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** **

 

** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 
| **x**      | **Quarterly Report pursuant to  Section 13 or 15 (d) of the Securities Exchange Act of 1934**                                                                                                                                                                                                                                                                                                            |
|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                         |
| ** ** | **for the Quarterly Period Ended  September 30, 2008.**                                                                                                                                                                                                                                                                                                                                                       |
| ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                         |
| **o**      | **Transition report pursuant to  Section 13 or 15 (d) of the Exchange Act**                                                                                                                                                                                                                                                                                                                              |
| ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                         |
| ** ** | **for the Transition Period from                                  to                               .** |

 

**No. 0-17077**

**(CommissionFile Number)**

 

**PENNS WOODS BANCORP, INC.**

(Exact name ofRegistrant as specified in its charter)

 

| **PENNSYLVANIA**                                                     | ** ** | **23-2226454**       |
|----------------------------------------------------------------------|------------|----------------------|
| (State or other  jurisdiction of                                     |       | (I.R.S. Employer     |
| incorporation or  organization)                                      |       | Identification  No.) |
|                                                                 |       |                 |
| **300 Market  Street, P.O. Box 967 Williamsport, Pennsylvania** |       | **17703-0967**       |
| (Address of  principal executive offices)                            |       | (Zip Code)           |

 

**(570)322-1111**

Registrant’stelephone number, including area code

 

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

YES x              NO  o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reportingcompany.  See the definition of “largeaccelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2of the Exchange Act.  (Check one):
|   |   | Large  accelerated filer  ̈ |   | Accelerated  filer x            |
|--------|--------|---------------------------------|--------|---------------------------------|
|   |   | Non-accelerated  filer  ̈   |   | Small  reporting company  ̈ |

 

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

YES o              NO  x

 

On October 27, 2008there were 3,850,518 shares of the Registrant’s common stock outstanding.

 

 

 

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**PENNSWOODS BANCORP, INC.**

**INDEX TOQUARTERLY REPORT ON FORM 10-Q**

 
| ** **                                                                                                                              | ** ** | ** **                                                                                      | ** ** | **Page**   |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------|------------|------------|
| ** **                                                                                                                              | ** ** | ** **                                                                                      | ** ** | **Number** |
|                                                                                                                                    |       |                                                                                            |       |       |
| **Part I**                                                                                                                         | ** ** | **Financial Information**                                                                       | ** ** | ** ** |
| ** **                                                                                                                              | ** ** | ** **                                                                                      | ** ** | ** ** |
| **Item 1.**                                                                                                                             | ** ** | **Financial Statements**                                                                        | ** ** | ** ** |
| ** **                                                                                                                              | ** ** | ** **                                                                                      | ** ** | ** ** |
| Consolidated  Balance Sheet (unaudited) as of September 30, 2008 and December 31,  2007                                       |       | 3                                                                                               |
|                                                                                                                                    |       |                                                                                            |       |       |
| Consolidated Statement of Income  (unaudited) for the Three and Nine Months ended September 30, 2008 and  2007                     |       | 4                                                                                               |
|                                                                                                                                    |       |                                                                                            |       |       |
| Consolidated  Statement of Changes in Shareholders’ Equity (unaudited) for the Nine Months  ended September 30, 2008 and 2007 |       | 5                                                                                               |
|                                                                                                                                    |       |                                                                                            |       |       |
| Consolidated  Statement of Comprehensive Income (unaudited) for the Three and Nine Months  ended September 30, 2008 and 2007       |       | 5                                                                                               |
|                                                                                                                                    |       |                                                                                            |       |       |
| Consolidated  Statement of Cash Flows (unaudited) for the Nine Months ended  September 30, 2008 and 2007                           |       | 6                                                                                               |
|                                                                                                                                    |       |                                                                                            |       |       |
| Notes to Consolidated Financial Statements (unaudited)                                                                                  |       | 7                                                                                               |
|                                                                                                                                    |       |                                                                                            |       |       |
| **Item 2.**                                                                                                                             | ** ** | **Management’s  Discussion and Analysis of Financial Condition and Results of Operations** | ** ** | **15**     |
| **Item 3.**                                                                                                                             | ** ** | **Quantitative  and Qualitative Disclosures About Market Risk**                                 | ** ** | **32**     |
| **Item 4.**                                                                                                                             | ** ** | **Controls and  Procedures**                                                                    | ** ** | **32**     |
| ** **                                                                                                                              | ** ** | ** **                                                                                      | ** ** | ** ** |
| **Part II**                                                                                                                        | ** ** | **Other Information**                                                                           | ** ** | ** ** |
| ** **                                                                                                                              | ** ** | ** **                                                                                      | ** ** | ** ** |
| **Item 1.**                                                                                                                             | ** ** | **Legal Proceedings**                                                                           |       | 33         |
| **Item 1A.**                                                                                                                            | ** ** | **Risk Factors**                                                                                |       | 33         |
| **Item 2.**                                                                                                                             | ** ** | **Unregistered  Sales of Equity Securities and Use of Proceeds**                                |       | 33         |
| **Item 3.**                                                                                                                             | ** ** | **Defaults  Upon Senior Securities**                                                            |       | 33         |
| **Item 4.**                                                                                                                             | ** ** | **Submission  of Matters to a Vote of Security Holders**                                        |       | 33         |
| **Item 5.**                                                                                                                             | ** ** | **Other Information**                                                                           |       | 33         |
| **Item 6.**                                                                                                                             | ** ** | **Exhibits**                                                                                    |       | 34         |
| **Signatures**                                                                                                                          |       | 35                                                                                              |
| **Exhibit Index and Exhibits**                                                                                                     |       | 36                                                                                              |

 

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**Part I.  FINANCIAL INFORMATION**

 

**Item 1.  Financial Statements**

 

PENNS WOODSBANCORP, INC.

CONSOLIDATED BALANCE SHEET

(UNAUDITED)

 
| ** **                                                                                           | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| **(In Thousands, Except Share Data)**                                            | ** ** | **2008**               | ** ** | **2007**              | ** ** |
|                                                                                                 |       |                   |       |                  |       |
| ASSETS                                                                                               |       |                   |       |                  |       |
| Noninterest-bearing  balances                                                                        |       | $                      | 12,538     |                  | $          | 15,417 |   |
| Interest-bearing  deposits in other financial institutions                                           |       | 16                     |       | 16                    |       |
| Total cash and  cash equivalents                                                                     |       | 12,554                 |       | 15,433                |       |
|                                                                                                 |       |                   |       |                  |       |
| Investment  securities, available for sale, at fair value                                            |       | 201,220                |       | 214,455               |       |
| Investment  securities held to maturity (fair value of $136 and $279)                                |       | 135                    |       | 277                   |       |
| Loans held for  sale                                                                                 |       | 4,987                  |       | 4,214                 |       |
| Loans                                                                                                |       | 371,547                |       | 360,478               |       |
| Less: Allowance  for loan losses                                                                     |       | 4,268                  |       | 4,130                 |       |
| Loans, net                                                                                           |       | 367,279                |       | 356,348               |       |
| Premises and  equipment, net                                                                         |       | 7,835                  |       | 6,774                 |       |
| Accrued interest  receivable                                                                         |       | 3,451                  |       | 3,343                 |       |
| Bank-owned life  insurance                                                                           |       | 13,457                 |       | 12,375                |       |
| Investment in  limited partnerships                                                                  |       | 4,905                  |       | 5,439                 |       |
| Goodwill                                                                                             |       | 3,032                  |       | 3,032                 |       |
| Other assets                                                                                         |       | 13,389                 |       | 6,448                 |       |
| TOTAL ASSETS                                                                                         |       | $                      | 632,244    |                  | $          | 628,138 |   |
|                                                                                                 |       |                   |       |                  |       |
| LIABILITIES                                                                                          |       |                   |       |                  |       |
| Interest-bearing  deposits                                                                           |       | $                      | 356,985    |                  | $          | 314,351 |   |
| Noninterest-bearing  deposits                                                                        |       | 73,586                 |       | 74,671                |       |
| Total deposits                                                                                       |       | 430,571                |       | 389,022               |       |
|                                                                                                 |       |                   |       |                  |       |
| Short-term  borrowings                                                                               |       | 48,429                 |       | 55,315                |       |
| Long-term  borrowings, Federal Home Loan Bank (FHLB)                                                 |       | 86,778                 |       | 106,378               |       |
| Accrued interest  payable                                                                            |       | 1,371                  |       | 1,744                 |       |
| Other  liabilities                                                                                   |       | 5,534                  |       | 5,120                 |       |
| TOTAL  LIABILITIES                                                                                   |       | 572,683                |       | 557,579               |       |
|                                                                                                 |       |                   |       |                  |       |
| SHAREHOLDERS’  EQUITY                                                                           |       |                   |       |                  |       |
| Common stock,  par value $8.33, 10,000,000 shares authorized; 4,009,546 and 4,006,934 shares  issued |       | 33,413                 |       | 33,391                |       |
| Additional paid-in  capital                                                                          |       | 17,944                 |       | 17,888                |       |
| Retained  earnings                                                                                   |       | 27,680                 |       | 27,707                |       |
| Accumulated  other comprehensive loss:                                                               |       |                   |       |                  |       |
| Net unrealized  loss on available for sale securities                                                |       | (12,347                | )          | (2,159                | )          |
| Defined benefit  plan                                                                                |       | (1,375                 | )          | (1,375                | )          |
| Less: Treasury  stock at cost, 159,028 and 131,302 shares                                            |       | (5,754                 | )          | (4,893                | )          |
| TOTAL  SHAREHOLDERS’ EQUITY                                                                     |       | 59,561                 |       | 70,559                |       |
| TOTAL  LIABILITIES AND SHAREHOLDERS’ EQUITY                                                     |       | $                      | 632,244    |                  | $          | 628,138 |   |

 

See accompanyingnotes to the unaudited consolidated financial statements.

 

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PENNS WOODS BANCORP, INC.

CONSOLIDATED STATEMENT OF INCOME

(UNAUDITED)

 
| ** **                                                         | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **(In Thousands, Except Per Share Data)** | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| INTEREST AND  DIVIDEND INCOME                                      |       |                                                 |       |                                                |       |   |   |   |   |
| Loans including  fees                                              |       | $                                                    | 6,311      |                                                | $          | 6,621 |   | $ | 18,936 |   | $ | 19,560 |   |
| Investment  Securities:                                            |       |                                                 |       |                                                |       |   |   |   |   |
| Taxable                                                            |       | 1,391                                                |       | 964                                                 |       | 3,857 |   | 2,711 |   |
| Tax-exempt                                                         |       | 1,205                                                |       | 1,108                                               |       | 3,641 |   | 3,271 |   |
| Dividend and  other interest income                                |       | 201                                                  |       | 284                                                 |       | 658 |   | 907 |   |
| TOTAL INTEREST  AND DIVIDEND INCOME                                |       | 9,108                                                |       | 8,977                                               |       | 27,092 |   | 26,449 |   |
|                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| INTEREST EXPENSE                                                   |       |                                                 |       |                                                |       |   |   |   |   |
| Deposits                                                           |       | 2,410                                                |       | 2,835                                               |       | 7,502 |   | 8,215 |   |
| Short-term  borrowings                                             |       | 310                                                  |       | 368                                                 |       | 996 |   | 1,100 |   |
| Long-term  borrowings, FHLB                                        |       | 875                                                  |       | 909                                                 |       | 3,044 |   | 2,735 |   |
| TOTAL INTEREST  EXPENSE                                            |       | 3,595                                                |       | 4,112                                               |       | 11,542 |   | 12,050 |   |
|                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| NET INTEREST  INCOME                                               |       | 5,513                                                |       | 4,865                                               |       | 15,550 |   | 14,399 |   |
|                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| PROVISION FOR  LOAN LOSSES                                         |       | 110                                                  |       | 10                                                  |       | 230 |   | 60 |   |
|                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| NET INTEREST  INCOME AFTER PROVISION FOR LOAN LOSSES               |       | 5,403                                                |       | 4,855                                               |       | 15,320 |   | 14,339 |   |
|                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| NON-INTEREST  INCOME                                               |       |                                                 |       |                                                |       |   |   |   |   |
| Service charges                                                    |       | 594                                                  |       | 546                                                 |       | 1,704 |   | 1,654 |   |
| Securities  (losses) gains, net                                    |       | (1,504                                               | )          | —                                              |       | (1,717 | ) | 619 |   |
| Bank-owned life  insurance                                         |       | 121                                                  |       | 109                                                 |       | 367 |   | 310 |   |
| Gain on sale of  loans                                             |       | 314                                                  |       | 282                                                 |       | 678 |   | 654 |   |
| Insurance  commissions                                             |       | 416                                                  |       | 625                                                 |       | 1,482 |   | 1,613 |   |
| Other                                                              |       | 531                                                  |       | 444                                                 |       | 1,493 |   | 1,316 |   |
| TOTAL  NON-INTEREST INCOME                                         |       | 472                                                  |       | 2,006                                               |       | 4,007 |   | 6,166 |   |
|                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| NON-INTEREST  EXPENSE                                              |       |                                                 |       |                                                |       |   |   |   |   |
| Salaries and  employee benefits                                    |       | 2,355                                                |       | 2,330                                               |       | 7,275 |   | 6,912 |   |
| Occupancy, net                                                     |       | 315                                                  |       | 319                                                 |       | 967 |   | 987 |   |
| Furniture and  equipment                                           |       | 304                                                  |       | 267                                                 |       | 876 |   | 850 |   |
| Pennsylvania  shares tax                                           |       | 105                                                  |       | 160                                                 |       | 315 |   | 482 |   |
| Amortization of  investment in limited partnerships                |       | 178                                                  |       | 220                                                 |       | 534 |   | 503 |   |
| Other                                                              |       | 1,194                                                |       | 1,134                                               |       | 3,440 |   | 3,164 |   |
| TOTAL  NON-INTEREST EXPENSE                                        |       | 4,451                                                |       | 4,430                                               |       | 13,407 |   | 12,898 |   |
|                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| INCOME BEFORE  INCOME TAX (BENEFIT) PROVISION                      |       | 1,424                                                |       | 2,431                                               |       | 5,920 |   | 7,607 |   |
| INCOME TAX  (BENEFIT) PROVISION                                    |       | (128                                                 | )          | 109                                                 |       | 180 |   | 669 |   |
| NET INCOME                                                         |       | $                                                    | 1,552      |                                                | $          | 2,322 |   | $ | 5,740 |   | $ | 6,938 |   |
|                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| EARNINGS PER  SHARE - BASIC                                        |       | $                                                    | 0.40       |                                                | $          | 0.60 |   | $ | 1.49 |   | $ | 1.78 |   |
|                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| EARNINGS PER  SHARE - DILUTED                                      |       | $                                                    | 0.40       |                                                | $          | 0.60 |   | $ | 1.49 |   | $ | 1.78 |   |
|                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| WEIGHTED AVERAGE  SHARES OUTSTANDING - BASIC                       |       | 3,855,348                                            |       | 3,881,488                                           |       | 3,865,317 |   | 3,889,310 |   |
|                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| WEIGHTED AVERAGE  SHARES OUTSTANDING - DILUTED                     |       | 3,855,458                                            |       | 3,881,676                                           |       | 3,865,463 |   | 3,889,573 |   |
|                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| DIVIDENDS PER  SHARE                                               |       | $                                                    | 0.46       |                                                | $          | 0.45 |   | $ | 1.38 |   | $ | 1.33 |   |

 

See accompanyingnotes to the unaudited consolidated financial statements.

