same period in 2008. The net interest margin for the first six months of 2008
excluding the non-recurring items was 3.51%, or 7 basis points higher than the
2009 period.





Total
interest income on a tax-equivalent basis decreased $81,000, from $18,368,000 to
$18,287,000, when comparing the six-month periods ended June 30, 2008 and June
30, 2009 as the additional interest income generated from the growth in earning
assets was offset by the impact of declining yields on those assets. Interest
income increased $2,077,000 as a result of volume increases but declined
$2,158,000 as a result of lower yields. Average loans increased $36,452,000 to
$417,447,000, with average commercial real estate loans increasing $29,496,000,
or 16.4%, and average commercial and industrial loans increasing $3,792,000, or
5.5%, when comparing the six-month periods. Over this same period average
investment securities increased $36,381,000, to $233,463,000 with most of the
growth occurring in U.S. Government agency bonds or agency issued
mortgage-backed securities. The yield on earning assets decreased from 6.29% to
5.61% for the six-month periods with the yield on loans decreasing from 6.67% to
5.95% during this time. The yield on investments decreased from 5.69% to 5.11%
when comparing the six-month periods. As discussed previously, the decline in
yields reflects the impact of lower interest rates over the past year and a
half. Excluding the impact of the non-recurring loan income during the second
quarter of 2008 the yield on loans would have been 6.59% and the yield on
earning assets would have been 6.24% for the six-month period ended June 30,
2008.





Total
interest expense decreased $874,000, from $7,958,000 for the six-month period
ended June 30, 2008 to $7,084,000, for the six-month period ended June 30, 2009.
Approximately $2,033,000 of the decrease in interest expense was a result of
lower rates paid on deposits and borrowed funds. This was partially offset by an
increase in interest expense of $1,159,000 resulting primarily from deposit
growth. Lower interest expense on municipal demand deposits and time deposit
were the largest contributors to the decline in total interest expense. Interest
expense on municipal demand accounts declined by $305,000, with lower rates
contributing $180,000 and lower volume contributing $125,000 to the reduction.
The average balance of municipal demand deposits declined by $9,959,000, or
26.8%, to $27,200,000 while the average rate paid declined by 133 basis points
to 1.18%. The decline in balances relates to some of the municipalities moving
these deposits to higher paying QNB money market accounts or to other non-QNB
investment or deposit products. The decline in the rate paid reflects the
decline in the Federal funds target rate to which most of these accounts are
indexed. Interest expense on time deposits declined $365,000 with lower rates
paid reducing expense by $1,629,000 but higher volumes increasing expense by
$1,264,000. Average total time deposits increased by $58,188,000, or 21.7%, to
$325,784,000, when comparing the six-month periods with average time deposits
greater than $100,000 increasing $36,582,000, or 51.8%, to $107,176,000. As
mentioned previously, it appears that the increase in FDIC coverage is a major
factor in the increase in balances. The average rate paid on time deposits
decreased 101 basis points to 3.40% from 4.41% when comparing the six-month
periods ended June 30, 2009 and 2008.





Interest
expense on interest-bearing demand deposits increased $124,000, resulting from
both an $11,389,000, or 20.4%, increase in average balances and a 34 basis point
increase in the average rate paid. The interest rate paid on interest-bearing
demand accounts increased from 0.16% for the first half of 2008 to 0.50% for the
first half of 2009. As mentioned previously the introduction of the eRewards
checking account was the primary factor in both the growth in total
interest-bearing demand deposits as well as the increase in the rate paid.
Interest expense on money market accounts declined $154,000, resulting from a 72
basis point decline in the average rate paid from 2.03% for the first half of
2008 to 1.31% for the same period in 2009. The benefit of declining interest
rates was partially offset by additional expense resulting from a $3,342,000, or
6.8% increase in average balances. Interest expense on savings accounts declined
by $26,000 with lower rates offsetting the impact of higher balances. The rate
paid on savings accounts declined from 0.39% for the first half of 2008 to 0.25%
for the first half of 2009 while average balances increased $3,337,000, or 7.6%
over the same period. During the second quarter of 2009 QNB introduced an online
eSavings account to compete with other online savings accounts. This account
currently yields 1.85%. It is anticipated that as a result of this product both
the average balance of savings accounts as well as the average rate paid will
increase.




46




QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS


NET
INTEREST INCOME (Continued)
  Interest
expense on short-term borrowings decreased $157,000 as a result of both lower
balances and lower rates. The average rate paid decreased from 2.51% for the
first half of 2008 to 1.23% for the first half of 2009 resulting in a reduction
in interest expense of $113,000. Over this same period the average balance of
short-term borrowings, primarily commercial sweep accounts, declined by
$3,414,000 to $17,862,000.





PROVISION
FOR LOAN LOSSES





The
provision for loan losses represents management's determination of the amount
necessary to be charged to operations to bring the allowance for loan losses to
a level that represents management’s best estimate of the known and inherent
losses in the existing loan portfolio. Actual loan losses, net of recoveries,
serve to reduce the allowance.





Management
believes that it uses the best information available to make determinations
about the adequacy of the allowance and that it has established its existing
allowance for loan losses in accordance with U.S. generally accepted accounting
principles (GAAP). The determination of an appropriate level for the allowance
for loan losses is based upon an analysis of the risks inherent in QNB’s loan
portfolio. Management, in determining the allowance for loan losses, makes
significant estimates and assumptions. Since the allowance for loan losses is
dependent, to a great extent, on conditions that may be beyond QNB’s control, it
is at least reasonably possible that management’s estimates of the allowance for
loan losses and actual results could differ. In addition, various regulatory
agencies, as an integral part of their examination process, periodically review
QNB’s allowance for losses on loans. Such agencies may require QNB to
recognize changes to the allowance based on their judgments about information
available to them at the time of their examination.





Management
conducts a quarterly analysis of the appropriateness of the allowance for loan
losses. This analysis that considers a number of relevant factors including:
historical loan loss experience, general economic conditions, levels of and
trends in delinquent and non-performing loans, levels of classified loans,
trends in volume and terms of loans and concentrations of credit.





QNB
utilizes a risk weighting system that assigns a risk code to every commercial
loan. This risk weighting system is supplemented with a program that encourages
account officers to identify potentially deteriorating loan situations. The
officer analysis program is used to complement the on-going analysis of the loan
portfolio performed during the loan review function. In addition, QNB has a
committee that meets quarterly to review the appropriateness of the allowance
for loan losses based on the current and projected status of all relevant
factors pertaining to the loan portfolio.





As a
result of the significant growth in loans, an increase in net charge-offs and
non-performing loans and current economic conditions, QNB recorded a provision
for loan losses of $500,000 in the second quarter of 2009 and $1,100,000 for the
first half of 2009. This compares to a provision of $200,000 for the second
quarter of 2008 and $425,000 for the first half 2008. Net loan charge-offs were
$352,000 for the first half of 2009 compared with $231,000
for the first half of 2008. Indirect lease financing net charge-offs were
$229,000 and $187,000 of the total net charge-offs for the first half of 2009
and 2008, respectively. This portfolio includes loans to businesses in the
trucking and construction industries which were negatively impacted by the
significant increase in fuel costs during most of 2008 and the overall slowdown
in the economy over the past year. Also contributing to charge-offs for the
first half of 2009 were losses related to one commercial borrower totaling
$110,000; part relating to a commercial and industrial loan and part relating to
residential real estate classified as other real estate owned as of June 30,
2009.




47




QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS


PROVISION
FOR LOAN LOSSES (Continued)
  As
referenced in the following table, the levels of non-performing loans and
delinquency have trended higher. At June 30, 2009 non-performing loans totaled
$4,203,000 as compared with $1,308,000 at December 31, 2008. When compared to
total loans, non-performing loans have risen from 0.32% at December 31, 2008 to
0.96% at June 30, 2009. The increase in non-performing loans relates to the
classification of one loan totaling $1,932,000 as restructured. The loan was
modified to allow for interest only payments until June 30, 2009 at which time
the original terms of the loan resumed. This loan has performed under the
modified terms and may be returned to performing status if performance is
resumed under the original terms. The other factor in the increase in
non-performing loans was an increase in non-accrual loansfrom $830,000 at
December 31, 2008 to $1,991,000 at June 30, 2009. The increase relates to loans
to a residential home builder totaling $1,339,000 that were placed on
non-accrual because of concerns over their ability to continue to perform.
Several entities related to this home builder recently filed for Chapter 11
bankruptcy.





