UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-Q





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


SECURITIES
EXCHANGE ACT OF 1934





For
the quarterly period ended September 30, 2009





OR





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


SECURITIES
EXCHANGE ACT OF 1934





For the
transition period from ______________to______________________





Commission
file number: 333-90273





FIDELITY
D & D BANCORP, INC.





STATE OF
INCORPORATION:  IRS EMPLOYER IDENTIFICATION NO:


PENNSYLVANIA                                      23-3017653





Address
of principal executive offices:


BLAKELY
& DRINKER ST.


DUNMORE,
PENNSYLVANIA 18512





TELEPHONE:


570-342-8281





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





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files).   ̈ YES  ̈ NO





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





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





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





 ̈ YES x NO





The
number of outstanding shares of Common Stock of Fidelity D & D Bancorp, Inc.
at October 30, 2009, the latest practicable date, was 2,093,313
shares.











FIDELITY
D & D BANCORP, INC.





Form 10-Q September 30,
2009





Index


PagePart I.  Financial
      InformationItem
      1.
                                      Financial
      Statements:Consolidated
      Balance Sheets as of September 30, 2009 and December 31,
    2008
                                      3Consolidated
      Statements of Income for the three and nine months ended September 30,
      2009 and 2008
                                      4Consolidated
      Statements of Changes in Shareholders’ Equity for the nine months ended
      September 30, 2009 and 2008
                                      5Consolidated
      Statements of Cash Flows for the nine months ended September 30, 2009 and
      2008
                                      6Notes
      to Consolidated Financial Statements
                                      7Item
      2.
                                      Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                                      20Item
      3.
                                      Quantitative
      and Qualitative Disclosure about Market Risk
                                      34Item
      4T.
                                      Controls
      and Procedures
                                      39Part II.  Other
      InformationItem
      1.
                                      Legal
      Proceedings
                                      39Item
      1A.
                                      Risk
      Factors
                                      39Item
      2.
                                      Unregistered
      Sales of Equity Securities and Use of Proceeds
                                      40Item
      3.
                                      Defaults
      upon Senior Securities
                                      40Item
      4.
                                      Submission
      of Matters to a Vote of Security Holders
                                      40Item
      5.
                                      Other
      Information
                                      40Item
      6.
                                      Exhibits
                                      40Signatures
                                      
                                      42Exhibit
      index
                                      
                                      43





- 2
-





PART
I – Financial Information


Item
1: Financial Statements


FIDELITY
D & D BANCORP, INC. AND SUBSIDIARY


Consolidated
Balance Sheets







September
      30, 2009
                
                
                December
      31, 2008(unaudited)
                
                
                (audited)Assets:Cash
      and due from banks
                
                $
                11,725,108
                
                
                $
                12,335,905Federal
      funds sold
                
                
                5,563,000
                
                
                
                -Interest-bearing
      deposits with financial institutions
                
                
                344,073
                
                
                
                435,242Total
      cash and cash equivalents
                
                
                17,632,181
                
                
                
                12,771,147Available-for-sale
      securities
                
                
                82,401,730
                
                
                
                83,278,132Held-to-maturity
      securities
                
                
                740,387
                
                
                
                909,447Federal
      Home Loan Bank Stock
                
                
                4,781,100
                
                
                
                4,781,100Loans
      and leases, net (allowance for loan losses of $6,724,857 in 2009;
      $4,745,234 in 2008)
                
                
                420,833,765
                
                
                
                436,207,460Loans
      available-for-sale (fair value $893,873 in 2009; $85,312 in
      2008)
                
                
                881,109
                
                
                
                84,000Bank
      premises and equipment, net
                
                
                15,514,474
                
                
                
                16,056,362Cash
      surrender value of bank owned life insurance
                
                
                9,038,561
                
                
                
                8,807,784Other
      assets
                
                
                10,268,397
                
                
                
                8,929,917Accrued
      interest receivable
                
                
                2,543,333
                
                
                
                2,443,141Foreclosed
      assets held-for-sale
                
                
                1,364,397
                
                
                
                1,450,507Total
      assets
                
                $
                565,999,434
                
                
                $
                575,718,997Liabilities:Deposits:Interest-bearing
                
                $
                403,268,503
                
                
                $
                361,869,281Non-interest-bearing
                
                
                73,990,068
                
                
                
                71,442,651Total
      deposits
                
                
                477,258,571
                
                
                
                433,311,932Accrued
      interest payable and other liabilities
                
                
                3,338,059
                
                
                
                3,316,710Short-term
      borrowings
                
                
                5,238,457
                
                
                
                38,129,704Long-term
      debt
                
                
                32,000,000
                
                
                
                52,000,000Total
      liabilities
                
                
                517,835,087
                
                
                
                526,758,346Shareholders'
      equity:Preferred
      stock authorized 5,000,000 shares with no par value; none
      issued
                
                
                -
                
                
                
                -Capital
      stock, no par value (10,000,000 shares authorized; shares issued and
      outstanding; 2,093,313 in 2009; and 2,075,182 shares issued and 2,062,927
      shares outstanding in 2008)
                
                
                19,775,652
                
                
                
                19,410,306Treasury
      stock, at cost (no shares in 2009; 12,255 shares in 2008)
                
                
                -
                
                
                
                (351,665
                )Retained
      earnings
                
                
                35,336,330
                
                
                
                38,126,250Accumulated
      other comprehensive loss
                
                
                (6,947,635
                )
                
                
                (8,224,240
                )Total
      shareholders' equity
                
                
                48,164,347
                
                
                
                48,960,651Total
      liabilities and shareholders' equity
                
                $
                565,999,434
                
                
                $
                575,718,997





See notes
to consolidated financial statements





- 3
-





FIDELITY D & D BANCORP, INC. AND
SUBSIDIARY


Consolidated
Statements of Income


(unaudited)


Three
      months ended
                    
                    
                    Nine
      months endedSeptember
      30, 2009
                    
                    
                    September
      30, 2008
                    
                    
                    September
      30, 2009
                    
                    
                    September
      30, 2008Interest
      income:Loans
      and leases:Taxable
                    
                    $
                    6,435,487
                    
                    
                    $
                    6,811,968
                    
                    
                    $
                    19,353,099
                    
                    
                    $
                    20,396,282Nontaxable
                    
                    
                    110,566
                    
                    
                    
                    93,454
                    
                    
                    
                    338,828
                    
                    
                    
                    256,860Interest-bearing
      deposits with financial institutions
                    
                    
                    89
                    
                    
                    
                    606
                    
                    
                    
                    537
                    
                    
                    
                    2,408Investment
      securities:U.S.
      government agency and corporations
                    
                    
                    534,629
                    
                    
                    
                    1,047,561
                    
                    
                    
                    1,852,457
                    
                    
                    
                    3,584,878States
      and political subdivisions (nontaxable)
                    
                    
                    318,299
                    
                    
                    
                    170,098
                    
                    
                    
                    787,208
                    
                    
                    
                    469,330Other
      securities
                    
                    
                    50,994
                    
                    
                    
                    295,753
                    
                    
                    
                    393,502
                    
                    
                    
                    976,447Federal
      funds sold
                    
                    
                    3,422
                    
                    
                    
                    -
                    
                    
                    
                    10,781
                    
                    
                    
                    91,133Total
      interest income
                    
                    
                    7,453,486
                    
                    
                    
                    8,419,440
                    
                    
                    
                    22,736,412
                    
                    
                    
                    25,777,338Interest
      expense:Deposits
                    
                    
                    1,949,402
                    
                    
                    
                    2,598,805
                    
                    
                    
                    6,279,307
                    
                    
                    
                    8,663,941Securities
      sold under repurchase agreements
                    
                    
                    5,872
                    
                    
                    
                    11,545
                    
                    
                    
                    22,427
                    
                    
                    
                    92,141Other
      short-term borrowings and other
                    
                    
                    1,446
                    
                    
                    
                    142,954
                    
                    
                    
                    27,991
                    
                    
                    
                    256,625Long-term
      debt
                    
                    
                    1,075,934
                    
                    
                    
                    786,989
                    
                    
                    
                    2,420,466
                    
                    
                    
                    2,395,484Total
      interest expense
                    
                    
                    3,032,654
                    
                    
                    
                    3,540,293
                    
                    
                    
                    8,750,191
                    
                    
                    
                    11,408,191Net
      interest income
                    
                    
                    4,420,832
                    
                    
                    
                    4,879,147
                    
                    
                    
                    13,986,221
                    
                    
                    
                    14,369,147Provision
      for loan losses
                    
                    
                    3,125,000
                    
                    
                    
                    130,000
                    
                    
                    
                    3,850,000
                    
                    
                    
                    255,000Net
      interest income after provision for loan losses
                    
                    
                    1,295,832
                    
                    
                    
                    4,749,147
                    
                    
                    
                    10,136,221
                    
                    
                    
                    14,114,147Other
      income (loss):Service
      charges on deposit accounts
                    
                    
                    676,107
                    
                    
                    
                    715,528
                    
                    
                    
                    1,956,755
                    
                    
                    
                    2,216,127Fees
      and other service charges
                    
                    
                    428,049
                    
                    
                    
                    451,382
                    
                    
                    
                    1,407,538
                    
                    
                    
                    1,344,020Gain
      (loss) on sale or disposal of:Loans
                    
                    
                    139,451
                    
                    
                    
                    64,778
                    
                    
                    
                    957,777
                    
                    
                    
                    215,974Investment
      securities
                    
                    
                    -
                    
                    
                    
                    16,775
                    
                    
                    
                    -
                    
                    
                    
                    25,428Premises
      and equipment
                    
                    
                    (34,617
                    )
                    
                    
                    (34,674
                    )
                    
                    
                    (41,241
                    )
                    
                    
                    (35,658
                    )Foreclosed
      assets held-for-sale
                    
                    
                    7,780
                    
                    
                    
                    33,685
                    
                    
                    
                    33,667
                    
                    
                    
                    42,794Write-down
      of foreclosed assets held-for-sale
                    
                    
                    (77,560
                    )
                    
                    
                    -
                    
                    
                    
                    (77,560
                    )
                    
                    
                    -Impairment
      losses on investment securities:Other-than-temporary
      impairment on investment securities
                    
                    
                    (6,468,236
                    )
                    
                    
                    (403,031
                    )
                    
                    
                    (6,794,331
                    )
                    
                    
                    (403,031
                    )Non-credit
      related losses on investment securities not expectedto
      be sold (recognized in other comprehensive income/(loss))
                    
                    
                    4,036,470
                    
                    
                    
                    -
                    
                    
                    
                    4,036,470
                    
                    
                    
                    -Net
      impairment losses on investment securities recognized in
      earnings
                    
                    
                    (2,431,766
                    )
                    
                    
                    (403,031
                    )
                    
                    
                    (2,757,861
                    )
                    
                    
                    (403,031
                    )Total
      other (loss) income
                    
                    
                    (1,292,556
                    )
                    
                    
                    844,443
                    
                    
                    
                    1,479,075
                    
                    
                    
                    3,405,654Other
      expenses:Salaries
      and employee benefits
                    
                    
                    2,502,818
                    
                    
                    
                    2,474,969
                    
                    
                    
                    7,495,167
                    
                    
                    
                    7,364,817Premises
      and equipment
                    
                    
                    874,028
                    
                    
                    
                    813,380
                    
                    
                    
                    2,685,343
                    
                    
                    
                    2,385,489Advertising
                    
                    
                    117,897
                    
                    
                    
                    242,937
                    
                    
                    
                    396,290
                    
                    
                    
                    579,641Other
                    
                    
                    1,614,552
                    
                    
                    
                    1,141,368
                    
                    
                    
                    3,933,271
                    
                    
                    
                    3,179,996Total
      other expenses
                    
                    
                    5,109,295
                    
                    
                    
                    4,672,654
                    
                    
                    
                    14,510,071
                    
                    
                    
                    13,509,943(Loss)
      income before income taxes
                    
                    
                    (5,106,019
                    )
                    
                    
                    920,936
                    
                    
                    
                    (2,894,775
                    )
                    
                    
                    4,009,858(Credit)
      provision for income taxes
                    
                    
                    (1,895,339
                    )
                    
                    
                    179,821
                    
                    
                    
                    (1,421,306
                    )
                    
                    
                    975,850Net
      (loss) income
                    
                    $
                    (3,210,680
                    )
                    
                    $
                    741,115
                    
                    
                    $
                    (1,473,469
                    )
                    
                    $
                    3,034,008Per
      share data:Net
      (loss) income - basic
                    
                    $
                    (1.55
                    )
                    
                    $
                    0.35
                    
                    
                    $
                    (0.71
                    )
                    
                    $
                    1.46Net
      (loss) income – diluted
                    
                    $
                    (1.55
                    )
                    
                    $
                    0.35
                    
                    
                    $
                    (0.71
                    )
                    
                    $
                    1.46Dividends
                    
                    $
                    0.25
                    
                    
                    $
                    0.25
                    
                    
                    $
                    0.75
                    
                    
                    $
                    0.75





- 4
-





FIDELITY
D & D BANCORP, INC. AND SUBSIDIARY





Consolidated
Statements of Changes in Shareholders' Equity


For the
nine months ended September 30, 2009 and 2008


AccumulatedotherCapital
      stock
                                                          
                                                          
                                                          Treasury
      stock
                                                          
                                                          
                                                          Retained
                                                          
                                                          
                                                          comprehensiveShares
                                                          
                                                          
                                                          Amount
                                                          
                                                          
                                                          Shares
                                                          
                                                          
                                                          Amount
                                                          
                                                          
                                                          earnings
                                                          
                                                          
                                                          income
      (loss)
                                                          
                                                          
                                                          TotalBalance,
      December 31, 2007
                                                          
                                                          
                                                          2,072,929
                                                          
                                                          
                                                          $
                                                          19,223,363
                                                          
                                                          
                                                          
                                                          -
                                                          
                                                          
                                                          $
                                                          -
                                                          
                                                          
                                                          $
                                                          36,564,157
                                                          
                                                          
                                                          $
                                                          (596,226
                                                          )
                                                          
                                                          $
                                                          55,191,294Total
      comprehensive income (loss):Net
      income
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          3,034,008
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          3,034,008Change
      in net unrealized holding losseson
      available-for-sale securities, net ofreclassification
      adjustment and tax effects
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          (5,957,194
                                                          )
                                                          
                                                          
                                                          (5,957,194
                                                          )Change
      in cash flow hedge intrinsic value
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          96,383
                                                          
                                                          
                                                          
                                                          96,383Comprehensive
      loss
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          (2,826,803
                                                          )Issuance
      of common stock through Employee StockPurchase
      Plan
                                                          
                                                          
                                                          2,253
                                                          
                                                          
                                                          
                                                          57,891
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          57,891Stock-based
      compensation expense
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          129,052
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          129,052Purchase
      of treasury stock
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          (13,000
                                                          )
                                                          
                                                          
                                                          (379,810
                                                          )
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          (379,810
                                                          )Cash
      dividends declared
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          (1,553,635
                                                          )
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          (1,553,635
                                                          )Balance,
      September 30, 2008 (unaudited)
                                                          
                                                          
                                                          2,075,182
                                                          
                                                          
                                                          $
                                                          19,410,306
                                                          
                                                          
                                                          
                                                          (13,000
                                                          )
                                                          
                                                          $
                                                          (379,810
                                                          )
                                                          
                                                          $
                                                          38,044,530
                                                          
                                                          
                                                          $
                                                          (6,457,037
                                                          )
                                                          
                                                          $
                                                          50,617,989Balance,
      December 31, 2008
                                                          
                                                          
                                                          2,075,182
                                                          
                                                          
                                                          $
                                                          19,410,306
                                                          
                                                          
                                                          
                                                          (12,255
                                                          )
                                                          
                                                          $
                                                          (351,665
                                                          )
                                                          
                                                          $
                                                          38,126,250
                                                          
                                                          
                                                          $
                                                          (8,224,240
                                                          )
                                                          
                                                          $
                                                          48,960,651Cumulative
      effect of change in accountingprinciple,
      adoption of FASB ASC 320-10
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          350,720
                                                          
                                                          
                                                          
                                                          (350,720
                                                          )
                                                          
                                                          
                                                          -Total
      comprehensive income:Net
      loss
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          (1,473,469
                                                          )
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          (1,473,469
                                                          )Change
      in net unrealized holding losseson
      available-for-sale securities, net ofreclassification
      adjustment and tax effects
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          4,852,351
                                                          
                                                          
                                                          
                                                          4,852,351Non-credit
      related impairment losses oninvestment
      securities not expected to be sold,net
      of tax
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          (2,664,070
                                                          )
                                                          
                                                          
                                                          (2,664,070
                                                          )Change
      in cash flow hedge intrinsic value
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          (560,956
                                                          )
                                                          
                                                          
                                                          (560,956
                                                          )Comprehensive
      income
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          153,856Issuance
      of common stock through Employee StockPurchase
      Plan
                                                          
                                                          
                                                          1,701
                                                          
                                                          
                                                          
                                                          40,569
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          40,569Purchase
      of treasury stock
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          (2,500
                                                          )
                                                          
                                                          
                                                          (56,505
                                                          )
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          (56,505
                                                          )Dividends
      reinvested through DividendReinvestment
      Plan
                                                          
                                                          
                                                          16,430
                                                          
                                                          
                                                          
                                                          320,269
                                                          
                                                          
                                                          
                                                          14,755
                                                          
                                                          
                                                          
                                                          408,170
                                                          
                                                          
                                                          
                                                          (112,329
                                                          )
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          616,110Stock-based
      compensation expense
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          4,508
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          4,508Cash
      dividends declared
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          (1,554,842
                                                          )
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          
                                                          (1,554,842
                                                          )Balance,
      September 30, 2009 (unaudited)
                                                          
                                                          
                                                          2,093,313
                                                          
                                                          
                                                          $
                                                          19,775,652
                                                          
                                                          
                                                          
                                                          -
                                                          
                                                          
                                                          $
                                                          -
                                                          
                                                          
                                                          $
                                                          35,336,330
                                                          
                                                          
                                                          $
                                                          (6,947,635
                                                          )
                                                          
                                                          $
                                                          48,164,347










- 5
-





FIDELITY DEPOSIT & DISCOUNT BANCORP, INC. AND
SUBSIDIARY


Consolidated
Statements of Cash Flows


(unaudited)


Nine months ended September
    30,2009
                  
                  
                  2008Cash
      flows from operating activities:Net
      (loss) income
                  
                  $
                  (1,473,469
                  )
                  
                  $
                  3,034,008Adjustments
      to reconcile net (loss) income to net cash provided byoperating
      activities:Depreciation,
      amortization and accretion
                  
                  
                  1,130,120
                  
                  
                  
                  442,338Provision
      for loan losses
                  
                  
                  3,850,000
                  
                  
                  
                  255,000Deferred
      income tax expense
                  
                  
                  (1,211,999
                  )
                  
                  
                  158,834Stock-based
      compensation expense
                  
                  
                  4,508
                  
                  
                  
                  129,052Loss
      from investment in limited partnership
                  
                  
                  40,961
                  
                  
                  
                  60,300Proceeds
      from sale of loans available-for-sale
                  
                  
                  90,195,545
                  
                  
                  
                  42,687,143Originations
      of loans available-for-sale
                  
                  
                  (79,702,670
                  )
                  
                  
                  (11,163,004
                  )Write-down
      of foreclosed assets held-for-sale
                  
                  
                  77,560
                  
                  
                  
                  -Increase
      in cash surrender value of life insurance
                  
                  
                  (230,777
                  )
                  
                  
                  (239,905
                  )Net
      gain on sale of loans
                  
                  
                  (957,777
                  )
                  
                  
                  (215,974
                  )Net
      gain on sale of investment securities
                  
                  
                  -
                  
                  
                  
                  (25,428
                  )Net
      gain on sale of foreclosed assets held for sale
                  
                  
                  (33,667
                  )
                  
                  
                  (42,794
                  )Loss
      on disposal of equipment
                  
                  
                  41,241
                  
                  
                  
                  35,658Other-than-temporary
      impairment on securities
                  
                  
                  2,757,861
                  
                  
                  
                  403,031Change
      in:Accrued
      interest receivable
                  
                  
                  (285,893
                  )
                  
                  
                  (35,235
                  )Other
      assets
                  
                  
                  (1,262,594
                  )
                  
                  
                  (1,625,694
                  )Accrued
      interest payable and other liabilities
                  
                  
                  22,564
                  
                  
                  
                  130,552Net
      cash provided by operating activities
                  
                  
                  12,961,514
                  
                  
                  
                  33,987,882Cash
      flows from investing activities:Held-to-maturity
      securities:Proceeds
      from maturities, calls and principal pay-downs
                  
                  
                  169,017
                  
                  
                  
                  201,209Available-for-sale
      securities:Proceeds
      from sales
                  
                  
                  -
                  
                  
                  
                  48,402,449Proceeds
      from maturities, calls and principal pay-downs
                  
                  
                  30,396,495
                  
                  
                  
                  30,445,671Purchases
                  
                  
                  (28,383,313
                  )
                  
                  
                  (51,961,087
                  )Net
      decrease in FHLB stock
                  
                  
                  -
                  
                  
                  
                  (1,467,800
                  )Net
      increase in loans and leases
                  
                  
                  (85,653
                  )
                  
                  
                  (37,941,827
                  )Acquisition
      of bank premises and equipment
                  
                  
                  (808,304
                  )
                  
                  
                  (3,662,291
                  )Proceeds
      from sale of bank premises and equipment
                  
                  
                  -
                  
                  
                  
                  600Proceeds
      from sale of foreclosed assets held-for-sale
                  
                  
                  510,554
                  
                  
                  
                  262,406Net
      cash provided by (used in) investing activities
                  
                  
                  1,798,796
                  
                  
                  
                  (15,720,670
                  )Cash
      flows from financing activities:Net
      increase in deposits
                  
                  
                  43,946,639
                  
                  
                  
                  9,723,176Net
      decrease in short-term borrowings
                  
                  
                  (32,891,247
                  )
                  
                  
                  (22,570,040
                  )Repayments
      of long-term debt
                  
                  
                  (20,000,000
                  )
                  
                  
                  (637,016
                  )Purchase
      of treasury stock
                  
                  
                  (56,505
                  )
                  
                  
                  (321,105
                  )Proceeds
      from employee stock purchase plan
                  
                  
                  40,569
                  
                  
                  
                  57,891Dividends
      paid, net of dividends reinvested
                  
                  
                  (938,732
                  )
                  
                  
                  (1,553,635
                  )Net
      cash used in financing  activities
                  
                  
                  (9,899,276
                  )
                  
                  
                  (15,300,729
                  )Net
      increase in cash and cash equivalents
                  
                  
                  4,861,034
                  
                  
                  
                  2,966,483Cash
      and cash equivalents, beginning
                  
                  
                  12,771,147
                  
                  
                  
                  10,408,816Cash
      and cash equivalents, ending
                  
                  $
                  17,632,181
                  
                  
                  $
                  13,375,299





See notes
to consolidated financial statements





- 6
-





FIDELITY
D & D BANCORP, INC.





Notes
to Consolidated Financial Statements


(unaudited)




1.   Nature
of operations and critical accounting policies





Nature of
operations




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




Principles of
consolidation




The
accompanying unaudited consolidated financial statements of the Company and the
Bank have been prepared in accordance with accounting principles generally
accepted in the United States of America (GAAP) for interim financial
information and with the instructions to this Form 10-Q and Rule 10-01 of
Regulation S-X.  Accordingly, they do not include all of the
information and footnote disclosures required by GAAP for complete financial
statements.  In the opinion of management, all normal recurring
adjustments necessary for a fair presentation of the financial condition and
results of operations for the periods have been included.  All
significant inter-company balances and transactions have been eliminated in
consolidation.




