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 September 30,
2009




OR




o
            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 þNo 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 filero
            Accelerated
      fileroNon-accelerated
      filero
            Smaller
      Reporting Company þ





Indicate
by check mark whether the Registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act). Yes o No þ





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 November 11, 2009Common
      Stock, par value $0.625
            3,089,382









QNB
CORP. AND SUBSIDIARY


FORM
10-Q


QUARTER
ENDED SEPTEMBER 30, 2009





INDEX





PART
I - FINANCIAL INFORMATION





PAGEITEM
      1.
            
            CONSOLIDATED
      FINANCIAL STATEMENTS (Unaudited)Consolidated
      Balance Sheets at September 30, 2009and December 31,
      2008
            
            3Consolidated
      Statements of Income for the Three and NineMonths Ended September
      30, 2009 and 2008
            
            4Consolidated
      Statement of Shareholders’ Equity for the NineMonths Ended
      September 30, 2009
            
            5Consolidated
      Statements of Cash Flows for the NineMonths Ended September 30,
      2009 and 2008
            
            6Notes
      to Consolidated Financial Statements
            
            7ITEM
      2.
            
            MANAGEMENT'S
      DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
      OPERATIONS
            
            30ITEM
      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
            
            66SIGNATURESCERTIFICATIONS




2




QNB Corp. and
Subsidiary





CONSOLIDATED BALANCE
SHEETS





(in
      thousands, except share data)
              (unaudited)September
      30,
              2009
            
            
            December
      31,
              2008AssetsCash
      and due from banks
            
            $
            7,902
            
            
            $
            10,634Interest-bearing
      deposits in banks
            
            
            10,417
            
            
            
            1,276Federal
      funds sold
            
            
            –
            
            
            
            4,541Total
      cash and cash equivalents
            
            
            18,319
            
            
            
            16,451Investment
      securitiesAvailable-for-sale
      (amortized cost $245,443 and $219,950)
            
            
            250,432
            
            
            
            219,597Held-to-maturity
      (fair value $3,493 and $3,683)
            
            
            3,347
            
            
            
            3,598Restricted
      investment in bank stocks
            
            
            2,291
            
            
            
            2,291Loans
      held-for-sale
            
            
            608
            
            
            
            120Loans
      receivable
            
            
            437,460
            
            
            
            403,579Allowance
      for loan losses
            
            
            (5,573
            )
            
            
            (3,836
            )Net
      loans
            
            
            431,887
            
            
            
            399,743Bank-owned
      life insurance
            
            
            9,003
            
            
            
            8,785Premises
      and equipment, net
            
            
            6,288
            
            
            
            6,661Accrued
      interest receivable
            
            
            2,934
            
            
            
            2,819Other
      assets
            
            
            3,116
            
            
            
            4,329Total
      assets
            
            $
            728,225
            
            
            $
            664,394LiabilitiesDepositsDemand,
      non-interest bearing
            
            $
            50,113
            
            
            $
            53,280Interest-bearing
      demand
            
            
            106,396
            
            
            
            95,630Money
      market
            
            
            68,418
            
            
            
            45,572Savings
            
            
            52,983
            
            
            
            44,006Time
            
            
            216,865
            
            
            
            206,336Time
      of $100,000 or more
            
            
            109,384
            
            
            
            104,966Total
      deposits
            
            
            604,159
            
            
            
            549,790Short-term
      borrowings
            
            
            26,819
            
            
            
            21,663Long-term
      debt
            
            
            35,000
            
            
            
            35,000Accrued
      interest payable
            
            
            3,003
            
            
            
            2,277Other
      liabilities
            
            
            1,810
            
            
            
            1,755Total
      liabilities
            
            
            670,791
            
            
            
            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
            
            
            10,154
            
            
            
            10,057Retained
      earnings
            
            
            44,430
            
            
            
            43,667Accumulated
      other comprehensive income (loss), net
            
            
            3,292
            
            
            
            (233
            )Treasury
      stock, at cost; 164,569 and 113,344 shares
            
            
            (2,476
            )
            
            
            (1,610
            )Total
      shareholders' equity
            
            
            57,434
            
            
            
            53,909Total
      liabilities and shareholders' equity
            
            $
            728,225
            
            
            $
            664,394




The
accompanying notes are an integral part of the unaudited consolidated financial
statements.





3





QNB Corp. and
Subsidiary





CONSOLIDATED STATEMENTS OF
INCOME





(in
      thousands, except share data)
              (unaudited)Three
      Months
              Ended
      September 30,
            
            
            Nine
      Months
              Ended
      September 30,2009
            
            
            2008
            
            
            2009
            
            
            2008Interest
      IncomeInterest
      and fees on loans
            
            $
            6,389
            
            
            $
            6,005
            
            
            $
            18,451
            
            
            $
            18,399Interest
      and dividends on investment securities:Taxable
            
            
            1,981
            
            
            
            2,291
            
            
            
            6,361
            
            
            
            6,491Tax-exempt
            
            
            571
            
            
            
            466
            
            
            
            1,609
            
            
            
            1,385Interest
      on Federal funds sold
            
            
            –
            
            
            
            56
            
            
            
            2
            
            
            
            138Interest
      on interest-bearing balances and other interest income
            
            
            5
            
            
            
            14
            
            
            
            8
            
            
            
            47Total
      interest income
            
            
            8,946
            
            
            
            8,832
            
            
            
            26,431
            
            
            
            26,460Interest
      ExpenseInterest
      on depositsInterest-bearing
      demand
            
            
            210
            
            
            
            276
            
            
            
            537
            
            
            
            784Money
      market
            
            
            184
            
            
            
            198
            
            
            
            525
            
            
            
            693Savings
            
            
            44
            
            
            
            44
            
            
            
            103
            
            
            
            129Time
            
            
            1,684
            
            
            
            2,007
            
            
            
            5,352
            
            
            
            6,298Time
      of $100,000 or more
            
            
            851
            
            
            
            768
            
            
            
            2,681
            
            
            
            2,340Interest
      on short-term borrowings
            
            
            64
            
            
            
            113
            
            
            
            173
            
            
            
            379Interest
      on long-term debt
            
            
            382
            
            
            
            381
            
            
            
            1,132
            
            
            
            1,122Total
      interest expense
            
            
            3,419
            
            
            
            3,787
            
            
            
            10,503
            
            
            
            11,745Net
      interest income
            
            
            5,527
            
            
            
            5,045
            
            
            
            15,928
            
            
            
            14,715Provision
      for loan losses
            
            
            1,500
            
            
            
            150
            
            
            
            2,600
            
            
            
            575Net
      interest income after provision for loan losses
            
            
            4,027
            
            
            
            4,895
            
            
            
            13,328
            
            
            
            14,140Non-Interest
      IncomeTotal
      other-than-temporary impairment losses on investment
      securities
            
            
            (2,279
            )
            
            
            (103
            )
            
            
            (2,850
            )
            
            
            (302
            )Less:
      Portion of loss recognized in other comprehensive income (before
      taxes)
            
            
            1,526
            
            
            
            –
            
            
            
            1,574
            
            
            
            –Net
      other-than-temporary impairment losses on investment
      securities
            
            
            (753
            )
            
            
            (103
            )
            
            
            (1,276
            )
            
            
            (302
            )Net
      gain on sale of investment securities
            
            
            103
            
            
            
            –
            
            
            
            346
            
            
            
            303Net
      (loss) gain on investment securities
            
            
            (650
            )
            
            
            (103
            )
            
            
            (930
            )
            
            
            1Fees
      for services to customers
            
            
            470
            
            
            
            474
            
            
            
            1,288
            
            
            
            1,347ATM
      and debit card
            
            
            263
            
            
            
            237
            
            
            
            747
            
            
            
            698Bank-owned
      life insurance
            
            
            66
            
            
            
            63
            
            
            
            203
            
            
            
            233Mortgage
      servicing fees
            
            
            28
            
            
            
            31
            
            
            
            89
            
            
            
            72Net
      gain on sale of loans
            
            
            132
            
            
            
            13
            
            
            
            534
            
            
            
            85Other
            
            
            205
            
            
            
            100
            
            
            
            383
            
            
            
            592Total
      non-interest income
            
            
            514
            
            
            
            815
            
            
            
            2,314
            
            
            
            3,028Non-Interest
      ExpenseSalaries
      and employee benefits
            
            
            2,115
            
            
            
            1,999
            
            
            
            6,271
            
            
            
            5,925Net
      occupancy
            
            
            324
            
            
            
            324
            
            
            
            1,012
            
            
            
            997Furniture
      and equipment
            
            
            290
            
            
            
            295
            
            
            
            895
            
            
            
            870Marketing
            
            
            125
            
            
            
            171
            
            
            
            489
            
            
            
            496Third
      party services
            
            
            218
            
            
            
            196
            
            
            
            715
            
            
            
            589Telephone,
      postage and supplies
            
            
            147
            
            
            
            158
            
            
            
            452
            
            
            
            462State
      taxes
            
            
            131
            
            
            
            121
            
            
            
            399
            
            
            
            381FDIC
      insurance premiums
            
            
            235
            
            
            
            81
            
            
            
            967
            
            
            
            190Other
            
            
            341
            
            
            
            323
            
            
            
            1,039
            
            
            
            884Total
      non-interest expense
            
            
            3,926
            
            
            
            3,668
            
            
            
            12,239
            
            
            
            10,794Income
      before income taxes
            
            
            615
            
            
            
            2,042
            
            
            
            3,403
            
            
            
            6,374(Benefit)
      provision for income taxes
            
            
            (56
            )
            
            
            476
            
            
            
            411
            
            
            
            1,492Net
      Income
            
            $
            671
            
            
            $
            1,566
            
            
            $
            2,992
            
            
            $
            4,882Earnings
      Per Share - Basic
            
            $
            0.22
            
            
            $
            0.50
            
            
            $
            0.97
            
            
            $
            1.56Earnings
      Per Share - Diluted
            
            $
            0.22
            
            
            $
            0.50
            
            
            $
            0.96
            
            
            $
            1.54Cash
      Dividends Per Share
            
            $
            0.24
            
            
            $
            0.23
            
            
            $
            0.72
            
            
            $
            0.69




The
accompanying notes are an integral part of the unaudited consolidated financial
statements.




4




QNB Corp. and
Subsidiary





CONSOLIDATED STATEMENT OF SHAREHOLDERS'
EQUITY




(in
      thousands, except share data)
              (unaudited)
            
            Number
              of
      Shares
              Outstanding
            
            
            Common
              Stock
            
            
            Surplus
            
            
            Retained
              Earnings
            
            
            Accumulated
              Other
              Comprehesive
              Income
              (Loss)
            
            
            Treasury
              Stock
            
            
            TotalBalance,
      December 31, 2008
            
            
            3,131,815
            
            
            $
            2,028
            
            
            $
            10,057
            
            
            $
            43,667
            
            
            $
            (233
            )
            
            $
            (1,610
            )
            
            $
            53,909Comprehensive
      income:Net
      Income
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            2,992
            
            
            
            –
            
            
            
            –
            
            
            
            2,992Other
      comprehensive income
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            3,525
            
            
            
            –
            
            
            
            3,525Total
      comprehensive income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            6,517Cash
      dividends paid($0.72
      per share)
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            (2,229
            )
            
            
            –
            
            
            
            –
            
            
            
            (2,229
            )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
            
            
            –
            
            
            
            –
            
            
            
            41
            
            
            
            –
            
            
            
            –
            
            
            
            –
            
            
            
            41Balance,
      September 30, 2009
            
            
            3,089,382
            
            
            $
            2,034
            
            
            $
            10,154
            
            
            $
            44,430
            
            
            $
            3,292
            
            
            $
            (2,476
            )
            
            $
            57,434




The
accompanying notes are an integral part of the consolidated financial
statements.




5




QNB Corp. and
Subsidiary
 
 CONSOLIDATED STATEMENTS OF CASH
FLOWS
  (in
      thousands)
                (unaudited)Nine
      Months Ended September 30,
              
              2009
              
              
              2008Operating
      ActivitiesNet
      income
              
              $
              2,992
              
              
              $
              4,882Adjustments
      to reconcile net income to net cash provided by operating
      activitiesDepreciation
      and amortization
              
              
              655
              
              
              
              625Provision
      for loan losses
              
              
              2,600
              
              
              
              575Net
      securities losses (gains)
              
              
              930
              
              
              
              (1
              )Gain
      on sale of equity investment
              
              
              –
              
              
              
              (175
              )Net
      gain on sale of loans
              
              
              (534
              )
              
              
              (85
              )Net
      loss on disposal of premises and equipment
              
              
              –
              
              
              
              3Net
      loss (gain) on sale of repossessed assets and other real estate
      owned
              
              
              117
              
              
              
              (19
              )Proceeds
      from sales of residential mortgages
              
              
              22,954
              
              
              
              7,661Originations
      of residential mortgages held-for-sale
              
              
              (22,908
              )
              
              
              (6,946
              )Income
      on bank-owned life insurance
              
              
              (203
              )
              
              
              (233
              )Life
      insurance premiums
              
              
              (15
              )
              
              
              (16
              )Stock-based
      compensation expense
              
              
              41
              
              
              
              44Deferred
      income tax benefit
              
              
              (841
              )
              
              
              (57
              )Net
      increase in income taxes payable
              
              
              321
              
              
              
              153Net
      increase in accrued interest receivable
              
              
              (115
              )
              
              
              (238
              )Amortization
      of mortgage servicing rights and identifiable intangible
      assets
              
              
              52
              
              
              
              60Net
      amortization (accretion) of premiums and discounts on investment
      securities
              
              
              111
              
              
              
              (157
              )Net
      increase in accrued interest payable
              
              
              726
              
              
              
              367Increase
      in other assets
              
              
              (7
              )
              
              
              (274
              )(Decrease)
      increase in other liabilities
              
              
              (266
              )
              
              
              190Net
      cash provided by operating activities
              
              
              6,610
              
              
              
              6,359Investing
      ActivitiesProceeds
      from maturities and calls of investment securitiesavailable-for-sale
              
              
              68,084
              
              
              
              30,113held-to-maturity
              
              
              250
              
              
              
              380Proceeds
      from sales of investment securitiesavailable-for-sale
              
              
              7,161
              
              
              
              3,964Purchase
      of investment securities
                available-for-sale
              
              
              (101,777
              )
              
              
              (67,008
              )Proceeds
      from sale of equity investment
              
              
              –
              
              
              
              175Proceeds
      from sales of non-marketable equity securities
              
              
              –
              
              
              
              332Purchase
      of non-marketable equity securities
              
              
              –
              
              
              
              (720
              )Net
      (increase) decrease in loans
              
              
              (35,359
              )
              
              
              59Net
      purchases of premises and equipment
              
              
              (282
              )
              
              
              (535
              )Redemption
      of bank owned life insurance investment
              
              
              –
              
              
              
              224Proceeds
      from sale of repossessed assets and other real estate
owned
              
              
              689
              
              
              
              373Net
      cash used by investing activities
              
              
              (61,234
              )
              
              
              (32,623
              )Financing
      ActivitiesNet
      decrease in non-interest bearing deposits
              
              
              (3,167
              )
              
              
              (918
              )Net
      increase in interest-bearing non-maturity deposits
              
              
              42,589
              
              
              
              1,190Net
      increase in time deposits
              
              
              14,947
              
              
              
              32,523Net
      increase (decrease) in short-term borrowings
              
              
              5,156
              
              
              
              (14,433
              )Proceeds
      from issuance of long-term debt
              
              
              –
              
              
              
              10,000Tax
      benefit from employee stock transactions
              
              
              6
              
              
              
              –Cash
      dividends paid
              
              
              (2,229
              )
              
              
              (2,165
              )Purchase
      of treasury stock
              
              
              (866
              )
              
              
              –Proceeds
      from issuance of common stock
              
              
              56
              
              
              
              32Net
      cash provided by financing activities
              
              
              56,492
              
              
              
              26,229Increase
      (decrease) in cash and cash equivalents
              
              
              1,868
              
              
              
              (35
              )Cash
      and cash equivalents at beginning of year
              
              
              16,451
              
              
              
              14,322Cash
      and cash equivalents at end of period
              
              $
              18,319
              
              
              $
              14,287Supplemental
      Cash Flow DisclosuresInterest
      paid
              
              $
              9,777
              
              
              $
              11,378Income
      taxes paid
              
              
              909
              
              
              
              1,380Non-Cash
      TransactionsTransfer
      of loans to repossessed assets and other real estate owned
              
              
              615
              
              
              
              490
  The
accompanying notes are an integral part of the unaudited consolidated financial
statements.
  6


QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
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 nine-month periods ended September 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 September 30, 2009, for items that should potentially
be recognized or disclosed in these financial statements. The evaluation was
conducted through November 13, 2009, the date these financial statements were
issued.




