**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

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

**SECURITIES EXCHANGE ACT OF 1934**

 

**For thequarterly period ended March 31, 2008**

 

**OR**

 

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

**SECURITIES EXCHANGE 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 o 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).

 

o YES        xNO

 

The number of outstandingshares of Common Stock of Fidelity D & D Bancorp, Inc. at April 30,2008, the latest practicable date, was 2,075,182 shares.

 

 

----

 

**FIDELITYD & D BANCORP, INC.**

 

Form 10-Q March 31,2008

 

Index

 
|                                   |                                                                                                                      | **Page**   |
|----------------------------------------|---------------------------------------------------------------------------------------------------------------------------|------------|
| **Part I. Financial Information** |                                                                                                                      | ** ** |
|                                   |                                                                                                                      |       |
| Item 1.                                | Financial Statements:                                                                                                     |       |   |
|                                   | Consolidated  Balance Sheets as of March 31, 2008 and December 31, 2007                                                   |       | 3 |
|                                   | Consolidated Statements of  Income for the three months ended March 31, 2008 and 2007                                |       | 4 |
|                                   | Consolidated Statements of  Changes in Shareholders’ Equity for the three months ended March 31,  2008 and 2007 |       | 5 |
|                                   | Consolidated Statements of  Cash Flows for the three months ended March 31, 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                                                                |       | 24 |
|                                   |                                                                                                                      |       |   |
| Item 4.                                | Controls and Procedures                                                                                                   |       | 28 |
|                                   |                                                                                                                      |       |   |
| **Part II. Other  Information**   |                                                                                                                      |       |
|                                   |                                                                                                                      |       |   |
| Item 1.                                | Legal Proceedings                                                                                                         |       | 28 |
|                                   |                                                                                                                      |       |   |
| Item 1A.                               | Risk Factors                                                                                                              |       | 28 |
|                                   |                                                                                                                      |       |   |
| Item 2.                                | Unregistered  Sales of Equity Securities and Use of Proceeds                                                              |       | 28 |
|                                   |                                                                                                                      |       |   |
| Item 3.                                | Defaults  upon Senior Securities                                                                                          |       | 28 |
|                                   |                                                                                                                      |       |   |
| Item 4.                                | Submission  of Matters to a Vote of Security Holders                                                                      |       | 28 |
|                                   |                                                                                                                      |       |   |
| Item 5.                                | Other Information                                                                                                         |       | 28 |
|                                   |                                                                                                                      |       |   |
| Item 6.                                | Exhibits                                                                                                                  |       | 29 |
|                                   |                                                                                                                      |       |   |
| Signatures                             |                                                                                                                      |       | 30 |
|                                   |                                                                                                                      |       |   |
| Exhibit index                     |                                                                                                                      |       | 31 |

 

2

----

 

**PART I– Financial Information**

 

**Item 1:Financial Statements**

** **

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

 

Consolidated Balance Sheets

 
| ** **                                                                                                                                    | ** ** | **March 31, 2008** | ** **  | **December 31, 2007** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|-------------|---------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **(unaudited)**              | ** **  | **(audited)**                   | ** ** |
|                                                                                                                                          |       |                         |        |                            |       |
| Assets:                                                                                                                                       |       |                         |        |                            |       |
| Cash and due  from banks                                                                                                                      |       | $                            | 13,302,358  |                            | $          | 10,204,714 |   |
| Federal funds  sold                                                                                                                           |       | 9,900,000                    |        | —                          |       |
| Interest-bearing  deposits with financial institutions                                                                                        |       | 176,596                      |        | 204,102                         |       |
|                                                                                                                                          |       |                         |        |                            |       |
| Total cash and  cash equivalents                                                                                                              |       | 23,378,954                   |        | 10,408,816                      |       |
|                                                                                                                                          |       |                         |        |                            |       |
| Available-for-sale  securities                                                                                                                |       | 135,212,002                  |        | 121,836,851                     |       |
| Held-to-maturity  securities                                                                                                                  |       | 1,108,022                    |        | 1,147,309                       |       |
| Federal Home Loan  Bank Stock                                                                                                                 |       | 3,387,800                    |        | 3,302,900                       |       |
| Loans and  leases, net (allowance for loan losses of $ 4,378,924 in 2008; $4,824,401 in  2007)                                           |       | 393,989,244                  |        | 421,424,379                     |       |
| Loans  available-for-sale (fair value $1,228,281 in 2008; $842,923 in 2007)                                                                   |       | 1,214,600                    |        | 827,250                         |       |
| Bank premises  and equipment, net                                                                                                             |       | 12,947,438                   |        | 12,964,932                      |       |
| Cash surrender  value of bank owned life insurance                                                                                            |       | 8,564,950                    |        | 8,488,663                       |       |
| Other assets                                                                                                                                  |       | 11,115,787                   |        | 4,403,723                       |       |
| Accrued interest  receivable                                                                                                                  |       | 2,790,700                    |        | 2,500,696                       |       |
| Foreclosed  assets held-for-sale                                                                                                              |       | 167,036                      |        | 107,036                         |       |
|                                                                                                                                          |       |                         |        |                            |       |
| Total assets                                                                                                                                  |       | $                            | 593,876,533 |                            | $          | 587,412,555 |   |
|                                                                                                                                          |       |                         |        |                            |       |
| Liabilities:                                                                                                                                  |       |                         |        |                            |       |
| Deposits:                                                                                                                                     |       |                         |        |                            |       |
| Interest-bearing                                                                                                                              |       | $                            | 386,356,675 |                            | $          | 360,912,740 |   |
| Non-interest-bearing                                                                                                                          |       | 69,486,801                   |        | 64,795,621                      |       |
|                                                                                                                                          |       |                         |        |                            |       |
| Total deposits                                                                                                                                |       | 455,843,476                  |        | 425,708,361                     |       |
|                                                                                                                                          |       |                         |        |                            |       |
| Accrued interest  payable and other liabilities                                                                                               |       | 9,465,660                    |        | 4,147,869                       |       |
| Short-term  borrowings                                                                                                                        |       | 9,879,537                    |        | 39,656,354                      |       |
| Long-term debt                                                                                                                                |       | 62,494,906                   |        | 62,708,677                      |       |
|                                                                                                                                          |       |                         |        |                            |       |
| Total  liabilities                                                                                                                            |       | 537,683,579                  |        | 532,221,261                     |       |
|                                                                                                                                          |       |                         |        |                            |       |
| Shareholders’  equity:                                                                                                                   |       |                         |        |                            |       |
| Preferred stock  authorized 5,000,000 shares with no par value; none issued                                                                   |       | —                       |        | —                          |       |
| Capital stock  authorized 10,000,000 shares with no par value; issued and outstanding,  2,075,182 shares in 2008 and 2,072,929 shares in 2007 |       | 19,349,045                   |        | 19,223,363                      |       |
| Retained  earnings                                                                                                                            |       | 37,134,309                   |        | 36,564,157                      |       |
| Accumulated  other comprehensive loss                                                                                                         |       | (290,400                     | )           | (596,226                        | )          |
|                                                                                                                                          |       |                         |        |                            |       |
| Total  shareholders’ equity                                                                                                              |       | 56,192,954                   |        | 55,191,294                      |       |
|                                                                                                                                          |       |                         |        |                            |       |
| Total liabilities  and shareholders’ equity                                                                                              |       | $                            | 593,876,533 |                            | $          | 587,412,555 |   |

 

See notes to consolidated financial statements

 

3

----

 

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

 

Consolidated Statements ofIncome

(unaudited)

 
| ** **                                             | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                             | ** ** | **March 31, 2008**     | ** ** | **March 31, 2007** | ** ** |
|                                                   |       |                             |       |   |   |
| Interest income:                                       |       |                             |       |   |   |
| Loans and  leases:                                     |       |                             |       |   |   |
| Taxable                                                |       | $                                | 6,809,134  |   | $ | 7,175,029 |   |
| Nontaxable                                             |       | 78,076                           |       | 109,517 |   |
| Interest-bearing  deposits with financial institutions |       | 1,106                            |       | 2,792 |   |
| Investment  securities:                                |       |                             |       |   |   |
| U.S. government  agency and corporations               |       | 1,253,181                        |       | 919,288 |   |
| States and  political subdivisions (nontaxable)        |       | 144,130                          |       | 124,839 |   |
| Other securities                                       |       | 375,036                          |       | 245,899 |   |
| Federal funds  sold                                    |       | 84,169                           |       | 54,452 |   |
|                                                   |       |                             |       |   |   |
| Total interest  income                                 |       | 8,744,832                        |       | 8,631,816 |   |
|                                                   |       |                             |       |   |   |
| Interest  expense:                                     |       |                             |       |   |   |
| Deposits                                               |       | 3,233,736                        |       | 3,334,023 |   |
| Securities sold  under repurchase agreements           |       | 67,153                           |       | 115,457 |   |
| Other short-term  borrowings and other                 |       | 64,822                           |       | 73,073 |   |
| Long-term debt                                         |       | 832,285                          |       | 805,073 |   |
|                                                   |       |                             |       |   |   |
| Total interest  expense                                |       | 4,197,996                        |       | 4,327,626 |   |
|                                                   |       |                             |       |   |   |
| Net interest  income                                   |       | 4,546,836                        |       | 4,304,190 |   |
|                                                   |       |                             |       |   |   |
| Provision for  loan losses                             |       | —                           |       | — |   |
|                                                   |       |                             |       |   |   |
| Net interest  income after provision for loan losses   |       | 4,546,836                        |       | 4,304,190 |   |
|                                                   |       |                             |       |   |   |
| Other income:                                          |       |                             |       |   |   |
| Service charges  on deposit accounts                   |       | 763,269                          |       | 632,317 |   |
| Gain (loss) on  sale of:                               |       |                             |       |   |   |
| Loans                                                  |       | 91,606                           |       | 36,725 |   |
| Investment  securities                                 |       | 1,134                            |       | — |   |
| Premises and  equipment                                |       | —                           |       | 96,557 |   |
| Foreclosed  assets held-for-sale                       |       | 8,704                            |       | 15,128 |   |
| Fees and other  service charges                        |       | 430,829                          |       | 432,936 |   |
|                                                   |       |                             |       |   |   |
| Total other  income                                    |       | 1,295,542                        |       | 1,213,663 |   |
|                                                   |       |                             |       |   |   |
| Other expenses:                                        |       |                             |       |   |   |
| Salaries and  employee benefits                        |       | 2,417,546                        |       | 2,134,977 |   |
| Premises and  equipment                                |       | 790,640                          |       | 805,825 |   |
| Advertising                                            |       | 168,356                          |       | 159,005 |   |
| Other                                                  |       | 1,016,207                        |       | 1,013,236 |   |
|                                                   |       |                             |       |   |   |
| Total other  expenses                                  |       | 4,392,749                        |       | 4,113,043 |   |
|                                                   |       |                             |       |   |   |
| Income before  provision for income taxes              |       | 1,449,629                        |       | 1,404,810 |   |
|                                                   |       |                             |       |   |   |
| Provision for  income taxes                            |       | 360,682                          |       | 360,459 |   |
|                                                   |       |                             |       |   |   |
| Net income                                             |       | $                                | 1,088,947  |   | $ | 1,044,351 |   |
|                                                   |       |                             |       |   |   |
| Per share data:                                        |       |                             |       |   |   |
| Net income -  basic                                    |       | $                                | 0.52       |   | $ | 0.51 |   |
| Net income -  diluted                                  |       | $                                | 0.52       |   | $ | 0.51 |   |
| Dividends                                              |       | $                                | 0.25       |   | $ | 0.22 |   |

