UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-Q





xQUARTERLY REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THE


SECURITIES
EXCHANGE ACT OF 1934





For
the quarterly period ended September 30, 2010





OR





oTRANSITION REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THE


SECURITIES
EXCHANGE ACT OF 1934





For the
transition period from ______________to______________________





Commission
file number: 333-90273





FIDELITY
D & D BANCORP, INC.





STATE OF
INCORPORATION:  IRS EMPLOYER IDENTIFICATION NO:


PENNSYLVANIA                                     23-3017653





Address
of principal executive offices:


BLAKELY
& DRINKER ST.


DUNMORE,
PENNSYLVANIA 18512





TELEPHONE:


570-342-8281





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





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





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




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




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





The
number of outstanding shares of Common Stock of Fidelity D & D Bancorp, Inc.
on October 31, 2010, the latest practicable date, was 2,162,063
shares.










FIDELITY
D & D BANCORP, INC.





Form 10-Q September 30,
2010





Index




PagePart
      I.  Financial InformationItem
      1.
              
              Financial
      Statements (unaudited):Consolidated
      Balance Sheets as of September 30, 2010 and December 31,
    2009
              
              
              3Consolidated
      Statements of Income for the three and nine months ended September 30,
      2010 and 2009
              
              
              4Consolidated
      Statements of Changes in Shareholders’ Equity for the nine months ended
      September 30, 2010 and 2009
              
              
              5Consolidated
      Statements of Cash Flows for the nine months ended September 30, 2010 and
      2009
              
              
              6Notes
      to Consolidated Financial Statements (Unaudited)
              
              
              7Item
      2.
              
              Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
              
              
              17Item
      3.
              
              Quantitative
      and Qualitative Disclosure about Market Risk
              
              
              32Item
      4T.
              
              Controls
      and Procedures
              
              
              36Part
      II.  Other InformationItem
      1.
              
              Legal
      Proceedings
              
              
              37Item
      1A.
              
              Risk
      Factors
              
              
              37Item
      2.
              
              Unregistered
      Sales of Equity Securities and Use of Proceeds
              
              
              37Item
      3.
              
              Defaults
      upon Senior Securities
              
              
              37Item
      4.
              
              (Removed
      and Reserved)
              
              
              37Item
      5.
              
              Other
      Information
              
              
              37Item
      6.
              
              Exhibits
              
              
              37Signatures
              
              
              39Exhibit
      index
              
              
              40




-2-




PART
I – Financial Information


Item
1: Financial Statements




FIDELITY
D & D BANCORP, INC. AND SUBSIDIARY
 Consolidated
Balance Sheets
 (Unaudited)




September
      30, 2010
                      
                      
                      December
      31,2009Assets:Cash
      and due from banks
                      
                      $
                      10,489,922
                      
                      
                      $
                      8,173,199Interest-bearing
      deposits with financial institutions
                      
                      
                      37,081,253
                      
                      
                      
                      154,755Total
      cash and cash equivalents
                      
                      
                      47,571,175
                      
                      
                      
                      8,327,954Available-for-sale
      securities
                      
                      
                      86,720,420
                      
                      
                      
                      75,821,292Held-to-maturity
      securities (fair value $585,337 in 2010; $765,195 in
      2009)
                      
                      
                      535,261
                      
                      
                      
                      708,706Federal
      Home Loan Bank Stock
                      
                      
                      4,781,100
                      
                      
                      
                      4,781,100Loans
      and leases, net (allowance for loan losses of $7,484,253 in 2010;
      $7,573,603 in 2009)
                      
                      
                      414,185,347
                      
                      
                      
                      423,124,054Loans
      held-for-sale (fair value $1,037,337 in 2010; $1,233,345 in
      2009)
                      
                      
                      1,019,000
                      
                      
                      
                      1,221,365Bank
      premises and equipment, net
                      
                      
                      14,649,763
                      
                      
                      
                      15,361,810Cash
      surrender value of bank owned life insurance
                      
                      
                      9,347,707
                      
                      
                      
                      9,117,156Accrued
      interest receivable
                      
                      
                      2,233,322
                      
                      
                      
                      2,250,855Foreclosed
      assets held-for-sale
                      
                      
                      1,350,692
                      
                      
                      
                      887,397Other
      assets
                      
                      
                      14,204,811
                      
                      
                      
                      14,415,582Total
      assets
                      
                      $
                      596,598,598
                      
                      
                      $
                      556,017,271Liabilities:Deposits:Interest-bearing
                      
                      $
                      409,063,486
                      
                      
                      $
                      388,103,880Non-interest-bearing
                      
                      
                      81,819,441
                      
                      
                      
                      70,890,578Total
      deposits
                      
                      
                      490,882,927
                      
                      
                      
                      458,994,458Accrued
      interest payable and other liabilities
                      
                      
                      3,235,939
                      
                      
                      
                      2,815,159Short-term
      borrowings
                      
                      
                      21,804,259
                      
                      
                      
                      16,533,107Long-term
      debt
                      
                      
                      32,000,000
                      
                      
                      
                      32,000,000Total
      liabilities
                      
                      
                      547,923,125
                      
                      
                      
                      510,342,724Shareholders'
      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; 2,163,618 in 2010; and 2,105,860 in
2009)
                      
                      
                      20,793,445
                      
                      
                      
                      19,982,677Retained
      earnings
                      
                      
                      34,919,228
                      
                      
                      
                      34,886,265Accumulated
      other comprehensive loss
                      
                      
                      (7,037,200
                      )
                      
                      
                      (9,194,395
                      )Total
      shareholders' equity
                      
                      
                      48,675,473
                      
                      
                      
                      45,674,547Total
      liabilities and shareholders' equity
                      
                      $
                      596,598,598
                      
                      
                      $
                      556,017,271
  See notes
to unaudited consolidated financial statements
  -3-
  FIDELITY
D & D BANCORP, INC. AND SUBSIDIARY
 Consolidated
Statements of Income
 (Unaudited)
  Three
      months ended
                
                
                Nine
      months endedSeptember
      30, 2010
                
                
                September
      30, 2009
                
                
                September
      30, 2010
                
                
                September
      30, 2009Interest
      income:Loans
      and leases:Taxable
                
                $
                6,056,924
                
                
                $
                6,435,487
                
                
                $
                18,141,108
                
                
                $
                19,353,099Nontaxable
                
                
                157,015
                
                
                
                110,566
                
                
                
                457,166
                
                
                
                338,828Interest-bearing
      deposits with financial institutions
                
                
                21,970
                
                
                
                89
                
                
                
                38,288
                
                
                
                537Investment
      securities:U.S.
      government agency and corporations
                
                
                401,070
                
                
                
                534,629
                
                
                
                1,360,080
                
                
                
                1,852,457States
      and political subdivisions (non-taxable)
                
                
                261,005
                
                
                
                318,299
                
                
                
                770,415
                
                
                
                787,208Other
      securities
                
                
                55,607
                
                
                
                50,994
                
                
                
                184,578
                
                
                
                393,502Federal
      funds sold
                
                
                109
                
                
                
                3,422
                
                
                
                13,549
                
                
                
                10,781Total
      interest income
                
                
                6,953,700
                
                
                
                7,453,486
                
                
                
                20,965,184
                
                
                
                22,736,412Interest
      expense:Deposits
                
                
                1,244,438
                
                
                
                1,949,402
                
                
                
                3,958,215
                
                
                
                6,279,307Securities
      sold under repurchase agreements
                
                
                6,464
                
                
                
                5,872
                
                
                
                76,654
                
                
                
                22,427Other
      short-term borrowings and other
                
                
                130
                
                
                
                1,446
                
                
                
                763
                
                
                
                27,991Long-term
      debt
                
                
                429,896
                
                
                
                1,075,934
                
                
                
                1,280,565
                
                
                
                2,420,466Total
      interest expense
                
                
                1,680,928
                
                
                
                3,032,654
                
                
                
                5,316,197
                
                
                
                8,750,191Net
      interest income
                
                
                5,272,772
                
                
                
                4,420,832
                
                
                
                15,648,987
                
                
                
                13,986,221Provision
      for loan losses
                
                
                375,000
                
                
                
                3,125,000
                
                
                
                1,250,000
                
                
                
                3,850,000Net
      interest income after provision for loan losses
                
                
                4,897,772
                
                
                
                1,295,832
                
                
                
                14,398,987
                
                
                
                10,136,221Other
      (loss) income:Service
      charges on deposit accounts
                
                
                675,598
                
                
                
                676,107
                
                
                
                1,964,512
                
                
                
                1,956,755Fees
      and other service charges
                
                
                602,570
                
                
                
                428,049
                
                
                
                1,620,579
                
                
                
                1,407,538Gain
      (loss) on sale or disposal of:Loans
                
                
                211,019
                
                
                
                139,451
                
                
                
                439,735
                
                
                
                957,777Premises
      and equipment
                
                
                (7,359
                )
                
                
                (34,617
                )
                
                
                (23,530
                )
                
                
                (41,241
                )Foreclosed
      assets held-for-sale
                
                
                36,135
                
                
                
                7,780
                
                
                
                57,550
                
                
                
                33,667Write-down
      of foreclosed assets held-for-sale
                
                
                (39,700
                )
                
                
                (77,560
                )
                
                
                (39,700
                )
                
                
                (77,560
                )Impairment
      losses on investment securities:Other-than-temporary
      impairment on investment securities
                
                
                (2,166,122
                )
                
                
                (6,468,236
                )
                
                
                (4,431,359
                )
                
                
                (6,794,331
                )Non-credit
      related losses on investment securities not expectedto
      be sold (recognized in other comprehensive income/(loss))
                
                
                417,448
                
                
                
                4,036,470
                
                
                
                1,927,763
                
                
                
                4,036,470Net
      impairment losses on investment securities recognized in
      earnings
                
                
                (1,748,674
                )
                
                
                (2,431,766
                )
                
                
                (2,503,596
                )
                
                
                (2,757,861
                )Total
      other (loss) income
                
                
                (270,411
                )
                
                
                (1,292,556
                )
                
                
                1,515,550
                
                
                
                1,479,075Other
      expenses:Salaries
      and employee benefits
                
                
                2,167,403
                
                
                
                2,502,818
                
                
                
                7,169,335
                
                
                
                7,495,167Premises
      and equipment
                
                
                808,204
                
                
                
                874,028
                
                
                
                2,549,466
                
                
                
                2,685,343Advertising
                
                
                110,292
                
                
                
                117,897
                
                
                
                418,095
                
                
                
                396,290Other
                
                
                1,231,712
                
                
                
                1,614,552
                
                
                
                3,979,319
                
                
                
                3,933,271Total
      other expenses
                
                
                4,317,611
                
                
                
                5,109,295
                
                
                
                14,116,215
                
                
                
                14,510,071Income
      (loss) before income taxes
                
                
                309,750
                
                
                
                (5,106,019
                )
                
                
                1,798,322
                
                
                
                (2,894,775
                )(Credit)
      provision for income taxes
                
                
                (45,193
                )
                
                
                (1,895,339
                )
                
                
                168,527
                
                
                
                (1,421,306
                )Net
      income (loss)
                
                $
                354,943
                
                
                $
                (3,210,680
                )
                
                $
                1,629,795
                
                
                $
                (1,473,469
                )Per
      share data:Net
      income (loss) - basic
                
                $
                (0.44
                )
                
                $
                (1.55
                )
                
                $
                0.16
                
                
                $
                (0.71
                )Net
      income (loss) - diluted
                
                $
                (0.44
                )
                
                $
                (1.55
                )
                
                $
                0.16
                
                
                $
                (0.71
                )Dividends
                
                $
                0.25
                
                
                $
                0.25
                
                
                $
                0.75
                
                
                $
                0.75




See notes
to unaudited consolidated financial statements
  -4-


FIDELITY
      D & D BANCORP, INC. AND SUBSIDIARYConsolidated
      Statements of Changes in Shareholders' EquityFor
      the nine months ended September 30, 2010 and 2009(Unaudited)


AccumulatedotherCapital
      stock
              
              
              Treasury
      stock
              
              
              Retained
              
              
              comprehensiveShares
              
              
              Amount
              
              
              Shares
              
              
              Amount
              
              
              earnings
              
              
              loss
              
              
              TotalBalance,
      December 31, 2008
              
              
              2,075,182
              
              
              $
              19,410,306
              
              
              
              (12,255
              )
              
              $
              (351,665
              )
              
              $
              38,126,250
              
              
              $
              (8,224,240
              )
              
              $
              48,960,651Cumulative
      effect of change in accounting principle
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              350,720
              
              
              
              (350,720
              )
              
              
              -Total
      comprehensive income:Net
      loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (1,473,469
              )
              
              
              
              
              
              
              (1,473,469
              )Change
      in net unrealized holding losses on available-for-sale securities, net of
      reclassification adjustment and net of tax adjustments of
      $2,499,696
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              4,852,351
              
              
              
              4,852,351Non-credit
      related impairment losses on investment securities not expected to be
      sold, net of tax adjustments of $1,372,400
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (2,664,070
              )
              
              
              (2,664,070
              )Change
      in cash flow hedge intrinsic value
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (560,956
              )
              
              
              (560,956
              )Comprehensive
      income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              153,856Issuance
      of common stock through Employee StockPurchase
      Plan
              
              
              1,701
              
              
              
              40,569
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              40,569Purchase
      of treasury stock
              
              
              
              
              
              
              
              
              
              
              (2,500
              )
              
              
              (56,505
              )
              
              
              
              
              
              
              
              
              
              
              (56,505
              )Issuance
      of common stock through DividendReinvestment
      Plan
              
              
              16,430
              
              
              
              320,269
              
              
              
              14,755
              
              
              
              408,170
              
              
              
              (112,329
              )
              
              
              
              
              
              
              616,110Stock-based
      compensation expense
              
              
              
              
              
              
              4,508
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              4,508Cash
      dividends declared
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (1,554,842
              )
              
              
              
              
              
              
              (1,554,842
              )Balance,
      September 30, 2009
              
              
              2,093,313
              
              
              $
              19,775,652
              
              
              
              -
              
              
              $
              -
              
              
              $
              35,336,330
              
              
              $
              (6,947,635
              )
              
              $
              48,164,347Balance,
      December 31, 2009
              
              
              2,105,860
              
              
              $
              19,982,677
              
              
              
              -
              
              
              $
              -
              
              
              $
              34,886,265
              
              
              $
              (9,194,395
              )
              
              $
              45,674,547Total
      comprehensive income:Net
      income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              1,629,795
              
              
              
              
              
              
              
              1,629,795Change
      in net unrealized holding losses on available-for-sale securities, net of
      reclassification adjustment and net of tax adjustments of
      $1,766,721
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              3,429,518
              
              
              
              3,429,518Non-credit
      related impairment losses on investment securities not expected to be
      sold, net of tax adjustments of $655,440
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (1,272,323
              )
              
              
              (1,272,323
              )Comprehensive
      income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              3,786,990Issuance
      of common stock through Employee StockPurchase
      Plan
              
              
              4,754
              
              
              
              67,367
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              67,367Issuance
      of common stock through DividendReinvestment
      Plan
              
              
              53,004
              
              
              
              735,916
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              735,916Stock-based
      compensation expense
              
              
              
              
              
              
              7,485
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              7,485Cash
      dividends declared
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (1,596,832
              )
              
              
              
              
              
              
              (1,596,832
              )Balance,
      September 30, 2010
              
              
              2,163,618
              
              
              $
              20,793,445
              
              
              
              -
              
              
              $
              -
              
              
              $
              34,919,228
              
              
              $
              (7,037,200
              )
              
              $
              48,675,473


See notes
to unaudited consolidated financial statements
  -5-




FIDELITY DEPOSIT & DISCOUNT BANCORP, INC. AND
      SUBSIDIARYConsolidated
      Statements of Cash Flows(Unaudited)




Nine
      months ended September 30,2010
              
              
              2009Cash
      flows from operating activities:Net
      income (loss)
              
              $
              1,629,795
              
              
              $
              (1,473,469
              )Adjustments
      to reconcile net income (loss) to cash flows fromoperating
      activities:Depreciation,
      amortization and accretion
              
              
              1,484,101
              
              
              
              1,130,120Provision
      for loan losses
              
              
              1,250,000
              
              
              
              3,850,000Deferred
      income tax benefit
              
              
              (703,673
              )
              
              
              (1,211,999
              )Stock-based
      compensation expense
              
              
              7,485
              
              
              
              4,508Loss
      from investment in limited partnership
              
              
              -
              
              
              
              40,961Proceeds
      from sale of loans held-for-sale
              
              
              37,806,323
              
              
              
              90,195,545Originations
      of loans held-for-sale
              
              
              (33,780,457
              )
              
              
              (79,702,670
              )Write-down
      of foreclosed assets held-for-sale
              
              
              39,700
              
              
              
              77,560Increase
      in cash surrender value of life insurance
              
              
              (230,551
              )
              
              
              (230,777
              )Net
      gain from sales of loans
              
              
              (439,735
              )
              
              
              (957,777
              )Net
      gain from sales of foreclosed assets held-for-sale
              
              
              (57,550
              )
              
              
              (33,667
              )Loss
      from disposal of equipment
              
              
              23,530
              
              
              
              41,241Other-than-temporary
      impairment on securities
              
              
              2,503,596
              
              
              
              2,757,861Change
      in:Accrued
      interest receivable
              
              
              (74,406
              )
              
              
              (285,893
              )Other
      assets
              
              
              (67,783
              )
              
              
              (1,262,594
              )Accrued
      interest payable and other liabilities
              
              
              457,725
              
              
              
              22,564Net
      cash provided by operating activities
              
              
              9,848,100
              
              
              
              12,961,514Cash
      flows from investing activities:Held-to-maturity
      securities:Proceeds
      from maturities, calls and principal pay-downs
              
              
              173,443
              
              
              
              169,017Available-for-sale
      securities:Proceeds
      from maturities, calls and principal pay-downs
              
              
              29,266,139
              
              
              
              30,396,495Purchases
              
              
              (39,288,074
              )
              
              
              (28,383,313
              )Net
      decrease (increase) in loans and leases
              
              
              2,930,070
              
              
              
              (85,653
              )Acquisition
      of bank premises and equipment
              
              
              (623,134
              )
              
              
              (808,304
              )Proceeds
      from sale of foreclosed assets held-for-sale
              
              
              570,605
              
              
              
              510,554Net
      cash (used in) provided by investing activities
              
              
              (6,970,951
              )
              
              
              1,798,796Cash
      flows from financing activities:Net
      increase in deposits
              
              
              31,888,469
              
              
              
              43,946,639Net
      increase (decrease) in short-term borrowings
              
              
              5,271,152
              
              
              
              (32,891,247
              )Repayments
      of long-term debt
              
              
              -
              
              
              
              (20,000,000
              )Purchase
      of treasury stock
              
              
              -
              
              
              
              (56,505
              )Proceeds
      from Employee Stock Purchase Plan participants
              
              
              67,367
              
              
              
              40,569Dividends
      paid, net of dividends reinvested
              
              
              (1,067,807
              )
              
              
              (938,732
              )Proceeds
      from Dividend Reinvestment Plan participants
              
              
              206,891
              
              
              
              -Net
      cash provided by (used in) financing activities
              
              
              36,366,072
              
              
              
              (9,899,276
              )Net
      increase in cash and cash equivalents
              
              
              39,243,221
              
              
              
              4,861,034Cash
      and cash equivalents, beginning
              
              
              8,327,954
              
              
              
              12,771,147Cash
      and cash equivalents, ending
              
              $
              47,571,175
              
              
              $
              17,632,181


See notes to unaudited consolidated financial statements -6-


FIDELITY
D & D BANCORP, INC.





