**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM10-Q**

 

**QUARTERLYREPORT UNDER SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**FOR QUARTER ENDED SEPTEMBER 30,2004**

 

**COMMISSION FILE NUMBER: 333-90273**

 

**FIDELITYD & D BANCORP, INC.**

 

| STATE OF INCORPORATION: | IRS EMPLOYER  IDENTIFICATION NO: |
|-------------------------|----------------------------------|
| **PENNSYLVANIA**        | **23-3017653**                   |

 

PRINCIPAL OFFICE:

**BLAKELY & DRINKER ST.DUNMORE, PENNSYLVANIA 18512**

 

TELEPHONE:

**570-342-8281**

 

The Company (1)has filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the Company was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.

 

| ý | YES | o | NO |
|--------|-----|---|----|

 

The Registrant is an accelerated filer (as defined in Exchange Act Rule12b-2)

 

| o | YES | ý | NO |
|---|-----|--------|----|

 

The number of outstanding shares of Common Stock of Fidelity D & DBancorp, Inc. at October 29, 2004, the latest practicable date, was 1,835,462shares.

 

** **

----

 

**FIDELITYD & D BANCORP, INC.**

 

Form 10-Q September 30,2004

 

Index

 
| ** **                                | **Page**                                                                                                                |
|-------------------------------------------|-------------------------------------------------------------------------------------------------------------------------|
| **Part I. Financial information**         | ** **                                                                                                              |
|                                      |                                                                                                                    |
| Item 1. Financial Statements (unaudited): |                                                                                                                    |
|                                      |                                                                                                                    |   |
|                                      | Consolidated Balance Sheets  as of September 30, 2004 and December 31, 2003                                             | 3 |
|                                      |                                                                                                                    |   |
|                                      | Consolidated  Statements of Income for the three and nine months ended September 30, 2004  and 2003                     | 4 |
|                                      |                                                                                                                    |   |
|                                      | Consolidated  Statements of Changes in Shareholders’ Equity for the nine months ended  September 30, 2003 and 2004 | 5 |
|                                      |                                                                                                                    |   |
|                                      | Consolidated  Statements of Cash Flows for the nine months ended September 30, 2004 and  2003                           | 6 |
|                                      |                                                                                                                    |   |
|                                      | Notes to Consolidated Financial Statements                                                                              | 7 |
|                                      |                                                                                                                    |   |
| Item  2.                                  | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                             | 10 |
|                                      |                                                                                                                    |   |
| Item 3.                                   | Quantitative and  Qualitative Disclosure about Market Risk                                                              | 26 |
|                                      |                                                                                                                    |   |
| Item 4.                                   | Controls and  Procedures                                                                                                | 30 |
|                                      |                                                                                                                    |   |
| **Part II.**                              | **Other Information**                                                                                                   |   |
|                                      |                                                                                                                    |   |
| Item 1.                                   | Legal Proceedings                                                                                                       | 30 |
|                                      |                                                                                                                    |   |
| Item 2.                                   | Unregistered Sales of Equity  Securities and Use of Proceeds                                                            | 30 |
|                                      |                                                                                                                    |   |
| Item 3.                                   | Defaults upon  Senior Securities                                                                                        | 30 |
|                                      |                                                                                                                    |   |
| Item 4.                                   | Submission  of Matters to a Vote of Security Holders                                                                    | 31 |
|                                      |                                                                                                                    |   |
| Item 5.                                   | Other  Information                                                                                                      | 31 |
|                                      |                                                                                                                    |   |
| Item 6.                                   | Exhibits  and Reports on Form 8-K                                                                                       | 31 |
|                                      |                                                                                                                    |   |
| Signatures                                | 33                                                                                                                      |
|                                      |                                                                                                                    |
| Exhibit  index                            | 34                                                                                                                      |

 

2

----

 

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

Consolidated Balance Sheets

Asof September 30, 2004 and December 31, 2003

 
| ** **                                                                                                                                   | ** ** | **September 30, 2004** | ** **  | **December 31, 2003** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|-------------|-----------------------|------------|
| ** **                                                                                                                                   | ** ** | **(unaudited)**        | ** **  | **(audited)**         | ** ** |
| **ASSETS**                                                                                                                                   |       |                   |        |                  |       |
| Cash and due  from banks                                                                                                                     |       | $                      | 11,393,545  |                  | $          | 13,148,199 |   |
| Interest-bearing  deposits with financial institutions                                                                                       |       | 721,531                |        | 6,083,402             |       |
| Federal funds  sold                                                                                                                          |       | 950,000                |        | —                |       |
| Total cash and  cash equivalents                                                                                                             |       | 13,065,076             |        | 19,231,601            |       |
|                                                                                                                                         |       |                   |        |                  |       |
| Available-for-sale  securities                                                                                                               |       | 127,122,632            |        | 139,695,232           |       |
| Held-to-maturity  securities                                                                                                                 |       | 3,255,986              |        | 4,712,142             |       |
| Loans and  leases, net (allowance for loan losses of $6,108,966 in 2004 and $4,996,966  in 2003)                                             |       | 376,746,786            |        | 366,981,640           |       |
| Loans  available-for-sale (fair value $333,075 in 2004; $20,500,507 in 2003)                                                                 |       | 329,777                |        | 19,863,577            |       |
| Bank premises  and equipment, net                                                                                                            |       | 11,365,098             |        | 12,091,937            |       |
| Cash surrender  value of bank owned life insurance                                                                                           |       | 7,533,903              |        | 7,293,538             |       |
| Other assets                                                                                                                                 |       | 3,290,685              |        | 3,071,552             |       |
| Accrued interest  receivable                                                                                                                 |       | 2,135,909              |        | 1,807,081             |       |
| Foreclosed  assets held for sale                                                                                                             |       | 325,170                |        | 467,166               |       |
| **Total  assets**                                                                                                                            |       | $                      | 545,171,022 |                  | $          | 575,215,466 |   |
| **LIABILITIES**                                                                                                                              |       |                   |        |                  |       |
| Deposits                                                                                                                                     |       |                   |        |                  |       |
| Non-interest-bearing                                                                                                                         |       | $                      | 65,621,626  |                  | $          | 64,398,658 |   |
| Certificates of  deposit of $100,000 or more                                                                                                 |       | 99,209,191             |        | 112,857,420           |       |
| Other  interest-bearing deposits                                                                                                             |       | 210,598,885            |        | 224,186,468           |       |
| Total deposits                                                                                                                               |       | 375,429,702            |        | 401,442,546           |       |
|                                                                                                                                         |       |                   |        |                  |       |
| Long-term debt                                                                                                                               |       | 76,310,517             |        | 71,876,034            |       |
| Short-term borrowings                                                                                                                        |       | 44,489,958             |        | 54,756,978            |       |
| Accrued interest  payable and other liabilities                                                                                              |       | 3,061,301              |        | 3,208,009             |       |
| **Total  liabilities**                                                                                                                       |       | 499,291,478            |        | 531,283,567           |       |
| **SHAREHOLDERS’  EQUITY**                                                                                                               |       |                   |        |                  |       |
| Preferred stock  authorized 5,000,000 shares with no par value; none issued                                                                  |       | —                 |        | —                |       |
| Capital stock  authorized 10,000,000 shares with no par value; issued and outstanding  1,835,462 shares in 2004 and 1,828,270 shares in 2003 |       | 9,934,165              |        | 9,698,879             |       |
| Treasury stock,  at cost                                                                                                                     |       | —                 |        | (196,048              | )          |
| Retained  earnings                                                                                                                           |       | 35,794,667             |        | 34,641,976            |       |
| Accumulated  other comprehensive income (loss)                                                                                               |       | 150,712                |        | (212,908              | )          |
| **Total  shareholders’ equity**                                                                                                         |       | 45,879,544             |        | 43,931,899            |       |
| **Total  liabilities and shareholders’ equity**                                                                                         |       | $                      | 545,171,022 |                  | $          | 575,215,466 |   |

 

3

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**FIDELITYD & D BANCORP, INC.**

Consolidated Statements of Income

(unaudited)

 
| ** **                                                | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|-----------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                | ** ** | **September 30, 2004** | ** ** | **September 30, 2003** | ** ** | **September 30, 2004** | ** ** | **September 30, 2003** | ** ** |
| **Interest  income**                                      |       |                   |       |                   |       |   |   |   |   |
| Interest and fees  on loans:                              |       |                   |       |                   |       |   |   |   |   |
| Taxable                                                   |       | $                      | 5,386,418  |                   | $          | 5,550,672 |   | $ | 16,260,004 |   | $ | 17,168,633 |   |
| Nontaxable                                                |       | 75,264                 |       | 100,017                |       | 233,780 |   | 305,354 |   |
| Leases                                                    |       | 34,089                 |       | 68,773                 |       | 126,435 |   | 239,608 |   |
| Interest-bearing  deposits with financial institutions    |       | 1,861                  |       | 1,087                  |       | 4,071 |   | 5,456 |   |
| Investment  securities:                                   |       |                   |       |                   |       |   |   |   |   |
| US Government  agencies                                   |       | 1,064,878              |       | 897,928                |       | 3,356,887 |   | 3,290,892 |   |
| States and  political subdivisions (nontaxable)           |       | 114,858                |       | 108,079                |       | 366,564 |   | 332,965 |   |
| Other securities                                          |       | 59,303                 |       | 47,298                 |       | 155,235 |   | 180,348 |   |
| Federal funds  sold                                       |       | 1,028                  |       | 9,372                  |       | 11,238 |   | 44,552 |   |
| **Total  interest income**                                |       | 6,737,699              |       | 6,783,226              |       | 20,514,214 |   | 21,567,808 |   |
| **Interest  expense**                                     |       |                   |       |                   |       |   |   |   |   |
| Certificates of  deposit of $100,000 or more              |       | 700,172                |       | 1,125,724              |       | 2,301,440 |   | 3,733,010 |   |
| Other deposits                                            |       | 903,016                |       | 1,305,852              |       | 2,873,866 |   | 4,135,547 |   |
| Securities sold  under repurchase agreements              |       | 119,240                |       | 103,554                |       | 323,501 |   | 395,478 |   |
| Other short- and  long-term borrowings and other          |       | 997,357                |       | 907,728                |       | 2,973,383 |   | 2,702,298 |   |
| **Total  interest expense**                               |       | 2,719,785              |       | 3,442,858              |       | 8,472,190 |   | 10,966,333 |   |
| **Net  interest income**                                  |       | 4,017,914              |       | 3,340,368              |       | 12,042,024 |   | 10,601,475 |   |
| Provision for  loan losses                                |       | 450,000                |       | 300,000                |       | 1,700,000 |   | 1,060,000 |   |
| **Net  interest income, after provision for loan losses** |       | 3,567,914              |       | 3,040,368              |       | 10,342,024 |   | 9,541,475 |   |
| **Other  income:**                                        |       |                   |       |                   |       |   |   |   |   |
| Service charges  on deposit accounts                      |       | 554,394                |       | 552,181                |       | 1,620,614 |   | 1,373,072 |   |
|  Gain on  sale of:                                   |       |                   |       |                   |       |   |   |   |   |
| Investment  securities                                    |       | —                 |       | —                 |       | 9,497 |   | 213,828 |   |
| Loans                                                     |       | 61,065                 |       | 79,254                 |       | 155,452 |   | 503,660 |   |
| Loss on leased  assets                                    |       | (50,690                | )          | (57,197                | )          | (205,876 | ) | (146,791 | ) |
| Gain (loss) on  foreclosed assets held for sale           |       | 4,102                  |       | 20,461                 |       | (4,116 | ) | (19,711 | ) |
| Fees, other  service charges and other income             |       | 579,867                |       | 425,913                |       | 1,590,469 |   | 1,314,137 |   |
| **Total  other income**                                   |       | 1,148,738              |       | 1,020,612              |       | 3,166,040 |   | 3,238,195 |   |
| **Other  operating expenses:**                            |       |                   |       |                   |       |   |   |   |   |
| Salaries and  employee benefits                           |       | 1,745,107              |       | 1,660,377              |       | 5,193,127 |   | 4,888,554 |   |
| Premises and  equipment                                   |       | 690,847                |       | 711,272                |       | 2,128,474 |   | 2,090,683 |   |
| Advertising                                               |       | 158,193                |       | 110,727                |       | 303,385 |   | 253,232 |   |
| Other                                                     |       | 1,063,647              |       | 710,536                |       | 2,846,543 |   | 2,269,489 |   |
| **Total  other operating expenses**                       |       | 3,657,794              |       | 3,192,912              |       | 10,471,529 |   | 9,501,958 |   |
| **Income  before provision for income taxes**             |       | 1,058,858              |       | 868,068                |       | 3,036,535 |   | 3,277,712 |   |
| Provision for  income taxes                               |       | 245,346                |       | 183,433                |       | 677,223 |   | 782,806 |   |
| ** Net  income**                                     |       | $                      | 813,512    |                   | $          | 684,635 |   | $ | 2,359,312 |   | $ | 2,494,906 |   |
| Per share data:                                           |       |                   |       |                   |       |   |   |   |   |
| Net income -  basic                                       |       | $                      | 0.45       |                   | $          | 0.38 |   | $ | 1.29 |   | $ | 1.37 |   |
| Net income -  diluted                                     |       | $                      | 0.45       |                   | $          | 0.38 |   | $ | 1.29 |   | $ | 1.37 |   |
| Dividends                                                 |       | $                      | 0.22       |                   | $          | 0.22 |   | $ | 0.66 |   | $ | 0.66 |   |

 

4

----

 

