**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

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

**SECURITIES EXCHANGE ACT OF 1934**

 

**For thequarterly period ended March 31, 2006**

 

**OR**

 

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

**SECURITIES EXCHANGE ACT OF 1934**

 

**For thetransition period from                 to                **

 

**Commissionfile number: 333-90273**

 

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

 

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

 

Address ofprincipal executive offices:

**BLAKELY &DRINKER ST.**

**DUNMORE,PENNSYLVANIA 18512**

 

TELEPHONE:

**570-342-8281**

 

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

 

ý  YES    o  NO

 

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

 
| Large  accelerated filer o |   | Accelerated filer o |   | Non-accelerated filer ý |
|----------------------------|--------|---------------------|--------|------------------------------|

 

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

 

o  YES    ý  NO

 

The number of outstandingshares of Common Stock of Fidelity D & D Bancorp, Inc. at April 28,2006, the latest practicable date, was 2,044,802 shares.

 

 

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

 

Form 10-Q March 31,2006

 

Index

 
| **Part I. Financial Information** |                                                                                                                      |
|----------------------------------------|---------------------------------------------------------------------------------------------------------------------------|
|                                   |                                                                                                                      |   |
| Item 1.                                | Financial Statements:                                                                                                     |   |
|                                   | Consolidated Balance Sheets as of March 31,  2006 and December 31, 2005                                         |   |
|                                   | Consolidated Statements of  Income for the three months ended March 31, 2006 and 2005                                |   |
|                                   | Consolidated Statements of  Changes in Shareholders’ Equity for the three months ended March 31,  2006 and 2005 |   |
|                                   | Consolidated Statements of  Cash Flows for the three months ended March 31, 2006 and 2005                            |   |
|                                   | Notes to Consolidated  Financial Statements                                                                               |   |
|                                   |                                                                                                                      |   |
| Item 2.                                | Management’s Discussion and  Analysis of Financial Condition and Results of Operations                               |   |
|                                   |                                                                                                                      |   |
| Item 3.                                | Quantitative  and Qualitative Disclosure about Market Risk                                                                |   |
|                                   |                                                                                                                      |   |
| Item 4.                                | Controls and  Procedures                                                                                                  |   |
|                                   |                                                                                                                      |   |
| **Part II. Other  Information**   |                                                                                                                      |
|                                   |                                                                                                                      |   |
| Item 1.                                | Legal Proceedings                                                                                                         |   |
|                                   |                                                                                                                      |   |
| Item 1A.                               | Risk Factors                                                                                                              |   |
|                                   |                                                                                                                      |   |
| Item 2.                                | Unregistered  Sales of Equity Securities and Use of Proceeds                                                              |   |
|                                   |                                                                                                                      |   |
| Item 3.                                | Defaults  Upon Senior Securities                                                                                          |   |
|                                   |                                                                                                                      |   |
| Item 4.                                | Submission  of Matters to a Vote of Security Holders                                                                      |   |
|                                   |                                                                                                                      |   |
| Item 5.                                | Other Information                                                                                                         |   |
|                                   |                                                                                                                      |   |
| Item 6.                                | Exhibits                                                                                                                  |   |
|                                   |                                                                                                                      |   |
| Signatures                             |                                                                                                                      |   |
|                                   |                                                                                                                      |   |
| Exhibit index                     |                                                                                                                      |   |

 

2

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**PART I – Financial Information**

 

**Item 1: Financial Statements**

 

**FIDELITY D & DBANCORP, INC.**

Consolidated Balance Sheets

As of March 31, 2006 and December 31, 2005

 
| ** **                                                                                                                                | ** ** | **March 31, 2006** | ** **  | **December 31, 2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|-------------|---------------------------------|------------|
| ** **                                                                                                                                | ** ** | **(unaudited)**              | ** **  | **(audited)**                   | ** ** |
| **ASSETS**                                                                                                                                |       |                         |        |                            |       |
| Cash  and due from banks                                                                                                                  |       | $                            | 10,380,049  |                            | $          | 12,525,723 |   |
| Interest-bearing  deposits with financial institutions                                                                                    |       | 106,846                      |        | 68,817                          |       |
| Total  cash and cash equivalents                                                                                                          |       | 10,486,895                   |        | 12,594,540                      |       |
| Available-for-sale  securities                                                                                                            |       | 114,294,790                  |        | 95,681,654                      |       |
| Held-to-maturity  securities                                                                                                              |       | 1,911,062                    |        | 1,996,919                       |       |
| Federal  Home Loan Bank Stock                                                                                                             |       | 4,699,000                    |        | 4,628,200                       |       |
| Loans  and leases, net (allowance for loan losses of $5,716,473 in 2006; $5,984,649  in 2005)                                             |       | 410,379,842                  |        | 403,144,095                     |       |
| Loans  available-for-sale (fair value $964,715 in 2006; $434,272 in 2005)                                                                 |       | 953,252                      |        | 428,584                         |       |
| Bank  premises and equipment, net                                                                                                         |       | 11,543,777                   |        | 11,683,148                      |       |
| Cash  surrender value of bank owned life insurance                                                                                        |       | 7,962,307                    |        | 7,891,898                       |       |
| Other  assets                                                                                                                             |       | 4,776,255                    |        | 4,033,132                       |       |
| Accrued  interest receivable                                                                                                              |       | 2,186,604                    |        | 1,959,826                       |       |
| Foreclosed  assets held for sale                                                                                                          |       | 92,999                       |        | 18,702                          |       |
| **Total assets**                                                                                                                          |       | $                            | 569,286,783 |                            | $          | 544,060,698 |   |
| **LIABILITIES**                                                                                                                           |       |                         |        |                            |       |
| Deposits                                                                                                                                  |       |                         |        |                            |       |
| Non-interest-bearing                                                                                                                      |       | $                            | 67,692,897  |                            | $          | 70,361,086 |   |
| Certificates  of deposit of $100,000 or more                                                                                              |       | 69,369,516                   |        | 76,257,553                      |       |
| Other  interest-bearing deposits                                                                                                          |       | 271,441,861                  |        | 232,880,001                     |       |
| Total  deposits                                                                                                                           |       | 408,504,274                  |        | 379,498,640                     |       |
| Accrued  interest payable and other liabilities                                                                                           |       | 3,396,492                    |        | 3,238,844                       |       |
| Short-term  borrowings                                                                                                                    |       | 27,422,536                   |        | 28,772,997                      |       |
| Long-term  debt                                                                                                                           |       | 81,029,348                   |        | 83,704,188                      |       |
| **Total liabilities**                                                                                                                     |       | 520,352,650                  |        | 495,214,669                     |       |
|                                                                                                                                      |       |                         |        |                            |       |
| **COMMITMENTS AND CONTINGENCIES**                                                                                                         |       |                         |        |                            |       |
| ** **                                                                                                                                |       |                         |        |                            |       |
| **SHAREHOLDERS’ EQUITY**                                                                                                             |       |                         |        |                            |       |
| Preferred  stock authorized 5,000,000 shares with no par value; none issued                                                               |       | —                       |        | —                          |       |
| Capital  stock authorized 10,000,000 shares with no par value; issued and outstanding  2,044,802 shares in 2006; 2,039,639 shares in 2005 |       | 18,268,245                   |        | 10,594,901                      |       |
| Retained  earnings                                                                                                                        |       | 32,476,484                   |        | 39,363,461                      |       |
| Accumulated  other comprehensive loss                                                                                                     |       | (1,810,596                   | )           | (1,112,333                      | )          |
| **Total shareholders’ equity**                                                                                                       |       | 48,934,133                   |        | 48,846,029                      |       |
| **Total liabilities and shareholders’ equity**                                                                                       |       | $                            | 569,286,783 |                            | $          | 544,060,698 |   |

 

See Notes to ConsolidatedFinancial Statements

 

3

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**FIDELITY D & DBANCORP, INC.**

Consolidated Statements of Income

(unaudited)

 
| ** **                                                | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                | ** ** | **March 31, 2006**     | ** ** | **March 31, 2005** | ** ** |
| **Interest income**                                       |       |                             |       |   |   |
| Interest  and fees on loans and leases:                   |       |                             |       |   |   |
| Taxable                                                   |       | $                                | 6,498,618  |   | $ | 5,682,968 |   |
| Nontaxable                                                |       | 132,158                          |       | 98,410 |   |
| Interest-bearing  deposits with financial institutions    |       | 2,537                            |       | 2,688 |   |
| Investment  securities:                                   |       |                             |       |   |   |
| U.S.  Government agency and corporations                  |       | 885,182                          |       | 910,157 |   |
| States  and political subdivisions (nontaxable)           |       | 141,044                          |       | 112,455 |   |
| Other  securities                                         |       | 198,410                          |       | 126,815 |   |
| Federal  funds sold                                       |       | 35,488                           |       | 40,792 |   |
| **Total interest income**                                 |       | 7,893,437                        |       | 6,974,285 |   |
| **Interest expense**                                      |       |                             |       |   |   |
| Certificates  of deposit of $100,000 or more              |       | 666,409                          |       | 676,023 |   |
| Other  deposits                                           |       | 1,730,497                        |       | 880,216 |   |
| Securities  sold under repurchase agreements              |       | 135,449                          |       | 196,809 |   |
| Other  short-term borrowings and long-term debt           |       | 1,125,363                        |       | 940,851 |   |
| Other                                                     |       | 5,410                            |       | 4,582 |   |
| **Total interest expense**                                |       | 3,663,128                        |       | 2,698,481 |   |
| **Net interest income**                                   |       | 4,230,309                        |       | 4,275,804 |   |
| Provision  for loan losses                                |       | 75,000                           |       | 80,000 |   |
| **Net interest income, after provision for loan  losses** |       | 4,155,309                        |       | 4,195,804 |   |
| **Other income:**                                         |       |                             |       |   |   |
| Service  charges on deposit accounts                      |       | 631,727                          |       | 598,321 |   |
| Gain  (loss) on:                                          |       |                             |       |   |   |
| Investment  securities                                    |       | (168                             | )          | — |   |
| Loans                                                     |       | 14,985                           |       | (11,442 | ) |
| Leased  assets                                            |       | 15,054                           |       | (34,873 | ) |
| Foreclosed  assets held for sale                          |       | 405                              |       | 405 |   |
| Write-down  lease residual                                |       | —                           |       | (220,000 | ) |
| Fees  and other service charges                           |       | 465,262                          |       | 415,202 |   |
| **Total other income**                                    |       | 1,127,265                        |       | 747,613 |   |
| **Other expenses:**                                       |       |                             |       |   |   |
| Salaries  and employee benefits                           |       | 2,006,814                        |       | 1,742,921 |   |
| Premises  and equipment                                   |       | 800,851                          |       | 734,455 |   |
| Advertising                                               |       | 128,373                          |       | 131,209 |   |
| Professional  fees and services                           |       | 282,489                          |       | 382,043 |   |
| Other                                                     |       | 702,663                          |       | 575,284 |   |
| **Total other expenses**                                  |       | 3,921,190                        |       | 3,565,912 |   |
| **Income before provision for income taxes**              |       | 1,361,384                        |       | 1,377,505 |   |
| Provision  for income taxes                               |       | 329,753                          |       | 358,116 |   |
| **Net income**                                            |       | $                                | 1,031,631  |   | $ | 1,019,389 |   |
| Per  share data:                                          |       |                             |       |   |   |
| Net  income - basic                                       |       | $                                | 0.51       |   | $ | 0.50 |   |
| Net  income - diluted                                     |       | $                                | 0.50       |   | $ | 0.50 |   |
| Dividends                                                 |       | $                                | 0.22       |   | $ | 0.20 |   |

 

See Notes to ConsolidatedFinancial Statements

 

4

----

 

**FIDELITY D & DBANCORP, INC.**

ConsolidatedStatements of Changes in Shareholders’ Equity

For the Three Months Ended March 31,2006 and 2005

 
| ** **                                                                                                                             | ** ** | ** **             | ** ** | ** **   | ** ** | ** **        | ** ** | **Accumulated other** | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|--------------|------------|-------------------|------------|----------------------------|------------|------------|------------|
| ** **                                                                                                                             | ** ** | **Capital stock** | ** ** | **Retained** | ** ** | **comprehensive** | ** ** | ** **                 | ** ** |
| ** **                                                                                                                             | ** ** | **Shares ***      | ** ** | **Amount**   | ** ** | **earnings**      | ** ** | **(loss)**                 | ** ** | **Total**  | ** ** |
| Balance,  December 31, 2004 (audited)                                                                                             |       | 2,023,529              |       | $            | 10,072,134 |              | $          | 36,396,027                 |       | $          | (101,401   | ) | $ | 46,366,760 |   |
| Total  comprehensive income:                                                                                                           |       |                   |       |         |       |              |       |                       |       |       |       |
| Net  income                                                                                                                            |       |                   |       |         |       | 1,019,389         |       |                       |       | 1,019,389  |       |
| Change  in net unrealized holding gains (losses) on available-for-sale securities,  net of reclassification adjustment and tax effects |       |                   |       |         |       |              |       | (906,950                   | )          | (906,950   | )          |
| Comprehensive  income                                                                                                                  |       |                   |       |         |       |              |       |                       |       | 112,439    |       |
| Issuance  of common stock through Employee Stock Purchase Plan                                                                         |       | 1,134                  |       | 31,671       |       |              |       |                       |       | 31,671     |       |
| Dividends  reinvested through Dividend Reinvestment Plan                                                                               |       | 3,733                  |       | 120,572      |       |              |       |                       |       | 120,572    |       |
| Cash  dividend declared                                                                                                                |       |                   |       |         |       | (404,932          | )          |                       |       | (404,932   | )          |
| Balance,  March 31, 2005 (unaudited)                                                                                              |       | 2,028,396              |       | $            | 10,224,377 |              | $          | 37,010,484                 |       | $          | (1,008,351 | ) | $ | 46,226,510 |   |