2.
RECENT ACCOUNTING PRONOUNCEMENTS





In June
2009, the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standards (SFAS) No. 168, The FASB Accounting Standards
CodificationTMand the Hierarchy of Generally
Accepted Accounting Principles – a replacement of FASB Statement No. 162.
The FASB Accounting Standards CodificationTM (ASC)
will be the single source of authoritative nongovernmental generally accepted
accounting principles (GAAP) in the United States of America, excluding SEC
guidance. This guidance is codified in ASC 105 and is effective for financial
statements that cover interim and annual periods ending after September 15,
2009. Other than resolving certain minor inconsistencies in current GAAP, the
ASC is not intended to change GAAP, but rather to make it easier to review and
research GAAP applicable to a particular transaction or specific accounting
issue. Applying the guidance in ASC 105 did not impact the Company’s financial
condition and results of operations. The Company has revised its references to
pre-Codification GAAP in its financial statements for the three- and nine-month
periods ended September 30, 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
 SEPTEMBER
30, 2009 AND 2008, AND DECEMBER 31, 2008
 (Unaudited)




2.
RECENT ACCOUNTING PRONOUNCEMENTS (Continued)





In June
2009, the FASB issued SFAS No. 166, Accounting for Transfers of
Financial Assets, an amendment of FASB Statement No. 140.This
statement is not yet included in the codification, but will impact ASC 860,
Transfers and
Servicing. 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 is
continuing to evaluate the impact 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 is not yet included in the codification,
but will impact ASC 810, Consolidation. 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 April
2009, FASB issued new guidance in 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, now
codified in ASC 820, Fair
Value Measurements and Disclosures.The new guidance provides
additional guidance for determining fair value of a financial asset or financial
liability when the volume and level of activity for such asset or liability have
decreased significantly and also provides guidance for determining whether a
transaction is an orderly one. The new guidance is effective prospectively for
interim periods and annual years ending after June 15, 2009. The Company has
adopted this pronouncement and has included the necessary
disclosures.





In April
2009, the FASB issued FSP FAS No. 115-2 and FAS No. 124-2, Recognition and Presentation of
Other-Than-Temporary Impairments now codified in ASC 320, Investment – Debt and Equity
Securities. The new guidance 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.




8




QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2009 AND 2008, AND DECEMBER 31, 2008


(Unaudited)




2.
RECENT ACCOUNTING PRONOUNCEMENTS (Continued)





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, the new guidance 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.





The new
guidance 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 and has included the
necessary disclosures. For the nine months ended September 30, 2009, the
adoption resulted in the reclassification of other-than-temporary impairment
charges of $1,574,000 from earnings to other comprehensive income.





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.





In April
2009, the FASB issued new disclosure requirements in FSP FAS No. 107-1 and
Accounting Principles Board Opinion (APB) 28-1, Interim Disclosures about Fair Value
of Financial Instruments now codified in ASC 825, Financial Instruments. The
new guidance requires disclosures about fair value of financial instruments for
interim reporting periods of publicly traded companies as well as in annual
financial statements. The new guidance 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 and has included the necessary disclosures.





In August
2009, the FASB issued Accounting Standards Update (“ASU”) 2009-05, Measuring Liabilities at Fair
Value, to amend ASC 820, Fair Value Measurements and
Disclosures, to clarify how entities should estimate the fair value of
liabilities. ASC 820, as amended, includes clarifying guidance for circumstances
in which a quoted price in an active market is not available, the effect of the
existence of liability transfer restrictions, and the effect of quoted prices
for the identical liability, including when the identical liability is traded as
an asset. The amended guidance in ASC 820 on measuring liabilities at fair value
is effective for the first interim or annual reporting period beginning after
August 28, 2009, with earlier application permitted. The Company is in the
process of evaluating the impact the amended guidance in ASC 820 will have on
its consolidated financial statements.





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. 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.




9




QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2009 AND 2008, AND DECEMBER 31, 2008


(Unaudited)




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





Stock-based
compensation expense was approximately $12,000 and $14,000 for the three months
ended September 30, 2009 and 2008, respectively, and $41,000 and $44,000 for the
nine months ended September 30, 2009 and 2008, respectively. As of September 30,
2009, there was approximately $57,000 of unrecognized compensation cost related
to unvested share-based compensation awards granted that is expected to be
recognized over the next 27 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 September 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 September 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.





The
following assumptions were used in the option pricing model in determining the
fair value of options granted during the nine months ended September
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.




10


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




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





Stock
option activity during the nine months ended September 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 September 30, 2009
              
              
              206,371
              
              
              $
              21.18
              
              
              
              2.9
              
              
              $
              140Exercisable
      at September 30, 2009
              
              
              151,571
              
              
              $
              21.28
              
              
              
              2.7
              
              
              $
              140


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. There were no shares repurchased
during the third quarter of 2009. As of September 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 September 30, 2008, QNB had not repurchased any
shares.





11




QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
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
              
              
              For
      the Nine MonthsEnded
      September 30,
              
              
              Ended
      September 30,2009
              
              
              2008
              
              
              2009
              
              
              2008Numerator
      for basic and diluted earnings per share -
                net
      income
              
              $
              671
              
              
              $
              1,566
              
              
              $
              2,992
              
              
              $
              4,882Denominator
      for basic earnings per share - weighted
                average
      shares outstanding
              
              
              3,089,382
              
              
              
              3,136,423
              
              
              
              3,095,889
              
              
              
              3,135,451Effect
      of dilutive securities - employee stock options
              
              
              8,040
              
              
              
              25,417
              
              
              
              9,636
              
              
              
              28,702Denominator
      for diluted earnings per share - adjusted
                weighted
      average shares outstanding
              
              
              3,097,422
              
              
              
              3,161,840
              
              
              
              3,105,525
              
              
              
              3,164,153Earnings
      per share-basic
              
              $
              0.22
              
              
              $
              0.50
              
              
              $
              0.97
              
              
              $
              1.56Earnings
      per share-diluted
              
              $
              0.22
              
              
              $
              0.50
              
              
              $
              0.96
              
              
              $
              1.54


There
were 138,800 stock options that were anti-dilutive for the three- and nine-month
periods ended September 30, 2009, respectively. There were 121,600 and 87,100
stock options that were anti-dilutive for the three- and nine-month periods
ended September 30, 2008, respectively. These stock options were not included in
the above calculation.





12




QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2009 AND 2008, AND DECEMBER 31, 2008


(Unaudited)




6.
COMPREHENSIVE INCOME





For QNB,
the sole component of other comprehensive income 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 September 30, 2009 and 2008:





For
      the Three Months
              
              
              For
      the Nine MonthsEnded
      September 30,
              
              
              Ended
      September 30,2009
              
              
              2008
              
              
              2009
              
              
              2008Unrealized
      holding gains (losses) arising during the
                period
      on securities available-for-sale [net of (tax
                expense)
      taxbenefit of $(1,677), $483, $(1,501)
                and
      $1,682, respectively]
              
              $
              3,255
              
              
              $
              (938
              )
              
              $
              2,911
              
              
              $
              (3,265
              )Reclassification
      adjustment for losses (gains)
                included
      in net income [net of tax benefit of
                $(221),
      $(35), $(316) and $0, respectively]
              
              
              429
              
              
              
              68
              
              
              
              614
              
              
              
              (1
              )Net
      change in unrealized gains (losses) during
                the
      period
              
              
              3,684
              
              
              
              (870
              )
              
              
              3,525
              
              
              
              (3,266
              )Accumulated
      other comprehensive (loss) income,
                beginning
      of period
              
              
              (392
              )
              
              
              (892
              )
              
              
              (233
              )
              
              
              1,504Accumulated
      other comprehensive income
                (loss),
      end of period
              
              $
              3,292
              
              
              $
              (1,762
              )
              
              $
              3,292
              
              
              $
              (1,762
              )Net
      income
              
              $
              671
              
              
              $
              1,566
              
              
              $
              2,992
              
              
              $
              4,882Other
      comprehensive income, net of tax:Unrealized
      holding gains (losses) arising during
                the
      period [net of (tax expense) tax benefit
                of
      $(1,898), $448, $(1,817) and $1,682,
                respectively]
              
              
              3,684
              
              
              
              (870
              )
              
              
              3,525
              
              
              
              (3,266
              )Comprehensive
      income
              
              $
              4,355
              
              
              $
              696
              
              
              $
              6,517
              
              
              $
              1,616
  13
 QNB
CORP. AND SUBSIDIARY
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 SEPTEMBER
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 September 30, 2009 and December 31, 2008 were as
follows:





Available-for-SaleSeptember
      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
              
              $
              5,024
              
              
              $
              11
              
              
              $
              1
              
              
              $
              5,014
              
              
              $
              5,124
              
              
              $
              49
              
              
              
              -
              
              
              $
              5,075U.S.
      Government agencies
              
              
              56,170
              
              
              
              434
              
              
              
              46
              
              
              
              55,782
              
              
              
              44,194
              
              
              
              634
              
              
              $
              5
              
              
              
              43,565State
      and municipal securities
              
              
              50,957
              
              
              
              1,754
              
              
              
              4
              
              
              
              49,207
              
              
              
              42,300
              
              
              
              448
              
              
              
              512
              
              
              
              42,364Mortgage-backed
      securities
              
              
              75,019
              
              
              
              3,385
              
              
              
              -
              
              
              
              71,634
              
              
              
              67,347
              
              
              
              2,126
              
              
              
              -
              
              
              
              65,221Collateralized
      mortgageobligations
      (CMOs)
              
              
              57,835
              
              
              
              1,958
              
              
              
              71
              
              
              
              55,948
              
              
              
              49,067
              
              
              
              963
              
              
              
              591
              
              
              
              48,695Other
      debt securities
              
              
              1,813
              
              
              
              83
              
              
              
              3,030
              
              
              
              4,760
              
              
              
              8,476
              
              
              
              79
              
              
              
              3,171
              
              
              
              11,568Equity
      securities
              
              
              3,614
              
              
              
              549
              
              
              
              33
              
              
              
              3,098
              
              
              
              3,089
              
              
              
              9
              
              
              
              382
              
              
              
              3,462Total
      investment securities available-for-sale
              
              $
              250,432
              
              
              $
              8,174
              
              
              $
              3,185
              
              
              $
              245,443
              
              
              $
              219,597
              
              
              $
              4,308
              
              
              $
              4,661
              
              
              $
              219,950


The
amortized cost and estimated fair value of securities available-for-sale by
contractual maturity at September 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
                
                $
                8,097
                
                
                $
                7,960Due
      after one year through five years
                
                
                173,330
                
                
                
                170,646Due
      after five years through ten years
                
                
                33,877
                
                
                
                33,187Due
      after ten years
                
                
                31,514
                
                
                
                30,552Equity
      securities
                
                
                3,614
                
                
                
                3,098Total
      investment securities available-for-sale
                
                $
                250,432
                
                
                $
                245,443


Proceeds
from sales of investment securities available-for-sale were $7,161,000 and
$3,964,000 for the nine months ended September 30, 2009 and 2008,
respectively.




14




QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
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 these 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
      gainsNine months ended September 30,
      2009:
              
              Gains
              
              
              Losses
              
              
              losses
              
              
              (losses)Equity
      securities
              
              $
              211
              
              
              $
              (1
              )
              
              $
              (515
              )
              
              $
              (305
              )Debt
      securities
              
              
              136
              
              
              
              -
              
              
              
              (761
              )
              
              
              (625
              )Total
              
              $
              347
              
              
              $
              (1
              )
              
              $
              (1,276
              )
              
              $
              (930
              )


Other-than-Gross
              
              
              Gross
              
              
              temporaryRealized
              
              
              Realized
              
              
              impairment
              
              
              Net
      gainsNine months ended September 30,
      2008:
              
              Gains
              
              
              Losses
              
              
              losses
              
              
              (losses)Equity
      securities
              
              $
              247
              
              
              $
              (11
              )
              
              $
              (302
              )
              
              $
              (66
              )Debt
      securities
              
              
              71
              
              
              
              (4
              )
              
              
              -
              
              
              
              67Total
              
              $
              318
              
              
              $
              (15
              )
              
              $
              (302
              )
              
              $
              1


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
              
              
              Nine
      Months
                EndedSeptember
      30,
                2009
              
              
              September
      30,
                2009Balance
      of cumulative credit losses on investment securities,
                beginning
      of period
              
              $
              (8
              )
              
              $
              -Additions
      of credit losses recorded which were not previously
                recognized
      as components of earnings
              
              
              (753
              )
              
              
              (761
              )Ending
      balance of cumulative credit losses on investment securities,
                end
      of period
              
              $
              (761
              )
              
              $
              (761
              )





15




QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
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 September 30, 2009 and December 31, 2008 were as
follows:


Held-To-MaturitySeptember
      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
              
              
              $
              146
              
              
              
              -
              
              
              $
              3,493
              
              
              $
              3,598
              
              
              $
              90
              
              
              $
              5
              
              
              $
              3,683


The
amortized cost and estimated fair value of securities held-to-maturity by
contractual maturity at September 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
              
              $
              3,493
              
              
              $
              3,347Due
      after ten years
              
              
              -
              
              
              
              -Total
      investment securities held-to-maturity
              
              $
              3,493
              
              
              $
              3,347


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





At
September 30, 2009 and December 31, 2008, investment securities
available-for-sale totaling $128,798,000 and $101,302,000, respectively, were
pledged as collateral for repurchase agreements and deposits of public
funds.