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

Consolidated Statements ofChanges in Shareholders’ Equity

Forthe nine months ended September 30, 2003 and 2004

 
| ** **                                                                                                                  | ** ** | ** **         | ** ** | ** **          | ** ** | ** **   | ** ** | ** **        | ** ** | ** **   | ** ** | **Accumulated  other** | ** ** | ** ** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|---------------------|------------|--------------|------------|-------------------|------------|--------------|------------|------------------------|------------|------------|------------|
| ** **                                                                                                                  | ** ** | **Capital  stock** | ** ** | **Treasury  stock** | ** ** | **Retained** | ** ** | **comprehensive** | ** ** | ** **   | ** ** |
| ** **                                                                                                                  | ** ** | **Shares**         | ** ** | **Amount**          | ** ** | **Shares**   | ** ** | **Amount**        | ** ** | **earnings** | ** ** | **income  (loss)**     | ** ** | **Total**  | ** ** |
| Balance, December  31, 2002 (audited)                                                                                       |       | 1,825,363          |       | $                   | 9,590,142  |         | (5,987     | )                 | $          | (221,559     | )          | $                      | 34,600,626 |       | $          | 1,265,224 |   | $ | 45,234,433 |   |
| Comprehensive  income:                                                                                                      |       |               |       |                |       |         |       |              |       |         |       |                   |       |       |       |
| Net income                                                                                                                  |       |               |       |                |       |         |       |              |       | 2,494,906    |       |                   |       | 2,494,906  |       |
| Change in net  unrealized holding gains (losses) on available-for-sale securities, net net  of reclassification adjustments |       |               |       |                |       |         |       |              |       |         |       | (1,255,252             | )          | (1,255,252 | )          |
| Comprehensive  income                                                                                                       |       |               |       |                |       |         |       |              |       |         |       |                   |       | 1,239,654  |       |
| Issuance of  common stock through Employee Stock Purchase Plan                                                              |       |               |       |                |       | 1,264        |       | 42,654            |       |         |       |                   |       | 42,654     |       |
| Dividends  reinvested through Dividend Reinvestment Plan                                                                    |       | 3,133              |       | 109,918             |       | 7,529        |       | 278,929           |       |         |       |                   |       | 388,847    |       |
| Stock options  exercised                                                                                                    |       |               |       |                |       | 800          |       | 29,800            |       |         |       |                   |       | 29,800     |       |
| Purchase of  treasury stock                                                                                                 |       |               |       |                |       | (12,720      | )          | (457,920          | )          |         |       |                   |       | (457,920   | )          |
| Dividends  declared                                                                                                         |       |               |       |                |       |         |       |              |       | (1,201,632   | )          |                   |       | (1,201,632 | )          |
| Balance,  September 30, 2003 (unaudited)                                                                                    |       | 1,828,496          |       | $                   | 9,700,060  |         | (9,114     | )                 | $          | (328,096     | )          | $                      | 35,893,900 |       | $          | 9,972 |   | $ | 45,275,836 |   |
|                                                                                                                        |       |               |       |                |       |         |       |              |       |         |       |                   |       |       |       |
| Balance, December  31, 2003 (audited)                                                                                       |       | 1,828,270          |       | $                   | 9,698,879  |         | (5,227     | )                 | $          | (196,048     | )          | $                      | 34,641,976 |       | $          | (212,908 | ) | $ | 43,931,899 |   |
| Comprehensive  income:                                                                                                      |       |               |       |                |       |         |       |              |       |         |       |                   |       |       |       |
| Net income                                                                                                                  |       |               |       |                |       |         |       |              |       | 2,359,312    |       |                   |       | 2,359,312  |       |
| Change in net  unrealized holding gains (losses) on available-for-sale securities, net net  of reclassification adjustments |       |               |       |                |       |         |       |              |       |         |       | 363,620                |       | 363,620    |       |
| Comprehensive  income                                                                                                       |       |               |       |                |       |         |       |              |       |         |       |                   |       | 2,722,932  |       |
| Reissued treasury  stock through Employee Stock Purchase Plan                                                               |       |               |       | (8,329              | )          | 1,635        |       | 61,370            |       |         |       |                   |       | 53,041     |       |
| Dividends  reinvested through Dividend Reinvestment Plan                                                                    |       | 7,192              |       | 243,615             |       | 3,592        |       | 134,678           |       |         |       |                   |       | 378,293    |       |
| Dividends  declared                                                                                                         |       |               |       |                |       |         |       |              |       | (1,206,621   | )          |                   |       | (1,206,621 | )          |
| Balance,  September 30, 2004 (unaudited)                                                                                    |       | 1,835,462          |       | $                   | 9,934,165  |         | —     |              | $          | —       |       | $                      | 35,794,667 |       | $          | 150,712 |   | $ | 45,879,544 |   |

 

5

----

 

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

Consolidated Statements ofCash Flows

(unaudited)

 
| ** **                                                                         | ** ** | **Nine Months Ended**  | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                         | ** ** | **September 30, 2004** | ** ** | **September 30, 2003** | ** ** |
| **Cash  flows from operating activities:**                                         |       |                   |       |   |   |
| Net income                                                                         |       | $                      | 2,359,312  |   | $ | 2,494,906 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                   |       |   |   |
| Depreciation                                                                       |       | 911,171                |       | 942,335 |   |
| Amortization of  securities (net of accretion)                                     |       | 441,223                |       | 1,366,784 |   |
| Provision for  loan losses                                                         |       | 1,700,000              |       | 1,060,000 |   |
| Deferred income  tax                                                               |       | (594,889               | )          | (377,970 | ) |
| Write-down of  foreclosed assets held-for-sale                                     |       | 121,789                |       | 543,752 |   |
| Increase in cash  surrender value of life insurance                                |       | (240,365               | )          | (201,929 | ) |
| Gain on sale of  investment securities                                             |       | (9,497                 | )          | (213,828 | ) |
| Gain on sale of  loans                                                             |       | (155,452               | )          | (503,660 | ) |
| Loss on sale of  foreclosed assets held- for-sale                                  |       | 4,116                  |       | 19,711 |   |
| Loss on sale of  leased assets                                                     |       | 205,876                |       | 146,792 |   |
| Loss on disposal  of equipment                                                     |       | 3,661                  |       | — |   |
| Amortization of  loan servicing rights                                             |       | 71,078                 |       | 206,255 |   |
| Net (increase)  decrease in accrued interest receivable and other assets           |       | (184,878               | )          | 277,531 |   |
| Net (decrease)  increase in accrued interest payable and other liabilities         |       | (146,708               | )          | 282,842 |   |
| Net cash provided  by operating activities                                         |       | 4,486,437              |       | 6,043,521 |   |
| **Cash  flows from investing activities:**                                         |       |                   |       |   |   |
| Held-to-maturity  securities:                                                      |       |                   |       |   |   |
| Proceeds from  maturities, calls and paydowns                                      |       | 1,445,868              |       | 6,095,371 |   |
| Available-for-sale  securities:                                                    |       |                   |       |   |   |
| Proceeds from  sales                                                               |       | 5,472,762              |       | 49,933,261 |   |
| Proceeds from  maturities, calls and paydowns                                      |       | 19,920,791             |       | 46,416,179 |   |
| Purchases                                                                          |       | (12,691,452            | )          | (95,353,175 | ) |
| Proceeds from  sale of loans available-for-sale                                    |       | 15,491,238             |       | 22,817,694 |   |
| Net increase in  loans and leases                                                  |       | (8,648,029             | )          | (25,553,632 | ) |
| Purchase of life  insurance policies                                               |       | —                 |       | (7,000,000 | ) |
| Proceeds from  sale of leased assets                                               |       | 753,007                |       | 980,072 |   |
| Acquisition of  bank premises and equipment                                        |       | (187,993               | )          | (563,788 | ) |
| Proceeds from  sale of credit card receivables                                     |       | —                 |       | 2,977,526 |   |
| Proceeds from  sale of foreclosed assets held-for-sale                             |       | 411,514                |       | 620,592 |   |
| Net cash  provided by investing activities                                         |       | 21,967,706             |       | 1,370,100 |   |
| **Cash  flows from financing activities:**                                         |       |                   |       |   |   |
| Net increase in  noninterest-bearing deposits                                      |       | 1,222,968              |       | 9,700,484 |   |
| Net decrease in  certificates of deposit of $100,000 or more                       |       | (13,648,229            | )          | (11,609,343 | ) |
| Net decrease in  other interest-bearing deposits                                   |       | (13,587,583            | )          | (2,474,253 | ) |
| Net decrease in  short-term borrowings                                             |       | (10,267,020            | )          | (4,430,396 | ) |
| Purchase of  treasury stock                                                        |       | —                 |       | (457,920 | ) |
| Net increase in  long-term borrowings                                              |       | 4,434,483              |       | — |   |
| Dividends paid,  net of dividend reinvestment                                      |       | (828,328               | )          | (812,786 | ) |
| Proceeds from  exercise of stock options                                           |       | —                 |       | 29,800 |   |
| Proceeds from  employee stock purchase plan                                        |       | 53,041                 |       | 42,654 |   |
| Net cash used in  by financing activities                                          |       | (32,620,668            | )          | (10,011,760 | ) |
| Net decrease in  cash and cash equivalents                                         |       | (6,166,525             | )          | (2,598,139 | ) |
| Cash and cash  equivalents, beginning                                              |       | 19,231,601             |       | 26,219,247 |   |
| Cash and cash equivalents,  ending                                                 |       | $                      | 13,065,076 |   | $ | 23,621,108 |   |

 

6

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**FIDELITYD & D BANCORP, INC.**

 

**Notes****toConsolidated Financial Statements**

**(unaudited)**

 

**1. Nature of operations and critical accountingpolicies**

 

# **Principles ofconsolidation**

 

The accompanying unaudited consolidated financial statements ofFidelity D&D Bancorp, Inc., and its wholly owned subsidiary, The FidelityDeposit and Discount Bank (the “Bank”), (collectively, the “Company”) have beenprepared in accordance with accounting principles generally accepted in theUnited States of America (“GAAP”) for interim financial information and withthe instructions to this Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of theinformation and footnote disclosures required by GAAP for complete financialstatements.  In the opinion ofmanagement, all normal recurring adjustments necessary for a fair presentationof the financial condition and results of operations for the periods have beenincluded.  All significant inter-companybalances and transactions have been eliminated in consolidation. Prior periodamounts are reclassified when necessary to conform to the current period’spresentation.

 

The preparation of financial statements in conformity with GAAPrequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reported periods.  Actual results could differ from thoseestimates. For additional information and disclosures required under GAAP,please refer to the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2003.

 

# **Nature ofoperations**

 

The Bank is a commercial bank chartered in the Commonwealth ofPennsylvania and a wholly owned subsidiary of the Company. Having commencedoperations in 1903, the Bank provides a full range of traditional bankingservices, trust services and alternative financial products from its mainoffice located in Dunmore and other branches throughout Lackawanna and Luzernecounties.

 

Management is responsible for the fairness, integrity and objectivityof the unaudited financial statements included in this report.  Management prepared the unaudited financialstatements in accordance with GAAP.  Inmeeting its responsibility for the financial statements, management depends onthe Company’s accounting systems and related internal controls.  These systems and controls are designed toprovide reasonable, but not absolute, assurance that the financial recordsaccurately reflect the transactions of the Company, the Company’s assets aresafeguarded and that financial statements present fairly the financialcondition and results of operations of the Company.

 

In the opinion of management, the consolidated balance sheets as ofSeptember 30, 2004 and December 31, 2003 and the related consolidatedstatements of income for each of the three and nine month periods endedSeptember 30, 2004 and September 30, 2003 and changes in shareholders’ equityand cash flows for each of the nine month periods ended September 30, 2004 andSeptember 30, 2003 present fairly the financial condition and results ofoperations of the Company.  All materialadjustments required for a fair presentation have been made.  These adjustments are of a normal recurringnature.  There have been no materialchanges in accounting principles, practices or in the method of application andthere have been no retroactive adjustments during these periods. The results ofoperations for interim periods are not necessarily indicative of the results ofoperations for the entire year.

 

This Quarterly Report on Form 10-Q should be read in conjunction withthe Company’s audited financial statements for the year ended December 31, 2003and the notes included therein, included within the Company’s Annual Reportfiled on Form 10-K.

 

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# **Criticalaccounting policies**

 

The presentation of financial statements in conformity with GAAPrequires management to make estimates and assumptions that affect many of thereported amounts and disclosures. Actual results could differ from theseestimates.

 

A material estimate that is particularly susceptible to significantchange is the determination of the allowance for loan losses.  Management believes that the allowance forloan losses, as of September 30, 2004, is adequate and reasonable.  Given the subjective nature of identifyingand valuing loan losses, it is likely that well-informed individuals could makematerially different assumptions, and could, therefore calculate a materiallydifferent allowance value.  Whilemanagement uses available information to recognize losses on loans, changes ineconomic conditions may necessitate revisions in the future.  In addition, various regulatory agencies, asan integral part of their examination process, periodically review the Company’sallowance for loan losses.  Such agenciesmay require the Company to recognize adjustments to the allowance based ontheir judgments of information available to them at the time of theirexamination.

 

Another material estimate is the calculation of fair values of theCompany’s investment securities.  TheCompany receives estimated fair values of investment securities from anindependent valuation service.  Indeveloping these fair values, the valuation service uses estimates of cashflows based on historical performance of similar instruments in similar interestrate environments.  Based on experience,management is aware that estimated fair values of investment securities tend tovary among valuation services. Accordingly, when selling investment securities, management typicallyobtains price quotes from more than one source. The majority of the Company’s investment securities are classified asavailable-for-sale. Available-for-sale securities are carried at fair marketvalue on the consolidated balance sheet, with unrealized gains and losses, netof income tax, reported as a separate component of shareholders’ equity inaccumulated other comprehensive income (loss).

 

The fair marketvalue of residential mortgage loans, classified as available-for-sale (AFS), isobtained from the Federal National Mortgage Association (Fannie Mae).  The fair value of Small BusinessAdministration (SBA) loans, classified as AFS, is obtained from an outsidepricing source.  To determine the fair marketvalue of student loans, classified as AFS, the Bank uses the pricing obtainedfrom the most recent student loans sold from its AFS portfolio.  The market to which the Bank sells mortgageand other loans is restricted and price quotes from other sources are nottypically obtained.  As of September 30,2004, the Company had only student loans classified as AFS.

 

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**2. Earnings per share**

 

Basic earnings pershare (“EPS”) is computed by dividing net income by the weighted-average numberof common shares outstanding during the period. Diluted EPS is computed by dividing net income by the weighted- averagenumber of common shares outstanding plus the number of incremental shares thatwould be outstanding after giving effect to the assumed exercise of the stockoptions whose strike price is below the market price (in the money options).

 

The following dataillustrates the amounts used in computing EPS and the effects on income and theweighted-average number of shares of potentially dilutive common stock for thenine months ended September 30, 2004 and 2003:

 
| ** **                                  | ** ** | **Income  numerator** | ** ** | **Weighted-average  common shares  denominator** | ** ** | **EPS** | ** ** |
|---------------------------------------------|------------|-----------------------|------------|--------------------------------------------------|------------|---------|------------|
| September 30, 2004                          |       |                  |       |                                             |       |    |       |
| Basic EPS                                   |       | $                     | 2,359,312  |                                             | 1,828,814  |    | $          | 1.29 |   |
| Dilutive effect  of potential common stock: |       |                  |       |                                             |       |    |       |
| Stock options:                              |       |                  |       |                                             |       |    |       |
| Exercise of  outstanding options            |       |                  |       | 5,100                                            |       |    |       |
| Hypothetical  share repurchase at $35.00    |       |                  |       | (4,517                                           | )          |    |       |
| Diluted EPS                                 |       | $                     | 2,359,312  |                                             | 1,829,397  |    | $          | 1.29 |   |
|                                        |       |                  |       |                                             |       |    |       |
| September 30,  2003                         |       |                  |       |                                             |       |    |       |
| Basic EPS                                   |       | $                     | 2,494,906  |                                             | 1,820,446  |    | $          | 1.37 |   |
| Dilutive effect  of potential common stock: |       |                  |       |                                             |       |    |       |
| Stock options:                              |       |                  |       |                                             |       |    |       |
| Exercise of  outstanding options            |       |                  |       | 10,600                                           |       |    |       |
| Hypothetical  share repurchase at $36.25    |       |                  |       | (9,691                                           | )          |    |       |
| Diluted EPS                                 |       | $                     | 2,494,906  |                                             | 1,821,355  |    | $          | 1.37 |   |

 

**3. Stock plans**

 

As permitted by Accounting Principles Board (“APB”) Opinion No. 25,Accounting for Stock Issued to Employees, the Company uses the intrinsic valuemethod of accounting for stock compensation plans.  Under the intrinsic value method,compensation cost is measured by the excess of the quoted market price of thestock, as of the grant date (or other measurement date) over the stock’sexercise price.  Since all options issuedunder the plans had an exercise price equal to the quoted market value of theunderlying common stock on the date of grant, the stock is deemed to have nointrinsic value, and accordingly, no compensation cost is recorded.

