**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington,D.C. 20549**

**FORM 10-Q**

**x****QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

**For thequarterly period ended June 30, 2007**

**OR**

**o****TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

**For thetransition period from               to                      **

**Commissionfile number: 333-90273**

**FIDELITYD & D BANCORP, INC.**

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

 

Address of principalexecutive offices:

**BLAKELY & DRINKER ST.**

**DUNMORE,PENNSYLVANIA 18512**

TELEPHONE:

**570-342-8281**

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subjected to such filing requirements for thepast 90 days.

xYES    oNO

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

Large accelerated filer o     Acceleratedfiler o     Non-acceleratedfiler x

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

oYES    xNO

The number of outstanding shares of Common Stock of Fidelity D & DBancorp, Inc. at July 31, 2007, the latest practicable date, was 2,067,620shares.

----

**FIDELITYD & D BANCORP, INC.**

Form 10-Q June 30,2007

Index
| **Part I. Financial  Information** |
|------------------------------------|
| ** **                         |   |
| Item 1.                            | Financial  Statements: |
|                               | Consolidated  Balance Sheets as of June 30, 2007   and December 31, 2006 |
|                               | Consolidated  Statements of Income for the three and six   months ended June 30, 2007 and 2006 |
|                               | Consolidated  Statements of Changes in Shareholders’ Equity   for the six months ended June 30, 2007 and 2006 |
|                               | Consolidated  Statements of Cash Flows for the six months   ended June 30, 2007 and 2006 |
|                               | Notes to  Consolidated Financial Statements |
|                               |   |
| Item 2.                            | Management’s  Discussion and Analysis of Financial Condition   and Results of Operations |
|                               |   |
| Item 3.                            | Quantitative  and Qualitative Disclosure about Market Risk |
|                               |   |
| Item 4.                            | Controls and  Procedures |
|                               |   |
| **Part II. Other  Information**    |
| ** **                         |   |
| Item 1.                            | Legal Proceedings |
|                               |   |
| Item 1A.                           | Risk  Factors |
|                               |   |
| Item 2.                            | Unregistered  Sales of Equity Securities and Use of Proceeds |
|                               |   |
| Item 3.                            | Defaults  Upon Senior Securities |
|                               |   |
| Item 4.                            | Submission  of Matters to a Vote of Security Holders |
|                               |   |
| Item 5.                            | Other Information |
|                               |   |
| Item 6.                            | Exhibits |
|                               |   |
| Signatures                         |
|                               |   |
| Exhibit  index                     |

 

2

----

**PART I –Financial Information**

**Item 1:Financial Statements**

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

 

ConsolidatedBalance Sheets

 
| ** **                                                                                                                                    | ** ** | **June 30, 2007** | ** **  | **December 31, 2006** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|-------------|---------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **(unaudited)**             | ** **  | **(audited)**                   | ** ** |
|                                                                                                                                          |       |                        |        |                            |       |
| Assets:                                                                                                                                       |       |                        |        |                            |       |
| Cash and due  from banks                                                                                                                      |       | $                           | 12,096,955  |                            | $          | 13,732,137 |   |
| Interest-bearing  deposits with financial institutions                                                                                        |       | 123,578                     |        | 68,711                          |       |
|                                                                                                                                          |       |                        |        |                            |       |
| Total cash and  cash equivalents                                                                                                              |       | 12,220,533                  |        | 13,800,848                      |       |
|                                                                                                                                          |       |                        |        |                            |       |
| Available-for-sale  securities                                                                                                                |       | 106,712,776                 |        | 98,841,364                      |       |
| Held-to-maturity  securities                                                                                                                  |       | 1,251,710                   |        | 1,569,372                       |       |
| Federal Home  Loan Bank Stock                                                                                                                 |       | 4,151,900                   |        | 3,795,100                       |       |
| Loans and  leases, net (allowance for loan losses of $5,294,537 in 2007 and $5,444,303  in 2006)                                              |       | 420,153,494                 |        | 417,199,048                     |       |
| Loans  available-for-sale (fair value $208,896 in 2007; $123,156 in 2006)                                                                     |       | 204,800                     |        | 122,000                         |       |
| Bank premises  and equipment, net                                                                                                             |       | 13,331,402                  |        | 11,324,465                      |       |
| Cash surrender  value of bank owned life insurance                                                                                            |       | 8,331,225                   |        | 8,177,961                       |       |
| Other assets                                                                                                                                  |       | 4,587,944                   |        | 4,788,105                       |       |
| Accrued interest  receivable                                                                                                                  |       | 2,546,684                   |        | 2,502,576                       |       |
| Foreclosed  assets held for sale                                                                                                              |       | —                      |        | 197,149                         |       |
|                                                                                                                                          |       |                        |        |                            |       |
| Total assets                                                                                                                                  |       | $                           | 573,492,468 |                            | $          | 562,317,988 |   |
|                                                                                                                                          |       |                        |        |                            |       |
| Liabilities:                                                                                                                                  |       |                        |        |                            |       |
| Deposits:                                                                                                                                     |       |                        |        |                            |       |
| Interest-bearing                                                                                                                              |       | $                           | 349,263,741 |                            | $          | 336,592,620 |   |
| Non-interest-bearing                                                                                                                          |       | 72,067,616                  |        | 73,741,975                      |       |
|                                                                                                                                          |       |                        |        |                            |       |
| Total deposits                                                                                                                                |       | 421,331,357                 |        | 410,334,595                     |       |
|                                                                                                                                          |       |                        |        |                            |       |
| Accrued interest  payable and other liabilities                                                                                               |       | 4,235,491                   |        | 4,179,170                       |       |
| Short-term  borrowings                                                                                                                        |       | 29,601,083                  |        | 33,656,150                      |       |
| Long-term debt                                                                                                                                |       | 66,125,522                  |        | 62,536,210                      |       |
|                                                                                                                                          |       |                        |        |                            |       |
| Total  liabilities                                                                                                                            |       | 521,293,453                 |        | 510,706,125                     |       |
|                                                                                                                                          |       |                        |        |                            |       |
| Shareholders’ equity:                                                                                                                    |       |                        |        |                            |       |
| Preferred stock  authorized 5,000,000 shares with no par value; none issued                                                                   |       | —                      |        | —                          |       |
| Capital stock  authorized 10,000,000 shares with no par value; issued and outstanding,  2,067,620 shares in 2007 and 2,057,433 shares in 2006 |       | 19,056,491                  |        | 18,702,537                      |       |
| Retained  earnings                                                                                                                            |       | 35,170,129                  |        | 33,874,118                      |       |
| Accumulated  other comprehensive loss                                                                                                         |       | (2,027,605                  | )           | (964,792                        | )          |
|                                                                                                                                          |       |                        |        |                            |       |
| Total  shareholders’ equity                                                                                                              |       | 52,199,015                  |        | 51,611,863                      |       |
|                                                                                                                                          |       |                        |        |                            |       |
| Total  liabilities and shareholders’ equity                                                                                              |       | $                           | 573,492,468 |                            | $          | 562,317,988 |   |

 

See notes toconsolidated financial statements

3

----

 

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

 

ConsolidatedStatements of Income

(unaudited)

 
| ** **                                             | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                             | ** ** | **June 30, 2007**      | ** ** | **June 30, 2006**    | ** ** | **June 30, 2007** | ** ** | **June 30, 2006** | ** ** |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Interest income:                                       |       |                             |       |                           |       |   |   |   |   |
| Loans and leases:                                      |       |                             |       |                           |       |   |   |   |   |
| Taxable                                                |       | $                                | 7,141,888  |                           | $          | 6,879,670 |   | $ | 14,316,917 |   | $ | 13,378,288 |   |
| Nontaxable                                             |       | 118,352                          |       | 121,462                        |       | 227,869 |   | 253,620 |   |
| Interest-bearing deposits with financial  institutions |       | 1,929                            |       | 2,239                          |       | 4,721 |   | 4,776 |   |
| Investment securities:                                 |       |                             |       |                           |       |   |   |   |   |
| U.S. government agency and corporations                |       | 1,016,972                        |       | 986,083                        |       | 1,936,260 |   | 1,871,265 |   |
| States and political subdivisions (nontaxable)         |       | 124,512                          |       | 150,274                        |       | 249,351 |   | 291,318 |   |
| Other securities                                       |       | 280,523                          |       | 230,802                        |       | 526,422 |   | 429,212 |   |
| Federal funds sold                                     |       | 202                              |       | 638                            |       | 54,654 |   | 36,126 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Total interest income                                  |       | 8,684,378                        |       | 8,371,168                      |       | 17,316,194 |   | 16,264,605 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Interest  expense:                                     |       |                             |       |                           |       |   |   |   |   |
| Deposits                                               |       | 3,222,678                        |       | 2,750,117                      |       | 6,556,701 |   | 5,147,023 |   |
| Securities sold under repurchase agreements            |       | 115,576                          |       | 163,426                        |       | 231,033 |   | 298,875 |   |
| Other short-term borrowings and other                  |       | 260,939                          |       | 162,229                        |       | 334,012 |   | 224,191 |   |
| Long-term debt                                         |       | 762,629                          |       | 1,029,972                      |       | 1,567,702 |   | 2,098,783 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Total interest expense                                 |       | 4,361,822                        |       | 4,105,744                      |       | 8,689,448 |   | 7,768,872 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Net interest  income                                   |       | 4,322,556                        |       | 4,265,424                      |       | 8,626,746 |   | 8,495,733 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Provision for  loan losses                             |       | —                           |       | 175,000                        |       | — |   | 250,000 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Net interest  income after provision for loan losses   |       | 4,322,556                        |       | 4,090,424                      |       | 8,626,746 |   | 8,245,733 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Other income:                                          |       |                             |       |                           |       |   |   |   |   |
| Service charges on deposit accounts                    |       | 761,922                          |       | 635,054                        |       | 1,394,239 |   | 1,266,781 |   |
| Gain (loss) on sale of:                                |       |                             |       |                           |       |   |   |   |   |
| Loans                                                  |       | 31,171                           |       | 26,858                         |       | 67,896 |   | 41,843 |   |
| Investment securities                                  |       | —                           |       | 2                              |       | — |   | (166 | ) |
| Premises and equipment                                 |       | (22,924                          | )          | —                         |       | 73,633 |   | 1,560 |   |
| Leased assets                                          |       | —                           |       | 100                            |       | — |   | 15,154 |   |
| Foreclosed assets held for sale                        |       | 127,621                          |       | 216                            |       | 142,749 |   | 621 |   |
| Fees and other service charges                         |       | 431,324                          |       | 421,722                        |       | 864,260 |   | 886,984 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Total other income                                     |       | 1,329,114                        |       | 1,083,952                      |       | 2,542,777 |   | 2,212,777 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Other expenses:                                        |       |                             |       |                           |       |   |   |   |   |
| Salaries and employee benefits                         |       | 2,165,352                        |       | 1,974,057                      |       | 4,300,329 |   | 3,980,871 |   |
| Premises and equipment                                 |       | 784,285                          |       | 823,559                        |       | 1,590,110 |   | 1,624,410 |   |
| Advertising                                            |       | 183,620                          |       | 159,904                        |       | 342,625 |   | 288,277 |   |
| Other                                                  |       | 954,296                          |       | 990,629                        |       | 1,967,532 |   | 1,977,341 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Total other expenses                                   |       | 4,087,553                        |       | 3,948,149                      |       | 8,200,596 |   | 7,870,899 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Income before  provision for income taxes              |       | 1,564,117                        |       | 1,226,227                      |       | 2,968,927 |   | 2,587,611 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Provision for  income taxes                            |       | 405,384                          |       | 287,607                        |       | 765,843 |   | 617,360 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Net income                                             |       | $                                | 1,158,733  |                           | $          | 938,620 |   | $ | 2,203,084 |   | $ | 1,970,251 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Per share data:                                        |       |                             |       |                           |       |   |   |   |   |
| Net income - basic                                     |       | $                                | 0.56       |                           | $          | 0.45 |   | $ | 1.07 |   | $ | 0.96 |   |
| Net income - diluted                                   |       | $                                | 0.56       |                           | $          | 0.45 |   | $ | 1.07 |   | $ | 0.96 |   |
| Dividends                                              |       | $                                | 0.22       |                           | $          | 0.22 |   | $ | 0.44 |   | $ | 0.44 |   |

 

See Notes toConsolidated Financial Statements

4

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

 

