**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**x**** QUARTERLY REPORT PURSUANTTO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period endedSeptember 30, 2007**

 

**OR**

 

**o**** TRANSITION REPORT PURSUANTTO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period from                     to**

** **

**Commission file number: 333-90273**

 

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

 

STATE OFINCORPORATION:  IRS EMPLOYERIDENTIFICATION NO:

**PENNSYLVANIA                                     23-3017653**

 

Address of principalexecutive offices:

**BLAKELY & DRINKER ST.**

**DUNMORE, PENNSYLVANIA 18512**

 

TELEPHONE:

**570-342-8281**

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subjected tosuch filing requirements for the past 90 days.

 

x   YES    o   NO

 

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

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

 

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

 

o   YES    x   NO

 

The number of outstanding shares of Common Stock of Fidelity D & DBancorp, Inc. at October 31, 2007, the latest practicable date, was 2,072,929shares.

 

 

----

 

**FIDELITYD & D BANCORP, INC.**

 

Form 10-Q September 30,2007

 

Index

 
| **Part  I. Financial Information** |                                                                                        |                                                                                                                    |
|------------------------------------|---------------------------------------------------------------------------------------------|-------------------------------------------------------------------------------------------------------------------------|
|                               |                                                                                        |                                                                                                                    |   |
| Item 1.                            | Financial  Statements:                                                                      |                                                                                                                    |   |
|                               |                                                                                        | Consolidated  Balance Sheets as of September 30, 2007 and December 31, 2006                                             |   |
|                               |                                                                                        | Consolidated  Statements of Income for the three and nine months ended September 30, 2007  and 2006                     |   |
|                               |                                                                                        | Consolidated Statements of  Changes in Shareholders’ Equity for the nine months ended September 30, 2007  and 2006 |   |
|                               |                                                                                        | Consolidated  Statements of Cash Flows for the nine months ended September 30, 2007 and  2006                           |   |
|                               |                                                                                        | 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

----

 

**PART I – Financial Information**

 

**Item 1: Financial Statements**

 

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

 

Consolidated Balance Sheets

 
| ** **                                                                                                                                    | ** ** | **September 30, 2007** | ** **  | **December 31, 2006** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|-------------|---------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **(unaudited)**                  | ** **  | **(audited)**                   | ** ** |
|                                                                                                                                          |       |                             |        |                            |       |
| Assets:                                                                                                                                       |       |                             |        |                            |       |
| Cash and due  from banks                                                                                                                      |       | $                                | 13,187,169  |                            | $          | 13,732,137 |   |
| Interest-bearing  deposits with financial institutions                                                                                        |       | 183,943                          |        | 68,711                          |       |
|                                                                                                                                          |       |                             |        |                            |       |
| Total cash and  cash equivalents                                                                                                              |       | 13,371,112                       |        | 13,800,848                      |       |
|                                                                                                                                          |       |                             |        |                            |       |
| Available-for-sale  securities                                                                                                                |       | 120,700,576                      |        | 98,841,364                      |       |
| Held-to-maturity  securities                                                                                                                  |       | 1,196,077                        |        | 1,569,372                       |       |
| Federal Home  Loan Bank Stock                                                                                                                 |       | 3,558,300                        |        | 3,795,100                       |       |
| Loans and  leases, net (allowance for loan losses of $4,990,855 in 2007 and $5,444,303  in 2006)                                              |       | 420,790,921                      |        | 417,199,048                     |       |
| Loans  available-for-sale (fair value $388,121 in 2007; $123,156 in 2006)                                                                     |       | 382,000                          |        | 122,000                         |       |
| Bank premises  and equipment, net                                                                                                             |       | 13,306,479                       |        | 11,324,465                      |       |
| Cash surrender  value of bank owned life insurance                                                                                            |       | 8,408,987                        |        | 8,177,961                       |       |
| Other assets                                                                                                                                  |       | 4,399,408                        |        | 4,788,105                       |       |
| Accrued interest  receivable                                                                                                                  |       | 2,880,243                        |        | 2,502,576                       |       |
| Foreclosed  assets held for sale                                                                                                              |       | 107,036                          |        | 197,149                         |       |
|                                                                                                                                          |       |                             |        |                            |       |
| Total assets                                                                                                                                  |       | $                                | 589,101,139 |                            | $          | 562,317,988 |   |
|                                                                                                                                          |       |                             |        |                            |       |
| Liabilities:                                                                                                                                  |       |                             |        |                            |       |
| Deposits:                                                                                                                                     |       |                             |        |                            |       |
| Interest-bearing                                                                                                                              |       | $                                | 368,512,228 |                            | $          | 336,592,620 |   |
| Non-interest-bearing                                                                                                                          |       | 70,544,329                       |        | 73,741,975                      |       |
|                                                                                                                                          |       |                             |        |                            |       |
| Total deposits                                                                                                                                |       | 439,056,557                      |        | 410,334,595                     |       |
|                                                                                                                                          |       |                             |        |                            |       |
| Accrued interest  payable and other liabilities                                                                                               |       | 4,658,726                        |        | 4,179,170                       |       |
| Short-term  borrowings                                                                                                                        |       | 28,579,498                       |        | 33,656,150                      |       |
| Long-term debt                                                                                                                                |       | 62,917,875                       |        | 62,536,210                      |       |
|                                                                                                                                          |       |                             |        |                            |       |
| Total  liabilities                                                                                                                            |       | 535,212,656                      |        | 510,706,125                     |       |
|                                                                                                                                          |       |                             |        |                            |       |
| 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,  2,072,929 shares in 2007 and 2,057,433 shares in 2006 |       | 19,214,460                       |        | 18,702,537                      |       |
| Retained  earnings                                                                                                                            |       | 35,851,823                       |        | 33,874,118                      |       |
| Accumulated  other comprehensive loss                                                                                                         |       | (1,177,800                       | )           | (964,792                        | )          |
|                                                                                                                                          |       |                             |        |                            |       |
| Total  shareholders’ equity                                                                                                              |       | 53,888,483                       |        | 51,611,863                      |       |
|                                                                                                                                          |       |                             |        |                            |       |
| Total  liabilities and shareholders’ equity                                                                                              |       | $                                | 589,101,139 |                            | $          | 562,317,988 |   |

 

See notes to consolidatedfinancial statements

 

3

----

 

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

** **

ConsolidatedStatements of Income

(unaudited)

 
| ** **                                             | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                             | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Interest income:                                       |       |                             |       |                             |       |   |   |   |   |
| Loans and  leases:                                     |       |                             |       |                             |       |   |   |   |   |
| Taxable                                                |       | $                                | 7,223,183  |                             | $          | 7,122,621 |   | $ | 21,540,100 |   | $ | 20,500,909 |   |
| Nontaxable                                             |       | 122,594                          |       | 104,193                          |       | 350,463 |   | 357,813 |   |
| Interest-bearing  deposits with financial institutions |       | 2,190                            |       | 2,045                            |       | 6,911 |   | 6,821 |   |
| Investment  securities:                                |       |                             |       |                             |       |   |   |   |   |
| U.S. government  agency and corporations               |       | 1,093,098                        |       | 918,070                          |       | 3,029,358 |   | 2,789,335 |   |
| States and  political subdivisions (nontaxable)        |       | 124,922                          |       | 149,611                          |       | 374,273 |   | 440,929 |   |
| Other securities                                       |       | 278,100                          |       | 239,280                          |       | 804,522 |   | 668,492 |   |
| Federal funds  sold                                    |       | 48,259                           |       | 58,746                           |       | 102,913 |   | 94,872 |   |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Total interest  income                                 |       | 8,892,346                        |       | 8,594,566                        |       | 26,208,540 |   | 24,859,171 |   |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Interest  expense:                                     |       |                             |       |                             |       |   |   |   |   |
| Deposits                                               |       | 3,420,693                        |       | 3,132,402                        |       | 9,977,394 |   | 8,279,425 |   |
| Securities sold  under repurchase agreements           |       | 124,089                          |       | 177,668                          |       | 355,122 |   | 476,543 |   |
| Other short-term  borrowings and other                 |       | 26,013                           |       | 51,661                           |       | 360,025 |   | 275,852 |   |
| Long-term debt                                         |       | 899,196                          |       | 919,338                          |       | 2,466,898 |   | 3,018,121 |   |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Total interest  expense                                |       | 4,469,991                        |       | 4,281,069                        |       | 13,159,439 |   | 12,049,941 |   |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Net interest  income                                   |       | 4,422,355                        |       | 4,313,497                        |       | 13,049,101 |   | 12,809,230 |   |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| (Credit)  provision for loan losses                    |       | (60,000                          | )          | 75,000                           |       | (60,000 | ) | 325,000 |   |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Net interest  income after provision for loan losses   |       | 4,482,355                        |       | 4,238,497                        |       | 13,109,101 |   | 12,484,230 |   |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Other income:                                          |       |                             |       |                             |       |   |   |   |   |
| Service charges  on deposit accounts                   |       | 784,847                          |       | 698,839                          |       | 2,179,086 |   | 1,965,620 |   |
| Gain (loss) on  sale of:                               |       |                             |       |                             |       |   |   |   |   |
| Loans                                                  |       | 52,821                           |       | 20,707                           |       | 120,717 |   | 62,550 |   |
| Investment  securities                                 |       | —                           |       | —                           |       | — |   | (166 | ) |
| Premises and  equipment                                |       | 1,248                            |       | (16,334                          | )          | 74,881 |   | (14,774 | ) |
| Leased assets                                          |       | —                           |       | —                           |       | — |   | 15,154 |   |
| Foreclosed  assets held-for-sale                       |       | 405                              |       | (4,416                           | )          | 143,154 |   | (3,795 | ) |
| Fees and other  service charges                        |       | 469,440                          |       | 437,479                          |       | 1,333,700 |   | 1,324,463 |   |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Total other  income                                    |       | 1,308,761                        |       | 1,136,275                        |       | 3,851,538 |   | 3,349,052 |   |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Other expenses:                                        |       |                             |       |                             |       |   |   |   |   |
| Salaries and  employee benefits                        |       | 2,201,532                        |       | 2,078,715                        |       | 6,501,861 |   | 6,059,586 |   |
| Premises and  equipment                                |       | 807,978                          |       | 810,235                          |       | 2,398,088 |   | 2,434,645 |   |
| Advertising                                            |       | 156,848                          |       | 164,855                          |       | 499,473 |   | 453,132 |   |
| Other                                                  |       | 1,022,813                        |       | 941,959                          |       | 2,990,345 |   | 2,919,300 |   |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Total other  expenses                                  |       | 4,189,171                        |       | 3,995,764                        |       | 12,389,767 |   | 11,866,663 |   |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Income before  provision for income taxes              |       | 1,601,945                        |       | 1,379,008                        |       | 4,570,872 |   | 3,966,619 |   |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Provision for  income taxes                            |       | 424,023                          |       | 349,032                          |       | 1,189,866 |   | 966,392 |   |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Net income                                             |       | $                                | 1,177,922  |                             | $          | 1,029,976 |   | $ | 3,381,006 |   | $ | 3,000,227 |   |
|                                                   |       |                             |       |                             |       |   |   |   |   |
| Per share data:                                        |       |                             |       |                             |       |   |   |   |   |
| Net income -  basic                                    |       | $                                | 0.57       |                             | $          | 0.51 |   | $ | 1.64 |   | $ | 1.47 |   |
| Net income -  diluted                                  |       | $                                | 0.57       |                             | $          | 0.51 |   | $ | 1.64 |   | $ | 1.47 |   |
| Dividends                                              |       | $                                | 0.24       |                             | $          | 0.22 |   | $ | 0.68 |   | $ | 0.66 |   |

 

4

----

 