 

The alternative fair value method of accounting for stock-basedcompensation provided under Statement of Financial Accounting Standards (“SFAS”)No. 123, Accounting for Stock-BasedCompensation, requires the use of option valuation models, such as theBlack-Scholes option pricing model.  TheBlack-Scholes option pricing model was not developed for use in valuing stockoptions granted under employer stock option plans.  Rather, the Black-Scholes option pricingmodel was developed for use in estimating the fair market value of short-termoptions traded in organized exchanges. Options traded in organized exchanges have no vesting restrictions andare fully transferable.  In addition,option valuation models require the input of highly subjective assumptionsincluding the expected or implied volatility of the options underlyingstock.  Since the options granted underthe Company’s stock option plans have characteristics significantly differentfrom those of marketable options and because changes in the subjective inputassumptions can materially impact the estimated fair market value, inManagement’s opinion, the existing valuation models do no necessarily provide areliable single measure of the fair market value of its employee stock optionsat the time of grant.  In 2003 and forthe first nine months of 2004, the Company did not grant stock options underany of its stock plans.

 

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**Item 2****.****                                         Management’sDiscussion and Analysis of Results of Operations and Financial Condition**

 

The following is Management’s discussion and analysis of thesignificant changes in the consolidated financial condition of the Company asof September 30, 2004 and December 31, 2003 and the results of operations forthe three and nine months ended September 30, 2004 compared to the three andnine months ended September 30, 2003. Current performance may not be indicative of future results. Thisdiscussion should be read in conjunction with the Company’s 2003 Annual Reportfiled on Form 10-K.

 

**Forwardlooking statements**

 

This Interim Report on Form 10-Q contains a number of forward-lookingstatements within the meaning of Section 27A of the Securities Act of 1933, asamended, or the Securities Act, and Section 21E of the Securities Exchange Actof 1934, as amended, or the Exchange Act. These statements may be identified by the use of the words “anticipate,”“believe,” “could,” “estimate,” “expect,” “intend,” “may,” “outlook,” “plan,” “potential,”“predict,” “project,” “should,” “will,” “would” and similar terms and phrases,including references to assumptions. Forward looking statements include risksand uncertainties.

 

Forward-looking statements are based on various assumptions andanalyses made by us in light of Management’s experience and its perception ofhistorical trends, current conditions and expected future developments, as wellas other factors it believes are appropriate under the circumstances.  These statements are not guarantees of futureperformance and are subject to risks, uncertainties and other factors (many ofwhich are beyond our control) that could cause actual results to differ materiallyfrom future results expressed or implied by such forward-lookingstatements.  These factors include,without limitation, the following:

 

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

 

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

 

•                  changes in theinterest rate environment may reduce interest margins;

 

•                  changes indeposit flows, loan demand or real estate values may adversely affect ourbusiness;

 

•                  changes in accountingprinciples, policies or guidelines may cause our financial condition to beperceived differently;

 

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

 

•                  legislative orregulatory changes may adversely affect our business;

 

•                  technologicalchanges may be more difficult or expensive than we anticipate;

 

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

 

•                  acts of war orterrorism.

 

Management cautions readers not to place undue reliance onforward-looking statements, which reflect analyses only as of the date of thisreport.  We have no obligation to updateany forward-looking statements to reflect events or circumstances after thedate of this document.  Readers shouldreview the risk factors described in other documents that we file, from time totime, with the Securities and Exchange Commission, including Annual Reports toShareholders, Annual Reports filed on Form 10-K and other current reports filedon Form 8-K.

 

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**General**

 

The Company’s results of operations depend primarily on its netinterest income, which is the difference between interest income oninterest-earning assets, which principally consists of loans and investmentsecurities, and interest expense on interest-bearing liabilities, whichconsists of deposits and borrowings.  Netinterest income is determined by the Company’s interest rate spread (i.e., thedifference between the yields earned on its interest-earning assets and therates paid on its interest-bearing liabilities) and the relative amounts ofinterest-earning assets and interest-bearing liabilities.  The interest rate spread is influenced by theoverall interest rate environment, the composition and characteristics ofinterest-earning assets and interest-bearing liabilities and by the competitionin our marketplace. The interest rate spread and the changes in the interestrate spread, from period-to-period, is also influenced by differences in thematurity and re-pricing characteristics of assets compared to the maturity andre-pricing characteristics of liabilities that fund them.

 

The Company’s profitability is also affected by the level of itsnon-interest income and expenses, provision for loan losses and provision forincome taxes.  Non-interest incomeconsists mostly of service charges on the Bank’s various deposit products andincome from loan and other banking, trust and asset management service fees andincreases in the cash surrender value of the bank owned life insurance.  Non-interest expense consists of compensationand related employee benefit expenses, occupancy, equipment, data processing,advertising, marketing, professional fees, insurance and other operatingoverhead.

 

The Company’s profitability is significantly affected by generaleconomic and competitive conditions, changes in market interest rates,government policies and actions of regulatory authorities.  The Company’s loan portfolio is concentratedin commercial and commercial real estate. The properties underlying the Company’s mortgages are concentrated innortheastern Pennsylvania.  Credit risk,which represents the possibility of the Company not recovering amounts due fromits borrowers, is significantly related to local economic conditions in theareas the properties are located as well as the Company’s underwriting standards.  Economic conditions affect the market valueof the underlying collateral as well as the levels of occupancy of multi-familydwellings and levels of other income-producing properties and establishments.

 

**COMPARISONOF RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDEDSEPTEMBER 30, 2004 AND SEPTEMBER 30, 2003**

 

**Overview**

 

Net income for the third quarter of 2004 was $814,000, an increase of$129,000 or 19% from the $685,000 recorded in the same quarter in 2003.  Diluted earnings per share for the three monthsended September 30, 2004 improved to $0.45 from $0.38 for the three monthsended September 30, 2003.

 

The quarter-to-quarter comparison included an increase in net interestincome and an increase in non-interest income. These items were partially offset by an increase in the provision forloan losses, an increase in non-interest expense and an increase in theprovision for income taxes.

 

Return on average assets and return on average equity were 0.60% and7.29%, respectively, for the three months ended September 30, 2004 compared to0.48% and 6.09%, respectively, for the same period in 2003.

 

*Net interest income*

 

Net interest income is the Company’s primary source of earnings and isinfluenced primarily by the amount, distribution and re-pricing characteristicsof its interest-earning assets and interest-bearing liabilities as well as therelative levels and movements of interest rates.

 

Net interest income increased $677,000, or 20%, to $4,017,000 in thethird quarter of 2004, from the $3,340,000 recorded in the same period of2003.  The increase was attributable to a46 basis point decrease in rates paid on average interest-bearing liabilitiesin conjunction with a $29,131,000 decrease in the average balances on whichthey are paid.  The decrease in averageinterest-bearing liabilities was predominantly in the Bank’s certificate ofdeposits, which experienced a decline of $50,049,000 on average, from high costthirty-month product maturities and public fund certificate runoff, whencompared to the average balances for the third quarter of 2003.  As a result, interest expense

 

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declined $723,000, or 21%, in the third quarter of 2004 compared to thesame 2003 quarter.  Compared to the thirdquarter of 2003, average interest-earning assets were $20,022,000 lower thanthe same quarter of 2004 due to called, matured or pay-downs of investmentsecurities.  Despite the low interestrate environment, the book yield on interest-earning assets increased 18 basispoints to 5.26% in the 2004 quarter, primarily due to higher yields on the Bank’sportfolio of mortgage-backed securities which represents the highestconcentration of investments in the Bank’s investment portfolio.  During the 2003 quarter, the Bank experienceda higher amount of bond premium amortization caused by a significantly highvolume of mortgage prepayments.  Theprepayment activity has eased in 2004 and has resulted in lower amortization ofbond premium.  Partially offsetting theincreased yield in the investment portfolio, the Bank’s loan portfoliocontinues to re-price lower.  The bookyield on the loan portfolio decreased 17 basis points for the three monthsended September 30, 2004 compared to the same period in 2003.

 

The tax-equivalent yield on average interest-earning assets increased14 basis points to 5.34% for the quarter ended September 30, 2004 compared tothe third quarter of 2003.  During thethird quarter of 2004 the Bank’s tax equivalent margin and spread bothincreased 60 basis points compared to the third quarter of 2003.  The increase in margin and spread is theresult of the rates on the Bank’s interest-bearing liabilities declining at afaster pace than the yields earned on interest-earning assets.

 

The following table sets forth, a comparison of average balance sheetamounts and their corresponding tax equivalent earnings and expenses andannualized tax-equivalent yield and rate for the periods indicated (dollars inthousands):

 
| ** **                             | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** | **Year ended  December 31,** | ** ** |
|----------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|------------------------------|------------|
| ** **                             | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004**                     | ** ** | **2003** | ** ** | **2003** | ** ** |
| Average earning  assets:               |       |                                  |       |                                 |       |                         |       |   |   |   |   |
| Loans and leases                       |       | $                                     | 381,227    |                                 | $          | 383,902                      |       | $ | 387,981 |   | $ | 386,130 |   | $ | 387,099 |   |
| Investments                            |       | 127,720                               |       | 141,573                              |       | 134,180                      |       | 144,234 |   | 144,759 |   |
| Federal funds  sold                    |       | 308                                   |       | 3,957                                |       | 1,572                        |       | 5,061 |   | 3,919 |   |
| Interest-bearing  deposits             |       | 701                                   |       | 546                                  |       | 651                          |       | 782 |   | 761 |   |
| Total                                  |       | $                                     | 509,956    |                                 | $          | 529,978                      |       | $ | 524,384 |   | $ | 536,207 |   | $ | 536,538 |   |
|                                   |       |                                  |       |                                 |       |                         |       |   |   |   |   |
| Average  interest-bearing liabilities: |       |                                  |       |                                 |       |                         |       |   |   |   |   |
| Other  interest-bearing deposits       |       | $                                     | 110,946    |                                 | $          | 102,687                      |       | $ | 110,741 |   | $ | 98,397 |   | $ | 100,699 |   |
| Certificates of  deposit               |       | 197,586                               |       | 247,635                              |       | 210,437                      |       | 258,520 |   | 250,482 |   |
| Borrowed funds                         |       | 76,668                                |       | 64,617                               |       | 78,103                       |       | 65,354 |   | 69,471 |   |
| Repurchase  agreements                 |       | 40,279                                |       | 39,671                               |       | 41,071                       |       | 41,517 |   | 41,355 |   |
| Total                                  |       | $                                     | 425,479    |                                 | $          | 454,610                      |       | $ | 440,352 |   | $ | 463,788 |   | $ | 462,007 |   |

 

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| ** **                                    | ** ** | **Three months ended  September 30,** | ** **  | **Nine months ended  September 30,** | ** ** | **Year ended December 31,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------|-------------|--------------------------------------|------------|-----------------------------|------------|
| ** **                                    | ** ** | **2004**                              | ** **  | **2003**                             | ** ** | **2004**                    | ** ** | **2003** | ** ** | **2003** | ** ** |
| Interest income:                              |       |                                  |        |                                 |       |                        |       |   |   |   |   |
| Loans and leases                              |       | $                                     | 5,535       |                                 | $          | 5,771                       |       | $ | 16,741 |   | $ | 17,871 |   | $ | 23,440 |   |
| Investments                                   |       | 1,307                                 |        | 1,165                                |       | 4,095                       |       | 3,995 |   | 5,443 |   |
| Federal funds  sold                           |       | 1                                     |        | 9                                    |       | 11                          |       | 45 |   | 46 |   |
| Interest-bearing  deposits                    |       | 2                                     |        | 1                                    |       | 4                           |       | 5 |   | 6 |   |
| Total                                         |       | $                                     | 6,845       |                                 | $          | 6,946                       |       | $ | 20,851 |   | $ | 21,916 |   | $ | 28,935 |   |
|                                          |       |                                  |        |                                 |       |                        |       |   |   |   |   |
| Interest  expense:                            |       |                                  |        |                                 |       |                        |       |   |   |   |   |
| Other  interest-bearing deposits              |       | $                                     | 186         |                                 | $          | 146                         |       | $ | 547 |   | $ | 532 |   | $ | 697 |   |
| Certificates of  deposit                      |       | 1,418                                 |        | 2,286                                |       | 4,628                       |       | 7,337 |   | 9,334 |   |
| Borrowed funds                                |       | 997                                   |        | 907                                  |       | 2,973                       |       | 2,702 |   | 3,703 |   |
| Repurchase  agreements                        |       | 119                                   |        | 104                                  |       | 324                         |       | 395 |   | 503 |   |
| Total                                         |       | $                                     | 2,720       |                                 | $          | 3,443                       |       | $ | 8,472 |   | $ | 10,966 |   | $ | 14,237 |   |
|                                          |       |                                  |        |                                 |       |                        |       |   |   |   |   |
| Net Interest  Income                          |       | $                                     |  4,125 |                                 | $          |  3,503                 |       | $ |  12,379 |   | $ |  10,950 |   | $ |  14,698 |   |
|                                          |       |                                  |        |                                 |       |                        |       |   |   |   |   |
| Yield on average  earning assets              |       | 5.34                                  | %           | 5.20                                 | %          | 5.31                        | %          | 5.46 | % | 5.39 | % |
| Cost of average  interest-bearing liabilities |       | 2.54                                  | %           | 3.00                                 | %          | 2.57                        | %          | 3.16 | % | 3.08 | % |
|                                          |       |                                  |        |                                 |       |                        |       |   |   |   |   |
| Net interest  spread                          |       | 2.80                                  | %           | 2.20                                 | %          | 2.74                        | %          | 2.30 | % | 2.31 | % |
|                                          |       |                                  |        |                                 |       |                        |       |   |   |   |   |
| Net interest  margin                          |       | 3.22                                  | %           | 2.62                                 | %          | 3.15                        | %          | 2.73 | % | 2.74 | % |

 

In the table above, interest income was adjusted to a tax-equivalentbasis to recognize the income from the various tax-exempt assets as if theinterest was fully taxable.  Thistreatment allows a uniform comparison among the yields on interest-earningassets.  The calculations were computedon a fully tax-equivalent basis using the corporate federal tax rate of34%.  Net interest spread represents thedifference between the yield on interest-earning assets and the rate oninterest-bearing liabilities.  Netinterest margin represents the ratio of net interest income to total averageinterest-earning assets.

 

*Provision for loan losses*

 

The provision for loan losses represents the necessary amount chargedto operations with the purpose to increase the allowance for loan losses to alevel that represents Management’s best estimate of known and inherent lossesin the Bank’s loan portfolio.  Loans andleases determined to be uncollectible are charged-off against the allowance forloan losses.