ConsolidatedStatements of Changes in Shareholders’ Equity

For the six months endedJune 30, 2007 and 2006

 
| ** **                                                                                                                     | ** ** | ** **             | ** ** | ** **   | ** ** | ** **        | ** ** | **Accumulated**        | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|--------------|------------|-------------------|------------|------------------------|------------|------------|------------|
| ** **                                                                                                                     | ** ** | ** **             | ** ** | ** **   | ** ** | ** **        | ** ** | **other**              | ** ** | ** ** | ** ** |
| ** **                                                                                                                     | ** ** | **Capital stock** | ** ** | **Retained** | ** ** | **comprehensive** | ** ** | ** **             | ** ** |
| ** **                                                                                                                     | ** ** | **Shares**             | ** ** | **Amount**   | ** ** | **earnings**      | ** ** | **income (loss)** | ** ** | **Total**  | ** ** |
|                                                                                                                           |       |                   |       |         |       |              |       |                   |       |       |       |
| Balance,  December 31, 2005 (audited)                                                                                          |       | 1,854,217              |       | $            | 10,594,901 |              | $          | 39,363,461             |       | $          | (1,112,333 | ) | $ | 48,846,029 |   |
| Cumulative  effect of change in accounting principle, net of tax                                                               |       |                   |       |         |       | (343,717          | )          |                   |       | (343,717   | )          |
| Total  comprehensive income:                                                                                                   |       |                   |       |         |       |              |       |                   |       |       |       |
| Net income                                                                                                                     |       |                   |       |         |       | 1,970,251         |       |                   |       | 1,970,251  |       |
| Change in net unrealized holding losses on  available-for-sale securities, net of reclassification adjustment and tax  effects |       |                   |       |         |       |              |       | (1,235,511             | )          | (1,235,511 | )          |
| Comprehensive income                                                                                                           |       |                   |       |         |       |              |       |                   |       | 734,740    |       |
| Issuance of  common stock through Employee Stock Purchase Plan                                                                 |       | 1,571                  |       | 48,151       |       |              |       |                   |       | 48,151     |       |
| Dividends  reinvested through Dividend Reinvestment Plan                                                                       |       | 7,638                  |       | 283,819      |       |              |       |                   |       | 283,819    |       |
| Stock-based  compensation expense                                                                                              |       |                   |       | 28,744       |       |              |       |                   |       | 28,744     |       |
| Cash dividends  declared                                                                                                       |       |                   |       |         |       | (898,916          | )          |                   |       | (898,916   | )          |
| Stock dividend  declared                                                                                                       |       | 185,394                |       | 7,462,100    |       | (7,469,548        | )          |                   |       | (7,448     | )          |
|                                                                                                                           |       |                   |       |         |       |              |       |                   |       |       |       |
| Balance, June  30, 2006 (unaudited)                                                                                            |       | 2,048,820              |       | $            | 18,417,715 |              | $          | 32,621,531             |       | $          | (2,347,844 | ) | $ | 48,691,402 |   |
|                                                                                                                           |       |                   |       |         |       |              |       |                   |       |       |       |
| Balance,  December 31, 2006 (audited)                                                                                          |       | 2,057,433              |       | $            | 18,702,537 |              | $          | 33,874,118             |       | $          | (964,792   | ) | $ | 51,611,863 |   |
| Total  comprehensive income:                                                                                                   |       |                   |       |         |       |              |       |                   |       |       |       |
| Net income                                                                                                                     |       |                   |       |         |       | 2,203,084         |       |                   |       | 2,203,084  |       |
| Change in net unrealized holding losses on  available-for-sale securities, net of reclassification adjustment and tax  effects |       |                   |       |         |       |              |       | (1,034,092             | )          | (1,034,092 | )          |
| Change in cash flow hedge intrinsic value                                                                                      |       |                   |       |         |       |              |       | (28,721                | )          | (28,721    | )          |
| Comprehensive income                                                                                                           |       |                   |       |         |       |              |       |                   |       | 1,140,271  |       |
| Issuance of  common stock through Employee Stock Purchase Plan                                                                 |       | 2,266                  |       | 67,820       |       |              |       |                   |       | 67,820     |       |
| Dividends  reinvested through Dividend Reinvestment Plan                                                                       |       | 7,921                  |       | 279,176      |       |              |       |                   |       | 279,176    |       |
| Stock-based  compensation expense                                                                                              |       |                   |       | 6,958        |       |              |       |                   |       | 6,958      |       |
| Cash dividends  declared                                                                                                       |       |                   |       |         |       | (907,073          | )          |                   |       | (907,073   | )          |
|                                                                                                                           |       |                   |       |         |       |              |       |                   |       |       |       |
| Balance, June 30, 2007  (unaudited)                                                                                            |       | 2,067,620              |       | $            | 19,056,491 |              | $          | 35,170,129             |       | $          | (2,027,605 | ) | $ | 52,199,015 |   |

 

See Notes to ConsolidatedFinancial Statements

5

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

 

ConsolidatedStatements of Cash Flows

(unaudited)

 
| ** **                                                                         | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                         | ** ** | **June 30, 2007**    | ** ** | **June 30, 2006** | ** ** |
|                                                                               |       |                           |       |   |   |
| Cash flows from  operating activities:                                             |       |                           |       |   |   |
| Net income                                                                         |       | $                              | 2,203,084  |   | $ | 1,970,251 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities: |       |                           |       |   |   |
| Depreciation, amortization and accretion                                           |       | 586,199                        |       | 669,504 |   |
| Provision for loan losses                                                          |       | —                         |       | 250,000 |   |
| Deferred income tax (benefit) expense                                              |       | (67,626                        | )          | 32,967 |   |
| Stock-based compensation expense                                                   |       | 6,958                          |       | 28,744 |   |
| Loss from investment in limited partnership                                        |       | 40,200                         |       | 45,000 |   |
| Proceeds from sale of loans available-for-sale                                     |       | 7,285,804                      |       | 4,905,215 |   |
| Originations of loans available-for-sale                                           |       | (7,300,708                     | )          | (4,630,167 | ) |
| Increase in cash surrender value of life insurance                                 |       | (153,264                       | )          | (141,133 | ) |
| Net gain on sale of loans                                                          |       | (67,896                        | )          | (41,843 | ) |
| Net loss on sale of investment securities                                          |       | —                         |       | 166 |   |
| Net gain on sale of foreclosed assets held-for-sale                                |       | (142,749                       | )          | (621 | ) |
| Net gain on disposal of premises and equipment                                     |       | (73,633                        | )          | (1,560 | ) |
| Change in:                                                                         |       |                           |       |   |   |
| Accrued interest receivable                                                        |       | (44,108                        | )          | (631,911 | ) |
| Other assets                                                                       |       | (72,481                        | )          | (235,411 | ) |
| Accrued interest payable and other liabilities                                     |       | 57,131                         |       | 15,860 |   |
|                                                                               |       |                           |       |   |   |
| Net cash provided by operating activities                                          |       | 2,256,911                      |       | 2,235,061 |   |
|                                                                               |       |                           |       |   |   |
| Cash flows from  investing activities:                                             |       |                           |       |   |   |
| Held-to-maturity securities:                                                       |       |                           |       |   |   |
| Proceeds from maturities, calls and principal  pay-downs                           |       | 317,077                        |       | 210,027 |   |
| Available-for-sale securities:                                                     |       |                           |       |   |   |
| Proceeds from sales                                                                |       | —                         |       | 1,537,337 |   |
| Proceeds from maturities, calls and principal  pay-downs                           |       | 7,476,006                      |       | 3,247,531 |   |
| Purchases                                                                          |       | (16,764,629                    | )          | (22,776,490 | ) |
| Net (increase) decrease in FHLB stock                                              |       | (356,800                       | )          | 69,800 |   |
| Net increase in loans and leases                                                   |       | (3,199,446                     | )          | (14,906,819 | ) |
| Proceeds from sale of premises and equipment                                       |       | 247,008                        |       | 1,560 |   |
| Acquisition of bank premises and equipment                                         |       | (2,111,460                     | )          | (419,654 | ) |
| Proceeds from sale of foreclosed assets  held-for-sale                             |       | 584,088                        |       | 39,711 |   |
|                                                                               |       |                           |       |   |   |
| Net cash used in investing activities                                              |       | (13,808,156                    | )          | (32,996,997 | ) |
|                                                                               |       |                           |       |   |   |
| Cash flows from  financing activities:                                             |       |                           |       |   |   |
| Net increase in deposits                                                           |       | 10,996,762                     |       | 43,356,715 |   |
| Net (decrease) increase in short-term borrowings                                   |       | (4,055,067                     | )          | 2,886,109 |   |
| Repayments of long-term debt                                                       |       | (16,410,688                    | )          | (15,379,437 | ) |
| Proceeds from long-term debt advances                                              |       | 20,000,000                     |       | — |   |
| Proceeds from employee stock purchase plan                                         |       | 67,820                         |       | 48,151 |   |
| Dividends paid, net of dividends reinvested                                        |       | (627,897                       | )          | (615,097 | ) |
| Cash payments in lieu of fractional shares on stock  dividend                      |       | —                         |       | (7,448 | ) |
|                                                                               |       |                           |       |   |   |
| Net cash provided by financing activities                                          |       | 9,970,930                      |       | 30,288,993 |   |
|                                                                               |       |                           |       |   |   |
| Net decrease in  cash and cash equivalents                                         |       | (1,580,315                     | )          | (472,943 | ) |
|                                                                               |       |                           |       |   |   |
| Cash and cash  equivalents, beginning                                              |       | 13,800,848                     |       | 12,594,540 |   |
|                                                                               |       |                           |       |   |   |
| Cash and cash  equivalents, ending                                                 |       | $                              | 12,220,533 |   | $ | 12,121,597 |   |

 

See notes to consolidated financial statements

6

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

**Notes toConsolidated Financial Statements**

**(unaudited)**

**1.      Nature ofoperations and critical accounting policies**

# **Nature of operations**

# The Fidelity Deposit andDiscount Bank (the Bank) is a commercial bank chartered in the Commonwealth ofPennsylvania 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 providesuperior customer service, while offering a full range of banking products andfinancial and trust services, to both our consumer and commercial customersfrom our main office located in Dunmore and other branches throughoutLackawanna and Luzerne counties.

# **Principles of consolidation**

# The accompanying unauditedconsolidated financial statements of the Company and the Bank have beenprepared in accordance with accounting principles generally accepted in theUnited States of America (GAAP) for interim financial information and with theinstructions to this Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of theinformation and footnote disclosures required by GAAP for complete financialstatements.  In the opinion ofmanagement, all normal recurring adjustments necessary for a fair presentationof the financial condition and results of operations for the periods have beenincluded.  All significant inter-companybalances and transactions have been eliminated in consolidation.  Prior period amounts are reclassified whennecessary to conform to the current period’s presentation.

The preparation offinancial statements in conformity with GAAP requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reported periods.  Actualresults could differ from those estimates. For additional information and disclosures required under GAAP, refer tothe Company’s Annual Report on Form 10-K for the year ended December 31, 2006.

Management is responsiblefor the fairness, integrity and objectivity of the unaudited financialstatements included in this report. Management prepared the unaudited financial statements in accordancewith GAAP.  In meeting its responsibilityfor the financial statements, management depends on the Company’s accountingsystems and related internal controls. These systems and controls are designed to provide reasonable, but notabsolute, assurance that the financial records accurately reflect thetransactions of the Company, the Company’s assets are safeguarded and that thefinancial statements present fairly the financial condition and results ofoperations of the Company.

In the opinion ofmanagement, the consolidated balance sheets as of June 30, 2007 and December31, 2006 and the related consolidated statements of income for the three- andsix-month periods ended June 30, 2007 and 2006 and changes in shareholders’equity and cash flows for the six months ended June 30, 2007 and 2006 presentfairly the financial condition and results of operations of the Company.  All material adjustments required for a fairpresentation have been made.  Theseadjustments are of a normal recurring nature.

This Quarterly Report onForm 10-Q should be read in conjunction with the Company’s audited financialstatements for the year ended December 31, 2006, and the notes includedtherein, included within the Company’s Annual Report filed on Form 10-K.

# **Critical accounting policies**

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

A materialestimate that is particularly susceptible to significant change is thedetermination of the allowance for loan losses (the allowance).  Management believes that the allowance, as ofJune 30, 2007, is adequate and reasonable. Given the subjective nature of identifying and valuing loan losses, itis likely that well-informed individuals could make materially differentassumptions, and could, therefore, calculate a materially different allowancevalue.  While management uses availableinformation to recognize losses on loans, changes in economic conditions maynecessitate revisions in the future.  Inaddition, various regulatory agencies, as an integral part of their examinationprocess, periodically review the Company’s allowance.  Such agencies may require the Company torecognize adjustments to the allowance based on their judgments of informationavailable to them at the time of their examination.

7

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Another material estimateis the calculation of fair values of the Company’s investment securities.  The Company receives estimated fair values ofinvestment securities from an independent valuation service.  In developing these fair values, thevaluation service uses estimates of cash flows, based on historical performanceof similar instruments in similar interest rate environments.  Based on experience, management is aware thatestimated fair values of investment securities tend to vary among valuationservices.  Accordingly, when sellinginvestment securities, management may obtain price quotes from more than onesource.  Available-for-sale (AFS)securities are carried at fair value on the consolidated balance sheet, withunrealized gains and losses, net of income tax, reported separately withinshareholders’ equity through accumulated other comprehensive income (loss).

The fair value ofresidential mortgage loans, classified as AFS, is obtained from the FederalNational Mortgage Association or the Pennsylvania Housing FinanceAuthority.  To determine the fair valueof student loans, classified as AFS, the Bank uses the pricing obtained fromthe most recent student loans sold from its AFS portfolio.  From time-to-time, the Bank may originateSmall Business Administration (SBA) loans AFS. The fair value of SBA loans, classified as AFS, is obtained from anoutside pricing source.  The market towhich the Bank sells mortgage and other loans is restricted and price quotesfrom other sources are not typically obtained. As of June 30, 2007, the AFS loan portfolio consisted of residentialmortgages.