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

** **

Consolidated Statements of Changes in Shareholders’Equity

Forthe nine months ended September 30, 2007 and 2006

 
| ** **                                                                                                                     | ** ** | ** **             | ** ** | ** **   | ** ** | ** **        | ** ** | **Accumulated**        | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|--------------|------------|-------------------|------------|------------------------|------------|------------|------------|
| ** **                                                                                                                     | ** ** | ** **             | ** ** | ** **   | ** ** | ** **        | ** ** | **other**              | ** ** | ** ** | ** ** |
| ** **                                                                                                                     | ** ** | **Capital stock** | ** ** | **Retained** | ** ** | **comprehensive** | ** ** | ** **             | ** ** |
| ** **                                                                                                                     | ** ** | **Shares**             | ** ** | **Amount**   | ** ** | **earnings**      | ** ** | **income (loss)** | ** ** | **Total**  | ** ** |
|                                                                                                                           |       |                   |       |         |       |              |       |                   |       |       |       |
| Balance,  December 31, 2005 (audited)                                                                                          |       | 1,854,217              |       | $            | 10,594,901 |              | $          | 39,363,461             |       | $          | (1,112,333 | ) | $ | 48,846,029 |   |
| Cumulative  effect of change in accounting principle, net of tax                                                               |       |                   |       |         |       | (343,717          | )          |                   |       | (343,717   | )          |
| Total  comprehensive income:                                                                                                   |       |                   |       |         |       |              |       |                   |       |       |       |
| Net income                                                                                                                     |       |                   |       |         |       | 3,000,227         |       |                   |       | 3,000,227  |       |
| Change in net  unrealized holding losses on available-for-sale securities, net of reclassification  adjustment and tax effects |       |                   |       |         |       |              |       | (30,125                | )          | (30,125    | )          |
| Comprehensive  income                                                                                                          |       |                   |       |         |       |              |       |                   |       | 2,970,102  |       |
| Issuance of  common stock through Employee Stock Purchase Plan                                                                 |       | 1,571                  |       | 48,151       |       |              |       |                   |       | 48,151     |       |
| Dividends  reinvested through Dividend Reinvestment Plan                                                                       |       | 12,023                 |       | 427,003      |       |              |       |                   |       | 427,003    |       |
| Stock-based  compensation expense                                                                                              |       |                   |       | 28,744       |       |              |       |                   |       | 28,744     |       |
| Cash dividends  declared                                                                                                       |       |                   |       |         |       | (1,349,656        | )          |                   |       | (1,349,656 | )          |
| Stock dividend  declared                                                                                                       |       | 185,394                |       | 7,462,100    |       | (7,469,548        | )          |                   |       | (7,448     | )          |
|                                                                                                                           |       |                   |       |         |       |              |       |                   |       |       |       |
| Balance,  September 30, 2006 (unaudited)                                                                                       |       | 2,053,205              |       | $            | 18,560,899 |              | $          | 33,200,767             |       | $          | (1,142,458 | ) | $ | 50,619,208 |   |
|                                                                                                                           |       |                   |       |         |       |              |       |                   |       |       |       |
| Balance,  December 31, 2006 (audited)                                                                                          |       | 2,057,433              |       | $            | 18,702,537 |              | $          | 33,874,118             |       | $          | (964,792   | ) | $ | 51,611,863 |   |
| Total  comprehensive income:                                                                                                   |       |                   |       |         |       |              |       |                   |       |       |       |
| Net income                                                                                                                     |       |                   |       |         |       | 3,381,006         |       |                   |       | 3,381,006  |       |
| Change in net  unrealized holding losses on available-for-sale securities, net of reclassification  adjustment and tax effects |       |                   |       |         |       |              |       | (367,665               | )          | (367,665   | )          |
| Change in cash  flow hedge intrinsic value                                                                                     |       |                   |       |         |       |              |       | 154,657                |       | 154,657    |       |
| Comprehensive  income                                                                                                          |       |                   |       |         |       |              |       |                   |       | 3,167,998  |       |
| Issuance of  common stock through Employee Stock Purchase Plan                                                                 |       | 2,266                  |       | 67,820       |       |              |       |                   |       | 67,820     |       |
| Dividends  reinvested through Dividend Reinvestment Plan                                                                       |       | 13,230                 |       | 437,145      |       |              |       |                   |       | 437,145    |       |
| Stock-based  compensation expense                                                                                              |       |                   |       | 6,958        |       |              |       |                   |       | 6,958      |       |
| Cash dividends  declared                                                                                                       |       |                   |       |         |       | (1,403,301        | )          |                   |       | (1,403,301 | )          |
|                                                                                                                           |       |                   |       |         |       |              |       |                   |       |       |       |
| Balance,  September 30, 2007 (unaudited)                                                                                       |       | 2,072,929              |       | $            | 19,214,460 |              | $          | 35,851,823             |       | $          | (1,177,800 | ) | $ | 53,888,483 |   |

 

See Notes to ConsolidatedFinancial Statements

 

5

----

 

**FIDELITYDEPOSIT & DISCOUNT BANCORP, INC. AND SUBSIDIARY**

 

ConsolidatedStatements of Cash Flows

(unaudited)

 
| ** **                                                                         | ** ** | **Nine Months Ended**  | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                         | ** ** | **September 30, 2007** | ** ** | **September 30, 2006** | ** ** |
|                                                                               |       |                             |       |   |   |
| Cash flows from  operating activities:                                             |       |                             |       |   |   |
| Net income                                                                         |       | $                                | 3,381,006  |   | $ | 3,000,227 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                             |       |   |   |
| Depreciation,  amortization and accretion                                          |       | 929,540                          |       | 1,005,861 |   |
| (Credit)  provision for loan losses                                                |       | (60,000                          | )          | 325,000 |   |
| Deferred income  tax expense (benefit)                                             |       | 27,890                           |       | (27,073 | ) |
| Stock-based  compensation expense                                                  |       | 6,958                            |       | 28,744 |   |
| Loss from  investment in limited partnership                                       |       | 60,300                           |       | 67,500 |   |
| Proceeds from  sale of loans available-for-sale                                    |       | 12,121,477                       |       | 8,081,253 |   |
| Originations of  loans available-for-sale                                          |       | (12,260,760                      | )          | (8,011,308 | ) |
| Increase in cash  surrender value of life insurance                                |       | (231,026                         | )          | (213,273 | ) |
| Net gain on sale  of loans                                                         |       | (120,717                         | )          | (62,550 | ) |
| Net loss on sale  of investment securities                                         |       | —                           |       | 166 |   |
| Net (gain) loss  on sale of foreclosed assets held-for-sale                        |       | (143,154                         | )          | 3,795 |   |
| Net (gain) loss  on disposal of premises and equipment                             |       | (74,881                          | )          | 14,774 |   |
| Change in:                                                                         |       |                             |       |   |   |
| Accrued interest  receivable                                                       |       | (377,667                         | )          | (800,347 | ) |
| Other assets                                                                       |       | (102,938                         | )          | (185,187 | ) |
| Accrued interest  payable and other liabilities                                    |       | 480,771                          |       | 493,341 |   |
|                                                                               |       |                             |       |   |   |
| Net cash  provided by operating activities                                         |       | 3,636,799                        |       | 3,720,923 |   |
|                                                                               |       |                             |       |   |   |
| Cash flows from  investing activities:                                             |       |                             |       |   |   |
| Held-to-maturity  securities:                                                      |       |                             |       |   |   |
| Proceeds from  maturities, calls and principal pay-downs                           |       | 372,503                          |       | 274,397 |   |
| Available-for-sale  securities:                                                    |       |                             |       |   |   |
| Proceeds from  sales                                                               |       | —                           |       | 1,537,338 |   |
| Proceeds from  maturities, calls and principal pay-downs                           |       | 9,784,761                        |       | 16,798,981 |   |
| Purchases                                                                          |       | (31,953,887                      | )          | (22,776,489 | ) |
| Net decrease in  FHLB stock                                                        |       | 236,800                          |       | 1,368,800 |   |
| Net increase in  loans and leases                                                  |       | (3,883,909                       | )          | (7,005,816 | ) |
| Proceeds from  sale of premises and equipment                                      |       | 248,833                          |       | 1,560 |   |
| Acquisition of  bank premises and equipment                                        |       | (2,584,363                       | )          | (1,026,158 | ) |
| Proceeds from  sale of foreclosed assets held-for-sale                             |       | 584,088                          |       | 55,890 |   |
|                                                                               |       |                             |       |   |   |
| Net cash used in  investing activities                                             |       | (27,195,174                      | )          | (10,771,497 | ) |
|                                                                               |       |                             |       |   |   |
| Cash flows from  financing activities:                                             |       |                             |       |   |   |
| Net increase in  deposits                                                          |       | 28,721,962                       |       | 40,231,147 |   |
| Net decrease in  short-term borrowings                                             |       | (5,076,652                       | )          | (5,946,258 | ) |
| Repayments of  long-term debt                                                      |       | (19,618,335                      | )          | (34,114,126 | ) |
| Proceeds from  long-term debt advances                                             |       | 20,000,000                       |       | 16,000,000 |   |
| Proceeds from  employee stock purchase plan                                        |       | 67,820                           |       | 48,151 |   |
| Dividends paid,  net of dividends reinvested                                       |       | (966,156                         | )          | (922,653 | ) |
| Cash payments in  lieu of fractional shares on stock dividend                      |       | —                           |       | (7,448 | ) |
|                                                                               |       |                             |       |   |   |
| Net cash  provided by financing activities                                         |       | 23,128,639                       |       | 15,288,813 |   |
|                                                                               |       |                             |       |   |   |
| Net (decrease)  increase in cash and cash equivalents                              |       | (429,736                         | )          | 8,238,239 |   |
|                                                                               |       |                             |       |   |   |
| Cash and cash  equivalents, beginning                                              |       | 13,800,848                       |       | 12,594,540 |   |
|                                                                               |       |                             |       |   |   |
| Cash and cash  equivalents, ending                                                 |       | $                                | 13,371,112 |   | $ | 20,832,779 |   |

 

Seenotes to consolidated financial statements

 

6

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**FIDELITYD & D BANCORP, INC.**

 

**Notes toConsolidated Financial Statements**

**(unaudited)**

 

**1.****              Nature of operationsand critical accounting policies**

 

# **Nature ofoperations**

 

The Fidelity Deposit and Discount Bank (the Bank) is a commercial bankchartered in the Commonwealth of Pennsylvania and a wholly-owned subsidiary ofFidelity D & D Bancorp, Inc. (the Company or collectively, the Company). Havingcommenced operations in 1903, the Bank is committed to provide superiorcustomer service, while offering a full range of banking products and financialand trust services, to both our consumer and commercial customers from our mainoffice located in Dunmore and other branches throughout Lackawanna and Luzernecounties.

 

# **Principles ofconsolidation**

 

The accompanying unaudited consolidated financial statements of theCompany and the Bank have been prepared in accordance with accountingprinciples generally accepted in the United States of America (GAAP) forinterim financial information and with the instructions to this Form 10-Q andRule 10-01 of Regulation S-X. Accordingly, they do not include all of theinformation and footnote disclosures required by GAAP for complete financialstatements. In the opinion of management, all normal recurring adjustmentsnecessary for a fair presentation of the financial condition and results ofoperations for the periods have been included. All significant inter-companybalances and transactions have been eliminated in consolidation. Prior periodamounts are reclassified when necessary to conform to the current period’spresentation.

 

The preparation of financial statements in conformity with GAAPrequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reported periods. Actual results could differfrom those estimates. For additional information and disclosures required underGAAP, refer to the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2006.

 

Management is responsible for the fairness, integrity and objectivityof the unaudited financial statements included in this report. Managementprepared the unaudited financial statements in accordance with GAAP. In meetingits responsibility for the financial statements, management depends on theCompany’s accounting systems and related internal controls. These systems andcontrols are designed to provide reasonable, but not absolute, assurance thatthe financial records accurately reflect the transactions of the Company, theCompany’s assets are safeguarded and that the financial statements presentfairly the financial condition and results of operations of the Company.

 

In the opinion of management, the consolidated balance sheets as ofSeptember 30, 2007 and December 31, 2006 and the related consolidatedstatements of income for the three- and nine- month periods ended September 30,2007 and 2006 and changes in shareholders’ equity and cash flows for the ninemonths ended September 30, 2007 and 2006 present fairly the financial conditionand results of operations of the Company. All material adjustments required fora fair presentation have been made. These adjustments are of a normal recurringnature.

 

This Quarterly Report on Form 10-Q should be read in conjunction withthe Company’s audited financial statements for the year ended December 31,2006, and the notes included therein, included within the Company’s Annual Reportfiled on Form 10-K.

 

# **Criticalaccounting policies**

 

The presentation of financial statements in conformity with GAAPrequires management to make estimates and assumptions that affect many of thereported amounts and disclosures. Actual results could differ from theseestimates.

 

A material estimate that is particularly susceptible to significantchange is the determination of the allowance for loan losses (the allowance). Managementbelieves that the allowance, as of September 30, 2007, is adequate and reasonable.Given the subjective nature of identifying and valuing loan losses, it islikely that well-informed individuals could make materially differentassumptions, and could, therefore, calculate a materially different allowancevalue. While management uses available information to recognize losses onloans, changes in economic conditions may necessitate revisions in the future. Inaddition, 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.

 

7

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Another material estimate is the calculation of fair values of theCompany’s investment securities. The Company receives estimated fair values ofinvestment securities from an independent valuation service. In developingthese fair values, the valuation service uses estimates of cash flows, based onhistorical performance of similar instruments in similar interest rateenvironments. Based on experience, management is aware that estimated fairvalues of investment securities tend to vary among valuation services. Accordingly,when selling investment securities, management may obtain price quotes frommore than one source. Available-for-sale (AFS) securities are carried at fairvalue on the consolidated balance sheet, with unrealized gains and losses, netof income tax, reported separately within shareholders’ equity throughaccumulated other comprehensive income (loss).