Notes
to Consolidated Financial Statements


(Unaudited)




1.   Nature
of operations and critical accounting policies




Nature of
operations




Fidelity
Deposit and Discount Bank (the Bank) is a commercial bank chartered in the
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 Bank is committed to provide superior customer
service, while offering a full range of banking products and financial and trust
services to both our consumer and commercial customers from our main office
located in Dunmore and other branches located throughout Lackawanna and Luzerne
counties.




Principles of
consolidation




The
accompanying unaudited consolidated financial statements of the Company and the
Bank have been prepared in accordance with accounting principles generally
accepted in the United States of America (GAAP) for interim financial
information and with the instructions to this Form 10-Q and Rule 8-03 of
Regulation S-X.  Accordingly, they do not include all of the
information and footnote disclosures required by GAAP for complete financial
statements.  In the opinion of management, all normal recurring
adjustments necessary for a fair presentation of the financial condition and
results of operations for the periods have been included.  All
significant inter-company balances and transactions have been eliminated in
consolidation.




The
preparation of financial statements in conformity with GAAP requires management
to make estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reported periods.  Actual results could differ from those
estimates.  For additional information and disclosures required under
GAAP, refer to the Company’s Annual Report on Form 10-K for the year ended
December 31, 2009.




Management
is responsible for the fairness, integrity and objectivity of the unaudited
financial statements included in this report.  Management prepared the
unaudited financial statements in accordance with GAAP.  In meeting
its responsibility for the financial statements, management depends on the
Company's accounting systems and related internal controls.  These
systems and controls are designed to provide reasonable but not absolute
assurance that the financial records accurately reflect the transactions of the
Company, the Company’s assets are safeguarded and that the financial statements
present fairly the financial condition and results of operations of the
Company.




In the
opinion of management, the consolidated balance sheets as of September 30, 2010
and December 31, 2009 and the related consolidated statements of income for the
three- and nine-month periods ended September 30, 2010 and 2009 and changes in
shareholders’ equity and cash flows for the nine months ended September 30, 2010
and 2009 present fairly the financial condition and results of operations of the
Company.  All material adjustments required for a fair presentation
have been made.  These adjustments are of a normal recurring
nature.




This
Quarterly Report on Form 10-Q should be read in conjunction with the Company’s
audited financial statements for the year ended December 31, 2009, and the notes
included therein, included within the Company’s Annual Report filed on Form
10-K.




Critical accounting
policies




The
presentation of financial statements in conformity with GAAP requires management
to make estimates and assumptions that affect many of the reported amounts and
disclosures.  Actual results could differ from these
estimates.




A
material estimate that is particularly susceptible to significant change relates
to the determination of the allowance for loan losses.  Management
believes that the allowance for loan losses at September 30, 2010 is adequate
and reasonable.  Given the subjective nature of identifying and
valuing loan losses, it is likely that well-informed individuals could make
different assumptions, and could, therefore calculate a materially different
allowance value.  While management uses available information to
recognize losses on loans, changes in economic conditions may necessitate
revisions in the future.  In addition, various regulatory agencies, as
an integral part of their examination process, periodically review the Company’s
allowance for loan losses.  Such agencies may require the Company to
recognize adjustments to the allowance based on their judgment of information
available to them at the time of their examination.




Another
material estimate is the calculation of fair values of the Company’s investment
securities.  Except for the Company’s investment in corporate bonds,
consisting of pooled trust preferred securities, fair values of the other
investment securities are determined by prices provided by a third-party vendor
who is a provider of financial market data, analytics and related services to
financial institutions.  For the pooled trust preferred securities,
management is unable to obtain readily attainable and realistic pricing from
market traders due to lack of active market participants and therefore
management has determined the market for these securities to be
inactive.  In order to determine the fair value of the pooled trust
preferred securities, management relied on the use of an income valuation
approach (present value technique) that maximizes the use of observable inputs
and minimizes the use of unobservable inputs, the results of which are more
representative of fair value than the market approach valuation technique used
for the other investment securities.




-7-




Based on
experience, management is aware that estimated fair values of investment
securities tend to vary among valuation services.  Accordingly, when
selling investment securities, price quotes from more than one source may be
obtained.  The majority of the Company’s investment securities are
classified as available-for-sale (AFS).  AFS securities are carried at
fair value on the consolidated balance sheet, with unrealized gains and losses,
net of income tax, reported separately within shareholders’ equity through
accumulated other comprehensive income (loss).




The fair
value of residential mortgage loans, classified as held-for-sale (HFS), is
obtained from the Federal National Mortgage Association (FNMA) or the Federal
Home Loan Bank (FHLB).  Generally, the market to which the Company
sells mortgages it originates for sale is restricted and price quotes from other
sources are not typically obtained.  On occasion, the Company may
transfer loans from the loan and lease portfolio to loans HFS.  Under
these rare circumstances, pricing may be obtained from other entities and the
loans are transferred at the lower of cost or market value and simultaneously
sold.  For a further discussion on the accounting treatment of loans
HFS, see the section entitled “Loans held-for-sale,” contained within
management’s discussion and analysis.




For
purposes of reporting cash flows, cash and cash equivalents includes cash on
hand, amounts due from banks and interest-bearing deposits with financial
institutions.  For the nine months ended September 30, 2010 and 2009,
the Company paid interest of $5,365,000 and $9,140,000,
respectively.  The Company paid income taxes during the first nine
months of 2010 of $575,000, and $675,000 for the nine months ended September 30,
2009.  Transfers from loans to foreclosed assets held-for-sale
amounted to $1,053,000 and $470,000 during the first nine months of 2010 and
2009, respectively.  Transfers from loans to loans HFS amounted to
$3,706,000 and $11,140,000 during the nine months ended 2010 and 2009,
respectively.  Expenditures for construction in process, a component
of other assets in the consolidated balance sheets, are included in acquisition
of bank premises and equipment.




2.  New
Accounting Pronouncements




During
the first quarter of 2010, the Company adopted the new accounting guidance
related to the transfers and servicing of financial assets.  The
standard eliminates the concept of qualifying special purpose entities, provides
guidance as to when a portion of a transferred financial asset should be
evaluated for sale accounting, provides additional guidance with regard to
accounting for transfers of financial assets and requires additional
disclosures.  The adoption of the new accounting guidance did not have
a material impact on the Company’s consolidated financial
statements.




During
the first quarter of 2010, the Company adopted the amended accounting guidance
related to fair value measurements which entails new disclosures and clarifies
disclosure requirements about fair value measurement as set forth in previous
guidance.  The objective is to improve these disclosures and, thus,
increase the transparency in financial reporting.  Specifically, an
entity is required to disclose separately the amounts of significant transfers
in and out of Level 1 and Level 2 fair value measurements and describe the
reasons for the transfers; and in the reconciliation for fair value measurements
using significant unobservable inputs, a reporting entity should present
separately information about purchases, sales, issuances, and
settlements.  The amended guidance also clarifies the requirements of
the following disclosures: for purposes of reporting fair value measurement for
each class of assets and liabilities, a reporting entity needs to use judgment
in determining the appropriate classes of assets and liabilities; and a
reporting entity should provide disclosures about the valuation techniques and
inputs used to measure fair value for both recurring and non-recurring fair
value measurements.  The new guidance became effective for interim and
annual reporting periods beginning after December 15, 2009, except for the
disclosures about purchases, sales, issuances, and settlements in the roll
forward of activity in Level 3 fair value measurements.  Those
disclosures will become effective for fiscal years beginning after December 15,
2010, and for interim periods within those fiscal years.




In July
2010, the FASB issued new guidance on disclosures about the credit quality of
financing receivables and the allowance for credit losses.  The new
disclosure guidance will significantly expand the existing requirements for
greater transparency into a company's exposure to credit losses from lending
type arrangements.  The objectives of the expanded disclosures are to
provide information that will enable readers of financial statements to
understand the nature of credit risk in a company's financing receivables, how
that risk is analyzed in determining the related allowance for credit losses and
changes to the allowance during the reporting period.  The new
guidance applies to all companies.  The extensive new disclosures of
information as of the end of a reporting period will become effective for both
interim and annual reporting periods ending after December 15, 2010 for public
companies.  Specific items regarding activity that occurred before the
issuance of the new guidance, such as the allowance roll forward and
modification disclosures will be required for periods beginning after December
15, 2010 for public companies.




-8-




3.
Investment securities




The
amortized cost and fair value of investment securities at September 30, 2010 and
December 31, 2009 are summarized as follows (dollars in thousands):




September
      30, 2010Amortized
              
              
              Gross
      unrealized
              
              
              Gross
      unrealized
              
              
              Faircost
              
              
              gains
              
              
              losses
              
              
              valueHeld-to-maturity
      securities:MBS
      - GSE residential
              
              $
              535
              
              
              $
              50
              
              
              $
              -
              
              
              $
              585Available-for-sale
      securities:Agency
      - GSE
              
              $
              17,311
              
              
              $
              193
              
              
              $
              81
              
              
              $
              17,423Obligations
      of states andpolitical
      subdivisions
              
              
              23,248
              
              
              
              1,167
              
              
              
              -
              
              
              
              24,415Corporate
      bonds:Pooled
      trust preferred securities
              
              
              16,360
              
              
              
              -
              
              
              
              12,634
              
              
              
              3,726MBS
      - GSE residential
              
              
              40,142
              
              
              
              680
              
              
              
              105
              
              
              
              40,717Total
      debt securities
              
              
              97,061
              
              
              
              2,040
              
              
              
              12,820
              
              
              
              86,281Equity
      securities - financial services
              
              
              322
              
              
              
              117
              
              
              
              -
              
              
              
              439Total
      available-for-sale securities
              
              $
              97,383
              
              
              $
              2,157
              
              
              $
              12,820
              
              
              $
              86,720




December
      31, 2009Amortized
              
              
              Gross
      unrealized
              
              
              Gross
      unrealized
              
              
              Faircost
              
              
              gains
              
              
              losses
              
              
              valueHeld-to-maturity
      securities:MBS
      - GSE residential
              
              $
              709
              
              
              $
              56
              
              
              $
              -
              
              
              $
              765Available-for-sale
      securities:Agency
      - GSE
              
              $
              34,205
              
              
              $
              4
              
              
              $
              1,077
              
              
              $
              33,132Obligations
      of states andpolitical
      subdivisions
              
              
              23,013
              
              
              
              394
              
              
              
              137
              
              
              
              23,270Corporate
      bonds:Pooled
      trust preferred securities
              
              
              18,794
              
              
              
              -
              
              
              
              13,552
              
              
              
              5,242MBS
      - GSE residential
              
              
              13,418
              
              
              
              401
              
              
              
              71
              
              
              
              13,748Total
      debt securities
              
              
              89,430
              
              
              
              799
              
              
              
              14,837
              
              
              
              75,392Equity
      securities - financial services
              
              
              322
              
              
              
              121
              
              
              
              14
              
              
              
              429Total
      available-for-sale securities
              
              $
              89,752
              
              
              $
              920
              
              
              $
              14,851
              
              
              $
              75,821




-9-




The
amortized cost and fair value of debt securities at September 30, 2010 by
contractual maturity are summarized below (dollars in
thousands):




Amortized
              
              
              Marketcost
              
              
              valueHeld-to-maturity
      securities:MBS
      - GSE residential
              
              $
              535
              
              
              $
              585Available-for-sale
      securities:Debt
      securities:Due
      in one year or less
              
              $
              6,239
              
              
              $
              6,156Due
      after one year through five years
              
              
              1,000
              
              
              
              1,001Due
      after five years through ten years
              
              
              4,151
              
              
              
              4,228Due
      after ten years
              
              
              45,529
              
              
              
              34,179Total
      debt securities
              
              
              56,919
              
              
              
              45,564MBS
      - GSE residential
              
              
              40,142
              
              
              
              40,717Total
      available-for-sale debt securities
              
              $
              97,061
              
              
              $
              86,281




Expected
maturities will differ from contractual maturities because issuers and borrowers
may have the right to call or repay obligations with or without call or
prepayment penalty.  Federal agency and municipal securities are
included based on their original stated maturity.  Mortgage-backed
securities, which are based on weighted-average lives and subject to monthly
principal pay-downs, are listed in total.




The
following tables present the fair value and gross unrealized losses of
investment securities aggregated by investment type, the length of time and the
number of securities that have been in a continuous unrealized loss position as
of September 30, 2010 and December 31, 2009 (dollars in thousands):




September
      30, 2010Less
      than 12 months
              
              
              More
      than 12 months
              
              
              TotalFair
              
              
              Unrealized
              
              
              Fair
              
              
              Unrealized
              
              
              Fair
              
              
              Unrealizedvalue
              
              
              losses
              
              
              value
              
              
              losses
              
              
              value
              
              
              lossesAgency
      - GSE
              
              $
              -
              
              
              $
              -
              
              
              $
              6,006
              
              
              $
              81
              
              
              $
              6,006
              
              
              $
              81Corporate
      bonds:Pooled
      trust preferred securities
              
              
              -
              
              
              
              -
              
              
              
              3,726
              
              
              
              12,634
              
              
              
              3,726
              
              
              
              12,634MBS
      - GSE residential
              
              
              19,884
              
              
              
              105
              
              
              
              -
              
              
              
              -
              
              
              
              19,884
              
              
              
              105Total
      temporarily impaired securities
              
              $
              19,884
              
              
              $
              105
              
              
              $
              9,732
              
              
              $
              12,715
              
              
              $
              29,616
              
              
              $
              12,820Number
      of securities
              
              
              9
              
              
              
              
              
              
              
              14
              
              
              
              
              
              
              
              23




December
      31, 2009Less
      than 12 months
              
              
              More
      than 12 months
              
              
              TotalFair
              
              
              Unrealized
              
              
              Fair
              
              
              Unrealized
              
              
              Fair
              
              
              Unrealizedvalue
              
              
              losses
              
              
              value
              
              
              losses
              
              
              value
              
              
              lossesAgency
      - GSE
              
              $
              21,090
              
              
              $
              291
              
              
              $
              5,038
              
              
              $
              786
              
              
              $
              26,128
              
              
              $
              1,077Obligations
      of states andpolitical
      subdivisions
              
              
              3,534
              
              
              
              115
              
              
              
              2,600
              
              
              
              22
              
              
              
              6,134
              
              
              
              137Corporate
      bonds:Pooled
      trust preferred securities
              
              
              -
              
              
              
              -
              
              
              
              5,242
              
              
              
              13,552
              
              
              
              5,242
              
              
              
              13,552MBS
      - GSE residential
              
              
              5,055
              
              
              
              71
              
              
              
              -
              
              
              
              -
              
              
              
              5,055
              
              
              
              71Total
      debt securities
              
              
              29,679
              
              
              
              477
              
              
              
              12,880
              
              
              
              14,360
              
              
              
              42,559
              
              
              
              14,837Equity
      securities - financial services
              
              
              114
              
              
              
              10
              
              
              
              46
              
              
              
              4
              
              
              
              160
              
              
              
              14Total
      temporarily impaired securities
              
              $
              29,793
              
              
              $
              487
              
              
              $
              12,926
              
              
              $
              14,364
              
              
              $
              42,719
              
              
              $
              14,851Number
      of securities
              
              
              23
              
              
              
              
              
              
              
              17
              
              
              
              
              
              
              
              40




Management
conducts a formal review of investment securities on a quarterly basis for the
presence of other-than-temporary impairment (OTTI).  The accounting
guidance related to OTTI requires the Company to assess whether OTTI is present
when the fair value of a debt security is less than its amortized cost as of the
balance sheet date.  Under these circumstances, OTTI is considered to
have occurred if: (1) the entity has intent to sell the security;
(2) more likely than not the entity will be required to sell the security
before recovery of its amortized cost basis; or (3) the present value of
expected cash flows is not sufficient to recover the entire amortized
cost.




-10-




The
accounting guidance requires that credit-related OTTI be recognized in earnings
while non-credit-related OTTI on securities not expected to be sold be
recognized in other comprehensive income (OCI).  Non-credit-related
OTTI is based on other factors effecting market conditions, including
illiquidity.  The presentation of OTTI is made in the consolidated
statements of income on a gross basis with an offset for the amount of
non-credit-related OTTI recognized in OCI.




The
Company’s OTTI evaluation process also follows the guidance set forth in topics
related to debt and equity securities.  The guidance set forth in
these pronouncements requires the Company to take into consideration current
market conditions, fair value in relationship to cost, extent and nature of
changes in fair value, issuer rating changes and trends, volatility of earnings,
current analysts’ evaluations, all available information relevant to the
collectability of debt securities, the ability and intent to hold investments
until a recovery of fair value, which may be maturity, and other factors when
evaluating for the existence of OTTI.  This guidance also eliminates
the requirement that a holder’s best estimate of cash flows is based upon those
that a market participant would use.  Instead, the guidance requires
that OTTI be recognized as a realized loss through earnings when there has been
an adverse change in the holder’s expected cash flows such that the full amount
(principal and interest) will probably not be received.  This
requirement is consistent with the impairment model in the guidance for
accounting for debt and equity securities.




For all
security types discussed below, at September 30, 2010 the Company applied the
criteria provided in the recognition and presentation of OTTI
guidance.  That is, management has no intent to sell the securities
and no conditions were identified by management that more likely than not would
require the Company to sell the securities before recovery of their amortized
cost basis.  The results indicated there was no presence of OTTI for
the Company’s portfolios of Agency – Government Sponsored Enterprise (GSE),
Mortgage-backed securities (MBS) – GSE residential and Obligations of states and
political subdivisions.




Agency - GSE and MBS - GSE
residential


Agency –
GSE and MBS – GSE residential securities consist of medium and long-term notes
issued by Federal Home Loan Mortgage Corporation (FHLMC), Federal National
Mortgage Association (FNMA), Federal Home Loan Bank (FHLB) and Government
National Mortgage Association (GNMA).  These securities have interest
rates that are largely fixed-rate issues, have varying mid- to long-term
maturity dates and have contractual cash flows guaranteed by the U.S. government
or agencies of the U.S. government.




Obligations of states and
political subdivisions


The
municipal securities are bank qualified, general obligation bonds rated as
investment grade by various credit rating agencies and have fixed rates of
interest with mid- to long-term maturities.  Fair values of these
securities are highly driven by interest rates.  Management performs
ongoing credit quality reviews on these issues.




In all of
the above security types, the decline in fair value is attributable to changes
in interest rates and not credit quality.  Consequently, no OTTI is
considered necessary for these securities at September 30, 2010.




Pooled trust preferred
securities


A Pooled
Trust Preferred Collateralized Debt Obligation (CDO) is a type of investment
security collateralized by trust preferred securities (TPS) issued by banks,
insurance companies and real estate investment trusts (REITs).  The
primary collateral type is a TPS issued by a bank.  A TPS is a
hybrid security with both debt and equity characteristics such as the ability to
voluntarily defer interest payments for up to 20 consecutive
quarters.  A TPS is considered a junior security in the capital
structure of the issuer.