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

Basic earnings pershare (EPS) is computed by dividing income available to common shareholders bythe weighted-average number of common stock outstanding for the period.  Diluted EPS is computed in the same manner asbasic EPS but reflects the potential dilution that could occur if stock optionsto issue additional common stock were exercised, which would then result inadditional stock outstanding to share in or dilute the earnings of theCompany.  The Company maintains twoshare-based compensation plans that may generate additional potential dilutivecommon shares. Generally, dilution would occur if Company-issued stock optionswere exercised and converted into common stock.

In the computationof diluted EPS, the Company uses the treasury stock method to determine thedilutive effect of its granted but unexercised stock options.  Under this method, the assumed proceedsreceived from shares issued, in a hypothetical stock option exercise, are assumedto be used to purchase treasury stock. Pursuant to the guidance of Statement of Financial Accounting Standard(SFAS) No. 128, *Earnings Per Share,* proceedsinclude: proceeds from the exercise of outstanding stock options; compensationcost for future service that the Company has not yet recognized; and any“windfall” tax benefits that would be credited directly to shareholders’ equitywhen the grant generates a tax deduction (or a reduction in proceeds if thereis a charge to equity).  For a further discussionon the Company’s stock option plans, see Note 3, below.

The followingtable illustrates the data used in computing basic EPS and a reconciliation toderive at the components of diluted EPS for the periods indicated:
| Six months ended June 30,                 | ** ** | **2007**  | ** ** | **2006**  | ** ** |
|---------------------------------------------------------------|------------|-----------|------------|-----------|------------|
| Basic EPS:                                                    |       |      |       |      |       |
|                                                          |       |      |       |      |       |
| Net income  available to common shareholders                  |       | $         | 2,203,084  |      | $          | 1,970,251 |   |
|                                                          |       |      |       |      |       |
| Weighted-average  common shares outstanding                   |       | 2,062,416 |       | 2,043,865 |       |
|                                                          |       |      |       |      |       |
| Basic EPS                                                     |       | $         | 1.07       |      | $          | 0.96 |   |
|                                                          |       |      |       |      |       |
| Diluted EPS:                                                  |       |      |       |      |       |
|                                                          |       |      |       |      |       |
| Net income  available to common shareholders                  |       | $         | 2,203,084  |      | $          | 1,970,251 |   |
|                                                          |       |      |       |      |       |
| Weighted-average  common shares outstanding                   |       | 2,062,416 |       | 2,043,865 |       |
|                                                          |       |      |       |      |       |
| Dilutive  potential common shares                             |       | 1,080     |       | 2,024     |       |
|                                                          |       |      |       |      |       |
| Weighted-average  common shares and dilutive potential shares |       | 2,063,496 |       | 2,045,889 |       |
|                                                          |       |      |       |      |       |
| Diluted EPS                                                   |       | $         | 1.07       |      | $          | 0.96 |   |

 

8

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

The Company usesthe fair value method of accounting for stock-based compensation provided underSFAS 123R, *Share Based Payment*.  SFAS 123R requires that the cost ofshare-based payment transactions (including those with employees andnon-employees) be recognized in the financial statements.  SFAS 123R applies to all share-based paymenttransactions in which an entity acquires goods or services by issuing (oroffering to issue) its shares, share options, or other equity instruments(except for those held by an ESOP) or by incurring liabilities (1) in amountsbased (even in part) on the price of the entity’s shares or other equityinstruments, or (2) that require (or may require) settlement by the issuance ofan entity’s shares or other equity instruments.

The Company has twostock-based compensation plans (the stock option plans).  The stock option plans wereshareholder-approved and permit the grant of share-based compensation awards toits directors, key officers and certain other employees.  The Company believes that these stock optionplans better align the interest of its directors, key officers and employeeswith the interest of its shareholders. The Company further believes that the granting of share-based awards,under the provisions of the stock option plans, is necessary to retain theknowledge base, continuity and expertise of its directors, key officers andcertain employees.

The Company establishedthe 2000 Independent Directors Stock Option Plan and has reserved 55,000 sharesof its un-issued capital stock for issuance under the plan.  Under the 2000 Independent Directors StockOption Plan, each outside director is awarded stock options to purchase 500shares of the Company’s common stock on the first business day of January, eachyear, at the fair market value on date of grant.  No stock options were awarded during thefirst six months of 2007 or for the year ended December 31, 2006, due to thedirectors’ voluntary election to forego the award.  At June 30, 2007 there were 14,850unexercised stock options outstanding under this plan.

The Company has alsoestablished the 2000 Stock Incentive Plan and has reserved 55,000 shares of itsun-issued capital stock for issuance under the plan.  Under the 2000 Stock Incentive Plan, keyofficers and certain other employees are eligible to be awarded qualified stockoptions to purchase the Company’s common stock at the fair market value on thedate of grant.  No stock options wereawarded during the first six months of 2007. During the first six months of 2006, 2,200 stock options were issuedunder this plan at a grant-date fair value of $6.21 per share.  The options vest over a six month period andfor the six months ended June 30, 2006 approximately $14,000 of stock-basedcompensation expense was recorded and is included as a component of salariesand employee benefits in the consolidated statements of income.  As of June 30, 2007, there were 5,830 unexercisedstock options outstanding under this plan.

In addition to thetwo stock option plans above, the Company has established the 2002 EmployeeStock Purchase Plan (the ESPP) and has reserved 110,000 shares of its un-issuedcapital stock for issuance under the plan. The plan was designed to promote broad-based employee ownership of theCompany’s stock.  Under the 2002 ESPP,employees may have automatic payroll deductions to purchase the Company’scapital stock at a discounted price based on the fair market value of theCompany’s capital stock on either the commencement date or terminationdate.  At June 30, 2007, 8,317 shareshave been issued under the ESPP.  TheESPP is considered a compensatory plan and, as such, is required to comply withthe provisions of SFAS 123R.  The Companyrecognizes compensation expense on its ESPP Plan on the date the shares arepurchased.  For the six months ended June30, 2007 and 2006, compensation expense related to the ESPP approximated $7,000and $15,000, respectively, and is included as a component of salaries andemployee benefits in the consolidated statements of income.

**4.****      Derivative instruments**

As part of the Company’soverall interest rate risk management strategy, the Company has adopted apolicy whereby the Company may periodically use derivative instruments tominimize significant fluctuations in earnings caused by interest ratevolatility.  This interest rate riskmanagement strategy entails the use of interest rate floors, caps andswaps.  During the fourth quarter of2006, the Company entered into a three-year interest rate floor derivativeagreement on $20,000,000 notional value of its prime-based loan portfolio.  The transaction required the payment of apremium by the Company to the seller for the right to receive payments in theevent national prime drops below a pre-determined level (strike rate),essentially converting floating rate loans to fixed rate loans when prime dropsbelow the contractual strike rate.  Whenpurchased, the Company recorded an asset representing the fair value of thehedge at the time of purchase.  TheCompany has designated this agreement as a cash flow hedge pursuant to SFAS No.133.  Accordingly, the change in the fairvalue of the instrument related to the hedge’s intrinsic value, orapproximately -$29,000, is recorded as a component of other comprehensiveincome (OCI) in the consolidated statement of changes in shareholders’ equityand the portion of the change in fair value related to the time valueexpiration, or approximately $74,000, is recorded in the consolidatedstatements of income as a reduction of interest income for the six months endedJune 30, 2007.  No gain or loss has beenrecognized in earnings due to hedge ineffectiveness as of June 30, 2007.  As of June 30, 2007, the Company does notexpect to reclassify any amount from OCI to earnings over the next twelvemonths and no hedge has been discontinued. Also, as of June 30, 2007, the fair value of the derivative contractapproximated $122,000 and is a component of other assets in the consolidatedbalance sheet.

9

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**5.****      Recent accounting pronouncements**

In July 2006, theFinancial Accounting Standards Board (FASB) issued Interpretation No. 48, *Accounting for Uncertainty in Income Taxes—an interpretation of FASBStatement No. 109* (FIN 48). FIN 48 clarifies the accounting for uncertainty in income taxesrecognized in an enterprise’s financial statements in accordance with FASBStatement 109, *Accounting for Income Taxes*.  FIN 48 is effective for the year endingDecember 31, 2007.

The Company adopted FIN48 during the first quarter of 2007 and has evaluated its material taxpositions as of June 30, 2007.  Theadoption of FIN 48 does not have an immediate effect on its consolidatedfinancial statements.  Under the“more-likely-than-not” threshold guidelines, the Company believes nosignificant uncertain tax positions exist, either individually or in theaggregate, that would give rise to the non-recognition of an existing taxbenefit.  In periods subsequent to June30, 2007, determinations of potentially adverse material tax positions will beevaluated to determine whether an uncertain tax position may have previouslyexisted or has been originated.  In theevent an adverse tax position is determined to exist, penalty and interest willbe accrued, in accordance with the Internal Revenue Service guidelines, andrecorded as a component of other expenses in the Company’s consolidatedstatements of income.

As of June 30, 2007,there were no unrecognized tax benefits that, if recognized, wouldsignificantly affect the Company’s effective tax rate.  Also, as of June 30, 2007, there were nopenalties and interest recognized in the consolidated statements of income as aresult of the adoption of FIN 48, nor does the Company foresee a change in itsmaterial tax positions that would give rise to the non-recognition of anexisting tax benefit during the forthcoming twelve months.

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

The following ismanagement’s discussion and analysis of the significant changes in theconsolidated financial condition of the Company as of June 30, 2007 compared toDecember 31, 2006 and the results of operations for the three and six monthsended June 30, 2007 and 2006.  Currentperformance may not be indicative of future results.  This discussion should be read in conjunctionwith the Company’s 2006 Annual Report filed on Form 10-K.

**Forward-looking statements**

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

Forward-lookingstatements are based on various assumptions and analyses made by us in light ofmanagement’s experience and its perception of historical trends, currentconditions and expected future developments, as well as other factorsmanagement believes are appropriate under the circumstances.  These statements are not guarantees of futureperformance and are subject to risks, uncertainties and other factors (many ofwhich are beyond our control) that could cause actual results to differmaterially from future results expressed or implied by such forward-lookingstatements.  These factors include,without limitation, the following:

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

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

·                  changesin the interest rate environment may reduce interest margins;

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

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

10

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

·                  legislativeor regulatory changes may adversely affect our business;

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

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

·                  actsof war or terrorism; or

·                  naturaldisaster.

Management cautionsreaders not to place undue reliance on forward-looking statements, whichreflect analyses only as of the date of this document.  We have no obligation to update anyforward-looking statements to reflect events or circumstances after the date ofthis document.

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

**General**

The Company’s principalrevenues are derived from interest, dividends and fees earned on its interest-earningassets, which are comprised of loans, securities and other short-terminvestments.  The Company’s principalexpenses consist of interest paid on its interest-bearing liabilities, whichare comprised of deposits, short- and long-term borrowings and operating andgeneral expenses.  The Company’sprofitability depends primarily on its net interest income. Net interest incomeis the difference between interest income and interest expense.  Interest income is generated from yields oninterest-earning assets which consist principally of loans and investmentsecurities. Interest expense is incurred from rates paid on interest-bearingliabilities, which consist of deposits and borrowings. Net interest income isdependent upon the interest-rate spread (i.e., the difference between theyields earned on its interest-earning assets and the rates paid on itsinterest-bearing liabilities) and the relative amounts of interest-earningassets and interest-bearing liabilities. The interest rate spread is significantly impacted by: changes ininterest rates and market yield curves and their related impact on cash flows;the composition and characteristics of interest-earning assets andinterest-bearing liabilities; differences in the maturity and re-pricingcharacteristics of assets compared to the maturity and re-pricingcharacteristics of the liabilities that fund them and by the competition in ourmarketplace.

The Company’sprofitability is also affected by the level of its non-interest income andexpenses, provision for loan losses and provision for income taxes.  Non-interest income consists mostly ofservice charges on the Bank’s loan and deposit products, trust and assetmanagement service fees, increases in the cash surrender value of the bankowned life insurance (BOLI), net gains or losses from sales of loans andsecurities AFS and from the sales of other real estate (ORE) properties.  Non-interest expense consists of compensationand related employee benefit expenses, occupancy, equipment, data processing,advertising, marketing, professional fees, insurance and other operatingoverhead.

The Company’sprofitability is significantly affected by general economic and competitiveconditions, changes in market interest rates, government policies and actionsof regulatory authorities.  The Company’sloan portfolio is comprised principally of commercial and commercial realestate loans.  The properties underlyingthe Company’s mortgages are concentrated in Northeastern Pennsylvania.  Credit risk, which represents the possibilityof the Company not recovering amounts due from its borrowers, is significantlyrelated to local economic conditions in the areas the properties are located aswell as the Company’s underwriting standards. Economic conditions affect the market value of the underlying collateralas well as the levels of adequate cash flow and revenue generation fromincome-producing commercial and multi-family properties.

11

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**COMPARISONOF RESULTS OF OPERATIONS**

**THREE AND SIX MONTHS ENDED JUNE 30, 2007 AND JUNE30, 2006**

**Overview**

Net income for the secondquarter of 2007 was $1,159,000, or a 23% increase compared to $939,000 recordedin the same quarter in 2006.  Dilutedearnings per share were $0.56 and $0.45 for each of the respective periods.  For the six months ended June 30, 2007, netincome was $2,203,000, or $1.07 per share compared to $1,970,000, or $0.96 pershare for the six months ended June 30, 2006. The increase in net income for both the quarter and six months ended June30, 2007, compared to the prior year periods, was the result of increases innet interest income, non-interest income and a decrease in the provision forloan losses, partially offset by increases in non-interest expense and theprovision for income taxes.

