Tableof Contents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

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

 

**For thequarterly period ended June 30, 2009**

 

**OR**

 

**o****         TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**For thetransition period from                to                **

 

**Commissionfile number: 333-90273**

 

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

 

STATE OFINCORPORATION:  IRS EMPLOYERIDENTIFICATION NO:

**PENNSYLVANIA                                     23-3017653**

 

Address ofprincipal executive offices:

**BLAKELY &DRINKER ST.**

**DUNMORE,PENNSYLVANIA 18512**

 

TELEPHONE:

**570-342-8281**

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subjected to such filing requirements for thepast 90 days.  x YES o NO

 

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

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company.  See the definitions of “large acceleratedfiler,” “accelerated filer” and “smaller reporting company” in Rule 12b-2of the Exchange Act.  (Check one):

 

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

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).  o YES x NO

 

The number of outstandingshares of Common Stock of Fidelity D & D Bancorp, Inc. at July 31,2009, the latest practicable date, was 2,082,657 shares.

 

 

 

----

Tableof Contents

 

**FIDELITYD & D BANCORP, INC.**

 

Form 10-Q June 30,2009

 

Index

 
| ** **                             | ** **                                                                                                             | **Page** |
|----------------------------------------|------------------------------------------------------------------------------------------------------------------------|----------|
| **Part I. Financial Information** | ** **                                                                                                             |
|                                   |                                                                                                                   |     |
| Item 1.                                | Financial Statements:                                                                                                  |     |
|                                   | Consolidated Balance Sheets  as of June 30, 2009 and December 31, 2008                                       | 3        |
|                                   | Consolidated Statements of  Income for the three and six months ended June 30, 2009 and 2008                      | 4        |
|                                   | Consolidated Statements of  Changes in Shareholders’ Equity for the six months ended June 30, 2009  and 2008 | 5        |
|                                   | Consolidated Statements of  Cash Flows for the six months ended June 30, 2009 and 2008                            | 6        |
|                                   | Notes  to Consolidated Financial Statements                                                                            | 7        |
|                                   |                                                                                                                   |     |
| Item  2.                               | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                            |     |
|                                   |                                                                                                                   | 19       |
| Item  3.                               | Quantitative  and Qualitative Disclosure about Market Risk                                                             | 33       |
|                                   |                                                                                                                   |     |
| Item  4T.                              | Controls  and Procedures                                                                                               | 37       |
|                                   |                                                                                                                   |     |
| **Part II. Other Information**    |                                                                                                                   |
|                                   |                                                                                                                   |     |
| Item  1.                               | Legal  Proceedings                                                                                                     | 38       |
|                                   |                                                                                                                   |     |
| Item  1A.                              | Risk  Factors                                                                                                          | 38       |
|                                   |                                                                                                                   |     |
| Item  2.                               | Unregistered  Sales of Equity Securities and Use of Proceeds                                                           | 38       |
|                                   |                                                                                                                   |     |
| Item  3.                               | Defaults  upon Senior Securities                                                                                       | 38       |
|                                   |                                                                                                                   |     |
| Item  4.                               | Submission  of Matters to a Vote of Security Holders                                                                   | 38       |
|                                   |                                                                                                                   |     |
| Item  5.                               | Other  Information                                                                                                     | 38       |
|                                   |                                                                                                                   |     |
| Item  6.                               | Exhibits                                                                                                               | 38       |
|                                   |                                                                                                                   |     |
| Signatures                             | 40                                                                                                                     |
|                                   |                                                                                                                   |
| Exhibit index                     | 41                                                                                                                     |

 

2

----

Tableof Contents

 

**PART I— Financial Information**

 

**Item 1:Financial Statements**

 

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

Consolidated Balance Sheets

 
| ** **                                                                                                                                                                           | ** ** | **June 30, 2009** | ** **  | **December 31, 2008** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|-------------|----------------------------|------------|
| ** **                                                                                                                                                                           | ** ** | **(unaudited)**        | ** **  | **(audited)**              | ** ** |
|                                                                                                                                                                                 |       |                   |        |                       |       |
| Assets:                                                                                                                                                                              |       |                   |        |                       |       |
| Cash and due from banks                                                                                                                                                              |       | $                      | 10,959,880  |                       | $          | 12,335,905 |   |
| Federal funds sold                                                                                                                                                                   |       | 4,538,000              |        | —                     |       |
| Interest-bearing deposits with financial  institutions                                                                                                                               |       | 71,693                 |        | 435,242                    |       |
|                                                                                                                                                                                 |       |                   |        |                       |       |
| Total cash and cash equivalents                                                                                                                                                      |       | 15,569,573             |        | 12,771,147                 |       |
|                                                                                                                                                                                 |       |                   |        |                       |       |
| Available-for-sale securities                                                                                                                                                        |       | 76,476,415             |        | 83,278,132                 |       |
| Held-to-maturity securities                                                                                                                                                          |       | 842,679                |        | 909,447                    |       |
| Federal Home Loan Bank Stock                                                                                                                                                         |       | 4,781,100              |        | 4,781,100                  |       |
| Loans and leases, net (allowance for loan losses  of $5,215,736 in 2009; $4,745,234 in 2008)                                                                                         |       | 419,928,399            |        | 436,207,460                |       |
| Loans available-for-sale (fair value $2,307,950 in  2009; $85,312 in 2008)                                                                                                           |       | 2,287,993              |        | 84,000                     |       |
| Bank premises and equipment, net                                                                                                                                                     |       | 15,544,799             |        | 16,056,362                 |       |
| Cash surrender value of bank owned life insurance                                                                                                                                    |       | 8,962,081              |        | 8,807,784                  |       |
| Other assets                                                                                                                                                                         |       | 12,613,873             |        | 8,929,917                  |       |
| Accrued interest receivable                                                                                                                                                          |       | 2,248,236              |        | 2,443,141                  |       |
| Foreclosed assets held-for-sale                                                                                                                                                      |       | 1,199,060              |        | 1,450,507                  |       |
|                                                                                                                                                                                 |       |                   |        |                       |       |
| Total assets                                                                                                                                                                         |       | $                      | 560,454,208 |                       | $          | 575,718,997 |   |
|                                                                                                                                                                                 |       |                   |        |                       |       |
| Liabilities:                                                                                                                                                                         |       |                   |        |                       |       |
| Deposits:                                                                                                                                                                            |       |                   |        |                       |       |
| Interest-bearing                                                                                                                                                                     |       | $                      | 384,370,177 |                       | $          | 361,869,281 |   |
| Non-interest-bearing                                                                                                                                                                 |       | 69,503,187             |        | 71,442,651                 |       |
|                                                                                                                                                                                 |       |                   |        |                       |       |
| Total deposits                                                                                                                                                                       |       | 453,873,364            |        | 433,311,932                |       |
|                                                                                                                                                                                 |       |                   |        |                       |       |
| Accrued interest payable and other liabilities                                                                                                                                       |       | 6,577,952              |        | 3,316,710                  |       |
| Short-term borrowings                                                                                                                                                                |       | 8,880,343              |        | 38,129,704                 |       |
| Long-term debt                                                                                                                                                                       |       | 42,000,000             |        | 52,000,000                 |       |
|                                                                                                                                                                                 |       |                   |        |                       |       |
| Total liabilities                                                                                                                                                                    |       | 511,331,659            |        | 526,758,346                |       |
|                                                                                                                                                                                 |       |                   |        |                       |       |
| Shareholders’ equity:                                                                                                                                                           |       |                   |        |                       |       |
| Preferred stock authorized 5,000,000 shares with  no par value; none issued                                                                                                          |       | —                 |        | —                     |       |
| Capital stock, no par value (10,000,000 shares  authorized; shares issued and outstanding; 2,082,657 in 2009; and 2,075,182  shares issued and 2,062,927 shares outstanding in 2008) |       | 19,567,860             |        | 19,410,306                 |       |
| Treasury stock, at cost (no shares in 2009; 12,255  shares in 2008)                                                                                                                  |       | —                 |        | (351,665                   | )          |
| Retained earnings                                                                                                                                                                    |       | 39,067,674             |        | 38,126,250                 |       |
| Accumulated other comprehensive loss                                                                                                                                                 |       | (9,512,985             | )           | (8,224,240                 | )          |
|                                                                                                                                                                                 |       |                   |        |                       |       |
| Total shareholders’ equity                                                                                                                                                      |       | 49,122,549             |        | 48,960,651                 |       |
|                                                                                                                                                                                 |       |                   |        |                       |       |
| Total liabilities and shareholders’ equity                                                                                                                                      |       | $                      | 560,454,208 |                       | $          | 575,718,997 |   |

 

See notes to consolidated financial statements

 

3

----

Table of Contents

 

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

Consolidated Statements of Income

(unaudited)

 
| ** **                                                                                                                    | ** ** | **Three months ended** | ** ** | **Six months ended**   | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                                                                    | ** ** | **June 30, 2009** | ** ** | **June 30, 2008** | ** ** | **June 30, 2009** | ** ** | **June 30, 2008** | ** ** |
|                                                                                                                          |       |                   |       |                   |       |   |   |   |   |
| Interest income:                                                                                                              |       |                   |       |                   |       |   |   |   |   |
| Loans and leases:                                                                                                             |       |                   |       |                   |       |   |   |   |   |
| Taxable                                                                                                                       |       | $                      | 6,356,864  |                   | $          | 6,775,180 |   | $ | 12,917,612 |   | $ | 13,584,314 |   |
| Nontaxable                                                                                                                    |       | 113,488                |       | 85,330                 |       | 228,262 |   | 163,406 |   |
| Interest-bearing deposits with financial  institutions                                                                        |       | 337                    |       | 696                    |       | 448 |   | 1,802 |   |
| Investment securities:                                                                                                        |       |                   |       |                   |       |   |   |   |   |
| U.S. government agency and corporations                                                                                       |       | 550,457                |       | 1,284,136              |       | 1,317,828 |   | 2,537,317 |   |
| States and political subdivisions (nontaxable)                                                                                |       | 270,334                |       | 155,102                |       | 468,909 |   | 299,232 |   |
| Other securities                                                                                                              |       | 157,458                |       | 305,658                |       | 342,508 |   | 680,694 |   |
| Federal funds sold                                                                                                            |       | 6,575                  |       | 6,964                  |       | 7,359 |   | 91,133 |   |
|                                                                                                                          |       |                   |       |                   |       |   |   |   |   |
| Total interest income                                                                                                         |       | 7,455,513              |       | 8,613,066              |       | 15,282,926 |   | 17,357,898 |   |
|                                                                                                                          |       |                   |       |                   |       |   |   |   |   |
| Interest expense:                                                                                                             |       |                   |       |                   |       |   |   |   |   |
| Deposits                                                                                                                      |       | 2,138,133              |       | 2,831,400              |       | 4,329,905 |   | 6,065,136 |   |
| Securities sold under repurchase agreements                                                                                   |       | 8,081                  |       | 13,443                 |       | 16,555 |   | 80,596 |   |
| Other short-term borrowings and other                                                                                         |       | 405                    |       | 48,849                 |       | 26,545 |   | 113,671 |   |
| Long-term debt                                                                                                                |       | 568,325                |       | 776,210                |       | 1,344,532 |   | 1,608,495 |   |
|                                                                                                                          |       |                   |       |                   |       |   |   |   |   |
| Total interest expense                                                                                                        |       | 2,714,944              |       | 3,669,902              |       | 5,717,537 |   | 7,867,898 |   |
|                                                                                                                          |       |                   |       |                   |       |   |   |   |   |
| Net interest income                                                                                                           |       | 4,740,569              |       | 4,943,164              |       | 9,565,389 |   | 9,490,000 |   |
|                                                                                                                          |       |                   |       |                   |       |   |   |   |   |
| Provision for loan losses                                                                                                     |       | 300,000                |       | 125,000                |       | 725,000 |   | 125,000 |   |
|                                                                                                                          |       |                   |       |                   |       |   |   |   |   |
| Net interest income after provision for loan  losses                                                                          |       | 4,440,569              |       | 4,818,164              |       | 8,840,389 |   | 9,365,000 |   |
|                                                                                                                          |       |                   |       |                   |       |   |   |   |   |
| Other income:                                                                                                                 |       |                   |       |                   |       |   |   |   |   |
| Service charges on deposit accounts                                                                                           |       | 648,228                |       | 737,330                |       | 1,280,648 |   | 1,500,599 |   |
| Fees and other service charges                                                                                                |       | 472,313                |       | 461,809                |       | 979,489 |   | 892,638 |   |
| Gain (loss) on sale or disposal of:                                                                                           |       |                   |       |                   |       |   |   |   |   |
| Loans                                                                                                                         |       | 327,785                |       | 59,590                 |       | 818,326 |   | 151,196 |   |
| Investment securities                                                                                                         |       | —                 |       | 7,519                  |       | — |   | 8,653 |   |
| Premises and equipment                                                                                                        |       | (4,378                 | )          | (984                   | )          | (6,624 | ) | (984 | ) |
| Foreclosed assets held-for-sale                                                                                               |       | 14,891                 |       | 405                    |       | 25,887 |   | 9,109 |   |
| Impairment losses on investment securities:                                                                                   |       |                   |       |                   |       |   |   |   |   |
| Other-than-temporary impairment on investment  securities                                                                     |       | (570                   | )          | —                 |       | (326,095 | ) | — |   |
| Non-credit related losses on investment securities  not expected to be sold (recognized in other comprehensive income/(loss)) |       | —                 |       | —                 |       | — |   | — |   |
| Net impairment losses on investment securities  recognized in earnings                                                        |       | (570                   | )          | —                 |       | (326,095 | ) | — |   |
| Total other income                                                                                                            |       | 1,458,269              |       | 1,265,669              |       | 2,771,631 |   | 2,561,211 |   |
|                                                                                                                          |       |                   |       |                   |       |   |   |   |   |
| Other expenses:                                                                                                               |       |                   |       |                   |       |   |   |   |   |
| Salaries and employee benefits                                                                                                |       | 2,422,656              |       | 2,472,302              |       | 4,992,349 |   | 4,889,848 |   |
| Premises and equipment                                                                                                        |       | 904,893                |       | 781,469                |       | 1,811,315 |   | 1,572,109 |   |
| Advertising                                                                                                                   |       | 135,992                |       | 168,348                |       | 278,393 |   | 336,704 |   |
| Other                                                                                                                         |       | 1,275,293              |       | 1,022,421              |       | 2,318,719 |   | 2,038,628 |   |
|                                                                                                                          |       |                   |       |                   |       |   |   |   |   |
| Total other expenses                                                                                                          |       | 4,738,834              |       | 4,444,540              |       | 9,400,776 |   | 8,837,289 |   |
|                                                                                                                          |       |                   |       |                   |       |   |   |   |   |
| Income before provision for income taxes                                                                                      |       | 1,160,004              |       | 1,639,293              |       | 2,211,244 |   | 3,088,922 |   |
|                                                                                                                          |       |                   |       |                   |       |   |   |   |   |
| Provision for income taxes                                                                                                    |       | 247,851                |       | 435,347                |       | 474,033 |   | 796,029 |   |
|                                                                                                                          |       |                   |       |                   |       |   |   |   |   |
| Net income                                                                                                                    |       | $                      | 912,153    |                   | $          | 1,203,946 |   | $ | 1,737,211 |   | $ | 2,292,893 |   |
|                                                                                                                          |       |                   |       |                   |       |   |   |   |   |
| Per share data:                                                                                                               |       |                   |       |                   |       |   |   |   |   |
| Net income - basic                                                                                                            |       | $                      | 0.44       |                   | $          | 0.59 |   | $ | 0.84 |   | $ | 1.11 |   |
| Net income - diluted                                                                                                          |       | $                      | 0.44       |                   | $          | 0.59 |   | $ | 0.84 |   | $ | 1.11 |   |
| Dividends                                                                                                                     |       | $                      | 0.25       |                   | $          | 0.25 |   | $ | 0.50 |   | $ | 0.50 |   |

 

See notes to consolidated financial statements

 

4

----

Table of Contents

 

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

 

Consolidated Statements of Changes in Shareholders’ Equity

For the six months ended June 30, 2009 and 2008

 
| ** **                                                                                                                     | ** ** | ** **             | ** ** | ** **              | ** ** | ** **   | ** ** | ** **        | ** ** | ** **   | ** ** | **Accumulated**   | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-------------------------|------------|--------------|------------|-------------------|------------|--------------|------------|-------------------|------------|------------|------------|
| ** **                                                                                                                     | ** ** | ** **             | ** ** | ** **              | ** ** | ** **   | ** ** | ** **        | ** ** | ** **   | ** ** | **other**         | ** ** | ** ** | ** ** |
| ** **                                                                                                                     | ** ** | **Capital stock** | ** ** | **Treasury stock** | ** ** | **Retained** | ** ** | **comprehensive** | ** ** | ** **   | ** ** |
| ** **                                                                                                                     | ** ** | **Shares**             | ** ** | **Amount**              | ** ** | **Shares**   | ** ** | **Amount**        | ** ** | **earnings** | ** ** | **income (loss)** | ** ** | **Total**  | ** ** |
|                                                                                                                           |       |                   |       |                    |       |         |       |              |       |         |       |              |       |       |       |
| Balance,  December 31, 2007                                                                                               |       | 2,072,929              |       | $                       | 19,223,363 |         | —     |              | $          | —       |       | $                 | 36,564,157 |       | $          | (596,226 | ) | $ | 55,191,294 |   |
| Total  comprehensive income:                                                                                                   |       |                   |       |                    |       |         |       |              |       |         |       |              |       |       |       |
| Net  income                                                                                                                    |       |                   |       |                    |       |         |       |              |       | 2,292,893    |       |              |       | 2,292,893  |       |
| Change  in net unrealized holding losses on available-for-sale securities, net of reclassification  adjustment and tax effects |       |                   |       |                    |       |         |       |              |       |         |       | (3,531,356        | )          | (3,531,356 | )          |
| Change  in cash flow hedge intrinsic value                                                                                     |       |                   |       |                    |       |         |       |              |       |         |       | 97,818            |       | 97,818     |       |
| Comprehensive  income                                                                                                          |       |                   |       |                    |       |         |       |              |       |         |       |              |       | (1,140,645 | )          |
| Issuance  of common stock through Employee Stock                                                                               |       |                   |       |                    |       |         |       |              |       |         |       |              |       |       |       |
| Purchase  Plan                                                                                                                 |       | 2,253                  |       | 57,891                  |       |         |       |              |       |         |       |              |       | 57,891     |       |
| Stock-based  compensation expense                                                                                              |       |                   |       | 126,738                 |       |         |       |              |       |         |       |              |       | 126,738    |       |
| Purchase  of treasury stock                                                                                                    |       |                   |       |                    |       | (5,000       | )          | (145,605          | )          |         |       |              |       | (145,605   | )          |
| Cash  dividends declared                                                                                                       |       |                   |       |                    |       |         |       |              |       | (1,037,590   | )          |              |       | (1,037,590 | )          |
|                                                                                                                           |       |                   |       |                    |       |         |       |              |       |         |       |              |       |       |       |
| Balance,  June 30, 2008 (unaudited)                                                                                       |       | 2,075,182              |       | $                       | 19,407,992 |         | (5,000     | )                 | $          | (145,605     | )          | $                 | 37,819,460 |       | $          | (4,029,764 | ) | $ | 53,052,083 |   |
|                                                                                                                           |       |                   |       |                    |       |         |       |              |       |         |       |              |       |       |       |
| Balance,  December 31, 2008                                                                                               |       | 2,075,182              |       | $                       | 19,410,306 |         | (12,255    | )                 | $          | (351,665     | )          | $                 | 38,126,250 |       | $          | (8,224,240 | ) | $ | 48,960,651 |   |
| Cumulative  effect of change in accounting principle, adoption of FSP FAS 115-2 and 124-2                                      |       |                   |       |                    |       |         |       |              |       | 350,720      |       | (350,720          | )          | —     |       |
| Total  comprehensive income:                                                                                                   |       |                   |       |                    |       |         |       |              |       |         |       |              |       |       |       |
| Net  income                                                                                                                    |       |                   |       |                    |       |         |       |              |       | 1,737,211    |       |              |       | 1,737,211  |       |
| Change  in net unrealized holding losses on available-for-sale securities, net of reclassification  adjustment and tax effects |       |                   |       |                    |       |         |       |              |       |         |       | (603,309          | )          | (603,309   | )          |
| Change  in cash flow hedge intrinsic value                                                                                     |       |                   |       |                    |       |         |       |              |       |         |       | (334,716          | )          | (334,716   | )          |
| Comprehensive  income                                                                                                          |       |                   |       |                    |       |         |       |              |       |         |       |              |       | 799,186    |       |
| Issuance  of common stock through Employee Stock                                                                               |       |                   |       |                    |       |         |       |              |       |         |       |              |       |       |       |
| Purchase  Plan                                                                                                                 |       | 1,701                  |       | 40,569                  |       |         |       |              |       |         |       |              |       | 40,569     |       |
| Dividends  reinvested through Dividend                                                                                         |       |                   |       |                    |       |         |       |              |       |         |       |              |       |       |       |
| Reinvestment  Plan                                                                                                             |       | 5,774                  |       | 112,477                 |       | 14,755       |       | 408,170           |       | (112,329     | )          |              |       | 408,318    |       |
| Stock-based  compensation expense                                                                                              |       |                   |       | 4,508                   |       |         |       |              |       |         |       |              |       | 4,508      |       |
| Purchase  of treasury stock                                                                                                    |       |                   |       |                    |       | (2,500       | )          | (56,505           | )          |         |       |              |       | (56,505    | )          |
| Cash  dividends declared                                                                                                       |       |                   |       |                    |       |         |       |              |       | (1,034,178   | )          |              |       | (1,034,178 | )          |
|                                                                                                                           |       |                   |       |                    |       |         |       |              |       |         |       |              |       |       |       |
| Balance,  June 30, 2009 (unaudited)                                                                                       |       | 2,082,657              |       | $                       | 19,567,860 |         | —     |              | $          | —       |       | $                 | 39,067,674 |       | $          | (9,512,985 | ) | $ | 49,122,549 |   |