There are
various tranches or investment classes issued by
the CDO with the most senior tranche having the lowest yield but
the most protection from credit losses compared to other tranches
that are subordinate.  Losses are generally allocated from the lowest
tranche with the equity component holding the most risk and then subordinate
tranches in reverse order up to the senior tranche.  The allocation of
losses is defined in the indenture when the CDO was formed.




Unrealized
losses in the pooled trust preferred securities (PreTSLs) are caused mainly by
the following factors: (1) collateral deterioration due to bank failures
and credit concerns across the banking sector; (2) widening of credit
spreads and (3) illiquidity in the market.  The Company’s review
of these securities, in accordance with the previous discussion, determined that
in 2010, credit-related OTTI be recorded on six holdings of these securities all
of which are in the AFS securities portfolio.




-11-




The
following table summarizes the amount of OTTI recognized in earnings, by
security during the periods indicated (dollars in thousands):




Three
      months ended
              
              
              Nine
      months endedSeptember 30,
              
              
              September 30,2010
              
              
              2009
              
              
              2010
              
              
              2009Pooled
      trust preferred securities:PreTSL
      V, Mezzanine
              
              $
              122
              
              
              $
              -
              
              
              $
              122
              
              
              $
              -PreTSL
      VII, Mezzanine
              
              
              -
              
              
              
              325
              
              
              
              86
              
              
              
              651PreTSL
      IX, B1, B3
              
              
              -
              
              
              
              690
              
              
              
              -
              
              
              
              690PreTSL
      XI, B3
              
              
              -
              
              
              
              -
              
              
              
              60
              
              
              
              -PreTSL
      XV, B1
              
              
              285
              
              
              
              154
              
              
              
              285
              
              
              
              154PreTSL
      XVI, C
              
              
              681
              
              
              
              756
              
              
              
              1,290
              
              
              
              756PreTSL
      XVII, C
              
              
              661
              
              
              
              -
              
              
              
              661
              
              
              
              -PreTSL
      XXV, C1
              
              
              -
              
              
              
              507
              
              
              
              -
              
              
              
              507Total
              
              $
              1,749
              
              
              $
              2,432
              
              
              $
              2,504
              
              
              $
              2,758


The
following table is a tabular roll-forward of the cumulative amount of
credit-related OTTI recognized in earnings (dollars in thousands):




Inception
      toSeptember 30, 2010HTM
              
              
              AFS
              
              
              TotalBalance
      of credit-related OTTI - December 31, 2009
              
              $
              -
              
              
              $
              (3,198
              )
              
              $
              (3,198
              )Additions
      for credit-related OTTInot
      previously recognized
              
              
              -
              
              
              
              (843
              )
              
              
              (843
              )Additional
      credit-related OTTIpreviously
      recognized when thereis
      no intent to sell before recoveryof
      amortized cost basis
              
              
              -
              
              
              
              (1,661
              )
              
              
              (1,661
              )Ending
      balance of credit-related OTTI
              
              $
              -
              
              
              $
              (5,702
              )
              
              $
              (5,702
              )


To
determine the ending balance of credit-related OTTI, the Company uses discounted
present value cash flow analysis and compares the results with the bond’s face
value.  The analysis considered the following assumptions: the
discount rate which equated to the discount margin for each tranche (credit
spread) at the time of purchase which was then added to the appropriate
three-month Libor forward rate obtained from the forward Libor curve; historical
average default rates obtained from the FDIC for U.S. Banks and Thrifts for the
period spanning 1988 to 1991 increased by a factor of three and rolled forward
to project a rate of default of approximately one-third; the default rate was
reduced by the actual deferrals/defaults experienced in all preferred term
securities from 2008 through 2009; the remaining estimated default rate was then
stratified with higher default rates occurring in the beginning of 2010
regressing to normal in 2011, with an estimated 15% recovery by way of a two
year lag; and no prepayments of principal.




Two of
the Company’s initial mezzanine holdings (PreTSLs IV and V) are now senior
tranches and the remaining holdings are mezzanine tranches.  As of
September 30, 2010, none of the pooled trust preferred securities were
investment grade.  At the time of initial issue, the subordination in
the Company’s tranches ranged in size from approximately 8.0% to 25.9% of the
total principal amount of the respective securities and no more than 5% of any
pooled trust preferred security consisted of a security issued by any one bank
and 4% for insurance companies.  As of September 30, 2010, management
estimates the subordination in the Company’s tranches ranging from 0% to 19.2%
of the current performing collateral.  During the nine months of 2010,
PreTSL IX with a book value of $2.8 million and corresponding fair value of $1.1
million, and PreTSL XVII with a book value of $353,000 and no corresponding fair
value were placed on non-accrual status.




-12-




The
following table is the composition of the Company’s non-accrual PreTSL
securities as of the period indicated (dollars in thousands):




September
      30, 2010
              
              
              December
      31, 2009Book
              
              
              Fair
              
              
              Book
              
              
              FairDeal
              
              Class
              
              
              value
              
              
              value
              
              
              value
              
              
              valuePreTSL
      VII
              
              Mezzanine
              
              
              $
              332
              
              
              $
              154
              
              
              $
              432
              
              
              $
              219PreTSL  IX
              
              B-1,B-3
              
              
              
              2,765
              
              
              
              1,119
              
              
              
              -
              
              
              
              -PreTSL  XV
              
              B-1
              
              
              
              1,075
              
              
              
              125
              
              
              
              1,359
              
              
              
              297PreTSL
      XVI
              
              C
              
              
              
              -
              
              
              
              -
              
              
              
              1,290
              
              
              
              65PreTSL
      XVII
              
              C
              
              
              
              353
              
              
              
              -
              
              
              
              -
              
              
              
              -PreTSL
      XXV
              
              C-1
              
              
              
              507
              
              
              
              -
              
              
              
              507
              
              
              
              2$
              5,032
              
              
              $
              1,398
              
              
              $
              3,588
              
              
              $
              583


The
securities included in the above table, have experienced impairment of
principal, and interest was “paid-in-kind”.  On a quarterly basis,
each of the other issues will be evaluated for the presence of these two
conditions and placed on non-accrual status if necessary.




The following table provides additional
information with respect to the Company’s pooled trust preferred securities as
of September 30, 2010 (dollars in thousands):




Deal
              
              Class
              
              
              Book
      value
              
              
              Fair
      value
              
              
              Unrealized
      loss
              
              
              Moody's
      / Fitch ratings
              
              
              Current
      number of
                banks
      /
                insurance
      companies
              
              
              Actual
      Actual deferrals and defaults
              
              
              Actual
      deferrals and defaults as a % of current collateral
              
              
              Excess
      subordination
              
              
              Excess
      subordination* as a % of current performing collateral
              
              
              Effective
      subordination** as a % of current performing collateralPreTSL  IV
              
              Mezzanine
              
              
              $
              610
              
              
              $
              421
              
              
              $
              (189
              )
              
              Ca /
      CCC
              
              
              
              6 /
      -
              
              
              
              18,000
              
              
              
              27.1
              
              
              
              9,889
              
              
              
              19.2
              
              
              
              35.0PreTSL  V
              
              Mezzanine
              
              
              
              151
              
              
              
              151
              
              
              
              -
              
              
              Ba3
      / D
              
              
              
              3 /
      -
              
              
              
              28,950
              
              
              
              100.0
              
              
              None
              
              
              
              N/A
              
              
              
              N/APreTSL
      VII
              
              Mezzanine
              
              
              
              332
              
              
              
              154
              
              
              
              (178
              )
              
              Ca /
      C
              
              
              
              19 /
      -
              
              
              
              160,000
              
              
              
              70.5
              
              
              None
              
              
              
              N/A
              
              
              
              N/APreTSL  IX
              
              B-1,B-3
              
              
              
              2,766
              
              
              
              1,118
              
              
              
              (1,648
              )
              
              Ca /
      C
              
              
              
              49 /
      -
              
              
              
              131,510
              
              
              
              29.2
              
              
              None
              
              
              
              N/A
              
              
              
              N/APreTSL
      XI
              
              B-3
              
              
              
              2,341
              
              
              
              769
              
              
              
              (1,572
              )
              
              Ca /
      C
              
              
              
              65 /
      -
              
              
              
              142,780
              
              
              
              23.7
              
              
              None
              
              
              
              N/A
              
              
              
              6.9PreTSL  XV
              
              B-1
              
              
              
              1,075
              
              
              
              125
              
              
              
              (950
              )
              
              Ca /
      C
              
              
              
              63 /
      9
              
              
              
              209,450
              
              
              
              35.0
              
              
              None
              
              
              
              N/A
              
              
              
              N/APreTSL
      XVI
              
              C
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              Ca /
      C
              
              
              
              49 /
      7
              
              
              
              251,190
              
              
              
              43.6
              
              
              None
              
              
              
              N/A
              
              
              
              N/APreTSL
      XVII
              
              C
              
              
              
              353
              
              
              
              -
              
              
              
              (353
              )
              
              Ca /
      C
              
              
              
              51 /
      6
              
              
              
              187,670
              
              
              
              39.6
              
              
              None
              
              
              
              N/A
              
              
              
              N/APreTSL
      XVIII
              
              C
              
              
              
              1,017
              
              
              
              64
              
              
              
              (953
              )
              
              Ca /
      C
              
              
              
              66 /
      14
              
              
              
              158,140
              
              
              
              23.4
              
              
              None
              
              
              
              N/A
              
              
              
              4.8PreTSL
      XIX
              
              C
              
              
              
              2,566
              
              
              
              180
              
              
              
              (2,386
              )
              
              C /
      C
              
              
              
              60 /
      14
              
              
              
              172,400
              
              
              
              24.6
              
              
              None
              
              
              
              N/A
              
              
              
              5.1PreTSL
      XXIV
              
              B-1
              
              
              
              2,245
              
              
              
              194
              
              
              
              (2,051
              )
              
              Caa3
      / CC
              
              
              
              80 /
      13
              
              
              
              374,800
              
              
              
              35.7
              
              
              None
              
              
              
              N/A
              
              
              
              10.0PreTSL
      XXV
              
              C-1
              
              
              
              507
              
              
              
              -
              
              
              
              (507
              )
              
              C /
      C
              
              
              
              64 /
      9
              
              
              
              285,600
              
              
              
              32.6
              
              
              None
              
              
              
              N/A
              
              
              
              0.3PreTSL
      XXVII
              
              B
              
              
              
              2,397
              
              
              
              550
              
              
              
              (1,847
              )
              
              Ca /
      CC
              
              
              
              42 /
      7
              
              
              
              95,800
              
              
              
              29.4
              
              
              None
              
              
              
              N/A
              
              
              
              19.9$
              16,360
              
              
              $
              3,726
              
              
              $
              (12,634
              )





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




**
            Effective
      subordination represents the estimated percentage of the performing
      collateral that would need to defer or default at the next payment in
      order to trigger a loss of principal or interest.  This differs
      from excess subordination in that it considers the effect of excess
      interest earned on the performing
collateral.




For a
further discussion on the fair value determination of the Company’s investment
in pooled trust preferred securities, see “Investment securities” under the
caption “Comparison of financial condition at September 30, 2010 and December
31, 2009” of Part 1, Item 2, “Management’s Discussion and Analysis of Financial
Condition and Results of Operations”; below.




4.  Earnings
(loss) per share




Basic
earnings (loss) per share (EPS) is computed by dividing income available to
common shareholders by the weighted-average number of common stock outstanding
for the period.  Diluted EPS is computed in the same manner as basic
EPS but reflects the potential dilution that could occur if stock options to
issue additional common stock were exercised, which would then result in
additional stock outstanding to share in or dilute the earnings of the
Company.  The Company maintains two share-based compensation plans
that may generate additional potential dilutive common
shares.  Generally, dilution would occur if Company-issued stock
options were exercised and converted into common stock.




In the
computation of diluted EPS, the Company uses the treasury stock method to
determine the dilutive effect of its granted but unexercised stock
options.  Under the treasury stock method, the assumed proceeds
received from shares issued, in a hypothetical stock option exercise, are
assumed to be used to purchase treasury stock.  There were no
potentially dilutive shares outstanding in either period because the average
share market price of the Company’s common stock during the nine months ended
September 30, 2010 and 2009 was below the strike prices of all options
granted.  For a further discussion on the Company’s stock option
plans, see Note 5, “Stock plans,” below.




-13-




The
following table illustrates the data used in computing basic EPS and a
reconciliation to derive at the components of diluted EPS for the periods
indicated:




Three
      months ended
                September
      30,
              
              
              Nine
      months ended
                September
      30,2010
              
              
              2009
              
              
              2010
              
              
              2009Basic
      EPS:Net
      income (loss) available to common shareholders
              
              $
              354,943
              
              
              $
              (3,210,680
              )
              
              $
              1,629,795
              
              
              $
              (1,473,469
              )Weighted-average
      common shares outstanding
              
              
              2,151,880
              
              
              
              2,085,089
              
              
              
              2,132,974
              
              
              
              2,075,181Basic
      EPS
              
              $
              0.16
              
              
              $
              (1.55
              )
              
              $
              0.76
              
              
              $
              (0.71
              )Diluted
      EPS:Net
      income (loss) available to common shareholders
              
              $
              354,943
              
              
              $
              (3,210,680
              )
              
              $
              1,629,795
              
              
              $
              (1,473,469
              )Weighted-average
      common shares outstanding
              
              
              2,151,880
              
              
              
              2,085,089
              
              
              
              2,132,974
              
              
              
              2,075,181Potentially
      dilutive common shares
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Weighted-average
      common shares and dilutive potential shares
              
              
              2,151,880
              
              
              
              2,085,089
              
              
              
              2,132,974
              
              
              
              2,075,181Diluted
      EPS
              
              $
              0.16
              
              
              $
              (1.55
              )
              
              $
              0.76
              
              
              $
              (0.71
              )


5.  Stock
plans




The
Company has two stock-based compensation plans (the stock option plans) and
applies the fair value method of accounting for stock-based compensation
provided under the current accounting guidance.  The guidelines
require the cost of share-based payment transactions (including those with
employees and non-employees) be recognized in the financial
statements.  The stock option plans were shareholder-approved and
permit the grant of share-based compensation awards to its directors, key
officers and certain other employees.  The Company believes that the
stock option plans better align the interest of its directors, key officers and
employees with the interest of its shareholders.  The Company further
believes that the granting of share-based awards is necessary to retain the
knowledge base, continuity and expertise of its directors, key officers and
employees.  In the stock option plans, directors, key officers and
certain other employees are eligible to be awarded stock options to purchase the
Company’s common stock at the fair market value on the date of
grant.




The
Company established the 2000 Independent Directors Stock Option Plan and has
reserved 55,000 shares of its un-issued capital stock for issuance under the
plan.  No stock options were awarded during the nine months ended
September 30, 2010 and 2009.  As of September 30, 2010, there were
21,050 unexercised stock options outstanding under this plan.




The
Company also established the 2000 Stock Incentive Plan and has reserved 55,000
shares of its un-issued capital stock for issuance under the
plan.  There were no options awarded during the nine months ended
September 30, 2010 and 2009.  As of September 30, 2010, there were
6,810 unexercised stock options outstanding under this plan.




Since no
awards were vested in either of the stock option plans during the nine months
ended September 30, 2010 and 2009, there was no stock-based compensation expense
recognized related to either of the stock option plans.




In
addition to the two stock option plans, the Company established the 2002
Employee Stock Purchase Plan (the ESPP) and reserved 110,000 shares of its
un-issued capital stock for issuance.  The plan was designed to
promote broad-based employee ownership of the Company’s stock and to motivate
employees to improve job performance and enhance the financial results of the
Company.  Under the ESPP, employees use automatic payroll withholdings
to purchase the Company’s capital stock at a discounted price based on the fair
market value of the capital stock as measured on either the commencement date or
termination date.  As of September 30, 2010, 17,025 shares have been
issued under the ESPP.  The ESPP is considered a compensatory plan and
as such, is required to comply with the provisions of authoritative accounting
guidance.  The Company recognizes compensation expense on its ESPP on
the date the shares are purchased.  For the nine months ended
September 30, 2010 and 2009, compensation expense related to the ESPP
approximated $7,000 and $5,000, respectively, and is included as a component of
salaries and employee benefits in the consolidated statements of
income.




6.  Fair value
measurements




The
accounting guidelines established a framework for measuring fair value and
enhancing disclosures about fair value measurements.  The guidelines
of fair value reporting instituted a valuation hierarchy for disclosure of the
inputs used to measure fair value.  This hierarchy prioritizes the
inputs into three broad levels as follows:




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




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




-14-




Level 3
inputs are unobservable inputs based on our own assumptions to measure assets
and liabilities at fair value.  Level 3 pricing for securities may
also include unobservable inputs based upon broker-traded
transactions.  A financial asset or liability’s classification within
the hierarchy is determined based on the lowest level input that is significant
to the fair value measurement.




The
Company uses fair value to measure certain assets and, if necessary, liabilities
on a recurring basis when fair value is the primary measure for
accounting.  Thus, the Company uses fair value for AFS
securities.  Fair value is used on a non-recurring basis to measure
certain assets when adjusting carrying values to market values, such as impaired
loans.




The
following table illustrates the financial instruments measured at fair value on
a recurring basis segregated by hierarchy fair value levels as of September 30,
2010 and December 31, 2009 (dollars in thousands):




Fair
      value measurements at September 30, 2010:Assets:
              
              Total
      carrying value at
                September 30,
                2010
              
              
              Quoted
      prices in active markets
                (Level 1)
              
              
              Significant
      other observable inputs
                (Level 2)
              
              
              Significant
      unobservable inputs
                (Level 3)Available-for-sale
      securities:Agency
      - GSE
              
              $
              17,423
              
              
              $
              -
              
              
              $
              17,423
              
              
              $
              -Obligations
      of states andpolitical
      subdivisions
              
              
              24,415
              
              
              
              -
              
              
              
              24,415
              
              
              
              -Corporate
      bonds:Pooled
      trust preferred securities
              
              
              3,726
              
              
              
              -
              
              
              
              -
              
              
              
              3,726MBS
      - GSE residential
              
              
              40,717
              
              
              
              -
              
              
              
              40,717
              
              
              
              -Equity
      securities - financial services
              
              
              439
              
              
              
              439
              
              
              
              -
              
              
              
              -Total
      available-for-sale securities
              
              $
              86,720
              
              
              $
              439
              
              
              $
              82,555
              
              
              $
              3,726







Fair
      value measurements at December 31, 2009:Assets:
              
              Total
      carrying value at
                December 31,
                2009
              
              
              Quoted
      prices in active markets
                (Level 1)
              
              
              Significant
      other observable inputs
                (Level 2)
              
              
              Significant
      unobservable inputs
                (Level 3)Available-for-sale
      securities:Agency
      - GSE
              
              $
              33,132
              
              
              $
              -
              
              
              $
              33,132
              
              
              $
              -Obligations
      of states andpolitical
      subdivisions
              
              
              23,270
              
              
              
              -
              
              
              
              23,270
              
              
              
              -Corporate
      bonds:Pooled
      trust preferred securities
              
              
              5,242
              
              
              
              -
              
              
              
              -
              
              
              
              5,242MBS
      - GSE residential
              
              
              13,748
              
              
              
              -
              
              
              
              13,748
              
              
              
              -Equity
      securities - financial services
              
              
              429
              
              
              
              429
              
              
              
              -
              
              
              
              -Total
      available-for-sale securities
              
              $
              75,821
              
              
              $
              429
              
              
              $
              70,150
              
              
              $
              5,242


Equity
securities in the AFS portfolio are measured at fair value using quoted market
prices for identical assets and are classified within Level 1 of the valuation
hierarchy.  Other than the Company’s investment in corporate bonds,
consisting of pooled
trust preferred securities, all other debt securities in the AFS portfolio are
measured at fair value using prices provided by a third-party vendor, who is a
provider of financial market data, analytics and related services to financial
institutions.  Assets classified as Level 2 use valuation techniques
that are common to bond valuations.  That is, in active markets
whereby bonds of similar characteristics frequently trade, quotes for similar
assets are obtained.  For the nine months ended September 30, 2010,
there were no transfers to and from Level 1 and Level 2 fair value measurements
for financial assets measured on a recurring basis.