 

----

* The number of shares has been adjustedto reflect the retroactive effect of a 10% stock dividend paid on February 15,2006.

 
| ** **                                                                                                                             | ** ** | ** **             | ** ** | ** **   | ** ** | ** **        | ** ** | **Accumulated other** | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|--------------|------------|-------------------|------------|----------------------------|------------|------------|------------|
| ** **                                                                                                                             | ** ** | **Capital stock** | ** ** | **Retained** | ** ** | **comprehensive** | ** ** | ** **                 | ** ** |
| ** **                                                                                                                             | ** ** | **Shares**             | ** ** | **Amount**   | ** ** | **earnings**      | ** ** | **(loss)**                 | ** ** | **Total**  | ** ** |
| Balance,  December 31, 2005 (audited)                                                                                             |       | 1,854,217              |       | $            | 10,594,901 |              | $          | 39,363,461                 |       | $          | (1,112,333 | ) | $ | 48,846,029 |   |
| Total  comprehensive income:                                                                                                           |       |                   |       |         |       |              |       |                       |       |       |       |
| Net  income                                                                                                                            |       |                   |       |         |       | 1,031,631         |       |                       |       | 1,031,631  |       |
| Change  in net unrealized holding gains (losses) on available-for-sale securities,  net of reclassification adjustment and tax effects |       |                   |       |         |       |              |       | (698,263                   | )          | (698,263   | )          |
| Comprehensive  income                                                                                                                  |       |                   |       |         |       |              |       |                       |       | 333,368    |       |
| Issuance  of common stock through Employee Stock Purchase Plan                                                                         |       | 1,571                  |       | 48,151       |       |              |       |                       |       | 48,151     |       |
| Dividends  reinvested through Dividend Reinvestment Plan                                                                               |       | 3,620                  |       | 141,180      |       |              |       |                       |       | 141,180    |       |
| Stock-based  compensation expense                                                                                                      |       |                   |       | 21,913       |       |              |       |                       |       | 21,913     |       |
| Cash  dividend declared                                                                                                                |       |                   |       |         |       | (449,060          | )          |                       |       | (449,060   | )          |
| Stock  dividend declared                                                                                                               |       | 185,394                |       | 7,462,100    |       | (7,462,100        | )          |                       |       | —     |       |
| Cash  paid for fractional shares on stock dividend                                                                                     |       |                   |       |         |       | (7,448            | )          |                       |       | (7,448     | )          |
| Balance,  March 31, 2006 (unaudited)                                                                                              |       | 2,044,802              |       | $            | 18,268,245 |              | $          | 32,476,484                 |       | $          | (1,810,596 | ) | $ | 48,934,133 |   |

 

See Notes to Consolidated FinancialStatements

 

5

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**FIDELITY D & DBANCORP, INC.**

Consolidated Statements of Cash Flows

(unaudited)

 
| ** **                                                                         | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                         | ** ** | **March 31, 2006**     | ** ** | **March 31, 2005** | ** ** |
| **Cash flows from operating activities:**                                          |       |                             |       |   |   |
| Net  income                                                                        |       | $                                | 1,031,631  |   | $ | 1,019,389 |   |
| Adjustments  to reconcile net income to net cash provided by operating activities: |       |                             |       |   |   |
| Depreciation                                                                       |       | 294,860                          |       | 285,546 |   |
| Net  amortization of securities                                                    |       | 26,505                           |       | 108,079 |   |
| Provision  for loan losses                                                         |       | 75,000                           |       | 80,000 |   |
| Deferred  income tax expense (benefit)                                             |       | 91,443                           |       | (105,682 | ) |
| Stock-based  compensation expense                                                  |       | 21,913                           |       | — |   |
| Amortization  of investment in limited partnership                                 |       | 22,500                           |       | 22,500 |   |
| Proceeds  from sale of loans available-for-sale                                    |       | 1,777,954                        |       | 404,963 |   |
| Originations  of loans available for sale                                          |       | (2,287,637                       | )          | (240,019 | ) |
| Write-down  of foreclosed assets held for sale                                     |       | —                           |       | 28,603 |   |
| Write-down  lease residual                                                         |       | —                           |       | 220,000 |   |
| Increase  in cash surrender value of life insurance                                |       | (70,409                          | )          | (57,792 | ) |
| Loss  on sale of investment securities                                             |       | 168                              |       | — |   |
| (Gain)  loss on sale of loans                                                      |       | (14,985                          | )          | 11,442 |   |
| Gain  on sale of foreclosed assets held-for-sale                                   |       | (405                             | )          | (405 | ) |
| Loss  on sale of leased assets                                                     |       | —                           |       | 34,873 |   |
| Amortization  of loan servicing rights                                             |       | 18,813                           |       | 27,952 |   |
| Change  in:                                                                        |       |                             |       |   |   |
| Accrued  interest receivable                                                       |       | (226,778                         | )          | (355,499 | ) |
| Other  assets                                                                      |       | (516,168                         | )          | (459,472 | ) |
| Accrued  interest payable and other liabilities                                    |       | 158,053                          |       | 570,995 |   |
| Net  cash provided by operating activities                                         |       | 402,458                          |       | 1,595,473 |   |
| **Cash flows from investing activities:**                                          |       |                             |       |   |   |
| Held-to-maturity  securities:                                                      |       |                             |       |   |   |
| Proceeds  from maturities, calls and principal pay-downs                           |       | 85,055                           |       | 164,184 |   |
| Available-for-sale  securities:                                                    |       |                             |       |   |   |
| Proceeds  from sales                                                               |       | 1,537,336                        |       | — |   |
| Proceeds  from maturities, calls and principal pay-downs                           |       | 1,542,173                        |       | 4,376,627 |   |
| Purchases                                                                          |       | (22,776,490                      | )          | (1,454,954 | ) |
| Net  (increase) decrease in FHLB stock                                             |       | (70,800                          | )          | 737,500 |   |
| Net  (increase) decrease in loans and leases                                       |       | (7,385,044                       | )          | 3,478,773 |   |
| Proceeds  from sale of leased assets                                               |       | —                           |       | 210,671 |   |
| Acquisition  of bank premises and equipment                                        |       | (155,489                         | )          | (77,537 | ) |
| Proceeds  from sale of foreclosed assets held-for-sale                             |       | —                           |       | 5,817 |   |
| Net  cash (used in) provided by investing activities                               |       | (27,223,259                      | )          | 7,441,081 |   |
| **Cash flows from financing activities:**                                          |       |                             |       |   |   |
| Net  (decrease) increase in non-interest-bearing deposits                          |       | (2,668,189                       | )          | 485,776 |   |
| Net  decrease in certificates of deposit of $100,000 or more                       |       | (6,888,037                       | )          | (1,484,239 | ) |
| Net  increase in other interest-bearing deposits                                   |       | 38,561,860                       |       | 15,408,496 |   |
| Net  decrease in short-term borrowings                                             |       | (1,350,461                       | )          | (11,463,224 | ) |
| Repayments  of long-term debt                                                      |       | (2,674,840                       | )          | (192,758 | ) |
| Dividends  paid, net of dividend reinvestment                                      |       | (307,880                         | )          | (284,360 | ) |
| Proceeds  from employee stock purchase plan                                        |       | 48,151                           |       | 31,671 |   |
| Cash  payments in lieu of fractional shares on stock dividend                      |       | (7,448                           | )          | — |   |
| Net  cash provided by financing activities                                         |       | 24,713,156                       |       | 2,501,362 |   |
| Net (decrease) increase  in cash and cash equivalents                              |       | (2,107,645                       | )          | 11,537,916 |   |
| Cash  and cash equivalents, beginning                                              |       | 12,594,540                       |       | 10,216,394 |   |
| Cash  and cash equivalents, ending                                                 |       | $                                | 10,486,895 |   | $ | 21,754,310 |   |

 

See Notes to ConsolidatedFinancial Statements

 

6

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**FIDELITYD & D BANCORP, INC.**

 

**Notes to Consolidated Financial Statements**

**(unaudited)**

 

**1.****                                      Natureof operations and critical accounting policies**

 

**Principles of consolidation**

 

The accompanying unaudited consolidated financial statements ofFidelity D & D Bancorp, Inc., and its wholly-owned subsidiary,The Fidelity Deposit and Discount Bank (the Bank or collectively, the Company)have been prepared in accordance with accounting principles generally acceptedin the United States of America (“GAAP”) for interim financial information andwith the instructions to this Form 10-Q and Rule 10-01 of RegulationS-X. Accordingly, they do not include all of the information and footnotedisclosures required by GAAP for complete financial statements. In the opinionof management, all normal recurring adjustments necessary for a fairpresentation of the financial condition and results of operations for theperiods have been included. All significant inter-company balances andtransactions have been eliminated in consolidation. Prior period amounts arereclassified when necessary to conform to the current period’spresentation. During the fourth quarter of 2005, the Company changed itsclassification, within the consolidated statements of cash flows, of theactivity associated with loans available-for-sale from investing activities tooperating activities. Accordingly, the cash flows for the quarter ended March 31,2005 have been reclassified to conform to the current year’s quarterpresentation. The effect of the change increased operating cash flows by$165,000 and decreased investing cash flows by $165,000. The Company believesthe change in classification of loans available-for-sale is preferable becauseit better reflects the primary business purpose of these transactions andcomplies with the requirements of SFAS 102, *Statement of CashFlows—Exemption of Certain Enterprises and Classification of Cash Flows fromCertain Securities Acquired for Resale.*On January 17, 2006,the Board of Directors declared a 10% stock dividend. The new common shareswere distributed on February 15, 2006 to shareholders of record at theclose of business on January 30, 2006. All common stock and per-share data,presented in the prior period, has been adjusted to reflect the retroactiveeffect of the 10% stock dividend.

 

 The preparation of financial statements inconformity with GAAP requires management to make estimates and assumptions thataffect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reported periods. Actualresults could differ from those estimates. For additional information anddisclosures required under GAAP, refer to the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2005.

 

**Nature of operations**

 

The Bank is a commercialbank chartered in the Commonwealth of Pennsylvania and a wholly-ownedsubsidiary of the Company. Having commenced operations in 1903, the Bank iscommitted to provide superior customer service, while offering a full range ofbanking products and financial and trust services, to both our consumer andcommercial customers from its main office located in Dunmore and other branchesthroughout Lackawanna and Luzerne counties.

 

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 financial statements present fairly the financial conditionand results of operations of the Company.

 

In the opinion of Management,the consolidated balance sheets as of March 31, 2006 and December 31,2005 and the related consolidated statements of income for each of the threemonth periods ended March 31, 2006 and March 31, 2005 and changes inshareholders’ equity and cash flows for each of the three month periods ended March 31,2006 and March 31, 2005 present fairly the financial condition and resultsof operations of the Company. All material adjustments required for a fairpresentation have been made. These adjustments are of a normal recurring nature.As indicated in Note 3, “Stock Plans”, included herein, the Company adoptedStatement of Financial Accounting Standard 123R,*Share-Based Payment,*during the first quarter of 2006. There have been no other materialchanges in accounting principles and practices or in the method of application.Other than the retroactive adjustment of 2005 common stock and the related per-sharedata, as a result of the 10% stock dividend noted above,

 

7

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there have been no otherretroactive adjustments during these periods. The results of operations forinterim periods are not necessarily indicative of the results of operations forthe entire year.

 

This Quarterly Report on Form 10-Qshould be read in conjunction with the Company’s audited financial statementsfor the year ended December 31, 2005 and the notes included therein,included within the Company’s Annual Report filed on Form 10-K.

 

**Critical accounting policies**

 

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

 

A material estimate thatis particularly susceptible to significant change is the determination of theallowance for loan losses (the allowance). Management believes that theallowance, as of March 31, 2006, is adequate and reasonable. Given thesubjective nature of identifying and valuing loan losses, it is likely thatwell-informed individuals could make materially different assumptions, andcould, therefore calculate a materially different allowance value. Whilemanagement uses available information to recognize losses on loans, changes ineconomic conditions may necessitate revisions in the future. In addition,various regulatory agencies, as an integral part of their examinationprocess, periodically review the Company’s allowance. Such agencies may requirethe Company to recognize adjustments to the allowance based on their judgmentsof information available to them at the time of their examination.

 

Another material estimateis the calculation of fair values of the Company’s investment securities. TheCompany receives estimated fair values of investment securities from anindependent valuation service. In developing these fair values, the valuationservice uses estimates of cash flows, based on historical performance ofsimilar instruments in similar interest rate environments. Based on experience,Management is aware that estimated fair values of investment securities tend tovary among valuation services. Accordingly, when selling investment securities,Management may obtain price quotes from more than one source. Available-for-sale(“AFS”) securities are carried at fair value on the consolidated balance sheet,with unrealized gains and losses, net of income tax, reported separately withinshareholders’ equity through accumulated other comprehensive income (loss).