The
preparation of financial statements in conformity with GAAP requires management
to make estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reported periods.  Actual results could differ from those
estimates.  For additional information and disclosures required under
GAAP, refer to the Company’s Annual Report on Form 10-K for the year ended
December 31, 2008.




Management
is responsible for the fairness, integrity and objectivity of the unaudited
financial statements included in this report.  Management prepared the
unaudited financial statements in accordance with GAAP.  In meeting
its responsibility for the financial statements, management depends on the
Company's accounting systems and related internal controls.  These
systems and controls are designed to provide reasonable but not absolute
assurance that the financial records accurately reflect the transactions of the
Company, the Company’s assets are safeguarded and that the financial statements
present fairly the financial condition and results of operations of the
Company.




In the
opinion of management, the consolidated balance sheets as of September 30, 2009
and December 31, 2008 and the related consolidated statements of income for the
three- and nine-month periods ended September 30, 2009 and 2008 and changes in
shareholders’ equity and cash flows for the nine months ended September 30, 2009
and 2008 present fairly the financial condition and results of operations of the
Company.  All material adjustments required for a fair presentation
have been made.  These adjustments are of a normal recurring
nature.




This
Quarterly Report on Form 10-Q should be read in conjunction with the Company’s
audited financial statements for the year ended December 31, 2008, and the notes
included therein, included within the Company’s Annual Report filed on Form
10-K.




Critical accounting
policies




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




A
material estimate that is particularly susceptible to significant change relates
to the determination of the allowance for loan losses.  Management
believes that the allowance for loan losses at September 30, 2009 is adequate
and reasonable.  Given the subjective nature of identifying and
valuing loan losses, it is likely that well-informed individuals could make
different assumptions, and could, therefore calculate a materially different
allowance value.  While management uses available information to
recognize losses on loans, changes in economic conditions may necessitate
revisions in the future.  In addition, various regulatory agencies, as
an integral part of their examination process, periodically review the Company’s
allowance for loan losses.  Such agencies may require the Company to
recognize adjustments to the allowance based on their judgment of information
available to them at the time of their examination.





- 7
-





Another
material estimate is the calculation of fair values of the Company’s investment
securities.  Except for the Company’s investment in corporate bonds,
consisting of pooled trust preferred securities, fair values on the other
investment securities are determined by prices provided by a third-party vendor,
who is a provider of financial market data, analytics and related services to
financial institutions.  For the pooled trust preferred securities,
management was unable to obtain readily attainable and realistic pricing from
market traders due to lack of active market participants and therefore
management has determined the market for these securities to be
inactive.  In order to determine the fair value of the pooled trust
preferred securities, management relied on the use of an income valuation
approach (present value technique) that maximizes the use of relevant observable
inputs and minimizes the use of unobservable inputs, the results of which are
more representative of fair value than the market approach valuation technique
used for the other investment securities.




Based on
experience, management is aware that estimated fair values of investment
securities tend to vary among valuation services.  Accordingly, when
selling investment securities, price quotes from more than one source may be
obtained.  The majority of the Company’s investment securities are
classified as available-for-sale (AFS).  AFS securities are carried at
fair value on the consolidated balance sheet, with unrealized gains and losses,
net of income tax, reported separately within shareholders’ equity through
accumulated other comprehensive income (loss).




The fair
value of residential mortgage loans, classified as AFS, is obtained from the
Federal National Mortgage Association (FNMA) or the Federal Home Loan Bank
(FHLB).  Generally, the market to which the Company sells mortgages it
originates for sale is restricted and price quotes from other sources are not
typically obtained.  On occasion, the Company may transfer loans from
the loan and lease portfolio to loans AFS.  Under these circumstances,
pricing may be obtained from other entities and the loans are transferred at the
lower of cost or market value and simultaneously sold.  For a further
discussion on the accounting treatment of AFS loans, see the section entitled
“Loans available-for-sale,” contained within management’s discussion and
analysis.  As of September 30, 2009 and December 31, 2008, loans
classified as AFS consisted of residential mortgages.




2.  New
Accounting Pronouncements




In
June 2009, the Financial Accounting Standards Board (FASB) issued SFAS
No. 168 (FASB ASC 105-10), The FASB Accounting Standards
Codification and the Hierarchy of Generally Accepted Accounting
Principles (SFAS 168) (FASB ASC 105-10).  SFAS 168 (FASB ASC 105-10)
establishes the FASB Accounting Standards Codification (codification) as the
single source of authoritative non-governmental U.S. generally accepted
accounting principles, superseding existing FASB, American Institute of
Certified Public Accountants (AICPA), Emerging Issues Task Force (EITF) and
related accounting literature.  The codification does not change
GAAP.  Instead, it takes the thousands of individual pronouncements
that currently comprise GAAP and reorganizes them into approximately 90
accounting topics, and displays all topics using a consistent structure. 
Contents in each topic are further organized first by subtopic, then
section and finally paragraph.  The paragraph level is the only
level that contains substantive content.  Citing particular content in
the codification involves specifying the unique numeric path to the content
through the topic, subtopic, section and paragraph
structure.  FASB suggests that all citations begin with “FASB ASC,”
where ASC stands for Accounting Standards Codification.  SFAS 168,
(FASB ASC 105-10) is effective for interim and annual periods ending after
September 15, 2009 and has impacted the Company’s financial statements only
to the extent that references to authoritative accounting literature are now
referenced in accordance with FASB ASC 105-10.  Accordingly, where
deemed necessary, the balance of this report will reference the Accounting
Standards Codification (ASC).




On
January 1, 2009, the Company adopted FASB ASC 350-30-35, Determination of the Useful Life of
Intangible Assets, which provides guidance on the factors that should be
considered in developing renewal or extension assumptions used to determine the
useful life of a recognized intangible asset under FASB ASC 350-10, Goodwill and Other Intangible
Assets.  The intent of this guidance is to improve the
consistency between the useful life of a recognized intangible asset and the
period of expected cash flows, particularly as used to measure fair value in
business combinations.  FASB ASC 350-30-35 is effective for fiscal
years beginning after December 15, 2008, and is immaterial as it relates to
the Company’s consolidated financial statements.




On
January 1, 2009, the Company adopted FASB ASC 815-10-50, Disclosures about Derivative
Instruments and Hedging Activitiesthat provides guidance on the
disclosure requirements of derivative instruments and hedging
activities.  The guidance requires qualitative disclosures about
objectives and strategies for using derivatives, quantitative disclosures about
fair value amounts of gains and losses on derivative instruments, and
disclosures about credit-risk-related contingent features in derivative
agreements.  The adoption of FASB ASC 815-10-50 had no impact on the
Company’s consolidated financial statements.




In May
2009, the FASB issued FASB ASC 855-10, Subsequent Events, which
establishes standards under which an entity shall recognize and disclose events
that occur after a balance sheet date but before the related financial
statements are issued or are available to be issued.  The requirements
of the subsequent events standard are effective for interim and annual reporting
periods ending after June 15, 2009.  The adoption of FASB ASC
855-10 had no impact on the Company’s consolidated financial
statements.





- 8
-





Prior to
the FASB Accounting Standards Codification and the Hierarchy of Generally
Accepted Accounting Principles, in June 2009, the FASB issued SFAS
No. 166 (Not yet reflected in FASB ASC), Accounting for Transfers of
Financial Assets, an amendment of FASB Statement No. 140 (FASB ASC
860-10).  SFAS No. 166 makes several significant amendments to
SFAS No. 140 (FASB ASC 860-10), including the removal of the concept of a
qualifying special-purpose entity from SFAS No. 140 (FASB ASC
860-10).  SFAS No. 166 also clarifies that a transferor must evaluate
whether it has maintained effective control of a financial asset by considering
its continuing direct or indirect involvement with the transferred financial
asset.  The provisions of SFAS No. 166 are effective for interim and
annual reporting periods that begin after November 15, 2009.  The adoption
of the provisions of SFAS No. 166 is not expected to have a material impact
on the Company’s consolidated financial statements.




Prior to
the FASB Accounting Standards Codification and the Hierarchy of Generally
Accepted Accounting Principles, in June 2009, the FASB issued SFAS
No. 167 (Not yet reflected in FASB ASC), Amendments to FASB Interpretation
No. 46(R) (FASB ASC 810-10).  SFAS No. 167 requires a
qualitative rather than a quantitative analysis to determine the primary
beneficiary of a variable interest entity (VIE) for consolidation
purposes.  The primary beneficiary of a VIE is the enterprise that has:
(1) the power to direct the activities of the VIE that most significantly
impact the VIE’s economic performance, and (2) the obligation to absorb
losses of the VIE that could potentially be significant to the VIE or the right
to receive benefits of the VIE that could potentially be significant to the
VIE.  The provisions of SFAS No. 167 are effective for interim and
annual reporting periods that begin after November 15, 2009.  The adoption
of the provisions of SFAS No. 167 is not expected to have an impact on the
Company’s consolidated financial statements.




Additional
accounting pronouncements recently adopted are discussed where applicable in the
notes to the consolidated financial statements.




3.
Investment securities




The
amortized cost and fair value of investment securities at September 30, 2009 and
December 31, 2008 are summarized as follows (dollars in thousands):




September 30, 2009Amortized
                    
                    
                    Gross
      unrealized
                    
                    
                    Gross
      unrealized
                    
                    
                    Faircost
                    
                    
                    gains
                    
                    
                    losses
                    
                    
                    valueHeld-to-maturity
securities:Mortgage-backed
      securities
                    
                    $
                    740
                    
                    
                    $
                    56
                    
                    
                    $
                    -
                    
                    
                    $
                    796Available-for-sale
    securities:U.S.
      government agencies and corporations
                    
                    $
                    36,175
                    
                    
                    $
                    177
                    
                    
                    $
                    1,356
                    
                    
                    $
                    34,996Obligations
      of states and political subdivisions
                    
                    
                    28,365
                    
                    
                    
                    1,409
                    
                    
                    
                    10
                    
                    
                    
                    29,764Corporate
      bonds:Pooled
      trust preferred securities
                    
                    
                    19,300
                    
                    
                    
                    -
                    
                    
                    
                    11,461
                    
                    
                    
                    7,839Mortgage-backed
      securities
                    
                    
                    8,836
                    
                    
                    
                    521
                    
                    
                    
                    -
                    
                    
                    
                    9,357Total
      debt securities
                    
                    
                    92,676
                    
                    
                    
                    2,107
                    
                    
                    
                    12,827
                    
                    
                    
                    81,956Equity
      securities
                    
                    
                    322
                    
                    
                    
                    143
                    
                    
                    
                    19
                    
                    
                    
                    446Total
      available-for-sale
                    
                    $
                    92,998
                    
                    
                    $
                    2,250
                    
                    
                    $
                    12,846
                    
                    
                    $
                    82,402





- 9
-




December 31, 2008Amortized
                    
                    
                    Gross
      unrealized
                    
                    
                    Gross
      unrealized
                    
                    
                    Faircost
                    
                    
                    gains
                    
                    
                    losses
                    
                    
                    valueHeld-to-maturity
securities:Mortgage-backed
      securities
                    
                    $
                    909
                    
                    
                    $
                    31
                    
                    
                    $
                    -
                    
                    
                    $
                    940Available-for-sale
    securities:U.S.
      government agencies and corporations
                    
                    $
                    45,824
                    
                    
                    $
                    134
                    
                    
                    $
                    2,451
                    
                    
                    $
                    43,507Obligations
      of states and political subdivisions
                    
                    
                    18,009
                    
                    
                    
                    97
                    
                    
                    
                    553
                    
                    
                    
                    17,553Corporate
      bonds:Pooled
      trust preferred securities
                    
                    
                    21,415
                    
                    
                    
                    -
                    
                    
                    
                    11,155
                    
                    
                    
                    10,260Mortgage-backed
      securities
                    
                    
                    11,088
                    
                    
                    
                    442
                    
                    
                    
                    -
                    
                    
                    
                    11,530Total
      debt securities
                    
                    
                    96,336
                    
                    
                    
                    673
                    
                    
                    
                    14,159
                    
                    
                    
                    82,850Equity
      securities
                    
                    
                    322
                    
                    
                    
                    122
                    
                    
                    
                    16
                    
                    
                    
                    428Total
      available-for-sale
                    
                    $
                    96,658
                    
                    
                    $
                    795
                    
                    
                    $
                    14,175
                    
                    
                    $
                    83,278




The
amortized cost and fair value of debt securities at September 30, 2009 and
December 31, 2008 by contractual maturity are summarized below (dollars in
thousands):




September 30, 2009
                    
                    
                    December 31, 2008Amortized
                    
                    
                    Market
                    
                    
                    Amortized
                    
                    
                    Marketcost
                    
                    
                    value
                    
                    
                    cost
                    
                    
                    valueHeld-to-maturity
securities:Mortgage-backed
      securities
                    
                    $
                    740
                    
                    
                    $
                    796
                    
                    
                    $
                    909
                    
                    
                    $
                    940Available-for-sale
    securities:Debt
      securities:Due
      in one year or less
                    
                    $
                    -
                    
                    
                    $
                    -
                    
                    
                    $
                    -
                    
                    
                    $
                    -Due
      after one year through five years
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Due
      after five years through ten years
                    
                    
                    6,273
                    
                    
                    
                    6,331
                    
                    
                    
                    10,649
                    
                    
                    
                    10,706Due
      after ten years
                    
                    
                    77,567
                    
                    
                    
                    66,268
                    
                    
                    
                    74,599
                    
                    
                    
                    60,614Total
      debt securities
                    
                    
                    83,840
                    
                    
                    
                    72,599
                    
                    
                    
                    85,248
                    
                    
                    
                    71,320Mortgage-backed
      securities
                    
                    
                    8,836
                    
                    
                    
                    9,357
                    
                    
                    
                    11,088
                    
                    
                    
                    11,530Total
      available-for-sale debt securities
                    
                    $
                    92,676
                    
                    
                    $
                    81,956
                    
                    
                    $
                    96,336
                    
                    
                    $
                    82,850




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




The
following tables present the fair value and gross unrealized losses of
investment securities aggregated by investment type, the length of time and the
number of securities that have been in a continuous unrealized loss position as
of September 30, 2009 and December 31, 2008 (dollars in thousands):





- 10
-




September 30, 2009Less than 12 months
                
                
                More than 12 months
                
                
                TotalFair
                
                
                Unrealized
                
                
                Fair
                
                
                Unrealized
                
                
                Fair
                
                
                Unrealizedvalue
                
                
                losses
                
                
                value
                
                
                losses
                
                
                value
                
                
                lossesU.S.
      government agencies and corporations
                
                $
                7,019
                
                
                $
                73
                
                
                $
                4,454
                
                
                $
                1,283
                
                
                $
                11,473
                
                
                $
                1,356Obligations
      of states and political subdivisions
                
                
                -
                
                
                
                -
                
                
                
                2,615
                
                
                
                10
                
                
                
                2,615
                
                
                
                10Corporate
      bonds:Pooled
      trust preferred securities
                
                
                -
                
                
                
                -
                
                
                
                7,839
                
                
                
                11,461
                
                
                
                7,839
                
                
                
                11,461Total
      debt securities
                
                
                7,019
                
                
                
                73
                
                
                
                14,908
                
                
                
                12,754
                
                
                
                21,927
                
                
                
                12,827Equity
      securities
                
                
                112
                
                
                
                12
                
                
                
                70
                
                
                
                7
                
                
                
                182
                
                
                
                19Total
      securities
                
                $
                7,131
                
                
                $
                85
                
                
                $
                14,978
                
                
                $
                12,761
                
                
                $
                22,109
                
                
                $
                12,846Number
      of securities
                
                
                8
                
                
                
                
                
                
                
                19
                
                
                
                
                
                
                
                27





December 31, 2008Less than 12 months
                
                
                More than 12 months
                
                
                TotalFair
                
                
                Unrealized
                
                
                Fair
                
                
                Unrealized
                
                
                Fair
                
                
                Unrealizedvalue
                
                
                losses
                
                
                value
                
                
                losses
                
                
                value
                
                
                lossesU.S.
      government agencies and corporations
                
                $
                12,506
                
                
                $
                1,878
                
                
                $
                5,145
                
                
                $
                573
                
                
                $
                17,651
                
                
                $
                2,451Obligations
      of states and political subdivisions
                
                
                8,154
                
                
                
                496
                
                
                
                1,455
                
                
                
                57
                
                
                
                9,609
                
                
                
                553Corporate
      bonds:Pooled
      trust preferred securities
                
                
                2,235
                
                
                
                2,352
                
                
                
                8,025
                
                
                
                8,803
                
                
                
                10,260
                
                
                
                11,155Mortgage-backed
      securities
                
                
                17
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                17
                
                
                
                -Total
      debt securities
                
                
                22,912
                
                
                
                4,726
                
                
                
                14,625
                
                
                
                9,433
                
                
                
                37,537
                
                
                
                14,159Equity
      securities
                
                
                -
                
                
                
                -
                
                
                
                60
                
                
                
                16
                
                
                
                60
                
                
                
                16Total
      securities
                
                $
                22,912
                
                
                $
                4,726
                
                
                $
                14,685
                
                
                $
                9,449
                
                
                $
                37,597
                
                
                $
                14,175Number
      of securities
                
                
                20
                
                
                
                
                
                
                
                22
                
                
                
                
                
                
                
                42




In the
table above, the unrealized losses on mortgage-backed securities were less than
$1,000 in 2008.




Management
conducts a formal review of investment securities on a quarterly basis for the
presence of other-than-temporary-impairment (OTTI).  During the second
quarter of 2009, the Company adopted FASB ASC 320-10-65, Recognition and Presentation of
Other-Than-Temporary Impairments.  The Company assesses whether
OTTI is present when the fair value of a debt security is less than its
amortized cost basis at the balance sheet date.  Under these
circumstances as required by the guidance, OTTI is considered to have occurred
if: (1) the entity has intent to sell the security; (2) more likely
than not the entity will be required to sell the security before recovery of its
amortized cost basis; or (3) the present value of expected cash flows is
not sufficient to recover the entire amortized cost.




The
guidance requires that credit-related OTTI be recognized in earnings while
non-credit-related OTTI on securities not expected to be sold be recognized in
other comprehensive income (OCI).  Non-credit-related OTTI is based on
other factors effecting market conditions, including
illiquidity.  Presentation of OTTI is made in the statement of income
on a gross basis with an offset for the amount of non-credit related OTTI
recognized in OCI.  Non-credit-related OTTI recognized in earnings
prior to April 1, 2009 has been reclassified from retained earnings to
accumulated OCI as a cumulative effect adjustment.




The
Company’s OTTI evaluation process also follows the guidance of FASB ASC 320-10,
Investments - Debt and Equity
Securities and FASB ASC 325-40, Investments – Other - Beneficial
Interests in Securitized Financial Assets.This guidance
requires the Company to take into consideration current market conditions, fair
value in relationship to cost, extent and nature of changes in fair value,
issuer rating changes and trends, volatility of earnings, current analysts’
evaluations, all available information relevant to the collectability of debt
securities, the ability and intent to hold investments until a recovery of fair
value, which may be maturity, and other factors when evaluating for the
existence of OTTI in securities portfolios.  The requirements of this
guidance are effective for reporting periods ending after December 15,
2008.  This guidance also eliminates the requirement that a holder’s
best estimate of cash flows is based upon those that a market participant would
use.  Instead, the guidance requires that OTTI be recognized as a
realized loss through earnings when there has been an adverse change in the
holder’s expected cash flows such that the full amount (principal and interest)
will probably not be received.  This requirement is consistent with
the impairment model in the guidance for accounting for debt and equity
securities.





- 11
-





For all
security types discussed below where no OTTI is considered necessary at
September 30, 2009, the Company applied the criteria provided in the recognition
and presentation of OTTI guidance.  That is, management has no intent
to sell the securities and no conditions were identified by management that more
likely than not would require the Company to sell the securities before recovery
of their amortized cost basis.




U.S. government agencies and
corporations


The
agency securities consist of medium and long-term notes issued by Federal Home
Loan Mortgage Corporation (FHLMC) and Federal National Mortgage Association
(FNMA).  These securities are fixed-rate issues, have varying mid- to
long-term maturity dates and have contractual cash flows guaranteed by agencies
of the U.S. government.  In the latter half of 2008, the U.S.
Government provided substantial liquidity to FNMA and FHLMC to bolster their
creditworthiness.




Agency guaranteed
mortgage-backed securities


The
agency mortgage-backed securities are comprised largely of fixed-rate
residential mortgage-backed securities issued by FNMA or FHLMC.  They
have mid- to long-term maturity dates and have contractual cash flows guaranteed
by agencies of the U.S. Government.  In the latter half of 2008, the
U.S. government provided substantial liquidity to both FNMA and FHLMC to bolster
their creditworthiness.




Obligations of states and
political subdivisions


The
municipal securities are rated as investment grade by various credit rating
agencies and are at fixed rates with mid- to long-term
maturities.  Fair values of these securities are highly driven by
interest rates.  Management performs ongoing credit quality reviews on
these issues.




In the
above three securities types, the decline in fair value is attributable to
changes in interest rates and not credit quality.  As such, no OTTI is
considered necessary for these securities at September 30, 2009.




Pooled trust preferred
securities


A Pooled
Trust Preferred Collateralized Debt Obligation (CDO) is a type of investment
security collateralized by trust preferred securities (TPS) issued by banks,
insurance companies and REITs.  The primary collateral type is a TPS
issued by a bank.  A TPS is a hybrid security with both debt and
equity characteristics such as the ability to voluntarily defer interest
payments for up to 20 consecutive quarters.  A TPS is a junior
security in the capital structure of the issuer.




There are
various tranches or classes issued by the CDO with the most
senior tranche having the lowest yield but the most protection
from credit losses (versus other tranches that are
subordinate).  Losses are generally allocated from the lowest tranche
with the equity piece holding the most risk and then subordinate tranches in
reverse order up to the senior tranche.  The allocation of losses is
defined in the indenture when the CDO was formed.