 

See notes to consolidated financial statements

 

5

----

Tableof Contents

 

**FIDELITY DEPOSIT & DISCOUNTBANCORP, INC. AND SUBSIDIARY**

Consolidated Statementsof Cash Flows

(unaudited)

 
| ** **                                                                         | ** ** | **Six months ended June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                         | ** ** | **2009**                           | ** ** | **2008** | ** ** |
|                                                                               |       |                               |       |   |   |
| Cash flows from operating activities:                                              |       |                               |       |   |   |
| Net income                                                                         |       | $                                  | 1,737,211  |   | $ | 2,292,893 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities: |       |                               |       |   |   |
| Depreciation, amortization and accretion                                           |       | 609,143                            |       | 296,817 |   |
| Provision for loan losses                                                          |       | 725,000                            |       | 125,000 |   |
| Deferred income tax expense                                                        |       | 133,518                            |       | 240,736 |   |
| Stock-based compensation expense                                                   |       | 4,508                              |       | 126,738 |   |
| Loss from investment in limited partnership                                        |       | 40,200                             |       | 40,200 |   |
| Proceeds from sale of loans available-for-sale                                     |       | 74,147,662                         |       | 37,691,085 |   |
| Originations of loans available-for-sale                                           |       | (64,393,533                        | )          | (6,626,744 | ) |
| Increase in cash surrender value of life insurance                                 |       | (154,297                           | )          | (156,934 | ) |
| Net gain on sale of loans                                                          |       | (818,326                           | )          | (151,196 | ) |
| Net gain on sale of investment securities                                          |       | —                             |       | (8,653 | ) |
| Net gain on sale of foreclosed assets held for  sale                               |       | (25,887                            | )          | (9,109 | ) |
| Loss on disposal of equipment                                                      |       | 6,624                              |       | 984 |   |
| Other-than-temporary impairment on securities                                      |       | 326,095                            |       | — |   |
| Change in:                                                                         |       |                               |       |   |   |
| Accrued interest receivable                                                        |       | 74,687                             |       | (174,221 | ) |
| Other assets                                                                       |       | (1,339,119                         | )          | (1,881,674 | ) |
| Accrued interest payable and other liabilities                                     |       | 629,634                            |       | 1,170,971 |   |
|                                                                               |       |                               |       |   |   |
| Net cash provided by operating activities                                          |       | 11,703,120                         |       | 32,976,893 |   |
|                                                                               |       |                               |       |   |   |
| Cash flows from investing activities:                                              |       |                               |       |   |   |
| Held-to-maturity securities:                                                       |       |                               |       |   |   |
| Proceeds from maturities, calls and principal  pay-downs                           |       | 66,727                             |       | 87,104 |   |
| Available-for-sale securities:                                                     |       |                               |       |   |   |
| Proceeds from sales                                                                |       | —                             |       | 12,889,251 |   |
| Proceeds from maturities, calls and principal  pay-downs                           |       | 29,835,486                         |       | 26,121,600 |   |
| Purchases                                                                          |       | (23,752,046                        | )          | (50,247,929 | ) |
| Net decrease in FHLB stock                                                         |       | —                             |       | (1,055,400 | ) |
| Net decrease (increase) in loans and leases                                        |       | 4,282,109                          |       | (24,092,055 | ) |
| Acquisition of bank premises and equipment                                         |       | (415,925                           | )          | (2,104,991 | ) |
| Proceeds from sale of foreclosed assets  held-for-sale                             |       | 408,680                            |       | 62,090 |   |
|                                                                               |       |                               |       |   |   |
| Net cash provided by (used in) investing  activities                               |       | 10,425,031                         |       | (38,340,330 | ) |
|                                                                               |       |                               |       |   |   |
| Cash flows from financing activities:                                              |       |                               |       |   |   |
| Net increase in deposits                                                           |       | 20,561,432                         |       | 22,525,504 |   |
| Net decrease in short-term borrowings                                              |       | (29,249,361                        | )          | (9,982,018 | ) |
| Repayments of long-term debt                                                       |       | (10,000,000                        | )          | (423,095 | ) |
| Purchase of treasury stock                                                         |       | (56,505                            | )          | (145,605 | ) |
| Proceeds from employee stock purchase plan                                         |       | 40,569                             |       | 57,891 |   |
| Dividends paid, net of dividends reinvested                                        |       | (625,860                           | )          | (1,037,590 | ) |
|                                                                               |       |                               |       |   |   |
| Net cash (used in) provided by financing  activities                               |       | (19,329,725                        | )          | 10,995,087 |   |
|                                                                               |       |                               |       |   |   |
| Net increase in cash and cash equivalents                                          |       | 2,798,426                          |       | 5,631,650 |   |
|                                                                               |       |                               |       |   |   |
| Cash and cash equivalents, beginning                                               |       | 12,771,147                         |       | 10,408,816 |   |
|                                                                               |       |                               |       |   |   |
| Cash and cash equivalents, ending                                                  |       | $                                  | 15,569,573 |   | $ | 16,040,466 |   |

 

Seenotes to consolidated financial statements

 

6

----

Tableof Contents

 

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

 

**Notes to Consolidated Financial Statements**

**(unaudited)**

 

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

 

# **Nature of operations**

#  

# TheFidelity Deposit and Discount Bank (the Bank) is a commercial bank chartered inthe Commonwealth of Pennsylvania and a wholly-owned subsidiary of Fidelity D &D Bancorp, Inc. (the Company or collectively, the Company).  Having commenced operations in 1903, the Bankis committed to provide superior customer service, while offering a full rangeof banking products and financial and trust services to both our consumer andcommercial customers from our main office located in Dunmore and other branchesthroughout Lackawanna and Luzerne counties.

#  

# **Principles of consolidation**

#  

# Theaccompanying unaudited consolidated financial statements of the Company and theBank have been prepared in accordance with accounting principles generallyaccepted in the United States of America (GAAP) for interim financialinformation and with the instructions to this Form 10-Q and Rule 10-01of Regulation S-X.  Accordingly, they donot include all of the information and footnote disclosures required by GAAPfor complete financial statements.  Inthe opinion of management, all normal recurring adjustments necessary for afair presentation of the financial condition and results of operations for theperiods have been included.  Allsignificant inter-company balances and transactions have been eliminated inconsolidation.

#  

The preparation offinancial statements in conformity with GAAP requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reported periods.  Actualresults could differ from those estimates. For additional information and disclosures required under GAAP, refer tothe Company’s Annual Report on Form 10-K for the year ended December 31,2008.

 

Management is responsiblefor the fairness, integrity and objectivity of the unaudited financialstatements included in this report. Management prepared the unaudited financial statements in accordancewith GAAP.  In meeting its responsibilityfor the financial statements, management depends on the Company’s accountingsystems and related internal controls. These systems and controls are designed to provide reasonable but notabsolute assurance that the financial records accurately reflect thetransactions of the Company, the Company’s assets are safeguarded and that thefinancial statements present fairly the financial condition and results ofoperations of the Company.

 

In the opinion ofmanagement, the consolidated balance sheets as of June 30, 2009 and December 31,2008 and the related consolidated statements of income for the three- andsix-month periods ended June 30, 2009 and 2008 and changes in shareholders’equity and cash flows for the six months ended June 30, 2009 and 2008present fairly the financial condition and results of operations of theCompany.  All material adjustmentsrequired for a fair presentation have been made.  These adjustments are of a normal recurringnature.

 

This Quarterly Report on Form 10-Qshould be read in conjunction with the Company’s audited financial statementsfor the year ended December 31, 2008, and the notes included therein,included within the Company’s Annual Report filed on Form 10-K.

 

# **Critical accounting policies**

#  

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

 

A material estimate thatis particularly susceptible to significant change relates to the determinationof the allowance for loan losses. Management believes that the allowance for loan losses at June 30,2009 is adequate and reasonable.  Giventhe subjective nature of identifying and valuing loan losses, it is likely thatwell-informed individuals could make different assumptions, and could,therefore calculate a materially different allowance value.  While management uses available informationto recognize losses on loans, changes in economic conditions and / orcollateral values 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 judgment of information available to them at the time of theirexamination.

 

Another material estimateis the calculation of fair values of the Company’s investment securities.  Except for the Company’s investment incorporate bonds, consisting of preferred term securities, fair values on theother investment securities are determined by prices provided by a third-partyvendor, who is a provider of financial market data, analytics 

 

7

----

Tableof Contents

 

and related services tofinancial institutions.  For the pooledtrust preferred securities, management was unable to obtain readily attainableand realistic pricing from market traders due to lack of active marketparticipants and therefore management has determined that the market for thesesecurities continues to be inactive.  Inorder to determine the fair value of the preferred term securities, managementrelied on the use of an income valuation approach (present value technique)that maximizes the use of relevant observable inputs and minimizes the use ofunobservable inputs, the results of which are more representative of fair valuethan the market approach valuation technique used for the other investmentsecurities.

 

Based on experience,management is aware that estimated fair values of investment securities tend tovary among valuation services. Accordingly, when selling investment securities, price quotes from morethan one source may be obtained.  A largemajority of the Company’s investment securities are classified asavailable-for-sale (AFS).  AFS securitiesare carried at fair value on the consolidated balance sheet, with unrealizedgains and losses, net of income tax, reported separately within shareholders’equity through accumulated other comprehensive income (loss).

 

The fair value ofresidential mortgage loans, classified as AFS, is obtained from the FederalNational Mortgage Association (FNMA) or the Federal Home Loan Bank (FHLB).  Generally, the market to which the Companysells mortgages it originates for sale is restricted and price quotes fromother sources are not typically obtained. On occasion, the Company may transfer loans from the loan and leaseportfolio to loans AFS.  Under thesecircumstances, pricing may be obtained from other entities and the loans aretransferred at the lower of cost or market value and simultaneously sold.  For a further discussion on the accountingtreatment of AFS loans, see the section entitled “Loans available-for-sale,”contained within management’s discussion and analysis.  As of June 30, 2009 and December 31,2008, loans classified as AFS consisted of residential mortgages.

 

**2.  New Accounting Pronouncements**

 

OnJanuary 1, 2009, the Company adopted Financial Accounting Standards Board(FASB) FASB Staff Position (FSP) No. 142-3, *Determinationof the Useful Life of Intangible Assets*, (FSP 142-3).  FSP 142-3 amends the factors that should beconsidered in developing renewal or extension assumptions used to determine theuseful life of a recognized intangible asset under FASB Statement No. 142,*Goodwill and Other Intangible Assets*.  The intent of FSP 142-3 is to improve theconsistency between the useful life of a recognized intangible asset and theperiod of expected cash flows, particularly as used to measure fair value inbusiness combinations.  FSP 142-3 is effectivefor fiscal years beginning after December 15, 2008, and is immaterial asit relates to the Company’s consolidated financial statements.

 

On January 1, 2009,the Company adopted Statement of Financial Accounting Standard (SFAS) No. 161,*Disclosures about Derivative Instruments andHedging Activities*. SFAS 161 amends and expands the disclosure requirements of SFAS133, *Accounting for Derivative Instruments and HedgingActivities*.  It requiresqualitative disclosures about objectives and strategies for using derivatives,quantitative disclosures about fair value amounts of gains and losses onderivative instruments, and disclosures about credit-risk-related contingentfeatures in derivative agreements.  Theadoption of SFAS No. 161 had no impact on the Company’s consolidatedfinancial statements.

 

In May 2009, theFASB issued SFAS No. 165, *Subsequent Events.*  SFAS No. 165 establishes standards underwhich an entity shall recognize and disclose events that occur after a balancesheet date but before the related financial statements are issued or areavailable to be issued.  SFAS No. 165is effective for interim and annual reporting periods ending after June 15,2009.  The adoption of SFAS No. 165had no impact on the Company’s consolidated financial statements.

 

InJune 2009, the FASB issued SFAS No. 166, *Accounting for Transfers of Financial Assets, an amendment of FASBStatement No. 140.*  SFAS No. 166 makes severalsignificant amendments to SFAS No. 140, *“Accountingfor Transfers and Servicing of Financial Assets and Extinguishments ofLiabilities,”* including the removal of the concept of a qualifyingspecial-purpose entity from SFAS No. 140.  SFAS No. 166 alsoclarifies that a transferor must evaluate whether it has maintained effectivecontrol of a financial asset by considering its continuing direct or indirectinvolvement with the transferred financial asset.  The provisions of SFAS No. 166are effective for interim and annual reporting periods that begin after November 15,2009.  The adoption of the provisions of SFAS No. 166 is not expectedto have a material impact on the Company’s consolidated financial statements.

 

In June 2009, the FASB issued SFAS No. 167,*Amendments to FASB Interpretation No. 46(R).* SFAS No. 167 requires a qualitative rather than a quantitative analysis todetermine the primary beneficiary of a variable interest entity (“VIE”) forconsolidation purposes.  The primary beneficiary of a VIE is theenterprise that has: (1) the power to direct the activities of the VIEthat most significantly impact the VIE’s economic performance, and (2) theobligation to absorb losses of the VIE that could potentially be significant tothe VIE or the right to receive benefits of the VIE that could potentially besignificant to the VIE.  The provisions of SFAS No. 167 are effectivefor interim and annual reporting periods that begin after November 15,2009.  The adoption of the provisions of SFAS No. 167 is not expectedto have an impact on the Company’s consolidated financial statements.

 

8

----

Tableof Contents

 

In June 2009, theFASB issued SFAS No. 168, *The FASB AccountingStandards Codification and the Hierarchy of Generally Accepted AccountingPrinciples* (SFAS168).  SFAS 168 will become the singlesource of authoritative nongovernmental U.S. generally accepted accountingprinciples, superseding existing FASB, American Institute of Certified PublicAccountants (AICPA), Emerging Issues Task Force (EITF) and related accountingliterature.  SFAS 168 reorganizes GAAP pronouncements and displaysthem using a consistent structure.  Thiswill have an impact on the Company’s financial statements since all futurereferences to authoritative accounting literature will be references inaccordance with SFAS 168.

 

Additionalaccounting pronouncements recently adopted are discussed where applicable inthe notes to the consolidated financial statements.

 

**3.Investment securities**

 

The amortized cost andfair value of investment securities at June 30, 2009 and December 31,2008 are summarized as follows (in thousands):

 
| ** **                                        | ** ** | **June 30, 2009** | ** ** |
|---------------------------------------------------|------------|------------------------|------------|
| ** **                                        | ** ** | **Amortized**          | ** ** | **Gross unrealized** | ** ** | **Gross unrealized** | ** ** | **Fair** | ** ** |
| ** **                                        | ** ** | **cost**               | ** ** | **gains** | ** ** | **losses** | ** ** | **value** | ** ** |
|                                              |       |                   |       |   |   |   |   |   |   |
| Held-to-maturity  securities:                     |       |                   |       |   |   |   |   |   |   |
| Mortgage-backed  securities                       |       | $                      | 843        |   | $ | 57 |   | $ | — |   | $ | 900 |   |
|                                              |       |                   |       |   |   |   |   |   |   |
| Available-for-sale  securities:                   |       |                   |       |   |   |   |   |   |   |
| U.S.  government agencies and corporations        |       | $                      | 32,146     |   | $ | 17 |   | $ | 1,531 |   | $ | 30,632 |   |
| Obligations  of states and political subdivisions |       | 27,721                 |       | 172 |   | 535 |   | 27,358 |   |
| Corporate  bonds:                                 |       |                   |       |   |   |   |   |   |   |
| Pooled  trust preferred securities                |       | 21,729                 |       | — |   | 13,466 |   | 8,263 |   |
| Mortgage-backed  securities                       |       | 9,382                  |       | 379 |   | — |   | 9,761 |   |
|                                              |       |                   |       |   |   |   |   |   |   |
| Total  debt securities                            |       | 90,978                 |       | 568 |   | 15,532 |   | 76,014 |   |
|                                              |       |                   |       |   |   |   |   |   |   |
| Equity  securities                                |       | 322                    |       | 147 |   | 7 |   | 462 |   |
|                                              |       |                   |       |   |   |   |   |   |   |
| Total  available-for-sale                         |       | $                      | 91,300     |   | $ | 715 |   | $ | 15,539 |   | $ | 76,476 |   |

 

9

----

Tableof Contents

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

 

The amortized cost andfair value of debt securities at June 30, 2009 and December 31, 2008by contractual maturity are summarized below (in thousands):

 
| ** **                                | ** ** | **June 30, 2009** | ** ** | **December 31, 2008** | ** ** |
|-------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                                | ** ** | **Amortized**          | ** ** | **Market**                 | ** ** | **Amortized** | ** ** | **Market** | ** ** |
| ** **                                | ** ** | **cost**               | ** ** | **value**                  | ** ** | **cost** | ** ** | **value** | ** ** |
| Held-to-maturity  securities:             |       |                   |       |                       |       |   |   |   |   |
| Mortgage-backed  securities               |       | $                      | 843        |                       | $          | 900 |   | $ | 909 |   | $ | 940 |   |
|                                      |       |                   |       |                       |       |   |   |   |   |
| Available-for-sale  securities:           |       |                   |       |                       |       |   |   |   |   |
| Debt  securities:                         |       |                   |       |                       |       |   |   |   |   |
| Due  in one year or less                  |       | $                      | —     |                       | $          | — |   | $ | — |   | $ | — |   |
| Due  after one year through five years    |       | —                 |       | —                     |       | — |   | — |   |
| Due after  five years through ten years   |       | 4,274                  |       | 4,289                      |       | 10,649 |   | 10,706 |   |
| Due  after ten years                      |       | 77,322                 |       | 61,964                     |       | 74,599 |   | 60,614 |   |
| Total  debt securities                    |       | 81,596                 |       | 66,253                     |       | 85,248 |   | 71,320 |   |
|                                      |       |                   |       |                       |       |   |   |   |   |
| Mortgage-backed  securities               |       | 9,382                  |       | 9,761                      |       | 11,088 |   | 11,530 |   |
|                                      |       |                   |       |                       |       |   |   |   |   |
| Total  available-for-sale debt securities |       | $                      | 90,978     |                       | $          | 76,014 |   | $ | 96,336 |   | $ | 82,850 |   |

 

Expected maturities willdiffer from contractual maturities because issuers and borrowers may have theright to call or repay obligations with or without call or prepaymentpenalty.  Federal agency and municipalsecurities are included based on their original stated maturity.  Mortgage-backed securities, which are basedon weighted-average lives and subject to monthly principal pay-downs, arelisted in total.

 

The following tablespresent the fair value and gross unrealized losses of investment securitiesaggregated by investment type, the length of time and the number of securitiesthat have been in a continuous unrealized loss position as of June 30,2009 and December 31, 2008 (in thousands):

 

10

----

Tableof Contents

 
| ** **                                        | ** ** | **June 30, 2009**  | ** ** |
|---------------------------------------------------|------------|-------------------------|------------|
| ** **                                        | ** ** | **Less than 12 months** | ** ** | **More than 12 months** | ** ** | **Total** | ** ** |
| ** **                                        | ** ** | **Fair**                | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                                        | ** ** | **value**               | ** ** | **losses** | ** ** | **value** | ** ** | **losses** | ** ** | **value** | ** ** | **losses** | ** ** |
| U.S.  government agencies and corporations        |       | $                       | 18,278     |   | $ | 214 |   | $ | 4,337 |   | $ | 1,317 |   | $ | 22,615 |   | $ | 1,531 |   |
| Obligations  of states and political subdivisions |       | 12,492                  |       | 309 |   | 6,181 |   | 226 |   | 18,673 |   | 535 |   |
| Corporate  bonds:                                 |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Pooled  trust preferred securities                |       | —                  |       | — |   | 8,263 |   | 13,466 |   | 8,263 |   | 13,466 |   |
| Mortgage-backed  securities                       |       | —                  |       | — |   | — |   | — |   | — |   | — |   |
| Total  debt securities                            |       | 30,770                  |       | 523 |   | 18,781 |   | 15,009 |   | 49,551 |   | 15,532 |   |
| Equity  securities                                |       | —                  |       | — |   | 69 |   | 7 |   | 69 |   | 7 |   |
| Total  securities                                 |       | $                       | 30,770     |   | $ | 523 |   | $ | 18,850 |   | $ | 15,016 |   | $ | 49,620 |   | $ | 15,539 |   |
| Number  of securities                             |       | 34                      |       |   |   | 26 |   |   |   | 60 |   |   |   |

 
| ** **                                        | ** ** | **December 31, 2008** | ** ** |
|---------------------------------------------------|------------|----------------------------|------------|
| ** **                                        | ** ** | **Less than 12 months**    | ** ** | **More than 12 months** | ** ** | **Total** | ** ** |
| ** **                                        | ** ** | **Fair**                   | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                                        | ** ** | **value**                  | ** ** | **losses** | ** ** | **value** | ** ** | **losses** | ** ** | **value** | ** ** | **losses** | ** ** |
| U.S.  government agencies and corporations        |       | $                          | 12,506     |   | $ | 1,878 |   | $ | 5,145 |   | $ | 573 |   | $ | 17,651 |   | $ | 2,451 |   |
| Obligations  of states and political subdivisions |       | 8,154                      |       | 496 |   | 1,455 |   | 57 |   | 9,609 |   | 553 |   |
| Corporate  bonds:                                 |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Pooled  trust preferred securities                |       | 2,235                      |       | 2,352 |   | 8,025 |   | 8,803 |   | 10,260 |   | 11,155 |   |
| Mortgage-backed  securities                       |       | 17                         |       | — |   | — |   | — |   | 17 |   | — |   |
| Total  debt securities                            |       | 22,912                     |       | 4,726 |   | 14,625 |   | 9,433 |   | 37,537 |   | 14,159 |   |
| Equity  securities                                |       | —                     |       | — |   | 60 |   | 16 |   | 60 |   | 16 |   |
| Total  securities                                 |       | $                          | 22,912     |   | $ | 4,726 |   | $ | 14,685 |   | $ | 9,449 |   | $ | 37,597 |   | $ | 14,175 |   |
| Number  of securities                             |       | 20                         |       |   |   | 22 |   |   |   | 42 |   |   |   |

 

In the table above, the unrealized losses on mortgage-backed securities wereless than $1,000 in 2008.

