Tableof Contents

 

 

 

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

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

**SECURITIESEXCHANGE ACT OF 1934**

 

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

 

**OR**

 

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

**SECURITIESEXCHANGE ACT OF 1934**

 

**For thetransition period from                            to                 **

 

**Commissionfile number: 333-90273**

 

**FIDELITYD & D BANCORP, INC.**

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

 

Address ofprincipal executive offices:

**BLAKELY &DRINKER ST.**

**DUNMORE,PENNSYLVANIA 18512**

 

TELEPHONE:

**570-342-8281**

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant was requiredto file such reports), and (2) has been subjected to such filingrequirements for the 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 the definitions of“large accelerated filer,” “accelerated filer” and “smaller reporting company”in Rule 12b-2 of the Exchange Act. (Check one):

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

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

 

o YES    x NO

 

The number of outstandingshares of Common Stock of Fidelity D & D Bancorp, Inc. at October 31,2008, the latest practicable date, was 2,062,182 shares.

 

 

 

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Tableof Contents

 

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

 

Form 10-QSeptember 30, 2008

 

Index

 
| ** **                           | ** **                                                                                                                   | **Page** |
|--------------------------------------|------------------------------------------------------------------------------------------------------------------------------|----------|
| **Part I.  Financial Information**   |                                                                                                                         |
|                                 |                                                                                                                         |     |
| Item 1.                              | Financial Statements:                                                                                                        |     |
|                                 | Consolidated  Balance Sheets as of September 30, 2008 and December 31, 2007                                        | 3        |
|                                 | Consolidated  Statements of Income for the three and nine months ended September 30,  2008 and 2007                     | 4        |
|                                 | Consolidated  Statements of Changes in Shareholders’ Equity for the nine months ended  September 30, 2008 and 2007 | 5        |
|                                 | Consolidated  Statements of Cash Flows for the nine months ended September 30, 2008  and 2007                           | 6        |
|                                 | Notes to Consolidated Financial Statements                                                                                   | 7        |
|                                 |                                                                                                                         |     |
| Item 2.                              | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                  | 12       |
|                                 |                                                                                                                         |     |
| Item 3.                              | Quantitative  and Qualitative Disclosure about Market Risk                                                                   | 26       |
|                                 |                                                                                                                         |     |
| Item 4.                              | Controls and  Procedures                                                                                                     | 30       |
|                                 |                                                                                                                         |     |
| **Part II.  Other Information** |                                                                                                                         |
|                                 |                                                                                                                         |     |
| Item 1.                              | Legal Proceedings                                                                                                            | 30       |
|                                 |                                                                                                                         |     |
| Item 1A.                             | Risk Factors                                                                                                                 | 30       |
|                                 |                                                                                                                         |     |
| Item 2.                              | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                 | 31       |
|                                 |                                                                                                                         |     |
| Item 3.                              | Defaults  upon Senior Securities                                                                                             | 31       |
|                                 |                                                                                                                         |     |
| Item 4.                              | Submission  of Matters to a Vote of Security Holders                                                                         | 31       |
|                                 |                                                                                                                         |     |
| Item 5.                              | Other Information                                                                                                            | 31       |
|                                 |                                                                                                                         |     |
| Item 6.                              | Exhibits                                                                                                                     | 32       |
|                                 |                                                                                                                         |     |
| Signatures                           | 33                                                                                                                           |
|                                 |                                                                                                                         |     |
| Exhibit index                   | 34                                                                                                                           |

 

2

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Tableof Contents

 

**PART I– Financial Information**

 

**Item 1:Financial Statements**

 

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

ConsolidatedBalance Sheets

 
| ** **                                                                                                                                                                       | ** ** | **September 30, 2008** | ** **  | **December 31, 2007** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|-------------|---------------------------------|------------|
| ** **                                                                                                                                                                       | ** ** | **(unaudited)**                  | ** **  | **(audited)**                   | ** ** |
|                                                                                                                                                                             |       |                             |        |                            |       |
| Assets:                                                                                                                                                                          |       |                             |        |                            |       |
| Cash and due  from banks                                                                                                                                                         |       | $                                | 12,806,375  |                            | $          | 10,204,714 |   |
| Interest-bearing  deposits with financial institutions                                                                                                                           |       | 568,924                          |        | 204,102                         |       |
|                                                                                                                                                                             |       |                             |        |                            |       |
| Total cash and  cash equivalents                                                                                                                                                 |       | 13,375,299                       |        | 10,408,816                      |       |
|                                                                                                                                                                             |       |                             |        |                            |       |
| Available-for-sale  securities                                                                                                                                                   |       | 86,233,884                       |        | 121,836,851                     |       |
| Held-to-maturity  securities                                                                                                                                                     |       | 945,665                          |        | 1,147,309                       |       |
| Federal Home  Loan Bank Stock                                                                                                                                                    |       | 4,770,700                        |        | 3,302,900                       |       |
| Loans and  leases, net (allowance for loan losses of $4,205,566 in 2008; $4,824,401 in  2007)                                                                                    |       | 426,455,593                      |        | 421,424,379                     |       |
| Loans  available-for-sale (fair value $642,573 in 2008; $842,923 in 2007)                                                                                                        |       | 632,400                          |        | 827,250                         |       |
| Bank premises  and equipment, net                                                                                                                                                |       | 16,018,219                       |        | 12,964,932                      |       |
| Cash surrender  value of bank owned life insurance                                                                                                                               |       | 8,728,568                        |        | 8,488,663                       |       |
| Other assets                                                                                                                                                                     |       | 8,418,646                        |        | 4,403,723                       |       |
| Accrued interest  receivable                                                                                                                                                     |       | 2,535,931                        |        | 2,500,696                       |       |
| Foreclosed  assets held-for-sale                                                                                                                                                 |       | 1,428,507                        |        | 107,036                         |       |
|                                                                                                                                                                             |       |                             |        |                            |       |
| Total assets                                                                                                                                                                     |       | $                                | 569,543,412 |                            | $          | 587,412,555 |   |
|                                                                                                                                                                             |       |                             |        |                            |       |
| Liabilities:                                                                                                                                                                     |       |                             |        |                            |       |
| Deposits:                                                                                                                                                                        |       |                             |        |                            |       |
| Interest-bearing                                                                                                                                                                 |       | $                                | 365,812,303 |                            | $          | 360,912,740 |   |
| Non-interest-bearing                                                                                                                                                             |       | 69,619,234                       |        | 64,795,621                      |       |
|                                                                                                                                                                             |       |                             |        |                            |       |
| Total deposits                                                                                                                                                                   |       | 435,431,537                      |        | 425,708,361                     |       |
|                                                                                                                                                                             |       |                             |        |                            |       |
| Accrued interest  payable and other liabilities                                                                                                                                  |       | 4,335,911                        |        | 4,147,869                       |       |
| Short-term  borrowings                                                                                                                                                           |       | 17,086,314                       |        | 39,656,354                      |       |
| Long-term debt                                                                                                                                                                   |       | 62,071,661                       |        | 62,708,677                      |       |
|                                                                                                                                                                             |       |                             |        |                            |       |
| Total  liabilities                                                                                                                                                               |       | 518,925,423                      |        | 532,221,261                     |       |
|                                                                                                                                                                             |       |                             |        |                            |       |
| Shareholders’  equity:                                                                                                                                                      |       |                             |        |                            |       |
|                                                                                                                                                                             |       |                             |        |                            |       |
| Preferred stock  authorized 5,000,000 shares with no par value; none issued                                                                                                      |       | —                           |        | —                          |       |
| Capital stock,  no par value (10,000,000 shares authorized; 2,075,182 shares issued and  2,062,182 shares outstanding in 2008; 2,072,929 shares issued and outstanding  in 2007) |       | 19,410,306                       |        | 19,223,363                      |       |
| Treasury stock,  at cost (13,000 shares in 2008; none in 2007)                                                                                                                   |       | (379,810                         | )           | —                          |       |
| Retained  earnings                                                                                                                                                               |       | 38,044,530                       |        | 36,564,157                      |       |
| Accumulated  other comprehensive loss                                                                                                                                            |       | (6,457,037                       | )           | (596,226                        | )          |
|                                                                                                                                                                             |       |                             |        |                            |       |
| Total  shareholders’ equity                                                                                                                                                 |       | 50,617,989                       |        | 55,191,294                      |       |
|                                                                                                                                                                             |       |                             |        |                            |       |
| Total  liabilities and shareholders’ equity                                                                                                                                 |       | $                                | 569,543,412 |                            | $          | 587,412,555 |   |

 

See notes to consolidatedfinancial statements

 

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

ConsolidatedStatements of Income

(unaudited)

 
| ** **                                             | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                             | ** ** | **September 30, 2008** | ** ** | **September 30, 2007** | ** ** | **September 30, 2008** | ** ** | **September 30, 2007** | ** ** |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Interest income:                                       |       |                             |       |                             |       |   |   |   |   |
| Loans and  leases:                                     |       |                             |       |                             |       |   |   |   |   |
| Taxable                                                |       | $                                | 6,811,968  |                             | $          | 7,223,183 |   | $ | 20,396,282 |   | $ | 21,540,100 |   |
| Nontaxable                                             |       | 93,454                           |       | 122,594                          |       | 256,860 |   | 350,463 |   |
| Interest-bearing  deposits with financial institutions |       | 606                              |       | 2,190                            |       | 2,408 |   | 6,911 |   |
| Investment  securities:                                |       |                             |       |                             |       |   |   |   |   |
| U.S. government  agency and corporations               |       | 1,047,561                        |       | 1,093,098                        |       | 3,584,878 |   | 3,029,358 |   |
| States and  political subdivisions (nontaxable)        |       | 170,098                          |       | 124,922                          |       | 469,330 |   | 374,273 |   |
| Other securities                                       |       | 295,753                          |       | 278,100                          |       | 976,447 |   | 804,522 |   |
| Federal funds  sold                                    |       | —                           |       | 48,259                           |       | 91,133 |   | 102,913 |   |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Total interest  income                                 |       | 8,419,440                        |       | 8,892,346                        |       | 25,777,338 |   | 26,208,540 |   |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Interest  expense:                                     |       |                             |       |                             |       |   |   |   |   |
| Deposits                                               |       | 2,598,805                        |       | 3,420,693                        |       | 8,663,941 |   | 9,977,394 |   |
| Securities sold  under repurchase agreements           |       | 11,545                           |       | 124,089                          |       | 92,141 |   | 355,122 |   |
| Other short-term  borrowings and other                 |       | 142,954                          |       | 26,013                           |       | 256,625 |   | 360,025 |   |
| Long-term debt                                         |       | 786,989                          |       | 899,196                          |       | 2,395,484 |   | 2,466,898 |   |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Total interest  expense                                |       | 3,540,293                        |       | 4,469,991                        |       | 11,408,191 |   | 13,159,439 |   |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Net interest  income                                   |       | 4,879,147                        |       | 4,422,355                        |       | 14,369,147 |   | 13,049,101 |   |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Provision  (credit) for loan losses                    |       | 130,000                          |       | (60,000                          | )          | 255,000 |   | (60,000 | ) |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Net interest  income after provision for loan losses   |       | 4,749,147                        |       | 4,482,355                        |       | 14,114,147 |   | 13,109,101 |   |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Other income:                                          |       |                             |       |                             |       |   |   |   |   |
| Service charges  on deposit accounts                   |       | 715,528                          |       | 784,847                          |       | 2,216,127 |   | 2,179,086 |   |
| Gain (loss) on  sale of:                               |       |                             |       |                             |       |   |   |   |   |
| Loans                                                  |       | 64,778                           |       | 52,821                           |       | 215,974 |   | 120,717 |   |
| Investment  securities                                 |       | 16,775                           |       | —                           |       | 25,428 |   | — |   |
| Premises and  equipment                                |       | (34,674                          | )          | 1,248                            |       | (35,658 | ) | 74,881 |   |
| Foreclosed  assets held-for-sale                       |       | 33,685                           |       | 405                              |       | 42,794 |   | 143,154 |   |
| Other-than-temporary  impairment on securities         |       | (403,031                         | )          | —                           |       | (403,031 | ) | — |   |
| Fees and other  service charges                        |       | 451,382                          |       | 469,440                          |       | 1,344,020 |   | 1,333,700 |   |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Total other  income                                    |       | 844,443                          |       | 1,308,761                        |       | 3,405,654 |   | 3,851,538 |   |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Other expenses:                                        |       |                             |       |                             |       |   |   |   |   |
| Salaries and  employee benefits                        |       | 2,474,969                        |       | 2,201,532                        |       | 7,364,817 |   | 6,501,861 |   |
| Premises and  equipment                                |       | 813,380                          |       | 807,978                          |       | 2,385,489 |   | 2,398,088 |   |
| Advertising                                            |       | 242,937                          |       | 156,848                          |       | 579,641 |   | 499,473 |   |
| Other                                                  |       | 1,141,368                        |       | 1,022,813                        |       | 3,179,996 |   | 2,990,345 |   |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Total other  expenses                                  |       | 4,672,654                        |       | 4,189,171                        |       | 13,509,943 |   | 12,389,767 |   |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Income before  provision for income taxes              |       | 920,936                          |       | 1,601,945                        |       | 4,009,858 |   | 4,570,872 |   |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Provision for  income taxes                            |       | 179,821                          |       | 424,023                          |       | 975,850 |   | 1,189,866 |   |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Net income                                             |       | $                                | 741,115    |                             | $          | 1,177,922 |   | $ | 3,034,008 |   | $ | 3,381,006 |   |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Per share data:                                        |       |                             |       |                             |       |   |   |   |   |
| Net income -  basic                                    |       | $                                | 0.35       |                             | $          | 0.57 |   | $ | 1.46 |   | $ | 1.64 |   |
| Net income -  diluted                                  |       | $                                | 0.35       |                             | $          | 0.57 |   | $ | 1.46 |   | $ | 1.64 |   |
| Dividends                                              |       | $                                | 0.25       |                             | $          | 0.24 |   | $ | 0.75 |   | $ | 0.68 |   |

 

See Notes toConsolidated Financial Statements

 

