Tableof Contents

 

 

 

**FORM 10-Q**

 

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

** **

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

**OF THE SECURITIES EXCHANGE ACT OF 1934**

** **

**For the quarter ended September 30, 2008**

**Commission file number:  0-12826**

** **

**TOWER BANCORP INC.**

(Exact name of registrant as specified in itscharter)

 

| **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, including  area code: |       | **(717) 597-2137**  |

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for shorter period that the registrantwas required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

Yes  x   No  o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer or a smaller reporting company. Seedefinitions of “accelerated filer, large accelerated filer and smallerreporting company” in Rule 12b-2 of the Exchange Act.

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

 

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

 

Yes  o   No  x

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date.

 

2,315,280shares of common stock outstanding at October 24, 2008

 

 

 

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Table ofContents

 

TOWER BANCORP, INC.

 

INDEX

 
| ** **                                                                                                                     | **Page** |
|--------------------------------------------------------------------------------------------------------------------------------|----------|
|                                                                                                                           |     |
| PART I  - FINANCIAL INFORMATION                                                                                           |     |
|                                                                                                                           |     |
| Item 1 - Financial Statements                                                                                                  |     |
| Condensed consolidated  balance sheets – September 30, 2008 and December 31, 2007                               | 4        |
| Condensed consolidated  statements of income - three months ended September 30, 2008 and 2007                             | 5        |
| Condensed  consolidated statements of income – nine months ended September 30, 2008  and 2007                        | 6        |
| Condensed consolidated statements of comprehensive  income – three and nine months ended September 30, 2008 and 2007 | 7        |
| Condensed consolidated statements of cash flows – nine  months ended September 30, 2008 and 2007                     | 8        |
| Notes to condensed consolidated financial statements                                                                           | 9 - 16   |
| Item 2 - Management’s discussion and analysis of  financial condition and results of operations                           | 17 - 29  |
| Item 3 - Quantitative and qualitative disclosures  about market risk                                                           | 29       |
| Item 4 - Controls and procedures                                                                                               | 29       |
|                                                                                                                           |     |
| PART II  - OTHER INFORMATION                                                                                              | 31       |
|                                                                                                                           |     |   |
| Item  1 – Legal proceedings                                                                                               | 31       |
| Item 1A – Risk Factors                                                                                                    | 31       |
| Item 2 – Unregistered sales of equity securities and  use of proceeds                                                     | 31       |
| Item 3 – Defaults upon senior securities                                                                                  | 31       |
| Item 4 – Submission of matters to a vote of security  holders                                                             | 31       |
| Item  5 – Other information                                                                                               | 32       |
| Item  6 – Index to Exhibits                                                                                               | 32 - 33  |
|                                                                                                                           |     |
| Signatures                                                                                                                     | 34       |
|                                                                                                                           |     |
| Exhibits                                                                                                                       |     |
|                                                                                                                                |          |  |

 

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PART I- FINANCIAL INFORMATION

 

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TOWER BANCORP, INC. AND ITSWHOLLY-OWNED SUBSIDIARY

 

CONDENSEDCONSOLIDATED BALANCE SHEETS

 
| ** **                                                                                             | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                             | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| ** **                                                                                             | ** ** | **(Unaudited)**        | ** ** | **(Audited)***        | ** ** |
| ** **                                                                                             | ** ** | **(000 Omitted)** | ** ** | ** **            | ** ** |
| ASSETS                                                                                                 |       |                   |       |                  |       |
| Cash and due  from banks                                                                               |       | $                      | 11,739     |                  | $          | 16,770 |   |
| Federal funds  sold                                                                                    |       | 0                      |       | 20,081                |       |
| Interest bearing  balances with other banks                                                            |       | 802                    |       | 0                     |       |
| Investment  securities available for sale                                                              |       | 59,525                 |       | 49,985                |       |
| Equity  securities available for sale                                                                  |       | 23,535                 |       | 33,861                |       |
| Restricted bank  stock                                                                                 |       | 4,823                  |       | 2,914                 |       |
| Loans:                                                                                                 |       |                   |       |                  |       |
| Real estate  mortgages                                                                                 |       | 364,965                |       | 350,976               |       |
| Commercial                                                                                             |       | 26,804                 |       | 30,444                |       |
| Consumer                                                                                               |       | 15,587                 |       | 17,059                |       |
| Gross loans                                                                                            |       | 407,356                |       | 398,479               |       |
| Less:     reserve  for possible loan losses                                   |       | (4,522                 | )          | (3,854                | )          |
| Loans, net                                                                                             |       | 402,834                |       | 394,625               |       |
| Bank premises,  equipment, furniture and fixtures                                                      |       | 11,933                 |       | 9,861                 |       |
| Real estate  owned other than premises                                                                 |       | 1,991                  |       | 2,313                 |       |
| Accrued interest  receivable                                                                           |       | 1,987                  |       | 1,861                 |       |
| Cash surrender  value of life insurance                                                                |       | 11,103                 |       | 10,768                |       |
| Goodwill                                                                                               |       | 16,558                 |       | 16,558                |       |
| Core deposit  intangible, net                                                                          |       | 1,420                  |       | 1,693                 |       |
| Other assets                                                                                           |       | 1,664                  |       | 346                   |       |
| Total assets                                                                                           |       | $                      | 549,914    |                  | $          | 561,636 |   |
|                                                                                                   |       |                   |       |                  |       |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                             |       |                   |       |                  |       |
| LIABILITIES                                                                                            |       |                   |       |                  |       |
| Deposits in domestic  offices:                                                                         |       |                   |       |                  |       |
| Demand                                                                                                 |       | $                      | 41,850     |                  | $          | 46,860 |   |
| Savings                                                                                                |       | 218,888                |       | 223,904               |       |
| Time                                                                                                   |       | 156,969                |       | 169,166               |       |
| Liabilities for  borrowed money                                                                        |       | 40,381                 |       | 37,735                |       |
| Federal funds  purchased                                                                               |       | 14,960                 |       | 0                     |       |
| Accrued interest  payable                                                                              |       | 738                    |       | 999                   |       |
| Other liabilities                                                                                      |       | 2,784                  |       | 4,558                 |       |
| Total  liabilities                                                                                     |       | 476,570                |       | 483,222               |       |
|                                                                                                   |       |                   |       |                  |       |
| STOCKHOLDERS’  EQUITY                                                                             |       |                   |       |                  |       |
| Capital stock,  common, no par, authorized 5,000,000 shares; 2,420,481 shares issued                   |       | 2,225                  |       | 2,225                 |       |
| Additional  paid-in capital                                                                            |       | 34,810                 |       | 34,831                |       |
| Retained  earnings                                                                                     |       | 41,734                 |       | 40,696                |       |
| Accumulated  other comprehensive income (loss)                                                         |       | (1,250                 | )          | 4,558                 |       |
| Less:     cost  of treasury stock; 2008 -105,426 shares; 2007 - 98,055 shares |       | (4,175                 | )          | (3,896                | )          |
| Total  stockholders’ equity                                                                       |       | 73,344                 |       | 78,414                |       |
|                                                                                                   |       |                   |       |                  |       |
| Total liabilities  and stockholders’ equity                                                       |       | $                      | 549,914    |                  | $          | 561,636 |   |
|                                                                                                        |            |                        |            |                       |            |  |  |  |

 

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*    Condensedfrom audited financial statements.

 

The accompanying notes arean integral part of these condensed financial statements.

 

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TOWER BANCORP, INC. AND ITSWHOLLY-OWNED SUBSIDIARY

 

CONDENSEDCONSOLIDATED STATEMENTS OF INCOME

THREE MONTHS ENDED SEPTEMBER30, 2008 and 2007

(UNAUDITED)