 

The fair value of residential mortgage loans, classified as AFS, isobtained from the Federal National Mortgage Association or the PennsylvaniaHousing Finance Authority. To determine the fair value of student loans,classified as AFS, the Bank uses the pricing obtained from the most recentstudent loans sold from its AFS portfolio. From time-to-time, the Bank mayoriginate Small Business Administration (SBA) loans AFS. The fair value of SBAloans, classified as AFS, is obtained from an outside pricing source. Themarket to which the Bank sells mortgage and other loans is restricted and pricequotes from other sources are not typically obtained. As of September 30, 2007,the AFS loan portfolio consisted of residential mortgages.

 

**2.****              Earnings per share**

 

Basic earnings pershare (EPS) is computed by dividing net income available to common shareholdersby the weighted-average number of common stock outstanding for the period. DilutedEPS is computed in the same manner as basic EPS but reflects the potentialdilution that could occur if stock options to issue additional common stockwere exercised, which would then result in additional stock outstanding toshare in or dilute the earnings of the Company. The Company maintains twoshare-based compensation plans that may generate additional potential dilutivecommon shares. Generally, dilution would occur if Company-issued stock optionswere exercised and converted into common stock.

 

In the computationof diluted EPS, the Company uses the treasury stock method to determine thedilutive effect of its granted but unexercised stock options. Under thismethod, the assumed proceeds received from shares issued, in a hypotheticalstock option exercise, are assumed to be used to purchase treasury stock. Pursuantto the guidance of Statement of Financial Accounting Standard (SFAS) No. 128, *Earnings Per Share,* proceeds include: proceeds from theexercise of outstanding stock options; compensation cost for future servicethat the Company has not yet recognized; and any “windfall” tax benefits thatwould be credited directly to shareholders’ equity when the grant generates atax deduction (or a reduction in proceeds if there is a charge to equity). Fora further discussion on the Company’s stock option plans, see Note 3, below.

 

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

 
| **Nine months ended September 30,**       | ** ** | **2007**  | ** ** | **2006**  | ** ** |
|---------------------------------------------------------------|------------|-----------|------------|-----------|------------|
|                                                          |       |      |       |      |       |
| Basic EPS:                                                    |       |      |       |      |       |
| Net income  available to common shareholders                  |       | $         | 3,381,006  |      | $          | 3,007,227 |   |
| Weighted-average  common shares outstanding                   |       | 2,064,578 |       | 2,045,872 |       |
| Basic EPS                                                     |       | $         | 1.64       |      | $          | 1.47 |   |
|                                                          |       |      |       |      |       |
| Diluted EPS:                                                  |       |      |       |      |       |
| Net income  available to common shareholders                  |       | $         | 3,381,006  |      | $          | 3,007,227 |   |
| Weighted-average  common shares outstanding                   |       | 2,064,578 |       | 2,045,872 |       |
| Dilutive  potential common shares                             |       | 608       |       | 1,454     |       |
| Weighted-average  common shares and dilutive potential shares |       | 2,065,186 |       | 2,047,326 |       |
| Diluted EPS                                                   |       | $         | 1.64       |      | $          | 1.47 |   |

 

8

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**3.****              Stock plans**

 

The Company uses the fair value method of accounting for stock-basedcompensation provided under SFAS 123R, *Share Based Payment*.SFAS 123R 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) on theprice of the entity’s shares or other equity instruments, or (2) that require(or may require) settlement by the issuance of an entity’s shares or otherequity instruments.

 

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

 

The Company establishedthe 2000 Independent Directors Stock Option Plan and reserved 55,000 shares ofits 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 nine months of 2007 or for the yearended December 31, 2006, due to the directors’ voluntary election to forego theaward. At September 30, 2007 there were 14,850 unexercised stock optionsoutstanding under this plan. On October 2, 2007, the Company amended the 2000Independent Directors Stock Option Plan. For a further discussion on theamendment, see Note 6, below.

 

The Company alsoestablished the 2000 Stock Incentive Plan and reserved 55,000 shares of itsun-issued capital stock for issuance under the plan. Under the 2000 StockIncentive Plan, key officers and certain other employees are eligible to beawarded qualified stock options to purchase the Company’s common stock at thefair market value on the date of grant. No stock options were awarded duringthe first nine months of 2007. During the first nine months of 2006, 2,200stock options were issued under this plan at a grant-date fair value of $6.21per share. The options vest over a six month period and for the nine monthsended September 30, 2006 approximately $14,000 of stock-based compensationexpense was recorded and is included as a component of salaries and employeebenefits in the consolidated statements of income. As of September 30, 2007,there were 5,830 unexercised stock options outstanding under this plan. OnOctober 2, 2007, the Company amended the 2000 Stock Incentive Plan. For afurther discussion on this amendment, see Note 6, below.

 

In addition to the two stock option plans above, the Company hasestablished the 2002 Employee Stock Purchase Plan (the ESPP) and reserved 110,000shares of its un-issued capital stock for issuance under the plan. The plan wasdesigned to promote broad-based employee ownership of the Company’s stock. Underthe 2002 ESPP, employees may have automatic payroll deductions to purchase theCompany’s capital stock at a discounted price based on the fair market value ofthe Company’s capital stock on either the commencement date or termination date.At September 30, 2007, 8,317 shares have been issued under the ESPP. The ESPPis considered a compensatory plan and, as such, is required to comply with theprovisions of SFAS 123R. The Company recognizes compensation expense on itsESPP on the date the shares are purchased. For the nine months ended September30, 2007 and 2006, compensation expense related to the ESPP approximated $7,000and $15,000, respectively, and is included as a component of salaries andemployee benefits in the consolidated statements of income.

 

**4.****              Derivativeinstruments**

 

As part of the Company’soverall interest rate risk management strategy, the Company has adopted apolicy whereby the Company may periodically use derivative instruments tominimize significant fluctuations in earnings caused by interest ratevolatility. This interest rate risk management strategy entails the use of interestrate floors, caps and swaps. During the fourth quarter of 2006, the Companyentered into a three-year interest rate floor derivative agreement on$20,000,000 notional value of its prime-based loan portfolio. The transactionrequired the payment of a premium by the Company to the seller for the right toreceive payments in the event national prime drops below a pre-determined level(strike rate), essentially converting floating rate loans to fixed rate loanswhen prime drops below the contractual strike rate. When purchased, the Companyrecorded an asset representing the fair value of the hedge at the time ofpurchase. The Company has designated this agreement as a cash flow hedgepursuant to SFAS No. 133. Accordingly, the change in the fair value of theinstrument related to the hedge’s intrinsic value, or approximately $155,000,is recorded as a component of other comprehensive income (OCI) in theconsolidated statement of changes in shareholders’ equity and the portion ofthe change in fair value related to the time value expiration, or approximately$131,000, is recorded in the consolidated statements of income as a reductionof interest income for the nine months ended September 30, 2007. No gain orloss has been recognized in earnings due to hedge ineffectiveness as ofSeptember 30, 2007. As of September 30, 2007, the Company does not expect toreclassify any amount from OCI to earnings over the next twelve months and nohedge has been discontinued.

 

9

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Also, as of September 30,2007, the fair value of the derivative contract approximated $249,000 and is acomponent of other assets in the consolidated balance sheet.

 

**5.****              Recent accountingpronouncements**

 

In July 2006, the Financial Accounting Standards Board (FASB) issuedInterpretation No. 48, *Accounting for Uncertaintyin Income Taxes—an interpretation of FASB Statement No. 109* (FIN 48).FIN 48 clarifies the accounting for uncertainty in income taxes recognized inan enterprise’s financial statements in accordance with FASB Statement 109, *Accounting for Income Taxes*.

 

The Company adopted FIN 48 during the first quarter of 2007 and hasevaluated its material tax positions as of September 30, 2007. The adoption ofFIN 48 does not have an immediate effect on its consolidated financialstatements. Under the “more-likely-than-not” threshold guidelines, the Companybelieves no significant uncertain tax positions exist, either individually orin the aggregate, that would give rise to the non-recognition of an existingtax benefit. In periods subsequent to September 30, 2007, determinations ofpotentially adverse material tax positions will be evaluated to determinewhether an uncertain tax position may have previously existed or has beenoriginated. In the event an adverse tax position is determined to exist,penalty and interest will be accrued, in accordance with the Internal RevenueService guidelines, and recorded as a component of other expenses in theCompany’s consolidated statements of income.

 

As of September 30, 2007, there were no unrecognized tax benefits that,if recognized, would significantly affect the Company’s effective tax rate. Also,as of September 30, 2007, there were no penalties and interest recognized inthe consolidated statements of income as a result of the adoption of FIN 48,nor does the Company foresee a change in its material tax positions that wouldgive rise to the non-recognition of an existing tax benefit during theforthcoming twelve months.

 

**6.****              Subsequent events**

 

On October 2, 2007, the Board of Directors of the Company approvedamendments to the 2000 Stock Incentive Plan (the Incentive Plan) and the 2000Independent Directors Stock Option Plan (the Directors’ Plan) (collectively,the Plans).

 

Various amendment provisions to the Plans concerning the administrationof the Plans are intended to qualify the Plans for exemption from theapplication of Section 409A of the Internal Revenue Code, as contemplated bythe recently released final Treasury Regulations under the Code. The IncentivePlan was also amended to provide that no qualified stock options will begranted after the date of the amendment. The Directors’ Plan was also amendedto remove the automatic stock option grant in January of each year and allowthe grant of stock options at any time at the discretion of the Company’s Boardof Directors. The Directors’ Plan also adds a six-month vesting period foroptions granted.

 

The Company does not expect the amendments to the Plans to have amaterial impact on the results of operations or financial condition of theCompany.

 

**Item2:  Management’s Discussion and Analysisof Financial Condition and Results of Operations**

 

The following is management’s discussion and analysis of thesignificant changes in the consolidated financial condition of the Company asof September 30, 2007 compared to December 31, 2006 and the results ofoperations for the three and nine months ended September 30, 2007 and 2006. Currentperformance may not be indicative of future results. This discussion should beread in conjunction with the Company’s 2006 Annual Report filed on Form 10-K.

 

**Forward-lookingstatements**

 

This Interim Report on Form 10-Q contains a number of forward-lookingstatements within the meaning of Section 27A of the Securities Act of 1933, asamended, or the Securities Act, and Section 21E of the Securities Exchange Actof 1934, as amended, or the Exchange Act. These statements may be identified bythe 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-lookingstatements include risks and uncertainties.

 

 

 

10

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Forward-looking statements are based on various assumptions andanalyses made by us in light of management’s experience and its perception ofhistorical trends, current conditions and expected future developments, as wellas other factors management believes are appropriate under the circumstances.These statements are not guarantees of future performance and are subject torisks, uncertainties and other factors (many of which are beyond our control)that could cause actual results to differ materially from future resultsexpressed or implied by such forward-looking statements. These factors include,without limitation, the following:

 

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

 

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

 

•                  changes in theinterest rate environment may reduce interest margins;

 

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

 

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

 

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

 

•                  legislative orregulatory changes may adversely affect our business;

 

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

 

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

 

•                  acts of war orterrorism; or

 

•                  naturaldisaster.

 

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

 

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

 

**General**

 

The Company’s principal revenues are derived from interest, dividendsand fees earned on its interest-earning assets, which are comprised of loans,securities and other short-term investments. The Company’s principal expensesconsist of interest paid on its interest-bearing liabilities, which arecomprised of deposits, short- and long-term borrowings and operating andgeneral expenses. The Company’s profitability depends primarily on its netinterest income. Net interest income is the difference between interest incomeand interest expense. Interest income is generated from yields oninterest-earning assets which consist principally of loans and investmentsecurities. Interest expense is incurred from rates paid on interest-bearingliabilities, which consist of deposits and borrowings. Net interest income isdependent upon the interest-rate spread (i.e., the difference between theyields earned on its interest-earning assets and the rates paid on itsinterest-bearing liabilities) and the relative amounts of interest-earningassets and interest-bearing liabilities. The interest rate spread issignificantly impacted by: changes in interest rates and market yield curvesand their related impact on cash flows; the composition and characteristics ofinterest-earning assets and interest-bearing liabilities; differences in thematurity and re-pricing characteristics of assets compared to the maturity andre-pricing characteristics of the liabilities that fund them and by thecompetition in our marketplace.

 

 

 

11

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The Company’s profitability is also affected by the level of itsnon-interest income and expenses, provision for loan losses and provision forincome taxes. Non-interest income consists mostly of service charges on the Bank’sloan and deposit products, trust and asset management service fees, increasesin the cash surrender value of the bank owned life insurance (BOLI), net gainsor losses from sales of loans and securities AFS and from the sales of otherreal estate (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’s profitability is significantly affected by generaleconomic and competitive conditions, changes in market interest rates,government policies and actions of regulatory authorities. The Company’s loanportfolio is comprised principally of commercial and commercial real estate loans.The properties underlying the Company’s mortgages are concentrated inNortheastern Pennsylvania. Credit risk, which represents the possibility of theCompany not recovering amounts due from its borrowers, is significantly relatedto local economic conditions in the areas the properties are located as well asthe Company’s underwriting standards. Economic conditions affect the marketvalue of the underlying collateral as well as the levels of adequate cash flowand revenue generation from income-producing commercial and multi-familyproperties.