 

See Notes toConsolidated Financial Statements

 

4

----

 

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

 

ConsolidatedStatements of Changes in Shareholders’ EquityFor the three months ended March 31, 2008 and 2007

 
| ** **                                                                                                                   | ** ** | ** **             | ** ** | ** **   | ** ** | ** **        | ** ** | **Accumulated**        | ** ** | ** ** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|--------------|------------|-------------------|------------|------------------------|------------|------------|------------|
| ** **                                                                                                                   | ** ** | ** **             | ** ** | ** **   | ** ** | ** **        | ** ** | **other**              | ** ** | ** ** | ** ** |
| ** **                                                                                                                   | ** ** | **Capital stock** | ** ** | **Retained** | ** ** | **comprehensive** | ** ** | ** **             | ** ** |
| ** **                                                                                                                   | ** ** | **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                                                                                                                   |       |                   |       |         |       | 1,044,351         |       |                   |       | 1,044,351  |       |
| Change in net  unrealized holding losseson available-for-sale securities, net ofreclassification adjustment and tax  effects |       |                   |       |         |       |              |       | 159,150                |       | 159,150    |       |
| Change in cash  flow hedge intrinsic value                                                                                   |       |                   |       |         |       |              |       | 59,256                 |       | 59,256     |       |
| Comprehensive  income                                                                                                        |       |                   |       |         |       |              |       |                   |       | 1,262,757  |       |
| Issuance of  common stock through Employee StockPurchase Plan                                                                |       | 2,266                  |       | 67,820       |       |              |       |                   |       | 67,820     |       |
| Dividends  reinvested through DividendReinvestment Plan                                                                      |       | 3,658                  |       | 137,175      |       |              |       |                   |       | 137,175    |       |
| Stock-based compensation  expense                                                                                            |       |                   |       | 6,958        |       |              |       |                   |       | 6,958      |       |
| Cash dividends  declared                                                                                                     |       |                   |       |         |       | (453,134          | )          |                   |       | (453,134   | )          |
|                                                                                                                         |       |                   |       |         |       |              |       |                   |       |       |       |
| Balance,  March 31, 2007 (unaudited)                                                                                    |       | 2,063,357              |       | $            | 18,914,490 |              | $          | 34,465,335             |       | $          | (746,386   | ) | $ | 52,633,439 |   |
|                                                                                                                         |       |                   |       |         |       |              |       |                   |       |       |       |
| Balance, December 31,  2007 (audited)                                                                                   |       | 2,072,929              |       | $            | 19,223,363 |              | $          | 36,564,157             |       | $          | (596,226   | ) | $ | 55,191,294 |   |
| Total  comprehensive income:                                                                                                 |       |                   |       |         |       |              |       |                   |       |       |       |
| Net income                                                                                                                   |       |                   |       |         |       | 1,088,947         |       |                   |       | 1,088,947  |       |
| Change in net  unrealized holding losseson available-for-sale securities, net ofreclassification adjustment and tax  effects |       |                   |       |         |       |              |       | (59,310                | )     | (59,310    | )          |
| Change in cash  flow hedge intrinsic value                                                                                   |       |                   |       |         |       |              |       | 365,136                |       | 365,136    |       |
| Comprehensive  income                                                                                                        |       |                   |       |         |       |              |       |                   |       | 1,394,773  |       |
| Issuance of  common stock through Employee StockPurchase Plan                                                                |       | 2,253                  |       | 57,891       |       |              |       |                   |       | 57,891     |       |
| Dividends  reinvested through DividendReinvestment Plan                                                                      |       |                   |       |         |       |              |       |                   |       | —     |       |
| Stock-based  compensation expense                                                                                            |       |                   |       | 67,791       |       |              |       |                   |       | 67,791     |       |
| Cash dividends  declared                                                                                                     |       |                   |       |         |       | (518,795          | )     |                   |       | (518,795   | )          |
|                                                                                                                         |       |                   |       |         |       |              |       |                   |       |       |       |
| Balance,  March 31, 2008 (unaudited)                                                                                    |       | 2,075,182              |       | $            | 19,349,045 |              | $          | 37,134,309             |       | $          | (290,400   | ) | $ | 56,192,954 |   |
|                                                                                                                              |            |                        |            |              |            |                   |            |                        |            |            |            |  |  |  |  |  |

 

SeeNotes to Consolidated Financial Statements

 

5

----

 

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

 

Consolidated Statementsof Cash Flows

(unaudited)

 
| ** **                                                                        | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                        | ** ** | **March 31, 2008**     | ** ** | **March 31, 2007** | ** ** |
|                                                                              |       |                             |       |   |   |
| Cash flows from  operating activities:                                            |       |                             |       |   |   |
| Net income                                                                        |       | $                                | 1,088,947  |   | $ | 1,044,351 |   |
| Adjustments to  reconcile net income to net cash provided byoperating activities: |       |                             |       |   |   |
| Depreciation,  amortization and accretion                                         |       | 143,933                          |       | 294,105 |   |
| Deferred income  tax expense (benefit)                                            |       | 159,737                          |       | (63,692 | ) |
| Stock-based  compensation expense                                                 |       | 67,791                           |       | 6,958 |   |
| Loss from  investment in limited partnership                                      |       | 20,100                           |       | 20,100 |   |
| Proceeds from  sale of loans available-for-sale                                   |       | 33,446,667                       |       | 3,998,013 |   |
| Originations of  loans available-for-sale                                         |       | (4,096,160                       | )          | (4,210,038 | ) |
| Increase in cash  surrender value of life insurance                               |       | (76,287                          | )          | (76,816 | ) |
| Net gain on sale  of loans                                                        |       | (91,606                          | )          | (36,725 | ) |
| Net gain on sale  of investment securities                                        |       | (1,134                           | )          | — |   |
| Net gain on sale  of foreclosed assets held-for-sale                              |       | (8,704                           | )          | (15,128 | ) |
| Net gain on  disposal of premises and equipment                                   |       | —                           |       | (96,557 | ) |
| Change in:                                                                        |       |                             |       |   |   |
| Accrued interest  receivable                                                      |       | (290,004                         | )          | (111,836 | ) |
| Other assets                                                                      |       | (950,950                         | )          | (301,492 | ) |
| Accrued interest  payable and other liabilities                                   |       | 56,470                           |       | (192,854 | ) |
|                                                                              |       |                             |       |   |   |
| Net cash  provided by operating activities                                        |       | 29,468,800                       |       | 258,389 |   |
|                                                                              |       |                             |       |   |   |
| Cash flows from  investing activities:                                            |       |                             |       |   |   |
| Held-to-maturity  securities:                                                     |       |                             |       |   |   |
| Proceeds from  maturities, calls and principal pay-downs                          |       | 39,133                           |       | 199,356 |   |
| Available-for-sale  securities:                                                   |       |                             |       |   |   |
| Proceeds from  sales                                                              |       | 12,881,733                       |       | — |   |
| Proceeds from  maturities, calls and principal pay-downs                          |       | 15,104,801                       |       | 4,187,592 |   |
| Purchases                                                                         |       | (41,209,106                      | )          | (4,943,639 | ) |
| Net (increase)  decrease in FHLB stock                                            |       | (84,900                          | )          | 196,500 |   |
| Net increase in  loans and leases                                                 |       | (2,324,907                       | )          | (270,967 | ) |
| Proceeds from  sale of premises and equipment                                     |       | —                           |       | 247,008 |   |
| Acquisition of  bank premises and equipment                                       |       | (651,129                         | )          | (643,661 | ) |
| Proceeds from  sale of foreclosed assets held-for-sale                            |       | 62,090                           |       | 172,814 |   |
|                                                                              |       |                             |       |   |   |
| Net cash used in  investing activities                                            |       | (16,182,285                      | )          | (854,997 | ) |
|                                                                              |       |                             |       |   |   |
| Cash flows from  financing activities:                                            |       |                             |       |   |   |
| Net increase in  deposits                                                         |       | 30,135,115                       |       | 3,732,401 |   |
| Net decrease in  short-term borrowings                                            |       | (29,776,817                      | )          | (2,048,184 | ) |
| Repayments of  long-term debt                                                     |       | (213,771                         | )          | (204,580 | ) |
| Proceeds from  employee stock purchase plan                                       |       | 57,891                           |       | 67,820 |   |
| Dividends paid,  net of dividends reinvested                                      |       | (518,795                         | )          | (315,959 | ) |
|                                                                              |       |                             |       |   |   |
| Net cash (used  in) provided by financing activities                              |       | (316,377                         | )          | 1,231,498 |   |
|                                                                              |       |                             |       |   |   |
| Net increase in  cash and cash equivalents                                        |       | 12,970,138                       |       | 634,890 |   |
|                                                                              |       |                             |       |   |   |
| Cash and cash  equivalents, beginning                                             |       | 10,408,816                       |       | 13,800,848 |   |
|                                                                              |       |                             |       |   |   |
| Cash and cash  equivalents, ending                                                |       | $                                | 23,378,954 |   | $ | 14,435,738 |   |

 

See notes to consolidatedfinancial statements

 

6

----

 

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

 

**Notes to Consolidated Financial Statements**

**(unaudited)**

 

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

 

# **Nature ofoperations**

 

The Fidelity Deposit and Discount Bank (the Bank) is a commercial bankchartered in the Commonwealth of Pennsylvania and a wholly-owned subsidiary ofFidelity D & D Bancorp, Inc. (the Company or collectively, theCompany).  Having commenced operations in1903, the Bank is committed to provide superior customer service, whileoffering a full range of banking products and financial and trust services, toboth our consumer and commercial customers from its main office located inDunmore and other branches throughout Lackawanna and Luzerne counties.

 

# **Principles ofconsolidation**

 

The accompanying unaudited consolidated financial statements of theCompany and the Bank have been prepared in accordance with accountingprinciples generally accepted in the United States of America (GAAP) forinterim financial information and with the instructions to this Form 10-Qand Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotedisclosures required by GAAP for complete financial statements.  In the opinion of management, all normalrecurring adjustments necessary for a fair presentation of the financialcondition and results of operations for the periods have been included.  All significant inter-company balances andtransactions 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 March 31, 2008 and December 31,2007 and the related consolidated statements of income for the three-monthperiods ended March 31, 2008 and 2007 and changes in shareholders’ equityand cash flows for the three month periods ended March 31, 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.