 

Managementconducts a formal review of investment securities on a quarterly basis for thepresence of other-than-temporary-impairment (OTTI).  During the second quarter of 2009, theCompany adopted FSP FAS 115-2 and FAS 124-2, *Recognitionand Presentation of Other-Than-Temporary Impairments*, issued by theFASB on April 9, 2009.  The Companyassesses whether OTTI is present when the fair value of a debt security is lessthan its amortized cost basis at the balance sheet date.  Under these circumstances as required by thenew FSP, OTTI is considered to have occurred if (1) the entity hasintent to sell the security; (2) more likely than not the entity will berequired to sell the security before recovery of its amortized cost basis; or (3) thepresent value of expected cash flows is not sufficient to recover the entireamortized cost basis.

 

The FSP requiresthat credit-related OTTI is recognized in earnings while non-credit-relatedOTTI on securities not expected to be sold is recognized in other comprehensiveincome (OCI).  Non-credit-related OTTI isbased on other factors effecting market conditions, including illiquidity.  Presentation of OTTI is made in the statementof income on a gross basis with an offset for the amount of OTTI recognized inOCI.  Non-credit-related OTTI recognizedin earnings previous to April 1, 2009 has been reclassified from retainedearnings to accumulated OCI as a cumulative effect adjustment.

 

The Company’s OTTIevaluation process also follows the guidance of SFAS No. 115, *Accounting for Certain Investments in Debt and EquitySecurities*, Emerging Issues Task Force (EITF) Issue No. 99-20, *Recognition of Interest Income and Impairment onPurchased and Retained Beneficial Interests in Securitized Financial Assets*,and FSP No.  EITF 99-20-1,*Amendmentsto the Impairment and Interest Income Measurement Guidance of EITF Issue No. 99-20. *This guidance requires the Companyto take into consideration current market conditions, fair value inrelationship to cost, extent and nature of changes in fair value, issuer ratingchanges and trends, volatility of earnings, current analysts’ evaluations, allavailable information relevant to the collectability of debt securities, theability and intent to hold investments until a recovery of fair value, whichmay be maturity, and other factors when evaluating for the existence of OTTI insecurities portfolios.  FSP EITF 99-20-1was issued on January 12, 2009 and is effective for reporting periodsending after December 15, 2008. This FSP amends EITF 99-20 by eliminating the requirement that a holder’sbest estimate of cash 

 

11

----

Tableof Contents

 

flows is basedupon those that a market participant would use. Instead, the FSP requires that OTTI be recognized as a realized lossthrough earnings when there has been an adverse change in the holder’s expectedcash flows such that the full amount (principal and interest) will probably notbe received.  This requirement isconsistent with the impairment model in SFAS 115.

 

For all securitytypes discussed below where no OTTI is considered necessary at June 30,2009, the Company applied the criteria of FSP FAS 115-2 and 124-2.  That is, management has no intent to sell thesecurities and no conditions were identified by management that more likelythan not would require the Company to sell the securities before recovery oftheir amortized cost basis.  There was nonon-credit related OTTI on securities not expected to be sold recognized in OCIduring the three months ended June 30, 2009.

 

U.S. government agencies and corporations

 

The agency securities consist of medium and long-term notes issued byFederal Home Loan Mortgage Corporation (FHLMC) and Federal National MortgageAssociation (FNMA).  These securities arefixed rate issues, have varying mid- to long-term maturity dates and havecontractual cash flows guaranteed by agencies of the U.S. government.  In the latter half of 2008, the U.S.Government provided substantial liquidity to FNMA and FHLMC to bolster theircreditworthiness.

 

Agency guaranteed mortgage-backed securities

 

The agencymortgage-backed securities are comprised largely of fixed rate residentialmortgage-backed securities issued by FNMA or FHLMC.  They have mid- to long-term maturity datesand have contractual cash flows guaranteed by agencies of the U.S.Government.  In the latter half of 2008,the U.S. government provided substantial liquidity to both FNMA and FHLMC tobolster their creditworthiness.

 

Obligations of states and political subdivisions

 

The municipalsecurities are rated as investment grade by various credit rating agencies andare at fixed rates with mid- to long-term maturities.  Fair values of these securities are highlydriven by interest rates.  Managementperforms ongoing credit quality reviews on these issues.

 

In the above threesecurities types, the decline in fair value is attributable to changes ininterest rates and not credit quality. As such, no OTTI is considered necessary for these securities at June 30,2009.

 

Pooled trustpreferred securities

 

A Pooled TrustPreferred Collateralized Deal Obligation (CDO) is a type of investment securitycollateralized by trust preferred securities (TPS) issued by banks, insurancecompanies and REITS.  The primarycollateral type is a TPS issued by a bank. A TPS is a hybrid security with both debt and equitycharacteristics such as the ability to voluntarily defer interest payments forup to 20 consecutive quarters.  ATPS is a junior security in the capital structure of the issuer.

 

There arevarious tranches or classes issued by the CDO with the mostsenior tranche having the lowest yield but the most protectionfrom credit losses (versus other tranches that aresubordinate).  Losses are generally allocated from the lowest tranchewith the equity piece holding the most risk and then subordinate tranches inreverse order up to the senior tranche. The allocation of losses is defined in the indenture when the CDO wasformed.

 

Unrealized losseswere caused mainly by the following factors: (1) collateral deteriorationdue to bank failures and credit concerns across the banking sector; (2) wideningof credit spreads; and (3) illiquidity in the market.  Our review of these securities, in accordancewith the previous discussion, determined that an OTTI credit loss be recordedon one of our holdings of these securities.

 

The following tablesummarizes the amount of credit-related OTTI recognized in earnings for theperiods indicated.  There was no OTTI forthe first six months of 2008 (in thousands):

 
| ** **                          | ** ** | **Three months ended** | ** ** | **Six months ended**   | ** ** |
|-------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                          | ** ** | **June 30, 2009** | ** ** | **June 30, 2009** | ** ** |
| ** **                          | ** ** | **HTM**                | ** ** | **AFS**                | ** ** | **Total** | ** ** | **HTM** | ** ** | **AFS** | ** ** | **Total** | ** ** |
| Pooled  trust preferred securities: |       |                   |       |                   |       |   |   |   |   |   |   |   |   |
| PreTSL  VII, Mezzanine              |       | $                      | —     |                   | $          | 1 |   | $ | 1 |   | $ | — |   | $ | 326 |   | $ | 326 |   |
|                                     |            |                        |            |                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

12

----

Tableof Contents

 

The following table is atabular roll-forward of the amount of credit-related OTTI recognized inearnings (in thousands)**:**

** **
| ** **                                                                                                                     | ** ** | **Three months ended** | ** ** | **Six months ended**   | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                                                                     | ** ** | **June 30, 2009** | ** ** | **June 30, 2009** | ** ** |
| ** **                                                                                                                     | ** ** | **HTM**                | ** ** | **AFS**                | ** ** | **Total** | ** ** | **HTM** | ** ** | **AFS** | ** ** | **Total** | ** ** |
| Beginning  balance of credit-related OTTI                                                                                      |       | $                      | —     |                   | $          | (755 | ) | $ | (755 | ) | $ | — |   | $ | (429 | ) | $ | (429 | ) |
| Reduction  - cumulative effect of accounting change                                                                            |       | —                 |       | 531                    |       | 531 |   | — |   | 531 |   | 531 |   |
| Additions  for credit-related OTTI not previously recognized                                                                   |       | —                 |       | —                 |       | — |   | — |   | — |   | — |   |
| Additional  credit-related OTTI previously recognized when there is no intent to sell  before recovery of amortized cost basis |       | —                 |       | —                 |       | — |   |   |   | (326 | ) | (326 | ) |
| Ending  balance of credit-related OTTI                                                                                         |       | $                      | —     |                   | $          | (224 | ) | $ | (224 | ) | $ | — |   | $ | (224 | ) | $ | (224 | ) |

 

To determine the endingbalance of credit-related OTTI, the Company used discounted present value cashflow analysis and compared the results with the bond’s face value.  The analysis considered the followingassumptions: the discount rate of 3.03% which approximated the bond’s yield forthe three months ended June 30, 2009; historical average default ratesobtained from the FDIC for U.S. Banks and Thrifts for the period spanning 1988to 1991 increased by a factor of three to create a very onerous 30% rate ofdefault; the default rate was reduced by the actual deferrals / defaultsexperienced in all Preferred Term Securities for the full year 2008 and thefirst quarter of 2009; the remaining 18% estimated default rate was thenstratified with higher default rates occurring in the beginning regressing tonormal in 2011 with an estimated 15% recovery by way of a two year lag ; and noprepayments with receipt of principal at maturity.  The present value of PreTSL VII as modeledresulted in cash flow of $777,000 as of April 1, 2009, or approximately$224,000 below the bond’s face value of $1,001,000.  Upon adoption of this FSP, in the secondquarter of 2009, and as a result of the credit-related OTTI determination asexplained, the $531,000 non-credit related portion of OTTI that existed priorto April 1, 2009, or $351,000 after tax, was reclassified from retainedearnings to OCI as a cumulative effect adjustment.

 

As of June 30, 2009,the book value of the Company’s pooled trust preferred securities amounted to$21,729,000 with an estimated fair value of $8,263,000.

 

All of the Company’sholdings are mezzanine tranches.  As of June 30,2009, none of the pooled trust preferred securities were investment grade.  At the time of initial issue, thesubordination in the Company’s tranches ranged in size from approximately 8.0%to 25.2% of the total principal amount of the respective securities and no morethan 5% of any pooled trust preferred security consisted of a security issuedby any one bank and 4% for insurance companies. As of June 30, 2009, management estimates the subordination in theCompany’s tranches ranging from 0% to 23.5% of the current performingcollateral.  The following table providesadditional information with respect to the Company’s pooled trust preferredsecurities:

 
| ** **     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **     | ** ** | ** **          | ** **  | **Current**   | ** ** | ** **        | ** ** | **Actual**        | ** ** | ** **        | ** ** | **Excess**             | ** ** | **Effective**           | ** ** |
|----------------|------------|------------|------------|------------|------------|------------|------------|----------------|------------|---------------------|-------------|---------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|------------------------|------------|-------------------------|------------|
| ** **     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **     | ** ** | ** **          | ** **  | **number**    | ** ** | ** **        | ** ** | **deferrals**     | ** ** | ** **        | ** ** | **subordination******* | ** ** | **subordination******** | ** ** |
| ** **     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **     | ** ** | ** **          | ** **  | **of**        | ** ** | **Actual**        | ** ** | **and  defaults** | ** ** | ** **        | ** ** | **as a %  of**         | ** ** | **as a %  of**          | ** ** |
| ** **     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **     | ** ** | **Moody’s  /** | ** **  | **banks /**   | ** ** | **deferrals**     | ** ** | **as a %  of**    | ** ** | **Excess**        | ** ** | **current**            | ** ** | **current**             | ** ** |
| ** **     | ** ** | ** ** | ** ** | **Book**   | ** ** | **Fair**   | ** ** | **Unrealized** | ** ** | **Fitch**           | ** **  | **insurance** | ** ** | **and  defaults** | ** ** | **current**       | ** ** | **subordination** | ** ** | **performing**         | ** ** | **performing**          | ** ** |
| **Deal**       | ** ** | **Class**  | ** ** | **value**  | ** ** | **value**  | ** ** | **loss**       | ** ** | **ratings**         | ** **  | **companies** | ** ** | **$(000)**        | ** ** | **collateral**    | ** ** | **$(000)**        | ** ** | **collateral**         | ** ** | **collateral**          | ** ** |
| Pre  TSL IV    |       | Mezzanine  |       | $          | 609,971    |       | $          | 569,834        |       | $                   | (40,137     | )             | Ca / B     |              | 6 / -      |              | 18,000     |              | 27.1       |                   | 9,677      |                    | 18.9       |   | 36.1 |   |
| Pre  TSL V     |       | Mezzanine  |       | 275,503    |       | 259,110    |       | (16,393        | )          | Ba3 / A             |        | 4 / -         |       | 8,950             |       | 20.4              |       | 8,540             |       | 23.5                   |       | 24.8                    |       |
| Pre  TSL VII   |       | Mezzanine  |       | 777,386    |       | 405,647    |       | (371,739       | )          | Ca / CC             |        | 20 / -        |       | 113,000           |       | 46.9              |       | None              |       | N/A                    |       | N/A                     |       |
| Pre  TSL IX    |       | B-1,B-3    |       | 3,500,000  |       | 1,783,600  |       | (1,716,400     | )          | Ca / CC             |        | 49 / -        |       | 85,980            |       | 19.1              |       | None              |       | N/A                    |       | 10.2                    |       |
| Pre  TSL XI    |       | B-3        |       | 2,408,743  |       | 1,601,885  |       | (806,858       | )          | Ca / CC             |        | 65 / -        |       | 86,750            |       | 14.4              |       | None              |       | N/A                    |       | 15.7                    |       |
| Pre  TSL XV    |       | B-1        |       | 1,505,400  |       | 540,300    |       | (965,100       | )          | Ca / CC             |        | 63 / 9        |       | 103,700           |       | 17.3              |       | None              |       | N/A                    |       | 9.6                     |       |
| Pre  TSL XVI   |       | C          |       | 2,551,253  |       | 585,394    |       | (1,965,859     | )          | Ca / CC             |        | 50 / 8        |       | 111,910           |       | 18.5              |       | None              |       | N/A                    |       | 11.6                    |       |
| Pre  TSL XVII  |       | C          |       | 992,588    |       | 279,046    |       | (713,542       | )          | Ca / CC             |        | 51 / 8        |       | 84,700            |       | 16.9              |       | None              |       | N/A                    |       | 14.3                    |       |
| Pre  TSL XVIII |       | C          |       | 994,686    |       | 134,186    |       | (860,500       | )          | Ca / CCC            |        | 66 / 14       |       | 111,938           |       | 16.5              |       | None              |       | N/A                    |       | 12.0                    |       |
| Pre  TSL XIX   |       | C          |       | 2,516,026  |       | 404,187    |       | (2,111,839     | )          | Ca / CC             |        | 60 / 14       |       | 96,000            |       | 13.7              |       | None              |       | N/A                    |       | 15.7                    |       |
| Pre  TSL XXIV  |       | B-1        |       | 2,206,028  |       | 503,225    |       | (1,702,803     | )          | B2 / BB             |        | 80 / 13       |       | 216,300           |       | 20.6              |       | 15,373            |       | 1.8                    |       | 26.2                    |       |
| Pre  TSL XXV   |       | C-1        |       | 1,009,639  |       | 139,560    |       | (870,079       | )          | Ca / C              |        | 64 / 9        |       | 178,100           |       | 20.3              |       | None              |       | N/A                    |       | 12.6                    |       |
| Pre  TSL XXVII |       | B          |       | 2,381,886  |       | 1,056,898  |       | (1,324,988     | )          | B3 / BB             |        | 42 / 7        |       | 45,300            |       | 13.9              |       | 33,046            |       | 11.7                   |       | 31.8                    |       |
|           |       |       |       | $          | 21,729,109 |       | $          | 8,262,872      |       | $                   | (13,466,237 | )             |       |              |       |              |       |              |       |                   |       |                    |       |   |   |   |

 

----

* Excess subordination represents the excess (ifany) of the amount of performing collateral over the given class of bonds.

** Effectivesubordination represents the estimated percentage of the performing collateralthat would need to defer or default at the next payment in order to trigger aloss of principal or interest.  Thisdiffers from excess subordination in that it considers the effect of excessinterest earned on the performing collateral.

 

13

----

Tableof Contents

 

For a furtherdiscussion the fair value determination of the Company’s investment in pooledtrust preferred securities, see “Investment securities” under the caption “Comparisonof financial condition at June 30, 2009 and December 31, 2008” of Part 1,Item 2, “Management’s Discussion and Analysis of Financial Condition andResults of Operations”; below.

 

**4.  Earnings per share**

 

Basic earnings pershare (EPS) is computed by dividing income available to common shareholders bythe weighted-average number of common stock outstanding for the period.  Diluted EPS is computed in the same manner asbasic EPS but reflects the potential dilution that could occur if stock optionsto issue additional common stock were exercised, which would then result inadditional stock outstanding to share in or dilute the earnings of theCompany.  The Company maintains twoshare-based compensation plans that may generate additional potential dilutivecommon shares.  Generally, dilution wouldoccur if Company-issued stock options were exercised and converted into commonstock.  There were no potentiallydilutive shares outstanding at June 30, 2009 and 5 potentially dilutiveshares outstanding at June 30, 2008.

 

In the computationof diluted EPS, the Company uses the treasury stock method to determine thedilutive effect of its granted but unexercised stock options.  Under the treasury stock method, the assumedproceeds received from shares issued, in a hypothetical stock option exercise,are assumed to be used to purchase treasury stock.  For a further discussion on the Company’sstock option plans, see note 5, “Stock plans,” below.

 

The followingtable illustrates the data used in computing basic EPS and a reconciliation toderive at the components of diluted EPS for the periods indicated:

 
| **Six months ended June 30,**                            | ** ** | **2009**  | ** ** | **2008**  | ** ** |
|---------------------------------------------------------------|------------|-----------|------------|-----------|------------|
|                                                          |       |      |       |      |       |
| Net income available to common shareholders                   |       | $         | 1,737,211  |      | $          | 2,292,893 |   |
| Weighted-average common shares outstanding                    |       | 2,070,144 |       | 2,074,558 |       |
| Basic EPS                                                     |       | $         | 0.84       |      | $          | 1.11 |   |
|                                                          |       |      |       |      |       |
| Diluted EPS:                                                  |       |      |       |      |       |
| Net income available to common shareholders                   |       | $         | 1,737,211  |      | $          | 2,292,893 |   |
| Weighted-average common shares outstanding                    |       | 2,070,144 |       | 2,074,558 |       |
| Potentially dilutive common shares                            |       | —    |       | 5         |       |
| Weighted-average common shares and dilutive  potential shares |       | 2,070,144 |       | 2,074,563 |       |
| Diluted EPS                                                   |       | $         | 0.84       |      | $          | 1.11 |   |

 

**5.  Stock plans**

 

The Company has twostock-based compensation plans (the stock option plans) and applies the fairvalue method of accounting for stock-based compensation provided underStatement of Financial Accounting Standard (SFAS) No. 123R, *Share Based Payment*. SFAS 123R requires that the cost of share-based payment transactions(including those with employees and non-employees) be recognized in thefinancial statements.

 

Under the stock option plans,options are granted with an exercise price equal to the market price of theCompany’s stock on the date of grant. The awards vest based on six months of continuous service from the dateof grant and have 10-year contractual terms. Stock-based compensation expense is recognized over the six-monthvesting period.  Generally, all sharesthat are granted become fully vested. Stock-based compensation is recorded in the consolidated incomestatement as a component of salaries and employee benefits.

 

The Company establishedthe 2000 Independent Directors Stock Option Plan and has reserved 55,000 sharesof its un-issued capital stock for issuance under the plan.  No stock options were awarded during the sixmonths ended June 30, 2009 and 2008. As of June 30, 2009, there were 27,400 unexercised stock optionsoutstanding under this plan.

 

The Company alsoestablished the 2000 Stock Incentive Plan and has reserved 55,000 shares of itsun-issued capital stock for issuance under the plan.  There were no options awarded during the sixmonths ended June 30, 2009.  Duringthe six months ended June 30, 2008, 2,000 stock options were issued underthis plan at a weighted-average grant-date fair value of $4.85 per share.  The Company uses the Black-Scholes OptionPricing Valuation Model to determine the fair value of awarded options on thedate of grant.  The model considersexpected volatility, expected dividends, risk-free interest rate and theexpected term.  As of June 30, 2009,there were 10,190 unexercised stock options outstanding under this plan.

