**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**WASHINGTON,
      DC 20549**


**FORM
      10-K**





T
            Annual
                Report Pursuant to Section 13 or 15(d) of the Securities Exchange
                Act of
                1934.


For
      the
      fiscal year ended December 31, 2006





*
            Transition
                Report Pursuant to Section 13 or 15(d) of the Securities Exchange
                Act of
                1934





Commission
      File Number 000-23129





**NORTHWAY
      FINANCIAL, INC.**


(Exact
      name of registrant as specified in its charter)





New
                Hampshire
            04-3368579(State
                or other jurisdiction of
            (I.R.S.
                Employerincorporation
                or organization)
            Identification
                No.)





9
                Main StreetBerlin,
                New Hampshire
            03570(Address
                of principal executive offices)
            (Zip
                Code)





(603)
      752-1171


(Registrant’s
      telephone number, including area code)





Securities
      registered pursuant to Section 12(b) of the Act:


Title
                of Each Class
            Name
                of Each Exchange on Which RegisteredCommon
                Stock
            NASDAQ
                Stock Market LLC





Securities
      registered pursuant to Section 12(g) of the Act:  None





Indicate
      by check mark if the registrant is a well-known seasoned issuer, as defined
      in
      Rule 405 of the Securities Act. YES * NO T





Indicate
      by check mark if the registrant is not required to file reports pursuant to
      Section 13 or Section 15(d) of the Act. YES * NO T





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





Indicate
      by check mark if disclosure of delinquent filers pursuant to Item 405 of
      Regulation S-K is not contained herein, and will not be contained, to the best
      of registrant’s knowledge, in definitive proxy or information statements
      incorporated by reference in Part III of this Form 10-K or any amendment to
      this
      Form 10-K. T





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated file. See definition of “accelerated
      filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.. Large
      Accelerated Filer * Accelerated Filer * Non-Accelerated Filer T





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Act). YES * NO T





The
      number of shares of voting and nonvoting common stock, par value $1.00 per
      share, held by nonaffiliates of the registrant as of June 30, 2006 was 1,270,163
      shares with an aggregate market value, computed by reference to the last
      reported sales price on the NASDAQ Global Market on such date, of $45,725,868.
      Although directors and executive officers of the registrant were assumed to
      be
“affiliates” of the registrant for purposes of this calculation, this
      classification is not to be interpreted as an admission of such
      status.





At March
      25,
      2007 ,
      there
      were 1,491,174 shares of common stock outstanding, par value $1.00 per
      share.





DOCUMENTS
      INCORPORATED BY REFERENCE





Portions
      of the registrant’s proxy statement for its 2007 Annual Meeting of Stockholders
      are incorporated by reference in Items 10, 11, 12, 13 and 14 of Part
      III.





**Table
          of
          Contents**





**NORTHWAY
      FINANCIAL, INC.**


**2006
      FORM 10-K ANNUAL REPORT**





**TABLE
      OF CONTENTS**







PART
                IITEM
                1
            Business
            1ITEM
                1A
            Risk
                Factors
            9ITEM
                2
            Properties
            11ITEM
                3
            Legal
                Proceedings
            11ITEM
                4
            Submission
                of Matters to a Vote of Security
                Holders
            11PART
                IIITEM
                5
            Market
                for Registrant’s Common Equity, Related Stockholder
                Matters and Issuer Purchases of Equity Securities
            12ITEM
                6
            Selected
                Financial Data
            13ITEM
                7
            Management’s
                Discussion and Analysis of Financial Condition
                and Results of Operations
            14ITEM
                7A
            Quantitative
                and Qualitative Disclosures About Market
                Risk
            28ITEM
                8
            Financial
                Statements and Supplementary
                Data
            29ITEM
                9
            Changes
                in and Disagreements with Accountants on Accounting
                and Financial Disclosure
            58ITEM
                9A
            Controls
                and Procedures
            58ITEM
                9B
            Other
                Information
            58PART
                IIIITEM
                10
            Directors,
                Executive Officers and Corporate
                Governance
            58ITEM
                11
            Executive
                Compensation
            58ITEM
                12
            Security
                Ownership of Certain Beneficial Owners and
                Management and Related Stockholder Matters
            58ITEM
                13
            Certain
                Relationships and Related Transactions and Director
                Independence
            58ITEM
                14
            Principal
                Accountant Fees and Services
            58ITEM
                15
            Exhibits,
                Financial Statement Schedules
            59Signatures
            60