16




QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2009 AND 2008, AND DECEMBER 31, 2008


(Unaudited)




7.
INVESTMENT SECURITIES (Continued)


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


At
      September 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.
      Treasury notes
              
              
              1
              
              
              $
              1,004
              
              
              $
              1
              
              
              
              
              
              
              
              
              $
              1,004
              
              
              $
              1U.S.
      Government agencies
              
              
              9
              
              
              
              9,952
              
              
              
              46
              
              
              
              -
              
              
              
              -
              
              
              
              9,952
              
              
              
              46State
      and municipal securities
              
              
              2
              
              
              
              -
              
              
              
              -
              
              
              $
              668
              
              
              $
              4
              
              
              
              668
              
              
              
              4Collateralized
      mortgage obligations (CMOs)
              
              
              2
              
              
              
              -
              
              
              
              -
              
              
              
              2,607
              
              
              
              71
              
              
              
              2,607
              
              
              
              71Other
      debt securities
              
              
              8
              
              
              
              -
              
              
              
              -
              
              
              
              1,284
              
              
              
              3,030
              
              
              
              1,284
              
              
              
              3,030Equity
      securities
              
              
              3
              
              
              
              290
              
              
              
              18
              
              
              
              132
              
              
              
              15
              
              
              
              422
              
              
              
              33Total
              
              
              25
              
              
              $
              11,246
              
              
              $
              65
              
              
              $
              4,691
              
              
              $
              3,120
              
              
              $
              15,937
              
              
              $
              3,185
  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
      mortgageobligations
      (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 the CMO category relates to non-agency issued securities
whose market price has been adversely impacted by current residential mortgage
market conditions. These securities are not Fannie Mae, Freddie Mac or Ginnie
Mae securities and do not have a government guarantee, either explicit or
implied. 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 nine 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 these securities and its belief that it will not 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 September 30, 2009 are pooled trust preferred
security issues. QNB holds eight of these securities with an amortized cost of
$4,314,000 and a fair value of $1,284,000. 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


SEPTEMBER
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 September 30, 2009:





Deal
              
              Class
              
              Book
                value
              
              
              Fair
                value
              
              
              Unrealized
                loss
              
              
              Realized
                OTTI
                Credit
                Loss
                (YTD
      2009)
              
              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
              
              
              $
              151
              
              
              $
              (93
              )
              
              $
              -
              
              Ca/B
              
              
              6
              
              
              
              -
              
              
              
              27.1
              %
              
              
              18.9
              %PreTSL
      V
              
              Mezzanine*
              
              
              275
              
              
              
              174
              
              
              
              (101
              )
              
              
              -
              
              Ba3/A
              
              
              4
              
              
              
              -
              
              
              
              43.1
              %
              
              No
      excessPreTSL
      VI
              
              Mezzanine*
              
              
              121
              
              
              
              100
              
              
              
              (21
              )
              
              
              (8
              )
              Caa1/CCC
              
              
              5
              
              
              
              -
              
              
              
              61.4
              %
              
              No
      excessPreTSL
      XVII
              
              Mezzanine
              
              
              974
              
              
              
              335
              
              
              
              (639
              )
              
              
              -
              
              Ca/CC
              
              
              51
              
              
              
              8
              
              
              
              20.1
              %
              
              No
      excessPreTSL
      XIX
              
              Mezzanine
              
              
              987
              
              
              
              337
              
              
              
              (650
              )
              
              
              -
              
              Ca/CC
              
              
              60
              
              
              
              14
              
              
              
              14.7
              %
              
              No
      excessPreTSL
      XXV
              
              Mezzanine
              
              
              941
              
              
              
              114
              
              
              
              (827
              )
              
              
              (47
              )
              Ca/C
              
              
              64
              
              
              
              9
              
              
              
              30.1
              %
              
              No
      excessPreTSL
      XXVI
              
              Mezzanine
              
              
              772
              
              
              
              73
              
              
              
              (699
              )
              
              
              (706
              )
              Ca/C
              
              
              64
              
              
              
              10
              
              
              
              20.0
              %
              
              No
      excess$
              4,314
              
              
              $
              1,284
              
              
              $
              (3,030
              )
              
              $
              (761
              )Mezzanine*
      - only class of bonds still outstanding (represents the senior-most
      obligation of the trust)




The
market for these securities at September 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). 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. In the third quarter of
2009, $753,000 in other-than-temporary impairment charges representing credit
impairment were recognized on our pooled trust preferred collateralized debt
obligations. 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


SEPTEMBER
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 ASC 325 (formerly
known as 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
Amendments to the Impairment
Guidance of EITF Issue No. 99-20(formerly known as EITF
99-20-1). QNB performs a discounted cash flow analysis on all of its
impaired debt securities to determine if the amortized cost basis of an impaired
security will be recovered. In determining whether a credit loss exists, QNB
uses its best estimate of the present value of cash flows expected to be
collected from the debt security and discounts them at the effective yield
implicit in the security at the date of acquisition. 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 (including prepayments), credit
worthiness of the underlying banks and insurance companies and determination of
probability and severity 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 desktop
      valuation 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 capitalization, asset quality, profitability, liquidity, stock
      price performance and whether the institution has received TARP
      funding.




·
            Probability
      of Default and Severity of Loss – A near-term probability of default is
      determined for each issuer based on its financial condition and is used to
      calculate the expected impact of future deferrals and defaults on the
      expected cash flows. Each issuer in the collateral pool is assigned a
      near-term probability of default and then deferrals are assumed to return
      to two times historical levels for future years (0.75%). Banks currently
      in default or deferring interest payments are assigned a 100% probability
      of default. All other banks in the pool are assigned a probability of
      default based on their unique credit characteristics and market
      indicators. In addition a severity of loss (projected recovery) is
      determined in all cases. In the current analysis, the severity of loss
      ranges from 25% to 100% depending on the estimated credit worthiness of
      the issuer.




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 September 30, 2009, it is
probable that we will collect all contractual principal and interest payments on
four of our eight pooled trust preferred securities. The expected principal
shortfall on PreTSL VI, PreTSL XXV and PreTSL XXVI (2 bonds) resulted in an
$8,000 credit related other-than-temporary impairment charge in the second
quarter of 2009 and a $753,000 credit related other-than-temporary impairment
charge in the third quarter of 2009.




19




QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2009 AND 2008, AND DECEMBER 31, 2008


(Unaudited)




8.
LOANS & ALLOWANCE FOR LOAN LOSSES





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





September
      30,
              
              
              December
      31,2009
              
              
              2008Commercial
      and industrial
              
              $
              97,380
              
              
              $
              97,238Construction
              
              
              31,427
              
              
              
              21,894Real
      estate-commercial
              
              
              163,021
              
              
              
              142,499Real
      estate-residential
              
              
              129,622
              
              
              
              124,538Consumer
              
              
              3,865
              
              
              
              4,483Indirect
      lease financing
              
              
              12,169
              
              
              
              12,762Total
      loans
              
              
              437,484
              
              
              
              403,414Net
      unearned (fees) costs
              
              
              (24
              )
              
              
              165Loans
      receivable
              
              $
              437,460
              
              
              $
              403,579


Activity
in the allowance for loan losses is shown below:





Three
      Months Ended
              
              
              Nine
      Months EndedSeptember
      30,
              
              
              September
      30,2009
              
              
              2008
              
              
              2009
              
              
              2008Balance
      at beginning of period
              
              $
              4,584
              
              
              $
              3,473
              
              
              $
              3,836
              
              
              $
              3,279Charge-offs
              
              
              (585
              )
              
              
              (140
              )
              
              
              (992
              )
              
              
              (412
              )Recoveries
              
              
              74
              
              
              
              9
              
              
              
              129
              
              
              
              50Net
      charge-offs
              
              
              (511
              )
              
              
              (131
              )
              
              
              (863
              )
              
              
              (362
              )Provision
      for loan losses
              
              
              1,500
              
              
              
              150
              
              
              
              2,600
              
              
              
              575Balance
      at end of period
              
              $
              5,573
              
              
              $
              3,492
              
              
              $
              5,573
              
              
              $
              3,492


A loan is
considered impaired when it is probable that interest and principal will not be
collected according to the contractual terms of the loan agreement. Information
with respect to loans that are considered to be impaired at September 30, 2009
and December 31, 2008 is as follows:





At
      September 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
              
              $
              1,202
              
              
              $
              614
              
              
              $
              586
              
              
              $
              188Recorded
      investment in impaired loans at period-end
                requiring
      no specific reserve for loan losses
              
              
              3,740
              
              
              
              
              
              
              
              238Recorded
      investment in impaired loans at period-end
              
              $
              4,942
              
              
              
              
              
              
              $
              824Recorded
      investment in non-accrual and
                restructured
      loans
              
              $
              4,516
              
              
              
              
              
              
              $
              830




20




QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
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
$79,971,000 and $67,412,000 at September 30, 2009 and December 31, 2008,
respectively.





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





Nine
      Months Ended
              
              
              Year
      EndedSeptember
      30,
              
              
              December
      31,2009
              
              
              2008Mortgage
      servicing rights beginning balance
              
              $
              402
              
              
              $
              451Mortgage
      servicing rights capitalized
              
              
              171
              
              
              
              60Mortgage
      servicing rights amortized
              
              
              (80
              )
              
              
              (77
              )Fair
      market value adjustments
              
              
              28
              
              
              
              (32
              )Mortgage
      servicing rights ending balance
              
              $
              521
              
              
              $
              402


The
balance of these mortgage servicing assets are included in other assets at
September 30, 2009 and


December
31, 2008. The fair value of these rights was $651,000 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
              
              $
              1122010
              
              
              1192011
              
              
              952012
              
              
              722013
              
              
              54





10.
FAIR VALUE MEASUREMENTS AND DISCLOSURES





Financial
Accounting Standards Board (FASB) ASC 820, Fair Value Measurements and
Disclosures, defines fair value as an exit price, representing the amount
that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants (fair values are not adjusted
for transaction costs). ASC 820 also establishes a framework (fair value
hierarchy) for measuring fair value under GAAP, and expands disclosures about
fair value measurements.





In
December 2007, the FASB issued guidance which permitted a delay for fair value
measurements and disclosures related to 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 began
to account and report for non-financial assets and liabilities in
2009.




21




QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2009 AND 2008, AND DECEMBER 31, 2008


(Unaudited)




10.
FAIR VALUE MEASUREMENTS AND DISCLOSURES (Continued)





ASC 820
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 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.





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.





At
September 30, 2009, the Company determined that no active market existed for
pooled trust preferred securities with an amortized cost of $4,314,000 and an
estimated fair value of $1,284,000. 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.




22


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




10.
FAIR VALUE MEASUREMENTS AND DISCLOSURES (Continued)





Impaired Loans (generallycarried atfairvalue): Impaired loans
are loans, in which the Company 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 September 30,
2009 consists of loan balances of $1,202,000 less a valuation allowance of
$614,000. The fair value of impaired loans as of December 31, 2008 consists of
loan balances of $586,000 less a valuation allowance of $188,000.





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 September 30, 2009.





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.





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 PeriodSeptember
      30, 2009Securities
      available-for-sale
              
              $
              8,638
              
              
              $
              240,510
              
              
              $
              1,284
              
              
              $
              250,432December
      31, 2008Securities
      available-for-sale
              
              $
              8,213
              
              
              $
              209,421
              
              
              $
              1,963
              
              
              $
              219,597


23




QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2009 AND 2008, AND DECEMBER 31, 2008


(Unaudited)




10.
FAIR VALUE MEASUREMENTS AND DISCLOSURES (Continued)





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 September 30, 2009Balance
      at
                June
      30,
                2009
              
              Total
                Unrealized
                Gains
      or
                (Losses)
              
              Total
                Realized
                Gains
      or
                (Losses)
              
              Purchases
                (Sales
      or
                Paydowns)
              
              Balance
      at
                September
      30,
                2009Securities
      available-for-sale
              
              $
              829
              
              
              $
              1,208
              
              
              $
              (753
              )
              
              $
              -
              
              
              $
              1,284


For
      the Nine Months Ended September 30, 2009Balance
      at
                December
      31,
                2008
              
              Total
                Unrealized
                Gains
      or
                (Losses)
              
              Total
                Realized
                Gains
      or
                (Losses)
              
              Purchases
                (Sales
      or
                Paydowns)
              
              Balance
      at
                September
      30,
                2009Securities
      available-for-sale
              
              $
              1,963
              
              
              $
              86
              
              
              $
              (761
              )
              
              $
              (4
              )
              
              $
              1,284


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 September 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.





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 September 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.




24




QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2009 AND 2008, AND DECEMBER 31, 2008


(Unaudited)




10.
FAIR VALUE MEASUREMENTS AND DISCLOSURES (Continued)





The Bank
is aware of several factors indicating that recent transactions of TRUP CDO
securities are not orderly including an increased spread between bid/ask prices,
lower sales transaction volumes for these types of securities, and a lack of new
issuances.  As a result, the Bank engaged an independent third party
to value the securities using a discounted cash flow analysis.  The
estimated cash flows are based on specific assumptions about defaults, deferrals
and prepayments of the trust preferred securities underlying each TRUP
CDO.  The resulting collateral cash flows are allocated to the bond
waterfall using the INTEX desktop valuation model.





The
estimates for the conditional default rates (CDR) are based on the payment
characteristics of the trust preferred securities themselves (e.g. current,
deferred, or defaulted) as well as the financial condition of the trust
preferred issuers in the pool.  A near-term CDR for each issuer in the
pool is estimated based on their financial condition using key financial ratios
relating to the financial institution’s capitalization, asset quality,
profitability and liquidity.  Over the long term, the default rates
are modeled to migrate to two times the historic norms.





The base
loss severity assumption is 95 percent.  The severity factor for
near-term CDRs is vectored to reflect the relative expected performance of the
institutions modeled to default, with lower forecasted severities used for the
higher quality institutions.  The long-term loss severity is modeled
at 95%.





Prepayments
are modeled to take into account the disruption in the asset-backed securities
marketplace and the lack of new trust preferred issuances.





The rates
used to discount the cash flows were developed using a build-up method based on
the risk free rate for the expected duration of the securities, plus a risk
premium for bearing the uncertainty in the cash flows, and plus other case
specific factors that would be considered by market participants, including a
normal liquidity adjustment.





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 PeriodSeptember
      30, 2009Mortgage
      servicing rights
              
              $
              -
              
              
              $
              -
              
              
              $
              26
              
              
              $
              26Impaired
      loans, net
              
              $
              -
              
              
              $
              -
              
              
              $
              588
              
              
              $
              588December
      31, 2008Mortgage
      servicing rights
              
              $
              -
              
              
              $
              -
              
              
              $
              228
              
              
              $
              228Impaired
      loans
              
              $
              -
              
              
              $
              -
              
              
              $
              398
              
              
              $
              398
  25
 QNB
CORP. AND SUBSIDIARY
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 SEPTEMBER
30, 2009 AND 2008, AND DECEMBER 31, 2008
 (Unaudited)




10.
FAIR VALUE MEASUREMENTS AND DISCLOSURES (Continued)





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 September 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.





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.




26




QNB
CORP. AND SUBSIDIARY





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


SEPTEMBER
30, 2009 AND 2008, AND DECEMBER 31, 2008


(Unaudited)




10.
FAIR VALUE MEASUREMENTS AND DISCLOSURES (Continued)





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.





The
estimated fair values and carrying amounts of the Company’s financial
instruments are summarized as follows:





September
      30, 2009
              
              
              December
      31, 2008Carrying
              
              
              Estimated
              
              
              Carrying
              
              
              EstimatedAmount
              
              
              Fair
      Value
              
              
              Amount
              
              
              Fair
      ValueFinancial
      AssetsCash
      and due from banks
              
              $
              7,902
              
              
              $
              7,902
              
              
              $
              10,634
              
              
              $
              10,634Interest-bearing
      deposits in banks
              
              
              10,417
              
              
              
              10,417
              
              
              
              1,276
              
              
              
              1,276Federal
      funds sold
              
              
              -
              
              
              
              -
              
              
              
              4,541
              
              
              
              4,541Investment
      securities available-for-sale
              
              
              250,432
              
              
              
              250,432
              
              
              
              219,597
              
              
              
              219,597Investment
      securities held-to-maturity
              
              
              3,347
              
              
              
              3,493
              
              
              
              3,598
              
              
              
              3,683Restricted
      investment in bank stocks
              
              
              2,291
              
              
              
              2,291
              
              
              
              2,291
              
              
              
              2,291Loans
      held-for-sale
              
              
              608
              
              
              
              629
              
              
              
              120
              
              
              
              124Net
      loans
              
              
              431,887
              
              
              
              416,417
              
              
              
              399,743
              
              
              
              397,232Mortgage
      servicing rights
              
              
              521
              
              
              
              651
              
              
              
              402
              
              
              
              440Accrued
      interest receivable
              
              
              2,934
              
              
              
              2,934
              
              
              
              2,819
              
              
              
              2,819Financial
      LiabilitiesDeposits
      with no stated maturities
              
              
              277,910
              
              
              
              277,910
              
              
              
              238,488
              
              
              
              238,488Deposits
      with stated maturities
              
              
              326,249
              
              
              
              328,312
              
              
              
              311,302
              
              
              
              316,239Short-term
      borrowings
              
              
              26,819
              
              
              
              26,819
              
              
              
              21,663
              
              
              
              21,663Long-term
      debt
              
              
              35,000
              
              
              
              36,845
              
              
              
              35,000
              
              
              
              37,352Accrued
      interest payable
              
              
              3,003
              
              
              
              3,003
              
              
              
              2,277
              
              
              
              2,277


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





September
      30, 2009
              
              
              December
      31, 2008Notional
              
              
              Estimated
              
              
              Notional
              
              
              EstimatedAmount
              
              
              Fair
      Value
              
              
              Amount
              
              
              Fair
      ValueCommitments
      to extend credit
              
              $
              100,111
              
              
              $
              -
              
              
              $
              87,227
              
              
              $
              -Standby
      letters of credit
              
              
              15,373
              
              
              
              -
              
              
              
              12,051
              
              
              
              -
  27
  QNB
CORP. AND SUBSIDIARY
 
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 SEPTEMBER
30, 2009 AND 2008, AND DECEMBER 31, 2008
 (Unaudited)
  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:




September
      30,
              
              
              December
      31,2009
              
              
              2008Commitments
      to extend credit and unused lines of credit
              
              $
              100,111
              
              
              $
              87,227Standby
      letters of credit
              
              
              15,373
              
              
              
              12,051$
              115,484
              
              
              $
              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 September 30, 2009 and December 31, 2008 for
guarantees under standby letters of credit issued is not material.