 
| ** **                                            | ** ** | **2008**               | ** ** | **2007**  | ** ** |
|-------------------------------------------------------|------------|------------------------|------------|-----------|------------|
| ** **                                            | ** ** | **(000 Omitted)** | ** ** |
| Interest Income                                       |       |                   |       |      |       |
| Interest &  fees on loans                    |       | $                      | 6,681      |      | $          | 7,233 |   |
| Interest on  investment securities available for sale |       | 967                    |       | 689       |       |
| Interest on  federal funds sold                       |       | 13                     |       | 565       |       |
| Total  interest & dividend income            |       | 7,661                  |       | 8,487     |       |
|                                                  |       |                   |       |      |       |
| Interest Expense                                      |       |                   |       |      |       |
| Interest on  deposits                                 |       | 1,878                  |       | 3,095     |       |
| Interest on  borrowed money                           |       | 529                    |       | 498       |       |
| Total interest  expense                               |       | 2,407                  |       | 3,593     |       |
|                                                  |       |                   |       |      |       |
| Net interest  income                                  |       | 5,254                  |       | 4,894     |       |
|                                                  |       |                   |       |      |       |
| Provision for  loan losses                            |       | 525                    |       | 150       |       |
|                                                  |       |                   |       |      |       |
| Net interest  income after provision for loan losses  |       | 4,729                  |       | 4,744     |       |
|                                                  |       |                   |       |      |       |
| Other Income                                          |       |                   |       |      |       |
| Investment  service income                            |       | 120                    |       | 227       |       |
| Service charges  on deposit accounts                  |       | 506                    |       | 471       |       |
| Other service  charges                                |       | 307                    |       | 636       |       |
| Other operating  income                               |       | 127                    |       | 101       |       |
| Investment  securities gains (losses), net            |       | (401                   | )          | 172       |       |
| Total other  income                                   |       | 659                    |       | 1,607     |       |
|                                                  |       |                   |       |      |       |
| Other Expense                                         |       |                   |       |      |       |
| Salaries, wages  and other benefits                   |       | 2,075                  |       | 1,965     |       |
| Occupancy and  equipment expense                      |       | 1,029                  |       | 890       |       |
| Professional  fees                                    |       | 302                    |       | 193       |       |
| Amortization of  core deposit intangibles             |       | 85                     |       | 96        |       |
| Marketing                                             |       | 102                    |       | 87        |       |
| FDIC Insurance                                        |       | 98                     |       | 13        |       |
| Taxes not based  on income                            |       | 163                    |       | 136       |       |
| Other operating  expenses                             |       | 481                    |       | 469       |       |
| Total other  expenses                                 |       | 4,335                  |       | 3,849     |       |
|                                                  |       |                   |       |      |       |
| Income before  taxes                                  |       | 1,053                  |       | 2,502     |       |
| Applicable  income taxes                              |       | 150                    |       | 684       |       |
| Net income                                            |       | $                      | 903        |      | $          | 1,818 |   |
|                                                  |       |                   |       |      |       |
| Earnings per  share:                                  |       |                   |       |      |       |
| Basic earnings  per share                             |       | $                      | 0.39       |      | $          | 0.78 |   |
| Weighted average  shares outstanding                  |       | 2,315,003              |       | 2,340,221 |       |
| Diluted earnings  per share                           |       | $                      | 0.39       |      | $          | 0.77 |   |
| Weighted average  shares outstanding                  |       | 2,318,459              |       | 2,348,147 |       |
|                                                  |       |                   |       |      |       |
| Dividends  declared per share                         |       | $                      | 0.28       |      | $          | 0.26 |   |

 

The accompanying notes arean integral part of these condensed financial statements.

 

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TOWER BANCORP, INC. AND ITSWHOLLY-OWNED SUBSIDIARY

 

CONDENSEDCONSOLIDATED STATEMENTS OF INCOMENINE MONTHS ENDED SEPTEMBER 30, 2008 and 2007

(UNAUDITED)

 
| ** **                                            | ** ** | **2008**               | ** ** | **2007**  | ** ** |
|-------------------------------------------------------|------------|------------------------|------------|-----------|------------|
| ** **                                            | ** ** | **(000 Omitted)** | ** ** |
| Interest Income                                       |       |                   |       |      |       |
| Interest &  fees on loans                    |       | $                      | 20,604     |      | $          | 21,216 |   |
| Interest on  investment securities available for sale |       | 2,823                  |       | 2,158     |       |
| Interest on  federal funds sold                       |       | 258                    |       | 1,590     |       |
| Total  interest & dividend income            |       | 23,685                 |       | 24,964    |       |
| Interest Expense                                      |       |                   |       |      |       |
| Interest on  deposits                                 |       | 6,466                  |       | 9,056     |       |
| Interest on  borrowed money                           |       | 1,582                  |       | 1,520     |       |
| Total interest  expense                               |       | 8,048                  |       | 10,576    |       |
|                                                  |       |                   |       |      |       |
| Net interest  income                                  |       | 15,637                 |       | 14,388    |       |
|                                                  |       |                   |       |      |       |
| Provision for  loan losses                            |       | 1,075                  |       | 450       |       |
|                                                  |       |                   |       |      |       |
| Net interest  income after provision for loan losses  |       | 14,562                 |       | 13,938    |       |
|                                                  |       |                   |       |      |       |
| Other Income                                          |       |                   |       |      |       |
| Investment  service income                            |       | 529                    |       | 690       |       |
| Service charges  on deposit accounts                  |       | 1,413                  |       | 1,324     |       |
| Other service  charges                                |       | 918                    |       | 1,214     |       |
| Other operating  income                               |       | 343                    |       | 440       |       |
| Investment  securities gains (losses), net            |       | 323                    |       | 1,861     |       |
| Total other  income                                   |       | 3,526                  |       | 5,529     |       |
|                                                  |       |                   |       |      |       |
| Other Expense                                         |       |                   |       |      |       |
| Salaries, wages  and other benefits                   |       | 6,368                  |       | 6,123     |       |
| Occupancy and  equipment expense                      |       | 3,041                  |       | 2,714     |       |
| Professional  fees                                    |       | 801                    |       | 542       |       |
| Amortization of  core deposit intangible              |       | 273                    |       | 305       |       |
| Marketing                                             |       | 310                    |       | 290       |       |
| FDIC Insurance                                        |       | 204                    |       | 37        |       |
| Taxes not based  on income                            |       | 505                    |       | 494       |       |
| Other operating  expenses                             |       | 1,441                  |       | 1,513     |       |
| Total other  expenses                                 |       | 12,943                 |       | 12,018    |       |
|                                                  |       |                   |       |      |       |
| Income before  taxes                                  |       | 5,145                  |       | 7,449     |       |
| Applicable  income taxes                              |       | 1,160                  |       | 1,949     |       |
| Net income                                            |       | $                      | 3,985      |      | $          | 5,500 |   |
|                                                  |       |                   |       |      |       |
| Earnings per  share:                                  |       |                   |       |      |       |
| Basic earnings  per share                             |       | $                      | 1.72       |      | $          | 2.34 |   |
| Weighted average  shares outstanding                  |       | 2,317,151              |       | 2,350,585 |       |
| Diluted earnings  per share                           |       | $                      | 1.72       |      | $          | 2.33 |   |
| Weighted average  shares outstanding                  |       | 2,321,857              |       | 2,359,013 |       |
|                                                  |       |                   |       |      |       |
| Dividends  declared per share                         |       | $                      | 0.84       |      | $          | 0.78 |   |

 

The accompanying notes arean integral part of these condensed financial statements.

 

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TOWER BANCORP, INC. AND ITSWHOLLY-OWNED SUBSIDIARY

 

CONDENSEDCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOMETHREE AND NINE MONTHS ENDED SEPTEMBER 30, 2008 and 2007

(UNAUDITED)

 
| ** **                                     | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|
| ** **                                     | ** ** | **September 30**            | ** ** |
| ** **                                     | ** ** | **2008**                         | ** ** | **2007** | ** ** |
| ** **                                     | ** ** | **(000 Omitted)**                | ** ** |
|                                           |       |                             |       |   |   |
| Net income                                     |       | $                                | 903        |   | $ | 1,818 |   |
|                                           |       |                             |       |   |   |
| Other  comprehensive income:                   |       |                             |       |   |   |
| Net (gains) losses  realized, net of tax       |       | 264                              |       | (77 | ) |
| Change in fair  value, net of tax              |       | (748                             | )          | (1,548 | ) |
|                                           |       |                             |       |   |   |
| Unrealized  holding gains (losses), net of tax |       | (484                             | )          | (1,625 | ) |
|                                           |       |                             |       |   |   |
| Comprehensive  income                          |       | $                                | 419        |   | $ | 193 |   |
|                                                |            |                                  |            |  |  |  |  |  |

 
| ** **                                     | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------|------------|---------------------------------|------------|
| ** **                                     | ** ** | **September 30**           | ** ** |
| ** **                                     | ** ** | **2008**                        | ** ** | **2007** | ** ** |
| ** **                                     | ** ** | **(000 Omitted)**          | ** ** |
|                                           |       |                            |       |   |   |
| Net income                                     |       | $                               | 3,985      |   | $ | 5,500 |   |
|                                           |       |                            |       |   |   |
| Other  comprehensive income:                   |       |                            |       |   |   |
| Net (gains) losses  realized, net of tax       |       | (214                            | )          | (1,192 | ) |
| Change in fair  value, net of tax              |       | (5,594                          | )          | (2,895 | ) |
|                                           |       |                            |       |   |   |
| Unrealized holding  gains (losses), net of tax |       | (5,808                          | )          | (4,087 | ) |
|                                           |       |                            |       |   |   |
| Comprehensive  income (loss)                   |       | $                               | (1,823     | ) | $ | 1,413 |   |
|                                                |            |                                 |            |  |  |  |  |  |

 

The accompanying notes arean integral part of these condensed financial statements.