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

ConsolidatedStatements of Changes in Shareholders’ Equity

For the ninemonths ended September 30, 2008 and 2007

 
| ** **                                                                                                                     | ** ** | ** **             | ** ** | ** **              | ** ** | ** **   | ** ** | ** **        | ** ** | ** **   | ** ** | **Accumulated**        | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-------------------------|------------|--------------|------------|-------------------|------------|--------------|------------|------------------------|------------|------------|------------|
| ** **                                                                                                                     | ** ** | ** **             | ** ** | ** **              | ** ** | ** **   | ** ** | ** **        | ** ** | ** **   | ** ** | **other**              | ** ** | ** ** | ** ** |
| ** **                                                                                                                     | ** ** | **Capital stock** | ** ** | **Treasury stock** | ** ** | **Retained** | ** ** | **comprehensive** | ** ** | ** **   | ** ** |
| ** **                                                                                                                     | ** ** | **Shares**             | ** ** | **Amount**              | ** ** | **Shares**   | ** ** | **Amount**        | ** ** | **earnings** | ** ** | **income (loss)** | ** ** | **Total**  | ** ** |
|                                                                                                                           |       |                   |       |                    |       |         |       |              |       |         |       |                   |       |       |       |
| Balance, December  31, 2006 (audited)                                                                                          |       | 2,057,433              |       | $                       | 18,702,537 |         | —     |              | $          | —       |       | $                      | 33,874,118 |       | $          | (964,792 | ) | $ | 51,611,863 |   |
| Total  comprehensive income:                                                                                                   |       |                   |       |                    |       |         |       |              |       |         |       |                   |       |       |       |
| Net income                                                                                                                     |       |                   |       |                    |       |         |       |              |       | 3,381,006    |       |                   |       | 3,381,006  |       |
| Change in net  unrealized holding losses on available-for-sale securities, net of  reclassification adjustment and tax effects |       |                   |       |                    |       |         |       |              |       |         |       | (367,665               | )          | (367,665   | )          |
| Change in cash  flow hedge intrinsic value                                                                                     |       |                   |       |                    |       |         |       |              |       |         |       | 154,657                |       | 154,657    |       |
| Comprehensive income                                                                                                           |       |                   |       |                    |       |         |       |              |       |         |       |                   |       | 3,167,998  |       |
| Issuance of  common stock through Employee Stock                                                                               |       |                   |       |                    |       |         |       |              |       |         |       |                   |       |       |       |
| Purchase Plan                                                                                                                  |       | 2,266                  |       | 67,820                  |       |         |       |              |       |         |       |                   |       | 67,820     |       |
| Dividends  reinvested through Dividend Reinvestment Plan                                                                       |       | 13,230                 |       | 437,145                 |       |         |       |              |       |         |       |                   |       | 437,145    |       |
| Stock-based  compensation expense                                                                                              |       |                   |       | 6,958                   |       |         |       |              |       |         |       |                   |       | 6,958      |       |
| Cash dividends  declared                                                                                                       |       |                   |       |                    |       |         |       |              |       | (1,403,301   | )          |                   |       | (1,403,301 | )          |
|                                                                                                                           |       |                   |       |                    |       |         |       |              |       |         |       |                   |       |       |       |
| Balance,  September 30, 2007 (unaudited)                                                                                       |       | 2,072,929              |       | $                       | 19,214,460 |         | —     |              | $          | —       |       | $                      | 35,851,823 |       | $          | (1,177,800 | ) | $ | 53,888,483 |   |
|                                                                                                                           |       |                   |       |                    |       |         |       |              |       |         |       |                   |       |       |       |
| Balance, December  31, 2007 (audited)                                                                                          |       | 2,072,929              |       | $                       | 19,223,363 |         | —     |              | $          | —       |       | $                      | 36,564,157 |       | $          | (596,226 | ) | $ | 55,191,294 |   |
| Total  comprehensive loss:                                                                                                     |       |                   |       |                    |       |         |       |              |       |         |       |                   |       |       |       |
| Net income                                                                                                                     |       |                   |       |                    |       |         |       |              |       | 3,034,008    |       |                   |       | 3,034,008  |       |
| Change in net  unrealized holding losses on available-for-sale securities, net of  reclassification adjustment and tax effects |       |                   |       |                    |       |         |       |              |       |         |       | (5,957,194             | )          | (5,957,194 | )          |
| Change in cash  flow hedge intrinsic value                                                                                     |       |                   |       |                    |       |         |       |              |       |         |       | 96,383                 |       | 96,383     |       |
| Comprehensive  loss                                                                                                            |       |                   |       |                    |       |         |       |              |       |         |       |                   |       | (2,826,803 | )          |
| Issuance of  common stock through Employee Stock                                                                               |       |                   |       |                    |       |         |       |              |       |         |       |                   |       |       |       |
| Purchase Plan                                                                                                                  |       | 2,253                  |       | 57,891                  |       |         |       |              |       |         |       |                   |       | 57,891     |       |
| Stock-based  compensation expense                                                                                              |       |                   |       | 129,052                 |       |         |       |              |       |         |       |                   |       | 129,052    |       |
| Purchase of treasury  stock                                                                                                    |       |                   |       |                    |       | (13,000      | )          | (379,810          | )          |         |       |                   |       | (379,810   | )          |
| Cash dividends  declared                                                                                                       |       |                   |       |                    |       |         |       |              |       | (1,553,635   | )          |                   |       | (1,553,635 | )          |
|                                                                                                                           |       |                   |       |                    |       |         |       |              |       |         |       |                   |       |       |       |
| Balance,  September 30, 2008 (unaudited)                                                                                       |       | 2,075,182              |       | $                       | 19,410,306 |         | (13,000    | )                 | $          | (379,810     | )          | $                      | 38,044,530 |       | $          | (6,457,037 | ) | $ | 50,617,989 |   |

 

See Notes toConsolidated Financial Statements

 

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

ConsolidatedStatements of Cash Flows

(unaudited)

 
| ** **                                                                         | ** ** | **Nine Months Ended**  | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                         | ** ** | **September 30, 2008** | ** ** | **September 30, 2007** | ** ** |
|                                                                               |       |                             |       |   |   |
| Cash flows from  operating activities:                                             |       |                             |       |   |   |
| Net income                                                                         |       | $                                | 3,034,008  |   | $ | 3,381,006 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                             |       |   |   |
| Depreciation,  amortization and accretion                                          |       | 442,338                          |       | 929,540 |   |
| Provision  (credit) for loan losses                                                |       | 255,000                          |       | (60,000 | ) |
| Deferred income  tax expense                                                       |       | 158,834                          |       | 27,890 |   |
| Stock-based compensation  expense                                                  |       | 129,052                          |       | 6,958 |   |
| Loss from  investment in limited partnership                                       |       | 60,300                           |       | 60,300 |   |
| Proceeds from  sale of loans available-for-sale                                    |       | 42,687,143                       |       | 12,121,477 |   |
| Originations of  loans available-for-sale                                          |       | (11,163,004                      | )          | (12,260,760 | ) |
| Increase in cash  surrender value of life insurance                                |       | (239,905                         | )          | (231,026 | ) |
| Net gain on sale  of loans                                                         |       | (215,974                         | )          | (120,717 | ) |
| Net gain on sale  of investment securities                                         |       | (25,428                          | )          | — |   |
| Net gain on sale  of foreclosed assets held-for-sale                               |       | (42,794                          | )          | (143,154 | ) |
| Net loss (gain)  on disposal of premises and equipment                             |       | 35,658                           |       | (74,881 | ) |
| Other-than-temporary  impairment on securities                                     |       | 403,031                          |       | — |   |
| Change in:                                                                         |       |                             |       |   |   |
| Accrued interest  receivable                                                       |       | (35,235                          | )          | (377,667 | ) |
| Other assets                                                                       |       | (1,625,694                       | )          | (102,938 | ) |
| Accrued interest  payable and other liabilities                                    |       | 130,552                          |       | 480,771 |   |
|                                                                               |       |                             |       |   |   |
| Net cash  provided by operating activities                                         |       | 33,987,882                       |       | 3,636,799 |   |
|                                                                               |       |                             |       |   |   |
| Cash flows from  investing activities:                                             |       |                             |       |   |   |
| Held-to-maturity  securities:                                                      |       |                             |       |   |   |
| Proceeds from  maturities, calls and principal pay-downs                           |       | 201,209                          |       | 372,503 |   |
| Available-for-sale  securities:                                                    |       |                             |       |   |   |
| Proceeds from  sales                                                               |       | 48,402,449                       |       | — |   |
| Proceeds from  maturities, calls and principal pay-downs                           |       | 30,445,671                       |       | 9,784,761 |   |
| Purchases                                                                          |       | (51,961,087                      | )          | (31,953,887 | ) |
| Net (increase)  decrease in FHLB stock                                             |       | (1,467,800                       | )          | 236,800 |   |
| Net increase in  loans and leases                                                  |       | (37,941,827                      | )          | (3,883,909 | ) |
| Proceeds from  sale of premises and equipment                                      |       | 600                              |       | 248,833 |   |
| Acquisition of  bank premises and equipment                                        |       | (3,662,291                       | )          | (2,584,363 | ) |
| Proceeds from  sale of foreclosed assets held-for-sale                             |       | 262,406                          |       | 584,088 |   |
|                                                                               |       |                             |       |   |   |
| Net cash used in  investing activities                                             |       | (15,720,670                      | )          | (27,195,174 | ) |
|                                                                               |       |                             |       |   |   |
| Cash flows from  financing activities:                                             |       |                             |       |   |   |
| Net increase in  deposits                                                          |       | 9,723,176                        |       | 28,721,962 |   |
| Net decrease in  short-term borrowings                                             |       | (22,570,040                      | )          | (5,076,652 | ) |
| Repayments of  long-term debt                                                      |       | (637,016                         | )          | (19,618,335 | ) |
| Proceeds from  long-term debt advances                                             |       | —                           |       | 20,000,000 |   |
| Proceeds from  employee stock purchase plan                                        |       | 57,891                           |       | 67,820 |   |
| Dividends paid, net  of dividends reinvested                                       |       | (1,553,635                       | )          | (966,156 | ) |
| Purchase of  treasury stock                                                        |       | (321,105                         | )          | — |   |
|                                                                               |       |                             |       |   |   |
| Net cash (used  in) provided by financing activities                               |       | (15,300,729                      | )          | 23,128,639 |   |
|                                                                               |       |                             |       |   |   |
| Net increase  (decrease) in cash and cash equivalents                              |       | 2,966,483                        |       | (429,736 | ) |
|                                                                               |       |                             |       |   |   |
| Cash and cash  equivalents, beginning                                              |       | 10,408,816                       |       | 13,800,848 |   |
|                                                                               |       |                             |       |   |   |
| Cash and cash  equivalents, ending                                                 |       | $                                | 13,375,299 |   | $ | 13,371,112 |   |

 

See notes to consolidatedfinancial statements

 

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

 

**Notes to Consolidated Financial Statements**

**(unaudited)**

 

**1. Nature of operations andcritical accounting policies**

 

# **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 in 1903, the Bank is committed to providesuperior customer service, while offering a full range of banking products andfinancial and trust services, to both our consumer and commercial customersfrom its main office located in Dunmore and other branches throughoutLackawanna 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 ofthe information and footnote disclosures required by GAAP for completefinancial statements. In the opinion of management, all normal recurringadjustments necessary for a fair presentation of the financial condition andresults of operations for the periods have been included. All significantinter-company balances and transactions have been eliminated in consolidation.Prior period amounts are reclassified when necessary to conform to the currentperiod’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. Actual results could differ from those estimates.For additional information and disclosures required under GAAP, refer to theCompany’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 financialstatements in accordance with GAAP. In meeting its responsibility for thefinancial statements, management depends on the Company’s accounting systemsand related internal controls. These systems and controls are designed toprovide reasonable but not absolute assurance that the financial recordsaccurately reflect the transactions of the Company, the Company’s assets aresafeguarded and that the financial statements present fairly the financialcondition and results of operations of the Company.

 

In the opinion ofmanagement, the consolidated balance sheets as of September 30, 2008 andDecember 31, 2007 and the related consolidated statements of income for thethree- and nine-month periods ended September 30, 2008 and 2007 andchanges in shareholders’ equity and cash flows for the nine months endedSeptember 30, 2008 and 2007 present fairly the financial condition andresults of operations of the Company. All material adjustments required for afair presentation have been made. These adjustments are of a normal recurringnature.

 

This Quarterly Report onForm 10-Q should be read in conjunction with the Company’s auditedfinancial statements for the year ended December 31, 2007, and the notesincluded therein, included within the Company’s Annual Report filed onForm 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 forloan losses at September 30, 2008 is adequate and reasonable. Given thesubjective 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 managementuses available information to recognize losses on loans, changes in economicconditions may necessitate revisions in the future. In addition, variousregulatory agencies, as an integral part of their examination process,periodically review the 

 

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Company’s allowance forloan losses. Such agencies may require the Company to recognize adjustments tothe allowance based on their judgment of information available to them at thetime of their examination.

 

Another material estimateis the calculation of fair values of the Company’s investment securities.Generally, the fair value of the Company’s investments in debt instruments isprimarily impacted by changes in interest rates. As interest rates rise, thefair value of securities will decrease; as interest rates fall the fair valueof securities will increase. The Company conducts periodic reviews andevaluations of the securities portfolio to determine if the decline in the fairvalue of any security below its cost basis is other-than-temporary. Generallythe Company views changes in fair value caused by changes in interest rates astemporary, which is consistent with our experience. If we deem a decline to beother-than-temporary, the security is written down to a new cost basis with acorresponding charge to current period earnings that is reported as a componentof non-interest income. See Note 5, “Recent Accounting Pronouncements,” belowand Comparison of Financial Condition at September 30, 2008 andDecember 31, 2007, “Investment securities,” in Management’s Discussion andAnalysis of Financial Condition and Results of Operations, Part 2 of thisitem, also below, for further discussions on other-than-temporary impairment.

 

The Company receivesestimated fair values of investment securities from either an independentvaluation service or determines fair value using the income approach utilizingthe discount rate adjustment technique with estimates of cash flows based onhistorical performance of similar instruments in similar interest rateenvironments. Based on experience, management is aware that estimated fairvalues of investment securities tend to vary among valuation services ormodels. Accordingly, when selling investment securities, management may obtainprice quotes from more than one source. Available-for-sale (AFS) securities arecarried at fair value on the consolidated balance sheet with unrealized gainsand losses, net of income tax, reported separately within shareholders’ equitythrough accumulated other comprehensive income (loss).

 

The fair value ofresidential mortgage loans originated and classified as AFS, is obtained fromthe Federal National Mortgage Association (FNMA) and the Federal Home Loan Bank(FHLB). Generally, the market to which the Company sells mortgages itoriginates for sale is restricted and price quotes from other sources are nottypically obtained. On occasion, the Company may transfer loans from the loanand lease portfolio to loans AFS. Under these rare circumstances, pricing maybe obtained from other entities and the loans are transferred at the lower ofcost or market value and simultaneously sold.

 

**2. Earnings per share**

 

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

 

In the computation of diluted EPS, the Company uses the treasury stockmethod to determine the dilutive effect of its granted but unexercised stockoptions. Under the treasury stock method, the assumed proceeds received fromshares issued, in a hypothetical stock option exercise, are assumed to be usedto purchase treasury stock. For a further discussion on the Company’s stockoption plans, see Note No. 3, “Stock plans,” below.

 

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

 
| **Nine months ended September 30,**       | ** ** | **2008**  | ** ** | **2007**  | ** ** |
|---------------------------------------------------------------|------------|-----------|------------|-----------|------------|
| Basic EPS:                                                    |       |      |       |      |       |
| Net income  available to common shareholders                  |       | $         | 3,034,008  |      | $          | 3,381,006 |   |
| Weighted-average  common shares outstanding                   |       | 2,071,242 |       | 2,064,578 |       |
| Basic EPS                                                     |       | $         | 1.46       |      | $          | 1.64 |   |
|                                                          |       |      |       |      |       |
| Diluted EPS:                                                  |       |      |       |      |       |
| Net income  available to common shareholders                  |       | $         | 3,034,008  |      | $          | 3,381,006 |   |
| Weighted-average  common shares outstanding                   |       | 2,071,242 |       | 2,064,578 |       |
| Dilutive  potential common shares                             |       | 85        |       | 608       |       |
| Weighted-average  common shares and dilutive potential shares |       | 2,071,327 |       | 2,065,186 |       |
| Diluted EPS                                                   |       | $         | 1.46       |      | $          | 1.64 |   |

 

**3. Stock plans**

 

The Company uses the fair value method of accounting for stock-basedcompensation provided under Statement of Financial Accounting Standard (SFAS)No. 123R, *Share Based Payment*. SFAS 123Rrequires that the cost of share-based payment transactions (including thosewith employees and non-employees) be recognized in the financial statements.SFAS 123R applies to all share-based payment transactions in which an entityacquires goods or services by issuing (or offering to issue) its shares, shareoptions, or other equity instruments (except for those held by an ESOP) or byincurring liabilities (1) in amounts based (even in part) on the price ofthe entity’s shares or other equity instruments,

 

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or (2) that require(or may require) settlement by the issuance of an entity’s shares or otherequity instruments.

 

The Company has twostock-based compensation plans (the stock option plans). The stock option planswere shareholder-approved and permit the grant of share-based compensationawards to its directors, key officers and certain other employees. The Companybelieves that these stock option plans better align the interest of itsdirectors, key officers and employees with the interest of its shareholders.The Company further believes that the granting of share-based awards, under theprovisions of the stock option plans, is necessary to retain the knowledgebase, continuity and expertise of its directors, key officers and certainemployees.

 

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 monthsof continuous service from the date of grant and have 10-year contractualterms. Stock-based compensation expense is recognized over the six-monthvesting period. Generally, all shares that are granted become fully vested.Stock-based compensation is recorded in the consolidated income statement as acomponent of salaries and employee benefits.

 

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

 

The Company alsoestablished the 2000 Stock Incentive Plan and has reserved 55,000 shares of itsun-issued capital stock for issuance under the plan. During the nine monthsended September 30, 2008, 2,000 stock options were issued under this planat a weighted-average grant-date fair value of $4.85 per share. The Companyuses the Black-Scholes Option Pricing Valuation Model to determine the fairvalue of awarded options on the date of grant. The model considers expectedvolatility, expected dividends, risk-free interest rate and the expected term.No stock options were awarded during the first nine months of 2007. As ofSeptember 30, 2008, there were 12,830 unexercised stock options outstandingunder this plan.

 

The following tablesillustrate stock-based compensation expense recognized during the three- andnine- months ended September 30, 2008 and 2007 and the unrecognizedstock-based compensation expense as of September 30, 2008 andDecember 31, 2007 for each of the Company’s stock option plans: 

 
| ** **                              | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|-----------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                              | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                              | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| Stock-based  compensation expense:      |       |                             |       |                            |       |   |   |   |   |
| Director’s Plan                    |       | $                                | —     |                            | $          | — |   | $ | 90,550 |   | $ | — |   |
| Incentive Plan                          |       | 2,314                            |       | —                          |       | 35,562 |   | — |   |
|                                    |       |                             |       |                            |       |   |   |   |   |
| Total  stock-based compensation expense |       | $                                | 2,314      |                            | $          | — |   | $ | 126,112 |   | $ | — |   |
|                                    |       |                             |       |                            |       |   |   |   |   |

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

 

In addition to the twostock option plans, the Company established the 2002 Employee Stock PurchasePlan (the ESPP) and reserved 110,000 shares of its un-issued capital stock forissuance under the plan. The plan was designed to promote broad-based employeeownership of the Company’s stock. Under the ESPP, employees may elect topurchase the Company’s capital stock at a discounted price based on the fairmarket value of the Company’s capital stock on either the commencement date ortermination date. At September 30, 2008, 10,570 shares have been issuedunder the ESPP. The Company recognizes compensation expense on its ESPP on thedate the shares are purchased. For the nine months ended September 30,2008 and 2007, compensation expense related to the ESPP approximated $3,000 and$7,000, respectively, and is included as components of salaries and employeebenefits in the consolidated statements of income.

