Table of Contents

 

 

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

**x****QUARTERLY REPORT PURSUANT TO SECTION 13OR 15(d) OF THE**

**SECURITIESEXCHANGE ACT OF 1934**

 

**For thequarterly period ended June 30, 2008**

 

**OR**

 

**o****TRANSITION REPORT PURSUANT TO SECTION 13OR 15(d) OF THE**

**SECURITIESEXCHANGE ACT OF 1934**

 

**For thetransition period from                  to                 **

 

**Commissionfile number: 333-90273**

 

**FIDELITYD & D BANCORP, INC.**

 

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

 

Address ofprincipal executive offices:

**BLAKELY &DRINKER ST.**

**DUNMORE,PENNSYLVANIA 18512**

 

TELEPHONE:

**570-342-8281**

 

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

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company. See 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 o | Non-accelerated filer o                        | Smaller reporting  company x |
|---------------------------|--------------------------|------------------------------------------------|-----------------------------------|
|                      |                     | (Do not check if a smaller  reporting company) |                              |

 

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

 

oYES        xNO

 

The number of outstandingshares of Common Stock of Fidelity D & D Bancorp, Inc. at July 31,2008, the latest practicable date, was 2,064,182 shares.

 

 

 

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Tableof Contents

 

**FIDELITYD & D BANCORP, INC.**

 

Form 10-Q June 30,2008

 

Index

 
| ** **                             | **Page**                                                                                                          |
|----------------------------------------|-------------------------------------------------------------------------------------------------------------------|
| **Part I. Financial Information** | ** **                                                                                                        |
| ** **                             | ** **                                                                                                        |
| Item 1.                                | Financial Statements:                                                                                             |   |
|                                   | Consolidated Balance Sheets as of  June 30, 2008 and December 31, 2007                                       | 3 |
|                                   | Consolidated Statements of  Income for the three and six months ended June 30, 2008 and 2007                      | 4 |
|                                   | Consolidated Statements of  Changes in Shareholders’ Equity for the six months ended June 30, 2008 and  2007 | 5 |
|                                   | Consolidated Statements of  Cash Flows for the six months ended June 30, 2008 and 2007                            | 6 |
|                                   | Notes to  Consolidated Financial Statements                                                                       | 7 |
|                                   |                                                                                                              |   |
| Item 2.                                | Management’s  Discussion and Analysis of Financial Condition                                                 |   |
|                                   | and Results  of Operations                                                                                        | 12 |
|                                   |                                                                                                              |   |
| Item 3.                                | Quantitative  and Qualitative Disclosure about Market Risk                                                        | 25 |
|                                   |                                                                                                              |   |
| Item 4.                                | Controls and  Procedures                                                                                          | 29 |
|                                   |                                                                                                              |   |
| **Part II. Other  Information**   |                                                                                                              |
| ** **                             |                                                                                                              |   |
| Item 1.                                | Legal Proceedings                                                                                                 | 29 |
|                                   |                                                                                                              |   |
| Item 1A.                               | Risk Factors                                                                                                      | 29 |
|                                   |                                                                                                              |   |
| Item 2.                                | Unregistered  Sales of Equity Securities and Use of Proceeds                                                      | 30 |
|                                   |                                                                                                              |   |
| Item 3.                                | Defaults  upon Senior Securities                                                                                  | 30 |
|                                   |                                                                                                              |   |
| Item 4.                                | Submission  of Matters to a Vote of Security Holders                                                              | 30 |
|                                   |                                                                                                              |   |
| Item 5.                                | Other Information                                                                                                 | 30 |
|                                   |                                                                                                              |   |
| Item 6.                                | Exhibits                                                                                                          | 31 |
|                                   |                                                                                                              |   |
| Signatures                             |                                                                                                              | 32 |
|                                   |                                                                                                              |   |
| Exhibit index                     |                                                                                                              | 33 |

 

2

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Tableof Contents

 

**PART I – Financial Information**

 

**Item 1:Financial Statements**

 

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

ConsolidatedBalance Sheets

 
| ** **                                                                                                                                                                       | ** ** | **June 30, 2008** | ** **  | **December 31, 2007** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|-------------|---------------------------------|------------|
| ** **                                                                                                                                                                       | ** ** | **(unaudited)**             | ** **  | **(audited)**                   | ** ** |
|                                                                                                                                                                             |       |                        |        |                            |       |
| Assets:                                                                                                                                                                          |       |                        |        |                            |       |
| Cash and due  from banks                                                                                                                                                         |       | $                           | 15,737,564  |                            | $          | 10,204,714 |   |
| Interest-bearing  deposits with financial institutions                                                                                                                           |       | 302,902                     |        | 204,102                         |       |
|                                                                                                                                                                             |       |                        |        |                            |       |
| Total cash and  cash equivalents                                                                                                                                                 |       | 16,040,466                  |        | 10,408,816                      |       |
|                                                                                                                                                                             |       |                        |        |                            |       |
| Available-for-sale  securities                                                                                                                                                   |       | 128,184,265                 |        | 121,836,851                     |       |
| Held-to-maturity  securities                                                                                                                                                     |       | 1,059,902                   |        | 1,147,309                       |       |
| Federal Home  Loan Bank Stock                                                                                                                                                    |       | 4,358,300                   |        | 3,302,900                       |       |
| Loans and  leases, net (allowance for loan losses of $4,188,571 in 2008; $4,824,401 in  2007)                                                                                    |       | 414,309,318                 |        | 421,424,379                     |       |
| Loans  available-for-sale (fair value $154,024 in 2008; $842,923 in 2007)                                                                                                        |       | 152,430                     |        | 827,250                         |       |
| Bank premises  and equipment, net                                                                                                                                                |       | 12,912,023                  |        | 12,964,932                      |       |
| Cash surrender  value of bank owned life insurance                                                                                                                               |       | 8,645,597                   |        | 8,488,663                       |       |
| Other assets                                                                                                                                                                     |       | 9,329,642                   |        | 4,403,723                       |       |
| Accrued interest  receivable                                                                                                                                                     |       | 2,674,917                   |        | 2,500,696                       |       |
| Foreclosed  assets held-for-sale                                                                                                                                                 |       | 897,036                     |        | 107,036                         |       |
|                                                                                                                                                                             |       |                        |        |                            |       |
| Total assets                                                                                                                                                                     |       | $                           | 598,563,896 |                            | $          | 587,412,555 |   |
|                                                                                                                                                                             |       |                        |        |                            |       |
| Liabilities:                                                                                                                                                                     |       |                        |        |                            |       |
| Deposits:                                                                                                                                                                        |       |                        |        |                            |       |
| Interest-bearing                                                                                                                                                                 |       | $                           | 373,468,779 |                            | $          | 360,912,740 |   |
| Non-interest-bearing                                                                                                                                                             |       | 74,765,086                  |        | 64,795,621                      |       |
|                                                                                                                                                                             |       |                        |        |                            |       |
| Total deposits                                                                                                                                                                   |       | 448,233,865                 |        | 425,708,361                     |       |
|                                                                                                                                                                             |       |                        |        |                            |       |
| Accrued interest  payable and other liabilities                                                                                                                                  |       | 5,318,030                   |        | 4,147,869                       |       |
| Short-term  borrowings                                                                                                                                                           |       | 29,674,336                  |        | 39,656,354                      |       |
| Long-term debt                                                                                                                                                                   |       | 62,285,582                  |        | 62,708,677                      |       |
|                                                                                                                                                                             |       |                        |        |                            |       |
| Total  liabilities                                                                                                                                                               |       | 545,511,813                 |        | 532,221,261                     |       |
|                                                                                                                                                                             |       |                        |        |                            |       |
| Shareholders’  equity:                                                                                                                                                      |       |                        |        |                            |       |
| Preferred stock  authorized 5,000,000 shares with no par value; none issued                                                                                                      |       | —                      |        | —                          |       |
| Capital stock,  no par value (10,000,000 shares authorized; 2,075,182 shares issued and  2,070,182 shares outstanding in 2008; 2,072,929 shares issued and outstanding  in 2007) |       | 19,407,992                  |        | 19,223,363                      |       |
| Treasury stock,  at cost (5,000 shares in 2008; none in 2007)                                                                                                                    |       | (145,605                    | )           | —                          |       |
| Retained  earnings                                                                                                                                                               |       | 37,819,460                  |        | 36,564,157                      |       |
| Accumulated  other comprehensive loss                                                                                                                                            |       | (4,029,764                  | )           | (596,226                        | )          |
|                                                                                                                                                                             |       |                        |        |                            |       |
| Total  shareholders’ equity                                                                                                                                                 |       | 53,052,083                  |        | 55,191,294                      |       |
|                                                                                                                                                                             |       |                        |        |                            |       |
| Total liabilities and shareholders’ equity                                                                                                                                  |       | $                           | 598,563,896 |                            | $          | 587,412,555 |   |

 

See notes toconsolidated financial statements

 

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** **

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

ConsolidatedStatements of Income

(unaudited)

 
| ** **                                             | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                             | ** ** | **June 30, 2008**      | ** ** | **June 30, 2007**    | ** ** | **June 30, 2008** | ** ** | **June 30, 2007** | ** ** |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Interest income:                                       |       |                             |       |                           |       |   |   |   |   |
| Loans and  leases:                                     |       |                             |       |                           |       |   |   |   |   |
| Taxable                                                |       | $                                | 6,775,180  |                           | $          | 7,141,888 |   | $ | 13,584,314 |   | $ | 14,316,917 |   |
| Nontaxable                                             |       | 85,330                           |       | 118,352                        |       | 163,406 |   | 227,869 |   |
| Interest-bearing  deposits with financial institutions |       | 696                              |       | 1,929                          |       | 1,802 |   | 4,721 |   |
| Investment  securities:                                |       |                             |       |                           |       |   |   |   |   |
| U.S. government  agency and corporations               |       | 1,284,136                        |       | 1,016,972                      |       | 2,537,317 |   | 1,936,260 |   |
| States and  political subdivisions (nontaxable)        |       | 155,102                          |       | 124,512                        |       | 299,232 |   | 249,351 |   |
| Other securities                                       |       | 305,658                          |       | 280,523                        |       | 680,694 |   | 526,422 |   |
| Federal funds  sold                                    |       | 6,964                            |       | 202                            |       | 91,133 |   | 54,654 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Total interest income                                  |       | 8,613,066                        |       | 8,684,378                      |       | 17,357,898 |   | 17,316,194 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Interest  expense:                                     |       |                             |       |                           |       |   |   |   |   |
| Deposits                                               |       | 2,831,400                        |       | 3,222,678                      |       | 6,065,136 |   | 6,556,701 |   |
| Securities sold  under repurchase agreements           |       | 13,443                           |       | 115,576                        |       | 80,596 |   | 231,033 |   |
| Other short-term  borrowings and other                 |       | 48,849                           |       | 260,939                        |       | 113,671 |   | 334,012 |   |
| Long-term debt                                         |       | 776,210                          |       | 762,629                        |       | 1,608,495 |   | 1,567,702 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Total interest expense                                 |       | 3,669,902                        |       | 4,361,822                      |       | 7,867,898 |   | 8,689,448 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Net interest  income                                   |       | 4,943,164                        |       | 4,322,556                      |       | 9,490,000 |   | 8,626,746 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Provision for  loan losses                             |       | 125,000                          |       | —                         |       | 125,000 |   | — |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Net interest  income after provision for loan losses   |       | 4,818,164                        |       | 4,322,556                      |       | 9,365,000 |   | 8,626,746 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Other income:                                          |       |                             |       |                           |       |   |   |   |   |
| Service charges  on deposit accounts                   |       | 737,330                          |       | 761,922                        |       | 1,500,599 |   | 1,394,239 |   |
| Gain (loss) on  sale of:                               |       |                             |       |                           |       |   |   |   |   |
| Loans                                                  |       | 59,590                           |       | 31,171                         |       | 151,196 |   | 67,896 |   |
| Investment  securities                                 |       | 7,519                            |       | —                         |       | 8,653 |   | — |   |
| Premises and  equipment                                |       | (984                             | )          | (22,924                        | )          | (984 | ) | 73,633 |   |
| Foreclosed  assets held-for-sale                       |       | 405                              |       | 127,621                        |       | 9,109 |   | 142,749 |   |
| Fees and other  service charges                        |       | 461,809                          |       | 431,324                        |       | 892,638 |   | 864,260 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Total other income                                     |       | 1,265,669                        |       | 1,329,114                      |       | 2,561,211 |   | 2,542,777 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Other expenses:                                        |       |                             |       |                           |       |   |   |   |   |
| Salaries and  employee benefits                        |       | 2,472,302                        |       | 2,165,352                      |       | 4,889,848 |   | 4,300,329 |   |
| Premises and  equipment                                |       | 781,469                          |       | 784,285                        |       | 1,572,109 |   | 1,590,110 |   |
| Advertising                                            |       | 168,348                          |       | 183,620                        |       | 336,704 |   | 342,625 |   |
| Other                                                  |       | 1,022,421                        |       | 954,296                        |       | 2,038,628 |   | 1,967,532 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Total other expenses                                   |       | 4,444,540                        |       | 4,087,553                      |       | 8,837,289 |   | 8,200,596 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Income before  provision for income taxes              |       | 1,639,293                        |       | 1,564,117                      |       | 3,088,922 |   | 2,968,927 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Provision for  income taxes                            |       | 435,347                          |       | 405,384                        |       | 796,029 |   | 765,843 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Net income                                             |       | $                                | 1,203,946  |                           | $          | 1,158,733 |   | $ | 2,292,893 |   | $ | 2,203,084 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Per share data:                                        |       |                             |       |                           |       |   |   |   |   |
| Net income -  basic                                    |       | $                                | 0.59       |                           | $          | 0.56 |   | $ | 1.11 |   | $ | 1.07 |   |
| Net income -  diluted                                  |       | $                                | 0.59       |                           | $          | 0.56 |   | $ | 1.11 |   | $ | 1.07 |   |
| Dividends                                              |       | $                                | 0.25       |                           | $          | 0.22 |   | $ | 0.50 |   | $ | 0.44 |   |

 

See Notes toConsolidated Financial Statements

 