The
Company’s pooled trust preferred securities include both observable and
unobservable inputs to determine fair value and, therefore, are classified as
Level 3 inputs.  For a discussion on the fair value determination of
the Company’s investment in pooled trust preferred securities, see “Investment
securities” under the caption “Comparison of Financial Condition at September
30, 2010 and December 31, 2009” in “Management’s Discussion and Analysis of
Financial Condition and Results of Operations,” below.




-15-




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




As
      of and for the nine months ended
                September 30,
                2010
              
              
              As
      of and for the nine months ended
                September 30,
                2009Assets:Balance
      at beginning of period
              
              $
              5,242
              
              
              $
              10,260Realized
      / unrealized (losses) gains:in
      earnings
              
              
              (2,504
              )
              
              
              (2,758
              )in
      comprehensive income (loss)
              
              
              988
              
              
              
              (306
              )Purchases,
      sales, issuances and settlements,amortization
      and accretion, net
              
              
              -
              
              
              
              643Balance
      at end of period
              
              $
              3,726
              
              
              $
              7,839


The
following table illustrates the financial instruments measured at fair value on
a non-recurring basis segregated by hierarchy fair value levels as of September
30, 2010 and December 31, 2009 (dollars in thousands):




Fair
      value measurements at September 30, 2010 using:Assets:
              
              Total
      carrying value at
                September 30,
                2010
              
              
              Quoted
      prices in active markets
                (Level 1)
              
              
              Significant
      other observable inputs
                (Level 2)
              
              
              Significant
      unobservable inputs
                (Level 3)Impaired
      loans
              
              $
              4,141
              
              
              $
              -
              
              
              $
              4,039
              
              
              $
              102
  Fair
      value measurements at December 31, 2009 using:Assets:
              
              Total
      carrying value at
                December 31,
                2009
              
              
              Quoted
      prices in active markets
                (Level 1)
              
              
              Significant
      other observable inputs
                (Level 2)
              
              
              Significant
      unobservable inputs
                (Level 3)Impaired
      loans
              
              $
              4,842
              
              
              $
              15
              
              
              $
              4,447
              
              
              $
              380


Impaired
loans that are collateral dependent are written down to fair value through the
establishment of specific reserves.  Techniques used to value the
collateral that secures the impaired loan include: quoted market prices for
identical assets classified as Level 1 inputs; for Level 2, observable inputs,
employed by certified appraisers for similar assets are utilized if the loan is
collateral dependent and then discounted based upon the type and/or age of the
appraisal, the costs to sell and maintain the underlying
collateral.  If the loan is not considered to be collateral dependent,
any impairment may be determined based upon the present value of the reported
cash flows discounted at the loan’s effective interest rate.  In cases
where valuation techniques included inputs that are unobservable, the valuations
are based on commonly used and generally accepted industry liquidation advance
rates or estimates and assumptions developed by management, with significant
adjustments applied to the best information available under each
circumstance.  These asset valuations are classified as Level 3
inputs.  A net reduction or transfer out of the impaired loans with
Level 2 inputs occurred during the nine month period ended September 30, 2010
based upon payments received.   There were no significant
transfers during the quarter in the Level 1 and Level 3 impaired
loans.




-16-




A summary
of the carrying amounts and estimated fair values of certain financial
instruments follows as of the periods indicated (dollars in
thousands):




September
      30, 2010
                
                
                December
      31, 2009Carrying
                
                
                Estimated
                
                
                Carrying
                
                
                Estimatedamount
                
                
                fair
      value
                
                
                amount
                
                
                fair
      valueFinancial
      assets:Cash
      and cash equivalents
                
                $
                47,571
                
                
                $
                47,571
                
                
                $
                8,328
                
                
                $
                8,328Held-to-maturity
      securities
                
                
                535
                
                
                
                585
                
                
                
                709
                
                
                
                765Available-for-sale
      securities
                
                
                86,720
                
                
                
                86,720
                
                
                
                75,821
                
                
                
                75,821FHLB
      stock
                
                
                4,781
                
                
                
                4,781
                
                
                
                4,781
                
                
                
                4,781Loans
      and leases
                
                
                414,185
                
                
                
                412,054
                
                
                
                423,124
                
                
                
                420,908Loans
      held-for-sale
                
                
                1,019
                
                
                
                1,037
                
                
                
                1,221
                
                
                
                1,233Accrued
      interest
                
                
                2,233
                
                
                
                2,233
                
                
                
                2,251
                
                
                
                2,251Financial
      liabilities:Deposit
      liabilities
                
                
                490,883
                
                
                
                491,438
                
                
                
                458,994
                
                
                
                453,264Short-term
      borrowings
                
                
                21,804
                
                
                
                21,804
                
                
                
                16,533
                
                
                
                16,533Long-term
      debt
                
                
                32,000
                
                
                
                35,774
                
                
                
                32,000
                
                
                
                35,017Accrued
      interest
                
                
                616
                
                
                
                616
                
                
                
                665
                
                
                
                665


The
following summarizes the methodology used to determine estimated fair values in
the above table:




The
carrying value of short-term financial instruments, as listed below,
approximates their fair value.  These instruments generally have
limited credit exposure, no stated or short-term maturities and carry interest
rates that approximate market.




·
            Cash
      and cash equivalents




·
            Non-interest
      bearing deposit accounts




·
            Savings,
      NOW and money market accounts




·
            Short-term
      borrowings




·
            Accrued
      interest




Securities:  Except
for corporate bonds consisting of preferred term securities, fair values on the
other investment securities are determined by prices provided by a third-party
vendor, who is a provider of financial market data, analytics and related
services to financial institutions.  The fair values of pooled trust
preferred securities is determined based on a present value technique (income
valuation) as described under the caption “Investment securities” of the
comparison of financial condition at September 30, 2010 and December 31, 2009,
below.




FHLB
stock, or restricted regulatory equity, is carried at cost, which approximates
fair value.




Loans and
leases:  The fair value of all loans is estimated by the net present
value of the future expected cash flows discounted at current market
rates.




Loans
held-for-sale (HFS):  For loans HFS, the fair value is estimated using
rates currently offered for similar loans and are obtained from the FNMA or the
FHLB.




Certificates
of deposit:  The fair values of certificate of deposit accounts are
based on discounted cash flows using rates which approximate market rates of
deposits with similar maturities.




Long-term
debt:  The fair value is estimated using market rates currently
offered for similar borrowings.




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




The
following is management's discussion and analysis of the significant changes in
the consolidated financial condition of the Company as of September 30, 2010
compared to December 31, 2009 and a comparison of the results of operations for
the three- and nine-months ended September 30, 2010 and 2009. Current
performance may not be indicative of future results.  This discussion
should be read in conjunction with the Company’s 2009 Annual Report filed on
Form 10-K.




Forward-looking
statements




Certain
of the matters discussed in this Quarterly Report on Form 10-Q may constitute
forward-looking statements for purposes of the Securities Act of 1933, as
amended, and the Securities Exchange Act of 1934, as amended, and as such may
involve known and unknown risks, uncertainties and other factors which may cause
the actual results, performance or achievements of the Company to be materially
different from future results, performance or achievements expressed or implied
by such forward-looking statements.  The words “expect,” “anticipate,”
“intend,” “plan,” “believe,” “estimate,” and similar expressions are intended to
identify such forward-looking statements.




-17-




The
Company’s actual results may differ materially from the results anticipated in
these forward-looking statements due to a variety of factors, including, without
limitation:




·
            the
      effects of economic deterioration on current customers, specifically the
      effect of the economy on loan customers’ ability to repay
      loans;


·
            the
      costs and effects of litigation and of unexpected or adverse outcomes in
      such litigation;


·
            governmental
      monetary and fiscal policies, as well as legislative and regulatory
      changes, in particular the effects of the Dodd-Frank Wall Street Reform
      and Consumer Protection Act;


·
            the
      effect of changes in accounting policies and practices, as may be adopted
      by the regulatory agencies, as well as the Financial Accounting Standards
      Board and other accounting standard
setters;


·
            the
      risks of changes in interest rates on the level and composition of
      deposits, loan demand, and the values of loan collateral, securities and
      interest rate protection agreements, as well as interest rate
      risks;


·
            the
      effects of competition from other commercial banks, thrifts, mortgage
      banking firms, consumer finance companies, credit unions, securities
      brokerage firms, insurance companies, money market and other mutual funds
      and other financial institutions operating in our market area and
      elsewhere, including institutions operating locally, regionally,
      nationally and internationally, together with such competitors offering
      banking products and services by mail, telephone, computer and the
      internet;


·
            technological
      changes;


·
            acquisitions
      and integration of acquired
businesses;


·
            the
      failure of assumptions underlying the establishment of reserves for loan
      and lease losses and estimations of values of collateral and various
      financial assets and liabilities;


·
            volatilities
      in the securities markets;


·
            deteriorating
      economic conditions;


·
            acts
      of war or terrorism; and


·
            disruption
      of credit and equity markets.




Management
of the Company cautions readers not to place undue reliance on forward-looking
statements, which reflect analyses only as of the date of this
document.  We have no obligation to update any forward-looking
statements to reflect events or circumstances after the date of this
document.




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




General




The
Company’s results of operations depend primarily on net interest
income.  Net interest income is the difference between interest income
and interest expense.  Interest income is generated from yields on
interest-earning assets, which consist principally of loans and investment
securities.  Interest expense is incurred from rates paid on
interest-bearing liabilities, which consist of deposits and
borrowings.  Net interest income is determined by the Company’s
interest rate spread (the difference between the yields earned on its
interest-earning assets and the rates paid on its interest-bearing liabilities)
and the relative amounts of interest-earning assets and interest-bearing
liabilities.  Interest rate spread is significantly impacted by:
changes in interest rates and market yield curves and their related impact on
cash flows; the composition and characteristics of interest-earning assets and
interest-bearing liabilities; differences in the maturity and re-pricing
characteristics of assets compared to the maturity and re-pricing
characteristics of the liabilities that fund them and by the competition in our
marketplace.




The
Company’s profitability is 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 service charges on the Bank’s
loan and deposit products, trust and asset management service fees, increases in
the cash surrender value of the bank owned life insurance (BOLI), net gains or
losses from sales of loans, securities and foreclosed assets held-for-sale and
from credit-related other-than-temporary impairment (OTTI) charges on investment
securities.  Non-interest expense consists of compensation and related
employee benefit expenses, occupancy, equipment, data processing, advertising,
marketing, professional fees, insurance and other operating
overhead.




The
Company’s profitability is significantly affected by general economic and
competitive conditions, changes in market interest rates, government policies
and actions of regulatory authorities.  The Company’s loan portfolio
is comprised principally of commercial and commercial real estate
loans.  The properties underlying the Company’s mortgages are
concentrated in Northeastern Pennsylvania.  Credit risk, which
represents the possibility of the Company not recovering amounts due from its
borrowers, is significantly related to local economic conditions in the areas
the properties are located as well as the Company’s underwriting
standards.  Economic conditions affect the market value of the
underlying collateral as well as the levels of adequate cash flow and revenue
generation from income-producing commercial properties.




-18-




Comparison of the results of
operations


Three and nine months ended
September 30, 2010 and 2009




Overview




Net
income for the third quarter of 2010 was $355,000, or $0.16 per diluted share,
compared to a net loss of $3,211,000, or $1.55, recorded in the same quarter of
2009.  For the nine months ended September 30, 2010, net income was
$1,630,000, or $0.76 per diluted share, compared to a net loss $1,473,000, or
$0.71, recorded for the nine months ended September 30, 2009.  The
improvement in net earnings in the quarter and year-to-date comparisons was due
to: a decline in non-cash, other-than-temporary impairment (OTTI) charges
related to the Company’s investment portfolio, lower provisions for loan losses,
higher levels of net interest income, more collected fees and service charges
and lower operating expenses.  In addition, gains from mortgage
banking services improved by $72,000 in the quarter-to-quarter comparison and
declined $518,000 in the year-to-date comparative periods.




Return on
average assets (ROA) and return on average shareholders’ equity (ROE) were 0.24%
and 2.87%, respectively, for the three months ended September 30, 2010 compared
to -2.25% and -25.75%, respectively, for the three months ended September 30,
2009.  For the nine months ended September 30, 2010, ROA and ROE were
0.37% and 4.58%, respectively, compared to -0.35% and -4.07% for the same period
in 2009.  The improvements in both ROA and ROE are attributable to net
earnings recorded in both the current quarter and year.




Net interest income and
interest sensitive assets / liabilities




Net
interest income increased $852,000, or 19%, to $5,273,000 in the third quarter
of 2010, from $4,421,000 recorded in the same quarter of 2009.  The
improvement was principally from lower interest expense of $1,352,000 due to a
126 basis point reduction in rates paid on interest-bearing liabilities, where a
76 basis point reduction in deposit rates more than offset the effect of a
$14,636,000 increase in average balances.  Conversely, though average
interest-earning assets increased $16,200,000, interest income was negatively
impacted by a 52 basis point decline in yields earned resulting in a net decline
in interest income of $500,000 in the third quarter of 2010 compared to the
third quarter of 2009.




During
the third quarter of 2010, the Company’s tax-equivalent margin and spread were
3.93% and 3.68%, compared to 3.43% and 2.95%, respectively, during the third
quarter of 2009.  The improvement in spread was caused by a greater
reduction in rates paid on interest-bearing liabilities than the lower yields
earned on interest-earning assets.  The improvement in margin was from
higher net interest income.




For the
nine months ended September 30, 2010, net interest income improved 12%, or
$1,663,000, compared to the nine months ended September 30,
2009.  Similar to the third quarter comparison, the improvement was
principally from lower interest expense of $3,434,000 due to a 108 basis point
reduction in rates paid on interest-bearing liabilities including an 87 basis
point reduction in rates paid on deposits.  The decrease in interest
income of $1,771,000 was from lower yields on earning assets.




The
Company’s tax-equivalent margin and spread improved to 3.92% and 3.66%,
respectively, for the nine months ended September 30, 2010 from 3.62% and 3.17%
during the same period of 2009.  The improvements stem from deposit
rates declining more rapidly than yields from earning assets resulting in higher
net interest income.




The low
interest rate environment has dominated the economy for several quarters and the
probability of a near-term change is unlikely.  As the Company
continues to operate in this environment, earning assets will continue to
re-price to lower levels causing additional downward pressure on yields. 
However, the Company’s Asset Liability Management (ALM) team will, if and when
deemed necessary, adjust interest rates on deposits and repurchase agreements in
order to maintain acceptable interest rate margins.  At this time, the
Company’s deposit offering rates are at historical low levels and whether the
Company can grow and retain its deposit base will largely depend on customers’
desire to maintain relatively low-earning deposits.  Nonetheless, the
Company’s ALM team will continue to proactively address interest rate issues in
this difficult financial environment and is poised to create and offer products
that are fair for its customers yet equitable for the Company.




-19-




The table
that follows sets forth a comparison of average balances and their corresponding
fully tax-equivalent (FTE) interest income and expense and annualized
tax-equivalent yield and cost for the periods indicated (dollars in
thousands):




Three
      months ended:September 30, 2010
              
              
              September 30, 2009Average
              
              
              
              
              
              Yield
      /
              
              
              Average
              
              
              
              
              
              Yield
      /Assets
              
              balance
              
              
              Interest
              
              
              rate
              
              
              balance
              
              
              Interest
              
              
              rateInterest-earning
      assets:Loans
      and leases
              
              $
              424,053
              
              
              $
              6,295
              
              
              
              5.89
              %
              
              $
              431,024
              
              
              $
              6,603
              
              
              
              6.08
              %Investments
              
              
              94,448
              
              
              
              845
              
              
              
              3.55
              
              
              
              99,922
              
              
              
              1,065
              
              
              
              4.23Federal
      funds sold
              
              
              169
              
              
              
              -
              
              
              
              0.26
              
              
              
              5,335
              
              
              
              3
              
              
              
              0.25Interest-bearing
      deposits
              
              
              34,424
              
              
              
              22
              
              
              
              0.25
              
              
              
              622
              
              
              
              -
              
              
              
              0.06Total
      interest-earning assets
              
              
              553,094
              
              
              
              7,162
              
              
              
              5.14
              
              
              
              536,903
              
              
              
              7,671
              
              
              
              5.67Non-interest-earning
      assets
              
              
              32,848
              
              
              
              
              
              
              
              
              
              
              
              29,089Total
      assets
              
              $
              585,942
              
              
              
              
              
              
              
              
              
              
              $
              565,992Liabilities and
      shareholders' equityInterest-bearing
      liabilities:Other
      interest-bearing deposits
              
              $
              259,678
              
              
              $
              407
              
              
              
              0.63
              %
              
              $
              228,308
              
              
              $
              579
              
              
              
              1.01
              %Certificates
      of deposit
              
              
              146,952
              
              
              
              838
              
              
              
              2.29
              
              
              
              163,683
              
              
              
              1,370
              
              
              
              3.32Borrowed
      funds
              
              
              42,274
              
              
              
              430
              
              
              
              4.04
              
              
              
              42,746
              
              
              
              1,077
              
              
              
              10.00Repurchase
      agreements
              
              
              8,685
              
              
              
              6
              
              
              
              0.30
              
              
              
              7,266
              
              
              
              6
              
              
              
              0.32Total
      interest-bearing liabilities
              
              
              457,589
              
              
              
              1,681
              
              
              
              1.46
              
              
              
              442,003
              
              
              
              3,032
              
              
              
              2.72Non-interest-bearing
      deposits
              
              
              75,831
              
              
              
              
              
              
              
              
              
              
              
              70,412Other
      non-interest-bearing liabilities
              
              
              3,509
              
              
              
              
              
              
              
              
              
              
              
              4,102Shareholders'
      equity
              
              
              49,013
              
              
              
              
              
              
              
              
              
              
              
              49,475Total
      liabilities and shareholders' equity
              
              $
              585,942
              
              
              
              
              
              
              
              
              
              
              $
              565,992Net
      interest income / interest rate spread
              
              
              
              
              
              $
              5,481
              
              
              
              3.68
              %
              
              
              
              
              