 

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**4. Derivative instruments**

 

As part of the Company’soverall interest rate risk management strategy, the Company has adopted apolicy whereby it may periodically use derivative instruments to minimizesignificant fluctuations in earnings caused by interest rate volatility. Thisinterest rate risk management strategy entails the use of interest rate floors,caps and swaps. During the fourth quarter of 2006, the Company entered into athree-year interest rate floor derivative agreement on $20,000,000 notionalvalue of its prime-based loan portfolio. The transaction required the paymentof a premium by the Company to the seller for the right to receive payments inthe event 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. When purchased, the Company recorded anasset representing the fair value of the hedge at the time of purchase. TheCompany has designated this agreement as a cash flow hedge pursuant to SFASNo. 133, *Accounting for Derivative Instruments andHedging Activities.*Accordingly, the change in the fair value of theinstrument related to the hedge’s intrinsic value, or approximately $96,000 and$155,000 for the nine months ended September 30, 2008 and 2007,respectively, is recorded as a component of other comprehensive income (loss)(OCI) in the consolidated statement of changes in shareholders’ equity and theportion of the change in fair value related to the time value expiration, orapproximately $12,000 and $131,000 for the nine months ended September 30,2008 and 2007, respectively, is recorded in the consolidated statements ofincome as a reduction of interest income. No gain or loss has been recognizedin earnings due to hedge ineffectiveness as of September 30, 2008. As ofSeptember 30, 2008, the Company does not expect to reclassify any amountfrom OCI to earnings over the next twelve months and no hedge has beendiscontinued. Also, as of September 30, 2008 and December 31, 2007,the fair value of the derivative contract approximated $525,000 and $441,000and is recorded as a component of other assets in the consolidated balancesheet.

 

**5. Recent accountingpronouncements**

 

On January 1, 2008,the Company adopted SFAS 157, *Fair Value Measurements*.SFAS 157 defines fair value, establishes a framework for measuring fair valueand enhances disclosures about fair value measurements required under otheraccounting pronouncements, but does not change existing guidance as to whetheror not an instrument is carried at fair value. SFAS 157 establishes a valuationhierarchy for disclosure of the inputs used to measure fair value. Thishierarchy prioritizes the inputs into three broad levels as follows. Level 1inputs are quoted prices (unadjusted) in active markets for identical assets orliabilities. Level 2 inputs are quoted prices for similar assets andliabilities in active markets; quoted prices for identical or similar assets orliabilities in markets that are not active; or inputs that are observable forthe asset or liability, either directly or indirectly through marketcorroboration, for substantially the full term of the financial instrument.Level 3 inputs are unobservable inputs based on our own assumptions to measureassets and liabilities at fair value. Level 3 pricing for securities may alsoinclude unobservable inputs based upon broker-traded transactions. A financialasset or liability’s classification within the hierarchy is determined based onthe lowest level input that is significant to the fair value measurement. Theadoption of this statement had no effect on the Company’s financial statements.

 

In February 2008 theFinancial Accounting Standards Board (FASB) issued FASB Staff Position (FSP)157-2, *Effective Date of FASB Statement No. 157*,which delays the effective date of SFAS 157 to fiscal years beginning afterNovember 15, 2008 for non-financial assets and non-financial liabilitiesthat are not recognized or disclosed at fair value in the financial statementson a recurring basis. In October 2008, FASB issued FSP 157-3, *Determining the Fair Value of a Financial Asset When the Market forthat Asset is not Active*, which clarifies the application of FAS 157in a market that is not active and provides an example to illustrate keyconsiderations in determining the fair value of a financial asset when themarket for that financial asset is not active.

 

The initialimplementation of SFAS 157 for financial instruments did not have a materialimpact on the Company’s financial condition or results of operations. Thefinancial results for the third quarter of 2008 were impacted by the fair valuemeasurement for one preferred term security that resulted in the recognition ofan other-than-temporary impairment (OTTI). The market for the Company’sinvestment in preferred term securities continues to be inactive and thereforefair value is determined using the income approach, or the present value offuture cash flows. The fair values were based on an income approach utilizingmore complex models that applies discount rate adjustment technique, whichmaximizes the use of observable inputs and minimizes the use of unobservableadjustments. Inputs include yields for similar credit and investment graderatings of comparable instruments, with adjustments for liquidity premiums todetermine an appropriate risk adjusted discount rate for each issue. By usingthe income approach as described, the Company is able to determine a morerepresentative fair value for its preferred term securities as compared to amarket approach for the securities where pricing is unrealistic due to theinactivity. The Company’s investment in preferred term securities consists of13 pooled issues with each issue containing subordinated tiers collateralizedpredominately by multiple bank issuers. As of September 30, 2008, theCompany’s investment in corporate bonds consisted of preferred term securities,a component of securities AFS with a combined market value of $13,128,000, or$8,338,000 below their amortized cost basis of $21,466,000.

 

The following tableillustrates the financial instruments measured at fair value on a recurringbasis segregated by hierarchy fair value levels (dollars in thousands):

 
| ** **                     | ** ** | ** **                       | ** ** | **Fair value measurements at September 30, 2008 using:** | ** ** |
|--------------------------------|------------|----------------------------------|------------|---------------------------------------------------------------------------------------------|------------|
| ** **                     | ** ** | **Total carrying**          | ** ** | **Quoted prices**                                                                      | ** ** | **Significant other** | ** ** | **Significant** | ** ** |
| ** **                     | ** ** | **value at**                | ** ** | **in active markets**                                                             | ** ** | **observable inputs** | ** ** | **unobservable inputs** | ** ** |
| ** **                     | ** ** | **September 30, 2008** | ** ** | **(Level 1)**                                                                          | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| Assets:                        |       |                             |       |                                                                                        |       |   |   |   |   |
| Available-for-sale  securities |       | $                                | 86,234     |                                                                                        | $          | 462 |   | $ | 72,644 |   | $ | 13,128 |   |
| Loans  available-for-sale      |       | 632                              |       | —                                                                                      |       | 632 |   | — |   |
| Derivative  instrument         |       | 525                              |       | —                                                                                      |       | 525 |   | — |   |
| Total                          |       | $                                | 87,391     |                                                                                        | $          | 462 |   | $ | 73,801 |   | $ | 13,128 |   |

 

Equity securities in theavailable-for-sale securities portfolio are measured at fair value using quotedmarket prices for identical assets and are classified within Level 1of thevaluation hierarchy. Other than the Company’s investment in corporate bonds,all other debt securities in the available-for-sale securities portfolio aremeasured at fair value using quoted prices from an independent third party thatprovide valuation services for similar assets, with similar terms in activelytraded markets. The Company’s investment grade preferred term securities,classified under corporate bonds, include both observable and unobservableinputs to determine fair value as described above and, therefore, areconsidered Level 3 inputs. Once the market activity, including new issues,begins to occur, 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. Loansavailable-for-sale are measured at fair value from quotes received throughsecondary market sources, i.e., FNMA or FHLB, who provide pricing for similarassets with similar terms in actively traded markets. The derivativeinstrument, included in other assets, is measured at fair value from pricingprovided by a third party who considers observable interest rates, forwardyield curves at commonly quoted intervals and volatility.

 

The following tableillustrates the changes in Level 3 financial instruments measured at fair valueon a recurring basis for the periods indicated (dollars in thousands):

 

| ** **                                                                    | ** ** | **As of and for the** | ** ** | **As of and for the** | ** ** |
|-------------------------------------------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                    | ** ** | **three months ended**          | ** ** | **nine months ended**           | ** ** |
| ** **                                                                    | ** ** | **September 30, 2008**          | ** ** | **September 30, 2008**          | ** ** |
| Assets:                                                                       |       |                                      |       |                                      |       |
| Balance at  beginning of period                                               |       | $                                         | 16,866     |                                      | $          | 16,335 |   |
| Realized /  unrealized gains (losses):                                        |       |                                      |       |                                      |       |
| in earnings                                                                   |       | (397                                      | )          | (397                                      | )          |
| in comprehensive  income                                                      |       | (3,275                                    | )          | (7,142                                    | )          |
| Purchases,  sales, issuances and settlements, amortization and accretion, net |       | (66                                       | )          | 4,332                                     |       |
| Transfers into  (out of) Level 3                                              |       | —                                    |       | —                                    |       |
| Balance at end  of period                                                     |       | $                                         | 13,128     |                                      | $          | 13,128 |   |

 

The following tableillustrates the financial instruments measured at fair value on a nonrecurringbasis segregated by hierarchy fair value levels (dollars in thousands):

 
| ** **     | ** ** | ** **                       | ** ** | **Fair value measurements at September 30, 2008 using:** | ** ** |
|----------------|------------|----------------------------------|------------|---------------------------------------------------------------------------------------------|------------|
| ** **     | ** ** | **Total carrying**          | ** ** | **Quoted prices**                                                                      | ** ** | **Significant other** | ** ** | **Significant** | ** ** |
| ** **     | ** ** | **value at**                | ** ** | **in active markets**                                                             | ** ** | **observable inputs** | ** ** | **unobservable inputs** | ** ** |
| ** **     | ** ** | **September 30, 2008** | ** ** | **(Level 1)**                                                                          | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| Assets:        |       |                             |       |                                                                                        |       |   |   |   |   |
| Impaired loans |       | $                                | 1,652      |                                                                                        | $          | 15 |   | $ | 668 |   | $ | 969 |   |
|                |            |                                  |            |                                                                                             |            |  |  |  |  |  |  |  |  |

 

Impaired loans that arecollateral dependent are written down to fair value through the establishmentof specific reserves. Techniques used to value the collateral that secures theimpaired loan include: quoted market prices for identical assets classified asLevel 1 inputs; observable inputs, employed by certified appraisers, forsimilar assets classified as Level 2 inputs. In cases where valuationtechniques included inputs that are unobservable and are based on estimates andassumptions developed by management from the best information available undereach circumstance, the asset valuation is classified as Level 3 inputs.

 

On January 1, 2008, the Company adoptedSFAS No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilities*. SFAS 159 allowscompanies to elect to follow fair value accounting for certain financial assetsand liabilities in an effort to mitigate volatility in earnings without havingto apply complex hedge accounting provisions. The Company did not elect thefair value option for any of its financial instruments as of September 30,2008 and therefore the adoption of this statement had no effect on the Company’sfinancial statements.

 

In March 2008, the Financial AccountingStandards Board issued SFAS No. 161, *Disclosures aboutDerivative Instruments and Hedging Activities*. SFAS 161 amendsand expands the disclosure requirements of SFAS 133, *Accountingfor Derivative Instruments and Hedging Activities*. 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. This statement is effective for financialstatements issued for fiscal years beginning after November 15, 2008. TheCompany does not expect the adoption of this pronouncement to have a materialimpact 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 September 30, 2008compared to December 31, 2007 and the results of operations for the three-and nine- months ended September 30, 2008 and 2007. Current performancemay not be indicative of future results. This discussion should be read inconjunction with the Company’s 2007 Annual Report filed on Form 10-K.

 

**Forward-looking statements**

 

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

 

Forward-lookingstatements are based on various assumptions and analyses made by us in light ofmanagement’s experience and its perception of historical trends, currentconditions and expected future developments, as well as other factorsmanagement believes are appropriate under the circumstances. These statementsare not guarantees of future performance and are subject to risks,uncertainties and other factors (many of which are beyond our control) thatcould cause actual results to differ materially from future results expressedor implied by such forward-looking statements. These factors include, withoutlimitation, the following:

 

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

 

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

 

·                 changes in theinterest rate environment may reduce interest margins;

 

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

 

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

 

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

 

·                 legislative orregulatory changes may adversely affect our business;

 

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

 

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

 

·                 acts of war orterrorism; or

 

·                 natural disaster.

 

Management cautionsreaders not to place undue reliance on forward-looking statements, which reflectanalyses only as of the date of this document. We have no obligation to updateany forward-looking statements to reflect events or circumstances after thedate of this document.

 

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

 

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**General**

 

The Company’s principalrevenues are derived from interest, dividends and fees earned on itsinterest-earning assets, which are comprised of loans, securities and othershort-term investments. The Company’s principal expenses consist of interestpaid on its interest-bearing liabilities, which are comprised of deposits,short- and long-term borrowings and operating and general expenses. The Company’sprofitability depends primarily on its net interest income. Net interest incomeis the difference between interest income and interest expense. Interest incomeis generated from yields on interest-earning assets which consist principallyof loans and investment securities. Interest expense is incurred from ratespaid on interest-bearing liabilities, which consist of deposits and borrowings.Net interest income is dependent upon the interest-rate spread (i.e., thedifference between the yields earned on its interest-earning assets and therates paid on its interest-bearing liabilities) and the relative amounts ofinterest-earning assets and interest-bearing liabilities. The interest ratespread is significantly impacted by: changes in interest rates and market yieldcurves and their related impact on cash flows; the composition andcharacteristics of interest-earning assets and interest-bearing liabilities;differences in the maturity and re-pricing characteristics of assets comparedto the maturity and re-pricing characteristics of the liabilities that fundthem and by the competition 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-interestincome consists of service charges on the Bank’s loan and deposit products,trust and asset management service fees, increases in the cash surrender valueof the bank owned life insurance (BOLI), net gains or losses from sales ofloans and securities AFS, sales of other real estate (ORE) properties and fromOTTI charges for investment securities. Non-interest expense consists ofcompensation and related employee benefit expenses, occupancy, equipment, dataprocessing, advertising, marketing, professional fees, insurance and otheroperating overhead.

 

The Company’sprofitability is significantly affected by general economic and competitiveconditions, changes in market interest rates, government policies and actionsof regulatory authorities. The Company’s loan portfolio is comprisedprincipally of commercial and commercial real estate loans. The propertiesunderlying the Company’s mortgages are concentrated in NortheasternPennsylvania. Credit risk, which represents the possibility of the Company notrecovering amounts due from its borrowers, is significantly related to localeconomic conditions in the areas the properties are located as well as theCompany’s underwriting standards. Economic conditions affect the market valueof the underlying collateral as well as the levels of adequate cash flow andrevenue generation from income-producing commercial properties.

 

**COMPARISONOF RESULTS OF OPERATIONS**

**THREE ANDNINE MONTHS ENDED SEPTEMBER 30, 2008 AND 2007**

 

**Overview**

 

Net income for the thirdquarter of 2008 was $741,000 compared to $1,178,000 recorded in the samequarter of 2007. Diluted earnings per share was $0.35 and $0.57 for each of therespective periods. For the nine months ended September 30, 2008, netincome was $3,034,000, or $1.46 per share compared to $3,381,000, or $1.64 pershare for the nine months ended September 30, 2007. The decline in netincome for both the quarter and nine months ended September 30, 2008 wasprincipally the result of provisions for loan losses recorded in the 2008 periodscompared to credits for loan losses in 2007, an increase in other expenses anda decrease in non-interest income. Net interest income improved 10% for boththe three and nine months ended September 30, 2008 compared to the sameperiods in 2007. For the quarter and nine months ended September 30, 2008,non-interest income included a non-cash OTTI charge in the amount of $403,000related to the Company’s investment portfolio. The Company’s investmentportfolio includes a pooled preferred term security and an equity position inFNMA common stock, whose market values declined by $397,000 and $6,000,respectively, below their cost basis and based on analyses, management hasdeemed both declines in market value to be other-than-temporary.