 

The required amount of the provision for loan losses, based upon theadequate level of the allowance for loan losses, is subject to ongoing analysisof the loan portfolio. The Bank maintains a Special Asset Committee which meetsperiodically to review problem loans and leases. The committee is comprised ofBank management, including the credit administration officer, loan workoutofficer and collection personnel. The committee reports quarterly to the CreditAdministration Committee of the Board of Directors.

 

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Management continuously reviews the risks inherent in the loan andlease portfolio. Specific factors used to evaluate the adequacy of the loanloss provision during the formal process include:

 

•                  Specific loansthat could have loss potential

•                  Levels of andtrends in delinquencies and non-accrual loans

•                  Levels of andtrends in charge-offs and recoveries

•                  Trends in volumeand terms of loans

•                  Changes in riskselection and underwriting standards

•                  Changes inlending policies, procedures and practices

•                  Experience,ability and depth of lending personnel

•                  National andlocal economic trends and conditions

•                  Changes incredit concentrations

 

The provision for loan losses increased to $450,000, for the threemonths ended September 30, 2004, compared to $300,000 for the three monthsended September 30, 2003.  The increasein the provision for loan losses was driven by the risk associated with thenon-performing loans, which increased $2,006,000 from December 31, 2003.  During the third quarter of 2004, the specialassets committee expanded the measurement criteria as a basis to determine theadequacy of the allowance for loan losses and implemented a more stringentstandard for loans deemed to possess a higher risk of potential loss.  Loans that meet certain criteria have beenassigned a higher reserve requirement and has resulted in an increase in theprovision for loan losses during the quarter. For more information, refer to the sections titled “Allowance for LoanLoss” and “Non-performing Assets” under the Comparison of Financial Conditionat September 30, 2004 and December 31, 2003.

 

*Other income*

 

Other (non-interest) income consists of service charges or feescollected on the Bank’s various deposit and loan products, net mortgageservicing revenue, fees from trust, asset management and other financialservices, the increase in cash surrender value of bank owned life insurance, therealized gains and losses from the sales of investment securities, loans,leased assets and foreclosed assets held for sale and other variousclassifications of non-interest related income.

 

Total other income increased $128,000, or 13% for the three monthsended September 30, 2004 compared to the same period in 2003.  Amortization of mortgage servicing rights, anoffset to non-interest income, declined $83,000 in the quarter ended September30, 2004 compared to the same quarter in 2003. During 2003, when interest rates were at near record lows, the Bankexperienced a much higher volume of mortgage prepayments and refinancing whichresulted in the acceleration of servicing rights amortization.  Increased activity from the Bank’s trust andfinancial services businesses resulted in a combined increase in fees of$54,000 over what was recorded for the third quarter of 2003.  These items were partially offset by declinesin mortgage loan servicing charges and gains from sales of mortgages into thesecondary market.  The surge in sales in2003 was the result of the mortgage refinance activity that was spurred by therelatively low interest rate environment. As a result of lower sales activity, income from mortgage servicing feesand gains from sales of loans declined $31,000 and $18,000, respectively, inthe third quarter of 2004 compared to the same quarter of 2003.  Finally, during the third quarter of 2004,the Bank’s gain on sale of foreclosed assets held for sale was approximately$16,000 lower than what was recorded in the same quarter of 2003.

 

*Other expenses*

 

Other (non-interest) expenses increased $465,000, or 15% for the threemonths ended September 30, 2004 compared to the same period in 2003.  The increase was largely due to an $85,000increase in compensation and employee benefits expense, a $47,000 increase inadvertising and approximately $353,000 more in other operating expenses.  Operating expenses related to premises andequipment was down $20,000 quarter-to-quarter. The increase in compensation and benefits was due to the hiring ofadditional experienced staff in key positions in 2004, increased incentivecompensation and the related payroll taxes and the increased cost of variousemployee benefits.  The increase inadvertising was due to the implementation of various direct marketing programswith focus on brand awareness.  Theseinitiatives included advertising models which changed the way the Companyreaches its markets and now uses alternative media resources.  In addition, the Bank implemented depositproduct promotional campaigns during the quarter.  The increase in the other operating expenseswas primarily the result of recording an incremental obligation related to theretirement benefit for the Company’s former chairman and president in theamount of $198,000.  The retirementbenefit represents a present

 

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value obligation for certain benefits, to be paid periodically in thefuture, that include payments, reduced by appropriate taxes, and estimatedmedical insurance premiums.  Based uponthe subjective nature of the medical insurance premium portion of the accrual,as it relates to future premium costs, and the uncertainty of the futurebenefit period to be covered, the Company may find it necessary to increase ordecrease the accrual.  Variances in otheroperating expenses, for the third quarter of 2004 compared to the third quarterof 2003, include an increase in professional services of $110,000 caused byoutsourcing of the internal audit function, increased FDIC premium, andincreased legal and other contractual service fees.

 

*Income tax provision*

 

The difference between the expected provision and actual provision forincome taxes is primarily due to tax-free income and use of low-income housingtax credits.

 

For the three months ended September 30, 2004, the Company recorded atax provision of $245,000 compared to $183,000 for the three months endedSeptember 30, 2003.  For the respectiveperiods, the effective tax rates were 23.2% and 21.1%.  The effective tax rates for the periodsdiffer due primarily to the percentage of pre-tax earnings represented bytax-free income from the Bank’s portfolio of municipal securities, a portion ofdividends received from its investment in equity securities, tax-freecommercial mortgages and leases and increases in the cash surrender value ofthe bank owned life insurance.

 

**COMPARISONOF RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDEDSEPTEMBER 30, 2004 AND SEPTEMBER 30, 2003**

 

**Overview**

 

Net income for the nine months ended September 30, 2004 declined 5% to$2,359,000 from $2,495,000 for the nine months ended September 30, 2003.  Diluted earnings per share decreased to $1.29from $1.37 during the period 2003.

 

The decrease in net earnings recorded for the nine months endedSeptember 30, 2004 was the result of an increase in the provision for loanlosses, an increase in non-interest expense and a decrease in non-interestincome.  These items were partiallyoffset by an increase in net interest income.

 

Return on average assets and return on average equity were 0.57% and7.11%, respectively, for the nine months ended September 30, 2004 compared to0.58% and 7.36%, respectively, for the same period in 2003.

 

*Net interest income*

 

Net interest income increased $1,441,000, or 14%, to $12,042,000 forthe nine months ended September 30, 2004, from $10,601,000 for the same periodin 2003.  The increase was primarily dueto a combined 59 basis point decline in rates paid on interest-bearingliabilities and a $23,436,000 decrease in average interest-bearingliabilities.  The average balances in theBank’s certificates of deposit declined $48,083,000 from the average for thenine months of 2003, primarily from high cost thirty-month product maturitiesand public fund certificate runoff.  As aresult, interest expense for the nine months ended September 30, 2004 declined$2,494,000 or 23%, compared to the same 2003 period.  Average interest-earning assets decreased$11,823,000 during the nine months ended September 30, 2004 compared to thesame period in 2003.  The low interestrate environment that had been prevalent during the first half of 2004 causedbook yields on interest-earning assets to decline to 5.23%, from 5.38% for thenine months ended September 30, 2003. Lower rates on loan originations and re-pricings resulted in a 41 basispoint decline in the book yield on the loan portfolio while in investments, thebook yield increased 33 basis points due to significantly less amortization ofbond premium in 2004, caused by an easing of loan prepayments in the Bank’shighly concentrated portfolio of mortgage-backed securities.

 

The tax-equivalent yield on average interest-earning assets decreased15 basis points to 5.31% for the nine months ended September 30, 2004, comparedto 5.46% for the same period in 2003.  Duringthe first nine months of 2004 the Bank’s tax equivalent margin and spreadincreased 42 basis points and 44 basis points, respectively.  The increase in margin and spread is theresult of the Bank’s rates on interest-bearing liabilities declining at afaster pace than the yields earned on interest-earning assets.

 

15

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The ratio of average interest-earning assets to averageinterest-bearing liabilities increased from 115.6% for the nine months endedSeptember 30, 2003 to 119.1% for the nine months ended September 30, 2004.

 

*Provision for loan losses*

 

The provision for loan losses for the nine months ended September 30,2004 was $1,700,000 or $640,000 more than the provision recorded during thenine months ended September 30, 2003. The increase was due to an increase in non-performing loans ofapproximately $2,006,000 since December 31, 2003.  The increase in non-performing loans waslargely due to a single commercial relationship consisting of two loans of$4,825,000 in the aggregate.  These twoloans migrated to non-performing status during the first quarter of 2004.During the third quarter, 2004, the special assets committee expanded themeasurement criteria as a basis to determine the adequacy of the allowance forloan losses and implemented a more stringent standard for loans deemed topossess a higher risk of potential loss. Loans that meet certain criteria have been assigned a higher reserverequirement and has resulted in an increase in the provision for loan lossesfor the nine months ended September 30, 2004. For more information, refer to the sections titled “Allowance for LoanLoss” and “Non-performing Assets” under the Comparison of Financial Condition atSeptember 30, 2004 and December 31, 2003.

 

*Other income*

 

For the first nine months of 2004, other income decreased $72,000, or2%, compared to the same period in 2003. Other income was lower, in 2004, due primarily to a decline of $348,000in gains from sales of mortgage loans into the secondary market due to theaforementioned decline in loan refinance activity.  In addition the Bank experienced increasedlosses recorded from the sales of leased assets and lower net gains from thesales of investment securities. Partially offsetting these items was growth in service charges ondeposit accounts and other fees and charges, including an increase in the cashsurrender value of bank owned life insurance.

 

*Other expenses*

 

For the nine months ended September 30, 2004, other expenses increased$970,000, or approximately 10%, to $10,472,000 from the $9,502,000 recordedduring the same 2003 period.  The causeof the increase was a $305,000 increase in salary and benefits expense, a$38,000 increase in premises and equipment expenses, a $50,000 increase inadvertising and an increase of $577,000 in other operating expenses.  The increase in salaries and benefits was dueto added staff in key positions in 2004, increased incentive compensation andthe related payroll taxes and the escalating costs of the Company’s variousbenefit programs.  The increase inpremises and equipment was largely due to increased equipment repairs andrentals, partially offset by decreases in the expenses to maintain thebuildings and grounds.  The increase inadvertising was due to implementation of various direct marketing programs withfocus on brand awareness and the acquisition of core deposits.  These initiatives included advertising modelswhich changed the way the Company reaches its markets and now uses alternativemedia resources.  The increase in otheroperating expenses was primarily the result of recognition of an estimated$476,000 obligation related to the retirement benefit afforded to the Company’sformer chairman and president as described under the caption “Other expenses”in the Comparison of Results of Operations for the three months ended September30, 2004 and September 30, 2003, above. Variances in other operating expenses, for the first nine months of 2004compared to the same period in 2003, include an increase in professionalservices of $248,000 caused by outsourcing of the internal audit function,increased FDIC premiums and increases for professional advertising, legal andother contractual service fees.

 

*Income tax provision*

 

For the nine month periods ended September 30, 2004 and 2003, theCompany recorded tax provisions of $677,000 and $783,000, respectively,representing effective tax rates of 22.3% and 23.9%, for each of theperiods.  The effective tax rate for theperiods differ due mostly to the percentage of pre-tax earnings represented bytax-free income from the Bank’s portfolio of municipal securities, a portion ofdividends received from its investment in equity securities, tax-freecommercial mortgages and leases and the increase in the cash surrender value ofthe bank owned life insurance.

 

16

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**COMPARISONOF FINANCIAL CONDITION ATSEPTEMBER 30, 2004 AND DECEMBER 31, 2003**

 

**Overview**

 

Consolidated assets decreased $30,044,000, or 5%, during the ninemonths ended September 30, 2004 to $545,171,000.  The asset decline resulted from a decrease indeposits of $26,013,000 and a decline in total borrowings of $5,833,000.  Cash and cash equivalents, investments andloans decreased $6,167,000, $14,029,000 and $9,769,000, respectively, sinceDecember 31, 2003.  Shareholders’ equityincreased $1,948,000 from $43,932,000, at December 31, 2003, to $45,880,000, atSeptember 30, 2004.  The increase inshareholders’ equity was attributable to a $364,000 net unrealized holding gainon available-for-sale securities, recorded in other comprehensive income and byearnings net of dividends paid and an increase in common stock.  Common stock, net of treasury shares, grewfrom shares issued under the employee stock purchase and dividend re-investmentplans.

 

A comparison of selected balance sheet information as of September 30,2004 and December 31, 2003 follows:

 

*Investment securities*

 

The Bank’s investment policy is designed to complement its lendingactivities, generate a favorable return without incurring undue interest rateand credit risk, manage interest rate sensitivity, provide monthly cash flowand manage liquidity at acceptable levels. In establishing investment strategies, the Bank considers its businessand growth or restructuring plans, the economic environment, the interest ratesensitivity position, the types of securities held, permissible purchases,credit quality, maturity, call or average-life intervals and investmentconcentrations.

 

At the time of purchase, the Bank classifies investment securities intoone of three categories: trading, available-for-sale (AFS) or held to maturity(HTM).  To date, the Bank has notpurchased any securities for trading purposes. Management classifies mostsecurities as AFS even though it has no immediate intent to sell them.  The AFS designation affords Management theflexibility to sell securities and adjust the balance sheet in response tocapital levels, liquidity needs and/or changes in market conditions.  Securities AFS are carried at fair marketvalue in the consolidated balance sheet with an adjustment to stockholders’equity, net of tax, which is presented under the caption “Accumulated othercomprehensive income (loss).”  Securitiesdesignated as HTM are carried at amortized cost.

 

At September 30, 2004, the carrying value of investment securitiestotaled $130,379,000 or 24% of total assets. The portfolio is comprised of HTM and AFS securities with carryingvalues of $3,256,000 and $127,123,000, respectively.  Approximately 52% of the carrying value ofinvestment portfolio was comprised of mortgage-backed securities that amortizeand provide monthly cash flow.  Agencybonds and municipal bonds comprised 28% and 9% of the investment portfolio,respectively.

 

At September 30, 2004, the AFS portfolio had an estimated pre-taxunrealized market appreciation of $228,000 and an after-tax equity adjustmentof $151,000.  This represents anafter-tax portfolio appreciation of $364,000 in the estimated fair value sinceDecember 31, 2003.  The increase occurreddue to the composition of the Bank’s investment portfolio which includessecurities with yields greater than what can be readily obtained from similarsecurities with similar characteristics in the investment markets.