 

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PENNS WOODSBANCORP, INC.

CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’EQUITY

(UNAUDITED)

 
| ** **                                                                                                                   | ** ** | **COMMON  STOCK** | ** ** | **ADDITIONAL  PAID-IN** | ** ** | **RETAINED** | ** ** | **ACCUMULATED  OTHER  COMPREHENSIVE** | ** ** | **TREASURY** | ** ** | **TOTAL  SHAREHOLDERS’** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-------------------------|------------|--------------|------------|---------------------------------------|------------|--------------|------------|-------------------------------|------------|
| **(In Thousands, Except Per Share Data)**                                                           | ** ** | **SHARES**        | ** ** | **AMOUNT**              | ** ** | **CAPITAL**  | ** ** | **EARNINGS**                          | ** ** | **LOSS**     | ** ** | **STOCK**                     | ** ** | **EQUITY** | ** ** |
| Balance,  December 31, 2007                                                                                             |       | 4,006,934         |       | $                       | 33,391     |         | $          | 17,888                                |       | $            | 27,707     |                          | $          | (3,534 | ) | $ | (4,893 | ) | $ | 70,559 |   |
|                                                                                                                         |       |              |       |                    |       |         |       |                                  |       |         |       |                          |       |   |   |
| Comprehensive  Loss:                                                                                                         |       |              |       |                    |       |         |       |                                  |       |         |       |                          |       |   |   |
| Net income                                                                                                                   |       |              |       |                    |       |         |       | 5,740                                 |       |         |       |                          |       | 5,740 |   |
| Unrealized loss  on investments available for sale, net of reclassification adjustment, net of  income tax benefit of $5,248 |       |              |       |                    |       |         |       |                                  |       | (10,188      | )          |                          |       | (10,188 | ) |
| Total  comprehensive loss                                                                                                    |       |              |       |                    |       |         |       |                                  |       |         |       |                          |       | (4,448 | ) |
| Dividends  declared, ($1.38 per share)                                                                                       |       |              |       |                    |       |         |       | (5,330                                | )          |         |       |                          |       | (5,330 | ) |
| Purchase of  treasury stock (27,726 shares)                                                                                  |       |              |       |                    |       |         |       |                                  |       |         |       | (861                          | )          | (861 | ) |
| Cumulative effect  of change in accounting for postretirement benefits                                                       |       |              |       |                    |       |         |       | (437                                  | )          |         |       |                          |       | (437 | ) |
| Stock options  exercised                                                                                                     |       | 330               |       | 3                       |       | 8            |       |                                  |       |         |       |                          |       | 11 |   |
| Common shares  issued for employee stock purchase plan                                                                       |       | 2,282             |       | 19                      |       | 48           |       |                                  |       |         |       |                          |       | 67 |   |
| Balance,  September 30, 2008                                                                                            |       | 4,009,546         |       | $                       | 33,413     |         | $          | 17,944                                |       | $            | 27,680     |                          | $          | (13,722 | ) | $ | (5,754 | ) | $ | 59,561 |   |

 
| ** **                                                                                                                   | ** ** | **COMMON  STOCK** | ** ** | **ADDITIONAL  PAID-IN** | ** ** | **RETAINED** | ** ** | **ACCUMULATED  OTHER  COMPREHENSIVE** | ** ** | **TREASURY**       | ** ** | **TOTAL  SHAREHOLDERS’** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-------------------------|------------|--------------|------------|---------------------------------------|------------|--------------------|------------|-------------------------------|------------|
| **(In Thousands, Except Per Share Data)**                                                                                    | ** ** | **SHARES**        | ** ** | **AMOUNT**              | ** ** | **CAPITAL**  | ** ** | **EARNINGS**                          | ** ** | **INCOME  (LOSS)** | ** ** | **STOCK**                     | ** ** | **EQUITY** | ** ** |
| Balance,  December 31, 2006                                                                                             |       | 4,003,514         |       | $                       | 33,362     |         | $          | 17,810                                |       | $                  | 25,783     |                          | $          | 1,560 |   | $ | (3,921 | ) | $ | 74,594 |   |
|                                                                                                                         |       |              |       |                    |       |         |       |                                  |       |               |       |                          |       |   |   |
| Comprehensive  Income:                                                                                                       |       |              |       |                    |       |         |       |                                  |       |               |       |                          |       |   |   |
| Net income                                                                                                                   |       |              |       |                    |       |         |       | 6,938                                 |       |               |       |                          |       | 6,938 |   |
| Unrealized loss  on investments available for sale, net of reclassification adjustment, net of  income tax benefit of $2,061 |       |              |       |                    |       |         |       |                                  |       | (4,000             | )          |                          |       | (4,000 | ) |
| Total  comprehensive income                                                                                                  |       |              |       |                    |       |         |       |                                  |       |               |       |                          |       | 2,938 |   |
| Dividends  declared, ($1.33 per share)                                                                                       |       |              |       |                    |       |         |       | (5,169                                | )          |               |       |                          |       | (5,169 | ) |
| Purchase of  treasury stock (26,030 shares)                                                                                  |       |              |       |                    |       |         |       |                                  |       |               |       | (892                          | )          | (892 | ) |
| Stock options  exercised                                                                                                     |       | 330               |       | 3                       |       | 5            |       |                                  |       |               |       |                          |       | 8 |   |
| Common shares  issued for employee stock purchase plan                                                                       |       | 2,240             |       | 19                      |       | 54           |       |                                  |       |               |       |                          |       | 73 |   |
| Balance,  September 30, 2007                                                                                            |       | 4,006,084         |       | $                       | 33,384     |         | $          | 17,869                                |       | $                  | 27,552     |                          | $          | (2,440 | ) | $ | (4,813 | ) | $ | 71,552 |   |

 

PENNS WOODSBANCORP, INC.

 CONSOLIDATEDSTATEMENT OF COMPREHENSIVE INCOME

 (UNAUDITED)

 
| ** **                                                                       | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| **(In Thousands)**                                                          | ** ** | **2008**                                                 | ** ** | **2007**                                                | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                                             |       |                                                     |       |                                                    |       |   |   |   |   |
| Net Income                                                                       |       | $                                                        | 1,552      |                                                    | $          | 2,322 |   | $ | 5,740 |   | $ | 6,938 |   |
| Other  comprehensive (loss) income:                                              |       |                                                     |       |                                                    |       |   |   |   |   |
| Change in net  unrealized (losses) gains on available for sale securities        |       | (8,301                                                   | )          | 2,415                                                   |       | (17,153 | ) | (5,442 | ) |
| Less: Reclassification  adjustment for net (losses) gains included in net income |       | (1,504                                                   | )          | —                                                  |       | (1,717 | ) | 619 |   |
| Other  comprehensive (loss) income before tax                                    |       | (6,797                                                   | )          | 2,415                                                   |       | (15,436 | ) | (6,061 | ) |
| Income tax  (benefit) provision related to other comprehensive (loss) income     |       | (2,311                                                   | )          | 821                                                     |       | (5,248 | ) | (2,061 | ) |
| Other  comprehensive (loss) gain, net of tax                                     |       | (4,486                                                   | )          | 1,594                                                   |       | (10,188 | ) | (4,000 | ) |
| Comprehensive  (loss) income                                                     |       | $                                                        | (2,934     | )                                                       | $          | 3,916 |   | $ | (4,448 | ) | $ | 2,938 |   |

 

See accompanyingnotes to the unaudited consolidated financial statements.

 

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PENNS WOODSBANCORP, INC.

CONSOLIDATED STATEMENT OF CASH FLOWS

(UNAUDITED)

 
| ** **                                                                         | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **(In Thousands)**                                                            | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
|                                                                               |       |                                                |       |   |   |
| OPERATING  ACTIVITIES                                                              |       |                                                |       |   |   |
| Net Income                                                                         |       | $                                                   | 5,740      |   | $ | 6,938 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                                |       |   |   |
| Depreciation and  amortization                                                     |       | 490                                                 |       | 523 |   |
| Provision for  loan losses                                                         |       | 230                                                 |       | 60 |   |
| Accretion and  amortization of investment security discounts and premiums          |       | (982                                                | )          | (738 | ) |
| Securities  losses (gains), net                                                    |       | 1,717                                               |       | (619 | ) |
| Originations of  loans held for sale                                               |       | (31,276                                             | )          | (33,903 | ) |
| Proceeds of  loans held for sale                                                   |       | 31,181                                              |       | 31,770 |   |
| Gain on sale of  loans                                                             |       | (678                                                | )          | (654 | ) |
| Increases in  bank-owned life insurance                                            |       | (367                                                | )          | (310 | ) |
| Other, net                                                                         |       | (1,445                                              | )          | 303 |   |
| Net cash  provided by operating activities                                         |       | 4,610                                               |       | 3,370 |   |
| INVESTING  ACTIVITIES                                                              |       |                                                |       |   |   |
| Investment  securities available for sale:                                         |       |                                                |       |   |   |
| Proceeds from  sales                                                               |       | 39,994                                              |       | 39,226 |   |
| Proceeds from  calls and maturities                                                |       | 5,905                                               |       | 4,290 |   |
| Purchases                                                                          |       | (49,733                                             | )          | (67,067 | ) |
| Investment  securities held to maturity:                                           |       |                                                |       |   |   |
| Proceeds from  calls and maturities                                                |       | 179                                                 |       | 11 |   |
| Net (increase)  decrease in loans                                                  |       | (11,458                                             | )          | 2,516 |   |
| Acquisition of  bank premises and equipment                                        |       | (1,551                                              | )          | (627 | ) |
| Proceeds from  the sale of foreclosed assets                                       |       | 79                                                  |       | 66 |   |
| Purchase of  bank-owned life insurance                                             |       | (715                                                | )          | (619 | ) |
| Proceeds from  redemption of regulatory stock                                      |       | 3,663                                               |       | 3,045 |   |
| Purchases of  regulatory stock                                                     |       | (2,802                                              | )          | (3,620 | ) |
| Net cash used  for investing activities                                            |       | (16,439                                             | )          | (22,779 | ) |
| FINANCING  ACTIVITIES                                                              |       |                                                |       |   |   |
| Net increase in  interest-bearing deposits                                         |       | 42,634                                              |       | 9,833 |   |
| Net decrease in  noninterest-bearing deposits                                      |       | (1,085                                              | )          | (170 | ) |
| Proceeds of  long-term borrowings, FHLB                                            |       | 10,000                                              |       | 20,000 |   |
| Repayment of  long-term borrowings, FHLB                                           |       | (29,600                                             | )          | (16,500 | ) |
| Net (decrease)  increase in short-term borrowings                                  |       | (6,886                                              | )          | 10,096 |   |
| Dividends paid                                                                     |       | (5,330                                              | )          | (5,169 | ) |
| Issuance of  common stock                                                          |       | 67                                                  |       | 73 |   |
| Stock options  exercised                                                           |       | 11                                                  |       | 8 |   |
| Purchase of  treasury stock                                                        |       | (861                                                | )          | (892 | ) |
| Net cash  provided by financing activities                                         |       | 8,950                                               |       | 17,279 |   |
| NET DECREASE IN  CASH AND CASH EQUIVALENTS                                         |       | (2,879                                              | )          | (2,130 | ) |
| CASH AND CASH  EQUIVALENTS, BEGINNING                                              |       | 15,433                                              |       | 15,373 |   |
| CASH AND CASH  EQUIVALENTS, ENDING                                                 |       | $                                                   | 12,554     |   | $ | 13,243 |   |
|                                                                               |       |                                                |       |   |   |
| SUPPLEMENTAL  DISCLOSURES OF CASH FLOW INFORMATION                                 |       |                                                |       |   |   |
|                                                                               |       |                                                |       |   |   |
| Interest paid                                                                      |       | $                                                   | 11,915     |   | $ | 11,744 |   |
| Income taxes  paid                                                                 |       | 1,425                                               |       | 1,185 |   |

 

See accompanyingnotes to the unaudited consolidated financial statements.

 

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# **PENNS WOODS BANCORP, INC. AND SUBSIDIARIES**

**NOTES TO**

**CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

# **Note 1.  Basis of Presentation**

# ** **

# **The consolidated financial statementsinclude the accounts of Penns Woods Bancorp, Inc. (the “Company”) and itswholly-owned subsidiaries: Woods Investment Company, Inc., Woods RealEstate Development Company, Inc., and Jersey Shore State Bank (the “Bank”)and its wholly-owned subsidiary, The M Group, Inc. D/B/A The ComprehensiveFinancial Group (“The M Group”).  Allsignificant inter-company balances and transactions have been eliminated in theconsolidation.**

# ** **

The interim financialstatements are unaudited but, in the opinion of management, reflect alladjustments necessary for the fair presentation of results for suchperiods.  The results of operations forany interim period are not necessarily indicative of results for the full year.  These financial statements should be read inconjunction with financial statements and notes thereto contained in theCompany’s Annual Report on Form 10-K for the year ended December 31,2007.

 

Theaccounting policies followed in the presentation of interim financial resultsare the same as those followed on an annual basis.  These policies arepresented on pages 41 through 47 of the Annual Report on Form 10-Kfor the year ended December 31, 2007.

 

In reference to theattached financial statements, all adjustments are of a normal recurring naturepursuant to Rule 10-01(b) (8) of Regulation S-X.