 

Excluding the OTTI charge,in non-interest income, net income would have been $1,007,000, or $0.48 perfully diluted share and $3,300,000, or $1.59 per fully diluted share of thequarter and nine months ended September 30, 2008, respectively. Thefollowing table reconciles net income as reported to pro forma net operatingincome for the periods indicated:

 
| ** **                      | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|---------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                      | ** ** | **September 30, 2008** | ** ** |
| ** **                      | ** ** | **Amount**                       | ** ** | **Per share**              | ** ** | **Amount** | ** ** | **Per share** | ** ** |
|                            |       |                             |       |                            |       |   |   |   |   |
| Net income, as reported         |       | $                                | 741,115    |                            | $          | 0.35 |   | $ | 3,034,008 |   | $ | 1.46 |   |
| Other-than-temporary impairment |       | 403,031                          |       | 0.20                            |       | 403,031 |   | 0.20 |   |
| Tax effect                      |       | (137,031                         | )          | (0.07                           | )          | (137,031 | ) | (0.07 | ) |
| Net operating earnings          |       | $                                | 1,007,115  |                            | $          | 0.48 |   | $ | 3,300,008 |   | $ | 1.59 |   |

 

Return on average assets(ROA) and return on average shareholders’ equity (ROE) were 0.50% and 5.63%,respectively, for the three months ended September 30, 2008 compared to0.81% and 8.80% for the respective period in 2007. For the nine months endedSeptember 30, 2008 and 2007, ROA and ROE were 0.69% and 7.42%, compared to0.79% and 8.57%, respectively. The decline in both ROA and ROE for the quarterand nine months ended September 30, 2008 was due to lower levels of netincome. Excluding the aforementioned OTTI charge, ROA and ROE would have been0.69% and 7.65% for the three months ended September 30, 2008 and 0.75%and 8.07% for the nine months ended September 30, 2008.

 

*Net interest income and interestsensitive assets / liabilities*

 

For the three monthsended September 30, 2008, net interest income increased $457,000, or 10%,to $4,879,000 from $4,422,000 for the three months ended September 30,2007 and increased $1,320,000, or 10%, to $14,369,000 for the nine months endedSeptember 30, 2008 from $13,049,000 for the nine months ended September 30,2007. The tax-equivalent net interest margin increased to 3.62% for the threemonths ended September 30, 2008 from 3.31% for the three months endedSeptember 30, 2007 and increased to 3.57% for the nine months endedSeptember 30, 2008 from 3.34% for the nine months ended September 30,2007. The net interest rate spread increased to 3.10% for the three monthsended September 30, 2008 from 2.60% for the three months endedSeptember 30, 2007 and increased to 3.01% for the nine months ended September 30,2008 from 2.62% for the nine months ended September 30, 2007. The averagebalance of net interest-earning assets increased $5,749,000 to $552,007,000 forthe three months ended September 30, 2008 from $546,258,000 for the threemonths ended September 30, 2007 and increased $14,743,000 to $553,408,000million for the nine months ended September 30, 2008 from $538,665,000 forthe nine months ended September 30, 2007.

 

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The increases in netinterest income, the net interest margin and the net interest rate spread forthe three and nine months ended September 30, 2008, compared to the threeand nine months ended September 30, 2007, were primarily due to decreasesin interest expense, partially offset by decreases in interest income for eachof the comparative periods. The decrease in interest expense for the three andnine months ended September 30, 2008, compared to the three and ninemonths ended September 30, 2007 was primarily due to decreases in theaverage rates paid on interest bearing-liabilities partially offset byincreases in the average balances of interest-bearing liabilities. Thedecreases in interest income for the three and nine months endedSeptember 30, 2008 compared to the three and nine months endedSeptember 30, 2007 were primarily due to decreases in the average yieldson interest-earning assets.

 

Interest income declined$473,000, or 5%, to $8,419,000 for the three months ended September 30,2008, from $8,892,000 for the three months ended September 30, 2007primarily due to a decrease in the average yield on interest-earning assets to6.17% for the three months ended September 30, 2008 from 6.56% for thethree months ended September 30, 2007. The decrease in the average yieldon interest-earning assets was primarily the result of decreases in the averagevolume of mortgage loans plus the average yield in the commercial loanportfolio. The increase in the average balance of interest-earning assets wasprimarily due to an increase in the average balance of investments.

 

For the nine months endedSeptember 30, 2008, interest income decreased $431,000, or 2%, to$25,777,000 from $26,208,000 for the nine months ended September 30, 2007primarily due to a decrease in the average yield on interest-earning assets to6.32% for the nine months ended September 30, 2008 from 6.60% for the ninemonths ended September 30, 2007, partially offset by the $14,743,000increase in the average balance of interest-earning assets. The increase in theaverage balance of interest-earning assets was primarily due to increases inthe average balances of total investments and federal funds sold, partiallyoffset by a decrease in the loan and lease portfolio caused by the sale ofresidential mortgage loans during the first quarter of 2008.

 

Interest expensedecreased $930,000, or 21%, to $3,540,000 for the three months endedSeptember 30, 2008 from $4,470,000 for the three months ended September 30,2007 primarily due to a decrease in the average cost of interest-bearingliabilities to 3.07% from 3.96% for the comparative periods due to the decreasein the average costs on transactional deposits. The average balance ofinterest-bearing liabilities increased $10,227,000 for the three months endedSeptember 30, 2008 compared to the three months ended September 30,2007 primarily from an increase in the average balance of short-term overnightborrowings.

 

For the nine months endedSeptember 30, 2008, interest expense decreased $1,751,000, or 13%, to$11,408,000 from $13,159,000 for the nine months ended September 30, 2007primarily due to a decrease in the average cost of interest-bearing liabilitiesto 3.31% from 3.98% for the comparative periods due to decreases in the averagecost of deposits. During the same period, average interest-bearing depositsincreased $20,315,000 partially offsetting the effect of the decline ininterest costs for the nine months ended September 30, 2008 compared tothe nine months ended September 30, 2007.

 

The national economycontinues to border on, if not already having entered into, a recession and thehousing and real estate markets continue to decline. The current operatingenvironment is the result of the significant disruption and volatility in thefinancial and capital market places which began in the second half of 2007 andcontinues today. Due to concerns over the economy, the Federal Open MarketCommittee (FOMC) reduced the federal funds rate by 100 basis points during thesecond half of 2007 and by 225 basis points during the first nine months of2008. These actions have resulted in a more positively sloped yield curve aswell as volatility in mortgage loan interest rates, in which a reduction mayaccelerate prepayments and refinancing to lower rates. The national prime rate,the benchmark rate banks use to set rates on various lending and other interestsensitive financial instruments, has been reduced by similar amounts during thesame periods. Generally, this situation causes floating rate assets to re-priceat lower yields, and also causes fixed-rate assets to originate at yields lowerthan the yields earned in the prior comparable period, thereby reducinginterest income. To help mitigate this effect, in 2008the Company sold$28,100,000 of low yielding mortgage loans and used the proceeds to initiallypurchase investment securities, fund commercial loan growth, reduce overnightborrowings and help fund the Company’s branch office expansion project. Duringthe third quarter of 2008, the company sold approximately $35,000,000 ininvestment securities and used the proceeds to further reduce debt and fundloan growth. The Company’s Asset Liability Management team meets regularly todiscuss interest rate risk and if necessary adjust interest rates on depositsin response to rate movements that stem from the FOMC so that net interestincome is not disproportionately impacted during volatile rate environments.This proactive attention to interest rate risk in conjunction with our interestrate hedging strategy, as described in Note No. 4, “Derivativeinstruments,” within the notes to the consolidated financial statements inPart I, Item 1, should continue to help contain the Company’s net interestincome at acceptable levels.

 

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

 

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| ** **                                     | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** | **Year ended**   | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** | **December 31,** | ** ** |
| ** **                                     | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008**              | ** ** | **2007** | ** ** | **2007** | ** ** |
| Average  interest-earning assets:              |       |                             |       |                            |       |                  |       |   |   |   |   |
| Loans and leases                               |       | $                                | 426,002    |                            | $          | 425,502               |       | $ | 414,809 |   | $ | 423,811 |   | $ | 424,781 |   |
| Investments                                    |       | 125,901                          |       | 116,969                         |       | 134,010               |       | 112,063 |   | 116,217 |   |
| Federal funds  sold                            |       | —                           |       | 3,626                           |       | 4,465                 |       | 2,604 |   | 1,948 |   |
| Interest-bearing  deposits                     |       | 104                              |       | 161                             |       | 124                   |       | 187 |   | 184 |   |
| Total                                          |       | $                                | 552,007    |                            | $          | 546,258               |       | $ | 553,408 |   | $ | 538,665 |   | $ | 543,130 |   |
|                                           |       |                             |       |                            |       |                  |       |   |   |   |   |
| Average  interest-bearing liabilities:         |       |                             |       |                            |       |                  |       |   |   |   |   |
| Other  interest-bearing deposits               |       | $                                | 191,697    |                            | $          | 191,526               |       | $ | 193,508 |   | $ | 196,036 |   | $ | 194,452 |   |
| Certificates of  deposit                       |       | 168,730                          |       | 167,815                         |       | 179,712               |       | 156,869 |   | 161,418 |   |
| Borrowed funds                                 |       | 86,778                           |       | 67,392                          |       | 75,498                |       | 70,552 |   | 71,573 |   |
| Repurchase  agreements                         |       | 10,907                           |       | 21,152                          |       | 12,166                |       | 19,132 |   | 19,580 |   |
| Total                                          |       | $                                | 458,112    |                            | $          | 447,885               |       | $ | 460,884 |   | $ | 442,589 |   | $ | 447,023 |   |
|                                           |       |                             |       |                            |       |                  |       |   |   |   |   |
| Interest income  (FTE):                        |       |                             |       |                            |       |                  |       |   |   |   |   |
| Loans and leases                               |       | $                                | 6,953      |                            | $          | 7,409                 |       | $ | 20,785 |   | $ | 22,071 |   | $ | 29,477 |   |
| Investments                                    |       | 1,611                            |       | 1,568                           |       | 5,301                 |       | 4,424 |   | 6,219 |   |
| Federal funds  sold                            |       | —                           |       | 48                              |       | 91                    |       | 103 |   | 103 |   |
| Interest-bearing  deposits                     |       | 1                                |       | 2                               |       | 2                     |       | 7 |   | 9 |   |
| Total                                          |       | $                                | 8,565      |                            | $          | 9,027                 |       | $ | 26,179 |   | $ | 26,605 |   | $ | 35,808 |   |
|                                           |       |                             |       |                            |       |                  |       |   |   |   |   |
| Interest  expense:                             |       |                             |       |                            |       |                  |       |   |   |   |   |
| Other  interest-bearing deposits               |       | $                                | 799        |                            | $          | 1,468                 |       | $ | 2,746 |   | $ | 4,652 |   | $ | 6,029 |   |
| Certificates of  deposit                       |       | 1,800                            |       | 1,953                           |       | 5,918                 |       | 5,325 |   | 7,341 |   |
| Borrowed funds                                 |       | 930                              |       | 925                             |       | 2,652                 |       | 2,827 |   | 3,825 |   |
| Repurchase  agreements                         |       | 11                               |       | 124                             |       | 92                    |       | 355 |   | 465 |   |
| Total                                          |       | $                                | 3,540      |                            | $          | 4,470                 |       | $ | 11,408 |   | $ | 13,159 |   | $ | 17,660 |   |
|                                           |       |                             |       |                            |       |                  |       |   |   |   |   |
| Net interest  income (FTE)                     |       | $                                | 5,025      |                            | $          | 4,557                 |       | $ | 14,771 |   | $ | 13,446 |   | $ | 18,148 |   |
|                                           |       |                             |       |                            |       |                  |       |   |   |   |   |
| Yield on average  interest-earning assets      |       |                             |       |                            |       |                  |       |   |   |   |   |
| Loans and leases                               |       | 6.49                             | %          | 6.91                            | %          | 6.69                  | %          | 6.96 | % | 6.94 | % |
| Investments                                    |       | 5.09                             | %          | 5.32                            | %          | 5.28                  | %          | 5.28 | % | 5.35 | % |
| Federal funds  sold                            |       | —                           |       | 5.28                            | %          | 2.73                  | %          | 5.28 | % | 5.28 | % |
| Interest-bearing  deposits                     |       | 2.33                             | %          | 5.39                            | %          | 2.59                  | %          | 4.93 | % | 4.81 | % |
| Total                                          |       | 6.17                             | %          | 6.56                            | %          | 6.32                  | %          | 6.60 | % | 6.59 | % |
|                                           |       |                             |       |                            |       |                  |       |   |   |   |   |
| Rates on average  interest-bearing liabilities |       |                             |       |                            |       |                  |       |   |   |   |   |
| Other  interest-bearing deposits               |       | 1.66                             | %          | 3.04                            | %          | 1.90                  | %          | 3.17 | % | 3.10 | % |
| Certificates of  deposit                       |       | 4.24                             | %          | 4.62                            | %          | 4.40                  | %          | 4.54 | % | 4.55 | % |
| Borrowed funds                                 |       | 4.26                             | %          | 5.45                            | %          | 4.69                  | %          | 5.36 | % | 5.34 | % |
| Repurchase  agreements                         |       | 0.42                             | %          | 2.33                            | %          | 1.01                  | %          | 2.48 | % | 2.38 | % |
| Total                                          |       | 3.07                             | %          | 3.96                            | %          | 3.31                  | %          | 3.98 | % | 3.95 | % |
|                                           |       |                             |       |                            |       |                  |       |   |   |   |   |
| Net interest  spread                           |       | 3.10                             | %          | 2.60                            | %          | 3.01                  | %          | 2.62 | % | 2.64 | % |
| Net interest  margin                           |       | 3.62                             | %          | 3.31                            | %          | 3.57                  | %          | 3.34 | % | 3.34 | % |

 

In the table above, interest income was adjusted to atax-equivalent basis to recognize the income from the various tax-exempt assetsas if the interest was fully taxable. This treatment allows a uniformcomparison among the yields on interest-earning assets. The calculations werecomputed on a fully tax-equivalent basis using the corporate federal tax rateof 34%. Net interest spread represents the difference between the yield oninterest-earning assets and the rate on interest-bearing liabilities. Netinterest margin represents the ratio of net interest income to total averageinterest-earning assets.

 

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*Provision for loan losses*

 

The provision for loanlosses represents the necessary amount to charge against current earnings, thepurpose of which is to increase the allowance for loan losses to a level thatrepresents management’s best estimate of known and inherent losses in theCompany’s loan portfolio. Loans and leases determined to be uncollectible arecharged-off against the allowance for loan losses. The required amount of theprovision for loan losses, based upon the adequate level of the allowance forloan losses, is subject to ongoing analysis of the loan portfolio. The Bank’sSpecial Asset Committee meets periodically to review problem loans and leases.The committee is comprised of Bank management, including the chief riskofficer, loan workout officers and collection personnel. 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 factorsused to evaluate the adequacy of the loan loss provision during the formalprocess include:

 

· specific loansthat could have loss potential;

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

· levels of andtrends in charge-offs and recoveries;

· trends in volumeand terms of loans;

· changes in riskselection and underwriting standards;

· changes in lendingpolicies, procedures and practices;

· experience,ability and depth of lending management;

· national and localeconomic trends and conditions; and

· changes in creditconcentrations.

 

Provisions for loanlosses amounting to $130,000 were recorded in the third quarter of 2008,compared to a $60,000 credit for loan losses during the like period of 2007.The provision for loan losses increased as a result of new loan growth,particularly commercial and residential mortgage loans. Provisions for loanlosses totaled $255,000 in the nine months ended September 30, 2008,compared to a $60,000 credit for loan losses during the same period in 2007.After taking into account the provisions, charge-offs and recoveries, theallowance for loan losses was $4,206,000 at September 30, 2008 as comparedto $4,824,000 as of December 31, 2007 and $4,991,000 as ofSeptember 30, 2007. Lower non-accrual loans and a reduced level ofcriticized and classified loans resulted in a lower calculated level for the allowancefor loan losses at September 30, 2008. The level of the allowance has beendeemed adequate to absorb the known and inherent losses in the loan portfolioat September 30, 2008. For a further discussion on the allowance for loanlosses and non-accrual loans, see “Comparison of Financial Condition atSeptember 30, 2008 and December 31, 2007,” below.

 

*Other income*

 

In the third quarter of2008, other (non-interest) income declined $465,000, or 35%, to $844,000 from$1,309,000 recorded in third quarter of 2007. During the current year quarter,a non-cash OTTI charge of $403,000 was recorded. The OTTI charge is related tothe Company’s investment in a pooled preferred term security and a commonequity position in FNMA. The carrying values of these securities were writtendown to their fair market value as of September 30, 2008 as management hasdeemed the impairment to be other-than-temporary. There was no similar chargeduring 2007. Service charges from deposit accounts declined $69,000, or 9%, dueto a lower volume of overdraft charges. Also, during the third quarter of 2008,the Company disposed of unused or obsolete premises and equipment, andrecognized a loss of $35,000 compared to a minor gain recorded in the samequarter of 2007. Partially offsetting these losses were increases in gainsrecognized from the sales of loan and securities AFS and from the sales offoreclosed properties.