**Table
          of
          Contents**


**FORWARD-LOOKING
      STATEMENTS**





Certain
      statements in this report are “forward-looking statements” within the meaning of
      the Private Securities Litigation Reform Act of 1995. Such forward-looking
      statements may include, but are not limited to, projections of revenue, income
      or loss, plans for future operations and acquisitions, projections based on
      assumptions regarding market and liquidity risk, and plans related to products
      or services of Northway Financial, Inc. (“Northway”) and its subsidiaries (the
“Company”). Such forward-looking statements are subject to known and unknown
      risks, uncertainties and contingencies, many of which are beyond the control
      of
      the Company. To the extent any such risks, uncertainties and contingencies
      are
      realized, the Company’s actual results, performance or achievements could differ
      materially from anticipated results, performance or achievements. Factors that
      might affect such forward-looking statements include, among other factors,
      the
      factors described under the caption “Risk Factors” in Item 1A of this report,
      overall economic and business conditions, economic and business conditions
      in
      the Company’s market areas, interest rate fluctuations, a prolonged continuation
      of the current interest rate environment, the demand for the Company’s products
      and services, competitive factors in the industries in which the Company
      competes, changes in government regulations, and the timing, impact and other
      uncertainties of future acquisitions.





In
      addition to the factors described above, the following are some additional
      factors that could cause our financial performance to differ from any
      forward-looking statement contained herein: i) changes in interest rates over
      the past year and the relative relationship between the various interest rate
      indices that the Company uses; ii) a deterioration in the financial markets
      affecting the valuation of securities held in the Company’s investment
      portfolio; (iii) a change in product mix attributable to changing interest
      rates, customer preferences or competition; iv) a significant portion of the
      Company’s loan customers are in the hospitality business and therefore could be
      affected by a slower economy, adverse weather conditions and/or rising gasoline
      prices; and v) the effectiveness of advertising, marketing and promotional
      programs.





The
      words
“believe,” “expect,” “anticipate,” “intend,” “estimate,” “project” or the
      negative of such terms and other similar expressions which are predictions
      of or
      indicate future events and trends and which do not relate to historical matters
      identify forward-looking statements. Reliance should not be placed on
      forward-looking statements because they involve known or unknown risks,
      uncertainties or other factors, which may cause the actual results, performance
      or achievements of the Company to differ materially from anticipated future
      results, performance or achievements expressed or implied by such
      forward-looking statements. The Company expressly disclaims any obligation
      to
      publicly update or revise any forward-looking statement, whether as a result
      of
      new information, future events or otherwise.





Though
      the Company has attempted to list comprehensively the factors which might affect
      forward-looking statements, the Company wishes to caution you that other factors
      may in the future prove to be important in affecting the Company’s results of
      operations. New factors emerge from time to time and it is not possible for
      management to anticipate all of such factors, nor can it assess the impact
      of
      each such factor, or combination of factors, which may cause actual results
      to
      differ materially from forward-looking statements.





**PART
      1**





ITEM
      1. BUSINESS





**Description
      of Business**





Northway
      Financial, Inc. was incorporated on March 7, 1997, under the laws of the State
      of New Hampshire, for the purpose of becoming the holding company of The Berlin
      City Bank, a New Hampshire-chartered bank headquartered in Berlin, New Hampshire
      (“BCB”), pursuant to a reorganization transaction (the “BCB Reorganization”) by
      and among the Company, BCB, and a subsidiary of BCB, and, thereafter, the merger
      (the “Merger”) by and among the Company, BCB, Pemi Bancorp, Inc. (“PEMI”), and
      PEMI’s wholly owned subsidiary, The Pemigewasset National Bank of Plymouth, New
      Hampshire, a national bank headquartered in Plymouth, New Hampshire (“PNB”). The
      BCB Reorganization and the Merger became effective on September 30, 1997. As
      of
      such date, BCB and PNB became wholly owned subsidiaries of the Company. On
      October 1, 2005, BCB was renamed Northway Bank and PNB was merged into Northway
      Bank (“Bank”). Unless the context otherwise requires, references herein to the
“Company" include Northway Financial, Inc. and its consolidated
      subsidiary.





The
      Company derives substantially all of its revenue and income from the furnishing
      of bank and bank-related services, principally to individuals and small and
      medium-sized companies in New Hampshire. The Bank operates as a typical
      community banking institution and does not engage in any specialized finance
      or
      capital market activities. The Company functions primarily as the holder of
      stock of its subsidiary and assists the management of its subsidiary as
      appropriate.