Delinquent
loans are considered performing loans and exclude non-accrual loans,
restructured loans and loans 90 days or more past due and still accruing
interest (all of which are considered non-performing loans). Total delinquent
loans at June 30, 2009 and December 31, 2008 represent 0.93% and 0.66% of total
loans, respectively. The increase was primarily in the category of loans secured
by commercial real estate which increased by $1,673,000 to $1,968,000 at June
30, 2009. All of these loans were 30 days delinquent at June 30,
2009.





The
allowance for loan losses was $4,584,000 and $3,836,000 at June 30, 2009 and
December 31, 2008, respectively. The ratio of the allowance to total loans was
1.05% and 0.95% at the respective period end dates. The increase in the ratio
reflects the increase in the provision for loan losses recorded during 2008 and
the first half of 2009. The ratio is at a level that QNB management believes is
adequate based on its analysis.





A loan is
considered impaired, based on current information and events, if it is probable
that QNB will be unable to collect the scheduled payments of principal or
interest when due according to the contractual terms of the loan agreement.
Impaired loans are primarily those classified as non-accrual or restructured.
The measurement of impaired loans is generally based on the present value of
expected future cash flows discounted at the effective interest rate, except
that all collateral-dependent loans are measured for impairment based on the
fair value of the collateral. At June 30, 2009 and December 31, 2008, the
recorded investment in loans for which impairment had been recognized in
accordance with FASB Statement No. 114, Accounting by Creditors for
Impairment of a Loan—an amendment of FASB Statements No. 5 and 15,
totaled $3,651,000 and $824,000, respectively, of which $3,084,000 and $238,000,
respectively required no specific allowance for loan losses. The recorded
investment in impaired loans requiring a specific allowance for loan losses was
$567,000 and $586,000 at June 30, 2009 and December 31, 2008, respectively. At
June 30, 2009 and December 31, 2008 the related allowance for loan losses
associated with these loans was $151,000 and $188,000, respectively. Most of the
loans that have been identified as impaired are
collateral-dependent.





QNB has
loans to automobile dealers and residential home builders, two industries hit
hard by the recession. QNB will continue to monitor these industries and these
loans. Changes in conditions could result in the need for additional provision
for loan losses.




48




QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS


PROVISION
FOR LOAN LOSSES (Continued)





The
following table shows asset quality indicators for the periods
presented:





6/30/09
              
              
              12/31/08
              
              
              6/30/08
              
              
              12/31/07Non-performing
      loans
              
              $
              4,203
              
              
              $
              1,308
              
              
              $
              823
              
              
              $
              1,615Non-performing
      loans to total loans
              
              
              0.96
              %
              
              
              0.32
              %
              
              
              0.21
              %
              
              
              0.42
              %Delinquent
      loans
              
              
              4,049
              
              
              
              2,670
              
              
              
              1,556
              
              
              
              2,117Delinquent
      loans to total loans
              
              
              0.93
              %
              
              
              0.66
              %
              
              
              0.40
              %
              
              
              0.55
              %Total
      gross loans
              
              
              436,132
              
              
              
              403,699
              
              
              
              387,479
              
              
              
              381,704


The
following table shows detailed information and ratios pertaining to the
Company’s loans and asset quality:





June
      30,
              
              
              December
      31,2009
              
              
              2008Restructured
      loans
              
              $
              1,932
              
              
              
              -Non-accrual
      loans
              
              
              1,991
              
              
              $
              830Loans
      past due 90 days or more and still accruing interest
              
              
              280
              
              
              
              478Total
      non-performing loans
              
              
              4,203
              
              
              
              1,308Other
      real estate owned and repossessed assets
              
              
              380
              
              
              
              319Total
      non-performing assets
              
              $
              4,583
              
              
              $
              1,627Total
      loans, including loans held for sale
              
              $
              436,132
              
              
              $
              403,699Average
      total loans
              
              
              417,447
              
              
              
              382,998Allowance
      for loan losses
              
              
              4,584
              
              
              
              3,836Allowance
      for loan losses to:Non-performing
      assets
              
              
              100.03
              %
              
              
              235.81
              %Total
      loans
              
              
              1.05
              %
              
              
              0.95
              %Average
      total loans
              
              
              1.10
              %
              
              
              1.00
              %


An
analysis of loan charge-offs for the three and six months ended June 30, 2009
compared to 2008 is as follows:





For
      the Three Months
              
              
              For
      the Six MonthsEnded
      June 30,
              
              
              
              
              
              Ended
      June 30,2009
              
              
              2008
              
              
              2009
              
              
              2008Net
      charge-offs
              
              $
              136
              
              
              $
              138
              
              
              $
              352
              
              
              $
              231Net
      charge-offs (annualized) to:Total
      loans
              
              
              0.12
              %
              
              
              0.14
              %
              
              
              0.16
              %
              
              
              0.12
              %Average
      total loans
              
              
              0.13
              %
              
              
              0.14
              %
              
              
              0.17
              %
              
              
              0.12
              %Allowance
      for loan losses
              
              
              11.86
              %
              
              
              15.96
              %
              
              
              15.45
              %
              
              
              13.41
              %


49


QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS


NON-INTEREST
INCOME




Non-Interest
Income Comparison


Three
      Months Ended
                June
      30,
              
              
              Change
      from
                Prior
      Year
              
              
              Six
      Months Ended
                June
      30,
              
              
              Change
      from Prior Year2009
              
              
              2008
              
              
              Amount
              
              
              Percent
              
              
              2009
              
              
              2008
              
              
              Amount
              
              
              PercentFees
      for services to customers
              
              $
              423
              
              
              $
              428
              
              
              $
              (5
              )
              
              
              -1.2
              %
              
              $
              818
              
              
              $
              873
              
              
              $
              (55
              )
              
              
              -6.3
              %ATM
      and debit card
              
              
              256
              
              
              
              242
              
              
              
              14
              
              
              
              5.8
              %
              
              
              484
              
              
              
              461
              
              
              
              23
              
              
              
              5.0
              %Bank-owned
      life insurance
              
              
              66
              
              
              
              64
              
              
              
              2
              
              
              
              3.1
              %
              
              
              137
              
              
              
              170
              
              
              
              (33
              )
              
              
              -19.4
              %Mortgage
      servicing fees
              
              
              25
              
              
              
              21
              
              
              
              4
              
              
              
              19.0
              %
              
              
              61
              
              
              
              41
              
              
              
              20
              
              
              
              48.8
              %Net
      gain on sale of loans
              
              
              234
              
              
              
              40
              
              
              
              194
              
              
              
              485.0
              %
              
              
              402
              
              
              
              72
              
              
              
              330
              
              
              
              458.3
              %Net
      (loss) gain on invesmentsecurities
              
              
              (26
              )
              
              
              (118
              )
              
              
              92
              
              
              
              -78.0
              %
              
              
              (280
              )
              
              
              104
              
              
              
              (384
              )
              
              
              -369.2
              %Other
              
              
              89
              
              
              
              152
              
              
              
              (63
              )
              
              
              -41.4
              %
              
              
              178
              
              
              
              492
              
              
              
              (314
              )
              
              
              -63.8
              %Total
              
              $
              1,067
              
              
              $
              829
              
              
              $
              238
              
              
              
              28.7
              %
              
              $
              1,800
              
              
              $
              2,213
              
              
              $
              (413
              )
              
              
              -18.7
              %
  QNB,
through its core banking business, generates various fees and service charges.
Total non-interest income includes service charges on deposit accounts, ATM and
check card income, income on bank-owned life insurance, mortgage servicing fees,
gains and losses on the sale of investment securities and residential mortgage
loans.





Total
non-interest income for the second quarter of 2009 was $1,067,000 compared to
$829,000 for the second quarter of 2008. The primary contributors to the
$238,000 increase in non-interest income were gains on the sale of residential
mortgages which increased $194,000 and a $92,000 reduction in net losses on
investment securities. Partially offsetting these positive variances was an
increase of $97,000 in losses on other real estate owned and repossessed
assets.