 

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

#  

CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWSNINE MONTHS ENDED SEPTEMBER 30, 2008 and 2007

(UNAUDITED)

 
| ** **                                                                         | ** ** | **2008**               | ** ** | **2007**               | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                         | ** ** | **(000 omitted)** | ** ** | **(000 omitted)** | ** ** |
| Cash flows from  operating activities:                                             |       |                   |       |                   |       |
| Net income                                                                         |       | $                      | 3,985      |                   | $          | 5,500 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                   |       |                   |       |
| Depreciation and  amortization                                                     |       | 834                    |       | 949                    |       |
| Provision for  loan losses                                                         |       | 1,075                  |       | 450                    |       |
| Stockbased  compensation                                                           |       | 78                     |       | 108                    |       |
| (Gain) on sale  of investment securities, net                                      |       | (323                   | )          | (1,861                 | )          |
| Other (net)                                                                        |       | (1,949                 | )          | (224                   | )          |
| Net cash  provided by operating activities                                         |       | 3,700                  |       | 4,922                  |       |
|                                                                               |       |                   |       |                   |       |
| Cash flows from  investing activities:                                             |       |                   |       |                   |       |
| Federal funds  sold                                                                |       | 20,081                 |       | (30,956                | )          |
| Loans (net)                                                                        |       | (9,094                 | )          | (4,388                 | )          |
| Purchases of  bank premises, equipment, furniture and fixtures                     |       | (3,490                 | )          | (655                   | )          |
| Interest bearing  balances with banks                                              |       | (802                   | )          | 97                     |       |
| Purchases of  available for sale securities                                        |       | (14,741                | )          | (7,979                 | )          |
| Maturities/sales  of available for sale securities                                 |       | 7,412                  |       | 8,293                  |       |
| Redemption  (purchase) of restricted bank stock                                    |       | (2,201                 | )          | (121                   | )          |
| Proceeds from  sale of other real estate owned                                     |       | 1,011                  |       | 0                      |       |
| Net cash (used)  by investing activities                                           |       | (1,824                 | )          | (35,709                | )          |
|                                                                               |       |                   |       |                   |       |
| Cash flows from  financing activities:                                             |       |                   |       |                   |       |
| Federal funds  purchased                                                           |       | 14,960                 |       | 0                      |       |
| Net increase (decrease)  in deposits                                               |       | (22,302                | )          | 36,610                 |       |
| Long term  borrowings                                                              |       | 18,235                 |       | 0                      |       |
| Payments on long  term borrowings                                                  |       | (15,507                | )          | (5,000                 | )          |
| Net increase  (decrease) in short term borrowings                                  |       | (67                    | )          | (65                    | )          |
| Purchase of  treasury stock                                                        |       | (557                   | )          | (1,155                 | )          |
| Proceeds from  sale of treasury stock                                              |       | 278                    |       | 177                    |       |
| Cash dividends  paid                                                               |       | (1,947                 | )          | (1,834                 | )          |
| Net cash  provided (used) by financing activities                                  |       | (6,907                 | )          | 28,733                 |       |
|                                                                               |       |                   |       |                   |       |
| Net (decrease)  in cash and cash equivalents                                       |       | (5,031                 | )          | (2,054                 | )          |
|                                                                               |       |                   |       |                   |       |
| Cash and cash  equivalents at beginning of period                                  |       | 16,770                 |       | 14,128                 |       |
|                                                                               |       |                   |       |                   |       |
| Cash and cash  equivalents at end of period                                        |       | $                      | 11,739     |                   | $          | 12,074 |   |

 

The accompanying notes arean integral part of these condensed financial statements.

 

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NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2008

(UNAUDITED)

 

Note1.           Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statementshave been prepared in accordance with generally accepted accounting principlesin the United States for interim financial information, and accordingly do notinclude all of the information and footnotes required by generally acceptedaccounting principles for complete financial statements.  In the opinion of management, theaccompanying unaudited condensed consolidated financial statements contain alladjustments (consisting solely of normal recurring adjustments) necessary topresent fairly Tower Bancorp, Inc.’s consolidated financial position as ofSeptember 30, 2008 and the results of its operations for the three andnine month periods ended September 30, 2008 and 2007.  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 include the accounts ofTower Bancorp, Inc. (the “Company”) and its wholly owned subsidiary, theFirst National Bank of Greencastle (the “Bank”).  All significant intercompany accounts andtransactions have been eliminated.

 

The results of operations for the three and nine month periods ended September 30,2008 and 2007 are not necessarily indicative of the results to be expected forthe 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 areparticularly sensitive requiring significant judgments, estimates andassumptions to be made by management. Additional information is contained on pages 20, 24, and 25 of thisreport for the provision 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 postretirement.  EITF 06-04 requires that aliability equal to the present value of the cost of post retirement insurancebe recorded during the insured employees’ term of service.  The terms of this pronouncement require theinitial recording of this liability with a corresponding adjustment to retainedearnings to reflect the implementation of the pronouncement.  This EITF became effective for fiscal yearsbeginning after December 15, 2007. The effect of this change on January 1, 2008 was a reduction inretained earnings and an increase in accrued benefit liabilities of$ 1,001,000.

 

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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 significantlychange the financial accounting and reporting of business combinationtransactions.  SFAS 141(R) establishesthe criteria for how an acquiring entity in a business combination recognizesthe assets acquired 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 toinvestors and other users all of the information they need to evaluate andunderstand the nature 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 expectthe implementation to have a material impact 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 establishes accounting and reportingstandards for ownership interests in subsidiaries held by parties other thanthe parent, the amount of consolidated net income attributable to the parent andto the noncontrolling interest, changes in a parent’s ownership interest, andthe valuation of retained noncontrolling equity investments when a subsidiaryis deconsolidated.  The Statement alsoestablishes reporting requirements that provide sufficient disclosures toclearly identify and distinguish between the interests of the parent and theinterests of the noncontrolling owners. SFAS 160 is effective for fiscal years, and interim periods within thosefiscal years, beginning on or after December 15, 2008. Earlier adoption isprohibited.   The company does not expect the implementation of SFAS 160 to have amaterial impact on its financial statements.

 

In March 2008,the FASB issued Statement of Financial Accounting Standards 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 how and why an entity uses derivative instruments, howderivative instruments and related hedged items are accounted for underStatement 133 and its related interpretations, and how derivative instrumentsand related hedged items affect an entity’s financial position, financialperformance and cash flows.  SFAS 161 iseffective for fiscal years and interim periods beginning after November 15,2008, with early application permitted. Thecompany does not expect the implementation of SFAS 161 to have a materialimpact on its financial statements.

 

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In May 2008,the FASB issued Statement of Financial Accounting Standards No. 162, “TheHierarchy of Generally Accepted Accounting Principles” (SFAS 162).  This Statement identifies the sources ofaccounting principles and the framework for selecting the principles used inthe preparation of financial statements of nongovernmental entities that arepresented in conformity with generally accepted accounting principles in theUnited States.  SFAS 162 becomeseffective 60 days following the SEC’s approval of the Public Company AccountingOversight Board amendments to AU Section 411.  Thecompany does not expect the implementation of SFAS 162 to have a materialimpact on its financial statements.

 

In February 2008,the FASB issued FASB Staff Position (FSP) No. 157-2, “Effective Dateof FASB Statement No. 157” (FSP 157-2). FSP FAS 157-2 delays the effective date of SFAS 157, “Fair ValueMeasurements,” for nonfinancial assets and nonfinancial liabilities, except foritems that are recognized or disclosed at fair value in the financialstatements on a recurring basis (at least annually).  The delay is intended to allow the FASB andconstituents additional time to consider the effect of various implementationissues that have arisen, or that may arise, from the application of Statement157.  FSP 157-2 defers the effective dateof Statement 157 to fiscal years beginning after November 15, 2008, andinterim periods within those fiscal years, for items within the scope of thisFSP.  Examples of items to which thedeferral would and would not apply are listed in the FSP.  Thecompany does not expect the implementation of FSP 157-2 to have a materialimpact on its financial statements.

 

In April 2008, theFASB issued FSP 142-3, “Determination of the Useful Life of Intangible Assets”(FSP 142-3).  This FSP amends the factorsthat should be considered in developing renewal or extension assumptions usedto determine the useful life of a recognized intangible asset under SFAS 142, “Goodwilland Other Intangible Assets.”  The intentof this FSP is to improve the consistency between the useful life of arecognized intangible asset under Statement 142 and the period of expected cashflows used to measure the fair value of the asset under SFAS 141R, “BusinessCombinations,” and other U.S. generally accepted accounting principles. ThisFSP is effective for financial statements issued for fiscal years beginningafter December 15, 2008, and interim periods within those fiscalyears.  Early adoption isprohibited.  The company does notexpect the implementation of FSP 142-3 to have a material impact on its financialstatements.

 

In May 2008, theFASB issued FSP APB 14-1, “Accounting for Convertible Debt Instruments That May BeSettled in Cash upon Conversion (Including Partial Cash Settlement)” (FSPAPB 14-1).  FSP APB 14-1clarifies that convertible debt instruments that may be settled in cash uponconversion (including partial cash settlement) are not addressed by paragraph12 of APB Opinion No. 14, “Accounting for Convertible Debt and Debt Issuedwith Stock Purchase Warrants.”  The FSPrequires that issuers of such instruments should separately account for theliability (debt) and equity (conversion option) components in a manner thatreflects the issuer’s nonconvertible debt borrowing rate.  FSP APB 14-1 is effective for financialstatements issued for fiscal

 

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years beginning after December 15,2008 and interim periods within those years. The company does not expect theimplementation of FSP APB 14-1 to have a material impact on its financialstatements.

