**FORM 10-Q**

 

**SECURITIES AND EXCHANGECOMMISSION**

**Washington,D.C.  20549**

 

**QUARTERLY REPORT UNDER SECTION 13OR 15(d)**

**OF THE SECURITIES EXCHANGE ACT OF1934**

 

**For the quarter ended March 31,2008**

**Commission file number:  0-12826**

 

**TOWER BANCORP INC.**

(Exact name ofregistrant as specified in its charter)

 

| **Commonwealth  of Pennsylvania**         |   | **25-1445946**      |
|-------------------------------------------|--------|---------------------|
| (State or other  jurisdiction of          |   | (I.R.S. Employer    |
| incorporation or  organization)           |   | Identification No.) |
|                                      |   |                |
| **Center  Square**                        |   |                |
| **Greencastle,  Pennsylvania**            |   | **17225**           |
| (Address of principal  executive offices) |   | (Zip Code)          |

 

Registrant’s telephone number, includingarea code: **(717) 597-2137**

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for shorterperiod that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.

                       Yes  x    No  o

 

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

 

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

 

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

 

                       Yes o    No  x

 

Indicate the number of shares outstanding of each of theissuer’s classes of common stock, as of the latest practicable date.

 

2,319,573 shares of common stock outstanding at April 30,2008

 

 

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TOWER BANCORP, INC.

 

INDEX

 
| ** **                                                                                            | **Page**                                                                                                          |
|-------------------------------------------------------------------------------------------------------|-------------------------------------------------------------------------------------------------------------------|
| PART I  - FINANCIAL INFORMATION                                                                  |                                                                                                              |
|                                                                                                  |                                                                                                              |
| Item  1 - Financial Statements                                                                        |                                                                                                              |
|                                                                                                  | Condensed consolidated balance sheets – March 31,  2008 and December 31, 2007                      | 4 |
|                                                                                                  | Condensed consolidated statements of income - three  months ended March 31, 2008 and 2007                    | 5 |
|                                                                                                  | Condensed consolidated statements of comprehensive  income – three months ended March 31, 2008 and 2007 | 6 |
|                                                                                                  | Condensed consolidated statements of cash flows –  three months ended March 31, 2008 and 2007           | 7 |
|                                                                                                  | Notes to condensed consolidated financial statements                                                              | 8 - 13 |
| Item 2 -  Management’s discussion and analysis of financial condition and results of  operations | 14 - 23                                                                                                           |
| Item 3 - Quantitative and qualitative disclosures  about market risk                                  | 24                                                                                                                |
| Item 4 - Controls and procedures                                                                      | 24 - 25                                                                                                           |
|                                                                                                  |                                                                                                              |
| PART II  - OTHER INFORMATION                                                                     | 26                                                                                                                |
|                                                                                                  |                                                                                                              |
| Item  1 - Legal proceedings                                                                           | 27                                                                                                                |
| Item 1A  - Risk Factors                                                                               | 27                                                                                                                |
| Item 2 - Unregistered sales of equity securities and  use of proceeds                                 | 27                                                                                                                |
| Item 3 - Defaults upon senior securities                                                              | 28                                                                                                                |
| Item 4 - Submission of matters to a vote of security  holders                                         | 28                                                                                                                |
| Item  5 - Other information                                                                           | 28                                                                                                                |
| Item  6 - Index to Exhibits                                                                           | 28 - 29                                                                                                           |
|                                                                                                  |                                                                                                              |
|                                                                                                  | Signatures                                                                                                        | 30 |
|                                                                                                  |                                                                                                              |   |
|                                                                                                  | Exhibits                                                                                                          | 31 - 36 |

 

2

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PART I - FINANCIAL INFORMATION

 

3

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TOWERBANCORP, INC. AND ITS WHOLLY-OWNED SUBSIDIARY

 

CONDENSED CONSOLIDATED BALANCE SHEETS

 
| ** **                                                                                          | ** ** | **March 31,**     | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                          | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| ** **                                                                                          | ** ** | **(Unaudited)**        | ** ** | **(Audited)***        | ** ** |
| ** **                                                                                          | ** ** | **(000 Omitted)** | ** ** |
| ASSETS                                                                                              |       |                   |       |                  |       |
| Cash and due  from banks                                                                            |       | $                      | 14,025     |                  | $          | 16,770 |   |
| Federal funds  sold                                                                                 |       | 25,010                 |       | 20,081                |       |
| Interest bearing  balances with banks                                                               |       | 1,050                  |       | 0                     |       |
| Investment  securities available for sale                                                           |       | 60,794                 |       | 49,985                |       |
| Equity  securities available for sale                                                               |       | 31,263                 |       | 33,861                |       |
| Restricted bank  stock                                                                              |       | 4,223                  |       | 2,914                 |       |
| Loans:                                                                                              |       |                   |       |                  |       |
| Real estate  mortgages                                                                              |       | 347,345                |       | 350,976               |       |
| Commercial                                                                                          |       | 25,351                 |       | 30,444                |       |
| Consumer                                                                                            |       | 16,317                 |       | 17,059                |       |
| Gross loans                                                                                         |       | 389,013                |       | 398,479               |       |
| Less: reserve  for possible loan losses                                                             |       | (4,206                 | )          | (3,854                | )          |
| Loans, net                                                                                          |       | 384,807                |       | 394,625               |       |
| Bank premises,  equipment, furniture and fixtures, net                                              |       | 10,173                 |       | 9,861                 |       |
| Real estate  owned other than premises                                                              |       | 2,826                  |       | 2,313                 |       |
| Accrued interest  receivable                                                                        |       | 1,925                  |       | 1,861                 |       |
| Cash surrender  value of life insurance                                                             |       | 10,878                 |       | 10,768                |       |
| Goodwill                                                                                            |       | 16,558                 |       | 16,558                |       |
| Core deposit  intangible                                                                            |       | 1,598                  |       | 1,693                 |       |
| Other assets                                                                                        |       | 74                     |       | 346                   |       |
| Total assets                                                                                        |       | $                      | 565,204    |                  | $          | 561,636 |   |
|                                                                                                |       |                   |       |                  |       |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                          |       |                   |       |                  |       |
| LIABILITIES                                                                                         |       |                   |       |                  |       |
| Deposits in domestic  offices:                                                                      |       |                   |       |                  |       |
| Demand                                                                                              |       | $                      | 42,030     |                  | $          | 46,860 |   |
| Savings                                                                                             |       | 225,357                |       | 223,904               |       |
| Time                                                                                                |       | 168,389                |       | 169,166               |       |
| Liabilities for  borrowed money                                                                     |       | 46,743                 |       | 37,735                |       |
| Accrued interest  payable                                                                           |       | 1,000                  |       | 999                   |       |
| Other  liabilities                                                                                  |       | 4,609                  |       | 4,558                 |       |
| Total liabilities                                                                                   |       | 488,128                |       | 483,222               |       |
|                                                                                                |       |                   |       |                  |       |
| STOCKHOLDERS’  EQUITY                                                                          |       |                   |       |                  |       |
| Capital stock,  common, no par, authorized 5,000,000 shares; 2,420,481 and 2,420,481 shares  issued |       | 2,225                  |       | 2,225                 |       |
| Additional  paid-in capital                                                                         |       | 34,864                 |       | 34,831                |       |
| Retained  earnings                                                                                  |       | 40,530                 |       | 40,696                |       |
| Accumulated  other comprehensive income                                                             |       | 3,606                  |       | 4,558                 |       |
| Less: cost of  treasury stock; 2008 - 104,581 shares; 2007 - 98,055 shares                          |       | (4,149                 | )          | (3,896                | )          |
| Total  stockholders' equity                                                                         |       | 77,076                 |       | 78,414                |       |
|                                                                                                |       |                   |       |                  |       |
| Total  liabilities and stockholders’ equity                                                    |       | $                      | 565,204    |                  | $          | 561,636 |   |

 

----

*  Condensed from auditedfinancial statements.

 

Theaccompanying notes are an integral part of these

condensedfinancial statements.