 

The fair value ofresidential mortgage loans, classified as AFS, is obtained from the FederalNational Mortgage Association (“FNMA”). To determine the fair value of studentloans, classified as AFS, the Bank uses the pricing obtained from the mostrecent student loans sold from its AFS portfolio. From time-to-time, the Bank may originateSmall Business Administration (“SBA”) loans AFS. The fair value of SBA loans,classified as AFS, is obtained from an outside pricing source. The market towhich the Bank sells mortgage and other loans is restricted and price quotesfrom other sources are not typically obtained. As of March 31, 2006 and December 31,2005, the AFS loan portfolio consisted of residential mortgage and studentloans.

 

**2.****                                      Earningsper 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 or dilute the earnings of the Company. TheCompany 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 this method, the assumed proceeds received from shares issued,in a hypothetical stock option exercise, are assumed to be used to purchasetreasury stock. Pursuant to the guidance of Statement of Financial AccountingStandard (“SFAS”) No. 128, *Earning Per Share,*proceeds include: proceeds from the exercise of outstanding stock options;compensation cost for future service that the Company has not yet recognized;and any “windfall” tax benefits that would be credited directly to shareholders’equity when the grant generates a tax deduction (or a reduction in proceeds ifthere is a charge to equity). For a further discussion on the Company’s stockoption plans, see note 3, below.

 

The following table illustrates the data used in computing basic EPS anda reconciliation to derive at the components

 

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of diluted EPS for the periods indicated:

 
| **Three months ended March 31,**          | ** ** | **2006**  | ** ** | **2005**  | ** ** |
|---------------------------------------------------------------|------------|-----------|------------|-----------|------------|
| Basic  EPS:                                                   |       |      |       |      |       |
| Net  income available to common shareholders                  |       | $         | 1,031,631  |      | $          | 1,019,389 |   |
| Weighted-average  common shares outstanding                   |       | 2,041,979 |       | 2,025,425 |       |
| Basic  EPS                                                    |       | $         | 0.51       |      | $          | 0.50 |   |
|                                                          |       |      |       |      |       |
| Diluted  EPS:                                                 |       |      |       |      |       |
| Net  income available to common shareholders                  |       | $         | 1,031,631  |      | $          | 1,019,389 |   |
| Weighted-average  common shares outstanding                   |       | 2,041,979 |       | 2,025,425 |       |
| Dilutive  potential common shares                             |       | 2,321     |       | 580       |       |
| Weighted-average  common shares and dilutive potential shares |       | 2,044,300 |       | 2,026,005 |       |
| Diluted  EPS                                                  |       | $         | 0.50       |      | $          | 0.50 |   |

 

**3.****                                      Stockplans**

 

In December 2004,the Financial Accounting Standard Board, (the “FASB”) issued SFAS 123R*, Share-Based Payment,* which replaces SFAS 123, *Accounting for Stock-Based Compensation*,and supersedes Accounting Principles Bulletin Opinion 25, *Accounting for Stock Issued to Employees*. SFAS123R requires that the cost of share-based payment transactions (includingthose with employees and non-employees) be recognized in the financialstatements. SFAS 123R applies to all share-based payment transactions in whichan entity acquires goods or services by issuing (or offering to issue) itsshares, share options, or other equity instruments (except for those held by anESOP) or by incurring liabilities (1) in amounts based (even in part) onthe price of the entity’s shares or other equity instruments, or (2) thatrequire (or may require) settlement by the issuance of an entity’s sharesor other equity instruments.

 

On January 1, 2006,the Company implemented the provisions SFAS 123R using the Modified ProspectiveApplication transition method (the “MPA”). The MPA requires the Company toapply the provisions of SFAS 123R to: (a) new awards granted after itsadoption; (b) any awards that were granted after the first fiscal yearbeginning after December 15, 1994 that have not vested by the date theCompany adopts SFAS 123R; and (c) any outstanding liability awards. Underthe MPA, the Company is not required to adjust prior years’ financialstatements. In addition, as of December 31, 2005, all of the Bank’s stockoption awards granted, prior to that date, were fully vested and therefore theBank is not required to apply the provisions of SFAS 123R to these previouslygranted share-based awards. Therefore, the following discussion will be mostapplicable to share-based awards issued during the first quarter of 2006.

 

The Company has twostock-based compensation plans (the “plans”). The plans wereshareholder-approved and permit the grant of share-based compensation awards toits directors, key officers and certain other employees. The Company believesthat these plans better align the interest of its directors, key officers andemployees with the interest of its shareholders. The Company further believesthat the granting of share-based awards, under the provisions of the plans, isnecessary to retain the knowledge base, continuity and expertise of itsdirectors, key officers and certain employees.

 

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. Under the 2000Independent Directors Stock Option Plan, each outside director is awarded stockoptions to purchase 500 shares of the Company’s common stock on the firstbusiness day of January, each year, at the fair market value on date of grant. Nostock options were awarded during the first quarter of 2006 or for each of theyears ended December 31, 2005, 2004 and 2003 due to the directors’voluntary election to forego the award. At March 31, 2006 and December 31,2005, there were 14,850 unexercised stock options outstanding under this plan.

 

The Company has alsoestablished the 2000 Stock Incentive Plan and has reserved 55,000 shares of itsun-issued capital stock for issuance under the plan. Under the 2000 StockIncentive Plan, key officers and certain other

 

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employees are eligible tobe awarded qualified stock options to purchase the Company’s common stock atthe fair market value on the date of grant. During the first quarter of 2006,2,200 shares were issued under the 2000 Stock Incentive plan. No stock optionswere awarded for each of the years ended December 31, 2005, 2004 and 2003.As of March 31, 2006 and December 31, 2005, there were 5,830 and5,280, respectively, unexercised stock options outstanding under this plan.

 

Under both plans, optionsare granted with an exercise price equal to the market price of the Company’sstock at the date of grant. The awards vest based on six months of continuousservice from the date of grant and have 10-year contractual terms. Generally,all shares that are granted become fully vested.

 

The Company does not havestock options that are traded on organized capital exchanges. As such, theestimated fair value of options awarded under its plans is determined, on thedate of grant, using the Black-Scholes Option Pricing Valuation Model. For theoptions granted during the first quarter of 2006, the model incorporated theassumptions noted in the following table:

 
| Expected  volatility     |   | 16.00 | %           |
|--------------------------|--------|-------|-------------|
| Expected  dividend       |   | 2.41  | %           |
| Risk-free  interest rate |   | 4.35  | %           |
| Expected  term           |   | 5.25  |  years |

 

The expected volatilitywas determined based on the daily five-year historical volatility of theCompany’s stock. Management believes the five-year historical volatilitymeasurement closely resembles the fluctuation of its stock under most economicconditions and cycles. Because of the relatively short vesting period, themodel assumes that all options granted will fully vest. The risk-free rate isfor the period within the expected term of the options based on the U.S.Treasury yield curve. The Company used the simplified method to determine theterm in which options are expected to be outstanding.

 

A summary of the statusof the Company’s stock option plans as of March 31, 2006, December 31,2005 and December 31, 2004 and changes during the periods is presentedbelow:

 
| ** **                           | ** ** | ** **  | ** ** | ** **       | ** ** | **Weighted-**       | ** ** | ** **    | ** ** |
|--------------------------------------|------------|-------------|------------|------------------|------------|---------------------|------------|---------------|------------|
| ** **                           | ** ** | ** **  | ** ** | **Weighted-**    | ** ** | **average**         | ** ** | ** **    | ** ** |
| ** **                           | ** ** | ** **  | ** ** | **average**      | ** ** | **remaining**       | ** ** | **Aggregate** | ** ** |
| ** **                           | ** ** | ** **  | ** ** | **exercise**     | ** ** | **contractual**     | ** ** | **intrinsic** | ** ** |
| ** **                           | ** ** | **Options** | ** ** | **price *** | ** ** | **term (yrs)** | ** ** | **value**     | ** ** |
|                                 |       |        |       |             |       |                |       |          |       |
| Outstanding,  December 31, 2004 |       | 20,570      |       | $                | 32.29      |                | 5.7        |          |       |   |
| Granted                              |       | —      |       |             |       |                |       |          |       |
| Exercised                            |       | —      |       |             |       |                |       |          |       |
| Forfeited  or expired                |       | (440        | )          | 34.09            |       |                |       |          |       |
| Outstanding,  December 31, 2005 |       | 20,130      |       | 32.25            |       | 4.7                 |       |          |       |
| Granted                              |       | 2,200       |       | 36.59            |       |                |       |          |       |
| Exercised                            |       | —      |       |             |       |                |       |          |       |
| Forfeited  or expired                |       | (1,650      | )          | 33.07            |       |                |       |          |       |
| Outstanding,  March 31, 2006    |       | 20,680      |       | $                | 32.64      |                | 5.0        |          | $          | 102,482 |   |
| Exercisable,  March 31, 2006    |       | 18,480      |       | $                | 32.17      |                | 4.4        |          | $          | 100,260 |   |

 

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* Includes options with exercise pricesranging from $28.18 to $36.59 per share.

 

 

No options have beengranted under the 2000 Independent Directors Stock Option Plan since 2002 andall options previously granted and outstanding are fully vested. As of March 31,2006, no options have been exercised under the provisions of this plan.

 

Under the 2000 StockIncentive Plan, the grant-date fair value of the options granted during thethree months ended March 31, 2006 was determined to be $6.21 per share. Approximately$6,800 of stock-based compensation expense was recorded during the quarterended March 31, 2006 and is included as a component of salaries and employeebenefits in the consolidated income statement. Since the plan is a qualifiedoption plan under the Internal Revenue Code, no tax benefit will be recordeduntil the shares are exercised by the recipients. No options were exercised

 

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during the periodspresented. Since the Company adopted SFAS 123R on January 1, 2006, underthe MPA, the comparable data for the previous periods is not required to bereported. As of March 31, 2006, there were 2,200 non-vested shares with agrant-date fair value of $6.21 per share. Therefore, there was approximately $6,800of unrecognized compensation expense related to the non-vested share-basedcompensation agreements granted under the plan as of March 31, 2006. Thenon-vested shares and related unrecognized compensation are expected to fullyvest and be recognized during the second quarter of 2006.

 

In addition to the twostock option plans above, the Company has established the 2002 Employee StockPurchase Plan (the “ESPP”) and has reserved 110,000 shares of its un-issuedcapital stock for issuance under the plan. The plan was designed to promotebroad-based employee ownership of the Company’s stock. Under the 2002 ESPP,employees may have automatic payroll deductions to purchase the Company’scapital stock at a discounted price based on the fair market value of theCompany’s capital stock on either the commencement date or termination date. AtMarch 31, 2006, 6,051 shares have been issued under the plan. The ESPP isconsidered a compensatory plan and, as such, is required to comply with theprovisions of SFAS 123R. The Company recognizes compensation expense on itsESPP Plan on the date the shares are purchased. For the three months ended March 31,2006, compensation expense related to the ESPP amounted to approximately$15,000 and is included as a component of salaries and employee benefits in theconsolidated income statement.

 

**Item 2: Management’s Discussion and Analysis of FinancialCondition and Results of Operations**

 

The following is Management’sdiscussion and analysis of the significant changes in the consolidated financialcondition of the Company as of March 31, 2006 compared to December 31,2005 and the results of operations for the three months ended March 31,2006 and March 31, 2005. Current performance may not be indicative offuture results. This discussion should be read in conjunction with the Company’s2005 Annual Report filed on Form 10-K.

 

**Forward looking statements**

 

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

 

Forward-lookingstatements are based on various assumptions and analyses made by us in light ofManagement’s experience and its perception of historical trends, currentconditions and expected future developments, as well as other factors Managementbelieves are appropriate under the circumstances. These statements are notguarantees of future performance and are subject to risks, uncertainties andother factors (many of which are beyond our control) that could cause actualresults to differ materially from future results expressed or implied by suchforward-looking statements. These factors include, without limitation, thefollowing:

 

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

 

•                  theremay be increases in competitive pressure among financial institutions orfrom non-financial institutions;

 

•                  changesin the interest rate environment may reduce interest margins;

 

•                  changesin deposit flows, loan demand or real estate values may adversely affectour business;

 

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

 

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

 

•                  legislativeor regulatory changes may adversely affect our business;

 

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

 

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•                  successor consummation of new business initiatives may be more difficult orexpensive than we anticipate;

 

•                  actsof war or terrorism; or

 

•                  naturaldisaster.

 

Management cautionsreaders not to place undue reliance on forward-looking statements, whichreflect analyses only as of the date of this document. We have no obligation toupdate any forward-looking statements to reflect events or circumstances afterthe date of this document. Readers should review the risk factors described inother documents that we file or furnish, from time to time, with the Securitiesand Exchange Commission, including Annual Reports to Shareholders, AnnualReports filed on Form 10-K and other current reports filed or furnished onForm 8-K.

 

**General**

 

The Company’s principalrevenues are derived from interest, dividends and fees earned on itsinterest-earning assets, which are comprised of loans, securities and othershort-term investments. The Company’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, which is thedifference between interest income generated from its interest-earning assetsand the interest expense incurred on its interest-bearing liabilities. Netinterest income is dependent upon the interest-rate spread, which is thedifference between the average yield earned on interest-earning assets and theaverage rate paid on interest-bearing liabilities. When interest-earning assetsapproximate or exceed interest-bearing liabilities, any positive rate spreadwill generate net interest income. The interest rate spread is significantly impactedby changes in interest rates and market yield curves and their related impacton cash flows, customer deposit flows and loan demand. The interest rate spreadis further influenced by the composition and characteristics ofinterest-earning assets and interest-bearing liabilities and by the competitionin our marketplace. The interest rate spread and the changes in the interestrate spread, from period-to-period, is also affected by differences in thematurity and re-pricing characteristics of the assets compared to the maturityand re-pricing characteristics of the liabilities that fund them.