 

17

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The amortized cost and fair value of investment securities HTM and AFSat September 30, 2004 consisted of the following (dollars in thousands):

 
| ** **                                        | ** ** | **Amortized  Cost** | ** ** | **Gross unrealized  gains** | ** ** | **Gross unrealized  losses** | ** ** | **Fair  value** | ** ** |
|---------------------------------------------------|------------|---------------------|------------|-----------------------------|------------|------------------------------|------------|-----------------|------------|
|                                              |       |                |       |                        |       |                         |       |            |       |
| Held-to-maturity  securities:                     |       |                |       |                        |       |                         |       |            |       |
|                                              |       |                |       |                        |       |                         |       |            |       |
| Mortgage-backed  securities                       |       | $                   | 3,256      |                        | $          | 150                          |       | $               | —     |   | $ | 3,406 |   |
|                                              |       |                |       |                        |       |                         |       |            |       |
| Available-for-sale  securities:                   |       |                |       |                        |       |                         |       |            |       |
| U.S. government  agencies and corporations        |       | $                   | 37,015     |                        | $          | 36                           |       | $               | 374        |   | $ | 36,677 |   |
| Obligations of  states and municipal subdivisions |       | 11,048              |       | 218                         |       | 4                            |       | 11,262          |       |
| Corporate bonds                                   |       | 9,038               |       | 27                          |       | 30                           |       | 9,035           |       |
| Mortgage-backed  securities                       |       | 64,773              |       | 429                         |       | 241                          |       | 64,961          |       |
|                                              |       |                |       |                        |       |                         |       |            |       |
| Sub total                                         |       | 121,874             |       | 710                         |       | 649                          |       | 121,935         |       |
|                                              |       |                |       |                        |       |                         |       |            |       |
| Equity  securities:                               |       |                |       |                        |       |                         |       |            |       |
| Restricted  (regulatory equity)                   |       | 4,742               |       | —                      |       | —                       |       | 4,742           |       |
| Other                                             |       | 279                 |       | 167                         |       | —                       |       | 446             |       |
|                                              |       |                |       |                        |       |                         |       |            |       |
| Total  available-for-sale                         |       | $                   | 126,895    |                        | $          | 877                          |       | $               | 649        |   | $ | 127,123 |   |
|                                              |       |                |       |                        |       |                         |       |            |       |
| Total securities                                  |       | $                   | 130,151    |                        | $          | 1,027                        |       | $               | 649        |   | $ | 130,529 |   |

 

The amortized cost and fair value of investments held-to-maturity andavailable-for-sale by contractual maturity at September 30, 2004 are as follows(dollars in thousands):

 
| ** **                      | ** ** | **Amortized  cost** | ** ** | **Market  value** | ** ** |
|---------------------------------|------------|---------------------|------------|-------------------|------------|
| Held-to-maturity  securities:   |       |                |       |              |       |
| Due after ten  years            |       | $                   | 3,256      |              | $          | 3,406 |   |
|                            |       |                |       |              |       |
| Available-for-sale  securities: |       |                |       |              |       |
| One year or less                |       | $                   | —     |              | $          | — |   |
| One through five  years         |       | 3,430               |       | 3,428             |       |
| Five through ten  years         |       | 20,535              |       | 20,392            |       |
| Over ten years                  |       | 33,136              |       | 33,154            |       |
| Total agency and  muncipal      |       | 57,101              |       | 56,974            |       |
|                            |       |                |       |              |       |
| Mortgage-backed  securities     |       | 64,773              |       | 64,961            |       |
| Equity  securities              |       | 5,021               |       | 5,188             |       |
| Total  available-for-sale       |       | $                   | 126,895    |              | $          | 127,123 |   |
|                            |       |                |       |              |       |
| Total securities                |       | $                   | 130,151    |              | $          | 130,529 |   |

 

18

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Expected maturities will differ from contractual maturities becauseissuers and borrowers may have the right to call or repay obligations with orwithout call or prepayment penalty. Federal agency and municipal securities are included based upon theiroriginal stated maturity.  Mortgage-backedsecurities, which are based on weighted-average lives and subject to monthlyprincipal pay-downs, are listed in total. Equity securities, which have no stated maturity and are listed intotal, include stock of the Federal Home Loan Bank which is carried at cost.

 

*Loans available - for- sale (AFS)*

 

Upon origination, certain residential mortgages, the guaranteedportions of Small Business Administration loans and student loans areclassified as AFS.  Should market ratesincrease, fixed-rate loans and loans not immediately scheduled to re-pricewould no longer produce yields consistent with the current market.  In a declining interest rate environment, theBank would be exposed to prepayment risk and, as rates on adjustable rate loansdecrease, interest income would be negatively affected.  To better manage interest rate risk, loansthat meet these conditions may be classified as AFS.  Consideration is also given to the currentliquidity position and expected future liquidity needs.  Loans AFS are carried at the lower of cost orestimated fair value in the aggregate. Net unrealized losses are recognized through a valuation allowance bycharges to income.  Unrealized gains arerecognized to the extent of previous write-downs.

 

At September 30, 2004, loans AFS totaled $330,000, compared to$19,864,000, at December 31, 2003 or a decrease of $19,534,000.  During the second quarter of 2004, the Banktransferred higher yielding mortgage loans with relatively shorter lives withaggregate principal balances of $11,246,000 and aggregate market values of$11,446,000 from the AFS to its loan portfolio. Similarly, during the third quarter of 2004, the Bank transferred SBAloans, with aggregate principal and market values of $1,561,000 and $1,634,000,respectively, from AFS to its loan portfolio. In both cases, the loans were transferred at the lower of cost or marketand therefore, no gain or loss was recognized. The Bank has both the ability and intent to hold these loans untilmaturity and they will continue to provide the Bank with yields in excess ofcurrent market rates.  In addition, bytransferring the loans from the AFS to the loan portfolio, the Bank will nolonger be required to apply lower-of-cost-or market treatment to the principalbalance.  In an increasing interest rateenvironment, the loans AFS could attain market values significantly below theirprincipal balances and, as a result, could create a significant drag on currentearnings.  During 2004, loans totaling$15,439,000 have been sold into the secondary market and gains of approximately$155,000 have been recognized.

 

*Loans*

 

The Bank originates commercial and commercial real estate loans,residential, consumer, home equity and construction loans.  The relative volume of originations is dependentupon customer demand, current interest rates and the perception and duration offuture interest levels.  The Bankcontinues to focus its efforts on the expansion of variable-rate portfolios ofresidential and commercial loans as well as originations of fixed-rateresidential, including multi-family and consumer loans.  The broad spectrum of products providesdiversification which helps manage, to an extent, interest rate risk and creditconcentration risk.  Credit risk isfurther managed through underwriting policies and procedures and loanmonitoring practices.  Interest rate riskis managed using various asset/liability modeling techniques and analyses.  The interest rates on most commercial loansare adjustable with reset intervals of five years or less. Whenever practical,the Bank originates variable rate loans.

 

The majority of our loan portfolio is collateralized, at least in part,by real estate in the greater Lackawanna and Luzerne counties ofPennsylvania.  Commercial lendingactivities generally involve a greater degree of credit risk than residentiallending because they typically have larger balances and are more affected byadverse conditions in the economy. Because payments on loans secured by commercial and commercial realestate often depend upon the successful operation and management of theproperties and the businesses which operate from within them, repayment of suchloans may be affected by factors outside the borrower’s control.  Such factors may include adverse conditionsin the real estate market, the economy, the industry or changes in governmentregulations.  As such, commercial loansrequire more ongoing evaluation and monitoring that occurs with the Bank’scredit administration and outsourced loan review functions.

 

Loans, net of unearned income of $382,856,000 at September 30, 2004increased from $371,979,000 at December 31, 2003.  During the second and third quarters, theBank transferred residential mortgage loans and SBA loans from the AFS to theloan portfolio.  See “Loans-available-forsale,” above for further discussion on these loans.

 

19

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The followingtable sets forth the composition of the loan portfolio at September 30, 2004and December 31, 2003:

 
| ** **                             | ** ** | **September 30, 2004** | ** **  | **December 31, 2003** | ** ** |
|----------------------------------------|------------|------------------------|-------------|-----------------------|------------|
| Commercial and  commercial real estate |       | $                      | 222,725,386 |                  | $          | 221,275,922 |   |
| Residential real  estate               |       | 86,574,866             |        | 77,077,315            |       |
| Consumer and  home equity              |       | 62,494,656             |        | 62,919,070            |       |
| Real estate  construction              |       | 8,477,967              |        | 7,267,616             |       |
| Direct financing  leases               |       | 2,665,408              |        | 3,685,802             |       |
| Gross loans                            |       | 382,938,283            |        | 372,225,725           |       |
| Less:                                  |       |                   |        |                  |       |
| Unearned  discount                     |       | 82,531                 |        | 247,119               |       |
| Allowance for  loan losses             |       | 6,108,966              |        | 4,996,966             |       |
| Net loans                              |       | $                      | 376,746,786 |                  | $          | 366,981,640 |   |
|                                   |       |                   |        |                  |       |
| Loans available-for-sale               |       | $                      | 329,777     |                  | $          | 19,863,577 |   |

 

*Allowance for loan losses*

 

Management continually evaluates the credit quality of the Bank’s loanportfolio and performs a formal review of the allowance for loan loss adequacy,on a quarterly basis.  The allowance forloan loss reflects management’s best estimate of losses, both known andinherent, in the existing loan portfolio. Management’s judgment is based on theevaluation of individual loans, past experience, the assessment of currenteconomic conditions, and other relevant factors. The provision for loan lossesrepresents the amount necessary to maintain an appropriate allowance. Loanlosses are charged directly against the allowance for loan losses when loansare deemed to be uncollectible. Recoveries on previously charged-off loans areadded to the allowance when received.

 

Management applies two primary components during the loan reviewprocess to determine proper allowance levels. The two levels are specific loanloss allocation for loans that are deemed impaired and a general loan lossallocation for those loans not specifically allocated.  The methodology to analyze the adequacy ofthe allowance for loan losses is as follows:

 

•                  Identificationof specific problem loans by loan category by credit administration;

•                  Calculation ofspecific allowances required based on collateral and other persuasive evidence;

•                  Identificationof loans collateralized by cash and marketable securities;

•                  Determination ofremaining homogenous pools by loan category and eliminating loanscollateralized by cash, marketable securities and loans with specificallocations;

•                  Application ofhistorical loss percentages (three year average) to pools to determine theallowance allocation; and

•                  Application of aqualitative factor adjustment percentage to historical losses for trends orchanges in the loan portfolio.

 

Allocation of the allowance for loan losses for different categories ofloans is based on the methodology used by the Bank, as explained above. Thechanges in the allocations from period to period are based upon reviews of theloan and lease portfolios.

 

Net charge-offs for the nine months ended September 30, 2004 were$588,000, compared to $1,177,000, for the same period in 2003.  Commercial loan, consumer loan and realestate mortgage loan net charge-offs each decreased $180,000, $372,000 and$12,000, respectively, for the nine months ended September 30, 2004 compared tothe same period in 2003.  The Bankrecently recruited a seasoned loan work-out officer to supplement our existingwork-out specialist.  These twoindividuals in conjunction with our experienced credit administration officerand collections manager have enabled us to aggressively manage the loancollections and work-out processes and timely pursue the recovery of previouslywritten-off loans.  The recovery ofprevious loan write-offs increased $50,000 during the first nine months of2004, compared to the same period in 2003.

 

20

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Management believes that the current balance in the allowance for loanslosses of $6,109,000 is sufficient to withstand the identified potential creditquality issues that may arise that are inherent to the loan portfolio.  Currently, Management is unaware of anypotential problem loans that have not been reviewed.  Potential problem loans are those where thereis known information that leads Management to believe repayment of principaland/or interest is in jeopardy and the loans are neither in a non-accrualstatus nor are they past due 90 days or more. However, there could be instances which become identified over the yearthat may require additional charge-offs and/or increases to the allowance.  The ratio of allowance for loan losses tototal loans was 1.59% at September 30, 2004 compared to 1.28% at December 31,2003.

 

The following tables set forth the activity in the allowance for loanlosses and certain key ratios for the period indicated:

 
| ** **                       | ** ** | **As of and for the  nine months ended  September 30, 2004** | ** **  | **As of and for the  year ended  December 31, 2003** | ** ** | **As of and for the  nine months ended  September 30, 2003** | ** ** |
|----------------------------------|------------|--------------------------------------------------------------|-------------|------------------------------------------------------|------------|--------------------------------------------------------------|------------|
|                             |       |                                                         |        |                                                 |       |                                                         |       |
| Balance at  beginning of period  |       | $                                                            | 4,996,966   |                                                 | $          | 3,899,753                                                    |       | $ | 3,899,753 |   |
|                             |       |                                                         |        |                                                 |       |                                                         |       |
| Provision  charged to operations |       | 1,700,000                                                    |        | 3,715,000                                            |       | 1,060,000                                                    |       |
|                             |       |                                                         |        |                                                 |       |                                                         |       |
| Charge-offs:                     |       |                                                         |        |                                                 |       |                                                         |       |
| Commercial                       |       | 380,900                                                      |        | 1,334,144                                            |       | 546,249                                                      |       |
| Real estate                      |       | 229,087                                                      |        | 502,846                                              |       | 266,354                                                      |       |
| Consumer                         |       | 298,253                                                      |        | 1,166,831                                            |       | 632,547                                                      |       |
| Lease financing                  |       | 69,210                                                       |        | 92,264                                               |       | 71,578                                                       |       |
| Total                            |       | 977,450                                                      |        | 3,096,085                                            |       | 1,516,728                                                    |       |
|                             |       |                                                         |        |                                                 |       |                                                         |       |
| Recoveries:                      |       |                                                         |        |                                                 |       |                                                         |       |
| Commercial                       |       | 205,183                                                      |        | 204,137                                              |       | 190,211                                                      |       |
| Real estate                      |       | 9,000                                                        |        | 34,168                                               |       | 34,168                                                       |       |
| Consumer                         |       | 152,543                                                      |        | 229,879                                              |       | 115,267                                                      |       |
| Lease financing                  |       | 22,724                                                       |        | 10,114                                               |       | —                                                       |       |
| Total                            |       | 389,450                                                      |        | 478,298                                              |       | 339,646                                                      |       |
|                             |       |                                                         |        |                                                 |       |                                                         |       |
| Net charge-offs                  |       | 588,000                                                      |        | 2,617,787                                            |       | 1,177,082                                                    |       |
|                             |       |                                                         |        |                                                 |       |                                                         |       |
| Balance at end  of period        |       | $                                                            | 6,108,966   |                                                 | $          | 4,996,966                                                    |       | $ | 3,782,671 |   |
|                             |       |                                                         |        |                                                 |       |                                                         |       |
| Total loans, end  of period      |       | $                                                            | 383,185,529 |                                                 | $          | 391,842,183                                                  |       | $ | 383,904,839 |   |

 

21

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| ** **                                                                | ** ** | **As of and for the  nine months ended  September 30, 2004** | ** ** | **As of and for the  year ended  December 31, 2003** | ** ** | **As of and for the  nine months ended  September 30, 2003** | ** ** |
|---------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| Net charge-offs  to:                                                      |       |                                                         |       |                                                 |       |                                                         |       |
| Loans, end of  period                                                     |       | 0.15                                                         | %          | 0.67                                                 | %          | 0.31                                                         | %          |
| Allowance for  loan losses                                                |       | 9.63                                                         | %          | 52.39                                                | %          | 31.12                                                        | %          |
| Provisions for  loan losses                                               |       | 34.59                                                        | %          | 70.47                                                | %          | 111.05                                                       | %          |
|                                                                      |       |                                                         |       |                                                 |       |                                                         |       |
| Allowance for  loan losses to:                                            |       |                                                         |       |                                                 |       |                                                         |       |
| Total loans                                                               |       | 1.59                                                         | %          | 1.28                                                 | %          | 0.99                                                         | %          |
| Non-accrual  loans                                                        |       | 62.14                                                        | %          | 68.24                                                | %          | 70.05                                                        | %          |
| Non-performing  loans                                                     |       | 59.39                                                        | %          | 60.34                                                | %          | 36.83                                                        | %          |
| Net charge-offs                                                           |       | 10.39                                                        | x          | 1.91                                                 | x          | 3.21                                                         | x          |
|                                                                      |       |                                                         |       |                                                 |       |                                                         |       |
| Loans 30-89 days  past due and still accruing                             |       | $                                                            | 3,791,855  |                                                 | $          | 3,974,821                                                    |       | $ | 4,682,508 |   |
| Loans 90 days  past due and accruing                                      |       | $                                                            | 455,872    |                                                 | $          | 957,971                                                      |       | $ | 4,872,159 |   |
| Non-accrual  loans                                                        |       | $                                                            | 9,831,170  |                                                 | $          | 7,323,014                                                    |       | $ | 5,399,638 |   |
| Allowance for  loan losses to loans 90 days or more past due and accruing |       | 13.40                                                        | x          | 5.22                                                 | x          | 0.78                                                         | x          |

 

*Non-performing assets*

 

The Bank defines non-performing assets as accruing loans past due 90days or more, non-accrual loans, restructured loans, other real estate ownedand repossessed assets.  The Bank did nothave restructured loans at September 30, 2004 or December 31, 2003.  As of September 30, 2004, non-performingassets represented 1.95% of total assets compared to 1.52% at December 31,2003.