Fees for
services to customers are primarily comprised of service charges on deposit
accounts. These fees decreased $5,000, or 1.2%, to $423,000 when comparing the
three-month periods. Overdraft income decreased $18,000 for the three-month
period as a result of a significant decline in the volume of overdrafts. This
appears to be a reflection of the slower economy as customers reduce their
number of transactions. In February 2009, QNB increased the per item charge for
overdrafts by $2.00. Fees on business checking accounts increased $8,000 for the
three-month period. This increase reflects the impact of a lower earnings credit
rate in the second quarter of 2009 as compared to the second quarter of 2008,
resulting from the significant decline in short-term interest rates. These
credits are applied against service charges incurred.





ATM and
debit card income is primarily comprised of transaction income on debit cards
and ATM cards and ATM surcharge income for the use of QNB’s ATM machines by
non-QNB customers. ATM and debit card income was $256,000 for the second quarter
of 2009, an increase of $14,000, or 5.8%, from the amount recorded during the
second quarter of 2008. This primarily reflects growth in ATM and debit card
transactions; however, the rate of growth has slowed as spending by both
consumers and businesses declined as the economy contracted. During the third
quarter of 2008, QNB introduced eRewards checking, a high yield checking account
which requires a minimum of twelve debit card transactions per statement cycle
to receive the high interest rate. This may result in an increase in debit card
transactions, helping offset the impact of a slowdown in spending.




50





QNB
CORP. AND SUBSIDIARY





MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL


CONDITION
AND RESULTS OF OPERATIONS





NON-INTEREST
INCOME (Continued)





Income on
bank-owned life insurance represents the earnings and death benefits on life
insurance policies on which the Bank is the owner and beneficiary. The earnings
on these policies were $66,000 and $64,000 for the three months ended June 30,
2009 and 2008, respectively. The insurance carriers reset the rates on these
policies annually taking into consideration the interest rate environment as
well as mortality costs. The existing policies have rate floors which minimize
how low the earnings rate can go. Some of these policies are currently at their
floor.





When QNB
sells its residential mortgages in the secondary market, it retains servicing
rights. A normal servicing fee is retained on all mortgage loans sold and
serviced. QNB recognizes its obligation to service financial assets that are
retained in a transfer of assets in the form of a servicing asset. The servicing
asset is amortized in proportion to, and over, the period of net servicing
income or loss. On a quarterly basis, servicing assets are assessed for
impairment based on their fair value. Mortgage servicing fees for the
three-month periods ended June 30, 2009 and 2008 were $25,000 and $21,000,
respectively. During the three months ended June 30, 2009 there was a $3,000
reversal of a portion of the valuation allowance that was recorded at December
31, 2008. Amortization expense related to the mortgage servicing asset for the
three-month periods ended June 30, 2009 and 2008 was $26,000 and $23,000,
respectively. Mortgage refinance activity increased significantly during the
first half of 2009 as residential mortgage rates declined. The increase in
amortization expense reflects the increase in refinancing activity. The average
balance of mortgages serviced for others was $73,869,000 for the second quarter
of 2009 compared to $70,085,000 for the second quarter of 2008, an increase of
5.4%. The timing of mortgage payments and delinquencies also impacts the amount
of servicing fees recorded.





The net
gain on the sale of residential mortgage loans was $234,000 and $40,000 for the
quarters ended June 30, 2009 and 2008, respectively. This $194,000 increase in
the net gain on sale of loans was a result of the increased activity in the
current low interest rate environment. Residential mortgage loans to be sold are
identified at origination. The net gain on residential mortgage sales is
directly related to the volume of mortgages sold and the timing of the sales
relative to the interest rate environment. Included in the gains on the sale of
residential mortgages in these periods were $76,000 and $28,000, respectively,
related to the recognition of mortgage servicing assets. Proceeds from the sale
of residential mortgages were $10,263,000 and $3,770,000 for the second quarters
of 2009 and 2008, respectively.





The
fixed-income securities portfolio represents a significant portion of QNB’s
earning assets and is also a primary tool in liquidity and asset/liability
management. QNB actively manages its fixed income portfolio in an effort to take
advantage of changes in the shape of the yield curve and changes in spread
relationships in different sectors and for liquidity purposes. Management
continually reviews strategies that will result in an increase in the yield or
improvement in the structure of the investment portfolio.





Net
investment securities losses were $26,000 for the quarter ended June 30, 2009,
which included a $125,000 charge related to other-than-temporary impairment
(OTTI) in the carrying value of holdings in the equity investment portfolio and
an $8,000 OTTI charge on one issue in the pooled trust preferred securities
portfolio. During the second quarter of 2009, QNB realized gains of $107,000 on
the sale of equity securities. For the three-months ended June 30, 2008, QNB
recorded net securities losses of $118,000, which included a $198,000 charge
related to OTTI in the carrying value of holdings in the equity investment
portfolio that were written down at the end of June 2008. Also included in the
net securities losses for the second quarter of 2008 were net realized gains of
$79,000 on the sale of equity securities owned by the Company and gains of
$1,000 from the sale of corporate bonds by the Bank. At the end of June 2008,
the Company identified several equity holdings as other-than-temporarily
impaired and wrote down their value by $198,000.




51


QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS


NON-INTEREST
INCOME (Continued)





Other
income was $89,000 for the second quarter of 2009 and $152,000 for the same
period during 2008. The majority of the difference was caused by the
following:




·
            Valuation
      writedown of $66,000 on other real estate owned in
  2009.




·
            Loss
      on sale of repossessed assets was $31,000 higher than the second quarter
      of 2008.




·
            Merchant
      income increased $26,000, or 66.4%, for the three-month period which is
      attributable to a change in vendor and new merchant accounts being
      obtained.




·
            Letter
      of credit fees increased $12,000 mainly as a result of a quarterly fee
      related to a letter of credit participation which was entered into during
      the fourth quarter of 2008.




·
            Income
      from investment in title insurance company increased by $9,000 as a result
      of increased mortgage activity.




·
            Income
      related to official check program decreased $11,000 due to ending our
      relationship with our third-party provider and running the entire process
      internally.





Total
non-interest income for the six-month periods ended June 30, 2009 and 2008 was
$1,800,000 and $2,213,000, respectively. Positively impacting non-interest
income for the first half of 2008 was the recognition of $230,000 of income as a
result of the Visa initial public offering and $48,000 from the proceeds of life
insurance.





Fees for
services to customers decreased $55,000, or 6.3%, to $818,000 for the six months
ended June 30, 2009. Overdraft income declined $79,000 while fees on business
checking accounts increased $17,000 when comparing the six month
periods.





For the
six-month period, gains on the sale of residential mortgages increased $330,000
to $402,000 as mortgage originations and sales volume increased as a result of
lower interest rates. Included in the gains on the sale of residential mortgages
in these periods were $134,000 and $53,000, respectively, related to the
recognition of mortgage servicing assets. Proceeds from the sale of residential
mortgages were $17,948,000 and $7,048,000 for the first six months of 2009 and
2008, respectively.





Net
investment securities losses were $280,000 for the six months ended June 30,
2009. This compares to $104,000 of net securities gains in the first half of
2008. The net securities losses for 2009 include a $515,000 charge related to
other-than-temporary impairment (OTTI) in the carrying value of holdings in the
equity investment portfolio and an $8,000 OTTI charge on one pooled trust
preferred security. During the first six months of 2009 QNB recognized gains of
$107,000 on the sale of marketable equity securities and gains of $136,000 on
the sale of corporate bonds. The corporate bonds were sold to reduce credit risk
in the portfolio. Included in net securities gains in 2008 were gains on the
sale of debt and equity securities of $67,000 and $235,000, respectively and an
OTTI charge of $198,000 in the equity portfolio.





Other
income was $178,000 for the first six months of 2009 and $492,000 for the same
period during 2008. The majority of the difference was caused by the
following:




·
            Visa
      income of $230,000 recorded in 2008




·
            Valuation
      writedown of $66,000 on other real estate owned in
  2009




·
            Loss
      on sale of repossessed assets was $75,000 higher in 2009 than
      2008.




·
            Merchant
      income increased $38,000.




·
            Letter
      of credit fees increased $34,000.




·
            Income
      related to official check program decreased
  $27,000.