 

**COMPARISON OF RESULTS OFOPERATIONS**

**THREE AND NINE MONTHS ENDEDSEPTEMBER 30, 2007 AND SEPTEMBER 30, 2006**

 

**Overview**

 

Net income for the third quarter of 2007 was $1,178,000, or a 14%increase compared to $1,030,000 recorded in the same quarter in 2006. Dilutedearnings per share were $0.57 and $0.51 for each of the respective periods. Forthe nine months ended September 30, 2007, net income was $3,381,000, or $1.64per share compared to $3,007,000, or $1.47 per share for the nine months endedSeptember 30, 2006. The increase in net income for both the quarter and ninemonths ended September 30, 2007, compared to the prior year periods, was theresult of increases in net interest income, non-interest income and a decreasein the provision for loan losses, partially offset by increases in non-interestexpense and the provision for income taxes.

 

The increase in net income was the primary cause of the improvements inreturn on average assets (ROA) and return on average shareholders’ equity (ROE)to 0.81% and 8.80%, respectively, for the three months ended September 30, 2007compared to 0.72% and 8.18%, respectively, for the same period in 2006. For thenine months ended September 30, 2007, ROA and ROE were 0.79% and 8.57% comparedto 0.71% and 8.12% for the nine month period of 2006.

 

*Net interest income and interest sensitive assets /liabilities*

 

Net interest income increased $109,000 to $4,422,000 for the thirdquarter of 2007, from $4,313,000 recorded in the same period of 2006. Theincrease in net interest income was principally caused by the increase ininterest income on interest-earning assets being greater than the increase ininterest expense on interest-bearing liabilities. Interest income increased by$298,000 during the current year quarter compared to the third quarter of 2006with increases in both the loan and investment portfolios. While averageinterest-earning assets increased by more than $9,000,000 during the period,the rise in interest income was also bolstered by an increase in yield of 11basis points. Further contributing to the improvement in interest income was adecline in the average balance of non-accrual loans which decreased byapproximately $2,200,000 for the quarter ended September 30, 2007 compared tothe same 2006 quarter. Partially offsetting the increase in interest income wasan increase in interest expense of $189,000 for the three months endedSeptember 30, 2007 compared to the three months ended September 30, 2006. Interest-bearingdeposits increased by approximately $10,000,000, on average, and the rates paidthereon increased 22 basis points. The increase in deposit rates was primarilyfrom certificate of deposit accounts which increased 53 basis points on thequarter-to-quarter comparison. Rates paid on savings and transaction accountsdeclined during the period. The Bank will continue its competitive effort toraise deposit levels and reduce its dependency on borrowings. Interest expenseon borrowings and repurchase agreements declined $100,000 in the third quarterof 2007, compared to the third quarter of 2006, due mostly to a $5,400,000decline in the average balances.

 

During the third quarter of 2007, the Bank’s tax-equivalent margin andspread were 3.31% and 2.60%, respectively, compared to 3.29% and 2.62% duringthe third quarter of 2006. The decline in spread was due to rates oninterest-bearing liabilities increasing to a higher level than yields earnedfrom interest-earning assets during the third quarter of 2007 compared to thesame 2006 quarter. The improvement in margin is from higher net interest incomein the third quarter of 2007 compared to the third quarter of 2006.

 

 

 

12

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Similar to the third quarter comparisons, the Bank’s tax-equivalentmargin and spread for the nine months ended September 30, 2007 were 3.34% and2.63%, respectively, compared to 3.30% and 2.67% during the same period of2006. The decline in spread was from interest rates paid on costing liabilitiesoutpacing the yields from earning assets. The cost of interest-bearing depositsincreased 51 basis points during the first nine months of 2007 compared to thesame period of 2006. However, success in deposit gathering strategies hasresulted in a $13,900,000 increase in average balances of interest-bearingdeposits and enabled the Bank to reduce its position on high-cost borrowings byapproximately $11,800,000 on average. As a result, interest expense increased$1,109,000, or 9%, for the nine months ended September 30, 2007 compared to thenine months ended September 30, 2006. Offsetting the increase in interestexpense was an increase in interest income of $1,349,000, or 5%, for thecomparable periods. The migration of large non-accrual commercial loans to performingstatus as well as higher earning yields from all loan categories and theinvestment portfolio helped increase the yield on interest-earning assets by 31basis points during the first nine months of 2007 compared to the same 2006period. The four basis point improvement in the tax-equivalent margin is fromhigher net interest income which increased $197,000, or 2%, compared to 2006 ona slightly higher level of average interest-earning assets during the ninemonths of 2007.

 

The interest rate environment has improved slightly during the pastseveral months, but continues to remain challenging. The yield curve which hasbecome more positively sloped, with the recent fed rate cut, should helpimprove the operating environment for the Bank. This in conjunction with oursuccessful deposit gathering strategies, debt reduction, and improved creditquality of the Bank’s earning assets should continue to help position the Bankto optimize net interest income during this challenging rate environment andshould be further enhanced when the shape of the yield curve returns to an evensteeper, more positive slope.

 

 

13

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The following tables set forth a comparison of average balance sheetamounts and their corresponding fully tax-equivalent (FTE) interest income andexpense and annualized tax-equivalent yield and cost for the periods indicated(dollars in thousands):

 
| ** **                             | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** | **Year ended**   | ** ** |
|----------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|-----------------------|------------|
| ** **                             | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** | **December 31,** | ** ** |
| ** **                             | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007**              | ** ** | **2006** | ** ** | **2006** | ** ** |
| Average  interest-earning assets:      |       |                             |       |                            |       |                  |       |   |   |   |   |
| Loans and leases                       |       | $                                | 425,502    |                            | $          | 420,256               |       | $ | 423,811 |   | $ | 418,354 |   | $ | 418,390 |   |
| Investments                            |       | 116,969                          |       | 112,107                         |       | 112,063               |       | 116,262 |   | 115,319 |   |
| Federal funds  sold                    |       | 3,626                            |       | 4,414                           |       | 2,604                 |       | 2,618 |   | 2,479 |   |
| Interest-bearing  deposits             |       | 161                              |       | 181                             |       | 187                   |       | 221 |   | 240 |   |
| Total                                  |       | $                                | 546,259    |                            | $          | 536,958               |       | $ | 538,665 |   | $ | 537,455 |   | $ | 536,428 |   |
|                                   |       |                             |       |                            |       |                  |       |   |   |   |   |
| Average  interest-bearing liabilities: |       |                             |       |                            |       |                  |       |   |   |   |   |
| Other  interest-bearing deposits       |       | $                                | 191,526    |                            | $          | 197,727               |       | $ | 196,036 |   | $ | 185,014 |   | $ | 185,786 |   |
| Certificates of  deposit               |       | 167,815                          |       | 151,387                         |       | 156,869               |       | 154,008 |   | 154,474 |   |
| Borrowed funds                         |       | 67,392                           |       | 70,175                          |       | 70,552                |       | 82,339 |   | 79,627 |   |
| Repurchase  agreements                 |       | 21,152                           |       | 23,779                          |       | 19,132                |       | 24,203 |   | 23,391 |   |
| Total                                  |       | $                                | 447,885    |                            | $          | 443,068               |       | $ | 442,589 |   | $ | 445,564 |   | $ | 443,278 |   |
|                                   |       |                             |       |                            |       |                  |       |   |   |   |   |
| Interest income  (FTE):                |       |                             |       |                            |       |                  |       |   |   |   |   |
| Loans and leases                       |       | $                                | 7,409      |                            | $          | 7,281                 |       | $ | 22,071 |   | $ | 21,043 |   | $ | 28,357 |   |
| Investments                            |       | 1,568                            |       | 1,393                           |       | 4,424                 |       | 4,154 |   | 5,612 |   |
| Federal funds  sold                    |       | 48                               |       | 59                              |       | 103                   |       | 95 |   | 123 |   |
| Interest-bearing  deposits             |       | 2                                |       | 2                               |       | 7                     |       | 7 |   | 9 |   |
| Total                                  |       | $                                | 9,027      |                            | $          | 8,735                 |       | $ | 26,605 |   | $ | 25,299 |   | $ | 34,101 |   |
|                                   |       |                             |       |                            |       |                  |       |   |   |   |   |
| Interest  expense:                     |       |                             |       |                            |       |                  |       |   |   |   |   |
| Other  interest-bearing deposits       |       | $                                | 1,468      |                            | $          | 1,572                 |       | $ | 4,652 |   | $ | 3,947 |   | $ | 5,467 |   |
| Certificates of  deposit               |       | 1,953                            |       | 1,560                           |       | 5,325                 |       | 4,332 |   | 6,026 |   |
| Borrowed funds                         |       | 925                              |       | 971                             |       | 2,827                 |       | 3,294 |   | 4,244 |   |
| Repurchase  agreements                 |       | 124                              |       | 178                             |       | 355                   |       | 477 |   | 624 |   |
| Total                                  |       | $                                | 4,470      |                            | $          | 4,281                 |       | $ | 13,159 |   | $ | 12,050 |   | $ | 16,361 |   |
|                                   |       |                             |       |                            |       |                  |       |   |   |   |   |
| Net interest  income (FTE)             |       | $                                | 4,557      |                            | $          | 4,454                 |       | $ | 13,446 |   | $ | 13,249 |   | $ | 17,740 |   |

 

14

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| ** **                                     | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** | **Year ended**   | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** | **December 31,** | ** ** |
| ** **                                     | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007**              | ** ** | **2006** | ** ** | **2006** | ** ** |
| Yield on average  interest-earning assets      |       |                             |       |                            |       |                  |       |   |   |   |   |
| Loans and leases                               |       | 6.91                             | %          | 6.87                            | %          | 6.96                  | %          | 6.73 | % | 6.78 | % |
| Investments                                    |       | 5.32                             | %          | 4.93                            | %          | 5.28                  | %          | 4.78 | % | 4.87 | % |
| Federal funds  sold                            |       | 5.28                             | %          | 5.28                            | %          | 5.28                  | %          | 4.84 | % | 4.97 | % |
| Interest-bearing  deposits                     |       | 5.39                             | %          | 4.48                            | %          | 4.93                  | %          | 4.12 | % | 3.82 | % |
| Total                                          |       | 6.56                             | %          | 6.45                            | %          | 6.60                  | %          | 6.29 | % | 6.36 | % |
|                                           |       |                             |       |                            |       |                  |       |   |   |   |   |
| Rates on average  interest-bearing liabilities |       |                             |       |                            |       |                  |       |   |   |   |   |
| Other  interest-bearing deposits               |       | 3.04                             | %          | 3.16                            | %          | 3.17                  | %          | 2.85 | % | 2.94 | % |
| Certificates of  deposit                       |       | 4.62                             | %          | 4.09                            | %          | 4.54                  | %          | 3.76 | % | 3.90 | % |
| Borrowed funds                                 |       | 5.45                             | %          | 5.49                            | %          | 5.36                  | %          | 5.35 | % | 5.33 | % |
| Repurchase  agreements                         |       | 2.33                             | %          | 2.96                            | %          | 2.48                  | %          | 2.63 | % | 2.67 | % |
| Total                                          |       | 3.96                             | %          | 3.83                            | %          | 3.98                  | %          | 3.62 | % | 3.69 | % |
|                                           |       |                             |       |                            |       |                  |       |   |   |   |   |
| Net interest  spread                           |       | 2.60                             | %          | 2.62                            | %          | 2.62                  | %          | 2.67 | % | 2.67 | % |
| Net interest  margin                           |       | 3.31                             | %          | 3.29                            | %          | 3.34                  | %          | 3.30 | % | 3.31 | % |

 

In the tables above, interest income wasadjusted to a tax-equivalent basis to recognize the income from the varioustax-exempt assets as if the interest was fully taxable. This treatment allows auniform comparison among the yields on interest-earning assets. Thecalculations were computed on a fully tax-equivalent basis using the corporatefederal tax rate of 34%. Net interest spread represents the difference betweenthe yield on interest-earning assets and the rate on interest-bearingliabilities. Net interest margin represents the ratio of net interest income tototal average interest-earning assets.

 

*Provision for loan losses*

 

The provision for loan losses represents the necessary amount to chargeagainst current earnings, the purpose of which is to increase the allowance forloan losses to a level that represents management’s best estimate of known andinherent losses in the Bank’s loan and lease portfolio. Loans and leasesdetermined to be uncollectible are charged off against the allowance for loanlosses.