 

The non-accrual loan balance increased $2,508,000, to $9,831,000 duringthe first nine months of 2004.  Loansclassified as non-accrual of $6,868,000 were added during the first nine monthsof 2004 of which $430,000 was subsequently collected.  The increase was primarily in commercialloans caused mostly by a single relationship with two loans totaling$4,825,000.  These two loans have beensubsequently assumed by a new operating entity but will remain on non-accrualstatus until a repayment history is developed. This increase was partially offset by total payoffs or pay downs of$2,253,000, charge offs of $599,000 and $1,453,000 of loans that have migratedto performing status.

 

Foreclosed assets held for sale includes other real estate owned (OREO)and repossessed assets.  The $278,000OREO balance is represented by three properties that were foreclosed upon andtransferred from loans.  OREO propertiesare generally listed for sale with a local realtor.  Repossessed assets totaling $47,000 representindirect auto loans, the payments of which have become delinquent and thevehicles repossessed.

 

Non-performing loans increased $2,006,000 since December 31, 2003. Theincrease was primarily in commercial loans as described above.  The ratio of non-performing loans to end ofperiod total loans increased 59 basis points, during the nine month period, to2.73%.  At September 30, 2003, the ratioof non-performing loans to total loans was 2.70%.

 

22

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The following table sets forth non-performing assets data as of theperiod indicated:

 
| ** **                                                                         | ** ** | **September 30, 2004** | ** **  | **December 31, 2003** | ** ** | **September 30, 2003** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------|-------------|-----------------------|------------|------------------------|------------|
|                                                                               |       |                   |        |                  |       |                   |       |
| Loans past due  90 days or more and accruing                                       |       | $                      | 455,872     |                  | $          | 957,971                |       | $ | 4,872,159 |   |
| Non-accrual  loans                                                                 |       | 9,831,170              |        | 7,323,014             |       | 5,399,638              |       |
| Total  non-performing loans                                                        |       | 10,287,042             |        | 8,280,985             |       | 10,271,797             |       |
|                                                                               |       |                   |        |                  |       |                   |       |
| Restructured  loans                                                                |       | —                 |        | —                |       | —                 |       |
| Other real  estate owned                                                           |       | 277,804                |        | 394,246               |       | 97,141                 |       |
| Repossessed  assets                                                                |       | 47,365                 |        | 72,920                |       | 79,020                 |       |
| Total  non-performing assets                                                       |       | $                      | 10,612,211  |                  | $          | 8,748,151              |       | $ | 10,447,958 |   |
|                                                                               |       |                   |        |                  |       |                   |       |
| Net loans  including AFS                                                           |       | $                      | 377,076,563 |                  | $          | 386,845,214            |       | $ | 380,122,168 |   |
| Total assets                                                                       |       | $                      | 545,171,022 |                  | $          | 575,215,466            |       | $ | 568,475,355 |   |
| Non-accrual  loans to net loans                                                    |       | 2.61                   | %           | 1.89                  | %          | 1.42                   | %          |
| Non-performing  assets to net loans, foreclosed real estate and repossessed assets |       | 2.81                   | %           | 2.26                  | %          | 2.75                   | %          |
| Non-performing  assets to total assets                                             |       | 1.95                   | %           | 1.52                  | %          | 1.84                   | %          |
| Non-performing  loans to net loans                                                 |       | 2.73                   | %           | 2.14                  | %          | 2.70                   | %          |

 

*Other assets*

 

The $219,000 increase in other assets from $3,072,000, at December 31,2003, to $3,291,000, at September 30, 2004, was primarily due to an increase inprepaid expenses of $208,000 and other net changes from normal recurringoperations.

 

*Deposits*

 

The Bank is a community-based commercial financial institution andoffers a variety of deposit accounts with a range of interest rates andterms.  Deposit products include passbookand statement savings accounts, NOW, money market, demand deposit andcertificates of deposit accounts.  Theflow of deposits is influenced significantly by general economic conditions,changes in prevailing interest rates, pricing and competition.  Most of the Bank’s deposits are obtained fromthe communities surrounding the 12 branch offices.  We attempt to attract and retain depositcustomers via sales and marketing efforts with new products, quality service,competitive rates and long-standing customer relationships.

 

To determine the levels of deposit rates, consideration is given tolocal competition, market yields and the rates charged for alternative sourcesof funding such as borrowings.  Althoughwe have experienced a continued intense competition for deposits, we have notincreased rates significantly as we only consider cost effective strategies ina relatively low interest rate environment.

 

23

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The following table represents the composition of deposits as ofSeptember 30, 2004 and December 31, 2003:

 
| ** **                               | ** ** | **September 30, 2004** | ** **  | **December 31, 2003** | ** ** | **Dollar  change** | ** ** | **Percent  change** | ** **  |
|------------------------------------------|------------|------------------------|-------------|-----------------------|------------|--------------------|------------|---------------------|-------------|
| **Non-interest-bearing deposits**        | ** ** | ** **             | ** **  | ** **            | ** ** | ** **         | ** ** | ** **          | ** **  |
| Personal                                 |       | $                      | 28,419,847  |                  | $          | 26,206,156         |       | $                   | 2,213,691   |   | 8.45 | % |
| Non-personal                             |       | 28,172,058             |        | 29,561,169            |       | (1,389,111         | )          | -4.70               | %           |
| Public fund                              |       | 3,946,357              |        | 3,635,074             |       | 311,283            |       | 8.56                | %           |
| Bank checks                              |       | 5,083,364              |        | 4,996,259             |       | 87,105             |       | 1.74                | %           |
| Total                                    |       | $                      | 65,621,626  |                  | $          | 64,398,658         |       | $                   | 1,222,968   |   | 1.90 | % |
|                                     |       |                   |        |                  |       |               |       |                |        |
| **Time deposits of $100,000 or greater** |       |                   |        |                  |       |               |       |                |        |
| Personal                                 |       | $                      | 63,770,993  |                  | $          | 78,560,841         |       | $                   | (14,789,848 | ) | -18.83 | % |
| Non-personal                             |       | 16,741,948             |        | 16,057,391            |       | 684,557            |       | 4.26                | %           |
| Public fund                              |       | 13,046,802             |        | 12,412,714            |       | 634,088            |       | 5.11                | %           |
| IRA’s                               |       | 5,649,448              |        | 5,826,474             |       | (177,026           | )          | -3.04               | %           |
| Total                                    |       | $                      | 99,209,191  |                  | $          | 112,857,420        |       | $                   | (13,648,229 | ) | -12.09 | % |
|                                     |       |                   |        |                  |       |               |       |                |        |
| **Other interest-bearing deposits**      |       |                   |        |                  |       |               |       |                |        |
| Time deposits  less than $100,000:       |       |                   |        |                  |       |               |       |                |        |
| Personal                                 |       | $                      | 71,761,140  |                  | $          | 83,057,733         |       | $                   | (11,296,593 | ) | -13.60 | % |
| Non-personal                             |       | 4,436,056              |        | 5,387,417             |       | (951,361           | )          | -17.66              | %           |
| Public fund                              |       | 796,385                |        | 597,772               |       | 198,613            |       | 33.23               | %           |
| IRA’s                               |       | 19,079,433             |        | 19,694,374            |       | (614,941           | )          | -3.12               | %           |
| sub total                                |       | 96,073,014             |        | 108,737,296           |       | (12,664,282        | )          | -11.65              | %           |
| NOW accounts                             |       | 41,336,250             |        | 44,290,199            |       | (2,953,949         | )          | -6.67               | %           |
| Money market  deposits                   |       | 29,459,271             |        | 28,284,225            |       | 1,175,046          |       | 4.15                | %           |
| Savings and  clubs                       |       | 43,730,350             |        | 42,874,748            |       | 855,602            |       | 2.00                | %           |
| Total                                    |       | $                      | 210,598,885 |                  | $          | 224,186,468        |       | $                   | (13,587,583 | ) | -6.06 | % |
|                                     |       |                   |        |                  |       |               |       |                |        |
| **Total deposits**                       |       |                   |        |                  |       |               |       |                |        |
| Noninterest-bearing  deposits            |       | $                      | 65,621,626  |                  | $          | 64,398,658         |       | $                   | 1,222,968   |   | 1.90 | % |
| Interest-bearing  deposits               |       | 309,808,076            |        | 337,043,888           |       | (27,235,812        | )          | -8.08               | %           |
| Total                                    |       | $                      | 375,429,702 |                  | $          | 401,442,546        |       | $                   | (26,012,844 | ) | -6.48 | % |
|                                     |       |                   |        |                  |       |               |       |                |        |
| **Public funds**                         |       |                   |        |                  |       |               |       |                |        |
| Noninterest-bearing                      |       | $                      | 3,946,357   |                  | $          | 3,635,074          |       | $                   | 311,283     |   | 8.56 | % |
| Certificates of  deposit                 |       | 13,843,187             |        | 13,010,486            |       | 832,701            |       | 6.40                | %           |
| NOW accounts                             |       | 11,484,638             |        | 9,850,661             |       | 1,633,977          |       | 16.59               | %           |
| Money market  deposits                   |       | 4,538,132              |        | 8,029,671             |       | (3,491,539         | )          | -43.48              | %           |
| Savings and  clubs                       |       | 1,388,820              |        | 3,278,114             |       | (1,889,294         | )          | -57.63              | %           |
| Total                                    |       | $                      | 35,201,134  |                  | $          | 37,804,006         |       | $                   | (2,602,872  | ) | -6.89 | % |
|                                     |       |                   |        |                  |       |               |       |                |        |
| Total assets                             |       | $                      | 545,171,022 |                  | $          | 575,215,466        |       |                |        |   |   |
| Total deposits  to total assets          |       | 68.86                  | %           | 69.79                 | %          |               |       |                |        |
| Public funds to  total deposits          |       | 9.38                   | %           | 9.42                  | %          |               |       |                |        |
| Public funds to  total assets            |       | 6.46                   | %           | 6.57                  | %          |               |       |                |        |

 

Total deposits decreased $26,013,000 or 6% during the nine months endedSeptember 30, 2004 to $375,430,000. Total average deposits decreased $25,506,000 or 6% from $412,068,000, atDecember 31, 2003 to $386,562,000 at September 30, 2004.

 

Non-interest bearing demand deposits (DDA’s) are an important source offunds for the Bank as they lower the overall deposit costs.  The balance of these accounts increased$1,223,000 or approximately 2%.

 

24

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During the first nine months of 2004, the Bank’s deposit mix, thoughconcentrated in time deposits, experienced a decline in its core deposits.  Core deposits, which excludes time depositsof $100,000 or greater, decreased $12,365,000 or 4% during the nine monthsended September 30, 2004, to $276,221,000. Time deposits of $100,000 or greater decreased $13,648,000, or 12% from$112,857,000 million at December 31, 2003 to $99,209,000 at September 30, 2004.  The Bank experienced a reduction in itstransactional deposit products which includes both DDA’s and NOW accounts.  Checking accounts which includestransactional accounts less “bank checks”, decreased $1,818,000 or 2%, whilesavings and club accounts increased $856,000 or 2%.  Money market accounts increased $1,175,000,or 4% during 2004

 

Total time deposits, at September 30, 2004, were $195,282,000 or 52% oftotal deposits compared to $221,595,000 million or 55% at December 31,2003.  Approximately $43,200,000, or 22%,of total time deposits or 12% of total deposits are scheduled to mature duringthe remainder of 2004.  These maturingtime deposits provide an opportunity for the Bank to service these customersand retain these deposits at potentially lower rates. To remain competitive inthe markets in which we operate, offering rates on most interest-bearing timedeposit products were increased modestly in 2004.  However, management expects approximately 50%of the high costing certificate of deposit portfolio to mature during theremainder of 2004 and throughout 2005. If retained, a majority of those certificates will re-price to lowermarket rates. The tiered money market deposit account along with thetwenty-four and thirty-six month Smart certificate of deposit accounts, whichprovides the customer the ability to step up to a potentially higher interestrate at the one year anniversary, have been successful products that havecaptured part of these maturing deposits.

 

Public funds have been a somewhat stable source of deposits and now represent$35,201,000 or 9% of total deposits at September 30, 2004 compared to$37,804,000 or 9% at December 31, 2003. The Bank is able to maintain public funds due to long establishedrelationships and competitive product pricing. However, Management recognizes that public fund deposits are sensitiveto the operating demands and business cycles of the various public entities aswell as the forever-changing political landscape.  As such, the Bank could continue to experienceshifts and outflows of these balances throughout the year.

 

The Bank has begun implementation strategies with increased emphasis onexpansion of commercial and consumer relationships, with a goal to increaselower costing core deposits, curtail deposit outflows, retain maturing time depositsand grow the deposit base to a higher level. To maintain and grow the Bank’s asset size will be largely dependentupon deposit retention and new customer relationships.

 

*Borrowings*

 

Borrowings totaled $120,800,000 at September 30, 2004 compared to $126,633,000at December 31, 2003.