 

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 mostly of service charges on the Bank’s loan and depositproducts, trust and asset management service fees, increases in the cashsurrender value of the bank owned life insurance (“BOLI”), net gains or lossesfrom sales of leases, securities and loans AFS and from the sale of other realestate (“ORE”) properties. Non-interest expense consists of compensation andrelated employee benefit expenses, occupancy, equipment, data processing,advertising, marketing, professional fees, insurance and other operatingoverhead.

 

The Company’sprofitability is significantly affected by general economic and competitiveconditions, changes in market interest rates, government policies and actionsof regulatory authorities. The Company’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 and multi-family properties.

 

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**COMPARISONOF RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED**

**MARCH 31,2006 AND MARCH 31, 2005**

 

**Overview**

 

Net income for the first quarterof 2006 was $1,032,000, an increase of $13,000 or 1%, from the $1,019,000recorded in the same quarter in 2005. Diluted earnings per share for each ofthe respective periods was $0.50.

 

The improvement in netincome was primarily the result of an increase in total interest income and anincrease in non-interest income. These items were partially offset by increasesin interest expense and other operating expenses.

 

The change in net incomeresulted in marginal variances in return on average assets (“ROA”) and returnon average shareholders’ equity (“ROE”) at 0.75% and 8.81%, respectively, forthe three months ended March 31, 2006 compared to 0.77% and 8.85%,respectively, for the same period in 2005.

 

*Net interest income and interestsensitive assets / liabilities*

 

Net interest income decreased$46,000, or 1%, to $4,230,000 for the first quarter of 2006, from $4,276,000 recordedin the same period of 2005. The decrease was principally due to the effect risinginterest rates had on the rates paid on average interest-bearing liabilitiescompared to the effect rising interest rates had on our interest-earning assets.Rates paid increased 78 basis points, to 3.36%, for the three months ended March 31,2006 compared to 2.58% for the same 2005 period. In addition to the increase inrates paid, there was an increase in the average interest-bearing liabilitiesof $17,531,000 during the same comparable periods. To be competitive in ourmarketplace, Management has endeavored to attract and retain core deposits byaggressively pursing these products via various marketing and rate enhancing techniques.From these efforts, average core deposits, which excludes time deposits ofgreater than $100,000, increased approximately $42,157,000 during the firstquarter of 2006 compared to the fourth quarter of 2005 and increased $51,586,000from the quarter ended March 31, 2005. As a result, interest expense ondeposits increased $841,000, or 54%, during the first quarter of 2006 comparedto the same quarter of 2005. Interest expense on borrowings increased $124,000,or 11%, due predominantly to increases in market rates. Average balances of non-interestbearing deposits (“DDAs”) remained stable from year-end December 31, 2005.DDAs are an important funding source as they have the effect of reducing the costof money that is used to fund interest-earning assets. Management has committedto continue the campaign to attract and retain these core-deposits and will furtherimplement deposit-gathering strategies throughout 2006.

 

Partially offsetting theincrease in interest expense was a $919,000, or 13%, increase in interestincome. The increase was due primarily to a 49 basis point increase on therates earned on its average interest-earning assets which also increased in thefirst quarter of 2006 compared to the first quarter of 2005. During this period,the loan portfolio increased $28,556,000 on average and yielded 41 basis pointsmore during the current year quarter than in the same quarter of 2005. Theincrease in the loan portfolio was from the successful implementation ofvarious sales campaigns programs targeted at mortgage and home equity lendingproducts and increased production in commercial lending. Both the increase inyield and average interest-earning assets supported net interest income, but toa lesser degree than the effect higher rates paid on interest-bearingliabilities.

 

During the first quarterof 2006, the Bank’s tax-equivalent margin and spread both decreased 14 and 27 basispoints, respectively, compared to the first quarter of 2005. The decline inmargin and spread is the result of the rates paid on the Bank’sinterest-bearing liabilities increasing at a faster pace than the increase inthe yields earned on interest-earning assets.

 

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The following table setsforth, a comparison of average balance sheet amounts and their correspondingtax-equivalent interest income and expense and annualized tax-equivalent yield andcost for the periods indicated (dollars in thousands):

 
| ** **                                    | ** ** | **Three months ended** | ** ** | **Year ended**   | ** ** |
|-----------------------------------------------|------------|----------------------------------|------------|-----------------------|------------|
| ** **                                    | ** ** | **March 31,**               | ** ** | **December 31,** | ** ** |
| ** **                                    | ** ** | **2006**                         | ** ** | **2005**              | ** ** | **2005** | ** ** |
| Average  interest-earning assets:             |       |                             |       |                  |       |   |   |
| Loans  and leases                             |       | $                                | 414,410    |                  | $          | 385,854 |   | $ | 391,854 |   |
| Investments                                   |       | 114,098                          |       | 118,421               |       | 113,562 |   |
| Federal  funds sold                           |       | 3,385                            |       | 6,369                 |       | 1,866 |   |
| Interest-bearing  deposits                    |       | 280                              |       | 642                   |       | 540 |   |
| Total                                         |       | $                                | 532,173    |                  | $          | 511,286 |   | $ | 507,822 |   |
|                                          |       |                             |       |                  |       |   |   |
| Average  interest-bearing liabilities:        |       |                             |       |                  |       |   |   |
| Other  interest-bearing deposits              |       | $                                | 172,856    |                  | $          | 116,709 |   | $ | 126,481 |   |
| Certificates  of deposit                      |       | 157,446                          |       | 182,905               |       | 174,688 |   |
| Borrowed  funds                               |       | 87,158                           |       | 76,300                |       | 82,114 |   |
| Repurchase  agreements                        |       | 24,786                           |       | 48,801                |       | 35,106 |   |
| Total                                         |       | $                                | 442,246    |                  | $          | 424,715 |   | $ | 418,389 |   |
|                                          |       |                             |       |                  |       |   |   |
| Interest  income:                             |       |                             |       |                  |       |   |   |
| Loans  and leases                             |       | $                                | 6,699      |                  | $          | 5,832 |   | $ | 24,514 |   |
| Investments                                   |       | 1,306                            |       | 1,211                 |       | 4,979 |   |
| Federal  funds sold                           |       | 35                               |       | 40                    |       | 49 |   |
| Interest-bearing  deposits                    |       | 3                                |       | 3                     |       | 14 |   |
| Total                                         |       | $                                | 8,043      |                  | $          | 7,086 |   | $ | 29,556 |   |
|                                          |       |                             |       |                  |       |   |   |
| Interest  expense:                            |       |                             |       |                  |       |   |   |
| Other  interest-bearing deposits              |       | $                                | 1,050      |                  | $          | 232 |   | $ | 1,573 |   |
| Certificates  of deposit                      |       | 1,347                            |       | 1,324                 |       | 5,355 |   |
| Borrowed  funds                               |       | 1,131                            |       | 945                   |       | 4,159 |   |
| Repurchase  agreements                        |       | 135                              |       | 197                   |       | 634 |   |
| Total                                         |       | $                                | 3,663      |                  | $          | 2,698 |   | $ | 11,721 |   |
|                                          |       |                             |       |                  |       |   |   |
| Net  interest income                          |       | $                                | 4,380      |                  | $          | 4,388 |   | $ | 17,835 |   |
|                                          |       |                             |       |                  |       |   |   |
| Yield  on average interest-earning assets     |       | 6.13                             | %          | 5.62                  | %          | 5.82 | % |
| Rate  on average interest-bearing liabilities |       | 3.36                             | %          | 2.58                  | %          | 2.80 | % |
| Net  interest spread                          |       | 2.77                             | %          | 3.04                  | %          | 3.02 | % |
| Net  interest margin                          |       | 3.34                             | %          | 3.48                  | %          | 3.51 | % |

 

In the table above,interest income was adjusted to a tax-equivalent basis to recognize the income fromthe various tax-exempt assets as if the interest was fully taxable. Thistreatment allows a uniform comparison among the yields on interest-earningassets. The calculations were computed on a fully tax-equivalent basis usingthe corporate federal tax rate of 34%. Net interest spread represents thedifference between the yield on interest-earning assets and the rate oninterest-bearing liabilities. Net interest margin represents the ratio of netinterest income to total average interest-earning assets.

 

*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 the Bank’sloan and lease portfolio. Loans and leases determined to be uncollectible arecharged-off against the allowance for loan losses.

 

The required amount ofthe provision for loan losses, based upon the adequate level of the allowancefor loan losses, is subject to ongoing analysis of the loan portfolio. The Bank’sSpecial Asset Committee meets periodically to review problem loans and leases. Thecommittee is comprised of Bank Management, including the chief risk officer,loan

 

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workout officers andcollection personnel. The committee reports quarterly to the Credit AdministrationCommittee 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:

 

•                  Specificloans that could have loss potential

•                  Levelsof and trends in delinquencies and non-accrual loans

•                  Levelsof and trends in charge-offs and recoveries

•                  Trendsin volume and terms of loans

•                  Changesin risk selection and underwriting standards

•                  Changesin lending policies, procedures and practices

•                  Experience,ability and depth of lending management

•                  Nationaland local economic trends and conditions

•                  Changesin credit concentrations

 

The provision for loanlosses was $75,000, for the three months ended March 31, 2006, compared to$80,000 for the three months ended March 31, 2005. As a result, theallowance was $5,716,000 at March 31, 2006 compared to $6,001,000 at March 31,2005. The decrease in the provision for loan losses was driven by a decrease innon-performing loans, which consist of loans past due 90 days or more andnon-accrual loans. The balance of non-performing loans declined $654,000 to$8,996,000 at March 31, 2006, compared to $9,650,000 at December 31,2005. The decrease was mainly attributable to the collection and pay-offs ofnon-accrual loans. Our Special Assets Department continues to aggressivelymanage and pursue the collection and resolution of non-accruing loans which hasresulted in these reductions.

 

*Other income*

 

Total other (non-interest)income increased $380,000, or 51%, for the three months ended March 31,2006 compared to the same period in 2005. During the 2005 quarter, the Bankrecognized an estimated impairment charge of $220,000 in anticipation of projectedrealized losses from the future sales of its leased vehicles. The Bank’sautomobile lease finance business concluded in 2005, and similar impairmentcharges from this activity will not recur. Service charges on deposit accounts increased$33,000 or 6%, due primarily to growth in debit card activity. Fees, otherservice charges and other non-interest related income increased $50,000 or 12%,from increases in trust and financial service fees and an increase in the cashsurrender value of BOLI during the first quarter of 2006 compared to the sameperiod of 2005.

 

*Other operating expenses*

 

Other (non-interest) expensesincreased $355,000, or 10%, for the three months ended March 31, 2006 comparedto the same period in 2005. Salary and employee benefits increased $264,000, or15%, due to pay increases, increased number of full-time equivalent employees,one-time voluntary separation benefit payments and stock-based compensationexpense (see footnote 3, “Stock Plans”, of the consolidated financialstatements, included herein for a discussion on the Company’s adoption of SFAS123R). The increase in premises and equipment was caused by increased repairand maintenance associated with maintenance agreement renewal costs. Thedecrease in professional service fees was caused mostly by non-recurringexpenses associated with the 2005 Bank-wide participation in management skillsdevelopment and sales training programs as well as a decrease in outsideconsulting fees for Sarbanes-Oxley compliance documentation procedures.

 

*Income tax provision*

 

Compared to the firstquarter of 2005, income before provision for income taxes for the first quarterof 2006 was relatively unchanged. The effective federal income tax rate was 26.0%for 2005 and 24.2% for 2006. The effective tax rate decrease is attributable toan increased portion of combined tax-free interest income from municipalsecurities, tax-free loans and tax-free earnings from the BOLI, collectively representinga larger portion of pre-tax earnings.

 

15

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**COMPARISONOF FINANCIAL CONDITION AT**

**MARCH 31,2006 AND DECEMBER 31, 2005**

 

*Overview*

 

Consolidated assets increased $25,226,000, or 5%, during the threemonths ended March 31, 2006 to $569,287,000. The asset increase resultedfrom an increase in deposits of $29,006,000, partially offset by a decrease incombined short-and long-term borrowings of $4,025,000. Total investments andnet loans increased $18,527,000 and $7,760,000, respectively, since December 31,2005. Shareholders’ equity increased modestly with increases from net income,stock issuance from the Company sponsored employee stock purchase and thedividend reinvestment plans and recognition of stock-based compensation,partially offset by an increase in the unrealized loss on AFS securities and anincrease in cash dividends declared. The decline in the market value ofsecurities AFS is due to the predominant increasing interest rate environmentwhich largely began in 2004.

 

*Investment securities*

 

At the time of purchase, the Bank classifies investment securities intoone of three categories: trading, AFS or held-to- maturity (“HTM”). To date,Management has not purchased any securities for trading purposes. Managementclassifies most securities as AFS even though it has no immediate intent tosell them. The AFS designation affords Management the flexibility to sellsecurities and adjust the balance sheet in response to capital levels,liquidity needs, structuring strategies and/or changes in market conditions. SecuritiesAFS are carried at net fair market value in the consolidated balance sheet withan adjustment to stockholders’ equity, net of tax, which is presented under thecaption “Accumulated other comprehensive income (loss).”  Securities designated as HTM are carried atamortized cost.