 

In October 2008, theFASB issued FSP 157-3, “Determining the Fair Value of a Financial Asset Whenthe Market for That Asset Is Not Active” (FSP 157-3).  FSP 157-3 clarifies the application of SFAS157, “Fair Value Measurements,” in a market that is not active and provides anexample to illustrate key considerations in determining the fair value of afinancial asset when the market for that financial asset is not active.  This FSP was effective upon issuance,including prior periods for which financial statements have not been issued.

 

RECLASSIFICATION

 

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

 

Note2.           Income Taxes

 

Income tax expense is less than the amount calculated using thestatutory tax rate primarily as a result of tax exempt income earned from stateand municipal securities and loans.

 

Note3.           Commitments

 

In the normal course of business, the Company makes various commitmentsand incurs certain contingent liabilities which are not reflected in theaccompanying financial statements.  Thesecommitments include various guarantees and commitments to extend credit and thebank does not anticipate any losses as a result of these transactions.

 

Note4.           Stock Compensation Plans

 

At September 30, 2008, the Company had two stock-basedcompensation plans.  On January 1,2006, the Company adopted FASB Statement No. 123 (R) using the modifiedprospective method.  The fair value ofeach grant is estimated at the grant date using the Black-Scholesoption-pricing model.

 

Included in salaries andemployee benefits expense for the nine months ended September 30, 2008 and2007 is $ 56,000 and $ 66,000, respectively, of stock-basedcompensation expense.  Also included inother operating expense for the nine months ended September 30, 2008 and2007 is $ 20,000 and $ 38,000, respectively, of stock-basedcompensation expense.

 

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Stock option plan activity for the nine months ended September 30,2008 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                                                                    |       | N/A                                                                    |       |
| Granted                                 |       | 6,500      |       | 31.85                                  |       | 7.75                                                                 |       | N/A                                                                    |       |
| Exercised                               |       | 7,038      |       | 21.60                                  |       | N/A                                                                  |       | N/A                                                                    |       |
| Forfeited                               |       | 3,187      |       | 40.79                                  |       | N/A                                                                  |       | N/A                                                                    |       |
| Outstanding at  September 30, 2008 |       | 31,133     |       | 36.04                                  |       | 5                                                                    |       | 58,000                                                                 |       |
| Exercisable at  September 30, 2008 |       | 26,133     |       | 35.07                                  |       | 5                                                                    |       | 58,000                                                                 |       |

 

The total value of in-the-money options exercised during the first ninemonths ended September 30, 2008 was $118,000.

 

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 27,677shares were excluded from the calculation at September 30, 2008 becausethe effects were anti-dilutive. Potential dilutive common stock had no effecton income available to common stockholders.

 
| ** **                      | ** ** | **Three Months Ended** | ** ** |
|---------------------------------|------------|----------------------------------|------------|
| ** **                      | ** ** | **September 30, 2008** | ** ** | **September 30, 2007** | ** ** |
| ** **                      | ** ** | ** **                       | ** ** | **Per** | ** ** | ** ** | ** ** | **Per** | ** ** |
| ** **                      | ** ** | ** **                       | ** ** | **Share** | ** ** | ** ** | ** ** | **Share** | ** ** |
| ** **                      | ** ** | **Shares**                       | ** ** | **Amount** | ** ** | **Shares** | ** ** | **Amount** | ** ** |
| Basic earnings  per share       |       | 2,315,003                        |       | $ | 0.39 |   | 2,340,221 |   | $ | 0.78 |   |
| Effect of  dilutive securities: |       |                             |       |   |   |   |   |   |   |
| Stock options                   |       | 3,456                            |       |   |   | 7,927 |   |   |   |
| Diluted earnings  per share     |       | 2,318,459                        |       | $ | 0.39 |   | 2,348,148 |   | $ | 0.77 |   |

 
| ** **                      | ** ** | **Nine Months Ended**  | ** ** |
|---------------------------------|------------|----------------------------------|------------|
| ** **                      | ** ** | **September 30, 2008** | ** ** | **September 30, 2007** | ** ** |
| ** **                      | ** ** | ** **                       | ** ** | **Per** | ** ** | ** ** | ** ** | **Per** | ** ** |
| ** **                      | ** ** | ** **                       | ** ** | **Share** | ** ** | ** ** | ** ** | **Share** | ** ** |
| ** **                      | ** ** | **Shares**                       | ** ** | **Amount** | ** ** | **Shares** | ** ** | **Amount** | ** ** |
| Basic earnings  per share       |       | 2,317,151                        |       | $ | 1.72 |   | 2,350,585 |   | $ | 2.34 |   |
| Effect of  dilutive securities: |       |                             |       |   |   |   |   |   |   |
| Stock options                   |       | 4,706                            |       |   |   | 8,428 |   |   |   |
| Diluted earnings  per share     |       | 2,321,857                        |       | $ | 1.72 |   | 2,359,013 |   | $ | 2.33 |   |

 

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Note6.           Investment Securities in a Loss Position

 

The following table shows the Company’s gross unrealized losses andfair value, aggregated by investment category and length of time thatindividual securities have been in a continuous unrealized loss position, at September 30,2008 and December 31, 2007:

 
| ** **                                       | ** ** | **September 30, 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** | ** ** |
|                                             |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| Mortgage-backed  securities                      |       | $                                      | 26         |   | $ | 0 |   | $ | 10 |   | $ | 0 |   | $ | 36 |   | $ | 0 |   |
| Corporate bonds                                  |       | 2,904                                  |       | 153 |   | 1,134 |   | 319 |   | 4,038 |   | 472 |   |
| Equities                                         |       | 6,435                                  |       | 2,216 |   | 4,332 |   | 3,224 |   | 10,767 |   | 5,440 |   |
| Obligations of  state and political subdivisions |       | 8,559                                  |       | 193 |   | 0 |   | 0 |   | 8,559 |   | 193 |   |
| Total                                            |       | $                                      | 17,924     |   | $ | 2,562 |   | $ | 5,476 |   | $ | 3,543 |   | $ | 23,400 |   | $ | 6,105 |   |

 
| ** **                                       | ** ** | **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** | ** ** |
| ** **                                       | ** ** | ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| 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 |   |

 

Management evaluatessecurities for other-than-temporary impairment at least on a quarterly basis,but management’s intent is to hold all debt securities 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 September 30,2008, five (5) mortgage-backed securities, six (6) corporate bonds,eighty-five (85) equities, and twenty-four (24) obligations of state andpolitical subdivisions had unrealized losses.

 

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 hasdetermined that no declines are deemed to be other than temporary.  Unrealized losses are the result of marketconditions, not credit concerns.

 

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Note 7.           FairValue Measurements

 

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 follows:

 
| · |   | 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.                                                                                                                                                                       |

 

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 of securitieswith 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 other securities.  In certain cases where there is limitedactivity or less transparency around inputs to the valuation, securities areclassified within level 3 of the valuation hierarchy.  Currently, all equity securities held by theholding company with a total fair value of $ 25,535,000 are considered tobe Level 1 Securities.  All others areconsidered to 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 receivedon the quotes or bids are indicative of the fact that cost is lower than fairvalue.  At September 30, 2008, therewe no loans held for sale and recorded at cost.

 

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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.  At September 30, 2008, there were$6,693,000 loans that the Company has identified as impaired.

 

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.

 

Note 8.                                  Subsequent Event

 

Subsequent to September 30, 2008, President Bushsigned into law the Emergency Economic Stabilization Act of 2008.  FDIC insurance coverage was increased from$100,000 to $250,000 per depositor, through December 31, 2009.  Subsequent to that the US Treasury announceda Troubled Asset Relief Program (“TARP”) which includes provisions whereby theUS Treasury could infuse capital into qualifying banks via a capital purchaseprogram, a program that would fully insure most noninterest bearing transactionaccounts above $250,000 through December 31, 2009 and a program that wouldguarantee certain debt of financial institutions and their holding companiesthrough June 2012.  Management is inthe process of analyzing these programs with participation to be determined by November 14,2008 for the Capital infusion program and by December 5, 2008 for thetemporary limited guarantee program and the guarantee of certain debt of thefinancial institution.  The amount ofcapital available under TARP is limited to a minimum of 1% of risk weightedassets and a maximum of 3% of risk weighted assets.  The amount of capital potentially availableto the company would range between $3,700,000 and $11,100,000, but certainrestrictions apply if the funds are accepted. With the Company’s capital at approximately $73,344,000 as of September 30,2008, participation in the capital infusion program of TARP would be a materialtransaction.

 

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ITEM2.

 

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

 

September 30, 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 could beunsuccessful.

 

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 inother periodic reports and public documents that the Company files from time totime with the Securities and Exchange Commission.