 

For the nine months endedSeptember 30, 2008, other income declined $446,000, or 12%, compared tothe nine months ended September 30, 2007. The decline was mostly from theaforementioned current year OTTI charge and from large non-recurring gains of$218,000 recorded in 2007 from the sale of a foreclosed property and from thesale of a commercial building that the Company previously leased to anunrelated third party. These items were partially offset by growth in depositservice charges, other fees, and more gains from the sales of mortgages AFS.

 

*Other operating expenses*

 

For the quarter and ninemonths ended September 30, 2008, other (non-interest) expenses increased$483,000, or 12%, and $1,120,000, or 9%, respectively, compared to the same2007 periods. The most significant impact for both periods was caused byincreased salary and employee benefit costs and the incremental costsassociated with the opening of the Company’s newest branch office in WestScranton, Pennsylvania (West Scranton). Salary and employee benefits rose$273,000, or 12%, in the quarter-to-quarter comparison and $863,000, or 13%, inthe year-to-date comparison. The increase was due to payroll increases, anincrease in the number of full-time equivalent employees, higher stock-basedcompensation expense, more employee-related insurance costs and widerparticipation in the Company’s 401(k) plan. The increase in advertisingcosts was due to the branch office expansion project in West Scranton. Theother category of operating expenses was up for the quarter and year-to-dateperiods due to higher collection expenses associated with legal and foreclosurefees, the timing of charitable donations and normal increases in otheroperational expenses including incremental operating expenses from the newbranch office.

 

*Provision for income taxes*

 

The provision for incometaxes for the three and nine months ended September 30, 2008 was lowercompared to the same periods in 2007 primarily from lower pretax income.

 

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**COMPARISONOF FINANCIAL CONDITION AT**

**SEPTEMBER30, 2008 AND DECEMBER 31, 2007**

 

*Overview*

 

Consolidated assetsdeclined $17,869,000, or 3%, during the nine months ended September 30,2008. The decline was caused by a $22,570,000, or 57%, reduction in short-termborrowings, a decline of $4,573,000 or 8%, in shareholders’ equity, partiallyoffset by a $9,723,000, or 2%, increase in deposits. The decline inshareholders’ equity was caused by increased levels of unrealized losses in thesecurities AFS portfolio. The reduction in short-term borrowings was fromexecuting the Company’s de-levering strategy that used the proceeds from thesale of mortgage-backed investment securities to reduce its dependence onovernight funding sources as well as to help fund growth in the commercial loanportfolio and provide funding for our newly opened branch office.

 

*Investment securities*

 

At the time of purchase,management classifies investment securities into one of three categories:trading, AFS or held-to- maturity (HTM). To date, management has not purchasedany securities for trading purposes. Most of the securities purchased areclassified as AFS even though there is no immediate intent to sell them. TheAFS designation affords management the flexibility to sell securities and positionthe balance sheet in response to capital levels, liquidity needs or changes inmarket conditions. Securities AFS are carried at net fair value in theconsolidated balance sheet with an adjustment to shareholders’ equity, net oftax, 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.

 

As of September 30,2008, the carrying value of investment securities totaled $87,180,000, or 15%of total assets, compared to $122,984,000, or 21% of total assets, atDecember 31, 2007. At September 30, 2008, approximately 14% of thecarrying value of the investment portfolio was comprised of mortgage-backedsecurities that amortize and provide monthly cash flow. Agency, corporate andmunicipal bonds comprised 52%, 15% and 18%, respectively, of the investmentportfolio at September 30, 2008.

 

During the nine monthsended September 30, 2008, total investments decreased $35,805,000, net ofa $9,026,000 decline in the market value of AFS investments. The decrease inthe investment portfolio was mainly from the sales of approximately $48.5million of mortgage-backed and agency securities, of which $35 million occurredin the third quarter of 2008, the proceeds of which were used to reduce theCompany’s exposure to overnight funding, help fund growth in the commercialloan portfolio as well as to fund the expansion of the Company’s branchnetwork. The amortized cost and fair market value of investment securities iscomprised of HTM and AFS securities with carrying values of $946,000 and$86,234,000, respectively. As of September 30, 2008, the AFS debtsecurities were recorded with a net unrealized loss in the amount of$10,653,000 and equity securities were recorded with an unrealized gain of$140,000.

 

 

A comparison ofinvestment securities at September 30, 2008 and December 31, 2007 isas follows (dollars in thousands):

 
| ** **                          | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|-------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                          | ** ** | **Amount**                       | ** ** | **%**                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| U.S. government  agencies           |       | $                                | 45,418     |                            | 52.1       |   | $ | 35,244 |   | 28.6 |   |
| Mortgage-backed  securities         |       | 12,381                           |       | 14.2                            |       | 58,767 |   | 47.8 |   |
| State &  municipal subdivisions |       | 15,791                           |       | 18.1                            |       | 12,133 |   | 9.9 |   |
| Preferred term  securities          |       | 13,128                           |       | 15.1                            |       | 16,335 |   | 13.3 |   |
| Equity  securities                  |       | 462                              |       | 0.5                             |       | 505 |   | 0.4 |   |
| Total  investments                  |       | $                                | 87,180     |                            | 100.0      |   | $ | 122,984 |   | 100.0 |   |

 

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The amortized cost andfair value of investments at September 30, 2008 are as follows (dollars inthousands):

 
| ** **                                        | ** ** | **Amortized** | ** ** | **Gross unrealized** | ** ** | **Gross unrealized** | ** ** | **Fair**  | ** ** |
|---------------------------------------------------|------------|---------------|------------|---------------------------|------------|---------------------------|------------|-----------|------------|
| ** **                                        | ** ** | **cost**      | ** ** | **gains**                 | ** ** | **losses**                | ** ** | **value** | ** ** |
|                                              |       |          |       |                      |       |                      |       |      |       |
| Held-to-maturity  securities:                     |       |          |       |                      |       |                      |       |      |       |
| Mortgage-backed  securities                       |       | $             | 946        |                      | $          | 31                        |       | $         | —     |   | $ | 977 |   |
|                                              |       |          |       |                      |       |                      |       |      |       |
| Available-for-sale  securities:                   |       |          |       |                      |       |                      |       |      |       |
| U.S. government  agencies and corporations        |       | $             | 46,749     |                      | $          | 57                        |       | $         | 1,388      |   | $ | 45,418 |   |
| Obligations of  states and political subdivisions |       | 16,875        |       | 28                        |       | 1,112                     |       | 15,791    |       |
| Corporate bonds                                   |       | 21,466        |       | —                    |       | 8,338                     |       | 13,128    |       |
| Mortgage-backed  securities                       |       | 11,335        |       | 100                       |       | —                    |       | 11,435    |       |
|                                              |       |          |       |                      |       |                      |       |      |       |
| Total debt  securities                            |       | 96,425        |       | 185                       |       | 10,838                    |       | 85,772    |       |
|                                              |       |          |       |                      |       |                      |       |      |       |
| Equity  securities                                |       | 322           |       | 151                       |       | 11                        |       | 462       |       |
|                                              |       |          |       |                      |       |                      |       |      |       |
| Total  available-for-sale                         |       | $             | 96,747     |                      | $          | 336                       |       | $         | 10,849     |   | $ | 86,234 |   |

 

The amortized cost andfair value of debt securities at September 30, 2008 by contractualmaturity are as follows (dollars in thousands):

 
|                                      |       |          |       |       |       |       |       |       |       |   |   |   |   |
|-------------------------------------------|------------|---------------|------------|------------|------------|------------|------------|------------|------------|--------|--------|--------|--------|
| ** **                                | ** ** | **Amortized** | ** ** | **Market** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                | ** ** | **cost**      | ** ** | **value**  | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                      |       |          |       |       |       |       |       |       |       |
| Held-to-maturity  securities:             |       |          |       |       |       |       |       |       |       |
| Mortgage-backed  securities               |       | $             | 946        |       | $          | 977        |       |       |       |   |   |
|                                      |       |          |       |       |       |       |       |       |       |
| Available-for-sale  securities:           |       |          |       |       |       |       |       |       |       |
| Debt securities:                          |       |          |       |       |       |       |       |       |       |
| Due in one year  or less                  |       | $             | —     |       | $          | —     |       |       |       |   |   |
| Due after one  year through five years    |       | —        |       | —     |       |       |       |       |       |
| Due after five  years through ten years   |       | 8,916         |       | 8,899      |       |       |       |       |       |
| Due after ten  years                      |       | 76,174        |       | 65,438     |       |       |       |       |       |
| Total debt  securities                    |       | 85,090        |       | 74,337     |       |       |       |       |       |
|                                      |       |          |       |       |       |       |       |       |       |
| Mortgage-backed  securities               |       | 11,335        |       | 11,435     |       |       |       |       |       |
|                                      |       |          |       |       |       |       |       |       |       |
| Total  available-for-sale debt securities |       | $             | 96,425     |       | $          | 85,772     |       |       |       |   |   |

 

Expected maturities willdiffer from contractual maturities because issuers and borrowers may have theright to call or repay obligations with or without call or prepayment penalty.Federal agency and municipal securities are included based on their originalstated maturity. Mortgage-backed securities, which are based onweighted-average lives and subject to monthly principal pay-downs, are listedin total.

 

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Management performs areview of the investment portfolio quarterly to determine the cause of declinesin the fair value of each security, if any. The Company uses inputs provided byan independent third party to determine the fair values of its investment securitiesportfolio. Inputs provided by the third party are reviewed and corroborated bymanagement. Evaluations of the causes of the unrealized losses are performed todetermine whether impairment, if any, is temporary or other-than-temporary.Considerations such as the Company’s intent and ability to hold the securitiesto maturity, recoverability of the invested amounts over the intended holdingperiod, severity in pricing decline, the interest rate environment, receipts ofamounts contractually due and whether or not there is an active market for thesecurity, for example, are applied in determining whether a security isother-than-temporarily impaired. If a decline in value is deemed to beother-than-temporary, the value of the security is reduced by the impairmentamount and a corresponding charge to earnings is recognized. The impairmentcharge may be fully or partially recovered in the future, at the time of sale,call or maturity at a value that is equal to or greater than the security’s parvalue.

 

During the nine months of2008, uncertainty in the financial markets increased the volatility in fairvalue estimates for the securities in our investment portfolio. Compared toyear-end 2007, the fair values of securities have declined. Management believesthese changes were due mainly to liquidity problems in the financial markets,not deterioration in the creditworthiness of the issuers.

 

At September 30,2008, the securities with the most significant reductions in fair value andassociated estimated unrealized losses were in the Company’s corporate bondportfolio consisting of bank preferred term securities. Preferred termsecurities are pools of securities issued by regional and community banks,insurance companies and other financial institutions.

 

Over the course of thefirst nine months of 2008, the market for preferred term securities becameincreasingly illiquid due to negative perceptions about the health of thefinancial sector in general, the financial stability of the underlying issuersand the resulting lack of market participants, thereby reducing tradingactivity. This environment made it difficult to determine a fair value forthese securities as of September 30, 2008, and likewise difficult todetermine whether or not any of the issues had become other-than-temporarilyimpaired.

 

Based upon the testsperformed on our portfolio of preferred term securities, one issue did notprovide sufficient collateral to eliminate doubt as to the possibility forfuture credit loss and likewise produced an adverse change in estimated cashflows from the previous testing date. Having failed both the collateralsufficiency and cash flow tests and thereby increasing the likelihood of theCompany possibly not collecting full principal and interest due, the securityhas been deemed to be other-than-temporarily impaired and has been written downto its fair market value with a corresponding charge to current periodearnings.

 

Except for preferred termsecurities, market values on the other investment securities are determined byprices provided by a third-party vendor, who is a provider of financial marketdata, analytics and related services to financial institutions. For thepreferred term securities portfolio, management was unable to obtain readilyattainable and realistic pricing from market traders due to lack of activemarket participants and therefore management has determined that the market forthese securities is currently inactive. The fair values were based on an incomeapproach utilizing more complex models that applies discount rate adjustmenttechnique, which maximizes the use of observable inputs and minimizes the useof unobservable adjustments. Inputs include yields for similar credit andinvestment grade ratings of comparable instruments, with adjustments forliquidity premiums to determine an appropriate risk adjusted discount rate foreach issue. Based on this technique, the Company determined that as ofSeptember 30, 2008, the fair value of its impaired preferred term securityhad declined $397,000 below its cost basis and accordingly this amount has beenrecorded as an impairment charge and is included as a component of other incomein the consolidated income statements for the three and nine months endedSeptember 30, 2008. The market value of the Company’s investment inpreferred term securities has declined by $7,142,000 since December 31,2007. The Company intends to closely monitor the preferred term securitiesmarket and perform collateral sufficiency and cash flow analyses on at least aquarterly basis. Future analyses could yield results that may indicate furtherimpairment has occurred and therefore require additional write-downs andcorresponding other-than-temporary charges to current earnings. In addition tothe impairment charge on the preferred term securities portfolio, the Companyhad an equity position in FNMA common stock whose fair value declined below itscost basis by $6,000 and has also been deemed to be other-than-temporarilyimpaired and written down as of September 30, 2008.

 

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At September 30,2008, the AFS debt securities portfolio was carried at a net unrealized loss of$10,653,000 compared to a net unrealized loss of $1,663,000 atDecember 31, 2007. Management believes the cause of the unrealized lossesis related to changes in interest rates or the limited trading activity due torecent debt market illiquid conditions and is not directly related to creditquality, which is consistent with its past experience. In addition, the Companyhas the ability and intent to hold its investments for a period of timesufficient for the fair value of the securities to recover, which may be at maturity.

 

*Loans available-for-sale (AFS)*

 

Generally, uponorigination, certain residential mortgages are classified as AFS. In the eventof market rate increases, fixed-rate loans and loans not immediately scheduledto re-price would no longer produce yields consistent with the current market.In a declining interest rate environment, the Company would be exposed toprepayment risk and, as rates decrease, interest income would be negativelyaffected. Consideration is given to the Company’s current liquidity positionand projected future liquidity needs. To better manage prepayment and interestrate risk, loans that meet these conditions may be classified as AFS. Thecarrying value of loans AFS is at the lower of cost or estimated fair value. Ifthe fair values of these loans fall below their original cost, the differenceis written down and charged to current earnings. Subsequent appreciation in theportfolio is credited to current earnings but only to the extent of previouswrite-downs.

 

Loans AFS atSeptember 30, 2008 amounted to $632,000 with a corresponding fair value of$643,000, compared to $827,000 and $843,000, respectively, at December 31,2007. During the nine months ended September 30, 2008, residentialmortgages with principal balances of $42,471,000 were sold into the secondarymarket with net gains of approximately $216,000 recognized. Included in thesale was $28,100,000 of residential loans transferred from the loan and leaseportfolio.

 

*Loans and leases*

 

The Company originatescommercial and industrial (commercial) and commercial real estate (CRE) loans,residential mortgages, consumer, home equity and construction loans. Therelative volume of originations is dependent upon customer demand, currentinterest rates and the perception and duration of future interest levels. Thebroad spectrum of products provides diversification that helps manage, to anextent, interest rate and credit concentration risk. Credit risk is furthermanaged through underwriting policies and procedures and loan monitoring practices.Interest rate risk is managed using various asset/liability modeling techniquesand analyses. The interest rates on most commercial loans are adjustable withreset intervals of five years or less.

 

The majority of theCompany’s loan portfolio is collateralized, at least in part, by real estate inLackawanna and Luzerne Counties of Pennsylvania. Commercial lending activitiesgenerally involve a greater degree of credit risk than consumer lending becausethey typically have larger balances and are more affected by adverse conditionsin the economy. Because payments on commercial loans depend upon the successfuloperation and management of the properties and the businesses which operatefrom within them, repayment of such loans may be affected by factors outsidethe borrower’s control. Such factors may include adverse conditions in the realestate market, the economy, the industry or changes in government regulations.As such, commercial loans require more ongoing evaluation and monitoring whichoccurs with the Bank’s credit administration and outsourced loan reviewfunctions.