The
      Company is subject to regulation by the New Hampshire Bank Commissioner (the
      “Commissioner”), the Federal Deposit Insurance Corporation (the “FDIC”), and the
      Board of Governors of the Federal Reserve System. See "Supervision and
      Regulation" on page
      4 of this report


**Table
          of
          Contents**


The
      Bank
      is engaged in a general commercial banking business and offers commercial and
      construction loans, real estate mortgages, consumer loans, including personal
      secured and unsecured loans, and lines of credit.





The
      Bank
      accepts savings, time, demand, NOW and money market deposit accounts, and offers
      a variety of banking services including safe deposit boxes, credit cards,
      official checks and money orders, overdraft lines of credit, alternative
      investments, commercial cash management, and wire transfer services.





Northway
      is a legal entity separate and distinct from its subsidiary. The right of
      Northway to participate in any distribution of assets or earnings of the
      subsidiary is subject to the prior claims of creditors of the subsidiary, except
      to the extent that claims, if any, of Northway itself as a creditor may be
      recognized. See “Supervision and Regulation.”





The
      following information concerning the Company’s investment activities, lending
      activities, asset quality and allowance for loan losses should be read in
      conjunction with “Management’s Discussion and Analysis of Financial Condition
      and Results of Operations,” appearing under Item 7 of this report and the
      Company’s Consolidated Financial Statements and Notes thereto.





**Investment
      Activities**





The
      following table presents the carrying amount of the Company’s securities
      available-for-sale as of December 31, 2006, 2005 and 2004 ($000
      Omitted):





2006
            
            2005
            
            2004U.S.
                Treasury and other U.S. government agency securities
            
            $
            47,063
            
            $
            47,751
            
            $
            54,563Mortgage-backed
                securities(1)
            
            
            40,621
            
            
            23,939
            
            
            29,301Marketable
                equity securities
            
            
            3,617
            
            
            2,809
            
            
            1,931Corporate
                bonds
            
            
            3,522
            
            
            5,569
            
            
            12,287Asset
                backed securities
            
            
            4,968
            
            
            -
            
            
            -State
                and political subdivision bonds and notes
            
            
            27,998
            
            
            23,176
            
            
            3,051Total
                securities
            
            $
            127,789
            
            $
            103,244
            
            $
            101,133





(1)
            Includes
                collateralized mortgage obligations of $6, $8 and $10 for December
                31,
                2006, 2005 and 2004, respectively.





The
      following table sets forth the amortized cost of the Company’s investment in
      debt securities maturing within stated periods and their related weighted
      average yields, reported on a tax equivalent basis, as of December 31, 2006
      ($000 Omitted):





MaturitiesWithin
                one
                  year
            
            
            One
                to
              five
              years
            
            
            Five
                to
              ten
              years
            
            
            Over
              ten
              years
            
            
            Total
              amortized
              costAvailable-for-sale:U.S.
                Treasury and other U.S. government agency securities
            
            $
            6,300
            
            $
            30,455
            
            $
            10,983
            
            $
            -
            
            $
            47,738Mortgage-backed
                securities(1)
            
            
            -
            
            
            20
            
            
            -
            
            
            40,891
            
            
            40,911Corporate
                bonds
            
            
            1,508
            
            
            2,009
            
            
            -
            
            
            -
            
            
            3,517Asset
                backed securities
            
            
            -
            
            
            -
            
            
            -
            
            
            4,974
            
            
            4,974State
                and political subdivision bonds and notes
            
            
            1,506
            
            
            996
            
            
            -
            
            
            25,282
            
            
            27,784Total
                amortized cost
            
            $
            9,314
            
            $
            33,480
            
            $
            10,983
            
            $
            71,147
            
            $
            124,924Fair
                value
            
            $
            9,262
            
            $
            32,935
            
            $
            10,916
            
            $
            71,059
            
            $
            124,172Weighted
                average yield
            
            
            3.94
            %
            
            4.13
            %
            
            5.57
            %
            
            5.49
            %
            
            5.02
            %





(1)
            Includes
                collateralized mortgage obligations of
                $6


**Table
          of
          Contents**


**Lending
      Activities**





The
      following table sets forth information with respect to the composition of the
      Company’s loan portfolio, excluding loans held for sale, as of December 31,
      2006, 2005, 2004, 2003 and 2002 ($000 Omitted):