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

ConsolidatedStatements of Changes in Shareholders’ Equity

For the sixmonths ended June 30, 2008 and 2007

 
| ** **                                                                                                                     | ** ** | ** **             | ** ** | ** **              | ** ** | ** **   | ** ** | ** **        | ** ** | ** **   | ** ** | **Accumulated**        | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-------------------------|------------|--------------|------------|-------------------|------------|--------------|------------|------------------------|------------|------------|------------|
| ** **                                                                                                                     | ** ** | ** **             | ** ** | ** **              | ** ** | ** **   | ** ** | ** **        | ** ** | ** **   | ** ** | **other**              | ** ** | ** ** | ** ** |
| ** **                                                                                                                     | ** ** | **Capital stock** | ** ** | **Treasury stock** | ** ** | **Retained** | ** ** | **comprehensive** | ** ** | ** **   | ** ** |
| ** **                                                                                                                     | ** ** | **Shares**             | ** ** | **Amount**              | ** ** | **Shares**   | ** ** | **Amount**        | ** ** | **earnings** | ** ** | **income (loss)** | ** ** | **Total**  | ** ** |
|                                                                                                                           |       |                   |       |                    |       |         |       |              |       |         |       |                   |       |       |       |
| Balance,  December 31, 2006 (audited)                                                                                          |       | 2,057,433              |       | $                       | 18,702,537 |         | —     |              | $          | —       |       | $                      | 33,874,118 |       | $          | (964,792 | ) | $ | 51,611,863 |   |
| Total  comprehensive income:                                                                                                   |       |                   |       |                    |       |         |       |              |       |         |       |                   |       |       |       |
| Net income                                                                                                                     |       |                   |       |                    |       |         |       |              |       | 2,203,084    |       |                   |       | 2,203,084  |       |
| Change in net  unrealized holding losses on available-for-sale securities, net of reclassification  adjustment and tax effects |       |                   |       |                    |       |         |       |              |       |         |       | (1,034,092             | )          | (1,034,092 | )          |
| Change in cash  flow hedge intrinsic value                                                                                     |       |                   |       |                    |       |         |       |              |       |         |       | (28,721                | )          | (28,721    | )          |
| Comprehensive  income                                                                                                          |       |                   |       |                    |       |         |       |              |       |         |       |                   |       | 1,140,271  |       |
| Issuance of  common stock through Employee Stock                                                                               |       |                   |       |                    |       |         |       |              |       |         |       |                   |       |       |       |
| Purchase Plan                                                                                                                  |       | 2,266                  |       | 67,820                  |       |         |       |              |       |         |       |                   |       | 67,820     |       |
| Dividends  reinvested through Dividend Reinvestment Plan                                                                       |       | 7,921                  |       | 279,176                 |       |         |       |              |       |         |       |                   |       | 279,176    |       |
| Stock-based  compensation expense                                                                                              |       |                   |       | 6,958                   |       |         |       |              |       |         |       |                   |       | 6,958      |       |
| Cash dividends  declared                                                                                                       |       |                   |       |                    |       |         |       |              |       | (907,073     | )          |                   |       | (907,073   | )          |
|                                                                                                                           |       |                   |       |                    |       |         |       |              |       |         |       |                   |       |       |       |
| Balance, June  30, 2007 (unaudited)                                                                                            |       | 2,067,620              |       | $                       | 19,056,491 |         | —     |              | $          | —       |       | $                      | 35,170,129 |       | $          | (2,027,605 | ) | $ | 52,199,015 |   |
|                                                                                                                           |       |                   |       |                    |       |         |       |              |       |         |       |                   |       |       |       |
| Balance,  December 31, 2007 (audited)                                                                                          |       | 2,072,929              |       | $                       | 19,223,363 |         | —     |              | $          | —       |       | $                      | 36,564,157 |       | $          | (596,226 | ) | $ | 55,191,294 |   |
| Total  comprehensive income:                                                                                                   |       |                   |       |                    |       |         |       |              |       |         |       |                   |       |       |       |
| Net income                                                                                                                     |       |                   |       |                    |       |         |       |              |       | 2,292,893    |       |                   |       | 2,292,893  |       |
| Change in net  unrealized holding losses on available-for-sale securities, net of reclassification  adjustment and tax effects |       |                   |       |                    |       |         |       |              |       |         |       | (3,531,356             | )          | (3,531,356 | )          |
| Change in cash  flow hedge intrinsic value                                                                                     |       |                   |       |                    |       |         |       |              |       |         |       | 97,818                 |       | 97,818     |       |
| Comprehensive  income                                                                                                          |       |                   |       |                    |       |         |       |              |       |         |       |                   |       | (1,140,645 | )          |
| Issuance of  common stock through Employee Stock Purchase Plan                                                                 |       | 2,253                  |       | 57,891                  |       |         |       |              |       |         |       |                   |       | 57,891     |       |
| Stock-based  compensation expense                                                                                              |       |                   |       | 126,738                 |       |         |       |              |       |         |       |                   |       | 126,738    |       |
| Purchase of  treasury stock                                                                                                    |       |                   |       |                    |       | (5,000       | )          | (145,605          | )          |         |       |                   |       | (145,605   | )          |
| Cash dividends  declared                                                                                                       |       |                   |       |                    |       |         |       |              |       | (1,037,590   | )          |                   |       | (1,037,590 | )          |
|                                                                                                                           |       |                   |       |                    |       |         |       |              |       |         |       |                   |       |       |       |
| Balance, June  30, 2008 (unaudited)                                                                                            |       | 2,075,182              |       | $                       | 19,407,992 |         | (5,000     | )                 | $          | (145,605     | )          | $                      | 37,819,460 |       | $          | (4,029,764 | ) | $ | 53,052,083 |   |

 

See Notes toConsolidated Financial Statements

 

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**FIDELITY DEPOSIT & DISCOUNT BANCORP, INC. AND SUBSIDIARY**

ConsolidatedStatements of Cash Flows

(unaudited)

 
| ** **                                                                         | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                         | ** ** | **June 30, 2008**    | ** ** | **June 30, 2007** | ** ** |
|                                                                               |       |                           |       |   |   |
| Cash flows from  operating activities:                                             |       |                           |       |   |   |
| Net income                                                                         |       | $                              | 2,292,893  |   | $ | 2,203,084 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                           |       |   |   |
| Depreciation,  amortization and accretion                                          |       | 296,817                        |       | 586,199 |   |
| Provision for  loan losses                                                         |       | 125,000                        |       | — |   |
| Deferred income  tax expense (benefit)                                             |       | 240,736                        |       | (67,626 | ) |
| Stock-based compensation  expense                                                  |       | 126,738                        |       | 6,958 |   |
| Loss from  investment in limited partnership                                       |       | 40,200                         |       | 40,200 |   |
| Proceeds from  sale of loans available-for-sale                                    |       | 37,691,085                     |       | 7,285,804 |   |
| Originations of  loans available-for-sale                                          |       | (6,626,744                     | )          | (7,300,708 | ) |
| Increase in cash  surrender value of life insurance                                |       | (156,934                       | )          | (153,264 | ) |
| Net gain on sale  of loans                                                         |       | (151,196                       | )          | (67,896 | ) |
| Net gain on sale  of investment securities                                         |       | (8,653                         | )          | — |   |
| Net gain on sale  of foreclosed assets held-for-sale                               |       | (9,109                         | )          | (142,749 | ) |
| Net loss (gain)  on disposal of premises and equipment                             |       | 984                            |       | (73,633 | ) |
| Change in:                                                                         |       |                           |       |   |   |
| Accrued interest  receivable                                                       |       | (174,221                       | )          | (44,108 | ) |
| Other assets                                                                       |       | (1,881,674                     | )          | (72,481 | ) |
| Accrued interest  payable and other liabilities                                    |       | 1,170,971                      |       | 57,131 |   |
|                                                                               |       |                           |       |   |   |
| Net cash  provided by operating activities                                         |       | 32,976,893                     |       | 2,256,911 |   |
|                                                                               |       |                           |       |   |   |
| Cash flows from  investing activities:                                             |       |                           |       |   |   |
| Held-to-maturity  securities:                                                      |       |                           |       |   |   |
| Proceeds from  maturities, calls and principal pay-downs                           |       | 87,104                         |       | 317,077 |   |
| Available-for-sale  securities:                                                    |       |                           |       |   |   |
| Proceeds from  sales                                                               |       | 12,889,251                     |       | — |   |
| Proceeds from  maturities, calls and principal pay-downs                           |       | 26,121,600                     |       | 7,476,006 |   |
| Purchases                                                                          |       | (50,247,929                    | )          | (16,764,629 | ) |
| Net increase in  FHLB stock                                                        |       | (1,055,400                     | )          | (356,800 | ) |
| Net increase in  loans and leases                                                  |       | (24,092,055                    | )          | (3,199,446 | ) |
| Proceeds from  sale of premises and equipment                                      |       | —                         |       | 247,008 |   |
| Acquisition of  bank premises and equipment                                        |       | (2,104,991                     | )          | (2,111,460 | ) |
| Proceeds from  sale of foreclosed assets held-for-sale                             |       | 62,090                         |       | 584,088 |   |
|                                                                               |       |                           |       |   |   |
| Net cash used in  investing activities                                             |       | (38,340,330                    | )          | (13,808,156 | ) |
|                                                                               |       |                           |       |   |   |
| Cash flows from  financing activities:                                             |       |                           |       |   |   |
| Net increase in  deposits                                                          |       | 22,525,504                     |       | 10,996,762 |   |
| Net decrease in  short-term borrowings                                             |       | (9,982,018                     | )          | (4,055,067 | ) |
| Repayments of  long-term debt                                                      |       | (423,095                       | )          | (16,410,688 | ) |
| Proceeds from  long-term debt advances                                             |       | —                         |       | 20,000,000 |   |
| Proceeds from  employee stock purchase plan                                        |       | 57,891                         |       | 67,820 |   |
| Dividends paid,  net of dividends reinvested                                       |       | (1,037,590                     | )          | (627,897 | ) |
| Purchase of  treasury stock                                                        |       | (145,605                       | )          | — |   |
|                                                                               |       |                           |       |   |   |
| Net cash  provided by financing activities                                         |       | 10,995,087                     |       | 9,970,930 |   |
|                                                                               |       |                           |       |   |   |
| Net increase  (decrease) in cash and cash equivalents                              |       | 5,631,650                      |       | (1,580,315 | ) |
|                                                                               |       |                           |       |   |   |
| Cash and cash  equivalents, beginning                                              |       | 10,408,816                     |       | 13,800,848 |   |
|                                                                               |       |                           |       |   |   |
| Cash and cash  equivalents, ending                                                 |       | $                              | 16,040,466 |   | $ | 12,220,533 |   |

 

See notes toconsolidated financial statements

 

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

 

**Notes to Consolidated Financial Statements**

**(unaudited)**

 

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

 

# **Nature of operations**

#  

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

#  

# **Principles of consolidation**

#  

# Theaccompanying unaudited consolidated financial statements of the Company and theBank have been prepared in accordance with accounting principles generally acceptedin the United States of America (GAAP) for interim financial information andwith the instructions to this Form 10-Q and Rule 10-01 of RegulationS-X.  Accordingly, they do not includeall of the information and footnote disclosures required by GAAP for completefinancial statements.  In the opinion ofmanagement, all normal recurring adjustments necessary for a fair presentationof the financial condition and results of operations for the periods have beenincluded.  All significant inter-companybalances and transactions have been eliminated in consolidation.  Prior period amounts are reclassified whennecessary to conform to the current period’s presentation.

#  

The preparation offinancial statements in conformity with GAAP requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reported periods.  Actualresults could differ from those estimates. For additional information and disclosures required under GAAP, refer tothe Company’s Annual Report on Form 10-K for the year ended December 31,2007.

 

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

 

In the opinion ofmanagement, the consolidated balance sheets as of June 30, 2008 and December 31,2007 and the related consolidated statements of income for the three- andsix-month periods ended June 30, 2008 and 2007 and changes in shareholders’equity and cash flows for the six months ended June 30, 2008 and 2007present fairly the financial condition and results of operations of theCompany.  All material adjustmentsrequired for a fair presentation have been made.  These adjustments are of a normal recurringnature.

 

This Quarterly Report on Form 10-Qshould be read in conjunction with the Company’s audited financial statementsfor the year ended December 31, 2007, and the notes included therein,included within the Company’s Annual Report filed on Form 10-K.

 

# **Critical accounting policies**

#  

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

 

A material estimate thatis particularly susceptible to significant change relates to the determinationof the allowance for loan losses. Management believes that the allowance for loan losses at June 30,2008 is adequate and reasonable.  Giventhe subjective nature of identifying and valuing loan losses, it is likely thatwell-informed individuals could make different assumptions, and could,therefore calculate a materially different allowance value.  While management uses available informationto recognize losses on loans, changes in economic conditions may necessitaterevisions in the future.  In addition,various regulatory agencies, as an integral part of their examination process,periodically review the 

 

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Company’s allowance forloan losses.  Such agencies may requirethe Company to recognize adjustments to the allowance based on their judgmentof information available to them at the time of their examination.

 

Another material estimateis the calculation of fair values of the Company’s investment securities.  The Company receives estimated fair values ofinvestment securities from an independent valuation service.  In developing these fair values, thevaluation service uses estimates of cash flows, based on historical performanceof similar instruments in similar interest rate environments.  Based on experience, management is aware thatestimated fair values of investment securities tend to vary among valuationservices.  Accordingly, when sellinginvestment securities, management may obtain price quotes from more than onesource.  Available-for-sale (AFS) securitiesare carried at fair value on the consolidated balance sheet with unrealizedgains and losses, net of income tax, reported separately within shareholders’equity through accumulated other comprehensive income (loss).

 

The fair value ofresidential mortgage loans originated and classified as AFS, is obtained fromthe Federal National Mortgage Association (FNMA) and the Federal Home Loan Bank(FHLB).  Generally, the market to whichthe Company sells mortgages it originates for sale is restricted and pricequotes from other sources are not typically obtained.  On occasion, the Company may transfer loansfrom the loan and lease portfolio to loans AFS. Under these rare circumstances, pricing may be obtained from otherentities and the loans are transferred at the lower of cost or market value andsimultaneously sold.

 

**2.  Earnings per share**

 

Basic earnings pershare (EPS) is computed by dividing income available to common shareholders bythe weighted-average number of common stock outstanding for the period.  Diluted EPS is computed in the same manner asbasic EPS but reflects the potential dilution that could occur if stock optionsto issue additional common stock were exercised, which would then result inadditional stock outstanding to share in or dilute the earnings of theCompany.  The Company maintains twoshare-based compensation plans that may generate additional potential dilutivecommon shares. Generally, dilution would occur if Company-issued stock optionswere exercised and converted into common stock.

 

In the computationof diluted EPS, the Company uses the treasury stock method to determine thedilutive effect of its granted but unexercised stock options.  Under the treasury stock method, the assumedproceeds received from shares issued, in a hypothetical stock option exercise,are assumed to be used to purchase treasury stock.  For a further discussion on the Company’sstock option plans, see Note No. 3, “Stock plans,” below.