 

Borrowings are used as a complement to deposit generation as analternative funding source whereby the Bank will borrow from the Federal HomeLoan Bank (FHLB) for asset growth and liquidity needs.  Borrowings included $76,311,000 and$71,876,000 in long-term advances from the FHLB at September 30, 2004 andDecember 31, 2003, respectively.  Theincrease in long-term borrowings reflects a leveraged transaction consummatedduring the third quarter of 2004. Through funding from the FHLB, the Bank purchased $5,000,000 inpreferred term securities.  The interestrate reset intervals of this transaction is evenly matched with its fundingsource and therefore will be accretive to earnings.  Included in borrowings is short-term customerrepurchase (repos) agreements of $43,429,000 and $39,363,000, at September 30,2004 and December 31, 2003, respectively. Repos are non-insured low cost interest-bearing liabilities that have asecurity interest in qualified investment securities of the Bank.  Repos offered are either fixed-term or adaily-sweep product of the Bank.  Thebalance in customer repurchase agreements fluctuates daily because thedaily-sweep product is dependent on the level of available funds in depositoraccounts.

 

The combined short- and long-term weighted-average interest rate onborrowings was 3.57% and 3.39% at September 30, 2004 and December 31, 2003,respectively.

 

*Accrued interest payable and other liabilities*

 

Accrued expenses and other liabilities decreased $147,000 during thefirst nine months of 2004 and represents fluctuations that would be considerednormal recurring operating transactions. Accrued interest payable decreased $178,000 while other liabilities andaccrued expenses increased $31,000.

 

25

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**Item 3****.****                                         Quantitativeand Qualitative Disclosure about Market Risk**

 

*Management of interest rate risk and market riskanalysis*

 

The Company is subject to the interest rate risks inherent in ourlending, investing and financing activities. Fluctuations of interest rates will impact interest income and interestexpense along with affecting market values of all interest-earning assets andinterest-bearing liabilities, except for those assets or liabilities with ashort term remaining to maturity. Interest rate risk management is an integral part of the asset/liabilitymanagement process.  The Company hasinstituted certain procedures and policy guidelines to manage the interest raterisk position. Those internal policies enable the Company to react to changesin market rates to protect net interest income from significantfluctuations.  The primary objective inmanaging interest rate risk is to minimize the adverse impact of changes ininterest rates on net interest income along with creating an asset/liabilitystructure that maximizes earnings.

 

*Asset/Liability Management*: Onemajor objective of the Company when managing the rate sensitivity of its assetsand liabilities is to stabilize net interest income.  The management of and authority to assumeinterest rate risk is the responsibility of the Company’s Asset/LiabilityCommittee (ALCO), which is comprised of senior management and Boardmembers.  ALCO meets quarterly to monitorthe ratio of interest sensitive assets to interest sensitive liabilities.  The process to review interest rate riskmanagement is a regular part of management of the Company.  Consistent policies and practices ofmeasuring and reporting interest rate risk exposure, particularly regarding thetreatment of non-contractual assets and liabilities, are in effect.  In addition, there is an annual process toreview the interest rate risk policy with the Board of Directors which includeslimits on the impact to earnings from shifts in interest rates.

 

*Interest Rate Risk Measurement:*Interest rate risk is monitored through the use of three complementarymeasures:  static gap analysis, earningsat risk simulation and economic value at risk simulation.  While each of the interest rate riskmeasurements has limitations, taken together they represent a reasonablycomprehensive view of the magnitude of interest rate risk in the Company andthe distribution of risk along the yield curve, the level of risk through timeand the amount of exposure to changes in certain interest rate relationships.

 

*Static Gap:* The ratio betweenassets and liabilities re-pricing in specific time intervals is referred to asan interest rate sensitivity gap. Interest rate sensitivity gaps can be managed to take advantage of theslope of the yield curve as well as forecasted changes in the level of interestrate changes.

 

To manage this interest rate sensitivity position, an asset/liabilitymodel called ‘cumulative gap analysis’ is used to monitor the difference in thevolume of the Company’s interest sensitive assets and liabilities that matureor re-price within given periods.  Apositive gap (asset sensitive) indicates that more assets re-price during agiven period compared to liabilities, while a negative gap (liabilitysensitive) has the opposite effect.  TheCompany employs computerized net interest income simulation modeling to assistin quantifying interest rate risk exposure. This process measures and quantifies the impact on net interest incomethrough varying interest rate changes and balance sheet compositions.  The use of this model assists the ALCO togauge the effects of the interest rate changes on interest sensitive assets andliabilities in order to determine what impact these rate changes will have uponthe net interest spread.

 

At September 30, 2004, the Company maintained a one-year cumulativepositive gap of $62,975 or 11.55% of total assets.  The effect of this gap position provided apositive mismatch of assets and liabilities, which may expose the Bank to anincreased interest rate risk position during a period of declining interestrates.  Conversely, in an increasinginterest rate environment, net income could be positively affected because moreassets will re-price during a one-year period.

 

26

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The following table illustrates the Company’s interest sensitivity gapposition at September 30, 2004 (dollars in thousands):

 
| ** **                                 | ** ** | **3 months  or less** | ** ** | **3 through  12 months** | ** ** | **1 through  3 years** | ** ** | **Over  3 years** | ** ** | **Total** | ** ** |
|--------------------------------------------|------------|-----------------------|------------|--------------------------|------------|------------------------|------------|-------------------|------------|-----------|------------|
| Cash and cash  equivalents                 |       | $                     | 1,786      |                     | $          | —                 |       | $                 | —     |      | $          | 11,279 |   | $ | 13,065 |   |
| Investment  securities                     |       | 14,495                |       | 17,027                   |       | 43,960                 |       | 54,897            |       | 130,379   |       |
| Loans                                      |       | 138,668               |       | 88,987                   |       | 80,553                 |       | 68,869            |       | 377,077   |       |
| Fixed and other  assets                    |       | —                |       | 7,534                    |       | —                 |       | 17,116            |       | 24,650    |       |
| Total assets                               |       | $                     | 154,949    |                     | $          | 113,548                |       | $                 | 124,513    |      | $          | 152,161 |   | $ | 545,171 |   |
| Total cumulative  assets                   |       | $                     | 154,949    |                     | $          | 268,497                |       | $                 | 393,010    |      | $          | 545,171 |   |   |   |
|                                       |       |                  |       |                     |       |                   |       |              |       |      |       |
| Non-interest  bearing transaction deposits |       | $                     | —     |                     | $          | 6,562                  |       | $                 | 18,046     |      | $          | 41,014 |   | $ | 65,622 |   |
| Interest-bearing  transaction deposits     |       | 5,892                 |       | 54,317                   |       | 43,683                 |       | 10,634            |       | 114,526   |       |
| Time deposits                              |       | 43,239                |       | 46,981                   |       | 92,991                 |       | 12,071            |       | 195,282   |       |
| Repurchase  agreements                     |       | 32,325                |       | 4,334                    |       | 6,770                  |       | —            |       | 43,429    |       |
| Short-term  borrowings                     |       | 1,061                 |       | —                   |       | —                 |       | —            |       | 1,061     |       |
| Long-term debt                             |       | 10,203                |       | 608                      |       | 1,622                  |       | 63,878            |       | 76,311    |       |
| Other  liabilities                         |       | —                |       | —                   |       | —                 |       | 3,060             |       | 3,060     |       |
| Total  liabilities                         |       | $                     | 92,720     |                     | $          | 112,802                |       | $                 | 163,112    |      | $          | 130,657 |   | $ | 499,291 |   |
| Total cumulative  liabilities              |       | $                     | 92,720     |                     | $          | 205,522                |       | $                 | 368,634    |      | $          | 499,291 |   |   |   |
|                                       |       |                  |       |                     |       |                   |       |              |       |      |       |
| Interest  sensitivity gap                  |       | $                     | 62,229     |                     | $          | 746                    |       | $                 | (38,599    | )         | $          | 21,504 |   |   |   |
|                                       |       |                  |       |                     |       |                   |       |              |       |      |       |
| Cumulative gap                             |       | $                     | 62,229     |                     | $          | 62,975                 |       | $                 | 24,376     |      | $          | 45,880 |   |   |   |
|                                       |       |                  |       |                     |       |                   |       |              |       |      |       |
| Cumulative gap  to total assets            |       | 11.41                 | %          | 11.55                    | %          | 4.47                   | %          | 8.42              | %          |      |       |

 

Investmentsand loans are included in the earlier of the period in which interest rateswere next scheduled to adjust or the period in which they are due.  In addition, loans were included in theperiods in which they are scheduled to be repaid based on scheduledamortization.  For amortizing loans andmortgage-backed securities, annual prepayment rates are assumed reflectinghistorical experience as well as management’s knowledge of and experience withloan products.

 

The Bank’s demand and savings accounts weregenerally subject to immediate withdrawal. However, management considers a certain amount of such accounts to becore accounts having significantly longer effective maturities based on theretention experiences of such deposits in changing interest rateenvironments.  The effective maturitiespresented are the recommended maturity distribution limits for non-maturingdeposits based on historical deposit studies.

 

Certain shortcomings are inherent in the methodof analysis presented in the above table. Although certain assets and liabilities may have similar maturities orperiods of re-pricing, they may react in different degrees to changes in marketinterest rates.  The interest rates oncertain types of assets and liabilities may fluctuate in advance of changes inmarket interest rates, while interest rates on other types of assets andliabilities may lag behind changes in market interest rates.  Certain assets, such as adjustable-ratemortgages, have features which restrict changes in interest rates on ashort-term basis and over the life of the asset.  In the event of a change in interest rates,prepayment and early withdrawal levels may deviate significantly from thoseassumed in calculating the table.  Theability of many borrowers to service their adjustable-rate debt may decrease inthe event of an interest rate increase.

 

*Earnings at Risk and Economic Value at RiskSimulations:* The Company recognizes that more sophisticatedtools exist for measuring the interest rate risk in the balance sheet beyondstatic gap analysis.  Although it willcontinue to measure its static gap position, the Company utilizes additionalmodeling for identifying and measuring the interest rate risk in the overallbalance sheet.  The ALCO is responsiblefor focusing on “earnings at risk” and “economic value at risk”, and how bothrelate to the risk-based capital position when analyzing the interest raterisk.

 

27

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*Earnings at Risk:* Earnings atrisk simulation measure the change in net interest income and net income shouldinterest rates rise and fall.  Thesimulation recognizes that not all assets and liabilities re-price on aone-for-one basis with market rates (e.g., savings rate).  The ALCO looks at “earnings at risk” todetermine income changes from a base case scenario under an increase anddecrease of 200 basis points in interest rates simulation model.

 

*Economic Value at Risk:* Earningsat risk simulation measure the short-term risk in the balance sheet.  Economic value (or portfolio equity) at riskmeasures the long-term risk by finding the net present value of the future cashflows from the Company’s existing assets and liabilities.  The ALCO examines this ratio quarterlyutilizing an increase and decrease of 200 basis points in interest ratessimulation model. The ALCO recognizes that, in some instances, this ratio maycontradict the “earnings at risk” ratio.

 

The following table illustrates the simulated impact of 200 basispoints upward or downward movement in interest rates on net interest income,net income, and the change in economic value (portfolio equity).  This analysis assumed that interest-earningasset and interest-bearing liability levels at September 30, 2004 remainedconstant.  The impact of the rate movementswas developed by simulating the effect of rates changing over a twelve-monthperiod from the September 30, 2004 levels:

 
| ** **                                            | ** ** | **Rates +200** | ** ** | **Rates -200** | ** ** |
|-------------------------------------------------------|------------|----------------|------------|----------------|------------|
|                                                  |       |           |       |           |       |
| Earnings at  risk:                                    |       |           |       |           |       |
| Percent change  in:                                   |       |           |       |           |       |
| Net interest  income                                  |       | 8.2            | %          | (22.2          | )%         |
| Net income                                            |       | 22.1           |       | (58.9          | )          |
|                                                  |       |           |       |           |       |
| Economic value  at risk:                              |       |           |       |           |       |
| Percent change  in:                                   |       |           |       |           |       |
| Economic value  of equity                             |       | (13.3          | )          | (17.6          | )          |
| Economic value  of equity as a percent of book assets |       | (1.2           | )          | (1.6           | )          |

 

Economic value has the most meaning when viewed within the context ofrisk-based capital.  Therefore, theeconomic value may change beyond the Company’s policy guideline for a shortperiod of time as long as the risk-based capital ratio, after adjusting for theexcess equity exposure, is greater than 10%.

 

The table below summarizes estimated changes in net interest incomeover a twelve-month period beginning October 1, 2004, under alternate interestrate scenarios using the income simulation model described above:

 
| **Change  in interest rates** | ** ** | **Net interest  income**   | ** ** | **Dollar  variance** | ** ** | **Variance** | ** ** |
|-------------------------------|------------|----------------------------|------------|----------------------|------------|--------------|------------|
| ** **                    | ** ** | **(dollars in thousands)** | ** ** |
| +200 basis  points            |       | $                          | 19,175     |                 | $          | 1,453        |       | 8.2 | % |
| +100 basis  points            |       | 18,429                     |       | 707                  |       | 4.0          |       |
| Flat rate                     |       | 17,722                     |       | —               |       | —       |       |
| -100 basis  points            |       | 15,839                     |       | (1,883               | )          | (10.6        | )          |
| -200 basis  points            |       | 13,781                     |       | (3,941               | )          | (22.2        | )          |
|                               |            |                            |            |                      |            |              |            |  |  |

 

Simulation models require assumptions about certain categories ofassets and liabilities.  The modelsschedule existing assets and liabilities by their contractual maturity,estimated likely call date or earliest re-pricing opportunity.  Mortgage-backed securities and amortizingloans are scheduled based on their anticipated cash flow including estimatedprepayments.  For investment securities,we use a third party service to provide cash flow estimates in the various rateenvironments.  Savings accounts,including passbook, statement savings, money market and interest checkingaccounts do not have a stated maturity or re-pricing term and can be withdrawnor re-price at any time.  This may impactthe margin if more expensive alternative sources of deposits are required tofund loans or deposit runoff.  Managementprojects the re-pricing characteristics of these accounts based on historicalperformance and assumptions that it believes reflect their rate sensitivity.  The consulting model reinvests allmaturities, repayments and prepayments for each type of asset or liability intothe same product for a new like term then applies growth or run-off estimatesprovided by management.  As a result, themix of interest-earning assets and interest bearing-liabilities is not heldconstant.

 

28

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*Liquidity*

 

Liquidity management ensures that adequate funds will be available tomeet customers’ needs for borrowings, deposit withdrawals and maturities andnormal operating expenses of the Bank. Current sources of liquidity are cash and cash equivalents, assetmaturities and pay downs within one year, loans and investmentsavailable-for-sale, growth of core deposits, growth of repurchase agreements,increase of other borrowed funds from correspondent banks and issuance ofcapital stock.  In addition, the Bank’sother sources of liquidity are borrowings from the Federal Reserve DiscountWindow and Federal Home Loan Bank advances. Although regularly scheduled investment and loan payments are dependablesources of daily funds, the sale of loans and investment securitiesavailable-for-sale, deposit activity, and investment and loan prepayments aresignificantly influenced by general economic conditions and the level ofinterest rates.

 

At September 30,2004, the Company maintained $13,065,000 in cash and cash equivalents.  The Company also had $127,123,000 ininvestments available-for-sale and $330,000 of loans available-for-sale.  This combined total of $140,518,000 represented26% of total assets at September 30, 2004. In addition, at September 30, 2004, the Company had approximately$75,633,000 available to borrow from the Federal Home Loan Bank.  Management believes that the present level ofliquidity is adequate for current operations.