 

The required amount of the provision for loan losses, based upon theadequate level of the allowance for loan losses, is subject to ongoing analysisof the loan portfolio. The Bank’s Special Asset Committee meets periodically toreview problem loans and leases. The committee is comprised of Bank management,including the chief risk officer, loan workout officers and collectionpersonnel. The committee reports quarterly to the Credit AdministrationCommittee of the Board of Directors.

 

Management continuously reviews the risks inherent in the loan andlease portfolio. Specific factors used to evaluate the adequacy of the loanloss provision during the formal process include:

 

•                  Specific loansthat could have loss potential

•                  Levels of andtrends in delinquencies and non-accrual loans

•                  Levels of andtrends in charge-offs and recoveries

•                  Trends in volumeand terms of loans

•                  Changes in riskselection and underwriting standards

•                  Changes inlending policies, procedures and practices

•                  Experience,ability and depth of lending management

•                  National andlocal economic trends and conditions

•                  Changes incredit concentrations

 

The provision for loan losses for the three and nine months endedSeptember 30, 2006 was $75,000 and $325,000, respectively, compared to a creditfor loan losses of $60,000 for each of the respective periods of 2007. In 2007,the Company did not need to make provisions and had to reduce the allowance forloan losses due to a substantially reduced level of internally criticized andclassified assets during the three, nine and twelve months ended September 30,2007. These reductions occurred as a result of some adversely rated loans whicheither were upgraded due to credit improvement or were repaid.

 

15

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The Bank’s non-performing loans, which consists of loans past due 90days or more which are accruing, plus non-accruing loans, increased $1,245,000,or 36%, to $4,684,000 since December 31, 2006. However, non-performing loans ona comparative year-to-year basis declined by $396,000, from $5,079,000 atSeptember 30, 2006 to $4,684,000 at September 30, 2007. The non-accrualcomponent of non-performing loans showed a $565,000 increase while the 90 daydelinquencies declined $961,000 in the same period. The increase at September30, 2007 in the non-accrual loans occurred mainly because of one commercialloan, which is secured by a first lien mortgage on real estate, migrated tonon-accrual status. The decline in the 90 day delinquencies results from bothpayments received to bring loans current and movement of a loan to non-accrualstatus.

 

No provisions for loan losses were necessary during the first threequarters of 2007. After taking into account charge-offs, recoveries, and a$60,000 reduction of the allowance, the allowance for loan losses was$4,991,000 at September 30, 2007 as compared to $5,843,000 at September 30,2006. Although the non-accruals mentioned above increased from September 30,2006 and also from December 31, 2006, other adversely criticized and classifiedloans were substantially reduced from the same periods, which lead to an excessreserve position, which in turn had to be placed back into earnings accordingto Company policy.

 

*Other income*

 

Total other (non-interest) income improved $172,000, or 15%, for thethree months ended September 30, 2007 compared to the three months endedSeptember 30, 2006. Contributing to the increase were growth in deposit,financial services and trust related fees, increases from sales of mortgageloans into the secondary market and a 2006 loss from the disposal of premisesand equipment that did not recur in 2007. The growth in deposit fees wasprimary caused by overdraft charges.

 

For the nine months ended September 30, 2007, other income increased$502,000, or 15%, compared to the nine months ended September 30, 2006. TheBank recognized net gains of $143,000 from sales of foreclosed properties andexperienced growth in deposit and financial services revenue of $251,000, on acombined basis. The gain from the sale of foreclosed properties was the resultof excess collateral value compared to the net book value of the soldforeclosed property. The growth in deposit fees was due principally fromoverdraft charges. Also contributing to the increase was a first quarter 2007gain from the sale of an owned commercial facility previously leased to anon-related third party.

 

*Other operating expenses*

 

For the quarter ended September 30, 2007, other (non-interest) expensesincreased $193,000, or 5%, compared to the same 2006 quarter. Salaries andrelated employee benefits increased $123,000, or 6%, due to higher salary andrecognition of performance-based incentives. The $81,000 increase in otherexpenses was caused by moderate increases in professional services, donations,ATM and other branch-related expenses.

 

For the nine months ended September 30, 2007, other expenses increased$523,000, or 4%, compared to the nine months ended September 30, 2006. Salaryand related employee benefits increased $442,000, or 7%, due to pay increasesand recognition of performance-based incentives. Advertising increased $46,000,or 10%, during the period caused principally by the activities associated withthe grand opening and relocation project of one of the Bank’s branch offices. Otherexpenses increased $71,000, or 2%, for the comparative periods due mostly toincreased professional fees, mortgage appraisals, ATM and other branch relatedexpenses.

 

*Income tax provision*

 

Compared to 2006, income before provision for income taxes for thethird quarter and the first nine months of 2007 increased $223,000 and$604,000, respectively. The effective federal income tax rate was 26.5% and26.0% for the three and nine months ended September 30, 2007, compared to 25.3%and 24.4% for each of the respective 2006 periods. The effective tax rateincrease is attributable to higher pre-tax earnings and a net decrease intax-free income, collectively representing a smaller portion of pre-taxearnings.

 

16

----

 

**COMPARISON OF FINANCIAL CONDITIONAT**

**SEPTEMBER 30, 2007 AND DECEMBER31, 2006**

 

*Overview*

 

Consolidated assets increased $26,783,000, or 5%, during the ninemonths ended September 30, 2007. The net asset increase was due to increases intotal deposits of $28,722,000 and shareholders’ equity of $2,277,000 partiallyoffset by a net reduction in borrowings of $4,695,000.

 

*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 September 30, 2007, the carrying value of investment securitiestotaled $121,897,000, or 21% of total assets compared to $100,411,000, or 18%of total assets at December 31, 2006. Also as of September 30, 2007,approximately 47% of the carrying value of the investment portfolio wascomprised of mortgage-backed securities that amortize and provide monthly cashflow. Agency, corporate and municipal bonds comprised 31%, 12% and 10%,respectively, of the investment portfolio at September 30, 2007.

 

As illustrated in the following table of amortized cost and fair marketvalue of investment securities, the portfolio is comprised of HTM and AFSsecurities with carrying values of $1,196,000 and $120,701,000, respectively. AtSeptember 30, 2007, the AFS debt securities were recorded with a net unrealizedloss in the amount of $2,207,000 and equity securities were recorded with anunrealized gain of $187,000 (dollars in thousands):

 
| ** **                                        | ** ** | **Amortized** | ** ** | **Gross unrealized** | ** ** | **Gross unrealized** | ** ** | **Fair**  | ** ** |
|---------------------------------------------------|------------|---------------|------------|---------------------------|------------|---------------------------|------------|-----------|------------|
| ** **                                        | ** ** | **cost**      | ** ** | **gains**                 | ** ** | **losses**                | ** ** | **value** | ** ** |
|                                              |       |          |       |                      |       |                      |       |      |       |
| Held-to-maturity  securities:                     |       |          |       |                      |       |                      |       |      |       |
| Mortgage-backed  securities                       |       | $             | 1,196      |                      | $          | 24                        |       | $         | —     |   | $ | 1,220 |   |
|                                              |       |          |       |                      |       |                      |       |      |       |
| Available-for-sale  securities:                   |       |          |       |                      |       |                      |       |      |       |
| U.S. government  agencies and corporations        |       | $             | 38,204     |                      | $          | 61                        |       | $         | 863        |   | $ | 37,402 |   |
| Obligations of  states and political subdivisions |       | 12,139        |       | 23                        |       | 79                        |       | 12,083    |       |
| Corporate bonds                                   |       | 15,223        |       | —                    |       | 227                       |       | 14,996    |       |
| Mortgage-backed  securities                       |       | 56,876        |       | 32                        |       | 1,154                     |       | 55,754    |       |
|                                              |       |          |       |                      |       |                      |       |      |       |
| Total debt  securities                            |       | 122,442       |       | 116                       |       | 2,323                     |       | 120,235   |       |
|                                              |       |          |       |                      |       |                      |       |      |       |
| Equity  securities                                |       | 279           |       | 187                       |       | —                    |       | 466       |       |
|                                              |       |          |       |                      |       |                      |       |      |       |
| Total  available-for-sale                         |       | $             | 122,721    |                      | $          | 303                       |       | $         | 2,323      |   | $ | 120,701 |   |

 

17

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The amortized cost and fair value of debt securities at September 30,2007 by contractual maturity are as follows (dollars in thousands):

 
| ** **                                | ** ** | **Amortized** | ** ** | **Market** | ** ** |
|-------------------------------------------|------------|---------------|------------|------------|------------|
| ** **                                | ** ** | **cost**      | ** ** | **value**  | ** ** |
| Held-to-maturity  securities:             |       |          |       |       |       |
| Mortgage-backed  securities               |       | $             | 1,196      |       | $          | 1,220 |   |
|                                      |       |          |       |       |       |
| Available-for-sale  securities:           |       |          |       |       |       |
| Debt securities:                          |       |          |       |       |       |
| Due in one year  or less                  |       | $             | 1,000      |       | $          | 993 |   |
| Due after one  year through five years    |       | 5,999         |       | 5,985      |       |
| Due after five  years through ten years   |       | 19,256        |       | 19,207     |       |
| Due after ten  years                      |       | 39,311        |       | 38,296     |       |
| Total debt  securities                    |       | 65,566        |       | 64,481     |       |
|                                      |       |          |       |       |       |
| Mortgage-backed  securities               |       | 56,876        |       | 55,754     |       |
|                                      |       |          |       |       |       |
| Total  available-for-sale debt securities |       | $             | 122,442    |       | $          | 120,235 |   |

 

Expected maturities will differ from contractual maturities becauseissuers and borrowers may have the right to call or repay obligations with orwithout call or prepayment penalty. Federal agency and municipal securities areincluded 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) the length oftime 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) the intentand ability of the Company to retain its investment in the issuer for a periodof time sufficient to allow for any anticipated recovery in fair value.

 

At September 30, 2007, the AFS debt securities portfolio was carried ata net unrealized loss of $2,207,000 compared to a net unrealized loss of$1,656,000 at December 31, 2006, or a deterioration of $551,000. A largeportion of the unrealized losses was for a continuous period of more than 12months. Management believes the cause of these unrealized losses is directlyrelated to changes in market interest rates. As of September 30, 2007, most ofthe deterioration of the AFS debt portfolio is from investments that areguaranteed by the U.S. government or one of its agencies. In analyzing anissuer’s financial condition, management considers whether the securities areissued by the U.S. government, its agencies or other governments, whetherdowngrades by bond rating agencies have occurred and, if necessary, reviews ofthe issuer’s financial condition. Because the decline in market values isattributable to changes in interest rates and not credit quality, and theCompany has the ability and intent to hold those securities until recovery offair value, which may be maturity, management views these unrealized losses tobe temporary.

 

Excluding the net unrealized loss, the investment portfolio grew$22,043,000, or 22%, during the first nine months of 2007. The Company utilizedgrowth in deposits to grow the portfolio as well as to reduce short-termborrowings. The current interest rate environment, though improving, has beenessentially a sustained period of yield curve inversion that continues topreclude structured investment portfolio growth. As such, the Company willattempt to replace investment securities that mature, pay-down, are called oramortize with bonds that provide incremental earnings above the Bank’s fundingsources. In addition, cash flows from investments may be used to repay debt andfund growth in the loan portfolio.

 

18

----

 

*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 fairvalues of these loans fall below their amortized cost, the difference iswritten down and charged to current earnings. Subsequent appreciation in theportfolio, if any, is credited to current earnings but only to the extent ofprevious write-downs.

 

At September 30, 2007, loans AFS amounted to $382,000 with acorresponding fair value of $388,000, compared to $122,000 and $123,000,respectively, at December 31, 2006. During the third quarter of 2007,residential mortgages with principal balances of $4,795,000 were sold into thesecondary market with net gains of approximately $53,000 recognized.

 

*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 broad spectrum of products provides diversificationwhich helps manage, to an extent, interest rate risk and credit concentrationrisk. Credit risk is further managed through underwriting policies andprocedures and loan monitoring practices. Interest rate risk is managed usingvarious asset/liability modeling techniques and analyses. The interest rates onmost commercial loans are adjustable with reset intervals of five years orless.

 

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 more affectedby adverse conditions in the economy. Because payments on commercial loansdepend upon the successful operation and management of the properties and thebusinesses 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 from the loan officers’interaction with the Bank’s credit administration and outsourced loan reviewfunctions.