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.




28


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




12.
REGULATORY RESTRICTIONS (Continued)





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 September 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 September 30, 2009
              
              Amount
              
              
              Ratio
              
              
              Amount
              
              
              Ratio
              
              
              Amount
              
              
              RatioTotal
      Risk-Based Capital (to Risk Weighted Assets)Consolidated
              
              $
              59,947
              
              
              
              11.39
              %
              
              $
              42,091
              
              
              
              8.00
              %
              
              
              N/A
              
              
              
              N/ABank
              
              
              55,992
              
              
              
              10.72
              %
              
              
              41,803
              
              
              
              8.00
              %
              
              $
              52,253
              
              
              
              10.00
              %Tier
      I Capital (to Risk Weighted Assets)Consolidated
              
              
              54,142
              
              
              
              10.29
              %
              
              
              21,045
              
              
              
              4.00
              %
              
              
              N/A
              
              
              
              N/ABank
              
              
              50,419
              
              
              
              9.65
              %
              
              
              20,901
              
              
              
              4.00
              %
              
              
              31,352
              
              
              
              6.00
              %Tier
      I Capital (to Average Assets)Consolidated
              
              
              54,142
              
              
              
              7.45
              %
              
              
              29,086
              
              
              
              4.00
              %
              
              
              N/A
              
              
              
              N/ABank
              
              
              50,419
              
              
              
              6.97
              %
              
              
              28,936
              
              
              
              4.00
              %
              
              
              36,170
              
              
              
              5.00
              %


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
            %




29


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.





30




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.
During the third quarter of 2009 QNB recorded a credit related
other-than-temporary impairment charge of $753,000 on two of its holding of
pooled trust preferred securities. For the nine month period ended September 30,
2009, the Company recorded $1,276,000 of other-than-temporary charges: $761,000
related to three trust preferred security issues and $515,000 related to losses
in the equity securities portfolio.





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’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 September 30, 2009.





31




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 provision for loan losses is
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.





32




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. 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 third quarter of 2009 of $671,000, or $0.22 per
share on a diluted basis. This compares to $1,566,000, or $0.50 per share on a
diluted basis, for the same period in 2008. For the nine month period ended
September 30, 2009, QNB reported net income of $2,992,000, or $0.96 per share on
a diluted basis. This compares to net income of $4,882,000, or $1.54 per shared
on a diluted basis, for the nine month period ended September 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 nine
month periods ended September 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 credit related
other-than-temporary impairment charges (OTTI) on investment securities in its
trust preferred holdings and its 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. These FDIC actions were a
result of bank failures which have significantly impacted the level of the
Deposit Insurance Fund.




33




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


RESULTS
OF OPERATIONS – OVERVIEW (Continued)





The
factors contributing to the results for the three and nine month periods ended
September 30, 2009 consisted of:




·
            a
      $482,000, or 9.6%, increase in net interest income when comparing the
      three month periods and a $1,213,000, or 8.2%, increase in net interest
      income when comparing the nine month periods; a result of strong growth in
      loans and deposits,


·
            a
      $1,350,000 increase in the provision for loan losses for the three month
      period and a $2,025,000 increase for the nine month period versus the same
      periods in 2008. These higher provisions for loan losses resulted from an
      increase in loan charge-offs and delinquent loans combined with loan
      growth and current economic conditions,


·
            an
      increase in gains on the sale of residential mortgages as origination and
      sales activity picked up as a result of low interest rates. When comparing
      the three and nine month periods gains on the sale of mortgage loans
      increased $119,000 and $449,000, respectively,


·
            OTTI
      charges on investment securities of $753,000 for the third quarter of 2009
      compared to $103,000 for the third quarter of 2008 and OTTI charges of
      $1,276,000 for the nine months ended September 30, 2009 compared with
      $302,000 for the same period in 2008.


·
            higher
      industry-wide FDIC insurance premiums resulted in additional expense of
      $154,000 when comparing the two quarters and higher premiums plus a
      special assessment in the second quarter of 2009 contributed to a $777,000
      increase in FDIC expense when comparing the nine month
      periods.





The
primary component of QNB’s earnings is its net interest income which increased
$482,000, or 9.6%, to $5,527,000 for the third quarter of 2009 compared to the
third quarter of 2008 and $207,000, or 3.9%, compared to the second quarter of
2009. The improvement in net interest income, when comparing the three month
periods ended September 30, 2009 and 2008, is a result of a 13.4% growth in
average earning assets. Comparing the third quarter of 2009 to the same period
in 2008, average loans increased $56,168,000, or 14.8%, and average investment
securities increased $30,088,000, or 13.5%. 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 debt securities and agency mortgage-backed
securities.





Funding
the growth in earnings assets was an increase in average total deposits of
$76,769,000, or 14.4%, to $608,660,000 when comparing the third quarter of 2009
to the same period in 2008. The 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 10.4%, while average time deposit balances increased
18.1%. The growth in transaction accounts reflects the positive response to the
introduction of QNB’s two newest high rate deposit products, eRewards Checking
and Online eSavings.





The net
interest margin was 3.38% for the third quarter of 2009 compared to 3.49% for
the third quarter of 2008 and 3.40% for the second quarter of 2009. Impacting
net interest income and the net interest margin in the third quarter of 2009 was
the reversal of $100,000 of interest income on pooled trust preferred securities
placed on non-accrual status partially offset by the recognition of a $29,000
prepayment penalty on a commercial loan. Excluding these two items in the third
quarter of 2009 the net interest margin would have been 3.42%, an improvement
over the second quarter of 2009. The decline in the net interest margin from the
third quarter of 2008 is mainly the result of the yield earned on investment
securities declining to a greater degree than the cost of deposits.





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 $1,213,000, or 8.2%, to $15,928,000 comparing the
first nine months of 2009 and 2008. Comparing these time periods, average loans
and investment securities increased 11.3% and 16.7%, respectively, and average
total deposits increased 14.0%. The net interest margin for the first nine
months of 2009 was 3.42% compared to 3.54% for the first nine months of
2008.





As a
result of the significant growth in loans, current economic conditions, an
increase in net charge-offs and higher levels of non-performing and delinquent
loans, QNB recorded a provision for loan losses of $1,500,000 in the third
quarter of 2009 and $2,600,000 for the first nine months of 2009. This compares
to a provision of $150,000 for the third quarter of 2008 and $575,000 for the
first nine months of 2008. Net loan charge-offs were $511,000 and $131,000 for
the three months ended September 30, 2009 and 2008, respectively. For the nine
month periods ended September 30, 2009 and 2008, net charge-offs were $863,000,
or 0.27%, of average total loans and $362,000, or 0.13%, of average total loans,
respectively.





Total
non-performing loans, which represent loans on non-accrual status, loans past
due more than 90 days and still accruing and restructured loans, were
$5,199,000, or 1.19% of total loans, at September 30, 2009, compared to
$1,190,000, or 0.31% of total loans, at September 30, 2008 and $4,203,000, or
0.97%, at June 30, 2009. Total delinquent loans, which includes loans past due
more than 30 days, increased to 1.93% of total loans at September 30, 2009
compared with 0.90% and 1.45% of total loans at September 30, 2008 and June 30,
2009. QNB’s non-performing loan and total delinquent loan ratios continue to
compare favorably with the average of 1.78% and 2.61% of total loans,
respectively, for Pennsylvania commercial banks with assets between $500 million
and $1 billion, as reported by the FDIC using the most recent available data,
which is June 30, 2009.





QNB’s
allowance for loan losses of $5,573,000 represents 1.27% of total loans at
September 30, 2009 compared to an allowance for loan losses of $3,492,000, or
0.92% of total loans, at September 30, 2008 and $4,584,000, or 1.05% of total
loans, at June 30, 2009. Other real estate owned and other repossessed assets
were $127,000 at September 30, 2009 compared with $142,000 at September 30, 2008
and $379,000 at June 30, 2009.





Total
non-interest income was $514,000 for the third quarter of 2009, a decrease of
$301,000 compared with the same period in 2008. During the third quarter of
2009, QNB recorded credit related other-than-temporary impairment (OTTI) charges
of $753,000 on two of its holdings of pooled trust preferred securities. This
compares to OTTI charges of $103,000 in the third quarter of 2008 related to
holdings in the equity investment portfolio. Partially offsetting these charges
were gains on the sale of securities of $103,000 in the third quarter of 2009.
There were no such gains recorded in the third quarter of 2008. Also
contributing to non-interest income were gains on the sale of residential
mortgages which increased $119,000 when comparing these same periods, as the low
interest rate environment has resulted in an increase in mortgage refinancing
activity. An increase in merchant income, letter of credit fees, ATM and debit
card income and title insurance income contributed $110,000 in additional
non-interest income when comparing the three month periods.





Total
non-interest income for the nine month periods ended September 30, 2009 and 2008
was $2,314,000 and $3,028,000, respectively. Credit related OTTI charges were
$1,276,000 and $302,000 for the nine month periods ended September 30, 2009 and
2008, respectively. Included in the 2009 amount were $761,000 of OTTI charges
related to three trust preferred issues and $515,000 in OTTI charges related to
the equity securities portfolio. Net losses on other real estate owned and
repossessed assets increased $136,000 when comparing the nine month periods.
Partially offsetting these losses were gains on the sale of residential
mortgages which increased from $85,000 in 2008 to $534,000 in 2009. Positively
impacting non-interest income for the 2008 period 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. When comparing the nine month periods,
merchant income increased $69,000, letter of credit fees increased $54,000, ATM
and debit card income increased $49,000 and title insurance income increased
$32,000.




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 expense was $3,926,000 for the third quarter of 2009, an increase
of $258,000 from the third quarter of 2008. The largest contributing factor to
the increase in non-interest expense was FDIC insurance premium expense which
increased $154,000 to $235,000, comparing the third quarter of 2009 to 2008. The
higher expense is a result of deposit growth and an increased assessment rate
which was levied on all insured institutions by the FDIC in order to replenish
the Deposit Insurance Fund. Salary and benefit expense increased $116,000, or
5.8%, to $2,115,000 for the third 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 $12,239,000 for the nine month period ended September
30, 2009. This represents an increase of $1,445,000 from the same period in
2008. Higher industry-wide FDIC insurance premiums plus a special FDIC
assessment in the second quarter of 2009 contributed $777,000 of the increase.
This special assessment reduced the results for the nine month period 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. Higher salary and benefit expense also contributed to
the increase in total non-interest expense increasing $346,000 when comparing
the nine month periods.





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
  Average
Balances, Rate, and Interest Income and Expense Summary (Tax-Equivalent Basis)


Three
      Months EndedSeptember
      30, 2009
              
              September
      30, 2008Average
                Balance
              
              Average
                Rate
              
              Interest
              
              Average
                Balance
              
              Average
                Rate
              
              
              InterestAssetsFederal
      funds sold
              
              $
              -
              
              
              -
              %
              $
              -
              
              $
              11,136
              
              
              1.99
              %
              
              $
              56Investment
      securities:U.S.
      Treasury
              
              
              5,067
              
              
              1.49
              %
              
              19
              
              
              5,167
              
              
              3.46
              %
              
              
              45U.S.
      Government agencies
              
              
              52,686
              
              
              3.67
              %
              
              483
              
              
              42,786
              
              
              4.93
              %
              
              
              527State
      and municipal
              
              
              53,033
              
              
              6.53
              %
              
              866
              
              
              43,641
              
              
              6.48
              %
              
              
              707Mortgage-backed
      and CMOs
              
              
              129,780
              
              
              4.70
              %
              
              1,525
              
              
              111,769
              
              
              5.39
              %
              
              
              1,507Corporate
      bonds (fixed and variable)
              
              
              5,577
              
              
              -4.78
              %
              
              (67
              )
              
              11,612
              
              
              5.86
              %
              
              
              170Money
      market mutual funds
              
              
              3,174
              
              
              0.40
              %
              
              3
              
              
              3,201
              
              
              2.60
              %
              
              
              21Equities
              
              
              3,115
              
              
              3.15
              %
              
              25
              
              
              4,168
              
              
              2.61
              %
              
              
              27Total
      investment securities
              
              
              252,432
              
              
              4.52
              %
              
              2,854
              
              
              222,344
              
              
              5.40
              %
              
              
              3,004Loans:Commercial
      real estate
              
              
              229,153
              
              
              6.14
              %
              
              3,546
              
              
              182,712
              
              
              6.57
              %
              
              
              3,018Residential
      real estate
              
              
              25,447
              
              
              5.96
              %
              
              379
              
              
              21,426
              
              
              6.01
              %
              
              
              322Home
      equity loans
              
              
              63,853
              
              
              5.11
              %
              
              822
              
              
              68,223
              
              
              5.81
              %
              
              
              996Commercial
      and industrial
              
              
              75,407
              
              
              5.17
              %
              
              982
              
              
              67,073
              
              
              5.84
              %
              
              
              984Indirect
      lease financing
              
              
              14,557
              
              
              8.48
              %
              
              308
              
              
              12,952
              
              
              9.49
              %
              
              
              308Consumer
      loans
              
              
              3,873
              
              
              11.12
              %
              
              108
              
              
              4,687
              
              
              11.91
              %
              
              
              140Tax-exempt
      loans
              
              
              24,636
              
              
              5.92
              %
              
              368
              
              
              23,685
              
              
              6.03
              %
              
              
              359Total
      loans, net of unearned income*
              
              
              436,926
              
              
              5.91
              %
              
              6,513
              
              
              380,758
              
              
              6.40
              %
              
              
              6,127Other
      earning assets
              
              
              9,932
              
              
              0.20
              %
              
              5
              
              
              2,359
              
              
              2.38
              %
              
              
              14Total
      earning assets
              
              
              699,290
              
              
              5.32
              %
              
              9,372
              
              
              616,597
              
              
              5.94
              %
              
              
              9,201Cash
      and due from banks
              
              
              10,180
              
              
              
              
              
              
              
              
              11,825Allowance
      for loan losses
              
              
              (4,774
              )
              
              
              
              
              
              
              
              (3,493
              )Other
      assets
              
              
              22,456
              
              
              
              
              
              
              
              
              22,116Total
      assets
              
              $
              727,152
              
              
              
              
              
              
              
              $
              647,045Liabilities
      and Shareholders' EquityInterest-bearing
      deposits:Interest-bearing
      demand
              