Unrealized
losses were caused mainly by the following factors: (1) collateral
deterioration due to bank failures and credit concerns across the banking
sector; (2) widening of credit spreads; and (3) illiquidity in the
market.  The Company’s review of these securities, in accordance with
the previous discussion, determined that in 2009 credit-related OTTI be recorded
on five holdings of these securities all of which are in the AFS securities
portfolio.  The following table summarizes the amount of
credit-related OTTI recognized in earnings under the new guidance for 2009 and
the amount of credit- and non-credit related OTTI recognized in earnings under
the former guidance for 2008 by security during the periods indicated (dollars
in thousands):




Three
      months ended
                    
                    
                    Nine
      months endedSeptember 30,
                    
                    
                    September 30,2009
                    
                    
                    2008
                    
                    
                    2009
                    
                    
                    2008Pooled
      trust preferred securities:PreTSL
      VII, Mezzanine
                    
                    $
                    325
                    
                    
                    $
                    397
                    
                    
                    $
                    651
                    
                    
                    $
                    397PreTSL
      IX, B1, B3
                    
                    
                    690
                    
                    
                    
                    -
                    
                    
                    
                    690
                    
                    
                    
                    -PreTSL
      XV, B1
                    
                    
                    154
                    
                    
                    
                    -
                    
                    
                    
                    154
                    
                    
                    
                    -PreTSL
      XVI, C
                    
                    
                    756
                    
                    
                    
                    -
                    
                    
                    
                    756
                    
                    
                    
                    -PreTSL
      XXV, C1
                    
                    
                    507
                    
                    
                    
                    -
                    
                    
                    
                    507
                    
                    
                    
                    -Equity
      securities
                    
                    
                    -
                    
                    
                    
                    6
                    
                    
                    
                    -
                    
                    
                    
                    6Total
                    
                    $
                    2,432
                    
                    
                    $
                    403
                    
                    
                    $
                    2,758
                    
                    
                    $
                    403





- 12
-




The
following table is a tabular roll-forward of the amount of credit-related OTTI
recognized in earnings (dollars in thousands):




Three
      months ended
                  
                  
                  Nine
      months endedSeptember
      30, 2009
                  
                  
                  September
      30, 2009HTM
                  
                  
                  AFS
                  
                  
                  Total
                  
                  
                  HTM
                  
                  
                  AFS
                  
                  
                  TotalBeginning
      balance of credit-related OTTI
                  
                  $
                  -
                  
                  
                  $
                  (224
                  )
                  
                  $
                  (224
                  )
                  
                  $
                  -
                  
                  
                  $
                  (429
                  )
                  
                  $
                  (429
                  )Reduction
      - cumulative effect of accounting change
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  531
                  
                  
                  
                  531Additions
      for credit-related OTTI not previously recognized
                  
                  
                  -
                  
                  
                  
                  (2,107
                  )
                  
                  
                  (2,107
                  )
                  
                  
                  -
                  
                  
                  
                  (2,107
                  )
                  
                  
                  (2,107
                  )Additional
      credit-related OTTI previously recognized when there is no intent to sell
      before recovery of amortized cost basis
                  
                  
                  -
                  
                  
                  
                  (325
                  )
                  
                  
                  (325
                  )
                  
                  
                  
                  
                  
                  
                  (651
                  )
                  
                  
                  (651
                  )Ending
      balance of credit-related OTTI
                  
                  $
                  -
                  
                  
                  $
                  (2,656
                  )
                  
                  $
                  (2,656
                  )
                  
                  $
                  -
                  
                  
                  $
                  (2,656
                  )
                  
                  $
                  (2,656
                  )




To
determine the ending balance of credit-related OTTI, the Company used discounted
present value cash flow analysis and compared the results with the bond’s face
value.  The analysis considered the following assumptions: the
discount rate which equated to the discount margin for each tranche (credit
spread) at the time of purchase which was then added to the appropriate
three-month libor forward rate obtained from the forward libor curve; historical
average default rates obtained from the FDIC for U.S. Banks and Thrifts for the
period spanning 1988 to 1991 increased by a factor of three and rolled forward
to project a rate of default of approximately one-third; the default rate was
reduced by the actual deferrals / defaults experienced in all preferred term
securities for the full year 2008 and the first half of 2009; the remaining 10%
estimated default rate was then stratified with higher default rates occurring
in the beginning regressing to normal in 2011 with an estimated 15% recovery by
way of a two year lag; and no prepayments with receipt of principal at
maturity.  The present value of PreTSL VII as modeled resulted in cash
flow of $777,000 as of April 1, 2009, or approximately $224,000 below the bond’s
face value of $1,001,000.  Upon adoption, the recognition and
presentation of OTTI guidance in the second quarter of 2009, and as a result of
the credit-related OTTI determination as explained, the $531,000 non-credit
related portion of OTTI that existed prior to April 1, 2009, or $351,000 after
tax, was reclassified from retained earnings to OCI as a cumulative effect
adjustment.




As of
September 30, 2009, the book value of the Company’s pooled trust preferred
securities amounted to $19,300,000 with an estimated fair value of $7,839,000
compared to $21,415,000 and $10,260,000, respectively as of December 31,
2008.




Two of
the Company’s initial mezzanine holdings (PreTSLs IV and V) are now senior
tranches and the remainders are mezzanine tranches.  As of September
30, 2009, none of the pooled trust preferred securities were investment
grade.  At the time of initial issue, the subordination in the
Company’s tranches ranged in size from approximately 8.0% to 25.2% of the total
principal amount of the respective securities and no more than 5% of any pooled
trust preferred security consisted of a security issued by any one bank and 4%
for insurance companies.  As of September 30, 2009, management
estimates the subordination in the Company’s tranches ranging from 0% to 18.9%
of the current performing collateral.  The following table provides
additional information with respect to the Company’s pooled trust preferred
securities:




Current
                                      
                                      
                                      
                                      
                                      
                                      Actual
                                      
                                      
                                      
                                      
                                      
                                      Excess
                                      
                                      
                                      Effectivenumber
                                      
                                      
                                      
                                      
                                      
                                      deferrals
                                      
                                      
                                      
                                      
                                      
                                      subordination
      *
                                      
                                      
                                      subordination
      **of
                                      
                                      
                                      Actual
                                      
                                      
                                      and
      defaults
                                      
                                      
                                      
                                      
                                      
                                      as a
      % of
                                      
                                      
                                      as a
      % ofMoody's
      /
                                      
                                      banks
      /
                                      
                                      
                                      deferrals
                                      
                                      
                                      as a
      % of
                                      
                                      
                                      Excess
                                      
                                      
                                      current
                                      
                                      
                                      currentBook
                                      
                                      
                                      Fair
                                      
                                      
                                      Unrealized
                                      
                                      Fitch
                                      
                                      insurance
                                      
                                      
                                      and
      defaults
                                      
                                      
                                      current
                                      
                                      
                                      subordination
                                      
                                      
                                      performing
                                      
                                      
                                      performingDeal
                                      
                                      Class
                                      
                                      
                                      value
                                      
                                      
                                      value
                                      
                                      
                                      loss
                                      
                                      ratings
                                      
                                      companies
                                      
                                      
                                      $
                                      (000
                                      )
                                      
                                      collateral
                                      
                                      
                                      $
                                      (000
                                      )
                                      
                                      collateral
                                      
                                      
                                      collateralPre
      TSL  IV
                                      
                                      Mezzanine
                                      
                                      
                                      $
                                      609,971
                                      
                                      
                                      $
                                      458,454
                                      
                                      
                                      $
                                      (151,517
                                      )
                                      Ca /
      B
                                      
                                      
                                      6 /
      -
                                      
                                      
                                      
                                      18,000
                                      
                                      
                                      
                                      27.1
                                      
                                      
                                      
                                      9,718
                                      
                                      
                                      
                                      18.9
                                      
                                      
                                      
                                      33.1Pre
      TSL  V
                                      
                                      Mezzanine
                                      
                                      
                                      
                                      275,503
                                      
                                      
                                      
                                      194,477
                                      
                                      
                                      
                                      (81,026
                                      )
                                      Ba3
      / A
                                      
                                      
                                      4 /
      -
                                      
                                      
                                      
                                      18,950
                                      
                                      
                                      
                                      43.1
                                      
                                      
                                      None
                                      
                                      
                                      
                                      N/A
                                      
                                      
                                      
                                      N/APre
      TSL VII
                                      
                                      Mezzanine
                                      
                                      
                                      
                                      453,186
                                      
                                      
                                      
                                      275,952
                                      
                                      
                                      
                                      (177,234
                                      )
                                      Ca
      / CC
                                      
                                      
                                      20 /
      -
                                      
                                      
                                      
                                      138,000
                                      
                                      
                                      
                                      60.8
                                      
                                      
                                      None
                                      
                                      
                                      
                                      N/A
                                      
                                      
                                      
                                      N/APre
      TSL  IX
                                      
                                      B-1,B-3
                                      
                                      
                                      
                                      2,810,338
                                      
                                      
                                      
                                      1,517,600
                                      
                                      
                                      
                                      (1,292,738
                                      )
                                      Ca
      / CC
                                      
                                      
                                      49 /
      -
                                      
                                      
                                      
                                      118,480
                                      
                                      
                                      
                                      26.3
                                      
                                      
                                      None
                                      
                                      
                                      
                                      N/A
                                      
                                      
                                      
                                      0.4Pre
      TSL XI
                                      
                                      B-3
                                      
                                      
                                      
                                      2,390,079
                                      
                                      
                                      
                                      1,203,750
                                      
                                      
                                      
                                      (1,186,329
                                      )
                                      Ca
      / CC
                                      
                                      
                                      65 /
      -
                                      
                                      
                                      
                                      107,250
                                      
                                      
                                      
                                      17.8
                                      
                                      
                                      None
                                      
                                      
                                      
                                      N/A
                                      
                                      
                                      
                                      12.0Pre
      TSL  XV
                                      
                                      B-1
                                      
                                      
                                      
                                      1,359,562
                                      
                                      
                                      
                                      506,421
                                      
                                      
                                      
                                      (853,141
                                      )
                                      Ca
      / CC
                                      
                                      
                                      63 /
      9
                                      
                                      
                                      
                                      131,550
                                      
                                      
                                      
                                      22.0
                                      
                                      
                                      None
                                      
                                      
                                      
                                      N/A
                                      
                                      
                                      
                                      3.9Pre
      TSL XVI
                                      
                                      C
                                      
                                      
                                      
                                      1,808,881
                                      
                                      
                                      
                                      523,756
                                      
                                      
                                      
                                      (1,285,125
                                      )
                                      Ca
      / CC
                                      
                                      
                                      50 /
      8
                                      
                                      
                                      
                                      157,150
                                      
                                      
                                      
                                      25.9
                                      
                                      
                                      None
                                      
                                      
                                      
                                      N/A
                                      
                                      
                                      
                                      2.9Pre
      TSL XVII
                                      
                                      C
                                      
                                      
                                      
                                      997,495
                                      
                                      
                                      
                                      262,918
                                      
                                      
                                      
                                      (734,577
                                      )
                                      Ca
      / CC
                                      
                                      
                                      51 /
      8
                                      
                                      
                                      
                                      81,960
                                      
                                      
                                      
                                      17.0
                                      
                                      
                                      None
                                      
                                      
                                      
                                      N/A
                                      
                                      
                                      
                                      10.7Pre
      TSL XVIII
                                      
                                      C
                                      
                                      
                                      
                                      999,718
                                      
                                      
                                      
                                      293,417
                                      
                                      
                                      
                                      (706,301
                                      )
                                      Ca
      / CCC
                                      
                                      
                                      69 /
      14
                                      
                                      
                                      
                                      134,031
                                      
                                      
                                      
                                      19.8
                                      
                                      
                                      None
                                      
                                      
                                      
                                      N/A
                                      
                                      
                                      
                                      8.8Pre
      TSL XIX
                                      
                                      C
                                      
                                      
                                      
                                      2,527,613
                                      
                                      
                                      
                                      798,130
                                      
                                      
                                      
                                      (1,729,483
                                      )
                                      Ca
      / CC
                                      
                                      
                                      60 /
      14
                                      
                                      
                                      
                                      103,000
                                      
                                      
                                      
                                      14.7
                                      
                                      
                                      None
                                      
                                      
                                      
                                      N/A
                                      
                                      
                                      
                                      14.1Pre
      TSL XXIV
                                      
                                      B-1
                                      
                                      
                                      
                                      2,190,737
                                      
                                      
                                      
                                      681,711
                                      
                                      
                                      
                                      (1,509,026
                                      )
                                      Caa3
      /  BB
                                      
                                      
                                      80 /
      13
                                      
                                      
                                      
                                      299,300
                                      
                                      
                                      
                                      28.5
                                      
                                      
                                      None
                                      
                                      
                                      
                                      N/A
                                      
                                      
                                      
                                      17.6Pre
      TSL XXV
                                      
                                      C-1
                                      
                                      
                                      
                                      506,673
                                      
                                      
                                      
                                      78,441
                                      
                                      
                                      
                                      (428,232
                                      )
                                      Ca /
      C
                                      
                                      
                                      64 /
      9
                                      
                                      
                                      
                                      264,100
                                      
                                      
                                      
                                      30.1
                                      
                                      
                                      None
                                      
                                      
                                      
                                      N/A
                                      
                                      
                                      
                                      0.8Pre
      TSL XXVII
                                      
                                      B
                                      
                                      
                                      
                                      2,369,969
                                      
                                      
                                      
                                      1,043,561
                                      
                                      
                                      
                                      (1,326,408
                                      )
                                      B3
      / BB
                                      
                                      
                                      42 /
      7
                                      
                                      
                                      
                                      65,300
                                      
                                      
                                      
                                      20.0
                                      
                                      
                                      
                                      14,001
                                      
                                      
                                      
                                      5.4
                                      
                                      
                                      
                                      26.9$
                                      19,299,725
                                      
                                      
                                      $
                                      7,838,588
                                      
                                      
                                      $
                                      (11,461,137
                                      )




* Excess
subordination represents the excess (if any) of the amount of performing
collateral over the given class of bonds.




**Effective
subordination represents the estimated percentage of the performing collateral
that would need to defer or default at the next payment in order to trigger a
loss of principal or interest.  This differs from excess subordination
in that it considers the effect of excess interest earned on the performing
collateral.





- 13
-





For a
further discussion on the fair value determination of the Company’s investment
in pooled trust preferred securities, see “Investment securities” under the
caption “Comparison of financial condition at September 30, 2009 and December
31, 2008” of Part 1, Item 2, “Management’s Discussion and Analysis of Financial
Condition and Results of Operations”; below.




4.  Earnings
(loss) per share




Basic
earnings (loss) per share (EPS) is computed by dividing income (loss) available
to common shareholders by the weighted-average number of common stock
outstanding for the period.  Diluted EPS is computed in the same
manner as basic EPS but reflects the potential dilution that could occur if
stock options to issue additional common stock were exercised, which would then
result in additional stock outstanding to share in or dilute the earnings (loss)
of the Company.  The Company maintains two share-based compensation
plans that may generate additional potential dilutive common
shares.  Generally, dilution would occur if Company-issued stock
options were exercised and converted into common stock.  There were no
potentially dilutive shares outstanding at September 30, 2009 and 85 potentially
dilutive shares outstanding at September 30, 2008.




In the
computation of diluted EPS, the Company uses the treasury stock method to
determine the dilutive effect of its granted but unexercised stock
options.  Under the treasury stock method, the assumed proceeds
received from shares issued, in a hypothetical stock option exercise, are
assumed to be used to purchase treasury stock.  There were no
potentially dilutive shares outstanding as of September 30, 2009 because the
average share price of the Company’s common stock during the nine months ended
September 30, 2009 was below the strike prices of all options
granted.  For a further discussion on the Company’s stock option
plans, see note 5, “Stock plans,” below.




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




Nine months ended September
    30,
                      
                      2009
                      
                      
                      2008Net
      income (loss) available to common shareholders
                      
                      $
                      (1,473,469
                      )
                      
                      $
                      3,034,008Weighted-average
      common shares outstanding
                      
                      
                      2,075,181
                      
                      
                      
                      2,071,242Basic
      EPS
                      
                      $
                      (0.71
                      )
                      
                      $
                      1.46Diluted EPS:Net
      income (loss) available to common shareholders
                      
                      $
                      (1,473,469
                      )
                      
                      $
                      3,034,008Weighted-average
      common shares outstanding
                      
                      
                      2,075,181
                      
                      
                      
                      2,071,242Potentially
      dilutive common shares
                      
                      
                      -
                      
                      
                      
                      85Weighted-average
      common shares and dilutive potential shares
                      
                      
                      2,075,181
                      
                      
                      
                      2,071,327Diluted
      EPS
                      
                      $
                      (0.71
                      )
                      
                      $
                      1.46




5.  Stock
plans




The
Company has two stock-based compensation plans (the stock option plans) and
applies the fair value method of accounting for stock-based compensation
provided under the guidelines of FASB ASC 718-10, Share Based
Payment.  The guidelines require the cost of share-based
payment transactions (including those with employees and non-employees) be
recognized in the financial statements.




Under the
stock option plans, options are granted with an exercise price equal to the
market price of the Company’s stock on the date of grant.  The awards
vest based on six months of continuous service from the date of grant and have
10-year contractual terms.  Stock-based compensation expense is
recognized over the six-month vesting period.  Generally, all shares
that are granted become fully vested.  Stock-based compensation is
recorded in the consolidated income statement as a component of salaries and
employee benefits.




The
Company established the 2000 Independent Directors Stock Option Plan and has
reserved 55,000 shares of its un-issued capital stock for issuance under the
plan.  No stock options were awarded during the nine months ended
September 30, 2009 and 2008.  As of September 30, 2009, there were
27,400 unexercised stock options outstanding under this plan.




The
Company also established the 2000 Stock Incentive Plan and has reserved 55,000
shares of its un-issued capital stock for issuance under the
plan.  There were no options awarded during the nine months ended
September 30, 2009.  During the nine months ended September 30, 2008,
2,000 stock options were issued under this plan at a weighted-average grant-date
fair value of $4.85 per share.  The Company uses the Black-Scholes
Option Pricing Valuation Model to determine the fair value of awarded options on
the date of grant.  The model considers expected volatility, expected
dividends, risk-free interest rate and the expected term.  As of
September 30, 2009, there were 10,190 unexercised stock options outstanding
under this plan.





- 14
-





The
following tables illustrate stock-based compensation expense recognized during
the three- and nine months ended September 30, 2009 and 2008.  There
was no unrecognized stock-based compensation expense as of September 30,
2009,   September 30, 2008 and December 31, 2008:




Three months ended
                  
                  
                  Nine months endedSeptember 30,
                  
                  
                  September 30,2009
                  
                  
                  2008
                  
                  
                  2009
                  
                  
                  2008Stock-based
      compensation expense:Director's
      Plan
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  90,550Incentive
      Plan
                  
                  
                  -
                  
                  
                  
                  2,314
                  
                  
                  
                  -
                  
                  
                  
                  35,562Total
      stock-based compensation expense
                  
                  $
                  -
                  
                  
                  $
                  2,314
                  
                  
                  $
                  -
                  
                  
                  $
                  126,112




In
addition to the two stock option plans, the Company established the 2002
Employee Stock Purchase Plan (the ESPP) and reserved 110,000 shares of its
un-issued capital stock for issuance under the plan.  The plan was
designed to promote broad-based employee ownership of the Company’s
stock.  Under the ESPP, employees may elect to purchase the Company’s
capital stock at a discounted price based on the fair market value of the
Company’s capital stock on either the commencement date or termination
date.  At September 30, 2009, 12,271 shares have been issued under the
ESPP.  Under the guidelines required by share based payments, the
Company recognizes compensation expense on its ESPP on the date the shares are
purchased.  For the nine months ended September 30, 2009 and 2008,
compensation expense related to the ESPP approximated $5,000 and $3,000,
respectively, and is included as components of salaries and employee benefits in
the consolidated statements of income.




6.  Derivative
instruments




As part
of its overall interest rate risk management strategy, the Company has adopted a
policy whereby it may periodically use derivative instruments to minimize
significant fluctuations in earnings caused by interest rate
volatility.  This interest rate risk management strategy entails the
use of interest rate floors, caps and swaps.  During the fourth
quarter of 2006, the Company entered into a three-year interest rate floor
derivative agreement on $20,000,000 notional value of its prime-based loan
portfolio.  The transaction required the payment of a premium by the
Company to the seller for the right to receive payments in the event national
prime drops below a pre-determined level (strike rate), essentially converting
floating rate loans to fixed rate loans when prime drops below the contractual
strike rate.  When purchased, the Company recorded an asset
representing the fair value of the hedge at the time of purchase.  The
Company has designated this agreement as a cash flow hedge pursuant to the
implementation of FASB ASC 815-20, Accounting for Derivative
Instruments and Hedging Activities.  Accordingly, the change in
the fair value of the instrument related to the hedge’s intrinsic value, or
approximately ($561,000) and $96,000 for the nine months ended September 30,
2009 and 2008, respectively, is recorded as a component of other comprehensive
income (loss) (OCI) in the consolidated statement of changes in shareholders’
equity and the portion of the change in fair value related to the time value
expiration, or approximately $2,000 and $12,000 for the nine months ended
September 30, 2009 and 2008, respectively, is recorded in the consolidated
statements of income as a reduction of interest income.  No gain or
loss has been recognized in earnings due to hedge ineffectiveness as of
September 30, 2009.  Also, as of September 30, 2009 and December 31,
2008, the fair value of the derivative contract approximated $73,000 and
$636,000, respectively, and is recorded as a component of other assets in the
consolidated balance sheets.  As of September 30, 2009, the Company
expects to close out the residual net value of the derivative, or approximately
$29,000, from other assets and OCI to earnings during the fourth quarter in
concert with the contract’s expiration date.  The following table
illustrates the present value, intrinsic value and time value components of the
Company’s derivative contract and the financial statement impact of the change
in the fair value for the periods indicated:




- 15
-




Nine
      months ended or as of September 30,Present
                                
                                
                                Intrinsic
                                
                                
                                Timevalue
                                
                                
                                value
                                
                                
                                valueBalance
                                
                                
                                Balance
                                
                                
                                Incomesheet
                                
                                
                                sheet
                                
                                
                                statementOther assets
                                
                                
                                OCI
                                
                                
                                Interest income2009Beginning
      Balance
                                
                                $
                                635,839
                                
                                
                                $
                                606,492Change
      in fair value
                                
                                
                                (562,499
                                )
                                
                                
                                (560,956
                                )
                                
                                
                                (1,543
                                )Balance
      September 30, 2009
                                
                                $
                                73,340
                                
                                
                                $
                                45,5362008Beginning
      Balance
                                
                                $
                                440,593
                                
                                
                                $
                                385,741Change
      in fair value
                                
                                
                                84,402
                                
                                
                                
                                96,383
                                
                                
                                
                                (11,981
                                )Balance
      September 30, 2008
                                
                                $
                                524,995
                                
                                
                                $
                                482,124




As a
result of the low national prime rate relative to the contract’s strike rate,
the Company earned $683,000 and $353,000 for the nine months ended September 30,
2009 and 2008, respectively and $230,000 and $141,000 for the three months ended
September 30, 2009 and 2008, respectively, and is included as a component of
interest income from loans in the consolidated income statements.  The
contract expired early in the fourth quarter of 2009.




The use
of derivative instruments exposes the Company to credit risk in the event of
non-performance by the agreement’s counterparty to the derivative
instrument.  In the event of default by the counterparty, the Company
would have been subject to an economic loss that corresponded to the cost to
replace the agreement.  The Company controlled the credit risk
associated with the derivative instrument by engaging counterparties with high
credit ratings, establishing counterparty exposure limits and monitoring
procedures.




7.  Fair
value measurements




On
April 9, 2009, the FASB issued ASC 820-10-35, Determining Fair Value When the
Volume and Level of Activity for the Asset or Liability Have Significantly
Decreased and Identifying Transactions That Are Not Orderly, andFASB ASC
825-10-65,Interim Disclosures
about Fair Value of Financial Instruments.The Company adopted
the guidance under these topics in the second quarter of 2009.




This
topic provides guidance on estimating fair value when the volume and level of
activity for an asset or liability have significantly decreased in relation to
normal market activity.  The requirements of fair value measurement
also call for additional disclosures on fair value measurements and provide
additional guidance on circumstances that may indicate that a transaction is not
orderly.