 

**Note 2. RecentAccounting Pronouncements**

** **

In December 2007,the FASB issued FAS No. 141 (revised 2007), Business Combinations (“FAS141(R)”), which establishes principles and requirements for how an acquirerrecognizes and measures in its financial statements the identifiable assetsacquired, the liabilities assumed, and any noncontrolling interest in anacquiree, including the recognition and measurement of goodwill acquired in abusiness combination.  FAS No. 141(R) is effective for fiscalyears beginning on or after December 15, 2008.  Earlier adoption isprohibited.  Theadoption of this standard is not expected to have a material effect on theCompany’s results of operations or financial position.

 

In September 2006, the FASB issued FAS No. 157,Fair Value Measurements, which provides enhanced guidance for using fair valueto measure assets and liabilities.  Thestandard applies whenever other standards require or permit assets orliabilities to be measured at fair value. The Standard does not expand the use of fair value in any newcircumstances.  FAS No. 157 iseffective for financial statements issued for fiscal years beginning after November 15,2007 and interim periods within those fiscal years.  In February 2008, the FASB issued StaffPosition No. 157-1, Application of FASB Statement No. 157 to FASBStatement No. 13 and Other Accounting Pronouncements That Address FairValue Measurements for Purposes of Lease

 

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Classification or**Measurementunder Statement 13, which removed leasing transactions accounted for under FAS No. 13and related guidance from the scope of FAS No. 157*.*  Also in February 2008, the FASB issuedStaff Position No.157-2, Partial Deferral of the Effective Date of Statement157, which deferred the effective date of FAS No. 157 for all nonfinancialassets and nonfinancial liabilities to fiscal years beginning after November 15,2008.  On January 1, 2008, theCompany adopted FAS No. 157 which did not have a material effect on theCompany’s results of operations or financial position, see Note 8.

 

InSeptember 2006, the FASB issued FAS No. 158, Employers’ Accountingfor Defined Benefit Pension and Other Post Retirement Plans, an amendment ofFASB Statements No. 87, 88, 106 and 132(R). This Statement requires thatemployers measure plan assets and obligations as of the balance sheetdate.  This requirement is effective forfiscal years ending after December 15, 2008.  The other provisions of the Statement wereeffective as of the end of the fiscal year ending after December 15, 2006,for public companies.  The completeadoption of this standard is not expected to have a material effect on theCompany’s results of operations or financial position.

 

In February 2007, theFASB issued FAS No. 159, The Fair Value Option for Financial Assets andFinancial Liabilities — Including an amendment of FASB Statement No. 115,which provides all entities with an option to report selected financial assetsand liabilities at fair value. The objective of the FAS No. 159 is toimprove financial reporting by providing entities with the opportunity tomitigate volatility in earnings caused by measuring related assets andliabilities differently without having to apply the complex provisions of hedgeaccounting.  FAS No. 159 iseffective as of the beginning of an entity’s first fiscal year beginning after November 15,2007.  Early adoption is permitted as ofthe beginning of a fiscal year that begins on or before November 15, 2007provided the entity also elects to apply the provisions of FAS No. 157,Fair Value Measurements.  On January 31,2008, the Company adopted FAS No. 159 which did not have a material effecton the Company’s results of operations or financial position.

 

In December 2007, theFASB issued FAS No. 160, Noncontrolling Interests in ConsolidatedFinancial Statements — an amendment of ARB No. 51.  FAS No. 160 amends ARB No. 51 toestablish accounting and reporting standards for the noncontrolling interest ina subsidiary and for the deconsolidation of a subsidiary.  It clarifiesthat a noncontrolling interest in a subsidiary, which is sometimes referred toas minority interest, is an ownership interest in the consolidated entity thatshould be reported as equity in the consolidated financial statements. Among other requirements, this statement requires consolidated net income to bereported at amounts that include the amounts attributable to both the parentand the noncontrolling interest.  It also requires disclosure, on the faceof the consolidated income statement, of the amounts of consolidated net incomeattributable to the parent and to the noncontrolling interest.   FAS No. 160is effective for fiscal years beginning on or after December 15,2008.  Earlier adoption isprohibited.  The adoption of this standard is not expected to have amaterial effect on the Company’s results of operations or financial position.

 

In September 2006, theFASB reached consensus on the guidance provided by Emerging Issues Task ForceIssue 06-4 (“EITF 06-4”), Accounting for Deferred Compensation andPostretirement Benefit Aspects of Endorsement Split-Dollar Life InsuranceArrangements.  The guidance is applicableto endorsement split-dollar life insurance arrangements, whereby the

 

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employer owns and controlsthe insurance policy, that are associated with a postretirement benefit.  EITF 06-4 requires that for a split-dollarlife insurance arrangement within the scope of the Issue, an employer shouldrecognize a liability for future benefits in accordance with FAS No. 106(if, in substance, a postretirement benefit plan exists) or AccountingPrinciples Board Opinion No. 12 (if the arrangement is, in substance, anindividual deferred compensation contract) based on the substantive agreementwith the employee.  EITF 06-4 iseffective for fiscal years beginning after December 15, 2007.  On January 1, 2008, the Company adoptedEITF 06-04 which resulted in an adjustment to retained earnings and anassociated liability in the amount of $437,000.

 

In March 2007, the FASBratified Emerging Issues Task Force Issue No. 06-10 (“EITF 06-10”),Accounting for Collateral Assignment Split-Dollar Life Insurance Agreements.EITF 06-10 provides guidance for determining a liability for the postretirementbenefit obligation as well as recognition and measurement of the associatedasset on the basis of the terms of the collateral assignment agreement. EITF06-10 is effective for fiscal years beginning after December 15, 2007. On January 1,2008, the Company adopted EITF 06-10 which did not have a material effect onthe Company’s results of operations or financial position.

 

In June 2007, the FASBratified Emerging Issues Task Force Issue No. 06-11 (“EITF 06-11”),Accounting for Income Tax Benefits of Dividends on Share-Based PaymentAwards.  EITF 06-11 applies toshare-based payment arrangements with dividend protection features that entitleemployees to receive (a) dividends on equity-classified nonvested shares, (b) dividendequivalents on equity-classified nonvested share units, or (c) paymentsequal to the dividends paid on the underlying shares while an equity-classifiedshare option is outstanding, when those dividends or dividend equivalents arecharged to retained earnings under FAS No. 123R, Share-Based Payment, andresult in an income tax deduction for the employer. A consensus was reachedthat a realized income tax benefit from dividends or dividend equivalents thatare charged to retained earnings and are paid to employees forequity-classified nonvested equity shares, nonvested equity share units, andoutstanding equity share options should be recognized as an increase inadditional paid-in capital.  EITF 06-11is effective for fiscal years beginning after December 15, 2007, andinterim periods within those fiscal years. On January 1, 2008, the Company adopted EITF 06-11 which did nothave a material effect on the Company’s results of operations or financialposition.

 

In March 2008, the FASBissued FAS No. 161, Disclosures about Derivative Instruments and HedgingActivities, to require enhanced disclosures about derivative instruments andhedging activities. The new standard has revised financial reporting forderivative instruments and hedging activities by requiring more transparencyabout how and why an entity uses derivative instruments, how derivativeinstruments and related hedged items are accounted for under FAS No. 133,Accounting for Derivative Instruments and Hedging Activities; and howderivative instruments and related hedged items affect an entity’s financialposition, financial performance, and cash flows.  FAS No. 161 requires disclosure of thefair values of derivative instruments and their gains and losses in a tabularformat. It also requires entities to provide more information about theirliquidity by requiring disclosure of derivative features that are creditrisk-related. Further, it requires cross-referencing within footnotes to enablefinancial statement users to locate important information about derivativeinstruments.  FAS No. 161 is effective for

 

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financial statements issuedfor fiscal years and interim periods beginning after November 15, 2008,with early application encourage.  Theadoption of this standard is not expected to have a material effect on theCompany’s results of operations or financial position.

 

In May 2008, the FASB issued FAS No. 162,The Hierarchy of Generally Accepted Accounting Principles. FAS No. 162identifies the sources of accounting principles and the framework for selectingthe principles used in the preparation of financial statements ofnongovernmental entities that are presented in conformity with generallyaccepted accounting principles (the GAAP hierarchy). FAS No. 162 willbecome effective 60 days following the SEC’s approval of the PublicCompany Accounting Oversight Board amendments to AU Section 411, TheMeaning of Present Fairly in Conformity With Generally Accepted AccountingPrinciples. The Company does not expect the adoption of FAS No. 162 tohave a material effect on its results of operations and financial position.

 

In April 2008, the FASB issued FASB StaffPosition No. 142-3, Determination of the Useful Life of Intangible Assets(“FSP 142-3”). FSP 142-3 amends the factors that should be considered indeveloping assumptions about renewal or extension used in estimating the usefullife of a recognized intangible asset under FAS No. 142, Goodwill andOther Intangible Assets. This standard is intended to improve the consistencybetween the useful life of a recognized intangible asset under FAS No. 142and the period of expected cash flows used to measure the fair value of theasset under FAS No. 141R  and otherGAAP. FSP 142-3 is effective for financial statements issued for fiscal yearsbeginning after December 15, 2008. The measurement provisions of thisstandard will apply only to intangible assets of the Company acquired after theeffective date.

 

In June 2008, the FASBissued FASB Staff Position (FSP) No. EITF 03-6-1, Determining WhetherInstruments Granted in Share-Based Payment Transactions Are ParticipatingSecurities, to clarify that instruments granted in share-based paymenttransactions can be participating securities prior to the requisite servicehaving been rendered.  A basic principleof the FSP is that unvested share-based payment awards that containnonforfeitable rights to dividends or dividend equivalents (whether paid orunpaid) are participating securities and are to be included in the computationof EPS pursuant to the two-class method.  The provisions of this FSP are effective for financial statementsissued for fiscal years beginning after December 15, 2008, and interimperiods within those years. All prior-period EPS data presented (includinginterim financial statements, summaries of earnings, and selected financialdata) are required to be adjusted retrospectively to conform with theprovisions of the FSP.  The adoption of this FSP is not expected tohave a material effect on the Company’s results of operations or financialposition.

 

In October 2008, theFASB issued FSP No. 157-3, Determining the Fair Value of a Financial AssetWhen the Market for That Asset is Not Active.  This FSP clarifies the application of FAS Statement No. 157, FairValue Measurements, in a market that is not active and provides an example toillustrate key considerations in determining the fair value of a financialasset when the market for that financial asset is not active.  This FSP shall be effective upon issuance,including prior periods for which financial statements have not been issued.Revisions resulting from a change in the valuation technique or its applicationshall be accounted for as a change in accounting estimate (FAS Statement No. 154,Accounting Changes and Error Corrections). The disclosure provisions ofStatement 154 for a change in accounting estimate are not required forrevisions resulting from a change in valuation technique or itsapplication.  The adoption of this

 

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FSP is not expected to havea material effect on the Company’s results of operations or financial position.

 

**Note 3. Per Share Data**

 

The following table sets forth the composition of theweighted average common shares (denominator) used in the basic and dilutive pershare computation.  There are noconvertible securities which would affect the numerator in calculating basicand diluted earnings per share; therefore, net income as presented on theconsolidated statement of income will be used as the numerator.

 
| ** **                                                                                                 | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                                 | ** ** | **2008**                                                 | ** ** | **2007**                                                | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                                                                       |       |                                                     |       |                                                    |       |   |   |   |   |
| Weighted average  common shares outstanding                                                                |       | 4,009,070                                                |       | 4,005,583                                               |       | 4,008,094 |   | 4,004,778 |   |
|                                                                                                       |       |                                                     |       |                                                    |       |   |   |   |   |
| Average treasury  stock shares                                                                             |       | (153,722                                                 | )          | (124,095                                                | )          | (142,777 | ) | (115,468 | ) |
|                                                                                                       |       |                                                     |       |                                                    |       |   |   |   |   |
| Weighted average  common shares and common stock equivalents used to calculate basic earnings  per share   |       | 3,855,348                                                |       | 3,881,488                                               |       | 3,865,317 |   | 3,889,310 |   |
|                                                                                                       |       |                                                     |       |                                                    |       |   |   |   |   |
| Additional  common stock equivalents (stock options) used to calculate diluted earnings  per share         |       | 110                                                      |       | 188                                                     |       | 146 |   | 263 |   |
|                                                                                                       |       |                                                     |       |                                                    |       |   |   |   |   |
| Weighted average  common shares and common stock equivalents used to calculate diluted earnings  per share |       | 3,855,458                                                |       | 3,881,676                                               |       | 3,865,463 |   | 3,889,573 |   |

 

Options to purchase 8,273 and 9,593 shares of commonstock were outstanding during the three and nine months ended September 30,2008 but were not included in the computation of diluted earnings per share asthey were anti-dilutive due to the strike prices range of $31.82 to $40.29being greater than the market price of $29.00 at September 30, 2008.  Options to purchase 8,276 and 9,002 shares ofcommon stock were outstanding during the three and nine months ended September 30,2007 but were not included in the computation of diluted earnings per share asthey were anti-dilutive due to the strike price of $40.29 being greater thanthe market price of $31.99 at September 30, 2007.

 

**Note 4.****  NetPeriodic Benefit Cost-Defined Benefit Plans**

 

For a detailed disclosure on the Company’s pension andemployee benefits plans, please refer to Note 11 of the Company’s ConsolidatedFinancial Statements included in the Annual Report on Form 10-K for theyear ended December 31, 2007.

 

The following sets forth the components of the netperiodic benefit cost of the domestic non-contributory defined benefit plan forthe three and nine months ended September 30, 2008 and 2007, respectively:

 

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| ** **                             | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **(In Thousands)**                | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                   |       |                                                 |       |                                                |       |   |   |   |   |
| Service cost                           |       | $                                                    | 137        |                                                | $          | 117 |   | $ | 410 |   | $ | 350 |   |
| Interest cost                          |       | 152                                                  |       | 121                                                 |       | 456 |   | 364 |   |
| Expected return  on plan assets        |       | (161                                                 | )          | (140                                                | )          | (481 | ) | (421 | ) |
| Amortization of  transition obligation |       | (1                                                   | )          | (1                                                  | )          | (2 | ) | (2 | ) |
| Amortization of  prior service cost    |       | 6                                                    |       | 6                                                   |       | 19 |   | 19 |   |
| Amortization of  net loss              |       | 14                                                   |       | —                                              |       | 42 |   | — |   |
| Net periodic  cost                     |       | $                                                    | 147        |                                                | $          | 103 |   | $ | 444 |   | $ | 310 |   |

 

**EmployerContributions**

** **

The Company previously disclosed in its consolidatedfinancial statements, included in the Annual Report on Form 10-K for theyear ended December 31, 2007, that it expected to contribute $450,000 toits defined benefit plan in 2008.  As of September 30, 2008, acontribution in the amount of $500,000 was made for the 2007 plan year with noadditional contributions anticipated during 2008.