 

4

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TOWERBANCORP, INC. AND ITS WHOLLY-OWNED SUBSIDIARY

 

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

THREEMONTHS ENDED MARCH 31, 2008 and 2007

(UNAUDITED)

 
| ** **                                            | ** ** | **2008**               | ** ** | **2007**  | ** ** |
|-------------------------------------------------------|------------|------------------------|------------|-----------|------------|
| ** **                                            | ** ** | **(000 Omitted)** | ** ** |
| Interest Income                                       |       |                   |       |      |       |
| Interest &  fees on loans                         |       | $                      | 7,092      |      | $          | 6,930 |   |
| Interest on  investment securities available for sale |       | 912                    |       | 773       |       |
| Interest on  federal funds sold                       |       | 168                    |       | 479       |       |
| Total interest  income                                |       | 8,172                  |       | 8,182     |       |
| Interest Expense                                      |       |                   |       |      |       |
| Interest on  deposits                                 |       | 2,492                  |       | 2,931     |       |
| Interest on  borrowed money                           |       | 524                    |       | 514       |       |
| Total interest  expense                               |       | 3,016                  |       | 3,445     |       |
|                                                  |       |                   |       |      |       |
| Net interest  income                                  |       | 5,156                  |       | 4,737     |       |
|                                                  |       |                   |       |      |       |
| Provision for  loan losses                            |       | 400                    |       | 150       |       |
|                                                  |       |                   |       |      |       |
| Net interest  income after provision for loan losses  |       | 4,756                  |       | 4,587     |       |
|                                                  |       |                   |       |      |       |
| Other Income                                          |       |                   |       |      |       |
| Investment  service income                            |       | 238                    |       | 223       |       |
| Service charges  on deposit accounts                  |       | 441                    |       | 398       |       |
| Other service  charges                                |       | 320                    |       | 286       |       |
| Other operating  income                               |       | 111                    |       | 155       |       |
| Investment  securities gains                          |       | 397                    |       | 1,213     |       |
| Total other  income                                   |       | 1,507                  |       | 2,275     |       |
|                                                  |       |                   |       |      |       |
| Other Expense                                         |       |                   |       |      |       |
| Salaries, wages  and other benefits                   |       | 2,264                  |       | 2,135     |       |
| Occupancy and  equipment expense                      |       | 982                    |       | 934       |       |
| Professional  fees                                    |       | 231                    |       | 151       |       |
| Taxes not based  on income                            |       | 172                    |       | 27        |       |
| Other operating  expenses                             |       | 682                    |       | 953       |       |
| Total other  expenses                                 |       | 4,331                  |       | 4,200     |       |
|                                                  |       |                   |       |      |       |
| Income before  taxes                                  |       | 1,932                  |       | 2,662     |       |
| Applicable  income taxes                              |       | 448                    |       | 693       |       |
| Net income                                            |       | $                      | 1,484      |      | $          | 1,969 |   |
|                                                  |       |                   |       |      |       |
| Earnings per  share:                                  |       |                   |       |      |       |
| Basic earnings  per share                             |       | $                      | 0.64       |      | $          | 0.84 |   |
| Weighted average  shares outstanding                  |       | 2,318,502              |       | 2,357,802 |       |
| Diluted earnings  per share                           |       | $                      | 0.64       |      | $          | 0.82 |   |
| Weighted average  shares outstanding                  |       | 2,324,689              |       | 2,393,352 |       |
|                                                  |       |                   |       |      |       |
| Dividends  declared per share                         |       | $                      | 0.28       |      | $          | 0.26 |   |

 

Theaccompanying notes are an integral part of these

condensedfinancial statements.

 

5

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TOWERBANCORP, INC. AND ITS WHOLLY-OWNED SUBSIDIARY

 

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

THREEMONTHS ENDED MARCH 31, 2008 and 2007

(UNAUDITED)

 
| ** **                                     | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|
| ** **                                     | ** ** | **March 31**                | ** ** |
| ** **                                     | ** ** | **2008**                         | ** ** | **2007** | ** ** |
| ** **                                     | ** ** | **(000 Omitted)**           | ** ** |
|                                           |       |                             |       |   |   |
| Net income                                     |       | $                                | 1,484      |   | $ | 1,969 |   |
|                                           |       |                             |       |   |   |
| Other  comprehensive income:                   |       |                             |       |   |   |
| Unrealized  holding gains (losses), net of tax |       | (952                             | )          | (937 | ) |
|                                           |       |                             |       |   |   |
| Comprehensive  income                          |       | $                                | 532        |   | $ | 1,032 |   |

 

Theaccompanying notes are an integral part of these

condensedfinancial statements.

 

6

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#  

# TOWER BANCORP, INC. AND ITS WHOLLY-OWNED SUBSIDIARY

#  

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

THREE MONTHSENDED MARCH 31, 2008 and 2007

(UNAUDITED)

 
| ** **                                                                         | ** ** | **2008**               | ** ** | **2007** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------|------------|----------|------------|
| ** **                                                                         | ** ** | **(000 omitted)** | ** ** |
| Cash flows from  operating activities:                                             |       |                   |       |     |       |
| Net income                                                                         |       | $                      | 1,484      |     | $          | 1,969 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                   |       |     |       |
| Depreciation and  amortization                                                     |       | 326                    |       | 322      |       |
| Provision for  loan losses                                                         |       | 400                    |       | 150      |       |
| Stock-based  compensation                                                          |       | 78                     |       | 108      |       |
| (Gain) on sale  of investment securities                                           |       | (397                   | )          | (1,213   | )          |
| Other (net)                                                                        |       | (421                   | )          | (18      | )          |
| Net cash  provided by operating activities                                         |       | 1,470                  |       | 1,318    |       |
|                                                                               |       |                   |       |     |       |
| Cash flows from  investing activities:                                             |       |                   |       |     |       |
| Loans (net)                                                                        |       | 9,418                  |       | 24       |       |
| Purchases of  bank premises, equipment, furniture and fixtures                     |       | (1,039                 | )          | (32      | )          |
| Interest bearing  balances with banks                                              |       | (1,050                 | )          | 0        |       |
| Purchases of  available for sale securities                                        |       | (10,744                | )          | (1,593   | )          |
| Maturities/sales  of available for sale securities                                 |       | 1,487                  |       | 3,896    |       |
| Federal funds  sold                                                                |       | (4,929                 | )          | (34,031  | )          |
| Purchase of  restricted bank stock                                                 |       | (1,309                 | )          | (119     | )          |
| Net cash  provided (used) by investing activities                                  |       | (8,166                 | )          | (31,855  | )          |
|                                                                               |       |                   |       |     |       |
| Cash flows from  financing activities:                                             |       |                   |       |     |       |
| Net increase (decrease)  in deposits                                               |       | (4,154                 | )          | 33,742   |       |
| Net borrowings  (payments) in long term borrowings                                 |       | 9,068                  |       | (5,142   | )          |
| Net increase  (decrease) in short term borrowings                                  |       | (60                    | )          | (91      | )          |
| Purchase of  treasury stock                                                        |       | (366                   | )          | (220     | )          |
| Proceeds from  sale of treasury stock                                              |       | 113                    |       | 55       |       |
| Cash dividends  paid                                                               |       | (650                   | )          | (613     | )          |
| Net cash (used)  by financing activities                                           |       | 3,951                  |       | 27,731   |       |
|                                                                               |       |                   |       |     |       |
| Net decrease in  cash and cash equivalents                                         |       | (2,745                 | )          | (2,806   | )          |
|                                                                               |       |                   |       |     |       |
| Cash and cash  equivalents at beginning of period                                  |       | 16,770                 |       | 14,128   |       |
|                                                                               |       |                   |       |     |       |
| Cash and cash  equivalents at end of period                                        |       | $                      | 14,025     |     | $          | 11,322 |   |

 

Theaccompanying notes are an integral part of these

condensedfinancial statements.

 

7

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NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2008

(UNAUDITED)

 

Note 1.   Basis of Presentation

 

The accompanying unaudited condensed consolidatedfinancial statements have been prepared in accordance with generally acceptedaccounting principles in the United States for interim financial information,and accordingly do not include all of the information and footnotes required bygenerally accepted accounting principles for complete financialstatements.  In the opinion ofmanagement, the accompanying unaudited condensed consolidated financialstatements contain all adjustments (consisting solely of normal recurringadjustments) necessary to present fairly Tower Bancorp, Inc.’sconsolidated financial position as of March 31, 2008 and the results ofits operations for the three month periods ended March 31, 2008 and2007.  Information presented at December 31,2007 is condensed from audited year-end financial statements included in theAnnual Report on Form 10-K for the year ended December 31, 2007.

 

The condensed consolidated financial statements includethe accounts of Tower Bancorp, Inc. (the “Company”) and its wholly ownedsubsidiary, the First National Bank of Greencastle (the “Bank”).  All significant intercompany accounts andtransactions have been eliminated.

 

The results of operations for the three month periodsended March 31, 2008 and 2007 are not necessarily indicative of theresults to be expected for the full year.

 

CRITICAL ACCOUNTING POLICIES

 

Disclosure of the Company’s significant accountingpolicies is included in Note 1 to the consolidated financial statements of theCompany’s Annual Report on Form 10-K for the year ended December 31,2007. Some of these policies are particularly sensitive requiring significantjudgments, estimates and assumptions to be made by management. Additionalinformation is contained on pages 15 and 19 of this report for theprovision and allowance for loan losses.