              $
              4,639
              
              
              
              2.95
              %Net
      interest margin
              
              
              
              
              
              
              
              
              
              
              3.93
              %
              
              
              
              
              
              
              
              
              
              
              3.43
              %




Nine
      months ended:September 30, 2010
              
              
              September 30, 2009Average
              
              
              
              
              
              Yield /
              
              
              Average
              
              
              
              
              
              Yield /Assets
              
              balance
              
              
              Interest
              
              
              rate
              
              
              balance
              
              
              Interest
              
              
              rateInterest-earning
      assets:Loans
      and leases
              
              $
              431,108
              
              
              $
              18,834
              
              
              
              5.84
              %
              
              $
              432,607
              
              
              $
              19,866
              
              
              
              6.14
              %Investments
              
              
              95,686
              
              
              
              2,693
              
              
              
              3.76
              
              
              
              98,971
              
              
              
              3,436
              
              
              
              4.64Federal
      funds sold
              
              
              7,708
              
              
              
              14
              
              
              
              0.24
              
              
              
              5,872
              
              
              
              11
              
              
              
              0.25Interest-bearing
      deposits
              
              
              20,181
              
              
              
              38
              
              
              
              0.25
              
              
              
              722
              
              
              
              -
              
              
              
              0.10Total
      interest-earning assets
              
              
              554,683
              
              
              
              21,579
              
              
              
              5.20
              
              
              
              538,172
              
              
              
              23,313
              
              
              
              5.79Non-interest-earning
      assets
              
              
              31,892
              
              
              
              
              
              
              
              
              
              
              
              29,048Total
      assets
              
              $
              586,575
              
              
              
              
              
              
              
              
              
              
              $
              567,220Liabilities and
      shareholders' equityInterest-bearing
      liabilities:Other
      interest-bearing deposits
              
              $
              260,211
              
              
              $
              1,386
              
              
              
              1.07
              %
              
              $
              217,674
              
              
              $
              1,698
              
              
              
              1.04
              %Certificates
      of deposit
              
              
              145,586
              
              
              
              2,572
              
              
              
              3.56
              
              
              
              169,808
              
              
              
              4,581
              
              
              
              3.61Borrowed
      funds
              
              
              42,111
              
              
              
              1,281
              
              
              
              4.07
              
              
              
              49,138
              
              
              
              2,448
              
              
              
              6.66Repurchase
      agreements
              
              
              12,634
              
              
              
              77
              
              
              
              0.81
              
              
              
              9,144
              
              
              
              22
              
              
              
              0.33Total
      interest-bearing liabilities
              
              
              460,542
              
              
              
              5,316
              
              
              
              1.54
              
              
              
              445,764
              
              
              
              8,749
              
              
              
              2.62Non-interest-bearing
      deposits
              
              
              74,917
              
              
              
              
              
              
              
              
              
              
              
              69,143Other
      non-interest-bearing liabilities
              
              
              3,502
              
              
              
              
              
              
              
              
              
              
              
              3,950Shareholders'
      equity
              
              
              47,614
              
              
              
              
              
              
              
              
              
              
              
              48,363Total
      liabilities and shareholders' equity
              
              $
              586,575
              
              
              
              
              
              
              
              
              
              
              $
              567,220Net
      interest income / interest rate spread
              
              
              
              
              
              $
              16,263
              
              
              
              3.66
              %
              
              
              
              
              
              $
              14,564
              
              
              
              3.17
              %Net
      interest margin
              
              
              
              
              
              
              
              
              
              
              3.92
              %
              
              
              
              
              
              
              
              
              
              
              3.62
              %




In the
preceding table, interest income was adjusted to a tax-equivalent basis, using
the corporate federal tax rate of 34%, to recognize the income from tax-exempt
interest-earning assets as if the interest was taxable.  This
treatment allows a uniform comparison between yields on interest-earning
assets.  Loans include loans HFS and non-accrual loans but exclude the
allowance for loan losses.  Securities include non-accrual
securities.  Average balances are based on amortized cost and do not
reflect net unrealized gains or losses.  Net interest margin is
calculated by dividing net interest income by total average interest-earning
assets.




-20-




Provision for loan
losses




The
provision for loan losses represents the necessary amount to charge against
current earnings, the purpose of which is to increase the allowance for loan
losses to a level that represents management’s best estimate of known and
inherent losses in the Company’s loan portfolio.  Loans and leases
determined to be uncollectible are charged off against the allowance for loan
losses.  The required amount of the provision for loan losses, based
upon the adequate level of the allowance for loan losses, is subject to ongoing
analysis of the loan portfolio.  The Company’s Special Assets
Committee meets periodically to review problem loans and leases.  The
committee is comprised of management, including the senior loan officer, the
chief risk officer, loan officers, loan workout officers and collection
personnel.  The committee reports quarterly to the Credit
Administration Committee of the Board of Directors.




Management
continuously reviews the risks inherent in the loan and lease
portfolio.  Specific factors used to evaluate the adequacy 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-accrual
  loans;


·
            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 for loan losses was $375,000 for the three months ending September 30,
2010 and was $3,125,000 for the three month period ending September 30,
2009.  Total provisions for the nine months ended September 30, 2010
were $1,250,000 and $3,850,000 for the same nine months of 2009.  The
$375,000 provision for the current quarter was recorded to provide increased
allocations for commercial loans, residential mortgages and consumer loans
resulting from the continued locally weakened economic conditions and to reserve
for a decline in real estate values.  For a further discussion on
non-performing loans, see “Non-performing assets” under the caption “Comparison
of financial condition at September 30, 2010 and December 31, 2009”,
below.




The
allowance for loan losses was $7,484,000 at September 30, 2010 compared to
$7,574,000 at December 31, 2009.  For a further discussion on the
allowance for loan losses, see “Allowance for loan losses” under the caption
“Comparison of financial condition at September 30, 2010 and December 31, 2009”
below.




Other income
(loss)




In the
third quarter of 2010, other (non-interest) income/loss improved $1,022,000, or
79%, from a net loss of 1,292,000 recorded in the third quarter of 2009 to a net
loss of $270,000 recorded in the third quarter of 2010.  The
improvement was primarily from $683,000 lower non-cash OTTI charges recorded in
the current year quarter.  The OTTI is related to credit impairment in
the Company’s investments in pooled trust preferred securities that is discussed
more fully in Note 3, “Investment securities”.  Non-interest income
was bolstered by a $175,000, or 41%, increase in fees and other service charges
emanating mostly from lending activities.  In addition, the prolonged
low interest rate environment has again spiked mortgage loan origination and
refinancing activities.  As such, mortgage banking services recognized
$72,000 in additional gains in the current year third quarter compared to the
third quarter of 2009.




For the
nine months ended September 30, 2010, other income improved $36,000 compared to
the nine months ended September 30, 2009.  In the current year, the
Company recognized OTTI credit-related charges of $2,504,000 compared to
$2,758,000 in 2009, an improvement of approximately $254,000.  In
addition, other fees and service charges improved $213,000 on the strength of
lending and trust services activities.  Partially offsetting these
positive factors for the nine months ended September 30, 2010, the Company
recorded $440,000 in gains from mortgage banking services compared to $958,000
recognized during the first nine months of 2009, or a decline of
$518,000.  The 2009 gain included sales of $10,838,000 of loans
transferred from the loan and lease portfolio to loans HFS and simultaneously
sold.




Other operating
expenses




For the
quarter ended September 30, 2010, other (non-interest) expenses declined
$792,000, or 15%, compared to the quarter ended September 30,
2009.  Salary and employee benefits decreased $335,000, or 13%, due to
employee downsizing in conjunction with the planned reorganization of the
Company during the latter part of 2009 and first quarter of 2010.  The
number of full-time equivalent employees (FTE) amounted to 159 at September 30,
2010 compared to 185 at September 30, 2009.  The $66,000, or 8%,
savings in premises and equipment is principally from lower rental
expense.  The Company recently entered into a new lease agreement with
a new owner-landlord of the Company’s Eynon branch.  As a result, the
company was required to reverse previously accrued and unpaid future rental
obligations expensed in accordance with current accounting
guidance.  In conjunction with the new ownership, the previous lease
agreement with the previous owner-landlord terminated.  The other
category of other operating expense declined $383,000, or
24%.  Professional services declined $226,000, or 32%, due in part to
the one-time $162,000 consulting agreement expense paid to the Company’s former
chief executive officer in the third quarter of 2009 and to a lesser degree, the
permanent exemption of smaller reporting companies from the Sarbanes-Oxley
internal control audit requirement as a result of the signing into law, the
Dodd-Frank Wall Street Reform and Consumer Protection Act.  This
enactment eliminated the need to accrue expenses for this
effort.  Finally, in the 2010 third quarter, credit-collection related
costs were approximately half of the amount recognized in the third quarter of
2009 due to the recovery of some previously recognized expenses incurred on
larger problem credits.




-21-




For the
nine months ended September 30, 2010, non-interest related expenses decreased
$394,000, or 3%, from $14,510,000 recorded in 2009 compared to $14,116,000 in
2010.  Salary and employee benefits decreased $326,000, or 4%, despite
approximately $400,000 of one-time severance and voluntary termination payouts
from the previously mentioned planned, structured reorganization of the
Company.  Savings in property insurance, facility maintenance and the
aforementioned termination of the old and simultaneous signing of the new branch
lease agreement helped reduce premises and equipment expenses by $136,000, or
5%.  Advertising expenses increased $22,000, or 6%, due to costs for
the development of a new Company website, the implementation of a Company
branding campaign and the expenses associated with customer notification of
federal regulatory changes.  The other category of non-interest
expenses increased by $46,000, or 1% in 2010, compared to 2009, due to a sundry
of offsetting components consisting of: higher collection expense caused by
higher levels of non-performing loans; less deferral of mortgage-related
origination costs on less origination activity; the establishment of a loss
contingency reserve associated with potential off-balance sheet loan commitment
losses and an increase in promotion related expenses for sales campaigns
designed to bolster services for deposit customers.  Partially
offsetting these items were lower: professional services from the non-recurrence
of the consulting payments, ORE costs, travel related expenses and sold loan
charges on lower origination and sales volumes.




(Credit) provision for
income taxes




For the
nine months ended September 30, 2010 and 2009 the Company recorded a provision
for income taxes of $169,000 and an income tax benefit of $1,421,000,
respectively.  This is a result of the Company incurring pre-tax
losses during the first nine months of 2009 as compared to generating pre-tax
income for the first nine months of 2010.  Though the Company
generated pre-tax income during the third quarter of 2010, the tax benefit was
caused by a higher level net non-taxable permanent differences recognized during
the same period.




Comparison of financial
condition at


September 30, 2010 and
December 31, 2009




Overview




Consolidated
assets increased $40,581,000 to $596,598,000 or 7%, as of September 30, 2010
from $556,017,000 at December 31, 2009.  The increase was primarily
from $31,888,000 growth in deposits, an increase in short-term borrowings of
$5,271,000 and a $3,001,000 increase in shareholders’ equity.




Investment
securities




At the
time of purchase, management classifies investment securities into one of three
categories: trading, available-for-sale (AFS) or held-to-maturity
(HTM).  To date, management has not purchased any securities for
trading purposes.  Most of the securities purchased are classified as
AFS even though there is no immediate intent to sell them.  The AFS
designation affords management the flexibility to sell securities and position
the balance sheet in response to capital levels, liquidity needs or changes in
market conditions.  Securities AFS are carried at fair value in the
consolidated balance sheet with an adjustment to shareholders’ equity, net of
tax, presented under the caption “Accumulated other comprehensive income
(loss).”  Securities designated as HTM are carried at amortized cost
and represent debt securities that the Company has the ability and intent to
hold until maturity.




As of
September 30, 2010, the carrying value of investment securities amounted to
$87,255,000, or 15% of total assets, compared to $76,530,000, or 14% of total
assets, at December 31, 2009.  At September 30, 2010, approximately
47% of the carrying value of the investment portfolio was comprised of
mortgage-backed securities that amortize and provide monthly cash
flow.




As of
September 30, 2010, investment securities were comprised of HTM and AFS
securities with carrying values of $535,000 and $86,720,000,
respectively.  The AFS debt securities were recorded with a net
unrealized loss in the amount of $10,780,000 and equity securities were recorded
with an unrealized net gain of $117,000.  During the nine months ended
September 30, 2010, the carrying value of total investments increased
$10,725,000.  The increase includes $3,268,000 in net market value
appreciation in the AFS portfolio.  The Company used cash flow
generated from mortgage-backed securities, bond calls and pay downs as well as
excess cash reserves to diversify the securities portfolio weighted heavier in
mortgage-backed securities with relatively short durations and which provide a
regular source of cash flow.




-22-




A
comparison of investment securities at September 30, 2010 and December 31, 2009
is as follows (dollars in thousands):




September 30, 2010
              
              
              December 31, 2009Amount
              
              
              %
              
              
              Amount
              
              
              %Agency
      - GSE
              
              $
              17,423
              
              
              
              20.0
              
              
              $
              33,132
              
              
              
              43.3MBS
      - GSE residential
              
              
              41,252
              
              
              
              47.3
              
              
              
              14,457
              
              
              
              18.9State
      & municipal subdivisions
              
              
              24,415
              
              
              
              28.0
              
              
              
              23,270
              
              
              
              30.4Pooled
      trust preferred securities
              
              
              3,726
              
              
              
              4.2
              
              
              
              5,242
              
              
              
              6.8Equity
      securities - financial services
              
              
              439
              
              
              
              0.5
              
              
              
              429
              
              
              
              0.6Total
      investments
              
              $
              87,255
              
              
              
              100.0
              
              
              $
              76,530
              
              
              
              100.0


Quarterly,
management performs a review of the investment portfolio to determine the cause
of declines in the fair value of each security.  The Company uses
inputs provided by independent third parties to determine the fair value of its
investment securities portfolio.  The inputs provided are reviewed and
corroborated by management.  Evaluations of the causes of the
unrealized losses are performed to determine whether impairment is temporary or
other-than-temporary.  Considerations such as the Company’s intent to
sell the security, whether the Company will more likely than not be required to
sell the security before recovery of its amortized cost basis, the present value
of expected cash flows is not sufficient to recover the entire amortized cost
basis, recoverability of the invested amounts over the intended holding period,
the length of time and the severity in pricing decline below cost, the interest
rate environment, receipts of amounts contractually due and whether or not there
is an active market for the security, for example, are applied, along with the
financial condition of the issuer for management to make a realistic judgment of
the probability that the Company will be unable to collect all amounts
(principal and interest) due in determining whether a security is
other-than-temporarily impaired.  If a decline in value is deemed to
be other-than-temporary, the amortized cost of the security is reduced by the
credit impairment amount and a corresponding charge to earnings is
recognized.  If at the time of sale, call or maturity the proceeds
exceed the security’s amortized cost, the impairment charge may be fully or
partially recovered.




Under
these circumstances, OTTI is considered to have occurred if: (1) the
entity has intent to sell the security; (2) more likely than not the
entity will be required to sell the security before recovery of its amortized
cost basis; or (3) the present value of expected cash flows is not
sufficient to recover the entire amortized cost.




The
uncertainty in the financial markets continues to promote volatility in fair
value estimates for the securities in the Company’s investment
portfolio.  Fair values of the Company’s AFS investment securities
have improved since year-end 2009, but remain well below their amortized cost -
$10.7 million, or 11% as of September 30, 2010 and $13.9 million, or 16% as of
December 31, 2009.  Management believes fair values and their changes
are due mainly to a combination of the interest rate environment, instability in
the capital markets, limited trading activity and illiquid conditions in certain
financial markets, not deterioration in the creditworthiness of the
issuers.  Nearly all of the securities in the portfolio have fixed
rates or have predetermined scheduled rate changes, and many have call features
that allow the issuer to call the security at par before its stated maturity
without penalty.  The most significant component of the $10.7 million
net unrealized loss in the AFS securities portfolio, as of September 30, 2010,
was $12.6 million from the Company’s investments in corporate bonds consisting
of collateralized debt obligation (CDO) securities that are backed by pooled
trust preferred securities issued by banks, thrifts and insurance
companies.




Management
has been unable to obtain readily attainable and realistic pricing from market
traders for the pooled trust preferred securities portfolio because there
continues to be a lack of active market participants who deal in these
securities.




As of
September 30, 2010, the Company owned 13 tranches of pooled trust preferred
securities (PreTSLs).  Management has determined the market for these
securities and other issues of PreTSLs at September 30, 2010 is
inactive.  The inactivity was evidenced first by a significant
widening of the bid-ask spread in the brokered markets in which PreTSLs trade,
then by a significant decrease in the volume of trades relative to historical
levels and the lack of a new-issue market since 2007.  There are
currently very few market participants who are willing and/or able to transact
for these securities.  Given the conditions in the debt markets today
and the absence of observable transactions in the secondary and new issue
markets, management has made the following observations and has
determined:




·
            The
      few observable transactions and market quotations that were available were
      not reliable for purposes of determining fair value at September 30,
      2010,




·
            An
      income valuation approach (present value technique) that maximizes the use
      of relevant observable inputs and minimizes the use of unobservable inputs
      is equally or more representative of fair value than the market approach
      valuation technique, and




-23-




·
            The
      PreTSL securities are classified within “Level 3” in the fair value
      hierarchy (as defined in current accounting guidance and explained in Note
      6, “Fair Value Measurements” of the consolidated financial statements)
      because significant adjustments are required to determine fair value at
      the measurement date.  The valuations of the Company’s PreTSLs
      were prepared by an independent third party and corroborated by
      management.  The approach to determine fair value involved the
      following:




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




·
            The
      credit quality of the collateral is estimated using issuer-specific
      probability of default values,




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




·
            The
      loss given default, or amount of cash lost to the investor when a debt
      asset defaults, was assumed to be 100% (no recovery).  This
      replicates the historically high default loss levels on trust preferred
      instruments,




·
            The
      cash flows were forecast for the underlying collateral and applied to each
      tranche to determine the resulting distribution among the
      securities.  This ascertains which investors are paid and which
      investors incur losses.  Thus, these cash flow projections
      capture the credit risk,




·
            The
      expected cash flows utilize no prepayments and were discounted utilizing
      three-month LIBOR as the risk-free rate for the base case and then added a
      300bp liquidity premium as the discount rate to calculate the present
      value of the security,




·
            The
      effective discount rates on an overall basis range from 8.9% to 76.4% and
      are highly dependent upon the credit quality of the collateral, the
      relative position of the tranche within the capital structure of the
      security and the prepayment assumptions,
and




·
            The
      calculations were modeled in several thousand scenarios using a Monte
      Carlo engine to establish a distribution of intrinsic values and the
      average was used for valuation
purposes.




Based on
the technique described, the Company determined that as of September 30, 2010,
the fair value of eight PreTSL securities: V, VII, IX, XI, XV, XVI, XVII and XXV
had declined $7,710,000 in total below their amortized cost basis and since the
present value of the security’s expected cash flows were insufficient to recover
the entire amortized cost basis, the securities are deemed to have experienced
credit-related other-than-temporary impairment in the amount of $2,504,000 which
was charged to current earnings as a component of other income in the
consolidated statement of income for the nine months ended September 30,
2010.  This compares to $2,758,000 of credit-related impairment
charges recorded during the nine months ended September 30, 2009.  The
Company closely monitors the pooled trust preferred securities market and
performs collateral sufficiency and cash flow analyses on a quarterly
basis.  Future analyses could yield results that may indicate further
impairment has occurred and would therefore require additional write-downs and
corresponding other-than-temporary impairment charges to current
earnings.