 

# **Criticalaccounting policies**

 

The presentation offinancial statements in conformity with GAAP requires management to makeestimates and assumptions that affect many of the reported amounts anddisclosures. Actual results could 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 March 31,2008 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 Company’s allowance for loan losses.  Such agencies may require the Company torecognize adjustments to the allowance based on their judgment of informationavailable to them at the time of their examination.

 

7

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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, the valuationservice uses estimates of cash flows, based on historical performance ofsimilar 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)securities are carried at fair value on the consolidated balance sheet withunrealized gains and losses, net of income tax, reported separately withinshareholders’ 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).  Generally, the market to which the Companysells mortgages it originates for sale is restricted and price quotes fromother sources are not typically obtained. On occasion, the Company may transfer loans from the loan and leaseportfolio to loans AFS.  Under these rarecircumstances, pricing may be obtained from other entities and the loans aretransferred at the lower of cost or market value and simultaneously 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:

 
| **Three months ended March 31,**          | ** ** | **2008**  | ** ** | **2007**  | ** ** |
|---------------------------------------------------------------|------------|-----------|------------|-----------|------------|
|                                                          |       |      |       |      |       |
| Basic EPS:                                                    |       |      |       |      |       |
| Net income  available to common shareholders                  |       | $         | 1,088,947  |      | $          | 1,044,351 |   |
| Weighted-average  common shares outstanding                   |       | 2,075,033 |       | 2,060,517 |       |
| Basic EPS                                                     |       | $         | 0.52       |      | $          | 0.51 |   |
|                                                          |       |      |       |      |       |
| Diluted EPS:                                                  |       |      |       |      |       |
| Net income  available to common shareholders                  |       | $         | 1,088,947  |      | $          | 1,044,351 |   |
| Weighted-average  common shares outstanding                   |       | 2,075,033 |       | 2,060,517 |       |
| Dilutive  potential common shares                             |       | —    |       | 1,042     |       |
| Weighted-average  common shares and dilutive potential shares |       | 2,075,033 |       | 2,061,559 |       |
| Diluted EPS                                                   |       | $         | 0.52       |      | $          | 0.51 |   |

 

**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, or (2) that require (or may require)settlement by the issuance of an entity’s shares or other equity instruments.

 

8

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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 thefirst three months of 2008.  No stockoptions were awarded during the first quarter of 2007.  As of March 31, 2008, there were 32,350unexercised 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 first quarter of 2008, 2,000 stockoptions were issued under this plan at a weighted-average grant-date fair valueof $4.85 per share as determined using the Black-Scholes Option PricingValuation Model.  The model considersexpected volatility, expected dividends, risk-free interest rate and theexpected term.  No stock options wereawarded during the first quarter of 2007. As of March 31, 2008, there were 12,830 unexercised stock optionsoutstanding under this plan.

 

The following tablesillustrates the stock-based compensation expense recognized during the threemonths ended March 31, 2008 and 2007 and the unrecognized stock-basedcompensation expense as of March 31, 2008 and December 31, 2007:

 
| ** **                              | ** ** | **Three months ended** | ** ** |
|-----------------------------------------|------------|----------------------------------|------------|
| ** **                              | ** ** | **March 31,**               | ** ** |
| ** **                              | ** ** | **2008**                         | ** ** | **2007** | ** ** |
| Stock-based  compensation expense:      |       |                             |       |   |   |
| Director’s Plan                    |       | $                                | 48,471     |   | $ | — |   |
| Incentive Plan                          |       | 16,380                           |       | — |   |
|                                    |       |                             |       |   |   |
| Total  stock-based compensation expense |       | $                                | 64,851     |   | $ | — |   |

 
| ** **                                      | ** ** | **As of:**               | ** ** |
|-------------------------------------------------|------------|--------------------------|------------|
| ** **                                      | ** ** | **March 31,  2008** | ** ** | **December 31,  2007** | ** ** |
| Unrecognized  stock-based compensation expense: |       |                     |       |   |   |
| Director’s Plan                            |       | $                        | 42,079     |   | $ | 90,550 |   |
| Incentive Plan                                  |       | 19,182                   |       | 25,872 |   |
|                                            |       |                     |       |   |   |
| Unrecognized  stock-based compensation expense  |       | $                        | 61,261     |   | $ | 116,422 |   |

 

The amountunrecognized as of March 31, 2008 will be recognized during the second andthird quarters of 2008.  Stock-basedcompensation is recorded in the consolidated income statement as a component ofsalaries and employee benefits.

 

In addition to thetwo stock option plans, the Company established the 2002 Employee StockPurchase Plan (the ESPP) and reserved 110,000 shares of its un-issued capitalstock for issuance under the plan.  Theplan was designed to promote broad-based employee ownership of the Company’sstock.  Under the ESPP, employees mayelect to purchase the Company’s capital stock at a discounted price based onthe fair market value of the Company’s capital stock on either the commencementdate or termination date.  At March 31,2008, 10,570 shares have been issued under the ESPP.  The Company recognizes compensation expenseon its ESPP on the date the shares are purchased.  For the three months ended March 31,2008 and 2007, compensation expense related to the ESPP approximated $3,000 and$7,000, respectively, and is included as a component of salaries and employeebenefits in the consolidated statements of income.

 

9

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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 the hedgeat the time of purchase.  The Company hasdesignated this agreement as a cash flow hedge pursuant to SFAS No. 133, *Accounting for Derivative Instruments and Hedging Activities.*  Accordingly, the change in the fair value ofthe instrument related to the hedge’s intrinsic value, or approximately$365,000 and $59,000 for the three months ended March 31, 2008 and 2007,respectively, is recorded as a component of other comprehensive income (OCI) inthe consolidated statement of changes in shareholders’ equity and the portionof the change in fair value related to the time value expiration, orapproximately $23,000 and $51,000 for the three months ended March 31,2008 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 March 31, 2008. As of March 31, 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 March 31,2008 and December 31, 2007, the fair value of the derivative contractapproximated $782,000 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 fair value.  This hierarchy prioritizes the inputs intothree broad levels as follows.  Level 1inputs are quoted prices (unadjusted) in active markets for identical assets orliabilities.  Level 2 inputs are quotedprices for similar assets and liabilities in active markets; quoted prices foridentical or similar assets or liabilities in markets that are not active; orinputs that are observable for the asset or liability, either directly orindirectly through market corroboration, for substantially the full term of thefinancial instrument.  Level 3 inputs areunobservable inputs based on our own assumptions to measure assets andliabilities at fair value.  Level 3pricing for securities may also include unobservable inputs based upon brokertraded transactions.  A financial assetor liability’s classification within the hierarchy is determined based on thelowest level input that is significant to the fair value measurement.  The adoption of this statement had no effecton 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 March 31, 2008 using:** | ** ** |
|--------------------------------|------------|------------------------------|------------|-----------------------------------------------------------------------------------------|------------|
| ** **                     | ** ** | **Total carrying**      | ** ** | **Quoted prices**                                                                  | ** ** | **Significant other** | ** ** | **Significant** | ** ** |
| ** **                     | ** ** | **value at**            | ** ** | **in active markets**                                                         | ** ** | **observable inputs** | ** ** | **unobservable inputs** | ** ** |
| **Assets:**                    | ** ** | **March 31, 2008** | ** ** | **(Level 1)**                                                                      | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| Available-for-sale  securities |       | $                            | 135,212    |                                                                                    | $          | 467 |   | $ | 115,202 |   | $ | 19,543 |   |
| Loans  available-for-sale      |       | 1,215                        |       | —                                                                                  |       | 1,215 |   | — |   |
| Derivative  instrument         |       | 782                          |       | —                                                                                  |       | 782 |   | — |   |
| Total                          |       | $                            | 137,209    |                                                                                    | $          | 467 |   | $ | 117,199 |   | $ | 19,543 |   |

 

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 in investment-gradepreferred trust securities, classified under corporate bonds, the exit-pricingof which is obtained from a third party includes both observable and unobservableinputs.  Due to the recent, temporarylimited 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, whoprovides pricing for similar assets with similar terms in actively tradedmarkets.  The derivative instrument,included in other assets, is measured at fair value from pricing provided by athird party who considers observable interest rates, forward yield curves atcommonly 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** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------|------------|
| **Assets:**                                                                  | ** ** | **securities**         | ** ** |
|                                                                         |       |                   |       |
| Balance  January 1, 2008                                                |       | $                      | 16,335     |   |
| Realized /  unrealized gains (losses):                                       |       |                   |       |
| in earnings                                                                  |       | —                 |       |
| in comprehensive  income                                                     |       | (1,341                 | )          |
| Purchases, sales,  issuances and settlements amortization and accretion, net |       | 4,549                  |       |
| Transfers into  (out of) Level 3                                             |       | —                 |       |
| Balance  March 31, 2008                                                 |       | $                      | 19,543     |   |

 

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 March 31, 2008 using:** | ** ** |
|----------------|------------|------------------------------|------------|-----------------------------------------------------------------------------------------|------------|
| ** **     | ** ** | **Total carrying**      | ** ** | **Quoted prices**                                                                  | ** ** | **Significant other** | ** ** | **Significant** | ** ** |
| ** **     | ** ** | **value at**            | ** ** | **in active markets**                                                         | ** ** | **observable inputs** | ** ** | **unobservable inputs** | ** ** |
| **Assets:**    | ** ** | **March 31, 2008** | ** ** | **(Level 1)**                                                                      | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| Impaired loans |       | $                            | 2,223      |                                                                                    | $          | 16 |   | $ | 1,018 |   | $ | 1,189 |   |
|                |            |                              |            |                                                                                         |            |  |  |  |  |  |  |  |  |

 

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 based on the bestinformation available under each circumstance, the asset valuation isclassified as Level 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 March 31,2008 and therefore the adoption of this statement had no effect on the Company’sfinancial statements.

 

InMarch 2008, the Financial Accounting Standard 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 March 31, 2008compared to December 31, 2007 and the results of operations for the threemonths ended March 31, 2008 and March 31, 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 factors managementbelieves are appropriate under the circumstances.  These statements are not guarantees of futureperformance and are subject to risks, uncertainties and other factors (many ofwhich are beyond our control) that could cause actual results to differ materiallyfrom future results expressed or implied by such forward-lookingstatements.  These factors include,without limitation, the following:

 

·                  thetiming and occurrence or non-occurrence of events may be subject tocircumstances beyond our control;

 

·                  theremay be increases in competitive pressure among financial institutions or fromnon-financial institutions;

 

·                  changesin the interest rate environment may reduce interest margins;

 

·                  changesin deposit flows, loan demand or real estate values may adversely affect ourbusiness;

 

·                  changesin accounting principles, policies or guidelines may cause our financialcondition to be perceived differently;

 

·                  generaleconomic conditions, either nationally or locally in some or all areas in whichwe do business, or conditions in the securities markets or the banking industrymay be less favorable than we currently anticipate;

 

·                  legislativeor regulatory changes may adversely affect our business;

 

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

 

·                  successor consummation of new business initiatives may be more difficult or expensivethan we anticipate;

 

·                  actsof war or terrorism; 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 itsinterest-earning assets and the rates paid on its interest-bearing liabilities)and the relative amounts of interest-earning assets and interest-bearingliabilities.  The interest rate spread issignificantly impacted by: changes in interest rates and market yield curvesand their related impact on cash flows; the composition and characteristics ofinterest-earning assets and interest-bearing liabilities; differences in thematurity and re-pricing characteristics of assets compared to the maturity andre-pricing characteristics of the liabilities that fund them and by thecompetition in our marketplace.