 

CHANGE IN ACCOUNTING PRINCIPLE

 

In September 2006, the Emerging Issues Task Forceof the FASB (EITF) issued EITF 06-04. This pronouncement affects the recording of post retirement costs ofinsurance of bank owned life insurance policies in instances where the Companyhas promised a continuation of life insurance coverage to persons post retirement.  EITF 06-04 requires that a liability equal tothe present value of the cost of post retirement insurance be recorded duringthe insured employees’ term of service. The terms of this pronouncement require the initial recording of thisliability with a corresponding adjustment to retained earnings to reflect theimplementation of the pronouncement. This EITF becomes effective for fiscal years beginning after December 15,2007.  The effect of this change on January 1,2008 was a reduction in retained earnings and an increase in accrued benefitliabilities of $ 1,001,000.

 

8

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RECENT ACCOUNTING PRONOUNCEMENTS

 

In December 2007,the Financial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standards No. 141(R), “Business Combinations” (SFAS141(R)).  The Standard will change thefinancial accounting and reporting of business combination transactions.  SFAS 141(R) establishes the criteria forhow an acquiring entity in a business combination recognizes the assetsacquired and liabilities assumed in the transaction; establishes theacquisition date fair value as the measurement objective for all assetsacquired and liabilities assumed; and requires the acquirer to disclose to investorsand other users all of the information they need to evaluate and understand thenature and financial effect of the business combination.  Acquisition related costs including finder’sfees, advisory, legal, accounting valuation and other professional andconsulting fees are required to be expensed as incurred.  SFAS 141(R) is effective for fiscalyears beginning after December 15, 2008 and early implementation is notpermitted. The company does not expect the implementation to have a materialimpact on its financial statements.

 

In December 2007,the FASB issued Statement of Financial Accounting Standards No.160, “NoncontrollingInterests in Consolidated Financial Statements” (SFAS 160).  SFAS 160 requires the Company to establishaccounting and reporting standards for the noncontrolling interest in asubsidiary and for the deconsolidation of a subsidiary.  This Statement is effective for fiscal years,and interim periods within those fiscal years, beginning on or after December 15,2008. Earlier adoption is prohibited.  The company does not expect the implementation of SFAS 160 to have amaterial impact on its financial statements.

 

In March 2008, theFASB issued Statement of Financial Accounting Standards No. No. 161, “Disclosuresabout Derivative Instruments and Hedging Activities - an amendment of FASBStatement No. 133”**(SFAS161).  SFAS 161 changes the disclosurerequirements for derivative instruments and hedging activities.  Entities are required to provide enhanceddisclosures about (a) how and why an entity uses derivative instruments, (b) howderivative instruments and related hedged items are accounted for underStatement 133 and its related interpretations, and (c) how derivativeinstruments and related hedged items affect an entity’s financial position,financial performance and cash flows. SFAS 161 is effective for fiscal years and interim periods beginningafter November 15, 2008, with early application permitted. The company does not expect theimplementation of SFAS 161 to have a material impact on its financialstatements.

 

RECLASSIFICATION

 

Certainreclassifications have been made to the loan balances in the 2007 financialstatements to conform to reporting for 2008.

 

Note 2.   Income Taxes

 

Income tax expense is less than the amount calculatedusing the statutory tax rate primarily as a result of tax exempt income earnedfrom state and municipal securities and loans.

 

9

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Note 3.   Commitments

 

In the normal course of business, the Company makes variouscommitments and incurs certain contingent liabilities which are not reflectedin the accompanying financial statements. These commitments include various guarantees and commitments to extendcredit and the bank does not anticipate any losses as a result of thesetransactions.

 

Note 4.   Stock Compensation Plans

 

At March 31, 2008, the Company had two stock-basedcompensation plans.  On January 1,2006, the Company adopted FASB Statement No. 123 (R) using themodified prospective method.  The fairvalue of each grant is estimated at the grant date using the Black-Scholesoption-pricing model.

 

Included in salaries and employee benefits expense forthe three months ended March 31, 2008 and 2007 is $ 58,000 and$ 70,000, respectively, of stock-based compensation expense.  Also included in other operating expense forthe three months ended March 31, 2008 and 2007 is $ 20,000 and$ 38,000, respectively, of stock-based compensation expense.

 

Stock option plan activity for the three months ended March 31,2008 is summarized below:

 
| ** **                           | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Life  (in years)** | ** ** | **Value of  Unexercised  In-The-Money  Options  (in thousands)** | ** ** |
|--------------------------------------|------------|------------|------------|----------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------------|------------|
| Outstanding at January 1,  2008 |       | 34,858     |       | 34.34                                  |       | 6                                                                    |       | 289,000                                                                    |       |
| Granted                              |       | 6,500      |       | 31.85                                  |       | 7.75                                                                 |       | 41,000                                                                     |       |
| Exercised                            |       | 2,867      |       | 19.10                                  |       | N/A                                                                  |       | N/A                                                                        |       |
| Forfeited                            |       | 414        |       | 22.25                                  |       | N/A                                                                  |       | N/A                                                                        |       |
| Outstanding at  March 31, 2008  |       | 38,077     |       | 35.19                                  |       | 6                                                                    |       | 240,000                                                                    |       |
| Exercisable at  March 31, 2008  |       | 33,077     |       | 34.30                                  |       | 5                                                                    |       | 240,000                                                                    |       |

 

The total value of in-the-money options exercised duringthe first three months ended March 31, 2008 was $57,000.

 

10

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Note 5.   Earnings Per Share

 

The following shows the weighted average number ofshares used in computing earnings per share and the effect on the weightedaverage number of shares of diluted potential common stock. Options on 31,890shares were excluded from the calculation at March 31, 2008 because theeffects were anti-dilutive. Potential dilutive common stock had no effect onincome available to common stockholders.

 
| ** **                      | ** ** | **Three Months Ended** | ** ** |
|---------------------------------|------------|----------------------------------|------------|
| ** **                      | ** ** | **March 31, 2008**     | ** ** | **March 31, 2007** | ** ** |
| ** **                      | ** ** | ** **                       | ** ** | **Per** | ** ** | ** ** | ** ** | **Per** | ** ** |
| ** **                      | ** ** | ** **                       | ** ** | **Share** | ** ** | ** ** | ** ** | **Share** | ** ** |
| ** **                      | ** ** | **Shares**                       | ** ** | **Amount** | ** ** | **Shares** | ** ** | **Amount** | ** ** |
| Basic earnings  per share       |       | 2,318,502                        |       | $ | 0.64 |   | 2,357,802 |   | $ | 0.84 |   |
| Effect of  dilutive securities: |       |                             |       |   |   |   |   |   |   |
| Stock options                   |       | 6,187                            |       |   |   | 35,550 |   |   |   |
| Diluted earnings  per share     |       | 2,324,689                        |       | $ | 0.64 |   | 2,393,352 |   | $ | 0.82 |   |

 

Note 6.   Investment Securities in a LossPosition

 

Thefollowing table shows the Corporation’s gross unrealized losses and fair value,aggregated by investment category and length of time that individual securitieshave been in a continuous unrealized loss position, at March 31, 2008 and December 31,2007:

 
| ** **                                       | ** ** | **March 31, 2008**           | ** ** |
|--------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                       | ** ** | **(000 omitted)**                 | ** ** |
| ** **                                       | ** ** | **Less than 12 Months** | ** ** | **12 Months or Greater** | ** ** | **Total** | ** ** |
| **Description**                                  | ** ** | **Fair Value**                    | ** ** | **Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** |
| Obligations of  other U. S. government agencies  |       | $                                      | 0          |   | $ | 0 |   | $ | 0 |   | $ | 0 |   | $ | 0 |   | $ | 0 |   |
| Mortgage-backed  securities                      |       | 7                                      |       | 0 |   | 10 |   | 0 |   | 17 |   | 0 |   |
| Corporate bonds                                  |       | 832                                    |       | 130 |   | 383 |   | 107 |   | 1,215 |   | 237 |   |
| Equities                                         |       | 8,760                                  |       | 1,971 |   | 1,735 |   | 695 |   | 10,495 |   | 2,666 |   |
| Obligations of  state and political subdivisions |       | 1,947                                  |       | 14 |   | 0 |   | 0 |   | 1,947 |   | 14 |   |
| Total                                            |       | $                                      | 11,546     |   | $ | 2,115 |   | $ | 2,128 |   | $ | 802 |   | $ | 13,674 |   | $ | 2,917 |   |

 
| ** **                                       | ** ** | **December 31, 2007**        | ** ** |
|--------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                       | ** ** | **(000 omitted)**                 | ** ** |
| ** **                                       | ** ** | **Less than 12 Months** | ** ** | **12 Months or Greater** | ** ** | **Total** | ** ** |
| **Description**                                  | ** ** | **Fair  Value**                        | ** ** | **Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Unrealized  Losses** | ** ** |
| Obligations of  other U. S. government agencies  |       | $                                      | 0          |   | $ | 0 |   | $ | 0 |   | $ | 0 |   | $ | 0 |   | $ | 0 |   |
| Mortgage-backed  securities                      |       | 190                                    |       | 1 |   | 941 |   | 11 |   | 1,131 |   | 12 |   |
| Corporate bonds                                  |       | 854                                    |       | 108 |   | 458 |   | 32 |   | 1,312 |   | 140 |   |
| Equities                                         |       | 7,988                                  |       | 1,647 |   | 2,215 |   | 443 |   | 10,203 |   | 2,090 |   |
| Obligations of  state and political subdivisions |       | 1,236                                  |       | 0 |   | 6,041 |   | 22 |   | 7,277 |   | 22 |   |
| Total                                            |       | $                                      | 10,268     |   | $ | 1,756 |   | $ | 9,655 |   | $ | 508 |   | $ | 19,923 |   | $ | 2,264 |   |