52


QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS


NON-INTEREST
EXPENSE




Non-Interest
      Expense ComparisonThree
      Months Ended
              June
      30,
            
            
            Change
      from
              Prior
      Year
            
            
            Six
      Months Ended
              June
      30,
            
            
            Change
      from Prior Year2009
            
            
            2008
            
            
            Amount
            
            
            Percent
            
            
            2009
            
            
            2008
            
            
            Amount
            
            
            PercentSalaries
      and employee benefits
            
            $
            2,078
            
            
            $
            1,955
            
            
            $
            123
            
            
            
            6.3
            %
            
            $
            4,156
            
            
            $
            3,926
            
            
            $
            230
            
            
            
            5.9
            %Net
      occumpancy
            
            
            335
            
            
            
            333
            
            
            
            2
            
            
            
            0.6
            %
            
            
            688
            
            
            
            673
            
            
            
            15
            
            
            
            2.2
            %Furniture
      and equipment
            
            
            309
            
            
            
            286
            
            
            
            23
            
            
            
            8.0
            %
            
            
            605
            
            
            
            575
            
            
            
            30
            
            
            
            5.2
            %Marketing
            
            
            189
            
            
            
            172
            
            
            
            17
            
            
            
            9.9
            %
            
            
            364
            
            
            
            325
            
            
            
            39
            
            
            
            12.0
            %Third-party
      services
            
            
            267
            
            
            
            205
            
            
            
            62
            
            
            
            30.2
            %
            
            
            497
            
            
            
            393
            
            
            
            104
            
            
            
            26.5
            %Telephone,
      postage and supplies
            
            
            156
            
            
            
            143
            
            
            
            13
            
            
            
            9.1
            %
            
            
            305
            
            
            
            304
            
            
            
            1
            
            
            
            0.3
            %State
      taxes
            
            
            133
            
            
            
            130
            
            
            
            3
            
            
            
            2.3
            %
            
            
            268
            
            
            
            260
            
            
            
            8
            
            
            
            3.1
            %FDIC
      insurance premiums
            
            
            539
            
            
            
            75
            
            
            
            464
            
            
            
            618.7
            %
            
            
            732
            
            
            
            109
            
            
            
            623
            
            
            
            571.6
            %Other
            
            
            378
            
            
            
            284
            
            
            
            94
            
            
            
            33.1
            %
            
            
            698
            
            
            
            561
            
            
            
            137
            
            
            
            24.4
            %Total
            
            $
            4,384
            
            
            $
            3,583
            
            
            $
            801
            
            
            
            22.4
            %
            
            $
            8,313
            
            
            $
            7,126
            
            
            $
            1,187
            
            
            
            16.7
            %




Non-interest
expense is comprised of costs related to salaries and employee benefits, net
occupancy, furniture and equipment, marketing, third-party services and various
other operating expenses. Total non-interest expense was $4,384,000 for the
second quarter of 2009, an increase of $801,000 from the second quarter of 2008.
The largest contributing factor to the increase in non-interest expense was FDIC
insurance premium expense which increased $464,000 to $539,000, comparing the
second quarter of 2009 to 2008. The higher expense is a result of the special
assessment of $332,000 and an increased assessment rate which were both levied
on all insured institutions by the FDIC in order to replenish the Deposit
Insurance Fund. Strong deposit growth along with QNB’s participation in the
FDIC’s Transaction Account Guarantee Program also contributed to the higher
premiums.





Salaries
and benefits is the largest component of non-interest expense. Salaries and
benefits expense increased $123,000, or 6.3%, to $2,078,000 for the quarter
ended June 30, 2009 compared to the same quarter in 2008. Salary expense
increased $82,000, or 5.2%, during the period to $1,655,000. Prior year salary
expense included a $51,000 accrual for incentive compensation. There was no
accrual for incentive compensation during the second quarter of 2009. Excluding
the incentive compensation accrual, salary expense increased 8.8% when comparing
the second quarter of 2009 and 2008. Merit increases, as well as an increase in
the average number of full-time equivalent employees accounts for the higher
salary expense. The average number of full time-equivalent employees increased
by eight when comparing the second quarter of 2009 and 2008. Additional
commercial lending personnel and the staffing of the Wescosville branch, opened
in November 2008, account for the majority of the increase. Comparing the two
quarters, benefits expense increased $41,000, or 10.7%, to $423,000. Increases
in payroll tax expense, retirement plan contribution expense and medical and
life insurance premium expense all contributed to the increase in benefit
expense.





Furniture
and equipment expense increased $23,000 to $309,000 for the three months ended
June 30, 2009. An increase in depreciation expense and equipment maintenance
costs were the primary contributors to the higher expense.





Marketing
expense increased $17,000, to $189,000, for the quarter ended June 30, 2009. The
increase in marketing expense was a result of the timing of a customer
newsletter, an increase in sponsorships and the purchase of data for the
Customer Relationship Management system. These increases were partially offset
by a reduction in advertising expense.




53


QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS
 
 NON-INTEREST
EXPENSE (Continued)





Third-party
services are comprised of professional services, including legal, accounting,
auditing and consulting services, as well as fees paid to outside vendors for
support services of day-to-day operations. These support services include
correspondent banking services, statement printing and mailing, investment
security safekeeping and supply management services. Third-party services
expense increased $62,000 for the three months ended June 30, 2009 when
comparing the same period in 2008. Total expense was $267,000 for the second
quarter of 2009 compared to $205,000 for the second quarter of 2008. The largest
portion of the increase related to the following third-party
services:




·
            Legal
      expense increased by $24,000 primarily as a result of loan collection
      costs




·
            Consultant
      expense increased by $11,000. A consultant was used to assist in the
      revision of employee performance reviews as well as for the valuation of
      trust preferred securities.




·
            $9,000
      increase relates to vendor costs in connection with the eRewards checking
      account that was introduced during 2008. There were no such expenses for
      the first quarter of 2008.




·
            $8,000
      related to a new system to allow customers to open accounts online through
      a dedicated secure website.




·
            $6,000
      increase relates to a new service provider for outsourced Asset Liability
      reporting. In 2008, there were maintenance charges related to software
      that was utilized internally that were recorded in equipment
      maintenance.





Telephone,
postage and supplies expense increased $13,000 to $156,000, when comparing the
three-month periods. Supplies expense increased $7,000 primarily as a result of
costs related to the replacement of check card stock. Telephone expense
increased $9,000 to $45,000, when comparing the three months ended June 30, 2009
to the same period in 2008. The addition of a new branch in the fourth quarter
of 2008 as well as ongoing charges related to an upgraded Multiprotocol Label
Switching (MPLS) network were the reasons for the increase in expense compared
to the second quarter of 2008.





State tax
expense represents the accrual of the Pennsylvania shares tax, which is based on
the equity of the Bank, Pennsylvania sales and use tax and the Pennsylvania
capital stock tax. State tax expense was $133,000 for the second quarter of
2009, an increase of $3,000 compared to the same period in 2008. This increase
was a result of a higher shares tax of $7,000 resulting from an increase in the
Bank’s equity, partially offset by a reduction of $4,000 in the Company’s
capital stock tax.





Other
expense increased $94,000 to $378,000 for the second quarter of 2009. The main
contributors to the increase in this category were a $24,000 increase in service
and sales training for branch and call center personnel and $32,000 related to
expenses in connection with foreclosed real estate and repossessed assets. Also
contributing to the increase was a $33,000 increase in expenses related to the
processing of check card transactions as well as the production of replacement
cards related to a security breach at a third-party processor.





Total
non-interest expense was $8,313,000 for the six-month period ended June 30, 2009
compared to $7,126,000 for the same period in 2008, an increase of $1,187,000.
An increase in FDIC premiums accounts for $623,000 of this variance. The higher
expense is a result of the special assessment levied on all insured institutions
by the FDIC during the second quarter of 2009 as well as an increase in the
assessment rate levied on all insured institutions. These actions were taken by
the FDIC in order to replenish the Deposit Insurance Fund which has been reduced
as a result of the recent bank failures. The special assessment contributed
$332,000 of the total increase in FDIC costs. Strong deposit growth along with
QNB’s participation in the FDIC’s Transaction Account Guarantee Program also
contributed to the higher premiums. In addition, the amount of expense recorded
in the first quarter of 2008 was reduced by $130,000 by the use of the remaining
portion of a credit approved by the FDIC in 2006.