 

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The composition of theloan portfolio at September 30, 2008 and December 31, 2007, issummarized as follows (dollars in thousands):

 
| ** **                 | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|----------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                 | ** ** | **Amount**                       | ** ** | **%**                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| Commercial and  CRE        |       | $                                | 237,363    |                            | 55.1       |   | $ | 216,058 |   | 50.7 |   |
| Residential real  estate   |       | 97,877                           |       | 22.7                            |       | 116,978 |   | 27.5 |   |
| Consumer                   |       | 84,615                           |       | 19.7                            |       | 81,998 |   | 19.2 |   |
| Real estate  construction  |       | 10,345                           |       | 2.4                             |       | 10,703 |   | 2.5 |   |
| Direct financing  leases   |       | 461                              |       | 0.1                             |       | 511 |   | 0.1 |   |
| Gross loans                |       | 430,661                          |       | 100.0                           |       | 426,248 |   | 100.0 |   |
| Allowance for  loan losses |       | (4,206                           | )          |                            |       | (4,824 | ) |   |   |
| Net loans                  |       | $                                | 426,455    |                            |       |   | $ | 421,424 |   |   |   |

 

Gross loans increasedfrom $426,248,000, as of December 31, 2007 to $430,661,000 atSeptember 30, 2008. The increase was mostly from the efforts of ourrestructured commercial lending team in conjunction with the addition of ournew senior lender earlier in the year. Their collective effort has enabled theCompany to better serve its existing customer base and strategically penetrateand grow the commercial lending business in our market area. As a result commercialand CRE levels increased $21,300,000, or 10%, in the fist nine months of 2008.Partially offsetting the increase in commercial lending was a decline inresidential real estate mortgage loans. The decline was from the transfer from theloan and lease portfolio to the AFS portfolio and simultaneous sale of$28,100,000 of residential mortgage loans during the first quarter of 2008.

 

*Allowance for loan losses*

 

Management continuallyevaluates the credit quality of the Bank’s loan portfolio and performs a formalreview of the adequacy of the allowance for loan losses (the allowance), on aquarterly basis. The allowance reflects management’s best estimate of theamount of credit losses in the loan portfolio. Management’s judgment is based onthe evaluation of individual loans, past experience, the assessment of currenteconomic conditions and other relevant factors including the amounts and timingof cash flows expected to be received on impaired loans. Those estimates may besusceptible to significant change. The provision for loan losses represents theamount necessary to maintain an appropriate allowance. Loan losses are chargeddirectly against the allowance when loans are deemed to be uncollectible.Recoveries from previously charged-off loans are added to the allowance whenreceived.

 

Management applies twoprimary components during the loan review process to determine proper allowancelevels. The two components are a specific loan loss allocation for loans thatare deemed impaired and a general loan loss allocation for those loans notspecifically allocated. The methodology to analyze the adequacy of theallowance for loan losses is as follows:

 

·                 identificationof specific impaired loans by loan category;

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

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

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

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

 

Allocation of theallowance for different categories of loans is based on the methodology asexplained above. A key element of the methodology to determine the allowance isthe Company’s credit risk evaluation process, which includes credit riskgrading of individual commercial loans. Commercial loans are assigned credit riskgrades based on the Company’s assessment of conditions that affect the borrower’sability to meet its contractual obligations under the loan agreement. Thatprocess includes reviewing borrowers’ current financial information, historicalpayment experience, credit documentation, public information and otherinformation specific to each individual borrower. The changes in allocations inthe commercial loan portfolio from period to period are based upon the creditrisk grading system and from periodic reviews of the loan and lease portfolios.

 

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

 

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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 nine months ended September 30, 2008, were $874,000,compared to $393,000 for the same period in 2007. Consumer loan net charge-offswere $255,000 for the nine months ended September 30, 2008, an increase of$187,000 from the $68,000 recorded for the like period in 2007. Commercial loannet charge-offs were $587,000 for the nine months ended September 30,2008, compared to $340,000 recorded in the nine months endingSeptember 30, 2007. The increase in the commercial loan charge-offs duringthe nine months resulted from the final resolution of an impaired loan and thetransfer of a foreclosed property to other real estate owned (ORE) for which aspecific reserve had been previously allocated. Mortgage loans incurred netcharge-offs of $32,000 in the first nine months of 2008 compared to netrecoveries of $15,000 for the nine months ended September 30, 2007.

 

Management believes thatthe current balance in the allowance for loan losses of $4,206,000 issufficient to withstand the identified potential credit quality issues whichmay arise and other unidentified credit risks that are inherent to theportfolio. Currently, management is unaware of any potential problem loans thathave not been reviewed. Potential problem loans are those where there is knowninformation that leads management to believe repayment of principal and/orinterest is in jeopardy and the loans are currently neither on non-accrualstatus 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 loanlosses to total loans was 0.98% at September 30, 2008 compared to 1.13% atDecember 31, 2007.

 

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

 
| ** **                          | ** ** | **As of and for the** | ** **  | **As of and for the** | ** ** | **As of and for the** | ** ** |
|-------------------------------------|------------|-------------------------------------------|-------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                          | ** ** | **nine months ended**           | ** **  | **twelve months ended**         | ** ** | **nine months ended**           | ** ** |
| ** **                          | ** ** | **September 30, 2008**          | ** **  | **December 31, 2007**           | ** ** | **September 30, 2007**          | ** ** |
|                                |       |                                      |        |                                      |       |                                      |       |
| Balance at  beginning of period     |       | $                                         | 4,824,401   |                                      | $          | 5,444,303                                 |       | $ | 5,444,303 |   |
|                                |       |                                      |        |                                      |       |                                      |       |
| Provision  (credit) for loan losses |       | 255,000                                   |        | (60,000                                   | )          | (60,000                                   | )          |
|                                |       |                                      |        |                                      |       |                                      |       |
| Charge-offs:                        |       |                                      |        |                                      |       |                                      |       |
| Commercial                          |       | 666,588                                   |        | 375,356                                   |       | 356,989                                   |       |
| Residential real  estate            |       | 31,870                                    |        | 90,193                                    |       | 1,585                                     |       |
| Consumer                            |       | 283,783                                   |        | 256,215                                   |       | 188,171                                   |       |
| Total                               |       | 982,241                                   |        | 721,764                                   |       | 546,745                                   |       |
|                                |       |                                      |        |                                      |       |                                      |       |
| Recoveries:                         |       |                                      |        |                                      |       |                                      |       |
| Commercial                          |       | 79,253                                    |        | 18,076                                    |       | 16,979                                    |       |
| Residential real  estate            |       | 80                                        |        | 125,002                                   |       | 16,560                                    |       |
| Consumer                            |       | 29,073                                    |        | 18,784                                    |       | 119,758                                   |       |
| Total                               |       | 108,406                                   |        | 161,862                                   |       | 153,297                                   |       |
|                                |       |                                      |        |                                      |       |                                      |       |
| Net charge-offs                     |       | 873,835                                   |        | 559,902                                   |       | 393,448                                   |       |
|                                |       |                                      |        |                                      |       |                                      |       |
| Balance at end  of period           |       | $                                         | 4,205,566   |                                      | $          | 4,824,401                                 |       | $ | 4,990,855 |   |
|                                |       |                                      |        |                                      |       |                                      |       |
| Total loans, end  of period         |       | $                                         | 431,293,559 |                                      | $          | 427,076,030                               |       | $ | 426,163,776 |   |

 

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| ** **                                                               | ** ** | **As of and for the** | ** ** | **As of and for the** | ** ** | **As of and for the** | ** ** |
|--------------------------------------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                               | ** ** | **nine months ended**           | ** ** | **twelve months ended**         | ** ** | **nine months ended**           | ** ** |
| ** **                                                               | ** ** | **September 30, 2008**          | ** ** | **December 31, 2007**           | ** ** | **September 30, 2007**          | ** ** |
| Net charge-offs  to:                                                     |       |                                      |       |                                      |       |                                      |       |
| Loans, end of  period                                                    |       | 0.20                                      | %          | 0.13                                      | %          | 0.09                                      | %          |
| Allowance for  loan losses                                               |       | 20.78                                     | %          | 11.61                                     | %          | 7.88                                      | %          |
| Provision for  loan losses                                               |       | 3.43                                      | x          | —                                    | x          | —                                    | x          |
|                                                                     |       |                                      |       |                                      |       |                                      |       |
| Allowance for  loan losses to:                                           |       |                                      |       |                                      |       |                                      |       |
| Total loans                                                              |       | 0.98                                      | %          | 1.13                                      | %          | 1.17                                      | %          |
| Non-accrual  loans                                                       |       | 1.35                                      | x          | 1.27                                      | x          | 1.07                                      | x          |
| Non-performing  loans                                                    |       | 1.13                                      | x          | 1.26                                      | x          | 1.07                                      | x          |
| Net charge-offs                                                          |       | 4.81                                      | x          | 8.62                                      | x          | 12.68                                     | x          |
|                                                                     |       |                                      |       |                                      |       |                                      |       |
| Loans 30-89 days  past due and still accruing                            |       | $                                         | 1,251,282  |                                      | $          | 4,697,953                                 |       | $ | 2,907,941 |   |
| Loans 90 days  past due and accruing                                     |       | $                                         | 581,824    |                                      | $          | 25,470                                    |       | $ | 35,891 |   |
| Non-accrual  loans                                                       |       | $                                         | 3,125,997  |                                      | $          | 3,811,205                                 |       | $ | 4,647,858 |   |
| Allowance for  loan losses to loans 90days or more past due and accruing |       | 7.23                                      | x          | 189.41                                    | x          | 139.06                                    | x          |

 

*Non-performing assets*

 

The Bank definesnon-performing assets as accruing loans past due 90 days or more, non-accrualloans, restructured loans, ORE and repossessed assets. As of September 30,2008, non-performing assets represented 0.90% 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 place loans or leases on a non-accrualstatus is made on an individual basis after considering factors pertaining toeach specific loan.

 

The majority ofnon-performing assets for the period end September 30, 2008 werenon-accruing commercial loans and ORE. Most of the loans are collateralized,thereby mitigating the Bank’s potential for loss and the ORE has been listedfor sale with local realtor(s). At September 30, 2008, non-performingloans were $3,708,000 down from $3,837,000 at year-end 2007.

 

Loans 90 days past duethat were still accruing at September 30, 2008 aggregated $582,000,compared to $25,000 at December 31, 2007. Approximately $418,000 of thoseloans were residential mortgages which were adequately collateralized andexpected to be refinanced or brought current. The remainder of the loans 90days past due were comprised of several installment loans in the process ofcollection.

 

There were no repossessedassets or restructured loans at September 30, 2008 or December 31,2007. Specific action plans are developed for each of the Company’snon-performing assets. These plans at times include litigation and foreclosure.As such, our efforts to resolve non-performing assets at times can lead to atemporary increase in our ORE. Any increase is expected to be temporary as itis our practice to promptly market or list all such properties for sale.

 

Non-accrual loansaggregated $3,126,000 at September 30, 2008, compared to $3,811,000 atDecember 31, 2007. Additions to the non-accruals component of thenon-performing assets totaling $4,091,000 were made during the first ninemonths of 2008. These were partially offset by payoffs or reductions of$2,288,000, charge-offs of $824,000, $1,540,000 in transfers to ORE and$124,000 of loans that returned to performing status. Loans past due 90 days ormore and accruing totaled $582,000 at September 30, 2008, whilenon-accrual loans were $3,126,000 and ORE totaled $1,429,000. The aggregate ofthese three items comprise the non-performing assets of $5,136,000 at theperiod end September 30, 2008 compared to $3,944,000 at December 31,2007. Non-performing loans to net loans were 0.87% at September 30, 2008and 0.91% at December 31, 2007.

 

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

 
| ** **                                                      | ** ** | **September 30, 2008** | ** **  | **December 31, 2007** | ** ** | **September 30, 2007** | ** ** |
|-----------------------------------------------------------------|------------|----------------------------------|-------------|---------------------------------|------------|----------------------------------|------------|
|                                                            |       |                             |        |                            |       |                             |       |
| Loans past due  90 days or more and accruing                    |       | $                                | 581,824     |                            | $          | 25,470                           |       | $ | 35,891 |   |
| Non-accrual  loans                                              |       | 3,125,997                        |        | 3,811,205                       |       | 4,647,858                        |       |
| Total  non-performing loans                                     |       | 3,707,821                        |        | 3,836,675                       |       | 4,683,749                        |       |
|                                                            |       |                             |        |                            |       |                             |       |
| Other real  estate owned                                        |       | 1,428,507                        |        | 107,036                         |       | 107,036                          |       |
| Total  non-performing assets                                    |       | $                                | 5,136,328   |                            | $          | 3,943,711                        |       | $ | 4,790,785 |   |
|                                                            |       |                             |        |                            |       |                             |       |
| Net loans  including AFS                                        |       | $                                | 427,087,993 |                            | $          | 422,251,629                      |       | $ | 421,172,921 |   |
| Total assets                                                    |       | $                                | 569,543,412 |                            | $          | 587,412,555                      |       | $ | 589,101,139 |   |
| Non-accrual  loans to net loans                                 |       | 0.73                             | %           | 0.90                            | %          | 1.10                             | %          |
| Non-performing  assets to net loans, ORE and repossessed assets |       | 1.20                             | %           | 0.93                            | %          | 1.14                             | %          |
| Non-performing  assets to total assets                          |       | 0.90                             | %           | 0.67                            | %          | 0.81                             | %          |
| Non-performing  loans to net loans                              |       | 0.87                             | %           | 0.91                            | %          | 1.11                             | %          |

 

*Foreclosed**assets held-for-sale*

 

At September 30,2008, foreclosed assets held-for-sale was comprised of two ORE propertiesamounting to $1,429,000, which have been listed for sale with a local realtor.

 

*Premises and equipment, net*

 

The increase in premisesand equipment of $3,053,000, or 24%, is from the completion of the constructionproject of the Company’s new West Scranton branch office. In addition, duringthe nine months ended September 30, 2008, the Company wrote off anddisposed obsolete equipment which required the recognition of a loss andcorresponding reduction in premises and equipment of approximately $36,000mostly occurring from a branch closing.

 

*Other assets*

 

The increase in otherassets of $4,015,000 since December 31, 2007 was chiefly due to anincrease in the deferred tax asset related to the additional unrealized lossesrecorded in the AFS securities portfolio and to a lesser extent increases inprepaid expense accounts.

 

*Deposits*

 

The Bank is acommunity-based commercial financial institution, member FDIC, which offers avariety of deposit accounts with varying ranges of interest rates and terms.Deposit products include savings accounts, interest-bearing checking (NOW),money market, non-interest bearing checking (DDAs) and certificates of depositaccounts. Certificates of deposit accounts, or CDs, are deposits with statedmaturities ranging from seven days to ten years. The flow of deposits issignificantly influenced by general economic conditions, changes in prevailinginterest rates, pricing and competition. Most of the Company’s deposits are obtainedfrom the communities surrounding its 12 branch offices and are insured by theFDIC up to the full extent permitted by law. The Bank attempts to attract andretain deposit customers via sales and marketing efforts, new products, qualityservice, competitive rates and maintaining long-standing customerrelationships. To determine deposit product interest rates, the Companyconsiders local competition, market yields and the rates charged foralternative sources of funding such as borrowings. Though we continue toexperience intense competition for deposits, our rate-setting strategy includesconsideration of liquidity needs, balance sheet structure and cost effectivestrategies that are mindful of the current interest rate environment.

 

Compared to December 31,2007 total deposits grew $9,724,000, or 2%, during the nine months endedSeptember 30, 2008. The growth in total deposits was primarily due toincreases in money markets, DDAs and NOW accounts of $4,566,000, or 5%,$4,823,000, or 7%, and $2,130,000, or 4%, respectively, partially offset bylower CD balances. The net increase stems from the opening of the new WestScranton branch during the third quarter of 2008, related bank-wide promotions,improved relationships with existing depositors, new commercial depositors andseasonal activity with municipal customers.

 

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The following tablerepresents the components of deposits as of September 30, 2008 andDecember 31, 2007 (dollars in thousands):

 
| ** **               | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|--------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **               | ** ** | **Amount**                       | ** ** | **%**                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| Money market             |       | $                                | 92,458     |                            | 21.2       |   | $ | 87,892 |   | 20.6 |   |
| NOW                      |       | 56,825                           |       | 13.0                            |       | 54,695 |   | 12.9 |   |
| Savings and club         |       | 42,109                           |       | 9.7                             |       | 40,125 |   | 9.4 |   |
| Certificates of  deposit |       | 174,421                          |       | 40.1                            |       | 178,200 |   | 41.9 |   |
| Total  interest-bearing  |       | 365,813                          |       | 84.0                            |       | 360,912 |   | 84.8 |   |
| Non-interest-bearing     |       | 69,619                           |       | 16.0                            |       | 64,796 |   | 15.2 |   |
| Total deposits           |       | $                                | 435,432    |                            | 100.0      |   | $ | 425,708 |   | 100.0 |   |

 

Certificates of depositof $100,000 or more aggregated $76,888,000 and $80,857,000 atSeptember 30, 2008 and December 31, 2007, respectively. Certificatesof deposit of $250,000 or more aggregated $37,756,000 at September 30,2008.