 

**Note5.  Off Balance Sheet Risk**

 

The Company is a party to financial instrumentswith off-balance sheet risk in the normal course of business to meet thefinancing needs of its customers.  Thesefinancial instruments are primarily comprised of commitments to extend creditand standby letters of credit.  Theseinstruments involve, to varying degrees, elements of credit, interest rate, orliquidity risk in excess of the amount recognized in the consolidated balancesheet.  The contract amounts of theseinstruments express the extent of involvement the Company has in particularclasses of financial instruments.

 

The Company’s exposure to credit loss from nonperformanceby the other party to the financial instruments for commitments to extendcredit and standby letters of credit is represented by the contractual amountof these instruments.  The Company usesthe same credit policies in making commitments and conditional obligations asit does for on-balance sheet instruments. The Company may require collateral or other security to supportfinancial instruments with off-balance sheet credit risk.

 

Outstanding financial instruments with offbalance sheet risk are as follows:

 
| **(In Thousands)**       | ** ** | **September 30,  2008** | ** ** | **December 31,  2007** | ** ** |
|-------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Commitments to  extend credit |       | $                            | 93,999     |                        | $          | 74,349 |   |
| Standby letters  of credit    |       | 961                          |       | 974                         |       |
|                               |            |                              |            |                             |            |  |  |

 

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# **Note 6.  Reclassification of Comparative Amounts**

# ** **

Certain comparativeamounts for the prior period have been reclassified to conform to currentperiod presentations. Such reclassifications had no effect on net income orshareholders’ equity.

 

# **Note 7.  Employee Stock PurchasePlan**

# ** **

TheCompany issues shares under the Penns Woods Bancorp, Inc. 2006 EmployeeStock Purchase Plan (“Plan”) which is intended to encourage employeeparticipation in the ownership and economic progress of the Company.  The Plan allows for up to 1,000,000 shares tobe purchased by employees.  The purchaseprice of the shares is 95% of market value with an employee eligible topurchase up to the lesser of 15% of base compensation or $12,000 in marketvalue annually.  During the nine monthsended September 30, 2008 and 2007, there were 2,282 and 2,240 sharesissued under the plan, respectively.

 

# **Note 8.  Fair Value Measurements**

# ** **

EffectiveJanuary 1, 2008, the Company adopted FAS 157, which, among other things,requires enhanced disclosures about assets and liabilities carried at fairvalue. FAS 157 establishes a hierarchal disclosure framework associated withthe level of pricing observability utilized in measuring assets and liabilitiesat fair value. The three broad levels defined by FAS 157 hierarchy are asfollows:

 
| Level I:   |   | Quoted prices are available in active markets for  identical assets or liabilities as of the reported date.                                                                                                                                                                                                                                                                                    |
|------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |   |                                                                                                                                                                                                                                                                                                                                                                                           |
| Level II:  |   | Pricing inputs are other than quoted prices in  active markets, which are either directly or indirectly observable as of the  reported date. The nature of these assets and liabilities include items for  which quoted prices are available but traded less frequently, and items that  are fair valued using other financial instruments, the parameters of which  can be directly observed. |
|       |   |                                                                                                                                                                                                                                                                                                                                                                                           |
| Level III: |   | Assets and liabilities that have little to no  pricing observability as of the reported date. These items do not have  two-way markets and are measured using management’s best estimate of fair  value, where the inputs into the determination of fair value require  significant management judgment or estimation.                                                                    |

 

Thefollowing table presents the assets and liabilities reported on theconsolidated statements of financial condition at their fair value as of September 30,2008 by level within the fair value hierarchy. As required by FAS 157,financial assets and liabilities are classified in their entirety based on thelowest level of input that is significant to the fair value measurement.

 

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| ** **                                 | ** ** | **September 30, 2008** | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|
| **(In Thousands)**                    | ** ** | **Level I**                 | ** ** | **Level II** | ** ** | **Level III** | ** ** | **Total** | ** ** |
|                                       |       |                             |       |   |   |   |   |   |   |
| Assets:                                    |       |                             |       |   |   |   |   |   |   |
| Investment  Securities, available-for-sale |       | $                                | —     |   | $ | 201,220 |   | $ | — |   | $ | 201,220 |   |
|                                            |            |                                  |            |  |  |  |  |  |  |  |  |  |  |

 

**CAUTIONARYSTATEMENT FOR PURPOSES OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF1995**

 

This Report containscertain “forward-looking statements” including statements concerning plans,objectives, future events or performance and assumptions and other statementswhich are other than statements of historical fact.  The Company wishes to caution readers thatthe following important factors, among others, may have affected and could inthe future affect the Company’s actual results and could cause the Company’sactual results for subsequent periods to differ materially from those expressedin any forward-looking statement made by or on behalf of the Companyherein:  (i) the effect of changesin laws and regulations, including federal and state banking laws andregulations, with which the Company must comply, and the associated costs ofcompliance with such laws and regulations either currently or in the future asapplicable; (ii) the effect of changes in accounting policies andpractices, as may be adopted by the regulatory agencies as well as by theFinancial Accounting Standards Board, or of changes in the Company’sorganization, compensation and benefit plans; (iii) the effect on theCompany’s competitive position within its market area of the  increasing consolidation within the bankingand financial services industries, including the increased competition fromlarger regional and out-of-state banking organizations as well as non-bankproviders of various financial services; (iv) the effect of changes ininterest rates; and (v) the effect of changes in the business cycle anddownturns in the local, regional or national economies.

 

Youshould not put undue reliance on any forward-looking statements.  These statements speak only as of the date ofthis Quarterly Report on Form 10-Q, even if subsequently made available bythe Company on its website or otherwise. The Company undertakes no obligation to update or revise thesestatements to reflect events or circumstances occurring after the date of thisQuarterly Report on Form 10-Q.

 

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**Item 2.   Management’s Discussion and Analysis ofFinancial Condition and Results of Operation**

 

# **EARNINGS SUMMARY**

# ** **

**Comparisonof the Three and Nine Months Ended September 30, 2008 and 2007**

 

**SummaryResults**

 

Netincome for the three months ended September 30, 2008 was $1,552,000compared to $2,322,000 for the same period of 2007 as after-tax securitiesgains decreased $993,000 (from $0 to a loss of $993,000).  Included within the change in after-taxsecurities gains was an other than temporary impairment charge relating tocertain equity securities held in the investment portfolio of $1,222,000. Basicand diluted earnings per share for the three months ended September 30,2008 were $0.40 compared to $0.60 for the three months ended September 30,2007.  Return on average assets andreturn on average equity were 0.98% and 9.43% for the three months ended September 30,2008 compared to 1.57% and 13.21% for the corresponding period of 2007.  Net income from core operations (“operatingearnings”) increased 9.6% to $2,545,000 for the three months ended September 30,2008 compared to $2,322,000 for the same period of 2007.  Operating earnings per share for the threemonths ended September 30, 2008 increased 10.0% to $0.66 basic anddilutive compared to $0.60 basic and dilutive for the three months ended September 30,2007.

 

The nine months ended September 30,2008 generated net income of $5,740,000 compared to $6,938,000 for the sameperiod of 2007 due to a decline in after-tax securities gains of $1,542,000(from a gain of $409,000 to a loss of $1,133,000). Included within the change in after-taxsecurities gains was an other than temporary impairment charge relating tocertain equity securities held in the investment portfolio of $1,601,000. Earningsper share, basic and dilutive, for the nine months ended September 30,2008 were $1.49 as compared to $1.78 for the comparable period of 2007.  Return on average assets and return onaverage equity were 1.21% and 11.10% for the nine months ended September 30,2008 compared to 1.57% and 12.63% for the corresponding period of 2007. Operating earnings increased 5.3% to $6,873,000 for the nine monthsended September 30, 2008 compared to $6,529,000 for the comparable periodof 2007 resulting in basic and dilutive operating earnings per share of $1.78and $1.68 for the nine month periods ended September 30, 2008 and 2007,respectively.

 

(Management uses thenon-GAAP measure of net income from core operations in its analysis of theCompany’s performance.  This measure, asused by the Company, adjusts net income by significant gains or losses that areunusual in nature.  Because certain ofthese items and their impact on the Company’s performance are difficult topredict, management believes the presentation of financial measures excludingthe impact of such items provides useful supplemental information in evaluatingthe operating results of the Company’s core businesses.  For purposes of this Quarterly Report on Form 10-Q,net income from core operations means net income adjusted to exclude after-taxnet securities gains or losses.  Thesedisclosures should not be viewed as a substitute for net income determined inaccordance with GAAP, nor are they

 

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necessarily comparable tonon-GAAP performance measures that may be presented by other companies.)

 

**InterestAnd Dividend Income**

 

Interestand dividend income for the three months ended September 30, 2008increased $131,000 to $9,108,000 compared to $8,977,000 for the same period of2007.  The increase in interest incomewas primarily the result of growth in average taxable investment securities of$15,963,000 coupled with a 48 basis point (“bp”) increase in the relatedsecurities yields for the three months ended September 30, 2008 over thesame period of 2007.  This combinationresulted in a $345,000 increase in taxable investment securities interestincome. Over the same time frame, the average balance of tax-exempt investmentsecurities increased $8,048,000 with the portfolio yield remaining stable at7.06% resulting in a $97,000 increase in tax-exempt interest income.  On a taxable equivalent basis, the interestincome from the investment portfolio increased $492,000 due to the portfoliocomposition and increase in taxable investment security balance and yield.  The decrease in dividends received is theresult of a decrease in equity investments coupled with a general decline inthe dividends per share received from the equity holdings.  Interest and fee income from the loanportfolio decreased $310,000 as the rate reduction actions of the Federal ReserveBoard’s Federal Open Market Committee (“FOMC”) served as the foundation for the54 bp decline in loan portfolio yield.

 

Duringthe nine months ended September 30, 2008, interest and dividend income was$27,092,000, an increase of $643,000 over the same period of 2007.  The reasons for the 2.4% growth in interestincome for the nine month period are identical to those for the three monthperiod ending September 30, 2008 discussed above.  The growth in average loans of $6,972,000coupled with a 37 bp decrease in the loan portfolio yield due to the decreasingprime rate resulted in a decrease of $624,000 in loan interest and feeincome.   Average investment securitiesand interest bearing deposit income increased $1,267,000 due to an increase inaverage balance of $27,636,000 and a 12 bp increase in yield.  The increase in yield was due to an increasein yield on taxable and tax-exempt securities of 16 bp and 12 bp,respectively.  The increased yield wasprimarily the result of approximately $30,000,000 in bonds that were addedduring the last half of 2007 as part of a leverage strategy.  The asset allocation between loans and theinvestment portfolio composition resulted in taxable equivalent interest incomeincreasing $849,000 for the nine months ended September 30, 2008 comparedto the same period of 2007.

 

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Interestand dividend income composition for the three and nine months ended September 30,2008 and 2007 was as follows:

 
| ** **                          | ** ** | **For The Three Months Ended** | ** ** |
|-------------------------------------|------------|----------------------------------------------------|------------|
| ** **                          | ** ** | **September 30, 2008**                   | ** ** | **September 30, 2007** | ** ** | **Change** | ** ** |
| **(In Thousands)**             | ** ** | **Amount**                                         | ** ** | **% Total** | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **%** | ** ** |
| Loans including  fees               |       | $                                                  | 6,311      |   | 69.3 | % | $ | 6,621 |   | 73.8 | % | $ | (310 | ) | (4.7 | )% |
| Investment  securities:             |       |                                               |       |   |   |   |   |   |   |   |   |   |   |
| Taxable                             |       | 1,391                                              |       | 15.3 |   | 964 |   | 10.7 |   | 427 |   | 44.3 |   |
| Tax-exempt                          |       | 1,205                                              |       | 13.2 |   | 1,108 |   | 12.3 |   | 97 |   | 8.8 |   |
| Dividend and  other interest income |       | 201                                                |       | 2.2 |   | 284 |   | 3.2 |   | (83 | ) | (29.2 | ) |
| Total interest  and dividend income |       | $                                                  | 9,108      |   | 100.0 | % | $ | 8,977 |   | 100.0 | % | $ | 131 |   | 1.5 | % |

 
| ** **                          | ** ** | **For The Nine Months Ended** | ** ** |
|-------------------------------------|------------|---------------------------------------------------|------------|
| ** **                          | ** ** | **September 30, 2008**                  | ** ** | **September 30, 2007** | ** ** | **Change** | ** ** |
| **(In Thousands)**             | ** ** | **Amount**                                        | ** ** | **% Total** | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **%** | ** ** |
| Loans including  fees               |       | $                                                 | 18,936     |   | 69.9 | % | $ | 19,560 |   | 74.0 | % | $ | (624 | ) | (3.2 | )% |
| Investment securities:              |       |                                              |       |   |   |   |   |   |   |   |   |   |   |
| Taxable                             |       | 3,857                                             |       | 14.2 |   | 2,711 |   | 10.2 |   | 1,146 |   | 42.3 |   |
| Tax-exempt                          |       | 3,641                                             |       | 13.5 |   | 3,271 |   | 12.4 |   | 370 |   | 11.3 |   |
| Dividend and  other interest income |       | 658                                               |       | 2.4 |   | 907 |   | 3.4 |   | (249 | ) | (27.5 | ) |
| Total interest  and dividend income |       | $                                                 | 27,092     |   | 100.0 | % | $ | 26,449 |   | 100.0 | % | $ | 643 |   | 2.4 | % |

 

**InterestExpense**

 

Interestexpense for the three months ended September 30, 2008 decreased $517,000to $3,595,000 compared to $4,112,000 for the same period of 2007.  The decreased expense of $425,000 associatedwith deposits is primarily the result of a reduction in rate paid of 106 bp ontime deposits.  Factors that led to therate decreases include, but are not limited to, FOMC interest rate actions overthe past year, campaigns conducted to attract 8 to 12 month maturity CDs thathave resulted in an increased repricing frequency, and decreased averageutilization of $10,038,000 in brokered CDs. Short-term borrowings interest expense decreased $58,000 as the increasein average balance of $18,305,000 was countered by a decrease in the rate paidof 206 bp due to the FOMC rate actions over the past year.  Long-term borrowings interest expensedecreased $34,000 as the average balance of such borrowings increased$1,270,000 for the three months ended September 30, 2008 compared to thesame period of 2007, while the average rate decreased 31 bp to 4.33% for the2008 period.  The change in averagebalance and rate is reflective of $29,600,000 in long-term borrowing maturitiesduring the first half of 2008 at an average rate of 4.77% offset by theacquisition of $10,000,000 in long-term borrowings at a rate of 3.18% duringthe third quarter of 2008.