On
January 1, 2008, the Company adopted FASB ASC 820-10, Fair Value Measurements which
defines fair value, establishes a framework for measuring fair value and
enhances disclosures about fair value measurements.  The guidelines of
fair value reporting establishes a valuation hierarchy for disclosure of the
inputs used to measure fair value.  This hierarchy prioritizes the
inputs into three broad levels as follows:




Level 1
inputs are quoted prices (unadjusted) in active markets for identical assets or
liabilities;




Level 2
inputs are quoted prices for similar assets and liabilities in active markets;
quoted prices for identical or similar assets or liabilities in markets that are
not active; or inputs that are observable for the asset or liability, either
directly or indirectly through market corroboration, for substantially the full
term of the financial instrument;




Level 3
inputs are unobservable inputs based on our own assumptions to measure assets
and liabilities at fair value.  Level 3 pricing for securities may
also include unobservable inputs based upon broker-traded
transactions.  A financial asset or liability’s classification within
the hierarchy is determined based on the lowest level input that is significant
to the fair value measurement.




Adoption
of the requirements of the fair value measurement under generally accepted
account principles did not have an impact on the Company’s financial
statements.




The
Company uses fair value to measure certain assets and, if necessary, liabilities
on a recurring basis when fair value is the primary measure for
accounting.  This is done for AFS securities, loans AFS and
derivatives.  Fair value is used on a non-recurring basis to measure
certain assets when adjusting carrying values to market values, such as impaired
loans.





- 16
-




The
following table illustrates the financial instruments measured at fair value on
a recurring basis segregated by hierarchy fair value levels as of September 30,
2009 and December 31, 2008 (dollars in thousands):




Fair
      value measurements at September 30, 2009:Total
      carrying
                                                      
                                                      
                                                      Quoted
      prices
                                                      
                                                      Significant
      other
                                                      
                                                      Significantvalue
      at
                                                      
                                                      
                                                      in
      active markets
                                                      
                                                      observable
      inputs
                                                      
                                                      unobservable
      inputsSeptember
      30, 2009
                                                      
                                                      
                                                      (Level
      1)
                                                      
                                                      (Level
      2)
                                                      
                                                      (Level
      3)Assets:Available-for-sale
      securities:U.S.
      government agencies and corporations
                                                      
                                                      $
                                                      34,996
                                                      
                                                      
                                                      $
                                                      -
                                                      
                                                      $
                                                      34,996
                                                      
                                                      $
                                                      -Obligations
      of states and political subdivisions
                                                      
                                                      
                                                      29,764
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      29,764
                                                      
                                                      
                                                      -Corporate
      bonds:Pooled
      trust preferred securities
                                                      
                                                      
                                                      7,839
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      7,839Mortgage-backed
      securities
                                                      
                                                      
                                                      9,357
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      9,357
                                                      
                                                      
                                                      -Equity
      securities
                                                      
                                                      
                                                      446
                                                      
                                                      
                                                      
                                                      446
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      -Total
      available-for-sale securities:
                                                      
                                                      
                                                      82,402
                                                      
                                                      
                                                      
                                                      446
                                                      
                                                      
                                                      74,117
                                                      
                                                      
                                                      7,839Loans
      available-for-sale
                                                      
                                                      
                                                      881
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      881
                                                      
                                                      
                                                      -Derivative
      instrument
                                                      
                                                      
                                                      73
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      73
                                                      
                                                      
                                                      -Total
                                                      
                                                      $
                                                      83,356
                                                      
                                                      
                                                      $
                                                      446
                                                      
                                                      $
                                                      75,071
                                                      
                                                      $
                                                      7,839




Fair
      value measurements at December 31, 2008:Total
      carrying
                                                                      
                                                                      
                                                                      Quoted
      prices
                                                                      
                                                                      Significant
      other
                                                                      
                                                                      
                                                                      Significantvalue
      at
                                                                      
                                                                      
                                                                      in
      active markets
                                                                      
                                                                      observable
      inputs
                                                                      
                                                                      
                                                                      unobservable
      inputsDecember
      31, 2008
                                                                      
                                                                      
                                                                      (Level
      1)
                                                                      
                                                                      (Level
      2)
                                                                      
                                                                      
                                                                      (Level
      3)Assets:Available-for-sale
      securities:U.S.
      government agenciesand
      corporations
                                                                      
                                                                      $
                                                                      43,507
                                                                      
                                                                      
                                                                      $
                                                                      -
                                                                      
                                                                      $
                                                                      43,507
                                                                      
                                                                      
                                                                      $
                                                                      -Obligations
      of states andpolitical
      subdivisions
                                                                      
                                                                      
                                                                      17,553
                                                                      
                                                                      
                                                                      
                                                                      -
                                                                      
                                                                      
                                                                      17,553
                                                                      
                                                                      
                                                                      
                                                                      -Corporate
      bonds:Pooled
      trust preferred securities
                                                                      
                                                                      
                                                                      10,260
                                                                      
                                                                      
                                                                      
                                                                      -
                                                                      
                                                                      
                                                                      -
                                                                      
                                                                      
                                                                      
                                                                      10,260Mortgage-backed
      securities
                                                                      
                                                                      
                                                                      11,530
                                                                      
                                                                      
                                                                      
                                                                      -
                                                                      
                                                                      
                                                                      11,530
                                                                      
                                                                      
                                                                      
                                                                      -Equity
      securities
                                                                      
                                                                      
                                                                      428
                                                                      
                                                                      
                                                                      
                                                                      428
                                                                      
                                                                      
                                                                      -
                                                                      
                                                                      
                                                                      
                                                                      -Total
      available-for-sale securities:
                                                                      
                                                                      
                                                                      83,278
                                                                      
                                                                      
                                                                      
                                                                      428
                                                                      
                                                                      
                                                                      72,590
                                                                      
                                                                      
                                                                      
                                                                      10,260Loans
      available-for-sale
                                                                      
                                                                      
                                                                      84
                                                                      
                                                                      
                                                                      
                                                                      -
                                                                      
                                                                      
                                                                      84
                                                                      
                                                                      
                                                                      
                                                                      -Derivative
      instrument
                                                                      
                                                                      
                                                                      636
                                                                      
                                                                      
                                                                      
                                                                      -
                                                                      
                                                                      
                                                                      636
                                                                      
                                                                      
                                                                      
                                                                      -Total
                                                                      
                                                                      $
                                                                      83,998
                                                                      
                                                                      
                                                                      $
                                                                      428
                                                                      
                                                                      $
                                                                      73,310
                                                                      
                                                                      
                                                                      $
                                                                      10,260




Equity
securities in the AFS portfolio are measured at fair value using quoted market
prices for identical assets and are classified within Level 1 of the valuation
hierarchy.  Other than the Company’s investment in corporate bonds,
consisting of pooled trust preferred securities, all other debt securities in
the AFS portfolio are measured at fair value using prices provided by a
third-party vendor, who is a provider of financial market data, analytics and
related services to financial institutions.  The Company’s pooled
trust preferred securities include both observable and unobservable inputs to
determine fair value and, therefore, are considered Level 3
inputs.  For a further discussion on the fair value determination of
the Company’s investment in pooled trust preferred securities, see “Investment
securities” under the caption “Comparison of financial condition at September
30, 2009 and December 31, 2008” of Part 1, Item 2, “Management’s Discussion and
Analysis of Financial Condition and Results of Operations,”
below.


- 17
-




Loans AFS
are measured for fair value from quotes received through secondary market
sources, i.e., FNMA or FHLB, who provide pricing for similar assets with similar
terms in actively traded markets.  In the above table, loans AFS
reflect the carrying value which is the lower of cost or market
value.  The derivative instrument, included in other assets, is
measured at fair value from pricing provided by a third party who considers
observable interest rates, forward yield curves at commonly quoted intervals and
volatility.




The
following table illustrates the changes in Level 3 financial instruments,
consisting of the Company’s investment in pooled trust preferred securities,
measured at fair value on a recurring basis for the periods indicated (dollars
in thousands):




As
      of and for the
                                        
                                        
                                        As
      of and for thenine
      months ended
                                        
                                        
                                        twelve
      months endedSeptember 30, 2009
                                        
                                        
                                        December 31, 2008Assets:Balance
      at beginning of period
                                        
                                        $
                                        10,260
                                        
                                        
                                        $
                                        16,335Realized
      / unrealized gains (losses):in
      earnings
                                        
                                        
                                        (2,758
                                        )
                                        
                                        
                                        (430
                                        )in
      comprehensive income (loss)
                                        
                                        
                                        (306
                                        )
                                        
                                        
                                        (9,958
                                        )Purchases,
      sales, issuances and settlements,amortization
      and accretion, net
                                        
                                        
                                        643
                                        
                                        
                                        
                                        4,313Balance
      at end of period
                                        
                                        $
                                        7,839
                                        
                                        
                                        $
                                        10,260




The
following table illustrates the financial instruments measured at fair value on
a non-recurring basis segregated by hierarchy fair value levels as of September
30, 2009 and December 31, 2008 (dollars in thousands):




Fair
      value measurements at September 30, 2009 using:Total
      carrying
                                                  
                                                  
                                                  Quoted
      prices
                                                  
                                                  
                                                  Significant
      other
                                                  
                                                  
                                                  Significantvalue
      at
                                                  
                                                  
                                                  in
      active markets
                                                  
                                                  
                                                  observable
      inputs
                                                  
                                                  
                                                  unobservable
      inputsSeptember
      30, 2009
                                                  
                                                  
                                                  (Level
      1)
                                                  
                                                  
                                                  (Level
      2)
                                                  
                                                  
                                                  (Level
      3)Assets:Impaired loans
                                                  
                                                  $
                                                  3,147
                                                  
                                                  
                                                  $
                                                  13
                                                  
                                                  
                                                  $
                                                  2,280
                                                  
                                                  
                                                  $
                                                  854Fair
      value measurements at December 31, 2008 using:Total
      carrying
                                                  
                                                  
                                                  Quoted
      prices
                                                  
                                                  
                                                  Significant
      other
                                                  
                                                  
                                                  Significantvalue
      at
                                                  
                                                  
                                                  in
      active markets
                                                  
                                                  
                                                  observable
      inputs
                                                  
                                                  
                                                  unobservable
      inputsDecember
      31, 2008
                                                  
                                                  
                                                  (Level
      1)
                                                  
                                                  
                                                  (Level
      2)
                                                  
                                                  
                                                  (Level
      3)Assets:Impaired loans
                                                  
                                                  $
                                                  1,942
                                                  
                                                  
                                                  $
                                                  12
                                                  
                                                  
                                                  $
                                                  1,136
                                                  
                                                  
                                                  $
                                                  794




Impaired
loans that are collateral dependent are written down to fair value through the
establishment of specific reserves.  Techniques used to value the
collateral that secures the impaired loan include: quoted market prices for
identical assets classified as Level 1 inputs; observable inputs, employed by
certified appraisers for similar assets classified as Level 2
inputs.  In cases where valuation techniques included inputs that are
unobservable or are based on estimates and assumptions developed by management,
with significant adjustments from the best information available under each
circumstance, the asset valuation is classified as Level 3
inputs.


- 18
-




Fair
value measurement disclosures are now required for interim periods in addition
to the annual disclosures.  Accordingly, a summary of the carrying
values and estimated fair values of certain financial instruments as required by
the guidelines follows as of the periods indicated (dollars in
thousands):




September
      30, 2009
                  
                  
                  December
      31, 2008Carrying
                  
                  
                  Estimated
                  
                  
                  Carrying
                  
                  
                  Estimatedamount
                  
                  
                  fair
      value
                  
                  
                  amount
                  
                  
                  fair
      valueFinancial
      assets:Cash
      and cash equivalents
                  
                  $
                  17,632
                  
                  
                  $
                  17,632
                  
                  
                  $
                  12,771
                  
                  
                  $
                  12,771Held-to-maturity
      securities
                  
                  
                  740
                  
                  
                  
                  796
                  
                  
                  
                  910
                  
                  
                  
                  940Available-for-sale
      securities
                  
                  
                  82,402
                  
                  
                  
                  82,402
                  
                  
                  
                  83,278
                  
                  
                  
                  83,278FHLB
      stock
                  
                  
                  4,781
                  
                  
                  
                  4,781
                  
                  
                  
                  4,781
                  
                  
                  
                  4,781Loans
      and leases
                  
                  
                  420,834
                  
                  
                  
                  420,839
                  
                  
                  
                  436,207
                  
                  
                  
                  438,838Loans
      available-for-sale
                  
                  
                  881
                  
                  
                  
                  894
                  
                  
                  
                  84
                  
                  
                  
                  85Accrued
      interest
                  
                  
                  2,543
                  
                  
                  
                  2,543
                  
                  
                  
                  2,443
                  
                  
                  
                  2,443Financial
      liabilities:Deposit
      liabilities
                  
                  
                  477,258
                  
                  
                  
                  474,357
                  
                  
                  
                  433,312
                  
                  
                  
                  436,011Short-term
      borrowings
                  
                  
                  5,238
                  
                  
                  
                  5,238
                  
                  
                  
                  38,130
                  
                  
                  
                  38,130Long-term
      debt
                  
                  
                  32,000
                  
                  
                  
                  35,427
                  
                  
                  
                  52,000
                  
                  
                  
                  57,230Accrued
      interest
                  
                  
                  1,000
                  
                  
                  
                  1,000
                  
                  
                  
                  1,390
                  
                  
                  
                  1,390On-balance
      sheet derivative instrumentCash
      flow hedge
                  
                  
                  73
                  
                  
                  
                  73
                  
                  
                  
                  636
                  
                  
                  
                  636




The
following summarizes the methodology used to determine estimated fair values in
the above table:




The
carrying value of short-term financial instruments, as listed below,
approximates their fair value.  These instruments generally have
limited credit exposure, no stated or short-term maturities and carry interest
rates that approximate market.




·
            Cash
      and cash equivalents




·
            Non-interest
      bearing deposit accounts




·
            Savings,
      NOW and money market accounts




·
            Short-term
      borrowings




·
            Accrued
      interest




Securities:  With
the exception of preferred term securities, fair values on the other investment
securities are determined by prices provided by a third-party vendor, who is a
provider of financial market data, analytics and related services to financial
institutions.  The fair values of pooled trust preferred securities is
determined based on a present value technique (income valuation) as described
under the caption “Investment securities” of the comparison of financial
condition at September 30, 2009 and December 31, 2008 in Part I, Item II,
below.




FHLB
stock, or restricted regulatory equity, is carried at cost, which approximates
fair value.




Loans and
leases:  The fair value of all loans is estimated by the net present
value of the future expected cash flows discounted at the current offering
rates.




Loans
available-for-sale:  For loans available-for-sale, the fair value is
estimated using rates currently offered for similar loans and are obtained from
the FNMA or the FHLB.




Certificates
of deposit:  The fair values of certificate of deposit accounts are
based on discounted cash flows using rates which approximate the rates we offer
for deposits of similar maturities.




Long-term
debt:  The fair value is estimated using the rates currently offered
for similar borrowings.




Cash flow
hedge:  The carrying amount of interest rate contracts are based on
pricing provided by a third party who considers observable interest rates,
forward yield curves at commonly quoted intervals and volatility.




8.  Subsequent
Events




Pursuant
to the requirements for disclosing events after September 30, 2009, reportable
events have been evaluated through November 12, 2009, which is the date the
financial statements were available to be issued.  Through that date,
there were no events requiring disclosure.


- 19
-




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




The
following is management's discussion and analysis of the significant changes in
the consolidated financial condition of the Company as of September 30, 2009
compared to December 31, 2008 and the results of operations for the three- and
nine month periods ended September 30, 2009 and 2008.  Current
performance may not be indicative of future results.  This discussion
should be read in conjunction with the Company’s 2008 Annual Report filed on
Form 10-K.




Forward-looking
statements




Certain
of the matters discussed in this Interim Report on Form 10-Q may constitute
forward-looking statements for purposes of the Securities Act of 1933, as
amended, and the Securities Exchange Act of 1934, as amended, and as such may
involve known and unknown risks, uncertainties and other factors which may cause
the actual results, performance or achievements of the Company to be materially
different from future results, performance or achievements expressed or implied
by such forward-looking statements.  The words “expect,” “anticipate,”
“intend,” “plan,” “believe,” “estimate,” and similar expressions are intended to
identify such forward-looking statements.




The
Company’s actual results may differ materially from the results anticipated in
these forward-looking statements due to a variety of factors, including, without
limitation:




§
            the
      effects of economic deterioration on current customers, specifically the
      effect of the economy on loan customers’ ability to repay
      loans;


§
            the
      costs and effects of litigation and of unexpected or adverse outcomes in
      such litigation;


§
            governmental
      monetary and fiscal policies, as well as legislative and regulatory
      changes;


§
            the
      effect of changes in accounting policies and practices, as may be adopted
      by the regulatory agencies, as well as the Financial Accounting Standards
      Board and other accounting standard
setters;


§
            the
      risks of changes in interest rates on the level and composition of
      deposits, loan demand, and the values of loan collateral, securities and
      interest rate protection agreements, as well as interest rate
      risks;


§
            the
      effects of competition from other commercial banks, thrifts, mortgage
      banking firms, consumer finance companies, credit unions, securities
      brokerage firms, insurance companies, money market and other mutual funds
      and other financial institutions operating in our market area and
      elsewhere, including institutions operating locally, regionally,
      nationally and internationally, together with such competitors offering
      banking products and services by mail, telephone, computer and the
      internet;


§
            technological
      changes;


§
            acquisitions
      and integration of acquired
businesses;


§
            the
      failure of assumptions underlying the establishment of reserves for loan
      and lease losses and estimations of values of collateral and various
      financial assets and liabilities;


§
            volatilities
      in the securities markets;


§
            deteriorating
      economic conditions


§
            acts
      of war or terrorism; and


§
            disruption
      of credit and equity markets.




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




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




General




The
Company’s principal revenues are derived from interest, dividends and fees
earned on its interest-earning assets, which are comprised of loans, securities
and other short-term investments.  The Company’s principal expenses
consist of interest paid on its interest-bearing liabilities, which are
comprised of deposits, short- and long-term borrowings and operating and general
expenses.  The Company’s profitability depends primarily on its net
interest income.  Net interest income is the difference between
interest income and interest expense.  Interest income is generated
from yields on interest-earning assets which consist principally of loans and
investment securities.  Interest expense is incurred from rates paid
on interest-bearing liabilities, which consist of deposits and
borrowings.  Net interest income is dependent upon the interest-rate
spread (i.e., the difference between the yields earned on its interest-earning
assets and the rates paid on its interest-bearing liabilities) and the relative
amounts of interest-earning assets and interest-bearing
liabilities.  The interest rate spread is significantly impacted by:
changes in interest rates and market yield curves and their related impact on
cash flows; the composition and characteristics of interest-earning assets and
interest-bearing liabilities; differences in the maturity and re-pricing
characteristics of assets compared to the maturity and re-pricing
characteristics of the liabilities that fund them and by the competition in our
marketplace.


- 20
-




The
Company’s profitability is also affected by the level of its non-interest income
and expenses, provision for loan losses and provision for income
taxes.  Non-interest income consists of service charges on the Bank’s
loan and deposit products, trust and asset management service fees, increases in
the cash surrender value of the bank owned life insurance (BOLI), net gains or
losses from sales of loans and securities AFS, net gains or losses from sales of
foreclosed properties held-for-sale, write-down to market value of foreclosed
properties held-for-sale and from other-than-temporary-impairment (OTTI) charges
on investment securities.  Non-interest expense consists of
compensation and related employee benefit expenses, occupancy, equipment, data
processing, advertising, marketing, professional fees, insurance and other
operating overhead.




The
Company’s profitability is significantly affected by general economic and
competitive conditions, changes in market interest rates, government policies
and actions of regulatory authorities.  The Company’s loan portfolio
is comprised principally of commercial and commercial real estate
loans.  The properties underlying the Company’s mortgages are
concentrated in Northeastern Pennsylvania.  Credit risk, which
represents the possibility of the Company not recovering amounts due from its
borrowers, is significantly related to local economic conditions in the areas
the properties are located as well as the Company’s underwriting
standards.  Economic conditions affect the market value of the
underlying collateral as well as the levels of adequate cash flow and revenue
generation from income-producing commercial properties.




Comparison of the results of
operations


Three and nine months ended
September 30, 2009 and 2008




Overview




The
Company recorded a net loss of $3,211,000 for the third quarter of 2009 compared
to net income of $741,000 recorded in the same quarter of
2008.  Diluted (loss) earnings per share were ($1.55) and $0.35 for
each of the respective quarters.  For the nine months ended September
30, 2009, net loss was $1,473,000, or ($0.71) per share, compared to net income
of $3,034,000, or $1.46 per share, for the nine months ended September 30,
2008.  The decrease in earnings was due to an increase in the
provision for loan losses of $2,995,000 and $3,595,000, during the quarter and
year-to-date periods, respectively, and a decrease in non-interest income from
higher levels of non-cash credit-related OTTI charges from the pooled trust
preferred securities portfolio of $2,029,000 and $2,355,000, respectively,
recorded during the comparative periods.  Net interest income declined
in both the third quarter and for the nine months ended September 30, 2009
compared to the same periods of 2008.  During the third quarter of
2009, the Company paid off two of its $5.0 million FHLB advances and incurred a
$0.5 million interest penalty.  Non-interest expense increased 9% and
7%, respectively.  These items were partially offset by higher gains
recognized from mortgage banking services in the form of sales of mortgage loans
in the three- and nine- month periods ended September 30, 2009 compared to the
same periods of 2008.




Return on
average assets (ROA) and return on average shareholders’ equity (ROE) were
-2.25% and -25.75%, respectively, for the three months ended September 30, 2009
compared to 0.50% and 5.63%, respectively, for the same period in
2008.  For the nine months ended September 30, 2009, ROA and ROE were
-0.35% and -4.07%, respectively, compared to 0.69% and 7.42% for the same
periods in 2008.  The decrease in both ROA and ROE is attributable to
lower earnings.




Net interest income and
interest sensitive assets / liabilities




Net
interest income decreased $458,000, or 9%, to $4,421,000 for the third quarter
of 2009, from $4,879,000 recorded in the same period of 2008.  During
the current quarter, the Company paid off $10.0 million of long-term Federal
Home Loan Bank (FHLB) advances that were scheduled to mature during the third
quarter of 2010 and by doing so incurred approximately $0.5 million of
prepayment interest penalties that are included in interest
expense.  The paid-off advances carried a weighted-average rate of
6.12% and the deleveraging strategy is immediately accretive to
income.  Compared to 2008, the Company reduced its average balance of
FHLB advances by $20.4 million and short-term overnight borrowings by
approximately $23.7 million.  The FHLB advances were supplanted by
growth in average deposits which were also used to help reduce the Company’s
dependence on short-term borrowings.  In this low interest-rate
environment, the Company may explore and execute other deleveraging
opportunities that management deems prudent for earnings and capital
enhancement.  Further contributing to the decline in net interest
income was a combination of: a 50 basis point decline in yields from
earning-assets, mostly in the commercial loan and investment portfolios
partially offset by a 35 basis point decline on interest-bearing liabilities
primarily from a decrease in rates paid on deposits.




During
the third quarter of 2009, the Company’s tax-equivalent margin and spread were
3.43% and 2.95%, respectively, compared to 3.62% and 3.10% during the third
quarter of 2008.  The reduction in spread was caused by lower yields
earned on interest-earning assets as well as the early pay-off of the FHLB
advances.  The decrease in margin was predominately from lower net
interest income.