 

*Borrowings*

 

Borrowings are used as acomplement to deposit generation as an alternative funding source whereby theBank will borrow under customer repurchase agreements in the local market andadvances from the Federal Home Loan Bank of Pittsburgh (FHLB) and correspondentbanks for asset growth and liquidity needs. Repurchase agreements arenon-insured interest-bearing liabilities that have a security interest inqualified investment securities of the Bank and are offered in both sweep andfixed-term products. A sweep account is designed to ensure that, on a dailybasis, an attached DDA is adequately funded and excess DDA funds are transferred,or swept, into an overnight interest-bearing repurchase 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 overnightbalances which the Bank may require from time-to-time to fund daily liquidityneeds. Overnight balances and repurchase agreements are components ofshort-term borrowings on the consolidated balance sheets. FHLB advances arecomponents of long-term debt on the consolidated balance sheets. FHLB advanceswith maturity dates of less than one year amounted to $20,072,000 atSeptember 30, 2008.

 

The following tablerepresents the components of borrowings as of September 30, 2008 andDecember 31, 2007 (dollars in thousands):

 
| ** **                  | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** |
|-----------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                  | ** ** | **Amount**                       | ** ** | **%**                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| Overnight  borrowings       |       | $                                | 4,360      |                            | 5.5        |   | $ | 18,950 |   | 18.5 |   |
| Repurchase  agreements      |       | 11,705                           |       | 14.8                            |       | 20,504 |   | 20.0 |   |
| Demand note,  U.S. Treasury |       | 1,021                            |       | 1.3                             |       | 202 |   | 0.2 |   |
| FHLB advances               |       | 62,072                           |       | 78.4                            |       | 62,709 |   | 61.3 |   |
| Total borrowings            |       | $                                | 79,158     |                            | 100.0      |   | $ | 102,365 |   | 100.0 |   |

 

Borrowings have decreased$23,200,000, or 23%, during the nine months ended September 30, 2008. Overnightborrowings have declined as a result of the Company’s balance sheet de-leveringstrategies and deposit generation. The reduction in repurchase agreements wascaused by a combination of pricing competition for large, term repos abovewholesale rates and the volatile nature of the sweep product.

 

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**Item 3. Quantitative and Qualitative DisclosureAbout 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 interest rates will impact interest income andinterest expense along with affecting market values of all interest-earningassets and interest-bearing liabilities, except for those assets or liabilitieswith a short term remaining to maturity. Interest rate risk management is anintegral part of the asset/liability management process. The Company hasinstituted certain procedures and policy guidelines to manage the interest raterisk position. Those internal policies enable the Company to react to changesin market rates to protect net interest income from significant fluctuations.The primary objective in managing interest rate risk is to minimize the adverseimpact of changes in interest rates on net interest income along with creatingan asset/liability structure that maximizes earnings.

 

*Asset/Liability Management*.One major objective of the Company when managing the rate sensitivity of itsassets and liabilities is to stabilize net interest income. The management ofand authority to assume interest rate risk is the responsibility of theCompany’s Asset/Liability Committee (ALCO), which is comprised of seniormanagement and members of the board of directors. ALCO meets quarterly tomonitor the relationship of interest sensitive assets to interest sensitiveliabilities. The process to review interest rate risk is a regular part ofmanaging the Company. Consistent policies and practices of measuring andreporting interest rate risk exposure, particularly regarding the treatment ofnon-contractual assets and liabilities, are in effect. In addition, there is anannual process to review the interest rate risk policy with the board ofdirectors which includes limits on the impact to earnings from shifts ininterest rates.

 

*Interest Rate Risk Measurement.*Interestrate risk is monitored through the use of three complementary measures: staticgap analysis, earnings at risk simulation and economic value at risksimulation. While each of the interest rate risk measurements has limitations,taken together they represent a reasonably comprehensive view of the magnitudeof interest rate risk in the Company and the distribution of risk along theyield curve, the level of risk through time and the amount of exposure tochanges in certain interest rate relationships.

 

*Static Gap*. Theratio between assets and liabilities re-pricing in specific time intervals isreferred to as an interest rate sensitivity gap. Interest rate sensitivity gapscan be managed to take advantage of the slope of the yield curve as well asforecasted changes in 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 positive gap (asset sensitive) indicates thatmore assets will mature or re-price during a given period compared toliabilities, while a negative gap (liability sensitive) has the oppositeeffect. The Company employs computerized net interest income simulationmodeling to assist in quantifying interest rate risk exposure. This processmeasures and quantifies the impact on net interest income through varyinginterest rate changes and balance sheet compositions. The use of this modelassists the ALCO to gauge the effects of the interest rate changes oninterest-sensitive assets and liabilities in order to determine what impactthese rate changes will have upon the net interest spread. AtSeptember 30, 2008 the Bank maintained a one-year cumulative gap ofnegative $25.0 million, or -4.4%, of total assets. The effect of this negativegap position provided a mismatch of assets and liabilities which may expose theBank to interest rate risk during periods of rising interest rates. Conversely,in a falling interest rate environment, net interest income could be positivelyimpacted because more liabilities than assets would re-price downward duringthe one-year period.

 

Certain shortcomings areinherent in the method of analysis discussed above and presented in the nexttable. Although certain assets and liabilities may have similar maturities orperiods of re-pricing, they may react in different degrees to changes in marketinterest rates. The interest rates on certain types of assets and liabilities mayfluctuate in advance of changes in market interest rates, while interest rateson other types of assets and liabilities may lag behind changes in marketinterest rates. Certain assets, such as adjustable-rate mortgages, havefeatures which restrict changes in interest rates on a short-term basis andover the life of the asset. In the event of a change in interest rates,prepayment and early withdrawal levels may deviate significantly from thoseassumed in calculating the table. The ability of many borrowers to servicetheir adjustable-rate debt may decrease in the event of an interest rateincrease.

 

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

 
| ** **                                     | ** ** | **Three months** | ** ** | **Three to**      | ** ** | **One to**      | ** ** | **Over**             | ** ** | ** ** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|------------------------|------------|----------------------|------------|----------------------|------------|------------|------------|
| ** **                                     | ** ** | **or less**      | ** ** | **twelve months** | ** ** | **three years** | ** ** | **three years** | ** ** | **Total**  | ** ** |
| Cash and cash  equivalents                     |       | $                     | 642        |                   | $          | —               |       | $                    | —     |       | $          | 12,733 |   | $ | 13,375 |   |
| Investment  securities(1)(2)                   |       | 22,226                |       | 3,191                  |       | 10,394               |       | 56,139               |       | 91,950     |       |
| Loans (2)                                      |       | 113,687               |       | 63,128                 |       | 103,879              |       | 146,394              |       | 427,088    |       |
| Fixed and other  assets                        |       | —                |       | 8,729                  |       | —               |       | 28,401               |       | 37,130     |       |
| Total assets                                   |       | $                     | 136,555    |                   | $          | 75,048               |       | $                    | 114,273    |       | $          | 243,667 |   | $ | 569,543 |   |
| Total cumulative  assets                       |       | $                     | 136,555    |                   | $          | 211,603              |       | $                    | 325,876    |       | $          | 569,543 |   |   |   |
|                                           |       |                  |       |                   |       |                 |       |                 |       |       |       |
| Non-interest-bearing  transaction deposits (3) |       | $                     | —     |                   | $          | 6,962                |       | $                    | 19,145     |       | $          | 43,512 |   | $ | 69,619 |   |
| Interest-bearing  transaction deposits (3)     |       | 65,046                |       | —                 |       | 48,675               |       | 77,671               |       | 191,392    |       |
| Certificates of  deposit                       |       | 32,369                |       | 95,069                 |       | 42,941               |       | 4,042                |       | 174,421    |       |
| Repurchase  agreements                         |       | 11,705                |       | —                 |       | —               |       | —               |       | 11,705     |       |
| Short-term  borrowings                         |       | 5,381                 |       | —                 |       | —               |       | —               |       | 5,381      |       |
| Long-term debt                                 |       | 10,072                |       | 10,000                 |       | 21,000               |       | 21,000               |       | 62,072     |       |
| Other  liabilities                             |       | —                |       | —                 |       | —               |       | 4,335                |       | 4,335      |       |
| Total  liabilities                             |       | $                     | 124,573    |                   | $          | 112,031              |       | $                    | 131,761    |       | $          | 150,560 |   | $ | 518,925 |   |
| Total cumulative  liabilities                  |       | $                     | 124,573    |                   | $          | 236,604              |       | $                    | 368,365    |       | $          | 518,925 |   |   |   |
|                                           |       |                  |       |                   |       |                 |       |                 |       |       |       |
| Interest  sensitivity gap                      |       | $                     | 11,982     |                   | $          | (36,983              | )          | $                    | (17,488    | )          | $          | 93,107 |   |   |   |
|                                           |       |                  |       |                   |       |                 |       |                 |       |       |       |
| Cumulative gap                                 |       | $                     | 11,982     |                   | $          | (25,001              | )          | $                    | (42,489    | )          | $          | 50,618 |   |   |   |
|                                           |       |                  |       |                   |       |                 |       |                 |       |       |       |
| Cumulative gap  to total assets                |       | 2.10                  | %          | (4.39                  | )%         | (7.46                | )%         | 8.89                 | %          |       |       |

 

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

 

(2) Investments and loans are included in the earlier of the period in whichinterest rates were next scheduled to adjust or the period in which they aredue. In addition, loans are included in the periods in which they are scheduledto be repaid based on scheduled amortization. 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) The Bank’s demand and savings accounts are generally subject to immediatewithdrawal. However, management considers a certain amount of such accounts tobe core accounts having significantly longer effective maturities based on theretention experiences of such deposits in changing interest rate environments.The effective maturities presented are the recommended maturity distributionlimits for non-maturing deposits based on historical deposit studies.

 

*Earnings at Risk and EconomicValue at Risk Simulations*. The Company recognizes that moresophisticated tools exist for measuring the interest rate risk in the balancesheet that extend beyond static re-pricing gap analysis. Although it will continueto measure its re-pricing gap position, the Company utilizes additionalmodeling for identifying and measuring the interest rate risk in the overallbalance sheet. The ALCO is responsible for focusing on “earnings at risk” and“economic value at risk”, and how both relate to the risk-based capitalposition when analyzing the interest rate risk.

 

*Earnings at Risk*.Earnings at risk simulation measures the change in net interest income and netincome should interest rates rise and fall. The simulation recognizes that notall assets and liabilities re-price one-for-one with market rates (e.g.,savings rate). The ALCO looks at “earnings at risk” to determine income changesfrom a base case scenario under an increase and decrease of 200 basis points ininterest rate simulation models.

 

*Economic Value at Risk.*Earningsat risk simulation measures the short-term risk in the balance sheet. Economicvalue (or portfolio equity) at risk measures the long-term risk by finding thenet present value of the future cash flows from the Company’s existing assetsand liabilities. The ALCO examines this ratio quarterly utilizing an increaseand decrease of 200 basis points in interest rate simulation models. The ALCOrecognizes that, in some instances, this ratio may contradict the “earnings atrisk” ratio.

 

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The following tableillustrates the simulated impact of 200 basis points upward or downwardmovement in interest rates on net interest income, net income and the change inthe economic value (portfolio equity). This analysis assumes thatinterest-earning asset and interest-bearing liability levels atSeptember 30, 2008 remain constant. The impact of the rate movements wasdeveloped by simulating the effect of rates changing over a twelve-month periodfrom the September 30, 2008 levels:

 
| ** **                                             | ** ** | **Rates +200** | ** ** | **Rates -200** | ** ** |
|--------------------------------------------------------|------------|---------------------|------------|---------------------|------------|
| Earnings at  risk:                                     |       |                |       |                |       |
| Percent change  in:                                    |       |                |       |                |       |
| Net interest  income                                   |       | 0.2                 | %          | (0.2                | )%         |
| Net income                                             |       | 1.3                 |       | (1.1                | )          |
|                                                   |       |                |       |                |       |
| Economic value  at risk:                               |       |                |       |                |       |
| Percent change  in:                                    |       |                |       |                |       |
| Economic value  of equity                              |       | (26.2               | )          | (3.0                | )          |
| Economic value  of equityas  a percent of total assets |       | (2.8                | )          | (0.3                | )          |

 

Economic value has the mostmeaning when viewed within the context of risk-based capital. Therefore, theeconomic value may normally change beyond the Company’s policy guideline for ashort period of time as long as the risk-based capital ratio (after adjustingfor the excess equity exposure) is greater than 10%. At September 30,2008, the Company’s risk-based capital ratio was 13.9%.

 

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

 
| ** **                                  | ** ** | **Net interest** | ** ** | **$**        | ** ** | **%**        | ** ** |
|---------------------------------------------|------------|-----------------------|------------|--------------|------------|--------------|------------|
| **Change in interest rates** | ** ** | **income**            | ** ** | **variance** | ** ** | **variance** | ** ** |
|                                        |       |                  |       |         |       |         |       |
| +200 basis  points                          |       | $                     | 20,246     |         | $          | 34           |       | 0.2 | % |
| +100 basis  points                          |       | 20,225                |       | 13           |       | 0.1          |       |
|    Flat rate                      |       | 20,212                |       | —       |       | —       |       |
| -100 basis  points                          |       | 20,086                |       | (126         | )          | (0.6         | )          |
| -200 basis  points                          |       | 20,180                |       | (32          | )          | (0.2         | )          |
|                                             |            |                       |            |              |            |              |            |  |  |

 

Simulation models requireassumptions about certain categories of assets and liabilities. The modelsschedule existing assets and liabilities by their contractual maturity,estimated likely call date or earliest re-pricing opportunity. Mortgage-backedsecurities and amortizing loans are scheduled based on their anticipated cashflow including estimated prepayments. For investment securities, the Bank usesa third-party service to provide cash flow estimates in the various rateenvironments. Savings, money market and NOW accounts do not have a statedmaturity or re-pricing term and can be withdrawn or re-priced at any time. Thismay impact the margin if more expensive alternative sources of deposits are requiredto fund loans or deposit runoff. Management projects the re-pricingcharacteristics of these accounts based on historical performance andassumptions that it believes reflect their rate sensitivity. The modelreinvests all maturities, repayments and prepayments for each type of asset orliability into the same product for a new like term at current product interestrates provided by management. As a result, the mix of interest-earning assetsand interest bearing-liabilities is held constant.

 

*Derivative Financial Instruments.*As part of the Bank’s overall interest rate risk strategy,the Company has adopted a policy whereby the Company may periodically usederivative instruments to minimize significant fluctuations in earnings causedby interest rate volatility. This interest rate risk management strategyentails the use of interest rate floors, caps and swaps. In October 2006,the Bank entered into an interest rate floor derivative agreement on$20,000,000 notional value of its prime-based loan portfolio. The purpose ofthe hedge is to help protect the Bank’s interest income in the event interestrates decline below a pre-determined contractual interest rate. The strategy isreflected in the scenarios for earnings and economic value at risk and the netinterest income in the two immediately preceding tables. For a furtherdiscussion on the Bank’s derivative contract, see Note No. 4, “Derivativeinstruments,” contained within the notes to consolidated financial statementsin Part I, Item 1.

 

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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 sources of liquidity are cash and cashequivalents, asset maturities, calls and principal repayments, loans andinvestments AFS, growth of core deposits, growth of repurchase agreements,increases in other borrowed funds from correspondent banks and issuance ofcapital stock. Although regularly scheduled investment and loan payments aredependable sources of daily funds, the sales of both loans and investments AFS,deposit activity and investment and loan prepayments are significantlyinfluenced by general economic conditions and the level of interest rates.

 

For the nine months ended September 30, 2008, the Companygenerated approximately $3.0 million of cash. During this period, the Company’soperations provided approximately $34.0 million primarily from the sales ofmortgages AFS net of originations. This was partially offset by cash used forinvesting and financing of $31.0 million for funding loan growth, facilityexpansion and the repayment of short-term debt. The primary sources of fundsused for investing and financing was from the net proceeds from the sales ofinvestment securities, deposit generation as well as from the cash providedfrom operations. As of September 30, 2008, the Company maintained$13,375,000 in cash and cash equivalents, $86,234,000 of investments AFS and$632,000 of loans AFS. In addition, as of September 30, the Company had approximately$263,343,000 available to borrow from the FHLB and $20,000,000 available fromother correspondent banks. This combined total of $383,584,000 represented 67%of total assets at September 30, 2008. Management believes this level ofliquidity to be strong and adequate to support current operations. During thethird quarter of 2008, the Company terminated its relationship with acorrespondent bank, due to inactivity, that previously provided access to$10,000,000 of liquidity in the form of short-term overnight borrowings. TheCompany is currently analyzing replacement correspondent banks to provideaccess to similar funding levels, if needed. The termination of therelationship does not have a significant effect on the Company’s liquidityposition.