 

The following tables illustrate stock-based compensation expenserecognized during the three and six months ended June 30, 2009 and 2008 and theunrecognized stock-based compensation expense as of June 30, 2009 and2008.  There was no unrecognizedstock-based compensation expense as of December 31, 2008:

 

14

----

Tableof Contents

 
| ** **                              | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|-----------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                              | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                              | ** ** | **2009**               | ** ** | **2008**             | ** ** | **2009** | ** ** | **2008** | ** ** |
| Stock-based  compensation expense:      |       |                   |       |                 |       |   |   |   |   |
| Director’s  Plan                   |       | $                      | —     |                 | $          | 42,079 |   | $ | — |   | $ | 90,550 |   |
| Incentive  Plan                         |       | —                 |       | 16,868               |       | — |   | 33,248 |   |
|                                    |       |                   |       |                 |       |   |   |   |   |
| Total  stock-based compensation expense |       | $                      | —     |                 | $          | 58,947 |   | $ | — |   | $ | 123,798 |   |

 
| ** **                                      | ** ** | **As of:**             | ** ** |
|-------------------------------------------------|------------|-----------------------------|------------|
| ** **                                      | ** ** | **June 30, 2009** | ** ** | **June 30, 2008** | ** ** |
| Unrecognized  stock-based compensation expense: |       |                        |       |   |   |
| Director’s  Plan                           |       | $                           | —     |   | $ | — |   |
| Incentive  Plan                                 |       | —                      |       | 2,314 |   |
|                                            |       |                        |       |   |   |
| Unrecognized  stock-based compensation expense  |       | $                           | —     |   | $ | 2,314 |   |

 

In addition to thetwo stock option plans, the Company established the 2002 Employee StockPurchase Plan (the ESPP) and reserved 110,000 shares of its un-issued capitalstock for issuance under the plan.  Theplan was designed to promote broad-based employee ownership of the Company’sstock.  Under the ESPP, employees mayelect to purchase the Company’s capital stock at a discounted price based onthe fair market value of the Company’s capital stock on either the commencementdate or termination date.  At June 30,2009, 12,271 shares have been issued under the ESPP.  The Company recognizes compensation expenseon its ESPP on the date the shares are purchased.  For the six months ended June 30, 2009and 2008, compensation expense related to the ESPP approximated $5,000 and$3,000, respectively, and is included as components of salaries and employeebenefits in the consolidated statements of income.

 

**6.  Derivative instruments**

 

As part of the Company’soverall interest rate risk management strategy, the Company has adopted apolicy whereby it may periodically use derivative instruments to minimizesignificant fluctuations in earnings caused by interest rate volatility.  This interest rate risk management strategyentails the use of interest rate floors, caps and swaps.  During the fourth quarter of 2006, the Companyentered into a three-year interest rate floor derivative agreement on$20,000,000 notional value of its prime-based loan portfolio.  The transaction required the payment of apremium by the Company to the seller for the right to receive payments in theevent national prime drops below a pre-determined level (strike rate),essentially converting floating rate loans to fixed rate loans when prime dropsbelow the contractual strike rate.  Whenpurchased, the Company recorded an asset representing the fair value of thehedge at the time of purchase.  TheCompany has designated this agreement as a cash flow hedge pursuant to SFAS No. 133,*Accounting for Derivative Instruments and HedgingActivities*.  Accordingly, thechange in the fair value of the instrument related to the hedge’s intrinsicvalue, or approximately ($335,000) and $98,000 for the six months ended June 30,2009 and 2008, respectively, is recorded as a component of other comprehensiveincome (loss) (OCI) in the consolidated statement of changes in shareholders’equity and the portion of the change in fair value related to the time valueexpiration, or approximately $2,000 and $12,000 for the six months ended June 30,2009 and 2008, respectively, is recorded in the consolidated statements ofincome as a reduction of interest income. No gain or loss has been recognized in earnings due to hedgeineffectiveness as of June 30, 2009. As of June 30, 2009, the Company does not expect to reclassify anyamount from OCI to earnings over the next two quarters and no hedge has beendiscontinued.  Also, as of June 30,2009 and December 31, 2008, the fair value of the derivative contractapproximated $300,000 and $636,000, respectively, and is recorded as acomponent of other assets in the consolidated balance sheet.  The following table illustrates the presentvalue, intrinsic value and time value components of the Company’s derivativecontract and the financial statement impact of the change in the fair value forthe periods indicated:

 

15

----

Tableof Contents

 
| ** **                  | ** ** | **Six months ended or as of June 30,** | ** ** |
|-----------------------------|------------|---------------------------------------------|------------|
| ** **                  | ** ** | **Present**                                 | ** ** | **Intrinsic** | ** ** | **Time** | ** ** |
| ** **                  | ** ** | **value**                                   | ** ** | **value** | ** ** | **value** | ** ** |
| ** **                  | ** ** | **Balance**                                 | ** ** | **Balance** | ** ** | **Income** | ** ** |
| ** **                  | ** ** | **sheet**                                   | ** ** | **sheet** | ** ** | **statement** | ** ** |
| ** **                  | ** ** | **Other assets**                       | ** ** | **OCI** | ** ** | **Interest income** | ** ** |
| **2009**                    |       |                                        |       |   |   |   |   |
| Beginning  Balance          |       | $                                           | 635,839    |   | $ | 606,492 |   |   |   |
|                        |       |                                        |       |   |   |   |   |
| Change  in fair value       |       | (336,256                                    | )          | (334,716 | ) | (1,540 | ) |
|                        |       |                                        |       |   |   |   |   |
| Balance  June 30, 2009 |       | $                                           | 299,583    |   | $ | 271,776 |   |   |   |
|                        |       |                                        |       |   |   |   |   |
| **2008**                    |       |                                        |       |   |   |   |   |
| Beginning  Balance          |       | $                                           | 440,593    |   | $ | 385,741 |   |   |   |
|                        |       |                                        |       |   |   |   |   |
| Change  in fair value       |       | 85,360                                      |       | 97,819 |   | (12,459 | ) |
|                        |       |                                        |       |   |   |   |   |
| Balance  June 30, 2008 |       | $                                           | 525,953    |   | $ | 483,560 |   |   |   |

 

As a result of the lownational prime rate relative to the contract’s strike rate, the Company earned$453,000 and $212,000 for the six months ended June 30, 2009 and 2008,respectively and $228,000 and $135,000 for the three months ended June 30,2009 and 2008, respectively and is included as a component of interest incomefrom loans in the consolidated income statements.  The contract is scheduled to expire in thefourth quarter of 2009.

 

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

 

**7.  Fair value measurements**

 

On April 9,2009, the FASB issued FSP FAS 157-4, *DeterminingFair Value When the Volume and Level of Activity for the Asset or LiabilityHave Significantly Decreased and Identifying Transactions That Are Not Orderly,and*FSP FAS 107-1**and**APB28-1,*Interim Disclosures about Fair Valueof Financial Instruments. *TheCompany adopted both of these FSPs in the second quarter of 2009.

 

FSP FAS 157-4 providesadditional guidance on estimating fair value when the volume and level ofactivity for an asset or liability have significantly decreased in relation tonormal market activity.  FSP FAS 157-4 alsorequires additional disclosures on fair value measurements and providesadditional guidance on circumstances that may indicate that a transaction isnot orderly.  This FSP supersedes FAS157-3 (issued in October 2008), *Determiningthe Fair Value of a Financial Asset When the Market for That Asset Is NotActive* which clarifies the application of FAS 157 in a market thatis not active and provides an example to illustrate key considerations indetermining the fair value of a financial asset when the market for thatfinancial asset is not active.

 

On January 1,2008, the Company adopted SFAS 157, *Fair Value Measurements*.  SFAS 157 defines fair value, establishes aframework for measuring fair value and enhances disclosures about fair valuemeasurements required under other accounting pronouncements, but does notchange existing guidance as to whether or not an instrument is carried at fairvalue.  SFAS 157 establishes a valuationhierarchy for disclosure of the inputs used to measure fair value.  This hierarchy prioritizes the inputs intothree broad levels as follows:

 

Level 1 inputs are quotedprices (unadjusted) in active markets for identical assets or liabilities;

 

Level 2 inputs are quotedprices for similar assets and liabilities in active markets; quoted prices foridentical or similar assets or liabilities in markets that are not active; orinputs that are observable for the asset or liability, either directly orindirectly through market corroboration, for substantially the full term of thefinancial instrument;

 

Level 3 inputs areunobservable inputs based on our own assumptions to measure assets andliabilities at fair value.  Level 3pricing for securities may also include unobservable inputs based uponbroker-traded transactions.  A financialasset or liability’s classification within the hierarchy is determined based onthe lowest level input that is significant to the fair value measurement.

 

16

----

Tableof Contents

 

In February 2008 theFinancial Accounting Standards Board (FASB) issued FASB Staff Position (FSP)157-2, *Effective Date of FASB Statement No. 157*,which delays the effective date of SFAS 157 to fiscal years beginning after November 15,2008 for non-financial assets and non-financial liabilities that are notrecognized or disclosed at fair value in the financial statements on arecurring basis.  The adoption of FSP 157-2did not have an impact on the Company’s financial statements.

 

The Company usesfair value to measure certain assets and, if necessary, liabilities on arecurring basis when fair value is the primary measure for accounting.  This is done primarily for AFS securities,loans available for sale and derivatives. Fair value is used on a nonrecurring basis to measure certain assetswhen adjusting carrying values, such as impaired loans.

 

The followingtable illustrates the financial instruments measured at fair value on arecurring basis segregated by hierarchy fair value levels (dollars inthousands):

 
| ** **                                        | ** ** | ** **             | ** ** | **Fair value measurements at June 30, 2009:** | ** ** |
|---------------------------------------------------|------------|------------------------|------------|----------------------------------------------------|------------|
| ** **                                        | ** ** | **Total carrying**     | ** ** | **Quoted prices**                                  | ** ** | **Significant other** | ** ** | **Significant** | ** ** |
| ** **                                        | ** ** | **value at**           | ** ** | **in active markets**                              | ** ** | **observable inputs** | ** ** | **unobservable inputs** | ** ** |
| ** **                                        | ** ** | **June 30, 2009** | ** ** | **(Level 1)**                                      | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| Assets:                                           |       |                   |       |                                               |       |   |   |   |   |
| Available-for-sale  securities:                   |       |                   |       |                                               |       |   |   |   |   |
| U.S.  government agencies and corporations        |       | $                      | 30,632     |                                               | $          | — |   | $ | 30,632 |   | $ | — |   |
| Obligations  of states and political subdivisions |       | 27,358                 |       |                                               |       | 27,358 |   |   |   |
| Corporate  bonds:                                 |       |                   |       |                                               |       |   |   |   |   |
| Pooled  trust preferred securities                |       | 8,263                  |       |                                               |       |   |   | 8,263 |   |
| Mortgage-backed  securities                       |       | 9,761                  |       |                                               |       | 9,761 |   |   |   |
| Equity  securities                                |       | 462                    |       | 462                                                |       | — |   | — |   |
| Total  available-for-sale securities:             |       | 76,476                 |       | 462                                                |       | 67,751 |   | 8,263 |   |
| Loans  available-for-sale                         |       | 2,288                  |       | —                                             |       | 2,288 |   | — |   |
| Derivative  instrument                            |       | 300                    |       | —                                             |       | 300 |   | — |   |
| Total                                             |       | $                      | 79,064     |                                               | $          | 462 |   | $ | 70,339 |   | $ | 8,263 |   |

 

Equity securitiesin the available-for-sale securities portfolio are measured at fair value usingquoted market prices for identical assets and are classified within Level 1 ofthe valuation hierarchy.  Other than theCompany’s investment in corporate bonds, consisting of pooled trust preferredsecurities, all other debt securities in the available-for-sale securitiesportfolio are measured at fair value using prices provided by a third-partyvendor, who is a provider of financial market data, analytics and relatedservices to financial institutions.  TheCompany’s pooled trust preferred securities include both observable andunobservable inputs to determine fair value as described above and, therefore,are considered Level 3 inputs.  For afurther discussion on the fair value determination of the Company’s investmentin pooled trust preferred securities, see “Investment securities” under thecaption “Comparison of financial condition at June 30, 2009 and December 31,2008” of Part 1, Item 2, “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations”, below.

 

Loans available-for-saleare measured at fair value from quotes received through secondary marketsources, i.e., FNMA or FHLB, who provide pricing for similar assets withsimilar terms in actively traded markets. The derivative instrument, included in other assets, is measured at fairvalue from pricing provided by a third party who considers observable interestrates, forward yield curves at commonly quoted intervals and volatility.

 

The followingtable illustrates the changes in Level 3 financial instruments, consisting ofthe Company’s investment in pooled trust preferred securities, measured at fairvalue on a recurring basis for the periods indicated (dollars in thousands):

 

17

----

Tableof Contents

 
| ** **                                                                    | ** ** | **As of and for the**  | ** ** | **As of and for the**  | ** ** |
|-------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                    | ** ** | **six months ended**   | ** ** | **six months ended**   | ** ** |
| ** **                                                                    | ** ** | **June 30, 2009** | ** ** | **June 30, 2008** | ** ** |
| Assets:                                                                       |       |                   |       |                   |       |
| Balance  at beginning of period                                               |       | $                      | 10,260     |                   | $          | 16,335 |   |
| Realized  / unrealized gains (losses):                                        |       |                   |       |                   |       |
| in  earnings                                                                  |       | (326                   | )          | —                 |       |
| in  comprehensive income                                                      |       | (2,311                 | )          | (3,867                 | )          |
| Purchases,  sales, issuances and settlements, amortization and accretion, net |       | 640                    |       | 4,398                  |       |
| Balance  at end of period                                                     |       | $                      | 8,263      |                   | $          | 16,866 |   |

 

The followingtable illustrates the financial instruments measured at fair value on anonrecurring basis segregated by hierarchy fair value levels (dollars inthousands):

 
| ** **     | ** ** | ** **         | ** ** | **Fair value measurements at June 30, 2009 using:** | ** ** |
|----------------|------------|--------------------|------------|-----------------------------------------------------|------------|
| ** **     | ** ** | **Total carrying** | ** ** | **Quoted prices**                                   | ** ** | **Significant other** | ** ** | **Significant** | ** ** |
| ** **     | ** ** | **value at**       | ** ** | **in active markets**                               | ** ** | **observable inputs** | ** ** | **unobservable inputs** | ** ** |
| ** **     | ** ** | **June 30, 2009**  | ** ** | **(Level 1)**                                       | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| Assets:        | ** ** | ** **         | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Impaired loans |       | $                  | 2,280      |                                                | $          | 13 |   | $ | 1,345 |   | $ | 922 |   |
|                |            |                    |            |                                                     |            |  |  |  |  |  |  |  |  |

 

Impaired loansthat are collateral dependent are written down to fair value through theestablishment of specific reserves. Techniques used to value the collateral that secures the impaired loaninclude: quoted market prices for identical assets classified as Level 1inputs; observable inputs, employed by certified appraisers for similar assetsclassified as Level 2 inputs.  In caseswhere valuation techniques included inputs that are unobservable or are basedon estimates and assumptions developed by management, with significantadjustments from the best information available under each circumstance, theasset valuation is classified as Level 3 inputs.

 

FSP FAS 107-1 andAPB 28-1 extends the annual fair value disclosure requirements of SFAS No. 107,*Disclosures about Fair Value of FinancialInstruments*, to interim financial statements.

 

As required bySFAS 107, the following is a summary of the carrying values and estimated fairvalues of certain financial instruments (inthousands):

 
| ** **                              | ** ** | **June 30, 2009** | ** ** | **December 31, 2008** | ** ** |
|-----------------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                              | ** ** | **Carrying**           | ** ** | **Estimated**              | ** ** | **Carrying** | ** ** | **Estimated** | ** ** |
| ** **                              | ** ** | **amount**             | ** ** | **fair value**             | ** ** | **amount** | ** ** | **fair value** | ** ** |
|                                    |       |                   |       |                       |       |   |   |   |   |
| Financial  assets:                      |       |                   |       |                       |       |   |   |   |   |
| Cash  and cash equivalents              |       | $                      | 15,570     |                       | $          | 15,570 |   | $ | 12,771 |   | $ | 12,771 |   |
| Held-to-maturity  securities            |       | 843                    |       | 900                        |       | 910 |   | 940 |   |
| Available-for-sale  securities          |       | 76,476                 |       | 76,476                     |       | 83,278 |   | 83,278 |   |
| FHLB  stock                             |       | 4,781                  |       | 4,781                      |       | 4,781 |   | 4,781 |   |
| Loans  and leases                       |       | 419,928                |       | 418,408                    |       | 436,207 |   | 438,838 |   |
| Loans  available-for-sale               |       | 2,288                  |       | 2,308                      |       | 84 |   | 85 |   |
| Accrued  interest                       |       | 2,248                  |       | 2,248                      |       | 2,443 |   | 2,443 |   |
|                                    |       |                   |       |                       |       |   |   |   |   |
| Financial  liabilities:                 |       |                   |       |                       |       |   |   |   |   |
| Deposit  liabilities                    |       | 453,873                |       | 455,992                    |       | 433,312 |   | 436,011 |   |
| Short-term  borrowings                  |       | 8,880                  |       | 8,880                      |       | 38,130 |   | 38,130 |   |
| Long-term  debt                         |       | 42,000                 |       | 45,633                     |       | 52,000 |   | 57,230 |   |
| Accrued  interest                       |       | 1,484                  |       | 1,484                      |       | 1,390 |   | 1,390 |   |
|                                    |       |                   |       |                       |       |   |   |   |   |
| On-balance  sheet derivative instrument |       |                   |       |                       |       |   |   |   |   |
| Cash  flow hedge                        |       | 300                    |       | 300                        |       | 636 |   | 636 |   |
|                                         |            |                        |            |                            |            |  |  |  |  |  |  |  |  |

 

18

----

Tableof Contents

 

The followingsummarized the methodology used to determine estimated fair values in the abovetable:

 

The carrying valueof short-term financial instruments, as listed below, approximates their fairvalue.  These instruments generally havelimited credit exposure, no stated or short-term maturities and carry interestrates that approximate market.

 

·                  Cash and cash equivalents

 

·                  Non-interest bearing deposit accounts

 

·                  Savings, NOW and money market accounts

 

·                  Short-term borrowings

 

·                  Accrued interest

 

Securities:  With the exception of preferred termsecurities, fair values on the other investment securities are determined byprices provided by a third-party vendor, who is a provider of financial marketdata, analytics and related services to financial institutions.  The fair values of preferred term securitiesis determined based on a present value technique (income valuation) asdescribed under the caption “Investment securities” of the comparison offinancial condition at June 30, 2009 and December 31, 2008 in Part I,Item II, below.

 

Federal Home LoanBank stock, restricted regulatory equity, is carried at cost, whichapproximates fair value.

 

Loans andleases:  The fair value of all loans isestimated by the net present value of the future expected cash flows discountedat the current offering rates.

 

Loansavailable-for-sale:  For loans available-for-sale,the fair value is estimated using rates currently offered for similar loans andare obtained from the FNMA or the FHLB.

 

Certificates ofdeposit:  The fair values of certificateof deposit accounts are based on discounted cash flows using rates whichapproximate the rates we offer for deposits of similar maturities.

 

Long-termdebt:  The fair value is estimated usingthe rates currently offered for similar borrowings.

 

Cashflow hedge:  The carrying amount ofinterest rate contracts are based on pricing provided by a third party whoconsiders observable interest rates, forward yield curves at commonly quotedintervals and volatility.

 

**8.  Subsequent Events**

 

Pursuant to therequirements of SFAS 165, subsequent events have been evaluated through August 12,2009, which is the date the financial statements were available to beissued.  Through that date, there were noevents requiring disclosure.

 

**Item 2: Management’s Discussion and Analysis of Financial Condition and Resultsof Operations**

 

The following ismanagement’s discussion and analysis of the significant changes in theconsolidated financial condition of the Company as of June 30, 2009compared to December 31, 2008 and the results of operations for the three-and six month periods ended June 30, 2009 and 2008.  Current performance may not be indicative offuture results.  This discussion shouldbe read in conjunction with the Company’s 2008 Annual Report filed on Form 10-K.

 

**Forward-looking statements**

 

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

 

Forward-lookingstatements are based on various assumptions and analyses made by us in light ofmanagement’s experience and its perception of historical trends, currentconditions and expected future developments, as well as other factorsmanagement 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 differmaterially from future results expressed or implied by such forward-lookingstatements.  These factors include,without limitation, the following:

 

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

 

·                  volatilities in the securities market;

 

19

----

Tableof Contents

 

·                  deteriorating economic conditions;

 

·                  effects of deterioration of economic conditions oncustomers, specifically the effect on loan customers ability to repay theirloans;

 

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

 

·                  changes in the interest rate environment may reduceinterest margins;

 

·                  changes in deposit flows, loan demand or real estateand investment securities values may adversely affect our business;

 

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

 

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

 

·                  legislative or regulatory changes may adversely affectour business;

 

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

 

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

 

·                  acts of war or terrorism; and

 

·                  natural disaster.

 

Management cautionsreaders not to place undue reliance on forward-looking statements, whichreflect analyses only as of the date of this document.  We have no obligation to update anyforward-looking statements to reflect events or circumstances after the date ofthis document.

 

Readers should review therisk factors described in other documents that we file or furnish, from time totime, with the Securities and Exchange Commission, including Annual Reports toShareholders, Annual Reports filed on Form 10-K and other current reportsfiled or furnished on Form 8-K.

 

**General**

 

The Company’s principalrevenues are derived from interest, dividends and fees earned on itsinterest-earning assets, which are comprised of loans, securities and othershort-term investments.  The Company’sprincipal expenses consist of interest paid on its interest-bearingliabilities, which are comprised of deposits, short- and long-term borrowingsand operating and general expenses.  TheCompany’s profitability depends primarily on its net interest income.  Net interest income is the difference betweeninterest income and interest expense. Interest income is generated from yields on interest-earning assetswhich consist principally of loans and investment securities.  Interest expense is incurred from rates paidon interest-bearing liabilities, which consist of deposits and borrowings.  Net interest income is dependent upon theinterest-rate spread (i.e., the difference between the yields earned on itsinterest-earning assets and the rates paid on its interest-bearing liabilities)and the relative amounts of interest-earning assets and interest-bearingliabilities.  The interest rate spread issignificantly impacted by: changes in interest rates and market yield curvesand their related impact on cash flows; the composition and characteristics ofinterest-earning assets and interest-bearing liabilities; differences in thematurity and re-pricing characteristics of assets compared to the maturity andre-pricing characteristics of the liabilities that fund them and by thecompetition in our marketplace.