- 21
-




For the
nine months ended September 30, 2009, net interest income declined 3%, or,
$383,000 compared to the nine months ended September 30,
2008.  Excluding the aforementioned early-pay off of the $10.0 million
FHLB advances, there would have been a minor improvement in net interest
income.  Despite the lower net interest income, the Company’s
tax-equivalent margin and spread improved to 3.62% and 3.17%, respectively, from
3.57% and 3.01% during the same period of 2008.  The improvements were
largely from lower balances of interest-bearing liabilities – most notably from
lower long- and short-term borrowings and lower rates paid on
deposits.  In addition, the lower balance of interest-earning assets,
due to the sale of lower yielding residential mortgage loans during the first
quarter of 2009, contributed to the improvement in margin.  Rates paid
on deposits declined 93 basis points compared to lower yields from
earning-assets of 53 basis points.




The
current interest rate environment has remained essentially unchanged throughout
2009; however, it is much different than a year ago.  The interest
rate environment was considerably lower during the first nine months of 2009
compared to 2008.  The lower rates have caused assets to price and
re-price at significantly lower levels thereby pressuring earning-yields
downward.  Increased prepayment activity in asset portfolios, thereby
shortening the duration of interest-earning assets as well as increased activity
in loan refinancing all contribute to lower portfolio
yields.  However, the steepness of the curve has enabled the Company
to help mitigate the lower yields earned from its asset
portfolios.  To manage the interest rate margin to acceptable levels,
the Company’s Asset Liability Management (ALM) team meets regularly to discuss
interest rate risk and when deemed necessary adjusts interest rates on deposits
and repurchase agreements and when necessary uses lower costing wholesale
funding sources.  The actions of the ALM team have helped minimize the
effect rate changes have had on interest income so that net interest income is
not materially and disproportionately impacted during this lower yield
environment.  During the first quarter of 2009, the Company sold $10.8
million of lower yielding mortgage loans and used the proceeds to pay off one
$10.0 million FHLB advance that was scheduled to mature in the second quarter of
2009.  Similarly, during the third quarter, the Company paid down an
additional $10.0 million in FHLB advances with funds from deposit
growth.  The third quarter transaction required the payment of penalty
interest of approximately $0.5 million, however the weighted-average rate on the
advances was 6.12% and this strategy will be immediately accretive to future
earnings.  The Company’s proactive attention to interest rate risk
should continue to help contain the Company’s net interest margin at acceptable
levels.




The table
that follows sets forth a comparison of average balance sheet amounts and their
corresponding fully tax-equivalent (FTE) interest income and expense and
annualized tax-equivalent yield and cost for the periods indicated (dollars in
thousands):


- 22
-




Three
      months ended:September
      30, 2009
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            September
      30, 2008Average
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            Yield
      /
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            Average
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            Yield
      /balance
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            Interest
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            rate
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            balance
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            Interest
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            rateAssetsInterest-earning
      assets:Loans
      and leases
                                                                                                                                                            
                                                                                                                                                            $
                                                                                                                                                            431,024
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            $
                                                                                                                                                            6,603
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            6.08
                                                                                                                                                            %
                                                                                                                                                            
                                                                                                                                                            $
                                                                                                                                                            426,002
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            $
                                                                                                                                                            6,953
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            6.49
                                                                                                                                                            %Investments
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            99,922
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            1,065
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            4.23
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            125,901
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            1,611
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            5.09Federal
      funds sold
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            5,335
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            3
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            0.25
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            -
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            -
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            -Interest-bearing
      deposits
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            622
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            -
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            0.06
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            104
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            1
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            2.33Total
      interest-earning assets
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            536,903
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            7,671
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            5.67
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            552,007
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            8,565
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            6.17Non-interest-earning
      assets
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            29,089
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            32,023Total
      assets
                                                                                                                                                            
                                                                                                                                                            $
                                                                                                                                                            565,992
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            $
                                                                                                                                                            584,030Liabilities
      and shareholders' equityInterest-bearing
      liabilities:Other
      interest-bearing deposits
                                                                                                                                                            
                                                                                                                                                            $
                                                                                                                                                            228,308
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            $
                                                                                                                                                            579
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            1.01
                                                                                                                                                            %
                                                                                                                                                            
                                                                                                                                                            $
                                                                                                                                                            191,697
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            $
                                                                                                                                                            799
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            1.66
                                                                                                                                                            %Certificates
      of deposit
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            163,683
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            1,370
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            3.32
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            168,730
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            1,800
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            4.24Borrowed
      funds
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            42,746
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            1,077
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            10.00
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            86,778
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            930
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            4.26Repurchase
      agreements
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            7,266
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            6
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            0.32
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            10,907
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            11
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            0.42Total
      interest-bearing liabilities
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            442,003
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            3,032
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            2.72
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            458,112
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            3,540
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            3.07Non-interest-bearing
      deposits
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            70,412
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            69,069Other
      non-interest-bearing liabilities
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            4,102
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            4,466Shareholders'
      equity
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            49,475
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            52,383Total
      liabilities and shareholders' equity
                                                                                                                                                            
                                                                                                                                                            $
                                                                                                                                                            565,992
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            $
                                                                                                                                                            584,030Net
      interest income / interest rate spread
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            $
                                                                                                                                                            4,639
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            2.95
                                                                                                                                                            %
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            $
                                                                                                                                                            5,025
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            3.10
                                                                                                                                                            %Net
      interest margin
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            3.43
                                                                                                                                                            %
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            3.62
                                                                                                                                                            %Nine
      months ended:September
      30, 2009
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            September
      30, 2008Average
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            Yield
      /
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            Average
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            Yield
      /balance
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            Interest
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            rate
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            balance
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            Interest
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            rateAssetsInterest-earning
      assets:Loans
      and leases
                                                                                                                                                            
                                                                                                                                                            $
                                                                                                                                                            432,607
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            $
                                                                                                                                                            19,866
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            6.14
                                                                                                                                                            %
                                                                                                                                                            
                                                                                                                                                            $
                                                                                                                                                            414,809
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            $
                                                                                                                                                            20,785
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            6.69
                                                                                                                                                            %Investments
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            98,971
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            3,436
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            4.64
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            134,010
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            5,301
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            5.28Federal
      funds sold
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            5,872
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            11
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            0.25
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            4,465
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            91
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            2.73Interest-bearing
      deposits
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            722
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            -
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            0.10
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            124
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            2
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            2.59Total
      interest-earning assets
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            538,172
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            23,313
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            5.79
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            553,408
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            26,179
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            6.32Non-interest-earning
      assets
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            29,048
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            33,830Total
      assets
                                                                                                                                                            
                                                                                                                                                            $
                                                                                                                                                            567,220
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            $
                                                                                                                                                            587,238Liabilities
      and shareholders' equityInterest-bearing
      liabilities:Other
      interest-bearing deposits
                                                                                                                                                            
                                                                                                                                                            $
                                                                                                                                                            217,674
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            $
                                                                                                                                                            1,698
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            1.04
                                                                                                                                                            %
                                                                                                                                                            
                                                                                                                                                            $
                                                                                                                                                            193,508
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            $
                                                                                                                                                            2,746
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            1.90
                                                                                                                                                            %Certificates
      of deposit
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            169,808
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            4,581
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            3.61
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            179,712
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            5,918
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            4.40Borrowed
      funds
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            49,138
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            2,448
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            6.66
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            75,498
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            2,652
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            4.69Repurchase
      agreements
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            9,144
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            22
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            0.33
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            12,166
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            92
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            1.01Total
      interest-bearing liabilities
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            445,764
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            8,749
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            2.62
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            460,884
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            11,408
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            3.31Non-interest-bearing
      deposits
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            69,143
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            67,062Other
      non-interest-bearing liabilities
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            3,950
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            4,642Shareholders'
      equity
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            48,363
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            54,650Total
      liabilities and shareholders' equity
                                                                                                                                                            
                                                                                                                                                            $
                                                                                                                                                            567,220
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            $
                                                                                                                                                            587,238Net
      interest income / interest rate spread
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            $
                                                                                                                                                            14,564
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            3.17
                                                                                                                                                            %
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            $
                                                                                                                                                            14,771
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            3.01
                                                                                                                                                            %Net
      interest margin
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            3.62
                                                                                                                                                            %
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            
                                                                                                                                                            3.57
                                                                                                                                                            %




In
the preceding table, interest income was adjusted to a tax-equivalent basis to
recognize the income from the various tax-exempt assets as if the interest was
fully taxable.  This treatment allows a uniform comparison among the
yields on interest-earning assets.  The calculations were computed on
a fully tax-equivalent basis using the corporate federal tax rate of
34%.  Net interest spread represents the difference between the yield
on interest-earning assets and the rate on interest-bearing
liabilities.  Net interest margin represents the ratio of net interest
income to total average interest-earning assets.


- 23
-


Provision for loan
losses




The
provision for loan losses represents the necessary amount to charge against
current earnings, the purpose of which is to increase the allowance for loan
losses to a level that represents management’s best estimate of known and
inherent losses in the Company’s loan portfolio.  Loans and leases
determined to be uncollectible are charged-off against the allowance for loan
losses.  The required amount of the provision for loan losses, based
upon the adequate level of the allowance for loan losses, is subject to ongoing
analysis of the loan portfolio.  The Company’s Special Assets
Committee meets periodically to review problem loans and leases.  The
committee is comprised of management, including the senior loan officer, the
chief risk officer, loan officers, loan workout officers and collection
personnel.  The committee reports quarterly to the Credit
Administration Committee of the Board of Directors.




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




•
            specific
      loans that could have loss
potential;


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


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


•
            trends
      in volume and terms of loans;


•
            changes
      in risk selection and underwriting
standards;


•
            changes
      in lending policies, procedures and
practices;


•
            experience,
      ability and depth of lending
management;


•
            national
      and local economic trends and conditions;
and


•
            changes
      in credit concentrations.




The
provision for loan losses was $3,125,000 for the third quarter and $3,850,000
for the nine month period ending September 30, 2009, as compared to $130,000 of
requirements for the same 2008 quarter and $255,000 for the same 2008 nine month
period.  The sizeable provision increase was due to internally
classified credit downgrades stemming from a proactive internal review of large
commercial credits, sustained weakening economic conditions and declining real
estate values.  In reviewing the loans for specific performance,
delinquency and collateral sufficiency, management concluded that there were
several loans in the commercial loan portfolio that lacked, or may in the
near-term lack, the ability to pay in accordance with contractual
terms.  As such, the risk ratings of those loans were
downgraded.   Approximately 46% of the provision for the current
quarter was attributable to the credit downgrades of five loan relationships
aggregating $13,125,000 in outstanding loans.  These five loan
relationships are unrelated to one another and are in diverse industries. 
The Company has taken measures to aggressively manage these credits including
the setting of specific action plans and benchmarks to resolve these downgraded
credits as well as the non-performing loans.  For a further discussion
on non-performing loans, see “Non-performing assets” under the caption
“Comparison of financial condition at September 30, 2009 and December 31, 2008”,
below.




The
allowance for loan losses was $6,725,000 at September 30, 2009 compared to
$4,206,000 at September 30, 2008.  For a further discussion on the
allowance for loan losses, see “Allowance for loan losses” under the caption
“Comparison of financial condition at September 30, 2009 and December 31, 2008”,
below.




Other (loss)
income




In the
third quarter of 2009, the Company recorded a net non-interest loss of
$1,293,000 compared to net non-interest income of $844,000 recorded in the third
quarter of 2008.  The decline in non-interest earnings was from a
non-cash OTTI charge of $2,432,000 recorded in the third quarter of 2009
compared to a $403,000 OTTI charge recorded in the third quarter of
2008.  The charges are related to credit-related OTTI from the
Company’s investment in pooled trust preferred securities.  See note
3, “Investment securities” for a further discussion on the Company’s portfolio
of pooled trust preferred securities.  Adding to the decline in
non-interest earnings, the Company wrote down, to fair value, the carrying
amount of its investment in two foreclosed assets held-for-sale by a total of
$78,000.  There were no similar write-downs in 2008.  The
assets represent two commercial real estate properties acquired in foreclosure
during 2008.  The current year subsequent write-downs were based on
sales indications received by the Company that were less than the carrying value
of the properties.  Fee income from deposits and loans declined from
lower service charges on deposit accounts and higher mortgage loan servicing
rights amortization.  The decline in deposit fees was mostly from
lower volume of overdraft charges.  Partially offsetting these
declines in non-interest earnings was increased gains from mortgage banking
services which increased by $75,000 in the quarter-to-quarter
comparison.




For the
nine months ended September 30, 2009, other income declined $1,927,000, or 57%,
compared to the nine months ended September 30, 2008.  The decline was
from the $2,758,000 OTTI charge from the pooled trust preferred securities
portfolio, as explained above, recorded in the first nine months of the current
year compared to OTTI charges of $403,000 recorded in the same period of
2008.  Service charges from deposit accounts declined $259,000, or
12%, due to lower volumes of overdraft transactions.  In the first
nine months of 2009, the Company sold $90,045,000 of residential mortgage loans
and recognized gains of $958,000, an increase of $742,000, compared to gains of
$216,000 recognized during the first nine months of 2008.  Included in
these sales for the current year were $10,838,000 of loans transferred from the
loan and lease portfolio to loans AFS during the first quarter of the current
year and simultaneously sold compared to $28,102,000 in the previous
year.


- 24
-


Other operating
expenses




For the
quarter ended September 30, 2009, other (non-interest) expenses increased
$437,000, or 9%, compared to the quarter ended September 30,
2008.  The other category of non-interest expenses increased by
$473,000, or 41%.  In the third quarter of 2009, the Company’s FDIC
insurance premium was $142,000 greater than the premium incurred in the 2008
quarter.  The current quarter includes the recognition of $162,000 in
consulting costs for services of the Company’s former chief executive
officer.  In addition, collection expense increased $159,000 due to
more legal and other costs associated with non-accrual, delinquent,
repossessions and other problem-loans.  The increase in premises and
equipment was mostly from added depreciation expense and property insurance for
the new West Scranton branch expansion project that opened during the third
quarter of 2008 and increased equipment maintenance mostly in information
technology.  The decrease in advertising expense of $125,000, or 51%,
was due to the new branch grand opening celebration in 2008 which did not recur
in 2009.




For the
nine months ended September 30, 2009, non-interest related expenses increased
$1.0 million, or 7%, compared to the nine months ended September 30,
2008.  For the first nine months of 2009, the Company’s FDIC insurance
premium was $525,000 greater than the premium incurred in the same 2008
period.  The increase was caused by higher premiums and a $255,000
special assessment imposed by the FDIC to all member-insured banks on June 30,
2009.  The current year includes the recognition of $162,000 in
consulting costs for services of the Company’s former chief executive
officer.  The 2% increase in salary and benefits was due to a full
nine months of operations of the Company’s West Scranton branch that was not
operational until the third quarter of 2008, a Company’s executive officer was
re-employed during the middle of the first quarter of 2008 compared to a full
nine-month impact in the current year, increased health care costs, higher
commissions earned on production by our asset management staff and partially
offset by lower stock-based compensation.  The $300,000, or 13%,
increase in premises and equipment is from depreciation and other ancillary
occupancy expenses for the new West Scranton branch and higher equipment
maintenance and depreciation, mostly for information technology.  An
increase in the level of problem loans and ORE activity, as a result of our
continued efforts to resolve non-performing assets, resulted in a $114,000
increase in the costs associated with foreclosure, the operating costs of
property ownership as well as an increase in collection expense of $113,000 in
the current year nine month period compared to the same period in
2008.  The 32% decrease in advertising stems from activity related to
opening a new branch in 2008 that did not occur in 2009.




(Credit) provision for
income taxes




The
pre-tax accounting loss for both the third quarter and year-to-date periods
ended September 30, 2009 resulted in a tax benefit compared to a tax provision
in 2008.




Comparison of financial
condition at


September 30, 2009 and
December 31, 2008




Overview




Consolidated
assets declined $9,720,000, or 2%, during the nine months ended September 30,
2009.  The decline was caused by a $52,891,000, or 59%, reduction in
total borrowings, partially offset by a $43,947,000, or 10%, increase in total
deposits.  The reduction in borrowings was from implementing a
de-leveraging strategy during the year that used the proceeds from the sale of
residential mortgage loans and deposit growth to reduce overnight borrowings and
FHLB advances.




Investment
securities




At the
time of purchase, management classifies investment securities into one of three
categories: trading, AFS or held-to- maturity (HTM).  To date,
management has not purchased any securities for trading
purposes.  Most of the securities purchased are classified as AFS even
though there is no immediate intent to sell them.  The AFS designation
affords management the flexibility to sell securities and position the balance
sheet in response to capital levels, liquidity needs or changes in market
conditions.  Securities AFS are carried at fair value in the
consolidated balance sheet with an adjustment to shareholders’ equity, net of
tax, presented under the caption “Accumulated other comprehensive income
(loss).”  Securities designated as HTM are carried at amortized cost
and represent debt securities that the Company has the ability and intent to
hold until maturity.




As of
September 30, 2009, the carrying value of investment securities totaled
$83,142,000, or 15% of total assets, compared to $84,187,000, or 15% of total
assets, at December 31, 2008.  At September 30, 2009, approximately
12% of the carrying value of the investment portfolio was comprised of
mortgage-backed securities that amortize and provide monthly cash
flow.  Agency, municipal and corporate bonds comprised 42%, 36% and
10%, respectively, of the investment portfolio at September 30,
2009.


- 25
-




During
the nine months ended September 30, 2009, total investments decreased
$1,045,000.  Investment securities are comprised of HTM and AFS
securities with carrying values of $740,000 and $82,402,000,
respectively.  As of September 30, 2009, the AFS debt securities were
recorded with a net unrealized loss in the amount of $10,720,000 and equity
securities were recorded with an unrealized net gain of $124,000.




A
comparison of investment securities at September 30, 2009 and December 31, 2008
is as follows (dollars in thousands):




September 30, 2009
                      
                      
                      December 31, 2008Amount
                      
                      
                      %
                      
                      
                      Amount
                      
                      
                      %U.S.
      government agencies
                      
                      $
                      34,996
                      
                      
                      
                      42.1
                      
                      
                      $
                      43,507
                      
                      
                      
                      51.6Mortgage-backed
      securities
                      
                      
                      10,097
                      
                      
                      
                      12.1
                      
                      
                      
                      12,439
                      
                      
                      
                      14.8State
      & municipal subdivisions
                      
                      
                      29,764
                      
                      
                      
                      35.8
                      
                      
                      
                      17,553
                      
                      
                      
                      20.9Pooled
      trust preferred securities
                      
                      
                      7,839
                      
                      
                      
                      9.5
                      
                      
                      
                      10,260
                      
                      
                      
                      12.2Equity
      securities
                      
                      
                      446
                      
                      
                      
                      0.5
                      
                      
                      
                      428
                      
                      
                      
                      0.5Total
      investments
                      
                      $
                      83,142
                      
                      
                      
                      100.0
                      
                      
                      $
                      84,187
                      
                      
                      
                      100.0





Quarterly,
management performs a review of the investment portfolio to determine the cause
of declines in the fair value of each security.  The Company uses
inputs provided by independent third parties to determine the fair value of its
investment securities portfolio.  Inputs provided by the third party
are reviewed and corroborated by management.  Evaluations of the
causes of the unrealized losses are performed to determine whether impairment is
temporary or other-than-temporary.  Considerations such as the
Company’s intent and ability to hold the securities to maturity, recoverability
of the invested amounts over the intended holding period, the length of time and
the severity in pricing decline below cost, the interest rate environment,
receipts of amounts contractually due and whether or not there is an active
market for the security, for example, are applied, along with the financial
condition of the issuer for management to make a realistic judgment of the
probability that the Company will be unable to collect all amounts (principal
and interest) due in determining whether a security is other-than-temporarily
impaired.  If a decline in value is deemed to be other-than-temporary,
the amortized cost of the security is reduced by the credit impairment amount
and a corresponding charge to earnings is recognized.  If at the time
of sale, call or maturity the proceeds exceed the security’s amortized cost, the
impairment charge may be fully or partially recovered.




Uncertainty
continues to prevail in the financial markets which have increased the
volatility in fair value estimates for the securities in the Company’s
investment portfolio.  Though improved since year-end 2008, the fair
values of securities continue to be pressured by this
uncertainty.  Management believes fair value changes, other than for
pooled trust preferred securities, are due mainly to interest rate changes and
liquidity problems in the financial markets, not deterioration in the
creditworthiness of the issuers.




At
September 30, 2009 and December 31, 2008, the securities with the most
significant reductions in fair value and associated estimated unrealized losses
were in the Company’s corporate bond portfolio consisting of pooled trust
preferred securities issued by banks, thrifts and insurance
companies.




Except
for the pooled trust preferred securities, fair values of the other investment
securities are determined by prices provided by a third-party vendor, who is a
provider of financial market data, analytics and related services to financial
institutions.  For the pooled trust preferred securities portfolio,
management is unable to obtain readily attainable and realistic pricing from
market traders due to a lack of active market participants and therefore
management has determined that the market for these securities is
inactive.




The
Company owns 13 tranches of pooled trust preferred securities.  The
market for these securities at September 30, 2009 is inactive and markets for
similar securities were also not active.  The inactivity was evidenced
first by a significant widening of the bid-ask spread in the brokered markets in
which pooled trust preferred securities trade and then by a significant decrease
in the volume of trades relative to historical levels.  The new-issue
market is also inactive as no new pooled trust preferred securities have been
issued since 2007.  There are currently very few market participants
who are willing and / or able to transact for these securities.  Given
the conditions in the debt markets today and the absence of observable
transactions in the secondary and new issue markets, management
determined:




·
            The
      few observable transactions and market quotations that were available were
      not reliable for purposes of determining fair value at September 30,
      2009,




·
            An
      income valuation approach (present value technique) that maximizes the use
      of relevant observable inputs and minimizes the use of unobservable inputs
      will be equally or more representative of fair value than the market
      approach valuation technique, and




·
            The
      pooled trust preferred securities are classified within Level 3 of the
      fair value hierarchy because significant adjustments are required to
      determine fair value at the measurement date.  The valuations of
      the Company’s pooled trust preferred securities were prepared by an
      independent third party.  Their approach to determine fair value
      involved the following:


- 26
-




o
            Data
      about the issue structure as defined in the indenture and the underlying
      collateral were collected,




o
            The credit quality
      of the collateral is estimated using issuer-specific probability of
      default values,




o
            The
      default probabilities also considered the potential for 50% correlation
      among issuers within the same industry (e.g. banks with other banks) and
      30% correlation between industries (e.g. banks vs.
    insurance),




o
            The
      loss given default, or amount of cash lost to the investor when a debt
      asset defaults, was assumed to be 100% (no recovery) based upon Moody’s
      research.  This replicates the historically high default loss
      levels on trust preferred
instruments,




o
            The
      cash flows were forecast for the underlying collateral and applied to each
      tranche to determine the resulting distribution among the
      securities.  This ascertains which investors are
      paid and who takes a loss.  Thus, these cash flow projections
      capture the credit risk,




o
            The
      expected cash flows utilize no prepayments and were discounted utilizing
      three-month LIBOR as the risk-free rate for the base case and then added a
      300bp liquidity premium as the discount rate to calculate the present
      value of the security,




o
            The
      effective discount rates on an overall basis range from 8.90% to 63.52%
      and are highly dependent upon the credit quality of the collateral, the
      relative position of the tranche in the capital structure of the security
      and the prepayment assumptions, and




o
            The
      calculations were modeled in several thousand scenarios using a Monte
      Carlo engine to establish a distribution of intrinsic values and the
      average was used for valuation
purposes.