 

At March 31, 2006, the carrying value of investment securitiestotaled $116,206,000, or 20%, of total assets compared to $97,679,000 or 18%,as of December 31, 2005. The increase in investments was due to thedeployment of deposit inflow, mostly into short-term U.S. government agencysecurities, to meet regulatory requirements. At March 31, 2006,approximately 35% of the carrying value of the investment portfolio wascomprised of mortgage-backed securities that amortize and provide monthly cashflow. Also, as March 31, 2006, agency and municipal bonds comprised 44%and 13%, respectively, of the investment portfolio.

 

As illustrated in the following table of amortized cost and fair marketvalue of investment securities, the portfolio is comprised of HTM and AFS securitieswith carrying values of $1,911,000 and $114,295,000, respectively. At March 31,2006, the AFS debt securities were recorded with a net unrealized loss in theamount of $2,925,000 and equity securities were recorded with an unrealizedgain of $182,000:

 
| ** **                                        | ** ** | **Amortized** | ** ** | **Gross unrealized** | ** ** | **Gross unrealized** | ** ** | **Fair**  | ** ** |
|---------------------------------------------------|------------|---------------|------------|---------------------------|------------|---------------------------|------------|-----------|------------|
| **(dollars in thousands)**              | ** ** | **cost**      | ** ** | **gains**                 | ** ** | **losses**                | ** ** | **value** | ** ** |
|                                              |       |          |       |                      |       |                      |       |      |       |
| Held-to-maturity  securities:                     |       |          |       |                      |       |                      |       |      |       |
|                                              |       |          |       |                      |       |                      |       |      |       |
| Mortgage-backed  securities                       |       | $             | 1,911      |                      | $          | 30                        |       | $         | —     |   | $ | 1,941 |   |
|                                              |       |          |       |                      |       |                      |       |      |       |
| Available-for-sale  securities:                   |       |          |       |                      |       |                      |       |      |       |
| U.S.  government agencies and corporations        |       | $             | 51,907     |                      | $          | —                    |       | $         | 1,212      |   | $ | 50,695 |   |
| Obligations  of states and municipal subdivisions |       | 14,726        |       | 34                        |       | 172                       |       | 14,588    |       |
| Corporate  bonds                                  |       | 10,015        |       | 63                        |       | —                    |       | 10,078    |       |
| Mortgage-backed  securities                       |       | 40,111        |       | —                    |       | 1,638                     |       | 38,473    |       |
|                                              |       |          |       |                      |       |                      |       |      |       |
| Total debt                                        |       | 116,759       |       | 97                        |       | 3,022                     |       | 113,834   |       |
|                                              |       |          |       |                      |       |                      |       |      |       |
| Equity  securities                                |       | 279           |       | 182                       |       | —                    |       | 461       |       |
|                                              |       |          |       |                      |       |                      |       |      |       |
| Total  available-for-sale                         |       | $             | 117,038    |                      | $          | 279                       |       | $         | 3,022      |   | $ | 114,295 |   |

 

16

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The amortized cost andfair value of debt securities at March 31, 2006 by contractual maturityare as follows (dollars in thousands):

 

| ** **                                | ** ** | **Amortized** | ** ** | **Market** | ** ** |
|-------------------------------------------|------------|---------------|------------|------------|------------|
| ** **                                | ** ** | **cost**      | ** ** | **value**  | ** ** |
| Held-to-maturity  securities:             |       |          |       |       |       |
| Mortgage-backed  securities               |       | $             | 1,911      |       | $          | 1,941 |   |
|                                      |       |          |       |       |       |
| Available-for-sale  securities:           |       |          |       |       |       |
| Debt  securities:                         |       |          |       |       |       |
| One year or  less                         |       | $             | 14,951     |       | $          | 14,930 |   |
| One through  five years                   |       | 9,992         |       | 9,741      |       |
| Five through  ten years                   |       | 24,190        |       | 23,435     |       |
| Over ten  years                           |       | 27,515        |       | 27,255     |       |
| Total debt  securities                    |       | 76,648        |       | 75,361     |       |
|                                      |       |          |       |       |       |
| Mortgage-backed  securities               |       | 40,111        |       | 38,473     |       |
|                                      |       |          |       |       |       |
| Total  available-for-sale debt securities |       | $             | 116,759    |       | $          | 113,834 |   |

 

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

 

Management evaluates securities for other-than-temporary impairment ona quarterly basis or more frequently when economic conditions or marketconditions warrant such evaluation. Consideration is given to (1) thelength of time and the extent to which the fair value has been less than cost, (2) thefinancial condition and near-term prospects of the issuer, and (3) theintent and ability of the Company to retain its investment in the issuer for aperiod of time sufficient to allow for any anticipated recovery in fair value.

 

At March 31, 2006, the AFS debt securities portfolio was carriedat a net unrealized loss $2,925,000 compared to $1,859,000 at December 31,2005. The U.S. government or its agencies guarantee most of the debt andmortgage-backed securities. In analyzing an issuer’s financial condition,Management considers whether the securities are issued by the U.S. government,its agencies or other governments, whether downgrades by bond rating agencieshave occurred and the results of reviews of the issuer’s financial condition. Becausethe decline in market values is attributable to changes in interest rates andnot credit quality, and the Company has the ability and intent to hold thosesecurities until a recovery of fair value, which may be maturity,Management does not consider those securities to be other-than-temporarilyimpaired.

 

*Loans available - for- sale (“AFS”)*

 

Generally, upon origination, certain residential mortgages, theguaranteed portions of Small Business Administration loans and student loansare classified as AFS. In the event of market rate increases, fixed-rate loansand loans not immediately scheduled to re-price would no longer produce yieldsconsistent with the current market. In a declining interest rate environment,the Bank would be exposed to prepayment risk and, as rates on adjustable rateloans decrease, interest income would be negatively affected. To better manageprepayment and interest rate risk, loans that meet these conditions may beconsidered for sale in the secondary market. Consideration is also given to theCompany’s current liquidity position and expected future liquidity needs. LoansAFS are carried at the lower of cost or estimated fair value. If the fairmarket values of these loans fall below their amortized cost, the loan iswritten down by the difference with a corresponding charge to current earnings.Subsequent appreciation, if any, is credited to current earnings but only tothe extent of previous write-downs.

 

At March 31, 2006, loans AFS amounted to $953,000 with acorresponding fair value of $965,000, compared to $429,000 and $434,000,respectively, at December 31, 2005. For the first quarter of 2006,residential mortgage and student loans with principal balances of $1,769,000were sold into the secondary market with combined net gains of approximately$15,000 recognized.

 

17

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*Loans and leases*

 

The Bank originates commercial and industrial (commercial) andcommercial real estate loans, residential, consumer, home equity andconstruction loans. The relative volume of originations is dependent uponcustomer demand, current interest rates and the perception and duration offuture interest levels. The Bank continues to focus its efforts on theexpansion of variable-rate commercial loan portfolios and fixed-rateresidential mortgage and consumer loans. The broad spectrum of productsprovides diversification which helps manage, to an extent, interest rate riskand credit concentration risk. Credit risk is further managed throughunderwriting policies and procedures and loan monitoring practices. Interestrate risk is managed using various asset/liability modeling techniques andanalyses. The interest rates on most commercial loans are adjustable with resetintervals of five years or less.

 

The majority of our loan portfolio is collateralized, at least in part,by real estate in the greater Lackawanna and Luzerne Counties of Pennsylvania. Commerciallending activities generally involve a greater degree of credit risk thanresidential lending because they typically have larger balances and are moreaffected by adverse conditions in the economy. Because payments on commercialloans depend upon the successful operation and management of the properties andthe businesses which operate from within them, repayment of such loans may beaffected by factors outside the borrower’s control. Such factors may includeadverse conditions in the real estate market, the economy, the industry orchanges in government regulations. As such, commercial loans require moreongoing evaluation and monitoring which occurs with the Bank’s creditadministration and outsourced loan review functions.

 

Gross loans, of $416,096,000 at March 31, 2006 increased from$409,129,000 at December 31, 2005. Strength in origination activity hasboosted the commercial and residential real estate portfolios. Residential realestate loan growth was reasonably strong due to the demand generated from arelatively low interest rate environment and efforts of advertising andmarketing campaigns. The increase in commercial and commercial real estatelending is principally due to the addition of experienced senior lenders to thecommercial lending team and the team’s focus on providing outstanding serviceand value-added proposals to the Bank’s customer base.

 

The composition of the loan portfolio at March 31,2006 and December 31, 2005, is summarized as follows:

 
| ** **                             | ** ** | **March 31, 2006** | ** **  | **December 31, 2005** | ** ** |
|----------------------------------------|------------|------------------------------|-------------|---------------------------------|------------|
| ** **                             | ** ** | **Amount**                   | ** **  | **%**                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| Commercial  and commercial real estate |       | $                            | 219,743,485 |                            | 52.8       |   | $ | 216,288,597 |   | 52.9 |   |
| Residential  real estate               |       | 107,573,042                  |        | 25.8                            |       | 103,920,613 |   | 25.4 |   |
| Consumer and  home equity              |       | 74,463,688                   |        | 17.9                            |       | 74,070,328 |   | 18.1 |   |
| Real estate  construction              |       | 13,681,138                   |        | 3.3                             |       | 14,198,858 |   | 3.4 |   |
| Direct  financing leases               |       | 634,962                      |        | 0.2                             |       | 650,348 |   | 0.2 |   |
| Gross loans                            |       | 416,096,315                  |        | 100.0                           |       | 409,128,744 |   | 100.0 |   |
| Allowance  for loan losses             |       | (5,716,473                   | )           |                            |       | (5,984,649 | ) |   |   |
| Net loans                              |       | $                            | 410,379,842 |                            |       |   | $ | 403,144,095 |   |   |   |

 

*Allowance for loan losses*

 

Management continually evaluates the credit quality of the Bank’s loanand lease portfolio and performs a formal review of the adequacy of theallowance for loan losses (the “allowance”), on a quarterly basis. Theallowance reflects Management’s best estimate of the amount of credit losses inthe loan portfolio. Management’s judgment is based on the evaluation ofindividual loans, past experience, the assessment of current economicconditions and other relevant factors including the amounts and timing of cashflows 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. Recoveriesfrom previously charged-off loans are added to the allowance when received.

 

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

 

18

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•                  Identificationof specific problem loans by loan category;

•                  Calculationof specific allowances required based on collateral and objective andquantifiable evidence;

•                  Determinationof homogenous pools by loan category and eliminating loans with specificallocations;

•                  Applicationof historical loss percentages (three-year average) to pools to determine theallowance allocation; and

•                  Applicationof qualitative factor adjustment percentages to historical losses for trends orchanges in the loan portfolio.

 

Allocation of the allowance for different categories of loans is basedon the methodology as explained above. A key element of the methodology todetermine the allowance is the Company’s credit risk evaluation process, whichincludes credit risk grading of individual commercial loans. Commercial loansare assigned credit risk grades based on the Company’s assessment of conditionsthat affect the borrower’s ability to meet its contractual obligations underthe loan agreement. That process includes reviewing borrowers’ currentfinancial information, historical payment experience, credit documentation,public information and other information specific to each individual borrower. Thechanges in the allocations from period to period are based upon the credit riskgrading assigned from periodic reviews of the loan and lease portfolios.

 

Net charge-offs for the three months ended March 31, 2006 were$343,000, compared to $67,000 for the same period in 2005. Net charge-offs ofcommercial loans were $188,000 for the three months ended March 31, 2006compared to $36,000 in the first quarter of 2005. Real estate mortgage netcharge-offs were $32,000 in the first quarter of 2006 opposed to $2,000 in thefirst quarter of 2005. Consumer loan net charge-offs were $124,000 for thequarter ended March 31, 2006 as compared to $29,000 in the first quarterof 2005. The 2005 quarter included three sizeable recoveries. There were nolease financing charge-offs during the quarter ended March 31, 2006 andrecoveries posted were nominal.

 

Management believes that the current balance in the allowance for loanslosses of $5,716,000 is sufficient to withstand the identified potential creditquality issues that may arise and are inherent to the portfolio. Currently,Management is unaware of any potential problem loans that have not beenreviewed. Potential problem loans are those where there is known informationthat leads Management to believe repayment of principal and/or interest is injeopardy and the loans are neither on non-accrual status nor past due 90 daysor more. However, there could be instances which become identified over theyear that may require additional charge-offs and/or increases to theallowance. The ratio of allowance for loan losses to total loans was 1.37% at March 31,2006 compared 1.46% at December 31, 2005 and 1.56% at March 31, 2005.