 

Gross loans increased $3,138,000, or 0.7% to $425,781,000 at September30, 2007 compared to $422,643,000 at December 31, 2006. The increase in residentialreal estate is from transfers of real estate construction funding to permanentfinancing. The composition of the loan portfolio as of September 30, 2007 andDecember 31, 2006 is summarized as follows:

 
| ** **                             | ** ** | **September 30, 2007** | ** **  | **December 31, 2006** | ** ** |
|----------------------------------------|------------|----------------------------------|-------------|---------------------------------|------------|
| ** **                             | ** ** | **Amount**                       | ** **  | **%**                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| Commercial and  commercial real estate |       | $                                | 218,861,143 |                            | 51.4       |   | $ | 218,213,216 |   | 51.6 |   |
| Residential real  estate               |       | 117,098,994                      |        | 27.5                            |       | 112,742,692 |   | 26.7 |   |
| Consumer and  home equity              |       | 78,051,965                       |        | 18.3                            |       | 77,729,520 |   | 18.4 |   |
| Real estate construction               |       | 11,235,730                       |        | 2.6                             |       | 13,369,712 |   | 3.2 |   |
| Direct financing  leases               |       | 533,944                          |        | 0.1                             |       | 588,211 |   | 0.1 |   |
| Gross loans                            |       | 425,781,776                      |        | 100.0                           |       | 422,643,351 |   | 100.0 |   |
| Allowance for  loan losses             |       | (4,990,855                       | )           |                            |       | (5,444,303 | ) |   |   |
| Net loans                              |       | $                                | 420,790,921 |                            |       |   | $ | 417,199,048 |   |   |   |

 

19

----

 

*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. The allowancereflects management’s best estimate of the amount of credit losses in the loanportfolio. Management’s judgment is based on the evaluation of individualloans, past experience, the assessment of current economic conditions and otherrelevant factors including the amounts and timing of cash flows expected to bereceived on impaired loans. Those estimates may be susceptible to significantchange. The provision for loan losses represents the amount necessary tomaintain an appropriate allowance. Loan losses are charged directly against theallowance when loans are deemed to be uncollectible. Recoveries from previouslycharged-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:

 

•      Identification of specificimpaired loans by loan category;

•      Calculation of specificallowances where required for the impaired loans based on collateral and objectiveand quantifiable evidence;

•      Determination of homogenouspools by loan category and eliminating the impaired loans.

•      Application of historicalloss percentages (five-year average) to pools to determine the allowanceallocation; and

•      Application of qualitativefactor adjustment percentages to historical losses for trends or changes in theloan 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 also based upon the creditrisk grading assigned from periodic reviews of the loan and lease portfolios.

 

Net charge-offs for the nine months ended September 30, 2007 were$393,000, compared to $466,000 for the same period in 2006. Net charge-offs ofcommercial loans were $340,000 for the nine months ended September 30, 2007compared to net charge-offs of $289,000 for the same period of 2006. Realestate loans had net recoveries of $15,000 in the first nine months of 2007 ascompared to net charge-offs of $65,000 in the first nine months of 2006. Consumerloan net charge-offs were $68,000 in the nine months ended September 30, 2007as compared to $112,000 for the same period of 2006. There were no leasefinancing charge-offs during 2007.

 

Management believes that the current balance in the allowance for loanslosses of $4,991,000 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 beenaddressed. Potential problem loans are those where there is known informationthat leads management to believe repayment of principal and/or interest is injeopardy. However, there could be instances which become identified over theyear that may require charge-offs and/or increases to the allowance. The ratioof allowance for loan losses to total loans was 1.17% at September 30, 2007compared to 1.29% at December 31, 2006 and 1.41% at September 30, 2006. Thereduced level of the allowance was driven by a reduction in the level ofinternally criticized and classified loans during 2007, which in turn reducedthe need for loan loss provisions.

 

20

----

 

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** | ** ** |
|---------------------------------------------------------------------------|------------|-------------------------------------------|-------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                | ** ** | **nine months ended**           | ** **  | **twelve months ended**         | ** ** | **nine months ended**           | ** ** |
| ** **                                                                | ** ** | **September 30, 2007**          | ** **  | **December 31, 2006**           | ** ** | **September 30, 2006**          | ** ** |
|                                                                      |       |                                      |        |                                      |       |                                      |       |
| Balance at  beginning of period                                           |       | $                                         | 5,444,303   |                                      | $          | 5,984,649                                 |       | $ | 5,984,649 |   |
|                                                                      |       |                                      |        |                                      |       |                                      |       |
| (Credit)  provision for loan losses                                       |       | (60,000                                   | )           | 325,000                                   |       | 325,000                                   |       |
|                                                                      |       |                                      |        |                                      |       |                                      |       |
| Charge-offs:                                                              |       |                                      |        |                                      |       |                                      |       |
| Commercial                                                                |       | 356,989                                   |        | 660,471                                   |       | 350,203                                   |       |
| Residential real  estate                                                  |       | 1,585                                     |        | 109,164                                   |       | 65,759                                    |       |
| Consumer                                                                  |       | 188,171                                   |        | 285,379                                   |       | 226,812                                   |       |
| Total                                                                     |       | 546,745                                   |        | 1,055,014                                 |       | 642,774                                   |       |
|                                                                      |       |                                      |        |                                      |       |                                      |       |
| Recoveries:                                                               |       |                                      |        |                                      |       |                                      |       |
| Commercial                                                                |       | 16,979                                    |        | 64,173                                    |       | 60,732                                    |       |
| Residential real  estate                                                  |       | 16,560                                    |        | 532                                       |       | 502                                       |       |
| Consumer                                                                  |       | 119,758                                   |        | 124,763                                   |       | 115,229                                   |       |
| Lease financing                                                           |       | —                                    |        | 200                                       |       | 200                                       |       |
| Total                                                                     |       | 153,297                                   |        | 189,668                                   |       | 176,663                                   |       |
|                                                                      |       |                                      |        |                                      |       |                                      |       |
| Net charge-offs                                                           |       | 393,448                                   |        | 865,346                                   |       | 466,111                                   |       |
|                                                                      |       |                                      |        |                                      |       |                                      |       |
| Balance at end  of period                                                 |       | $                                         | 4,990,855   |                                      | $          | 5,444,303                                 |       | $ | 5,843,538 |   |
|                                                                      |       |                                      |        |                                      |       |                                      |       |
| Total loans, end  of period                                               |       | $                                         | 426,163,776 |                                      | $          | 422,765,351                               |       | $ | 415,494,402 |   |
|                                                                      |       |                                      |        |                                      |       |                                      |       |
| Net charge-offs  to:                                                      |       |                                      |        |                                      |       |                                      |       |
| Loans, end of  period                                                     |       | 0.09                                      | %           | 0.20                                      | %          | 0.11                                      | %          |
| Allowance for  loan losses                                                |       | 7.88                                      | %           | 15.89                                     | %          | 7.98                                      | %          |
| Provision for  loan losses                                                |       | —                                    | x      | 2.66x                                     |       | 1.43                                      | x     |
|                                                                      |       |                                      |        |                                      |       |                                      |       |
| Allowance for  loan losses to:                                            |       |                                      |        |                                      |       |                                      |       |
| Total loans                                                               |       | 1.17                                      | %           | 1.29                                      | %          | 1.41                                      | %          |
| Non-accrual  loans                                                        |       | 1.07                                      | x      | 1.62                                      | x     | 1.43                                      | x     |
| Non-performing  loans                                                     |       | 1.07                                      | x      | 1.58                                      | x     | 1.15                                      | x     |
| Net charge-offs                                                           |       | 12.68                                     | x      | 6.29                                      | x     | 12.54                                     | x     |
|                                                                      |       |                                      |        |                                      |       |                                      |       |
| Loans 30-89 days  past due and still accruing                             |       | $                                         | 2,907,941   |                                      | $          | 2,570,825                                 |       | $ | 2,525,382 |   |
| Loans 90 days  past due and accruing                                      |       | $                                         | 35,891      |                                      | $          | 80,603                                    |       | $ | 997,148 |   |
| Non-accrual  loans                                                        |       | $                                         | 4,647,858   |                                      | $          | 3,357,718                                 |       | $ | 4,082,222 |   |
| Allowance for  loan losses to loans 90 days or more past due and accruing |       | 139.06                                    | x           | 67.54                                     | x          | 5.86                                      | x          |

 

The $2,908,000 of loans in the 30-89 days past due category as of  September 30, 2007 consists of  several loan relationships that migratedbeyond the 30 days, but payments are expected, returning them to fully currentstatus.

 

 

 

21

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The internally criticized and classified loans are addressed in the allowancefor loan loss allocation either through the general loan loss allocation, aspecific reserve or through the qualitative factor adjustments. Managementbelieves the allocation of the allowance for loan losses on these loans isadequate to absorb the potential for losses and therefore did not requireadditional loan loss provisions.

 

*Non-performing assets*

 

The Bank defines non-performing assets as accruing loans which are pastdue 90 days or more, non-accrual loans, restructured loans, other real estateowned and repossessed assets. As of September 30, 2007, non-performing assetsrepresented 0.81% of total assets compared to 0.65% at December 31, 2006 and0.93% at September 30, 2006.

 

The non-accrual loans component of the non-performing assets increasedby a net $1,290,000 during the first nine months of 2007 to $4,648,000 atSeptember 30, 2007. Additions to the non-accrual loans totaling $2,823,000occurred during the first nine months of 2007, as a number of loanrelationships migrated to delinquent status and were placed on non-accrual. However,these additions were partially offset by payoffs or pay downs of $906,000,$146,000 of loans returned to accruing status, charge-offs of $129,000 and$352,000 of loans that were transferred to other real estate owned. The Bank’sSpecial Assets Committee has reviewed non-accrual loans at September 30, 2007and found the collateral to be adequate or has made reserve allocations wheredeemed appropriate.

 

At September 30, 2007 the 90-day past due loans that were stillaccruing totaled $36,000, compared to $81,000 at December 31, 2006 and $997,000at September 30, 2006.

 

There were no repossessed assets at September 30, 2007. Other realestate owned was $107,000 at September 30, 2007. An offer to purchase theproperty is currently pending.

 

Non-performing loans are defined as accruing loans that are past due 90days or more and non-accruing loans. The non-performing loans were $4,684,000at September 30, 2007, an increase of $1,245,000 from year-end 2006, but adecline of $396,000 compared to September 30, 2006. The bank’s Special AssetsDepartment has developed specific action plans to reduce each of the Company’snon-performing loans. The ratio of non-accrual loans to net loans was 1.10%, atSeptember 30, 2007 compared to 1.00% at September 30, 2006. It was up slightlyfrom the year-end ratio of 0.80%. At September 30, 2007, the ratio ofnon-performing loans to net loans was 1.11% compared to 0.82% at December 31,2006 and 1.24% at September 30, 2006. The ratio of non-performing assets tototal assets was 0.81% at September 30, 2007 and 0.65% at December 31, 2006,both down from 0.93% at September 30, 2006.

 

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

 
| ** **                                                                         | ** ** | **September 30, 2007** | ** **  | **December 31, 2006** | ** ** | **September 30, 2006** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------|-------------|---------------------------------|------------|----------------------------------|------------|
|                                                                               |       |                             |        |                            |       |                             |       |
| Loans past due  90 days or more and accruing                                       |       | $                                | 35,891      |                            | $          | 80,603                           |       | $ | 997,148 |   |
| Non-accrual  loans                                                                 |       | 4,647,858                        |        | 3,357,718                       |       | 4,082,222                        |       |
| Total  non-performing loans                                                        |       | 4,683,749                        |        | 3,438,321                       |       | 5,079,370                        |       |
|                                                                               |       |                             |        |                            |       |                             |       |
| Restructured  loans                                                                |       | —                           |        | —                          |       | —                           |       |
| Other real  estate owned                                                           |       | 107,036                          |        | 197,149                         |       | 131,849                          |       |
| Repossessed  assets                                                                |       | —                           |        | —                          |       | —                           |       |
| Total  non-performing assets                                                       |       | $                                | 4,790,785   |                            | $          | 3,635,470                        |       | $ | 5,211,219 |   |
|                                                                               |       |                             |        |                            |       |                             |       |
| Net loans  including AFS                                                           |       | $                                | 421,172,921 |                            | $          | 417,321,048                      |       | $ | 410,072,053 |   |
| Total assets                                                                       |       | $                                | 589,101,139 |                            | $          | 562,317,988                      |       | $ | 562,840,483 |   |
| Non-accrual  loans to net loans                                                    |       | 1.10                             | %           | 0.80                            | %          | 1.00                             | %          |
| Non-performing  assets to net loans, foreclosed real estate and repossessed assets |       | 1.14                             | %           | 0.87                            | %          | 1.27                             | %          |
| Non-performing  assets to total assets                                             |       | 0.81                             | %           | 0.65                            | %          | 0.93                             | %          |
| Non-performing  loans to net loans                                                 |       | 1.11                             | %           | 0.82                            | %          | 1.24                             | %          |

 

22

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*Bank premises and equipment, net*

 

Bank premises and equipment increased $1,982,000, or 18%, sinceDecember 31, 2006. The increase was due mostly to current year capitalexpenditures and the transfer of capitalized costs from other assets, both inconjunction with the completion of the Company’s branch relocation project. Theseitems were partially offset by the sale and disposal of property and equipmentincluding the sale of an owned commercial facility previously leased to anon-related third party.