 

11

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Note6.                   Investment Securities in a Loss Position(Continued)

 

Management evaluatessecurities for other-than-temporary impairment at least on a quarterly basis,but management’s intent is to hold all investments until maturity unlessmarket, economic or specific investment concerns warrant a sale ofsecurities.  Consideration is given to (1) thelength of time and the extent to which the fair value has been less than cost, (2) thefinancial condition and near-term prospects of the issuer, and (3) theintent and ability of the Corporation to retain its investment in the issuerfor a period of time sufficient to allow for any anticipated recovery in fairvalue.

 

At March 31,2008, two (2) mortgage-backed securities, three (3) corporate bonds,sixty-six (66) equities, and two (2) obligations of state and politicalsubdivisions had unrealized losses. Management has determined that no declines are deemed to be other thantemporary.

 

At December 31,2007, five (5) mortgage-backed securities, three (3) corporate bonds,sixty (60) equities, and fifteen (15) obligations of state and politicalsubdivisions had unrealized losses. Management has determined that no declines are deemed to be other thantemporary.

 

Note 7.                   Fair ValueMeasurements

 

SFAS No. 157, *Fair Value Measurements*, defines fairvalue, establishes a framework for measuring fair value, establishes athree-level valuation hierarchy for disclosure of fair value measurement andenhances disclosure requirements for fair value measurements.  The valuation hierarchy is based upon thetransparency of inputs to the valuation of an asset or liability as of themeasurement date.  The three levels aredefined as follow:

 
|   |   |         |   |                                                                                                                                                                                                                                                                       |
|--------|--------|--------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| · |   | Level 1 |   | inputs  to the valuation methodology are quoted prices (unadjusted) for identical  assets or liabilities in active markets.                                                                                                                                                |
|   |   |         |   |                                                                                                                                                                                                                                                                       |
| · |   | Level 2 |   | inputs  to the valuation methodology include quoted prices for similar assets and  liabilities in active markets, and inputs that are observable for the asset  or liability, either directly or indirectly, for substantially the full term  of the financial instrument. |
|   |   |         |   |                                                                                                                                                                                                                                                                       |
| · |   | Level 3 |   | inputs  to the valuation methodology are unobservable and significant to the fair  valuemeasurement.                                                                                                                                                                       |

 

12

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Note 7.                   Fair ValueMeasurements (Continued)

 

Following is a descriptionof the valuation methodologies used for instruments measured at fair value, aswell as the general classification of such instruments pursuant to thevaluation hierarchy:

 

Securities

 

Where quoted prices areavailable in an active market, securities are classified within level 1 of thevaluation hierarchy. Level 1 securities would include highly liquid governmentbonds, mortgage products and exchange traded equities.  If quoted market prices are not available,then fair values are estimated by using pricing models, quoted prices ofsecurities with similar characteristics, or discounted cash flow.  Level 2 securities would include U.S. agencysecurities, mortgage-backed agency securities, obligations of states andpolitical subdivisions and certain corporate, asset backed and othersecurities.  In certain cases where thereis limited activity or less transparency around inputs to the valuation,securities are classified within level 3 of the valuation hierarchy.  Currently, all equity securities held by theholding company with a total fair value of $ 31,000,000 are considered tobe Level 1 Securities.  All other are consideredto be Level 2.

 

Loans held for sale

 

Loans held for sale arerequired to be measured at lower of cost or fair value. Under SFAS No. 157,market value is to represent fair value. Management obtains quotes or bids on all or part of these loans directlyfrom the purchasing financial institutions. Premiums received or to be received on the quotes or bids are indicativeof the fact that cost is lower than fair value. At March 31, 2008, entire****balance ofloans held for sale was recorded at its cost.

 

Impaired loans

 

SFAS No. 157 applies toloans measured for impairment using the practical expedients permitted by SFAS No. 114,Accounting by Creditors for Impairmentof a Loan, including impaired loans measured at an observable marketprice (if available), or at the fair value of the loan’s collateral (if theloan is collateral dependent).  Fairvalue of the loan’s collateral, when the loan is dependent on collateral, isdetermined by appraisals or independent valuation which is then adjusted forthe cost related to liquidation of the collateral.

 

Other Real Estate Owned

 

Certain assets such as otherreal estate owned (OREO) are measured at fair value less cost to sell.  We believe that the fair value component inits valuation follows the provisions of SFAS No. 157.

 

13

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ITEM2.

 

MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

March 31, 2008

 

The following ismanagement’s discussion and analysis of the significant changes in theconsolidated results of operations, capital resources and liquidity presentedin the accompanying unaudited consolidated financial statements for theCompany. This discussion should be read in conjunction with the precedingcondensed consolidated financial statements and related footnotes, as well asthe Company’s December 31, 2007 Annual Report on Form 10-K. Currentperformance does not guarantee and may not be indicative of similar performancein the future.

 

In addition to historicalinformation, this quarterly report on Form 10-Q contains forward-lookingstatements. The forward-looking statements contained in this report are subjectto certain risks, assumptions and uncertainties. Because of the possibility ofchange in the underlying assumptions, actual results could differ materiallyfrom those projected in the forward-looking statements. Additional factors thatmight cause actual results to differ materially from those expressed in theforward-looking statements include, but are not limited to:

 

·                  operating, legal and regulatory risks;

·                  economic, political and competitive forces affectingthe Company’s services; and

·                  the risk that management’s analyses of these riskscould be incorrect and/or that the strategies developed to address them couldbe unsuccessful.

 

The Company’sforward-looking statements are relevant only as of the date on which thestatements are made. By making forward-looking statements, the Company assumesno duty to update them to reflect new, changing or unanticipated events orcircumstances. Readers should carefully review the risk factors described in otherperiodic reports and public documents that the Company files from time to timewith the Securities and Exchange Commission.

 

OVERVIEW

 

Net income for the threemonths ended March 31, 2008 and 2007 was $1,484,000 and $1,969,000,respectively. The decrease of $485,000, or 24.6%, is attributable to a decreaseof investment security gains and an increased provision expense for theallowance for loan losses.  Net interestincome increased 8.8%, other income decreased 33.8%, the provision for loanlosses increased 166.7% and other expenses increased 3.1%. On a basic anddiluted per share basis, net income for the three months ended March 31,2008 was $0.64 and $0.64, respectively, as compared with $0.84 and $0.82 forthe three months ended March 31, 2007. Net income as a percentage of totalaverage stockholders’ equity on an annualized basis, also known as return onaverage equity, was 7.64% and 9.67% for the first three months of 2008 and2007, respectively.  Return on averagetangible equity was 10.01% and 12.27% for the first three months of 2008 and2007 respectively, a decrease of 18.42%. The decrease in this ratio isattributable to a decreased level of net income.

 

14

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During the first threemonths of 2008, the Company’s assets increased $3,568,000, or 0.6%, to$565,204,000 as of March 31, 2008 from $561,636,000 as of December 31,2007. This increase is primarily attributable to an increase in investmentsecurities, funded by an increase in borrowed money. Total loans decreased 2.4%to $389,013,000. Total deposits decreased by $4,154,000, or 0.9%, during thefirst three months of 2008 to $435,776,000 as of March 31, 2008 from$439,930,000 as of December 31, 2007. As a result of competition in themarket, and, to a certain degree, customers’ continued uncertainty as to how tobest invest their monies, deposit declines may not be assumed at the currentrates.

 

RESULTS OF OPERATIONS

 

Net Interest Income

 

For the three monthsended March 31, 2008, total interest income decreased by $10,000, or 0.1%,to $8,172,000 as compared with $8,182,000 for the three months ended March 31,2007. This decrease is primarily due to decreased yields on overnight Federalfunds sold.  During the three monthsending March 31, 2008 earning assets increased 1.2% to $511,353,000. Forthe three months ended March 31, 2008, loans decreased by $9,466,000 or2.4% to $389,013,000 while investment securities increased $9,520,000 andovernight Fed Funds sold increased $4,929,000. Management continued to targetefforts to attract mortgage and small commercial loans. During the firstquarter of 2008, there was a 200 basis point decrease in the New York PrimeRate and about a 117 basis point drop in the One Year Constant MaturityTreasury Rate.