 

The Company’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 MONTHS ENDED MARCH 31, 2008 AND MARCH 31,2007**

 

**Overview**

 

Net income for the three months ended March 31,2008 was $1,089,000, a 4% increase compared to $1,044,000 recorded for thethree months ended March 31, 2007. Diluted earnings per share were $0.52 and $0.51 for each of therespective periods.  The increase in netincome was the result of increases in net interest income and non-interestincome, partially offset by increases in non-interest expense and the provisionfor income taxes.

 

Return on average assets (ROA) and return on averageshareholders’ equity (ROE) were 0.74% and 7.80%, respectively, for the threemonths ended March 31, 2008 compared to 0.75% and 8.12%, respectively, forthe same period in 2007.  The increase innet income had a positive influence on both ROA and ROE for the comparableperiods; however, the decline in ROE was caused by a higher balance of averageequity in the current period fueled by higher retained earnings.  The decrease in ROA was caused by a higherbalance of average assets at the end of the 2008 quarter compared to the end ofthe 2007 quarter.

 

*Net interest income and interestsensitive assets / liabilities*

 

Net interest income increased $243,000 to $4,547,000 for the firstquarter of 2008, from $4,304,000 recorded in the same period of 2007.  The increase in net interest income wasprincipally due to a combination of: $24,000,000 in growth of average earningassets mostly in the investment portfolio which increased by approximately$30,000,000 in the first quarter 2008 compared to the first quarter of 2007;and lower rates paid on interest-bearing deposits during the same period.  Growth in the investment portfolio was theresult of deposit growth and the sale of relatively low yielding, long-termmortgage loans, the proceeds of which were used to purchase better yieldinginvestments.  As a result, interestincome from the investment and loan portfolios and federal funds sold combined fora net increase of approximately $113,000 in the first quarter of 2008 comparedto the first quarter of 2007. Contributing to the improvement in net interest income was lowerinterest expense which decreased $130,000, or 3%, in the current year quartercompared to last year’s first quarter.  Though interest-bearing deposits increased by$26,000,000, on average, rates on deposits have been reducing in concert withthe current interest rate environment. Average rates paid on deposits have declined 40 

 

13

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basis points for the three months ended March 31, 2008 compared tothe three months ended March 31 2007. This reduction in rate had a greater influence on interest expense thanthe increase in average balances, both of which combined for a net reduction ininterest expense from deposits of $100,000.

 

During the firstquarter of 2008, the Bank’s tax-equivalent margin and spread were 3.37% and2.76%, respectively, compared to 3.36% and 2.66% during the first quarter of2007.  The improvement in both spread andmargin were from combined increased interest income and decreased interestexpense and the resulting higher level of net interest income.

 

The inverted treasury yield curve that was prevalent in 2006 and 2007has turned positive and continues to steepen. The Federal Open Market Committee (FOMC) has reduced fed funds interestrate by 300 basis points since the end of the first quarter of 2007 and 200basis points since year-end 2007.  Inturn, the national prime rate, the benchmark rate banks use to set rates onvarious lending and other interest sensitive financial instruments, has beenreduced by similar amounts during the same periods.  Generally, this situation causes floatingrate assets to re-price at lower yields, and also causes fixed rate assets tooriginate at yields lower than the yields earned in the prior comparableperiod, thereby reducing interest income. To help mitigate this effect, the Company sold $28,100,000 of lowyielding mortgage loans and used the proceeds to pay down borrowings andpurchase investment securities.

 

The Company’s Asset Liability Management team meets regularly todiscuss interest rate risk and if necessary adjust interest rates on payingdeposits in response to rate movements that emanate from the FOMC so that netinterest income is not disproportionately impacted during this down-rateenvironment.  This proactive attention tointerest rate risk in conjunction with our interest rate hedging strategy, asdescribed in Note No. 4, “Derivative instruments,” within the notes to theconsolidated financial statements in Part I, Item 1, has helped containthe Company’s net interest income at an acceptable level.

 

 

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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):

 
| ** **                                     | ** ** | **Three months ended** | ** ** | **Year ended**   | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **March 31,**               | ** ** | **December 31,** | ** ** |
| ** **                                     | ** ** | **2008**                         | ** ** | **2007**              | ** ** | **2007** | ** ** |
| Average  interest-earning assets:              |       |                             |       |                  |       |   |   |
| Loans and leases                               |       | $                                | 411,093    |                  | $          | 425,380 |   | $ | 424,781 |   |
| Investments                                    |       | 134,492                          |       | 104,521               |       | 116,217 |   |
| Federal funds  sold                            |       | 12,175                           |       | 4,178                 |       | 1,948 |   |
| Interest-bearing  deposits                     |       | 152                              |       | 211                   |       | 184 |   |
| Total                                          |       | $                                | 557,912    |                  | $          | 534,290 |   | $ | 543,130 |   |
|                                           |       |                             |       |                  |       |   |   |
| Average  interest-bearing liabilities:         |       |                             |       |                  |       |   |   |
| Other  interest-bearing deposits               |       | $                                | 191,295    |                  | $          | 200,164 |   | $ | 194,452 |   |
| Certificates of  deposit                       |       | 189,601                          |       | 154,738               |       | 161,418 |   |
| Borrowed funds                                 |       | 68,697                           |       | 67,400                |       | 71,573 |   |
| Repurchase  agreements                         |       | 15,372                           |       | 17,873                |       | 19,580 |   |
| Total                                          |       | $                                | 464,965    |                  | $          | 440,175 |   | $ | 447,023 |   |
|                                           |       |                             |       |                  |       |   |   |
| Interest income  (FTE):                        |       |                             |       |                  |       |   |   |
| Loans and leases                               |       | $                                | 6,928      |                  | $          | 7,341 |   | $ | 29,477 |   |
| Investments                                    |       | 1,856                            |       | 1,362                 |       | 6,219 |   |
| Federal funds  sold                            |       | 84                               |       | 54                    |       | 103 |   |
| Interest-bearing  deposits                     |       | 1                                |       | 3                     |       | 9 |   |
| Total                                          |       | $                                | 8,869      |                  | $          | 8,760 |   | $ | 35,808 |   |
|                                           |       |                             |       |                  |       |   |   |
| Interest  expense:                             |       |                             |       |                  |       |   |   |
| Other  interest-bearing deposits               |       | $                                | 1,094      |                  | $          | 1,630 |   | $ | 6,029 |   |
| Certificates of  deposit                       |       | 2,140                            |       | 1,705                 |       | 7,341 |   |
| Borrowed funds                                 |       | 897                              |       | 878                   |       | 3,825 |   |
| Repurchase  agreements                         |       | 67                               |       | 115                   |       | 465 |   |
| Total                                          |       | $                                | 4,198      |                  | $          | 4,328 |   | $ | 17,660 |   |
|                                           |       |                             |       |                  |       |   |   |
| Net interest  income (FTE)                     |       | $                                | 4,671      |                  | $          | 4,432 |   | $ | 18,148 |   |
|                                           |       |                             |       |                  |       |   |   |
| Yield on average  interest-earning assets      |       |                             |       |                  |       |   |   |
| Loans and leases                               |       | 6.78                             | %          | 7.00                  | %          | 6.94 | % |
| Investments                                    |       | 5.55                             | %          | 5.28                  | %          | 5.35 | % |
| Federal funds  sold                            |       | 2.78                             | %          | 5.29                  | %          | 5.28 | % |
| Interest-bearing  deposits                     |       | 2.93                             | %          | 5.36                  | %          | 4.81 | % |
| Total                                          |       | 6.39                             | %          | 6.65                  | %          | 6.59 | % |
|                                           |       |                             |       |                  |       |   |   |
| Rates on average  interest-bearing liabilities |       |                             |       |                  |       |   |   |
| Other  interest-bearing deposits               |       | 2.30                             | %          | 3.30                  | %          | 3.10 | % |
| Certificates of  deposit                       |       | 4.54                             | %          | 4.47                  | %          | 4.55 | % |
| Borrowed funds                                 |       | 5.25                             | %          | 5.28                  | %          | 5.34 | % |
| Repurchase  agreements                         |       | 1.76                             | %          | 2.62                  | %          | 2.38 | % |
| Total                                          |       | 3.63                             | %          | 3.99                  | %          | 3.95 | % |
|                                           |       |                             |       |                  |       |   |   |
| Net interest  spread                           |       | 2.76                             | %          | 2.66                  | %          | 2.64 | % |
| Net interest  margin                           |       | 3.37                             | %          | 3.36                  | %          | 3.34 | % |

 

Inthe table above, interest income was adjusted to a tax-equivalent basis torecognize the income from the various tax-exempt assets as if the interest wasfully taxable.  This treatment allows auniform comparison among the yields on interest-earning assets.  The calculations were computed on a fullytax-equivalent basis using the corporate federal tax rate of 34%.  Net interest spread represents the differencebetween the yield on interest-earning assets and the rate on interest-bearingliabilities.  Net interest marginrepresents the ratio of net interest income to total average interest-earningassets.

 

*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 

 

15

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the Company’s loanportfolio.  Loans and leases determinedto be uncollectible are charged-off against the allowance for loan losses.  The required amount of the provision for loanlosses, based upon the adequate level of the allowance for loan losses, issubject 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 and collectionpersonnel.  The committee reportsquarterly to the Credit Administration Committee of the Board of Directors.

 

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

 

·                  specific loans that could have loss potential;

·                  levels of and trends in delinquencies and non-accrual loans;

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

·                  trends in volume and terms of loans;

·                  changes in risk selection and underwriting standards;

·                  changes in lending policies, procedures and practices;

·                  experience, ability and depth of lending management;

·                  national and local economic trends and conditions; and

·                  changes in credit concentrations.

 

No provisions forloan losses were necessary during the first quarter of 2008.  After taking into account charge-offs andrecoveries, the allowance for loan losses was $4,379,000 at March 31, 2008as compared to $5,360,000 as of March 31, 2007.  Although the non-accrual loans have increasedcompared to balances at December 31, 2007 and March 31, 2007, otheradversely criticized and classified loans have declined during the sameperiods.  These reductions coupled withlower reserve allocations required for impaired loans and a reduced loanportfolio, due to the aforementioned sale of residential mortgage loans, hasresulted in a lower calculated allowance for loan losses as of March 31,2008.  The lower level of the allowancehas been deemed adequate to absorb the known and inherent losses in the loanportfolio at March 31, 2008 and therefore neither a provision nor a creditfor loan losses was necessary.  For afurther discussion on the allowance for loan losses and non-accrual loans, see “Comparisonof Financial Condition at March 31, 2008 and December 31, 2007,”below.