              $
              70,581
              
              
              0.59
              %
              
              105
              
              $
              58,772
              
              
              0.32
              %
              
              
              47Municipals
              
              
              39,177
              
              
              1.06
              %
              
              105
              
              
              50,019
              
              
              1.82
              %
              
              
              229Money
      market
              
              
              66,267
              
              
              1.10
              %
              
              184
              
              
              47,254
              
              
              1.67
              %
              
              
              198Savings
              
              
              51,375
              
              
              0.34
              %
              
              44
              
              
              44,456
              
              
              0.39
              %
              
              
              44Time
              
              
              218,934
              
              
              3.05
              %
              
              1,684
              
              
              200,341
              
              
              3.99
              %
              
              
              2,007Time
      of $100,000 or more
              
              
              108,730
              
              
              3.11
              %
              
              851
              
              
              77,019
              
              
              3.97
              %
              
              
              768Total
      interest-bearing deposits
              
              
              555,064
              
              
              2.13
              %
              
              2,973
              
              
              477,861
              
              
              2.74
              %
              
              
              3,293Short-term
      borrowings
              
              
              23,063
              
              
              1.10
              %
              
              64
              
              
              21,487
              
              
              2.09
              %
              
              
              113Long-term
      debt
              
              
              35,000
              
              
              4.27
              %
              
              382
              
              
              35,000
              
              
              4.27
              %
              
              
              381Total
      interest-bearing liabilities
              
              
              613,127
              
              
              2.21
              %
              
              3,419
              
              
              534,348
              
              
              2.82
              %
              
              
              3,787Non-interest-bearing
      deposits
              
              
              53,596
              
              
              
              
              
              
              
              
              54,030Other
      liabilities
              
              
              5,399
              
              
              
              
              
              
              
              
              4,749Shareholders'
      equity
              
              
              55,030
              
              
              
              
              
              
              
              
              53,918Total
      liabilities andshareholders'
      equity
              
              $
              727,152
              
              
              
              
              
              
              
              $
              647,045Net
      interest rate spread
              
              
              
              
              
              3.11
              %
              
              
              
              
              
              
              
              3.12
              %Margin/net
      interest income
              
              
              
              
              
              3.38
              %
              $
              5,953
              
              
              
              
              
              3.49
              %
              
              $
              5,414
 
 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)
  Nine
      Months EndedSeptember
      30, 2009
                
                
                September
      30, 2008Average
      Balance
                
                
                Average
      Rate
                
                
                Interest
                
                
                Average
      Balance
                
                
                Average
      Rate
                
                
                InterestAssetsFederal
      funds sold
                
                $
                1,326
                
                
                
                0.15
                %
                
                $
                2
                
                
                $
                8,244
                
                
                
                2.23
                %
                
                $
                138Investment
      securities:U.S.
      Treasury
                
                
                5,057
                
                
                
                1.56
                %
                
                
                59
                
                
                
                5,106
                
                
                
                3.72
                %
                
                
                142U.S.
      Government agencies
                
                
                45,138
                
                
                
                4.20
                %
                
                
                1,421
                
                
                
                34,158
                
                
                
                5.21
                %
                
                
                1,335State
      and municipal
                
                
                49,795
                
                
                
                6.53
                %
                
                
                2,439
                
                
                
                42,887
                
                
                
                6.53
                %
                
                
                2,099Mortgage-backed
      and CMOs
                
                
                125,789
                
                
                
                5.02
                %
                
                
                4,734
                
                
                
                105,062
                
                
                
                5.49
                %
                
                
                4,325Corporate
      bonds (fixed and variable)
                
                
                6,203
                
                
                
                1.47
                %
                
                
                68
                
                
                
                13,063
                
                
                
                6.19
                %
                
                
                607Money
      market mutual funds
                
                
                4,628
                
                
                
                0.68
                %
                
                
                23
                
                
                
                1,075
                
                
                
                2.60
                %
                
                
                21Equities
                
                
                3,245
                
                
                
                3.14
                %
                
                
                76
                
                
                
                4,213
                
                
                
                2.63
                %
                
                
                83Total
      investment securities
                
                
                239,855
                
                
                
                4.90
                %
                
                
                8,820
                
                
                
                205,564
                
                
                
                5.59
                %
                
                
                8,612Loans:Commercial
      real estate
                
                
                216,054
                
                
                
                6.19
                %
                
                
                9,996
                
                
                
                180,844
                
                
                
                6.77
                %
                
                
                9,165Residential
      real estate
                
                
                24,795
                
                
                
                5.97
                %
                
                
                1,110
                
                
                
                21,726
                
                
                
                6.12
                %
                
                
                997Home
      equity loans
                
                
                65,500
                
                
                
                5.16
                %
                
                
                2,527
                
                
                
                68,224
                
                
                
                5.92
                %
                
                
                3,024Commercial
      and industrial
                
                
                73,887
                
                
                
                5.07
                %
                
                
                2,804
                
                
                
                68,567
                
                
                
                6.15
                %
                
                
                3,156Indirect
      lease financing
                
                
                14,811
                
                
                
                8.65
                %
                
                
                961
                
                
                
                12,919
                
                
                
                9.77
                %
                
                
                946Consumer
      loans
                
                
                4,030
                
                
                
                10.52
                %
                
                
                317
                
                
                
                4,492
                
                
                
                11.51
                %
                
                
                387Tax-exempt
      loans
                
                
                24,934
                
                
                
                5.98
                %
                
                
                1,114
                
                
                
                24,144
                
                
                
                6.07
                %
                
                
                1,097Total
      loans, net of unearned income*
                
                
                424,011
                
                
                
                5.94
                %
                
                
                18,829
                
                
                
                380,916
                
                
                
                6.58
                %
                
                
                18,772Other
      earning assets
                
                
                6,013
                
                
                
                0.17
                %
                
                
                8
                
                
                
                2,295
                
                
                
                2.76
                %
                
                
                47Total
      earning assets
                
                
                671,205
                
                
                
                5.51
                %
                
                
                27,659
                
                
                
                597,019
                
                
                
                6.17
                %
                
                
                27,569Cash
      and due from banks
                
                
                9,813
                
                
                
                
                
                
                
                
                
                
                
                10,693Allowance
      for loan losses
                
                
                (4,364
                )
                
                
                
                
                
                
                
                
                
                
                (3,405
                )Other
      assets
                
                
                22,189
                
                
                
                
                
                
                
                
                
                
                
                21,873Total
      assets
                
                $
                698,843
                
                
                
                
                
                
                
                
                
                
                $
                626,180Liabilities
      and Shareholders' EquityInterest-bearing
      deposits:Interest-bearing
      demand
                
                $
                68,346
                
                
                
                0.53
                %
                
                
                273
                
                
                $
                56,812
                
                
                
                0.21
                %
                
                
                92Municipals
                
                
                31,236
                
                
                
                1.13
                %
                
                
                264
                
                
                
                41,477
                
                
                
                2.23
                %
                
                
                692Money
      market
                
                
                57,132
                
                
                
                1.23
                %
                
                
                525
                
                
                
                48,511
                
                
                
                1.91
                %
                
                
                693Savings
                
                
                48,502
                
                
                
                0.28
                %
                
                
                103
                
                
                
                43,957
                
                
                
                0.39
                %
                
                
                129Time
                
                
                218,718
                
                
                
                3.27
                %
                
                
                5,352
                
                
                
                198,123
                
                
                
                4.25
                %
                
                
                6,298Time
      of $100,000 or more
                
                
                107,700
                
                
                
                3.33
                %
                
                
                2,681
                
                
                
                72,751
                
                
                
                4.30
                %
                
                
                2,340Total
      interest-bearing deposits
                
                
                531,634
                
                
                
                2.31
                %
                
                
                9,198
                
                
                
                461,631
                
                
                
                2.96
                %
                
                
                10,244Short-term
      borrowings
                
                
                19,615
                
                
                
                1.18
                %
                
                
                173
                
                
                
                21,347
                
                
                
                2.37
                %
                
                
                379Long-term
      debt
                
                
                35,000
                
                
                
                4.26
                %
                
                
                1,132
                
                
                
                34,380
                
                
                
                4.29
                %
                
                
                1,122Total
      interest-bearing liabilities
                
                
                586,249
                
                
                
                2.40
                %
                
                
                10,503
                
                
                
                517,358
                
                
                
                3.03
                %
                
                
                11,745Non-interest-bearing
      deposits
                
                
                53,109
                
                
                
                
                
                
                
                
                
                
                
                51,266Other
      liabilities
                
                
                4,858
                
                
                
                
                
                
                
                
                
                
                
                4,528Shareholders'
      equity
                
                
                54,627
                
                
                
                
                
                
                
                
                
                
                
                53,028Total
      liabilities and shareholders' equity
                
                $
                698,843
                
                
                
                
                
                
                
                
                
                
                $
                626,180Net
      interest rate spread
                
                
                
                
                
                
                3.11
                %
                
                
                
                
                
                
                
                
                
                
                3.14
                %Margin/net
      interest income
                
                
                
                
                
                
                3.42
                %
                
                $
                17,156
                
                
                
                
                
                
                
                3.54
                %
                
                $
                15,824
  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
              
              
              Nine
      Months EndedSeptember
      30, 2009 compared to September 30, 2008
              
              
              September
      30, 2009 compared to September 30, 2008Total
              
              
              Due
      to change in:
              
              
              Total
              
              
              Due
      to change in:Change
              
              
              Volume
              
              
              Rate
              
              
              Change
              
              
              Volume
              
              
              RateInterest
      income:Federal
      funds sold
              
              $
              (56
              )
              
              $
              (56
              )
              
              $
              -
              
              
              $
              (136
              )
              
              $
              (115
              )
              
              $
              (21
              )Investment
      securities:U.S.
      Treasury
              
              
              (26
              )
              
              
              (1
              )
              
              
              (25
              )
              
              
              (83
              )
              
              
              (1
              )
              
              
              (82
              )U.S.
      Government agencies
              
              
              (44
              )
              
              
              123
              
              
              
              (167
              )
              
              
              86
              
              
              
              429
              
              
              
              (343
              )State
      and municipal
              
              
              159
              
              
              
              152
              
              
              
              7
              
              
              
              340
              
              
              
              338
              
              
              
              2Mortgage-backed
      and CMOs
              
              
              18
              
              
              
              243
              
              
              
              (225
              )
              
              
              409
              
              
              
              853
              
              
              
              (444
              )Corporate
      bonds (fixed and variable)
              
              
              (237
              )
              
              
              (89
              )
              
              
              (148
              )
              
              
              (539
              )
              
              
              (319
              )
              
              
              (220
              )Money
      market mutual funds
              
              
              (18
              )
              
              
              -
              
              
              
              (18
              )
              
              
              2
              
              
              
              69
              
              
              
              (67
              )Equities
              
              
              (2
              )
              
              
              (6
              )
              
              
              4
              
              
              
              (7
              )
              
              
              (19
              )
              
              
              12Loans:Commercial
      real estate
              
              
              528
              
              
              
              779
              
              
              
              (251
              )
              
              
              831
              
              
              
              1,775
              
              
              
              (944
              )Residential
      real estate
              
              
              57
              
              
              
              60
              
              
              
              (3
              )
              
              
              113
              
              
              
              140
              
              
              
              (27
              )Home
      equity loans
              
              
              (174
              )
              
              
              (61
              )
              
              
              (113
              )
              
              
              (497
              )
              
              
              (123
              )
              
              
              (374
              )Commercial
      and industrial
              
              
              (2
              )
              
              
              126
              
              
              
              (128
              )
              
              
              (352
              )
              
              
              242
              
              
              
              (594
              )Indirect
      lease financing
              
              
              -
              
              
              
              37
              
              
              
              (37
              )
              
              
              15
              
              
              
              139
              
              
              
              (124
              )Consumer
      loans
              
              
              (32
              )
              
              
              (24
              )
              
              
              (8
              )
              
              
              (70
              )
              
              
              (40
              )
              
              
              (30
              )Tax-exempt
      loans
              
              
              9
              
              
              
              16
              
              
              
              (7
              )
              
              
              17
              
              
              
              34
              
              
              
              (17
              )Other
      earning assets
              
              
              (9
              )
              
              
              46
              
              
              
              (55
              )
              
              
              (39
              )
              
              
              78
              
              
              
              (117
              )Total
      interest income
              
              
              171
              
              
              
              1,345
              
              
              
              (1,174
              )
              
              
              90
              
              
              
              3,480
              
              
              
              (3,390
              )Interest
      expense:Interest-bearing
      demand
              
              
              58
              
              
              
              9
              
              
              
              49
              
              
              
              181
              
              
              
              18
              
              
              
              163Municipals
              
              
              (124
              )
              
              
              (49
              )
              
              
              (75
              )
              
              
              (428
              )
              
              
              (171
              )
              
              
              (257
              )Money
      market
              
              
              (14
              )
              
              
              81
              
              
              
              (95
              )
              
              
              (168
              )
              
              
              123
              
              
              
              (291
              )Savings
              
              
              -
              
              
              
              6
              
              
              
              (6
              )
              
              
              (26
              )
              
              
              13
              
              
              
              (39
              )Time
              
              
              (323
              )
              
              
              193
              
              
              
              (516
              )
              
              
              (946
              )
              
              
              649
              
              
              
              (1,595
              )Time
      of $100,000 or more
              
              
              83
              
              
              
              320
              
              
              
              (237
              )
              
              
              341
              
              
              
              1,121
              
              
              
              (780
              )Short-term
      borrowings
              
              
              (49
              )
              
              
              8
              
              
              
              (57
              )
              
              
              (206
              )
              
              
              (32
              )
              
              
              (174
              )Long-term
      debt
              
              
              1
              
              
              
              1
              
              
              
              -
              
              
              
              10
              
              
              
              16
              
              
              
              (6
              )Total
      interest expense
              
              
              (368
              )
              
              
              569
              
              
              
              (937
              )
              
              
              (1,242
              )
              
              
              1,737
              
              
              
              (2,979
              )Net
      interest income
              
              $
              539
              
              
              $
              776
              
              
              $
              (237
              )
              
              $
              1,332
              
              
              $
              1,743
              
              
              $
              (411
              )
  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
nine-month periods ended September 30, 2009 and 2008.




For
      the Three Months
                Ended
      September 30,
              
              
              For
      the Nine Months
                Ended
      September 30,2009
              
              
              2008
              
              
              2009
              
              
              2008Total
      interest income
              
              $
              8,946
              
              
              $
              8,832
              
              
              $
              26,431
              
              
              $
              26,460Total
      interest expense
              
              
              3,419
              
              
              
              3,787
              
              
              
              10,503
              
              
              
              11,745Net
      interest income
              
              
              5,527
              
              
              
              5,045
              
              
              
              15,928
              
              
              
              14,715Tax-equivalent
      adjustment
              
              
              426
              
              
              
              369
              
              
              
              1,228
              
              
              
              1,109Net
      interest income (fully taxable-equivalent)
              
              $
              5,953
              
              
              $
              5,414
              
              
              $
              17,156
              
              
              $
              15,824





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 $482,000, or 9.6%, to $5,527,000 for the quarter ended
September 30, 2009 as compared to the quarter ended September 30, 2008. On a
tax-equivalent basis, net interest income increased by 10.0% from $5,414,000 for
the three months ended September 30, 2008 to $5,953,000 for the same period
ended September 30, 2009. Impacting net interest income in the third quarter of
2009 was the reversal of $100,000 of interest income on pooled trust preferred
securities placed on non-accrual status partially offset by the recognition of a
$29,000 prepayment penalty on a commercial loan. Excluding these two items net
interest income in a tax-equivalent basis for the third quarter of 2009 would
have increased by $610,000, or 11.3%, compared to the third quarter of 2008 and
a $299,000, or 5.2%, increase from the second quarter of 2009.





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 $76,769,000, or 14.4%, to $608,660,000
when comparing the three months ended September 30, 2009 and September 30, 2008.
Over this same time period total average loans increased $56,168,000, or 14.8%,
and total average investment securities increased $30,088,000, or 13.5%.
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
3.38% for the third quarter of 2009 compared to 3.49% for the third quarter of
2008 and 3.40% for the second quarter of 2009. Excluding the reversal of the
interest on the trust preferred securities and the prepayment penalty income
noted above, the net interest margin would have been 3.42% for the third quarter
of 2009, an improvement over the second quarter of 2009.




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. Coming off these historic lows, interest rates remained at low
levels during the first nine months 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 September 30, 2009 and 2008, the three-month T-bill rate was 0.14% and
0.92%, the two-year note yield was 0.95% and 2.00%, and the ten-year note yield
was 3.31% and 3.85%, respectively. During the first nine months 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.