 

*Other assets*

 

The decrease in other assets of $389,000, or 8%, from December 31, 2006to September 30, 2007 was principally due to the net reduction of $542,000 incapitalized costs that were transferred to bank premises and equipment inconjunction with the completion of the Company’s branch relocation project. Thiswas partially offset by an increase in prepaid expenses which representscharges that are paid but deferred until the expense is incurred.

 

*Deposits*

 

The Bank is a community-based commercial financial institution thatoffers a variety of deposit accounts with a range of interest rates and terms. Depositproducts include passbook and statement savings accounts, interest-bearingchecking (NOW), money market, non-interest bearing, or demand deposit accounts(DDAs), and certificates of deposit accounts. The flow of deposits issignificantly influenced by general economic conditions, changes in prevailinginterest rates, pricing and competition. Most of the Bank’s deposits areobtained from the communities surrounding its 12 branch offices. The Bankattempts to attract and retain deposit customers via sales and marketingefforts with new products, quality service, competitive rates, and maintaininglong-standing customer relationships. To determine deposit product interestrates, the Bank considers local competition, market yields and the ratescharged for alternative sources of funding such as borrowings. To becompetitive in our markets and continue to bolster our deposit base, we haveincreased rates on most deposit products; however, we have not increased ratesabove market rates, as we only consider cost effective rate-setting tactics inall interest rate environments.

 

Compared to December 31, 2006 total deposits increased $28,722,000, or7%, during the nine months ended September 30, 2007. The growth in totaldeposits was primarily due to increases in certificates of deposit, moneymarket and NOW accounts partially offset by reductions in savings and DDAs. Thegrowth in the certificates of deposits was due to increases in the personal andthe public fund sector. The increase in money market accounts of $15,869,000,or 22%, was due to the continued success in deposit-gathering strategies inconjunction with promotional interest rates, partially offset by a decrease insavings accounts.

 

The following table represents the components of deposits as ofSeptember 30, 2007 and December 31, 2006:

 
| ** **               | ** ** | **September 30, 2007** | ** **  | **December 31, 2006** | ** ** |
|--------------------------|------------|----------------------------------|-------------|---------------------------------|------------|
| ** **               | ** ** | **Amount**                       | ** **  | **%**                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| Money market             |       | $                                | 88,228,034  |                            | 20.1       |   | $ | 72,359,157 |   | 17.6 |   |
| NOW                      |       | 66,903,423                       |        | 15.2                            |       | 65,121,770 |   | 15.9 |   |
| Savings and club         |       | 42,075,206                       |        | 9.6                             |       | 45,300,838 |   | 11.0 |   |
| Certificates of  deposit |       | 171,305,565                      |        | 39.0                            |       | 153,810,855 |   | 37.5 |   |
| Total  interest-bearing  |       | 368,512,228                      |        | 83.9                            |       | 336,592,620 |   | 82.0 |   |
| Non-interest-bearing     |       | 70,544,329                       |        | 16.1                            |       | 73,741,975 |   | 18.0 |   |
| Total deposits           |       | $                                | 439,056,557 |                            | 100.0      |   | $ | 410,334,595 |   | 100.0 |   |

 

Certificates of deposit of $100,000 or more aggregated $73,273,000 and$63,020,000 at September 30, 2007 and December 31, 2006, respectively.

 

*Borrowings*

 

Borrowings are used as a complement to deposit generation as analternative funding source whereby the Bank will borrow under customerrepurchase agreements in the local market and advances from the Federal HomeLoan Bank of Pittsburgh (FHLB) and correspondent banks for asset growth andliquidity needs. Borrowings included $62,918,000 and $62,536,000 in long-termadvances from the FHLB at September 30, 2007 and December 31, 2006,respectively. To help reduce the Bank’s reliance on overnight funding, duringthe second quarter of 2007 $16,000,000 of advances that had matured or converted,and carried a weighted-average interest rate of 4.78%,

 

23

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were replaced with fixed- and capped floating- rate advances amountingto an aggregate of  $20,000,000 thatmature in 2009 and carry an initial weighted-average interest rate of 5.40%. Alsoincluded in borrowings were short-term repurchase agreements of $20,565,000 and$22,224,000, as of the respective periods. Repurchase agreements arenon-insured interest-bearing liabilities that have a security interest inqualified investment securities of the Bank and are offered in both sweep andfixed-term products. A sweep account is designed to ensure that, on a dailybasis, an attached DDA is adequately funded and excess DDA funds aretransferred, or swept into an overnight interest-bearing repurchase agreementaccount. The balance in customer repurchase agreement accounts can fluctuatedaily because the daily sweep product is dependent on the level of availablefunds in depositor accounts. In addition, short-term borrowings may includeovernight balances which the Bank may require from time-to-time to fund dailyliquidity needs. As of September 30, 2007, the Bank had $7,000,000 in overnightbalances compared to $10,395,000 at December 31, 2006.

 

**Item 3. Quantitative andQualitative Disclosure About Market Risk**

 

*Management of interest rate risk and market riskanalysis*

 

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*. Onemajor objective of the Company when managing the rate sensitivity of its assetsand liabilities is to stabilize net interest income. The management of andauthority to assume interest rate risk is the responsibility of the Company’sAsset/Liability Committee (ALCO), which is comprised of senior management andmembers of the Board of Directors. 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 the Company.Consistent policies and practices of measuring and reporting interest rate riskexposure, particularly regarding the treatment of non-contractual assets andliabilities, are in effect. In addition, there is an annual process to reviewthe interest rate risk policy with the Board of Directors which includes limitson 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.* The ratio betweenassets and liabilities re-pricing in specific time intervals is referred to asan interest rate sensitivity gap. Interest rate sensitivity gaps can be managedto take advantage of the slope of the yield curve as well as forecasted changesin the level of interest rate changes.

 

To manage this interest rate sensitivity gap position, anasset/liability model commonly known as cumulative gap analysis is used tomonitor the difference in the volume of the Company’s interest sensitive assetsand liabilities that mature or re-price within given periods. A positive gap(asset sensitive) indicates that more assets will re-price during a givenperiod compared to liabilities, while a negative gap (liability sensitive) hasthe opposite effect. The Company employs computerized net interest incomesimulation modeling to assist in quantifying interest rate risk exposure. Thisprocess measures and quantifies the impact on net interest income throughvarying interest rate changes and balance sheet compositions. The use of thismodel assists the ALCO to gauge the effects of the interest rate changes oninterest sensitive assets and liabilities in order to determine what impactthese rate changes will have upon the net interest spread. At September 30,2007, the Company maintained a negative one-year cumulative gap of $56,694,000or -9.6% of total assets. The effect of this negative gap position provided amismatch of assets and liabilities which may expose the Bank to interest raterisk during periods of rising interest rates. Conversely, in a declininginterest rate environment, net interest income could be positively impactedbecause more liabilities than assets will re-price downward during a one-yearperiod.

 

 

 

24

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

 

The following table illustrates the Company’s interest sensitivity gapposition at September 30, 2007 (dollars in thousands):

 
| ** **                                     | ** ** | **Three months** | ** ** | **Three to**      | ** ** | **One to**      | ** ** | **Over**             | ** ** | ** ** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|------------------------|------------|----------------------|------------|----------------------|------------|------------|------------|
| ** **                                     | ** ** | **or less**      | ** ** | **twelve months** | ** ** | **three years** | ** ** | **three years** | ** ** | **Total**  | ** ** |
| Cash and cash  equivalents                     |       | $                     | 239        |                   | $          | —               |       | $                    | —     |       | $          | 13,132 |   | $ | 13,371 |   |
| Investment  securities (1)(2)                  |       | 17,352                |       | 10,071                 |       | 30,931               |       | 67,101               |       | 125,455    |       |
| Loans (2)                                      |       | 108,385               |       | 64,828                 |       | 104,590              |       | 143,370              |       | 421,173    |       |
| Fixed and other  assets                        |       | —                |       | 8,409                  |       | —               |       | 20,693               |       | 29,102     |       |
| Total assets                                   |       | $                     | 125,976    |                   | $          | 83,308               |       | $                    | 135,521    |       | $          | 244,296 |   | $ | 589,101 |   |
| Total cumulative  assets                       |       | $                     | 125,976    |                   | $          | 209,284              |       | $                    | 344,805    |       | $          | 589,101 |   |   |   |
|                                           |       |                  |       |                   |       |                 |       |                 |       |       |       |
| Non-interest-bearing  transaction deposits (3) |       | $                     | —     |                   | $          | 7,059                |       | $                    | 19,398     |       | $          | 44,087 |   | $ | 70,544 |   |
| Interest-bearing  transaction deposits (3)     |       | 103,781               |       | —                 |       | 37,265               |       | 56,161               |       | 197,207    |       |
| Certificates of  deposit                       |       | 65,319                |       | 50,392                 |       | 52,428               |       | 3,167                |       | 171,306    |       |
| Repurchase  agreements                         |       | 20,414                |       | 151                    |       | —               |       | —               |       | 20,565     |       |
| Short-term  borrowings                         |       | 8,014                 |       | —                 |       | —               |       | —               |       | 8,014      |       |
| Long-term debt                                 |       | 10,212                |       | 636                    |       | 20,070               |       | 32,000               |       | 62,918     |       |
| Other  liabilities                             |       | —                |       | —                 |       | —               |       | 4,659                |       | 4,659      |       |
| Total  liabilities                             |       | $                     | 207,740    |                   | $          | 58,238               |       | $                    | 129,161    |       | $          | 140,074 |   | $ | 535,213 |   |
| Total cumulative  liabilities                  |       | $                     | 207,740    |                   | $          | 265,978              |       | $                    | 395,139    |       | $          | 535,213 |   |   |   |
|                                           |       |                  |       |                   |       |                 |       |                 |       |       |       |
| Interest sensitivity  gap                      |       | $                     | (81,764    | )                      | $          | 25,070               |       | $                    | 6,360      |       | $          | 104,222 |   |   |   |
|                                           |       |                  |       |                   |       |                 |       |                 |       |       |       |
| Cumulative gap                                 |       | $                     | (81,764    | )                      | $          | (56,694              | )          | $                    | (50,334    | )          | $          | 53,888 |   |   |   |
|                                           |       |                  |       |                   |       |                 |       |                 |       |       |       |
| Cumulative gap  to total assets                |       | (13.88                | )%         | (9.62                  | )%         | (8.54                | )%         | 9.15                 | %          |       |       |

 

----

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

 

(2)   Investments and loans areincluded 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 and savingsaccounts are generally subject to immediate withdrawal. However, managementconsiders a certain amount of such accounts to be core accounts havingsignificantly longer effective maturities based on the retention experiences ofsuch deposits in changing interest rate environments. The effective maturitiespresented are the recommended maturity distribution limits for non-maturingdeposits based on historical deposit studies.

 

*Earnings at Risk and Economic Value at RiskSimulations.*The Company recognizes that more sophisticatedtools exist for measuring the interest rate risk in the balance sheet beyondstatic re-pricing gap analysis. Although it will continue to measure itsre-pricing gap position, the Company utilizes additional modeling foridentifying and measuring the interest rate risk in the overall balance sheet. TheALCO is responsible for focusing on “earnings at risk” and “economic value atrisk,” and how both relate to the risk-based capital position when analyzingthe interest rate risk.

 

25

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*Earnings at Risk.*Earnings atrisk 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 in interestrate simulation models.

 

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

 

The following table illustrates the simulated impact of 200 basispoints upward or downward movement in interest rates on net interest income,net income and the change in the economic value (portfolio equity). This analysisassumed that interest-earning asset and interest-bearing liability levels atSeptember 30, 2007 remained constant. The impact of the rate movements wasdeveloped by simulating the effect of rates changing over a twelve-month periodfrom the September 30, 2007 levels:

 
| ** **                                             | ** ** | **Rates +200** | ** ** | **Rates -200** | ** ** |
|--------------------------------------------------------|------------|---------------------|------------|---------------------|------------|
| Earnings at  risk:                                     |       |                |       |                |       |
| Percent change  in:                                    |       |                |       |                |       |
| Net interest  income                                   |       | (6.7                | )%         | 3.0                 | %          |
| Net income                                             |       | (19.3               | )          | 8.2                 |       |
|                                                   |       |                |       |                |       |
| Economic value  at risk:                               |       |                |       |                |       |
| Percent change  in:                                    |       |                |       |                |       |
| Economic value  of equity                              |       | (29.0               | )          | 4.9                 |       |
| Economic value  of equityas  a percent of total assets |       | (3.1                | )          | 0.5                 |       |

 

Economic value has the most meaning when viewed within the context ofrisk-based capital. Therefore, the economic value may normally change beyondthe 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 September 30, 2007, the Company’s risk-based capital ratiowas 13.5%.