54


QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS


NON-INTEREST
EXPENSE (Continued)





Salaries
and benefits expense increased $230,000, or 5.9%, to $4,156,000 for the six
months ended June 30, 2009 compared to the same period in 2008. Salary expense
increased $161,000, or 5.1%, during the period to $3,302,000. Prior year salary
expense included a $102,000 accrual for incentive compensation. There was no
accrual for incentive compensation in 2009. Excluding the incentive compensation
accrual, salary expense increased 8.7% when comparing the six month periods. The
average number of full time-equivalent employees increased by eight when
comparing the periods. Benefits expense increased $69,000, or 8.8%, to $854,000
when comparing the six month periods. Similar to the quarter, increases in
payroll tax expense, retirement plan contribution expense and medical and life
insurance premium expense contributed to the increase in benefit
expense





Third
party service expense was $497,000 for the six month period ended June 30, 2009,
an increase of $104,000 from the same period in 2008. Contributing to this
increase were higher legal costs of $26,000 and higher consulting costs of
$10,000. The largest portion of the increase related to the following
third-party services:




·
            $8,000
      increase in fees for correspondent banking services, primarily caused by
      much lower crediting rates to help offset the fees incurred on these
      accounts.




·
            $17,000
      increase relates to vendor costs in connection with the eRewards checking
      account that was introduced during 2008. There were no such expenses for
      the first quarter of 2008.




·
            $8,000
      related to a new system to allow customers to open accounts online through
      a dedicated secure website.




·
            $14,000
      increase relates to a new service provider for outsourced Asset Liability
      reporting. In 2008, there were maintenance charges related to software
      that was utilized internally that were recorded in equipment
      maintenance.




·
            $9,000
      increase in statement printing and mailing
  expenses





Other
expense increased $137,000 to $698,000 for the six months ended June 30, 2009
compared to the same period in 2008. The primary contributors to the increase in
this category were similar to the explanations for the increase in the quarterly
expense comparisons. These included a $43,000 increase in service and sales
training and $58,000 related to expenses in connection with foreclosed real
estate and repossessed assets. Also contributing to the increase was a $34,000
increase in expenses related to the processing of check card transactions as
well as the production of replacement cards.




INCOME
TAXES





QNB
utilizes an asset and liability approach for financial accounting and reporting
of income taxes. As of June 30, 2009, QNB’s net deferred tax asset was
$1,954,000. The primary components of deferred taxes are a deferred tax asset of
$1,559,000 relating to the allowance for loan losses, a deferred tax asset of
$472,000 generated by OTTI charges on equity securities, and a deferred tax
asset of $202,000 resulting from unrealized losses on available for sale
securities. As of June 30, 2008, QNB’s net deferred tax asset was $1,872,000.
The primary components of deferred taxes are a deferred tax asset of $1,181,000
related to the allowance for loan losses, a deferred tax asset of $460,000
resulting from unrealized losses on available-for-sale securities and a deferred
tax asset of $152,000 related to impaired securities.





The
realizability of deferred tax assets is dependent upon a variety of factors,
including the generation of future taxable income, the existence of taxes paid
and recoverable, the reversal of deferred tax liabilities and tax planning
strategies. Based upon these and other factors, management believes it is more
likely than not that QNB will realize the benefits of these remaining deferred
tax assets. The net deferred tax asset is included in other assets on the
consolidated balance sheet.




55


QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS


INCOME
TAXES (Continued)





Applicable
income taxes and effective tax rates were $276,000, or 18.4%, for the
three-month period ended June 30, 2009, and $496,000, or 23.6%, for the same
period in 2008. For the six-month periods ended June 30, 2009 and 2008
applicable income taxes and the effective tax rate were $467,000, or 16.8%, and
$1,016,000, or 23.5%, respectively. The lower effective tax rate for both
periods in 2009 is predominantly a result of tax-exempt income from loans and
securities comprising a higher proportion of pre-tax income.




FINANCIAL
CONDITION ANALYSIS





The
following balance sheet analysis compares average balance sheet data for the six
months ended June 30, 2009 and 2008, as well as the period ended balances as of
June 30, 2009 and December 31, 2008.





Average
earning assets for the six-month period ended June 30, 2009 increased
$69,808,000, or 11.9%, to $656,930,000 from $587,122,000 for the six months
ended June 30, 2008. The mix of earning assets changed slightly when comparing
the two periods. Average loans increased $36,452,000, or 9.6%, while average
investment securities increased $36,381,000, or 18.5%. Average loans represented
63.5% of earning assets for the first half of 2009 while average investment
securities represented 35.5% for the same period. This compares to 64.9% and
33.6% for the first half of 2008. Average Federal funds sold decreased
$4,784,000 when comparing these same periods. Given the low yield on Federal
funds sold QNB has attempted to keep these balances low by being fully invested
in debt securities or keeping excess liquidity in AAA rated money market mutual
funds which on average yielded 61 basis points more for the six months than the
average yield on Federal funds.





QNB’s
primary business is accepting deposits and making loans to meet the credit needs
of the communities it serves. Loans are the most significant component of
earning assets and growth in loans to small businesses and residents of these
communities has been a primary focus of QNB. QNB has been successful in
achieving strong growth in total loans, while at the same time maintaining asset
quality. Inherent within the lending function is the evaluation and acceptance
of credit risk and interest rate risk. QNB manages credit risk associated with
its lending activities through portfolio diversification, underwriting policies
and procedures and loan monitoring practices.





Total
loans increased 12.5% between June 30, 2008 and June 30, 2009 and increased 7.9%
since December 31, 2008. The growth in loans despite the economic environment
reflects QNB’s commitment to make credit available to its customers. The hiring
of three experienced commercial loan officers in 2008 provides support to our
continued goal of increasing loans outstanding and building customer
relationships.





Average
total commercial loans increased $33,998,000 when comparing the first six months
of 2009 to the first six months of 2008. Most of the 12.4% growth in average
commercial loans was in loans secured by real estate, either commercial or
residential properties, which increased $29,496,000, or 16.4%, to $209,396,000.
Included in this category are construction loans which increased from
$21,894,000 at December 31, 2008 to $28,254,000 at June 30, 2009. This portfolio
is diversified among different types of collateral and borrowers including: 1-4
family residential construction, medical facilities, factories, office buildings
and land development loans. Commercial and industrial loans represent commercial
purpose loans that are either secured by collateral other than real estate or
unsecured. Many of these loans are for operating lines of credit. Average
commercial and industrial loans increased $3,792,000, or 5.5%, when comparing
the average balances for the six month periods.




56


QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS


FINANCIAL
CONDITION ANALYSIS (Continued)





Indirect
lease financing receivables represent loans to small businesses that are
collateralized by equipment. These loans tend to have higher risk
characteristics but generally provide higher rates of return. These loans are
originated by third parties and purchased by QNB based on criteria specified by
QNB. The criteria include minimum credit scores of the borrower, term of the
lease, type and age of equipment financed and geographic area. The geographic
area primarily represents Pennsylvania and states contiguous to Pennsylvania.
QNB is not the lessor and does not service these loans. Average indirect lease
financing loans increased $2,039,000, or 15.8%, when comparing the six-month
periods. This increase is primarily related to a lease to the United States
Department of Agriculture and a University.





Average
residential mortgage loans increased $2,586,000, or 11.8%, when comparing the
first six months of 2009 to the first six months of 2008. Included in this
category are mortgages held-for-sale which increased on average $1,429,000
during this period. With the decline in mortgage rates during the fourth quarter
of 2008 and the first half of 2009, mortgage activity, especially refinancing
activity, has increased significantly. QNB does not originate or hold subprime
1-4 family mortgages or any other high-risk 1-4 family mortgage products. In
addition, QNB sells, but continues to service, most of the fixed rate 1-4 family
residential mortgages it originates, especially in the current low interest rate
environment.





Average
home equity loans continue to decline with average balances falling from
$68,224,000 for the first half of 2008 to $66,337,000 for the first six months
of 2009. With the decline in mortgage interest rates customers are paying down
their home equity loans when they refinance their first mortgage. The other
impact of the low interest rate environment is movement from fixed rate home
equity loans to floating rate lines tied to prime. Fixed rate home equity term
loans declined by $9,442,000 to $45,784,000 when comparing the six-month
periods. In contrast average floating rate home equity lines have increased by
$7,555,000 comparing the same periods. The introduction of the Equity Choice
product contributed to this migration.