 

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

 
| **Six months ended June 30,**             | ** ** | **2008**  | ** ** | **2007**  | ** ** |
|---------------------------------------------------------------|------------|-----------|------------|-----------|------------|
| Basic EPS:                                                    |       |      |       |      |       |
| Net income  available to common shareholders                  |       | $         | 2,292,893  |      | $          | 2,203,084 |   |
| Weighted-average  common shares outstanding                   |       | 2,074,558 |       | 2,062,416 |       |
| Basic EPS                                                     |       | $         | 1.11       |      | $          | 1.07 |   |
|                                                          |       |      |       |      |       |
| Diluted EPS:                                                  |       |      |       |      |       |
| Net income  available to common shareholders                  |       | $         | 2,292,893  |      | $          | 2,203,084 |   |
| Weighted-average  common shares outstanding                   |       | 2,074,558 |       | 2,062,416 |       |
| Dilutive  potential common shares                             |       | 5         |       | 1,080     |       |
| Weighted-average  common shares and dilutive potential shares |       | 2,074,563 |       | 2,063,496 |       |
| Diluted EPS                                                   |       | $         | 1.11       |      | $          | 1.07 |   |

 

**3.  Stock plans**

 

The Company usesthe fair value method of accounting for stock-based compensation provided underStatement of Financial Accounting Standard (SFAS) No. 123R, *Share Based Payment*. SFAS 123R requires that the cost of share-based payment transactions(including those with employees and non-employees) be recognized in thefinancial statements.  SFAS 123R appliesto all share-based payment transactions in which an entity acquires goods orservices by issuing (or offering to issue) its shares, share options, or otherequity instruments (except for those held by an ESOP) or by incurringliabilities (1) in amounts based (even in part) on the price of the entity’sshares or other equity instruments, 

 

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or (2) thatrequire (or may require) settlement by the issuance of an entity’s shares orother equity instruments.

 

The Company has twostock-based compensation plans (the stock option plans).  The stock option plans wereshareholder-approved and permit the grant of share-based compensation awards toits directors, key officers and certain other employees.  The Company believes that these stock optionplans better align the interest of its directors, key officers and employeeswith the interest of its shareholders. The Company further believes that the granting of share-based awards,under the provisions of the stock option plans, is necessary to retain theknowledge base, continuity and expertise of its directors, key officers andcertain employees.

 

Under the stock optionplans, options are granted with an exercise price equal to the market price ofthe Company’s stock at the date of grant. The awards vest based on six months of continuous service from the dateof grant and have 10-year contractual terms. Stock-based compensation expense is recognized over the six-monthvesting period.  Generally, all sharesthat are granted become fully vested.

 

The Company establishedthe 2000 Independent Directors Stock Option Plan and has reserved 55,000 sharesof its un-issued capital stock for issuance under the plan.  No stock options were awarded during the sixmonths of 2008 and 2007.  As of June 30,2008, there were 30,150 unexercised stock options outstanding under this plan.

 

The Company alsoestablished the 2000 Stock Incentive Plan and has reserved 55,000 shares of itsun-issued capital stock for issuance under the plan.  During the six months ended June 30,2008, 2,000 stock options were issued under this plan at a weighted- averagegrant-date fair value of $4.85 per share as determined using the Black-ScholesOption Pricing Valuation Model.  Themodel considers expected volatility, expected dividends, risk-free interestrate and the expected term.  No stockoptions were awarded during the first six months of 2007.  As of June 30, 2008, there were 12,830unexercised stock options outstanding under this plan.

 

The following tablesillustrate stock-based compensation expense recognized during the three and sixmonths ended June 30, 2008 and 2007 and the unrecognized stock-basedcompensation expense as of June 30, 2008 and December 31, 2007 underthe Company’s stock option plans:  

 
| ** **                              | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|-----------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                              | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                              | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| Stock-based  compensation expense:      |       |                             |       |                           |       |   |   |   |   |
| Director’s Plan                    |       | $                                | 42,079     |                           | $          | — |   | $ | 90,550 |   | $ | — |   |
| Incentive Plan                          |       | 16,868                           |       | —                         |       | 33,248 |   | — |   |
|                                    |       |                             |       |                           |       |   |   |   |   |
| Total  stock-based compensation expense |       | $                                | 58,947     |                           | $          | — |   | $ | 123,798 |   | $ | — |   |

 
| ** **                                      | ** ** | **As of:**             | ** ** |
|-------------------------------------------------|------------|-----------------------------|------------|
| ** **                                      | ** ** | **June 30, 2008** | ** ** | **December 31, 2007** | ** ** |
| Unrecognized stock-based  compensation expense: |       |                        |       |   |   |
| Director’s Plan                            |       | $                           | —     |   | $ | 90,550 |   |
| Incentive Plan                                  |       | 2,314                       |       | 25,872 |   |
|                                            |       |                        |       |   |   |
| Unrecognized  stock-based compensation expense  |       | $                           | 2,314      |   | $ | 116,422 |   |

 

The amount unrecognizedas of June 30, 2008 will be recognized during the third quarter of2008.  Stock-based compensation isrecorded in the consolidated income statement as a component of salaries andemployee benefits.

 

In addition to thetwo stock option plans, the Company established the 2002 Employee Stock PurchasePlan (the ESPP) and reserved 110,000 shares of its un-issued capital stock forissuance under the plan.  The plan wasdesigned to promote broad-based employee ownership of the Company’s stock.  Under the ESPP, employees may elect topurchase the Company’s capital stock at a discounted price based on the fairmarket value of the Company’s capital stock on either the commencement date ortermination date.  At June 30, 2008,10,570 shares have been issued under the ESPP. The Company recognizes compensation expense on its ESPP on the date theshares are purchased.  For the six monthsended June 30, 2008 and 2007, compensation expense related to the ESPPapproximated $3,000 and $7,000, respectively, and is included as a component ofsalaries and employee benefits in the consolidated statements of income.

 

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**4.  Derivative instruments**

 

As part of the Company’soverall interest rate risk management strategy, the Company has adopted apolicy whereby it may periodically use derivative instruments to minimizesignificant fluctuations in earnings caused by interest rate volatility.  This interest rate risk management strategyentails the use of interest rate floors, caps and swaps.  During the fourth quarter of 2006, theCompany entered into a three-year interest rate floor derivative agreement on$20,000,000 notional value of its prime-based loan portfolio.  The transaction required the payment of apremium by the Company to the seller for the right to receive payments in theevent national prime drops below a pre-determined level (strike rate),essentially converting floating rate loans to fixed rate loans when prime dropsbelow the contractual strike rate.  Whenpurchased, the Company recorded an asset representing the fair value of thehedge at the time of purchase.  TheCompany has designated this agreement as a cash flow hedge pursuant to SFAS No. 133,*Accounting for Derivative Instruments and HedgingActivities.*  Accordingly, thechange in the fair value of the instrument related to the hedge’s intrinsicvalue, or approximately $98,000 and -$29,000 for the six months ended June 30,2008 and 2007, respectively, is recorded as a component of other comprehensiveincome (loss) (OCI) in the consolidated statement of changes in shareholders’equity and the portion of the change in fair value related to the time valueexpiration, or approximately $12,000 and $74,000 for the six months ended June 30,2008 and 2007, respectively, is recorded in the consolidated statements ofincome as a reduction of interest income. No gain or loss has been recognized in earnings due to hedgeineffectiveness as of June 30, 2008. As of June 30, 2008, the Company does not expect to reclassify anyamount from OCI to earnings over the next twelve months and no hedge has beendiscontinued.  Also, as of June 30,2008 and December 31, 2007, the fair value of the derivative contractapproximated $526,000 and $441,000 and is recorded as a component of otherassets in the consolidated balance sheet.

 

**5.  Recent accounting pronouncements**

 

On January 1,2008, the Company adopted SFAS 157, *Fair Value Measurements*.  SFAS 157 defines fair value, establishes aframework for measuring fair value and enhances disclosures about fair valuemeasurements required under other accounting pronouncements, but does notchange existing guidance as to whether or not an instrument is carried at fairvalue.  SFAS 157 establishes a valuationhierarchy for disclosure of the inputs to valuation used to measure fairvalue.  This hierarchy prioritizes theinputs into three broad levels as follows. Level 1 inputs are quoted prices (unadjusted) in active markets foridentical assets or liabilities.  Level 2inputs are quoted prices for similar assets and liabilities in active markets;quoted prices for identical or similar assets or liabilities in markets thatare not active; or inputs that are observable for the asset or liability,either directly or indirectly through market corroboration, for substantiallythe full term of the financial instrument. Level 3 inputs are unobservable inputs based on our own assumptions tomeasure assets and liabilities at fair value. Level 3 pricing for securities may also include unobservable inputsbased upon broker-traded transactions.  Afinancial asset or liability’s classification within the hierarchy is determinedbased on the lowest level input that is significant to the fair valuemeasurement.  The adoption of thisstatement had no effect on the Company’s financial statements.

 

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

 
| ** **                     | ** ** | ** **                  | ** ** | **Fair value measurements at June 30, 2008 using:** | ** ** |
|--------------------------------|------------|-----------------------------|------------|----------------------------------------------------------------------------------------|------------|
| ** **                     | ** ** | **Total carrying**     | ** ** | **Quoted prices**                                                                 | ** ** | **Significant other** | ** ** | **Significant** | ** ** |
| ** **                     | ** ** | **value at**           | ** ** | **in active markets**                                                        | ** ** | **observable inputs** | ** ** | **unobservable inputs** | ** ** |
| ** **                     | ** ** | **June 30, 2008** | ** ** | **(Level 1)**                                                                     | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| Assets:                        |       |                        |       |                                                                                   |       |   |   |   |   |
| Available-for-sale  securities |       | $                           | 128,184    |                                                                                   | $          | 476 |   | $ | 110,842 |   | $ | 16,866 |   |
| Loans  available-for-sale      |       | 152                         |       | —                                                                                 |       | 152 |   | — |   |
| Derivative  instrument         |       | 526                         |       | —                                                                                 |       | 526 |   | — |   |
| Total                          |       | $                           | 128,862    |                                                                                   | $          | 476 |   | $ | 111,520 |   | $ | 16,866 |   |

 

Equity securitiesin the available-for-sale securities portfolio are measured at fair value usingquoted market prices for identical assets and are classified within Level 1ofthe valuation hierarchy.  Other than theCompany’s investment in corporate bonds, all other debt securities in theavailable-for-sale securities portfolio are measured at fair value using quotedprices from an independent third party that provide valuation services forsimilar assets, with similar terms in actively traded markets.  The Company’s investment-grade preferredtrust securities, classified under corporate bonds, include both observable andunobservable inputs to determine the exit-pricing which is obtained from athird party.  Due to the recent,temporary limited market activity in these instruments, a large portion of theunobservable inputs are subjective in nature and, therefore, are consideredLevel 3 inputs.  Once the marketactivity, including new issues, begins to occur regularly, and 

 

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the unobservablesubjective inputs are replaced by market activity, these securities may betransferred out of Level 3 into a Level 2 classification by management.  Loans available-for-sale are measured at fairvalue from quotes received through secondary market sources, i.e., FNMA orFHLB, who provide pricing for similar assets with similar terms in activelytraded markets.  The derivativeinstrument, included in other assets, is measured at fair value from pricing providedby a third party who considers observable interest rates, forward yield curvesat commonly quoted intervals and volatility.

 

The followingtable illustrates the changes in Level 3 financial instruments measured at fairvalue on a recurring basis (dollars in thousands):

 
| ** **                                                                    | ** ** | **Available-for-sale** | ** ** |
|-------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                    | ** ** | **securities**         | ** ** |
| Assets:                                                                       |       |                   |       |
| Balance January  1, 2008                                                      |       | $                      | 16,335     |   |
| Realized /  unrealized gains (losses):                                        |       |                   |       |
| in earnings                                                                   |       | —                 |       |
| in comprehensive  income                                                      |       | (3,867                 | )          |
| Purchases,  sales, issuances and settlements, amortization and accretion, net |       | 4,398                  |       |
| Transfers into  (out of) Level 3                                              |       | —                 |       |
| Balance June 30,  2008                                                        |       | $                      | 16,866     |   |

 

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

 
| ** **     | ** ** | ** **                  | ** ** | **Fair value measurements at June 30, 2008 using:** | ** ** |
|----------------|------------|-----------------------------|------------|----------------------------------------------------------------------------------------|------------|
| ** **     | ** ** | **Total carrying**     | ** ** | **Quoted prices**                                                                 | ** ** | **Significant other** | ** ** | **Significant** | ** ** |
| ** **     | ** ** | **value at**           | ** ** | **in active markets**                                                        | ** ** | **observable inputs** | ** ** | **unobservable inputs** | ** ** |
| ** **     | ** ** | **June 30, 2008** | ** ** | **(Level 1)**                                                                     | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| Assets:        |       |                        |       |                                                                                   |       |   |   |   |   |
| Impaired loans |       | $                           | 2,239      |                                                                                   | $          | 16 |   | $ | 1,205 |   | $ | 1,018 |   |
|                |            |                             |            |                                                                                        |            |  |  |  |  |  |  |  |  |

 

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

 

OnJanuary 1, 2008, the Company adopted SFAS No. 159, *The Fair Value Option for Financial Assets and Financial Liabilities*.  SFAS 159 allows companies to elect to followfair value accounting for certain financial assets and liabilities in an effortto mitigate volatility in earnings without having to apply complex hedgeaccounting provisions.  The Company didnot elect the fair value option for any of its financial instruments as of June 30,2008 and therefore the adoption of this statement had no effect on the Company’sfinancial statements.

 

InMarch 2008, the Financial Accounting Standards Board issued SFAS No. 161,*Disclosures about Derivative Instruments andHedging Activities*. SFAS 161 amends and expands the disclosure requirements of SFAS133, *Accounting for Derivative Instruments and HedgingActivities*.  It requiresqualitative disclosures about objectives and strategies for using derivatives,quantitative disclosures about fair value amounts of gains and losses onderivative instruments, and disclosures about credit-risk-related contingentfeatures in derivative agreements.  Thisstatement is effective for financial statements issued for fiscal yearsbeginning after November 15, 2008. The Company does not expect the adoption of this pronouncement to have amaterial impact on its consolidated financial statements.

 

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

 

The following ismanagement’s discussion and analysis of the significant changes in theconsolidated financial condition of the Company as of June 30, 2008compared to December 31, 2007 and the results of operations for the three-and six- months ended June 30, 2008 and June 30, 2007.  Current performance may not be indicative offuture results.  This discussion shouldbe read in conjunction with the Company’s 2007 Annual Report filed on Form 10-K.

 

**Forward-looking statements**

 

This InterimReport on Form 10-Q contains a number of forward-looking statements withinthe meaning of Section 27A of the Securities Act of 1933, as amended, orthe Securities Act, and Section 21E of the Securities Exchange Act of1934, as amended, or the Exchange Act. These statements may be identified by the use of the words “anticipate,”“believe,” “could,” “estimate,” “expect,” “intend,” “may,” “outlook,” “plan,” “potential,”“predict,” “project,” “should,” “will,” “would” and similar terms and phrases,including references to assumptions. Forward-looking statements include risks and uncertainties.

 

Forward-lookingstatements are based on various assumptions and analyses made by us in light ofmanagement’s experience and its perception of historical trends, currentconditions and expected future developments, as well as other factorsmanagement believes are appropriate under the circumstances.  These statements are not guarantees of futureperformance and are subject to risks, uncertainties and other factors (many ofwhich are beyond our control) that could cause actual results to differmaterially from future results expressed or implied by such forward-lookingstatements.  These factors include,without limitation, the following:

 

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

 

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

 

·                  changes in theinterest rate environment may reduce interest margins;

 

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

 

·                  changes inaccounting principles, policies or guidelines may cause our financial conditionto be perceived differently;

 

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

 

·                  legislative orregulatory changes may adversely affect our business;

 

·                  technologicalchanges may be more rapid, difficult or expensive than we anticipate;

 

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

 

·                  acts of war orterrorism; or

 

·                  naturaldisaster.