The increases in netincome was the primary cause of the improvement in return on average assets(ROA) and return on average shareholders’ equity (ROE) to 0.82% and 8.79%,respectively, for the three months ended June 30, 2007 compared to 0.66% and7.66%, respectively, for the same period in 2006.  For the six months ended June 30, 2007, ROAand ROE were 0.78% and 8.46% compared to 0.70% and 8.08% for the first half of2006.

*Netinterest income and interest sensitive assets / liabilities*

Net interest incomeincreased $57,000 to $4,322,000 for the second quarter of 2007, from $4,265,000recorded in the same period of 2006.  Theincrease was partially due to the restoration of some large commercial loansfrom non-performing to performing status during the second half of 2006.  During the second quarter of 2007, the yieldon the commercial loan portfolio increased 29 basis points compared to thesecond quarter of 2006.  In addition, allother categories of earning assets were either originated or re-priced athigher rates in the second quarter of 2007 compared to the second quarter of2006.  Compared to the second quarter of2006, the yield on interest-earning assets increased 32 basis points during thesecond 2007 quarter.  As a result, totalinterest income increased $313,000, or 4%, during the three months ended June30, 2007, compared to the three months ended June 30, 2006.  Partially offsetting the effect interestrates had on interest-earning assets was an increase in interest expense of$256,000, or 6%, caused mostly by increases in rates paid on interest-bearingdeposits.  The blended rate paid on allinterest-bearing deposits increased 48 basis points in the current year quartercompared to the comparative quarter of 2006. The increase in rates paid was due to deposit-gathering strategies andcompetitive pressure in conjunction with the prolonged inverted-shaped interestrate yield curve.  The average balance oftotal interest-bearing deposits increased $6,800,000 during the second quarterof 2007 compared to the same quarter of 2006 and is also $4,200,000 higher onaverage than the average for the full year 2006.  The Bank will continue its quest to raisedeposit levels and reduce its dependency on borrowings.  Interest expense on borrowings and repurchaseagreements declined $216,000 in the second quarter of 2007, compared to thesecond quarter of 2006, due mostly to an $18,500,000 decline in the averagebalances.

During the second quarterof 2007, the Bank’s tax-equivalent margin and spread were 3.34% and 2.63%,respectively, compared to 3.26% and 2.64% during the second quarter of2006.  The decline in spread was frominterest costs outpacing the yields earned on assets.  The eight basis point improvement in marginis from higher net interest income on a lower level of interest-earning assetsin the second quarter of 2007 compared to the second quarter of 2006.

Similar to the secondquarter comparisons, the Bank’s tax-equivalent margin and spread for the sixmonths ended June 30, 2007 were 3.35% and 2.65%, respectively, compared to3.30% and 2.70% during the same period for 2006.  The decline in spread was from interest costsoutpacing the yields earned on assets. The cost of interest-bearing deposits increased 67 basis points duringthe first half of 2007 compared to the first half of 2006.  However, success in deposit gatheringstrategies has resulted in a $15,700,000 increase in average balances ofinterest-bearing deposits and enabled the Bank to reduce its position onhigh-cost borrowings by $22,600,000 on average. As a result, interest expense increased $921,000, or 12%, for the sixmonths ended June 30, 2007 compared to the six months ended June 30, 2006.  Offsetting the increase in interest expensewas an increase in interest income of $1,052,000, or 6%, for the comparableperiods.  The migration of the largecommercial loans to performing status as well as higher earning rates in theother loan categories and the investment portfolio helped increase the yield oninterest-earning assets by 42 basis points during the first half of 2007compared to the same 2006 period.  Thefive basis point improvement in the tax-equivalent margin is from higher netinterest income which increased $131,000, or 2%, compared to the first half of2006, on a similar level of interest-earning assets during the first half of2007.

The interest rateenvironment has improved slightly during the past several months, but continuesto remain challenging.  The yield curvewhich has recently become positively sloped still remains relatively flat, therebylimiting profitable growth opportunities. The more positively-shaped yield curve and our successful depositgathering strategies, debt reduction, and improved credit quality of the Bank’searning assets will help position the Bank to optimize net interest income duringthis challenging rate environment and should be further enhanced when the shapeof the yield curve returns to a steeper, more positive, normal slope.

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The following tables setforth, a comparison of average balance sheet amounts and their correspondingfully tax-equivalent (FTE) interest income and expense and annualizedtax-equivalent yield and cost for the periods indicated (dollars in thousands):
| ** **                             | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** | **Year ended** | ** ** |
|----------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|---------------------|------------|
| ** **                             | ** ** | **June 30,**                | ** ** | **June 30,**                   | ** ** | **December 31,**    | ** ** |
| ** **                             | ** ** | **2007**                         | ** ** | **2006**                       | ** ** | **2007**            | ** ** | **2006** | ** ** | **2006** | ** ** |
| Average  interest-earning assets:      |       |                             |       |                           |       |                |       |   |   |   |   |
| Loans and leases                       |       | $                                | 420,551    |                           | $          | 420,394             |       | $ | 422,952 |   | $ | 417,403 |   | $ | 418,390 |   |
| Investments                            |       | 114,561                          |       | 122,582                        |       | 109,569             |       | 118,340 |   | 115,319 |   |
| Federal funds  sold                    |       | 15                               |       | 56                             |       | 2,085               |       | 1,720 |   | 2,479 |   |
| Interest-bearing  deposits             |       | 190                              |       | 203                            |       | 201                 |       | 241 |   | 240 |   |
| Total                                  |       | $                                | 535,317    |                           | $          | 543,235             |       | $ | 534,807 |   | $ | 537,704 |   | $ | 536,428 |   |
|                                   |       |                             |       |                           |       |                |       |   |   |   |   |
| Average  interest-bearing liabilities: |       |                             |       |                           |       |                |       |   |   |   |   |
| Other  interest-bearing deposits       |       | $                                | 196,513    |                           | $          | 184,461             |       | $ | 198,328 |   | $ | 178,658 |   | $ | 185,786 |   |
| Certificates of  deposit               |       | 147,909                          |       | 153,192                        |       | 151,305             |       | 155,319 |   | 154,474 |   |
| Borrowed funds                         |       | 76,868                           |       | 89,684                         |       | 72,158              |       | 88,421 |   | 79,627 |   |
| Repurchase  agreements                 |       | 18,336                           |       | 24,042                         |       | 18,106              |       | 24,414 |   | 23,391 |   |
| Total                                  |       | $                                | 439,626    |                           | $          | 451,379             |       | $ | 439,897 |   | $ | 446,812 |   | $ | 443,278 |   |
|                                   |       |                             |       |                           |       |                |       |   |   |   |   |
| Interest income  (FTE):                |       |                             |       |                           |       |                |       |   |   |   |   |
| Loans and leases                       |       | $                                | 7,321      |                           | $          | 7,064               |       | $ | 14,662 |   | $ | 13,763 |   | $ | 28,357 |   |
| Investments                            |       | 1,494                            |       | 1,454                          |       | 2,856               |       | 2,760 |   | 5,612 |   |
| Federal funds  sold                    |       | 1                                |       | 1                              |       | 55                  |       | 36 |   | 123 |   |
| Interest-bearing  deposits             |       | 2                                |       | 2                              |       | 5                   |       | 5 |   | 9 |   |
| Total                                  |       | $                                | 8,818      |                           | $          | 8,521               |       | $ | 17,578 |   | $ | 16,564 |   | $ | 34,101 |   |
|                                   |       |                             |       |                           |       |                |       |   |   |   |   |
| Interest  expense:                     |       |                             |       |                           |       |                |       |   |   |   |   |
| Other  interest-bearing deposits       |       | $                                | 1,554      |                           | $          | 1,324               |       | $ | 3,184 |   | $ | 2,374 |   | $ | 5,467 |   |
| Certificates of  deposit               |       | 1,667                            |       | 1,426                          |       | 3,372               |       | 2,773 |   | 6,026 |   |
| Borrowed funds                         |       | 1,024                            |       | 1,193                          |       | 1,902               |       | 2,323 |   | 4,244 |   |
| Repurchase  agreements                 |       | 116                              |       | 163                            |       | 231                 |       | 299 |   | 624 |   |
| Total                                  |       | $                                | 4,361      |                           | $          | 4,106               |       | $ | 8,689 |   | $ | 7,769 |   | $ | 16,361 |   |
|                                   |       |                             |       |                           |       |                |       |   |   |   |   |
| Net interest income  (FTE)             |       | $                                | 4,457      |                           | $          | 4,415               |       | $ | 8,889 |   | $ | 8,795 |   | $ | 17,740 |   |

 

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| ** **                                     | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** | **Year ended**   | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** | **December 31,** | ** ** |
| ** **                                     | ** ** | **2007**                         | ** ** | **2006**                       | ** ** | **2007**              | ** ** | **2006** | ** ** | **2006** | ** ** |
| Yield on average  interest-earning assets      |       |                             |       |                           |       |                  |       |   |   |   |   |
| Loans and leases                               |       | 6.98                             | %          | 6.74                           | %          | 6.99                  | %          | 6.65 | % | 6.78 | % |
| Investments                                    |       | 5.23                             | %          | 4.76                           | %          | 5.26                  | %          | 4.70 | % | 4.87 | % |
| Federal funds  sold                            |       | 5.28                             | %          | 4.56                           | %          | 5.29                  | %          | 4.23 | % | 4.97 | % |
| Interest-bearing  deposits                     |       | 4.07                             | %          | 4.42                           | %          | 4.75                  | %          | 3.99 | % | 3.82 | % |
| Total                                          |       | 6.61                             | %          | 6.29                           | %          | 6.63                  | %          | 6.21 | % | 6.36 | % |
|                                           |       |                             |       |                           |       |                  |       |   |   |   |   |
| Rates on average  interest-bearing liabilities |       |                             |       |                           |       |                  |       |   |   |   |   |
| Other  interest-bearing deposits               |       | 3.17                             | %          | 2.88                           | %          | 3.24                  | %          | 2.68 | % | 2.94 | % |
| Certificates of  deposit                       |       | 4.52                             | %          | 3.73                           | %          | 4.49                  | %          | 3.60 | % | 3.90 | % |
| Borrowed funds                                 |       | 5.34                             | %          | 5.33                           | %          | 5.31                  | %          | 5.30 | % | 5.33 | % |
| Repurchase  agreements                         |       | 2.53                             | %          | 2.73                           | %          | 2.57                  | %          | 2.47 | % | 2.67 | % |
| Total                                          |       | 3.98                             | %          | 3.65                           | %          | 3.98                  | %          | 3.51 | % | 3.69 | % |
|                                           |       |                             |       |                           |       |                  |       |   |   |   |   |
| Net interest  spread                           |       | 2.63                             | %          | 2.64                           | %          | 2.65                  | %          | 2.70 | % | 2.67 | % |
| Net interest margin                            |       | 3.34                             | %          | 3.26                           | %          | 3.35                  | %          | 3.30 | % | 3.31 | % |

 

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

*Provisionfor loan losses*

The provision for loanlosses represents the necessary amount to charge against current earnings, thepurpose of which is to increase the allowance for loan losses to a level thatrepresents management’s best estimate of known and inherent losses in theBank’s loan and lease portfolio.  Loansand leases determined to be uncollectible are charged off against the allowancefor loan losses.

The required amount ofthe provision for loan losses, based upon the adequate level of the allowancefor loan losses, is subject to ongoing analysis of the loan portfolio.  The Bank’s Special Asset Committee meetsperiodically to review problem loans and leases.  The committee is comprised of Bank management,including the chief risk officer, loan workout officers and collection personnel.  The committee reports quarterly to the CreditAdministration Committee of the Board of Directors.

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

·                  Specificloans that could have loss potential

·                  Levelsof and trends in delinquencies and non-accrual loans

·                  Levelsof and trends in charge-offs and recoveries

·                  Trendsin volume and terms of loans

·                  Changesin risk selection and underwriting standards

·                  Changesin lending policies, procedures and practices

·                  Experience,ability and depth of lending management

·                  Nationaland local economic trends and conditions

·                  Changes incredit concentrations

Noprovision for loan losses has been recorded during 2007.  The Bank’s non-performing loans, whichconsists of loans past due 90 days or more plus non-accruing loans, increased$1,060,000, or 31%, to $4,498,000 since December 31, 2006.  However, non-performing loans declinedyear-to-year by $3,252,000, or 42%, from $7,750,000 at June 30, 2006.  The non-accrual component of non-performingloans showed a $3,109,000 decline while the 90 day delinquencies showed a$143,000 decline in the same period.  The decrease from June 30, 2006 was mainlyattributable to the collection and pay-offs of 

14

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non-performingloans.  The increase from December 31,2006 was due mainly to commercial loan relationships that had migrated todelinquent status and were placed on non-accrual.  Because there is sufficient collateral thatsecured these loans, there have been fewer charge-offs, mild loan growth andthe allowance for loan losses is deemed to be adequate to absorb the potentialfor future losses on existing problem loans, no provision for loan losses wasrequired during the first half of 2007. This compares with $175,000 and $250,000 recorded during thequarter and six months ended June 30, 2006. After taking into account charge-offs and recoveries, the allowance was$5,295,000 at June 30, 2007 compared to $5,738,000 at June 30, 2006.