December
                31,2006
            
            2005
            
            2004
            
            2003
            
            2002Real
                estate:Residential
            
            $
            167,172
            
            $
            158,729
            
            $
            147,333
            
            $
            129,493
            
            $
            114,526Commercial
            
            
            158,464
            
            
            143,456
            
            
            130,334
            
            
            120,366
            
            
            111,941Construction
            
            
            10,700
            
            
            13,241
            
            
            5,366
            
            
            3,851
            
            
            6,330Commercial
            
            
            33,569
            
            
            27,349
            
            
            27,013
            
            
            24,528
            
            
            23,885Installment
            
            
            42,489
            
            
            35,786
            
            
            29,345
            
            
            30,291
            
            
            40,169Indirect
                installment
            
            
            28,714
            
            
            62,221
            
            
            116,520
            
            
            150,807
            
            
            139,477Other
            
            
            20,843
            
            
            19,507
            
            
            18,901
            
            
            14,530
            
            
            9,652Total
                loans
            
            
            461,951
            
            
            460,289
            
            
            474,812
            
            
            473,866
            
            
            445,980Unamortized
                cost/(unearned income)
            
            
            279
            
            
            84
            
            
            (106
            )
            
            (247
            )
            
            (207
            )Allowance
                for loan losses
            
            
            (5,581
            )
            
            (5,150
            )
            
            (5,204
            )
            
            (5,036
            )
            
            (4,920
            )Total
                unamortized cost/(unearned income) and allowance for loan
                losses
            
            
            (5,302
            )
            
            (5,066
            )
            
            (5,310
            )
            
            (5,283
            )
            
            (5,127
            )Net
                loans
            
            $
            456,649
            
            $
            455,223
            
            $
            469,502
            
            $
            468,583
            
            $
            440,853





The
      following table presents the maturity distribution of the Company’s real estate
      construction and commercial loans at December 31, 2006 ($000
      Omitted):





Amount
            
            Percent
                of
              TotalWithin
                one year
            
            $
            12,088
            
            
            27.31
            %After
                one through five years
            
            
            15,154
            
            
            34.23Over
                five years
            
            
            17,027
            
            
            38.46$
            44,269
            
            
            100.00
            %





The
      Company’s real estate construction and commercial loans due after one year at
      December 31, 2006 were comprised of the following ($000 Omitted):





AmountFixed
                interest rate
            
            $
            14,965Adjustable
                interest rate
            
            
            17,216$
            32,181


**Table
          of
          Contents**


**Analysis
      of the Allowance for Loan Losses**





The
      following table reflects activity in the Company’s allowance for loan losses for
      the years ended December 31, 2006, 2005, 2004, 2003 and 2002 ($000
      Omitted):





Years
                ended December 31,2006
            
            2005
            
            2004
            
            2003
            
            2002Balance
                at the beginning of period
            
            $
            5,150
            
            $
            5,204
            
            $
            5,036
            
            $
            4,920
            
            $
            4,642Charge-offs:Real
                estate
            
            
            9
            
            
            8
            
            
            56
            
            
            -
            
            
            83Commercial
            
            
            -
            
            
            10
            
            
            28
            
            
            120
            
            
            12Installment
                loans
            
            
            323
            
            
            397
            
            
            581
            
            
            750
            
            
            729Total
            
            
            332
            
            
            415
            
            
            665
            
            
            870
            
            
            824Recoveries:Real
                estate
            
            
            56
            
            
            44
            
            
            162
            
            
            25
            
            
            64Commercial
            
            
            16
            
            
            85
            
            
            16
            
            
            11
            
            
            4Installment
                loans
            
            
            226
            
            
            157
            
            
            160
            
            
            145
            
            
            134Total
            
            
            298
            
            
            286
            
            
            338
            
            
            181
            
            
            202Net
                charge-offs
            
            
            34
            
            
            129
            
            
            327
            
            
            689
            
            
            622Provision
                charged to expense
            
            
            465
            
            
            75
            
            
            495
            
            
            805
            
            
            900Balance
                at the end of period
            
            $
            5,581
            
            $
            5,150
            
            $
            5,204
            
            $
            5,036
            
            $
            4,920Ratio
                of net charge-offs to average loans
            
            
            0.01
            %
            
            0.03
            %
            
            0.07
            %
            
            0.15
            %
            
            0.15
            %





The
      increase in the provision for loan losses in 2006 was due in large part to
      an
      increase in commercial loans, especially large hospitality loans, which require
      a higher risk weighting in the allowance for loan losses calculation. The
      decrease in the 2005 provision was due in part to a reduction in average loans
      of approximately $19.8 million. The decrease in the 2004 provision was due
      in
      part to a reduction in average impaired loans of approximately $1.1 million
      as
      well as the fact that the Company realized significant recoveries during 2004,
      which allowed the Company to maintain its coverage ratio. The decrease in the
      2003 provision was due in large part to the recording of $70,000 to other
      expense for a provision for losses related to unfunded loan commitments such
      as
      unused lines of credit and unused portions of home-equity loans. This provision
      had previously been calculated as part of the allowance for loan losses. The
      2002 provision was unchanged from the provision recorded in 2001due to an
      increase in loan balances and an increased level of loan
      charge-offs.