 

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

 

The Company’s profitabilityis significantly affected by general economic and competitive conditions,changes in market interest rates, government policies and actions of regulatoryauthorities.  The Company’s loanportfolio is comprised principally of commercial and commercial real estateloans.  The properties underlying theCompany’s mortgages are concentrated in Northeastern Pennsylvania.  Credit risk, which represents the possibilityof the Company not recovering

 

20

----

Tableof Contents

 

amounts due from itsborrowers, is significantly related to local economic conditions in the areasthe 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 adequate cash flow andrevenue generation from income-producing commercial properties.

 

**Comparison of the results of operations**

**Three and six months ended June 30, 2009 and2008**

 

**Overview**

 

Net income for the second quarter of 2009 was $912,000 compared to$1,204,000 recorded in the same quarter of 2008.  Diluted earnings per share were $0.44 and$0.59 for each of the respective quarters. For the six months ended June 30, 2009, net income was $1,737,000,or $0.84 per share compared to $2,293,000, or $1.11 per share for the sixmonths ended June 30, 2008.  Thedecrease in net income, in the quarterly comparison, was due to a reduction ofnet interest income and increases in the provision for loan losses andnon-interest expenses, partially offset by an increase in non-interestincome.  The decline in net income in thefirst half of 2009 compared to the first half of 2008 was caused by an increasein the provision for loans losses, an increase in non-interest expenses and anon-cash OTTI charge of $326,000 related to the Company’s investment portfoliothat did not occur during the first half of 2008.  These items were partially offset by highergains from the sales of mortgage loans in the three- and six- month periodsended June 30, 2009 compared to the same period of 2008.  For the six months ended June 30, 2009,net income excluding the OTTI charge would have been $1,952,000, or $0.94 pershare.  The following table reconcilesnet income as reported to pro forma net operating income for the periodsindicated:

 
| ** **                       | ** ** | **Three months  ended June 30,** | ** ** | **Six  months ended June 30,** | ** ** |
|----------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                       | ** ** | **2009**                              | ** ** | **2008**                            | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                       | ** ** | **Amount**                            | ** ** | **Per  share**                      | ** ** | **Amount** | ** ** | **Per  share** | ** ** | **Amount** | ** ** | **Per  share** | ** ** | **Amount** | ** ** | **Per  share** | ** ** |
|                             |       |                                  |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net  income, as reported         |       | $                                     | 912,153    |                                | $          | 0.44 |   | $ | 1,203,946 |   | $ | 0.59 |   | $ | 1,737,211 |   | $ | 0.84 |   | $ | 2,292,893 |   | $ | 1.11 |   |
| Other-than-temporary  impairment |       | 570                                   |       | 0.00                                |       | — |   | — |   | 326,095 |   | 0.15 |   | — |   | — |   |
| Tax  effect                      |       | (194                                  | )          | (0.00                               | )          | — |   | — |   | (110,872 | ) | (0.05 | ) | — |   | — |   |
| Net  operating earnings          |       | $                                     | 912,529    |                                | $          | 0.44 |   | $ | 1,203,946 |   | $ | 0.59 |   | $ | 1,952,434 |   | $ | 0.94 |   | $ | 2,292,893 |   | $ | 1.11 |   |

 

Return on average assets (ROA) and return on average shareholders’equity (ROE) were 0.65% and 7.63%, respectively, for the three months ended June 30,2009 compared to 0.83% and 8.73%, respectively, for the same period in2008.  For the six months ended June 30,2009, ROA and ROE were 0.62% and 7.33%, respectively, compared to 0.78% and8.26% for the same period in 2008.  Thedecrease in both ROA and ROE is attributable to lower net income.

 

*Net interest income and interest sensitive assets /liabilities*

 

Net interestincome decreased $202,000, or 4%, to $4,741,000 for the second quarter of 2009,from $4,943,000 recorded in the same period of 2008.  The decline in net interest income wasprincipally due to a combination of: a 70 basis point decline in yields fromearning-assets, mostly in the commercial loan and investment portfoliospartially offset by a decrease in rates paid on deposits and lower balances ofinterest-bearing liabilities mostly from a reduction of $10,000,000 inlong-term Federal Home Loan Banks (FHLB) advances and short-termborrowings.  The decline in FHLB advanceswere supplanted by growth in average deposits which were used to help reducedependence on short-term borrowings.

 

During the secondquarter of 2009, the Company’s tax-equivalent margin and spread were 3.70% and3.28%, respectively, compared to 3.71% and 3.18% during the second quarter of2008.  The improvement in spread wascaused by a greater reduction in rates paid on interest-bearing liabilitiesthan the lower yields earned on interest-earning assets.  Rates paid on interest-bearing liabilitiesdeclined 75 basis points compared to a decline in yield of 65 basis points.

 

For the six monthsended June 30, 2009, net interest income improved 1%, or, $75,000 comparedto the six months ended June 30, 2008. The Company’s tax-equivalent margin and spread improved to 3.71% and3.27%, respectively, from 3.54% and 2.97% during the same period of 2008.  The improvements were largely from lowerbalances of interest-bearing liabilities — most notably from lower long-andshort-term borrowings.  Rates paid ondeposits declined 94 basis points compared to lower yields from earning-assetsof 58 basis points.

 

The currentinterest rate environment has not materially changed since year-end 2008;however, it is much different than a year ago. The interest rate environment was considerably lower during the firsthalf of 2009 compared to 2008, albeit the treasury yield curve is somewhatsteeper today.  The lower rates havecaused assets to price and re-price at significantly

 

21

----

Tableof Contents

 

lower levelsthereby pressuring earning-yields downward. Increased prepayment activity in asset portfolios, thereby shorteningthe duration of interest-earning assets as well as increased activity in loanrefinancing all contribute to lower portfolio yields.  However, the steepness of the curve hasenabled the Company to help mitigate the lower yields earned from its assetportfolios.  To manage the interest ratemargin to acceptable levels, the Company’s Asset Liability Management (ALM)team meets regularly to discuss interest rate risk and when deemed necessaryadjusts interest rates on deposits and repurchase agreements and when necessaryuses lower costing wholesale funding sources. The actions of the ALM team have helped minimize the effect rate changeshave had on interest income so that net interest income is not materially anddisproportionately impacted during this lower yield environment.  During the first quarter of 2009, the Companysold $10.8 million of lower yielding mortgage loans and used the proceeds topay off the aforementioned FHLB advance that was scheduled to mature in thesecond quarter of 2009.  The Company’sproactive attention to interest rate risk should continue to help contain theCompany’s net interest income at acceptable levels.

 

The followingtable sets forth a comparison of average balance sheet amounts and theircorresponding fully tax-equivalent (FTE) interest income and expense andannualized tax-equivalent yield and cost for the periods indicated (dollars inthousands):

 

22

----

Tableof Contents

 
| ** **                                       | ** ** | **Three months ended:** | ** ** |
|--------------------------------------------------|------------|-------------------------|------------|
| ** **                                       | ** ** | **June 30, 2009**  | ** ** | **June 30, 2008** | ** ** |
| ** **                                       | ** ** | **Average**             | ** ** | ** ** | ** ** | **Yield /** | ** ** | **Average** | ** ** | ** ** | ** ** | **Yield /** | ** ** |
| ** **                                       | ** ** | **balance**             | ** ** | **Interest** | ** ** | **rate** | ** ** | **balance** | ** ** | **Interest** | ** ** | **rate** | ** ** |
| **Assets**                                       | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest-earning  assets:                        |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Loans  and leases                                |       | $                       | 428,079    |   | $ | 6,529 |   | 6.12 | % | $ | 407,208 |   | $ | 6,904 |   | 6.82 | % |
| Investments                                      |       | 94,535                  |       | 1,113 |   | 4.72 |   | 141,728 |   | 1,834 |   | 5.20 |   |
| Federal  funds sold                              |       | 10,793                  |       | 7 |   | 0.24 |   | 1,268 |   | 7 |   | 2.21 |   |
| Interest-bearing  deposits                       |       | 1,419                   |       | — |   | 0.10 |   | 118 |   | 1 |   | 2.37 |   |
| Total  interest-earning assets                   |       | 534,826                 |       | 7,649 |   | 5.74 |   | 550,322 |   | 8,746 |   | 6.39 |   |
| Non-interest-earning  assets                     |       | 28,615                  |       |   |   |   |   | 35,317 |   |   |   |   |   |
| Total  assets                                    |       | $                       | 563,441    |   |   |   |   |   | $ | 585,639 |   |   |   |   |   |
|                                             |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| **Liabilities and shareholders’ equity**    |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  liabilities:                   |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Other  interest-bearing deposits                 |       | $                       | 217,249    |   | $ | 550 |   | 1.02 | % | $ | 197,552 |   | $ | 852 |   | 1.73 | % |
| Certificates  of deposit                         |       | 172,573                 |       | 1,588 |   | 3.69 |   | 180,925 |   | 1,980 |   | 4.40 |   |
| Borrowed  funds                                  |       | 42,578                  |       | 569 |   | 5.36 |   | 70,896 |   | 825 |   | 4.68 |   |
| Repurchase  agreements                           |       | 9,837                   |       | 8 |   | 0.33 |   | 10,234 |   | 13 |   | 0.53 |   |
| Total  interest-bearing liabilities              |       | 442,237                 |       | 2,715 |   | 2.46 |   | 459,607 |   | 3,670 |   | 3.21 |   |
| Non-interest-bearing  deposits                   |       | 68,909                  |       |   |   |   |   | 65,591 |   |   |   |   |   |
| Other  non-interest-bearing liabilities          |       | 4,373                   |       |   |   |   |   | 5,005 |   |   |   |   |   |
| Shareholders’  equity                       |       | 47,922                  |       |   |   |   |   | 55,436 |   |   |   |   |   |
| Total  liabilities and shareholders’ equity |       | $                       | 563,441    |   |   |   |   |   | $ | 585,639 |   |   |   |   |   |
| Net  interest income / interest rate spread      |       |                    |       | $ | 4,934 |   | 3.28 | % |   |   | $ | 5,076 |   | 3.18 | % |
| Net  interest margin                             |       |                    |       |   |   | 3.70 | % |   |   |   |   | 3.71 | % |

 
| ** **                                       | ** ** | **Six months ended:**  | ** ** |
|--------------------------------------------------|------------|------------------------|------------|
| ** **                                       | ** ** | **June 30, 2009** | ** ** | **June 30, 2008** | ** ** |
| ** **                                       | ** ** | **Average**            | ** ** | ** ** | ** ** | **Yield /** | ** ** | **Average** | ** ** | ** ** | ** ** | **Yield /** | ** ** |
| ** **                                       | ** ** | **balance**            | ** ** | **Interest** | ** ** | **rate** | ** ** | **balance** | ** ** | **Interest** | ** ** | **rate** | ** ** |
| **Assets**                                       |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Interest-earning  assets:                        |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Loans  and leases                                |       | $                      | 433,412    |   | $ | 13,263 |   | 6.17 | % | $ | 409,151 |   | $ | 13,832 |   | 6.80 | % |
| Investments                                      |       | 98,488                 |       | 2,372 |   | 4.86 |   | 138,110 |   | 3,690 |   | 5.37 |   |
| Federal  funds sold                              |       | 6,145                  |       | 7 |   | 0.24 |   | 6,721 |   | 91 |   | 2.73 |   |
| Interest-bearing  deposits                       |       | 773                    |       | — |   | 0.12 |   | 135 |   | 2 |   | 2.69 |   |
| Total  interest-earning assets                   |       | 538,818                |       | 15,642 |   | 5.85 |   | 554,117 |   | 17,615 |   | 6.39 |   |
| Non-interest-earning  assets                     |       | 29,027                 |       |   |   |   |   | 34,743 |   |   |   |   |   |
| Total  assets                                    |       | $                      | 567,845    |   |   |   |   |   | $ | 588,860 |   |   |   |   |   |
|                                             |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| **Liabilities and shareholders’ equity**    |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  liabilities:                   |       |                   |       |   |   |   |   |   |   |   |   |   |   |
| Other  interest-bearing deposits                 |       | $                      | 212,270    |   | $ | 1,119 |   | 1.06 | % | $ | 194,424 |   | $ | 1,946 |   | 2.01 | % |
| Certificates  of deposit                         |       | 172,922                |       | 3,210 |   | 3.74 |   | 185,263 |   | 4,119 |   | 4.47 |   |
| Borrowed  funds                                  |       | 52,387                 |       | 1,371 |   | 5.28 |   | 69,796 |   | 1,722 |   | 4.96 |   |
| Repurchase  agreements                           |       | 10,098                 |       | 17 |   | 0.33 |   | 12,803 |   | 81 |   | 1.27 |   |
| Total  interest-bearing liabilities              |       | 447,677                |       | 5,717 |   | 2.58 |   | 462,286 |   | 7,868 |   | 3.42 |   |
| Non-interest-bearing  deposits                   |       | 68,498                 |       |   |   |   |   | 66,048 |   |   |   |   |   |
| Other  non-interest-bearing liabilities          |       | 3,873                  |       |   |   |   |   | 4,730 |   |   |   |   |   |
| Shareholders’  equity                       |       | 47,797                 |       |   |   |   |   | 55,796 |   |   |   |   |   |
| Total  liabilities and shareholders’ equity |       | $                      | 567,845    |   |   |   |   |   | $ | 588,860 |   |   |   |   |   |
| Net  interest income / interest rate spread      |       |                   |       | $ | 9,925 |   | 3.27 | % |   |   | $ | 9,747 |   | 2.97 | % |
| Net  interest margin                             |       |                   |       |   |   | 3.71 | % |   |   |   |   | 3.54 | % |

 

In the table above, interestincome was adjusted to a tax-equivalent basis to recognize the income from thevarious tax-exempt assets as if the interest was fully taxable.  This treatment allows a uniform comparison amongthe yields on interest-earning assets. The calculations were computed on a fully tax-equivalent basis using thecorporate federal tax rate of 34%.  Netinterest spread represents the difference between the yield on interest-earningassets and the rate on interest-bearing liabilities.  Net interest margin represents the ratio ofnet interest income to total average interest-earning assets.

 

23

----

Tableof Contents

 

*Provisionfor loan losses*

 

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

 

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

 

·                  specific loans that could have loss potential;

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

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

·                  trends in volume and terms of loans;

·                  changes in risk selection and underwriting standards;

·                  changes in lending policies, procedures and practices;

·                  experience, ability and depth of lending management;

·                  national and local economic trends and conditions; and

·                  changes in credit concentrations.

 

The provision forloan loss was $300,000 for the second quarter of 2009 and $725,000 for the sixmonth period ending June 30, 2009, as compared to $125,000 for the same2008 quarter and six month periods.  Aprovision for loan loss was required due to internally classified creditdowngrades, weakening economic conditions, plus commercial loan growth duringthe second quarter of 2009.

 

The allowance forloan losses was $5,216,000 at June 30, 2009 compared to $4,189,000 at June 30,2008.  For a further discussion on theallowance for loan losses, see “Allowance for loan losses” under the caption “Comparisonof financial condition at June 30, 2009 and December 31, 2008”,below.

 

*Otherincome*

 

In the second quarterof 2009, other (non-interest) income increased $193,000, or 15%, to $1,458,000from $1,265,000 recorded in second quarter of 2008.  The increase was the result of higher volumesof mortgage origination / refinance activity that has been prevalent throughout2009.  Most fixed-rate mortgage loanoriginations are sold into the secondary market with gains of $328,000recognized during the current year quarter compared to $60,000 recognizedduring the same 2008 quarter.  A decreasein the volume of deposit overdraft transactions has resulted in an $89,000decline in service charges on deposit accounts for the three months ended June 30,2009 compared to the three months ended June 30, 2008.

 

For the six monthsended June 30, 2009, other income improved by $210,000, or 8%, compared tothe six months ended June 30, 2008. In the first half of 2009, the Company sold $74,148,000 of residentialmortgage loans and recognized gains of $818,000.  Included in these sales were $10,838,000 ofloans transferred from the loan and lease portfolio to loans AFS during thefirst quarter of the current year and simultaneously sold.  Partially offsetting this gain was a non-cashOTTI charge of $326,000 from the investment portfolio.  The OTTI charge is related to the Company’sinvestment in a pooled trust preferred security.  The carrying value of this security wasfurther written down to its fair market value during the first half of 2009 asmanagement has deemed the additional impairment to beother-than-temporary.  There was nosimilar OTTI charge during the first half of 2008.  Service charges from deposit accountsdeclined $220,000, or 15%, due to lower volumes of overdraft transactions.

 

*Other operating expenses*

 

For the quarterended June 30, 2009, other (non-interest) expenses increased $294,000, or7%, compared to the quarter ended June 30, 2008.  In the second quarter of 2009, the Company’sFDIC insurance premium was $321,000 greater than the premium incurred in the2008 quarter.  The increase was caused bythe $255,000, 5 basis points on total assets less tier I capital, specialassessment imposed by the FDIC to all member-insured banks on June 30,2009.  The increase in premises andequipment is from added depreciation expense for the new West Scranton branchexpansion project that opened in the third quarter of 2008, property insuranceand increased equipment maintenance in information technology.

 

For the six monthsended June 30, 2009, non-interest related expenses increased $563,000, or6%, compared to the six months ended June 30, 2008.  The previously mentioned FDIC specialassessment and increased premiums contributed to $383,000 of the increase.  The 2% increase in salary and benefits wasdue to a full six month of operations of the Company’s

 

24

----

Tableof Contents

 

West Scrantonbranch that was not operational until the third quarter of 2008, a Company’sexecutive officer was re-employed during the middle of the first quarter of2008 compared to a full six-month impact in the current year, highercommissions earned on production by our financial services staff, increasedhealth care and partially offset by lower stock-based compensation.  The increase in premises and equipment isfrom depreciation expense for the new West Scranton branch.  An increase in the level of ORE, as a resultof our efforts to resolve non-performing assets, resulted in a $126,000 increasein the costs associated with foreclosure and the resultant operating costs ofproperty ownership.

 

*Provisionfor income taxes*

 

The provision forincome taxes for the three- and six- months ended June 30, 2009 was lowercompared to the same periods in 2008 primarily from lower pretax income.

 

**Comparison of financial condition at**

**June 30, 2009 and December 31, 2008**

 

*Overview*

 

Consolidatedassets declined $15,265,000, or 3%, during the six months ended June 30,2009.  The decline was caused by a$39,249,000, or 43%, reduction in total borrowings, partially offset by a$20,561,000, or 4%, increase in total deposits. The reduction in borrowings was from implementing a de-leveragingstrategy, during the first quarter that used the proceeds from the sale ofresidential mortgage loans to reduce a FHLB advance that was scheduled tomature during the second quarter of 2009. The increase in deposits was used to reduce overnight borrowings andfund commercial loan growth.

 

*Investment securities*

 

At the time ofpurchase, management classifies investment securities into one of threecategories: trading, AFS or held-to- maturity (HTM).  To date, management has not purchased anysecurities for trading purposes.  Most ofthe securities purchased are classified as AFS even though there is noimmediate intent to sell them.  The AFSdesignation affords management the flexibility to sell securities and positionthe balance sheet in response to capital levels, liquidity needs or changes inmarket conditions.  Securities AFS arecarried at fair value in the consolidated balance sheet with an adjustment toshareholders’ equity, net of tax, presented under the caption “Accumulatedother comprehensive income (loss).” Securities designated as HTM are carried at amortized cost and representdebt securities that the Company has the ability and intent to hold untilmaturity.

 

As of June 30,2009, the carrying value of investment securities totaled $77,319,000, or 14%of total assets, compared to $84,187,000, or 15% of total assets, at December 31,2008.  At June 30, 2009,approximately 14% of the carrying value of the investment portfolio wascomprised of mortgage-backed securities that amortize and provide monthly cashflow.  Agency, municipal and corporatebonds comprised 40%, 35% and 11%, respectively, of the investment portfolio at June 30,2009.

 

During the sixmonths ended June 30, 2009, total investments decreased $6,868,000, net ofa $1,444,000 decline in the market value of AFS investments.  The investment securities are comprised ofHTM and AFS securities with carrying values of $843,000 and $76,014,000,respectively.  As of June 30, 2009,the AFS debt securities were recorded with a net unrealized loss in the amountof $14,964,000 and equity securities were recorded with an unrealized net gainof $140,000.

 

A comparison ofinvestment securities at June 30, 2009 and December 31, 2008 is asfollows (dollars in thousands):

 
| ** **                               | ** ** | **June 30, 2009** | ** ** | **December 31, 2008** | ** ** |
|------------------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                               | ** ** | **Amount**             | ** ** | **%**                      | ** ** | **Amount** | ** ** | **%** | ** ** |
| U.S.  government agencies                |       | $                      | 30,632     |                       | 39.6       |   | $ | 43,507 |   | 51.6 |   |
| Mortgage-backed  securities              |       | 10,604                 |       | 13.7                       |       | 12,439 |   | 14.8 |   |
| State &  municipal subdivisions |       | 27,358                 |       | 35.4                       |       | 17,553 |   | 20.9 |   |
| Pooled  trust preferred securities       |       | 8,263                  |       | 10.7                       |       | 10,260 |   | 12.2 |   |
| Equity  securities                       |       | 462                    |       | 0.6                        |       | 428 |   | 0.5 |   |
| Total  investments                       |       | $                      | 77,319     |                       | 100.0      |   | $ | 84,187 |   | 100.0 |   |

 

Quarterly, managementperforms a review of the investment portfolio to determine the cause ofdeclines in the fair value of each security. The Company uses inputs provided by independent third parties todetermine the fair value of its investment securities portfolio.  Inputs provided by the third party arereviewed and corroborated by management. Evaluations of the causes of the unrealized losses are performed todetermine whether impairment, if any, is temporary orother-than-temporary.  Considerationssuch as the Company’s intent and ability to hold the securities to maturity,recoverability of the invested amounts over the intended holding period, thelength of time and the severity in pricing decline below cost, the

 

25

----

Table of Contents

 

interest rateenvironment, receipts of amounts contractually due and whether or not there isan active market for the security, for example, are applied, along with thefinancial condition of the issuer for management to make a realistic judgmentof the probability that the Company will be unable to collect all amounts(principal and interest) due in determining whether a security isother-than-temporarily impaired.  If adecline in value is deemed to be other-than-temporary, the amortized cost ofthe security is reduced by the credit impairment amount and a correspondingcharge to earnings is recognized.  If atthe time of sale, call or maturity the proceeds exceed the security’s amortizedcost, the impairment charge may be fully or partially recovered.