Based on
the technique described, the Company determined that as of September 30, 2009,
the fair values of five pooled trust preferred securities, PreTSLs VII, IX, XV,
XVI and XXV had declined $6,794,000, in total below their amortized cost basis
and since the present value of the security’s expected cash flows were
insufficient to recover the entire amortized cost basis, the securities are
deemed to have experienced credit related other-than-temporary impairment of
$2,758,000 which was charged to current earnings as a component of other income
in the consolidated income statement for the nine months ended September 30,
2009.  The Company closely monitors the pooled trust preferred
securities market and performs collateral sufficiency and cash flow analyses on
at least a quarterly basis.  Future analyses could yield results that
may indicate further impairment has occurred and therefore require additional
write-downs and corresponding other-than-temporary charges to current
earnings.  The OTTI charges recorded during the first nine months
of 2008 amounted to $403,000.




At
September 30, 2009, the AFS debt securities portfolio was carried with a net
unrealized loss of $10,720,000 compared to a net unrealized loss of $13,486,000
at December 31, 2008.  Management believes the cause of the unrealized
losses is related to changes in interest rates or the limited trading activity
due to recent debt market illiquid conditions and is not directly or fully
related to credit quality, which is consistent with its past
experience.  In addition, the Company has no intent to sell the
securities and it is more likely than not that the Company will not be required
to sell the securities before recovery of its amortized cost
basis.  As of September 30, 2009, the Company has the ability and
intent to hold its investments for a period of time sufficient for the fair
value of the securities to recover, which may be at maturity.  For a
further discussion on the investment securities portfolio, see note 3,
“Investment securities” of the notes to the consolidated financial statements in
Part I, Item I, herein.




Federal Home Loan Bank
Stock




Investment
in FHLB stock is required for membership in the organization and is carried at
cost since there is no market value available.  The amount the Company
is required to invest is dependent upon the relative size of outstanding
borrowings the Company has with the FHLB.  Excess stock is typically
repurchased from the Company at par if the borrowings decline to a predetermined
level.  Throughout most of 2008, the Company earned a return or
dividend on the amount invested.  In late December 2008, the FHLB
announced that it had suspended the payment of dividends and the repurchase of
excess capital stock to preserve its capital level.  That decision was
based on the FHLB’s analysis and consideration of certain negative market trends
and the impact those trends had on their financial condition.  Based
on the financial results of the FHLB for the year-ended December 31, 2008 and
for the six months ended June 30, 2009, management believes that the suspension
of both the dividend payments and excess capital stock repurchase is temporary
in nature.  Management further believes that the FHLB will continue to
be a primary source of wholesale liquidity for both short- and long-term funding
and has concluded that its investment in FHLB stock is not
other-than-temporarily impaired.  The Company will continue to monitor
the financial condition of the FHLB quarterly to assess its ability to resume
these activities in the future.


- 27
-




Loans available-for-sale
(AFS)




Generally,
upon origination, certain residential mortgages are classified as
AFS.  In the event of market rate increases, fixed-rate loans and
loans not immediately scheduled to re-price would no longer produce yields
consistent with the current market.  In a declining interest rate
environment, the Company would be exposed to prepayment risk and, as rates
decrease, interest income could be negatively affected.  Consideration
is given to the Company’s current liquidity position and projected future
liquidity needs.  To better manage prepayment and interest rate risk,
loans that meet these conditions may be classified as AFS.  The
carrying value of loans AFS is at the lower of cost or estimated fair
value.  If the fair values of these loans fall below their original
cost, the difference is written down and charged to current
earnings.  Subsequent appreciation in the portfolio is credited to
current earnings but only to the extent of previous write-downs.




Loans AFS
at September 30, 2009 amounted to $881,000 with a corresponding fair value of
$894,000, compared to $84,000 and $85,000, respectively, at December 31,
2008.  During the nine months ended September 30, 2009, residential
mortgage loans with principal balances of $90,045,000 were sold into the
secondary market with net gains of approximately $958,000
recognized.  Included in the sale was $10,838,000 of residential loans
transferred from the loan and lease portfolio during the first quarter of
2009.




Loans and
leases




The
Company originates commercial and industrial (commercial) and commercial real
estate (CRE) loans, residential mortgages, consumer, home equity and
construction loans.  The relative volume of originations is dependent
upon customer demand, current interest rates and the perception and duration of
future interest levels.  As part of the overall strategy to serve the
business community in which we operate, the Company is focused on developing and
implementing products and services to the small business
community.  Not only will this serve to provide credit support to our
customers and prospects, but it will continue to diversify our loan portfolio,
thereby reducing risks associated with the larger million dollar or more
credits.  The broad spectrum of products provides diversification that
helps manage, to an extent, interest rate and credit concentration
risk.  Credit risk is further managed through underwriting policies
and procedures and loan monitoring practices.  Interest rate risk is
managed using various asset/liability modeling techniques and
analyses.  The interest rates on most commercial loans are adjustable
with reset intervals of five years or less.




The
majority of the Company’s loan portfolio is collateralized, at least in part, by
real estate in Lackawanna and Luzerne Counties of
Pennsylvania.  Commercial lending activities generally involve a
greater degree of credit risk than consumer lending because they typically have
larger balances and are more affected by adverse conditions in the
economy.  Because payments on commercial loans depend upon the
successful operation and management of the properties and the businesses which
operate from within them, repayment of such loans may be affected by factors
outside the borrower’s control.  Such factors may include adverse
conditions in the real estate market, the economy, the industry or changes in
government regulations.  As such, commercial loans require more
ongoing evaluation and monitoring which occurs with the Bank’s credit
administration and outsourced loan review functions.




The
composition of the loan portfolio at September 30, 2009 and December 31, 2008,
is summarized as follows (dollars in thousands):





September 30, 2009
                            
                            
                            December 31, 2008Amount
                            
                            
                            %
                            
                            
                            Amount
                            
                            
                            %
                            
                            
                            Variance
                            
                            
                            %Real
      estate:Commercial
                            
                            $
                            183,141
                            
                            
                            
                            42.8
                            
                            
                            $
                            164,772
                            
                            
                            
                            37.4
                            
                            
                            $
                            18,369
                            
                            
                            
                            11.1Residential
                            
                            
                            71,222
                            
                            
                            
                            16.7
                            
                            
                            
                            98,510
                            
                            
                            
                            22.3
                            
                            
                            
                            (27,288
                            )
                            
                            
                            (27.7
                            )Construction
                            
                            
                            9,746
                            
                            
                            
                            2.3
                            
                            
                            
                            11,427
                            
                            
                            
                            2.6
                            
                            
                            
                            (1,681
                            )
                            
                            
                            (14.7
                            )Commercial
      and industrial
                            
                            
                            79,014
                            
                            
                            
                            18.4
                            
                            
                            
                            80,708
                            
                            
                            
                            18.3
                            
                            
                            
                            (1,694
                            )
                            
                            
                            (2.1
                            )Consumer
                            
                            
                            84,051
                            
                            
                            
                            19.7
                            
                            
                            
                            85,091
                            
                            
                            
                            19.3
                            
                            
                            
                            (1,040
                            )
                            
                            
                            (1.2
                            )Direct
      financing leases
                            
                            
                            385
                            
                            
                            
                            0.1
                            
                            
                            
                            444
                            
                            
                            
                            0.1
                            
                            
                            
                            (59
                            )
                            
                            
                            (13.3
                            )Gross
      loans
                            
                            
                            427,559
                            
                            
                            
                            100.0
                            
                            
                            
                            440,952
                            
                            
                            
                            100.0
                            
                            
                            $
                            (13,393
                            )
                            
                            
                            (3.0
                            )Allowance
      for loan losses
                            
                            
                            (6,725
                            )
                            
                            
                            
                            
                            
                            
                            (4,745
                            )Net
      loans
                            
                            $
                            420,834
                            
                            
                            
                            
                            
                            
                            $
                            436,207


- 28
-


Gross
loans decreased from $440,952,000, as of December 31, 2008 to $427,559,000 at
September 30, 2009.  The decline was predominately from the transfer
from the loan and lease portfolio, to the AFS portfolio, and simultaneous sale
of $10,838,000 of residential mortgage loans during the first quarter of
2009.  The balance of the residential real estate mortgage decline is
mostly from net pay-downs during the first three quarters of 2009 as borrowers’
desire, during this low-rate environment, is to re-finance their existing
mortgage and home equity debt into new lower rate mortgage
loans.  Most of the mortgage loans that were originated in 2009 were
sold on a servicing-retained basis.  New commercial business and
relationship emphasis has resulted in an increase in commercial real estate
loans of $18,369,000, or 11%.




Allowance for loan
losses




Management
continually evaluates the credit quality of the Company’s loan portfolio and
performs a formal review of the adequacy of the allowance for loan losses (the
allowance) on a quarterly basis.  The allowance reflects management’s
best estimate of the amount of credit losses in the loan
portfolio.  Management’s judgment is based on the evaluation of
individual loans, past experience, the assessment of current economic conditions
and other relevant factors including the amounts and timing of cash flows
expected to be received on impaired loans.  Those estimates may be
susceptible to significant change.  The provision for loan losses
represents the amount necessary to maintain an appropriate
allowance.  Loan losses are charged directly against the allowance
when loans are deemed to be uncollectible.  Recoveries from previously
charged-off loans are added to the allowance when received.




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




•
            identification
      of specific impaired loans by loan
category;


•
            calculation
      of specific allowances where required for the impaired loans based on
      collateral and other objective and quantifiable
  evidence;


•
            determination
      of homogenous pools by loan category and eliminating the impaired
      loans;


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


•
            application
      of qualitative factor adjustment percentages to historical losses for
      trends or changes in the loan portfolio, and /or current economic
      conditions.




Allocation
of the allowance for different categories of loans is based on the methodology
as explained above.  A key element of the methodology to determine the
allowance is the Company’s credit risk evaluation process, which includes credit
risk grading of individual commercial loans.  Commercial loans are
assigned credit risk grades based on the Company’s assessment of conditions that
affect the borrower’s ability to meet its contractual obligations under the loan
agreement.  That process includes reviewing borrowers’ current
financial information, historical payment experience, credit documentation,
public information and other information specific to each individual
borrower.  Upon review, the commercial loan credit risk grade is
revised or reaffirmed.  The credit risk grades may be changed at any
time management feels an upgrade or downgrade may be warranted.  The
credit risk grades for the commercial loan portfolio are taken into account in
the reserve methodology and loss factors are applied based upon the credit risk
grades.  The loss factors applied are based upon the company’s
historical experience as well as what management believes to be best practices
and within common industry standards.  Historical experience reveals
there is a direct correlation between the credit risk grades and loan
charge-offs.  The changes in allocations in the commercial loan
portfolio from period-to-period are based upon the credit risk grading system
and from periodic reviews of the loan and lease portfolios.




Each
quarter, management performs an assessment of the allowance and the provision
for loan losses.  The Company’s Special Assets Committee meets
quarterly and the applicable lenders discuss each relationship under review and
reach a consensus on the appropriate estimated loss amount based ASC 310 “Receivables” as it relates
to loans that are identified for evaluation or that are individually considered
impaired.  The Special Assets Committee’s focus is on ensuring the
pertinent facts are considered and the specific reserve amounts determined in
accordance with the guidance are reasonable.  The assessment process
includes the review of all loans on a non-accruing basis as well as a review of
certain loans to which the lenders or the Special Assets Committee have assigned
a criticized or classified risk rating.




Total
charge-offs net of recoveries for the nine months ending September 30, 2009,
were $1,870,000, compared to $874,000 in the first nine months of
2008.  The higher level of charge-offs recorded in the year primarily
resulted from a personal, as well as business bankruptcy filing by one customer
and the write-down of a separate impaired loan to current fair
value.  Commercial real estate loan net charge-offs of $841,000 were
recorded during the nine months ending September 30, 2009 versus $539,000 at
September 30, 2008.  Commercial and industrial loan net charge-offs
were $730,000 for the nine months ending September 30, 2009 compared to net
charge-offs of $49,000 in the same period of 2008.  Residential real
estate loan net charge-offs totaled $9,000 for the nine months ending September
30, 2009 compared to $32,000 in the like period of 2008.  Consumer
loan net charge-offs of $289,000 were recorded during the nine months ending
September 30, 2009 versus $255,000 at September 30, 2008.  For a
discussion on the provision for loan losses, see the “Provision for loan
losses,” located in the results of operations section of management’s discussion
and analysis contained herein.


- 29
-


The
allowance for loan losses was $6,725,000 at September 30, 2009, an increase of
$1,980,000 from December 31, 2008.  The increase in the allowance was
primarily driven by a migration of commercial loan risk ratings from pass to
classified status.




Management
believes that the current balance in the allowance for loan losses of $6,725,000
is sufficient to withstand the identified potential credit quality issues that
may arise and others unidentified but inherent to the portfolio as of this
time.  Potential problem loans are those where there is known
information that leads management to believe repayment of principal and/or
interest is in jeopardy and the loans are currently neither on non-accrual
status or past due 90 days or more.  Given continuing pressure on
property values and the generally uncertain economic backdrop, there could be
additional instances which become identified in future periods that may require
additional charge-offs and/or increases to the allowance.  The ratio
of allowance for loan losses to total loans was 1.57% at September 30, 2009
compared to 0.98% at September 30, 2008.




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




As
      of and for the
                    
                    
                    As
      of and for the
                    
                    
                    As
      of and for thenine
      months ended
                    
                    
                    twelve
      months ended
                    
                    
                    nine
      months endedSeptember
      30, 2009
                    
                    
                    December
      31, 2008
                    
                    
                    September
      30, 2008Balance
      at beginning of period
                    
                    $
                    4,745,234
                    
                    
                    $
                    4,824,401
                    
                    
                    $
                    4,824,401Provision
      charged to operations
                    
                    
                    3,850,000
                    
                    
                    
                    940,000
                    
                    
                    
                    255,000Charge-offs:Real
      estate:Commercial
                    
                    
                    843,526
                    
                    
                    
                    565,193
                    
                    
                    
                    556,789Residential
                    
                    
                    9,158
                    
                    
                    
                    44,800
                    
                    
                    
                    31,870Commercial
      and industrial
                    
                    
                    746,093
                    
                    
                    
                    168,021
                    
                    
                    
                    109,799Consumer
                    
                    
                    299,041
                    
                    
                    
                    350,856
                    
                    
                    
                    283,783Total
                    
                    
                    1,897,818
                    
                    
                    
                    1,128,870
                    
                    
                    
                    982,241Recoveries:Real
      estate:Commercial
                    
                    
                    2,075
                    
                    
                    
                    18,020
                    
                    
                    
                    18,020Residential
                    
                    
                    -
                    
                    
                    
                    97
                    
                    
                    
                    80Commercial
      and industrial
                    
                    
                    16,018
                    
                    
                    
                    61,233
                    
                    
                    
                    61,233Consumer
                    
                    
                    9,348
                    
                    
                    
                    30,353
                    
                    
                    
                    29,073Total
                    
                    
                    27,441
                    
                    
                    
                    109,703
                    
                    
                    
                    108,406Net
      charge-offs
                    
                    
                    1,870,377
                    
                    
                    
                    1,019,167
                    
                    
                    
                    873,835Balance
      at end of period
                    
                    $
                    6,724,857
                    
                    
                    $
                    4,745,234
                    
                    
                    $
                    4,205,566Total
      loans, end of period
                    
                    $
                    428,439,731
                    
                    
                    $
                    441,036,694
                    
                    
                    $
                    431,293,559


- 30
-





As
      of and for the
                                          
                                          
                                          
                                          As
      of and for the
                                          
                                          
                                          
                                          As
      of and for thenine
      months ended
                                          
                                          
                                          
                                          twelve
      months ended
                                          
                                          
                                          
                                          nine
      months endedSeptember
      30, 2009
                                          
                                          
                                          
                                          December
      31, 2008
                                          
                                          
                                          
                                          September
      30, 2008Net charge-offs to:Loans,
      end of period
                                          
                                          
                                          0.44
                                          %
                                          
                                          
                                          
                                          0.23
                                          %
                                          
                                          
                                          
                                          0.20
                                          %Allowance
      for loan losses
                                          
                                          
                                          27.81
                                          %
                                          
                                          
                                          
                                          21.48
                                          %
                                          
                                          
                                          
                                          20.78
                                          %Provision
      for loan losses
                                          
                                          
                                          0.49
                                          
                                          x
                                          
                                          
                                          1.08
                                          
                                          x
                                          
                                          
                                          3.43
                                          
                                          xAllowance for loan losses
    to:Total
      loans
                                          
                                          
                                          1.57
                                          %
                                          
                                          
                                          
                                          1.08
                                          %
                                          
                                          
                                          
                                          0.98
                                          %Non-accrual
      loans
                                          
                                          
                                          0.85
                                          
                                          x
                                          
                                          
                                          1.36
                                          
                                          x
                                          
                                          
                                          1.35
                                          
                                          xNon-performing
      loans
                                          
                                          
                                          0.76
                                          
                                          x
                                          
                                          
                                          1.16
                                          
                                          x
                                          
                                          
                                          1.13
                                          
                                          xNet
      charge-offs
                                          
                                          
                                          3.60
                                          
                                          x
                                          
                                          
                                          4.66
                                          
                                          x
                                          
                                          
                                          4.81
                                          
                                          xLoans
      30-89 days past due and still accruing
                                          
                                          $
                                          3,077,722
                                          
                                          
                                          
                                          $
                                          1,858,481
                                          
                                          
                                          
                                          $
                                          1,251,282Loans
      90 days past due and accruing
                                          
                                          $
                                          1,002,720
                                          
                                          
                                          
                                          $
                                          604,140
                                          
                                          
                                          
                                          $
                                          581,824Non-accrual
      loans
                                          
                                          $
                                          7,900,547
                                          
                                          
                                          
                                          $
                                          3,493,169
                                          
                                          
                                          
                                          $
                                          3,125,997Allowance
      for loan losses to loans 90 days or more past due and
      accruing
                                          
                                          
                                          6.71
                                          
                                          x
                                          
                                          
                                          7.85
                                          
                                          x
                                          
                                          
                                          7.23
                                          
                                          x




Non-performing
assets




The
Company defines non-performing assets as accruing loans past due 90 days or
more, non-accrual loans, restructured loans, other real estate owned (ORE) and
repossessed assets.  As of September 30, 2009, non-performing assets
represented 1.81% of total assets compared to 0.90% at September 30,
2008.  The increase was driven by the higher level of non-performing
loans at September 30, 2009.




In the
review of loans for both delinquency and collateral sufficiency, management
concluded that there were a number of loans that lacked the ability to repay in
accordance with contractual terms.  The decision to place loans or
leases on a non-accrual status is made on an individual basis after considering
factors pertaining to each specific loan.  The commercial loans are
placed on non-accrual status when management has determined that payment of all
contractual principal and interest is in doubt or the loan is past due 90 days
or more as to principal and interest, unless well-secured and in the process of
collection.  Consumer loans secured by real estate are placed on
non-accrual status at 120 days past due as to principal and interest, and,
unsecured consumer loans are charged-off when the loan is 90 days or more past
due as to principal and interest.  Uncollected interest income accrued
on all non-accrual loans is reversed and charged to interest
income.




The
majority of the non-performing assets for the period are attributed to
non-accruing commercial business loans, non-accruing real estate loans and
ORE.  Most of the loans are collateralized, thereby mitigating the
Company’s potential for loss.  At September 30, 2009 non-performing
loans were $8,903,000 compared to $4,097,000 at December 31,
2008.  The increase was primarily driven by one commercial loan
relationship of approximately $3 million and two jumbo residential real estate
mortgages aggregating about $1.2 million which defaulted in their loan payments
and were moved to non-performing status.  Action plans for the
resolution of each of the Company’s non-performing loans have been developed and
are periodically updated as needed.  There were no restructured loans
or repossessed assets at September 30, 2009 or at December 31,
2008.  ORE at September 30, 2009 was $1,364,000 and consisted of five
properties.  At September 30, 2009, the non-accrual loans aggregated
$7,901,000 as compared to $3,493,000 at December 31, 2008.  Additions
to the non-accrual component of the non-performing assets totaling $7,515,000
were made during the first nine months of the year.   These were
partially offset by reductions or payoffs of $916,000, charge-offs of
$1,646,000, $469,000 of transfers to ORE and $77,000 of loans that returned to
performing status.  Loans past due 90 days or more and accruing were
$1,003,000 at September 30, 2009 and $604,000, at December 31,
2008.  The rise is mainly attributed to one commercial loan on which
payment was expected by September 30th;
however, it was not received until after quarter-end.  Non-performing
loans to net loans were 2.11% at September 30, 2009, and 0.94% at December 31,
2008.  The percentage of non-performing assets to total assets was
1.81% at September 30, 2009, an increase from 0.96% at December 31, 2008,
primarily driven by the aforementioned increase in the non-accrual loans
component.




The 30-89
day past due loans at September 30, 2009 were $3,077,000 and $1,858,000 at
December 31, 2008.  The rise in these past due loans was driven by
increased commercial and mortgage loan delinquencies as current economic
conditions take their toll on borrowers.  Approximately, $500,000 of
these past due loans were paid to current status shortly after the
quarter-end.


- 31
-




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




September
      30, 2009
                  
                  
                  December
      31, 2008
                  
                  
                  September
      30, 2008Loans
      past due 90 days or more and accruing
                  
                  $
                  1,002,720
                  
                  
                  $
                  604,140
                  
                  
                  $
                  581,824Non-accrual
      loans
                  
                  
                  7,900,547
                  
                  
                  
                  3,493,169
                  
                  
                  
                  3,125,997Total
      non-performing loans
                  
                  
                  8,903,267
                  
                  
                  
                  4,097,309
                  
                  
                  
                  3,707,821Other
      real estate owned
                  
                  
                  1,364,397
                  
                  
                  
                  1,450,507
                  
                  
                  
                  1,428,507Total
      non-performing assets
                  
                  $
                  10,267,664
                  
                  
                  $
                  5,547,816
                  
                  
                  $
                  5,136,328Net
      loans including AFS
                  
                  $
                  421,714,874
                  
                  
                  $
                  436,291,460
                  
                  
                  $
                  427,087,993Total
      assets
                  
                  $
                  565,999,434
                  
                  
                  $
                  575,718,997
                  
                  
                  $
                  569,543,412Non-accrual
      loans to net loans
                  
                  
                  1.87
                  %
                  
                  
                  0.80
                  %
                  
                  
                  0.73
                  %Non-performing
      assets to net loans, foreclosed real estate and repossessed
      assets
                  
                  
                  2.43
                  %
                  
                  
                  1.27
                  %
                  
                  
                  1.20
                  %Non-performing
      assets to total assets
                  
                  
                  1.81
                  %
                  
                  
                  0.96
                  %
                  
                  
                  0.90
                  %Non-performing
      loans to net loans
                  
                  
                  2.11
                  %
                  
                  
                  0.94
                  %
                  
                  
                  0.87
                  %




The
composition of non-performing loans as of September 30, 2009 is as follows
(dollars in thousands):




Gross
                        
                        
                        Past
      due 90
                        
                        
                        Non-
                        
                        
                        Total
      non-
                        
                        
                        %
      ofloan
                        
                        
                        days
      or more
                        
                        
                        accrual
                        
                        
                        performing
                        
                        
                        grossbalances
                        
                        
                        and
      still accruing
                        
                        
                        loans
                        
                        
                        loans
                        
                        
                        loansReal
      estate:Commercial
                        
                        $
                        183,141
                        
                        
                        $
                        905
                        
                        
                        $
                        3,399
                        
                        
                        $
                        4,304
                        
                        
                        
                        2.35
                        %Residential
                        
                        
                        71,222
                        
                        
                        
                        38
                        
                        
                        
                        3,306
                        
                        
                        
                        3,344
                        
                        
                        
                        4.70
                        %Construction
                        
                        
                        9,746
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Commercial
      and industrial
                        
                        
                        79,014
                        
                        
                        
                        -
                        
                        
                        
                        840
                        
                        
                        
                        840
                        
                        
                        
                        1.06
                        %Consumer
                        
                        
                        84,051
                        
                        
                        
                        60
                        
                        
                        
                        355
                        
                        
                        
                        415
                        
                        
                        
                        0.49
                        %Direct
      financing leases
                        
                        
                        385
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Total
                        
                        $
                        427,559
                        
                        
                        $
                        1,003
                        
                        
                        $
                        7,900
                        
                        
                        $
                        8,903
                        
                        
                        
                        2.08
                        %





Foreclosedassets
held-for-sale




Foreclosed
assets held-for-sale, consisting of ORE, was $1,364,000 at September 30, 2009
comprised of five properties.  One property has been sold, a second
has a signed sales agreement for its sale and the remainder are listed for sale
with realtors.