The yield
on earning assets on a tax-equivalent basis decreased 62 basis points from 5.94%
for the third quarter of 2008 to 5.32% for the third quarter of 2009 and
decreased 18 basis points when compared to a yield on earning assets of 5.50%
reported in the second quarter of 2009. In comparison, the rate paid on
interest-bearing liabilities decreased 61 basis points from 2.82% for the third
quarter of 2008 to 2.21% for the third quarter of 2009 and decreased 20 basis
points when compared to 2.41% reported in the second quarter of
2009.





Interest
income on investment securities decreased $150,000 when comparing the two
quarters as the increase in average balances could only partially offset the 88
basis point decline in the average yield of the portfolio. The average yield on
the investment portfolio was 4.52% for the third quarter of 2009 compared with
5.40% for the third quarter of 2008 and 4.91% for the second quarter of 2009.
Excluding the reversal of the $100,000 in interest on the trust preferred
securities the yield on the portfolio would have been 4.68% for the third
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 and municipal 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 on tax-exempt municipal
securities increased $159,000 with higher balances accounting for $152,000 of
additional income. The yield on the state and municipal portfolio increased from
6.48% for the third quarter of 2008 to 6.53% for the third 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 income on mortgage-backed securities and CMOs
increased $18,000 with growth in the portfolio contributing $243,000. This was
partially offset by a $225,000 decrease in interest income resulting from a 69
basis point decline in yield. The yield on the mortgage-backed portfolio
decreased from 5.39% to 4.70% when comparing the third quarter of 2008 and 2009.
It also represents a decline of 24 basis points from the second quarter 2009
yield of 4.94%. Income on Government agency securities decreased by $44,000 as
the 23.1%
growth in average balances was offset by a 126 basis point decline in yield from
4.93% for the third quarter of 2008 to 3.67% for the same period in 2009. The
yield on agency bonds was 4.36% for the second 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 current low interest
rate environment. The proceeds from these called bonds were reinvested in
securities with significantly lower yields. Interest on corporate bonds declined
by $237,000 with the reversal of interest on the trust preferred securities
placed on nonaccrual status contributing $100,000. To reduce credit risk in the
portfolio, in January 2009, QNB sold $6,000,000 in corporate bonds issued by
financial institutions at a gain of $136,000. The bonds sold had an average
yield of 6.89%. This had the impact of reducing interest income, the average
balance and the average yield on the corporate bond portfolio. The yield on the
total investment portfolio is anticipated to continue to decline as cash flow
from the portfolio as well as excess liquidity is reinvested at current market
rates which are below the projected portfolio yield at September 30, 2009 of
4.67%.


41
 QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS
  NET
INTEREST INCOME (Continued)
  Income on
loans increased $386,000 to $6,513,000 when comparing the third quarters of 2009
and 2008 as the impact of declining interest rates was offset by the growth in
the portfolio. Average loans increased $56,168,000, or 14.8%, and contributed an
additional $933,000 in interest income. The yield on loans decreased 49 basis
points, to 5.91% when comparing the same periods, resulting in a reduction in
interest income of $547,000. 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 third quarter 2009
yield of 5.91% representing only a 2 basis points decline from the 5.93% yield
recorded in the second quarter of 2009 and a 6 basis point decline from the
5.97% yield for 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. The rate earned on loans has not fallen
to the degree that the rate earned on investment securities, which are more
closely tied to the treasury yield curve.





Most of
the growth in the loan portfolio, both in terms of balances and interest income,
was in the category of commercial real estate loans. This category of loans
includes commercial purpose loans secured by either commercial properties such
as office buildings, factories, warehouses, medical facilities and retail
establishments, or residential real estate, usually the residence of the
business owner. The category also includes construction and land development
loans. Income on these loans increased $528,000, with average balances
increasing $46,441,000, or 25.4%, to $229,153,000, for the three months ended
September 30, 2009. The yield on commercial real estate loans was 6.14% for the
third quarter of 2009, a decline of 43 basis points from the 6.57% reported for
the third quarter of 2008. Interest on commercial and industrial loans, the
second largest category, decreased $2,000 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 $8,334,000, or 12.4%, to $75,407,000
for the third quarter of 2009, contributing an additional $126,000 in interest
income. The average yield on these loans decreased 67 basis points to 5.17%
resulting in a reduction in interest income of $128,000. 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
$57,000 when comparing the two quarters, as the increase in balances offset the
slight decline in yield. The average balance of residential mortgages increased
$4,021,000, or 18.8%, when comparing the two quarters while the average yield
decreased by 5 basis points to 5.96% for the third quarter of 2009. 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
$924,000 in residential mortgages held-for-sale. The increase in residential
real estate loans held in portfolio
was in the category of hybrid arms, mostly loans with a rate fixed for 10 years
followed by annual adjustments.




42




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


NET INTEREST INCOME
(Continued)




Income on
home equity loans declined by $174,000 when comparing the two quarters. Over
this same time period average home equity loans decreased $4,370,000, or 6.4%,
to $63,853,000, while the yield on the home equity portfolio decreased 70 basis
points to 5.11%. The demand for home equity loans has declined as home values
have fallen preventing some homeowners from having equity in their homes to
borrow against while others have taken advantage of the low interest rates on
mortgages and refinanced their home equity loans into a new mortgage. 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 $5,906,000,
or 34.8%, to $22,861,000 for the third quarter of 2009. In contrast, average
fixed rate home equity loans declined by $10,276,000, or 20.0%, to $40,992,000.
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 $56,000 when comparing the two quarters,
a result of the decision by management to invest its short-term excess funds in
either AAA rated money market mutual funds included in the investment securities
portfolio or in its account at the Federal Reserve Bank, both of which were
paying more than Federal funds. The average balance of Federal funds sold for
the third quarter of 2008 was $11,136,000 and the average rate earned was 1.99%.
Income on money market mutual funds was $3,000 and $21,000 for the respective
three month periods ended September 30, 2009 and 2008 while the average balances
were $3,174,000 and $3,201,000 for the same periods resulting in a yield of
0.40% and 2.60%, respectively. The average balance held at the Federal Reserve
Bank was $7,520,000 for the three months ended September 30, 2009 compared with
$208,000 for the third quarter of 2008. Beginning in the fourth quarter of 2008
the Fed began paying 0.25% on balances in excess of required reserves. This
resulted in interest income of $5,000 included in other earning
assets.





Income on
other earning assets is comprised of interest on deposits in correspondent
banks, primarily the Federal Reserve Bank as discussed above, and dividends on
restricted investments in bank stocks, primarily the Federal Home Loan Bank of
Pittsburgh (FHLB). Income on other earning assets declined from $14,000 for the
third quarter of 2008 to $5,000 for the third quarter of 2009. In December 2008,
the FHLB notified member banks that it was suspending dividend payments to
preserve capital. FHLB dividend income was $10,000 for the third quarter of
2008.





For the
most part, earning assets are funded by deposits, which increased on average by
$76,769,000, or 14.4%, to $608,660,000, when comparing the third 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 Account 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.
On August 26, 2009 the FDIC amended the program to extend the date six months
until June 30, 2010 to those institutions that do not opt out of participating.
In addition the fees charged to participate were increased to a range of 15 to
25 basis points depending on the institutions risk category. Based on QNB’s last
notification it will be charged as a category 1 institution and pay 15 basis
points.





43




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


While
total income on earning assets on a tax-equivalent basis increased $171,000 when
comparing the third quarter of 2009 to the third quarter of 2008, total interest
expense declined $368,000. Interest expense on total deposits decreased $320,000
while interest expense on borrowed funds decreased $48,000 when comparing the
two quarters. The rate paid on interest-bearing liabilities decreased 61 basis
points from 2.82% for the third quarter of 2008 to 2.21% for the third quarter
of 2009. During this same period, the rate paid on interest-bearing deposits
also decreased 61 basis points from 2.74% to 2.13%.





While
most categories of deposits increased when comparing the two quarters, the
largest balance increase in average deposits was in time deposits which grew
$50,304,000, or 18.1%, to $327,664,000 for the third quarter of 2009. Included
in this total was $108,730,000 of time deposits of $100,000 or more, an increase
of $31,711,000 from the $77,019,000 reported for the third 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 $36,908,000 for the third quarter of 2009. Total
average time deposits represent 53.8% of total average deposits for the third
quarter of 2009 compared to 52.1% for the third quarter of 2008.





When
comparing the third quarter of 2009 to the third quarter of 2008, interest
expense on time deposits decreased $240,000. 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 nine months of 2009 a significant amount of time deposits have
repriced lower as rates have declined. The average rate paid on time deposits
decreased from 3.98% to 3.07% when comparing the three-month periods and as a
result interest expense declined by $753,000. Partially offsetting the impact of
lower rates was $513,000 in additional expense related to the 18.1% increase in
average balances.





Approximately
$237,962,000, or 72.9%, of time deposits at September 30, 2009 will reprice or
mature over the next 12 months. The average rate paid on these time deposits is
approximately 2.85%. 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. The challenge will be to retain these deposits which to date QNB
has been extremely successful.





Average
interest-bearing demand accounts increased $11,809,000, or 20.1%, to $70,581,000
for the three months ended September 30, 2009 compared to the three months ended
September 30, 2008. Interest expense on interest-bearing demand accounts
increased from $47,000 for the third quarter of 2008 to $105,000 for the third
quarter of 2009 while the average rate paid increased from 0.32% to 0.59%.
Included in this category is eRewards checking, a high rate checking account
introduced during the third quarter of 2008. At the time of introduction the
account paid interest of 4.01% 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 third quarter of 2009, the average
balance in the product was $15,102,000 and the related interest expense was
$98,000 for an average yield of 2.56%. This lower rate than the 3.25% reflects
the lower rate paid on accounts that do not meet the qualifications or on
balances in excess of $25,000. In comparison the average balance for the third
quarter of 2008
was $2,591,000 with a related interest expense of $23,000 and an average rate
paid of 3.55%. 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 $229,000
for the third quarter of 2008 to $105,000 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
$10,842,000, or 21.7%, while the average interest rate paid on these accounts
decreased from 1.82% for the third quarter of 2008 to 1.06% for the third
quarter of 2009. The decline in average balances accounted for $49,000 of the
decrease in interest expense while the decline in the average rate paid
contributed $75,000. Most of these accounts are tied directly to the Federal
funds rate with some having rate floors of 1.00%. The balances in many of these
accounts are seasonal in nature and are dependant upon the timing of the receipt
of taxes and the disbursement by the schools and municipalities. The third
quarter usually represents the high balance in these accounts.





Average
money market accounts increased $19,013,000, or 40.2%, to $66,267,000 for the
third quarter of 2009 compared with the third quarter of 2008. Despite the
significant increase in balances, interest expense on money market accounts
declined $14,000 to $184,000 for the third quarter of 2009 compared to the third
quarter of 2008. Interest expense related to the increase in average balances
was $81,000 while the decline in the rate paid had the impact of decreasing
interest expense by $95,000. The average interest rate paid on money market
accounts was 1.67% for the third quarter of 2008 and 1.10% for the third quarter
of 2009, a decline of 57 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. The growth in balances is in both consumer and business
accounts and appears to reflect the desire for safety, liquidity and a rate
comparable with short-term time deposits.





During
the second quarter of 2009 QNB introduced an online only eSavings account to
compete with other online savings accounts. This product, with an average
balance of $3,083,000 for the quarter, contributed to the $6,919,000, or 15.6%,
increase in average savings accounts when comparing the third quarters of 2009
and 2008. Statement savings accounts also increased $3,996,000, or 9.3% when
comparing the same periods. The average rate paid on savings accounts declined 5
basis points from 0.39% for the third quarter of 2008 to 0.34% for the third
quarter of 2009. Since the eSavings account pays a yield of 1.85%, the average
rate paid on total savings accounts will most likely increase as growth occurs
in this product.





Contributing
to the decrease in total interest expense was a reduction in interest expense on
short-term borrowings of $49,000. The average rate paid on short-term borrowings
declined from 2.09% for thethird
quarter of 2008 to 1.10% for the third 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 increased from $21,487,000 for the third quarter of 2008 to
$23,063,000 for the third quarter of 2009.





For the
nine-month period ended September 30, 2009 tax-equivalent net interest income
increased $1,332,000, or 8.4% to $17,156,000. As mentioned previously, QNB
recognized a $29,000 prepayment penalty on a commercial loan. Included in net
interest income for the first nine months of 2008 was the recognition of
$156,000 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 both 2009 and 2008 for these
items, net interest income on a tax-equivalent basis for the nine months ended
September 30, 2009 increased $1,459,000, or 9.3%, compared to the same
period in 2008. Average earning assets increased $74,186,000, or 12.4%, to
$671,205,000 with average loans and investment securities increasing 11.3% and
16.7%, respectively. Average total deposits increased $71,846,000, or 14.0%, to
$584,743,000 for the nine month period ended September 30, 2009 compared to the
same period in 2008. The net interest margin on a tax-equivalent basis was 3.42%
for the nine-month period ended September 30, 2009 compared with 3.54% for the
same period in 2008.




45




QNB
CORP. AND SUBSIDIARY
 
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS
 NET INTEREST INCOME
(Continued)
  Total
interest income on a tax-equivalent basis increased $90,000, from $27,569,000 to
$27,659,000, when comparing the nine-month periods ended September 30, 2008 and
September 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 $3,480,000 as a result of volume increases but
declined $3,390,000 as a result of lower yields. Average loans increased
$43,095,000 to $424,011,000, with average commercial real estate loans
increasing $35,210,000, or 19.5%, and average commercial and industrial loans
increasing $5,320,000, or 7.8%, when comparing the nine-month periods. Over this
same period average investment securities increased $34,291,000, to $239,855,000
with most of the growth occurring in U.S. Government agency bonds, agency issued
mortgage-backed securities and tax-free state and municipal bonds. The yield on
earning assets decreased from 6.17% to 5.51% for the nine-month periods with the
yield on loans decreasing from 6.58% to 5.94% during this time. The yield on
investments decreased from 5.59% to 4.90% when comparing the nine-month
periods.





Total
interest expense decreased $1,242,000, from $11,745,000 for the nine-month
period ended September 30, 2008 to $10,503,000, for the nine-month period ended
September 30, 2009. Approximately $2,979,000 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 $1,737,000 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
$428,000, with lower rates contributing $257,000 and lower volume contributing
$171,000 to the reduction. The average balance of municipal demand deposits
declined by $10,241,000, or 24.7%, to $31,236,000 while the average rate paid
declined by 110 basis points to 1.13%. 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 $605,000
with lower rates paid reducing expense by $2,375,000 but higher volumes
increasing expense by $1,770,000. Average total time deposits increased by
$55,544,000, or 20.5%, to $326,418,000, when comparing the nine-month periods
with average time deposits greater than $100,000 increasing $34,949,000, or
48.0%, to $107,700,000. 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 97 basis points to 3.29% from 4.26% when
comparing the nine-month periods ended September 30, 2009 and 2008.





Interest
expense on interest-bearing demand deposits increased $181,000, resulting from
both an $11,534,000, or 20.3%, increase in average balances and a 32 basis point
increase in the average rate paid. The interest rate paid on interest-bearing
demand accounts increased from 0.21% for the first nine months of 2008 to 0.53%
for the same period in 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 $168,000, resulting from a 68 basis
point decline in the average rate paid from 1.91% for the first nine months of
2008 to 1.23% for the same period in 2009. The benefit of declining interest
rates was partially offset by additional expense resulting from an $8,621,000,
or 17.8%, 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 nine months
of 2008 to 0.28% for the first nine months of 2009 while average balances
increased $4,545,000, or 10.3%, over the same period.




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 $206,000 as a result of both lower
balances and lower rates. The average rate paid decreased from 2.37% for the
nine months ended September 30, 2008 to 1.18% for the same period in 2009,
resulting in a reduction in interest expense of $174,000 when comparing the two
periods. When comparing the same periods the average balance of short-term
borrowings, primarily commercial sweep accounts, declined by $1,732,000 to
$19,615,000 and resulted in a reduction in interest expense of
$32,000.