*Other income*

Total other(non-interest) income improved $245,000, or 23%, for the three months endedJune 30, 2007 compared to the three months ended June 30, 2006.  The Bank recognized net gains of $127,000from sales of foreclosed properties and experienced growth in deposit feesrevenue of $127,000.  The gain from thesale of foreclosed properties was the result of excess collateral valuecompared to the net book value of sold foreclosed property.  The increase in deposit fees was caused by growthin debit card interchange and overdraft charges.

For the six months endedJune 30, 2007 other income increased $330,000, or 15%, compared to the sixmonths ended June 30, 2006.  Contributingto the increase were growth in deposit fees, gains from sales of foreclosedproperties and a first quarter 2007 gain from the sale of an owned commercialfacility previously leased to a non-related third party.

*Otheroperating expenses*

For the second quarter endedJune 30, 2007, other (non-interest) expenses increased $139,000, or 4%,compared to the same 2006 quarter. Salaries and related employee benefits increased $191,000, or 10%, dueto annual merit pay increases, more full-time equivalent employees and interimrecognition of performance-based incentives. The $39,000 decline in premises and equipment was due to less equipmentrelated maintenance costs required in 2007 compared to 2006.  Advertising expense increased $24,000 duringthe quarter ended June 30, 2007 compared to the quarter ended June 30, 2006,with the grand opening and relocation project of one branch office.  The $36,000 decline in the other component ofother operating expenses was caused mostly by reductions in professional feesand the Bank’s FDIC assessment.

For the six months endedJune 30, 2007, other expenses increased $330,000, or 4%, compared to the sixmonths ended June 30, 2006.  Salary andrelated employee benefits increased $319,000, or 8%, due to pay increases andperformance-based incentives. Advertising increased $54,000, or 19%, during the period causedprincipally by the aforementioned activities associated with the branchrelocation project and a winter deposit-gathering campaign earlier this year.

*Incometax provision*

Compared to 2006,income before provision for income taxes for the second quarter and first sixmonths of 2007 increased $338,000 and $381,000, respectively.  The effective federal income tax rate was25.9% and 25.8% for the three and six months ended June 30, 2007, compared to23.5% and 23.9% for each of the respective 2006 periods.  The effective tax rate increase isattributable to higher pre-tax earnings and a decrease in tax-free interestincome from municipal securities and tax-free loans, partially offset by anincrease in the tax-free earnings from the BOLI, collectively representing asmaller portion of pre-tax earnings.

**COMPARISON OF FINANCIAL CONDITIONAT**

**JUNE 30,2007 AND DECEMBER 31, 2006**

*Overview*

Consolidated assetsincreased $11,174,000, or 2%, during the six months ended June 30, 2007.  The net asset increase in total assets wasdue to increases in total deposits of $11,000,000 and shareholders’ equity of$587,000 partially offset by a net reduction in borrowings of $466,000.

*Investmentsecurities*

At the time of purchase,the Bank classifies investment securities into one of three categories:trading, AFS or held-to- maturity (HTM). To date, management has not purchased any securities for tradingpurposes.  Management classifies mostsecurities as AFS even though it has no immediate intent to sell them.  The AFS designation affords management theflexibility to sell securities and adjust the balance sheet in response tocapital levels, liquidity needs, structuring strategies and/or changes inmarket conditions.  Securities AFS arecarried at net fair market value in the consolidated balance sheet 

15

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with an adjustment tostockholders’ equity, net of tax, which is presented under the caption“Accumulated other comprehensive income (loss).”  Securities designated as HTM are carried atamortized cost.

At June 30, 2007, thecarrying value of investment securities totaled $107,965,000, or 19% of totalassets compared to $100,411,000, or 18% of total assets at December 31,2006.  Also as of June 30, 2007, approximately46% of the carrying value of the investment portfolio was comprised ofmortgage-backed securities that amortize and provide monthly cash flow.  Agency, corporate and municipal bondscomprised 30%, 12% and 11%, respectively, of the investment portfolio at June 30,2007.

As illustrated in thefollowing table of amortized cost and fair market value of investmentsecurities, the portfolio is comprised of HTM and AFS securities with carryingvalues of $1,252,000 and $106,713,000, respectively.  At June 30, 2007, the AFS debt securitieswere recorded with a net unrealized loss in the amount of $3,231,000 and equitysecurities were recorded with an unrealized gain of $201,000 (dollars inthousands):
| ** **                                       | ** ** | **Amortized** | ** ** | **Gross unrealized** | ** ** | **Gross unrealized** | ** ** | **Fair**  | ** ** |
|--------------------------------------------------|------------|---------------|------------|---------------------------|------------|---------------------------|------------|-----------|------------|
| ** **                                       | ** ** | **cost**      | ** ** | **gains**                 | ** ** | **losses**                | ** ** | **value** | ** ** |
|                                             |       |          |       |                      |       |                      |       |      |       |
| Held-to-maturity  securities:                    |       |          |       |                      |       |                      |       |      |       |
| Mortgage-backed securities                       |       | $             | 1,252      |                      | $          | 14                        |       | $         | 1          |   | $ | 1,265 |   |
|                                             |       |          |       |                      |       |                      |       |      |       |
| Available-for-sale  securities:                  |       |          |       |                      |       |                      |       |      |       |
| U.S. government agencies and corporations        |       | $             | 33,162     |                      | $          | —                    |       | $         | 1,057      |   | $ | 32,105 |   |
| Obligations of states and political subdivisions |       | 12,286        |       | 1                         |       | 200                       |       | 12,087    |       |
| Corporate bonds                                  |       | 13,209        |       | 42                        |       | 28                        |       | 13,223    |       |
| Mortgage-backed securities                       |       | 50,807        |       | —                    |       | 1,989                     |       | 48,818    |       |
|                                             |       |          |       |                      |       |                      |       |      |       |
| Total debt securities                            |       | 109,464       |       | 43                        |       | 3,274                     |       | 106,233   |       |
|                                             |       |          |       |                      |       |                      |       |      |       |
| Equity securities                                |       | 279           |       | 201                       |       | —                    |       | 480       |       |
|                                             |       |          |       |                      |       |                      |       |      |       |
| Total  available-for-sale                        |       | $             | 109,743    |                      | $          | 244                       |       | $         | 3,274      |   | $ | 106,713 |   |

 

16

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The amortized cost and fair value of debt securitiesat June 30, 2007 by contractual maturity are as follows (dollars in thousands):
|                                           | ** ** | **Amortized  cost** | ** ** | **Market  value** | ** ** |
|-------------------------------------------|------------|---------------------|------------|-------------------|------------|
| Held-to-maturity  securities:             |       |                |       |              |       |
| Mortgage-backed securities                |       | $                   | 1,252      |              | $          | 1,265 |   |
|                                      |       |                |       |              |       |
| Available-for-sale  securities:           |       |                |       |              |       |
| Debt securities:                          |       |                |       |              |       |
|                                      |       |                |       |              |       |
| Due in one year or less                   |       | $                   | 1,000      |              | $          | 985 |   |
| Due after one year through five years     |       | 5,998               |       | 5,900             |       |
| Due after five years through ten years    |       | 19,391              |       | 18,958            |       |
| Due after ten years                       |       | 32,268              |       | 31,572            |       |
| Total debt securities                     |       | 58,657              |       | 57,415            |       |
|                                      |       |                |       |              |       |
| Mortgage-backed securities                |       | 50,807              |       | 48,818            |       |
|                                      |       |                |       |              |       |
| Total  available-for-sale debt securities |       | $                   | 109,464    |              | $          | 106,233 |   |

 

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

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

At June 30, 2007, the AFSdebt securities portfolio was carried at a net unrealized loss of $3,231,000compared to a net unrealized loss of $1,656,000 at December 31, 2006, or adeterioration of $1,575,000.  A largeportion of the unrealized losses was for a continuous period of more than 12months.  Management believes the cause ofthese unrealized losses is directly related to changes in market interestrates.  As of June 30, 2007, however,most all of the deterioration of the AFS debt portfolio is from investmentsthat are guaranteed by the U.S. government or one of its agencies.  In analyzing an issuer’s financial condition,management considers whether the securities are issued by the U.S. government,its agencies or other governments, whether downgrades by bond rating agencieshave occurred and, if necessary, reviews of the issuer’s financialcondition.  Because the decline in marketvalues is attributable to changes in interest rates and not credit quality, andthe Company has the ability and intent to hold those securities until recoveryof fair value, which may be maturity, management views these unrealized lossesto be temporary.

Excluding the netunrealized loss, the investment portfolio grew $9,121,000, or 9%, during thefirst six months of 2007.  The Companyutilized growth in deposits to grow the portfolio as well as to reduceshort-term borrowings. The current interest rate environment, essentially asustained period of yield curve inversion, continues to preclude structuredinvestment portfolio growth.  As such,the Company will attempt to replace investment securities that mature,pay-down, are called or amortize with bonds that provide incremental earningsabove the Bank’s funding sources.  Inaddition, cash flows from investments may be used to repay debt and fund growthin the loan portfolio.

*Loans available-for-sale (AFS)*

Generally, uponorigination, certain residential mortgages, the guaranteed portions of SmallBusiness Administration loans and student loans are classified as AFS.  In the event of market rate increases,fixed-rate loans and loans not immediately scheduled to re-price would no longerproduce yields consistent with the current market.  In a declining interest rate environment, theBank would be exposed to prepayment risk and, as rates on adjustable rate loansdecrease, interest income would be negatively affected.  To better manage prepayment and interest raterisk, loans that meet these conditions may be considered for sale in thesecondary market.  Consideration is alsogiven to the Company’s current liquidity position and 

17

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expected future liquidityneeds.  Loans AFS are carried at thelower of cost or estimated fair value. If the fair values of these loans fall below their amortized cost, thedifference is written down and charged to current earnings.  Subsequent appreciation in the portfolio, ifany, is credited to current earnings but only to the extent of previous write-downs.

At June 30, 2007, loansAFS amounted to $205,000 with a corresponding fair value of $209,000, comparedto $122,000 and $123,000, respectively, at December 31, 2006.  During the second quarter of 2007,residential mortgage and student loans with principal balances of $3,251,000were sold into the secondary market with combined net gains of approximately$31,000 recognized.

*Loans and leases*

The Bank originatescommercial and industrial (commercial) and commercial real estate loans,residential, consumer, home equity and construction loans.  The relative volume of originations isdependent upon customer demand, current interest rates and the perception andduration of future interest levels.  TheBank continues to focus its efforts on the expansion of variable-ratecommercial loan portfolios and origination of residential mortgage and consumerloans.  The broad spectrum of productsprovides diversification which helps manage, to an extent, interest rate risk andcredit concentration risk.  Credit riskis further managed through underwriting policies and procedures and loanmonitoring practices.  Interest rate riskis managed using various asset/liability modeling techniques and analyses.  The interest rates on most commercial loansare adjustable with reset intervals of five years or less.

The majority of our loanportfolio is collateralized, at least in part, by real estate in the greaterLackawanna and Luzerne Counties of Pennsylvania.  Commercial lending activities generallyinvolve a greater degree of credit risk than residential lending because theytypically have larger balances and are more affected by adverse conditions inthe economy.  Because payments oncommercial loans depend upon the successful operation and management of theproperties and the businesses which operate from within them, repayment of suchloans may be affected by factors outside the borrower’s control.  Such factors may include adverse conditionsin the real estate market, the economy, the industry or changes in government regulations.  As such, commercial loans require moreongoing evaluation and monitoring which occurs with the Bank’s creditadministration and outsourced loan review functions.

Gross loans increased$2,805,000, or 0.7% to $425,448,000 at June 30, 2007 compared to $422,643,000at December 31, 2006.  The increase inconsumer and home equity loans is from the successful sales campaign for homeequity loans during the current year second quarter.  The composition of the loan portfolio at June30, 2007 and December 31, 2006, is summarized as follows:
|                                        | ** ** | **June 30, 2007** | ** **  | **December 31, 2006** | ** ** |
|----------------------------------------|------------|-----------------------------|-------------|---------------------------------|------------|
| ** **                             | ** ** | **Amount**                  | ** **  | **%**                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| Commercial and  commercial real estate |       | $                           | 218,439,536 |                            | 51.3       |   | $ | 218,213,216 |   | 51.6 |   |
| Residential real  estate               |       | 115,965,734                 |        | 27.3                            |       | 112,742,692 |   | 26.7 |   |
| Consumer and  home equity              |       | 79,028,349                  |        | 18.6                            |       | 77,729,520 |   | 18.4 |   |
| Real estate  construction              |       | 11,464,265                  |        | 2.7                             |       | 13,369,712 |   | 3.2 |   |
| Direct financing  leases               |       | 550,147                     |        | 0.1                             |       | 588,211 |   | 0.1 |   |
| Gross loans                            |       | 425,448,031                 |        | 100.0                           |       | 422,643,351 |   | 100.0 |   |
| Allowance for  loan losses             |       | (5,294,537                  | )           |                            |       | (5,444,303 | ) |   |   |
| Net loans                              |       | $                           | 420,153,494 |                            |       |   | $ | 417,199,048 |   |   |   |

 

18

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*Allowance for loan losses*

Management continuallyevaluates the credit quality of the Bank’s loan and lease portfolio andperforms a formal review of the adequacy of the allowance for loan losses (theallowance) on a quarterly basis.  Theallowance reflects management’s best estimate of the amount of credit losses inthe loan portfolio.  Management’sjudgment is based on the evaluation of individual loans, past experience, theassessment of current economic conditions and other relevant factors includingthe amounts and timing of cash flows expected to be received on impairedloans.  Those estimates may besusceptible to significant change.  Theprovision for loan losses represents the amount necessary to maintain anappropriate allowance.  Loan losses arecharged directly against the allowance when loans are deemed to beuncollectible.  Recoveries frompreviously charged-off loans are added to the allowance when received.