 

OVERVIEW

 
| ** **                 | ** ** | **Three Months  Ended** | ** ** | ** ** | ** ** | ** **              | ** ** |
|----------------------------|------------|------------------------------|------------|------------|------------|-------------------------|------------|
| ** **                 | ** ** | **September 30**        | ** ** | ** ** | ** ** | ** **              | ** ** |
| ** **                 | ** ** | **2008**                     | ** ** | **2007**   | ** ** | **Increase/(Decrease)** | ** ** |
|                       |       |                         |       |       |       |                    |       |   |   |
| Net interest  income       |       | $                            | 5,254      |       | $          | 4,894                   |       | $ | 360 |   | 7.4 | % |
| Other income               |       | 659                          |       | 1,607      |       | (948                    | )          | -59.0 | % |
| Provision for  loan losses |       | 525                          |       | 150        |       | 375                     |       | 250.0 | % |
| Other expenses             |       | 4,335                        |       | 3,849      |       | 486                     |       | 12.6 | % |
| Applicable  income taxes   |       | 150                          |       | 684        |       | (534                    | )          | -78.1 | % |
|                       |       |                         |       |       |       |                    |       |   |   |
| Net income                 |       | $                            | 903        |       | $          | 1,818                   |       | $ | (915 | ) | 50.3 | % |

 

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The overall decrease innet income is attributable to a decrease of investment security gains, anincrease in the provision for the allowance for loan losses, and a decrease inother service charges.  On a basic and dilutedper share basis, net income for the three months ended September 30, 2008was $0.39 and $0.39, respectively, as compared with $0.78 and $0.77 for thethree months ended September 30, 2007.

 
| ** **                 | ** ** | **Nine Months Ended** | ** ** | ** ** | ** ** | ** **              | ** ** |
|----------------------------|------------|---------------------------------|------------|------------|------------|-------------------------|------------|
| ** **                 | ** ** | **September 30**           | ** ** | ** ** | ** ** | ** **              | ** ** |
| ** **                 | ** ** | **2008**                        | ** ** | **2007**   | ** ** | **Increase/(Decrease)** | ** ** |
| ** **                 | ** ** | ** **                      | ** ** | ** ** | ** ** | ** **              | ** ** | ** ** | ** ** |
| Net interest  income       |       | $                               | 15,637     |       | $          | 14,388                  |       | $ | 1,249 |   | 8.7 | % |
| Other income               |       | 3,526                           |       | 5,529      |       | (2,003                  | )          | -36.2 | % |
| Provision for  loan losses |       | 1,075                           |       | 450        |       | 625                     |       | 138.9 | % |
| Other expenses             |       | 12,943                          |       | 12,018     |       | 925                     |       | 7.7 | % |
| Applicable  income taxes   |       | 1,160                           |       | 1,949      |       | (789                    | )          | -40.5 | % |
|                       |       |                            |       |       |       |                    |       |   |   |
| Net income                 |       | $                               | 3,985      |       | $          | 5,500                   |       | (1,515 | ) | -27.5 | % |
|                            |            |                                 |            |            |            |                         |            |  |  |  |  |  |

 

The overall decrease innet income is attributable to a decrease of investment security gains and anincrease in the provision for the allowance for loan losses. On a basic anddiluted per share basis, net income for the nine months ended September 30,2008 was $1.72 and $1.72, respectively, as compared with $2.34 and $2.33 forthe nine months ended September 30, 2007. Net income as a percentage oftotal average stockholders’ equity on an annualized basis, also known as returnon average equity, was 6.81% and 8.77% for the first nine months of 2008 and2007, respectively.  Return on averagetangible equity was 8.91% and 11.26% for the first nine months of 2008 and 2007respectively, a decrease of 20.9%. The decrease in this ratio is attributableto a decreased level of net income.

 

During the first ninemonths of 2008, the Company’s assets decreased $ 11,722,000, or 2.1%, to$549,914,000 as of September 30, 2008 from $ 561,636,000 as of December 31,2007. This decrease is primarily attributable to a decrease in Federal fundssold.  Federal funds sold decreased100.0% to $ 0 due primarily to a decrease in deposits and an increase inloans.  Total loans increased by $8,877,000or 2.2% during the first nine months of 2008 to $ 407,356,000 as of September 30,2008 from $ 398,479,000 as of December 31, 2007.  Total deposits decreased by$ 22,223,000, or 5.1%, during the first nine months of 2008 to$ 417,707,000 as of September 30, 2008 from $ 439,930,000 as of December 31,2007. As a result of competition in the market, and, to a certain degree,customers’ continued uncertainty as to how to best invest their monies, depositincreases may not be assumed to continue at historical levels.

 

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RESULTS OF OPERATIONS

 

Net Interest Income

 

For the three monthsended September 30, 2008, total interest income decreased by$ 826,000, or 9.7%, to $ 7,661,000 as compared with $8,487,000 forthe three months ended September 30, 2007. This decrease is primarily due to decreased yields on loans and adecrease of earning assets as noted below.

 

Total interest expensedecreased by $1,186,000, or 33.0% to $2,407,000 for the three months ended September 30,2008 from $3,593,000 for the three months ended September 30, 2007. Thisdecrease is primarily due to lower deposit rates and lower rates on bankborrowings.  The cost of interest bearingfunds at the bank decreased to 2.17% for the third quarter of 2008 compared to3.12% for the third quarter of 2007.

 

Net interest incomeincreased by $360,000, or 7.4%, to $5,254,000 for the three months ending September 30,2008 from $4,894,000 for the three months ending September 30, 2007. Thisincrease is primarily due to the lower cost of interest bearing funds at thebank.

 

For the nine months endedSeptember 30, 2008, total interest income decreased by $ 1,279,000,or 5.1%, to $ 23,685,000 as compared with $24,964,000 for the nine monthsended September 30, 2007. This decrease is primarily due to decreasedyields on earning assets and a decrease of earning assets as noted below.

 

Total interest expensedecreased by $ 2,528,000, or 23.9% to $ 8,048,000 for the nine monthsended September 30, 2008 from $ 10,576,000 for the nine months ended September 30,2007.  This decrease is primarily due tolower deposit rates and lower rates on bank borrowings.  The cost of interest bearing funds at thebank decreased to 2.42% for the first nine months of 2008 compared to 3.12% forthe first nine months of 2007.

 

Net interestincome increased by $ 1,249,000, or 8.7%, to $ 15,637,000 for thenine months ended September 30, 2008 from $14,388,000 for the nine monthsended September 30, 2007.  Thisincrease is primarily due to the lower cost of interest bearing funds at thebank.

 

Changes in earningassets impacting net interest income were as follows:

 
| ** **                            | ** ** | **September 30** | ** ** | ** ** | ** ** | ** **              | ** ** |
|---------------------------------------|------------|-----------------------|------------|------------|------------|-------------------------|------------|
| ** **                            | ** ** | **2008**              | ** ** | **2007**   | ** ** | **Increase/(Decrease)** | ** ** |
|                                  |       |                  |       |       |       |                    |       |   |   |
| Federal funds  sold                   |       | $                     | 0          |       | $          | 37,486                  |       | $ | (37,486 | ) | -100.0 | % |
| Interest bearing  balances with banks |       | 802                   |       | 0          |       | 802                     |       | N/A |   |
| Investments                           |       | 87,883                |       | 86,229     |       | 1,654                   |       | 1.9 | % |
| Loans                                 |       | 407,356               |       | 394,732    |       | 12,624                  |       | 3.2 | % |
|                                  |       |                  |       |       |       |                    |       |   |   |
| Earning assets                        |       | $                     | 496,041    |       | $          | 518,447                 |       | $ | (22,406 | ) | -4.3 | % |

 

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Management continued totarget efforts to attract mortgage and small commercial loans.  Changes in market interest rates during thethree and nine month periods ended September 30, 2008 were as follows:

 
| ** **                       | ** ** | **Basis Points** | ** ** |
|----------------------------------|------------|------------------|------------|
| ** **                       | ** ** | **3 months**     | ** ** | **9 months** | ** ** |
|                             |       |             |       |   |   |
| New York Prime  rate             |       | No Change        |       | (225 | ) |
| One year  constant maturity rate |       | (51              | )          | (135 | ) |

 

Provision for Loan Losses

 

The provision for loanlosses was $ 525,000 for the three months ended September 30, 2008compared with $ 150,000 for the three months ended September 30,2007, an increase of 250.0%.

 

The provision for loanlosses was $ 1,075,000 for the nine months ended September 30, 2008compared with $ 450,000 for the nine months ended September 30, 2007,an increase of 138.9%.

 

The increase in theprovision is in response to a slower housing market, declining prices of realestate, increased charge-offs, and increased delinquencies.  The level of provision is commensurate withthe risk identified in the loan portfolio.

 

Theallowance for loan losses represented 1.11% of total loans at September 30,2008, compared with 0.97% as of December 31, 2007 and 1.01% as of September 30,2007. 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 September 30, 2008, the reserve isreasonable and sufficient to support the current level of loans in light of theasset quality as supported by the ratios reflected in Table 2 on page 25.