 

Total interest expensedecreased by $429,000, or 12.5% to $3,016,000 for the three months ended March 31,2008 from $3,445,000 for the three months ended March 31, 2007. Thisdecrease is primarily due to lower deposit rates and lower rates on bankborrowings.  The cost of interest bearingfunds at the bank decreased to 2.72% for the first quarter of 2008 compared to3.09% for the first quarter of 2007.

 

Net interest incomeincreased by $419,000, or 8.8%, to $5,156,000 for the three months ending March 31,2008 from $4,737,000 for the three months ending March 31, 2007. Thisincrease is primarily due to the lower cost of interest bearing funds at thebank.

 

Provision for Loan Losses

 

The provision for loanlosses was $400,000 for the three months ending March 31, 2008 comparedwith $150,000 for the three months ending March 31, 2007, an increase of166.7%. The increase in the provision is in response to a slower housing marketand declining prices of real estate.  Thelevel of provision is commensurate with the risk identified in the loanportfolio.

 

Theallowance for loan losses represented 1.08% of total loans at March 31,2008, compared with 0.97% as of December 31, 2007 and 0.95% as of March 31,2007. Management performs ongoing assessments of the loan loss reserve in relation to loan portfolio growth, creditexposure to individual borrowers, overall trends in the loan portfolio,including delinquencies, and other relevant factors. Based upon these factors,management believes that as of March 31, 2008, the reserve is reasonableand sufficient to support the current level of loans in light of the strongasset quality as supported by the ratios reflected in Table 2 on page 19.

 

15

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Other Income

 

For the three monthsended March 31, 2008, other income was $1,507,000, a decrease of $768,000,or 33.6%, compared with other income of $2,275,000 for the three months ended March 31,2007. The decrease was primarily due to a decrease of $816,000 in net gainsfrom the sale of securities, which were $397,000 for the three months ended March 31,2008 and $1,213,000 for the three months ended March 31, 2007. Otherincome was positively impacted by increases of $39,000 in NSF fees, $24,000 inATM/Debit card interchange fees, and $20,000 in trust revenues.  Income from bank owned life insurance (BOLI)was down $35,000.  In 2007 $52,000 ofBOLI income related to proceeds from death benefits, of which there were nonein 2008.  In February 2008, the bankinitiated a cash rewards program for debit cards.  The Bank re-established and reactivated itsTrust Department in the third quarter of 2006.

 

Other Expenses

 

Other expenses, whichinclude salary, occupancy, equipment and all other expenses incidental to theoperation of the Company, increased to $4,331,000 for the three months ended March 31,2008 from $4,200,000 for the three months ended March 31, 2007. The$131,000, or 3.1% increase was primarily due to $181,000 increase of employeebenefits and health insurance expenses.

 

Salaries and employeebenefit expenses, which make up the largest component of other expenses,increased $129,000, or 6.0%, to $2,264,000 for the three months ended March 31,2008 from $2,135,000 for the three months ended March 31, 2007. Theincrease is primarily attributable to $111,000 increase of employee benefitsand a $70,000 increase of health insurance premium expense.  The employee benefit expense included aone-time charge of $98,000 to make the final 2007 contributions to the profitsharing and employee stock ownership plans. Health insurance premiums increased 33.2%.

 

Occupancy and equipmentexpenses increased $48,000, or 5.1%, to $982,000 for the three months ended March 31,2008 from $934,000 for the three months ended March 31, 2007.  The increase is primarily due to $29,000 or22.7% increase of equipment maintenance expense and $14,000 or 10.1% increaseof equipment depreciation expense.  Thebank has updated security systems at a number of branches and continues toinvest in computer network initiatives.

 

Other operating expensesduring the three months ended March 31, 2008 decreased $45,000, or 4.0% to$1,085,000 from $1,130,000 during the three months ended March 31, 2007.The decrease is primarily due to decreases of $56,000 of holding company expenses,partially due to lower security gains, $23,000 of supply expenses and $22,000of state and local taxes due to lower income. Legal expenses increased $65,000 and FDIC insurance increased $26,000.

 

Income Taxes

 

Income tax expense was$448,000 for the three months ended March 31, 2008, a decrease of$245,000, or 35.4%, compared with $693,000 for the three months ended March 31,2007.  The lower income tax expense isdue to lower pre-tax income.

 

16

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Net Income

 

Net income for the threemonths ended March 31, 2008 was $1,484,000, a decrease of $485,000, or24.6%, compared with $1,969,000 for the three months ended March 31, 2007.The decrease in net income is the result of a decrease of $816,000 in securitygains, a $250,000 increase in the allowance for loan loss provision expense anda $131,000 increase in other operating expenses.  Offsetting the above decreases in net incomewere a $419,000 increase in net interest income, a $245,000 decrease in federalincome tax expense and $48,000 increase in other income, excluding securitygains and losses.   Basic and dilutedearnings per share for the three months ended March 31, 2008 were $0.64and $0.64 as compared with $0.84 and $0.82 for the three months ended March 31,2007.

 

Securities

 

The Company’s securitiesportfolio is comprised of securities that not only provide interest anddividend income, including tax-exempt income, but also provide a source ofliquidity, diversify the earning assets portfolio, allow for the management ofrisk and tax liability, and provide collateral for repurchase agreements andpublic fund deposits. Policies are in place to address various aspects ofmanaging the portfolio, including but not limited to, concentrations, liquidity,credit quality, interest rate sensitivity and regulatory guidelines.

 

Although the Companygenerally intends to hold its investment securities to maturity, all of thesecurities portfolio is classified as available for sale, with new purchasesgenerally categorized as such. Securities in the available for sale categoryare accounted for at fair value with unrealized appreciation or depreciation,net of tax, reported as a separate component of stockholders’ equity.Securities in the held to maturity category, of which the Company has none,would be accounted for at amortized cost. The Company holds no tradingsecurities in its portfolio. The securities portfolio includes equities ownedby the holding company, most of which are investments in banks, bank holdingcompanies and financial institutions. Equity investments are accounted for atfair market value. The remaining securities, primarily debt instruments, areowned by the bank.

 

The consolidatedsecurities portfolio at March 31, 2008 was $92,057,000, compared to$83,846,000 at March 31, 2007, an increase of $8,211,000, or 9.8%. Theincrease is due primarily to the purchase of $10,733,000 investment securitiesby the bank, offset by $2,345,000 decrease in unrealized gains on investmentsheld by the holding company.

 

Bank Owned Securities

 

The bank owned securitiesportfolio at March 31, 2008 was $60,794,000, compared to $49,985,000 at December 31,2007, an increase of $10,809,000, or 21.6%. The increase is due primarily tothe purchase of $10,733,000 state and municipal bonds and a $903,000 increasein unrealized gains, less principal payments on mortgage backed securities.

 

17

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The carrying value of theavailable for sale portion of the portfolio at March 31, 2008 includes anunrealized gain of $1,732,000 (reflected as accumulated other comprehensiveincome of $1,143,000 in stockholders’ equity, net of a deferred income taxliability of $589,000). This compares with an unrealized gain at December 31,2007 of $826,000 (reflected as accumulated other comprehensive income of$547,000 in stockholders’ equity, net of a deferred income tax liability of$282,000).

 

Holding Company OwnedSecurities

 

The securities portfolioat March 31, 2008 was $31,263,000, compared to $33,861,000 at December 31,2007, a decrease of $2,598,000, or 7.7%. The decrease includes a decrease of$2,345,000 in unrealized gains. The securities portfolio is exclusivelyinvested in financial institutions and bank holding companies.  This sector has underperformed the broaderstock indexes in recent quarters. Realized gains on sale of equity securities were $397,000 for the threemonths ended March 31, 2008.

 

The carrying value of theavailable for sale portion of the portfolio at March 31, 2008 includes anunrealized gain of $3,732,000 (reflected as accumulated other comprehensiveincome of $2,463,000 in stockholders’ equity, net of a deferred income taxliability of $1,269,000). This compares with an unrealized gain at December 31,2007 of $6,077,000 (reflected as accumulated other comprehensive income of$4,011,000 in stockholders’ equity, net of a deferred income tax liability of$2,066,000).

 

Loans

 

The loan portfoliocomprises the major component of the Company’s earning assets and generally isthe highest yielding asset category. Gross loans receivable, net of unearnedfees and origination costs, decreased $9,466,000, or 2.4%, to $389,013,000 at March 31,2008 from $398,479,000 at December 31, 2007. Gross loans represented 89.3%of total deposits at March 31, 2008 as compared with 90.6% at December 31,2007. This decrease is primarily due a decrease in loan demand caused partiallyby a slowing economy and a depressed local real estate market.