Federal Home Loan Bank
Stock




In order
to gain access to the low-cost products and services offered by the FHLB,
investment in FHLB stock is required for membership in the organization and is
carried at cost since there is no market value available.  The amount
the Company is required to invest is dependent upon the relative size of
outstanding borrowings the Company has with the FHLB.  Excess stock is
typically repurchased from the Company at par if the level of borrowings
declines to a predetermined level.  In addition, the Company normally
earns a return or dividend on the amount invested.  In order to
preserve its capital level, in December 2008 the FHLB announced that it had
suspended the payment of dividends and excess capital stock repurchasing and as
of September 30, 2010, that position has not changed.  That decision
was based on the FHLB’s analysis and consideration of certain negative market
trends and the impact those trends will have on their financial
condition.  Based on the financial results of the FHLB for the nine
months ended September 30, 2010 and for the year-ended December 31, 2009,
management believes that the suspension of both the dividend payments and excess
capital stock repurchase is temporary in nature.  Management further
believes that the FHLB will continue to be a primary source of wholesale
liquidity for both short- and long-term funding and has concluded that its
investment in FHLB stock is not other-than-temporarily
impaired.  There can be no assurance, however, that future negative
changes to the financial condition of the FHLB may not require the Company to
recognize an impairment charge with respect to such holdings.  The
Company will continue to monitor the financial condition of the FHLB and assess
its future ability to resume normal dividend payments and stock redemption
activities.




-24-




Loans held-for-sale
(HFS)




Generally,
upon origination, certain residential mortgages are classified as
HFS.  In the event of market rate increases, fixed-rate loans and
loans not immediately scheduled to re-price would no longer produce yields
consistent with the current market.  In a declining interest rate
environment, the Company would be exposed to prepayment risk and, as rates
decrease, interest income could be negatively affected.  Consideration
is given to the Company’s current liquidity position and projected future
liquidity needs.  To better manage prepayment and interest rate risk,
loans that meet these conditions may be classified as HFS.  The
carrying value of loans HFS is at the lower of cost or estimated fair
value.  If the fair values of these loans fall below their original
cost, the difference is written down and charged to current
earnings.  Subsequent appreciation in the portfolio is credited to
current earnings but only to the extent of previous write-downs.




Loans HFS
at September 30, 2010 amounted to $1,019,000 with a corresponding fair value of
approximately $1,037,000, compared to $1,221,000 and $1,233,000, respectively,
at December 31, 2009.  During the nine months ended September 30,
2010, residential mortgage loans with principal balances of $37,690,000 were
sold into the secondary market with net gains of approximately $440,000
recognized, compared to $90,045,000 and $958,000, respectively, during the nine
months ended September 30, 2009.  Included in the 2009 sales was
$10,838,000 of residential mortgage loans transferred from the loan and lease
portfolio during the first quarter of 2009.  The Company expects loan
originations and the related sales to decline in 2010, though volumes have
increased somewhat during the third quarter of 2010.




Loans and
leases




The
Company originates commercial and industrial (C&I) and commercial real
estate (CRE) loans, collectively, commercial loans, residential mortgages,
consumer, home equity and construction loans.  The relative volume of
originations is dependent upon customer demand, current interest rates and the
perception and duration of future interest rate levels.  As part of
the overall strategy to serve the business community in which it operates, the
Company is focused on developing and implementing products and services to the
broad spectrum of businesses that operate in our marketplace.  The
Company’s goals center on building relationships by providing credit and
non-credit products and services, continuing to diversify its loan portfolio and
utilizing participations to reduce risk in larger credit transactions. 
Especially in the current economic climate, the Company, in providing credit to
existing and new customers, has implemented policies and procedures to reduce
the associated risk.  The risks associated with interest rates are being
managed by utilizing floating versus long-term fixed rates and exploring
programs where we can match our cost of funds.




The
majority of the Company’s loan portfolio is collateralized, at least in part, by
real estate primarily located in Lackawanna and Luzerne Counties of
Pennsylvania.  Commercial lending activities may involve a greater
degree of risk than consumer lending because typically they have larger balances
and are likely more affected by adverse conditions in the
economy.  Because payments on commercial loans depend upon the
successful operation and management of the properties and the businesses which
operate from within them, repayment of such loans may be affected by factors
outside the borrower’s control.  Such factors may include adverse
conditions in the real estate market, the economy, the industry or changes in
government regulations.  As such, commercial loans require more
ongoing evaluation and monitoring which occurs with the Bank’s credit
administration and outsourced loan review functions.




The
composition of the loan portfolio at September 30, 2010 and December 31, 2009,
is summarized as follows (dollars in thousands):




September 30, 2010
              
              
              December 31, 2009Amount
              
              
              %
              
              
              Amount
              
              
              %Real
      estate:Commercial
              
              $
              173,754
              
              
              
              41.1
              
              
              $
              186,727
              
              
              
              43.3Residential
              
              
              65,554
              
              
              
              15.6
              
              
              
              71,001
              
              
              
              16.5Construction
              
              
              10,754
              
              
              
              2.6
              
              
              
              10,125
              
              
              
              2.4Commercial
      and industrial
              
              
              84,287
              
              
              
              20.0
              
              
              
              76,788
              
              
              
              17.8Consumer
              
              
              87,015
              
              
              
              20.6
              
              
              
              85,690
              
              
              
              19.9Direct
      financing leases
              
              
              305
              
              
              
              0.1
              
              
              
              367
              
              
              
              0.1Gross
      loans
              
              
              421,669
              
              
              
              100.0
              
              
              
              430,698
              
              
              
              100.0Allowance
      for loan losses
              
              
              (7,484
              )
              
              
              
              
              
              
              (7,574
              )Net
      loans
              
              $
              414,185
              
              
              
              
              
              
              $
              423,124


The $9.0
million net decline in gross loans during the first half of 2010 was
predominantly from the payoff of some sizeable CRE credits that the Company
aggressively sought for settlement.  The growth in C&I is
attributable to a short-term, match funded loan with a municipal
customer.  This loan matures during the fourth quarter of 2010.




-25-




Allowance for loan
losses




Management
continually evaluates the credit quality of the Company’s loan portfolio and
performs a formal review of the adequacy of the allowance for loan losses (the
allowance) on a quarterly basis.  The allowance reflects management’s
best estimate of the amount of credit losses in the loan
portfolio.  Management’s judgment is based on the evaluation of
individual loans, past experience, the assessment of current economic conditions
and other relevant factors including the amounts and timing of cash flows
expected to be received on impaired loans.  Those estimates may be
susceptible to significant change.  The provision for loan losses
represents the amount necessary to maintain an appropriate
allowance.  Loan losses are charged directly against the allowance
when loans are deemed to be uncollectible.  Recoveries from previously
charged-off loans are added to the allowance when received.




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




·
            identification
      of specific impaired loans by loan
category;


·
            calculation
      of specific allowances where required for the impaired loans based on
      collateral and other objective and quantifiable
  evidence;


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


·
            application
      of historical loss percentages (two-/three-year average) to pools to
      determine the allowance allocation;


·
            application
      of qualitative factor adjustment percentages to historical losses for
      trends or changes in the loan portfolio, and /or current economic
      conditions.




Allocation
of the allowance for different categories of loans is based on the methodology
as explained above.  A key element of the methodology to determine the
allowance is the Company’s credit risk evaluation process, which includes credit
risk grading of individual commercial loans.  Commercial loans are
assigned credit risk grades based on the Company’s assessment of conditions that
affect the borrower’s ability to meet its contractual obligations under the loan
agreement.  That process includes reviewing borrowers’ current
financial information, historical payment experience, credit documentation,
public information and other information specific to each individual
borrower.  Upon review, the commercial loan credit risk grade is
revised or reaffirmed.  The credit risk grades may be changed at any
time management feels an upgrade or downgrade may be warranted.  The
credit risk grades for the commercial loan portfolio are taken into account in
the reserve methodology and loss factors are applied based upon the credit risk
grades.  The loss factors applied are based upon the Company’s
historical experience as well as what management believes to be best practices
and within common industry standards.  Historical experience reveals
there is a direct correlation between the credit risk grades and loan
charge-offs.  The changes in allocations in the commercial loan
portfolio from period-to-period are based upon the credit risk grading system
and from periodic reviews of the loan and lease portfolios.




Each
quarter, management performs an assessment of the allowance and the provision
for loan losses.  The Company’s Special Assets Committee meets
quarterly and the applicable lenders discuss each relationship under review and
reach a consensus on the appropriate estimated loss amount based on current
accounting guidelines.  The Special Assets Committee’s focus is on
ensuring the pertinent facts are considered and the reserve amounts pursuant to
the accounting principles are reasonable.  The assessment process
includes the review of all loans on a non-accruing basis as well as a review of
certain loans to which the lenders or the Company’s Credit Administration
function have assigned a criticized or classified risk rating.




Total
charge-offs net of recoveries for the nine months ending September 30, 2010,
were $1,339,000, compared to $1,870,000 in the first nine months of
2009.  The reduced level of charge-offs recorded in the current year
is primarily attributable to lower charge-offs incurred on commercial and
industrial as well as consumer loans.  The  commercial and
industrial loan net charge-offs were $320,000 for the nine months ending
September 30, 2010 compared to net charge-offs of $730,000 in the same period of
2009.  Consumer loan net charge-offs of $166,000 were recorded during
the nine months ending September 30, 2010 versus $289,000 at the September 30,
2009 like period end.   On an aggregate basis the commercial and
residential real estate net charge-offs were relatively level, totaling $853,000
at September 30, 2010 and $850,000 at September 30,
2009.   Commercial real estate loan net charge-offs were $531,000
during the nine month period ending September 30, 2010 versus $841,000 at
September 30, 2009.  Residential real estate loan net charge-offs
totaled $322,000 for the nine month period ending September 30, 2010, and were
$9,000 in the like period of 2009  For a discussion on the provision
for loan losses, see the “Provision for loan losses,” located in the results of
operations section of management’s discussion and analysis contained
herein.




The
allowance for loan losses was $7,484,000 at September 30, 2010 and $7,574,000 at
December 31, 2009.  Management believes that the current balance in
the allowance for loan losses of $7,484,000 is sufficient to withstand the
identified potential credit quality issues that may arise and others
unidentified but inherent to the portfolio as of this time.  Potential
problem loans are those where there is known information that leads management
to believe repayment of principal and/or interest is in jeopardy and the loans
are currently neither on non-accrual status or past due 90 days or
more.  Given continuing pressure on property values and the generally
uncertain economic backdrop, there could be additional instances which become
identified in future periods that may require additional charge-offs and/or
increases to the allowance.  The ratio of allowance for loan losses to
total loans was 1.77% at September 30, 2010 compared to 1.75% at December 31,
2009.




-26-




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




As
      of and for the nine months ended
                September
      30,
                2010
              
              
              As
      of and for the twelve months ended
                December
      31,
                2009
              
              
              As
      of and for the nine months ended
                September
      30,
                2009Balance
      at beginning of period
              
              $
              7,573,603
              
              
              $
              4,745,234
              
              
              $
              4,745,234Provision
      charged to operations
              
              
              1,250,000
              
              
              
              5,050,000
              
              
              
              3,850,000Charge-offs:Real
      estate:Commercial
              
              
              534,260
              
              
              
              843,527
              
              
              
              843,526Residential
              
              
              322,433
              
              
              
              9,158
              
              
              
              9,158Commercial
      and industrial
              
              
              323,077
              
              
              
              983,490
              
              
              
              746,093Consumer
              
              
              195,096
              
              
              
              432,951
              
              
              
              299,041Total
              
              
              1,374,866
              
              
              
              2,269,126
              
              
              
              1,897,818Recoveries:Real
      estate:Commercial
              
              
              3,236
              
              
              
              2,075
              
              
              
              2,075Residential
              
              
              -
              
              
              
              -
              
              
              
              -Commercial
      and industrial
              
              
              3,149
              
              
              
              34,735
              
              
              
              16,018Consumer
              
              
              29,131
              
              
              
              10,685
              
              
              
              9,348Total
              
              
              35,516
              
              
              
              47,495
              
              
              
              27,441Net
      charge-offs
              
              
              1,339,350
              
              
              
              2,221,631
              
              
              
              1,870,377Balance
      at end of period
              
              $
              7,484,253
              
              
              $
              7,573,603
              
              
              $
              6,724,857Total
      loans, end of period
              
              $
              422,688,600
              
              
              $
              431,919,023
              
              
              $
              428,439,731




As
      of and for the nine months ended
                  September
      30,
                  2010
                
                
                As
      of and for the twelve months ended
                  December
      31,
                  2009
                
                
                As
      of and for the nine months ended
                  September
      30,
                  2009Net charge-offs to
      (annualized):Average
      loans
                
                
                0.41
                %
                
                
                0.51
                %
                
                
                0.58
                %Allowance
      for loan losses
                
                
                23.86
                %
                
                
                29.33
                %
                
                
                37.08
                %Provision
      for loan losses
                
                
                1.07
                x
                
                
                0.44
                x
                
                
                0.49
                xAllowance for loan
      losses to:Total
      loans
                
                
                1.77
                %
                
                
                1.75
                %
                
                
                1.57
                %Non-accrual
      loans
                
                
                0.78
                x
                
                
                0.61
                x
                
                
                0.85
                xNon-performing
      loans
                
                
                0.77
                x
                
                
                0.59
                x
                
                
                0.76
                xNet
      charge-offs (annualized)
                
                
                4.19
                x
                
                
                3.41
                x
                
                
                2.70
                xLoans
      30-89 days past due and still accruing
                
                $
                2,869,909
                
                
                $
                5,173,394
                
                
                $
                3,077,722Loans
      90 days past due and accruing
                
                $
                119,566
                
                
                $
                554,806
                
                
                $
                1,002,720Non-accrual
      loans
                
                $
                9,581,793
                
                
                $
                12,329,338
                
                
                $
                7,900,547Allowance
      for loan losses to loans 90days
      or more past due and accruing
                
                
                62.60
                x
                
                
                13.65
                x
                
                
                6.71
                x


-27-




Non-performing
assets




The
Company defines non-performing assets as accruing loans past due 90 days or
more, non-accrual loans, restructured loans, other real estate owned (ORE),
non-accrual securities and repossessed assets.  As of September 30,
2010, non-performing assets represented 2.22% of total assets compared to 2.58%
at December 31, 2009.  The decline at September 30, 2010 was driven by
reductions in both the loans past due more than 90 days as well as the reduced
non-accrual levels.




In the
review of loans for both delinquency and collateral sufficiency, management
concluded that there were a number of loans that lacked the ability to repay in
accordance with contractual terms.  The decision to place loans or
leases on a non-accrual status is made on an individual basis after considering
factors pertaining to each specific loan.  The commercial loans are
placed on non-accrual status when management has determined that payment of all
contractual principal and interest is in doubt or the loan is past due 90 days
or more as to principal and interest, unless well-secured and in the process of
collection.  Consumer loans secured by real estate are placed on
non-accrual status at 120 days past due as to principal and interest, and
unsecured consumer loans are charged-off when the loan is 90 days or more past
due as to principal and interest.  Uncollected interest income accrued
on all non-accrual loans is reversed and charged to interest
income.




The
majority of the non-performing assets for the period were comprised of
non-accruing commercial business loans, non-accruing real estate loans,
non-accrual securities and ORE.  Most of the loans are collateralized,
thereby mitigating the Company’s potential for loss.  During the first
nine months of 2010, $1,398,000 of corporate bonds consisting of pooled trust
preferred securities were on non-accrual status.  There were no
non-accrual securities prior to 2009.  For a further discussion on the
Company’s securities portfolio, see Note 3, “Investments Securities”, within the
notes to the consolidated financial statements and the section entitled
“Investments”, contained within this management discussion and analysis
section.




Non-performing
loans were reduced from $12,884,000 on December 31, 2009 to $9,701,000 on
September 30, 2010.   At December 31, 2009, the over 90 day past
due portion was comprised of nine loans ranging from $1,000 to $294,000, and the
non-accrual loan portion numbered 58 loans ranging from $2,600 to
$2,800,000.  At September 30, 2010, there were five loans ranging from
$2,000 to $94,000 in the over 90 days past due category, and 59 loans ranging
from $2,600 to $1,300,000 in the non-accrual category.  The reduction
of $3,183,000 in non-performing loans from December 31, 2009 to September 30,
2010 resulted mainly from non-accrual commercial loan repayments and the
transfer of $1,053,000 from non-accrual to ORE.




The
Company, on a regular basis, reviews changes to loans to determine if they meet
the definition of a troubled debt restructuring (TDR).  TDR loans
arise when a borrower experiences financial difficulty and the Company grants a
concession that it would not otherwise make in order to maximize the Company’s
recovery.  TDR loans were $786,000 at September 30, 2010 and consisted
of $601,000 of accruing commercial real estate loans and $185,000 of accruing
commercial and industrial loans.  If applicable, a TDR loan classified
as non-accrual would require a minimum of six months of payments before
consideration for a return to accrual status.  Concessions made to
borrowers typically involve an extension of the loan’s maturity date or a change
in the loan’s amortization period.  The Company believes its
concessions have been successful as the borrowers are generally current with
respect to the restructured terms. The Company has not reduced interest rates,
forgiven principal or entered into any forbearance or other actions with respect
to these loans.  If loans characterized as a TDR perform according to
the restructured terms for a satisfactory period of time, the TDR designation
may be removed in a new calendar year if the loan yields a market rate of
interest.  There were no TDR loans at December 31, 2009.




-28-




ORE at
September 30, 2010 was $1,351,000 and consisted of five
properties.  At September 30, 2010, the non-accrual loans aggregated
$9,582,000 as compared to $12,329,000 at December 31, 2009.  The net
reduction in the level of non-accrual loans at September 30, 2010 occurred as
follows: Additions to the non-accrual loan component of the non-performing
assets totaling $7,118,000 were made during the first nine months of the
year.   These were partially offset by reductions or payoffs of
$7,333,000, charge-offs of $1,071,000, transfers to ORE of $1,053,000 and
$408,000 of loans that returned to performing status.  Loans past due
90 days or more and accruing were $120,000 at September 30, 2010 and $555,000,
at December 31, 2009.  Non-accrual securities were $1,398,000 at
September 30, 2010 and $583,000 at December 31, 2009.




Non-performing
loans to total loans were 2.30% at September 30, 2010, down from 2.98% at
December 31, 2009.  The percentage of non-performing assets to total
assets was 2.22% at September 30, 2010, also down from 2.58% at December 31,
2009, primarily driven by the aforementioned decline in the non-accrual loans
component.




The 30-89
day past due loans at September 30, 2010 were $2,870,000 reduced from $5,173,000
at December 31, 2009.  The reduced level occurred as a result of the
transfer of some loans to non-accrual, payments collected on others and the
conversion / transfer of a loan to ORE status.