 

Other Income

 

For the three monthsended September 30, 2008, other income was $ 659,000, a decrease of$ 948,000, or 59.0%, compared with other income of $ 1,607,000 forthe three months ended September 30, 2007. The decrease was primarily dueto a decrease of $ 573,000 in net gains from the sale of securities, whichwere a $ 401,000 loss for the three months ended September 30, 2008compared to a $ 172,000 gain for the three months ended September 30,2007. Losses were taken in the third quarter of 2008 to allow reinvestment andto avoid any “other than temporarily impaired” issues.  Other income was positively impacted by anincrease of $ 32,000 in NSF fees. Other income was negatively impacted by a $ 7,000 decrease for the valueof mortgage servicing rights, an $ 89,000 decrease in revenues frominvestment service fees, a $ 20,000 decrease in fees on sale of mortgagesand $ 17,000 decrease in trust revenues. The bank began recognizing mortgage servicing rights valuation in thethird quarter of 2007.

 

For the nine months endedSeptember 30, 2008, other income was $ 3,526,000, a decrease of$ 2,003,000, or 36.2%, compared with other income of $ 5,529,000 forthe nine months ended September 30, 2007. The decrease was primarily dueto a decrease of $ 1,538,000 in net gains from

 

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the sale of securities,which were $ 323,000 for the nine months ended September 30, 2008compared to $ 1,861,000 for the nine months ended September 30, 2007.Other income was positively impacted by an increase of $ 78,000 in NSFfees, a $42,000 increase in ATM/Debit Card fees, a $32,000 increase in latefees on loans and an increase of $ 25,000 in trust revenues.  Other income was negatively impacted by a $54,000 decrease for the value of mortgage servicing rights, a $ 185,000decrease in revenues from investment service fees, a $ 95,000 decrease inBOLI income, and $ 22,000 decrease in fees on sale of mortgages.  During the first nine months of 2007, BOLIincome included $ 132,000 which were death benefits proceeds.  The bank began recognizing mortgage servicingrights valuation in the third quarter of 2007. In February 2008, the bank initiated a cash rewards program fordebit cards.  The Bank re-established andreactivated its Trust Department in the third quarter of 2006.

 

Other Expenses

 

Other expenses for thethree months ended September 30 were as follows:

 
| ** **                          | ** ** | **2008** | ** ** | **2007** | ** ** | **Increase/(Decrease)** | ** ** |
|-------------------------------------|------------|----------|------------|----------|------------|-------------------------|------------|
| Salaries, wages  and other benefits |       | $        | 2,075      |     | $          | 1,965                   |       | $ | 110 |   | 5.6 | % |
| Occupancy and  equipment expense    |       | 1,029    |       | 890      |       | 139                     |       | 15.6 | % |
| Other operating  expenses           |       | 1,231    |       | 994      |       | 237                     |       | 23.8 | % |
|                                |       |     |       |     |       |                    |       |   |   |
| Total other  expenses               |       | $        | 4,335      |     | $          | 3,849                   |       | $ | 486 |   | 12.6 | % |

 

Salaries, wages and otherbenefits, which make up the largest component of other expenses, were impactedby increases in health insurance of $79,000 (or 29.1%) and salary expense of$68,000 (or 5.0%).

 

Occupancy and equipmentexpense was impacted by a $60,000 (or 17.1%)increase in data processing expenseand a $47,000 (or 38.7%)increase in equipment depreciation expense.  The Bank has updated security systems at anumber of branches and continues to invest in computer network initiatives.

 

Other operating expenseswere impacted by an increase of $117,000 in legal and consulting fees, as wellas an increase of $85,000 in FDIC insurance premium expense and a $15,000increase in marketing expense.

 

Other expenses for thenine months ended September 30 were as follows:

 
| ** **                          | ** ** | **2008** | ** ** | **2007** | ** ** | **Increase/(Decrease)** | ** ** |
|-------------------------------------|------------|----------|------------|----------|------------|-------------------------|------------|
| Salaries, wages  and other benefits |       | $        | 6,368      |     | $          | 6,123                   |       | $ | 245 |   | 4.0 | % |
| Occupancy and  equipment expense    |       | 3,041    |       | 2,714    |       | 327                     |       | 12.0 | % |
| Other operating  expenses           |       | 3,534    |       | 3,181    |       | 353                     |       | 11.1 | % |
|                                |       |     |       |     |       |                    |       |   |   |
| Total other  expenses               |       | $        | 12,943     |     | $          | 12,018                  |       | $ | 925 |   | 7.7 | % |

 

Salaries, wages and otherbenefits were impacted by increases in health insurance of $226,000 andexpenses related to split-dollar life insurance of $90,000.

 

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Occupancy and equipmentexpense was impacted by a $150,000 (or 13.6%) increase in data processingexpense and a $94,000 (or 23.8%)increase in equipment depreciationexpense.  The Bank has updated security systemsat a number of branches and continues to invest in computer networkinitiatives.

 

Other operating expenseswere impacted by an increase of $182,000 in legal and consulting fees, as wellas an increase of $167,000 in FDIC insurance premiums.

 

Income Taxes

 

Income tax expense was$ 150,000 for the three months ended September 30, 2008, a decreaseof $ 534,000, or 78.1%, compared with $684,000 for the three months ended September 30,2007.  Income tax expense was $1,160,000for the nine months ended September 30, 2008, a decrease of$ 789,000, or 40.5%, compared with $1,949,000 for the nine months ended September 30,2007.  The lower income tax expense isdue to lower pre-tax income.

 

Net Income

 

Net income for the threemonths ended September 30, 2008 was $ 903,000, a decrease of$ 915,000, or 50.3%, compared with $ 1,818,000 for the three monthsended September 30, 2007. The decrease in net income is the result ofchanges in the components of net income noted above.  Basic and diluted earnings per share for thethree months ended September 30, 2008 were $ 0.39 and $ 0.39 ascompared with $ 0.78 and $ 0.77 for the three months ended September 30,2007.

 

Net income for the ninemonths ended September 30, 2008 was $ 3,985,000, a decrease of$ 1,515,000, or 27.5%, compared with $ 5,500,000 for the nine monthsended September 30, 2007.  Thedecrease in net income is the result of changes in the components of net incomenoted above.

 

Basic and dilutedearnings per share for the nine months ended September 30, 2008 were$ 1.72 and $ 1.72, respectively, as compared with $ 2.34 and$ 2.33, respectively, for the nine months ended September 30, 2007.

 

Securities

 

The Company’s securitiesportfolio is comprised of securities that not only provide interest and dividendincome, including tax-exempt income, but also provide a source of liquidity,diversify the earning assets portfolio, allow for the management of risk andtax liability, and provide collateral for repurchase agreements and public funddeposits. Policies are in place to address various aspects of managing theportfolio, including but not limited to, concentrations, liquidity, creditquality, 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

 

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at amortized cost.  The Company holds no trading securities inits portfolio.  The securities portfolioincludes equities owned by the holding company, most of which are investmentsin banks, bank holding companies and financial institutions.  Equity investments are accounted for at fairmarket value. The remaining securities, primarily debt instruments, are ownedby the bank.

 

The consolidatedsecurities portfolio at September 30, 2008 was $ 83,060,000, comparedto $ 83,846,000 at December 31, 2007, a decrease of $ 786,000,or 0.9%. The decrease is due primarily to the net purchase of $ 12,370,000investment securities by the bank, offset by $ 8,471,000 decrease inunrealized gains on investments held by the holding company and a net decreaseof $ 1,856,000 in securities at cost held by the holding company.

 

Bank Owned Securities

 

The bank owned securitiesportfolio at September 30, 2008 was $ 59,525,000, compared to$ 49,985,000 at December 31, 2007, an increase of $ 9,540,000,or 19.1%.  The increase is due primarilyto the purchase of $ 15,085,000 security investments, the maturity orcalling of $ 2,715,000 and a $ 329,000 decrease in unrealized gains,less principal payments on mortgage backed securities.

 

The carrying value of theavailable for sale portion of the portfolio at September 30, 2008 includesan unrealized gain of $ 500,000 (reflected as accumulated othercomprehensive income of $ 330,000 in stockholders’ equity, net of a deferredincome tax liability of $ 170,000). This compares with an unrealized gainat December 31, 2007 of $ 829,000 (reflected as accumulated othercomprehensive income of $ 547,000 in stockholders’ equity, net of adeferred income tax liability of $ 282,000).

 

Holding Company OwnedSecurities

 

The securities portfolioat September 30, 2008 was $ 23,535,000, compared to $ 33,861,000at December 31, 2007, a decrease of $ 10,326,000, or 30.5%.  The decrease includes $ 8,471,000 inunrealized losses.  The securitiesportfolio is exclusively invested in financial institutions and bank holdingcompanies.  This sector hasunderperformed the broader stock indexes in recent quarters.  Realized gains on sale of equity securitieswere $ 318,000 for the nine months ended September 30, 2008.

 

The carrying value of theavailable for sale portion of the portfolio at September 30, 2008 includesan unrealized loss of $ 2,394,000 (reflected as accumulated othercomprehensive - loss of $ 1,580,000 in stockholders’ equity, net of adeferred income tax asset of $ 814,000). 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 taxliability 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 unearned fees and origination costs,increased $ 8,877,000, or 2.2% to $ 407,356,000 at September 30,2008 from $ 398,479,000 at December 31, 2007. Gross loans represented97.5% of total deposits at September 30, 2008 as compared with 90.6% at December 31,2007. This increase in the loans to deposit ratio is primarily due a decreasein deposits, particularly time deposits.