 

During 2008 and today,uncertainty in the financial markets increased the volatility in fair valueestimates for the securities in our investment portfolio.  Compared to year-end 2008, the fair values ofsecurities have declined.  Managementbelieves these changes were due mainly to interest rate changes and liquidityproblems in the financial markets, not deterioration in the creditworthiness ofthe issuers.

 

At June 30, 2009 andDecember 31, 2008, the securities with the most significant reductions infair value and associated estimated unrealized losses were in the Company’scorporate bond portfolio consisting of pooled trust preferred securities issuedby banks, thrifts and insurance companies.

 

Except for the pooledtrust preferred securities, fair values of the other investment securities aredetermined by prices provided by a third-party vendor, who is a provider offinancial market data, analytics and related services to financialinstitutions.  For the pooled trustpreferred securities portfolio, management was unable to obtain readilyattainable and realistic pricing from market traders due to a lack of activemarket participants and therefore management has determined that the market forthese securities is inactive.

 

The Company owns 13tranches of pooled trust preferred securities. The market for these securities at June 30, 2009 is inactive andmarkets for similar securities were also not active.  The inactivity was evidenced first by asignificant widening of the bid-ask spread in the brokered markets in whichpooled trust preferred securities trade and then by a significant decrease inthe volume of trades relative to historical levels.  The new issue market is also inactive as nonew pooled trust preferred securities have been issued since 2007.  There are currently very few marketparticipants who are willing and / or able to transact for thesesecurities.  Given the conditions in thedebt markets today and the absence of observable transactions in the secondaryand new issue markets, we determined:

 

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

 

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

 

·                  The pooled preferred trust securities are classified within Level 3 ofthe fair value hierarchy because significant adjustments are required todetermine fair value at the measurement date. Our pooled preferred trust securities valuations were prepared by anindependent third party.  Their approachto determine fair value involved the following:

 

·                  Data about the issue structure as defined in the indenture and theunderlying collateral were collected,

 

·                  The credit quality of the collateral is estimated using averageprobability of default values for each issuer (adjusted for rating levels andstressed to reflect the current environment),

 

·                  The default probabilities also considered the potential for 50%correlation among issuers within the same industry (e.g. banks with otherbanks) and 30% correlation between industries (e.g. banks vs. insurance),

 

·                  The loss given default was assumed to be 100%,

 

·                  The cash flows were forecast at no prepayments and zero recovery forthe underlying collateral and applied to each tranche to determine theresulting distribution among the securities,

 

·                  The expected cash flows were discounted at 300 basis points over Liborto calculate the present value of the security,

 

·                  The effective discount rates on an overall basis range from 3.28% to16.73% and are highly dependent upon the credit quality of the collateral, the relativeposition of the tranche in the capital structure of the security and theprepayment assumptions, and

 

·                  The calculations were modeled in ten thousand scenarios using a MonteCarlo engine to establish a distribution of intrinsic values and the averagewas used for valuation purposes.

 

26

----

Tableof Contents

 

Based on thetechnique described, the Company determined that as of June 30, 2009, thefair value of one pooled trust preferred security, PreTSL VII, had declined$326,000 below its amortized cost basis and since the present value of thesecurity’s expected cash flows was insufficient to recover the entire amortizedcost basis, the security is deemed to have experienced credit relatedother-than-temporarily impairment and the full amount was charged to currentearnings as a component of other income in the consolidated income statementfor the six months ended June 30, 2009. Excluding the impairment, the market value of the Company’s investmentin pooled trust preferred securities has declined by $6,040,000 since December 31,2008.  The Company closely monitors thepooled trust preferred securities market and performs collateral sufficiencyand cash flow analyses on at least a quarterly basis.  Future analyses could yield results that mayindicate further impairment has occurred and therefore require additionalwrite-downs and corresponding other-than-temporary charges to currentearnings.  There were no OTTI chargesrecorded during the first six months of 2008.

 

On July 15, 2009, anissuer in several of the pooled trust preferred securities that the Companyowns announced its intent to defer future payment of interest on its pooledtrust preferred securities.  Afterperforming initial analysis of the impact of this deferral on cash flowprojections, management believes that it is possible for this event tonegatively impact the cash flow projections on two of the pooled trustpreferred securities owned by the Company. As of June 30, 2009, the Company’s investment in these twosecurities, PreTSL V and PreTSL VII, amounted to $276,000 and $777,000 withcorresponding fair values of $259,000 and $406,000, respectively.  It appears that these securities’ creditenhanced subordinate collateral will not be sufficient to cover the interestdue and therefore it is possible that the Company may be required to chargeadditional credit related OTTI to current earnings during the third quarter of2009.  Management is in the process ofevaluating the impact of this event.

 

At June 30, 2009,the AFS debt securities portfolio was carried with a net unrealized loss of$14,964,000 compared to a net unrealized loss of $13,486,000 at December 31,2008.  Management believes the cause ofthe unrealized losses is related to changes in interest rates or the limitedtrading activity due to recent debt market illiquid conditions and is notdirectly or fully related to credit quality, which is consistent with its pastexperience.  In addition, the Company hasno intent to sell the securities and it is more likely than not that theCompany will not be required to sell the securities before recovery of itsamortized cost basis.  As of June 30,2009, the Company has the ability and intent to hold its investments for aperiod of time sufficient for the fair value of the securities to recover,which may be at maturity.  For a furtherdiscussion on the investment securities portfolio, see note 3, “Investmentsecurities” of the notes to the consolidated financial statements in Part I,Item I, herein.

 

*Federal Home Loan Bank Stock*

 

Investment in FHLB stockis required for membership in the organization and is carried at cost sincethere is no market value available.  Theamount the Company is required to invest is dependent upon the relative size ofoutstanding borrowings the Company has with the FHLB.  Excess stock is typically repurchased fromthe Company at par if the borrowings decline to a predetermined level.  Throughout most of 2008, the Company earned areturn or dividend on the amount invested. In late December 2008, the FHLB announced that it had suspended thepayment of dividends and the repurchase of excess capital stock to preserve itscapital level.  That decision was basedon FHLB’s analysis and consideration of certain negative market trends and theimpact those trends had on their financial condition.  Based on the financial results of the FHLBfor the year-ended December 31, 2008 and the first quarter of 2009,management believes that the suspension of both the dividend payments andexcess capital stock repurchase is temporary in nature.  Management further believes that the FHLBwill continue to be the primary source of wholesale liquidity for both short-and long-term funding and has concluded that its investment in FHLB stock isnot other-than-temporarily impaired.  TheCompany will continue to monitor the financial condition of the FHLB quarterlyto assess its ability to resume these activities in the future.

 

*Loans available-for-sale (AFS)*

 

Generally, uponorigination, certain residential mortgages are classified as AFS.  In the event of market rate increases,fixed-rate loans and loans not immediately scheduled to re-price would nolonger produce yields consistent with the current market.  In a declining interest rate environment, theCompany would be exposed to prepayment risk and, as rates decrease, interestincome could be negatively affected. Consideration is given to the Company’s current liquidity position andprojected future liquidity needs.  Tobetter manage prepayment and interest rate risk, loans that meet theseconditions may be classified as AFS.  Thecarrying value of loans AFS is at the lower of cost or estimated fairvalue.  If the fair values of these loansfall below their original cost, the difference is written down and charged tocurrent earnings.  Subsequentappreciation in the portfolio is credited to current earnings but only to theextent of previous write-downs.

 

Loans AFS at June 30,2009 amounted to $2,288,000 with a corresponding fair value of $2,308,000,compared to $84,000 and $85,000, respectively, at December 31, 2008.  During the six months ended June 30,2009, residential mortgage loans with principal balances of $73,329,000 weresold into the secondary market with net gains of approximately $818,000 recognized.  Included in the sale was $10,838,000 ofresidential loans transferred from the loan and lease portfolio during thefirst quarter of 2009.

 

27

----

Table of Contents

* *

*Loans and leases*

 

The Companyoriginates commercial and industrial (commercial) and commercial real estate(CRE) loans, residential mortgages, consumer, home equity and constructionloans.  The relative volume of originationsis dependent upon customer demand, current interest rates and the perceptionand duration of future interest levels. The broad spectrum of products provides diversification that helpsmanage, to an extent, interest rate and credit concentration risk.  Credit risk is further managed throughunderwriting policies and procedures and loan monitoring practices.  Interest rate risk is managed using variousasset/liability modeling techniques and analyses.  The interest rates on most commercial loansare adjustable with reset intervals of five years or less.

 

The majority ofthe Company’s loan portfolio is collateralized, at least in part, by realestate in Lackawanna and Luzerne Counties of Pennsylvania.  Commercial lending activities generallyinvolve a greater degree of credit risk than consumer lending because theytypically have larger balances and are more affected by adverse conditions inthe economy.  Because payments oncommercial loans depend upon the successful operation and management of the propertiesand the businesses which operate from within them, repayment of such loans maybe 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 which occurs with the Bank’scredit administration and outsourced loan review functions.

 

The composition ofthe loan portfolio at June 30, 2009 and December 31, 2008, issummarized as follows (dollars in thousands):

 
| ** **                 | ** ** | **June 30, 2009** | ** ** | **December 31, 2008** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------|------------|------------------------|------------|----------------------------|------------|------------|------------|------------|------------|
| ** **                 | ** ** | **Amount**             | ** ** | **%**                      | ** ** | **Amount** | ** ** | **%**      | ** ** | **Variance** | ** ** | **%** | ** ** |
| Real  estate:              |       |                   |       |                       |       |       |       |       |       |   |   |   |   |
| Commercial                 |       | $                      | 181,990    |                       | 42.8       |       | $          | 164,772    |       | 37.4 |   | $ | 17,218 |   | 10.4 |   |
| Residential                |       | 72,059                 |       | 17.0                       |       | 98,510     |       | 22.3       |       | (26,451 | ) | (26.9 | ) |
| Contruction                |       | 8,568                  |       | 2.0                        |       | 11,427     |       | 2.6        |       | (2,859 | ) | (25.0 | ) |
| Commercial  and industrial |       | 79,002                 |       | 18.5                       |       | 80,708     |       | 18.3       |       | (1,706 | ) | (2.1 | ) |
| Consumer                   |       | 83,122                 |       | 19.6                       |       | 85,091     |       | 19.3       |       | (1,969 | ) | (2.3 | ) |
| Direct  financing leases   |       | 403                    |       | 0.1                        |       | 444        |       | 0.1        |       | (41 | ) | (9.2 | ) |
| Gross  loans               |       | 425,144                |       | 100.0                      |       | 440,952    |       | 100.0      |       | $ | (15,808 | ) | (3.6 | ) |
| Allowance  for loan losses |       | (5,216                 | )          |                       |       | (4,745     | )          |       |       |   |   |   |   |
| Net  loans                 |       | $                      | 419,928    |                       |       |       | $          | 436,207    |       |   |   |   |   |   |   |

 

Gross loans decreasedfrom $440,952,000, as of December 31, 2008 to $425,144,000 at June 30,2009.  The decline was predominately fromthe transfer from the loan and lease portfolio, to the AFS portfolio, andsimultaneous sale of $10,838,000 of residential mortgage loans during the firstquarter of 2009.  The balance of thedecline is mostly from net pay-downs during the first half of 2009 as borrowers’sentiment, during this low-rate environment, is to re-finance their existingmortgage and home equity debt into new mortgage loans.  Most of the mortgage loans that wereoriginated in the first half of 2009 were sold on a servicing-retainedbasis.  New commercial business andrelationship emphasis has resulted in an increase in commercial real estateloans of $17,218,000, or 10%.

 

*Allowance for loan losses*

 

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

 

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

 

28

----

Tableof Contents

 

·                  identification of specific impaired loans by loancategory;

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

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

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

·                  application of qualitative factor adjustmentpercentages for trends or estimated future changes in the loan portfolio.

 

Allocation of theallowance for different categories of loans is based on the methodology asexplained above.  A key element of themethodology to determine the allowance is the Company’s credit risk evaluationprocess, which includes credit risk grading of individual commercialloans.  Commercial loans are assignedcredit risk grades based on the Company’s assessment of conditions that affectthe borrower’s ability to meet its contractual obligations under the loanagreement.  That process includesreviewing borrowers’ current financial information, historical paymentexperience, credit documentation, public information and other informationspecific to each individual borrower. The changes in allocations in the commercial loan portfolio from periodto period are based upon the credit risk grading system and from periodicreviews of the loan and lease portfolios.

 

Each quarter, managementperforms an assessment of the allowance and the provision for loan losses.  The Company’s Special Assets Committee meetsquarterly and the applicable lenders discuss each relationship under review andreach a consensus on the appropriate estimated loss amount based on Statementof Financial Accounting Standards No. 114, “*Accountingby Creditors for Impairment of a Loan*,” (SFAS 114).  The Special Assets Committee’s focus is onensuring the pertinent facts are considered and the SFAS 114 reserve amountsare reasonable.  The assessment processincludes the review of all loans on a non-accruing basis as well as a review ofcertain loans to which the lenders or the Company’s Credit Administrationfunction have assigned a criticized or classified risk rating.

 

Total charge-offs net ofrecoveries for the six months ending June 30, 2009, were $254,000,compared to $761,000 in the first half of 2008. The higher level of charge-offs recorded in the previous year resultedprimarily from the resolution of an impaired commercial real estate loan andthe partial charge-off of a commercial real estate loan for which specificreserves had been allocated.  Commercialreal estate loan net charge-offs of $9,000 were recorded during the six monthsending June 30, 2009 versus $535,000 at June 30, 2008.  Commercial and industrial loan netcharge-offs were $116,000 for the six months ending June 30, 2009 comparedto net recoveries of $25,000 in the same period of 2008.  Residential real estate loan net charge-offstotaled $3,000 for the six months ending June 30, 2009 compared to $32,000in the like period of 2008.  Consumerloan net charge-offs of $126,000 were recorded during the six months ending June 30,2009 versus $218,000 at June 30, 2008. For a discussion on the provision for loan losses, see the “Provisionfor loan losses,” located in the results of operations section of management’sdiscussion and analysis contained herein. For a discussion on the provision for loan losses, see the “Provisionfor loan losses,” located in the results of operations section of management’sdiscussion and analysis contained herein.

 

Managementbelieves that the current balance in the allowance for loan losses of$5,216,000 is sufficient to withstand the identified potential credit qualityissues that may arise and others unidentified but are inherent to theportfolio.  At June 30, 2009, managementwas unaware of any potential problem loans that have not been reviewed.  Potential problem loans are those where thereis known information that leads management to believe repayment of principaland/or interest is in jeopardy and the loans are currently neither onnon-accrual status or past due 90 days or more. However, there could be certain instances which become identified overthe upcoming year that may require additional charge-offs and/or increases tothe allowance.  The ratio of allowancefor loan losses to total loans was 1.22% at June 30, 2009 compared to1.00% at June 30, 2008.

 

The followingtables set forth the activity in the allowance for loan losses and certain keyratios for the period indicated:

 

29

----

Tableof Contents

 
| ** **                       | ** ** | **As of and for the**  | ** **  | **As of and for the**      | ** ** | **As of and for the**  | ** ** |
|----------------------------------|------------|------------------------|-------------|----------------------------|------------|------------------------|------------|
| ** **                       | ** ** | **six months ended**   | ** **  | **twelve months ended**    | ** ** | **six months ended**   | ** ** |
| ** **                       | ** ** | **June 30, 2009** | ** **  | **December 31, 2008** | ** ** | **June 30, 2008** | ** ** |
|                             |       |                   |        |                       |       |                   |       |
| Balance  at beginning of period  |       | $                      | 4,745,234   |                       | $          | 4,824,401              |       | $ | 4,824,401 |   |
|                             |       |                   |        |                       |       |                   |       |
| Provision  charged to operations |       | 725,000                |        | 940,000                    |       | 125,000                |       |
|                             |       |                   |        |                       |       |                   |       |
| Charge-offs:                     |       |                   |        |                       |       |                   |       |
| Real  estate:                    |       |                   |        |                       |       |                   |       |
| Commercial                       |       | 24,932                 |        | 565,193                    |       | 553,193                |       |
| Residential                      |       | 3,158                  |        | 44,800                     |       | 31,870                 |       |
| Commercial  and industrial       |       | 118,520                |        | 168,021                    |       | 33,836                 |       |
| Consumer                         |       | 133,617                |        | 350,856                    |       | 236,797                |       |
| Total                            |       | 280,227                |        | 1,128,870                  |       | 855,696                |       |
|                             |       |                   |        |                       |       |                   |       |
| Recoveries:                      |       |                   |        |                       |       |                   |       |
| Real  estate:                    |       |                   |        |                       |       |                   |       |
| Commercial                       |       | 15,808                 |        | 18,020                     |       | 18,020                 |       |
| Residential                      |       | —                 |        | 97                         |       | 50                     |       |
| Commercial  and industrial       |       | 2,075                  |        | 61,233                     |       | 58,462                 |       |
| Consumer                         |       | 7,846                  |        | 30,353                     |       | 18,334                 |       |
| Total                            |       | 25,729                 |        | 109,703                    |       | 94,866                 |       |
|                             |       |                   |        |                       |       |                   |       |
| Net  charge-offs                 |       | 254,498                |        | 1,019,167                  |       | 760,830                |       |
|                             |       |                   |        |                       |       |                   |       |
| Balance  at end of period        |       | $                      | 5,215,736   |                       | $          | 4,745,234              |       | $ | 4,188,571 |   |
|                             |       |                   |        |                       |       |                   |       |
| Total  loans, end of period      |       | $                      | 427,432,128 |                       | $          | 441,036,694            |       | $ | 418,650,319 |   |

 
| ** **                                                                | ** ** | **As of and for the**  | ** ** | **As of and for the**      | ** ** | **As of and for the**  | ** ** |
|---------------------------------------------------------------------------|------------|------------------------|------------|----------------------------|------------|------------------------|------------|
| ** **                                                                | ** ** | **six months ended**   | ** ** | **twelve months ended**    | ** ** | **six months ended**   | ** ** |
| ** **                                                                | ** ** | **June 30, 2009** | ** ** | **December 31, 2008** | ** ** | **June 30, 2008** | ** ** |
| Net  charge-offs to:                                                      |       |                   |       |                       |       |                   |       |
| Loans,  end of period                                                     |       | 0.06                   | %          | 0.23                       | %          | 0.18                   | %          |
| Allowance  for loan losses                                                |       | 4.88                   | %          | 21.48                      | %          | 18.16                  | %          |
| Provision  for loan losses                                                |       | 0.35                   | x          | 1.08                       | x          | 6.09                   | x          |
|                                                                      |       |                   |       |                       |       |                   |       |
| Allowance  for loan losses to:                                            |       |                   |       |                       |       |                   |       |
| Total  loans                                                              |       | 1.22                   | %          | 1.08                       | %          | 1.00                   | %          |
| Non-accrual  loans                                                        |       | 0.70                   | x          | 1.36                       | x          | 1.14                   | x          |
| Non-performing  loans                                                     |       | 0.69                   | x          | 1.16                       | x          | 1.09                   | x          |
| Net  charge-offs                                                          |       | 20.49                  | x          | 4.66                       | x          | 5.51                   | x          |
|                                                                      |       |                   |       |                       |       |                   |       |
| Loans  30-89 days past due and still accruing                             |       | $                      | 2,360,786  |                       | $          | 1,858,481              |       | $ | 2,199,056 |   |
| Loans  90 days past due and accruing                                      |       | $                      | 180,800    |                       | $          | 604,140                |       | $ | 177,431 |   |
| Non-accrual  loans                                                        |       | $                      | 7,398,505  |                       | $          | 3,493,169              |       | $ | 3,667,929 |   |
| Allowance  for loan losses to loans 90 days or more past due and accruing |       | 28.85                  | x          | 7.85                       | x          | 23.61                  | x          |

 

*Non-performing assets*

 

The Company definesnon-performing assets as accruing loans past due 90 days or more, non-accrualloans, restructured loans, other real estate owned (ORE) and repossessedassets.  As of June 30, 2009,non-performing assets represented 1.57% of total assets compared to 0.79% at June 30,2008.  The increase was driven by thehigher level of non-accrual loans and ORE at June 30, 2009.

 

In the review of loansfor both delinquency and collateral sufficiency, management concluded thatthere were a number of

 

30

----

Tableof Contents

 

loans that lacked theability to repay in accordance with contractual terms.  The decision to place loans or leases on anon-accrual status is made on an individual basis after considering factorspertaining to each specific loan.