 

*Capital*

 

The Company is subject to various regulatory capital requirementsadministered by the federal banking agencies. Failure to meet minimum capitalrequirements can initiate certain mandatory and possible additionaldiscretionary actions by regulators that, if undertaken, could have a directmaterial effect on the Company’s financial statements. Under capital adequacyguidelines and the regulatory framework for prompt corrective action, theCompany must meet specific capital guidelines that involve quantitativemeasures of the Company’s assets, liabilities and certain off-balance-sheetitems as calculated under regulatory accounting practices.  The Company’s capital amounts andclassification are also subject to qualitative judgments by the regulatorsabout components, risk weightings and other factors.

 

Capital is fundamental to support our continued growth. In addition,the Company and Bank are subject to various regulatory capital requirements.Regulatory capital is defined in terms of Tier 1 capital (shareholders’ equityplus the allowable portion of the minority interest in equity of subsidiaries,minus unrealized gains or plus unrealized losses on available for salesecurities, and minus certain intangible assets), Tier 2 capital (whichincludes the allowable portion of the allowance for loan losses, minorityinterest in equity of subsidiaries and subordinated debt), and total capital(Tier 1 plus Tier 2). Risk-based capital ratios are expressed as percentages ofrisk-weighted assets. Risk-weighted assets are determined by assigning variousweights to all assets and off-balance sheet financial instruments, such asletters of credit and loan commitments, based on associated risk. Regulatorshave also adopted minimum Tier 1 leverage ratio standards, which measure theratio of Tier 1 capital to total average quarterly assets.

 

Quantitative measures, established by regulation to ensure capitaladequacy, require the Company to maintain minimum amounts and ratios (set forthin the following table as defined in the regulations) of total and Tier Icapital to risk-weighted assets, and of Tier I capital to average assets.  Capital is evaluated in relation to totalassets and the risk associated with those assets.  As of September 30, 2004, the Company meetsall capital adequacy requirements to which it is subject.  Both the Company’s and the Bank’s actualcapital amounts and ratios are presented below:

 

29

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| ** **                                | ** ** | **Actual** | ** ** | ** ** | ** ** | **For capital  adequacy purposes** | ** ** | **To be well capitalized  under prompt corrective  action provisions** | ** ** |
|-------------------------------------------|------------|------------|------------|------------|------------|------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                | ** ** | **Amount** | ** ** | **Ratio**  | ** ** | **Amount**                         | ** ** | **Ratio**                                                              | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
|                                      |       |       |       |       |       |                               |       |                                                                   |       |   |   |   |   |
| Total capital  (to risk-weighted assets)  |       |       |       |       |       |                               |       |                                                                   |       |   |   |   |   |
| Consolidated                              |       | $          | 50,459,558 |       | 13.48      | %                                  | $          | 29,952,237                                                             |       | 8.00 | % | N/A |   | N/A |   |
| Bank                                      |       | $          | 50,132,238 |       | 13.40      | %                                  | $          | 29,937,454                                                             |       | 8.00 | % | $ | 37,421,817 |   | 10.00 | % |
| Tier 1 capital  (to risk-weighted assets) |       |       |       |       |       |                               |       |                                                                   |       |   |   |   |   |
| Consolidated                              |       | $          | 45,686,794 |       | 12.20      | %                                  | $          | 14,976,118                                                             |       | 4.00 | % | N/A |   | N/A |   |
| Bank                                      |       | $          | 45,427,687 |       | 12.14      | %                                  | $          | 14,968,727                                                             |       | 4.00 | % | $ | 22,453,090 |   | 6.00 | % |
| Tier 1 Capital  (to average assets)       |       |       |       |       |       |                               |       |                                                                   |       |   |   |   |   |
| Consolidated                              |       | $          | 45,686,794 |       | 8.50       | %                                  | $          | 21,503,556                                                             |       | 4.00 | % | N/A |   | N/A |   |
| Bank                                      |       | $          | 45,427,687 |       | 8.46       | %                                  | $          | 21,476,641                                                             |       | 4.00 | % | $ | 26,845,802 |   | 5.00 | % |

 

**Item 4****.****                                         Controlsand Procedures**

 

The Company maintains controls and procedures designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission. Based upon their evaluation of those controls and procedures as of the end of the period covered by this report, the Chief Executive and Chief Financial Officers of the Company concluded that the Company’s disclosure controls and procedures were adequate.

 

**PART II.Other Information**

 

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

 

The nature of the Company’s business generates somelitigation involving matters arising in the ordinary course of business.However, in the opinion of the Company, after consulting with legalcounsel, no legal proceedings are pending, which, if determined adversely tothe Company or the Bank, would have a material effect on the Company’s undividedprofits or financial condition.  No legalproceedings are pending other than ordinary routine litigation incidental tothe business of the Company and the Bank. In addition, to management’s knowledge, no governmental authorities haveinitiated or contemplated any material legal actions against the Company or theBank.

 

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

 

None

 

**Item 3.****                                         Default upon Senior Securities**

 

None

 

30

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

 

None

 

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

 

None

 

**Item 6.****                                         Exhibits and Reports on Form 8-K**

 

a)              Exhibits

 

***3(i)******                                   Amendedand Restated Articles of Incorporation of Registrant.***Incorporated byreference to Exhibit 3(i) to Registrant’s Registration Statement No. 333-90273on Form S-4, filed with the SEC on November 3, 1999 and as amended on April 6,2000.

 

***3(ii)******                               Bylawsof Registrant.***Incorporated by reference to Exhibit 3(ii) to Registrant’sRegistration Statement No. 333-90273 on Form S-4, filed with the SEC onNovember 3, 1999 and as amended on April 6, 2000.

 

***10.1******                              1998Independent Directors Stock Option Plan of The Fidelity Deposit and DiscountBank, as assumed by Registrant.***Incorporated by reference to Exhibit10.1 to Registrant’s Registration Statement No. 333-90273 on Form S-4, filedwith the SEC on November 3, 1999 and as amended on April 6, 2000.

 

***10.2******                              1998Stock Incentive Plan of The Fidelity Deposit and Discount Bank, as assumed byRegistrant.***Incorporated by reference to Exhibit 10.2 of Registrant’sRegistration Statement No. 333-90273 on Form S-4, filed with the SEC onNovember 3, 1999 and as amended on April 6, 2000.

 

***10.3******                              Formof Deferred Compensation Plan of The Fidelity Deposit and Discount Bank.***Incorporatedby reference to Exhibit 10.3 to Registrant’s Registration StatementNo.333-45668 on Form S-1, filed with the SEC on September 12, 2000 and asamended on October 11, 2000.

 

***10.4******                              Registrant’s2000 Dividend Reinvestment Plan.***Incorporated by reference to Exhibit 4to Registrant’s Registration Statement No. 333-45668 on Form S-1, filed withthe SEC on September 12, 2000 and as amended by Pre-Effective Amendment No. 1on October 11, 2000 and by Post-Effective Amendment No. 1 on May 30, 2001.

 

***10.5******                              Registrant’s2000 Independent Directors Stock Option Plan.***Incorporated by referenceto Exhibit 4.3 to Registrant’s Registration Statement No. 333-64356 on Form S-8filed with the SEC on July 2, 2001.

 

***10.6******                              Registrant’s2000 Stock Incentive Plan***. Incorporated by reference to Exhibit 4.4 toRegistrant’s Registration Statement No. 333-64356 on Form S-8 filed with theSEC on July 2, 2001.

 

***10.7******                              Registrant’s2002 Employee Stock Purchase Plan.***Incorporated by reference to Exhibit4.5 to Registrant’s Registration Statement No. 333-113339 on Form S-8 filedwith the SEC on March 5, 2004 and Appendix A to Registrant’s Definitive ProxyStatement filed with the SEC on March 28, 2002.

 

***10.***8                               ***Employment Agreement between Registrant, TheFidelity Deposit and Discount Bank and Steven C. Ackmann, dated June 21, 2004.***Incorporatedby reference to Exhibit 99.1 to Registrant’s Current Report on Form 8-K filedwith the SEC on June 24, 2004.

 

***10.9******                              CompleteSettlement Agreement and General Release between Michael F. Marranca,Registrant and The Fidelity Deposit and Discount Bank, dated July30, 2004.*** Incorporated by reference to Exhibit 99.1 toRegistrant’s Current Report on Form 8-K filed with the SEC on August 10, 2004.

 

31

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***11******                                        Statementregarding computation of earnings per share.***Included herein in Note 2 “Earningsper Share”, contained within the Notes to Consolidated Financial Statements,and incorporated herein by reference.

 

***31.1******                              Rule13a-14(a) Certification of Principal Executive Officer, filed herewith.***

 

***31.2          Rule 13a-14(a) Certification ofPrincipal Financial Officer, filed herewith.***

 

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

 

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

 

32

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**FIDELITYD&D BANCORP, INC.**

 

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

 

 
|   | **FIDELITY D&D BANCORP, INC.**     |
|--------|----------------------------------------|
|   | ** **                             |
|   |                                   |
| Date:  | November 9, 2004                       |   |   | /s/ Steven C. Ackmann |   |
|   | Steven C.  Ackmann,                    |
|   | President and Chief  Executive Officer |
|   |                                   |
|   |                                   |
| Date:  | November 9, 2004                       |   | /s/ Salvatore R. DeFrancesco, Jr. |   |
|   | Salvatore R.  DeFrancesco, Jr.,        |
|   | Treasurer and Chief  Financial Officer |
|        |                                        |  |  |  |  |  |

 

33

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**FIDELITYD&D BANCORP, INC.**

 

Exhibit Index

 
| ** **  | ** **                                                                                                                                                                                                                                                                                                                                       | **Page** |
|-------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------|
|        |                                                                                                                                                                                                                                                                                                                                             |     |
| ***3(i)***  | ***Amended and Restated Articles  of Incorporation of Registrant.*** Incorporated by  reference to Exhibit 3(i) to Registrant’s Registration Statement No.  333-90273 on Form S-4, filed with the SEC on November 3, 1999 and as amended  on April 6, 2000.                                                                                 | *******  |   |
|        |                                                                                                                                                                                                                                                                                                                                             |     |   |
| ***3(ii)*** | ***Bylaws of Registrant***.  Incorporated by reference to Exhibit 3 (ii) to Registrant’s Registration  Statement No. 333-90273 on Form S-4, filed with the SEC on November 3, 1999  and as amended on April 6, 2000.                                                                                                                        | *******  |   |
|        |                                                                                                                                                                                                                                                                                                                                             |     |   |
| ***10.1***  | ***1998 Independent Directors  Stock Option Plan of The Fidelity Deposit and Discount Bank, as assumed by  Registrant.*** Incorporated by reference to Exhibit 10.1  to Registrant’s Registration Statement No. 333-90273 on Form S-4, filed with  the SEC on November 3, 1999 and as amended on April 6, 2000.                             | *******  |   |
|        |                                                                                                                                                                                                                                                                                                                                             |     |   |
| ***10.2***  | ***1998 Stock Incentive Plan of  The Fidelity Deposit and Discount Bank, as assumed by Registrant.***Incorporated  by reference to Exhibit 10.2 of Registrant’s Registration Statement No.  333-90273 on Form S-4, filed with the SEC on Nov. 3, 1999 and as amended on  April 6, 2000.                                                     | *******  |   |
|        |                                                                                                                                                                                                                                                                                                                                             |     |   |
| ***10.3***  | ***Form of Deferred Compensation  Plan of The Fidelity Deposit and Discount Bank.***Incorporated  by reference to Exhibit 10.3 to Registrant’s Registration Statement No.  333-45668 on Form S-1, filed with the SEC on September 12, 2000 and as  amended on October 11, 2000.                                                             | *******  |   |
|        |                                                                                                                                                                                                                                                                                                                                             |     |   |
| ***10.4***  | ***Registrant’s 2000 Dividend  Reinvestment Plan****.*Incorporated  by reference to Exhibit 4 to Registrant’s Registration Statement No.  333-45668 on Form S-1, filed with the SEC on September 12, 2000 and as  amended by Pre-Effective Amendment No. 1 on October 11, 2000 and by  Post-Effective Amendment No. 1 on May 30, 2001. | *******  |   |
|        |                                                                                                                                                                                                                                                                                                                                             |     |   |
| ***10.5***  | ***Registrant’s 2000 Independent  Directors Stock Option Plan.***Incorporated by reference  to Exhibit 4.3 to Registrant’s Registration Statement No. 333-64356 on Form  S-8 filed with the SEC on July 2, 2001.                                                                                                                       | *******  |   |
|        |                                                                                                                                                                                                                                                                                                                                             |     |   |
| ***10.6***  | ***Registrant’s 2000 Stock  Incentive Plan.***Incorporated by reference to Exhibit  4.4 to Registrant’s Registration Statement No. 333-64356 on Form S-8 filed  with the SEC on July 2, 2001.                                                                                                                                          | *******  |   |

 

34

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| ***10.7***   | ***Registrant’s 2002 Employee  Stock Purchase Plan. ***Incorporated  by reference to Exhibit 4.5 to Registrant’s Registration Statement No.  333-113339 on Form S-8 filed with the SEC on March 5, 2004.                                                                              | *******      |   |
|--------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------|--------|
|         |                                                                                                                                                                                                                                                                                                 |         |   |
| ***10.8***   | ***Employment Agreement between  Registrant, The Fidelity Deposit and Discount Bank and Steven C. Ackmann,  dated June 21, 2004****.*Incorporated  by reference to Exhibit 99.1 to Registrant’s Current Report on Form 8-K filed  with the SEC on June 24, 2004.                                | *******      |   |
| *** *** | *** ***                                                                                                                                                                                                                                                                                         | *** *** |   |
| ***10.9***   | ***Complete Settlement Agreement  and General Release between Michael F. Marranca, Registrant and The Fidelity  Deposit and Discount Bank, dated July 30, 2004.***Incorporated  by reference to Exhibit 99.1 to Registrant’s Current Report on Form 8-K filed  with the SEC on August 10, 2004. | *******      |   |
|         |                                                                                                                                                                                                                                                                                                 |         |   |
| ***11***     | ***Statement regarding computation  of earnings per share***. Included herein.                                                                                                                                                                                                                       | ***9***      |   |
|         |                                                                                                                                                                                                                                                                                                 |         |   |
| ***31.1***   | ***Rule 13a-14(a) Certification of  Principal Executive Officer.***                                                                                                                                                                                                                                  | ***36***     |   |
|         |                                                                                                                                                                                                                                                                                                 |         |   |
| ***31.2***   | ***Rule 13a-14(a) Certification of  Principal Financial Officer.***                                                                                                                                                                                                                                  | ***37***     |   |
|         |                                                                                                                                                                                                                                                                                                 |         |   |
| ***32.1***   | ***Certification of Principal  Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.***                                                                                                                                       | ***38***     |   |
|         |                                                                                                                                                                                                                                                                                                 |         |   |
| ***32.2***   | ***Certification of Principal  Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.***                                                                                                                                       | ***39***     |   |

 

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*******-Incorporated by Reference

 

35

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