 

Credit Risk and LoanQuality

 

The Company continues tobe prudent in its efforts to minimize credit risk. The Bank’s written lendingpolicy requires underwriting, loan documentation and credit analysis standardsto be met prior to the approval and funding of any loan. In accordance withthat policy, the loan review process monitors the loan portfolio on an ongoingbasis. The Loan Review area then prepares an analysis of the allowance for loanlosses which is then submitted to the Board of Directors for its assessment asto the adequacy of the allowance. The allowance for loan losses is anaccumulation of expenses that has been charged against past and presentearnings in anticipation of potential losses in the loan portfolio.

 

The allowance for loanlosses at March 31, 2008 and December 31, 2007 was $4,206,000 and$3,854,000, respectively. At March 31, 2008, the allowance for loan lossesrepresented 1.08% of the gross loan portfolio, compared with 0.97% at December 31,2007.  This increase is due to anincreased provision for loan losses and decreases in loan balances.  At March 31, 2008, in consideration ofthe bank’s assessment of asset quality, management believes the allowance forloan loss reserve to be reasonable and adequate to support the loan growth and toaddress any potential losses.

 

18

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Table 1 -“Analysis ofAllowance for Loan Loss” -details the activity, which occurred in the allowanceover the first three months of 2008 and 2007.

 

**Table 1 -Analysis of Allowance for Loan Loss (1)**

 
| **(in thousands)**                               | ** ** | **2008** | ** ** | **2007** | ** ** |
|-------------------------------------------------------|------------|----------|------------|----------|------------|
| Balance,  January 1                              |       | $        | 3,854      |     | $          | 3,610 |   |
| Provision  charged to operating expense               |       | 400      |       | 150      |       |
| Charge-offs:                                          |       |     |       |     |       |
| Commercial                                            |       | (11      | )          | 0        |       |
| Real Estate                                           |       | 0        |       | 0        |       |
| Consumer                                              |       | (74      | )          | (82      | )          |
| Total charge-offs                                     |       | (85      | )          | (82      | )          |
|                                                  |       |     |       |     |       |
| Recoveries:                                           |       |     |       |     |       |
| Commercial                                            |       | 21       |       | 1        |       |
| Real Estate                                           |       | 0        |       | 0        |       |
| Consumer                                              |       | 16       |       | 36       |       |
| Total Recoveries                                      |       | 37       |       | 37       |       |
|                                                  |       |     |       |     |       |
| Net (charge-offs)  recoveries                         |       | (48      | )          | (45      | )          |
|                                                  |       |     |       |     |       |
| Balance,  March 31                               |       | $        | 4,206      |     | $          | 3,715 |   |
|                                                  |       |     |       |     |       |
| Net  (charge-offs) or recoveries to average net loans |       | (0.01    | )          | (0.01    | )          |

 

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(1)  Bank’s loan portfolio is entirely domestic

 

The Bank’s lending policyis executed through the assignment of tiered loan limit authorities toindividual officers of the Bank, the Officer’s Loan Committee and the Board ofDirectors. Although the Bank maintains sound credit policies, certain loans maydeteriorate for a variety of reasons. The Bank’s policy is to place all loanson a non-accrual status upon becoming 90 days delinquent in their payments,unless there is a documented and reasonable expectation of the collection ofthe delinquent amount. Loans are reviewed monthly as to their status, and on aquarterly basis presented to the Board of Directors. Management is not aware ofany material potential loan credit problems that have not been disclosed inthis report.  A summary of the loans thatthe Company has identified as impaired follows:

 
| ** **         | ** ** | **3/31/08**             | ** ** | **12/31/07** | ** ** |
|--------------------|------------|-------------------------|------------|--------------|------------|
| ** **         | ** ** | **(in thousands)** | ** ** |
| Balance            |       | $                       | 6,982      |         | $          | 7,059 |   |
| Related  allowance |       | 1,007                   |       | 940          |       |
|                    |            |                         |            |              |            |  |  |

 

Table 2 - “Assets QualityRatios” - summarizes pertinent asset quality ratios at March 31, 2008 and December 31,2007.

 

**Table 2 -Asset Quality Ratios**

 
| ** **                                  | ** ** | **3/31/08** | ** ** | **12/31/07** | ** ** |
|---------------------------------------------|------------|-------------|------------|--------------|------------|
| Non-accrual  loans/total loans              |       | 1.15        | %          | 1.10         | %          |
| Non-performing  assets (1)/total loans      |       | 1.37        | %          | 1.36         | %          |
| Net (charge  offs) recoveries/average loans |       | (0.01       | )%         | (0.09        | )%         |
| Allowance/total  loans                      |       | 1.08        | %          | 0.97         | %          |
| Allowance/non-accrual  loans                |       | 94.4        | %          | 87.7         | %          |
| Allowance/non-performing  loans (1)         |       | 88.2        | %          | 71.1         | %          |

 

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(1) - Includesnon-accrual loans

 

19

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At March 31, 2008and December 31, 2007, the Company had other real estate owned (not usedin operations) in the amount of $2,826,000 and $2,313,000 respectively of which$ 542,000 and $ 25,000, respectively, represents foreclosedproperty.  At March 31, 2008 and December 31,2007, the Company had non-accrual loans in the amount of $4,457,000 and$4,397,000, respectively.

 

Loan concentrations areconsidered to exist when the total amount of loans to any one or a multiplenumber of borrowers engaged in similar activities or having similarcharacteristics exceeds 10% of loans outstanding in any one category. TheCompany maintains a diversified loan portfolio, granting agribusiness,commercial and residential loans to customers. The majority of the Bank’slending is made within its primary market area, which includes Fulton Countyand southern Franklin County, Pennsylvania and northern Washington County,Maryland. Although no concentrations exist to one borrower or related group ofborrowers or industry sector, the Bank’s commercial lending is primarilysecured by real estate.

 

Bank Owned Life Insurance

 

The Company has BankOwned Life Insurance (“BOLI”) for certain officers and directors, in which theBank is the owner and beneficiary of the policies. The Bank’s deposits andproceeds from the sale of investment securities funded the BOLI. Earnings fromthe BOLI are recognized as other income. The BOLI is profitable from theappreciation of the cash surrender values of the pool of insurance, and its taxadvantage to the Company. This profitability is used to offset a portion ofcurrent and future employee and director benefit costs.

 

The Company had$10,878,000 and $10,768,000 in BOLI as of March 31, 2008 and December 31,2007, respectively. This increase is primarily due to the cash valueappreciation.  Although the BOLI is anasset that may be liquidated, it is the Company’s intention to hold this poolof insurance because it provides tax-exempt income that lowers the Company’stax liability, while enhancing its overall capital position.

 

Deposits

 

Deposits are the majorsource of the Company’s funds for lending and investment purposes. Totaldeposits at March 31, 2008 were $435,776,000, a decrease of $4,154,000, or0.9%, from total deposits of $439,930,000 at December 31, 2007. This decreaseis primarily due to a $4,830,000 decrease in demand deposits, which managementconsiders to be normal fluctuations in these types of accounts.

 

Short-Term Borrowings

 

Short term borrowings at March 31,2008 were $10,011,000, compared to $10,996,000 at December 31, 2007, adecrease of $985,000, or 9.0%. Federal funds purchased, Treasury Tax and Loandemand note, lines of credits with banks and overnight borrowings with theFederal Home Loan Bank of Pittsburgh are considered to be short term borrowings.Short term borrowings fluctuate daily to meet the liquidity needs of theCompany.

 

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Long-Term Debt Borrowings

 

Long term borrowings at March 31,2008 were $36,732,000, compared to $26,740,000 at December 31, 2007, anincrease of $9,992,000, or 37.4%. This increase is primarily due to a$ 10,000,000 borrowing with the Federal Home Loan Bank for a term of 10years and settling in February 2008.

 

Asset/LiabilityManagement

 

The management ofinterest rate risk involves measuring and analyzing the maturity and repricingof interest-earning assets and interest bearing liabilities at specific pointsin time. The imbalance between interest earning assets and interest bearingliabilities is commonly referred to as the interest rate gap. The interest rategap is one measure of the risk inherent in the existing balance sheet as itrelates to potential changes in net interest income. Maintaining an appropriatebalance between interest-earning assets and interest bearing liabilities is ameans of monitoring and possibly avoiding material fluctuations in the netinterest margin during periods of changing interest rates.