 

Managementcautions 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 anyforward-looking statements to reflect events or circumstances after the date ofthis document.

 

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

 

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**General**

 

The Company’sprincipal revenues are derived from interest, dividends and fees earned on itsinterest-earning assets, which are comprised of loans, securities and othershort-term investments.  The Company’sprincipal expenses consist of interest paid on its interest-bearingliabilities, which are comprised of deposits, short- and long-term borrowingsand operating and general expenses.  TheCompany’s profitability depends primarily on its net interest income. Netinterest income is the difference between interest income and interestexpense.  Interest income is generatedfrom yields on interest-earning assets which consist principally of loans andinvestment securities. Interest expense is incurred from rates paid oninterest-bearing liabilities, which consist of deposits and borrowings.  Net interest income is dependent upon theinterest-rate spread (i.e., the difference between the yields earned on its interest-earningassets and the rates paid on its interest-bearing liabilities) and the relativeamounts of interest-earning assets and interest-bearing liabilities.  The interest rate spread is significantlyimpacted by: changes in interest rates and market yield curves and theirrelated impact on cash flows; the composition and characteristics ofinterest-earning assets and interest-bearing liabilities; differences in thematurity and re-pricing characteristics of assets compared to the maturity andre-pricing characteristics of the liabilities that fund them and by thecompetition in our marketplace.

 

The Company’sprofitability is also affected by the level of its non-interest income andexpenses, provision for loan losses and provision for income taxes.  Non-interest income consists mostly ofservice charges on the Bank’s loan and deposit products, trust and assetmanagement service fees, increases in the cash surrender value of the bankowned life insurance (BOLI), net gains or losses from sales of loans andsecurities AFS and from the sales of other real estate (ORE) properties.  Non-interest expense consists of compensationand related employee benefit expenses, occupancy, equipment, data processing,advertising, marketing, professional fees, insurance and other operatingoverhead.

 

The Company’sprofitability is significantly affected by general economic and competitiveconditions, changes in market interest rates, government policies and actionsof regulatory authorities.  The Company’sloan portfolio is comprised principally of commercial and commercial realestate loans.  The properties underlyingthe Company’s mortgages are concentrated in Northeastern Pennsylvania.  Credit risk, which represents the possibilityof the Company not recovering amounts due from its borrowers, is significantlyrelated to local economic conditions in the areas the properties are located aswell as the Company’s underwriting standards. Economic conditions affect the market value of the underlying collateralas well as the levels of adequate cash flow and revenue generation fromincome-producing commercial properties.

 

**COMPARISON OF RESULTS OF OPERATIONS**

**THREE AND SIX MONTHS ENDED JUNE 30, 2008 AND JUNE30, 2007**

 

**Overview**

 

Net income for the second quarter of 2008 was $1,204,000,a 4% increase compared to $1,159,000 recorded in the same quarter of 2007.  Diluted earnings per share were $0.59 and$0.56 for each of the respective periods. For the six months ended June 30, 2008, net income was $2,293,000,or $1.11 per share compared to $2,203,000, or $1.07 per share for the sixmonths ended June 30, 2007.  Theincrease in net income for both the quarter and six months ended June 30,2008, compared to the prior year periods, was principally the result ofincreased net interest income, partially offset by increases in the provisionfor loan losses and non-interest expense. In addition, non-interest income was down $63,000, or 5%, in the secondquarter of 2008 but up modestly in the first half of 2008 compared to therespective 2007 periods.

 

Return on average assets (ROA) and return on averageshareholders’ equity (ROE) were 0.83% and 8.73%, respectively, for the threemonths ended June 30, 2008 compared to 0.82% and 8.79%, respectively, forthe same period in 2007.  For the sixmonths ended June 30, 2008, ROA and ROE were 0.78% and 8.26%,respectively, compared to 0.78% and 8.46% for the same period in 2007.  The decrease in ROE is attributable toincreased average equity fueled by a higher level of retained earnings.

 

*Net interest income and interestsensitive assets / liabilities*

 

Net interest income increased $621,000, or 14%, to $4,943,000 for thesecond quarter of 2008, from $4,322,000 recorded in the same period of2007.  The increase in net interestincome was principally due to a combination of: $15,000,000 in growth ofaverage earning assets, mostly in the investment portfolio; lower rates paid oninterest-bearing deposits during the same period; offset by lower yield earnedfrom all sources stemming from operating in a lower interest rateenvironment.  Growth in the investmentportfolio was the result of deposit growth and the sale of relatively lowyielding, long-term mortgage loans, the proceeds of which were used to purchaseshorter duration investments.  However,despite 

 

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a larger volume of interest-earning assets, interest income declined byapproximately $71,000 in the second quarter of 2008 compared to the secondquarter of 2007 as yields earned from all sources were lower in the currentyear quarter.

 

Contributing to the improvement in net interest income was lowerinterest expense which decreased $692,000, or 16%, in the current year’s secondquarter compared to last year’s second quarter. Though interest-bearing deposits increased by $34,000,000, on average,rates on deposits continue to decrease in concert with the current interestrate environment.  Average rates paid ondeposits have declined 74 basis points for the three months ended June 30,2008 compared to the three months ended June 30, 2007.  This reduction in rate had a greaterinfluence on interest expense than the increase in average balances, both ofwhich combined for a net reduction in interest expense from deposits of$391,000.  The remaining reduction ininterest expense is from reduced long- and short-term debt of $14,100,000 inconjunction with a 64 basis point reduction in rates paid.

 

During the secondquarter of 2008, the Company’s tax-equivalent margin and spread were 3.71% and3.18%, respectively, compared to 3.34% and 2.63% during the second quarter of2007.  The improvement in both spread andmargin were from increased net interest income.

 

For the six months ended June 30, 2008, the Company’stax-equivalent margin and spread improved to 3.54% and 2.97%, respectively,from 3.35% and 2.65% during the same period of 2007.  The improvements are largely from lower ratespaid on interest-bearing liabilities – most notably from deposits whichdecreased 57 basis points during the first half of 2008 compared to the firsthalf of 2007, or a reduction of $492,000 in interest expense.  In addition, rates paid on borrowingsdeclined 37 basis points which, when combined with a reduction in volume,resulted in a decrease in interest expense of $330,000 during the first sixmonths of 2008 compared to the first six months of 2007.

 

After a sustainedperiod of treasury yield curve inversion throughout 2006 and 2007, the yieldcurve has turned positive after the Federal Open Market Committee (FOMC)periodically reduced the federal funds rate by 325 basis points since the endof the second quarter of 2007 and by 225 basis points since year-end 2007.  Likewise, the national prime rate, thebenchmark rate banks use to set rates on various lending and other interestsensitive financial instruments, has been reduced by similar amounts during thesame periods.  Generally, this situationcauses floating rate assets to re-price at lower yields, and also causesfixed-rate assets to originate at yields lower than the yields earned in theprior comparable period, thereby reducing interest income.  To help mitigate this effect, the Company sold$28,100,000 of low yielding mortgage loans and used the proceeds to initiallypurchase investment securities and ultimately fund commercial loan growth.

 

The Company’s Asset Liability Management team meets regularly todiscuss interest rate risk and if necessary adjust interest rates on depositsin response to rate movements that emanate from the FOMC, so that net interestincome is not disproportionately impacted during volatile rate environments.  This proactive attention to interest raterisk in conjunction with our interest rate hedging strategy, as described inNote No. 4, “Derivative instruments,” within the notes to the consolidatedfinancial statements in Part I, Item 1, will continue to help contain theCompany’s net interest income at acceptable levels.

 

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

 

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| ** **                                     | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** | **Year ended**   | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** | **December 31,** | ** ** |
| ** **                                     | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008**              | ** ** | **2007** | ** ** | **2007** | ** ** |
| Average  interest-earning assets:              |       |                             |       |                           |       |                  |       |   |   |   |   |
| Loans and leases                               |       | $                                | 407,208    |                           | $          | 420,551               |       | $ | 409,151 |   | $ | 422,952 |   | $ | 424,781 |   |
| Investments                                    |       | 141,728                          |       | 114,561                        |       | 138,110               |       | 109,569 |   | 116,217 |   |
| Federal funds  sold                            |       | 1,268                            |       | 15                             |       | 6,721                 |       | 2,085 |   | 1,948 |   |
| Interest-bearing  deposits                     |       | 118                              |       | 190                            |       | 135                   |       | 201 |   | 184 |   |
| Total                                          |       | $                                | 550,322    |                           | $          | 535,317               |       | $ | 554,117 |   | $ | 534,807 |   | $ | 543,130 |   |
|                                           |       |                             |       |                           |       |                  |       |   |   |   |   |
| Average  interest-bearing liabilities:         |       |                             |       |                           |       |                  |       |   |   |   |   |
| Other  interest-bearing deposits               |       | $                                | 197,552    |                           | $          | 196,513               |       | $ | 194,424 |   | $ | 198,328 |   | $ | 194,452 |   |
| Certificates of  deposit                       |       | 180,925                          |       | 147,909                        |       | 185,263               |       | 151,305 |   | 161,418 |   |
| Borrowed funds                                 |       | 70,896                           |       | 76,868                         |       | 69,796                |       | 72,158 |   | 71,573 |   |
| Repurchase  agreements                         |       | 10,234                           |       | 18,336                         |       | 12,803                |       | 18,106 |   | 19,580 |   |
| Total                                          |       | $                                | 459,607    |                           | $          | 439,626               |       | $ | 462,286 |   | $ | 439,897 |   | $ | 447,023 |   |
|                                           |       |                             |       |                           |       |                  |       |   |   |   |   |
| Interest income  (FTE):                        |       |                             |       |                           |       |                  |       |   |   |   |   |
| Loans and leases                               |       | $                                | 6,904      |                           | $          | 7,321                 |       | $ | 13,832 |   | $ | 14,662 |   | $ | 29,477 |   |
| Investments                                    |       | 1,834                            |       | 1,494                          |       | 3,690                 |       | 2,856 |   | 6,219 |   |
| Federal funds  sold                            |       | 7                                |       | 1                              |       | 91                    |       | 55 |   | 103 |   |
| Interest-bearing  deposits                     |       | 1                                |       | 2                              |       | 2                     |       | 5 |   | 9 |   |
| Total                                          |       | $                                | 8,746      |                           | $          | 8,818                 |       | $ | 17,615 |   | $ | 17,578 |   | $ | 35,808 |   |
|                                           |       |                             |       |                           |       |                  |       |   |   |   |   |
| Interest  expense:                             |       |                             |       |                           |       |                  |       |   |   |   |   |
| Other  interest-bearing deposits               |       | $                                | 852        |                           | $          | 1,554                 |       | $ | 1,946 |   | $ | 3,184 |   | $ | 6,029 |   |
| Certificates of  deposit                       |       | 1,980                            |       | 1,667                          |       | 4,119                 |       | 3,372 |   | 7,341 |   |
| Borrowed funds                                 |       | 825                              |       | 1,024                          |       | 1,722                 |       | 1,902 |   | 3,825 |   |
| Repurchase  agreements                         |       | 13                               |       | 116                            |       | 81                    |       | 231 |   | 465 |   |
|                                           |       |                             |       |                           |       |                  |       |   |   |   |   |
| Total                                          |       | $                                | 3,670      |                           | $          | 4,361                 |       | $ | 7,868 |   | $ | 8,689 |   | $ | 17,660 |   |
|                                           |       |                             |       |                           |       |                  |       |   |   |   |   |
| Net interest  income (FTE)                     |       | $                                | 5,076      |                           | $          | 4,457                 |       | $ | 9,747 |   | $ | 8,889 |   | $ | 18,148 |   |
|                                           |       |                             |       |                           |       |                  |       |   |   |   |   |
| Yield on average  interest-earning assets      |       |                             |       |                           |       |                  |       |   |   |   |   |
| Loans and leases                               |       | 6.82                             | %          | 6.98                           | %          | 6.80                  | %          | 6.99 | % | 6.94 | % |
| Investments                                    |       | 5.20                             | %          | 5.23                           | %          | 5.37                  | %          | 5.26 | % | 5.35 | % |
| Federal funds  sold                            |       | 2.21                             | %          | 5.28                           | %          | 2.73                  | %          | 5.29 | % | 5.28 | % |
| Interest-bearing  deposits                     |       | 2.37                             | %          | 4.07                           | %          | 2.69                  | %          | 4.75 | % | 4.81 | % |
| Total                                          |       | 6.39                             | %          | 6.61                           | %          | 6.39                  | %          | 6.63 | % | 6.59 | % |
|                                           |       |                             |       |                           |       |                  |       |   |   |   |   |
| Rates on average  interest-bearing liabilities |       |                             |       |                           |       |                  |       |   |   |   |   |
| Other  interest-bearing deposits               |       | 1.73                             | %          | 3.17                           | %          | 2.01                  | %          | 3.24 | % | 3.10 | % |
| Certificates of  deposit                       |       | 4.40                             | %          | 4.52                           | %          | 4.47                  | %          | 4.49 | % | 4.55 | % |
| Borrowed funds                                 |       | 4.68                             | %          | 5.34                           | %          | 4.96                  | %          | 5.31 | % | 5.34 | % |
| Repurchase  agreements                         |       | 0.53                             | %          | 2.53                           | %          | 1.27                  | %          | 2.57 | % | 2.38 | % |
| Total                                          |       | 3.21                             | %          | 3.98                           | %          | 3.42                  | %          | 3.98 | % | 3.95 | % |
|                                           |       |                             |       |                           |       |                  |       |   |   |   |   |
| Net interest  spread                           |       | 3.18                             | %          | 2.63                           | %          | 2.97                  | %          | 2.65 | % | 2.64 | % |
| Net interest  margin                           |       | 3.71                             | %          | 3.34                           | %          | 3.54                  | %          | 3.35 | % | 3.34 | % |

 

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

 

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*Provision for loan losses*

 

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

 

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

 

·                                                specificloans that could have loss potential;

·                                                levelsof and trends in delinquencies and non-accrual loans;

·                                                levelsof and trends in charge-offs and recoveries;

·                                                trendsin volume and terms of loans;

·                                                changesin risk selection and underwriting standards;

·                                                changesin lending policies, procedures and practices;

·                                                experience,ability and depth of lending management;

·                                                nationaland local economic trends and conditions; and

·                                                changesin credit concentrations.

 

Provisions forloan losses amounting to $125,000 have been recorded in the first half of 2008 –all occurring in the second quarter, compared to no provision during the firsthalf of 2007.  Although the loanportfolio decreased since December 31, 2007, the provision for loan losseswas necessary to fund new loan growth, particularly commercial and CREloans.  After taking into account the$125,000 provision, charge-offs and recoveries, the allowance for loan losseswas $4,189,000 at June 30, 2008 as compared to $4,824,000 as of December 31,2007 and $5,295,000 as of June 30, 2007. The reduced level of the loan portfolio, lower non-accrual loans andreduced criticized and classified loans has resulted in a lower calculatedlevel for the allowance for loan losses at June 30, 2008.  The lower level of the allowance has beendeemed adequate to absorb the known and inherent losses in the loan portfolioat June 30, 2008.  For a furtherdiscussion on the allowance for loan losses and non-accrual loans, see “Comparisonof Financial Condition at June 30, 2008 and December 31, 2007,”below.