 

Interestexpense for the nine months ended September 30, 2008 decreased $508,000 to$11,542,000 compared to $12,050,000 for the same period of 2007.  Interest on deposits decreased $713,000 dueto the reasons noted in the three month analysis discussed in the proceeding paragraph.  Borrowing costs increased primarily due tothe addition of borrowings during the latter portion of 2007 as part of aprogram to increase net interest income through the purchase of fixed rateinvestment securities.

 

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Interestexpense composition for the three and nine months ended September 30, 2008and 2007 was as follows:

 
| ** **                  | ** ** | **For The Three Months Ended** | ** ** |
|-----------------------------|------------|----------------------------------------------------|------------|
| ** **                  | ** ** | **September 30, 2008**                   | ** ** | **September 30, 2007** | ** ** | **Change** | ** ** |
| **(In Thousands)**     | ** ** | **Amount**                                         | ** ** | **% Total** | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **%** | ** ** |
| Deposits                    |       | $                                                  | 2,410      |   | 67.0 | % | $ | 2,835 |   | 68.9 | % | $ | (425 | ) | (15.0 | )% |
| Short-term  borrowings      |       | 310                                                |       | 8.6 |   | 368 |   | 9.0 |   | (58 | ) | (15.8 | ) |
| Long-term  borrowings, FHLB |       | 875                                                |       | 24.4 |   | 909 |   | 22.1 |   | (34 | ) | (3.7 | ) |
| Total interest  expense     |       | $                                                  | 3,595      |   | 100.0 | % | $ | 4,112 |   | 100.0 | % | $ | (517 | ) | (12.6 | )% |

 
| ** **                  | ** ** | **For The  Nine Months Ended** | ** ** |
|-----------------------------|------------|--------------------------------|------------|
| ** **                  | ** ** | **September 30,  2008**   | ** ** | **September 30,  2007** | ** ** | **Change** | ** ** |
| **(In  Thousands)**         | ** ** | **Amount**                     | ** ** | **% Total** | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **%** | ** ** |
| Deposits                    |       | $                              | 7,502      |   | 65.0 | % | $ | 8,215 |   | 68.2 | % | $ | (713 | ) | (8.7 | )% |
| Short-term  borrowings      |       | 996                            |       | 8.6 |   | 1,100 |   | 9.1 |   | (104 | ) | (9.5 | ) |
| Long-term  borrowings, FHLB |       | 3,044                          |       | 26.4 |   | 2,735 |   | 22.7 |   | 309 |   | 11.3 |   |
| Total interest  expense     |       | $                              | 11,542     |   | 100.0 | % | $ | 12,050 |   | 100.0 | % | $ | (508 | ) | (4.2 | )% |

 

**Net Interest Margin**

** **

Thenet interest margin (“NIM”) for the three months ended September 30, 2008was 4.23% compared to 3.98% for the corresponding period of 2007.  The increase in the NIM was driven by a 74 bpdecline in the rate paid on interest bearing liabilities that more thancompensated for a 29 bp decline in the yield on earning assets.  The decrease in earning asset yield is due tothe impact on the loan portfolio of the FOMC rate decreases over the past yearoffset in part by increases in yield and balance within the investmentportfolio.  The growth in the investmentportfolio was driven by a strategic initiative in the third quarter of 2007 toincrease tax equivalent net interest income by purchasing fixed rateinstruments in anticipation of the decreasing rate environment that hascontinued to date.  The decrease in thecost of interest bearing liabilities to 2.93% from 3.67% was driven primarilyby a reduction in the rate paid on time deposits of 106 bp.  The reduction was the result of a shorteningof the time deposit portfolio initiated in the early stages of 2007 that hasresulted in an increasing repricing frequency during this period of decreasingrates.

 

TheNIM for the nine months ended September 30, 2008 and 2007 were 4.04% and3.96%, respectively.  The impact of theitems mentioned in the three month discussion also applies to the nine monthperiod.  A 65 bp decline in the rate paidon time deposits served as the foundation for a 41 bp decline in rate paid ondeposits, while the FOMC actions steered the yield on earning assets and costof borrowings.

 

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Followingis a schedule of average balances and associated yields for the three and ninemonth periods ended September 30, 2008 and 2007:

 
| ** **                                       | ** ** | **AVERAGE BALANCES AND INTEREST RATES**    | ** ** |
|--------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                       | ** ** | **Three Months Ended  September 30, 2008** | ** ** | **Three Months Ended  September 30, 2007** | ** ** |
| **(In Thousands)**                          | ** ** | **Average Balance**                                       | ** ** | **Interest** | ** ** | **Average Rate** | ** ** | **Average Balance** | ** ** | **Interest** | ** ** | **Average Rate** | ** ** |
| Assets:                                          |       |                                                           |       |   |   |   |   |   |   |   |   |   |   |
| Tax-exempt loans                                 |       | $                                                              | 9,108      |   | $ | 148 |   | 6.46 | % | $ | 7,652 |   | $ | 118 |   | 6.12 | % |
| All other loans                                  |       | 364,926                                                        |       | 6,213 |   | 6.77 | % | 354,032 |   | 6,543 |   | 7.33 | % |
| Total loans                                      |       | 374,034                                                        |       | 6,361 |   | 6.77 | % | 361,684 |   | 6,661 |   | 7.31 | % |
|                                             |       |                                                           |       |   |   |   |   |   |   |   |   |   |   |
| Taxable  investment securities                   |       | 107,751                                                        |       | 1,592 |   | 5.91 | % | 91,788 |   | 1,247 |   | 5.43 | % |
| Tax-exempt  investment securities                |       | 103,431                                                        |       | 1,826 |   | 7.06 | % | 95,383 |   | 1,679 |   | 7.04 | % |
| Total securities                                 |       | 211,182                                                        |       | 3,418 |   | 6.47 | % | 187,171 |   | 2,926 |   | 6.25 | % |
|                                             |       |                                                           |       |   |   |   |   |   |   |   |   |   |   |
| Interest bearing  deposits                       |       | 34                                                             |       | — |   | 0.00 | % | 40 |   | 1 |   | 9.92 | % |
|                                             |       |                                                           |       |   |   |   |   |   |   |   |   |   |   |
| Total  interest-earning assets                   |       | 585,250                                                        |       | 9,779 |   | 6.66 | % | 548,895 |   | 9,588 |   | 6.95 | % |
|                                             |       |                                                           |       |   |   |   |   |   |   |   |   |   |   |
| Other assets                                     |       | 50,225                                                         |       |   |   |   |   | 43,706 |   |   |   |   |   |
|                                             |       |                                                           |       |   |   |   |   |   |   |   |   |   |   |
| Total assets                                     |       | $                                                              | 635,475    |   |   |   |   |   | $ | 592,601 |   |   |   |   |   |
|                                             |       |                                                           |       |   |   |   |   |   |   |   |   |   |   |
| Liabilities:                                     |       |                                                           |       |   |   |   |   |   |   |   |   |   |   |
| Savings                                          |       | $                                                              | 62,792     |   | 120 |   | 0.76 | % | $ | 60,262 |   | 114 |   | 0.75 | % |
| Super Now  deposits                              |       | 52,970                                                         |       | 175 |   | 1.31 | % | 46,531 |   | 153 |   | 1.30 | % |
| Money market  deposits                           |       | 34,915                                                         |       | 208 |   | 2.37 | % | 23,183 |   | 131 |   | 2.24 | % |
| Time deposits                                    |       | 205,346                                                        |       | 1,907 |   | 3.69 | % | 203,690 |   | 2,437 |   | 4.75 | % |
| Total deposits                                   |       | 356,023                                                        |       | 2,410 |   | 2.69 | % | 333,666 |   | 2,835 |   | 3.37 | % |
|                                             |       |                                                           |       |   |   |   |   |   |   |   |   |   |   |
| Short-term  borrowings                           |       | 51,215                                                         |       | 310 |   | 2.38 | % | 32,910 |   | 368 |   | 4.44 | % |
| Long-term  borrowings, FHLB                      |       | 79,061                                                         |       | 875 |   | 4.33 | % | 77,791 |   | 909 |   | 4.64 | % |
| Total borrowings                                 |       | 130,276                                                        |       | 1,185 |   | 3.57 | % | 110,701 |   | 1,277 |   | 4.58 | % |
|                                             |       |                                                           |       |   |   |   |   |   |   |   |   |   |   |
| Total  interest-bearing liabilities              |       | 486,299                                                        |       | 3,595 |   | 2.93 | % | 444,367 |   | 4,112 |   | 3.67 | % |
|                                             |       |                                                           |       |   |   |   |   |   |   |   |   |   |   |
| Demand deposits                                  |       | 75,863                                                         |       |   |   |   |   | 70,689 |   |   |   |   |   |
| Other  liabilities                               |       | 7,467                                                          |       |   |   |   |   | 7,249 |   |   |   |   |   |
| Shareholders’  equity                       |       | 65,846                                                         |       |   |   |   |   | 70,296 |   |   |   |   |   |
| Total  liabilities and shareholders’ equity |       | $                                                              | 635,475    |   |   |   |   |   | $ | 592,601 |   |   |   |   |   |
|                                             |       |                                                           |       |   |   |   |   |   |   |   |   |   |   |
| Interest rate  spread                            |       |                                                           |       |   |   | 3.73 | % |   |   |   |   | 3.28 | % |
| Net interest  income/margin                      |       |                                                           |       | $ | 6,184 |   | 4.23 | % |   |   | $ | 5,476 |   | 3.98 | % |

 

1.               Informationon this table has been calculated using average daily balance sheets to obtainaverage balances.

2.               Nonaccrualloans have been included with loans for the purpose of analyzing net interestearnings.

3.               Incomeand rates on a fully taxable equivalent basis include an adjustment for thedifference between annual income from tax-exempt obligations and the taxableequivalent of such income at the standard 34% tax rate.

 

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| ** **                                       | ** ** | **AVERAGE BALANCES AND INTEREST RATES**   | ** ** |
|--------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                       | ** ** | **Nine Months Ended  September 30, 2008** | ** ** | **Nine Months Ended  September 30, 2007** | ** ** |
| **(In Thousands)**                          | ** ** | **Average Balance**                                      | ** ** | **Interest** | ** ** | **Average Rate** | ** ** | **Average Balance** | ** ** | **Interest** | ** ** | **Average Rate** | ** ** |
| Assets:                                          |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Tax-exempt loans                                 |       | $                                                             | 8,534      |   | $ | 411 |   | 6.43 | % | $ | 7,913 |   | $ | 365 |   | 6.17 | % |
| All other loans                                  |       | 359,570                                                       |       | 18,665 |   | 6.93 | % | 353,219 |   | 19,320 |   | 7.31 | % |
| Total loans                                      |       | 368,104                                                       |       | 19,076 |   | 6.92 | % | 361,132 |   | 19,685 |   | 7.29 | % |
|                                             |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Taxable  securities                              |       | 104,604                                                       |       | 4,514 |   | 5.75 | % | 85,930 |   | 3,600 |   | 5.59 | % |
| Tax-exempt  securities                           |       | 108,877                                                       |       | 5,517 |   | 6.76 | % | 99,497 |   | 4,956 |   | 6.64 | % |
| Total securities                                 |       | 213,481                                                       |       | 10,031 |   | 6.27 | % | 185,427 |   | 8,556 |   | 6.15 | % |
|                                             |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Interest bearing  deposits                       |       | 13                                                            |       | 1 |   | 10.28 | % | 431 |   | 18 |   | 5.58 | % |
|                                             |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Total  interest-earning assets                   |       | 581,598                                                       |       | 29,108 |   | 6.68 | % | 546,990 |   | 28,259 |   | 6.90 | % |
|                                             |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Other assets                                     |       | 49,638                                                        |       |   |   |   |   | 42,390 |   |   |   |   |   |
|                                             |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Total assets                                     |       | $                                                             | 631,236    |   |   |   |   |   | $ | 589,380 |   |   |   |   |   |
|                                             |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Liabilities:                                     |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Savings                                          |       | $                                                             | 60,857     |   | 343 |   | 0.75 | % | $ | 59,726 |   | 329 |   | 0.74 | % |
| Super Now  deposits                              |       | 51,228                                                        |       | 513 |   | 1.34 | % | 46,309 |   | 455 |   | 1.31 | % |
| Money market  deposits                           |       | 28,372                                                        |       | 481 |   | 2.26 | % | 24,362 |   | 414 |   | 2.27 | % |
| Time deposits                                    |       | 201,950                                                       |       | 6,165 |   | 4.08 | % | 198,401 |   | 7,017 |   | 4.73 | % |
| Total Deposits                                   |       | 342,407                                                       |       | 7,502 |   | 2.93 | % | 328,798 |   | 8,215 |   | 3.34 | % |
|                                             |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Short-term  borrowings                           |       | 47,894                                                        |       | 996 |   | 2.75 | % | 32,443 |   | 1,100 |   | 4.53 | % |
| Other borrowings                                 |       | 90,088                                                        |       | 3,044 |   | 4.44 | % | 78,818 |   | 2,735 |   | 4.64 | % |
| Total borrowings                                 |       | 137,982                                                       |       | 4,040 |   | 3.85 | % | 111,261 |   | 3,835 |   | 4.61 | % |
|                                             |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Total  interest-bearing liabilities              |       | 480,389                                                       |       | 11,542 |   | 3.19 | % | 440,059 |   | 12,050 |   | 3.66 | % |
|                                             |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Demand deposits                                  |       | 73,205                                                        |       |   |   |   |   | 69,203 |   |   |   |   |   |
| Other  liabilities                               |       | 8,672                                                         |       |   |   |   |   | 6,866 |   |   |   |   |   |
| Shareholders’  equity                       |       | 68,970                                                        |       |   |   |   |   | 73,252 |   |   |   |   |   |
|                                             |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |
| Total  liabilities and shareholders’ equity |       | $                                                             | 631,236    |   |   |   |   |   | $ | 589,380 |   |   |   |   |   |
| Interest rate  spread                            |       |                                                          |       |   |   | 3.49 | % |   |   |   |   | 3.24 | % |
| Net interest  income/margin                      |       |                                                          |       | $ | 17,566 |   | 4.04 | % |   |   | $ | 16,209 |   | 3.96 | % |

 

1.               Informationon this table has been calculated using average daily balance sheets to obtainaverage balances.