**Allocation
      of the Allowance for Loan Losses**





The
      following table sets forth the breakdown of the Company’s allowance for loan
      losses in the Company’s portfolio by category of loan and the percentage of
      loans in each category to total loans in the respective portfolios at the dates
      indicated ($000 Omitted):





December
                31,2006
            
            2005
            
            2004
            
            2003
            
            2002Amount
            
            Percent
                of
              loans
                in each
              category
                to
              total
                loans
            
            Amount
            
            Percent
                of
              loans
                in each
              category
                to
              total
                loans
            
            Amount
            
            Percent
                of
              loans
                in each
              category
                to
              total
                loans
            
            Amount
            
            Percent
                of
              loans
                in each
              category
                to
              total
                loans
            
            Amount
            
            Percent
                of
              loans
                in each
              category
                to
              total
                loansReal
                estate:Residential
            
            $
            996
            
            
            36.2
            %
            $
            784
            
            
            34.5
            %
            $
            644
            
            
            31.0
            %
            $
            624
            
            
            27.3
            %
            $
            598
            
            
            25.9
            %Commercial
                & construction
            
            
            3,422
            
            
            36.6
            
            
            3,032
            
            
            34.0
            
            
            1,892
            
            
            28.6
            
            
            1,724
            
            
            26.2
            
            
            2,008
            
            
            26.7Commercial
            
            
            339
            
            
            7.3
            
            
            278
            
            
            6.0
            
            
            174
            
            
            5.7
            
            
            155
            
            
            5.2
            
            
            216
            
            
            5.4Installment
            
            
            747
            
            
            15.4
            
            
            985
            
            
            21.3
            
            
            2,398
            
            
            30.7
            
            
            2,505
            
            
            38.2
            
            
            2,084
            
            
            40.6Other
            
            
            77
            
            
            4.5
            
            
            71
            
            
            4.2
            
            
            96
            
            
            4.0
            
            
            28
            
            
            3.1
            
            
            14
            
            
            1.4$
            5,581
            
            
            100.0
            %
            $
            5,150
            
            
            100.0
            %
            $
            5,204
            
            
            100.0
            %
            $
            5,036
            
            
            100.0
            %
            $
            4,920
            
            
            100.0
            %





**Deposits**





See
      “Financial Statements and Supplementary Data” in Item 8 of this
      report.




**Table
          of Contents**


**Supervision
      and Regulation**





The
      business in which the Company is engaged is subject to extensive supervision,
      regulation and examination by various bank regulatory authorities and other
      governmental agencies. State and federal banking laws have as their principal
      objective either the maintenance of the safety and soundness of financial
      institutions and the federal deposit insurance system or the protection of
      consumers or classes of consumers, and depositors in particular, rather than
      the
      specific protection of stockholders of a bank or its parent company.





Set
      forth
      below is a brief description of certain laws and regulations that relate to
      the
      regulation of the Company and its banking subsidiary. To the extent the
      following material describes statutory or regulatory provisions, it is qualified
      in its entirety by reference to the particular statute or regulation.





Regulation
      of the Company





*General.* As
      a
      registered bank holding company, the Company is subject to regulation under
      the
      Bank Holding Company Act of 1956, as amended (“BHCA”) and to inspection,
      examination and supervision by the Board of Governors of the Federal Reserve
      System (“FRB”). The Company is also subject to the laws of the State of New
      Hampshire.





The
      FRB
      has the authority to issue orders to bank holding companies to cease and desist
      from unsound banking practices and violations of conditions imposed by, or
      violations of agreements with, the FRB. The FRB is also empowered to assess
      civil money penalties against companies or individuals who violate the BHCA
      or
      orders or regulations thereunder, to order termination of non-banking activities
      of non-banking subsidiaries of bank holding companies, and to order termination
      of ownership and control of a non-banking subsidiary by a bank holding company.
      Under the BHCA, the Company may not generally engage in activities or acquire
      more than 5% of any class of voting securities of any company engaged in
      activities other than banking or activities that are closely related to banking.
      However, a bank holding company that has elected to be treated as a “financial
      holding company” may engage in activities that are financial in nature or
      incidental or complementary to such financial activities, as determined by
      the
      FRB alone, or together with the Secretary of the Department of the Treasury.
      The
      Company has not elected financial holding company status. Under certain
      circumstances, the Company may be required to give notice to or seek approval
      of
      the FRB before engaging in activities other than banking.