 

19

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

 
| ** **                       | ** ** | **As of and for the** | ** **  | **As of and for the** | ** ** | **As of and for the** | ** ** |
|----------------------------------|------------|-------------------------------------------|-------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                       | ** ** | **three months ended**          | ** **  | **year ended**                       | ** ** | **three months ended**          | ** ** |
| ** **                       | ** ** | **March 31, 2006**              | ** **  | **December 31, 2005**           | ** ** | **March 31, 2005**              | ** ** |
|                             |       |                                      |        |                                      |       |                                      |       |
| Balance at  beginning of period  |       | $                                         | 5,984,649   |                                      | $          | 5,987,798                                 |       | $ | 5,987,798 |   |
|                             |       |                                      |        |                                      |       |                                      |       |
| Provision  charged to operations |       | 75,000                                    |        | 830,000                                   |       | 80,000                                    |       |
|                             |       |                                      |        |                                      |       |                                      |       |
| Charge-offs:                     |       |                                      |        |                                      |       |                                      |       |
| Commercial                       |       | 213,093                                   |        | 1,076,721                                 |       | 322,425                                   |       |
| Real estate                      |       | 31,626                                    |        | 20,875                                    |       | 1,846                                     |       |
| Consumer                         |       | 137,334                                   |        | 287,676                                   |       | 70,437                                    |       |
| Lease  financing                 |       | —                                    |        | 8,373                                     |       | —                                    |       |
| Total                            |       | 382,053                                   |        | 1,393,645                                 |       | 394,708                                   |       |
|                             |       |                                      |        |                                      |       |                                      |       |
| Recoveries:                      |       |                                      |        |                                      |       |                                      |       |
| Commercial                       |       | 25,576                                    |        | 395,162                                   |       | 286,133                                   |       |
| Real estate                      |       | 30                                        |        | 10,677                                    |       | 30                                        |       |
| Consumer                         |       | 13,071                                    |        | 154,557                                   |       | 41,703                                    |       |
| Lease  financing                 |       | 200                                       |        | 100                                       |       | —                                    |       |
| Total                            |       | 38,877                                    |        | 560,496                                   |       | 327,866                                   |       |
|                             |       |                                      |        |                                      |       |                                      |       |
| Net  charge-offs                 |       | 343,176                                   |        | 833,149                                   |       | 66,842                                    |       |
|                             |       |                                      |        |                                      |       |                                      |       |
| Balance at  end of period        |       | $                                         | 5,716,473   |                                      | $          | 5,984,649                                 |       | $ | 6,000,956 |   |
|                             |       |                                      |        |                                      |       |                                      |       |
| Total loans,  end of period      |       | $                                         | 416,096,315 |                                      | $          | 409,128,744                               |       | $ | 383,893,563 |   |

 
| ** **                                                                | ** ** | **As of and for the** | ** ** | **As of and for the** | ** ** | **As of and for the** | ** ** |
|---------------------------------------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                | ** ** | **three months ended**          | ** ** | **year ended**                       | ** ** | **three months ended**          | ** ** |
| ** **                                                                | ** ** | **March 31, 2006**              | ** ** | **December 31, 2005**           | ** ** | **March 31, 2005**              | ** ** |
| Net  charge-offs to:                                                      |       |                                      |       |                                      |       |                                      |       |
| Loans, end  of period                                                     |       | 0.08                                      | %          | 0.20                                      | %          | 0.02                                      | %          |
| Allowance  for loan losses                                                |       | 6.00                                      | %          | 13.92                                     | %          | 1.11                                      | %          |
| Provision  for loan losses                                                |       | 4.58                                      | x          | 1.00                                      | x          | 0.84                                      | x          |
|                                                                      |       |                                      |       |                                      |       |                                      |       |
| Allowance  for loan losses to:                                            |       |                                      |       |                                      |       |                                      |       |
| Total loans                                                               |       | 1.37                                      | %          | 1.46                                      | %          | 1.56                                      | %          |
| Non-accrual  loans                                                        |       | 0.65                                      | x          | 0.63                                      | x          | 0.66                                      | x          |
| Non-performing  loans                                                     |       | 0.64                                      | x          | 0.62                                      | x          | 0.62                                      | x          |
| Net  charge-offs                                                          |       | 16.66                                     | x          | 7.18                                      | x          | 89.78                                     | x          |
|                                                                      |       |                                      |       |                                      |       |                                      |       |
| Loans 30-89  days past due and still accruing                             |       | $                                         | 1,180,974  |                                      | $          | 1,608,970                                 |       | $ | 3,709,674 |   |
| Loans 90  days past due and accruing                                      |       | $                                         | 156,640    |                                      | $          | 196,928                                   |       | $ | 608,130 |   |
| Non-accrual  loans                                                        |       | $                                         | 8,838,950  |                                      | $          | 9,452,788                                 |       | $ | 9,125,051 |   |
| Allowance  for loan losses to loans 90 days or more past due and accruing |       | 36.49                                     | x          | 30.39                                     | x          | 9.87                                      | x          |

 

*Non-performing assets*

 

The Bank defines non-performing assets as accruing loans past due 90days or more, non-accrual loans, restructured loans, other real estate ownedand repossessed assets. As of March 31, 2006, non-performing assetsrepresented 1.60% of total assets compared to 1.78% at December 31, 2005and 1.84% at March 31, 2005.

 

20

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Thenon-accrual loan balance declined by $614,000 during the first three months of2006 to $8,839,000. There were additions to the non-accrual loans totaling$379,000 during the first three months of 2006. These additions were offset bypayoffs or pay downs of $567,000, charge offs of $332,000 and $93,000 of loansthat were transferred to other real estate owned. As of March 31, 2006,approximately one-half of the non-accrual loan balances consisted of a singlerelationship.

 

Foreclosedassets held for sale includes other real estate owned and repossessed assets. Otherreal estate owned represents three residential properties that were foreclosedupon and transferred from loans. The total of these three properties was$93,000 at March 31, 2006. All properties have been listed for sale withrealtors. There were no repossessed assets at quarter end March 31, 2006.

 

Non-performingloans declined $654,000 from year-end 2005, to $8,996,000 at March 31,2006. The decline occurred mainly in the commercial loans. The ratio ofnon-performing loans to end of period net loans declined 20 basis points,during the three month period ended March 31, 2006. For the same period in2005, the ratio of non-performing loans to net loans was 2.58%, compared to2.19% at March 31, 2006, or a decrease of 39 basis points. The ratio ofnon-performing assets to total assets decreased to 1.60%, at March 31,2006, from 1.78%, at year-end 2005. This is a result of the reduced levels ofdelinquencies and non-accrual loans, and an increase in assets.

 

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

 
| ** **                                                                         | ** ** | **March 31, 2006** | ** **  | **December 31, 2005** | ** ** | **March 31, 2005** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------|-------------|---------------------------------|------------|------------------------------|------------|
|                                                                               |       |                         |        |                            |       |                         |       |
| Loans past  due 90 days or more and accruing                                       |       | $                            | 156,640     |                            | $          | 196,928                      |       | $ | 608,130 |   |
| Non-accrual  loans                                                                 |       | 8,838,950                    |        | 9,452,788                       |       | 9,125,051                    |       |
| Total  non-performing loans                                                        |       | 8,995,590                    |        | 9,649,716                       |       | 9,733,181                    |       |
|                                                                               |       |                         |        |                            |       |                         |       |
| Restructured  loans                                                                |       | —                       |        | —                          |       | —                       |       |
| Other real  estate owned                                                           |       | 92,999                       |        | —                          |       | 163,000                      |       |
| Repossessed  assets                                                                |       | —                       |        | 18,702                          |       | 44,271                       |       |
| Total  non-performing assets                                                       |       | $                            | 9,088,589   |                            | $          | 9,668,418                    |       | $ | 9,940,452 |   |
|                                                                               |       |                         |        |                            |       |                         |       |
| Net loans  including AFS                                                           |       | $                            | 411,333,094 |                            | $          | 403,572,679                  |       | $ | 377,892,607 |   |
| Total assets                                                                       |       | $                            | 569,286,783 |                            | $          | 544,060,698                  |       | $ | 539,859,529 |   |
| Non-accrual  loans to net loans                                                    |       | 2.15                         | %           | 2.34                            | %          | 2.41                         | %          |
| Non-performing  assets to net loans, foreclosed real estate and repossessed assets |       | 2.21                         | %           | 2.40                            | %          | 2.63                         | %          |
| Non-performing  assets to total assets                                             |       | 1.60                         | %           | 1.78                            | %          | 1.84                         | %          |
| Non-performing  loans to net loans                                                 |       | 2.19                         | %           | 2.39                            | %          | 2.58                         | %          |

 

*Accrued interest receivable and other assets*

 

The increase in accrued interest receivable of $227,000 or 12%, from December 31,2005 to March 31, 2006 was principally due to the additional investmentsecurities purchased during the quarter. The increase in other assets of$743,000, or 18%, for the same period, was due to an increase in the deferredincome tax asset caused by the decline in value in the securities AFS portfolioand the cyclical increase in prepaid expenses.

 

*Deposits*

 

The Bank is a community-based commercial financial institution andoffers a variety of deposit accounts with a range of interest rates and terms. Depositproducts include non-interest bearing, savings, NOW, money market, andcertificates of deposit accounts. The flow of deposits is significantlyinfluenced by general economic conditions, changes in prevailing interestrates, pricing and competition. Most of the Bank’s deposits are obtained fromthe communities surrounding its 12 branch offices. We attempt to attract andretain deposit customers via sales and marketing efforts with new products,quality service, competitive rates and maintaining long-standing customer relationships.

 

To determine deposit product interest rates, the Bank considers localcompetition, market yields and the rates charged for alternative sources offunding such as borrowings. Although we have experienced a continued intensecompetition for deposits, we have not increased rates above market rates, as weonly consider cost effective strategies in all interest

 

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rate environments.

 

The following table represents the major components of deposits as of March 31,2006 and December 31, 2005:

 
| ** **                                   | ** ** | **March 31, 2006** | ** **  | **December 31, 2005** | ** ** |
|----------------------------------------------|------------|------------------------------|-------------|---------------------------------|------------|
| ** **                                   | ** ** | **Amount**                   | ** **  | **%**                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| Money market                                 |       | $                            | 64,615,816  |                            | 15.8       |   | $ | 51,583,473 |   | 13.6 |   |
| NOW                                          |       | 74,916,215                   |        | 18.3                            |       | 50,048,331 |   | 13.2 |   |
| Savings and  club                            |       | 47,278,126                   |        | 11.6                            |       | 46,434,150 |   | 12.3 |   |
| Certificates  of deposit less than $100,000  |       | 84,631,704                   |        | 20.7                            |       | 84,814,047 |   | 22.3 |   |
| Certificates  of deposit of $100,000 or more |       | 69,369,516                   |        | 17.0                            |       | 76,257,553 |   | 20.1 |   |
| Total  interest-bearing                      |       | 340,811,377                  |        | 83.4                            |       | 309,137,554 |   | 81.5 |   |
| Non-interest  bearing                        |       | 67,692,897                   |        | 16.6                            |       | 70,361,086 |   | 18.5 |   |
| Total  deposits                              |       | $                            | 408,504,274 |                            | 100.0      |   | $ | 379,498,640 |   | 100.0 |   |

 

Compared to December 31, 2005, total deposits increased$29,005,000, or 8%, during the three months ended March 31, 2006. Theincrease in total deposits was primarily due to a $24,867,000, or 50%, increasein NOW accounts, much of which stems from our continued positive relationshipwith our public sector customers. The $13,032,000, or 25%, increase in moneymarket accounts was due to the successful implementation of deposit-gatheringstrategies in conjunction with increased short-term promotional interest ratesand transfers from less attractive time deposits. Though the Bank hasintroduced some promotional strategies for shorter-term time deposits,Management did not aggressively pursue time deposits; rather, most of theefforts were targeted to attracting transactional, no-term core deposits suchas NOW and money market accounts. Despite the decline in non-interest bearingdeposits, from a 2005 year-end business deposit surge, the Bank did experiencegrowth from personal relationship customers. Going forward, Management willcontinue to develop strategies and implement campaigns to attract thisall-important cost-lowering funding source.

 

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

 

*Management of interest rate risk and marketrisk analysis*

 

The Company is subject to the interest rate risks inherent in ourlending, investing and financing activities. Fluctuations of interest rateswill impact interest income and interest expense along with affecting marketvalues of all interest-earning assets and interest-bearing liabilities, exceptfor those assets or liabilities with a short-term remaining to maturity. Interestrate risk management is an integral part of the asset/liability managementprocess. The Company has instituted certain procedures and policy guidelines tomanage the interest rate risk position. Those internal policies enable theCompany to react to changes in market rates to protect net interest income fromsignificant fluctuations. The primary objective in managing interest rate riskis to minimize the adverse impact of changes in interest rates on net interestincome along with creating an asset/liability structure that maximizesearnings.

 

*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 the Company’sAsset/Liability Committee (“ALCO”), which is comprised of Senior Management andmembers of the Board of Directors. ALCO meets quarterly to monitor therelationship of interest sensitive assets to interest sensitive liabilities. Theprocess to review interest rate risk is a regular part of managing theCompany. Consistent policies and practices of measuring and reporting interestrate risk exposure, particularly regarding the treatment of non-contractualassets and liabilities, are in effect. In addition, there is an annual processto review the interest rate risk policy with the Board of Directors whichincludes limits on the impact to earnings from shifts in interest rates.

 

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

 

*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 as forecastedchanges in the level 

 

22

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of interest rate changes.