2.               Nonaccrualloans have been included with loans for the purpose of analyzing net interestearnings.

3.               Incomeand rates on a fully taxable equivalent basis include an adjustment for thedifference between annual income from tax-exempt obligations and the taxableequivalent of such income at the standard 34% tax rate.

 

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# **Table of Contents**

 

# **The following table presents theadjustment to convert net interest income to net interest income on a fullytaxable equivalent basis for the three and nine month periods ended September 30,2008 and 2007.**

# ** **

| ** **                                      | ** ** | **For the Three Months Ended  September 30,** | ** ** | **For the Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------|------------|------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| **(In Thousands)**                         | ** ** | **2008**                                                               | ** ** | **2007**                                                              | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                            |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Total interest  income                          |       | $                                                                      | 9,108      |                                                                  | $          | 8,977 |   | $ | 27,092 |   | $ | 26,449 |   |
| Total interest  expense                         |       | 3,595                                                                  |       | 4,112                                                                 |       | 11,542 |   | 12,050 |   |
|                                            |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Net interest  income                            |       | 5,513                                                                  |       | 4,865                                                                 |       | 15,550 |   | 14,399 |   |
| Tax equivalent  adjustment                      |       | 671                                                                    |       | 611                                                                   |       | 2,016 |   | 1,810 |   |
|                                            |       |                                                                   |       |                                                                  |       |   |   |   |   |
| Net interest  income (fully taxable equivalent) |       | $                                                                      | 6,184      |                                                                  | $          | 5,476 |   | $ | 17,566 |   | $ | 16,209 |   |

# ** **

# **The following table sets forth therespective impact that both volume and rate changes have had on net interestincome on a fully taxable equivalent basis for the three and nine month periodsended September 30, 2008 and 2007:**

# ** **

| ** **                          | ** ** | **Three Months Ended September 30,**          | ** ** | **Nine Months Ended September 30,**           | ** ** |
|-------------------------------------|------------|-------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                          | ** ** | **2008 vs 2007  Increase (Decrease)  Due to** | ** ** | **2008 vs 2007  Increase (Decrease)  Due to** | ** ** |
| **(In Thousands)**             | ** ** | **Volume**                                                        | ** ** | **Rate**                                                          | ** ** | **Net** | ** ** | **Volume** | ** ** | **Rate** | ** ** | **Net** | ** ** |
| Interest income:                    |       |                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Loans,  tax-exempt                  |       | $                                                                 | 23         |                                                              | $          | 7 |   | $ | 30 |   | $ | 30 |   | $ | 16 |   | $ | 46 |   |
| Loans                               |       | 220                                                               |       | (550                                                              | )          | (330 | ) | 347 |   | (1,002 | ) | (655 | ) |
| Taxable  investment securities      |       | 229                                                               |       | 116                                                               |       | 345 |   | 803 |   | 111 |   | 914 |   |
| Tax-exempt  investment securities   |       | 142                                                               |       | 5                                                                 |       | 147 |   | 474 |   | 87 |   | 561 |   |
| Interest bearing  deposits          |       | —                                                            |       | (1                                                                | )          | (1 | ) | (17 | ) | — |   | (17 | ) |
| Total  interest-earning assets      |       | 614                                                               |       | (423                                                              | )          | 191 |   | 1,637 |   | (788 | ) | 849 |   |
|                                |       |                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Interest  expense:                  |       |                                                              |       |                                                              |       |   |   |   |   |   |   |   |   |
| Savings deposits                    |       | 5                                                                 |       | 1                                                                 |       | 6 |   | 6 |   | 8 |   | 14 |   |
| Super Now  deposits                 |       | 21                                                                |       | 1                                                                 |       | 22 |   | 50 |   | 8 |   | 58 |   |
| Money market  deposits              |       | 69                                                                |       | 8                                                                 |       | 77 |   | 68 |   | (1 | ) | 67 |   |
| Time deposits                       |       | 21                                                                |       | (551                                                              | )          | (530 | ) | 128 |   | (980 | ) | (852 | ) |
| Short-term  borrowings              |       | 522                                                               |       | (580                                                              | )          | (58 | ) | 1,501 |   | (1,605 | ) | (104 | ) |
| Long-term  borrowings, FHLB         |       | 10                                                                |       | (44                                                               | )          | (34 | ) | 437 |   | (128 | ) | 309 |   |
| Total  interest-bearing liabilities |       | 648                                                               |       | (1,165                                                            | )          | (517 | ) | 2,190 |   | (2,698 | ) | (508 | ) |
| Change in net  interest income      |       | $                                                                 | (34        | )                                                                 | $          | 742 |   | $ | 708 |   | $ | (553 | ) | $ | 1,910 |   | $ | 1,357 |   |

# ** **

# **Provision for LoanLosses**

# ** **

Theprovision for loan losses is based upon management’s quarterly review of theloan portfolio.  The purpose of thereview is to assess loan quality, identify impaired loans, analyzedelinquencies, ascertain loan growth, evaluate potential charge-offs andrecoveries, and assess general economic conditions in the markets served.  An external independent loan review is also

 

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performedannually for the Bank.  Managementremains committed to an aggressive program of problem loan identification andresolution.

 

The allowance for loanlosses is determined by applying loss factors to outstanding loans by type,excluding loans for which a specific allowance has been determined.  Loss factors are based on management’sconsideration of the nature of the portfolio segments, changes in mix andvolume of the loan portfolio, and historical loan loss experience.  In addition, management considers industrystandards and trends with respect to non-performing loans and its knowledge andexperience with specific lending segments.

 

Although managementbelieves it uses the best information available to make such determinations andthat the allowance for loan losses is adequate at September 30, 2008,future adjustments could be necessary if circumstances or economic conditionsdiffer substantially from the assumptions used in making the initialdeterminations.  A downturn in the localeconomy, increased unemployment, and delays in receiving financial informationfrom borrowers could result in increased levels of nonperforming assets,charge-offs, loan loss provisions, and reductions in income.  Additionally, as an integral part of theexamination process, bank regulatory agencies periodically review the Bank’sloan loss allowance.  The bankingagencies could require the recognition of additions to the loan loss allowancebased on their judgment of information available to them at the time of theirexamination.

 

While determining theappropriate allowance level, management has attributed the allowance for loanlosses to various portfolio segments; however, the allowance is available forthe entire portfolio as needed.

 

The allowance for loanlosses increased from $4,130,000 at December 31, 2007 to $4,268,000 at September 30,2008.  At September 30, 2008 and December 31,2007, the allowance for loan losses to total loans was 1.15%.

 

The provision for loanlosses totaled $110,000 and $230,000 for the three and nine months ended September 30,2008, compared to $10,000 and $60,000 for the same periods in 2007.  The amount of the increase in the provisionwas the result of several continuing positive factors, including but notlimited to, an increase in gross loans of $11,069,000 since December 31,2007, a ratio of annualized net charge offs to average loans of 0.03% for thenine months ended September 30, 2008, a ratio of nonperforming loans tototal loans of 0.25%, and a ratio of the allowance for loan losses tononperforming loans of 453.56% at September 30, 2008.

 

**Non-interestIncome**

 

Totalnon-interest income for the three months ended September 30, 2008 comparedto the same period in 2007 decreased $1,534,000 to $472,000 due to a $1,504,000decrease in net securities gains and losses realized when comparing the threemonth periods ended September 30, 2008 and 2007.  Excluding net securities gains and losses,non-interest income for the third quarter of 2008 would have decreased $30,000as compared to the 2007 period.  Depositservice charges increased $48,000 as overdraft fee income compensated forcustomers migrating to no service charge checking accounts that were introducedas part of a customer acquisition and retention

 

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program.  Other income increased due to increasedrevenue from electronic card (debit/credit) usage and title insurance.

 

Insurancecommissions for the three months ended September 30, 2008 decreased$209,000 compared to the same period in 2007 due to a softening market andshift in product mix.  Management of TheM Group continues to pursue new and build upon current relationships.  The sales call program continues to expand toother financial institutions, which results in additional revenue for The MGroup.  However, the addition of anothersales outlet for The M Group can take up to a year or more to be completed.

 

Totalnon-interest income for the nine months ended September 30, 2008 comparedto the same period in 2007 decreased $2,159,000.  Excluding net securities gains, non-interestincome would have increased $177,000 as compared to the 2007 period.   The increase in non-interest income for thenine month period is the result of the same items noted in the three monthdiscussion.

 

Non-interestincome composition for the three and nine months ended September 30, 2008and 2007 was as follows:

 
| ** **                      | ** ** | **For The Three Months Ended** | ** ** |
|---------------------------------|------------|----------------------------------------------------|------------|
| ** **                      | ** ** | **September 30, 2008**                   | ** ** | **September 30, 2007** | ** ** | **Change** | ** ** |
| **(In Thousands)**         | ** ** | **Amount**                                         | ** ** | **% Total** | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **%** | ** ** |
| Deposit service  charges        |       | $                                                  | 594        |   | 125.8 | % | $ | 546 |   | 27.2 | % | $ | 48 |   | 8.8 | % |
| Securities  (losses) gains, net |       | (1,504                                             | )          | (318.6 | ) | — |   | — |   | (1,504 | ) | N/A |   |
| Bank owned life  insurance      |       | 121                                                |       | 25.6 |   | 109 |   | 5.4 |   | 12 |   | 11.0 |   |
| Gain on sale of  loans          |       | 314                                                |       | 66.5 |   | 282 |   | 14.1 |   | 32 |   | 11.3 |   |
| Insurance  commissions          |       | 416                                                |       | 88.1 |   | 625 |   | 31.2 |   | (209 | ) | (33.4 | ) |
| Other                           |       | 531                                                |       | 112.6 |   | 444 |   | 22.1 |   | 87 |   | 19.5 |   |
| Total  non-interest income      |       | $                                                  | 472        |   | 100.0 | % | $ | 2,006 |   | 100.0 | % | $ | (1,534 | ) | (76.5 | )% |

 
| ** **                      | ** ** | **For The Nine Months Ended** | ** ** |
|---------------------------------|------------|---------------------------------------------------|------------|
| ** **                      | ** ** | **September 30, 2008**                  | ** ** | **September 30, 2007** | ** ** | **Change** | ** ** |
| **(In Thousands)**         | ** ** | **Amount**                                        | ** ** | **% Total** | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **%** | ** ** |
| Deposit service  charges        |       | $                                                 | 1,704      |   | 42.5 | % | $ | 1,654 |   | 26.8 | % | $ | 50 |   | 3.0 | % |
| Securities  (losses) gains, net |       | (1,717                                            | )          | (42.9 | ) | 619 |   | 10.0 |   | (2,336 | ) | (377.4 | ) |
| Bank owned life  insurance      |       | 367                                               |       | 9.2 |   | 310 |   | 5.0 |   | 57 |   | 18.4 |   |
| Gain on sale of  loans          |       | 678                                               |       | 16.9 |   | 654 |   | 10.6 |   | 24 |   | 3.7 |   |
| Insurance  commissions          |       | 1,482                                             |       | 37.0 |   | 1,613 |   | 26.2 |   | (131 | ) | (8.1 | ) |
| Other                           |       | 1,493                                             |       | 37.3 |   | 1,316 |   | 21.4 |   | 177 |   | 13.4 |   |
| Total  non-interest income      |       | $                                                 | 4,007      |   | 100.0 | % | $ | 6,166 |   | 100.0 | % | $ | (2,159 | ) | (35.0 | )% |

 

**Non-interestExpense**

 

Totalnon-interest expense increased $21,000 for the three months ended September 30,2008 compared to the same period of 2007. The increase in salaries and employee benefits was attributable toseveral items including standard cost of living wage adjustments for employees,increased pension expense, and other benefit costs.  Pennsylvania shares tax decreased $55,000 dueto the use of Pennsylvania Enterprise Zone tax credits from a low incomehousing 

 

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partnershipcommitted to during 2007.  Other expensesincreased primarily due to normal anticipated inflationary adjustments toongoing business operating costs and the amortization related to the beforementioned low income housing.

 

Totalnon-interest expense increased $509,000 for the nine months ended September 30,2008 compared to the same period of 2007. As noted above in the three month discussion, normal increases ingeneral business expenses and the amortization of a low income housing partnershipimpacted the level of non-interest expenses.