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

·                  Identification of specific problemloans by loan category;

·                  Calculation of specific allowancesrequired based on collateral and objective and quantifiable evidence;

·                  Determination of homogenous pools byloan category and eliminating loans with specific allocations;

·                  Application of historical losspercentages (five-year average) to pools to determine the allowance allocation;and

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

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

Net charge-offs for thesix months ended June 30, 2007 were $150,000, compared to $496,000 for the sameperiod in 2006.  Net charge-offs ofcommercial loans were $30,000 for the six months ended June 30, 2007 comparedto net charge-offs of $311,000 for the same six month period of 2006.  Real estate loans had net recoveries of$12,000 in the first six months of 2007 as compared to net charge-offs of$32,000 in the first six months of 2006. Consumer loan net charge-offs were $132,000 in the six months ended June30, 2007 as compared to $154,000 for the same period of 2006.  There were no lease financing charge-offs.

Management believes thatthe current balance in the allowance for loans losses of $5,295,000 issufficient to withstand the identified potential credit quality issues that mayarise and are inherent to the portfolio. Currently, management is unaware of any potential problem loans thathave not been reviewed.  Potentialproblem loans are those where there is known information that leads managementto believe repayment of principal and/or interest is in jeopardy and the loansare neither on non-accrual status nor past due 90 days or more.  However, there could be instances whichbecome identified over the year that may require additional charge-offs and/orincreases to the allowance.  The ratio ofallowance for loan losses to total loans was 1.24% at June 30, 2007 compared to1.29% at December 31, 2006 and 1.36% at June 30, 2006.

19

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The following tables setforth the activity in the allowance for loan losses and certain key ratios forthe period indicated:
| ** **                       | ** ** | **As of and for the** | ** **  | **As of and for the** | ** ** | **As of and for the** | ** ** |
|----------------------------------|------------|-------------------------------------------|-------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                       | ** ** | **six months ended**            | ** **  | **twelve months ended**         | ** ** | **six months ended**            | ** ** |
| ** **                       | ** ** | **June 30, 2007**               | ** **  | **December 31, 2006**           | ** ** | **June 30, 2006**               | ** ** |
|                             |       |                                      |        |                                      |       |                                      |       |
| Balance at beginning of  period  |       | $                                         | 5,444,303   |                                      | $          | 5,984,649                                 |       | $ | 5,984,649 |   |
|                             |       |                                      |        |                                      |       |                                      |       |
| Provision charged to  operations |       | —                                    |        | 325,000                                   |       | 250,000                                   |       |
|                             |       |                                      |        |                                      |       |                                      |       |
| Charge-offs:                     |       |                                      |        |                                      |       |                                      |       |
| Commercial                       |       | 41,942                                    |        | 660,471                                   |       | 350,133                                   |       |
| Residential real  estate         |       | 1,586                                     |        | 109,164                                   |       | 31,626                                    |       |
| Consumer                         |       | 146,986                                   |        | 285,379                                   |       | 195,636                                   |       |
| Lease financing                  |       | —                                    |        | —                                    |       | —                                    |       |
| Total                            |       | 190,514                                   |        | 1,055,014                                 |       | 577,395                                   |       |
|                             |       |                                      |        |                                      |       |                                      |       |
| Recoveries:                      |       |                                      |        |                                      |       |                                      |       |
| Commercial                       |       | 12,415                                    |        | 64,173                                    |       | 39,197                                    |       |
| Residential real  estate         |       | 13,603                                    |        | 532                                       |       | 60                                        |       |
| Consumer                         |       | 14,730                                    |        | 124,763                                   |       | 41,759                                    |       |
| Lease financing                  |       | —                                    |        | 200                                       |       | 200                                       |       |
| Total                            |       | 40,748                                    |        | 189,668                                   |       | 81,216                                    |       |
|                             |       |                                      |        |                                      |       |                                      |       |
| Net charge-offs                  |       | 149,766                                   |        | 865,346                                   |       | 496,179                                   |       |
|                             |       |                                      |        |                                      |       |                                      |       |
| Balance at end of  period        |       | $                                         | 5,294,537   |                                      | $          | 5,444,303                                 |       | $ | 5,738,470 |   |
|                             |       |                                      |        |                                      |       |                                      |       |
| Total loans, end of period       |       | $                                         | 425,652,831 |                                      | $          | 422,765,351                               |       | $ | 423,465,087 |   |

 
| ** **                                                                | ** ** | **As of and for the** | ** ** | **As of and for the** | ** ** | **As of and for the** | ** ** |
|---------------------------------------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                | ** ** | **six months ended**            | ** ** | **twelve months ended**         | ** ** | **six months ended**            | ** ** |
| ** **                                                                | ** ** | **June 30, 2007**               | ** ** | **December 31, 2006**           | ** ** | **June 30, 2006**               | ** ** |
| Net charge-offs  to:                                                      |       |                                      |       |                                      |       |                                      |       |
| Loans, end of period                                                      |       | 0.04                                      | %          | 0.20                                      | %          | 0.12                                      | %          |
| Allowance for loan losses                                                 |       | 2.83                                      | %          | 15.89                                     | %          | 8.65                                      | %          |
| Provisions for loan losses                                                |       | —                                    | x          | 2.66                                      | x          | 1.98                                      | x          |
|                                                                      |       |                                      |       |                                      |       |                                      |       |
|                                                                      |       |                                      |       |                                      |       |                                      |       |
| Allowance for  loan losses to:                                            |       |                                      |       |                                      |       |                                      |       |
| Total loans                                                               |       | 1.24                                      | %          | 1.29                                      | %          | 1.36                                      | %          |
| Non-accrual loans                                                         |       | 1.21                                      | x          | 1.62                                      | x          | 0.77                                      | x          |
| Non-performing loans                                                      |       | 1.18                                      | x          | 1.58                                      | x          | 0.74                                      | x          |
| Net charge-offs                                                           |       | 35.35                                     | x          | 6.29                                      | x          | 11.57                                     | x          |
|                                                                      |       |                                      |       |                                      |       |                                      |       |
|                                                                      |       |                                      |       |                                      |       |                                      |       |
| Loans 30-89 days  past due and still accruing                             |       | $                                         | 6,596,917  |                                      | $          | 2,570,825                                 |       | $ | 3,696,924 |   |
| Loans 90 days  past due and accruing                                      |       | $                                         | 134,485    |                                      | $          | 80,603                                    |       | $ | 277,250 |   |
| Non-accrual  loans                                                        |       | $                                         | 4,363,589  |                                      | $          | 3,357,718                                 |       | $ | 7,472,830 |   |
| Allowance for loan  losses to loans 90 days or more past due and accruing |       | 39.37                                     | x          | 67.54                                     | x          | 20.70                                     | x          |

 

20

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The $6,597,000 of loansin the 30-89 days past due category as of June 30, 2007 consists of  a fewrelationships that migrated beyond the 30 days, but continue to make current paymentsalthough not in amounts sufficient to bring them to fully current status.  Of this amount, $1,000,000 was brought fullycurrent subsequent to the quarter end. The remainder are expected to be resolved in the third quarter.  The larger, problematic loans that enteredinto this category of delinquencies had been reflected in the allowance forloan loss allocation either through the general loan loss allocation, aspecific reserve or through the qualitative factor adjustments.  Management believes the allocation of theallowance for loan losses on these loans is adequate to absorb the potentialfor losses and therefore did not require additional loan loss provisions.

*Non-performing assets*

The Bank definesnon-performing assets as accruing loans past due 90 days or more, non-accrualloans, restructured loans, other real estate owned and repossessed assets.  As of June 30, 2007, non-performing assetsrepresented 0.78% of total assets compared to 0.65% at December 31, 2006 and1.36% at June 30, 2006.

Thenon-accrual loans increased by a net $1,006,000 during the first six months of2007 to $4,364,000 at June 30, 2007. Additions to the non-accrual loans component of the non-performingassets totaling $2,107,000 occurred during the first six months of 2007 as afew commercial loan relationships migrated to delinquent status and were placedon non-accrual.  These additions werepartially offset by payoffs or pay downs of $591,000, $146,000 of loansreturned to accruing status, charge-offs of $119,000 and $245,000 of loans thatwere transferred to other real estate owned. The Bank’s Special Assets Committee has reviewed these loans and foundthe collateral to be adequate or made reserve allocations where deemedappropriate.

AtJune 30, 2007 the 90-day past due loans that were still accruing totaled$134,000, compared to $81,000 at December 31, 2006 and $277,000 at June 30,2006.

Therewere no repossessed assets or other real estate owned at June 30, 2007.  All previously held real estate owned wassold.

Non-performingloans were $4,498,000 at June 30, 2007, an increase of $1,060,000 from year-end2006, but a decline of $3,252,000 compared to June 30, 2006.  Declines occurred in the three portfolios:commercial loans, real estate and consumer. The Special Assets Department had developed specific action plans foreach of the Company’s non-performing loans and completed several of them.  The ratio of non-accrual loans to net loanswas 1.04%, at June 30, 2007 compared to 1.79% at June 30, 2006.  It was up slightly from the year-end ratio of0.80%.  At June 30, 2007, the ratio ofnon-performing loans to net loans was 1.07% compared to 0.82% at December 31,2006 and 1.85% at June 30, 2006.  Theratio of non-performing assets to total assets was 0.78% at June 30, 2007 and0.65% at December 31, 2006, both down from 1.36% at June 30, 2006.

The following table setsforth non-performing assets data as of the period indicated:
|                                                                                    | ** ** | **June 30, 2007** | ** **  | **December 31, 2006** | ** ** | **June 30, 2006** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------------|-------------|---------------------------------|------------|-----------------------------|------------|
|                                                                               |       |                        |        |                            |       |                        |       |
| Loans past due  90 days or more and accruing                                       |       | $                           | 134,485     |                            | $          | 80,603                      |       | $ | 277,250 |   |
| Non-accrual  loans                                                                 |       | 4,363,589                   |        | 3,357,718                       |       | 7,472,830                   |       |
| Total non-performing loans                                                         |       | 4,498,074                   |        | 3,438,321                       |       | 7,750,080                   |       |
|                                                                               |       |                        |        |                            |       |                        |       |
| Restructured  loans                                                                |       | —                      |        | —                          |       | —                      |       |
| Other real  estate owned                                                           |       | —                      |        | 197,149                         |       | 53,099                      |       |
| Repossessed  assets                                                                |       | —                      |        | —                          |       | —                      |       |
| Total non-performing assets                                                        |       | $                           | 4,498,074   |                            | $          | 3,635,470                   |       | $ | 7,803,179 |   |
|                                                                               |       |                        |        |                            |       |                        |       |
| Net loans  including AFS                                                           |       | $                           | 420,358,294 |                            | $          | 417,321,048                 |       | $ | 417,921,996 |   |
| Total assets                                                                       |       | $                           | 573,492,468 |                            | $          | 562,317,988                 |       | $ | 575,128,225 |   |
| Non-accrual  loans to net loans                                                    |       | 1.04                        | %           | 0.80                            | %          | 1.79                        | %          |
| Non-performing  assets to net loans, foreclosed real estate and repossessed assets |       | 1.07                        | %           | 0.87                            | %          | 1.87                        | %          |
| Non-performing  assets to total assets                                             |       | 0.78                        | %           | 0.65                            | %          | 1.36                        | %          |
| Non-performing loans to  net loans                                                 |       | 1.07                        | %           | 0.82                            | %          | 1.85                        | %          |

 

21

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*Bank premises and equipment, net*

Bank premises andequipment increased $2,007,000, or 18%, since December 31, 2006.  The increase was due mostly to the transferof capitalized costs from other assets and current year capital expenditures,both in conjunction with the completion of the Company’s branch relocationproject.  These items were partiallyoffset by the sale and disposal of property and equipment including the sale ofan owned commercial facility previously leased to a non-related third party.

*Other assets*

The decrease in otherassets of $200,000, or 4%, from December 31, 2006 to June 30, 2007 wasprincipally due to the net reduction of $681,000 in capitalized costs that weretransferred to bank premises and equipment in conjunction with the completionof the Company’s branch relocation project. This was partially offset by an increase in deferred tax assets relatedto the increase in the unrealized loss within the Company’s AFS investmentportfolio.