Total
investment securities were $241,277,000 at June 30, 2009 and $223,195,000 at
December 31, 2008. The growth in the investment portfolio was primarily in high
quality U.S. Government agency and agency mortgage-backed and CMO securities and
tax-exempt State and municipal bonds which increased by $4,751,000, $16,463,000
and $3,959,000, respectively, when comparing December 31, 2008 and June 30,
2009. During the first quarter of 2009 QNB sold $6,000,000 in corporate bonds
issued by financial institutions at a gain of $136,000. These bonds were sold to
reduce credit risk in the portfolio.





Collateralized
debt obligations (CDO) are securities derived from the packaging of various
assets with many backed by subprime mortgages. These instruments are complex and
difficult to value. QNB did a review of its mortgage related securities and
concluded that it has minimal exposure to subprime mortgages within its
mortgage-backed securities portfolio and its CMO portfolio (both U.S. government
sponsored agency issued securities (FHLMC and FNMA) and non-agency issued
securities). QNB does not own any CDOs backed by subprime
mortgages.




57


QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS
 FINANCIAL CONDITION ANALYSIS
(Continued)


QNB does
own CDOs in the form of pooled trust preferred securities. These securities are
comprised mainly of securities issued by financial institutions, and to a lesser
degree, insurance companies. QNB owns the mezzanine tranches of these
securities. These securities are structured so that the senior and mezzanine
tranches are protected from defaults by over-collateralization and cash flow
default protection provided by subordinated tranches. The senior tranches have
the greatest level of protection, then the mezzanine tranches, and finally the
income note holders who have the least protection. QNB holds eight of these
securities with a book value of $5,145,000 and a fair value of $829,000. The
market for these securities at June 30, 2009 is not active and markets for
similar securities are also not active. The inactivity was evidenced first by a
significant widening of the bid-ask spread in the brokered markets in which
pooled trust preferred securities trade and then by a significant decrease in
the volume of trades relative to historical levels. The new issue market is
also inactive as no new pooled trust preferred securities have been issued since
2007. There are currently very few market participants who are willing and or
able to transact for these securities. The market values for these securities
are very depressed relative to historical levels. Thus in today’s market, a low
market price for a particular bond may only provide evidence of stress in the
credit markets in general versus being an indicator of credit problems with a
particular issuer. Although these securities are classified as
available-for-sale, the Company has the intent to hold the securities and does
not believe it will be required to sell the securities before recovery occurs.
All of the trust preferred securities are rated lower than AA and are subject to
the guidance of EITF 99-20-1. Cash flow analyses for these trust preferred
securities were prepared by a third party using various default and deferral
scenarios of the issuers to determine if there was possible
impairment. When evaluating these investments we determine a credit related
portion and a non-credit related portion of OTTI. The credit related portion is
recognized in earnings and represents the expected shortfall in future cash
flows. The non-credit related portion is recognized in other comprehensive
income and represents the difference between the fair value of the security and
the amount of credit related impairment. A discounted cash flow analysis
provides the best estimate of credit related OTTI for these
securities. During the second quarter of 2009 an $8,000
other-than-temporary impairment charge was taken on one issue. It is possible
that future calculations could require recording additional other-than-temporary
impairment charges through earnings.





For the
most part, earning assets are funded by deposits. Total average deposits
increased $69,290,000, or 13.8%, to $572,587,000 for the first half of 2009
compared to the first half of 2008. It appears that customers are looking for
the safety of FDIC insured deposits and the stability of a strong local
community bank as opposed to the volatility of the equity markets and the
uncertainty of the larger regional and national banks.





Most of
the increase in average deposits was time deposits which increased $58,188,000,
or 21.7%, to $325,784,000 for the first half of 2009. Included in this total was
$107,176,000 of time deposits of $100,000 or more, an increase of $36,582,000
from the $70,594,000 reported for the first half of 2008. Higher yields relative
to alternative investments, including other bank deposits, the opening of the
Wescosville branch in November 2008, and the increase in FDIC coverage from
$100,000 to $250,000 appear to be the impetus behind this growth.





Average
non-interest bearing and interest-bearing demand accounts increased $2,993,000,
or 6.0%, and $11,389,000, or 20.4%, respectively, when comparing the first half
of 2009 and 2008. The high yielding eRewards checking product is the primary
factor behind the growth. Average money market and savings account balances
increased $3,342,000, or 6.8%, and $3,337,000, or 7.6%, when comparing the same
periods while the average balance of municipal interest-bearing demand accounts
decreased $9,959,000, or 26.8%. Municipalities and school districts have moved
funds to other higher yielding QNB products or to alternative investments
outside of QNB.





Total
assets at June 30, 2009 were $717,735,000 compared with $664,394,000 at December
31, 2008, an increase of 8.0%. Most of the growth in total assets since December
31, 2008 was in loans receivable and investment securities, which increased
$31,942,000 and $18,082,000, respectively. In addition, interest-bearing
deposits in banks increased by $6,951,000 as excess funds were kept in QNB’s
Federal Reserve account as a higher yielding alternative to Federal funds
sold.





On the
liability side, total deposits increased by $51,164,000, or 9.3%, since
year-end. In comparison to prior periods where the growth was centered in time
deposits, the current growth reflects increases in both lower-cost core
deposits, including checking, savings and money market accounts, as well as
higher-cost time deposits. Non-interest bearing demand accounts increased
$3,860,000, or 7.2%, to $57,140,000 and interest-bearing demand accounts
increased $3,752,000, or 3.9%, to $99,382,000. These deposits can be volatile
depending on the timing of deposits and withdrawals. The increase in
interest-bearing demand accounts was primarily in the eRewards checking account product
whose balances increased from $6,897,000 at December 31, 2008 to $14,020,000 at
June 30, 2009. Personal interest-bearing demand accounts declined by $3,156,000
during this same time period.




58


QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS
 FINANCIAL
CONDITION ANALYSIS (Continued)


Money
market accounts increased $17,941,000, or 39.4%, from December 31, 2008 to
$63,513,000 at June 30, 2009. Personal money market accounts increased by
$7,097,000 while business accounts increased by $10,844,000. Savings account
balances increased from $44,006,000 at December 31, 2008 to $49,998,000 at June
30, 2009, an increase of 13.6%. During the second quarter of 2009 QNB introduced
an online eSavings account to compete with other online savings accounts. This
account currently yields 1.85% and had balances of $802,000 as of June 30,
2009.





Time
deposits continued to grow, increasing $19,619,000 since December 31, 2008. The
addition of the Wescosville branch during the fourth quarter of 2008 contributed
to the growth in both total deposits and time deposits. Total deposits at this
branch were $40,706,000 at June 30, 2009 compared with $22,479,000 at December
31, 2008. Included in these amounts were time deposits of $36,392,000 and
$22,377,000, respectively at June 30, 2009 and December 31, 2008.




LIQUIDITY





Liquidity
represents an institution’s ability to generate cash or otherwise obtain funds
at reasonable rates to satisfy demand for loans and deposit withdrawals. QNB
attempts to manage its mix of cash, Federal funds sold and investment securities
in order to match the volatility, seasonality, interest sensitivity and growth
trends of its loans and deposits. The Company manages its liquidity risk by
measuring and monitoring its liquidity sources and estimated funding needs.
Liquidity is provided from asset sources through maturities and repayments of
loans and investment securities. The portfolio of investment securities
classified as available-for-sale and QNB's policy of selling certain residential
mortgage originations in the secondary market also provide sources of liquidity.
Core deposits and cash management repurchase agreements have historically been
the most significant funding source for QNB. These deposits and repurchase
agreements are generated from a base of consumers, businesses and public funds
primarily located in the Company’s market area. QNB faces increased competition
for these funds from various financial institutions.





Additional
sources of liquidity are provided by the Bank’s membership in the FHLB. At June
30, 2009, the Bank had a maximum borrowing capacity with the FHLB of
approximately $119,506,000. At June 30, 2009, QNB had $10,000,000 in outstanding
borrowings from the FHLB at a rate of 2.97%. These borrowings mature in January
2010. The maximum borrowing capacity changes as a function of qualifying
collateral assets. In addition, the Bank maintains Federal funds lines with two
correspondent banks totaling $18,000,000. At June 30, 2009, there were no
outstanding borrowings under these lines. Future availability under these lines
is subject to the policies of the granting banks and may be
withdrawn.