*Riegle-Neal
      Interstate Banking and Branching Efficiency Act of 1994* (“Riegle-Neal”). Riegle-Neal permits adequately- or well-capitalized and
      adequately- or well-managed bank holding companies, as determined by the FRB,
      to
      acquire banks in any state subject to certain concentration limits and other
      conditions. Riegle-Neal also generally authorizes the interstate merger of
      banks. In addition, among other things, Riegle-Neal permits banks to establish
      new branches on an interstate basis provided that the law of the host state
      specifically authorizes such action. However, as a bank holding company, the
      Company is required to obtain prior FRB approval before acquiring more than
      5%
      of a class of voting securities, or substantially all of the assets of a bank
      holding company, bank or savings association.





*Control
      Acquisitions* .
      The
      Change in Bank Control Act prohibits a person or group of persons from acquiring
      “control” of a bank holding company, such as the Company, unless the FRB has
      been notified and has not objected to the transaction. Under a rebuttable
      presumption established by the FRB, the acquisition of 10% or more of a class
      of
      voting securities of a bank holding company with a class of securities
      registered under Section 12 of the Securities Exchange Act of 1934, as amended,
      would, under the circumstances set forth in the presumption, constitute
      acquisition of control of the bank holding company. In addition, a company
      is
      required to obtain the approval of the FRB under the BHCA before acquiring
      25%
      (5% in the case of an acquirer that is a bank holding company) or more of any
      class of outstanding voting securities of a bank holding company, or otherwise
      obtaining control or a “controlling influence” over that bank holding
      company .





*Bank
      Holding Company Dividends* .
      The FRB
      has authority to prohibit bank holding companies from paying dividends if such
      payment is deemed to be unsafe or unsound. The FRB has indicated generally
      that
      it may be an unsafe or unsound practice for bank holding companies to pay
      dividends unless the bank holding company’s net income over the preceding year
      is sufficient to fund the dividends and the expected rate of earnings retention
      is consistent with the organization’s capital needs, asset quality and overall
      financial condition. The Company depends in part upon dividends received from
      its subsidiary bank to fund its activities, including the payment of dividends. As
      described below, the FDIC and the banks regulatory agencies may regulate the
      amount of dividends payable by the subsidiary banks. The inability of the Bank
      to pay a dividend may have an adverse effect on the Company.





Regulation
      of the Bank





The
      Bank
      is organized under New Hampshire law and is subject to the regulations of the
      Commissioner and the FDIC, including requirements and restrictions related
      to
      the maintenance of adequate levels of capital, the payment of dividends,
      investments, the nature and amount of loans which can be originated and the
      rate
      of interest that can be charged thereon, and other activities. Capital
      requirements applicable to the Bank are substantially similar to those adopted
      by the FRB regarding bank holding companies as described above.





*Insurance
      of Accounts and FDIC Regulation* .
      The
      Bank pays deposit insurance premiums to the FDIC based on an assessment rate
      established by the FDIC. In 2006, the FDIC enacted various rules to implement
      the provision of the Federal Deposit Insurance Reform Act of 2005 (the “FDI
      Reform Act”). Pursuant to the FDI Reform Act, in 2006 the FDIC merged the Bank
      Insurance Fund with the Savings Association Insurance Fund to create a newly
      named Deposit Insurance Fund (the “DIF”) that covers both banks and savings
      associations. The FDIC also revised, effective January 1, 2007, the risk-based
      premium system under which the FDIC classifies institutions based on the factors
      described below and generally assesses higher rates on those institutions that
      tend to pose greater risk to the DIF. For most banks and savings associations,
      including the Bank, FDIC rates will depend upon a combination of CAMELS
      component ratings and financial ratios. CAMELS ratings reflect the applicable
      bank regulatory agency’s evaluation of the financial institution’s capital,
      asset quality, management, earnings, liquidity and sensitivity to risk. For
      large banks and savings associations that have long-term debt issuer ratings,
      assessment rates will depend upon such ratings, and CAMELS component ratings.
      For institutions, such as the Bank, which are in the lowest risk category,
      assessment rates will vary initially from five (5) to seven (7) basis points
      per
      $100 of insured deposits. The Federal Deposit Insurance Act (“FDIA”) as amended
      by the FDI Reform Act requires the FDIC to set a ratio of deposit insurance
      reserves to estimated insured deposits, the designated reserve ratio (the “DRR”)
      for a particular year within a range of 1.15% to 1.50%. For 2007, the FDIC
      has
      set the initial DRR at 1.25%. Under the FDI Reform Act and the FDIC’s revised
      premium assessment program, every FDIC-insured institution will pay some level
      of deposit insurance assessments regardless of the level of the DRR. We cannot
      predict whether, as a result of an adverse change in economic conditions or
      other reasons, the FDIC will be required in the future to increase deposit
      insurance assessments above 2007 levels. The FDI Reform Act allows eligible
      insured depository institutions to share a one-time assessment credit pool
      of
      approximately $4.7 billion. The Bank will, therefore, receive a one-time credit
      of $447,000 to be applied against any future deposit insurance assessments.
      During 2006, the Bank paid FDIC premiums totaling $59,000.