 

The Company’s overallsensitivity to interest rate risk is low due to its non-complex balance sheet.The Company manages its balance sheet with the intent of stabilizing netinterest income and net economic value under a broad range of interest rateenvironments. The Company has the ability to effect various strategies tomanage interest rate risk, which include, but are not limited to, selling newlyoriginated residential mortgage loans, controlling the volume mix offixed/variable rate commercial loans, mortgage loans and securities,increasing/ decreasing deposits via interest rate changes, borrowing from theFederal Home Loan Bank of Pittsburgh, and buying/selling securities.Adjustments to the mix of assets and liabilities are made periodically in aneffort to give the Company dependable and steady growth in net interest income,while at the same time, managing the related risks.

 

Liquidity

 

Liquidity represents theCompany’s ability to efficiently manage cash flows at reasonable rates tosupport possible commitments to borrowers or the demands of depositors.Liquidity is essential to compensate for fluctuations in the balance sheet andprovide funds for growth and normal operating expenditures. Liquidity needs maybe met by converting assets into cash or obtaining sources of additionalfunding.

 

Liquidity from assetcategories is provided through cash, amounts due from banks, interest-bearingdeposits with banks and federal funds sold, which were $40,086,000 at March 31,2008, compared to $36,851,000 at December 31, 2007, an increase of$3,235,000 or 8.8%. This increase is primarily due to an increase of $4,929,000in Federal funds sold.  Additional assetliquidity sources include principal and interest payments from securities inthe Company’s investment portfolio and cash flow from its amortizing loanportfolio. Longer-term liquidity needs may be met by selling securitiesavailable for sale, selling loans or raising additional capital. At March 31,2008, there was $76,820,000 in liquid securities as compared to $68,573,000 at December 31,2007. Liquid securities increased by $8,247,000

 

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since year end primarilydue to the purchase of investment securities available for sale at thebank.  Liquid securities held at TowerBancorp decreased $2,598,000 due to sales, calls and maturity of investmentsecurities exceeding purchases and market value fluctuations.

 

Liability liquiditysources include attracting deposits at competitive rates. Deposits at March 31,2008 were $435,776,000, compared to $439,930,000 at December 31, 2007. Inaddition, the Company has borrowing capacity and lines of credit with theFederal Home Loan Bank of Pittsburgh, Atlantic Central Bankers Bank and severallocal banks.

 

The Company’s financialstatements do not reflect various off-balance sheet commitments that are madein the normal course of business, which may involve some liquidity risk.Off-balance sheet arrangements are discussed in detail below.

 

Management is of theopinion that its liquidity position at March 31, 2008 is adequate torespond to fluctuations “on” and “off” the balance sheet. In addition,management knows of no trends, demands, commitments, events or uncertaintiesthat may result in, or that are reasonably likely to result in the Company’sinability to meet anticipated or unexpected liquidity needs.

 

Off-Balance SheetArrangements

 

The Company’s financialstatements do not reflect various off-balance sheet arrangements that are madein the normal course of business. These commitments consist mainly of loansapproved but not yet funded, unused lines of credit and letters of credit madein accordance with the same standards as on-balance sheet instruments. Unusedcommitments at March 31, 2008 were $107,894,000, which consisted of$104,538,000 in unfunded commitments to existing loans and unfunded new loansand $3,356,000 in letters of credit. Because these instruments have fixedmaturity dates, and because many of them will expire without being drawn upon,they do not generally present a significant liquidity risk to the Company.Management believes that any amounts actually drawn upon can be funded in thenormal course of operations. The Company has no investment in or financialrelationship with any unconsolidated entities that are reasonably likely tohave a material effect on liquidity or the availability of capital resources.

 

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Capital

 

The following Table 3presents the risk-based and leverage capital amounts and ratios at March 31,2008 for the Company and the Bank.

 

**Table 3 -Capital Ratios**

 
| ** **                                      | ** ** | **Actual**                           | ** ** | **Minimum for  Capital Adequacy  Purposes** | ** ** | **To be Well  Capitalized under  Prompt Corrective  Action Provisions** | ** ** |
|-------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------|------------|
| ** **                                      | ** ** | **Amount**                           | ** ** | **Ratio**                                             | ** ** | **Amount**                                                                                       | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| ** **                                      | ** ** | **(Dollars in Thousands)** | ** ** |
| Total risk based  capital/risk weighted assets: |       |                                 |       |                                                  |       |                                                                                             |       |   |   |   |   |   |   |
| Company                                         |       | $                                    | 60,855     |                                                  | 16.6       | %>                                                                                            | 29,382     | >  | 8.0 | % | N/A |   | N/A |   |
| Bank                                            |       | 47,473                               |       | 13.1                                                  | %>      | 29,033                                                                                           | >  | 8.0 | % | 36,292 | >  | 10.0 | % |
|                                            |       |                                 |       |                                                  |       |                                                                                             |       |   |   |   |   |   |   |
| Tier 1  capital/risk weighted assets:           |       |                                 |       |                                                  |       |                                                                                             |       |   |   |   |   |   |   |
| Company                                         |       | 55,000                               |       | 15.0                                                  | %>      | 14,691                                                                                           | >  | 4.0 | % | N/A |   | N/A |   |
| Bank                                            |       | 43,267                               |       | 11.9                                                  | %>      | 14,517                                                                                           | >  | 4.0 | % | 21,775 | >  | 6.0 | % |
|                                            |       |                                 |       |                                                  |       |                                                                                             |       |   |   |   |   |   |   |
| Tier 1  capital/average assets                  |       |                                 |       |                                                  |       |                                                                                             |       |   |   |   |   |   |   |
| Company                                         |       | 55,000                               |       | 10.1                                                  | %>      | 21,829                                                                                           | >  | 4.0 | % | N/A |   | N/A |   |
| Bank                                            |       | 43,267                               |       | 8.5                                                   | %>      | 20,461                                                                                           | >  | 4.0 | %> | 25,576 | >  | 5.0 | % |
|                                                 |            |                                      |            |                                                       |            |                                                                                                  |            |  |  |  |  |  |  |  |

 

These capital ratioscontinue to remain at levels which are considered to be “well-capitalized” asdefined by regulatory guidelines.

 

Banking laws andregulations limit the amount of cash dividends that may be paid without priorapproval from the Company’s regulatory agencies. In abidance with suchrequirements, on January 9, 2008, the Board of Directors authorized anddeclared a quarterly cash dividend in the amount of $0.28 per share, payable onFebruary 15, 2008 to all shareholders of record as of February 1,2008. The payment of this quarterly cash dividend decreased retained earningsby $650,000.

 

23

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**ITEM 3 - QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

Therehave been no material changes to the quantitative and qualitative disclosuresmade in Tower Bancorp’s annual report on Form 10-K for the year ended December 31,2007.

 

**ITEM 4 - CONTROLS AND PROCEDURES**

 

**CONTROLS AND PROCEDURES**

 

The Company’s Chief Executive Officer and Chief Financial Officer haveevaluated the effectiveness of the Company’s disclosure controls and procedures(as such term is defined in the Rules 13a-15(e) under the SecuritiesExchange Act of 1934, as amended (the “Exchange Act”))as of March 31,2008. Based on such evaluation, such officers have concluded that, as of March 31,2008, the Company’s disclosure controls and procedures are effective inalerting them on a timely basis to material information relating to the Company(including its consolidated subsidiary) required to be included in the Company’speriodic filings under the Exchange Act.

 

**CHANGES IN INTERNAL CONTROLS**

 

Duringthe quarter ended March 31, 2008, management made a number of changes toremediate material weakness noted in our December 31, 2007 10-Kfiling.  Our full time Loan ReviewOfficer conducted independent loan reviews throughout the first quarter.  The reviews included an assessment ofmanagement risk identification for loans. An outside accounting firm will test the Loan Review Officer’s workperiodically.  The same firm will alsoreview the methodology surrounding the allowance for loan loss calculation.

 

Inorder to improve our management information system in the lending area, we haveincluded some additional coding of assets, and are in the process of a systemwide review of the loan portfolio to assure completeness of this coding.  We also are risk-rating the commercialportfolio to aid management of the bank in determining quarterly allowancerequirements.  All loan policy exceptionsare being noted and more detailed coding has been implemented to determine riskexposure in the various business sectors. Trend analysis will be used in the futureto note any concentrations in any of the sectors.

 

Creditadministration is doing a completely independent credit analysis of borrowersover a defined threshold and obtaining current financial information from theborrowers in order to do the analysis. We now have a procedure in place toassure receipt of current financial information for all commercial loans inthis defined threshold on an on-going basis.

 

Additionalpersonnel have been employed by the bank and provided the training to reviewloan documentation in all loan files, and bring to the attention of managementany missing documents or irregularities that are found. Procedures have beenput in place to assure that the responsible person obtains the informationneeded on a more timely basis.

 

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Thebank’s loan policy continues to be developed and some of the procedures thataccompany sections of the policy have already been completed.