 

The majority of thenon-performing assets for the period are attributed to non-accruing commercialreal estate loans, non-accruing residential real estate loans and ORE.  Most of the loans are collateralized, therebymitigating the Company’s potential for loss. At June 30, 2009 non-performing loans were $7,579,000 compared to$4,097,000 at December 31, 2008. During the first quarter of this year, the Company was notified by acustomer of a significant adverse business event causing management to placethe customer’s $3,300,000 loan relationship on non-accrual status.  Management does not expect this will have amaterial impact on income going forward. Action plans for the resolution of each of the Company’s non-performingloans have been developed and are periodically updated as needed.  There were no restructured loans orrepossessed assets at June 30, 2009 or at December 31, 2008.  ORE at June 30, 2009 was $1,199,000 andconsisted of four properties of which two had an agreement to sell.  At June 30, 2009, the non-accrual loansaggregated $7,399,000 as compared to $3,493,000 at December 31, 2008.  Additions to the non-accrual component of thenon-performing assets totaling $5,009,000 were made during the first six monthsof the year.  These were partially offsetby reductions or payoffs of $681,000, charge-offs of $213,000, $132,000 oftransfers to ORE and $77,000 of loans that returned to performing status.  Loans past due 90 days or more and accruingdeclined to $181,000 at June 30, 2009, from $604,000, at December 31,2008.  Non-performing loans to net loanswere 1.80% at June 30, 2009, and 0.94% at December 31, 2008.  The percentage of non-performing assets tototal assets was 1.57% at June 30, 2009, an increase from 0.96% at December 31,2008, primarily due to the aforementioned increase in the non-accrual loanscomponent.

 

The 30-89 day past dueloans at June 30, 2009 were $2,361,000 and $1,858,000 at December 31,2008.

 

The followingtable sets forth non-performing assets data as of the period indicated:

 
| ** **                                                                         | ** ** | **June 30, 2009** | ** **  | **December 31, 2008** | ** ** | **June 30, 2008** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------|-------------|----------------------------|------------|------------------------|------------|
|                                                                               |       |                   |        |                       |       |                   |       |
| Loans past due 90 days or more and accruing                                        |       | $                      | 180,800     |                       | $          | 604,140                |       | $ | 177,431 |   |
| Non-accrual loans                                                                  |       | 7,398,505              |        | 3,493,169                  |       | 3,667,929              |       |
| Total non-performing loans                                                         |       | 7,579,305              |        | 4,097,309                  |       | 3,845,360              |       |
|                                                                               |       |                   |        |                       |       |                   |       |
| Other real estate owned                                                            |       | 1,199,060              |        | 1,450,507                  |       | 897,036                |       |
| Total non-performing assets                                                        |       | $                      | 8,778,365   |                       | $          | 5,547,816              |       | $ | 4,742,396 |   |
|                                                                               |       |                   |        |                       |       |                   |       |
| Net loans including AFS                                                            |       | $                      | 422,216,392 |                       | $          | 436,291,460            |       | $ | 414,461,748 |   |
| Total assets                                                                       |       | $                      | 560,454,208 |                       | $          | 575,718,997            |       | $ | 598,563,896 |   |
| Non-accrual loans to net loans                                                     |       | 1.75                   | %           | 0.80                       | %          | 0.88                   | %          |
| Non-performing assets to net loans, foreclosed real  estate and repossessed assets |       | 2.07                   | %           | 1.27                       | %          | 1.14                   | %          |
| Non-performing assets to total assets                                              |       | 1.57                   | %           | 0.96                       | %          | 0.79                   | %          |
| Non-performing loans to net loans                                                  |       | 1.80                   | %           | 0.94                       | %          | 0.93                   | %          |

 

*Foreclosed**assets held-for-sale*

 

Foreclosed assetsheld-for-sale, consisting of ORE, was $1,199,000 at June 30, 2009comprised of four properties, two of which were under an agreement to besold.  The remaining two properties arelisted for sale with a realtor.

 

*Other assets*

 

Pending receivableof securities purchases of $2,632,000 was the primary cause of other assets toincrease $3,684,000, or 41%, during the first half of 2009.  The purchases, which included agency andmunicipal obligations, settled in July 2009.  Further contributing to the increase in otherassets, the Company’s deferred tax asset increased $358,000 on further declinesin the investment portfolio and mortgage servicing rights increased $436,000due to high volume of mortgage real estate sales that the Company normallysells into the secondary market on a serving-retained basis.

 

*Deposits*

 

The Bank is acommunity-based commercial financial institution, member FDIC, which offers avariety of deposit accounts with varying ranges of interest rates andterms.  Deposit products include savingsaccounts, interest-bearing checking (NOW), money market, non-interest bearingchecking (DDAs) and certificates of deposit accounts.  Certificates of deposit accounts, or CDs, aredeposits with stated maturities ranging from seven days to ten years.  The flow of deposits is

 

31

----

Tableof Contents

 

significantly influencedby general economic conditions, changes in prevailing interest rates, pricingand competition.  Most of the Company’sdeposits are obtained from the communities surrounding its 12 branch officesand are insured by the FDIC up to the full extent permitted by law.  The Bank attempts to attract and retaindeposit customers via sales and marketing efforts, new products, qualityservice, competitive rates and maintaining long-standing customerrelationships.  To determine depositproduct interest rates, the Company considers local competition, market yieldsand the rates charged for alternative sources of funding such asborrowings.  Though we continue toexperience intense competition for deposits, our rate-setting strategy includesconsideration of liquidity needs, balance sheet structure and cost effectivestrategies that are mindful of the current interest rate environment.

 

Compared to December 31,2008 total deposits grew $20,561,000, or 5%, during the six month period endingJune 30, 2009.  The growth in totaldeposits was due to increases in money market, NOW and savings accounts of$17,115,000, or 18%, $6,919,000, or 14%, and $3,159,000, or 8%, respectively,partially offset by lower DDA and CD balances. The opening of the West Scranton branch during the third quarter of 2008and bank-wide money market promotions that the Company attempts to customize topersonal and non-personal needs of our customers contributed to growth indeposits during the first half of 2009. On July 20, 2009, the Company closed its Wyoming Avenue, Scrantonbranch and consolidated with the Financial Center branch located on North WashingtonAvenue, Scranton.  The consolidation isnot expected to have a material effect on the Company’s deposits.

 

The following tablerepresents the components of deposits as of the date indicated:

 
| ** **               | ** ** | **June 30, 2009** | ** **  | **December 31, 2008** | ** ** |
|--------------------------|------------|------------------------|-------------|----------------------------|------------|
| ** **               | ** ** | **Amount**             | ** **  | **%**                      | ** ** | **Amount** | ** ** | **%** | ** ** |
| Money  market            |       | $                      | 113,852,919 |                       | 25.1       |   | $ | 96,738,006 |   | 22.3 |   |
| NOW                      |       | 57,042,434             |        | 12.5                       |       | 50,123,744 |   | 11.6 |   |
| Savings  and club        |       | 44,485,585             |        | 9.8                        |       | 41,326,616 |   | 9.5 |   |
| Certificates  of deposit |       | 162,400,639            |        | 35.8                       |       | 173,680,915 |   | 40.1 |   |
| CDARS                    |       | 6,588,600              |        | 1.5                        |       | — |   | — |   |
| Total  interest-bearing  |       | 384,370,177            |        | 84.7                       |       | 361,869,281 |   | 83.5 |   |
| Non-interest-bearing     |       | 69,503,187             |        | 15.3                       |       | 71,442,651 |   | 16.5 |   |
| Total  deposits          |       | $                      | 453,873,364 |                       | 100.0      |   | $ | 433,311,932 |   | 100.0 |   |

 

Certificates of depositof $100,000 or more aggregated $62,800,000 and $74,250,000 at June 30,2009 and December 31, 2008, respectively. Certificates of deposit of $250,000 or more aggregated $22,334,000 and$35,108,000 at June 30, 2009 and December 31, 2008.

 

During the first quarterof 2009, the Company began to use the Certificate of Deposit Account RegistryService (CDARS) in order to obtain FDIC insurance protection for customers whohave large deposits that at times exceed the FDIC maximum amount of$250,000.  In the CDARS program, depositsare sold at varying terms and interest rates, are originated in our own marketplace and are placed with other financial institutions that are members in theCDARS network.  By placing these depositsin other participating institutions, the deposits of our customers are fullyinsured by the FDIC.  In return fordeposits we place with network institutions, we can receive from networkinstitutions deposits that are approximately equal in amount of what was placedfor our customers.  Deposits that wereceive, or reciprocal deposits, from other institutions are consideredbrokered deposits.  As of June 30,2009, CDARS represented $6,589,000, or 2%, of total deposits.

 

Approximately 51% oftotal CDs are scheduled to mature in 2009. Renewing CDs may re-price to market rates depending on the direction ofinterest rate movements, the shape of the yield curve, competition, the rateprofile of the maturing accounts and depositor preference for alternativeproducts.  To help reduce the financialimpact of the unpredictable and highly volatile interest rate environment,management will deploy prudent strategies that will diversify the deposit mixacross the entire spectrum of products offered. Although we continue to experience intense competition for deposits, we havenot adjusted rates above market levels as we consider cost effective strategiesas well as relationship retention and development when setting interest rateson deposit accounts.

 

*Borrowings*

 

Borrowings areused as a complement to deposit generation as an alternative funding sourcewhereby the Bank will borrow under customer repurchase agreements in the localmarket, advances from the Federal Home Loan Bank of Pittsburgh (FHLB) and othercorrespondent banks for asset growth and liquidity needs.  Repurchase agreements are non-insuredinterest-bearing liabilities that have a security interest in qualifiedinvestment securities of the Bank and are offered through a sweep product.  A sweep account is designed to ensure that,on a daily basis, an attached DDA is adequately funded and

 

32

----

Table ofContents

 

excess DDA fundsare transferred, or swept, into an overnight interest-bearing repurchaseagreement account.  The balance incustomer repurchase agreement accounts can fluctuate daily because the dailysweep product is dependent on the level of available funds in depositoraccounts.  In addition, short-termborrowings may include overnight balances which the Bank may require to funddaily liquidity needs.  Overnightbalances and repurchase agreements are components of short-term borrowings andFHLB advances are components of long-term debt on the consolidated balancesheets.

 

The following tablerepresents the components of borrowings as of June 30, 2009 and December 31,2008 (dollars in thousands):

 
| ** **                  | ** ** | **June 30, 2009** | ** ** | **December 31, 2008** | ** ** |
|-----------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                  | ** ** | **Amount**             | ** ** | **%**                      | ** ** | **Amount** | ** ** | **%** | ** ** |
| Overnight  borrowings       |       | $                      | —     |                       | —     |   | $ | 25,668 |   | 28.5 |   |
| Repurchase  agreements      |       | 7,895                  |       | 15.5                       |       | 11,412 |   | 12.6 |   |
| Demand  note, U.S. Treasury |       | 985                    |       | 1.9                        |       | 1,050 |   | 1.2 |   |
| FHLB  advances              |       | 42,000                 |       | 82.6                       |       | 52,000 |   | 57.7 |   |
| Total  borrowings           |       | $                      | 50,880     |                       | 100.0      |   | $ | 90,130 |   | 100.0 |   |

 

Borrowings havedecreased $39,250,000, or 44%, during the six months ended June 30,2009.  Overnight borrowings and FHLBadvances have declined as a result of the Company’s balance sheet de-leveragingand deposit generation.  The reduction inrepurchase agreements was caused by a combination of pricing and the volatilenature of the sweep product.

 

*Accrued interest payable and otherliabilities*

 

The $3,261,000increase in accrued expenses and other liabilities stems from the securitiespurchase commitments that settled in July 2009.

 

**Item 3. Quantitative and Qualitative Disclosure About Market Risk**

 

*Management of interest rate riskand market risk analysis*

 

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

 

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

 

*InterestRate Risk Measurement.* Interest rate risk is monitoredthrough the use of three complementary measures: 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 between assets and liabilities re-pricing in specific timeintervals is referred to as an interest rate sensitivity gap.  Interest rate sensitivity gaps can be managedto take advantage of the slope of the yield curve as well as forecasted changesin the level of interest rate changes.

 

To manage this interestrate sensitivity gap position, an asset/liability model commonly known ascumulative gap analysis is used to monitor the difference in the volume of theCompany’s interest-sensitive assets and liabilities that mature or re-pricewithin given time intervals.  A positivegap (asset sensitive) indicates that more assets will mature or re-price duringa given period compared to liabilities, while a negative gap (liabilitysensitive) has the opposite effect.  TheCompany employs

 

33

----

Table of Contents

 

computerized net interestincome simulation modeling to assist in quantifying interest rate riskexposure.  This process measures andquantifies the impact on net interest income through varying interest ratechanges and balance sheet compositions. The use of this model assists the ALCO to gauge the effects of theinterest rate changes on interest-sensitive assets and liabilities in order todetermine what impact these rate changes will have upon the net interestspread.  At June 30, 2009 the Bankmaintained a one-year cumulative gap of positive $16.5 million, or 2.95%, oftotal assets.  The effect of thispositive gap position provided a mismatch of assets and liabilities which mayexpose the Bank to interest rate risk during periods of falling interestrates.  Conversely, in an increasinginterest rate environment, net interest income could be positively impactedbecause more assets than liabilities would re-price upward during the one-yearperiod.

 

Certain shortcomings areinherent in the method of analysis discussed above and presented in the nexttable.  Although certain assets andliabilities may have similar maturities or periods of re-pricing, they may reactin different degrees to changes in market interest rates.  The interest rates on certain types of assetsand liabilities may fluctuate in advance of changes in market interest rates,while interest rates on other types of assets and liabilities may lag behindchanges in market interest rates. Certain assets, such as adjustable-rate mortgages, have features whichrestrict changes in interest rates on a short-term basis and over the life ofthe asset.  In the event of a change ininterest rates, prepayment and early withdrawal levels may deviatesignificantly from those assumed in calculating the table.  The ability of many borrowers to servicetheir adjustable-rate debt may decrease in the event of an interest rate increase.

 

The following table illustrates the Company’s interestsensitivity gap position at June 30, 2009 (dollars in thousands):

 
| ** **                                     | ** ** | **Interest sensitivity gap at June 30, 2009** | ** ** |
|------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                     | ** ** | **Three months**                                   | ** ** | **Three to** | ** ** | **One to** | ** ** | **Over** | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | **or less**                                        | ** ** | **twelve months** | ** ** | **three years** | ** ** | **three years** | ** ** | **Total** | ** ** |
| Cash  and cash equivalents                     |       | $                                                  | 4,634      |   | $ | — |   | $ | — |   | $ | 10,936 |   | $ | 15,570 |   |
| Investment  securities (1)(2)                  |       | 24,499                                             |       | 4,509 |   | 15,373 |   | 37,720 |   | 82,101 |   |
| Loans  (2)                                     |       | 119,890                                            |       | 64,396 |   | 99,761 |   | 138,169 |   | 422,216 |   |
| Fixed  and other assets                        |       | —                                             |       | 8,962 |   | — |   | 31,605 |   | 40,567 |   |
| Total  assets                                  |       | $                                                  | 149,023    |   | $ | 77,867 |   | $ | 115,134 |   | $ | 218,430 |   | $ | 560,454 |   |
| Total  cumulative assets                       |       | $                                                  | 149,023    |   | $ | 226,890 |   | $ | 342,024 |   | $ | 560,454 |   |   |   |
|                                           |       |                                               |       |   |   |   |   |   |   |   |   |
| Non-interest  bearing transaction deposits (3) |       | $                                                  | —     |   | $ | 6,950 |   | $ | 19,113 |   | $ | 43,440 |   | $ | 69,503 |   |
| Interest-bearing  transaction deposits (3)     |       | 62,771                                             |       | — |   | 58,018 |   | 94,592 |   | 215,381 |   |
| Time  deposits                                 |       | 55,402                                             |       | 76,365 |   | 29,190 |   | 8,032 |   | 168,989 |   |
| Repurchase  agreements                         |       | 7,895                                              |       | — |   | — |   | — |   | 7,895 |   |
| Short-term  borrowings                         |       | 986                                                |       | — |   | — |   | (1 | ) | 985 |   |
| Long-term  debt                                |       | —                                             |       | — |   | 21,000 |   | 21,000 |   | 42,000 |   |
| Other  liabilities                             |       | —                                             |       | — |   | — |   | 6,578 |   | 6,578 |   |
| Total  liabilities                             |       | $                                                  | 127,054    |   | $ | 83,315 |   | $ | 127,321 |   | $ | 173,641 |   | $ | 511,331 |   |
| Total  cumulative liabilities                  |       | $                                                  | 127,054    |   | $ | 210,369 |   | $ | 337,690 |   | $ | 511,331 |   |   |   |
|                                           |       |                                               |       |   |   |   |   |   |   |   |   |
| Interest  sensitivity gap                      |       | $                                                  | 21,969     |   | $ | (5,448 | ) | $ | (12,187 | ) | $ | 44,789 |   |   |   |
|                                           |       |                                               |       |   |   |   |   |   |   |   |   |
| Cumulative  gap                                |       | $                                                  | 21,969     |   | $ | 16,521 |   | $ | 4,334 |   | $ | 49,123 |   |   |   |
|                                           |       |                                               |       |   |   |   |   |   |   |   |   |
| Cumulative  gap to total assets                |       | 3.92                                               | %          | 2.95 | % | 0.77 | % | 8.76 | % |   |   |

 

----

(1)  Includes FHLB stock and the net unrealizedgains/losses on securities AFS.

 

(2)  Investments and loans are included in the earlier of theperiod in which interest rates were next scheduled to adjust or the period inwhich they are due.  In addition, loansare included in the periods in which they are scheduled to be repaid based onscheduled amortization.  For amortizingloans and mortgage-backed securities, annual prepayment rates are assumedreflecting historical experience as well as management’s knowledge andexperience of its loan products.

 

(3)  The Bank’s demand and savings accounts are generally subjectto immediate withdrawal.  However,management considers a certain amount of such accounts to be core accountshaving significantly longer effective maturities based on the retentionexperiences of such deposits in changing interest rate environments.  The effective maturities presented are therecommended maturity distribution limits for non-maturing deposits based onhistorical deposit studies.

 

*Earnings at Risk and EconomicValue at Risk Simulations*.  The Company recognizes thatmore sophisticated tools exist for measuring the interest rate risk in thebalance sheet that extend beyond static re-pricing gap analysis.  Although it will

 

34

----

Tableof Contents

 

continue to measure itsre-pricing gap position, the Company utilizes additional modeling foridentifying and measuring the interest rate risk in the overall balancesheet.  The ALCO is responsible forfocusing on “earnings at risk” and “economic value at risk”, and how bothrelate to the risk-based capital position when analyzing the interest raterisk.

 

*Earnings at Risk*. Earnings at risk simulation measures the change in net interest incomeand net income should interest rates rise and fall.  The simulation recognizes that not all assetsand liabilities re-price one-for-one with market rates (e.g., 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 rate simulation models.

 

*EconomicValue at Risk.* Earnings at risk simulation measures theshort-term risk in the balance sheet. Economic value (or portfolio equity) at risk measures the long-term riskby finding the net present value of the future cash flows from the Company’sexisting assets and liabilities.  TheALCO examines this ratio quarterly utilizing an increase and decrease of 200basis points in interest rate simulation models.  The ALCO recognizes that, in some instances,this ratio may contradict 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 the economic value (portfolio equity).  This analysis assumes that interest-earningasset and interest-bearing liability levels at June 30, 2009 remainconstant.  The impact of the ratemovements was developed by simulating the effect of rates changing over atwelve-month period from the June 30, 2009 levels:

 
| ** **                                            | ** ** | **Rates +200** | ** ** | **Rates -200** | ** ** |
|-------------------------------------------------------|------------|----------------|------------|----------------|------------|
| Earnings  at risk:                                    |       |           |       |           |       |
| Percent  change in:                                   |       |           |       |           |       |
| Net  interest income                                  |       | 0.7            | %          | 4.5            | %          |
| Net  income                                           |       | 3.7            |       | 17.0           |       |
|                                                  |       |           |       |           |       |
| Economic  value at risk:                              |       |           |       |           |       |
| Percent  change in:                                   |       |           |       |           |       |
| Economic  value of equity                             |       | (31.6          | )          | 0.2            |       |
| Economic  value of equity as a percent of book assets |       | (2.7           | )          | 0.0            |       |

 

Economic value has themost meaning when viewed within the context of risk-based capital.  Therefore, the economic value may normallychange beyond the Company’s policy guideline for a short period of time as longas the risk-based capital ratio (after adjusting for the excess equityexposure) is greater than 10%.  At June 30,2009, the Company’s risk-based capital ratio was 11.7%.

 

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

 

| ** **                   | ** ** | **Net interest** | ** ** | **$**        | ** ** | **%**        | ** ** |
|------------------------------|------------|------------------|------------|--------------|------------|--------------|------------|
| **Change in interest rates** | ** ** | **income**       | ** ** | **variance** | ** ** | **variance** | ** ** |
|                         |       |             |       |         |       |         |       |
| +200  basis points           |       | $                | 19,793     |         | $          | 141          |       | 0.7 | % |
| +100  basis points           |       | 19,574           |       | (78          | )          | (0.4         | )          |
| Flat  rate                   |       | 19,652           |       | —       |       | —       |       |
| -100  basis points           |       | 20,189           |       | 537          |       | 2.7          |       |
| -200  basis points           |       | 20,540           |       | 888          |       | 4.5          |       |
|                              |            |                  |            |              |            |              |            |  |  |

 

Simulation models requireassumptions about certain categories of assets and liabilities.  The models schedule existing assets andliabilities by their contractual maturity, estimated likely call date orearliest re-pricing opportunity. Mortgage-backed securities and amortizing loans are scheduled based ontheir anticipated cash flow including estimated prepayments.  For investment securities, the Bank uses athird-party service to provide cash flow estimates in the various rateenvironments.  Savings, money market andNOW accounts do not have a stated maturity or re-pricing term and can bewithdrawn or re-priced at any time.  Thismay impact the margin if more expensive alternative sources of deposits arerequired to fund loans or deposit runoff. Management projects the re-pricing characteristics of these accountsbased on historical performance and assumptions that it believes reflect theirrate sensitivity.  The model reinvestsall maturities, repayments and prepayments for each type of asset or liabilityinto the same product for a new like term at current product interest ratesprovided by management.  As a result, themix of interest-earning assets and interest bearing-liabilities is heldconstant.