 

To manage this interest rate sensitivity gap position, anasset/liability model called cumulative gap analysis is used to monitor thedifference in the volume of the Company’s interest sensitive assets andliabilities that mature or re-price within given periods. A positive gap (assetsensitive) indicates that more assets re-price during a given period comparedto liabilities, 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 varying interestrate changes and balance sheet compositions. The use of this model assists theALCO to gauge the effects of the interest rate changes on interest sensitiveassets and liabilities in order to determine what impact these rate changeswill have upon the net interest spread. At March 31, 2006, the Companymaintained a negative one-year cumulative gap of $68,373,000 or -12.0% of totalassets. The effect of this negative gap position provided a mismatch of assetsand liabilities, which may expose the Bank to interest rate risk during aperiod of increasing interest rates. Conversely, in a declining interest rateenvironment, net interest income could be positively impacted because moreliabilities than assets will re-price downward during a one-year period.

 

Certain shortcomings are inherent in themethod of analysis discussed above and presented in the next table. Althoughcertain assets and liabilities may have similar maturities or periods ofre-pricing, they may react in different degrees to changes in marketinterest rates. The interest rates on certain types of assets and liabilities may fluctuatein advance of changes in market interest rates, while interest rates on othertypes of asset and liabilities may lag behind changes in market interestrates. Certain assets, such as adjustable-rate mortgages, have features whichrestrict changes in interest rates on a short-term basis and over the life ofthe asset. In the event of a change in interest rates, prepayment and earlywithdrawal levels may deviate significantly from those assumed incalculating the table. The ability of many borrowers to service theiradjustable-rate debt may decrease in the event of an interest rateincrease.

 

23

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The following table illustrates the Company’s interest sensitivity gapposition at March 31, 2006 (dollars in thousands):

 
| ** **                                     | ** ** | **3 months** | ** ** | **3 through** | ** ** | **1 through** | ** ** | **Over**         | ** ** | ** ** | ** ** |
|------------------------------------------------|------------|-------------------|------------|--------------------|------------|--------------------|------------|------------------|------------|------------|------------|
| ** **                                     | ** ** | **or less**  | ** ** | **12 months** | ** ** | **3 years**   | ** ** | **3 years** | ** ** | **Total**  | ** ** |
| Cash and  cash equivalents                     |       | $                 | 137        |               | $          | —             |       | $                | —     |       | $          | 10,350 |   | $ | 10,487 |   |
| Investment  securities (1)(2)                  |       | 11,760            |       | 22,454             |       | 18,244             |       | 68,447           |       | 120,905    |       |
| Loans (2)                                      |       | 119,196           |       | 60,356             |       | 98,011             |       | 133,770          |       | 411,333    |       |
| Fixed and  other assets                        |       | —            |       | 7,962              |       | —             |       | 18,600           |       | 26,562     |       |
| Total assets                                   |       | $                 | 131,093    |               | $          | 90,772             |       | $                | 116,255    |       | $          | 231,167 |   | $ | 569,287 |   |
| Total  cumulative assets                       |       | $                 | 131,093    |               | $          | 221,865            |       | $                | 338,120    |       | $          | 569,287 |   |   |   |
|                                           |       |              |       |               |       |               |       |             |       |       |       |
| Non-interest  bearing transaction deposits (3) |       | $                 | —     |               | $          | 6,770              |       | $                | 18,616     |       | $          | 42,307 |   | $ | 67,693 |   |
| Interest-bearing  transaction deposits (3)     |       | 80,715            |       | 53,604             |       | 42,837             |       | 9,654            |       | 186,810    |       |
| Time  deposits                                 |       | 32,324            |       | 74,431             |       | 28,341             |       | 18,905           |       | 154,001    |       |
| Repurchase  agreements                         |       | 16,241            |       | 6,175              |       | 1,745              |       | —           |       | 24,161     |       |
| Short-term  borrowings                         |       | 3,262             |       | —             |       | —             |       | —           |       | 3,262      |       |
| Long-term  debt                                |       | 7,730             |       | 8,986              |       | 11,313             |       | 53,000           |       | 81,029     |       |
| Other  liabilities                             |       | —            |       | —             |       | —             |       | 3,397            |       | 3,397      |       |
| Total  liabilities                             |       | $                 | 140,272    |               | $          | 149,966            |       | $                | 102,852    |       | $          | 127,263 |   | $ | 520,353 |   |
| Total  cumulative liabilities                  |       | $                 | 140,272    |               | $          | 290,238            |       | $                | 393,090    |       | $          | 520,353 |   |   |   |
|                                           |       |              |       |               |       |               |       |             |       |       |       |
| Interest  sensitivity gap                      |       | $                 | (9,179     | )                  | $          | (59,194            | )          | $                | 13,403     |       | $          | 103,904 |   |   |   |
|                                           |       |              |       |               |       |               |       |             |       |       |       |
| Cumulative  gap                                |       | $                 | (9,179     | )                  | $          | (68,373            | )          | $                | (54,970    | )          | $          | 48,934 |   |   |   |
|                                           |       |              |       |               |       |               |       |             |       |       |       |
| Cumulative  gap to total assets                |       | -1.61             | %          | -12.01             | %          | -9.66              | %          | 8.60             | %          |       |       |

 

----

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

 

(2)          Investments and loansare included in the earlier of the period in which interest rates were nextscheduled to adjust or the period in which they are due. In addition, loans areincluded in the periods in which they are scheduled to be repaid based onscheduled amortization. For amortizing loans and mortgage-backed securities,annual prepayment rates are assumed reflecting historical experience as well asManagement’s knowledge and experience of its loan products.

 

(3)          The Bank’s demand andsavings accounts are generally subject to immediate withdrawal. However,Management considers a certain amount of such accounts to be core accountshaving significantly longer effective maturities based on the retentionexperiences of such deposits in changing interest rate environments. Theeffective maturities presented are the recommended maturity distribution limitsfor non-maturing deposits based on historical deposit studies.

 

*Earnings at Risk and Economic Value at RiskSimulations:* The Company recognizes that moresophisticated tools exist for measuring the interest rate risk in the balancesheet beyond static re-pricing gap analysis. Although it will continue tomeasure its re-pricing gap position, the Company utilizes additional modelingfor identifying and measuring the interest rate risk in the overall balancesheet. The ALCO is responsible for focusing on earnings at risk and economicvalue at risk, and how both relate to the risk-based capital position whenanalyzing the interest rate risk.

 

*Earnings at Risk.*Earningsat risk simulation measures the change in net interest income and net incomeshould interest rates rise and fall. The simulation recognizes that not allassets and liabilities re-price one-for-one with market rates (e.g., savingsrate). The ALCO looks at earnings at risk to determine income changes from abase case scenario under an increase and decrease of 200 basis points ininterest rate simulation models.

 

*Economic Value at Risk.*Earningsat risk simulation measure 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 rates simulation model. The ALCOrecognizes that, in some instances, this ratio may contradict the earningsat risk ratio.

 

24

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The following table illustrates the simulated impact of 200 basispoints upward or downward movement in interest rates on net interest income,net income and the change in economic value (portfolio equity). This analysisassumed that interest-earning asset and interest-bearing liability levels at March 31,2006 remained constant. The impact of the rate movements was developed bysimulating the effect of rates changing over a twelve-month period from the March 31,2006 levels:

 
| ** **                                            | ** ** | **Rates +200** | ** ** | **Rates -200** | ** ** |
|-------------------------------------------------------|------------|---------------------|------------|---------------------|------------|
|                                                  |       |                |       |                |       |
| Earnings at  risk:                                    |       |                |       |                |       |
| Percent  change in:                                   |       |                |       |                |       |
| Net interest  income                                  |       | 0.3                 | %          | (6.2                | )%         |
| Net income                                            |       | 1.6                 |       | (16.5               | )          |
|                                                  |       |                |       |                |       |
| Economic  value at risk:                              |       |                |       |                |       |
| Percent  change in:                                   |       |                |       |                |       |
| Economic  value of equity                             |       | (28.4               | )          | 7.4                 |       |
| Economic  value of equity as a percent of book assets |       | (2.8                | )          | 0.7                 |       |

 

Economic value has the most meaning when viewed within the context ofrisk-based capital. Therefore, the economic value may normally changebeyond the Company’s policy guideline for a short period of time as long as therisk-based capital ratio (after adjusting for the excess equity exposure) isgreater than 10%. At March 31, 2006, the Company’s risk-based capitalratio was 13.6%.

 

The table below summarizes estimated changes in net interest incomeover a twelve-month period beginning April 1, 2006, under alternateinterest rate scenarios using the income simulation model described above(dollars in thousands):

 
| ** **                                  | ** ** | **Net interest** | ** ** | **Dollar**   | ** ** | **Percent**  | ** ** |
|---------------------------------------------|------------|-----------------------|------------|--------------|------------|--------------|------------|
| **Change in interest rates** | ** ** | **income**            | ** ** | **variance** | ** ** | **variance** | ** ** |
|                                        |       |                  |       |         |       |         |       |
| +200 basis  points                          |       | $                     | 18,344     |         | $          | 62           |       | 0.3 | % |
| +100 basis  points                          |       | 18,257                |       | (25          | )          | (0.1         | )          |
| Flat rate                                   |       | 18,282                |       | —       |       | —       |       |
| -100 basis  points                          |       | 17,940                |       | (342         | )          | (1.9         | )          |
| -200 basis  points                          |       | 17,142                |       | (1,140       | )          | (6.2         | )          |
|                                             |            |                       |            |              |            |              |            |  |  |

 

Simulation models require assumptions about certain categories ofassets and liabilities. The models schedule existing assets andliabilities by their contractual maturity, estimated likely call date orearliest re-pricing opportunity. Mortgage-backed securities and amortizingloans are scheduled based on their anticipated cash flow including estimatedprepayments. For investment securities, we use a third party service to providecash flow estimates in the various rate environments. Savings accounts,including passbook, statement savings, money market and interest checkingaccounts do not have a stated maturity or re-pricing term and can be withdrawnor re-price at any time. This may impact the margin if more expensivealternative sources of deposits are required to fund loans or deposit run-off. Managementprojects the re-pricing characteristics of these accounts based on historicalperformance and assumptions that it believes reflect their rate sensitivity. Theconsulting model reinvests all maturities, repayments and prepayments for eachtype of asset or liability into the same product for a new like-term thenapplies growth or run-off estimates provided by Management. As a result, themix of interest-earning assets and interest bearing-liabilities is not heldconstant.

 

*Liquidity*

 

Liquidity management ensures that adequate funds will be available tomeet customers’ needs for borrowings, deposit withdrawals and maturities andnormal operating expenses of the Bank. Current sources of liquidity are cashand cash equivalents, asset maturities and pay downs within one year, loans andinvestments AFS, growth of core deposits, growth of repurchase agreements,increases of 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.

 

At March 31, 2006, the Companymaintained $10,487,000 in cash and cash equivalents. The Company also had

 

25

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$114,295,000 in investments AFS and$953,000 of loans AFS. This combined total of $125,735,000 represented 22% oftotal assets at March 31, 2006. Management believes this level ofliquidity to be strong and adequate to support current operations.

 

*Capital*

 

The Company is subject to various regulatory capital requirementsadministered by the federal banking agencies. Failure to meet minimum capitalrequirements can initiate certain mandatory and possible additionaldiscretionary actions by regulators that, if undertaken, could have a directmaterial effect on the Company’s financial statements. Under capital adequacyguidelines and the regulatory framework for prompt corrective action, theCompany 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 areassigned to broad risk categories, each with appropriate weights. The resultingcapital ratios represent capital as a percentage of total risk-weighted assetsand certain off-balance sheet items. The guidelines require all banks and bankholding companies to maintain a minimum ratio of total risk-based capital tototal risk-weighted assets (“Total Risk Adjusted Capital”) of 8%, includingTier I capital to total risk-weighted assets (“Tier I Capital”) of 4% and TierI capital to average total assets (“Leverage Ratio”) of at least 4%.

 

As of March 31, 2006, the Company meets all capital adequacyrequirements to which it is subject. The following table depicts the capitalamounts and ratios of the Company and the Bank as of March 31, 2006:

 
| ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                            | ** ** | **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                              |       | $          | 55,941,617 |       | 13.61      | %                          | $          | 32,885,118                            |       | 8.00                                      | %          | N/A |   | N/A |   |
| Bank                                      |       | $          | 55,591,199 |       | 13.53      | %                          | $          | 32,858,608                            |       | 8.00                                      | %          | $ | 41,073,260 |   | 10.00 | % |
| Tier I  capital (to risk-weighted assets) |       |       |       |       |       |                       |       |                                  |       |                                      |       |   |   |
| Consolidated                              |       | $          | 50,714,115 |       | 12.34      | %                          | $          | 16,442,559                            |       | 4.00                                      | %          | N/A |   | N/A |   |
| Bank                                      |       | $          | 50,443,299 |       | 12.28      | %                          | $          | 16,429,304                            |       | 4.00                                      | %          | $ | 24,643,956 |   | 6.00 | % |
| Tier I  Capital (to average assets)       |       |       |       |       |       |                       |       |                                  |       |                                      |       |   |   |
| Consolidated                              |       | $          | 50,714,115 |       | 9.05       | %                          | $          | 22,421,949                            |       | 4.00                                      | %          | N/A |   | N/A |   |
| Bank                                      |       | $          | 50,443,299 |       | 9.01       | %                          | $          | 22,405,435                            |       | 4.00                                      | %          | $ | 28,006,794 |   | 5.00 | % |

 

**Item 4. Controls and Procedures**

 

The Company maintains controls and procedures designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission. Based upon their evaluation of those controls and procedures as of the end of the period covered by this report, the Chief Executive and Chief Financial Officers of the Company concluded that the Company’s disclosure controls and procedures were adequate.