 

Managementbelieves the above steps show substantial progress has been made to remediatethe material weaknesses noted in our December 31, 2007 10-K filing.  Management expects further steps to be takenin subsequent periods to continue to strengthen controls.

 

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PART II- OTHER INFORMATION

 

26

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PART II- OTHER INFORMATION

 

Item 1 - Legal Proceedings

 

Thenature of the Company’s business generates some litigation involving mattersarising in the ordinary course of business. In the opinion of Tower’s management, Tower has adequate legal defensesand/or insurance coverage respecting any and each of these actions and does notbelieve that they will materially affect Tower’s operations or financialposition.  However, in the opinion of theCompany, after consulting with legal counsel, no legal proceedings are pending,which are expected to have a material adverse effect on the company orsubsidiary. No legal proceedings are pending other than ordinary routinelitigation incidental to the business of the Company and the Bank. In addition,to Management’s knowledge, no governmental authorities have initiated orcontemplated any material legal actions against the Company or the Bank.

 

Item 1A - Risk Factors

 

Therehave been no material changes to the Company’s risk factors since these factorswere previously disclosed in the Company’s Annual Report on Form 10-K forthe period ended December 31, 2007.

 

Item 2 - Unregistered Sales ofEquity Securities and Use of Proceeds

 

On September 13,2006, the Board of Directors authorized the Company to redeem or repurchase100,000 shares of the Company’s common stock from specific shareholders or inthe open market.  The stock repurchaseplan does not expire.

 

ISSUER PURCHASES OFEQUITY SECURITIES

 
| **Period**         | ** ** | **(a)  Total Number  of shares  purchased** | ** ** | **(b)  Average price  paid per  share** | ** ** | **(c)  Total number  of shares  purchased as  part of  publicly  announced  plan** | ** ** | **(d)  Maximum  number of shares  that may yet  be purchased  under the  plan** | ** ** |
|--------------------|------------|-------------------------------------------------------|------------|---------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------|------------|
|               |       |                                                  |       |                                              |       |                                                                                                   |       |                                                                                                          |       |
| January 2008  |       | 7,220                                                 |       | 38.82                                             |       | 7,220                                                                                                  |       | 41,054                                                                                                        |       |
|               |       |                                                  |       |                                              |       |                                                                                                   |       |                                                                                                          |       |
| February 2008 |       | 2,000                                                 |       | 39.50                                             |       | 2,000                                                                                                  |       | 39,054                                                                                                        |       |
|               |       |                                                  |       |                                              |       |                                                                                                   |       |                                                                                                          |       |
| March 2008    |       | 173                                                   |       | 39.75                                             |       | 173                                                                                                    |       | 38,881                                                                                                        |       |
|               |       |                                                  |       |                                              |       |                                                                                                   |       |                                                                                                          |       |
| Total              |       | 9,393                                                 |       | 38.98                                             |       | 9,393                                                                                                  |       | 38,881                                                                                                        |       |

 

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Item 3 - Defaults Upon Senior Securities

 

Not applicable

 

Item 4 - Submission of Matters to a Vote of SecurityHolders

 

Not applicable

 

Item 5 - Other Information

 

There have been no materialchanges to the procedures for which a shareholder may recommend nominees to theCompany’s Board of Directors.

 

Item 6 - Index to Exhibits

 
| **Exhibit** | ** ** | **Description of Exhibit**                                                                                                                                                                                                                               |
|-------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |       |                                                                                                                                                                                                                                                     |
| 3.1         |       | Articles of  Incorporation of Tower Bancorp, Inc. (incorporated by reference to  Exhibit 3.1 of Tower Bancorp, Inc.’s Form 10-Q for the quarter  ended September 30, 2005).                                                |
|        |       |                                                                                                                                                                                                                                                     |
| 3.2         |       | Bylaws of Tower  Bancorp, Inc. (incorporated by reference to Exhibit 3.2 of Tower  Bancorp, Inc.’s Form 10-Q for the quarter ended September 30,  2005).                                                                   |
|        |       |                                                                                                                                                                                                                                                     |
| 10.1        |       | Change of Control  Agreement of Jeffrey B. Shank dated as of September 25, 2002  (incorporated by referenced to Exhibit 99.4 of Tower  Bancorp, Inc.’s Form 10-Q for the quarter ended September 30,  2002).               |
|        |       |                                                                                                                                                                                                                                                     |
| 10.2        |       | Change of Control  Agreement of Franklin T. Klink, III dated as of November 26, 2001  (incorporated by reference to Exhibit 10.1 of Tower Bancorp, Inc.’s  Form 10-K for the year ended December 31, 2001).           |
|        |       |                                                                                                                                                                                                                                                     |
| 10.3        |       | Change of Control  Agreement of Donald G. Kunkle dated as of January 4, 2002 (incorporated  by reference to Exhibit 10.2 of Tower Bancorp, Inc.’s  Form 10-K for the year ended December 31, 2001).                        |
|        |       |                                                                                                                                                                                                                                                     |
| 10.4        |       | Change of Control  Agreement of John H. McDowell, Sr. dated as of December 23, 1998  (incorporated by reference to Exhibit 10.2 of Tower Bancorp, Inc.’s  Form 10-K for the year ended December 31, 1998).            |
|        |       |                                                                                                                                                                                                                                                     |
| 10.5        |       | Tower  Bancorp, Inc.’s 1995 Non-Qualified Stock Option Plan (incorporated by  reference to Exhibit 99.1 to Tower Bancorp, Inc.’s Registration  Statement on Form S-8 (File No. 333-4066 1)).                          |
|        |       |                                                                                                                                                                                                                                                     |
| 10.6        |       | Tower  Bancorp, Inc. Stock Option Plan for Outside Directors (incorporated by  reference to Exhibit 99.2 to Tower Bancorp, Inc.’s Registration  Statement on Form S-8 (File No. 333-40661)).                               |
|        |       |                                                                                                                                                                                                                                                     |
| 10.7        |       | Supplemental Executive  Retirement Agreement of Jeffrey B. Shank dated as of September 25, 2002  (incorporated by reference to Exhibit 99.3 of Tower Bancorp, Inc.’s  Form 10-Q for the quarter ended September 30, 2002). |

 

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| **Exhibit** | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                                 |
|-------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |       |                                                                                                                                                                                                                                                                       |
| 10.8        |       | Form of Amendment  and Restatement of the First National Bank of Greencastle Group Term  Replacement Plan A (incorporated by reference to Exhibit 10.8 of Tower  Bancorp, Inc.’s Registration Statement on Form S-4 (File  No. 333-130485)). |
|        |       |                                                                                                                                                                                                                                                                       |
| 10.9        |       | Form of Amendment  and Restatement of the First National Bank of Greencastle Group Term  Replacement Plan B (incorporated by reference to Exhibit 10.8 of Tower  Bancorp, Inc.’s Registration Statement on Form S-4 (File  No. 333-130485)). |
|        |       |                                                                                                                                                                                                                                                                       |
| 10.10       |       | Form of Amendment  an Restatement of the First National Bank of Greencastle Executive Bonus  Agreement (incorporated by reference to Exhibit 10.8 of Tower  Bancorp, Inc.’s Registration Statement on Form S-4 (File  No. 333-130485)).      |
|        |       |                                                                                                                                                                                                                                                                       |
| 10.11       |       | First National Bank of  Greencastle Employees’ Stock Ownership Plan Incorporated by reference to  Exhibit 99.3 to Tower Bancorp, Inc.’s Registration Statement on  Form S-8(File No.333-40661).                                                   |
|        |       |                                                                                                                                                                                                                                                                       |
| 31.1        |       | Certification of Chief  Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of  2002.                                                                                                                                                                 |
|        |       |                                                                                                                                                                                                                                                                       |
| 31.2        |       | Certification of Chief  Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of  2002.                                                                                                                                                                 |
|        |       |                                                                                                                                                                                                                                                                       |
| 32.1        |       | Certification of Chief  Executive Officer pursuant to 18 U.S.C. Section 1350                                                                                                                                                                                          |
|        |       |                                                                                                                                                                                                                                                                       |
| 32.2        |       | Certification of Chief  Financial Officer pursuant to 18 U.S.C. Section 1350                                                                                                                                                                                          |

 

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SIGNATURES

 

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

 
|   | TOWER BANCORP, INC.              |
|--------|----------------------------------|
|   | (REGISTRANT)                     |
|   |                             |
|   | /s/  Jeff B. Shank          |
|   | Jeff B. Shank,  President, CEO   |
|   | (Principal Executive  Officer)   |
| Date:  | May 9, 2008                 |   |   |
|   |                             |
|   | /s/ Franklin T.  Klink, III |
|   | Franklin T.  Klink, III,    |
|   | Treasurer                        |
|   | (Principal Financial  Officer)   |
| Date:  | May 9, 2008                 |   |   |

 

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