 

In October 2008, the FDIC announced the Temporary LiquidityGuarantee Program to strengthen confidence and encourage liquidity in thebanking system. The new program will (1) guarantee newly issued seniorunsecured debt of eligible institutions, including FDIC-insured banks andthrifts, as well as certain holding companies, and (2) provide fulldeposit insurance coverage for non-interest bearing deposit transactionaccounts in FDIC-insured institutions, regardless of the dollar amount.Generally, the amount of the debt covered by the senior unsecured debtguarantee program may not exceed 125% of the debt that the Company hadoutstanding as of September 30, 2008. Since some banks, such as theCompany, did not have any such debt outstanding as of September 30, 2008,this group of banks is awaiting further guidance from the FDIC on the amountavailable under this program. Participation in the program is automatic foreligible institutions for the first 30 days at no cost to the Company. Prior tothe end of the 30-day period, institutions may opt out of one or both parts ofthe program; otherwise, fees will apply for future participation. The Companyis currently analyzing the financial impact of the debt guarantee program andis awaiting further guidance from the FDIC before it can make a determinationon whether to participate. The Company will participate to provide full FDICinsurance coverage for non-interest bearing deposit transaction accounts.

 

*Capital*

 

During the third quarterof 2008 the Company’s Board of Directors announced its intent to initiate acapital stock repurchase program covering up to 50,000 shares of itsoutstanding capital stock. The repurchased shares would become treasury stockand could be available for issuance under the Company’s various stock-basedcompensation, employee stock purchase and dividend reinvestment plans and forgeneral corporate purposes. The repurchases will be made from time-to-time inopen-market transactions, subject to availability, pursuant to safe harbor rule 10b-18under the Securities Exchange Act of 1934. Currently, the Company reacquired13,000 shares at a weighted-average cost of $29.22 per share. For a furtherdiscussion about this program, see I**t**em 2,“Unregistered Sales of Equity Securities and Use of Proceeds” included inPart II, Item 2, “Other Information,” below.

 

During the nine monthsended September 30, 2008, shareholders’ equity decreased $4,573,000, or8%, due principally from increased unrealized net losses in the securities AFSportfolio, the declaration of cash dividends and the repurchase of theCompany’s capital stock (treasury stock). Conversely, shareholders’ equity wasenhanced by current year earnings, stock issued from the Company’s EmployeeStock Purchase Plan, and an increase in the intrinsic value of the Company’scash flow hedge instrument.

 

In October 2008, theU.S. Department of Treasury (Treasury), the Board of Governors of the FederalReserve System (FRB) and the FDIC issued a joint statement announcing(1) a voluntary capital purchase program where the Treasury will purchasesenior preferred stock of certain financial institutions and (2) theTemporary Liquidity Guarantee Program. A summary of the Temporary LiquidityGuarantee Program is described in the *Liquidity*section, above. Under the capital purchase program, the Treasury has allocated$250 billion from the $700 billion under the Troubled Asset Relief Program(TARP) created under the Economic Stabilization Act of 2008 (ESSA) to purchasesenior preferred stock in banks through the Capital Purchase Program. Half ofthe allocated $250 billion is earmarked for the purchase of senior preferredstock in nine major U.S. banks, and the remaining $125 billion will beavailable to small and mid-sized institutions that apply for the investment byNovember 14, 2008. The Treasury will determine eligibility of institutionsand allocation of purchases after the institution has requested to be includedin the program. Participation in this program is regulated by the Treasury andcontains many provisions, limits and terms that the Company is currentlyanalyzing to determine whether participation in the program is economicallyfeasible.

 

The Company is subject to various regulatory capitalrequirements administered by the federal banking agencies. Failure to meetminimum capital requirements can initiate certain mandatory and possibleadditional discretionary actions by regulators that, if undertaken, could havea direct material effect on the Company’s financial statements. Under capitaladequacy guidelines and the regulatory framework for prompt corrective action,the Company must meet specific capital guidelines that involve quantitativemeasures of the Company’s assets, liabilities and certain off-balance-sheetitems as calculated under regulatory accounting practices. The Company’scapital amounts and classification are also subject to qualitative judgments bythe regulators about components, risk-weightings and other factors.

 

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

 

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

 
| ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                            | ** ** | **To be well capitalized** | ** ** |
|----------------------------|------------|------------|------------|------------|------------|----------------------------|------------|---------------------------------------|------------|-------------------------------------------|------------|
| ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | **For capital**       | ** ** | **under prompt corrective** | ** ** |
| ** **                 | ** ** | **Actual** | ** ** | ** ** | ** ** | **adequacy purposes** | ** ** | **action provisions**            | ** ** |
| ** **                 | ** ** | **Amount** | ** ** | **Ratio**  | ** ** | **Amount**                 | ** ** | **Ratio**                             | ** ** | **Amount**                                | ** ** | **Ratio** | ** ** |
| Total capital              |       |       |       |       |       |                       |       |                                  |       |                                      |       |   |   |
| (to  risk-weighted assets) |       |       |       |       |       |                       |       |                                  |       |                                      |       |   |   |
| Consolidated               |       | $          | 61,292,211 |       | 13.9       | %   >         | $          | 35,375,056                            | >  | 8.0                                       | %          | N/A |   | N/A |   |
| Bank                       |       | $          | 60,945,018 |       | 13.8       | %   >         | $          | 35,364,711                            | >  | 8.0                                       | %          | $ | 44,205,889 | >  | 10.0 | % |
| Tier I capital             |       |       |       |       |       |                       |       |                                  |       |                                      |       |   |   |
| (to  risk-weighted assets) |       |       |       |       |       |                       |       |                                  |       |                                      |       |   |   |
| Consolidated               |       | $          | 57,023,947 |       | 12.9       | %   >         | $          | 17,687,528                            | >  | 4.0                                       | %          | N/A |   | N/A |   |
| Bank                       |       | $          | 56,739,171 |       | 12.8       | %   >         | $          | 17,682,356                            | >  | 4.0                                       | %          | $ | 26,523,533 | >  | 6.0 | % |
| Tier I capital             |       |       |       |       |       |                       |       |                                  |       |                                      |       |   |   |
| (to average  assets)       |       |       |       |       |       |                       |       |                                  |       |                                      |       |   |   |
| Consolidated               |       | $          | 57,023,947 |       | 9.8        | %   >         | $          | 23,349,666                            | >  | 4.0                                       | %          | N/A |   | N/A |   |
| Bank                       |       | $          | 56,739,171 |       | 9.7        | %   >         | $          | 23,337,462                            | >  | 4.0                                       | %          | $ | 29,171,828 | >  | 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 September 30, 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 the opinion of the Company, afterconsulting with legal counsel, no legal proceedings are pending, which, ifdetermined adversely to the Company or the Bank, would have a material effecton the Company’s undivided profits or financial condition. No legal proceedingsare pending other than ordinary routine litigation incidental to the businessof the Company and the Bank. In addition, to management’s knowledge, nogovernmental authorities have initiated or contemplated any material legalactions against the Company or the Bank.

 

**Item 1A.Risk Factors**

 

The following are additionalrisk factors that should be read in conjunction with Item 1A, “RiskFactors” that were disclosed in the Company’s December 31, 2007Form 10-K filed with the SEC on March 13, 2008:

 

The capital and credit marketshave experienced unprecedented levels of volatility.

 

During 2008 the capitaland credit markets experienced severe volatility and disruption. In the thirdquarter of 2008, the volatility and disruption reached unprecedented levels.Reflecting concern about the stability of the financial markets generally andthe strength of counterparties, many lenders and institutional investors havereduced, and in some cases ceased to provide, funding to borrowers, includingother financial institutions. Although to date we have not suffered liquidityproblems, we are part of the financial system and a systemic lack of availablecredit, a lack of confidence in the financial sector, increased volatility inthe financial markets and reduced business activity could materially andadversely affect our business, financial condition and results of operations.

 

In response to theturmoil in the banking system and financial markets, the U.S. government hastaken unprecedented actions, including the U.S. Treasury’s plan to injectcapital and to purchase mortgage loans and mortgage-backed and other securitiesfrom financial institutions for the purpose of stabilizing the financialmarkets generally or particular financial institutions. There is no assurancethat these government actions will achieve their purpose.

 

The failure to helpstabilize the financial markets and a continuation or worsening of the currentfinancial market conditions could have a material adverse affect on ourbusiness, our financial condition, the financial condition of our customers,our common stock trading price, as well as our ability to access credit. It could also result in further declines in our investment portfolio whichcould be “other-than-temporary impairments.”

 

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

 

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

 
| ** **           | ** ** | ** ** | **(a)**                                 | ** ** | ** ** | **(b)**                                | ** ** | ** ** | **(c)**                                 | ** ** | ** ** | **(d)**                                            | ** ** |
|----------------------|------------|------------|-----------------------------------------|------------|------------|----------------------------------------|------------|------------|-----------------------------------------|------------|------------|----------------------------------------------------|------------|
| ** **           | ** ** | ** ** | ** **                              | ** ** | ** ** | ** **                             | ** ** | ** ** | **Total number of**           | ** ** | ** ** | ** **                                         | ** ** |
| ** **           | ** ** | ** ** | ** **                              | ** ** | ** ** | ** **                             | ** ** | ** ** | **shares (or units)**         | ** ** | ** ** | **Maximum number of**                    | ** ** |
| ** **           | ** ** | ** ** | **Total Number**                   | ** ** | ** ** | ** **                             | ** ** | ** ** | **purchased as part as** | ** ** | ** ** | **shares (or units) that may** | ** ** |
| ** **           | ** ** | ** ** | **of shares (or units)** | ** ** | ** ** | **Average price paid**       | ** ** | ** ** | **publicly announced plans**  | ** ** | ** ** | **yet be purchased under the** | ** ** |
| **Period**           | ** ** | ** ** | **purchased**                           | ** ** | ** ** | **per share (or unit)** | ** ** | ** ** | **or programs**                    | ** ** | ** ** | **plans or programs**                    | ** ** |
| July 1, 2008 to      |       |       |                                    |       |       |                                   |       |       |                                    |       |       |                                               |       |
| July 31, 2008        |       |       | 6,000                                   |       |       | $                                      | 29.25      |       |                                    | 6,000      |       |                                               | 39,000     |   |
| August 1, 2008 to    |       |       |                                    |       |       |                                   |       |       |                                    |       |       |                                               |       |
| August 31, 2008      |       |       | —                                  |       |       | —                                 |       |       | —                                  |       |       | 39,000                                             |       |
| September 1, 2008 to |       |       |                                    |       |       |                                   |       |       |                                    |       |       |                                               |       |
| September 30, 2008   |       |       | 2,000                                   |       |       | $                                      | 29.35      |       |                                    | 2,000      |       |                                               | 37,000     |   |
| Total                |       |       | 8,000                                   |       |       | $                                      | 29.28      |       |                                    | 8,000      |       |                                               | 37,000     |   |

 

On June 3, 2008 theCompany’s Board of Directors approved and on June 5, 2008 the Company publiclyannounced its intent to initiate a capital stock repurchase program covering upto 50,000 share, or approximately 2.4% of its outstanding capital stock as ofMay 31, 2008. The Company has not made any purchases of its shares ofcapital that has not been publicly announced. Neither an expiration date nor amaximum dollar amount has been fixed to the program. The repurchases will bemade from time-to-time in open-market transactions, subject to availability.The repurchased shares would become treasury stock and could be available forissuance under the Company’s various stock-based compensation, employee stockpurchase and dividend reinvestment plans and for general corporate purposes. Norepurchase program has expired or has been subject to a determination toterminate during the period covered by the above table. The 2,000 shares reacquired inSeptember were for committed purchases that settled on October 1,2008.

 

**Item 3.Default Upon Senior Securities**

 

None

 

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

 

None

 

**Item 5.Other Information**

 

None

 

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**Item 6.Exhibits**

 

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

 

***3(i) Amendedand Restated Articles of Incorporation of Registrant.***Incorporatedby reference to Annex B to the Proxy Statement Prospectus included inRegistrant’s Amendment 4 to its Registration Statement No.333-90273 onForm 4 filed with the SEC on April 6, 2000.

 

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

 

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

 

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

 

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

 

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

 

****10.6 Registrant’s 2000Dividend Reinvestment Plan. ***Incorporated byreference to Exhibit 4 to Registrant’s  Registration StatementNo. 333-45668 on Form S-1, filed with the SEC on September 12,2000 and as amended by Pre-Effective Amendment No. 1 filed onOctober 11, 2000, by Post-Effective Amendment No. 1 filed onMay 30, 2001, by Post-Effective Amendment No. 2 filed onJuly 7, 2005 and by Registration Statement No.  333-152806on Form S-3 filed on August 6, 2008.

 

** *11******Statement regarding computation of earnings pershare.***Included herein in Note No. 2, “Earnings pershare,” contained within the Notes to Consolidated Financial Statements, andincorporated herein by reference.

 

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

 

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

 

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

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

 

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

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

 

----

***  **Management contract or compensatory plan orarrangement.

 

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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: November 4, 2008 | /s/ Steven C. Ackmann                      |
|                        | Steven C.  Ackmann,                        |
|                        | President and  Chief Executive Officer     |

 

 
| Date: November 4, 2008 | /s/ Salvatore R. DeFrancesco, Jr. |
|-----------------------------|----------------------------------------|
|                        | Salvatore R.  DeFrancesco, Jr.,   |
|                        | Treasurer and  Chief Financial Officer |

 

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**EXHIBITINDEX**

 
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | **Page** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------|
| ***3(i) Amended  and Restated Articles of Incorporation of Registrant.***Incorporated  by reference to Annex B to the Proxy Statement Prospectus included in  Registrant’s Amendment 4 to its Registration Statement No.333-90273 on  Form 4 filed with the SEC on April 6, 2000.                                                                                                                                                                                                                                                                                                     | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |     |
| ***3(ii) Amended  and Restated Bylaws of Registrant.***Incorporated by  reference to Exhibit 3(ii) to Registrant’s Form 8-K filed with the  SEC on November 21, 2007.                                                                                                                                                                                                                                                                                                                                                                                                            | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |     |
| ***10.1  Amended and Restated Executive Employment Agreement between Fidelity  D & D Bancorp, Inc., The Fidelity Deposit and Discount Bank and  Steven C. Ackmann, dated July 11, 2007.***Incorporated  by reference to Exhibit 10.1 to Registrant’s Current Report on  Form 8-K filed with the SEC on July 13, 2007.                                                                                                                                                                                                                                              | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |     |
| ***10.2  Amendment, dated October 2, 2007, to the Registrant’s 2000 Independent  Directors Stock Option Plan.***Incorporated by reference  to Exhibit 10.2 to Registrant’s Form 8-K filed with the SEC on  October 4, 2007.                                                                                                                                                                                                                                                                                                                                                 | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |     |
| ***10.3  Amendment, dated October 2, 2007, to the Registrant’s 2000 Stock  Incentive Plan.***Incorporated by reference to  Exhibit 10.1 to Registrant’s Form 8-K filed with the SEC on  October 4, 2007.                                                                                                                                                                                                                                                                                                                                                                    | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |     |
| ***10.4  Executive Employment Agreement between Fidelity D & D  Bancorp, Inc., The Fidelity Deposit and Discount Bank******and Timothy P. O’Brien, dated January 3,  2008.***Incorporated by reference to Exhibit 10.1 to  Registrant’s Current Report on Form 8-K filed with the SEC on  January 10, 2008.                                                                                                                                                                                                                                                   | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |     |
| ***10.5  Executive Employment Agreement between Fidelity D & D  Bancorp, Inc., The Fidelity Deposit and Discount Bank******and Daniel J. Santaniello, dated  February 28, 2008.***Incorporated by reference to  Exhibit 10.1 to Registrant’s Current Report on Form 8-K filed with  the SEC on March 3, 2008.                                                                                                                                                                                                                                                      | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |     |
| ***10.6 Registrant’s 2000 Dividend Reinvestment Plan. ***Incorporated  by reference to Exhibit 4 to Registrant’s Registration Statement  No. 333-45668 on Form S-1, filed with the SEC on September 12,  2000 and as amended by Pre-Effective Amendment No. 1 filed on  October 11, 2000, by Post-Effective Amendment No. 1 filed on  May 30, 2001, by Post-Effective Amendment No. 2 filed on  July 7, 2005 and by Registration Statement  No.  333-152806 on Form S-3 filed on August 6, 2008. | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |     |
| ***11******Statement regarding computation of earnings per  share.***                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     | 8        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |     |
| ***31.1  Rule 13a-14(a) Certification of Principal Executive Officer.***                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | 36       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |     |
| ***31.2  Rule 13a-14(a) Certification of Principal Financial Officer.***                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | 37       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |     |
| ***32.1  Certification of Principal Executive Officer pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.***                                                                                                                                                                                                                                                                                                                                                                                                                            | 38       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |     |
| ***32.2  Certification of Principal Financial Officer pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.***                                                                                                                                                                                                                                                                                                                                                                                                                            | 39       |

 

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* Incorporated byReference

 

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