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




September
      30,
                2010
              
              
              December
      31,
                2009
              
              
              September
      30,
                2009Loans
      past due 90 days or moreand
      accruing
              
              $
              119,566
              
              
              $
              554,806
              
              
              $
              1,002,720Non-accrual
      loans
              
              
              9,581,793
              
              
              
              12,329,338
              
              
              
              7,900,547Total
      non-performing loans
              
              
              9,701,359
              
              
              
              12,884,144
              
              
              
              8,903,267Troubled
      debt restructurings
              
              
              786,000
              
              
              
              -
              
              
              
              -Other
      real estate owned
              
              
              1,350,692
              
              
              
              887,397
              
              
              
              1,364,397Non-accrual
      securities
              
              
              1,397,514
              
              
              
              583,390
              
              
              
              -Total
      non-performing assets
              
              $
              13,235,565
              
              
              $
              14,354,931
              
              
              $
              10,267,664Total
      loans including HFS
              
              $
              422,688,600
              
              
              $
              431,919,023
              
              
              $
              415,204,347Total
      assets
              
              $
              596,598,598
              
              
              $
              556,017,271
              
              
              $
              565,999,434Non-accrual
      loans to total loans
              
              
              2.27
              %
              
              
              2.85
              %
              
              
              1.90
              %Non-performing
      loans to total loans
              
              
              2.30
              %
              
              
              2.98
              %
              
              
              2.14
              %Non-performing
      assets to total assets
              
              
              2.22
              %
              
              
              2.58
              %
              
              
              1.81
              %


The
composition of gross loans and non-performing loans as of September 30, 2010
(dollars in thousands):




Gross
      loan balances
                
                
                Past
      due 90 days or more and still accruing
                
                
                Non-
      accrual loans
                
                
                Total
      non- performing loans
                
                
                %
      of gross loansReal
      estate:Commercial
                
                $
                173,754
                
                
                $
                3
                
                
                $
                2,878
                
                
                $
                2,881
                
                
                
                1.66
                %Residential
      (1-4 family)
                
                
                66,573
                
                
                
                95
                
                
                
                3,993
                
                
                
                4,088
                
                
                
                6.14
                %Construction
                
                
                10,754
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Commercial
      and industrial
                
                
                84,287
                
                
                
                20
                
                
                
                2,150
                
                
                
                2,170
                
                
                
                2.57
                %Consumer
                
                
                87,015
                
                
                
                2
                
                
                
                561
                
                
                
                563
                
                
                
                0.65
                %Direct
      financing leases
                
                
                305
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Total
                
                $
                422,688
                
                
                $
                120
                
                
                $
                9,582
                
                
                $
                9,702
                
                
                
                2.30
                %





-29-




Bank premises and equipment,
net




The
Company entered into a new lease agreement with a new owner-landlord of its
Eynon branch.  Under the terms of the new operating lease, as defined
in the accounting guidance, the terms contain an initial ten year period
supplemented with four renewal options of five years each.  The terms
and minimum lease payments under the new lease agreement are not materially
different than the terms and minimum rental payments of the original, terminated
lease.




Foreclosedassets
held-for-sale




Foreclosed
assets held-for-sale, consisting of ORE, was $1,351,000 at September 30, 2010
comprised of five properties which are listed for sale with local
realtors.  The $464,000 rise in ORE from the December 31, 2009 balance
of $887,000 occurred from the sale of one commercial property with a book
balance of $550,000, an ORE fair value write-down of $39,000 and the transfer
into ORE of three properties at an aggregate fair value of
$1,053,000.




Other
assets




Other
assets at September 30, 2010 declined $211,000, or 1%, from December 31,
2010.  A lower net deferred tax asset from the net appreciation in
fair values in the securities portfolio partially offset increased
credit-related OTTI charges in the Company’s portfolio of pooled trust preferred
securities.  In addition, the period recognition and associated
reduction of the pre-funded FDIC insurance premiums caused a $341,000 reduction
in prepaid expenses.  These decreases were partially offset by an
increase in construction in process associated with leasehold improvements of
the Peckville branch office and higher levels of other prepaid
expenses.




Deposits




The Bank
is a community-based commercial financial institution, member FDIC, which offers
a variety of deposit products with varying ranges of interest rates and
terms.  Deposit products include savings, clubs, interest-bearing
checking (NOW), money market, non-interest-bearing checking (DDAs) and
certificates of deposit accounts.  Certificates of deposit accounts,
or CDs, are deposits with stated maturities which can range from seven days to
ten years.  The flow of deposits is significantly influenced by
general economic conditions, changes in prevailing interest rates, pricing and
competition.  To determine deposit product interest rates, the Company
considers local competition, spreads to earning-asset yields, liquidity position
and rates charged for alternative sources of funding such as borrowings which
include repurchase agreements.  Though the Company tends to experience
intense competition for deposits, the interest rate setting strategy also
includes consideration of the Company’s balance sheet structure and cost
effective strategies that are mindful of the current economic
climate.




Compared
to December 31, 2009 total deposits grew $31,889,000, or 7%, during the nine
months ended September 30, 2010.  The growth in total deposits was due
to increases in DDA, NOW and savings accounts of $10,929,000, or 15%,
$19,130,000, or 31% and $16,336,000, or 19%, respectively, partially offset by
lower CD and money market balances.  Generally, deposits are obtained
from consumers and businesses within the communities that surround the Company’s
11 branch offices and all deposits are insured by the FDIC up to the full extent
permitted by law.  In an effort to grow and retain core deposits, the
Company introduces innovative options to its variety of deposit
products.  The multi-tiered interest rate savings account developed in
2009 continued to grow, while NOW account balances have prospered from the
seasonal influx of local municipal tax deposits and growth in the non-personal,
business sector.  The Company will continue to provide superb customer
service and bring innovative ideas to the market in order to continue to grow
and retain deposits.




The
following table represents the components of deposits as of the date
indicated:




September 30, 2010
              
              
              December 31, 2009Amount
              
              
              %
              
              
              Amount
              
              
              %Money
      market
              
              $
              77,594
              
              
              
              15.8
              
              
              $
              91,488
              
              
              
              19.9NOW
              
              
              81,161
              
              
              
              16.5
              
              
              
              62,031
              
              
              
              13.5Savings
      and club
              
              
              102,671
              
              
              
              20.9
              
              
              
              86,335
              
              
              
              18.8Certificates
      of deposit
              
              
              135,828
              
              
              
              27.7
              
              
              
              139,502
              
              
              
              30.5CDARS
              
              
              11,810
              
              
              
              2.4
              
              
              
              8,748
              
              
              
              1.9Total
      interest-bearing
              
              
              409,064
              
              
              
              83.3
              
              
              
              388,104
              
              
              
              84.6Non-interest-bearing
              
              
              81,819
              
              
              
              16.7
              
              
              
              70,890
              
              
              
              15.4Total
      deposits
              
              $
              490,883
              
              
              
              100.0
              
              
              $
              458,994
              
              
              
              100.0




-30-




The
Company uses the Certificate of Deposit Account Registry Service (CDARS)
reciprocal program to obtain FDIC insurance protection for customers who have
large deposits that at times may exceed the FDIC maximum amount of
$250,000.  In the CDARS program, deposits with varying terms and
interest rates, originated in the Company’s own markets, are exchanged for
deposits of other financial institutions that are members in the CDARS
network.  By placing these deposits in other participating
institutions, the deposits of our customers are fully insured by the
FDIC.  In return for deposits placed with network institutions, the
Company receives from network institutions deposits that are approximately equal
in amount and contain similar terms as those placed for our
customers.  Deposits the Company receives, or reciprocal deposits,
from other institutions are considered brokered deposits by regulatory
definitions.




Excluding
CDARS, certificates of deposit accounts of $100,000 or more amounted to
$53,143,000 and $54,941,000 at September 30, 2010 and December 31, 2009,
respectively.  Certificates of deposit of $250,000 or more amounted to
$20,300,000 and $20,641,000 as of September 30, 2010 and December 31,
2009.




Including
CDARS, approximately 13% and 46% of the CDs are scheduled to mature in 2010 and
2011, respectively.  Renewing CDs may re-price to lower or higher
market rates depending on the direction of interest rate movements, the shape of
the yield curve, competition, the rate profile of the maturing accounts and
depositor preference for alternative products.  In this current low
interest rate environment, a widespread preference has been for customers with
maturing CDs to hold their deposits in readily available transaction products
such as savings accounts.  When interest rates begin to rise, the
Company expects CDs to grow to more normal levels.




In July
2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer
Protection Act, which, in part, permanently raises the current standard maximum
deposit insurance amount to $250,000.  The standard maximum insurance
amount of $100,000 had been temporarily raised to $250,000 until December 31,
2013.  In addition, non-interest bearing transaction accounts will be
fully insured, for a two year extension period beginning January 1,
2011.  The FDIC insurance coverage and limits apply per depositor, per
insured depository institution for each account ownership
category.  Low interest-bearing consumer checking accounts and
Interest on Lawyer Trust Accounts (IOLTA) will be ineligible for the unlimited
guarantee during the extension period.




Borrowings




Borrowings
are used as a complement to deposit generation as an alternative funding source
whereby the Bank will borrow under customer repurchase agreements in the local
market, advances from the Federal Home Loan Bank of Pittsburgh (FHLB) and other
correspondent banks for asset growth and liquidity needs.




Repurchase
agreements are non-insured interest-bearing liabilities that have a perfected
security interest in qualified investments of the Company.  The FDIC
Depositor Protection Act of 2009 requires banks to provide a perfected security
interest to the purchasers of uninsured repurchase
agreements.  Repurchase agreements 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 excess funds are transferred, or swept,
into an interest-bearing overnight repurchase agreement account.  Due
to the constant flow of funds in to and out of the sweep product, their balances
tend to be somewhat volatile mimicking the likes of a DDA.  Customer
liquidity is the typical cause for variances in repurchase agreements, which for
the first nine months of 2010 increased $4,021,000 from December 31,
2009.




The
components of borrowings as of September 30, 2010 and December 31, 2009 are as
follows (dollars in thousands):




September 30, 2010
              
              
              December 31, 2009Amount
              
              
              %
              
              
              Amount
              
              
              %Overnight
      borrowings
              
              $
              -
              
              
              
              -
              
              
              $
              8,573
              
              
              
              17.7Repurchase
      agreements
              
              
              11,767
              
              
              
              21.8
              
              
              
              7,747
              
              
              
              16.0Demand
      note, U.S. Treasury
              
              
              537
              
              
              
              1.0
              
              
              
              213
              
              
              
              0.4FHLB
      advances:Short-term
              
              
              9,500
              
              
              
              17.7
              
              
              
              -
              
              
              
              -Long-term
              
              
              32,000
              
              
              
              59.5
              
              
              
              32,000
              
              
              
              65.9Total
      borrowings
              
              $
              53,804
              
              
              
              100.0
              
              
              $
              48,533
              
              
              
              100.0


Total
borrowings have increased $5,271,000 or 11%, during the nine months ended
September 30, 2010.  While growth in deposits has reduced the
Company’s frequency for overnight funding needs, the increase in total
borrowings is from growth in repurchase agreements and the use of a short-term
FHLB advance.  The advance is a low-cost means to accommodate a
short-term, match funded commercial loan with a municipal
customer.  The advance matures in the fourth quarter of
2010.




-31-




Recent
Developments




Dodd-Frank Wall
Street Reform and Consumer Protection Act.   On July 21,
2010, President Obama signed into law the Dodd-Frank Wall Street Reform and
Consumer Protection Act (the “Act”).  The Act will result in sweeping
financial regulatory reform aimed at strengthening the nation’s financial
services sector.




The Act’s
provisions that have received the most public attention generally have been
those applying to larger institutions or institutions that engage in practices
in which we do not engage.  These provisions include growth
restrictions, credit exposure limits, higher prudential standards, prohibitions
on proprietary trading, and prohibitions on sponsoring and investing in hedge
funds and private equity funds.




However,
the Act contains numerous other provisions that likely will directly impact the
Company.  These include increased fees payable by banks to regulatory
agencies, new capital guidelines for banks and bank holding companies,
permanently increasing the FDIC insurance coverage from $100,000 to $250,000 per
depositor, new mortgage lending provisions, new liquidation procedures for
banks, new regulations affecting consumer financial products, new corporate
governance disclosures and requirements and the increased cost of supervision
and compliance more generally.  Many aspects of the law are subject to
rulemaking by various government agencies and will take effect over several
years.  This time table, combined with the Act’s significant deference
to future rulemaking by various regulatory agencies, makes it difficult for us
to anticipate the Act’s overall financial, competitive and regulatory impact on
us, our customers, and the financial industry more generally.




Item
3.  Quantitative and Qualitative Disclosure About Market
Risk




Management of interest rate
risk and market risk analysis




The
Company is subject to the interest rate risks inherent in its lending, investing
and financing activities.  Fluctuations of interest rates will impact
interest income and interest expense along with affecting market values of all
interest-earning assets and interest-bearing liabilities, except for those
assets or liabilities with a short term remaining to
maturity.  Interest rate risk management is an integral part of the
asset/liability management process.  The Company has instituted
certain procedures and policy guidelines to manage the interest rate risk
position.  Those internal policies enable the Company to react to
changes in market rates to protect net interest income from significant
fluctuations.  The primary objective in managing interest rate risk is
to minimize the adverse impact of changes in interest rates on net interest
income along with creating an asset/liability structure that maximizes
earnings.




Asset/Liability
Management.  One major objective of the Company when managing
the rate sensitivity of its assets and liabilities is to stabilize net interest
income.  The management of and authority to assume interest rate risk
is the responsibility of the Company’s Asset/Liability Committee (ALCO), which
is comprised of senior management and members of the board of
directors.  ALCO meets quarterly to monitor the relationship of
interest-sensitive assets to interest- sensitive liabilities.  The
process to review interest rate risk is a regular part of managing the
Company.  Consistent policies and practices of measuring and reporting
interest rate risk exposure, particularly regarding the treatment of
non-contractual assets and liabilities, are in effect.  In addition,
there is an annual process to review the interest rate risk policy with the
board of directors which includes limits on the impact to earnings from shifts
in interest rates.




Interest Rate Risk Measurement.Interest rate risk is monitored through the use of three complementary
measures: static gap analysis, earnings at risk simulation and economic value at
risk simulation.  While each of the interest rate risk measurements
has limitations, taken together they represent a reasonably comprehensive view
of the magnitude of interest rate risk in the Company and the distribution of
risk along the yield curve, the level of risk through time and the amount of
exposure to changes in certain interest rate relationships.




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




To manage
this interest rate sensitivity gap position, an asset/liability model commonly
known as cumulative gap analysis is used to monitor the difference in the volume
of the Company’s interest-sensitive assets and liabilities that mature or
re-price within given time intervals.  A positive gap (asset
sensitive) indicates that more assets will mature or re-price during a given
period compared to liabilities, while a negative gap (liability sensitive) has
the opposite effect.  The Company employs computerized net interest
income simulation modeling to assist in quantifying interest rate risk
exposure.  This process measures and quantifies the impact on net
interest income through varying interest rate changes and balance sheet
compositions.  The use of this model assists the ALCO to gauge the
effects of the interest rate changes on interest-sensitive assets and
liabilities in order to determine what impact these rate changes will have upon
the net interest spread.  As of September 30, 2010, the Bank
maintained a one-year cumulative gap of positive $50.4 million, or 8.44%, of
total assets.  The effect of this positive gap position provided a
mismatch of assets and liabilities which may expose the Bank to interest rate
risk during periods of falling interest rates.  Conversely, in an
increasing interest rate environment, net interest income could be positively
impacted because more assets than liabilities would re-price upward during the
one-year period.




-32-




Certain
shortcomings are inherent in the method of analysis discussed above and
presented in the next table.  Although certain assets and liabilities
may have similar maturities or periods of re-pricing, they may react in
different degrees to changes in market interest rates.  The interest
rates on certain types of assets and liabilities may fluctuate in advance of
changes in market interest rates, while interest rates on other types of assets
and liabilities may lag behind changes in market interest
rates.  Certain assets, such as adjustable-rate mortgages, have
features which restrict changes in interest rates on a short-term basis and over
the life of the asset.  In the event of a change in interest rates,
prepayment and early withdrawal levels may deviate significantly from those
assumed in calculating the table.  The ability of many borrowers to
service their adjustable-rate debt may decrease in the event of an interest rate
increase.




The
following table illustrates the Company’s interest sensitivity gap position at
September 30, 2010 (dollars in thousands):




Three
      months or less
              
              
              Three
      to twelve months
              
              
              One
      to three years
              
              
              Over
      three years
              
              
              TotalCash
      and cash equivalents
              
              $
              89
              
              
              $
              -
              
              
              $
              -
              
              
              $
              47,482
              
              
              $
              47,571Investment
      securities(1)(2)
              
              
              19,695
              
              
              
              11,834
              
              
              
              22,219
              
              
              
              33,508
              
              
              
              87,256Loans
      (2)
              
              
              135,184
              
              
              
              73,005
              
              
              
              120,095
              
              
              
              86,920
              
              
              
              415,204Fixed
      and other assets
              
              
              -
              
              
              
              9,348
              
              
              
              -
              
              
              
              37,220
              
              
              
              46,568Total
      assets
              
              $
              154,968
              
              
              $
              94,187
              
              
              $
              142,314
              
              
              $
              205,130
              
              
              $
              596,599Total
      cumulative assets
              
              $
              154,968
              
              
              $
              249,155
              
              
              $
              391,469
              
              
              $
              596,599Non-interest
      bearing transaction deposits (3)
              
              $
              -
              
              
              $
              8,182
              
              
              $
              22,500
              
              
              $
              51,137
              
              
              $
              81,819Interest-bearing
      transaction deposits (3)
              
              
              80,775
              
              
              
              -
              
              
              
              68,842
              
              
              
              111,809
              
              
              
              261,426Time
      deposits
              
              
              19,477
              
              
              
              57,554
              
              
              
              56,327
              
              
              
              14,280
              
              
              
              147,638Repurchase
      agreements
              
              
              11,767
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              11,767Short-term
      borrowings
              
              
              10,037
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              10,037Long-term
      debt
              
              
              11,000
              
              
              
              -
              
              
              
              -
              
              
              
              21,000
              
              
              
              32,000Other
      liabilities
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              3,236
              
              
              
              3,236Total
      liabilities
              
              $
              133,056
              
              
              $
              65,736
              
              
              $
              147,669
              
              
              $
              201,462
              
              
              $
              547,923Total
      cumulative liabilities
              
              $
              133,056
              
              
              $
              198,792
              
              
              $
              346,461
              
              
              $
              547,923Interest
      sensitivity gap
              
              $
              21,912
              
              
              $
              28,451
              
              
              $
              (5,355
              )
              
              $
              3,668Cumulative
      gap
              
              $
              21,912
              
              
              $
              50,363
              
              
              $
              45,008
              
              
              $
              48,676Cumulative
      gap to total assets
              
              
              3.67
              %
              
              
              8.44
              %
              
              
              7.54
              %
              
              
              8.16
              %





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




(2)
            Investments
      and loans are included in the earlier of the period in which interest
      rates were next scheduled to adjust or the period in which they are
      due.  In addition, loans are included in the periods in which
      they are scheduled to be repaid based on scheduled
      amortization.  For amortizing loans and MBS – GSE residential,
      annual prepayment rates are assumed reflecting historical experience as
      well as management’s knowledge and experience of its loan
      products.