 

*Otherincome*

 

In the secondquarter of 2008, other (non-interest) income declined $63,000, or 5%, to$1,266,000 from $1,329,000 recorded in second quarter of 2007.  Most of the decline, or $127,000, was theresult of large gains recorded from the sale of foreclosed properties less the$23,000 write-off of furniture and equipment that was taken out of service inconjunction with the Company’s branch relocation project in the 2007 quarterthat did not recur in 2008.  Partiallyoffsetting this disparity were gains from the sales of mortgages AFS whichincreased $28,000, or nearly doubled, from the gains recognized in the 2007 quarter.

 

For the six monthsended June 30, 2008, other income improved by $18,000, or 1%, compared tothe six months ended June 30, 2007. The Company experienced $106,000 of growth in deposit service fees andincreased sales of residential mortgages into the secondary market, that hasresulted in $83,000 more net gains in the current year compared to the prioryear.  These were partially offset by thenon-recurring gains from the sale of the foreclosed properties and from thesale of a commercial building that the Company previously leased to anunrelated third party, net of the asset write-offs.

 

*Other operating expenses*

 

For the quarterand six months ended June 30, 2008, other (non-interest) expensesincreased $357,000, or 9%, and $637,000, or 8%, respectively, compared to thesame 2007 periods.  The most significantimpact was caused by increased salaries and related employee benefits, whichrose $307,000 in the quarter-to-quarter period and $590,000 in the year-to-datecomparative periods, or 14% in each of the periods.  The increase was due to payroll and incentiveincreases, an increase in the number of full-time equivalent employees, higherstock-based compensation expense, more employee related insurance costs andwider participation in the Company’s 401(k) plan.  Further contributing to the increase in otherexpenses for the second quarter and first half of 2008 were from collectionexpenses associated with legal and foreclosure fees, the timing of charitabledonations made and normal increases in other operational expenses.

 

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**COMPARISON OF FINANCIAL CONDITIONAT**

**JUNE 30, 2008 AND DECEMBER 31,2007**

 

*Overview*

 

Consolidated assets increased $11,151,000 during the six months ended June 30,2008.  The increase was caused by a$22,526,000, or 5%, increase in deposits partially offset by a $9,982,000, 25%,reduction in short-term borrowings and a $2,139,000, 3%, decline inshareholders’ equity.  The decline inshareholders’ equity was caused by increased levels of unrealized losses in thesecurities AFS portfolio.

 

*Investment securities*

 

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

 

As of June 30, 2008, the carrying value of investment securitiestotaled $129,244,000, or 22% of total assets compared to $122,984,000 or 21% oftotal assets at December 31, 2007. At June 30, 2008, approximately 33% of the carrying value of theinvestment portfolio was comprised of mortgage-backed securities that amortizeand provide monthly cash flow.  Agency,corporate and municipal bonds comprised 42%, 13% and 12%, respectively, of theinvestment portfolio at June 30, 2008. Furthermore, management sold $16.4 million of securities AFS to produceneeded liquidity in July 2008.

 

Total investments increased $6,260,000, net of a $5,352,000 decline inthe market value of AFS investments.  Theincrease in the investment portfolio was mainly from the liquidity created fromthe sale of mortgage loans.  Theamortized cost and fair market value of investment securities is comprised ofHTM and AFS securities with carrying values of $1,060,000 and $128,184,000,respectively.  As of June 30, 2008,the AFS debt securities were recorded with a net unrealized loss in the amountof $6,986,000 and equity securities were recorded with an unrealized gain of$147,000.  A comparison of investmentsecurities at June 30, 2008 and December 31, 2007 is as follows(dollars in thousands):

 
| ** **                          | ** ** | **June 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|-------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| ** **                          | ** ** | **Amount**                  | ** ** | **%**                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| U.S. government  agencies           |       | $                           | 54,357     |                            | 42.1       |   | $ | 35,244 |   | 28.6 |   |
| Mortgage-backed  securities         |       | 42,611                      |       | 33.0                            |       | 58,767 |   | 47.8 |   |
| State &  municipal subdivisions |       | 14,934                      |       | 11.5                            |       | 12,133 |   | 9.9 |   |
| Preferred term  securities          |       | 16,866                      |       | 13.0                            |       | 16,335 |   | 13.3 |   |
| Equity  securities                  |       | 476                         |       | 0.4                             |       | 505 |   | 0.4 |   |
| Total  investments                  |       | $                           | 129,244    |                            | 100.0      |   | $ | 122,984 |   | 100.0 |   |

 

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The amortized cost and fair value of investments at June 30, 2008are as follows (dollars in thousands):

 
| ** **                                        | ** ** | **Amortized** | ** ** | **Gross unrealized** | ** ** | **Gross unrealized** | ** ** | **Fair**  | ** ** |
|---------------------------------------------------|------------|---------------|------------|---------------------------|------------|---------------------------|------------|-----------|------------|
| ** **                                        | ** ** | **cost**      | ** ** | **gains**                 | ** ** | **losses**                | ** ** | **value** | ** ** |
|                                              |       |          |       |                      |       |                      |       |      |       |
| Held-to-maturity  securities:                     |       |          |       |                      |       |                      |       |      |       |
| Mortgage-backed  securities                       |       | $             | 1,060      |                      | $          | 33                        |       | $         | —     |   | $ | 1,093 |   |
|                                              |       |          |       |                      |       |                      |       |      |       |
| Available-for-sale  securities:                   |       |          |       |                      |       |                      |       |      |       |
| U.S. government  agencies and corporations        |       | $             | 55,516     |                      | $          | 97                        |       | $         | 1,256      |   | $ | 54,357 |   |
| Obligations of  states and political subdivisions |       | 15,178        |       | 34                        |       | 278                       |       | 14,934    |       |
| Corporate bonds                                   |       | 21,930        |       | —                    |       | 5,064                     |       | 16,866    |       |
| Mortgage-backed  securities                       |       | 42,070        |       | 24                        |       | 543                       |       | 41,551    |       |
|                                              |       |          |       |                      |       |                      |       |      |       |
| Total debt  securities                            |       | 134,694       |       | 155                       |       | 7,141                     |       | 127,708   |       |
|                                              |       |          |       |                      |       |                      |       |      |       |
| Equity  securities                                |       | 329           |       | 160                       |       | 13                        |       | 476       |       |
|                                              |       |          |       |                      |       |                      |       |      |       |
| Total  available-for-sale                         |       | $             | 135,023    |                      | $          | 315                       |       | $         | 7,154      |   | $ | 128,184 |   |

 

The amortized cost and fair value of debt securities at June 30,2008 by contractual maturity are as follows (dollars in thousands):

 

 
| ** **                                | ** ** | **Amortized** | ** ** | **Market** | ** ** |    |   |   |   |
|-------------------------------------------|------------|---------------|------------|------------|------------|---------|--------|--------|--------|
| ** **                                | ** ** | **cost**      | ** ** | **value**  | ** ** |    |   |   |   |
| Held-to-maturity  securities:             |       |          |       |       |       |    |   |   |   |
| Mortgage-backed  securities               |       | $             | 1,060      |       | $          | 1,093   |   |   |   |   |   |
|                                      |       |          |       |       |       |    |   |   |   |
| Available-for-sale  securities:           |       |          |       |       |       |    |   |   |   |
| Debt securities:                          |       |          |       |       |       |    |   |   |   |
| Due in one year  or less                  |       | $             | —     |       | $          | —  |   |   |   |   |   |
| Due after one  year through five years    |       | 3,000         |       | 3,011      |       |    |   |   |   |
| Due after five  years through ten years   |       | 14,935        |       | 14,984     |       |    |   |   |   |
| Due after ten  years                      |       | 74,689        |       | 68,163     |       |    |   |   |   |
| Total debt  securities                    |       | 92,624        |       | 86,158     |       |    |   |   |   |
|                                      |       |          |       |       |       |    |   |   |   |
| Mortgage-backed  securities               |       | 42,070        |       | 41,550     |       |    |   |   |   |
|                                      |       |          |       |       |       |    |   |   |   |
| Total  available-for-sale debt securities |       | $             | 134,694    |       | $          | 127,708 |   |   |   |   |   |

 

Expected maturities will differ from contractual maturities becauseissuers and borrowers may have the right to call or repay obligations with orwithout call or prepayment penalty. Federal agency and municipal securities are included based on theiroriginal stated maturity. Mortgage-backed securities, which are based on weighted-average livesand subject to monthly principal pay-downs, are listed in total.

 

Management evaluates securities for other-than-temporary impairment ona quarterly basis or more frequently when economic conditions or marketconditions warrant such evaluation. Consideration is given to (1) the length of time and the extent towhich the fair value has been less than cost, (2) the financial conditionand near-term prospects of the issuer, and (3) the intent and ability ofthe Company to retain its investment in the issuer for a period of timesufficient to allow for any anticipated recovery in fair value.

 

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Additional consideration may be given to support the realizable valueof securities in the corporate bond portfolio, consisting of bank trust preferredsecurities, in order to determine collateral sufficiency and/or a significantadverse change in the future cash flows, if occurred would create another-than-temporary impairment.  Themarket value of the Company’s investment in trust preferred securities hasdeclined by $3.9 million since December 31, 2007.  The decline is from lower market values,based upon analyses of limited market activity to determine an exit price bythe third party traders, who make a market for these issues.  The market activity for these types ofsecurities has significantly declined since the end of 2007.  In response, the Company obtained acollateral balance stress test and discounted cash flow projection on eachissue.  The results as of June 30,2008 indicate adequate collateral balances exist and there is not a significantchange in the cash flow behavior based upon current market conditions.  In addition, all of the securities arecurrent with respect to payment of principal and interest.  The Company intends to closely monitor thetrust preferred market and perform collateral balance and cash flow analyses onat least a quarterly basis.  However,future analyses could yield different results that may require another-than-temporary charge to current earnings.  Management has determined that based upon theabove analyses, as of June 30, 2008, other-than-temporary impairment doesnot exist.

 

At June 30, 2008, the AFS debt securities portfolio was carried ata net unrealized loss of $6,986,000 compared to a net unrealized loss of$1,663,000 at December 31, 2007. Management believes the cause of the unrealized losses is directlyrelated to changes in interest rates or the limited trading activity due torecent debt market illiquid conditions and is not directly related to creditquality, which is consistent with its past experience.  In addition, the Company has the ability andintent to hold its investments for a period of time sufficient for the fairvalue of the securities to recover, which may be at maturity.  There were no other-than-temporary impairmentwrite-downs recorded during the six months ended June 30, 2008 nor havethere been any write-downs recorded for the year-ended December 31, 2007.

 

*Loans available-for-sale (AFS)*

 

Generally, upon origination, certain residential mortgages areclassified as AFS.  In the event ofmarket rate increases, fixed-rate loans and loans not immediately scheduled tore-price would no longer produce yields consistent with the current market.  In a declining interest rate environment, theBank would be exposed to prepayment risk and, as rates decrease, interestincome would be negatively affected. Consideration is given to the Company’s current liquidity position andprojected future liquidity needs.  Tobetter manage prepayment and interest rate risk, loans that meet theseconditions may be classified as AFS.  Thecarrying value of loans AFS is at the lower of cost or estimated fairvalue.  If the fair values of these loansfall below their original cost, the difference is written down and charged tocurrent earnings.  Subsequentappreciation in the portfolio is credited to current earnings but only to theextent of previous write-downs.

 

Loans AFS at June 30, 2008 amounted to $152,000 with acorresponding fair value of $154,000, compared to $827,000 and $843,000,respectively, at December 31, 2007. During the first half of 2008, residential mortgages with principalbalances of $37,540,000 were sold into the secondary market with net gains ofapproximately $151,000 recognized.  Includedin the sale were $28,100,000 of residential loans transferred from the loan andlease portfolio.

 

*Loans and leases*

 

The Company originates commercial and industrial (commercial) andcommercial real estate (CRE) loans, residential mortgages, consumer, homeequity and construction loans.  Therelative volume of originations is dependent upon customer demand, currentinterest rates and the perception and duration of future interest levels.  The broad spectrum of products providesdiversification that helps manage, to an extent, interest rate and creditconcentration risk.  Credit risk isfurther managed through underwriting policies and procedures and loanmonitoring practices.  Interest rate riskis managed using various asset/liability modeling techniques and analyses.  The interest rates on most commercial loansare adjustable with reset intervals of five years or less.

 

The majority of the Company’s loan portfolio is collateralized, atleast in part, by real estate in Lackawanna and Luzerne Counties of Pennsylvania.  Commercial lending activities generallyinvolve a greater degree of credit risk than consumer lending because theytypically have larger balances and are more affected by adverse conditions inthe economy.  Because payments oncommercial loans depend upon the successful operation and management of theproperties and the businesses which operate from within them, repayment of suchloans may be affected by factors outside the borrower’s control.  Such factors may include adverse conditionsin the real estate market, the economy, the industry or changes in governmentregulations.  As such, commercial loansrequire more ongoing evaluation and monitoring which occurs with the Bank’scredit administration and outsourced loan review functions.

 

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The composition of the loan portfolio at June 30, 2008 and December 31,2007, is summarized as follows (dollars in thousands):

 
| ** **                 | ** ** | **June 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|----------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| ** **                 | ** ** | **Amount**                  | ** ** | **%**                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| Commercial and  CRE        |       | $                           | 230,506    |                            | 55.1       |   | $ | 216,058 |   | 50.7 |   |
| Residential real  estate   |       | 92,704                      |       | 22.1                            |       | 116,978 |   | 27.5 |   |
| Consumer                   |       | 83,675                      |       | 20.0                            |       | 81,998 |   | 19.2 |   |
| Real estate  construction  |       | 11,135                      |       | 2.7                             |       | 10,703 |   | 2.5 |   |
| Direct financing  leases   |       | 478                         |       | 0.1                             |       | 511 |   | 0.1 |   |
| Gross loans                |       | 418,498                     |       | 100.0                           |       | 426,248 |   | 100.0 |   |
| Allowance for  loan losses |       | (4,189                      | )          |                            |       | (4,824 | ) |   |   |
| Net loans                  |       | $                           | 414,309    |                            |       |   | $ | 421,424 |   |   |   |

 

Gross loans declined from$426,248,000, as of December 31, 2007 to $418,498,000 at June 30,2008.  The decrease is mostly from thetransfer from the loan and lease portfolio to the AFS portfolio andsimultaneous sale of $28,100,000 of residential mortgage loans partially offsetby increased origination activity from our commercial lending department.  The restructuring of the Company’s team ofcommercial lending officers in conjunction with the hiring of a new seniorlender earlier this year has enabled us to better serve our existing customersand strategically penetrate our market area.