Cash and
due from banks, interest-bearing deposits in banks, Federal funds sold,
investment securities available-for-sale and loans held-for-sale totaled
$258,640,000 and $236,168,000 at June 30, 2009 and December 31, 2008,
respectively. The increase in liquidity sources is primarily the result of an
increase of the available-for-sale securities portfolio and interest-bearing
deposits held at the Federal Reserve Bank. These sources should be adequate to
meet normal fluctuations in loan demand and deposit withdrawals. With the
current low interest rate environment, it is anticipated that the investment
portfolio will continue to provide significant liquidity as agency and municipal
bonds are called and as cash flow on mortgage-backed and CMO securities
continues to be steady.




59


QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS


LIQUIDITY
(Continued)





Approximately
$101,849,000 and $101,302,000 of available-for-sale securities at June 30, 2009
and December 31, 2008, respectively, were pledged as collateral for repurchase
agreements and deposits of public funds.





In 2008,
QNB opted into the FDIC’s Transaction Account Guarantee Program. This program
provides unlimited deposit insurance for non-interest bearing transaction
accounts. This program expires December 31, 2009.





As an
additional source of liquidity, QNB has made the decision to become a
member of the Certificate of Deposit Account Registry Service (CDARS)
program offered by the Promontory Interfinancial Network, LLC. CDARS is a
funding and liquidity management tool that is used by banks to access funds and
manage its balance sheet. It enables financial institutions to provide customers
with full FDIC insurance on time deposits over $250,000.




CAPITAL
ADEQUACY





A strong
capital position is fundamental to support continued growth and profitability
and to serve the needs of depositors. QNB's shareholders' equity at June 30,
2009 was $53,808,000, or 7.50% of total assets, compared to shareholders' equity
of $53,909,000, or 8.11% of total assets, at December 31, 2008. Shareholders’
equity at June 30, 2009 included a negative adjustment of $392,000 related to
unrealized holding losses, net of taxes, on investment securities
available-for-sale while shareholders’ equity at December 31, 2008 included a
negative adjustment of $233,000 related to unrealized holding losses, net of
taxes, on investment securities available-for-sale. Without these adjustments,
shareholders' equity to total assets would have been 7.55% and 8.15% at June 30,
2009 and December 31, 2008, respectively.





Average
shareholders' equity and average total assets were $54,422,000 and $684,454,000
for the first six months of 2009, an increase of 1.7% and 8.4%, respectively,
from the averages for the year ended December 31, 2008. The ratio of average
total equity to average total assets was 7.95% for the first six months of 2009
compared to 8.47% for all of 2008.





QNB is
subject to various regulatory capital requirements as issued by Federal
regulatory authorities. Regulatory capital is defined in terms of Tier I capital
(shareholders’ equity excluding unrealized gains or losses on available-for-sale
debt securities and disallowed intangible assets), Tier II capital, which
includes the allowance for loan losses and a portion of the unrealized gains on
equity securities, and total capital (Tier I plus Tier II). Risk-based capital
ratios are expressed as a percentage of risk-weighted assets. Risk-weighted
assets are determined by assigning various weights to all assets and off-balance
sheet arrangements, such asletters of credit and
loan commitments, based on associated risk. Regulators have also adopted minimum
Tier I leverage ratio standards, which measure the ratio of Tier I capital to
total quarterly average assets.




60


QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS


CAPITAL
ADEQUACY (Continued)





The
following table sets forth consolidated information for QNB Corp.:




Capital
Analysis


June
      30,
              2009
            
            
            December
      31,
              2008Tier
      IShareholder's
      Equity
            
            $
            53,808
            
            
            $
            53,909Net
      unrealized securities losses
            
            
            392
            
            
            
            233Net
      unrealized losses on available-for-sale equity securities
            
            
            -
            
            
            
            (246
            )Total
      Tier I risk-based capital
            
            $
            54,200
            
            
            $
            53,896Tier
      IIAllowable
      portion: Allowance for loan losses
            
            
            4,584
            
            
            
            3,836Unrealized
      gains on equity securities
            
            
            35
            
            
            
            -Total
      risk-based capital
            
            $
            58,819
            
            
            $
            57,732Risk-weighted
      assets
            
            $
            521,147
            
            
            $
            466,721Average
      assets
            
            $
            702,665
            
            
            $
            648,110




Capital
Ratios




June
      30,
              2009
            
            
            December
      31,
              2008Tier
      I capital/risk-weighted assets
            
            
            10.40
            %
            
            
            11.55
            %Total
      risk-based capital/risk-weighted assets
            
            
            11.29
            %
            
            
            12.37
            %Tier
      I capital/average assets (leverage ratio)
            
            
            7.71
            %
            
            
            8.32
            %




The
minimum regulatory capital ratios are 4.00% for Tier I, 8.00% for the total
risk-based capital and 4.00% for leverage. QNB had a Tier I capital ratio of
10.40% and 11.55%, a total risk-based ratio of 11.29% and 12.37% and a leverage
ratio of 7.71% and 8.32% at June 30, 2009 and December 31, 2008,
respectively.





The
decline in capital ratios from December 31, 2008 was a result of asset growth
exceeding the growth rate of capital. Capital levels were impacted by the
decision to repurchase common stock as well as the decision to increase the cash
dividend during the first quarter of 2009. On January 24, 2008, QNB announced
that the Board of Directors authorized the repurchase of up to 50,000 shares of
its common stock in open market or privately negotiated transactions. The
repurchase authorization does not bear a termination date. On February 9, 2009,
the Board of Directors approved increasing the authorization to 100,000 shares.
As of June 30, 2009, 57,883 shares were repurchased under this authorization at
an average price of $16.97 and a total cost of $982,000. As of June 30, 2008,
QNB had not repurchased any shares.




61


QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS


CAPITAL
ADEQUACY (Continued)





Also
impacting the regulatory capital ratios was an increase in risk-weighted assets
during the first half of 2009. Loan growth, primarily centered in commercial
loans, accounted for approximately $33.3 million of the growth in risk-weighted
assets while $29.4 million of the increase in risk-weighted assets was due to
mezzanine tranches of pooled trust preferred securities that were downgraded
below investment grade during the first quarter of 2009. Although the amortized
cost of these securities was only $5,145,000 at June 30, 2009, regulatory
guidance required an additional $29,370,000 to be included in risk-weighted
assets. The Bank utilized the method as outlined in the Call Report Instructions
for an available-for-sale bond that has not triggered the Low Level Exposure
(LLE) rule. The mezzanine tranches of CDOs that utilized this method of
risk-weighting are 5 out of 8 pooled trust preferred securities (PreTSLs) held
by the Bank as of June 30, 2009. The other 3 pooled trust preferred securities
have only one tranche remaining so the treatment noted above does not apply.
Partially offsetting these increases in risk-weighted assets was a decline of
approximately $6.3 million of off-balance sheet items including letters of
credit and unused commitments.





The
Federal Deposit Insurance Corporation Improvement Act of 1991 established five
capital level designations ranging from "well capitalized" to "critically
undercapitalized." At June 30, 2009 and December 31, 2008, management believes
that the Company and the Bank met all capital adequacy requirements to which
they are subject and have met the "well capitalized" criteria which requires
minimum Tier I and total risk-based capital ratios of 6.00% and 10.00%,
respectively, and a leverage ratio of 5.00%.




INTEREST
RATE SENSITIVITY





Since the
assets and liabilities of QNB have diverse repricing characteristics that
influence net interest income, management analyzes interest sensitivity through
the use of gap analysis and simulation models. Interest rate sensitivity
management seeks to minimize the effect of interest rate changes on net interest
margins and interest rate spreads and to provide growth in net interest income
through periods of changing interest rates. QNB’s Asset/Liability Management
Committee (ALCO) is responsible for managing interest rate risk and for
evaluating the impact of changing interest rate conditions on net interest
income.





Gap
analysis measures the difference between volumes of rate-sensitive assets and
liabilities and quantifies these repricing differences for various time
intervals. Static gap analysis describes interest rate sensitivity at a point in
time. However, it alone does not accurately measure the magnitude of changes in
net interest income because changes in interest rates do not impact all
categories of assets and liabilities equally or simultaneously. Interest rate
sensitivity analysis also involves assumptions on certain categories of assets
and deposits. For purposes of interest rate sensitivity analysis, assets and
liabilities are stated at their contractual maturity, estimated likely call
date, or earliest repricing opportunity. Mortgage-backed securities, CMOs and
amortizing loans are scheduled based on their anticipated cash flow.
Interest-bearing demand accounts, money market accounts and savings accounts do
not have stated maturities or repricing terms and can be withdrawn or repriced
at any time. This may impact QNB’s margin if more expensive alternative sources
of deposits or borrowed funds are required to fund loans or deposit runoff.
Management projects the repricing characteristics of these accounts based on
historical performance and assumptions that it believes reflect their rate
sensitivity.