 

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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 September 30, 2008 and December 31, 2007 was$ 4,522,000 and $ 3,854,000, respectively.  At September 30, 2008, the allowance forloan losses represented 1.11% of the gross loan portfolio, compared with 0.97%at December 31, 2007.  This increaseis due to an increased provision for loan losses in response to a slowerhousing market, declining prices of real estate, and increased delinquenciesoffsetting a small increase in gross loan volumes.  At September 30, 2008, in considerationof the bank’s assessment of asset quality, management believes the allowancefor loan loss reserve to be reasonable and adequate to support the loan growthand to address any potential losses.

 

Table 1 - “Analysis ofAllowance for Loan Loss” -details the activity which occurred in the allowanceover the first nine 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               |       | 1,075    |       | 450      |       |
| Charge-offs:                                          |       |     |       |     |       |
| Commercial                                            |       | (298     | )          | 0        |       |
| Real Estate                                           |       | 0        |       | 0        |       |
| Consumer                                              |       | (182     | )          | (147     | )          |
| Total  charge-offs                                    |       | (480     | )          | (147     | )          |
|                                                  |       |     |       |     |       |
| Recoveries:                                           |       |     |       |     |       |
| Commercial                                            |       | 34       |       | 3        |       |
| Real Estate                                           |       | 0        |       | 0        |       |
| Consumer                                              |       | 39       |       | 69       |       |
| Total Recoveries                                      |       | 73       |       | 72       |       |
|                                                  |       |     |       |     |       |
| Net  (charge-offs) recoveries                         |       | (407     | )          | (75      | )          |
|                                                  |       |     |       |     |       |
| Balance,  September 30                           |       | $        | 4,522      |     | $          | 3,985 |   |
|                                                  |       |     |       |     |       |
| Net  (charge-offs) or recoveries to average net loans |       | (0.10    | )          | (0.02    | )          |

 

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(1) Bank’s loanportfolio is entirely domestic

 

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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 loan is consideredimpaired when, based on current information and events, it is probable that theCompany will be able to collect the scheduled payments of principal or interestwhen due according to the contractual terms of the loan agreement.  The larger commercial loans are evaluated forimpairment.  Impairment is measured on aloan-by-loan basis by comparing the contractual principal and interest paymentsto the present value of expected future cash flows discounted at the loan’seffective interest rate, the loan’s obtainable market price, or the fair valueof the collateral if the loan is collateral dependent.  Consumer loans such as residential mortgagesand installments, comprised of smaller balance homogeneous loans, are collectivelyevaluated for impairment.  Interestincome generally is not recognized on specific impaired loans unless thelikelihood of further loss is remote. Interest income on such loans is recognized only to the extent ofinterest payments received.

 

A summary of the loansthat the Company has identified as impaired follows:

 
| ** **         | ** ** | **9/30/08**        | ** ** | **12/31/07** | ** ** |
|--------------------|------------|--------------------|------------|--------------|------------|
| ** **         | ** ** | **(in thousands)** | ** ** |
| Balance            |       | $                  | 6,693      |         | $          | 7,059 |   |
| Related  allowance |       | 706                |       | 940          |       |
|                    |            |                    |            |              |            |  |  |

 

Table 2 – “Asset QualityRatios” – summarizes pertinent asset quality ratios at September 30, 2008and December 31, 2007.

 

**Table 2 –Asset Quality Ratios**

 
| ** **                                  | ** ** | **9/30/08** | ** ** | **12/31/07** | ** ** |
|---------------------------------------------|------------|-------------|------------|--------------|------------|
| Non-accrual  loans/total loans              |       | 1.14        | %          | 1.10         | %          |
| Non-performing  assets (1)/total loans      |       | 1.16        | %          | 1.36         | %          |
| Net (charge  offs) recoveries/average loans |       | (0.10       | )%         | (0.09        | )%         |
| Allowance/total  loans                      |       | 1.11        | %          | 0.97         | %          |
| Allowance/non-accrual  loans                |       | 97.0        | %          | 87.7         | %          |
| Allowance/non-performing  loans (1)         |       | 95.8        | %          | 71.1         | %          |

 

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(1) – Includes non-accrual loans

 

At September 30,2008 and December 31, 2007, the Company had other real estate owned (notused in operations) in the amount of $1,991,000 and $2,313,000, respectively,of which $ 0 and $ 25,000, respectively, represents foreclosedproperty.  Other real estate owned, notused in operations, is held for future growth and new branch sites.  At September 30, 2008 and December 31,2007, the Company had non-accrual loans in the amount of $ 4,661,000 and$4,397,000, respectively.  The Companyalso had loans 90 days or more past due (still accruing interest) of$ 59,000 and $ 1,001,000 at September 30, 2008 and December 31,2007, respectively.

 

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Loan concentrations areconsidered to exist when the total amount of loans to any one or a multiple numberof borrowers engaged in similar activities or having similar characteristicsexceeds 10% of loans outstanding in any one category. The Company maintains adiversified loan portfolio, granting agribusiness, commercial and residentialloans to customers. The majority of the Bank’s lending is made within itsprimary market area, which includes Fulton County and southern Franklin County,Pennsylvania and northern Washington County, Maryland. Although noconcentrations exist to one borrower or related group of borrowers or industrysector, the Bank’s commercial lending is primarily secured 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$11,103,000 and $10,768,000 in BOLI as of September 30, 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 September 30, 2008 were $ 417,707,000, a decrease of$ 22,223,000, or 5.1%, from total deposits of $ 439,930,000 at December 31,2007. This decrease is primarily due to a $ 12,197,000 decrease in timedeposits, which have declined due to lower rates being offered by the bank anda $ 5,010,000 decrease in demand deposits, which management considers tobe normal fluctuations in these types of accounts.

 

Short-Term Borrowings

 

Short term borrowings at September 30,2008 were $ 23,624,000, compared to $ 10,996,000 at December 31,2007, an increase of $ 12,628,000, or 114.8%. Federal funds purchased,Treasury Tax and Loan demand note, lines of credits with banks and overnightborrowings with the Federal Home Loan Bank of Pittsburgh are considered to beshort term borrowings. Short term borrowings fluctuate daily to meet theliquidity needs of the Company.

 

Long-Term Debt Borrowings

 

Long term borrowings at September 30,2008 were $31,717,000, compared to $26,740,000 at December 31, 2007, anincrease of $4,977,000, or 18.6%. This increase is primarily due to a$ 10,000,000 borrowing with the Federal Home Loan Bank for a term of 10years commencing February 2008 and the maturity of a $ 5,000,000 borrowingin September 2008.

 

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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 rate gap is one measure of therisk inherent in the existing balance sheet as it relates to potential changesin net interest income.  Maintaining anappropriate balance between interest-earning assets and interest-bearingliabilities is a means of monitoring and possibly avoiding materialfluctuations in the net interest margin during periods of changing interestrates.

 

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 $ 12,541,000 at September 30,2008, compared to $36,851,000 at December 31, 2007, a decrease of$ 24,310,000 or 66.0%.  Thisdecrease is primarily due to a decrease of $ 20,081,000 in federal fundssold which was needed to fund loan demand. Additional asset liquidity sources include principal and interestpayments from securities in the Company’s investment portfolio and cash flowfrom its amortizing loan portfolio. Longer-term liquidity needs may be met by selling securities availablefor sale, selling loans or raising additional capital.  At September 30, 2008, there was$ 68,334,000 in liquid securities as compared to $ 68,573,000 at December 31,2007.  Liquid securities decreased by$ 239,000 since the end of 2007, primarily due to the purchase of investmentsecurities available for sale at the bank and the sale of securities held atthe holding company and the market value fluctuations.  Liquid securities held at Tower Bancorpdecreased $ 10,326,000 due to sales, calls and maturity of investmentsecurities exceeding purchases and market value fluctuations.

 

Liability liquiditysources include attracting deposits at competitive rates.  Deposits at September 30, 2008 were$ 417,707,000, compared to $ 439,930,000 at December 31,2007.  In addition, the Company hasborrowing capacity and lines of credit with the Federal Home Loan Bank ofPittsburgh, Atlantic Central Bankers Bank and several local banks.

 

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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 September 30, 2008 is adequate torespond to fluctuations “on” and “off” the balance sheet.  In addition, management knows of no trends,demands, commitments, events or uncertainties that may result in, or that arereasonably likely to result in the Company’s inability to meet anticipated orunexpected 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.  Thesecommitments consist mainly of loans approved but not yet funded, unused linesof credit and letters of credit made in accordance with the same standards ason-balance sheet instruments. Unused commitments at September 30, 2008were $ 82,643,000, which consisted of $ 79,446,000 in unfundedcommitments to existing loans and unfunded new loans and $ 3,197,000 inletters of credit.  Because theseinstruments have fixed maturity dates, and because many of them will expirewithout being drawn upon, they do not generally present a significant liquidityrisk to the Company.

 

Management believes thatany amounts actually drawn upon can be funded in the normal course ofoperations.  The Company has noinvestment in or financial relationship with any unconsolidated entities thatare reasonably likely to have a material effect on liquidity or theavailability of capital resources.