*Deposits*

The Bank is acommunity-based commercial financial institution that offers a variety ofdeposit accounts with a range of interest rates and terms.  Deposit products include passbook andstatement savings accounts, interest-bearing checking (NOW), money market,non-interest bearing, or demand deposit accounts (DDAs), and certificates ofdeposit accounts.  The flow of depositsis significantly influenced by general economic conditions, changes inprevailing interest rates, pricing and competition.  Most of the Bank’s deposits are obtained fromthe communities surrounding its 12 branch offices.  The Bank attempts to attract and retaindeposit customers via sales and marketing efforts with new products, qualityservice, competitive rates, and maintaining long-standing customer relationships.  To determine deposit product interest rates,the Bank considers local competition, market yields and the rates charged foralternative sources of funding such as borrowings.  To be competitive in our markets and continueto bolster our deposit base, we have increased rates on most deposit products;however, we have not increased rates above market rates, as we only considercost effective rate-setting tactics in all interest rate environments.

Compared to December 31,2006 total deposits increased $10,997,000, or 3%, during the six months endedJune 30, 2007.  The growth in totaldeposits was primarily due to increases in certificates of deposit and moneymarket accounts partially offset by reductions in NOW, savings and DDAs.  The growth in the certificates of depositswas due to increases in the public fund sector which was largely offset by adecline in the NOW public fund accounts. The increase in money market accounts of $9,781,000, or 14%, was due tothe continued success in deposit-gathering strategies in conjunction withincreased promotional interest rates, partially offset by a decrease in savingsaccounts.  The decline in DDAs wasprimarily from a decrease in official checks outstanding.

The following tablerepresents the major components of deposits as of June 30, 2007 and December31, 2006:
|                          | ** ** | **June 30, 2007** | ** **  | **December 31, 2006** | ** ** |
|--------------------------|------------|-----------------------------|-------------|---------------------------------|------------|
| ** **               | ** ** | **Amount**                  | ** **  | **%**                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| Money market             |       | $                           | 82,140,255  |                            | 19.5       |   | $ | 72,359,157 |   | 17.6 |   |
| NOW                      |       | 60,843,396                  |        | 14.4                            |       | 65,121,770 |   | 15.9 |   |
| Savings and club         |       | 43,223,666                  |        | 10.3                            |       | 45,300,838 |   | 11.0 |   |
| Certificates of  deposit |       | 163,056,424                 |        | 38.7                            |       | 153,810,855 |   | 37.5 |   |
| Total interest-bearing   |       | 349,263,741                 |        | 82.9                            |       | 336,592,620 |   | 82.0 |   |
| Non-interest-bearing     |       | 72,067,616                  |        | 17.1                            |       | 73,741,975 |   | 18.0 |   |
| Total deposits           |       | $                           | 421,331,357 |                            | 100.0      |   | $ | 410,334,595 |   | 100.0 |   |

 

Certificates of depositof $100,000 or more aggregated $70,318,000 and $63,020,000 at June 30, 2007 andDecember 31, 2006, respectively.

*Borrowings*

Borrowings are used as acomplement to deposit generation as an alternative funding source whereby theBank will borrow under customer repurchase agreements in the local market andadvances from the Federal Home Loan Bank of Pittsburgh (FHLB) and correspondentbanks for asset growth and liquidity needs. Borrowings included $66,126,000 and $62,536,000 in long-term advancesfrom the FHLB at June 30, 2007 and December 31, 2006, respectively.  To help reduce the Bank’s 

22

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reliance on overnightfunding, during the quarter $16,000,000 of advances that had matured orconverted, and carried a weighted-average interest rate of 4.78%, were replacedwith fixed- and capped floating- rate advances amounting to an aggregateof  $20,000,000 that mature in 2009 andcarry an initial weighted-average interest rate of 5.40%.  Also included in borrowings were short-termrepurchase agreements of $21,476,000 and $22,224,000, as of the respectiveperiods.  Repurchase agreements arenon-insured interest-bearing liabilities that have a security interest inqualified investment securities of the Bank and are offered in both sweep andfixed-term products.  A sweep account isdesigned to ensure that, on a daily basis, an attached DDA is adequately fundedand excess DDA funds are transferred, or swept into an overnight interest-bearingrepurchase agreement account.  Thebalance in customer repurchase agreement accounts can fluctuate daily becausethe daily sweep product is dependent on the level of available funds indepositor accounts.  In addition,short-term borrowings may include overnight balances which the Bank may requirefrom time-to-time to fund daily liquidity needs.  As of June 30, 2007, the Bank had $7,110,000in overnight balances compared to $10,395,000 at December 31, 2006.

**Item3.  Quantitative and QualitativeDisclosure About Market Risk**

*Management of interest rate riskand market risk analysis*

The Company is subject tothe interest rate risks inherent in our lending, investing and financingactivities.  Fluctuations of interestrates will impact interest income and interest expense along with affecting marketvalues of all interest-earning assets and interest-bearing liabilities, exceptfor those assets or liabilities with a short term remaining to maturity.  Interest rate risk management is an integralpart of the asset/liability management process. The Company has instituted certain procedures and policy guidelines tomanage the interest rate risk position. Those internal policies enable the Company to react to changes in marketrates to protect net interest income from significant fluctuations.  The primary objective in managing interestrate risk is to minimize the adverse impact of changes in interest rates on netinterest income along with creating an asset/liability structure that maximizesearnings.

*Asset/Liability Management*.  One major objective of the Company whenmanaging the rate sensitivity of its assets and liabilities is to stabilize netinterest income.  The management of andauthority to assume interest rate risk is the responsibility of the Company’sAsset/Liability Committee (ALCO), which is comprised of senior management andmembers of the Board of Directors.  ALCOmeets quarterly to monitor the relationship of interest sensitive assets tointerest sensitive liabilities.  Theprocess to review interest rate risk is a regular part of managing theCompany.  Consistent policies andpractices of measuring and reporting interest rate risk exposure, particularlyregarding the treatment of non-contractual assets and liabilities, are ineffect.  In addition, there is an annualprocess to review the interest rate risk policy with the Board of Directorswhich includes limits on the impact to earnings from shifts in interest rates.

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

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

To manage this interest rate sensitivity gap position,an asset/liability model commonly known as cumulative gap analysis is used tomonitor the difference in the volume of the Company’s interest sensitive assetsand liabilities that mature or re-price within given periods.  A positive gap (asset sensitive) indicatesthat more assets will re-price during a given period compared to liabilities,while a negative gap (liability sensitive) has the opposite effect.  The Company employs computerized net interestincome simulation modeling to assist in quantifying interest rate riskexposure.  This process measures andquantifies the impact on net interest income through varying interest ratechanges and balance sheet compositions. The use of this model assists the ALCO to gauge the effects of theinterest rate changes on interest sensitive assets and liabilities in order todetermine what impact these rate changes will have upon the net interestspread.  At June 30, 2007, the Companymaintained a negative one-year cumulative gap of $60,715,000 or -10.6% of totalassets.  The effect of this negative gapposition provided a mismatch of assets and liabilities which may expose theBank to interest rate risk during periods of rising interest rates.  Conversely, in a declining interest rateenvironment, net interest income could be positively impacted because moreliabilities than assets will re-price downward during a one-year period.

Certain shortcomings are inherent in the methodof analysis discussed above and presented in the next table.  Although certain assets and liabilities mayhave similar maturities or periods of re-pricing, they may react in differentdegrees to changes in market interest rates. The interest rates on certain types of assets and liabilities mayfluctuate in advance of 

23

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changes in market interest rates, while interestrates on other types of assets and liabilities may lag behind changes in marketinterest rates.  Certain assets, such asadjustable-rate mortgages, have features which restrict changes in interestrates 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 thoseassumed in calculating the table.  Theability of many borrowers to service their adjustable-rate debt may decrease inthe event of an interest rate increase.

The followingtable illustrates the Company’s interest sensitivity gap position at June 30,2007 (dollars in thousands):
| ** **                                     | ** ** | **Three months** | ** ** | **Three to**      | ** ** | **One to**      | ** ** | **Over**             | ** ** | ** ** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|------------------------|------------|----------------------|------------|----------------------|------------|------------|------------|
| ** **                                     | ** ** | **or less**      | ** ** | **twelve months** | ** ** | **three years** | ** ** | **three years** | ** ** | **Total**  | ** ** |
| Cash and cash  equivalents                     |       | $                     | 198        |                   | $          | —               |       | $                    | —     |       | $          | 12,023 |   | $ | 12,221 |   |
| Investment securities(1)(2)                    |       | 15,221                |       | 7,079                  |       | 23,104               |       | 66,712               |       | 112,116    |       |
| Loans (2)                                      |       | 108,848               |       | 65,034                 |       | 102,852              |       | 143,624              |       | 420,358    |       |
| Fixed and other assets                         |       | —                |       | 8,331                  |       | —               |       | 20,466               |       | 28,797     |       |
| Total assets                                   |       | $                     | 124,267    |                   | $          | 80,444               |       | $                    | 125,956    |       | $          | 242,825 |   | $ | 573,492 |   |
| Total cumulative  assets                       |       | $                     | 124,267    |                   | $          | 204,711              |       | $                    | 330,667    |       | $          | 573,492 |   |   |   |
|                                           |       |                  |       |                   |       |                 |       |                 |       |       |       |
| Non-interest-bearing  transaction deposits (3) |       | $                     | —     |                   | $          | 7,206                |       | $                    | 19,818     |       | $          | 45,044 |   | $ | 72,068 |   |
| Interest-bearing  transaction deposits(3)      |       | 96,229                |       | —                 |       | 35,968               |       | 54,010               |       | 186,207    |       |
| Certificates of deposit                        |       | 45,698                |       | 72,982                 |       | 40,332               |       | 4,044                |       | 163,056    |       |
| Repurchase agreements                          |       | 21,294                |       | 181                    |       | —               |       | —               |       | 21,475     |       |
| Short-term borrowings                          |       | 8,126                 |       | —                 |       | —               |       | —               |       | 8,126      |       |
| Long-term debt                                 |       | 13,177                |       | 533                    |       | 10,415               |       | 42,000               |       | 66,125     |       |
| Other liabilities                              |       | —                |       | —                 |       | —               |       | 4,236                |       | 4,236      |       |
| Total  liabilities                             |       | $                     | 184,524    |                   | $          | 80,902               |       | $                    | 106,533    |       | $          | 149,334 |   | $ | 521,293 |   |
| Total cumulative  liabilities                  |       | $                     | 184,524    |                   | $          | 265,426              |       | $                    | 371,959    |       | $          | 521,293 |   |   |   |
|                                           |       |                  |       |                   |       |                 |       |                 |       |       |       |
| Interest sensitivity  gap                      |       | $                     | (60,257    | )                      | $          | (458                 | )          | $                    | 19,423     |       | $          | 93,491 |   |   |   |
|                                           |       |                  |       |                   |       |                 |       |                 |       |       |       |
| Cumulative gap                                 |       | $                     | (60,257    | )                      | $          | (60,715              | )          | $                    | (41,292    | )          | $          | 52,199 |   |   |   |
|                                           |       |                  |       |                   |       |                 |       |                 |       |       |       |
| Cumulative gap to total assets                 |       | (10.51                | )%         | (10.59                 | )%         | (7.20                | )%         | 9.10                 | %          |       |       |

 

----

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

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

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

*Earnings at Risk and Economic Value at RiskSimulations.* The Company recognizes that more sophisticatedtools exist for measuring the interest rate risk in the balance sheet beyondstatic re-pricing gap analysis.  Althoughit will continue to measure its re-pricing gap position, the Company utilizesadditional modeling for identifying and measuring the interest rate risk in theoverall balance sheet.  The ALCO isresponsible for focusing on “earnings at risk” and “economic value at risk,”and how both relate to the risk-based capital position when analyzing theinterest rate risk.

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

*Economic Value at Risk. *Earnings at risk simulationmeasures the short-term risk in the balance sheet.  Economic value (or portfolio equity) at riskmeasures the long-term risk by finding the net present value of the future cashflows from the 

24

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Company’s existing assets and liabilities.  The ALCO examines this ratio quarterlyutilizing an increase and decrease of 200 basis points in interest ratessimulation models.  The ALCO recognizesthat, in some instances, this ratio may contradict the “earnings at risk” ratio.

The following table illustrates the simulated impact of 200 basispoints upward or downward movement in interest rates on net interest income,net income and the change in the economic value (portfolio equity).  This analysis assumed that interest-earningasset and interest-bearing liability levels at June 30, 2007 remainedconstant.  The impact of the ratemovements was developed by simulating the effect of rates changing over atwelve-month period from the June 30, 2007 levels:
|                                                        | ** ** | **Rates +200** | ** ** | **Rates -200** | ** ** |
|--------------------------------------------------------|------------|---------------------|------------|---------------------|------------|
| Earnings at  risk:                                     |       |                |       |                |       |
| Percent change in:                                     |       |                |       |                |       |
| Net interest income                                    |       | (10.0               | )%         | 5.0                 | %          |
| Net income                                             |       | (29.1               | )          | 14.1                |       |
|                                                   |       |                |       |                |       |
| Economic value  at risk:                               |       |                |       |                |       |
| Percent change in:                                     |       |                |       |                |       |
| Economic value of equity                               |       | (27.4               | )          | 8.4                 |       |
| Economic value  of equity as a percent of total assets |       | (3.1                | )          | 0.9                 |       |

 

Economic value has themost meaning when viewed within the context of risk-based capital.  Therefore, the economic value may normallychange beyond the Company’s policy guideline for a short period of time as longas the risk-based capital ratio (after adjusting for the excess equityexposure) is greater than 10%.  At June30, 2007, the Company’s risk-based capital ratio was 13.9%.