A
positive gap results when the amount of interest rate sensitive assets exceeds
interest rate sensitive liabilities. A negative gap results when the amount of
interest rate sensitive liabilities exceeds interest rate sensitive
assets.




62


QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS


INTEREST
RATE SENSITIVITY (Continued)





QNB also
uses a simulation model to assess the impact of changes in interest rates on net
interest income. The model reflects management’s assumptions related to asset
yields and rates paid on liabilities, deposit sensitivity, and the size,
composition and maturity or repricing characteristics of the balance sheet. The
assumptions are based on the interest rate environment at period end. Management
also evaluates the impact of higher and lower interest rates by simulating the
impact on net interest income of changing rates. While management performs rate
shocks of 100, 200 and 300 basis points, it believes that, given the level of
interest rates at June 30, 2009, it is unlikely that interest rates would
decline by 200 or 300 basis points. The simulation results can be found in the
chart below.





Net
interest income declines in a falling rate environment. This result reflects
that income on earning assets would decline to a greater degree than the expense
associated with interest-bearing liabilities. In a lower rate environment, the
cash flow or repricing characteristics from both the loan and investment
portfolios would increase and be reinvested at lower rates resulting in less
income. Loan customers would likely either refinance their fixed rate loans at
lower rates or request rate reductions on their existing loans. While interest
expense on time deposits would decrease, the interest rate floors on some
municipal interest-bearing demand accounts, hypothetical interest rate floors on
interest-bearing transaction accounts, regular money market accounts and savings
accounts would prevent a reduction in interest expense on these accounts. In a
rising rate environment net interest income increases as loans and investments
reprice more than rates on interest-bearing liabilities. The rate of increase in
net interest income declines the more rates increase because prepayments and
calls on investments and loans slow resulting in fewer amounts repricing at
higher rates. Actual results may differ from simulated results due to various
factors including time, magnitude and frequency of interest rate changes, the
relationship or spread between various rates, loan pricing and deposit
sensitivity, and asset/liability strategies.





Management
believes that the assumptions utilized in evaluating the vulnerability of QNB’s
net interest income to changes in interest rates approximate actual experience.
However, the interest rate sensitivity of QNB’s assets and liabilities as well
as the estimated effect of changes in interest rates on net interest income
could vary substantially if different assumptions are used or actual experience
differs from the experience on which the assumptions were based.





The
nature of QNB’s current operation is such that it is not subject to foreign
currency exchange or commodity price risk. At June 30, 2009, QNB did not have
any hedging transactions in place such as interest rate swaps, caps or
floors.





The table
below summarizes estimated changes in net interest income over a twelve-month
period, under alternative interest rate scenarios.





Change
      in Interest Rates
            
            Net
      Interest
              Income
            
            
            Dollar
      Change
            
            
            %
      Change+300
      Basis Points
            
            $
            25,286
            
            
            $
            1,379
            
            
            
            5.77
            %+200
      Basis Points
            
            
            24,888
            
            
            
            981
            
            
            
            4.10+100
      Basis Points
            
            
            24,421
            
            
            
            514
            
            
            
            2.15Flat
      Rate
            
            
            23,907
            
            
            
            -
            
            
            
            --100
      Basis Points
            
            
            23,370
            
            
            
            (537
            )
            
            
            (2.25
            )





63


QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS


ITEM
3.     QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT
MARKET RISK.





The
information required in response to this item is set forth in Item 2,
above.




ITEM
4.     CONTROLS AND PROCEDURES





We
maintain a system of controls and procedures designed to provide reasonable
assurance as to the reliability of the consolidated financial statements and
other disclosures included in this report, as well as to safeguard assets from
unauthorized use or disposition. We evaluated the effectiveness of the design
and operation of our disclosure controls and procedures under the supervision
and with the participation of management, including our Chief Executive Officer
and Chief Financial Officer. Based upon that evaluation, our Chief Executive
Officer and Chief Financial Officer concluded that our disclosure controls and
procedures are effective as of the end of the period covered by this report. No
changes were made to our internal control over financial reporting during the
fiscal quarter covered by this report that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.





64




QNB
CORP. AND SUBSIDIARY




PART
II.  OTHER INFORMATION




JUNE
30, 2009





Item
1.       Legal
Proceedings




None.





Item
1A.    Risk
Factors




There
were no material changes to the Risk Factors described in Item 1A in QNB’s
Annual Report on Form 10-K for the period ended December 31, 2008.





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





Period
            
            Total
      Number of Shares Purchased
            
            
            Average
      Price Paid per Share
            
            
            Total
      Number of Shares Purchased as Part of Publicly Announced
    Plan
            
            
            Maximum
      Number of Shares that may yet be Purchased Under the PlanApril
      1, 2009 through April 30, 2009
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            42,117May
      1, 2009 through May 31, 2009
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            42,117June
      1, 2009 through June 30, 2009
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            42,117Total
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            42,117




(1)
              Transactions
      are reported as of settlement
dates.
  (2)
              QNB’s
      current stock repurchase plan was approved by its Board of Directors and
      announced onJanuary
      24, 2008 and subsequently increased on February 9,
  2009.
  (3)
              The
      number of shares approved for repurchase under QNB’s current stock
      repurchase plan is 100,000as
      of the filing of this Form 10-Q.
  (4)
              QNB’s
      current stock repurchase plan has no expiration
  date.
  (5)
              QNB
      has no stock repurchase plan that it has determined to terminate or under
      which it does notintend
      to make further purchases.




Item
3.       Default Upon Senior
Securities




None.





Item
4.       Submission of Matters to
Vote of Security Holders




The 2009
Annual Meeting (the Meeting) of the shareholders of QNB Corp. (the Registrant)
was held on May 19, 2009. A Notice of the Meeting was mailed to shareholders of
record as of April 6, 2009 on or about April 20, 2009, together with proxy
solicitation materials prepared in accordance with Section 14(a) of the
Securities Exchange Act of 1934, as amended, and the regulations promulgated
thereunder.




65





The
Meeting was held for the following purposes:




(1) To
elect three (3) Directors





There was
no solicitation in opposition to the nominees of the Board of Directors for
election to the Board of Directors and all such nominees were elected. The
number of votes cast for or withheld for each of the nominees for election to
the Board of Directors was as follows:





Nominee
            
            For
            
            
            WithholdThomas
      J. Bisko
            
            
            2,437,275
            
            
            
            23,567Dennis
      Helf
            
            
            2,437,235
            
            
            
            23,607G.
      Arden Link
            
            
            2,435,491
            
            
            
            25,351





The
continuing directors of the Registrant are:




Kenneth
F. Brown, Jr., Charles M. Meredith, III, Anna Mae Papso, Gary S. Parzych, Bonnie
L. Rankin, Henry L. Rosenberger, and Edgar L. Stauffer





Item
5.       Other
Information




None.





Item
6.       Exhibits




Exhibit  3(i)
            
            Articles
      of Incorporation of Registrant, as amended. (Incorporated by reference to
      Exhibit 3(i) of Registrants Form DEF 14-A filed with the Commission on
      April 15, 2005).Exhibit  3(ii)
            
            Bylaws
      of Registrant, as amended. (Incorporated by reference to Exhibit 3(ii) of
      Registrants Form 8-K filed with the Commission on January 23,
      2006).Exhibit  11
            
            Statement
      Re: Computation of Earnings Per Share. (Included in Part I, Item I,
      hereof.)Exhibit
      31.1
            
            Section
      302 Certification of President and CEOExhibit
      31.2
            
            Section
      302 Certification of Chief Financial OfficerExhibit
      32.1
            
            Section
      906 Certification of President and CEOExhibit
      32.2
            
            Section
      906 Certification of Chief Financial
Officer





66





SIGNATURES




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




QNB
      Corp.Date:August 14,
2009
              By:
              /s/
      Thomas J. BiskoThomas
      J. BiskoPresident/CEO


Date:August 14,
      2009
              By:
              /s/ Bret H.
      KrevolinBret
      H. KrevolinChief
      Financial Officer
  67