Other
assets




The
increase in other assets of $1,338,000, or 15%, from December 31, 2008 to
September 30, 2009 was caused mostly from a net increase in the Company’s
deferred tax asset related to further declines in the market value of the
investment portfolio and an increase in mortgage servicing rights of $462,000
due to high volume of mortgage real estate sales that the Company normally sells
into the secondary market on a servicing-retained basis.  Contributing
to the net increase was $212,000 of prepaid expense replenishments.




Deposits




The Bank
is a community-based commercial financial institution, member FDIC, which offers
a variety of deposit accounts with varying ranges of interest rates and
terms.  Deposit products include savings accounts, interest-bearing
checking (NOW), money market, non-interest-bearing checking (DDAs) and
certificates of deposit accounts.  Certificates of deposit accounts,
or CDs, are deposits with stated maturities ranging from seven days to ten
years.  The flow of deposits is significantly influenced by general
economic conditions, changes in prevailing interest rates, pricing and
competition.  Most of the Company’s deposits are obtained from the
communities surrounding its 11 branch offices and are insured by the FDIC up to
the full extent permitted by law.  The Bank attempts to attract and
retain deposit customers via sales and marketing efforts, new products, quality
service, competitive rates and maintaining long-standing customer
relationships.  To determine deposit product interest rates, the
Company considers local competition, market yields and the rates charged for
alternative sources of funding such as borrowings.  Though we continue
to experience intense competition for deposits, our rate-setting strategy
includes consideration of liquidity needs, balance sheet structure, cost
effective strategies that are mindful of the current interest rate environment
and customer needs.


- 32
-




Compared
to December 31, 2008 total deposits grew $43,947,000, or 10%, during the nine
month period ended September 30, 2009.  The growth in total deposits
was due to increases in DDAs, savings, NOW and money market accounts of
$2,547,000, or 4%, $34,636,000, or 84%, $16,963,000, or 34%, and $9,648,000, or
10%, respectively, partially offset by lower CD balances.  The opening
of the West Scranton branch during the third quarter of 2008 and bank-wide money
market and savings promotions that the Company attempts to tailor to individual
customers’ needs contributed to growth in deposits during the nine months of
2009.  On July 20, 2009, the Company closed its Wyoming Avenue,
Scranton branch which then consolidated with the Financial Center branch located
on North Washington Avenue, Scranton.  The consolidation did not have
a material effect on the Company’s deposits.




The
following table represents the components of deposits as of the date
indicated:




September 30, 2009
                
                
                December 31, 2008Amount
                
                
                %
                
                
                Amount
                
                
                %Money
      market
                
                $
                106,385,512
                
                
                
                22.3
                
                
                $
                96,738,006
                
                
                
                22.3NOW
                
                
                67,086,761
                
                
                
                14.1
                
                
                
                50,123,744
                
                
                
                11.6Savings
      and club
                
                
                75,962,710
                
                
                
                15.9
                
                
                
                41,326,616
                
                
                
                9.5Certificates
      of deposit
                
                
                147,144,939
                
                
                
                30.8
                
                
                
                173,680,915
                
                
                
                40.1CDARS
                
                
                6,688,581
                
                
                
                1.4
                
                
                
                -
                
                
                
                -Total
      interest-bearing
                
                
                403,268,503
                
                
                
                84.5
                
                
                
                361,869,281
                
                
                
                83.5Non-interest-bearing
                
                
                73,990,068
                
                
                
                15.5
                
                
                
                71,442,651
                
                
                
                16.5Total
      deposits
                
                $
                477,258,571
                
                
                
                100.0
                
                
                $
                433,311,932
                
                
                
                100.0




Certificates
of deposit of $100,000 or more aggregated $56,863,000 and $74,250,000 at
September 30, 2009 and December 31, 2008, respectively.  Certificates
of deposit of $250,000 or more aggregated $21,441,000 and $35,108,000 at
September 30, 2009 and December 31, 2008.




During
the first quarter of 2009, the Company began to use the Certificate of Deposit
Account Registry Service (CDARS) in order to obtain FDIC insurance protection
for customers who have large deposits that at times exceed the FDIC maximum
amount of $250,000.  In the CDARS program, deposits are sold at
varying terms and interest rates, are originated in our own market place and are
placed with other financial institutions that are members in the CDARS
network.  By placing these deposits in other participating
institutions, the deposits of our customers are fully insured by the
FDIC.  In return for deposits we place with network institutions, we
can receive from network institutions deposits that are approximately equal in
amount of what was placed for our customers.  Deposits we receive, or
reciprocal deposits, from other institutions are considered brokered
deposits.  As of September 30, 2009, CDARS represented $6,689,000, or
1%, of total deposits.




Including
CDARS, approximately 25% of total CDs are scheduled to mature in
2009.  Renewing CDs may re-price to market rates depending on the
direction of interest rate movements, the shape of the yield curve, competition,
the rate profile of the maturing accounts and depositor preference for
alternative products.  To help reduce the financial impact of the
unpredictable and highly volatile interest rate environment, management will
deploy prudent strategies that will diversify the deposit mix across the entire
spectrum of products offered.  Although we continue to experience
intense competition for deposits, we have not adjusted rates above market levels
as we consider cost effective strategies, liquidity as well as relationship
retention and development when setting interest rates on deposit
accounts.




Borrowings




Borrowings
are used as a complement to deposit generation as an alternative funding source
whereby the Bank will borrow under customer repurchase agreements in the local
market, advances from the Federal Home Loan Bank of Pittsburgh (FHLB) and other
correspondent banks for asset growth and liquidity needs.  Repurchase
agreements are non-insured interest-bearing liabilities that have a perfected
security interest in qualified investment securities of the Bank.  The
FDIC Depositor Protection Act of 2009 requires banks to provide a perfected
security interest to the purchasers of uninsured repurchase
agreements.  Holders of existing contracts that did not conform to the
amended requirements were considered unsecured creditors of the
Company.  In effect, the Company had to enter into new agreements with
all repurchase agreement participants.  At September 30, 2009, $3.0
million of the reported $5.2 million in repurchase agreements were held by
participants who had not renegotiated their contracts.  The situation
is expected to be resolved during the fourth quarter.  The repurchase
agreements are offered through a sweep product.  A sweep account is
designed to ensure that, on a daily basis, an attached DDA is adequately funded
and excess DDA funds are transferred, or swept, into an overnight
interest-bearing repurchase agreement account.  The balance in
customer repurchase agreement accounts can fluctuate daily because the daily
sweep product is dependent on the level of available funds in depositor
accounts.  In addition, short-term borrowings may include overnight
balances which the Bank may require to fund daily liquidity
needs.  Overnight balances and repurchase agreements are components of
short-term borrowings and FHLB advances are components of long-term debt on the
consolidated balance sheets.


- 33
-




The
following table represents the components of borrowings as of September 30, 2009
and December 31, 2008 (dollars in thousands):




September 30, 2009
                  
                  
                  December 31, 2008Amount
                  
                  
                  %
                  
                  
                  Amount
                  
                  
                  %Overnight
      borrowings
                  
                  $
                  -
                  
                  
                  
                  -
                  
                  
                  $
                  25,668
                  
                  
                  
                  28.5Repurchase
      agreements
                  
                  
                  5,176
                  
                  
                  
                  13.9
                  
                  
                  
                  11,412
                  
                  
                  
                  12.6Demand
      note, U.S. Treasury
                  
                  
                  62
                  
                  
                  
                  0.2
                  
                  
                  
                  1,050
                  
                  
                  
                  1.2FHLB
      advances
                  
                  
                  32,000
                  
                  
                  
                  85.9
                  
                  
                  
                  52,000
                  
                  
                  
                  57.7Total
      borrowings
                  
                  $
                  37,238
                  
                  
                  
                  100.0
                  
                  
                  $
                  90,130
                  
                  
                  
                  100.0




Borrowings
have decreased $52,892,000, or 59%, during the nine months ended September 30,
2009.  Overnight borrowings and FHLB advances have declined as a
result of the Company’s balance sheet de-leveraging and deposit
growth.  The reduction in repurchase agreements was caused by a
combination of pricing, movement of customers to insured products and the
volatile nature of the sweep product.




Item
3.  Quantitative and Qualitative Disclosure About Market
Risk




Management of interest rate
risk and market risk analysis




The
Company is subject to the interest rate risks inherent in its lending, investing
and financing activities.  Fluctuations of interest rates will impact
interest income and interest expense along with affecting market values of all
interest-earning assets and interest-bearing liabilities, except for those
assets or liabilities with a short term remaining to
maturity.  Interest rate risk management is an integral part of the
asset/liability management process.  The Company has instituted
certain procedures and policy guidelines to manage the interest rate risk
position.  Those internal policies enable the Company to react to
changes in market rates to protect net interest income from significant
fluctuations.  The primary objective in managing interest rate risk is
to minimize the adverse impact of changes in interest rates on net interest
income along with creating an asset/liability structure that maximizes
earnings.




Asset/Liability
Management.  One major objective of the Company when managing
the rate sensitivity of its assets and liabilities is to stabilize net interest
income.  The management of and authority to assume interest rate risk
is the responsibility of the Company’s Asset/Liability Committee (ALCO), which
is comprised of senior management and members of the board of
directors.  ALCO meets quarterly to monitor the relationship of
interest sensitive assets to interest sensitive liabilities.  The
process to review interest rate risk is a regular part of managing the
Company.  Consistent policies and practices of measuring and reporting
interest rate risk exposure, particularly regarding the treatment of
non-contractual assets and liabilities, are in effect.  In addition,
there is an annual process to review the interest rate risk policy with the
board of directors which includes limits on the impact to earnings from shifts
in interest rates.




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




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




To manage
this interest rate sensitivity gap position, an asset/liability model commonly
known as cumulative gap analysis is used to monitor the difference in the volume
of the Company’s interest-sensitive assets and liabilities that mature or
re-price within given time intervals.  A positive gap (asset
sensitive) indicates that more assets will mature or re-price during a given
period compared to liabilities, while a negative gap (liability sensitive) has
the opposite effect.  The Company employs computerized net interest
income simulation modeling to assist in quantifying interest rate risk
exposure.  This process measures and quantifies the impact on net
interest income through varying interest rate changes and balance sheet
compositions.  The use of this model assists the ALCO to gauge the
effects of the interest rate changes on interest-sensitive assets and
liabilities in order to determine what impact these rate changes will have upon
the net interest spread.  At September 30, 2009 the Bank maintained a
one-year cumulative gap of positive $37.4 million, or 6.60%, of total
assets.  The effect of this positive gap position provided a mismatch
of assets and liabilities which may expose the Bank to interest rate risk during
periods of falling interest rates.  Conversely, in an increasing
interest rate environment, net interest income could be positively impacted
because more assets than liabilities would re-price upward during the one-year
period.


- 34
-




Certain
shortcomings are inherent in the method of analysis discussed above and
presented in the next table.  Although certain assets and liabilities
may have similar maturities or periods of re-pricing, they may react in
different degrees to changes in market interest rates.  The interest
rates on certain types of assets and liabilities may fluctuate in advance of
changes in market interest rates, while interest rates on other types of assets
and liabilities may lag behind changes in market interest
rates.  Certain assets, such as adjustable-rate mortgages, have
features which restrict changes 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 withdrawal levels may deviate significantly from those
assumed in calculating the table.  The ability of many borrowers to
service their adjustable-rate debt may decrease in the event of an interest rate
increase.




The
following table illustrates the Company’s interest sensitivity gap position at
September 30, 2009 (dollars in thousands):




Interest
      sensitivity gap at September 30, 2009Three
      months
                                                
                                                
                                                Three
      to
                                                
                                                
                                                One
      to
                                                
                                                
                                                Overor
      less
                                                
                                                
                                                twelve
      months
                                                
                                                
                                                three
      years
                                                
                                                
                                                three
      years
                                                
                                                
                                                TotalCash
      and cash equivalents
                                                
                                                $
                                                5,921
                                                
                                                
                                                $
                                                -
                                                
                                                
                                                $
                                                -
                                                
                                                
                                                $
                                                11,711
                                                
                                                
                                                $
                                                17,632Investment
      securities(1)(2)
                                                
                                                
                                                33,936
                                                
                                                
                                                
                                                5,943
                                                
                                                
                                                
                                                15,704
                                                
                                                
                                                
                                                32,340
                                                
                                                
                                                
                                                87,923Loans
      (2)
                                                
                                                
                                                126,192
                                                
                                                
                                                
                                                64,028
                                                
                                                
                                                
                                                104,960
                                                
                                                
                                                
                                                126,535
                                                
                                                
                                                
                                                421,715Fixed
      and other assets
                                                
                                                
                                                -
                                                
                                                
                                                
                                                9,039
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                29,690
                                                
                                                
                                                
                                                38,729Total
      assets
                                                
                                                $
                                                166,049
                                                
                                                
                                                $
                                                79,010
                                                
                                                
                                                $
                                                120,664
                                                
                                                
                                                $
                                                200,276
                                                
                                                
                                                $
                                                565,999Total
      cumulative assets
                                                
                                                $
                                                166,049
                                                
                                                
                                                $
                                                245,059
                                                
                                                
                                                $
                                                365,723
                                                
                                                
                                                $
                                                565,999Non-interest
      bearing transaction deposits (3)
                                                
                                                $
                                                -
                                                
                                                
                                                $
                                                7,400
                                                
                                                
                                                $
                                                20,348
                                                
                                                
                                                $
                                                46,242
                                                
                                                
                                                $
                                                73,990Interest-bearing
      transaction deposits (3)
                                                
                                                
                                                62,385
                                                
                                                
                                                
                                                30,909
                                                
                                                
                                                
                                                56,086
                                                
                                                
                                                
                                                100,055
                                                
                                                
                                                
                                                249,435Time
      deposits
                                                
                                                
                                                38,297
                                                
                                                
                                                
                                                63,462
                                                
                                                
                                                
                                                41,436
                                                
                                                
                                                
                                                10,639
                                                
                                                
                                                
                                                153,834Repurchase
      agreements
                                                
                                                
                                                5,176
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                5,176Short-term
      borrowings
                                                
                                                
                                                62
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                62Long-term
      debt
                                                
                                                
                                                -
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                11,000
                                                
                                                
                                                
                                                21,000
                                                
                                                
                                                
                                                32,000Other
      liabilities
                                                
                                                
                                                -
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                3,338
                                                
                                                
                                                
                                                3,338Total
      liabilities
                                                
                                                $
                                                105,920
                                                
                                                
                                                $
                                                101,771
                                                
                                                
                                                $
                                                128,870
                                                
                                                
                                                $
                                                181,274
                                                
                                                
                                                $
                                                517,835Total
      cumulative liabilities
                                                
                                                $
                                                105,920
                                                
                                                
                                                $
                                                207,691
                                                
                                                
                                                $
                                                336,561
                                                
                                                
                                                $
                                                517,835Interest
      sensitivity gap
                                                
                                                $
                                                60,129
                                                
                                                
                                                $
                                                (22,761
                                                )
                                                
                                                $
                                                (8,206
                                                )
                                                
                                                $
                                                19,002Cumulative
      gap
                                                
                                                $
                                                60,129
                                                
                                                
                                                $
                                                37,368
                                                
                                                
                                                $
                                                29,162
                                                
                                                
                                                $
                                                48,164Cumulative
      gap to total assets
                                                
                                                
                                                10.62
                                                %
                                                
                                                
                                                6.60
                                                %
                                                
                                                
                                                5.15
                                                %
                                                
                                                
                                                8.51
                                                %





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




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




(3)
              The
      Bank’s demand and savings accounts are generally subject to immediate
      withdrawal.  However, management considers a certain amount of
      such accounts to be core accounts having significantly longer effective
      maturities based on the retention experiences of such deposits in changing
      interest rate environments.  The effective maturities presented
      are the recommended maturity distribution limits for non-maturing deposits
      based on historical deposit
studies.




Earnings at Risk and Economic Value
at Risk Simulations.  The Company recognizes that more
sophisticated tools exist for measuring the interest rate risk in the balance
sheet that extend beyond static re-pricing gap analysis.  Although it
will continue to measure its re-pricing gap position, the Company utilizes
additional modeling for identifying and measuring the interest rate risk in the
overall balance sheet.  The ALCO is responsible for focusing on
“earnings at risk” and “economic value at risk”, and how both relate to the
risk-based capital position when analyzing the interest rate risk.




Earnings at
Risk.  Earnings at risk simulation measures the change in net
interest income and net income should interest rates rise and
fall.  The simulation recognizes that not all assets and liabilities
re-price one-for-one with market rates (e.g., savings rate).  The ALCO
looks at “earnings at risk” to determine income changes from a base case
scenario under an increase and decrease of 200 basis points in interest rate
simulation models.


- 35
-




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




The
following table illustrates the simulated impact of 200 basis points upward or
downward movement in interest rates on net interest income, net income and the
change in the economic value (portfolio equity).  This analysis
assumes that interest-earning asset and interest-bearing liability levels at
September 30, 2009 remain constant.  The impact of the rate movements
was developed by simulating the effect of rates changing over a twelve-month
period from the September 30, 2009 levels:




Earnings
      at risk:
                    
                    Rates +200
                    
                    
                    Rates -200Percent
      change in:Net
      interest income
                    
                    
                    3.4
                    %
                    
                    
                    0.5
                    %Net
      income
                    
                    
                    11.0
                    
                    
                    
                    0.9Economic
      value at risk:Percent
      change in:Economic
      value of equity
                    
                    
                    (43.1
                    )
                    
                    
                    (1.5
                    )Economic
      value of equity as a percent of book assets
                    
                    
                    (3.6
                    )
                    
                    
                    (0.1
                    )




Economic
value has the most meaning when viewed within the context of risk-based
capital.  Therefore, the economic value may normally change beyond the
Company's policy guideline for a short period of time as long as the risk-based
capital ratio (after adjusting for the excess equity exposure) is greater than
10%.  At September 30, 2009, the Company’s risk-based capital ratio
was 11.3%.




The table
below summarizes estimated changes in net interest income over a twelve-month
period beginning October 1, 2009 under alternate interest rate scenarios using
the income simulation model described above (dollars in thousands):




Net
      interest
                          
                          
                          $
                          
                          
                          %Change
      in interest rates
                          
                          income
                          
                          
                          variance
                          
                          
                          variance+200 basis
      points
                          
                          $
                          21,323
                          
                          
                          $
                          700
                          
                          
                          3.4
                          %+100
      basis points
                          
                          
                          20,813
                          
                          
                          
                          190
                          
                          
                          0.9Flat
      rate
                          
                          
                          20,623
                          
                          
                          
                          -
                          
                          
                          --100
      basis points
                          
                          
                          20,777
                          
                          
                          
                          154
                          
                          
                          0.7-200
      basis points
                          
                          
                          20,722
                          
                          
                          
                          99
                          
                          
                          0.5




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




Derivative Financial
Instruments.As part of the Bank’s overall interest rate risk
strategy, the Company has adopted a policy whereby the Company may periodically
use derivative instruments to minimize significant fluctuations in earnings
caused by interest rate volatility.  This interest rate risk
management strategy entails the use of interest rate floors, caps and
swaps.  In October 2006, the Bank entered into an interest rate floor
derivative agreement on $20,000,000 notional value of its prime-based loan
portfolio.  The purpose of the hedge is to help protect the Bank’s
interest income in the event interest rates decline below a pre-determined
contractual interest rate.  The strategy is reflected in the scenarios
for earnings and economic value at risk and the net interest income in the two
immediately preceding tables.  For a further discussion on the Bank’s
derivative contract, see note 4, “Derivative instruments,” contained within the
notes to consolidated financial statements in Part I,
Item 1.


- 36
-




Liquidity




Liquidity
management ensures that adequate funds will be available to meet loan and
investment commitments, deposit withdrawals and maturities and normal operating
requirements of the Bank.  Current sources of liquidity are cash and
cash equivalents, asset maturities, calls and principal repayments, loans and
investments AFS, growth of core deposits, growth of repurchase agreements,
increases in other borrowed funds from correspondent banks and issuance of
capital stock.  Although regularly scheduled investment and loan
payments are dependable sources of daily funds, the sales of both loans and
investments AFS, deposit activity and investment and loan prepayments are
significantly influenced by general economic conditions and the level of
interest rates.  During declining interest rate environments,
prepayments from interest-sensitive assets tend to accelerate and provide
significant liquidity which can be used to invest in other interest-earning
assets but at lower market rates.  Conversely, in a period of rising
interest rates, prepayment from interest-sensitive assets tend to decelerate
causing cash flow from mortgage loans and mortgage-backed securities portfolio
to decrease.  Deposit inflow may accelerate and be invested at higher
market interest rates.  The Company closely monitors activity in the
capital markets and takes appropriate action to ensure that the liquidity levels
are adequate for funding, investing and operating activities.




For the
nine months ended September 30, 2009, the Company generated approximately $4.9
million of cash.  During this period, the Company’s operations
provided approximately $13.0 million primarily from the sales of mortgages AFS
net of originations and the investing activities provided approximately $1.8
million from pay-downs of loans and bonds and from the sale of foreclosed
properties held-for-sale, partially offset by the acquisition of premises and
equipment.  Partially offsetting these cash generators was a use of
$9.9 million in financing activities, mostly from the pay-down of total
borrowings net of deposit growth and the payment of cash dividends to
shareholders.  As of September 30, 2009, the Company maintained $17.6
million of cash and cash equivalents, $82.4 million of investments AFS and $0.9
million of loans AFS.  In addition, as of September 30, 2009 the
Company had approximately $101.3 million available to borrow from the FHLB,
$10.0 million available from other correspondent banks, $2.3 million from the
Federal Reserve Bank Discount Window and $57.5 million from
CDARS.  This combined total of $272.0 million represented 48% of total
assets at September 30, 2009.  The Company is in the process of
renewing its relationship with a former correspondent bank, a provider of up to
$20.0 million in overnight funds availability, if needed.  The renewal
should be completed in the fourth quarter.  Management believes the
level of current and available liquidity to be strong and adequate to support
current operations.