 

The Company assesses the adequacy of its internal control over financial reporting quarterly and enhances its controls in response to internal control assessments and internal and external audit and regulatory recommendations. Based on this assessment, the Company’s Management concluded that there have been no changes in the Company’s internal controls or in other factors that has materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

26

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**PART II - Other Information**

 

**Item 1.****           LegalProceedings**

 

Thenature of the Company’s business generates some litigation involving mattersarising in the ordinary course of business. However, in the opinion of theCompany, after consulting with legal counsel, no legal proceedings are pending,which, if determined adversely to the Company or the Bank, would have amaterial effect on the Company’s undivided profits or financial condition. Nolegal proceedings are pending other than ordinary routine litigation incidentalto the business of the Company and the Bank. In addition, to Management’sknowledge, no governmental authorities have initiated or contemplated anymaterial legal actions against the Company or the Bank.

 

**Item 1A.****            RiskFactors**

 

None

 

**Item 2.****           UnregisteredSales of Equity Securities and Use of Proceeds**

 

None

 

**Item 3.****           DefaultUpon Senior Securities**

 

None

 

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

 

None

 

**Item 5.****           OtherInformation**

 

None

 

**Item 6.****           Exhibits**

 

***3(i)******                                   Amendedand Restated Articles of Incorporation of Registrant.***Incorporated byreference to Exhibit 3(i) to Registrant’s Registration Statement No. 333-90273on Form S-4, filed with the SEC on November 3, 1999 and as amended onApril 6, 2000.

 

***3(ii)******                               Bylawsof Registrant.***Incorporated by reference to Exhibit 3(ii) to Registrant’sRegistration Statement No. 333-90273 on Form S-4, filed with the SECon November 3, 1999 and as amended on April 6, 2000.

 

***10.1******                              1998Independent Directors Stock Option Plan of The Fidelity Deposit and DiscountBank, as assumed by Registrant.***Incorporated by reference to Exhibit 10.1to Registrant’s Registration Statement No. 333-90273 on Form S-4,filed with the SEC on November 3, 1999 and as amended on April 6,2000.

 

***10.2******                              1998Stock Incentive Plan of The Fidelity Deposit and Discount Bank, as assumed byRegistrant.***Incorporated by reference to Exhibit 10.2 ofRegistrant’s Registration Statement No. 333-90273 on Form S-4, filedwith the SEC on November 3, 1999 and as amended on April 6, 2000.

 

***10.3******                              Form ofDeferred Compensation Plan of The Fidelity Deposit and Discount Bank.***Incorporatedby reference to Exhibit 10.3 to Registrant’s Registration StatementNo.333-45668 on Form S-1, filed with the SEC on September 12, 2000and as amended on October 11, 2000.

 

***10.4******                              Registrant’s2000 Dividend Reinvestment Plan.***Incorporated by reference to Exhibit 4to Registrant’s Registration Statement No. 333-45668 on Form S-1,filed with the SEC on September 12, 2000 and as amended by Pre-EffectiveAmendment No. 1 on October 11, 2000, by Post-Effective Amendment No. 1on May 30, 2001 and by Post-Effective Amendment No 2 on July 7, 2005.

 

***10.5******                              Registrant’s2000 Independent Directors Stock Option Plan.***Incorporated by referenceto Exhibit 4.3 to Registrant’s Registration Statement No. 333-64356on Form S-8 filed with the SEC on July 2, 2001.

 

***10.6******                              Registrant’s2000 Stock Incentive Plan***. Incorporated by reference to Exhibit 4.4to Registrant’s Registration Statement No. 333-64356 on Form S-8filed with the SEC on July 2, 2001.

 

***10.7******                              Registrant’s2002 Employee Stock Purchase Plan.***Incorporated by reference to Exhibit 4.5to

 

27

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Registrant’s Registration Statement No. 333-113339on Form S-8 filed with the SEC on March 5, 2004.

 

***10.***8                               ***Employment Agreement between Registrant, TheFidelity Deposit and Discount Bank and Steven C. Ackmann, dated June 21,2004.***Incorporated by reference to Exhibit 99.1 toRegistrant’s Current Report on Form 8-K filed with the SEC on June 24,2004.

 

***10.9******                              CompleteSettlement Agreement and General Release between Michael F. Marranca,Registrant and The Fidelity Deposit and Discount Bank, dated July30, 2004.***Incorporatedby reference to Exhibit 99.1 to Registrant’s Current Report on Form 8-Kfiled with the SEC on August 10, 2004.

 

***10.10******                    Changeof Control and Severance Agreement between James T. Gorman, Registrant and TheFidelity Deposit and Discount Bank, dated September 19, 2005.***Incorporatedby reference to Exhibit 99.1 to Registrant’s Current Report on Form 8-Kfiled with the SEC on September 22, 2005.

 

***10.11******                    Amendmentand Termination of the Deferred Compensation Agreement with Joseph J. Earyes,Daniel Santaniello, Registrant and The Fidelity Deposit and Discount Bank,dated November 1, 2005.***Incorporated by reference to Exhibits99.1and 99.2 to Registrant’s Current Report on Form 8-K filed with the SECon November 3, 2005.

 

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

 

***10.13******                    Changeof Control Agreements with Daniel J. Santaniello, Salvatore R. DeFrancesco,James T. Gorman, Registrant and The Fidelity Deposit and Discount Bank, dated March 21,2006.***Incorporated by reference to Exhibit 99.1, 99.2 and 99.3,respectively, to Registrant’s Current Report on Form 8-K filed with theSEC on March 27, 2006.

 

*** 11******                                  Statementregarding computation of earnings per share.***Included herein in Note 2 “Earningsper Share”, contained within the Notes to Consolidated Financial Statements,and incorporated herein by reference.

 

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

 

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

 

***32.1******                           Certificationof Principal Executive Officer pursuant to 18 U.S.C. Section 1350,******as adopted pursuant to Section 906 of theSarbanes-Oxley Act of 2002, filed herewith.***

 

***32.2******                              Certificationof Principal Financial Officer pursuant to 18 U.S.C. Section 1350,******as adopted pursuant to Section 906 of theSarbanes-Oxley Act of 2002, filed herewith.***

 

28

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**FIDELITY D & DBANCORP, INC.**

 

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

 

 
|                   | **FIDELITY D & D BANCORP, INC.**     |
|------------------------|----------------------------------------------------|
|                   |                                               |
|                   |                                               |
| Date: May 2, 2006 | /s/ Steven C. Ackmann                              |   |
|                   | Steven C.  Ackmann,                                |
|                   |   President  and Chief Executive Officer |
|                   |                                               |
|                   |                                               |
| Date: May 2, 2006 | /s/ Salvatore R. DeFrancesco, Jr.             |   |
|                   | Salvatore R.  DeFrancesco, Jr.,               |
|                   |   Treasurer  and Chief Financial Officer |
|                        |                                                    |  |  |

 

29

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EXHIBIT INDEX

 
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                         | ** ** | **Page** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| ***3(i) Amended and Restated Articles of  Incorporation of Registrant.***Incorporated by  reference to Exhibit 3(i) to Registrant’s Registration Statement No. 333-90273  on Form S-4, filed with the SEC on November 3, 1999 and as amended  on April 6, 2000.                                                                                                                                            |       | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                               |       |     |
| ***3(ii) Bylaws of Registrant.***Incorporated  by reference to Exhibit 3 (ii) to Registrant’s Registration  Statement No. 333-90273 on Form S-4, filed with the SEC on November 3,  1999 and as amended on April 6, 2000.                                                                                                                                                                                  |       | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                               |       |     |
| ***10.1 1998 Independent Directors Stock  Option Plan of The Fidelity Deposit and Discount Bank, as assumed by  Registrant.***Incorporated by reference to Exhibit 10.1  to Registrant’s Registration Statement No. 333-90273 on Form S-4,  filed with the SEC on November 3, 1999 and as amended on April 6,  2000.                                                                                                 |       | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                               |       |     |
| ***10.2 1998 Stock Incentive Plan of The  Fidelity Deposit and Discount Bank, as assumed by Registrant.***  Incorporated by reference to Exhibit 10.2 of Registrant’s Registration  Statement No. 333-90273 on Form S-4, filed with the SEC on Nov. 3,  1999 and as amended on April 6, 2000.                                                                                                                        |       | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                               |       |     |
| ***10.3 Form of Deferred Compensation  Plan of The Fidelity Deposit and Discount Bank.***Incorporated  by reference to Exhibit 10.3 to Registrant’s Registration Statement No. 333-45668  on Form S-1, filed with the SEC on September 12, 2000 and as  amended on October 11, 2000.                                                                                                                            |       | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                               |       |     |
| ***10.4 Registrant’s 2000 Dividend  Reinvestment Plan.***Incorporated by reference to Exhibit 4  to Registrant’s Registration Statement No. 333-45668 on Form S-1,  filed with the SEC on September 12, 2000 and as amended by Pre-Effective  Amendment No. 1 on October 11, 2000, by Post-Effective Amendment No. 1  on May 30, 2001and by Post-Effective Amendment No 2 on July 7,  2005. |       | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                               |       |     |
| ***10.5 Registrant’s 2000 Independent  Directors Stock Option Plan.***Incorporated by  reference to Exhibit 4.3 to Registrant’s Registration Statement No. 333-64356  on Form S-8 filed with the SEC on July 2, 2001.                                                                                                                                                                                                |       | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                               |       |     |
| ***10.6 Registrant’s 2000 Stock Incentive  Plan.***Incorporated by reference to Exhibit 4.4  to Registrant’s Registration Statement No. 333-64356 on Form S-8  filed with the SEC on July 2, 2001.                                                                                                                                                                                                                   |       | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                               |       |     |
| ***10.7 Registrant’s 2002 Employee Stock  Purchase Plan.***Incorporated by reference to Exhibit 4.5  to Registrant’s Registration Statement No. 333-113339 on Form S-8 filed  with the SEC on March 5, 2004.                                                                                                                                                                                                         |       | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                               |       |     |
| ***10.8 Employment Agreement between Fidelity  D & D Bancorp, Inc., The Fidelity Deposit and Discount Bank and  Steven C. Ackmann, dated June 21, 2004.***Incorporated  by reference to Exhibit 99.1 to Registrant’s Current Report on Form 8-K  filed with the SEC on June 24, 2004.                                                                                                                       |       | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                               |       |     |
| ***10.9 Complete Settlement Agreement and  General Release between Michael F. Marranca, Registrant and The Fidelity  Deposit and Discount Bank, dated July 30, 2004.***Incorporated  by reference to Exhibit 99.1 to Registrant’s Current Report on Form 8-K  filed with the SEC on August 10, 2004.                                                                                                                      |       | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                               |       |     |
| ***10.10 Change of Control and Severance  Agreement between James T. Gorman, Registrant and the Fidelity Deposit and  Discount Bank, dated September 19, 2005.***Incorporated  by reference to Exhibit 99.1 to Registrant’s Current Report on Form 8-K  filed with the SEC on September 22, 2005.                                                                                                                         |       | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                               |       |     |
| ***10.11 Amendment and Termination of the  Deferred Compensation Agreement with Joseph J. Earyes, Daniel Santaniello,  Registrant and The Fidelity Deposit and Discount Bank, dated November 1,  2005.***Incorporated by reference to Exhibits 99.1  and 99.2 to Registrant’s Current Report on Form 8-K filed with the SEC  on November 3, 2005.                                                                              |       | *        |
|                                                                                                                                                                                                                                                                                                                                                                                                                                               |       |     |
| ***10.12 Amendment to the Complete Settlement  Agreement and General Release between Michael F. Marranca, Registrant and The  Fidelity Deposit and Discount Bank, dated November 4, 2005.***Incorporated  by reference to Exhibit 99.1 to Registrant’s Current Report on Form 8-K  filed with the SEC on November 9, 2005.                                                                                                |       | *        |
| *** ***                                                                                                                                                                                                                                                                                                                                                                                                                                       |       |     |
| ***10.13***  ***Change of Control Agreements with Daniel J.  Santaniello, Salvatore R. DeFrancesco, James T. Gorman, Registrant and The  Fidelity Deposit and Discount Bank, dated March 21, 2006.***Incorporated  by reference to Exhibit 99.1, 99.2 and 99.3, respectively, to Registrant’s  Current Report on Form 8-K filed with the SEC on March 27, 2006.                                                      |       | *        |

 

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| ** **                                                                                                                                                                    | ** ** | **Page** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| ***11***  ***Statement regarding computation of earnings per  share.***Included herein.                                                                                  |       | 8        |
|                                                                                                                                                                          |       |     |
| ***31.1 Rule 13a-14(a) Certification  of Principal Executive Officer.***                                                                                            |       | 32       |
|                                                                                                                                                                          |       |     |
| ***31.2 Rule 13a-14(a) Certification  of Principal Financial Officer.***                                                                                            |       | 33       |
|                                                                                                                                                                          |       |     |
| ***32.1 Certification of Principal Executive  Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906  of the Sarbanes-Oxley Act of 2002.*** |       | 34       |
|                                                                                                                                                                          |       |     |
| ***32.2 Certification of Principal Financial  Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906  of the Sarbanes-Oxley Act of 2002.*** |       | 35       |

 

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* Incorporated by Reference

 

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