**Table
          of Contents**


*Bank
      Holding Company Support of Subsidiary Banks* .
      Under
      FRB policy, a bank holding company is expected to act as a source of financial
      and managerial strength to each of its subsidiary banks and to commit resources
      to their support. This support may be required at times when the bank holding
      company may not have the resources to provide it. Similarly, under the
      cross-guarantee provisions of FDIA, the FDIC can hold any FDIC-insured
      depository institution liable for any loss suffered or anticipated by the FDIC
      in connection with (1) the “default” of a commonly controlled FDIC-insured
      depository institution; or (2) any assistance provided by the FDIC to a commonly
      controlled FDIC-insured depository institution “in danger of default.” The Bank
      is an FDIC-insured depository institution.





*Regulatory
      Capital Requirements.* The FRB
      and the FDIC have issued substantially similar risk-based and leverage capital
      guidelines applicable to United States banking organizations. In addition,
      these
      regulatory agencies may from time to time require that a banking organization
      maintain capital above the minimum levels, whether because of its financial
      condition or actual or anticipated growth.





The
      FRB
      risk-based guidelines define a three-tier capital framework. Tier 1 capital
      includes common stockholders’ equity and qualifying preferred stock, less
      goodwill and other adjustments. Tier 2 capital consists of preferred stock not
      qualifying as Tier 1 capital, mandatory convertible debt, limited amounts of
      subordinated debt, other qualifying term debt and the allowance for loan losses
      up to 1.25 percent of risk-weighted assets. Tier 3 capital includes subordinated
      debt that is unsecured, fully paid, has an original maturity of at least two
      years, is not redeemable before maturity without prior approval by the FRB
      and
      includes a lock-in clause precluding payment of either interest or principal
      if
      the payment would cause the issuing bank’s risk-based capital ratio to fall or
      remain below the required minimum. The sum of Tier 1 and Tier 2 capital less
      investments in unconsolidated subsidiaries represents qualifying total capital.
      Risk-based capital ratios are calculated by dividing Tier 1 and total capital
      by
      risk-weighted assets. Assets and off-balance sheet exposures are assigned to
      one
      of four categories of risk-weights, based primarily on relative credit risk.
      The
      minimum Tier 1 capital ratio is four percent and the minimum total capital
      ratio
      is eight percent. The Company’s tier 1 calculation as of December 31, 2006
      equaled 14.02% and its total capital ratio as of December 31, 2006 was 15.95%.





The
      leverage ratio is determined by dividing Tier 1 capital by adjusted average
      total assets for the quarter. Although the stated minimum ratio is 100 to 200
      basis points above three percent, banking organizations are required to maintain
      a ratio of at least five percent to be classified as “well capitalized”. The
      Company’s leverage ratio as of December 31, 2006 was 9.31%.





The
      Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), among
      other things, identifies five capital categories for insured depository
      institutions (well capitalized, adequately capitalized, undercapitalized,
      significantly undercapitalized and critically undercapitalized) and requires
      the
      federal bank regulatory agencies to implement systems for “prompt corrective
      action” for insured depository institutions that do not meet minimum capital
      requirements within such categories. FDICIA imposes progressively more
      restrictive constraints on operations, management and capital distributions,
      depending on the category in which an institution is classified. Failure to
      meet
      the capital guidelines could also subject a banking institution to capital
      raising requirements. An “undercapitalized” bank must develop a capital
      restoration plan and its parent holding company must guarantee that bank’s
      compliance with the plan. The liability of the parent holding company under
      any
      such guarantee is limited to the lesser of five percent of the bank’s assets at
      the time it became “undercapitalized” or the amount needed to comply with the
      plan. Furthermore, in the event of the bankruptcy of the parent holding company,
      such guarantee would take priority over the parent’s general unsecured
      creditors. In addition, FDICIA requires the various regulatory agencies to
      prescribe certain non-capital standards for safety and soundness relating
      generally to operations and management, asset quality and executive compensation
      and permits regulatory action against a financial institution that does not
      meet
      such standards.