In
October 2008, the FDIC announced the Temporary Liquidity Guarantee Program
(TLGP) to strengthen confidence and encourage liquidity in the banking
system.  Among other things, this new program provides full deposit
insurance coverage for non-interest bearing deposit transaction accounts in
FDIC-insured institutions regardless of the dollar amount.  To protect
its depositors, the Company has participated in the Transaction Account
Guarantee (TAG) component of the TLGP.  Under the TAG, all depositors
who hold funds in non-interest bearing accounts, or interest-bearing accounts
with an interest rate of 0.50% or less, including the Lawyers Trust Accounts,
will have a temporary unlimited guarantee from the FDIC which was scheduled to
expire on December 31, 2009.  To assure an orderly phase out of the
TAG component of the TLGP, the FDIC has extended the program, on a voluntary
basis to June 30, 2010.  Participation in the extended program will
require the assessment of a higher premium – from 15 to 25 basis points
depending on pre-determined risk factors assigned to financial
institutions.  To protect the deposit base, the Company has opted to
extend its participation in the TAG program.  Under the program,
through June 30, 2010, all noninterest-bearing transaction accounts will
continue to be fully guaranteed by the FDIC for the entire account
balance.  The Company, rated with the lowest tier 1 risk factor, will
be assessed 15 basis points and as a result anticipates to incur an estimated
$42,000 of additional FDIC premiums to voluntarily participate in the TAG
extension program.  Coverage under the TAG program is in addition to
and separate from coverage available under the FDIC’s general deposit insurance
rules, which insures accounts up to $250,000 until the end of 2013, unless
extended.




Capital




During
the nine months ended September 30, 2009, shareholders' equity declined
$796,000, or 2%, due principally from the net loss generated during the nine
months ended September 30, 2009, non-credit related OTTI recorded during the
third quarter, the declaration of cash dividends and a decline in the intrinsic
value of the Company’s cash flow hedge.  These items were partially
offset by a decline in the unrealized losses in the securities AFS portfolio and
issuance of common stock via the Company’s Employee Stock Purchase and Dividend
Reinvestment Plans.




As of
September 30, 2009, the Company reported a net unrealized loss of $6,993,000,
net of tax, from the securities AFS portfolio including $3,015,000 of non-credit
related OTTI recorded in 2009 from the securities AFS portfolio compared to a
net unrealized loss of $8,831,000 as of December 31, 2008.  While the
unrealized loss position has improved, the prolonged economic downturn has
created uncertainty and in certain circumstances illiquidity in the financial
and capital markets and has had a sizable negative impact on the fair value
estimates for securities in banks’ investment portfolios.  Management
believes these changes are due mainly to liquidity problems in the financial
markets and to a lesser extent the deterioration in the creditworthiness of the
issuers.  For a further discussion on the fair value determination of
the Company’s investment portfolio, see “Investment securities” under the
caption “Comparison of financial condition at September 30, 2009 and December
31, 2008” of Part 1, Item 2, “Management’s Discussion and Analysis of Financial
Condition and Results of Operations;” and notes 3 and 5, “Investment securities”
and “Fair value measurement” in the notes to the consolidated financial
statements, incorporated by reference in Part I, Item 1.


- 37
-




During
the second quarter of 2008, the Company’s Board of Directors announced its
intent to initiate a capital stock repurchase program covering up to 50,000
shares of its outstanding capital stock.  The repurchased shares would
become treasury stock and could be available for issuance under the Company’s
various stock-based compensation, employee stock purchase and dividend
reinvestment (DRP) plans and for general corporate purposes.  The
repurchases may be made from time-to-time in open-market transactions, subject
to availability, pursuant to safe harbor rule 10b-18 under the Securities
Exchange Act of 1934.  Management has suspended repurchase-plan
activity as a prudent means, in light of the current economic pressures on
banking, to preserve and grow the Company’s capital base.  Since the
program’s inception, the Company has reacquired (at $27.83 per share) and
reissued (at $21.11 per share) 17,500 shares to participants in the Company’s
DRP.




The
Company (on a consolidated basis) and the Bank are subject to various regulatory
capital requirements administered by the federal banking
agencies.  Failure to meet minimum capital requirements can initiate
certain mandatory and possible additional discretionary actions by regulators
that, if undertaken, could have a direct material effect on the Company’s and
the Bank’s financial statements.  Under capital adequacy guidelines
and the regulatory framework for prompt corrective action, the Company and the
Bank must meet specific capital guidelines that involve quantitative measures of
their assets, liabilities and certain off-balance-sheet items as calculated
under regulatory accounting practices.  The capital amounts and
classification are also subject to qualitative judgments by the regulators about
components, risk-weightings and other factors.  Prompt corrective
action provisions are not applicable to bank holding companies.




Under
these guidelines, assets and certain off-balance sheet items are assigned to
broad risk categories, each with appropriate weights.  The resulting
capital ratios represent capital as a percentage of total risk-weighted assets
and certain off-balance sheet items.  The appropriate risk-weighting,
pursuant to regulatory guidelines, required an increase in the risk-weighting of
securities that were recently rated below investment grade, thus significantly
inflating the total risk-weighted assets.  Compared to December 31,
2008, the total capital and Tier I capital ratios were reduced by the increase
in risk-weighted assets.  The guidelines require all banks and bank
holding companies to maintain a minimum ratio of total risk-based capital to
total risk-weighted assets (Total Risk Adjusted Capital) of 8%, including Tier I
capital to total risk-weighted assets (Tier I Capital) of 4% and Tier I capital
to average total assets (Leverage Ratio) of at least 4%.  As of
September 30, 2009, the Company and the Bank met all capital adequacy
requirements to which it was subject.




The
Company continues to closely monitor and evaluate alternatives to enhance its
capital ratios as the regulatory and economic environments
change.  The following table depicts the capital amounts and ratios of
the Company and the Bank as of September 30, 2009:




To
      be well capitalizedFor
      capital
                                          
                                          
                                          
                                          under
      prompt correctiveActual
                                          
                                          
                                          
                                          
                                          
                                          adequacy
      purposes
                                          
                                          
                                          
                                          action
      provisionsAmount
                                          
                                          Ratio
                                          
                                          
                                          
                                          Amount
                                          
                                          
                                          
                                          Ratio
                                          
                                          
                                          
                                          Amount
                                          
                                          
                                          RatioTotal
      capital(to
      risk-weighted assets)Consolidated
                                          
                                          $
                                          61,798,162
                                          
                                          11.3
                                          %
                                          ≥
                                          
                                          $
                                          43,786,753
                                          
                                          ≥
                                          
                                          8.0
                                          %
                                          
                                          
                                          
                                          N/A
                                          
                                          
                                          N/ABank
                                          
                                          $
                                          61,395,511
                                          
                                          11.2
                                          %
                                          ≥
                                          
                                          $
                                          43,776,532
                                          
                                          ≥
                                          
                                          8.0
                                          %
                                          ≥
                                          
                                          $
                                          54,720,665
                                          
                                          ≥
                                          10.0
                                          %Tier
      I capital(to
      risk-weighted assets)Consolidated
                                          
                                          $
                                          55,017,563
                                          
                                          10.1
                                          %
                                          ≥
                                          
                                          $
                                          21,893,377
                                          
                                          ≥
                                          
                                          4.0
                                          %
                                          
                                          
                                          
                                          N/A
                                          
                                          
                                          N/ABank
                                          
                                          $
                                          54,670,373
                                          
                                          10.0
                                          %
                                          ≥
                                          
                                          $
                                          21,888,266
                                          
                                          ≥
                                          
                                          4.0
                                          %
                                          ≥
                                          
                                          $
                                          32,832,399
                                          
                                          ≥
                                          6.0
                                          %Tier
      I capital(to
      average assets)Consolidated
                                          
                                          $
                                          55,017,563
                                          
                                          9.6
                                          %
                                          ≥
                                          
                                          $
                                          23,010,518
                                          
                                          ≥
                                          
                                          4.0
                                          %
                                          
                                          
                                          
                                          N/A
                                          
                                          
                                          N/ABank
                                          
                                          $
                                          54,670,373
                                          
                                          9.5
                                          %
                                          ≥
                                          
                                          $
                                          22,996,223
                                          
                                          ≥
                                          
                                          4.0
                                          %
                                          ≥
                                          
                                          $
                                          28,745,278
                                          
                                          ≥
                                          5.0
                                          %




Other matters – FDIC
rulemaking




On
September 29, 2009, the Board of Directors of the FDIC adopted a notice of
proposed rulemaking that would require insured institutions to prepay their
estimated quarterly risk-based assessments for the fourth quarter of 2009 and
for all of 2010, 2011 and 2012.  The FDIC also voted to adopt a
uniform three-basis point increase in assessment rates effective on January 1,
2011.  Each institution would record the entire amount of its prepaid
assessment as a prepaid expense (asset) as of December 31, 2009.  As
of December 31, 2009, and each quarter thereafter, each institution would record
an expense (charge to earnings) for its regular quarterly assessment for the
quarter and an offsetting credit to the prepaid assessment until the asset is
exhausted.  Once the asset is exhausted, the institution would record
an accrued expense payable each quarter for the assessment payment, which would
be paid in arrears to the FDIC at the end of the following
quarter.  If the prepaid assessment is not exhausted by December 30,
2014, any remaining amount would be returned to the depository
institution.


- 38
-




Item
4T.  Controls and Procedures




As of the
end of the period covered by this Quarterly Report on Form 10-Q, an evaluation
was carried out by the Company’s management, with the participation of its
Interim President and Chief Executive Officer and Chief Financial Officer, of
the effectiveness of the Company’s disclosure controls and procedures, as
defined in Rule 13a-15(e) under the Securities Exchange Act of
1934.  Based on such evaluation, the Interim President and Chief
Executive Officer and Chief Financial Officer concluded that the Company’s
disclosure controls and procedures are designed to ensure that information
required to be disclosed in the reports the Company files or furnishes under the
Securities Exchange Act of 1934 is recorded, processed, summarized and reported
within the time periods specified in the SEC’s rules and regulations, and are
operating in an effective manner.  The Company made no significant
changes in its internal controls over financial reporting or in other factors
that materially affected, or are reasonably likely to materially affect, these
controls during the last fiscal quarter ended September 30, 2009.




PART
II - Other Information




Item
1.  Legal Proceedings




The
nature of the Company’s business generates some litigation involving matters
arising in the ordinary course of business.  However, in the opinion
of the Company, after consultation with legal counsel, no legal proceedings are
pending, which, if determined adversely to the Company or the Bank, would have a
material effect on the Company’s undivided profits or financial
condition.  No legal proceedings are pending other than ordinary
routine litigation incidental to the business of the Company and the
Bank.  In addition, to management’s knowledge, no governmental
authorities have initiated or contemplated any material legal actions against
the Company or the Bank.





Item
1A.  Risk Factors




The
following are additional risk factors that should be read in conjunctions with
Item 1A, “Risk Factors” that were disclosed in the Company’s December 31, 2008
Form 10-K filed with the Securities and Exchange Commission on March 12,
2009.




The
Company may need or be compelled to raise additional capital in the future, but
that capital may not be available when it is needed and on terms favorable to
current shareholders.




Federal
banking regulators require the Company and Bank to maintain adequate levels of
capital to support their operations.  These capital levels are
determined and dictated by law, regulation and banking regulatory
agencies.  In addition, capital levels are also determined by the
Company’s management and board of directors based on capital levels that they
believe are necessary to support the Company’s business
operations.  The Company is evaluating its present and future capital
requirements and needs, is developing a comprehensive capital plan and is
analyzing capital raising alternatives, methods and options.  Even if
the Company succeeds in meeting the current regulatory capital requirements, the
Company may need to raise additional capital in the near future to support
possible loan losses during future periods or to meet future regulatory capital
requirements.





Further,
the Company’s regulators may require it to increase its capital levels. If the
Company raises capital through the issuance of additional shares of its common
stock or other securities, it would likely dilute the ownership interests of
current investors and would likely dilute the per-share book value and earnings
per share of its common stock.  Furthermore, it may have an adverse
impact on the Company’s stock price.  New investors may also have
rights, preferences and privileges senior to the Company’s current shareholders,
which may adversely impact its current shareholders.  The Company’s
ability to raise additional capital will depend on conditions in the capital
markets at that time, which are outside its control, and on its financial
performance.  Accordingly, the Company cannot assure you of its
ability to raise additional capital on terms and time frames acceptable to it or
to raise additional capital at all.  If the Company cannot raise
additional capital in sufficient amounts when needed, its ability to comply with
regulatory capital requirements could be materially
impaired.  Additionally, the inability to raise capital in sufficient
amounts may adversely affect the Company’s operations, financial condition and
results of operations.


- 39
-


If
we conclude that the decline in value of any of our investment securities is
other than temporary, we will be required to write down the credit-related
portion of the impairment of that security through a charge to
earnings.




We review
our investment securities portfolio at each quarter-end reporting period to
determine whether the fair value is below the current carrying
value.  When the fair value of any of our investment securities has
declined below its carrying value, we are required to assess whether the decline
is other than temporary.  If we conclude that the decline is other
than temporary, we will be required to write down the credit-related portion of
the impairment of that security through a charge to earnings.  As of
September 30, 2009, the book value of the Company’s pooled trust preferred
securities was $19,300,000 with an estimated fair value of
$7,839,000.  Changes in the expected cash flows of these securities
and/or prolonged price declines have resulted and may result in our concluding
in future periods that there is additional impairment of these securities that
is other than temporary, which would require a charge to earnings for the
portion of the impairment that is deemed to be-credit-related.  Due to
the complexity of the calculations and assumptions used in determining whether
an asset, such as pooled trust preferred securities, is impaired, the impairment
disclosed may not accurately reflect the actual impairment in the
future.




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




None




Item
3.  Default Upon Senior Securities




None




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




None





Item
5.  Other Information


None




Item
6.  Exhibits




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




3(i) Amended and
Restated Articles of Incorporation of Registrant.Incorporated by
reference to Annex B of the Proxy Statement/Prospectus included in Registrant’s
Amendment 4 to its Registration Statement No. 333-90273 on Form S-4, filed with
the SEC on April 6, 2000.




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




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




*10.2 1998 Stock
Incentive Plan of The Fidelity Deposit and Discount Bank, as assumed by
Registrant.Incorporated by reference to Exhibit 10.2 of Registrant’s
Registration Statement No. 333-90273 on Form S-4, filed with the SEC on November
3, 1999.




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




*10.4 Registrant’s
2000 Independent Directors Stock Option Plan.Incorporated by
reference to Exhibit 4.3 to Registrant’s Registration Statement No. 333-64356 on
Form S-8 filed with the SEC on July 2, 2001.




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




*10.6 Registrant’s
2000 Stock Incentive Plan.Incorporated by reference to
Exhibit 4.4 to Registrant’s Registration Statement No. 333-64356 on Form S-8
filed with the SEC on July 2, 2001.




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




*10.8 Registrant’s
2002 Employee Stock Purchase Plan.Incorporated by reference
to Exhibit 4.4 to Registrant’s Registration Statement No. 333-113339 on Form S-8
filed with the SEC on March 5, 2004.




*10.9 Complete
Settlement Agreement and General Release between Michael F. Marranca, Registrant
and The Fidelity Deposit and Discount Bank, dated July 30,
2004.  Incorporated by reference to Exhibit 99.1 to
Registrant’s Current Report on Form 8-K filed with the SEC on August 10,
2004.


- 40
-




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




*10.11 Change of
Control Agreements with Salvatore R. DeFrancesco, Registrant and The Fidelity
Deposit and Discount Bank, dated March 21, 2006.Incorporated
by reference to Exhibit 99.2 to Registrant’s Current Report on Form 8-K filed
with the SEC on March 27, 2006.




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




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




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




*10.15 Release
Agreement between Steven C. Ackmann, Registrant and The Fidelity Deposit and
Discount Bank, dated August 31, 2009.  Incorporated by
reference to Exhibit 99.1 to Registrant’s Current Report on Form 8-K filed with
the SEC on September 8, 2009.




*10.16 Consulting
Agreement between Steven C. Ackmann, former President and Chief Executive
Officer of the Registrant and The Fidelity Deposit and Discount Bank, and The
Fidelity Deposit and Discount Bank, dated September 1, 2009.  Incorporated by
reference to Exhibit 99.2 to Registrant’s Current Report on Form 8-K filed with
the SEC on September 8, 2009.




11Statement
regarding computation of earnings per share.  Included herein
in Note No. 4, “Earnings per share,” contained within the Notes to Consolidated
Financial Statements, and incorporated herein by reference.




31.1
      Rule 13a-14(a) Certification of Principal Executive Officer, filed
      herewith.




31.2
      Rule 13a-14(a) Certification of Principal Financial Officer, filed
      herewith.




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


as
adoptedpursuant to Section 906
of the Sarbanes-Oxley Act of 2002, filed herewith.




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


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


________________________________________________




*Management
contract or compensatory plan or arrangement.








- 41
-





FIDELITY
D & 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 the undersigned thereunto
duly authorized.





FIDELITY
      D & D BANCORP, INC.Date:
      November 12, 2009
                  /s/
      Patrick J. DempseyPatrick
      J. DempseyInterim
      President and Chief Executive OfficerDate:
      November 12, 2009
                  /s/
      Salvatore R. DeFrancesco, Jr.Salvatore
      R. DeFrancesco, Jr.,Treasurer
      and Chief Financial
Officer


- 42
-





EXHIBIT
INDEX


Page3(i)
      Amended and Restated Articles of Incorporation of Registrant.Incorporated by reference to Annex B of the Proxy
      Statement/Prospectus included in Registrant’s Amendment 4 to its
      Registration Statement No. 333-90273 on Form S-4, filed with the SEC on
      April 6, 2000.
              *3(ii)
      Amended and Restated Bylaws of Registrant.Incorporated by
      reference to Exhibit 3(ii) to Registrant’s Form 8-K filed with the SEC on
      November 21, 2007.
              *10.1 1998
      Independent Directors Stock Option Plan of The Fidelity Deposit and
      Discount Bank, as assumed by Registrant.Incorporated by reference
      to Exhibit 10.1 to Registrant’s Registration Statement No. 333-90273 on
      Form S-4, filed with the SEC on November 3, 1999.
              *10.2 1998
      Stock Incentive Plan of The Fidelity Deposit and Discount Bank, as assumed
      by Registrant.Incorporated by reference to Exhibit 10.2 of
      Registrant’s Registration Statement No. 333-90273 on Form S-4, filed with
      the SEC on November 3, 1999.
              *10.3
      Registrant’s 2000 Dividend Reinvestment
      Plan.Incorporated by reference to Exhibit 4 to
      Registrant’s Registration Statement No. 333-45668 on Form S-1, filed with
      the SEC on September 12, 2000 and as amended by Pre-Effective Amendment
      No. 1 on October 11, 2000, by Post-Effective Amendment No. 1 on May 30,
      2001, by Post-Effective Amendment No. 2 on July 7, 2005 and by
      Registration Statement No.  333-152806 on Form S-3 filed on
      August 6, 2008.
              *10.4
      Registrant’s 2000 Independent Directors Stock Option
      Plan.Incorporated by reference to Exhibit 4.3 to
      Registrant’s Registration Statement No. 333-64356 on Form S-8 filed with
      the SEC on July 2, 2001.
              *10.5
      Amendment, dated October 2, 2007, to the Registrant’s 2000 Independent
      Directors Stock Option Plan.Incorporated by reference
      to Exhibit 10.2 to Registrant’s Form 8-K filed with the SEC on October 4,
      2007.
              *10.6
      Registrant’s 2000 Stock Incentive Plan.Incorporated by
      reference to Exhibit 4.4 to Registrant’s Registration Statement No.
      333-64356 on Form S-8 filed with the SEC on July 2, 2001.
              *10.7
      Amendment, dated October 2, 2007, to the Registrant’s 2000 Stock Incentive
      Plan.Incorporated by reference to Exhibit 10.1 to
      Registrant’s Form 8-K filed with the SEC on October 4,
    2007.
              *10.8
      Registrant’s 2002 Employee Stock Purchase
      Plan.Incorporated by reference to Exhibit 4.4 to
      Registrant’s Registration Statement No. 333-113339 on Form S-8 filed with
      the SEC on March 5, 2004.
              *10.9
      Complete Settlement Agreement and General Release between Michael F.
      Marranca, Registrant and The Fidelity Deposit and Discount Bank, dated
      July 30, 2004.  Incorporated by reference to Exhibit 99.1
      to Registrant’s Current Report on Form 8-K filed with the SEC on August
      10, 2004.
              *10.10
      Amendment to the Complete Settlement Agreement and General Release between
      Michael F. Marranca, Registrant and The Fidelity Deposit and Discount
      Bank, dated November 4, 2005.Incorporated
      by reference toExhibit 99.1 to
      Registrant’s Current Report on Form 8-K filed with the SEC on November 9,
      2005.
              *10.11
      Change of Control Agreements with Salvatore R. DeFrancesco, Registrant and
      The Fidelity Deposit and Discount Bank, dated March 21,
      2006.Incorporated by reference to Exhibit 99.2 to
      Registrant’s Current Report on Form 8-K filed with the SEC on March 27,
      2006.
              *10.12
      Amended and Restated Executive Employment Agreement between Fidelity D
      & D Bancorp, Inc., The Fidelity Deposit and Discount Bank and Steven
      C. Ackmann, dated July 11, 2007.Incorporated by
      reference to Exhibit 10.1 to Registrant’s Current Report on Form 8-K filed
      with the SEC on July 13, 2007.
              *10.13
      Executive Employment Agreement between Fidelity D & D Bancorp, Inc.,
      The Fidelity Deposit and Discount Bank and Timothy
      P. O’Brien, dated January 3, 2008.Incorporated by
      reference to Exhibit 10.1 to Registrant’s Current Report on Form 8-K filed
      with the SEC on January 10, 2008.
              *10.14
      Executive Employment Agreement between Fidelity D & D Bancorp, Inc.,
      The Fidelity Deposit and Discount Bank and Daniel J. Santaniello, dated
      February 28, 2008.Incorporated by reference to Exhibit
      10.1 to Registrant’s Current Report on Form 8-K filed with the SEC on
      March 3, 2008.
              *


- 43
-





*10.15
      Release Agreement between Steven C. Ackmann, Registrant and The Fidelity
      Deposit and Discount Bank, dated August 31,
      2009.Incorporated by reference to Exhibit 99.1 to
      Registrant’s Current Report on Form 8-K filed with the SEC on September 8,
      2009.
                **10.16
      Consulting Agreement between Steven C. Ackmann, former President and Chief
      Executive Officer of the Registrant and The Fidelity Deposit and Discount
      Bank, and The Fidelity Deposit and Discount Bank, dated September 1,
      2009.  Incorporated by reference to Exhibit 99.2 to
      Registrant’s Current Report on Form 8-K filed with the SEC on September 8,
      2009.
                *11
      Statement
      regarding computation of earnings per share.
                1431.1
      Rule 13a-14(a) Certification of Principal Executive
    Officer.
                4531.2
      Rule 13a-14(a) Certification of Principal Financial
    Officer.
                4632.1
      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.
                4732.2
      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.
                48


*
Incorporated by Reference


- 44
-