 

*Otherincome*

 

Total other(non-interest) income improved $82,000, or 7%, to $1,296,000 for the threemonths ended March 31, 2008 from $1,214,000 for the three months ended March 31,2007.  The Company experienced $131,000of growth in deposit service fees. Increased sales of residential mortgages into the secondary market haveresulted in $55,000 more net gains in the current quarter compared to the prioryear quarter.  During the quarter ended March 31,2007, the Company recorded a $97,000 gain from the sale of a commercialproperty that did not recur in the 2008 quarter.

 

*Other operating expenses*

 

For the firstquarter ended March 31, 2008, other (non-interest) expenses increased$280,000, or 7%, compared to the same 2007 quarter.  Salaries and related employee benefitsincreased $283,000, or 13%, due to payroll and incentive increases, an increasein the number of full-time equivalent employees, higher stock-based compensationexpense and increased health insurance costs.

 

**COMPARISON OF FINANCIAL CONDITION AT**

**MARCH 31, 2008 AND DECEMBER 31, 2007**

 

*Overview*

 

Consolidatedassets increased $6,464,000 during the three months ended March 31,2008.  The increase was caused by the recordingof an investment security purchase commitment of $5,300,000, carried in otherassets, scheduled to settle early in the second quarter of 2008 and an increasein shareholders’ equity of $1,002,000, predominantly from the first quarter’snet income.  The offset to the purchasecommitment was a recording of a liability to purchase.  Upon settlement, both assets and liabilitieswill be reduced by $5,300,000.

 

*Investment securities*

 

At the time ofpurchase, management classifies investment securities into one of threecategories: trading, AFS or held-to- maturity (HTM).  To date, management has not purchased anysecurities for trading purposes.  Most ofthe securities 

 

16

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purchased areclassified as AFS even though there is no immediate intent to sell them.  The AFS designation affords management theflexibility to sell securities and position the balance sheet in response tocapital levels, liquidity needs or changes in market conditions.  Securities AFS are carried at net fair valuein the consolidated balance sheet with an adjustment to shareholders’ equity,net of tax, presented under the caption “Accumulated other comprehensive income(loss).”  Securities designated as HTMare carried at amortized cost and represent debt securities that the Companyhas the ability and intent to hold until maturity.

 

At March 31,2008, the carrying value of investment securities totaled $136,320,000, or 23%of total assets compared to $122,984,000 or 21% of total assets at December 31,2007.  At March 31, 2008,approximately 40% of the carrying value of the investment portfolio wascomprised of mortgage-backed securities that amortize and provide monthly cashflow.  Agency, corporate and municipalbonds comprised 32%, 15% and 12%, respectively, of the investment portfolio at March 31,2008.

 

Total investmentsincreased $13,336,000, net of a $91,000 decline in the market value of AFSinvestments.  The increase in theinvestment portfolio in the first quarter of 2008 was from liquidity createdfrom the sale of mortgage loans.  Theamortized cost and fair market value of investment securities is comprised ofHTM and AFS securities with carrying values of $1,108,000 and $135,212,000,respectively.  At March 31, 2008,the AFS debt securities were recorded with a net unrealized loss in the amountof $1,716,000 and equity securities were recorded with an unrealized gain of$138,000.  A comparison of investmentsecurities at March 31, 2008 and December 31, 2007 is as follows(dollars in thousands):

 
| ** **                               | ** ** | **March 31, 2008** | ** ** | **December 31, 2007** | ** ** |
|------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **                               | ** ** | **Amount**                   | ** ** | **%**                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| U.S. government  agencies                |       | $                            | 55,177     |                            | 40.5       |   | $ | 35,244 |   | 28.6 |   |
| Mortgage-backed  securities              |       | 45,707                       |       | 33.5                            |       | 58,767 |   | 47.8 |   |
| State &  municipal subdivisions |       | 15,426                       |       | 11.3                            |       | 12,133 |   | 9.9 |   |
| Preferred term  securities               |       | 19,543                       |       | 14.4                            |       | 16,335 |   | 13.3 |   |
| Equity  securities                       |       | 467                          |       | 0.3                             |       | 505 |   | 0.4 |   |
| Total  investments                       |       | $                            | 136,320    |                            | 100.0      |   | $ | 122,984 |   | 100.0 |   |

 

17

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The amortized cost and fair value of investments at March 31, 2008 areas follows (dollars in thousands):

 
| ** **                                        | ** ** | **Amortized** | ** ** | **Gross unrealized** | ** ** | **Gross unrealized** | ** ** | **Fair**  | ** ** |
|---------------------------------------------------|------------|---------------|------------|---------------------------|------------|---------------------------|------------|-----------|------------|
| ** **                                        | ** ** | **cost**      | ** ** | **gains**                 | ** ** | **losses**                | ** ** | **value** | ** ** |
|                                              |       |          |       |                      |       |                      |       |      |       |
| Held-to-maturity  securities:                     |       |          |       |                      |       |                      |       |      |       |
| Mortgage-backed  securities                       |       | $             | 1,108      |                      | $          | 43                        |       | $         | —     |   | $ | 1,151 |   |
|                                              |       |          |       |                      |       |                      |       |      |       |
| Available-for-sale  securities:                   |       |          |       |                      |       |                      |       |      |       |
| U.S. government  agencies and corporations        |       | $             | 54,925     |                      | $          | 356                       |       | $         | 104        |   | $ | 55,177 |   |
| Obligations of  states and political subdivisions |       | 15,444        |       | 91                        |       | 109                       |       | 15,426    |       |
| Corporate bonds                                   |       | 22,081        |       | —                    |       | 2,538                     |       | 19,543    |       |
| Mortgage-backed  securities                       |       | 44,011        |       | 594                       |       | 6                         |       | 44,599    |       |
|                                              |       |          |       |                      |       |                      |       |      |       |
| Total debt  securities                            |       | 136,461       |       | 1,041                     |       | 2,757                     |       | 134,745   |       |
|                                              |       |          |       |                      |       |                      |       |      |       |
| Equity  securities                                |       | 329           |       | 147                       |       | 9                         |       | 467       |       |
|                                              |       |          |       |                      |       |                      |       |      |       |
| Total  available-for-sale                         |       | $             | 136,790    |                      | $          | 1,188                     |       | $         | 2,766      |   | $ | 135,212 |   |

 

The amortized costand fair value of debt securities at March 31, 2008 by contractualmaturity are as follows (dollars in thousands):

 
| ** **                                | ** ** | **Amortized** | ** ** | **Market** | ** ** |
|-------------------------------------------|------------|---------------|------------|------------|------------|
| ** **                                | ** ** | **cost**      | ** ** | **value**  | ** ** |
| Held-to-maturity  securities:             |       |          |       |       |       |
| Mortgage-backed  securities               |       | $             | 1,108      |       | $          | 1,151 |   |
|                                      |       |          |       |       |       |
| Available-for-sale  securities:           |       |          |       |       |       |
| Debt securities:                          |       |          |       |       |       |
| Due in one year  or less                  |       | $             | 5,130      |       | $          | 5,129 |   |
| Due after one  year through five years    |       | 6,006         |       | 6,046      |       |
| Due after five  years through ten years   |       | 12,205        |       | 12,398     |       |
| Due after ten  years                      |       | 69,109        |       | 66,573     |       |
| Total debt  securities                    |       | 92,450        |       | 90,146     |       |
|                                      |       |          |       |       |       |
| Mortgage-backed  securities               |       | 44,011        |       | 44,599     |       |
|                                      |       |          |       |       |       |
| Total  available-for-sale debt securities |       | $             | 136,461    |       | $          | 134,745 |   |

 

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

 

Management evaluatessecurities for other-than-temporary impairment on a quarterly basis or morefrequently when economic conditions or market conditions warrant suchevaluation.  Consideration is given to (1) thelength of time and the extent to which the fair value has been less than cost, (2) thefinancial condition and near-term prospects of the issuer, and (3) theintent and ability of the Company to retain its investment in the issue for aperiod of time sufficient to allow for any anticipated recovery in fair value.

 

At March 31, 2008,the AFS debt securities portfolio was carried at a net unrealized loss of$1,716,000 compared to a net unrealized loss of $1,663,000 at December 31,2007.  Management believes the cause ofthe unrealized losses is directly related to changes in interest rates and notcredit quality, which is consistent with its experience.  In addition, the Company 

 

18

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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 three months ended March 31, 2008 nor havethere been any write-downs recorded for the year-ended December 31, 2007.

 

*Loans available-for-sale (AFS)*

 

Generally, uponorigination, certain residential mortgages are classified as AFS.  In the event of market rate increases,fixed-rate loans and loans not immediately scheduled to re-price would nolonger produce yields consistent with the current market.  In a declining interest rate environment, 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 March 31,2008 amounted to $1,215,000 with a corresponding fair value of $1,228,000,compared to $827,000 and $843,000, respectively, at December 31,2007.  During the first quarter of 2008,residential mortgages with principal balances of $33,355,000 were sold into thesecondary market with net gains of approximately $92,000 recognized.  Included in the sale were $28,100,000 ofresidential loans transferred from the loan and lease portfolio.

 

*Loans and leases*

 

The Companyoriginates commercial and industrial (commercial) and commercial real estate(CRE) loans, residential, consumer, home equity and construction loans.  The relative volume of originations isdependent upon customer demand, current interest rates and the perception andduration of future interest levels.  Thebroad spectrum of products provides diversification that helps manage to anextent, interest rate and credit concentration risk.  Credit risk is further managed throughunderwriting policies and procedures and loan monitoring practices.  Interest rate risk is managed using variousasset/liability modeling techniques and analyses.  The interest rates on most commercial loansare adjustable with reset intervals of five years or less.

 

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

 

The composition ofthe loan portfolio at March 31, 2008 and December 31, 2007, issummarized as follows (dollars in thousands):

 
| ** **                 | ** ** | **March 31, 2008** | ** ** | **December 31, 2007** | ** ** |
|----------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **                 | ** ** | **Amount**                   | ** ** | **%**                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| Commercial and  CRE        |       | $                            | 216,588    |                            | 54.4       |   | $ | 216,058 |   | 50.7 |   |
| Residential real  estate   |       | 90,022                       |       | 22.6                            |       | 116,978 |   | 27.5 |   |
| Consumer                   |       | 81,391                       |       | 20.4                            |       | 81,998 |   | 19.2 |   |
| Real estate  construction  |       | 9,872                        |       | 2.5                             |       | 10,703 |   | 2.5 |   |
| Direct financing  leases   |       | 495                          |       | 0.1                             |       | 511 |   | 0.1 |   |
| Gross loans                |       | 398,368                      |       | 100.0                           |       | 426,248 |   | 100.0 |   |
| Allowance for  loan losses |       | (4,379                       | )          |                            |       | (4,824 | )  |   |   |
| Net loans                  |       | $                            | 393,989    |                            |       |   | $ | 421,424 |   |   |   |

 

Gross loans declined from$426,248,000, as of December 31, 2007 to $398,368,000 at March 31,2008.  The decline stems from thetransfer to the AFS portfolio and simultaneous sale of $28,100,000 ofresidential mortgage loans.