 

Non-interestexpense composition for the three and nine months ended September 30, 2008and 2007 was as follows:

 
| ** **                                          | ** ** | **For The Three Months Ended** | ** ** |
|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                          | ** ** | **September 30, 2008**                   | ** ** | **September 30, 2007** | ** ** | **Change** | ** ** |
| **(In Thousands)**                             | ** ** | **Amount**                                         | ** ** | **% Total** | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **%** | ** ** |
| Salaries and  employee benefits                     |       | $                                                  | 2,355      |   | 52.9 | % | $ | 2,330 |   | 52.6 | % | $ | 25 |   | 1.1 | % |
| Occupancy, net                                      |       | 315                                                |       | 7.1 |   | 319 |   | 7.2 |   | (4 | ) | (1.3 | ) |
| Furniture and  equipment                            |       | 304                                                |       | 6.8 |   | 267 |   | 6.0 |   | 37 |   | 13.9 |   |
| Pennsylvania  shares tax                            |       | 105                                                |       | 2.4 |   | 160 |   | 3.6 |   | (55 | ) | (34.4 | ) |
| Amortization of  investment in limited partnerships |       | 178                                                |       | 4.0 |   | 220 |   | 5.0 |   | (42 | ) | (19.1 | ) |
| Other                                               |       | 1,194                                              |       | 26.8 |   | 1,134 |   | 25.6 |   | 60 |   | 5.3 |   |
| Total  non-interest expense                         |       | $                                                  | 4,451      |   | 100.0 | % | $ | 4,430 |   | 100.0 | % | $ | 21 |   | 0.5 | % |

 
| ** **                                          | ** ** | **For The Nine Months Ended** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                          | ** ** | **September 30, 2008**                  | ** ** | **September 30, 2007** | ** ** | **Change** | ** ** |
| **(In Thousands)**                             | ** ** | **Amount**                                        | ** ** | **% Total** | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **%** | ** ** |
| Salaries and  employee benefits                     |       | $                                                 | 7,275      |   | 54.3 | % | $ | 6,912 |   | 53.6 | % | $ | 363 |   | 5.3 | % |
| Occupancy, net                                      |       | 967                                               |       | 7.2 |   | 987 |   | 7.7 |   | (20 | ) | (2.0 | ) |
| Furniture and  equipment                            |       | 876                                               |       | 6.5 |   | 850 |   | 6.6 |   | 26 |   | 3.1 |   |
| Pennsylvania  shares tax                            |       | 315                                               |       | 2.3 |   | 482 |   | 3.7 |   | (167 | ) | (34.6 | ) |
| Amortization of  investment in limited partnerships |       | 534                                               |       | 4.0 |   | 503 |   | 3.9 |   | 31 |   | 6.2 |   |
| Other                                               |       | 3,440                                             |       | 25.7 |   | 3,164 |   | 24.5 |   | 276 |   | 8.7 |   |
| Total  non-interest expense                         |       | $                                                 | 13,407     |   | 100.0 | % | $ | 12,898 |   | 100.0 | % | $ | 509 |   | 3.9 | % |

 

**Provisionfor Income Taxes**

 

Incometaxes decreased $237,000 and $489,000 for the three and nine month periodsended September 30, 2008 compared to the same period of 2007.  The effective tax rate for the three and ninemonths ended September 30, 2008 was (9.0%) and 3.0% as compared to 4.5%and 8.8% for the same periods of 2007. The decline in the effective tax rate is primarily the result of netsecurities losses of $1,504,000 and $1,717,000 for the three and nine monthsended September 30, 2008 compared to net gains of $619,000 for the ninemonths ended September 30, 2007. The current effective tax rate has resulted in a deferred tax asset dueto the low income housing tax credits. Management has reviewed the deferred tax asset and has determined thatthe asset will be utilized within the appropriate carry forward period andtherefore does not require a valuation allowance.

 

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# **ASSET/LIABILITYMANAGEMENT**

# ** **

# **Cash and CashEquivalents**

# ** **

Cash and cash equivalentsdecreased $2,879,000 from $15,433,000 at December 31, 2007 to $12,554,000at September 30, 2008 primarily as a result of the following activitiesduring the nine months ended September 30, 2008:

 

# **Loans Held forSale**

# ** **

Activity regarding loansheld for sale resulted in sale proceeds lagging loan originations, less$678,000 in realized gains, by $773,000 for the nine months ended September 30,2008.

 

**Loans**

 

Gross loans increased$11,069,000 since December 31, 2007 due to the increase of residentialmortgages coupled with increased competition for commercial loans and asoftening of the market.

 

The allocation of the loan portfolio, by category,as of September 30, 2008 and December 31, 2007 is presented below:

 
| ** **                              | ** ** | **September 30,** | ** ** | **December 31,** | ** ** | **Change** | ** ** |
|-----------------------------------------|------------|------------------------|------------|-----------------------|------------|------------|------------|
| **(In Thousands)**                 | ** ** | **2008**               | ** ** | **2007**              | ** ** | **Amount** | ** ** | **%** | ** ** |
| Commercial,  financial and agricultural |       | $                      | 35,365     |                  | $          | 35,739     |       | $ | (374 | ) | (1.0 | )% |
| Real estate  mortgage:                  |       |                   |       |                  |       |       |       |   |   |
| Residential                             |       | 174,009                |       | 163,268               |       | 10,741     |       | 6.6 |   |
| Commercial                              |       | 134,232                |       | 132,943               |       | 1,289      |       | 1.0 |   |
| Construction                            |       | 16,176                 |       | 16,152                |       | 24         |       | 0.1 |   |
| Installment  loans to individuals       |       | 12,759                 |       | 13,317                |       | (558       | )          | (4.2 | ) |
| Less: Net  deferred loan fees           |       | 994                    |       | 941                   |       | 53         |       | 5.6 |   |
| Gross loans                             |       | $                      | 371,547    |                  | $          | 360,478    |       | $ | 11,069 |   | 3.1 | % |

 

The recorded investment in loans for which impairment has beenrecognized in accordance with Statement of Financial Accounting Standards No. 114,*Accounting by Creditors for Impairment of a Loan*,amounted to $4,438,000 at September 30, 2008, compared to $1,477,000 at December 31,2007.  The valuation allowance related toimpaired loans amounted to $97,000 at September 30, 2008 and $102,000 at December 31,2007.  The increase in impaired loans andvaluation allowance is from a few commercial relationships.

 

A loan is considered impaired, based on current information and events,if it is probable that the Bank will be unable to collect the scheduledpayments of principal or interest when due according to the contractual termsof the loan agreement. The measurement of impaired loans is generally based onthe present value of expected future cash flows discounted at the historical 

 

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effective interest rate, except that all collateral-dependent loans aremeasured for impairment based on the fair value of the collateral.

 

**Investments**

 

Theestimated fair value of the investment securities portfolio in total at September 30,2008 has decreased $13,378,000 since December 31, 2007, while theamortized cost increased $2,059,000.  Themajority of the changes in value occurred within the agency securities andstate and municipal segments of the portfolio. The amortized cost position in state and political securities increased$21,012,000 as the Bank continued its strategy to build call protection,maintain taxable equivalent yields, reduce the effective federal income taxrate, and invest in communities across the Commonwealth of Pennsylvania and thecountry.  Over the same time period, thisabove strategy resulted in the amortized cost position of available for saleU.S. Government and agency securities to decrease by $15,080,000. The increasedlevel of unrealized losses within the bond portfolio, which offset the increasein amortized cost, was the result of changes in the yield curve and virtualfreeze of trading in the municipal market, not credit quality, as the creditquality of the portfolio remains sound.

 

Theequity portfolio continues to feel the effects of the economic turbulence thatis effecting the financial sector.  Thissector of the portfolio, as of September 30, 2008, held $1,906,000 inunrealized losses on an amortized cost basis of $15,743,000.  The amount of the declines has caused severalof our equity holdings to be deemed other than temporarily impaired resultingin a write down in value of these holdings of $1,851,000 and $2,425,000 for thethree and nine months ended September 30, 2008.  Certain positions may be liquidated, in wholeor part, through the balance of 2008 so that the losses can be carried back fortax purposes and offset against gains that have been recognized over the pastseveral years.

 

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Theamortized cost of investment securities and their estimated fair values are asfollows:

 
| ** **                             | ** ** | **September 30, 2008** | ** ** |
|----------------------------------------|------------|----------------------------------|------------|
| ** **                             | ** ** | ** **                       | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                             | ** ** | **Amortized**                    | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| **(In Thousands)**                | ** ** | **Cost**                         | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| Available for  sale (AFS)              |       |                             |       |   |   |   |   |   |   |
| U.S. Government  and agency securities |       | $                                | 47,302     |   | $ | 206 |   | $ | (33 | ) | $ | 47,475 |   |
| State and  political securities        |       | 140,663                          |       | 257 |   | (15,163 | ) | 125,757 |   |
| Other debt  securities                 |       | 16,219                           |       | — |   | (2,441 | ) | 13,778 |   |
| Total debt  securities                 |       | 204,184                          |       | 463 |   | (17,637 | ) | 187,010 |   |
| Equity  securities                     |       | 15,743                           |       | 373 |   | (1,906 | ) | 14,210 |   |
| Total investment  securities AFS       |       | $                                | 219,927    |   | $ | 836 |   | $ | (19,543 | ) | $ | 201,220 |   |
|                                   |       |                             |       |   |   |   |   |   |   |
| Held to maturity  (HTM)                |       |                             |       |   |   |   |   |   |   |
| U.S. Government  and agency securities |       | $                                | 10         |   | $ | 1 |   | $ | — |   | $ | 11 |   |
| Other debt  securities                 |       | 125                              |       | — |   | — |   | 125 |   |
| Total investment  securities HTM       |       | $                                | 135        |   | $ | 1 |   | $ | — |   | $ | 136 |   |

 
| ** **                             | ** ** | **December 31, 2007** | ** ** |
|----------------------------------------|------------|---------------------------------|------------|
| ** **                             | ** ** | ** **                      | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                             | ** ** | **Amortized**                   | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| **(In Thousands)**                | ** ** | **Cost**                        | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| Available for  sale (AFS)              |       |                            |       |   |   |   |   |   |   |
| U.S. Government  and agency securities |       | $                               | 62,382     |   | $ | 522 |   | $ | — |   | $ | 62,904 |   |
| State and  political securities        |       | 119,651                         |       | 581 |   | (2,417 | ) | 117,815 |   |
| Other debt  securities                 |       | 15,917                          |       | 290 |   | (440 | ) | 15,767 |   |
| Total debt  securities                 |       | 197,950                         |       | 1,393 |   | (2,857 | ) | 196,486 |   |
| Equity  securities                     |       | 19,776                          |       | 496 |   | (2,303 | ) | 17,969 |   |
| Total investment  securities AFS       |       | $                               | 217,726    |   | $ | 1,889 |   | $ | (5,160 | ) | $ | 214,455 |   |
|                                   |       |                            |       |   |   |   |   |   |   |
| Held to maturity  (HTM)                |       |                            |       |   |   |   |   |   |   |
| U.S. Government  and agency securities |       | $                               | 14         |   | $ | 1 |   | $ | — |   | $ | 15 |   |
| Other debt  securities                 |       | 263                             |       | 1 |   | — |   | 264 |   |
| Total investment  securities HTM       |       | $                               | 277        |   | $ | 2 |   | $ | — |   | $ | 279 |   |

 

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# **Financing Activities**

# ** **

# **Deposits**

# ** **

Totaldeposits increased 10.7% or $41,549,000 from December 31, 2007 to September 30,2008.  The growth was led by an 88.4% or$18,598,000 increase in money market accounts coupled with double digit growthin NOW, savings, and time deposits from December 31, 2007 to September 30,2008.  The increase in core deposits(deposits less time deposits) of 14.2% or $28,855,000 has allowed for areduction in brokered time deposits of 55.8%. The increase in deposits is the result of a deposit gathering programcoupled with customers coming back to their hometown bank in wake of theeconomic turbulence.

 

# **Deposit balances and their changesfor the periods being discussed follow:**

# ** **

| ** **                | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** | **Change** | ** ** |
|---------------------------|------------|----------------------------------|------------|---------------------------------|------------|------------|------------|
| **(In Thousands)**   | ** ** | **Amount**                       | ** ** | **% Total**                | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **%** | ** ** |
| Demand deposits           |       | $                                | 73,586     |                            | 17.1       | %          | $          | 74,671 |   | 19.2 | % | $ | (1,085 | ) | (1.5 | )% |
| NOW accounts              |       | 56,391                           |       | 13.1                            |       | 50,883     |       | 13.1 |   | 5,508 |   | 10.8 |   |
| Money market  deposits    |       | 39,627                           |       | 9.2                             |       | 21,029     |       | 5.4 |   | 18,598 |   | 88.4 |   |
| Savings deposits          |       | 62,591                           |       | 14.5                            |       | 56,757     |       | 14.6 |   | 5,834 |   | 10.3 |   |
| Time deposits             |       | 194,469                          |       | 45.2                            |       | 176,851    |       | 45.4 |   | 17,618 |   | 10.0 |   |
| Time deposits -  brokered |       | 3,907                            |       | 0.9                             |       | 8,831      |       | 2.3 |   | (4,924 | ) | (55.8 | ) |
| Total deposits            |       | $                                | 430,571    |                            | 100.0      | %          | $          | 389,022 |   | 100.0 | % | $ | 41,549 |   | 10.7 | % |

# ** **

# **Borrowed Funds**

# ** **

Total borrowed fundsdecreased 16.4% or $26,486,000 at September 30, 2008 compared to$161,693,000 at December 31, 2007. The decrease in borrowed funds is primarily the result of the previouslydiscussed deposit gathering campaigns that were utilized to provide funds toreduce the level of higher cost short-term borrowings and to assist inreplacing long-term borrowing maturities. Long-term borrowings decreased $19,600,000 since December 31, 2007due to the maturity of several borrowings that carried rates between 3.14% and5.56%.

 
| ** **                                     | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** | **Change** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|------------|------------|
| **(In Thousands)**                        | ** ** | **Amount**                       | ** ** | **% Total**                | ** ** | **Amount** | ** ** | **% Total** | ** ** | **Amount** | ** ** | **%** | ** ** |
| Short-term  borrowings:                        |       |                             |       |                            |       |       |       |   |   |   |   |   |   |
| FHLB repurchase  agreements                    |       | $                                | 29,950     |                            | 22.1       | %          | $          | 38,160 |   | 23.6 | % | $ | (8,210 | ) | (21.5 | )% |
| Securities sold  under agreement to repurchase |       | 18,479                           |       | 13.7                            |       | 17,155     |       | 10.6 |   | 1,324 |   | 7.7 |   |
| Total short-term  borrowings                   |       | 48,429                           |       | 35.8                            | %          | 55,315     |       | 34.2 | % | (6,886 | ) | (12.4 | ) |
|                                           |       |                             |       |                            |       |       |       |   |   |   |   |   |   |
| Long-term  borrowings, FHLB                    |       | 86,778                           |       | 64.2                            |       | 106,378    |       | 65.8 |   | (19,600 | ) | (18.4 | ) |
| Total borrowed  funds                          |       | $                                | 135,207    |                            | 100.0      | %          | $          | 161,693 |   | 100.0 | % | $ | (26,486 | ) | (16.4 | )% |

 

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# **Capital**

##  

## The adequacy of the Company’s capital is reviewed onan ongoing basis with reference to the size, composition, and quality of theCompany’s resources and regulatory guidelines. Management seeks to maintain a level of capital sufficient to supportexisting assets and anticipated asset growth, maintain favorable access tocapital markets, and preserve high quality credit ratings.