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, current economic conditions, an
increase in net charge-offs and higher levels of non-performing loans and
delinquent loans, QNB recorded a provision for loan losses of $1,500,000 in the
third quarter of 2009 and $2,600,000 for the first nine months of 2009. This
compares to a provision of $150,000 for the third quarter of 2008 and $575,000
for the first nine months of 2008. Net loan charge-offs were $511,000, or 0.47%
(annualized) of average total loans and $131,000, or 0.14% (annualized) of
average total loans for the three months ended September 30, 2009 and 2008,
respectively. For the nine month periods ended September 30, 2009 and 2008, net
charge-offs were $863,000, or 0.27% (annualized) of average total loans and
$362,000, or 0.13% (annualized) of average total loans, respectively. Of the
charge-offs for the third quarter of 2009, $460,000 relates to a commercial
borrower whose loans were secured by junior liens on his residence and whose
business was negatively impacted by the downturn in the economy. Indirect lease
financing net charge-offs were $44,000 and $112,000 for the three months ended
September 30, 2009 and 2008, respectively. Indirect lease financing net
charge-offs were $272,000 and $299,000 of the total net charge-offs for the
first nine months of 2009 and 2008, respectively.




47




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


PROVISION
FOR LOAN LOSSES (Continued)




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
18 months. Also contributing to charge-offs for the first nine months 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. This real
estate was sold during the third quarter of 2009.





As
referenced in the following table, the levels of non-performing loans and
delinquency have trended higher. At September 30, 2009 non-performing loans
totaled $5,199,000 as compared with $1,308,000 at December 31, 2008. This also
represents an increase from the $4,203,000 reported as of June 30, 2009. When
compared to total loans, non-performing loans have risen from 0.32% at December
31, 2008 to 1.19% at September 30, 2009. The increase in non-performing loans
relates to the classification of one loan totaling $1,924,000 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 has resumed performing 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 $2,592,000 at September 30, 2009. The increase relates to
loans to a residential home builder totaling $1,334,000 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. In addition, during the third quarter of 2009, $479,000 of loans to
a contractor, secured by junior liens on his residence, were put on nonaccrual.
Despite the increase in non-performing loans over the past year QNB’s
non-performing loans to total loans ratio continues to compare favorably with
the average 1.78% of total loans for Pennsylvania commercial banks with assets
between $500 million and $1 billion as reported by the FDIC using June 30, 2009
data.





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 September 30, 2009 and December 31, 2008 represent 1.19% and 0.66% of
total loans, respectively. The increase was primarily in the category of loans
secured by commercial real estate which increased by $1,869,000 to $2,164,000 at
September 30, 2009. The total
delinquent loan ratio also compares favorably with the average of 2.61% for the
same peer group.





The
allowance for loan losses was $5,573,000 and $3,836,000 at September 30, 2009
and December 31, 2008, respectively. The ratio of the allowance to total loans
was 1.27% 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 the
past year. 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 September 30, 2009 and December 31, 2008, the
recorded investment in impaired loans totaled $4,942,000 and $824,000,
respectively, of which $3,740,000 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 $1,202,000 and $586,000 at
September 30, 2009 and December 31, 2008, respectively. At September 30, 2009
and December 31, 2008 the related allowance for loan losses associated with
these loans was $614,000 and $188,000, respectively. Most of the loans that have
been identified as impaired are collateral-dependent.





48


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


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.





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




9/30/09
              
              
              12/31/08
              
              
              9/30/08
              
              
              12/31/07Non-performing
      loans
              
              $
              5,199
              
              
              $
              1,308
              
              
              $
              1,190
              
              
              $
              1,615Non-performing
      loans to total loans
              
              
              1.19
              %
              
              
              0.32
              %
              
              
              0.31
              %
              
              
              0.42
              %Delinquent
      loans (30-89 days past due)
              
              
              5,210
              
              
              
              2,670
              
              
              
              2,257
              
              
              
              2,117Delinquent
      loans to total loans
              
              
              1.19
              %
              
              
              0.66
              %
              
              
              0.59
              %
              
              
              0.55
              %Total
      loans, including loans held for sale
              
              
              438,068
              
              
              
              403,699
              
              
              
              380,105
              
              
              
              381,704





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




September
      30,
              
              
              December
      31,2009
              
              
              2008Restructured
      loans
              
              $
              1,924
              
              
              
              -Non-accrual
      loans
              
              
              2,592
              
              
              $
              830Loans
      past due 90 days or more and still accruing interest
              
              
              683
              
              
              
              478Total
      non-performing loans
              
              $
              5,199
              
              
              $
              1,308Total
      loans, including loans held for sale
              
              $
              438,068
              
              
              $
              403,699Average
      total loans (YTD average)
              
              
              424,011
              
              
              
              382,998Allowance
      for loan losses
              
              
              5,573
              
              
              
              3,836Allowance
      for loan losses to:Non-performing
      loans
              
              
              107.19
              %
              
              
              293.24
              %Total
      loans
              
              
              1.27
              %
              
              
              0.95
              %Average
      total loans
              
              
              1.31
              %
              
              
              1.00
              %





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




For
      the Three Months
                Ended
      September 30,
              
              
              For
      the Nine Months
                Ended
      September 30,2009
              
              
              2008
              
              
              2009
              
              
              2008Net
      charge-offs
              
              $
              511
              
              
              $
              131
              
              
              $
              863
              
              
              $
              362Net
      charge-offs (annualized) to:Total
      loans
              
              
              0.47
              %
              
              
              0.14
              %
              
              
              0.26
              %
              
              
              0.13
              %Average
      total loans
              
              
              0.47
              %
              
              
              0.14
              %
              
              
              0.27
              %
              
              
              0.13
              %Allowance
      for loan losses
              
              
              36.75
              %
              
              
              14.93
              %
              
              
              20.65
              %
              
              
              13.82
              %
 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
                September
      30,
              
              
              Change
      from
                Prior
      Year
              
              
              Nine
      Months Ended
                September
      30,
              
              
              Change
      from
                Prior
      Year2009
              
              
              2008
              
              
              Amount
              
              
              Percent
              
              
              2009
              
              
              2008
              
              
              Amount
              
              
              PercentFees
      for services to customers
              
              $
              470
              
              
              $
              474
              
              
              $
              (4
              )
              
              
              -0.8
              %
              
              $
              1,288
              
              
              $
              1,347
              
              
              $
              (59
              )
              
              
              -4.4
              %ATM
      and debit card
              
              
              263
              
              
              
              237
              
              
              
              26
              
              
              
              11.0
              %
              
              
              747
              
              
              
              698
              
              
              
              49
              
              
              
              7.0
              %Bank-owned
      life insurance
              
              
              66
              
              
              
              63
              
              
              
              3
              
              
              
              4.8
              %
              
              
              203
              
              
              
              233
              
              
              
              (30
              )
              
              
              -12.9
              %Mortgage
      servicing fees
              
              
              28
              
              
              
              31
              
              
              
              (3
              )
              
              
              -9.7
              %
              
              
              89
              
              
              
              72
              
              
              
              17
              
              
              
              23.6
              %Net
      gain on sale of loans
              
              
              132
              
              
              
              13
              
              
              
              119
              
              
              
              915.4
              %
              
              
              534
              
              
              
              85
              
              
              
              449
              
              
              
              528.2
              %Net
      (loss) gain on invesmentsecurities
              
              
              (650
              )
              
              
              (103
              )
              
              
              (547
              )
              
              
              531.1
              %
              
              
              (930
              )
              
              
              1
              
              
              
              (931
              )
              
              
              -93100.0
              %Other
              
              
              205
              
              
              
              100
              
              
              
              105
              
              
              
              105.0
              %
              
              
              383
              
              
              
              592
              
              
              
              (209
              )
              
              
              -35.3
              %Total
              
              $
              514
              
              
              $
              815
              
              
              $
              (301
              )
              
              
              -36.9
              %
              
              $
              2,314
              
              
              $
              3,028
              
              
              $
              (714
              )
              
              
              -23.6
              %




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 third quarter of 2009 was $514,000 compared to
$815,000 for the third quarter of 2008. The primary contributor to the $301,000
decrease in non-interest income was a $547,000 increase in realized losses on
investment securities, primarily related to OTTI charges on pooled trust
preferred investment securities. Partially offsetting this negative variance was
an increase of $119,000 in gains on the sale of residential mortgages and
increases in ATM and debit card fees, letter of credit fees, merchant income and
title company income.





Fees for
services to customers are primarily comprised of service charges on deposit
accounts. These fees decreased $4,000, to $470,000, when comparing the
three-month periods. Overdraft income decreased $23,000 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. Partially offsetting the decline in overdraft income was an
increase in fees on business checking accounts of $11,000 for the three-month
period. This increase reflects the impact of a lower earnings credit rate in the
third quarter of 2009 as compared to the third quarter of 2008, which correlates
with the significant decline in short-term interest rates. These earnings
credits are applied against service charges to reduce the costs paid by the
customer.





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 $263,000 for the third quarter
of 2009, an increase of $26,000 from the amount recorded during the third
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 $63,000 for the three months ended September
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 September 30, 2009 and 2008 were $28,000 and
$31,000, respectively. Amortization expense related to the mortgage servicing
asset for the three-month periods ended September 30, 2009 and 2008 was $21,000
and $14,000, respectively. Mortgage refinance activity increased significantly
during the first half of 2009 as residential mortgage rates declined. This
activity has slowed during the third quarter, but is still much higher than the
activity in the third quarter of 2008. The increase in amortization expense
reflects the increase in refinancing activity. The average balance of mortgages
serviced for others was $78,775,000 for the third quarter of 2009 compared to
$69,788,000 for the third quarter of 2008, an increase of 12.9%. 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 $132,000 and $13,000 for the
quarters ended September 30, 2009 and 2008, respectively. This $119,000 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 $37,000 and $5,000, respectively,
related to the recognition of mortgage servicing assets. Proceeds from the sale
of residential mortgages were $5,006,000 and $613,000 for the third 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  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 $650,000 for the quarter ended September 30,
2009, which included a $753,000 charge related to other-than-temporary
impairment (OTTI) in the carrying value of three pooled trust preferred
securities. QNB had a valuation analysis performed by an independent third party
that included a review of all eight pooled trust preferred securities owned by
the Bank. A description of the valuation methodology used can be found in
Footnotes 7 and 10. During the third quarter of 2009, QNB realized gains of
$103,000 on the sale of equity securities. For the three months ended September
30, 2008, QNB recorded net securities losses of $103,000. With the decline in
stock values during 2008, QNB  recorded other-than-temporary
impairment charges in its portfolio of equity securities, accounting for the
$103,000 loss during the third quarter.





51
 
 QNB
CORP. AND SUBSIDIARY
 MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL
 CONDITION
AND RESULTS OF OPERATIONS


NON-INTEREST
INCOME (Continued)




Other
income was $205,000 for the third quarter of 2009 and $100,000 for the same
period during 2008. The majority of the difference was caused by the
following:




·
            Merchant
      income increased $31,000, or 88.5%, for the three-month period which is
      attributable to a change in vendor and new merchant accounts being
      obtained.


·
            Letter
      of credit fees increased $33,000 mainly as a result of fees for new
      letters of credit, including 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 $23,000 as a
      result of significant increase in mortgage activity compared to prior
      year.


·
            Miscellaneous
      income increased $18,000 as a result of a Board of Directors decision to
      amend the terms of a group term life plan and reverse $44,000 of an
      accrual that was related to prior years. Prior year included income
      related to a $24,000 Pennsylvania sales and use tax refund received in
      2008.





Total
non-interest income for the nine-month periods ended September 30, 2009 and 2008
was $2,314,000 and $3,028,000, respectively. Positively impacting non-interest
income for the first nine months 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 a life insurance policy.





Fees for
services to customers decreased $59,000, or 4.4%, to $1,288,000 for the nine
months ended September 30, 2009. Overdraft income declined $102,000 while fees
on business checking accounts increased $28,000 when comparing the nine-month
periods.





For the
nine-month period, gains on the sale of residential mortgages increased $449,000
to $534,000 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 $171,000 and $58,000, respectively, related to the
recognition of mortgage servicing assets. Proceeds from the sale of residential
mortgages were $22,954,000 and $7,661,000 for the first nine months of 2009 and
2008, respectively.





Net
investment securities losses were $930,000 for the nine months ended September
30, 2009. This compares to $1,000 of net securities gains in the first nine
months of 2008. The net securities losses for 2009 include a $515,000 charge
related to OTTI in the carrying value of holdings in the equity investment
portfolio and $761,000 of OTTI charges on four out of eight pooled trust
preferred securities held by the Bank. During the first nine months of 2009 QNB
recognized gains of $210,000 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 $302,000 in the equity
portfolio.





Other
income was $383,000 for the first nine months of 2009 and $592,000 for the same
period during 2008. The majority of the difference was caused by the
following:




·
            Visa
      income of $230,000 recorded in 2008


·
            Loss
      on sales of other real estate owned and repossessed assets was $117,000
      compared to a gain of $19,000 in 2008.


·
            Merchant
      income increased $69,000, or 63.6%.


·
            Letter
      of credit fees increased $66,000.


·
            Due
      to the official check process no longer being outsourced, the income
      related to the official check program was $0 for 2009 compared to $30,000
      for 2008.


·
            Income
      from investment in title insurance company increased by
      $32,000.





52




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


NON-INTEREST
EXPENSE




Non-Interest
Expense Comparison


Three
      Months Ended
                September
      30,
              
              
              Change
      from
                Prior
      Year
              
              
              Nine
      Months Ended
                September
      30,
              
              
              Change
      from
                Prior
      Year2009
              
              
              2008
              
              
              Amount
              
              
              Percent
              
              
              2009
              
              
              2008
              
              
              Amount
              
              
              PercentSalaries
      and employee benefits
              
              $
              2,115
              
              
              $
              1,999
              
              
              $
              116
              
              
              
              5.8
              %
              
              $
              6,271
              
              
              $
              5,925
              
              
              $
              346
              
              
              
              5.8
              %Net
      occumpancy
              
              
              324
              
              
              
              324
              
              
              
              -
              
              
              
              0.0
              %
              
              
              1,012
              
              
              
              997
              
              
              
              15
              
              
              
              1.5
              %Furniture
      and equipment
              
              
              290
              
              
              
              295
              
              
              
              (5
              )
              
              
              -1.7
              %
              
              
              895
              
              
              
              870
              
              
              
              25
              
              
              
              2.9
              %Marketing
              
              
              125
              
              
              
              171
              
              
              
              (46
              )
              
              
              -26.9
              %
              
              
              489
              
              
              
              496
              
              
              
              (7
              )
              
              
              -1.4
              %Third-party
      services
              
              
              218
              
              
              
              196
              
              
              
              22
              
              
              
              11.2
              %
              
              
              715
              
              
              
              589
              
              
              
              126
              
              
              
              21.4
              %Telephone,
      postage and supplies
              
              
              147
              
              
              
              158
              
              
              
              (11
              )
              
              
              -7.0
              %
              
              
              452
              
              
              
              462
              
              
              
              (10
              )
              
              
              -2.2
              %State
      taxes
              
              
              131
              
              
              
              121
              
              
              
              10
              
              
              
              8.3
              %
              
              
              399
              
              
              
              381
              
              
              
              18
              
              
              
              4.7
              %FDIC
      insurance premiums
              
              
              235
              
              
              
              81
              
              
              
              154
              
              
              
              190.1
              %
              
              
              967
              
              
              
              190
              
              
              
              777
              
              
              
              408.9
              %Other
              
              
              341
              
              
              
              323
              
              
              
              18
              
              
              
              5.6
              %
              
              
              1,039
              
              
              
              884
              
              
              
              155
              
              
              
              17.5
              %Total
              
              $
              3,926
              
              
              $
              3,668
              
              
              $
              258
              
              
              
              7.0
              %
              
              $
              12,239
              
              
              $
              10,794
              
              
              $
              1,445
              
              
              
              13.4
              %





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 $3,926,000 for the
third quarter of 2009, an increase of $258,000 from the third quarter of 2008.
The largest contributing factor to the increase in non-interest expense was FDIC
insurance premium expense which increased $154,000 to $235,000, comparing the
third quarter of 2009 to 2008. The higher expense is a result of strong deposit
growth coupled with an increased assessment rate which was levied on all insured
institutions by the FDIC in order to replenish the Deposit Insurance Fund and
QNB’s participation in the FDIC’s Transaction Account Guarantee
Program.