The table belowsummarizes estimated changes in net interest income over a twelve-month periodbeginning July 1, 2007 under alternate interest rate scenarios using the incomesimulation model described above (dollars in thousands):
|                                             | ** ** | **Net interest** | ** ** | **$**        | ** ** | **%**        | ** ** |
|---------------------------------------------|------------|-----------------------|------------|--------------|------------|--------------|------------|
| **Change in interest rates** | ** ** | **income**            | ** ** | **variance** | ** ** | **variance** | ** ** |
|                                        |       |                  |       |         |       |         |       |
| +200 basis  points                          |       | $                     | 16,599     |         | $          | (1,848       | )          | (10.0 | )% |
| +100 basis  points                          |       | 17,839                |       | (608         | )          | (3.3         | )          |
| Flat rate                                   |       | 18,447                |       | —       |       | —       |       |
| -100 basis  points                          |       | 19,213                |       | 766          |       | 4.2          |       |
| -200 basis points                           |       | 19,371                |       | 924          |       | 5.0          |       |
|                                             |            |                       |            |              |            |              |            |  |  |

 

Simulation models requireassumptions about certain categories of assets and liabilities.  The models schedule existing assets andliabilities by their contractual maturity, estimated likely call date orearliest re-pricing opportunity. Mortgage-backed securities and amortizing loans are scheduled based ontheir anticipated cash flow including estimated prepayments.  For investment securities, the Bank uses athird-party service to provide cash flow estimates in the various rateenvironments.  Savings accounts,including passbook, statement savings, money market and NOW accounts, do nothave a stated maturity or re-pricing term and can be withdrawn or re-priced atany time.  This may impact the margin ifmore expensive alternative sources of deposits are required to fund loans ordeposit runoff.  Management projects there-pricing characteristics of these accounts based on historical performanceand 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 sameproduct for a new like term at current product interest rates provided bymanagement.  As a result, the mix ofinterest-earning assets and interest bearing-liabilities is not held constant.

*Derivative FinancialInstruments. *As partof the Bank’s overall interest rate risk management strategy, the Company hasadopted a policy whereby the Bank may periodically use derivative instrumentsto minimize significant fluctuations in earnings caused by interest ratevolatility.  This interest rate riskmanagement strategy entails the use of interest rate 

25

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floors, caps andswaps.  The Bank entered into an interestrate floor agreement in 2006 and is reflected in the scenarios for earnings andeconomic value at risk and the net interest income in the two immediatelypreceding tables.

*Liquidity*

Liquidity managementensures that adequate funds will be available to meet customers’ needs forborrowings, deposit withdrawals and maturities and normal operating expenses ofthe Bank.  Current sources of liquidityare cash and cash equivalents, asset maturities and pay-downs within one year,loans and investments AFS, growth of core deposits, growth of repurchaseagreements, increases in other borrowed funds from correspondent banks andissuance of capital stock.  Althoughregularly scheduled investment and loan payments are dependable sources ofdaily funds, the sales of both loans and investments AFS, deposit activity, andinvestment and loan prepayments are significantly influenced by general economicconditions and the level of interest rates.

As of June 30, 2007, the Company maintained approximately $12,221,000in cash and cash equivalents, $106,713,000 of investments AFS and $205,000 ofloans AFS.  In addition, as of June 30,2007, the Company had approximately $127,162,000 available to borrow from theFHLB and $30,000,000 available from other correspondent banks.  This combined total of $276,301,000represented 48% of total assets at June 30, 2007.  Management believes this level of liquidityto be strong and adequate to support current operations.

*Capital*

During the first half of2007, shareholders’ equity increased from net income, stock issuance from theCompany’s various sponsored stock plans, partially offset by an increase in theunrealized loss on AFS securities, a decrease in the intrinsic value of theBank’s cash flow hedge and the declaration of cash dividends.  The Company is subject to various regulatorycapital requirements administered by the federal banking agencies.  Failure to meet minimum capital requirementscan initiate certain mandatory and possible additional discretionary actions byregulators that, if undertaken, could have a direct material effect on theCompany’s financial statements.  Undercapital adequacy guidelines and the regulatory framework for prompt correctiveaction, the Company must meet specific capital guidelines that involvequantitative measures of the Company’s assets, liabilities and certainoff-balance-sheet items as calculated under regulatory accounting practices.  The Company’s capital amounts andclassification are also subject to qualitative judgments by the regulatorsabout components, risk-weightings and other factors.

Under theseguidelines, assets and certain off-balance sheet items are assigned to broadrisk categories, each with appropriate weights. The resulting capital ratios represent capital as a percentage of totalrisk-weighted assets and certain off-balance sheet items.  The guidelines require all banks and bankholding companies to maintain a minimum ratio of total risk-based capital tototal risk-weighted assets (Total Risk Adjusted Capital) of 8%, including TierI capital to total risk-weighted assets (Tier I Capital) of 4% and Tier Icapital to average total assets (Leverage Ratio) of at least 4%.

As of June 30, 2007, theCompany and the Bank met all capital adequacy requirements to which it wassubject.  The following table depicts thecapital amounts and ratios of the Company and the Bank as of June 30, 2007:
| ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                            | ** ** | **To be well capitalized** | ** **     |
|----------------------------|------------|------------|------------|------------|------------|----------------------------|------------|---------------------------------------|------------|-------------------------------------------|----------------|
| ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | **For capital**       | ** ** | **under prompt corrective** | ** ** |
| ** **                 | ** ** | **Actual** | ** ** | ** ** | ** ** | **adequacy purposes** | ** ** | **action provisions**            | ** ** |
| ** **                 | ** ** | **Amount** | ** ** | **Ratio**  | ** ** | **Amount**                 | ** ** | **Ratio**                             | ** ** | **Amount**                                | ** **     | **Ratio** | ** ** |
| Total capital              |       |       |       |       |       |                       |       |                                  |       |                                      |           |   |   |
| (to risk-weighted  assets) |       |       |       |       |       |                       |       |                                  |       |                                      |           |   |   |
| Consolidated               |       | $          | 59,579,254 |       | 13.9       | %  3             | $          | 34,423,338                            | 3     | 8.0                                       | %              | N/A |   | N/A |   |
| Bank                       |       | $          | 59,252,490 |       | 13.8       | %  3             | $          | 34,417,303                            | 3     | 8.0                                       | %  3 | $ | 43,021,629 | 3 | 10.0 | % |
| Tier I capital             |       |       |       |       |       |                       |       |                                  |       |                                      |           |   |   |
| (to risk-weighted  assets) |       |       |       |       |       |                       |       |                                  |       |                                      |           |   |   |
| Consolidated               |       | $          | 54,194,168 |       | 12.6       | %  3             | $          | 17,211,669                            | 3     | 4.0                                       | %              | N/A |   | N/A |   |
| Bank                       |       | $          | 53,948,927 |       | 12.5       | %  3             | $          | 17,208,651                            | 3     | 4.0                                       | %  3 | $ | 25,812,977 | 3 | 6.0 | % |
| Tier I capital             |       |       |       |       |       |                       |       |                                  |       |                                      |           |   |   |
| (to average assets)        |       |       |       |       |       |                       |       |                                  |       |                                      |           |   |   |
| Consolidated               |       | $          | 54,194,168 |       | 9.6        | %  3             | $          | 22,690,263                            | 3     | 4.0                                       | %              | N/A |   | N/A |   |
| Bank                       |       | $          | 53,948,927 |       | 9.5        | %  3             | $          | 22,675,370                            | 3     | 4.0                                       | %  3 | $ | 28,344,213 | 3 | 5.0 | % |

 

26

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**Item4.  Controls and Procedures**

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

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

**PART II - Other Information**

**Item 1. Legal Proceedings**

The nature of the Company’s business generates some litigationinvolving matters arising in the ordinary course of business.  However, in the opinion of the Company, afterconsulting with legal counsel, no legal proceedings are pending, which, ifdetermined adversely to the Company or the Bank, would have a material effecton the Company’s undivided profits or financial condition.  No legal proceedings are pending other thanordinary routine litigation incidental to the business of the Company and theBank.  In addition, to management’sknowledge, no governmental authorities have initiated or contemplated anymaterial legal actions against the Company or the Bank.

**Item 1A.  Risk Factors**

Management of the Companydoes not believe there have been any material changes in the risk factors thatwere disclosed in the Form 10-K filed with the Securities and ExchangeCommission on March 20, 2007.

**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**

At the annual meeting ofshareholders held on May 1, 2007, the judges of election made the reportconcerning the results of balloting. Holders of 1,628,253 shares of common stock, representing 79% of thetotal number of shares outstanding, were represented in person or by proxy atthe 2007 annual meeting of shareholders.

The following votes werecast:

Election of Class CDirectors to serve for a three-year term:
|                    | ** ** | **For**   | ** ** | **Withhold authority** | ** ** | **Abstain** | ** ** |
|--------------------|------------|-----------|------------|-----------------------------|------------|-------------|------------|
| Brian J. Cali      |       | 1,612,938 |       | 15,315                      |       | —      |       |
| Patrick J. Dempsey |       | 1,613,916 |       | 14,336                      |       | —      |       |

 

In addition to theabove elected Class C Directors, at the conclusion of its annual meeting, theCompany’s Board of Directors consisted of: Samuel C. Cali, Mary E. McDonald andDavid L. Tressler, Sr. as Class B Directors whose term expires in 2008; andPaul A. Barrett, John T. Cognetti and Michael J. McDonald as Class A Directorswhose term expires in 2009.  Mr. Barrettpassed away on May 14, 2007.

Ratification ofindependent certified public accountants:
|                        | ** ** | **For**   | ** ** | **Against** | ** ** | **Abstain** | ** ** |
|------------------------|------------|-----------|------------|-------------|------------|-------------|------------|
| Parente  Randolph, LLC |       | 1,620,487 |       | 7,234       |       | —      |       |

 

27

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**Item 5.    Other Information**

                           None

**Item 6.   Exhibits**

The followingexhibits are filed herewith or incorporated by reference as a part of this Form10-Q:
|              | ****10.1*** | *** *** | ***Amended  and Restated Executive Employment Agreement between Fidelity D & D  Bancorp, Inc., The Fidelity Deposit and Discount Bank and Steven C. Ackmann,  dated July 11, 2007. ***Incorporated  by reference to Exhibit 99.1 to Registrant’s Current Report on Form 8-K filed  with the SEC on July 13, 2007. |
|--------------|-------------|--------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|         |        |         |                                                                                                                                                                                                                                                                                                                            |
| *** *** | ***11***    | *** *** | ***Statement  regarding computation of earnings per share. ***Included herein in Note 2, “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 adopted  pursuant 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.***                                                                                                                                                  |

 

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* Managementcontract or compensatory plan or arrangement.

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

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.
|                       | **FIDELITY D & D BANCORP, INC.** |
|-----------------------|--------------------------------------|
| ** **            | ** **                           |
| ** **            | ** **                           |
| Date: August 6,  2007 | /s/ Steven C. Ackmann                |   |
|                  |                                 | Steven C.  Ackmann, |
|                  |                                 | President and  Chief Executive Officer |
|                  |                                 |
|                  |                                 |
| Date: August 6,  2007 | /s/ Salvatore R. DeFrancesco, Jr.    |   |
|                  |                                 | Salvatore R. DeFrancesco, Jr., |
|                  |                                 | Treasurer and  Chief Financial Officer |
|                       |                                      |  |  |

 

28

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**EXHIBITINDEX**
|                                                                                                                                                                                                                                                                                                                                       | ** ** | **Page**   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
| ** **                                                                                                                                                                                                                                                                                                                            | ** ** | ** ** |
| ***10.1  Amended and Restated Executive Employment Agreement between Fidelity D & D  Bancorp, Inc., The Fidelity Deposit and Discount Bank and Steven C. Ackmann,  dated July 11, 2007.***   Incorporated by reference to Exhibit 99.1 to Registrant’s Current  Report on Form 8-K filed with the SEC on July 13, 2007. |       | *          |
|                                                                                                                                                                                                                                                                                                                                  |       |       |
| ***11******Statement regarding computation of earnings per  share.***  Included herein.                                                                                                                                                                                                                                          |       |   8   |
|                                                                                                                                                                                                                                                                                                                                  |       |       |
| ***31.1  Rule 13a-14(a) Certification of Principal Executive Officer.***                                                                                                                                                                                                                                                              |       | 30         |
|                                                                                                                                                                                                                                                                                                                                  |       |       |
| ***31.2  Rule 13a-14(a) Certification of Principal Financial Officer.***                                                                                                                                                                                                                                                              |       | 31         |
|                                                                                                                                                                                                                                                                                                                                  |       |       |
| ***32.1  Certification of Principal Executive Officer pursuant to 18 U.S.C. Section  1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.***                                                                                                                                                                   |       | 32         |
|                                                                                                                                                                                                                                                                                                                                  |       |       |
| ***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.***                                                                                                                                                                   |       | 32         |

 

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* Incorporated byReference

29

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