 

The table below summarizes estimated changes in net interest incomeover a twelve-month period beginning October 1, 2007 under alternate interestrate scenarios using the income simulation model described above (dollars inthousands):

 
| ** **                                  | ** ** | **Net interest** | ** ** | **$**        | ** ** | **%**        | ** ** |
|---------------------------------------------|------------|-----------------------|------------|--------------|------------|--------------|------------|
| **Change in interest rates** | ** ** | **income**            | ** ** | **variance** | ** ** | **variance** | ** ** |
|                                        |       |                  |       |         |       |         |       |
| +200 basis  points                          |       | $                     | 17,201     |         | $          | (1,232       | )          | (6.7 | )% |
| +100 basis  points                          |       | 17,847                |       | (586         | )          | (3.2         | )          |
| Flat rate                                   |       | 18,433                |       | —       |       | —       |       |
| -100 basis  points                          |       | 18,954                |       | 521          |       | 2.8          |       |
| -200 basis  points                          |       | 18,985                |       | 552          |       | 3.0          |       |
|                                             |            |                       |            |              |            |              |            |  |  |

 

Simulation models require assumptions about certain categories ofassets and liabilities. The models schedule existing assets and liabilities bytheir contractual maturity, estimated likely call date or earliest re-pricingopportunity. Mortgage-backed securities and amortizing loans are scheduledbased on their anticipated cash flow including estimated prepayments. Forinvestment securities, the Bank uses a third-party service to provide cash flowestimates in the various rate environments. Savings accounts, including passbook,statement savings, money market and NOW accounts, do not have a stated maturityor re-pricing term and can be withdrawn or re-priced at any time. This mayimpact the margin if more expensive alternative sources of deposits arerequired to fund loans or deposit runoff. Management projects the re-pricingcharacteristics of these accounts based on historical performance andassumptions that it believes reflect their rate sensitivity. The modelreinvests all maturities, repayments and prepayments for each type of asset orliability into the same product for a new like term at current product interestrates provided by management. As a result, the mix of interest-

 

26

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earning assets and interest bearing-liabilities is held constant.

 

*Derivative Financial Instruments.*Aspart of the Bank’s overall interest rate risk management strategy, the Companyhas adopted a policy whereby the Bank may periodically use derivativeinstruments to minimize significant fluctuations in earnings caused by interestrate volatility. This interest rate risk management strategy entails the use ofinterest rate floors, caps and swaps. The Bank entered into an interest ratefloor agreement in 2006 and is reflected in the scenarios for earnings andeconomic value at risk and the net interest income in the two immediatelypreceding tables.

 

*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 in other borrowed funds from correspondent banks and issuance ofcapital stock. Although regularly scheduled investment and loan payments aredependable sources of daily funds, the sales of both loans and investments AFS,deposit activity, and investment and loan prepayments are significantlyinfluenced by general economic conditions and the level of interest rates.

 

As of September30, 2007, the Company maintained approximately $13,371,000 in cash and cashequivalents, $120,701,000 of investments AFS and $382,000 of loans AFS. Inaddition, as of September 30, 2007, the Company had approximately $112,018,000available to borrow from the FHLB and $23,000,000 available from othercorrespondent banks. This combined total of $269,472,000 represented 46% oftotal assets at September 30, 2007. Management believes this level of liquidityto be strong and adequate to support current operations.

 

*Capital*

 

During the nine months ended September 30, 2007, shareholders’ equityincreased from net income, stock issuance from the Company’s various sponsoredstock plans and an increase in the intrinsic value of the Bank’s cash flowhedge. The increase was partially offset by an increase in the unrealized losson AFS securities and the declaration of cash dividends. The Company is subjectto various regulatory capital requirements administered by the federal bankingagencies. Failure to meet minimum capital requirements can initiate certainmandatory and possible additional discretionary actions by regulators that, ifundertaken, could have a direct material effect on the Company’s financialstatements. Under capital adequacy guidelines and the regulatory framework forprompt corrective action, the Company must meet specific capital guidelinesthat involve quantitative measures of the Company’s assets, liabilities andcertain off-balance-sheet items as calculated under regulatory accountingpractices. The Company’s capital amounts and classification are also subject toqualitative judgments by the regulators about components, risk-weightings andother 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%, including TierI capital to total risk-weighted assets (Tier I Capital) of 4% and Tier Icapital to average total assets (Leverage Ratio) of at least 4%.

 

27

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As of September 30, 2007, the Company and the Bank met all capitaladequacy requirements to which they were subject. The following table depictsthe capital amounts and ratios of the Company and the Bank as of September 30,2007:

 
| ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                 | ** ** | ** ** | ** ** | ** **                            | ** ** | ** ** | ** ** | **To be well capitalized** | ** ** |
|----------------------------|------------|------------|------------|------------|------------|------------|------------|----------------------------|------------|------------|------------|---------------------------------------|------------|------------|------------|-------------------------------------------|------------|
| ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **For capital**       | ** ** | ** ** | ** ** | **under prompt corrective** | ** ** |
| ** **                 | ** ** | **Actual** | ** ** | ** ** | ** ** | ** ** | ** ** | **adequacy purposes** | ** ** | ** ** | ** ** | **action provisions**            | ** ** |
| ** **                 | ** ** | **Amount** | ** ** | **Ratio**  | ** ** | ** ** | ** ** | **Amount**                 | ** ** | ** ** | ** ** | **Ratio**                             | ** ** | ** ** | ** ** | **Amount**                                | ** ** | ** ** | ** ** | **Ratio** | ** ** |
| Total capital              |       |       |       |       |       |       |       |                       |       |       |       |                                  |       |       |       |                                      |       |   |   |   |   |
| (to  risk-weighted assets) |       |       |       |       |       |       |       |                       |       |       |       |                                  |       |       |       |                                      |       |   |   |   |   |
| Consolidated               |       | $          | 60,108,329 |       | 13.5       | %          | >  |                       | $          | 35,528,634 |       | >                             |       | 8.0        | %          |                                      |       | N/A |   |   |   | N/A |   |
| Bank                       |       | $          | 59,748,497 |       | 13.5       | %          | >  |                       | $          | 35,526,635 |       | >                             |       | 8.0        | %          | >                                 |       | $ | 44,408,294 |   | >  |   | 10.0 | % |
| Tier I capital             |       |       |       |       |       |       |       |                       |       |       |       |                                  |       |       |       |                                      |       |   |   |   |   |
| (to  risk-weighted assets) |       |       |       |       |       |       |       |                       |       |       |       |                                  |       |       |       |                                      |       |   |   |   |   |
| Consolidated               |       | $          | 55,033,232 |       | 12.4       | %          | >  |                       | $          | 17,764,317 |       | >                             |       | 4.0        | %          |                                      |       | N/A |   |   |   | N/A |   |
| Bank                       |       | $          | 54,749,252 |       | 12.3       | %          | >  |                       | $          | 17,763,318 |       | >                             |       | 4.0        | %          | >                                 |       | $ | 26,644,976 |   | >  |   | 6.0 | % |
| Tier I capital             |       |       |       |       |       |       |       |                       |       |       |       |                                  |       |       |       |                                      |       |   |   |   |   |
| (to average  assets)       |       |       |       |       |       |       |       |                       |       |       |       |                                  |       |       |       |                                      |       |   |   |   |   |
| Consolidated               |       | $          | 55,033,232 |       | 9.5        | %          | >  |                       | $          | 23,119,373 |       | >                             |       | 4.0        | %          |                                      |       | N/A |   |   |   | N/A |   |
| Bank                       |       | $          | 54,749,252 |       | 9.5        | %          | >  |                       | $          | 23,103,707 |       | >                             |       | 4.0        | %          | >                                 |       | $ | 28,879,634 |   | >  |   | 5.0 | % |

 

**Item 4. Controlsand Procedures**

 

The Company maintains controls and procedures designed to ensure that information required to be disclosed in the reports that the Company files or furnishes under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the 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 have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

**PART II - Other Information**

 

**Item 1. Legal Proceedings**

 

The nature of theCompany’s business generates some litigation involving matters arising in theordinary course of business. However, in the opinion of the Company, afterconsulting with legal counsel, no legal proceedings are pending, which, ifdetermined adversely to the Company or the Bank, would have a material effecton the Company’s undivided profits or financial condition. No legal proceedingsare pending other than ordinary routine litigation incidental to the businessof the Company and the Bank. In addition, to management’s knowledge, nogovernmental authorities have initiated or contemplated any material legalactions against the Company or the Bank.

 

**Item 1A. Risk Factors**

 

Management of the Company does not believe there have been any materialchanges in the risk factors that were disclosed in the Form 10-K filed with theSecurities and Exchange Commission on March 20, 2007.

 

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

 

None

 

**Item 3. Default Upon SeniorSecurities**

 

None

 

**Item 4. Submission of Matters toa Vote of Security Holders**

 

None

 

**Item 5. Other Information**

 

None

 

28

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**Item 6. Exhibits**

 

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

 

****10.1Amended and Restated Executive Employment Agreement between Fidelity D & DBancorp, Inc., The Fidelity Deposit and Discount Bank and Steven C. Ackmann,dated July 11, 2007.***Incorporated by reference to Exhibit99.1 to Registrant’s Current Report on Form 8-K filed with the SEC on July 13,2007.

 

****10.2 Amendment to Registrant’s2000 Stock Incentive Plan.***Incorporated by reference toExhibit 10.1 to Registrant’s Current Report on Form 8-K filed with the SEC onOctober 4, 2007.

 

****10.3 Amendment to Registrant’s2000 Independent Directors Stock Option Plan.***Incorporatedby reference to Exhibit 10.2 to Registrant’s Current Report on Form 8-K filedwith the SEC on October 4, 2007.

 

***11 Statement regardingcomputation of earnings per share.***Included herein inNote 2, “Earnings per share,”                contained within the Notes to Consolidated Financial Statements, andincorporated herein by reference.

 

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

 

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

 

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

 

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

 

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* Management contract orcompensatory plan or arrangement.

 

**FIDELITYD & D BANCORP, INC.**

 

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

 

 
|                   | **FIDELITY D & D BANCORP, INC.**                                             |
|------------------------|----------------------------------------------------------------------------------|
|                   | ** **                                                                       |
|                   |                                                                             |
| Date: November 6, 2007 | /s/ Steven C. Ackmann                                                            |   |
|                   |      Steven  C. Ackmann,                                |
|                   |        President  and Chief Executive Officer |
|                   |                                                                             |
|                   |                                                                             |
| Date: November 6, 2007 | /s/ Salvatore R. DeFrancesco, Jr.                                                |   |
|                   |      Salvatore R.  DeFrancesco, Jr.,                    |
|                   |        Treasurer  and Chief Financial Officer |
|                        |                                                                                  |  |  |

 

 

29

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**EXHIBIT INDEX**

 
| ** **                                                                                                                                                                                                                                                                                                                    | ** **   | **Page**     |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------|--------------|
| ***10.1 Amended and Restated  Executive Employment Agreement between Fidelity D & D Bancorp, Inc., The  Fidelity Deposit and Discount Bank and Steven C. Ackmann, dated July 11,  2007.***Incorporated by reference to Exhibit 99.1 to  Registrant’s Current Report on Form 8-K filed with the SEC on July 13, 2007. |         | *            |
| *** ***                                                                                                                                                                                                                                                                                                                  | *** *** | *** *** |
| ***10.2 Amendment to Registrant’s  2000 Stock Incentive Plan.***Incorporated by reference to  Exhibit 10.1 to Registrant’s Current Report on Form 8-K filed with the SEC on  October 4, 2007.                                                                                                                       |         | *            |
| *** ***                                                                                                                                                                                                                                                                                                                  | *** *** | *** *** |
| ***10.3 Amendment to Registrant’s  2000 Independent Directors Stock Option Plan***.  Incorporated by reference to Exhibit 10.2 to Registrant’s Current Report on  Form 8-K filed with the SEC on October 4, 2007.                                                                                                   |         | *            |
| *** ***                                                                                                                                                                                                                                                                                                                  | *** *** | *** *** |
| ***11 Statement regarding  computation of earnings per share.***Included herein.                                                                                                                                                                                                                                              |         | 8            |
| *** ***                                                                                                                                                                                                                                                                                                                  | *** *** | *** *** |
| ***31.1 Rule 13a-14(a)  Certification of Principal Executive Officer.***                                                                                                                                                                                                                                                      |         | 31           |
|                                                                                                                                                                                                                                                                                                                          |         |         |
| ***31.2 Rule 13a-14(a) Certification  of Principal Financial Officer.***                                                                                                                                                                                                                                                      |         | 32           |
|                                                                                                                                                                                                                                                                                                                          |         |         |
| ***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.***                                                                                                                                                           |         | 33           |
|                                                                                                                                                                                                                                                                                                                          |         |         |
| ***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.***                                                                                                                                                           |         | 34           |

 

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* Incorporated byReference

 

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