 

19

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*Allowance for loan losses*

 

Managementcontinually evaluates the credit quality of the Bank’s loan portfolio andperforms a formal review of the adequacy of the allowance for loan losses (theallowance), on a quarterly basis.  Theallowance reflects management’s best estimate of the amount of credit losses inthe loan portfolio.  Management’sjudgment is based on the evaluation of individual loans, past experience, theassessment of current economic conditions and other relevant factors includingthe amounts and timing of cash flows expected to be received on impaired loans.  Those estimates may be susceptible tosignificant change.  The provision forloan losses represents the amount necessary to maintain an appropriateallowance.  Loan losses are chargeddirectly against the allowance when loans are deemed to be uncollectible.  Recoveries from previously charged-off loansare added to the allowance when received.

 

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

 

·                  identification of specific impaired loans by loan category;

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

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

·                  application of historical loss percentages (five-year average) to poolsto determine the allowance allocation; and

·                  application of qualitative factor adjustment percentages to historicallosses for trends or changes in the loan portfolio.

 

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

 

Each quarter, managementperforms an assessment of the allowance and the provision for loan losses.  The Company’s Special Assets Committee meetsquarterly and the applicable lenders discuss each relationship under review andreach a consensus on the appropriate estimated loss amount based on SFAS 114, *Accounting by Creditors for Impairment of a Loan*.  The Special Assets Committee’s focus is onensuring the pertinent facts are considered and the SFAS 114 reserve amountsare reasonable.  The assessment processincludes the review of all loans on a non-accruing basis as well as a review ofcertain loans to which the lenders or the Company’s Credit Administrationfunction have assigned a criticized or classified risk rating.

 

Total charge-offs, net ofrecoveries, for the quarter ended March 31, 2008, were $445,000, comparedto $85,000 for the same period in 2007. Consumer loan net charge-offs were $94,000 for the three months ended atMarch 31, 2008, down slightly from the $102,000 recorded for the likeperiod in 2007.  Commercial loan netcharge-offs were $320,000 for the three months ended March 31, 2008,compared to $6,000 of recoveries recorded in the three months ending March 31,2007.  The commercial loan charge-offs inthe current quarter resulted from the final resolution of an impaired loan forwhich a specific reserve had been previously allocated.  Mortgage loans incurred net charge-offs of$32,000 in the first three months of 2008 compared to net recoveries of $12,000for the three months ended March 31, 2007.

 

Managementbelieves that the current balance in the allowance for loan losses of$4,379,000 is sufficient to withstand the identified potential credit qualityissues that may arise and others unidentified but are inherent to theportfolio.  Currently, management isunaware of any potential problem loans that have not been reviewed.  Potential problem loans are those where thereis known information that leads management to believe repayment of principaland/or interest is in jeopardy and the loans are currently neither onnon-accrual status 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 1.10% at March 31,2008 compared to 1.13% at December 31, 2007.

 

20

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

 
| ** **                                                                | ** ** | **As of and for the** | ** **  | **As of and for the** | ** ** | **As of and for the** | ** ** |
|---------------------------------------------------------------------------|------------|-------------------------------------------|-------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                | ** ** | **three months ended**          | ** **  | **twelve months ended**         | ** ** | **three months ended**          | ** ** |
| ** **                                                                | ** ** | **March 31, 2008**              | ** **  | **December 31, 2007**           | ** ** | **March 31, 2007**              | ** ** |
|                                                                      |       |                                      |        |                                      |       |                                      |       |
| Balance at  beginning of period                                           |       | $                                         | 4,824,401   |                                      | $          | 5,444,303                                 |       | $ | 5,444,303 |   |
|                                                                      |       |                                      |        |                                      |       |                                      |       |
| (Credit)  provision for loan losses                                       |       | —                                    |        | (60,000                                   | )          | —                                    |       |
|                                                                      |       |                                      |        |                                      |       |                                      |       |
| Charge-offs:                                                              |       |                                      |        |                                      |       |                                      |       |
| Commercial                                                                |       | 378,107                                   |        | 375,356                                   |       | —                                    |       |
| Residential real  estate                                                  |       | 31,871                                    |        | 90,193                                    |       | 1,585                                     |       |
| Consumer                                                                  |       | 109,127                                   |        | 256,215                                   |       | 109,657                                   |       |
| Total                                                                     |       | 519,105                                   |        | 721,764                                   |       | 111,242                                   |       |
|                                                                      |       |                                      |        |                                      |       |                                      |       |
| Recoveries:                                                               |       |                                      |        |                                      |       |                                      |       |
| Commercial                                                                |       | 58,463                                    |        | 18,076                                    |       | 5,723                                     |       |
| Residential real  estate                                                  |       | 30                                        |        | 125,002                                   |       | 13,563                                    |       |
| Consumer                                                                  |       | 15,135                                    |        | 18,784                                    |       | 7,411                                     |       |
| Total                                                                     |       | 73,628                                    |        | 161,862                                   |       | 26,697                                    |       |
|                                                                      |       |                                      |        |                                      |       |                                      |       |
| Net charge-offs                                                           |       | 445,477                                   |        | 559,902                                   |       | 84,545                                    |       |
|                                                                      |       |                                      |        |                                      |       |                                      |       |
| Balance at end  of period                                                 |       | $                                         | 4,378,924   |                                      | $          | 4,824,401                                 |       | $ | 5,359,758 |   |
|                                                                      |       |                                      |        |                                      |       |                                      |       |
| Total loans, end  of period                                               |       | $                                         | 399,582,768 |                                      | $          | 427,076,030                               |       | $ | 422,955,523 |   |
|                                                                      |       |                                      |        |                                      |       |                                      |       |
| Net charge-offs  to:                                                      |       |                                      |        |                                      |       |                                      |       |
| Loans, end of  period                                                     |       | 0.11                                      | %           | 0.13                                      | %          | 0.02                                      | %          |
| Allowance for  loan losses                                                |       | 10.17                                     | %           | 11.61                                     | %          | 1.58                                      | %          |
| Provision for  loan losses                                                |       | —                                    | x           | —                                    | x          | —                                    | x          |
|                                                                      |       |                                      |        |                                      |       |                                      |       |
| Allowance for  loan losses to:                                            |       |                                      |        |                                      |       |                                      |       |
| Total loans                                                               |       | 1.10                                      | %           | 1.13                                      | %          | 1.27                                      | %          |
| Non-accrual  loans                                                        |       | 0.97                                      | x           | 1.27                                      |  x    | 1.69                                      | x          |
| Non-performing  loans                                                     |       | 0.91                                      | x           | 1.26                                      | x          | 1.52                                      | x          |
| Net charge-offs                                                           |       | 9.83                                      | x           | 8.62                                      | x          | 63.40                                     | x          |
|                                                                      |       |                                      |        |                                      |       |                                      |       |
| Loans 30-89 days  past due and still accruing                             |       | $                                         | 3,582,873   |                                      | $          | 4,697,953                                 |       | $ | 4,482,637 |   |
| Loans 90 days  past due and accruing                                      |       | $                                         | 336,627     |                                      | $          | 25,470                                    |       | $ | 347,200 |   |
| Non-accrual  loans                                                        |       | $                                         | 4,498,424   |                                      | $          | 3,811,205                                 |       | $ | 3,172,782 |   |
| Allowance for  loan losses to loans 90 days or more past due and accruing |       | 13.01                                     | x           | 189.41                                    | x          | 15.44                                     | x          |

 

*Non-performingassets*

 

The Bank definesnon-performing assets as accruing loans past due 90 days or more, non-accrualloans, restructured loans, other real estate owned (ORE) and repossessedassets.  As of March 31, 2008,non-performing assets represented 0.84% of total assets compared to 0.67% at December 31,2007.

 

In the review of loansfor both delinquency and collateral sufficiency, management concluded thatthere were loans that lacked the ability to repay in accordance withcontractual terms.  The decision to placeloans or leases on a non-accrual status is made on an individual basis afterconsidering factors pertaining to each specific loan.

 

21

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The majority ofnon-performing assets for the period is attributed to non-accruing commercialbusiness loans and non-accruing real estate loans in the process offoreclosure.  Most of these loans arecollateralized, thereby mitigating the Bank’s potential for loss.  At March 31, 2008, non-performing loanswere $4,835,000 compared to $3,837,000 at year-end 2007.  There were no repossessed assets orrestructured loans at March 31, 2008 or December 31, 2007.  Specific action plans are developed for eachof the Company’s non-performing assets.

 

Non-accrual loansaggregated $4,498,000 at March 31, 2008, compared to $3,811,000 at December 13,2007.  During the first quarter of 2008approximately $3,069,000 of loans were placed in non-accrual status.  These were partially offset by payoffs orreductions of $1,879,000, charge-offs of $436,000, $60,000 in transfers to OREand $7,000 of loans that returned to performing status.  Loans past due 90 days or more and accruingtotaled $337,000 at March 31, 2008. The non-accrual loans were $4,498,000 and ORE totaled $167,000.  These three items comprise the non-performingassets of $5,002,000 at the March 31, 2008 quarter end.  Non-performing loans to net loans were 1.22%at March 31, 2008, and 0.91% at December 31, 2007.

 

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

 
| ** **                                                      | ** ** | **March 31, 2008** | ** **  | **December 31, 2007** | ** ** | **March 31, 2007** | ** ** |
|-----------------------------------------------------------------|------------|------------------------------|-------------|---------------------------------|------------|------------------------------|------------|
|                                                            |       |                         |        |                            |       |                         |       |
| Loans past due  90 days or more and accruing                    |       | $                            | 336,627     |                            | $          | 25,470                       |       | $ | 347,200 |   |
| Non-accrual  loans                                              |       | 4,498,424                    |        | 3,811,205                       |       | 3,172,782                    |       |
| Total  non-performing loans                                     |       | 4,835,051                    |        | 3,836,675                       |       | 3,519,982                    |       |
|                                                            |       |                         |        |                            |       |                         |       |
| Other real  estate owned                                        |       | 167,036                      |        | 107,036                         |       | 284,058                      |       |
| Total  non-performing assets                                    |       | $                            | 5,002,087   |                            | $          | 3,943,711                    |       | $ | 3,804,040 |   |
|                                                            |       |                         |        |                            |       |                         |       |
| Net loans  including AFS                                        |       | $                            | 395,203,844 |                            | $          | 422,251,629                  |       | $ | 417,595,765 |   |
| Total assets                                                    |       | $                            | 593,876,533 |                            | $          | 587,412,555                  |       | $ | 564,625,942 |   |
| Non-accrual  loans to net loans                                 |       | 1.14                         | %           | 0.90                            | %          | 0.76                         | %          |
| Non-performing  assets to net loans, ORE and repossessed assets |       | 1.27                         | %           | 0.93                            | %          | 0.91                         | %          |
| Non-performing  assets to total assets                          |       | 0.84                         | %           | 0.67                            | %          | 0.67                         | %          |
| Non-performing  loans to net loans                              |       | 1.22                         | %           | 0.91                            | %          | 0.84                         | %          |

 

*Foreclosed**assets held-for-sale*

 

At March 31, 2008,foreclosed assets held-for-sale consisted of two ORE properties amounting to$167,000 at March 31, 2008.  Oneproperty is under an agreement to sell and the other is listed for sale with alocal realtor.