 

*Allowance for loan losses*

 

Management continually evaluates the credit quality of the Bank’s loanportfolio and performs a formal review of the adequacy of the allowance forloan losses (the allowance), on a quarterly basis.  The allowance reflects management’s bestestimate of the amount of credit losses in the loan portfolio.  Management’s judgment is based on theevaluation of individual loans, past experience, the assessment of currenteconomic conditions and other relevant factors including the amounts and timingof cash flows expected to be received on impaired loans.  Those estimates may be susceptible tosignificant change.  The provision forloan losses represents the amount necessary to maintain an appropriateallowance.  Loan losses are chargeddirectly against the allowance when loans are deemed to be uncollectible.  Recoveries from previously charged-off loansare added to the allowance when received.

 

Management applies two primary components during the loan reviewprocess to determine proper allowance levels. The two components are a specific loan loss allocation for loans thatare deemed impaired and a general loan loss allocation for those loans notspecifically allocated.  The methodologyto analyze the adequacy of the allowance for loan losses is as follows:

 

·                  identificationof specific impaired loans by loan category;

·                  calculationof specific allowances where required for the impaired loans based oncollateral and other objective and quantifiable evidence;

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

·                  applicationof historical loss percentages (five-year average) to pools to determine theallowance allocation; and

·                  applicationof qualitative factor adjustment percentages to historical losses for trends orchanges in the loan portfolio.

 

Allocation of the allowance for different categories of loans is basedon the methodology as explained above.  Akey element of the methodology to determine the allowance is the Company’scredit risk evaluation process, which includes credit risk grading ofindividual commercial loans.  Commercialloans are assigned credit risk grades based on the Company’s assessment ofconditions that affect the borrower’s ability to meet its contractualobligations under the loan agreement. That process includes reviewing borrowers’ current financialinformation, historical payment experience, credit documentation, publicinformation and other information specific to each individual borrower.  The changes in allocations in the commercialloan portfolio from period to period are based upon the credit risk gradingsystem and from periodic reviews of the loan and lease portfolios.

 

Each quarter, management performs an assessment of the allowance andthe provision for loan losses.  TheCompany’s Special Assets Committee meets quarterly and the applicable lendersdiscuss each relationship under review and reach a consensus on the appropriateestimated loss amount based on SFAS 114, *Accounting by Creditorsfor Impairment of a Loan*. This Committee’s focus is on ensuring the pertinent facts are consideredand the SFAS 114 reserve amounts are reasonable.  

 

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The assessment process includes the review of all loans on anon-accruing basis as well as a review of certain loans to which the lenders orthe Company’s Credit Administration function have assigned a criticized orclassified risk rating.

 

Total charge-offs, net of recoveries, for the six months ended June 30,2008, were $761,000, compared to $150,000 for the same period in 2007.  Consumer loan net charge-offs were $218,000for the six months ended June 30, 2008, an increase of $86,000 from the$132,000 recorded for the like period in 2007. Commercial loan net charge-offs were $510,000 for the six months ended June 30,2008, compared to $30,000 recorded in the six months ending June 30,2007.  The increase in the commercialloan charge-offs during the six months resulted from the final resolution of animpaired loan and the transfer of a foreclosed property to other real estateowned (ORE) for which a specific reserve had been previously allocated.  Mortgage loans incurred net charge-offs of$32,000 in the first six months of 2008 compared to net recoveries of $12,000for the six months ended June 30, 2007.

 

Management believes that the current balance in the allowance for loanlosses of $4,189,000 is sufficient to withstand the identified potential creditquality issues which may arise and other unidentified credit risks that areinherent to the portfolio.  Currently,management is unaware of any potential problem loans that have not beenreviewed.  Potential problem loans arethose where there is known information that leads management to believerepayment of principal and/or interest is in jeopardy and the loans arecurrently neither on non-accrual status nor past due 90 days or more.  However, there could be certain instanceswhich become identified over the upcoming year that may require additionalcharge-offs and/or increases to the allowance. The ratio of allowance for loan losses to total loans was 1.00% at June 30,2008 compared to 1.13% at December 31, 2007.

 

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

 
| ** **                          | ** ** | **As of and for the** | ** **  | **As of and for the** | ** ** | **As of and for the** | ** ** |
|-------------------------------------|------------|-------------------------------------------|-------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                          | ** ** | **six months ended**            | ** **  | **twelve months ended**         | ** ** | **six months ended**            | ** ** |
| ** **                          | ** ** | **June 30, 2008**               | ** **  | **December 31, 2007**           | ** ** | **June 30, 2007**               | ** ** |
|                                |       |                                      |        |                                      |       |                                      |       |
| Balance at  beginning of period     |       | $                                         | 4,824,401   |                                      | $          | 5,444,303                                 |       | $ | 5,444,303 |   |
|                                |       |                                      |        |                                      |       |                                      |       |
| (Credit)  provision for loan losses |       | 125,000                                   |        | (60,000                                   | )          | —                                    |       |
|                                |       |                                      |        |                                      |       |                                      |       |
| Charge-offs:                        |       |                                      |        |                                      |       |                                      |       |
| Commercial                          |       | 587,029                                   |        | 375,356                                   |       | 41,942                                    |       |
| Residential real  estate            |       | 31,870                                    |        | 90,193                                    |       | 1,586                                     |       |
| Consumer                            |       | 236,797                                   |        | 256,215                                   |       | 146,986                                   |       |
| Total                               |       | 855,696                                   |        | 721,764                                   |       | 190,514                                   |       |
|                                |       |                                      |        |                                      |       |                                      |       |
| Recoveries:                         |       |                                      |        |                                      |       |                                      |       |
| Commercial                          |       | 76,482                                    |        | 18,076                                    |       | 12,415                                    |       |
| Residential real  estate            |       | 50                                        |        | 125,002                                   |       | 13,603                                    |       |
| Consumer                            |       | 18,334                                    |        | 18,784                                    |       | 14,730                                    |       |
| Total                               |       | 94,866                                    |        | 161,862                                   |       | 40,748                                    |       |
|                                |       |                                      |        |                                      |       |                                      |       |
| Net charge-offs                     |       | 760,830                                   |        | 559,902                                   |       | 149,766                                   |       |
|                                |       |                                      |        |                                      |       |                                      |       |
| Balance at end  of period           |       | $                                         | 4,188,571   |                                      | $          | 4,824,401                                 |       | $ | 5,294,537 |   |
|                                |       |                                      |        |                                      |       |                                      |       |
| Total loans, end  of period         |       | $                                         | 418,650,319 |                                      | $          | 427,076,030                               |       | $ | 425,653,831 |   |

 

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| ** **                                                               | ** ** | **As of and for the** | ** ** | **As of and for the** | ** ** | **As of and for the** | ** ** |
|--------------------------------------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                               | ** ** | **six months ended**            | ** ** | **twelve months ended**         | ** ** | **six months ended**            | ** ** |
| ** **                                                               | ** ** | **June 30, 2008**               | ** ** | **December 31, 2007**           | ** ** | **June 30, 2007**               | ** ** |
| Net charge-offs  to:                                                     |       |                                      |       |                                      |       |                                      |       |
| Loans, end of  period                                                    |       | 0.18                                      | %          | 0.13                                      | %          | 0.04                                      | %          |
| Allowance for  loan losses                                               |       | 18.16                                     | %          | 11.61                                     | %          | 2.83                                      | %          |
| Provision for  loan losses                                               |       | 6.09                                      | x          | —                                    | x          | —                                    | x          |
|                                                                     |       |                                      |       |                                      |       |                                      |       |
| Allowance for  loan losses to:                                           |       |                                      |       |                                      |       |                                      |       |
| Total loans                                                              |       | 1.00                                      | %          | 1.13                                      | %          | 1.24                                      | %          |
| Non-accrual  loans                                                       |       | 1.14                                      | x          | 1.27                                      | x          | 1.21                                      | x          |
| Non-performing  loans                                                    |       | 1.09                                      | x          | 1.26                                      | x          | 1.18                                      | x          |
| Net charge-offs                                                          |       | 5.51                                      | x          | 8.62                                      | x          | 35.35                                     | x          |
|                                                                     |       |                                      |       |                                      |       |                                      |       |
| Loans 30-89 days  past due and still accruing                            |       | $                                         | 2,199,056  |                                      | $          | 4,697,953                                 |       | $ | 6,596,917 |   |
| Loans 90 days  past due and accruing                                     |       | $                                         | 177,431    |                                      | $          | 25,470                                    |       | $ | 134,485 |   |
| Non-accrual  loans                                                       |       | $                                         | 3,667,929  |                                      | $          | 3,811,205                                 |       | $ | 4,363,589 |   |
| Allowance for  loan losses to loans 90days or more past due and accruing |       | 23.61                                     | x          | 189.41                                    | x          | 39.37                                     | x          |

 

*Non-performing assets*

 

The Bank defines non-performing assets as accruing loans past due 90days or more, non-accrual loans, restructured loans, ORE and repossessedassets.  As of June 30, 2008,non-performing assets represented 0.79% of total assets compared to 0.67% at December 31,2007.

 

In the review of loans for both delinquency and collateral sufficiency,management concluded that there were loans that lacked the ability to repay inaccordance with contractual terms.  Thedecision to place loans or leases on a non-accrual status is made on anindividual basis after considering factors pertaining to each specific loan.

 

The majority of non-performing assets for the period is attributed tonon-accruing commercial business loans and non-accruing real estate loans inthe process of foreclosure.  Most ofthese loans are collateralized, thereby mitigating the Bank’s potential forloss.  At June 30, 2008,non-performing loans were $3,845,000 compared to $3,837,000 at year-end 2007.

 

There were no repossessed assets or restructured loans at June 30,2008 or December 31, 2007.  Specificaction plans are developed for each of the Company’s non-performingassets.  These plans at times includelitigation and foreclosure.  As such, ourefforts to resolve non-performing assets may lead to a temporary increase inour ORE during the latter part of this year. Any increase is expected to be temporary as it is our practice topromptly market or list all such properties for sale with a local realtor.

 

Non-accrual loans aggregated $3,668,000 at June 30, 2008, comparedto $3,811,000 at December 13, 2007. Additions to the non-accruals component of the non-performing assetstotaling $3,750,000 were made during the first six months of 2008.  These were partially offset by payoffs orreductions of $2,234,000, charge-offs of $745,000, $790,000 in transfers to OREand $124,000 of loans that returned to performing status.  Loans past due 90 days or more and accruingtotaled $177,000 at June 30, 2008. The non-accrual loans were $3,668,000 and ORE totaled $897,000.  These three items comprise the non-performingassets of $4,742,000 at the period end June 30, 2008.  Non-performing loans to net loans were 0.93%at June 30, 2008 and 0.91% at December 31, 2007.

 

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

 
| ** **                                                      | ** ** | **June 30, 2008** | ** **  | **December 31, 2007** | ** ** | **June 30, 2007** | ** ** |
|-----------------------------------------------------------------|------------|-----------------------------|-------------|---------------------------------|------------|-----------------------------|------------|
|                                                            |       |                        |        |                            |       |                        |       |
| Loans past due  90 days or more and accruing                    |       | $                           | 177,431     |                            | $          | 25,470                      |       | $ | 134,485 |   |
| Non-accrual  loans                                              |       | 3,667,929                   |        | 3,811,205                       |       | 4,363,589                   |       |
| Total  non-performing loans                                     |       | 3,845,360                   |        | 3,836,675                       |       | 4,498,074                   |       |
|                                                            |       |                        |        |                            |       |                        |       |
| Other real  estate owned                                        |       | 897,036                     |        | 107,036                         |       | —                      |       |
| Total  non-performing assets                                    |       | $                           | 4,742,396   |                            | $          | 3,943,711                   |       | $ | 4,498,074 |   |
|                                                            |       |                        |        |                            |       |                        |       |
| Net loans  including AFS                                        |       | $                           | 414,461,748 |                            | $          | 422,251,629                 |       | $ | 420,358,294 |   |
| Total assets                                                    |       | $                           | 598,563,896 |                            | $          | 587,412,555                 |       | $ | 573,492,468 |   |
| Non-accrual  loans to net loans                                 |       | 0.88                        | %           | 0.90                            | %          | 1.04                        | %          |
| Non-performing  assets to net loans, ORE and repossessed assets |       | 1.14                        | %           | 0.93                            | %          | 1.07                        | %          |
| Non-performing  assets to total assets                          |       | 0.79                        | %           | 0.67                            | %          | 0.78                        | %          |
| Non-performing  loans to net loans                              |       | 0.93                        | %           | 0.91                            | %          | 1.07                        | %          |

 

*Foreclosed**assets held-for-sale*

 

At June 30, 2008, foreclosed assets held-for-sale was comprised ofthree ORE properties amounting to $897,000. One property has since been sold, a second is under an agreement to selland the other is listed for sale with a local realtor.

 

*Other assets*

 

The increase in other assets of $4,926,000 from December 31, 2007to June 30, 2008 was principally due to an increase in the deferred taxasset related to additional unrealized losses recorded in the securities AFSinvestment portfolio, a net increase in capitalized construction costs relatedto activities associated with the Company’s branch expansion project and therecording of an investment security receivable that is scheduled to settleduring the third quarter of this year. The Company expects to launch the opening of its newest branch officeduring the third quarter of 2008. Capitalized construction costs will then be transferred to premises andequipment at which time systematic depreciation will commence.

 

*Deposits*

 

The Bank is a community-based commercial financial institution thatoffers a variety of deposit accounts with a range of interest rates andterms.  Deposit products include savingsaccounts, interest-bearing checking (NOW), money market, non-interest bearingdeposits (DDAs) and certificates of deposit accounts.  Certificates of deposit accounts, or CDs, aredeposits with stated maturities ranging from seven days to ten years.  The flow of deposits is significantlyinfluenced by general economic conditions, changes in prevailing interestrates, pricing and competition.  Most ofthe Company’s deposits are obtained from the communities surrounding its 11branch offices.  The Bank attempts toattract and retain deposit customers via sales and marketing efforts, newproducts, quality service, competitive rates and maintaining long-standingcustomer relationships.  To determinedeposit product interest rates, the Company considers local competition, marketyields and the rates charged for alternative sources of funding such asborrowings.  Though we continue toexperience intense competition for deposits, our rate-setting strategy includesconsideration of liquidity needs, balance sheet structure and cost effectivestrategies that are mindful of the current interest rate environment.

 

Compared to December 31, 2007 total deposits grew $22,526,000, or5%, during the six months ended June 30, 2008.  The growth in total deposits was primarilydue to increases in money markets, DDAs and NOW accounts of $13,553,000, or15%, $9,969,000, or 15%, and $3,734,000, or 7%, respectively, partially offsetby lower CD balances.  The net increasestems from seasonal activity with our municipal customers and higher period endbalances in non-personal DDA accounts.  InJuly 2008, the Company experienced significant deposit outflows from thesemunicipal customers’ normal operations and a reduction in balances by ourlargest depositor.