##  

## Bank holding companies are required to comply with theFederal Reserve Board’s risk-based capital guidelines.  The risk-based capital rules aredesigned to make regulatory capital requirements more sensitive to differencesin risk profiles among banks and bank holding companies and to minimizedisincentives for holding liquid assets. Specifically, each is required to maintain certain minimum dollaramounts and ratios of Total risk-based, Tier I risk-based, and Tier I leveragecapital. In addition to the capital requirements, the Federal Deposit InsuranceCorporation Improvements Act (FDICIA) established five capital categoriesranging from “well capitalized” to “critically undercapitalized.” To beclassified as “well capitalized”, Total risk-based, Tier I risked-based, andTier I leverage capital ratios must be at least 10%, 6%, and 5%,respectively.

##  

TheEmergency Economic Stabilization Act of 2008, signed into law on October 3,2008, provides authority to the United States Department of Treasury (“Treasury”)to, among other things, purchase up to $700 billion of mortgages, mortgagebacked securities and certain other financial instruments from financialinstitutions.  On October 14, 2008,the Treasury announced it will offer to qualifying U.S. banking institutionsthe opportunity to issue and sell preferred stock, along with warrants topurchase common stock, to the Treasury on what may be considered attractiveterms under the Troubled Asset Relief Program Capital Purchase Program (the “Program”).  Although the Company’s capital ratios remainwell above the minimum levels required for well capitalized status, it iscurrently evaluating the Program.  Inaddition, the FDIC has initiated the Temporary Liquidity Guarantee Program thatwill provide a 100 percent guarantee for a limited period of time to newlyissued senior unsecured debt and non-interest bearing transactiondeposits.  Coverage under the TemporaryLiquidity Guarantee Program is available for 30 days without charge andthereafter at a cost of 75 basis points per annum for senior unsecured debt and10 basis points per annum for non-interest bearing transaction deposits.  Management is currently evaluating theTemporary Liquidity Guarantee Program.

 

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Capitalratios as of September 30, 2008 and December 31, 2007 were asfollows:

 
| ** **                                                         | ** ** | **2008**   | ** ** | **2007**  | ** ** |
|--------------------------------------------------------------------|------------|------------|------------|-----------|------------|
| **(In Thousands)**                                            | ** ** | **Amount** | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| Total Capital

    (to  Risk-weighted Assets)  |       |       |       |      |       |   |   |   |   |
|                                                               |       |       |       |      |       |   |   |   |   |
| Actual                                                             |       | $          | 68,678     |      | 16.8       | % | $ | 70,381 |   | 18.0 | % |
| For Capital  Adequacy Purposes                                     |       | 32,713     |       | 8.0       |       | 31,280 |   | 8.0 |   |
| To Be Well  Capitalized                                            |       | 40,891     |       | 10.0      |       | 39,100 |   | 10.0 |   |
|                                                               |       |       |       |      |       |   |   |   |   |
| Tier I Capital

    (to  Risk-weighted Assets) |       |       |       |      |       |   |   |   |   |
|                                                               |       |       |       |      |       |   |   |   |   |
| Actual                                                             |       | $          | 64,410     |      | 15.8       | % | $ | 66,251 |   | 16.9 | % |
| For Capital  Adequacy Purposes                                     |       | 16,356     |       | 4.0       |       | 15,640 |   | 4.0 |   |
| To Be Well  Capitalized                                            |       | 24,534     |       | 6.0       |       | 23,460 |   | 6.0 |   |
|                                                               |       |       |       |      |       |   |   |   |   |
| Tier I Capital

    (to  Average Assets)       |       |       |       |      |       |   |   |   |   |
|                                                               |       |       |       |      |       |   |   |   |   |
| Actual                                                             |       | $          | 64,410     |      | 10.1       | % | $ | 66,251 |   | 10.8 | % |
| For Capital  Adequacy Purposes                                     |       | 25,407     |       | 4.0       |       | 24,664 |   | 4.0 |   |
| To Be Well  Capitalized                                            |       | 31,759     |       | 5.0       |       | 30,830 |   | 5.0 |   |

 

# **Liquidity andInterest Rate Sensitivity**

 

## The asset/liability committee addresses the liquidityneeds of the Company to ensure that sufficient funds are available to meetcredit demands and deposit withdrawals as well as to the placement of availablefunds in the investment portfolio.  Inassessing liquidity requirements, equal consideration is given to the currentposition as well as the future outlook.

##  

The following liquiditymeasures are monitored for compliance within the limits cited:

 

1.  Net Loans to Total Assets, 85% maximum

2.  Net Loans to Total Deposits, 100% maximum

3.  Cumulative 90 day Maturity GAP %, +/- 20%maximum

4.  Cumulative 1 Year Maturity GAP %, +/- 25%maximum

 

Fundamentalobjectives of the Company’s asset/liability management process are to maintainadequate liquidity while minimizing interest rate risk.  The maintenance of adequate liquidityprovides the Company with the ability to meet its financial obligations todepositors, loan customers, and shareholders. Additionally, it provides funds for normal operating expenditures

 

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andbusiness opportunities as they arise. The objective of interest rate sensitivity management is to increase netinterest income by managing interest sensitive assets and liabilities in such away that they can be repriced in response to changes in market interest rates.

 

TheBank, like other financial institutions, must have sufficient funds availableto meet its liquidity needs for deposit withdrawals, loan commitments andoriginations, and expenses.  In order tocontrol cash flow, the Bank estimates future flows of cash from deposits, loanpayments, and investment security payments. The primary sources of funds are deposits, principal and interestpayments on loans and investment securities, FHLB borrowings, and brokereddeposits.  Management believes the Bankhas adequate resources to meet its normal funding requirements.

 

Managementmonitors the Company’s liquidity on both a long and short-term basis, therebyproviding management necessary information to react to current balance sheettrends.  Cash flow needs are assessed andsources of funds are determined.  Fundingstrategies consider both customer needs and economical cost.  Both short and long-term funding needs areaddressed by maturities and sales of available for sale investment securities,loan repayments and maturities, and liquidating money market investments suchas federal funds sold.  The use of theseresources, in conjunction with access to credit provides core ingredients tosatisfy depositor, borrower, and creditor needs.

 

Managementmonitors and determines the desirable level of liquidity.  Consideration is given to loan demand,investment opportunities, deposit pricing and growth potential, as well as thecurrent cost of borrowing funds.  TheCompany has a current borrowing capacity at the FHLB of $209,525,000.  Inaddition to this credit arrangement, the Company has additional lines of creditwith correspondent banks of $28,797,000. Management believes it has sufficientliquidity to satisfy estimated short-term and long-term funding needs.  FHLB borrowings totaled $116,728,000 as of September 30,2008.

 

Interestrate sensitivity, which is closely related to liquidity management, is afunction of the repricing characteristics of the Company’s portfolio of assetsand liabilities.  Asset/liabilitymanagement strives to match maturities and rates between loan and investmentsecurity assets with the deposit liabilities and borrowings that fund them.  Successful asset/liability management resultsin a balance sheet structure which can cope effectively with market ratefluctuations. The matching process is affected by segmenting both assets andliabilities into future time periods (usually 12 months, or less) based uponwhen repricing can be effected. Repriceable assets are subtracted from repriceable liabilities, for aspecific time period to determine the “gap”, or difference. Once known, the gapis managed based on predictions about future market interest rates.  Intentional mismatching, or gapping, canenhance net interest income if market rates move as predicted.  However, if market rates behave in a mannercontrary to predictions, net interest income will suffer.  Gaps, therefore, contain an element of riskand must be prudently managed.  Inaddition to gap management, the Company has an asset/liability managementpolicy which incorporates a market value at risk calculation which is used todetermine the effects of interest rate movements on shareholders’ equity and asimulation analysis to monitor the effects of interest rate changes on theCompany’s balance sheet.

 

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Therehave been no substantial changes in the Company’s gap analyses or simulationanalyses compared to the information provided in the Company’s Form 10-Kfor the year ended December 31, 2007.

 

Generally,management believes the Company is well positioned to respond in a timelymanner when the market interest rate outlook changes.

 

# **Inflation**

# ** **

The asset and liabilitystructure of a financial institution is primarily monetary in nature.  Therefore, interest rates rather thaninflation have a more significant impact on the Company’s performance.  Interest rates are not always affected in thesame direction or magnitude as prices of other goods and services, but arereflective of fiscal policy initiatives or economic factors which are not measuredby a price index.

 

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

 

Marketrisk for the Company is comprised primarily of interest rate risk exposure andliquidity risk.  Interest rate risk andliquidity risk management is performed at the Bank level as well as the Companylevel.  The Company’s interest ratesensitivity is monitored by management through selected interest rate riskmeasures produced by an independent third party.  There have been no substantial changes in theCompany’s gap analyses or simulation analyses compared to the informationprovided in the Annual Report on Form 10-K for the period ended December 31,2007.  Additional information and detailsare provided in the “Liquidity and Interest Rate Sensitivity” section of “Item2. Management’s Discussion and Analysis of Financial Condition and Results ofOperations.”

 

Generally,management believes the Company is well positioned to respond in a timelymanner when the market interest rate outlook changes.

 

**Item 4.  Controls and Procedures**

 

An analysis was performed under the supervision and with theparticipation of the Company’s management, including the Chief ExecutiveOfficer and the Principal Financial Officer, of the effectiveness of the designand operation of the Company’s disclosure controls and procedures. Based onthat evaluation, the Company’s Chief Executive Officer and Principal FinancialOfficer concluded that the Company’s disclosure controls and procedures wereeffective as of September 30, 2008. There were no changes in the Company’s internal control over financialreporting that occurred during the quarter ended September 30, 2008, thathave materially affected, or are reasonably likely to materially affect, theCompany’s internal control over financial reporting.

 

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### **Table of Contents**

 

### **Part II.  OTHER INFORMATION**

### ** **

**Item 1.          LegalProceedings**

 

None.

 

**Item1A.      ****Risk Factors**

 

There are no materialchanges to the risk factors set forth in Part I, Item 1A, “Risk Factors,”of the Company’s Annual Report on Form 10-K for the year ended December 31,2007.  Please refer to that section fordisclosures regarding the risks and uncertainties related to the Company’sbusiness.

 

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

 
| **Period**                                             | ** ** | **Total  Number of  Shares (or  Units)  Purchased** | ** ** | **Average  Price Paid  per Share  (or Units)  Purchased** | ** ** | **Total Number of  Shares (or Units)  Purchased as Part of  Publicly Announced  Plans or Programs** | ** ** | **Maximum Number (or  Approximate Dollar Value)  of Shares (or Units) that  May Yet Be Purchased  Under the Plans or Programs** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                             |
|                                                   |       |                                                          |       |                                                                     |       |                                                                                                                                                  |       |                                                                                                                                                                                                       |       |
| Month #1  (July 1 - July 31, 2008)           |       | —                                                        |       | —                                                                   |       | —                                                                                                                                                |       | —                                                                                                                                                                                                     |       |
|                                                   |       |                                                          |       |                                                                     |       |                                                                                                                                                  |       |                                                                                                                                                                                                       |       |
| Month #2  (August 1 - August 31, 2008)       |       | 9,210                                                         |       | $                                                                        | 30.05      |                                                                                                                                                  | 9,210      |                                                                                                                                                                                                       | 98,344     |   |
|                                                   |       |                                                          |       |                                                                     |       |                                                                                                                                                  |       |                                                                                                                                                                                                       |       |
| Month #3  (September 1 - September 30, 2008) |       | —                                                        |       | —                                                                   |       | —                                                                                                                                                |       | —                                                                                                                                                                                                     |       |
|                                                        |            |                                                               |            |                                                                          |            |                                                                                                                                                       |            |                                                                                                                                                                                                            |            |  |

 

On April 22, 2008,the Board of Directors extended the previously approved authorization torepurchase up to 197,000 shares, or approximately 5%, of the outstanding sharesof the Company for an additional year to April 30, 2009.  To date, there have been 98,656 sharesrepurchased under this plan.

 

**Item 3.          DefaultsUpon Senior Securities**

 

None

 

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

 

### **None**

### ** **

### **Item 5.          OtherInformation**

### ** **

None

 

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**Item 6.          Exhibits**

 
| (3)  | (i)  | Articles  of Incorporation of the Registrant, as presently in effect (incorporated by  reference to Exhibit 3(i) of the Registrant’s Annual Report on  Form 10-K for the year ended December 31, 2007). |
|------|------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (3)  | (ii) | Bylaws  of the Registrant’s as presently in effect (incorporated by reference to  Exhibit 3(ii) of the Registrant’s Current Report on Form 8-K  filed June 17, 2005).                              |
| (31) | (i)  | Rule 13a-14(a)/Rule 15d-14(a) Certification  of Chief Executive Officer.                                                                                                                                          |
| (31) | (ii) | Rule 13a-14(a)/Rule 15d-14(a) Certification  of Principal Financial Officer.                                                                                                                                      |
| (32) | (i)  | Section 1350  Certification of Chief Executive Officer.                                                                                                                                                                     |
| (32) | (ii) | Section 1350  Certification of Principal Financial Officer.                                                                                                                                                                 |

 

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## **SIGNATURES**

##  

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|                         |   | PENNS WOODS BANCORP,  INC.                                                                                    |
|------------------------------|--------|---------------------------------------------------------------------------------------------------------------|
|                         |   |                  (Registrant) |
|                         |   |                                                                                                          |
|                         |   |                                                                                                          |
| Date: November 7,  2008 |   | /s/ Ronald A. Walko                                                                                           |
|                         |   | Ronald A. Walko,  President and Chief Executive Officer                                                       |
|                         |   |                                                                                                          |
|                         |   |                                                                                                          |
| Date: November 7,  2008 |   | /s/ Brian L. Knepp                                                                                            |
|                         |   | Brian L. Knepp, Chief  Financial Officer (Principal  Financial Officer)                                       |

 

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| **EXHIBIT INDEX**   |   |                                                                                       |
|---------------------|--------|--------------------------------------------------------------------------------------------|
|                |   |                                                                                       |
| Exhibit 31(i)  |   | Rule 13a-14(a)/Rule 15d-14(a) Certification  of Chief Executive Officer     |
| Exhibit 31(ii) |   | Rule 13a-14(a)/Rule 15d-14(a) Certification  of Principal Financial Officer |
| Exhibit 32(i)  |   | Section 1350  Certification of Chief Executive Officer                                |
| Exhibit 32(ii) |   | Section 1350  Certification of Principal Financial Officer                            |

 

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