 

*Other assets*

 

The increase inother assets of $6,712,000 from December 31, 2007 to March 31, 2008was principally due to the recording of the commitment to purchase a $5,300,000investment security that will settle early in the second quarter.  Also contributing to the increase was addedcapitalized construction costs related to activities associated with theCompany’s branch expansion project plus the increase in the fair value of theCompany’s derivative contract.

 

*Deposits*

 

The Bank is acommunity-based commercial financial institution that offers a variety ofdeposit accounts with a range of interest rates and terms.  Deposit products include savings accounts,interest-bearing checking (NOW), money market, non-interest bearing deposits(DDAs) and certificates of deposit accounts. Certificate of deposits, or CDs, are deposits with stated maturitiesranging from seven days to five years. The flow of deposits is significantly influenced by general economicconditions, changes in prevailing interest rates, pricing and competition.  Most of the Company’s deposits are obtainedfrom the communities surrounding its 12 branch offices.  The Bank attempts to attract and retain depositcustomers via sales and marketing efforts, new products, quality service,competitive rates and maintaining long-standing customer relationships.  To determine deposit product interest rates,the Company considers local competition, market yields and the rates chargedfor alternative sources of funding such as borrowings.  Though we continue to experience intensecompetition 

 

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for deposits, our ratesetting strategy includes consideration of liquidity needs, balance sheetstructure and cost effective strategies that is mindful of the current interestrate environment.

 

Compared to December 31,2007 total deposits increased $30,135,000, or 7%, during the three months endedMarch 31, 2008.  The growth in totaldeposits was primarily due to increases in NOW and DDAs of $22,900,000, or 42%,and $4,700,000, or 7%, respectively.  Thecombined increase stems from seasonal activity with our municipal customers.  The improvement in CD’s is from growth inpersonal accounts offset partially by a decline from the public sector.

 

The following tablerepresents the components of deposits as of March 31, 2008 and December 31,2007 (dollars in thousands):

 
| ** **               | ** ** | **March 31, 2008** | ** ** | **December 31, 2007** | ** ** |
|--------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **               | ** ** | **Amount**                   | ** ** | **%**                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| Money market             |       | $                            | 85,224     |                            | 18.7       |   | $ | 87,892 |   | 20.6 |   |
| NOW                      |       | 77,581                       |       | 17.0                            |       | 54,695 |   | 12.9 |   |
| Savings and club         |       | 40,122                       |       | 8.8                             |       | 40,125 |   | 9.4 |   |
| Certificates of  deposit |       | 183,429                      |       | 40.3                            |       | 178,200 |   | 41.9 |   |
| Total  interest-bearing  |       | 386,356                      |       | 84.8                            |       | 360,912 |   | 84.8 |   |
| Non-interest-bearing     |       | 69,487                       |       | 15.2                            |       | 64,796 |   | 15.2 |   |
| Total deposits           |       | $                            | 455,843    |                            | 100.0      |   | $ | 425,708 |   | 100.0 |   |

 

Certificates of deposit,of $100,000 or more aggregated $84,065,000 and $80,857,000 at March 31,2008 and December 31, 2007, respectively.

 

*Borrowings*

 

Borrowings areused as a complement to deposit generation as an alternative funding sourcewhereby the Bank will borrow under customer repurchase agreements in the localmarket and advances from the Federal Home Loan Bank of Pittsburgh (FHLB) andcorrespondent banks for asset growth and liquidity needs.  Repurchase agreements are non-insuredinterest-bearing liabilities that have a security interest in qualifiedinvestment securities of the Bank and are offered in both sweep and fixed-termproducts.  A sweep account is designed toensure that, on a daily basis, an attached DDA is adequately funded and excessDDA funds are transferred, or swept into an overnight interest-bearingrepurchase agreement account.  Thebalance in customer repurchase agreement accounts can fluctuate daily becausethe daily sweep product is dependent on the level of available funds indepositor accounts.  In addition,short-term borrowings may include overnight balances which the Bank may requirefrom time-to-time to fund daily liquidity needs.  Overnight balances and repurchase agreementsare components of short-term borrowings on the consolidated balancesheets.  FHLB advances are components oflong-term debt on the consolidated balance sheets.

 

The following tablerepresents the components of borrowings as of March 31, 2008 and December 31,2007 (dollars in thousands):

 
| ** **                  | ** ** | **March 31, 2008** | ** ** | **December 31, 2007** | ** ** |
|-----------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **                  | ** ** | **Amount**                   | ** ** | **%**                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| Overnight  borrowings       |       | $                            | —     |                            | —     |   | $ | 18,950 |   | 18.5 |   |
| Repurchase agreements       |       | 9,559                        |       | 13.2                            |       | 20,504 |   | 20.0 |   |
| Demand note,  U.S. Treasury |       | 320                          |       | 0.4                             |       | 202 |   | 0.2 |   |
| FHLB advances               |       | 62,495                       |       | 86.4                            |       | 62,709 |   | 61.3 |   |
| Total borrowings            |       | $                            | 72,374     |                            | 100.0      |   | $ | 102,365 |   | 100.0 |   |

 

The pay-down ofovernight borrowings resulted from the previously mentioned deposit growth andliquidity produced by the sale of residential mortgage loans.  The reduction in repurchase agreements wascaused by a combination of competition and the volatile nature of the sweepproduct.

 

23

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*Accrued interest payable andother liabilities*

 

The increase inaccrued interest payable and other liabilities $5,318,000 from December 31,2007 to March 31, 2008 was principally due to the recording of thecommitment to purchase a $5,300,000 investment security that will settle earlyin the second quarter.

 

**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/LiabilityManagement*.  One major objective of the Company whenmanaging the rate sensitivity of its assets and liabilities is to stabilize netinterest income.  The management of andauthority to assume interest rate risk is the responsibility of the Company’sAsset/Liability Committee (ALCO), which is comprised of senior management andmembers of the board of directors.  ALCOmeets quarterly to monitor the relationship of interest sensitive assets tointerest sensitive liabilities.  Theprocess to review interest rate risk is a regular part of managing 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 directorswhich includes limits on the impact to earnings from shifts in interest rates.

 

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

 

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

 

To manage this interestrate sensitivity gap position, an asset/liability model commonly known ascumulative gap analysis is used to monitor the difference in the volume of theCompany’s interest sensitive assets and liabilities that mature or re-pricewithin given time intervals.  A positivegap (asset sensitive) indicates that more assets will re-price during a givenperiod compared to liabilities, while a negative gap (liability sensitive) hasthe opposite effect.  The Company employscomputerized net interest income simulation modeling to assist in quantifyinginterest rate risk exposure.  Thisprocess measures and quantifies the impact on net interest income throughvarying interest rate changes and balance sheet compositions.  The use of this model assists the ALCO togauge the effects of the interest rate changes on interest-sensitive assets andliabilities in order to determine what impact these rate changes will have uponthe net interest spread.  At March 31,2008 the Bank maintained a one-year cumulative gap of $5.6 million, or 0.9%, oftotal assets.  The effect of thispositive gap position provided a mismatch of assets and liabilities which mayexpose the Bank to interest rate risk during periods of falling interestrates.  Conversely, in a rising interestrate environment, net interest income could be positively impacted because moreassets than liabilities will re-price upward during the one-year period.

 

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

 

24

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The following table illustrates the Company’s interestsensitivity gap position at March 31, 2008 (dollars in thousands):

 
| ** **                                     | ** ** | **Three months** | ** ** | **Three to**      | ** ** | **One to**      | ** ** | **Over**             | ** ** | ** ** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|------------------------|------------|----------------------|------------|----------------------|------------|------------|------------|
| ** **                                     | ** ** | **or less**      | ** ** | **twelve months** | ** ** | **three years** | ** ** | **three years** | ** ** | **Total**  | ** ** |
| Cash and cash  equivalents                     |       | $                     | 10,136     |                   | $          | —               |       | $                    | —     |       | $          | 13,243 |   | $ | 23,379 |   |
| Investment  securities (1)(2)                  |       | 30,998                |       | 20,892                 |       | 28,608               |       | 59,210               |       | 139,708    |       |
| Loans (2)                                      |       | 110,167               |       | 76,501                 |       | 103,072              |       | 105,464              |       | 395,204    |       |
| Fixed and other  assets                        |       | —                |       | 8,563                  |       | —               |       | 27,022               |       | 35,585     |       |
| Total assets                                   |       | $                     | 151,301    |                   | $          | 105,956              |       | $                    | 131,680    |       | $          | 204,939 |   | $ | 593,876 |   |
| Total cumulative  assets                       |       | $                     | 151,301    |                   | $          | 257,257              |       | $                    | 388,937    |       | $          | 593,876 |   |   |   |
|                                           |       |                  |       |                   |       |                 |       |                 |       |       |       |
| Non-interest-bearing  transaction deposits (3) |       | $                     | —     |                   | $          | 6,948                |       | $                    | 19,109     |       | $          | 43,430 |   | $ | 69,487 |   |
| Interest-bearing  transaction deposits (3)     |       | 106,146               |       | —                 |       | 38,094               |       | 58,687               |       | 202,927    |       |
| Certificates of  deposit                       |       | 22,948                |       | 95,250                 |       | 62,393               |       | 2,838                |       | 183,429    |       |
| Repurchase  agreements                         |       | 9,559                 |       | —                 |       | —               |       | —               |       | 9,559      |       |
| Short-term  borrowings                         |       | 320                   |       | —                 |       | —               |       | —               |       | 320        |       |
| Long-term debt                                 |       | 10,212                |       | 283                    |       | 31,000               |       | 21,000               |       | 62,495     |       |
| Other  liabilities                             |       | —                |       | —                 |       | —               |       | 9,466                |       | 9,466      |       |
| Total  liabilities                             |       | $                     | 149,185    |                   | $          | 102,481              |       | $                    | 150,596    |       | $          | 135,421 |   | $ | 537,683 |   |
| Total cumulative  liabilities                  |       | $                     | 149,185    |                   | $          | 251,666              |       | $                    | 402,262    |       | $          | 537,683 |   |   |   |
|                                           |       |                  |       |                   |       |                 |       |                 |       |       |       |
| Interest  sensitivity gap                      |       | $                     | 2,116      |                   | $          | 3,475                |       | $                    | (18,916    | )          | $          | 69,518 |   |   |   |
|                                           |       |                  |       |                   |       |                 |       |                 |       |       |       |
| Cumulative gap                                 |       | $                     | 2,116      |                   | $          | 5,591                |       | $                    | (13,325    | )          | $          | 56,193 |   |   |   |
|                                           |       |                  |       |                   |       |                 |       |                 |       |       |       |
| Cumulative gap  to total assets                |       | 0.36                  | %          | 0.94                   | %          | (2.24                | )%         | 9.46                 | %          |       |       |

 

----

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

 

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

 

(3)   TheBank’s demand and savings accounts are generally subject to immediatewithdrawal.  However, managementconsiders a certain amount of such accounts to be core accounts havingsignificantly longer effective maturities based on the retention experiences ofsuch deposits in changing interest rate environments.  The effective maturities presented are therecommended maturity distribution limits for non-maturing deposits based onhistorical deposit studies.