 

Capital

 

The following Table 3presents the risk-based and leverage capital amounts and ratios at September 30,2008 for the Company and the Bank.

 

**Table 3 –Capital Ratios**

 
| ** **                                      | ** ** | ** **                           | ** ** | ** **   | ** ** | ** **                 | ** ** | ** **                 | ** ** | **To be Well** | ** ** |
|-------------------------------------------------|------------|--------------------------------------|------------|--------------|------------|----------------------------|------------|----------------------------|------------|--------------------------|------------|
| ** **                                      | ** ** | ** **                           | ** ** | ** **   | ** ** | **Minimum for**       | ** ** | **Capitalized under** | ** ** |
| ** **                                      | ** ** | ** **                           | ** ** | ** **   | ** ** | **Capital Adequacy**  | ** ** | **Prompt Corrective** | ** ** |
| ** **                                      | ** ** | **Actual**                           | ** ** | **Purposes** | ** ** | **Action Provisions** | ** ** |
| ** **                                      | ** ** | **Amount**                           | ** ** | **Ratio**    | ** ** | **Amount**                 | ** ** | **Ratio**                  | ** ** | **Amount**               | ** ** | **Ratio** | ** ** |
| ** **                                      | ** ** | **(Dollars in Thousands)** | ** ** |
| Total risk based  capital/risk weighted assets: |       |                                 |       |         |       |                       |       |                       |       |                     |       |   |   |   |   |
| Company                                         |       | $                                    | 59,532     |         | 16.1       | %                          | >  | 29,615                     | >  | 8.0                      | %          |   | N/A |   | N/A |   |
| Bank                                            |       | 49,539                               |       | 13.4         | %          | >                  | 29,659     | >                  | 8.0        | %                        |       | 37,073 | >  | 10.0 | % |
|                                            |       |                                 |       |         |       |                       |       |                       |       |                     |       |   |   |   |   |
| Tier 1  capital/risk weighted assets:           |       |                                 |       |         |       |                       |       |                       |       |                     |       |   |   |   |   |
| Company                                         |       | 55,010                               |       | 14.9         | %          | >                  | 14,807     | >                  | 4.0        | %                        |       | N/A |   | N/A |   |
| Bank                                            |       | 45,017                               |       | 12.1         | %          | >                  | 14,829     | >                  | 4.0        | %                        |       | 22,244 | >  | 6.0 | % |
|                                            |       |                                 |       |         |       |                       |       |                       |       |                     |       |   |   |   |   |
| Tier 1  capital/average assets                  |       |                                 |       |         |       |                       |       |                       |       |                     |       |   |   |   |   |
| Company                                         |       | 55,010                               |       | 10.3         | %          | >                  | 21,442     | >                  | 4.0        | %                        |       | N/A |   | N/A |   |
| Bank                                            |       | 45,017                               |       | 8.8          | %          | >                  | 20,419     | >                  | 4.0        | %                        | >  | 25,524 | >  | 5.0 | % |
|                                                 |            |                                      |            |              |            |                            |            |                            |            |                          |            |  |  |  |  |  |

 

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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 July 9, 2008, the Board of Directors authorized anddeclared a quarterly cash dividend in the amount of $0.28 per share, payable onAugust 15, 2008 to all shareholders of record as of August 1, 2008.The payment of this quarterly cash dividend decreased retained earnings by$648,000.

 

**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

 

Securities Exchange Act of 1934, as amended (the “Exchange Act”))as of September 30,2008. Based on such evaluation, such officers have concluded that, as of September 30,2008, 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 September 30, 2008, management made a number of changesto remediate material weaknesses noted in our December 31, 2007 10-Kfiling.  Our full time Loan ReviewOfficer conducted independent loan reviews throughout the third quarter.  The reviews included an assessment ofmanagement risk identification for loans. An outside accounting firm has tested and will continue to test the LoanReview Officer’s work periodically.  Thesame firm has reviewed the methodology surrounding the allowance for loan losscalculation.

 

Inorder to improve our management information system in the lending area, we haveincluded some additional coding of assets, and are in the process of asystem-wide review of the loan portfolio to assure completeness of thiscoding.  We also are risk-rating thecommercial portfolio to aid management of the bank in determining quarterlyallowance requirements.  All loan policyexceptions are being noted and more detailed coding has been implemented todetermine risk exposure in the various business sectors. Trend analysis will beused in the future to 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.

 

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Aconsulting firm has been engaged to review the bank’s management systems, loanadministration and operations.  Theirwork began during the second quarter and will continue through year end.

 

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 – OTHERINFORMATION

 

Item 1 – Legal Proceedings

 

The nature of the Company’sbusiness generates some litigation involving matters arising in the ordinarycourse of business.  In the opinion ofTower’s management, Tower has adequate legal defenses and/or insurance coveragerespecting any and each of these actions and does not believe that they willmaterially affect Tower’s operations or financial position.  However, in the opinion of the Company, afterconsulting with legal counsel, no legal proceedings are pending which areexpected to have a material adverse effect on the company or subsidiary. Nolegal proceedings are pending other than ordinary routine litigation incidentalto the business of the Company and the Bank. In addition, to Management’sknowledge, no governmental authorities have initiated or contemplated anymaterial legal actions against the Company or the Bank.

 

Item 1A – Risk Factors

 

There have been no materialchanges to the Company’s risk factors since these factors were previouslydisclosed in the Company’s Annual Report on Form 10-K for the period endedDecember 31, 2007.

 

Item 2 – Unregistered Sales of Equity Securities andUse of Proceeds

 

On September 13, 2006,the Board of Directors authorized the Company to redeem or repurchase 100,000shares of the Company’s common stock from specific shareholders or in the openmarket.  The stock repurchase plan doesnot expire.

 

ISSUER PURCHASES OF EQUITY 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** | ** ** |
|---------------------|------------|-------------------------------------------------------|------------|---------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------|------------|
|                |       |                                                  |       |                                              |       |                                                                                                   |       |                                                                                                          |       |
| July 2008      |       | 988                                                   |       | 37.10                                             |       | 988                                                                                                    |       | 33,865                                                                                                        |       |
|                |       |                                                  |       |                                              |       |                                                                                                   |       |                                                                                                          |       |
| August 2008    |       | 0                                                     |       | N/A                                               |       | 0                                                                                                      |       | 33,865                                                                                                        |       |
|                |       |                                                  |       |                                              |       |                                                                                                   |       |                                                                                                          |       |
| September 2008 |       | 0                                                     |       | N/A                                               |       | 0                                                                                                      |       | 33,865                                                                                                        |       |
|                |       |                                                  |       |                                              |       |                                                                                                   |       |                                                                                                          |       |
| Total               |       | 988                                                   |       | 37.10                                             |       | 988                                                                                                    |       | 33,865                                                                                                        |       |

 

Item3 — Defaults Upon Senior Securities

 

Not applicable

 

Item4 — Submission of Matters to a Vote of Security Holders

 

Not applicable

 

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Item5 – Other Information

 

There have been no material changes to the proceduresfor which a shareholder may recommend nominees to the Company’s Board ofDirectors.

 

The First National bank of Greencastle, a wholly ownedsubsidiary of Tower Bancorp, Inc., was recently examined by its primaryregulator, the Office of the Comptroller of the Currency (“OCC”).  The OCC issued its final report, whichcommunicated a number of findings which were disclosed in an August 27,2008 8-K filing.

 

Management and the Board of Directors are committed toaddressing these issues.  Management hasprepared a comprehensive action plan which outlines several significantorganizational, financial, operational, and compliance improvements andadjustments necessary to address the findings of the OCC and to strengthen theBank.

 

Item6 – 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)).                     |

 

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| **Exhibit** | ** ** | **Description of Exhibit**                                                                                                                                                                                                                                      |
|-------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |       |                                                                                                                                                                                                                                                                      |
| 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 20, 2002).                  |
|        |       |                                                                                                                                                                                                                                                                      |
| 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 as adopted pursuant Section 906 of the Sarbanes-Oxly  Act of 2002.                                                                                                                           |
|        |       |                                                                                                                                                                                                                                                                      |
| 32.2        |       | Certification of Chief Financial Officer pursuant to  18 U.S.C. Section 1350 as adopted pursuant Section 906 of the Sarbanes-Oxly  Act of 2002.                                                                                                                           |

 

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SIGNATURES

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
|   |                        | TOWER BANCORP, INC.            |
|--------|-----------------------------|--------------------------------|
|   |                        | (REGISTRANT)                   |
|   |                        |                           |
|   |                        | /s/  Jeff B. Shank        |
|   |                        | Jeff B. Shank,  President, CEO |
|   |                        | (Principal Executive  Officer) |
| Date:  | November 7, 2008       |                           |   |
|   |                        |                           |   |
|   |                        |                           | /s/ Franklin T.  Klink, III |
|   |                        |                           | Franklin T.  Klink, III, |
|   |                        |                           | Treasurer |
|   |                        |                           | (Principal Financial  Officer) |
|   |                        |                           |   |
| Date:  |  November 7, 2008 |                           |   |

 

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