 

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The following table represents the components of deposits as of June 30,2008 and December 31, 2007 (dollars in thousands):

 
| ** **               | ** ** | **June 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|--------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| ** **               | ** ** | **Amount**                  | ** ** | **%**                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| Money market             |       | $                           | 101,445    |                            | 22.6       |   | $ | 87,892 |   | 20.6 |   |
| NOW                      |       | 58,429                      |       | 13.0                            |       | 54,695 |   | 12.9 |   |
| Savings and club         |       | 39,527                      |       | 8.8                             |       | 40,125 |   | 9.4 |   |
| Certificates of  deposit |       | 174,068                     |       | 38.9                            |       | 178,200 |   | 41.9 |   |
| Total  interest-bearing  |       | 373,469                     |       | 83.3                            |       | 360,912 |   | 84.8 |   |
| Non-interest-bearing     |       | 74,765                      |       | 16.7                            |       | 64,796 |   | 15.2 |   |
| Total deposits           |       | $                           | 448,234    |                            | 100.0      |   | $ | 425,708 |   | 100.0 |   |

 

Certificates of depositof $100,000 or more aggregated $76,054,000 and $80,857,000 at June 30,2008 and December 31, 2007, respectively.

 

*Borrowings*

 

Borrowings are used as a complement to deposit generation as analternative funding source whereby the Bank will borrow under customerrepurchase agreements in the local market and advances from the Federal Home LoanBank of Pittsburgh (FHLB) and correspondent banks for asset growth andliquidity needs.  Repurchase agreementsare non-insured interest-bearing liabilities that have a security interest inqualified investment securities of the Bank and are offered in both sweep andfixed-term products.  A sweep account isdesigned to ensure that, on a daily basis, an attached DDA is adequately fundedand excess DDA funds are transferred, or swept, into an overnight interest-bearingrepurchase agreement account.  The balancein customer repurchase agreement accounts can fluctuate daily because the dailysweep product is dependent on the level of available funds in depositoraccounts.  In addition, short-termborrowings may include overnight balances which the Bank may require fromtime-to-time to fund daily liquidity needs. Overnight balances and repurchase agreements are components ofshort-term borrowings on the consolidated balance sheets.  FHLB advances are components of long-termdebt on the consolidated balance sheets.

 

The following table represents the components of borrowings as of June 30,2008 and December 31, 2007 (dollars in thousands):

 
| ** **                  | ** ** | **June 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|-----------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| ** **                  | ** ** | **Amount**                  | ** ** | **%**                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| Overnight  borrowings       |       | $                           | 18,700     |                            | 20.3       |   | $ | 18,950 |   | 18.5 |   |
| Repurchase  agreements      |       | 10,112                      |       | 11.0                            |       | 20,504 |   | 20.0 |   |
| Demand note,  U.S. Treasury |       | 862                         |       | 0.9                             |       | 202 |   | 0.2 |   |
| FHLB advances               |       | 62,286                      |       | 67.8                            |       | 62,709 |   | 61.3 |   |
| Total borrowings            |       | $                           | 91,960     |                            | 100.0      |   | $ | 102,365 |   | 100.0 |   |

 

The reduction in repurchase agreements was caused by a combination ofpricing competition for large repos above wholesale rates, as well as thevolatile nature of the daily sweep product.

 

*Accrued interest payable andother liabilities*

 

The increase in accrued interest payable and other liabilities of$1,170,000 from December 31, 2007 to June 30, 2008 was primarily dueto the recording of an $850,000 investment security purchase-commitment thatwill settle in the third quarter and an increase in accrued interest fromhigher interest-bearing balances.

 

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

 

*Management of interest rate riskand market risk analysis*

 

The Company is subject tothe interest rate risks inherent in its lending, investing and financingactivities.  Fluctuations of interestrates will impact interest income and interest expense along with affectingmarket values of all interest-earning assets and interest-bearing liabilities,except for those assets or liabilities with a short term remaining tomaturity.  Interest rate risk managementis an integral part of the asset/liability management process.  The Company has instituted certain proceduresand policy guidelines to manage the interest rate risk position.  Those internal policies enable the Company toreact to changes in market rates to protect net interest income fromsignificant fluctuations.  The primaryobjective in managing interest rate risk is to minimize the adverse impact ofchanges in interest rates on net interest income along with creating anasset/liability structure that maximizes earnings.

 

*Asset/Liability Management*.  One major objective of the Company whenmanaging the rate sensitivity of its assets and liabilities is to stabilize netinterest income.  The management of andauthority to assume interest rate risk is the responsibility of the Company’sAsset/Liability Committee (ALCO), which is comprised of senior management andmembers of the board of directors.  ALCOmeets quarterly to monitor the relationship of interest sensitive assets tointerest sensitive liabilities.  Theprocess to review interest rate risk is a regular part of managing theCompany.  Consistent policies andpractices of measuring and reporting interest rate risk exposure, particularlyregarding the treatment of non-contractual assets and liabilities, are ineffect.  In addition, there is an annualprocess to review the interest rate risk policy with the board of directors whichincludes limits on the impact to earnings from shifts in interest rates.

 

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

 

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

 

To manage this interest rate sensitivity gap position, anasset/liability model commonly known as cumulative gap analysis is used tomonitor the difference in the volume of the Company’s interest sensitive assetsand liabilities that mature or re-price within given time intervals.  A positive gap (asset sensitive) indicatesthat more assets will re-price during a given period compared to liabilities,while a negative gap (liability sensitive) has the opposite effect.  The Company employs computerized net interestincome simulation modeling to assist in quantifying interest rate risk exposure.  This process measures and quantifies theimpact on net interest income through varying interest rate changes and balancesheet compositions.  The use of thismodel assists the ALCO to gauge the effects of the interest rate changes oninterest-sensitive assets and liabilities in order to determine what impactthese rate changes will have upon the net interest spread.  At June 30, 2008 the Bank maintained aone-year cumulative gap of negative $34.0 million, or 5.7%, of totalassets.  The effect of this negative gapposition provided a mismatch of assets and liabilities which may expose theBank to interest rate risk during periods of rising interest rates.  Conversely, in a falling interest rateenvironment, net interest income could be positively impacted because moreliabilities than assets would re-price downward during the one-year period.

 

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

 

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The following tableillustrates the Company’s interest sensitivity gap position at June 30,2008 (dollars in thousands):

 
| ** **                                     | ** ** | **Three months** | ** ** | **Three to**      | ** ** | **One to**      | ** ** | **Over**             | ** ** | ** ** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|------------------------|------------|----------------------|------------|----------------------|------------|------------|------------|
| ** **                                     | ** ** | **or less**      | ** ** | **twelve months** | ** ** | **three years** | ** ** | **three years** | ** ** | **Total**  | ** ** |
| Cash and cash  equivalents                     |       | $                     | 367        |                   | $          | —               |       | $                    | —     |       | $          | 15,673 |   | $ | 16,040 |   |
| Investment  securities (1)(2)                  |       | 26,285                |       | 16,667                 |       | 16,620               |       | 74,030               |       | 133,602    |       |
| Loans (2)                                      |       | 112,836               |       | 66,370                 |       | 95,827               |       | 139,429              |       | 414,462    |       |
| Fixed and other  assets                        |       | —                |       | 8,646                  |       | —               |       | 25,814               |       | 34,460     |       |
| Total assets                                   |       | $                     | 139,488    |                   | $          | 91,683               |       | $                    | 112,447    |       | $          | 254,946 |   | $ | 598,564 |   |
| Total cumulative  assets                       |       | $                     | 139,488    |                   | $          | 231,171              |       | $                    | 343,618    |       | $          | 598,564 |   |   |   |
|                                           |       |                  |       |                   |       |                 |       |                 |       |       |       |
| Non-interest-bearing  transaction deposits (3) |       | $                     | —     |                   | $          | 7,476                |       | $                    | 20,561     |       | $          | 46,728 |   | $ | 74,765 |   |
| Interest-bearing  transaction deposits (3)     |       | 88,381                |       | —                 |       | 43,016               |       | 68,004               |       | 199,401    |       |
| Certificates of  deposit                       |       | 39,680                |       | 79,660                 |       | 51,148               |       | 3,580                |       | 174,068    |       |
| Repurchase  agreements                         |       | 10,112                |       | —                 |       | —               |       | —               |       | 10,112     |       |
| Short-term  borrowings                         |       | 19,562                |       | —                 |       | —               |       | —               |       | 19,562     |       |
| Long-term debt                                 |       | 10,214                |       | 10,071                 |       | 21,000               |       | 21,001               |       | 62,286     |       |
| Other  liabilities                             |       | —                |       | —                 |       | —               |       | 5,318                |       | 5,318      |       |
| Total  liabilities                             |       | $                     | 167,949    |                   | $          | 97,207               |       | $                    | 135,725    |       | $          | 144,631 |   | $ | 545,512 |   |
| Total cumulative  liabilities                  |       | $                     | 167,949    |                   | $          | 265,156              |       | $                    | 400,881    |       | $          | 545,512 |   |   |   |
|                                           |       |                  |       |                   |       |                 |       |                 |       |       |       |
| Interest  sensitivity gap                      |       | $                     | (28,461    | )                      | $          | (5,524               | )          | $                    | (23,278    | )          | $          | 110,315 |   |   |   |
|                                           |       |                  |       |                   |       |                 |       |                 |       |       |       |
| Cumulative gap                                 |       | $                     | (28,461    | )                      | $          | (33,985              | )          | $                    | (57,263    | )          | $          | 53,052 |   |   |   |
|                                           |       |                  |       |                   |       |                 |       |                 |       |       |       |
| Cumulative gap  to total assets                |       | (4.75                 | )%         | (5.68                  | )%         | (9.57                | )%         | 8.86                 | %          |       |       |

 

----

| (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 mortgage-backed securities, 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 RiskSimulations*.  TheCompany recognizes that more sophisticated tools exist for measuring theinterest rate risk in the balance sheet that extend beyond static re-pricinggap analysis.  Although it will continueto measure its re-pricing gap position, the Company utilizes additionalmodeling for identifying and measuring the interest rate risk in the overallbalance sheet.  The ALCO is responsiblefor focusing on “earnings at risk” and “economic value at risk”, and how bothrelate to the risk-based capital position when analyzing the interest raterisk.

 

*Earnings at Risk*.  Earnings at risk simulation measures thechange in net interest income and net income should interest rates rise andfall.  The simulation recognizes that notall assets and liabilities re-price one-for-one with market rates (e.g.,savings rate).  The ALCO looks at “earningsat risk” to determine income changes from a base case scenario under anincrease and decrease of 200 basis points in interest rate simulation models.

 

*Economic Value at Risk.* Earnings at risk simulation measures theshort-term risk in the balance sheet. Economic value (or portfolio equity) at risk measures the long-term riskby finding the net present value of the future cash flows from the Company’sexisting assets and liabilities.  TheALCO examines this ratio quarterly utilizing an increase and decrease of 200basis points in interest rate simulation models.  The ALCO recognizes that, in some instances,this ratio may contradict the “earnings at risk” ratio.

 

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The following table illustrates the simulated impact of 200 basispoints upward or downward movement in interest rates on net interest income,net income and the change in the economic value (portfolio equity).  This analysis assumes that interest-earningasset and interest-bearing liability levels at June 30, 2008 remainconstant.  The impact of the ratemovements was developed by simulating the effect of rates changing over atwelve-month period from the June 30, 2008 levels:

 
| ** **                                             | ** ** | **Rates +200** | ** ** | **Rates -200** | ** ** |
|--------------------------------------------------------|------------|---------------------|------------|---------------------|------------|
| Earnings at  risk:                                     |       |                |       |                |       |
| Percent change  in:                                    |       |                |       |                |       |
| Net interest  income                                   |       | (3.3                | )%         | 1.9                 | %          |
| Net income                                             |       | (8.7                | )          | 4.7                 |       |
|                                                   |       |                |       |                |       |
| Economic value  at risk:                               |       |                |       |                |       |
| Percent change  in:                                    |       |                |       |                |       |
| Economic value  of equity                              |       | (28.8               | )          | 1.5                 |       |
| Economic value  of equity as a percent of total assets |       | (3.1                | )          | 0.2                 |       |

 

Economic value has the most meaning when viewed withinthe context of risk-based capital. Therefore, the economic value may normally change beyond the Company’spolicy guideline for a short period of time as long as the risk-based capitalratio (after adjusting for the excess equity exposure) is greater than10%.  At June 30, 2008, the Company’srisk-based capital ratio was 14.1%.

 

The table below summarizes estimated changes in net interest incomeover a twelve-month period beginning July 1, 2008 under alternate interestrate scenarios using the income simulation model described above (dollars inthousands):

 
| ** **                                  | ** ** | **Net interest** | ** ** | **$**        | ** ** | **%**        | ** ** |
|---------------------------------------------|------------|-----------------------|------------|--------------|------------|--------------|------------|
| **Change in interest rates** | ** ** | **income**            | ** ** | **variance** | ** ** | **variance** | ** ** |
|                                        |       |                  |       |         |       |         |       |
| +200 basis  points                          |       | $                     | 19,623     |         | $          | (675         | )          | (3.3 | )% |
| +100 basis  points                          |       | 20,053                |       | (245         | )          | (1.2         | )          |
| Flat rate                                   |       | 20,298                |       | —       |       | —       |       |
| -100 basis  points                          |       | 20,512                |       | 214          |       | 1.1          |       |
| -200 basis  points                          |       | 20,674                |       | 376          |       | 1.9          |       |
|                                             |            |                       |            |              |            |              |            |  |  |

 

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

 

*Derivative FinancialInstruments. *As partof the Bank’s overall interest rate risk strategy, the Company has adopted apolicy whereby the Company may periodically use derivative instruments tominimize significant fluctuations in earnings caused by interest ratevolatility.  This interest rate riskmanagement strategy entails the use of interest rate floors, caps andswaps.  In October 2006, the Bankentered into an interest rate floor derivative agreement on $20,000,000notional value of its prime-based loan portfolio.  The purpose of the hedge is to help protectthe Bank’s interest income in the event interest rates decline below apre-determined contractual interest rate. The strategy is reflected in the scenarios for earnings and economicvalue at risk and the net interest income in the two immediately precedingtables.  For a further discussion on theBank’s derivative contract, see Note No. 4, “Derivative instruments,”contained within the notes to consolidated financial statements in Part I,Item 1.

 

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*Liquidity*

 

Liquidity management ensures that adequate funds willbe available to meet loan and investment commitments, deposit withdrawals andmaturities and normal operating requirements of the Bank.  Current sources of liquidity are cash andcash equivalents, asset maturities, calls and principal repayments, loans andinvestments AFS, growth of core deposits, growth of repurchase agreements,increases in other borrowed funds from correspondent banks and issuance ofcapital stock.  Although regularlyscheduled investment and loan payments are dependable sources of daily funds,the sales of both loans and investments AFS, deposit activity and investmentand loan prepayments are significantly influenced by general economicconditions and the level of interest rates.