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




Earnings at Risk and Economic Value
at Risk Simulations.  The Company recognizes that more
sophisticated tools exist for measuring the interest rate risk in the balance
sheet that extend beyond static re-pricing gap analysis.  Although it
will continue to measure its re-pricing gap position, the Company utilizes
additional modeling for identifying and measuring the interest rate risk in the
overall balance sheet.  The ALCO is responsible for focusing on
“earnings at risk” and “economic value at risk”, and how both relate to the
risk-based capital position when analyzing the interest rate risk.




Earnings at
Risk.  Earnings at risk simulation measures the change in net
interest income and net income should interest rates rise and
fall.  The simulation recognizes that not all assets and liabilities
re-price one-for-one with market rates (e.g., savings rate).  The ALCO
looks at “earnings at risk” to determine income changes from a base case
scenario under an increase and decrease of 200 basis points in interest rate
simulation models.




-33-




Economic Value at Risk.Earnings at risk simulation measures the short-term risk in the balance
sheet.  Economic value (or portfolio equity) at risk measures the
long-term risk by finding the net present value of the future cash flows from
the Company’s existing assets and liabilities.  The ALCO examines this
ratio quarterly utilizing an increase and decrease of 200 basis 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 basis points 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-earning asset and interest-bearing liability levels at
September 30, 2010 remain constant.  The impact of the rate movements
was developed by simulating the effect of rates changing over a twelve-month
period from the September 30, 2010 levels:




Earnings
      at risk:
              
              Rates +200
              
              
              Rates -200Percent
      change in:Net
      interest income
              
              
              2.4
              %
              
              
              (0.6
              )
       %Net
      income
              
              
              8.2
              
              
              
              (2.3
              )Economic
      value at risk:Percent
      change in:Economic
      value of equity
              
              
              (23.3
              )
              
              
              2.9Economic
      value of equityas
      a percent of book assets
              
              
              (1.6
              )
              
              
              0.2


Economic
value has the most meaning when viewed within the context of risk-based
capital.  Therefore, the economic value may normally change beyond the
Company's policy guideline for a short period of time as long as the risk-based
capital ratio (after adjusting for the excess equity exposure) is greater than
10%.  As of September 30, 2010, the Company’s risk-based capital ratio
was 12.2%.




The table
below summarizes estimated changes in net interest income over a twelve-month
period beginning October 1, 2010, under alternate interest rate scenarios using
the income simulation model described above (dollars in thousands):




Net
      interest
              
              
              $
              
              
              %Change
      in interest rates
              
              income
              
              
              variance
              
              
              variance+200
      basis points
              
              $
              21,381
              
              
              $
              499
              
              
              
              2.4
              %+100
      basis points
              
              
              21,064
              
              
              
              182
              
              
              
              0.9Flat
      rate
              
              
              20,882
              
              
              
              -
              
              
              
              --100
      basis points
              
              
              20,864
              
              
              
              (18
              )
              
              
              (0.1
              )-200
      basis points
              
              
              20,759
              
              
              
              (123
              )
              
              
              (0.6
              )


Simulation
models require assumptions about certain categories of assets and
liabilities.  The models schedule existing assets and liabilities by
their contractual maturity, estimated likely call date or earliest re-pricing
opportunity.  MBS – GSE residential securities and amortizing loans
are scheduled based on their anticipated cash flow including estimated
prepayments.  For investment securities, the Bank uses a third-party
service to provide cash flow estimates in the various rate
environments.  Savings, money market and NOW accounts do not have a
stated maturity or re-pricing term and can be withdrawn or re-priced at any
time.  This may impact the margin if more expensive alternative
sources of deposits are required to fund loans or deposit
runoff.  Management projects the re-pricing characteristics of these
accounts based on historical performance and assumptions that it believes
reflect their rate sensitivity.  The model reinvests all maturities,
repayments and prepayments for each type of asset or liability into the same
product for a new like term at current product interest rates.  As a
result, the mix of interest-earning assets and interest bearing-liabilities is
held constant.




Liquidity




Liquidity
management ensures that adequate funds will be available to meet customers’
needs for borrowings, deposit withdrawals and maturities and normal operating
expenses of the Company.  Current sources of liquidity are cash and
cash equivalents, asset maturities and pay-downs within one year, loans HFS and
investments AFS, growth of core deposits, growth of repurchase agreements,
increases of other borrowed funds from correspondent banks and issuance of
capital stock.  Although regularly scheduled investment and loan
payments are a dependable source of daily funds, the sales of loans HFS and
investments AFS, deposit activity and investment and loan prepayments are
significantly influenced by general economic conditions and the interest rate
environment.  During low and declining interest rate environments,
prepayments from interest-sensitive assets tend to accelerate and provide
significant liquidity which can be used to invest in other interest-earning
assets but at lower market rates.  Conversely, during periods of high
and rising interest rates, prepayments from interest-sensitive assets tend to
decelerate causing cash flow from mortgage loans and the MBS–GSE residential
securities portfolio to decrease.  Rising interest rates may also
cause deposit inflow to accelerate at higher market interest
rates.  The Company closely monitors activity in the capital markets
and takes appropriate action to ensure that the liquidity levels are adequate
for funding, investing and operating activities.




-34-




In 2010,
the Company implemented a contingency funding plan (CFP) that sets a framework
for handling liquidity issues in the event circumstances arise which the Company
deems to be less than normal.  To accomplish this, the Company
established guidelines for identifying, measuring, monitoring and managing the
resolution of potentially serious liquidity crises.  The Company’s CFP
outlines required monitoring tools, acceptable alternative funding sources and
required actions during various liquidity scenarios.  Thus, the
Company has implemented a proactive means for the measurement and resolution for
dealing with potentially significant adverse liquidity issues.  At
least quarterly, the CFP monitoring tools, current liquidity position and
monthly projected liquidity sources and uses are presented and reviewed by the
Company’s ALCO.  As of September 30, 2010, the Company has not
experienced any adverse liquidity issues that would give rise to its inability
to raise liquidity in an emergency situation.




For the
nine months ended September 30, 2010, the Company generated approximately $39.2
million of cash.  During 2010, the Company’s financing activities
provided $36.4 million, primarily from $37.2 million in growth of deposits and
repurchase agreements.  During the same period, the Company’s
operations provided approximately $9.8 million principally from the sales of
mortgages HFS, net of originations, and from increased pre-tax, pre-credit loss
earnings.  A portion of the cash generated from operations and
financing activities was used to purchase investment securities and to fund
capital investments.




As of
September 30, 2010, the Company maintained $47.6 million in cash and cash
equivalents and $87.7 million of investments AFS and loans HFS and also had
approximately $125.8 million available to borrow from the FHLB, $21.0 million
available from other correspondent banks, $22.9 million from the Discount Window
of the Federal Reserve Bank and $28.9 million with CDARS.  This
combined total of $333.9 million represented 56% of total assets at September
30, 2010.  Management believes this level of liquidity to be strong
and adequate to support current operations.




The
Company is a party to financial instruments with off-balance sheet risk in the
normal course of business in order to meet the financing needs of its customers
and in connection with the overall interest rate management
strategy.  These instruments involve, to a varying degree, elements of
credit, interest rate and liquidity risk.  In accordance with GAAP,
these instruments are not recorded in the consolidated financial
statements.  Such instruments primarily include lending commitments
and lease obligations.




Lending
commitments include commitments to originate loans and commitments to fund
unused lines of credit.  Commitments to extend credit are agreements
to lend to a customer as long as there is no violation of any condition
established by contract.  Commitments generally have fixed expiration
dates or other termination clauses and may require payment of a
fee.  Since some of the commitments are expected to expire without
being drawn upon, the total commitment amounts do not necessarily represent
future cash requirements.




In
addition to lending commitments, the Company has contractual obligations related
to operating lease commitments, certificates of deposit, FHLB advances and
repurchase agreements.  Operating lease commitments are obligations
under various non-cancelable operating leases on buildings and land used for
office space and other bank purposes.  The Company’s position with
respect to lending commitments and significant contractual obligations, both on
a short- and long-term basis has increased to $232.8 million in total at
September 30, 2010 compared to $219.9 million as of December 31,
2010.  The $12.9 million increase was caused by a short-term $9.5
million FHLB advance to match-fund a commercial loan, the proceeds of which are
scheduled to be re-paid by 2010 year-end.  The balance of the increase
is from normal business activity, mostly from growth in repurchase
agreements.  The Company does not consider this increase to have a
material effect on the Company’s ability to fund its obligations.




During
April 2010, the FHLB informed the Company of a 50% collateral maintenance
requirement on outstanding obligations and restrictions on utilization above 35%
of the amount available to borrow.  During October 2010, the FHLB
informed the Company that it has reduced the restrictions on utilization to
above 50% of the amount available to borrow.  The Company is
formulating strategies to continue to improve its position and have the
requirements eventually lifted.  The requirements only impose more
stringent collateral delivery requirements and utilization subject to prior
credit committee decision-making and does not minimize or reduce the amount the
Company may borrow.  Management does not consider this action to
significantly effect the liquidity position of the Company.




Capital




During
the nine months ended September 30, 2010, total shareholders' equity increased
$3,001,000, or 7%.  The improvement was caused by: net income of
$1,630,000; a $2,157,000 (net of $1,272,000 in non-credit-related OTTI) after
tax improvement in the market value of the AFS securities portfolio; $67,000 in
proceeds from employees enrolled in the Company’s Employee Stock Purchase Plan;
partially offset by $861,000 of dividends paid to shareholders, net of dividends
reinvested and optional cash payments received from participants in the
Company’s Dividend Reinvestment Plan.




-35-




As of
September 30, 2010, the Company reported a net unrealized loss of $7,037,000,
net of tax, from the securities AFS compared to a net unrealized loss of
$9,194,000 as of December 31, 2009.  While the unrealized loss
position has improved, the prolonged economic downturn continues to assert
uncertainty and in certain circumstances illiquidity in the financial and
capital markets and has had a sizable negative impact on the fair value
estimates on the securities in banks’ investment
portfolios.  Management maintains these changes are due mainly to
liquidity problems in the financial markets and to a lesser extent the
deterioration in the creditworthiness of the issuers.




The
Company (on a consolidated basis) and the Bank are subject to various regulatory
capital requirements administered by the federal banking
agencies.  Failure to meet minimum capital requirements can initiate
certain mandatory and possible additional discretionary actions by regulators
that, if undertaken, could have a direct material effect on the Company’s and
the Bank’s financial statements.  Under capital adequacy guidelines
and the regulatory framework for prompt corrective action, the Company and the
Bank must meet specific capital guidelines that involve quantitative measures of
their assets, liabilities and certain off-balance-sheet items as calculated
under regulatory accounting practices.  The capital amounts and
classification are also subject to qualitative judgments by the regulators about
components, risk-weightings and other factors.  Prompt corrective
action provisions are not applicable to bank holding companies.




Under
these guidelines, assets and certain off-balance sheet items are assigned to
broad risk categories, each with appropriate weights.  The resulting
capital ratios represent capital as a percentage of total risk-weighted assets
and certain off-balance sheet items.  The appropriate risk-weighting,
pursuant to regulatory guidelines, requires an increase in the risk-weighting of
securities that are rated below investment grade, thereby significantly
inflating the total risk-weighted assets.  The regulatory guidelines
require all banks and bank holding companies to maintain a minimum ratio of
total risk-based capital 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
least 4%.  As of September 30, 2010, the Company and the Bank met all
capital adequacy requirements to which it was subject.




The
Company continues to closely monitor and evaluate alternatives to enhance its
capital ratios as the regulatory and economic environments
change.  The following table depicts the capital amounts and ratios of
the Company and the Bank as of September 30, 2010:




Actual
                    
                    
                    
                    
                    For
      capital adequacy purposes
                    
                    
                    To
      be well capitalized under prompt corrective action
    provisionsAmount
                    
                    Ratio
                    
                    
                    Amount
                    
                    
                    Ratio
                    
                    
                    Amount
                    
                    
                    RatioTotal
      capital(to
      risk-weighted assets)Consolidated
                    
                    $
                    62,052,881
                    
                    12.2
                    %
                    ≥
                    $
                    40,696,324
                    
                    ≥
                    
                    8.0
                    %
                    
                    
                    N/A
                    
                    
                    
                    N/ABank
                    
                    $
                    61,681,557
                    
                    12.1
                    %
                    ≥
                    $
                    40,686,528
                    
                    ≥
                    8.0
                    %
                    ≥
                    $50,858,160
                    
                    ≥
                    
                    10.0
                    %Tier
      I capital(to
      risk-weighted assets)Consolidated
                    
                    $
                    55,626,693
                    
                    10.9
                    %
                    ≥
                    $
                    $20,348,162
                    
                    ≥
                    
                    4.0
                    %
                    
                    
                    N/A
                    
                    
                    
                    N/ABank
                    
                    $
                    55,309,537
                    
                    10.9
                    %
                    ≥
                    $
                    $20,343,264
                    
                    ≥
                    4.0
                    %
                    ≥
                    $30,514,896
                    
                    ≥
                    
                    6.0
                    %Tier
      I capital(to
      average assets)Consolidated
                    
                    $
                    55,626,693
                    
                    9.5
                    %
                    ≥
                    $
                    $23,432,653
                    
                    ≥
                    
                    4.0
                    %
                    
                    
                    N/A
                    
                    
                    
                    N/ABank
                    
                    $
                    55,309,537
                    
                    9.5
                    %
                    ≥
                    $
                    $23,415,435
                    
                    ≥
                    4.0
                    %
                    ≥
                    $29,269,294
                    
                    ≥
                    
                    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
Interim President and 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 Interim President and 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 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 September 30, 2010.




In July
2010, President Obama signed into law the Dodd-Frank Wall Street Reform and
Consumer Protection Act, which in part, provides smaller companies and debt-only
issuers with a permanent exemption from the Sarbanes-Oxley internal control
audit requirements.  Without this exemption, these companies would
have been required to comply with the internal control audit requirements for
fiscal years ended on or after June 15, 2010.  The permanent exemption
applies to entities that are commonly referred to as non-accelerated filers and
smaller reporting companies, such as the Company.  Generally speaking,
a non-accelerated filer and a smaller reporting company have public float, or
market capitalization of less than $75.0 million.  The permanent
exemption applies only to the Sarbanes-Oxley internal control audit
requirements.  Non-accelerated filers and smaller reporting companies
are still required to disclose management's assessment of the effectiveness of
internal control over financial reporting.




-36-




PART
II - Other Information




Item
1.  Legal Proceedings




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




Item
1A.  Risk Factors




The
following is an additional risk factor that should be read in
conjunction with Item 1A, “Risk Factors” that were disclosed in the Company’s
December 31, 2009 Form 10-K filed with the Securities and Exchange Commission on
March 8, 2010:




The
Company has an Interim Chief Executive Officer while it searches for a permanent
Chief Executive Officer.




During
the third quarter of 2009, our President and Chief Executive Officer (CEO)
resigned.  As a result, the board of directors formed a CEO search
committee and is currently conducting a search.  The process has taken
longer than we initially expected.  While we expect to recruit a new
CEO by year-end, we cannot assure you that the process will be concluded by
then.  Further, until we find a permanent CEO, we may be unable to
successfully manage and grow the business; and, our business, financial
condition and profitability may suffer.  We believe each member of our
senior management team is important to our success and the unexpected loss of
any of theses persons could impair our day-to-day operations as well as our
strategic direction.




Management
of the Company does not believe there have been any other material changes in
risk factors that were disclosed in the 2009 Form 10-K filed with the Securities
and Exchange Commission on March 8, 2010.




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




None




Item
3.  Default Upon Senior Securities




None




Item
4.  (Removed and Reserved)




None




Item
5.  Other Information




None




Item
6.  Exhibits




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




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.




-37-




*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, by Registration Statement No.
333-152806 on Form S-3 filed on August 6, 2008 and by Post-Effective
Amendment No. 1 on January 25, 2010.




*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 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.




*10.10 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.




*10.11 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.




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




*10.13 Release
Agreement between Steven C. Ackmann, Registrant and The Fidelity Deposit and
Discount Bank, dated August 31, 2009.  Incorporated by
reference to Exhibit 99.1 to Registrant’s Current Report on Form 8-K filed with
the SEC on September 8, 2009.




*10.14 Consulting
Agreement between Steven C. Ackmann, former President and Chief Executive
Officer of the Registrant and The Fidelity Deposit and Discount Bank, and The
Fidelity Deposit and Discount Bank, dated September 1, 2009.  Incorporated by
reference to Exhibit 99.2 to Registrant’s Current Report on Form 8-K filed with
the SEC on September 8, 2009.




11Statement
regarding computation of earnings per share.  Included herein
in Note No. 4, “Earnings (loss) per share,” contained within the Notes to
Consolidated Financial Statements, and incorporated herein by
reference.




31.1
Rule 13a-14(a) Certification of Principal Executive Officer, filed
herewith.




31.2
Rule 13a-14(a) Certification of Principal Financial Officer, filed
herewith.




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, filed
herewith.




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, filed
herewith.







*Management
contract or compensatory plan or arrangement.




-38-





Signatures





FIDELITY
D & D BANCORP, INC.





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




FIDELITY
      D & D BANCORP, INC.Date:
      November 9, 2010
              
              /s/
      Patrick J. DempseyPatrick
      J. Dempsey,Interim
      President andChief
      Executive OfficerDate:
      November 9, 2010
              
              /s/
      Salvatore R. DeFrancesco, Jr.Salvatore
      R. DeFrancesco, Jr.,Treasurer
      and Chief Financial Officer






-39-




EXHIBIT
INDEX




Page3(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 and by Post-Effective
      Amendment No. 1 on January 25, 2010.
            
            *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 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.
            
            *10.10
      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.
            
            *10.11
      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.
            
            *10.12
      Executive Employment Agreement between Fidelity D & D Bancorp, Inc.,
      The Fidelity Deposit and Discount Bank and Daniel J. Santaniello, dated
      February 28, 2008.Incorporated by reference to Exhibit
      10.1 to Registrant’s Current Report on Form 8-K filed with the SEC on
      March 3, 2008.
            
            *10.13
      Release Agreement between Steven C. Ackmann, Registrant and The Fidelity
      Deposit and Discount Bank, dated August 31,
      2009.Incorporated by reference to Exhibit 99.1 to
      Registrant’s Current Report on Form 8-K filed with the SEC on September 8,
      2009.
            
            *




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10.14
      Consulting Agreement between Steven C. Ackmann, former President and Chief
      Executive Officer of the Registrant and The Fidelity Deposit and Discount
      Bank, and The Fidelity Deposit and Discount Bank, dated September 1,
      2009.  Incorporated by reference to Exhibit 99.2 to
      Registrant’s Current Report on Form 8-K filed with the SEC on September 8,
      2009.
            
            *11
      Statement
      regarding computation of earnings per share.
            
            1331.1
      Rule 13a-14(a) Certification of Principal Executive
    Officer.
            
            4231.2
      Rule 13a-14(a) Certification of Principal Financial
    Officer.
            
            4332.1
      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.
            
            4432.2
      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.
            
            45




*
Incorporated by Reference





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