 

*Earnings at Risk and EconomicValue at Risk Simulations*. The Company recognizes that more sophisticated tools exist for measuringthe interest rate risk in the balance sheet that extend beyond staticre-pricing gap analysis.  Although itwill continue to measure its re-pricing gap position, the Company utilizesadditional modeling for identifying and measuring the interest rate risk in theoverall balance sheet.  The ALCO isresponsible for focusing on “earnings at risk” and “economic value at risk”,and how both relate to the risk-based capital position when analyzing theinterest rate risk.

 

*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.

 

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-

 

25

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earning asset and interest-bearing liability levels at March 31,2008 remain constant.  The impact of therate movements was developed by simulating the effect of rates changing over atwelve-month period from the March 31, 2008 levels:

 
| ** **                                             | ** ** | **Rates +200** | ** ** | **Rates -200** | ** ** |
|--------------------------------------------------------|------------|---------------------|------------|---------------------|------------|
| Earnings at  risk:                                     |       |                |       |                |       |
| Percent change  in:                                    |       |                |       |                |       |
| Net interest  income                                   |       | (1.2                | )%         | (4.1                | )%         |
| Net income                                             |       | (2.9                | )          | (12.7               | )          |
|                                                   |       |                |       |                |       |
| Economic value  at risk:                               |       |                |       |                |       |
| Percent change  in:                                    |       |                |       |                |       |
| Economic value  of equity                              |       | (20.7               | )          | (12.1               | )          |
| Economic value  of equity as a percent of total assets |       | (2.1                | )          | (1.2                | )          |

 

Economic value has themost meaning when viewed within the context of risk-based capital.  Therefore, the economic value may normallychange beyond the Company’s policy guideline for a short period of time as longas the risk-based capital ratio (after adjusting for the excess equityexposure) is greater than 10%.  At March 31,2008, the Company’s risk-based capital ratio was 14.6%.

 

The table belowsummarizes estimated changes in net interest income over a twelve-month periodbeginning April 1, 2008 under alternate interest rate scenarios using theincome simulation model described above (dollars in thousands):

 
| ** **                                  | ** ** | **Net interest** | ** ** | **$**        | ** ** | **%**        | ** ** |
|---------------------------------------------|------------|-----------------------|------------|--------------|------------|--------------|------------|
| **Change in interest rates** | ** ** | **income**            | ** ** | **variance** | ** ** | **variance** | ** ** |
|                                        |       |                  |       |         |       |         |       |
| +200 basis  points                          |       | $                     | 18,509     |         | $          | (216         | )          | (1.2 | )% |
| +100 basis  points                          |       | 18,748                |       | 23           |       | 0.1          |       |
|   Flat rate                            |       | 18,725                |       | —       |       | —       |       |
| -100 basis  points                          |       | 18,263                |       | (462         | )          | (2.5         | )          |
| -200 basis  points                          |       | 17,956                |       | (769         | )          | (4.1         | )          |
|                                             |            |                       |            |              |            |              |            |  |  |

 

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

 

*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 rate volatility.  This interest rate risk management strategyentails the use of interest rate floors, caps and swaps.  In October 2006, the Bank entered intoan interest rate floor derivative agreement on $20,000,000 notional value ofits prime-based loan portfolio.  Thepurpose of the hedge is to help protect the Bank’s interest income in the eventinterest rates decline below a pre-determined contractual interest rate.  The strategy is reflected in the scenariosfor earnings and economic value at risk and the net interest income in the twoimmediately preceding tables.  For afurther discussion on the Bank’s derivative contract, see Note No. 4, “Derivativeinstruments,” contained within the notes to consolidated financial statementsin Part I, Item 1.

 

26

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*Liquidity*

 

Liquidity managementensures that adequate funds will be available to meet loan and investmentcommitments, deposit withdrawals and maturities and normal operatingrequirements of the Bank.  Current sourcesof liquidity are cash and cash equivalents, asset maturities, calls andprincipal repayments, loans and investments AFS, growth of core deposits,growth of repurchase agreements, increases in other borrowed funds fromcorrespondent banks and issuance of capital stock.  Although regularly scheduled investment andloan payments are dependable sources of daily funds, the sales of both loansand investments AFS, deposit activity and investment and loan prepayments aresignificantly influenced by general economic conditions and the level ofinterest rates.

 

As of March 31, 2008, the Company maintained $23,379,000 in cashand cash equivalents, $135,212,000 of investments AFS and $1,215,000 of loansAFS.  In addition, as of March 31,2008, the Company had approximately $287,398,000 available to borrow from theFHLB and $30,000,000 available from other correspondent banks.  This combined total of $477,204,000,000represented 80% of total assets at March 31, 2008.  Management believes this level of liquidityto be strong and adequate to support current operations.

 

*Capital*

 

During the three monthsended March 31, 2008, shareholders’ equity increased $1,002,000 from netincome, stock from the Company’s Employee Stock Purchase Plan, the stock-basedcompensation expense offset from the Company sponsored stock option plans, anincrease in the intrinsic value of the Company’s cash flow hedge, partiallyoffset by an increase in the unrealized loss on AFS securities and by thedeclaration of cash dividends.  TheCompany is subject to various regulatory capital requirements administered bythe federal banking agencies.  Failure tomeet minimum 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 otherfactors.

 

Under these guidelines, assets and certain off-balancesheet items are assigned to broad risk categories, each with appropriateweights.  The resulting capital ratiosrepresent capital as a percentage of total risk-weighted assets and certainoff-balance sheet items.  The guidelinesrequire all banks and bank holding companies to maintain a minimum ratio oftotal risk-based capital to total risk-weighted assets (Total Risk AdjustedCapital) of 8%, including Tier I capital to total risk-weighted assets (Tier ICapital) of 4% and Tier I capital to average total assets (Leverage Ratio) ofat least 4%.

 

27

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As of March 31,2008, the Company and the Bank met all capital adequacy requirements to whichit was subject.  The following tabledepicts the capital amounts and ratios of the Company and the Bank as of March 31,2008:

 
| ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                 | ** ** | ** ** | **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                              |       | $          | 60,869,420 |       | 14.6       | %          | >                  | $          | 33,294,967 | >                                 | 8.0        | % |   | N/A |   | N/A |   |
| Bank                                      |       | $          | 60,435,824 |       | 14.5       | %          | >                  | $          | 33,284,189 | >                                 | 8.0        | % | >  | $ | 41,605,236 | >  | 10.0 | % |
| Tier I capital  (to risk-weighted assets) |       |       |       |       |       |       |                       |       |       |                                      |       |   |   |   |   |
| Consolidated                              |       | $          | 56,428,070 |       | 13.6       | %          | >                  | $          | 16,647,483 | >                                 | 4.0        | % |   | N/A |   | N/A |   |
| Bank                                      |       | $          | 56,054,987 |       | 13.5       | %          | >                  | $          | 16,642,094 | >                                 | 4.0        | % | >  | $ | 24,963,142 | >  | 6.0 | % |
| Tier I capital  (to average assets)       |       |       |       |       |       |       |                       |       |       |                                      |       |   |   |   |   |
| Consolidated                              |       | $          | 56,428,070 |       | 9.5        | %          | >                  | $          | 23,663,138 | >                                 | 4.0        | % |   | N/A |   | N/A |   |
| Bank                                      |       | $          | 56,054,987 |       | 9.5        | %          | >                  | $          | 23,646,548 | >                                 | 4.0        | % | >  | $ | 29,558,185 | >  | 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 March 31, 2008.

 

**PART II - Other Information**

 

**Item 1. Legal Proceedings**

 

The nature of the Company’sbusiness generates some litigation involving matters arising in the ordinarycourse of business.  However, in theopinion of the Company, after consulting with legal counsel, no legalproceedings are pending, which, if determined adversely to the Company or theBank, would have a material effect on the Company’s undivided profits orfinancial condition.  No legalproceedings are pending other than ordinary routine litigation incidental tothe business of the Company and the Bank. In addition, to management’s knowledge, no governmental authorities haveinitiated or contemplated any material legal actions against the Company or theBank.

 

**Item 1A.  Risk Factors**

 

Management of the Companydoes not believe there have been any material changes in the risk factors thatwere disclosed in the Form 10-K filed with the Securities and ExchangeCommission on March 13, 2008.

 

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

None

 

**Item 3.    Default Upon Senior Securities**

None

 

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

None

 

**Item 5.    Other Information**

None

 

28

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**Item 6.   Exhibits**

 

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

 

***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 & D Bancorp, 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 regardingcomputation of earnings 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 PrincipalExecutive Officer pursuant to 18 U.S.C. Section 1350,***

* as adopted**pursuant to Section 906of the Sarbanes-Oxley Act of 2002, filed herewith.***

 

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

 *as adopted pursuant**to Section 906 of the Sarbanes-Oxley Act of 2002, filed herewith.***

 

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* Management contract orcompensatory plan or arrangement.

 

 

29

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** **

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

 

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

 
|                   | **FIDELITY  D & D BANCORP, INC.**                                                   |
|------------------------|----------------------------------------------------------------------------------------------|
|                   | ** **                                                                                   |
|                   |                                                                                         |
| Date: May 6, 2008 | /s/ Steven C. Ackmann                                                                        |
|                   |        Steven  C. Ackmann,                                |
|                   |          President  and Chief Executive Officer |
|                   |                                                                                         |
|                   |                                                                                         |
| Date: May 6, 2008 | /s/ Salvatore R.  DeFrancesco, Jr.                                                      |
|                   |        Salvatore  R. DeFrancesco, Jr.,               |
|                   |          Treasurer  and Chief Financial Officer |

** **

 

30

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**EXHIBITINDEX**
|                                                                                                                                                                                                                                                                                                                                                         |   | **Page** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------|
|                                                                                                                                                                                                                                                                                                                                                         |   | *        |
| ***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.***                                                                                                                                                                                                                                                                           |   | 32       |
|                                                                                                                                                                                                                                                                                                                                                         |   |     |
| ***31.2  Rule 13a-14(a) Certification of Principal Financial Officer.***                                                                                                                                                                                                                                                                           |   | 33       |
|                                                                                                                                                                                                                                                                                                                                                         |   |     |
| ***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.***                                                                                                                                                                               |   | 34       |
|                                                                                                                                                                                                                                                                                                                                                         |   |     |
| ***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.***                                                                                                                                                                               |   | 35       |

 

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* Incorporated byReference

 

31

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