 

35

----

Table of Contents

 

*Derivative FinancialInstruments. *As part of the Bank’s overall interestrate risk strategy, the Company has adopted a policy whereby the Company mayperiodically use derivative instruments to minimize significant fluctuations inearnings caused by interest rate volatility. This interest rate risk management strategy entails the use of interestrate floors, caps and swaps.  In October 2006,the Bank entered into an interest rate floor derivative agreement on$20,000,000 notional value of its prime-based loan portfolio.  The purpose of the hedge is to help protectthe Bank’s interest income in the event interest rates decline below apre-determined contractual interest rate. The strategy is reflected in the scenarios for earnings and economicvalue at risk and the net interest income in the two immediately precedingtables.  For a further discussion on theBank’s derivative contract, see note 4, “Derivative instruments,” containedwithin the notes to consolidated financial statements in Part I, Item 1.

 

*Liquidity*

 

Liquidity managementensures that adequate funds will be available to meet loan and investmentcommitments, deposit withdrawals and maturities and normal operatingrequirements of the Bank.  Currentsources of liquidity are cash and cash equivalents, asset maturities, calls andprincipal repayments, loans and investments AFS, growth of core deposits,growth of repurchase agreements, increases in other borrowed funds fromcorrespondent banks and issuance of capital stock.  Although regularly scheduled investment andloan payments are dependable sources of daily funds, the sales of both loansand investments AFS, deposit activity and investment and loan prepayments aresignificantly influenced by general economic conditions and the level ofinterest rates.  During declininginterest rate environments, prepayments from interest-sensitive assets tend toaccelerate and provide significant liquidity which can be used to invest inother interest-earning assets but at lower market rates.  Conversely, in a period of rising interestrates, prepayment from interest-sensitive assets tend to decelerate causingcash flow from mortgage loans and mortgage-backed securities portfolio todecrease.  Deposit inflow may accelerateand be invested at higher market interest rates.  The Company closely monitors activity in thecapital markets and takes appropriate action to ensure that the liquiditylevels are adequate for funding, investing and operating activities.

 

For the six months ended June 30, 2009, the Company generatedapproximately $2.8 million of cash. During this period, the Company’s operations provided approximately$11.7 million primarily from the sales of mortgages AFS net of originations andthe investing activities provided approximately $10.4 million from pay-downs ofloans and bonds and from the sale of foreclosed properties held-for-sale.  Partially offsetting these cash generatorswas a use of $19.3 million in financing activities, mostly from the pay-down oftotal borrowings net of deposit growth. As of June 30, 2009, the Company maintained $15.6 million of cashand cash equivalents, $76.5 million of investments AFS and $2.3 million ofloans AFS.  In addition, as of June 30,2009 the Company had approximately $168.0 million available to borrow from theFHLB and $30.0 million available from other correspondent banks.  This combined total of $292.4 millionrepresented 52% of total assets at June 30, 2009.  Management believes this level of liquidityto be strong and adequate to support current operations.

 

Management identified over $20 million in large municipal and corporatedeposits that may depart over the next six months and if so, will be replacedwith borrowings.

 

In October 2008, the FDIC announced the Temporary LiquidityGuarantee Program (TLGP) to strengthen confidence and encourage liquidity inthe banking system.  Among other things,this new program provides full deposit insurance coverage for non-interestbearing deposit transaction accounts in FDIC-insured institutions regardless ofthe dollar amount.  To protect itsdepositors, the Company is participating in the TLGP.  Under the TLGP, all depositors who hold fundsin non-interest bearing accounts, or interest-bearing accounts with an interestrate of 0.50% or less, including the Lawyers Trust Accounts, will have atemporary unlimited guarantee from the FDIC until December 31, 2009.  TLGP may be extended into 2010 with a higherpremium — as much as 50 basis points. Management has not assessed if the Company will elect the extension andtake on the much higher costs.  Thecoverage of the TLGP is in addition to and separate from coverage availableunder the FDIC’s general deposit insurance rules, which insures accounts up to$250,000 until the end of 2013 unless extended.

 

*Capital*

 

During the six monthsended June 30, 2009, shareholders’ equity increased modestly, or $162,000,due principally from net income generated during the period and issuance ofcommon stock via the Company’s Employee Stock Purchase and DividendReinvestment Plans partially offset by increased unrealized net losses in thesecurities AFS portfolio, the declaration of cash dividends and a decline in theintrinsic value of the Company’s cash flow hedge.

 

As of June 30, 2009,the Company reported a net unrealized loss of $9,785,000, net of tax, from thesecurities AFS portfolio compared to a net unrealized loss of $8,831,000 as of December 31,2008.  The increase in the unrealizedloss during the first half of 2009 was caused by the prolonged economicdownturn which has created uncertainty and in certain circumstances illiquidityin the financial and capital markets and has had a sizable negative impact onthe fair value estimates for securities in banks’ investment portfolios.  Management believes these changes are duemainly to liquidity problems in the financial markets and to a lesser extentthe deterioration in the creditworthiness of the issuers.  For a further discussion on the fair valuedetermination of the Company’s investment portfolio, see “Investment securities”under the 

 

36

----

Table of Contents

 

caption “Comparison offinancial condition at June 30, 2009 and December 31, 2008” of Part 1,Item 2, “Management’s Discussion and Analysis of Financial Condition andResults of Operations;” and notes 3 and 5, “Investment securities” and “Fairvalue measurement” in the notes to the consolidated financial statements,incorporated by reference in Part I, Item 1.

 

During the second quarterof 2008, the Company’s Board of Directors announced its intent to initiate acapital stock repurchase program covering up to 50,000 shares of itsoutstanding capital stock.  Therepurchased shares would become treasury stock and could be available forissuance under the Company’s various stock-based compensation, employee stockpurchase and dividend reinvestment (DRP) plans and for general corporatepurposes.  The repurchases may be madefrom time-to-time in open-market transactions, subject to availability,pursuant to safe harbor rule 10b-18 under the Securities Exchange Act of1934.  Management has temporarilysuspended repurchase plan activity as a prudent means, in light of the currenteconomic pressures on banking, to preserve and grow the Company’s capitalbase.  Since the program’s inception, theCompany has reacquired (at $27.83 per share) and reissued (at $21.11 per share)17,500 shares to participants in the Company’s DRP.

 

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

 

Under these guidelines, assets and certain off-balancesheet items are assigned to broad risk categories, each with appropriateweights.  The resulting capital ratiosrepresent capital as a percentage of total risk-weighted assets and certainoff-balance sheet items.  The appropriaterisk-weighting, pursuant to regulatory guidelines, required an increase in therisk-weighting of securities that were recently rated below investment grade,thus significantly inflating the total risk-weighted assets.  Compared to December 31, 2008, the totalcapital and Tier I capital ratios were reduced by the increase in risk-weightedassets.  The guidelines require all banksand bank holding companies to maintain a minimum ratio of total risk-basedcapital to total risk-weighted assets (Total Risk Adjusted Capital) of 8%,including Tier I capital to total risk-weighted assets (Tier I Capital) of 4%and Tier I capital to average total assets (Leverage Ratio) of at least4%.  As of June 30, 2009, theCompany and the Bank met all capital adequacy requirements to which it wassubject.

 

The following tabledepicts the capital amounts and ratios of the Company and the Bank as of June 30,2009:

 
| ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **            | ** ** | ** ** | **To be well capitalized**  | ** ** |
|----------------------------|------------|------------|------------|------------|------------|------------|-----------------------|------------|------------|-----------------------------|------------|
| ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **For capital**       | ** ** | ** ** | **under prompt corrective** | ** ** |
| ** **                 | ** ** | **Actual** | ** ** | ** ** | ** ** | ** ** | **adequacy purposes** | ** ** | ** ** | **action provisions**       | ** ** |
| ** **                 | ** ** | **Amount** | ** ** | **Ratio**  | ** ** | ** ** | **Amount**            | ** ** | ** ** | **Ratio**                   | ** ** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| Total  capital             |       |       |       |       |       |       |                  |       |       |                        |       |   |   |   |   |   |
| (to  risk-weighted assets) |       |       |       |       |       |       |                  |       |       |                        |       |   |   |   |   |   |
| Consolidated               |       | $          | 63,822,538 |       | 11.7       | %          | >             | $          | 43,735,644 |                        | >  |  8.0 | % |   | N/A |   | N/A |   |
| Bank                       |       | $          | 63,408,547 |       | 11.6       | %          | >             | $          | 43,725,036 |                        | >  |  8.0 | % | >  |  $ | 54,656,295 | >  |  10.0 | % |
| Tier  I capital            |       |       |       |       |       |       |                  |       |       |                        |       |   |   |   |   |   |
| (to  risk-weighted assets) |       |       |       |       |       |       |                  |       |       |                        |       |   |   |   |   |   |
| Consolidated               |       | $          | 58,543,758 |       | 10.7       | %          | >             | $          | 21,867,822 |                        | >  |  4.0 | % |   | N/A |   | N/A |   |
| Bank                       |       | $          | 58,192,706 |       | 10.7       | %          | >             | $          | 21,862,518 |                        | >  |  4.0 | % | >  |  $ | 32,793,777 | >  |  6.0 | % |
| Tier  I capital            |       |       |       |       |       |       |                  |       |       |                        |       |   |   |   |   |   |
| (to  average assets)       |       |       |       |       |       |       |                  |       |       |                        |       |   |   |   |   |   |
| Consolidated               |       | $          | 58,543,758 |       | 10.4       | %          | >             | $          | 22,504,276 |                        | >  |  4.0 | % |   | N/A |   | N/A |   |
| Bank                       |       | $          | 58,192,706 |       | 10.4       | %          | >             | $          | 22,488,506 |                        | >  |  4.0 | % | >  |  $ | 28,110,633 | >  |  5.0 | % |

 

**Item 4T. Controls and Procedures**

 

As of the end of the period covered by this Quarterly Report on Form 10-Q, an evaluation was carried out by the Company’s management, with the participation of its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures, as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934.  Based on such evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports the Company files or furnishes under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time

 

37

----

Tableof Contents

 

periods specified in the SEC’s rules and regulations, and are operating in an effective manner.  The Company made no significant changes in its internal controls over financial reporting or in other factors that materially affected, or are reasonably likely to materially affect, these controls during the last fiscal quarter ended June 30, 2009.

 

**PART II - Other Information**

 

**Item 1. Legal Proceedings**

 

The nature of the Company’sbusiness generates some litigation involving matters arising in the ordinarycourse of business.  However, in theopinion of theCompany, after consultation with legal counsel, no legal proceedings arepending, which, if determined adversely to the Company or the Bank, would havea material effect on the Company’s undivided profits or financialcondition.  No legal proceedings arepending other than ordinary routine litigation incidental to the business ofthe Company and the Bank.  In addition,to management’s knowledge, no governmental authorities have initiated orcontemplated any material legal actions against the Company or the Bank.

 

**Item 1A. Risk Factors**

 

Management of the Company doesnot believe there have been any material changes in risk factors that weredisclosed in the Form 10-K filed with the Securities and ExchangeCommission on March 12, 2009.

 

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

 

None

 

**Item 3. Default Upon Senior Securities**

 

None

 

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

 

At the annual meeting ofshareholders held on May 5, 2009, the judges of election made the reportconcerning the results of balloting. Holders of 1,642,856 shares of common stock, representing 79% of thetotal number of shares outstanding, were represented in person or by proxy atthe 2009 annual meeting of shareholders. The following votes were cast:

 

Election of Class ADirectors to serve for a three-year term:

 
| ** **           | ** ** | **For**   | ** ** | **Withhold authority** | ** ** | **Abstain** | ** ** |
|----------------------|------------|-----------|------------|------------------------|------------|-------------|------------|
| John  T. Cognetti    |       | 1,632,218 |       | 10,638                 |       | —      |       |
| Michael  J. McDonald |       | 1,632,523 |       | 10,333                 |       | —      |       |

 

In addition to the aboveelected Class A Directors, at the conclusion of its annual meeting, theCompany’s Board of Directors consisted of: Steven C. Ackmann, Brian J. Cali andPatrick J. Dempsey as Class C Directors whose term expires in 2010; andSamuel C. Cali, Mary E. McDonald and David L. Tressler, Sr. as Class Bdirectors whose term expires in 2011.  Mr. SamuelC. Cali passed away on May 21, 2009.

 

Ratification ofindependent certified public accountants:

** **
| ** **             | ** ** | **For**   | ** ** | **Against** | ** ** | **Abstain** | ** ** |
|------------------------|------------|-----------|------------|-------------|------------|-------------|------------|
| Parente  Randolph, LLC |       | 1,631,841 |       | 10,212      |       | 803         |       |

 

**Item 5. Other Information**

 

None

 

**Item 6. Exhibits**

 

The followingexhibits are filed herewith or incorporated by reference as a part of this Form 10-Q:

 

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

 

***3(ii) Amendedand Restated Bylaws of Registrant.*** Incorporated byreference to Exhibit 3(ii) to Registrant’s Form 8-K filed withthe SEC on November 21, 2007.

 

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

 

38

----

Tableof Contents

 

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

 

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

 

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

 

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

 

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

 

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

 

****10.8 Registrant’s 2002 Employee Stock Purchase Plan. ***Incorporated by reference to Exhibit 4.4 toRegistrant’s Registration Statement No. 333-113339 on Form S-8 filedwith the SEC on March 5, 2004.

 

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

 

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

 

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

 

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

 

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

 

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

 

***11******Statement regarding computation of earnings pershare.***  Included herein in Note No. 4, “Earningsper share,” contained within the Notes to Consolidated Financial Statements,and incorporated herein by reference.

 

***31.1 Rule 13a-14(a) Certification of Principal ExecutiveOfficer, filed herewith.***

 

***31.2 Rule 13a-14(a) Certification of Principal FinancialOfficer, filed herewith.***

 

***32.1 Certification of Principal Executive Officer pursuant to 18 U.S.C.Section 1350,***

*asadopted**pursuant to Section 906 of theSarbanes-Oxley Act of 2002, filed herewith.***

 

***32.2 Certification of Principal Financial Officer pursuant to 18 U.S.C.Section 1350,***

***asadopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, filedherewith.***

 

----

***  **Managementcontract or compensatory plan or arrangement.

 

39

----

Table of Contents

 

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

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|                        | **FIDELITY D & D  BANCORP, INC.** |
|-----------------------------|--------------------------------------------|
|                        |                                       |
|                        |                                       |
| Date: August 12,  2009 | /s/ Steven C. Ackmann                      |
|                        | Steven C. Ackmann,                         |
|                        | President and Chief  Executive Officer     |
|                        |                                       |
|                        |                                       |
| Date: August 12,  2009 | /s/ Salvatore R.  DeFrancesco, Jr.    |
|                        | Salvatore R.  DeFrancesco, Jr.,       |
|                        | Treasurer and Chief  Financial Officer     |

 

40

----

Table of Contents

 

**EXHIBITINDEX**

 
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | ** ** | **Page** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| ***3(i) Amended  and Restated Articles of Incorporation of Registrant.***Incorporated by reference to Annex B of  the Proxy Statement/Prospectus included in Registrant’s Amendment 4 to its  Registration Statement No. 333-90273 on Form S-4, filed with the  SEC on April 6, 2000.                                                                                                                                                                                                                                                     |       | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |       |     |
| ***3(ii) Amended  and Restated Bylaws of Registrant.***Incorporated by reference to  Exhibit 3(ii) to Registrant’s Form 8-K filed with the SEC on  November 21, 2007.                                                                                                                                                                                                                                                                                                                                                                |       | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |       |     |
| ***10.1  1998 Independent Directors Stock Option Plan of The Fidelity Deposit and  Discount Bank, as assumed by Registrant.***Incorporated by reference to Exhibit 10.1 to  Registrant’s Registration Statement No. 333-90273 on Form S-4,  filed with the SEC on November 3, 1999.                                                                                                                                                                                                                                                       |       | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |       |     |
| ***10.2  1998 Stock Incentive Plan of The Fidelity Deposit and Discount Bank, as  assumed by Registrant.***Incorporated by reference to Exhibit 10.2 of  Registrant’s Registration Statement No. 333-90273 on Form S-4,  filed with the SEC on November 3, 1999.                                                                                                                                                                                                                                                                          |       | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |       |     |
| ***10.3  Registrant’s 2000 Dividend Reinvestment Plan.***Incorporated by reference to  Exhibit 4 to Registrant’s Registration Statement No. 333-45668 on  Form S-1, filed with the SEC on September 12, 2000 and as amended  by Pre-Effective Amendment No. 1 on October 11, 2000, by  Post-Effective Amendment No. 1 on May 30, 2001, by Post-Effective  Amendment No. 2 on July 7, 2005 and by Registration Statement  No.  333-152806 on Form S-3 filed on August 6, 2008. |       | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |       |     |
| ***10.4  Registrant’s 2000 Independent Directors Stock Option Plan.***Incorporated by reference to  Exhibit 4.3 to Registrant’s Registration Statement No. 333-64356 on  Form S-8 filed with the SEC on July 2, 2001.                                                                                                                                                                                                                                                                                                                |       | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |       |     |
| ***10.5  Amendment, dated October 2, 2007, to the Registrant’s 2000 Independent  Directors Stock Option Plan.***Incorporated by reference to Exhibit 10.2 to  Registrant’s Form 8-K filed with the SEC on October 4, 2007.                                                                                                                                                                                                                                                                                                           |       | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |       |     |
| ***10.6  Registrant’s 2000 Stock Incentive Plan.***Incorporated by reference to Exhibit 4.4 to  Registrant’s Registration Statement No. 333-64356 on Form S-8 filed  with the SEC on July 2, 2001.                                                                                                                                                                                                                                                                                                                                   |       | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |       |     |
| ***10.7  Amendment, dated October 2, 2007, to the Registrant’s 2000 Stock  Incentive Plan.***Incorporated by reference to Exhibit 10.1 to Registrant’s  Form 8-K filed with the SEC on October 4, 2007.                                                                                                                                                                                                                                                                                                                              |       | *        |
| *** ***                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |       |     |
| ***10.8  Registrant’s 2002 Employee Stock Purchase Plan.***Incorporated by reference to  Exhibit 4.4 to Registrant’s Registration Statement No. 333-113339  on Form S-8 filed with the SEC on March 5, 2004.                                                                                                                                                                                                                                                                                                                         |       | *        |
| *** ***                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |       |     |
| ***10.9  Complete Settlement Agreement and General Release between Michael F.  Marranca, Registrant and The Fidelity Deposit and Discount Bank, dated  July 30, 2004***. Incorporated by reference to Exhibit 99.1 to Registrant’s  Current Report on Form 8-K filed with the SEC on August 10, 2004.                                                                                                                                                                                                                                     |       | *        |
| *** ***                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |       |     |
| ***10.10  Amendment to the Complete Settlement Agreement and General Release between  Michael F. Marranca, Registrant and The Fidelity Deposit and Discount Bank,  dated November 4, 2005*****.**Incorporated by reference to****Exhibit 99.1  to Registrant’s Current Report on Form 8-K filed with the SEC on  November 9, 2005.                                                                                                                                                                                                        |       | *        |
| *** ***                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |       |     |
| ***10.11  Change of Control Agreements with Salvatore R. DeFrancesco, Registrant and  The Fidelity Deposit and Discount Bank, dated March 21, 2006.***Incorporated by reference to Exhibit 99.2  to Registrant’s Current Report on Form 8-K filed with the SEC on  March 27, 2006.                                                                                                                                                                                                                                                        |       | *        |
| *** ***                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |       |     |
| ***10.12  Amended and Restated Executive Employment Agreement between Fidelity  D & D Bancorp, Inc., The Fidelity Deposit and Discount Bank and  Steven C. Ackmann, dated July 11, 2007.*******Incorporated by reference to  Exhibit 10.1 to Registrant’s Current Report on Form 8-K filed with  the SEC on July 13, 2007.                                                                                                                                                                                                  |       | *        |
| *** ***                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |       |     |
| ***10.13  Executive Employment Agreement between Fidelity D & D  Bancorp, Inc., The Fidelity Deposit and Discount Bank******and Timothy P. O’Brien,  dated January 3, 2008.***Incorporated by reference to  Exhibit 10.1 to Registrant’s Current Report on Form 8-K filed with  the SEC on January 10, 2008.                                                                                                                                                                                                           |       | *        |
| *** ***                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |       |     |
| *** ***                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |       |     |
| ***10.14  Executive Employment Agreement between Fidelity D & D Bancorp, Inc.,  The Fidelity Deposit and Discount***                                                                                                                                                                                                                                                                                                                                                                                                                                 |       |     |

 

41

----

Tableof Contents

 
| ***Bank******and Daniel J.  Santaniello, dated February 28, 2008.***Incorporated by  reference to Exhibit 10.1 to Registrant’s Current Report on  Form 8-K filed with the SEC on March 3, 2008. |   | *      |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
| *** ***                                                                                                                                                                                                             |   |   |
| ***11******Statement regarding  computation of earnings per share.***                                                                                                                                                    |   | 14     |
|                                                                                                                                                                                                                     |   |   |
| ***31.1  Rule 13a-14(a) Certification of Principal Executive Officer.***                                                                                                                                       |   | 43     |
|                                                                                                                                                                                                                     |   |   |
| ***31.2  Rule 13a-14(a) Certification of Principal Financial Officer.***                                                                                                                                       |   | 44     |
|                                                                                                                                                                                                                     |   |   |
| ***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.***                                           |   | 45     |
|                                                                                                                                                                                                                     |   |   |
| ***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.***                                           |   | 46     |

 

----

* Incorporated byReference

 

42

----