 

As of June 30,2008, the Company maintained $16,040,000 in cash and cash equivalents,$128,184,000 of investments AFS and $152,000 of loans AFS.  In addition, as of June 30, the Companyhad approximately $247,036,000 available to borrow from the FHLB and$30,000,000 available from other correspondent banks.  This combined total of $421,412,000represented 70% of total assets at June 30, 2008.  Management believes this level of liquidityto be strong and adequate to support current operations.  In July 2008, management sold $16.4million of securities AFS in order to pay down overnight borrowing.

 

*Capital*

 

During the second quarter the Company’s Board ofDirectors announced its intent to initiate a capital stock repurchase programcovering up to 50,000 shares of its outstanding capital stock.  The repurchased shares would become treasurystock and could be available for issuance under the Company’s variousstock-based compensation, employee stock purchase and dividend reinvestmentplans and for general corporate purposes. The repurchases will be made from time-to-time in open-market transactions,subject to availability, pursuant to safe harbor rule 10b-18 under theSecurities Exchange Act of 1934.  As of June 30,2008, the Company reacquired 5,000 shares at a cost of $29.12 per share.  Subsequent to June 30, 2008, on July 10,2008, the Company reacquired an additional 6,000 shares at a cost of $29.25 pershare.  For a further discussion aboutthis program, see I**t**em 2, “UnregisteredSales of Equity Securities and Use of Proceeds” included in Part II, “OtherInformation,” below.

 

During the six monthsended June 30, 2008, shareholders’ equity decreased $2,139,000, mostlyfrom increased unrealized net losses in the securities AFS portfolio, thedeclaration of cash dividends and the repurchase of the Company’s capital stock(treasury stock).  Conversely,shareholders’ equity was enhanced by current year earnings, stock issued fromthe Company’s Employee Stock Purchase Plan, and an increase in the intrinsicvalue of the Company’s cash flow hedge instrument.

 

The Company issubject to various regulatory capital requirements administered by the federalbanking agencies.  Failure to meetminimum capital requirements can initiate certain mandatory and possibleadditional discretionary actions by regulators that, if undertaken, could havea direct material effect on the Company’s financial statements.  Under capital adequacy guidelines and theregulatory framework for prompt corrective action, the Company must meetspecific capital guidelines that involve quantitative measures of the Company’sassets, liabilities and certain off-balance-sheet items as calculated underregulatory accounting practices.  TheCompany’s capital amounts and classification are also subject to qualitativejudgments by the regulators about components, risk-weightings and other factors.

 

Under these guidelines,assets and certain off-balance sheet items are assigned to broad riskcategories, each with appropriate weights. The resulting capital ratios represent capital as a percentage of totalrisk-weighted assets and certain off-balance sheet items.  The guidelines require all banks and bankholding companies to maintain a minimum ratio of total risk-based capital tototal risk-weighted assets (Total Risk Adjusted Capital) of 8%, including Tier Icapital to total risk-weighted assets (Tier I Capital) of 4% and Tier I capitalto average total assets (Leverage Ratio) of at least 4%.  As of June 30, 2008, the Company and theBank met all capital adequacy requirements to which it was subject.

 

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The following tabledepicts the capital amounts and ratios of the Company and the Bank as of June 30,2008:

 
| ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                            | ** ** | **To be well capitalized** | ** ** |
|----------------------------|------------|------------|------------|------------|------------|----------------------------|------------|---------------------------------------|------------|-------------------------------------------|------------|
| ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | **For capital**       | ** ** | **under prompt corrective** | ** ** |
| ** **                 | ** ** | **Actual** | ** ** | ** ** | ** ** | **adequacy purposes** | ** ** | **action provisions**            | ** ** |
| ** **                 | ** ** | **Amount** | ** ** | **Ratio**  | ** ** | **Amount**                 | ** ** | **Ratio**                             | ** ** | **Amount**                                | ** ** | **Ratio** | ** ** |
| Total capital              |       |       |       |       |       |                       |       |                                  |       |                                      |       |   |   |
| (to  risk-weighted assets) |       |       |       |       |       |                       |       |                                  |       |                                      |       |   |   |
| Consolidated               |       | $          | 61,283,929 |       | 14.1       | %   >         | $          | 34,718,176                            | >  | 8.0                                       | %          | N/A |   | N/A |   |
| Bank                       |       | $          | 60,870,573 |       | 14.1       | %   >         | $          | 34,621,922                            | >  | 8.0                                       | %          | $ | 43,277,402 | >  | 10.0 | % |
| Tier I capital             |       |       |       |       |       |                       |       |                                  |       |                                      |       |   |   |
| (to  risk-weighted assets) |       |       |       |       |       |                       |       |                                  |       |                                      |       |   |   |
| Consolidated               |       | $          | 57,029,090 |       | 13.1       | %   >         | $          | 17,359,088                            | >  | 4.0                                       | %          | N/A |   | N/A |   |
| Bank                       |       | $          | 56,681,029 |       | 13.1       | %   >         | $          | 17,310,961                            | >  | 4.0                                       | %          | $ | 25,966,441 | >  | 6.0 | % |
| Tier I capital             |       |       |       |       |       |                       |       |                                  |       |                                      |       |   |   |
| (to average  assets)       |       |       |       |       |       |                       |       |                                  |       |                                      |       |   |   |
| Consolidated               |       | $          | 57,029,090 |       | 9.7        | %   >         | $          | 23,425,543                            | >  | 4.0                                       | %          | N/A |   | N/A |   |
| Bank                       |       | $          | 56,681,029 |       | 9.7        | %   >         | $          | 23,364,982                            | >  | 4.0                                       | %          | $ | 29,206,227 | >  | 5.0 | % |

 

**Item 4. Controls and Procedures**

 

As of the end of the period covered by this Quarterly Report on Form 10-Q, an evaluation was carried out by the Company’s management, with the participation of its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures, as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934.  Based on such evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports the Company files or furnishes under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and regulations, and are operating in an effective manner.  The Company made no significant changes in its internal controls over financial reporting or in other factors that materially affected, or are reasonably likely to materially affect, these controls during the last fiscal quarter ended June 30, 2008.

 

**PART II - Other Information**

 

**Item1.  Legal Proceedings**

 

The nature of the Company’s business generates somelitigation involving matters arising in the ordinary course of business.  However, in the opinion of theCompany, after consulting with legal counsel, no legal proceedings are pending,which, if determined adversely to the Company or the Bank, would have amaterial effect on the Company’s undivided profits or financial condition.  No legal proceedings are pending other thanordinary routine litigation incidental to the business of the Company and theBank.  In addition, to management’sknowledge, no governmental authorities have initiated or contemplated anymaterial legal actions against the Company or the Bank.

 

**Item1A.   Risk Factors**

 

Management of the Company does not believe there havebeen any material changes in the risk factors that were disclosed in the Form 10-Kfiled with the Securities and Exchange Commission on March 13, 2008.

 

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**Item2.     Unregistered Sales of EquitySecurities and Use of Proceeds**

 

(c)          The following tablesummarizes the activity in the Company’s stock repurchase program during thesecond quarter of 2008:

 
| ** **            | ** ** | ** ** | **(a)**                                 | ** ** | ** ** | **(b)**                                | ** ** | ** ** | **(c)**                                 | ** ** | ** ** | **(d)**                                            | ** ** |
|-----------------------|------------|------------|-----------------------------------------|------------|------------|----------------------------------------|------------|------------|-----------------------------------------|------------|------------|----------------------------------------------------|------------|
| ** **            | ** ** | ** ** | ** **                              | ** ** | ** ** | ** **                             | ** ** | ** ** | **Total number of**           | ** ** | ** ** | ** **                                         | ** ** |
| ** **            | ** ** | ** ** | ** **                              | ** ** | ** ** | ** **                             | ** ** | ** ** | **shares (or units)**         | ** ** | ** ** | **Maximum number of**                    | ** ** |
| ** **            | ** ** | ** ** | **Total Number**                   | ** ** | ** ** | ** **                             | ** ** | ** ** | **purchased as part as** | ** ** | ** ** | **shares (or units) that may** | ** ** |
| ** **            | ** ** | ** ** | **of shares (or units)** | ** ** | ** ** | **Average price paid**       | ** ** | ** ** | **publicly announced plans**  | ** ** | ** ** | **yet be purchased under the** | ** ** |
| **Period**            | ** ** | ** ** | **purchased**                           | ** ** | ** ** | **per share (or unit)** | ** ** | ** ** | **or programs**                    | ** ** | ** ** | **plans or programs**                    | ** ** |
| April 1, 2008 to |       |       |                                    |       |       |                                   |       |       |                                    |       |       |                                               |       |
| April 30, 2008   |       |       | —                                  |       |       | —                                 |       |       | —                                  |       |       | —                                             |       |
| May 1, 2008 to   |       |       |                                    |       |       |                                   |       |       |                                    |       |       |                                               |       |
| May 31, 2008     |       |       | —                                  |       |       | —                                 |       |       | —                                  |       |       | —                                             |       |
| June 1, 2008 to  |       |       |                                    |       |       |                                   |       |       |                                    |       |       |                                               |       |
| June 30, 2008    |       |       | 5,000                                   |       |       | $29.12                                 |       |       | 5,000                                   |       |       | 45,000                                             |       |
| Total                 |       |       | 5,000                                   |       |       | $29.12                                 |       |       | 5,000                                   |       |       | 45,000                                             |       |

 

On June 3, 2008 theCompany’s Board of Directors approved and on June 5, 2008 the Companypublicly announced its intent to initiate a capital stock repurchase programcovering up to 50,000 share, or approximately 2.4% of its outstanding capitalstock as of May 31, 2008.  TheCompany has not made any purchases of its shares of capital that has not beenpublicly announced.  Neither anexpiration date nor a maximum dollar amount has been fixed to the program.  The repurchases will be made from time-to-timein open-market transactions, subject to availability.  The repurchased shares would become treasurystock and could be available for issuance under the Company’s variousstock-based compensation, employee stock purchase and dividend reinvestmentplans and for general corporate purposes. No repurchase program has expired or has been subject to a determinationto terminate during the period covered by the above table.

 

**Item3.     Default Upon Senior Securities**

 

None

 

**Item4.     Submission of Matters to a Vote ofSecurity Holders**

 

At the annual meeting of shareholders held on May 6,2008, the judges of election made the report concerning the results ofballoting.  Holders of 1,618,153 sharesof common stock, representing 78% of the total number of shares outstanding,were represented in person or by proxy at the 2008 annual meeting ofshareholders.  The following votes werecast:

 

Election of Class B Directors to serve for athree-year term:

 

 
| ** **                   | ** ** | **For**   | ** ** | **Withhold authority** | ** ** | **Abstain** | ** ** |
|------------------------------|------------|-----------|------------|-----------------------------|------------|-------------|------------|
| Samuel C. Cali               |       | 1,593,204 |       | 24,948                      |       | —      |       |
| Mary E. McDonald             |       | 1,604,061 |       | 14,091                      |       | —      |       |
| David L.  Tressler, Sr. |       | 1,581,302 |       | 36,851                      |       | —      |       |

 

 

In addition to the above elected Class BDirectors, at the conclusion of its annual meeting, the Company’s Board ofDirectors consisted of: John T. Cognetti and Michael J. McDonald as Class ADirectors whose term expires in 2009; and Steven C. Ackmann, Brian J. Cali andPatrick J. Dempsey as Class C Directors whose term expires in 2010.

 

Ratification of independent certified publicaccountants:

 
| ** **             | ** ** | **For**   | ** ** | **Against** | ** ** | **Abstain** | ** ** |
|------------------------|------------|-----------|------------|-------------|------------|-------------|------------|
| Parente  Randolph, LLC |       | 1,606,965 |       | 8,429       |       | 2,758       |       |

 

 

**Item5.     Other Information**

 

None

 

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**Item6.    Exhibits**

 

The following exhibitsare filed herewith or incorporated by reference as a part of thisForm 10-Q:

 

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

 

***3(ii) Amendedand Restated Bylaws of Registrant.*** Incorporated by reference to Exhibit 3(ii) toRegistrant’s Form 8-K filed with the SEC on November 21, 2007.

 

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

 

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

 

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

 

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

 

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

 

***  11 Statement regarding computation ofearnings per share. ***Includedherein in Note No. 2, “Earnings per share,” contained within the Notes toConsolidated Financial Statements, and incorporated herein by reference.

 

***  31.1 Rule 13a-14(a) Certificationof Principal Executive Officer, filed herewith.***

 

***  31.2 Rule 13a-14(a) Certificationof Principal Financial Officer, filed herewith.***

 

***  32.1 Certification of Principal ExecutiveOfficer pursuant to 18 U.S.C. Section 1350,**** as adopted**pursuant toSection 906 of the Sarbanes-Oxley Act of 2002, filed herewith.***

 

***  32.2 Certification of Principal FinancialOfficer 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.

 

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**FIDELITYD & D BANCORP, INC.**

 

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

 

 
|                      | **FIDELITY  D & D BANCORP, INC.** |
|---------------------------|--------------------------------------------|
|                      | ** **                                 |
|                      |                                       |
| Date: August 5, 2008 | /s/ Steven C. Ackmann                      |
|                      | Steven C.  Ackmann,                        |
|                      | President and  Chief Executive Officer     |

 

 
| Date: August 5, 2008 | /s/ Salvatore R. DeFrancesco, Jr. |
|---------------------------|----------------------------------------|
|                      | Salvatore R.  DeFrancesco, Jr.,   |
|                      | Treasurer and  Chief Financial Officer |

 

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**EXHIBIT INDEX**

 
| ** **                                                                                                                                                                                                                                                                                                                                                   | **Page** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------|
| ***3(i) Amended  and Restated Articles of Incorporation of Registrant.***Incorporated  by reference to Annex B to the Proxy Statement Prospectus included in  Registrant’s Amendment 4 to its Registration Statement No.333-90273 on  Form 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  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. | *        |
|                                                                                                                                                                                                                                                                                                                                                         |     |
| ***10.2  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.                                                                                                    | *        |
|                                                                                                                                                                                                                                                                                                                                                         |     |
| ***10.3  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.                                                                                                                       | *        |
|                                                                                                                                                                                                                                                                                                                                                         |     |
| ***10.4  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.      | *        |
|                                                                                                                                                                                                                                                                                                                                                         |     |
| ***10.5  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.         | *        |
|                                                                                                                                                                                                                                                                                                                                                         |     |
| ***11******Statement regarding computation of earnings per  share.***                                                                                                                                                                                                                                                                                        | 8        |
|                                                                                                                                                                                                                                                                                                                                                         |     |
| ***31.1  Rule 13a-14(a) Certification of Principal Executive Officer.***                                                                                                                                                                                                                                                                           | 34       |
|                                                                                                                                                                                                                                                                                                                                                         |     |
| ***31.2  Rule 13a-14(a) Certification of Principal Financial Officer.***                                                                                                                                                                                                                                                                           | 35       |
|                                                                                                                                                                                                                                                                                                                                                         |     |
| ***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.***                                                                                                                                                                               | 36       |
|                                                                                                                                                                                                                                                                                                                                                         |     |
| ***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.***                                                                                                                                                                               | 37       |

 

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* Incorporated by Reference

 

33

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