Salaries
and benefits is the largest component of non-interest expense. Salaries and
benefits expense increased 5.8%, to $2,115,000 for the quarter ended September
30, 2009 compared to the same quarter in 2008. Salary expense increased
$111,000, or 6.7%, during the period to $1,771,000. Prior year salary expense
included a $51,000 accrual for incentive compensation. There was no accrual for
incentive compensation during the third quarter of 2009. Excluding the incentive
compensation accrual, salary expense increased 8.6% when comparing the third
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 nine when
comparing the third 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 $22,000, or 5.8%, to $393,000. Increases in payroll tax
expense, retirement plan contribution expense and medical and life insurance
premium expense all contributed to the increase in benefit
expense.





Marketing
expense decreased $46,000, to $125,000, for the quarter ended September 30,
2009. The decrease in marketing expense was a result of the timing of customer
newsletters, the timing of certain charitable contributions and the elimination
of advertising and promotional expenses related to a non-interest bearing
deposit program run during 2008.





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 $22,000 for the three months ended September 30, 2009 when
comparing the same period in 2008. Total expense was $218,000 for the third
quarter of 2009 compared to $196,000 for the third quarter of 2008. The largest
portion of the increase related to the following third-party
services:




·
            Legal
      expense increased by $23,000 primarily as a result of loan collection
      costs.


·
            Consultant
      expense increased  due to the use of an independent third party
      to analyze and value the Bank’s pooled trust preferred
      securities.


·
            $6,000
      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.


·
            $21,000
      decrease in audit and accounting fees due to the reversal of an accrual
      related to an audit of internal controls that will not be required until
      2010 based on a recent announcement by the
SEC.





Telephone,
postage and supplies expense decreased $11,000 to $147,000, when comparing the
three-month periods. Telephone expense decreased $13,000 to $47,000, when
comparing the three months ended September 30, 2009 to the same period in 2008.
In the third quarter of 2008 the Company installed new telephone lines and
incurred redundancy costs during the testing period. Also contributing to the
variance for the quarter was a decrease in postage expense of $3,000 and an
increase of $5,000 in supplies expense.





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 $131,000 for the third quarter of 2009,
an increase of $10,000 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 coupled with an increase of $3,000 in the Company’s capital stock
tax.





FDIC
insurance premium expense $154,000, to $235,000, comparing the third quarter of
2009 to 2008. The higher expense is a result of deposit growth and an increased
assessment rate which was levied on all insured institutions by the FDIC in
order to replenish the Deposit Insurance Fund.





Other
expense increased $18,000 to $341,000 for the third quarter of 2009. The main
contributors to the increase in this category were a $10,000 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. There was also an increase of $7,000 in ATM fee refunds in connection
with the eRewards checking account that was introduced in 2008.





Total
non-interest expense was $12,239,000 for the nine-month period ended September
30, 2009 compared to $10,794,000 for the same period in 2008, an increase of
$1,445,000. As discussed later, an increase in FDIC premiums accounts for more
than half of this variance, $777,000.





Salaries
and benefits expense increased $346,000, or 5.8%, to $6,271,000 for the nine
months ended September 30, 2009 compared to the same period in 2008. Salary
expense increased $294,000, or 6.0%, during the period to $5,166,000. Prior year
salary expense included a $153,000 accrual for incentive compensation. There was
no accrual for incentive compensation in 2009. Excluding the incentive
compensation accrual, salary expense increased 9.5% when comparing the
nine-month periods. The average number of full time-equivalent employees
increased by nine when comparing the periods. Benefits expense increased
$91,000, or 7.9%, to $1,248,000 when comparing the nine-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




54


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


NON-INTEREST
EXPENSE (Continued)




Third
party service expense was $715,000 for the nine-month period ended September 30,
2009, an increase of $126,000 from the same period in 2008. The largest portion
of the increase related to the following third-party services:




·
            Legal
      expenses increased $49,000 primarily as a result of loan collection
      costs.


·
            Consultant
      expense increased by $19,000. The majority of the increase is related to
      consultants used to analyze and value the Bank’s pooled trust preferred
      securities.


·
            $11,000
      increase in fees for correspondent banking services, primarily caused by
      much lower crediting rates to help offset the fees incurred on these
      accounts.


·
            $22,000
      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.


·
            $19,000
      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.





FDIC
insurance premiums increased $777,000, or 408.9%, to $967,000 for the nine
months ended September 30, 2009. 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.





Other
expense increased $155,000 to $1,039,000 for the nine months ended September 30,
2009 compared to the same period in 2008. The primary contributors to the
increase in this category were a $47,000 increase in service and sales training
for branch and call center personnel and $58,000 related to expenses in
connection with foreclosed real estate and repossessed assets. Also contributing
to the increase was a $43,000 increase in expenses related to the processing of
check card transactions as well as the production of replacement cards. There
was also an increase of $16,000 in ATM fee refunds in connection with the
eRewards checking account that was introduced last year.





INCOME
TAXES





QNB
utilizes an asset and liability approach for financial accounting and reporting
of income taxes. As of September 30, 2009, QNB’s net deferred tax asset was
$584,000. The primary components of deferred taxes are a deferred tax asset of
$1,894,000 relating to the allowance for loan losses, a deferred tax asset of
$432,000 generated by OTTI charges on equity securities and a deferred tax asset
of $259,000 related to OTTI charges on trust preferred securities. Partially
offsetting these deferred tax assets was a deferred tax liability of $1,696,000
resulting from unrealized gains on available-for-sale securities. As of
September 30, 2008, QNB’s net deferred tax asset was $2,296,000. The primary
components of deferred taxes are a deferred tax asset of $1,187,000 related to
the allowance for loan losses, a deferred tax asset of $908,000 resulting from
unrealized losses on available-for-sale securities and a deferred tax asset of
$171,000 related to impaired securities.





55


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


INCOME
TAXES (Continued)




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.





As a
result of the additional provision for loan losses and the OTTI charges on the
investment securities, QNB recorded a tax benefit of $56,000 for the third
quarter of 2009. Income tax expense was $476,000 for the three months ended
September 30, 2008 and the effective tax rate was 23.3%. For the nine-month
periods ended September 30, 2009 and 2008 applicable income taxes and the
effective tax rate were $411,000, or 12.1%, and $1,492,000, or 23.4%,
respectively. The negative and lower effective tax rate for the three months and
nine months ended September 30, 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
nine months ended September 30, 2009 and 2008, as well as the period ended
balances as of September 30, 2009 and December 31, 2008.





Average
earning assets for the nine-month period ended September 30, 2009 increased
$74,186,000, or 12.3%, to $671,205,000 from $597,019,000 for the nine months
ended September 30, 2008. The mix of earning assets changed slightly when
comparing the two periods. Average loans increased $43,095,000, or 11.3%, while
average investment securities increased $34,291,000, or 16.7%. Average loans
represented 63.2% of earning assets for the first nine months of 2009 while
average investment securities represented 35.7% for the same period. This
compares to 63.8% and 34.4% for the first nine months of 2008. Average Federal
funds sold decreased $6,918,000, or 83.9%, 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 53
basis points more for the nine months than the average yield on Federal funds.
Excess funds were also maintained at the Federal Reserve Bank, which was paying
about 10 basis points more than 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 15.2% between September 30, 2008 and September 30, 2009 and
increased 8.5% 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 $41,320,000 when comparing the first nine
months of 2009 to the first nine months of 2008. Most of the 15.1% growth in
average commercial loans was in loans secured by real estate, either commercial
or residential properties, which increased $35,210,000, or 19.5%, to
$216,054,000. Included in this category
are construction loans which increased from $21,894,000 at December 31, 2008 to
$31,427,000 at September 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 $5,320,000, or 7.8%, when comparing the average
balances for the nine 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 $1,892,000, or 14.6%, when comparing the nine-month
periods. This increase is primarily related to  leases to the United
States Department of Agriculture and a University.





Average
residential mortgage loans increased $3,069,000, or 14.1%, when comparing the
first nine months of 2009 to the first nine months of 2008. Included in this
category are mortgages held-for-sale which increased on average $1,031,000
during this period. With the historically low level of interest rates over the
past twelve months, 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 nine months of 2008 to $65,500,000 for the first nine 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 $9,728,000 to $44,169,000 when comparing the nine-month
periods. In contrast average floating rate home equity lines have increased by
$7,004,000 comparing the same periods. The introduction of the Equity Choice
product contributed to this migration.





Total
investment securities were $253,779,000 at September 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
$11,976,000, $16,440,000 and $8,657,000, respectively, when comparing December
31, 2008 and September 30, 2009. The growth in the investment portfolio reflects
the significant deposit inflows, in excess of the increase in loans, received by
the Company over the nine month period. QNB has increased its purchase of
Government National Mortgage Association (GNMA) CMOs as these securities qualify
for 0% risk-weighting for capital purposes. During 2009, approximately
$7,000,000 of these securities were purchased. 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 an amortized cost of $4,314,000 and a fair value of $1,284,000.
The market for these securities at September 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 does not intend to sell 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 ASC 325 (formerly EITF Issue No. 99-20). 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 third quarter of 2009 a $753,000 other-than-temporary impairment charge was
taken on three issues. 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 $71,846,000, or 14.0%, to $584,743,000 for the first nine months of
2009 compared to the first nine months 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 $55,544,000,
or 20.5%, to $326,418,000 for the first nine months of 2009. Included in this
total was $107,700,000 of time deposits of $100,000 or more, an increase of
$34,949,000 from the $72,751,000 reported for the first nine months 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 $1,843,000,
or 3.6%, and $11,534,000, or 20.3%, respectively, when comparing the first nine
months 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 $8,621,000, or 17.8%, and $4,545,000, or 10.3%, when
comparing the same periods while the average balance of municipal
interest-bearing demand accounts decreased $10,241,000, or 24.7%. Municipalities
and school districts have moved funds to other higher yielding QNB products or
to alternative investments outside of QNB.





58


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


FINANCIAL
CONDITION ANALYSIS (Continued)




Total
assets at September 30, 2009 were $728,225,000 compared with $664,394,000 at
December 31, 2008, an increase of 9.6%. Most of the growth in total assets since
December 31, 2008 was in loans receivable and investment securities, which
increased $33,881,000 and $30,584,000, respectively. In addition,
interest-bearing deposits in banks increased by $9,141,000 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 $54,369,000, or 9.9%, 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 savings and money market accounts, as well as higher-cost
time deposits. Interest-bearing demand accounts increased $10,766,000, or 11.3%,
to $106,396,000. 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 $16,440,000 at September 30, 2009. Personal
interest-bearing demand accounts declined by $4,724,000 during this same time
period.





Money
market accounts increased $22,846,000, or 50.1%, from December 31, 2008 to
$68,418,000 at September 30, 2009. Personal money market accounts increased by
$8,881,000 while business accounts increased by $13,965,000. Savings account
balances increased from $44,006,000 at December 31, 2008 to $52,983,000 at
September 30, 2009, an increase of 20.4%. 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 $5,540,000 at
September 30, 2009.





Time
deposits continued to grow, increasing $14,947,000 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 $42,777,000 at September 30, 2009 compared with $22,479,000 at
December 31, 2008. Included in these amounts were time deposits of $37,554,000
and $22,377,000, respectively, at September 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
September 30, 2009, the Bank had a maximum borrowing capacity with the FHLB of
approximately $121,074,000. At September 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 September 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.




59


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


LIQUIDITY (Continued)




Cash and
due from banks, interest-bearing deposits in banks, Federal funds sold,
investment securities available-for-sale and loans held-for-sale totaled
$269,359,000 and $236,168,000 at September 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.





Approximately
$128,798,000 and $101,302,000 of available-for-sale securities at September 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 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 their 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 September
30, 2009 was $57,434,000, or 7.89% of total assets, compared to shareholders'
equity of $53,909,000, or 8.11% of total assets, at December 31, 2008.
Shareholders’ equity at September 30, 2009 included a positive adjustment of
$3,292,000 related to unrealized holding gains, 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 tax benefits, on investment securities available-for-sale. Without these
adjustments, shareholders' equity to total assets would have been 7.43% and
8.15% at September 30, 2009 and December 31, 2008, respectively.





Average
shareholders' equity and average total assets were $54,627,000 and $698,843,000
for the first nine months of 2009, an increase of 2.1% and 10.6%, respectively,
from the averages for the year ended December 31, 2008. The ratio of average
total equity to average total assets was 7.82% for the first nine 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
 September
      30,
                2009
              
              
              December
      31,
                2008Tier
      IShareholder's
      Equity
              
              $
              57,434
              
              
              $
              53,909Net
      unrealized securities (losses) gains
              
              
              (3,292
              )
              
              
              233Net
      unrealized losses on available-for-sale equity securities
              
              
              -
              
              
              
              (246
              )Total
      Tier I risk-based capital
              
              $
              54,142
              
              
              $
              53,896Tier
      IIAllowable
      portion: Allowance for loan losses
              
              
              5,573
              
              
              
              3,836Unrealized
      gains on equity securities
              
              
              232
              
              
              
              -Total
      risk-based capital
              
              $
              59,947
              
              
              $
              57,732Risk-weighted
      assets
              
              $
              526,135
              
              
              $
              466,721Average
      assets
              
              $
              727,152
              
              
              $
              648,110
 Capital
Ratios
 September
      30,
                2009
              
              
              December
      31,
                2008Tier
      I capital/risk-weighted assets
              
              
              10.29
              %
              
              
              11.55
              %Total
      risk-based capital/risk-weighted assets
              
              
              11.39
              %
              
              
              12.37
              %Tier
      I capital/average assets (leverage ratio)
              
              
              7.45
              %
              
              
              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
10.29% and 11.55%, a total risk-based ratio of 11.39% and 12.37% and a leverage
ratio of 7.45% and 8.32% at September 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 September 30, 2009, 57,883 shares were repurchased under this
authorization at an average price of $16.97 and a total cost of $982,000. There
were no shares repurchased during the quarter ended September 30, 2009. As of
September 30, 2008, QNB had not repurchased any shares under the Board’s
authorization.





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 nine months of 2009. Loan growth, primarily centered in
commercial loans, accounted for approximately $38.5 million of the growth in
risk-weighted assets, while $28.0 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 $4,314,000 at September
30, 2009, regulatory guidance required an additional $27,986,000 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 September 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 $3.1 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 September 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 September 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 September 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
              
              $
              24,397
              
              
              $
              419
              
              
              
              1.7
              %+200
      Basis Points
              
              
              24,370
              
              
              
              392
              
              
              
              1.6+100
      Basis Points
              
              
              24,292
              
              
              
              314
              
              
              
              1.3Flat
      Rate
              
              
              23,978
              
              
              
              -
              
              
              
              --100
      Basis Points
              
              
              23,365
              
              
              
              (613
              )
              
              
              (2.6
              )
  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





SEPTEMBER
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 PlanJuly
      1, 2009 through July 31, 2009
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              42,117August
      1, 2009 through August 31, 2009
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              42,117September
      1, 2009 through September 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 on January 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 100,000 as 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 not intend to make further
  purchases.


Item
      3.
            Default Upon Senior
      Securities




None.





Item
      4.
            Submission of Matters
      to Vote of Security Holders




None.





Item
      5.
              Other
      Information




None.




65




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:
      November 13, 2009
            By:
            /s/
      Thomas J. BiskoThomas
      J. Bisko
              President/CEO






Date:
      November 13, 2009
              By:
              /s/
      Bret H. KrevolinBret
      H. Krevolin
                Chief
      Financial Officer