The
      various regulatory agencies have adopted substantially similar regulations
      that
      define the five capital categories identified by FDICIA, using the total
      risk-based capital, Tier 1 risk-based capital and leverage capital ratios as
      the
      relevant capital measures. Such regulations establish various degrees of
      corrective action to be taken when an institution is considered
      undercapitalized. Under the regulations, a “well capitalized” institution must
      have a Tier 1 risk-based capital ratio of at least six percent, a total
      risk-based capital ratio of at least ten percent and a leverage ratio of at
      least five percent and not be subject to a capital directive order.





Regulators
      also must take into consideration (a) concentrations of credit risk; (b)
      interest rate risk (when the interest rate sensitivity of an institution’s
      assets does not match the sensitivity of its liabilities or its
      off-balance-sheet position); and (c) risks from non-traditional activities,
      as
      well as an institution’s ability to manage those risks, when determining the
      adequacy of an institution’s capital. This evaluation will be made as a part of
      the institution’s regular safety and soundness examination. In addition, the
      Company, and any bank with significant trading activity, must incorporate a
      measure for market risk in their regulatory capital calculations. As of December
      31, 2006, the most recent notification from the FDIC categorized the Bank as
      “well capitalized”.




In
      2005,
      the federal banking agencies issued an advance notice of proposed rulemaking
      (“ANPR”) concerning potential changes in the risk-based capital rules (“Basel
      IA”) that are designed to apply to, and potentially reduce the risk capital
      requirements of bank holding companies, such as the Company, that are not among
      the 20 or so largest US bank holding companies. In December 2006, the FDIC
      issued a revised Interagency Notice of Proposed Rulemaking concerning Basel
      1-A
      (the “NPR”), which would allow banks and bank holding companies that are not
      among the 20 or so largest US bank holding companies to either adopt Basel
      1-A
      or remain subject to the existing risk-based capital rules. The NPR would also,
      among other changes, amend the ANPR to add new risk weights, expand the use
      of
      external credit ratings for certain exposures and expand the range of eligible
      collateral and guarantors used to mitigate credit risk. The NPR remains subject
      to approval by other regulatory agencies, and if approved, will be made
      available to the public for comment, and in all likelihood, will be subject
      to
      further revision. The effective date, if adopted, of the Basel 1-A rules also
      remains uncertain. Accordingly, the Company is not yet in a position to
      determine the effect of such rules on its risk capital requirements.





*Transactions
      with Affiliates.* Under
      Sections 23A and 23B of the Federal Reserve Act and Regulation W thereunder,
      there are various legal restrictions on the extent to which a bank holding
      company and its non-bank subsidiaries may borrow, obtain credit from or
      otherwise engage in "covered transactions" with its FDIC insured depository
      institution subsidiaries. Such borrowings and other covered transactions by
      an
      insured depository institution subsidiary (and its subsidiaries) with its
      non-depository institution affiliates are limited to the following amounts:
      (a)
      in the case of one such affiliate, the aggregate amount of covered transactions
      of the insured depository institution and its subsidiaries cannot exceed ten
      percent (10%) of the capital stock and surplus of the insured depository
      institution; and (b) in the case of all affiliates, the aggregate amount of
      covered transactions of the insured depository institution and its subsidiaries
      cannot exceed twenty percent (20%) of the capital stock and surplus of the
      insured depository institution.





"Covered
      transactions" are defined by statute for these purposes to include a loan or
      extension of credit to an affiliate, a purchase of or investment in securities
      issued by an affiliate, a purchase of assets from an affiliate unless exempted
      by the Federal Reserve Board, the acceptance of securities issued by an
      affiliate as collateral for a loan or extension of credit to any person or
      company, or the issuance of a guarantee, acceptance, or letter of credit on
      behalf of an affiliate. Covered transactions are also subject to certain
      collateral security requirements. Further, a bank holding company and its
      subsidiaries are prohibited from engaging in certain tying arrangements in
      connection with any extension of credit, lease or sale of property of any kind,
      or furnishing of any service.





*Limitations
      on Bank Dividends* .
      The
      FDIC has the authority to use its enforcement powers to prohibit a bank from
      paying dividends if, in its opinion, the payment of dividends would constitute
      an unsafe or unsound practice. Federal law also prohibits the payment of
      dividends by a bank that will result in the bank failing to meet its applicable
      capital requirements on a pro forma basis.




**Table
          of Contents**


*Customer
      Information Security.* The
      FDIC
      and other bank regulatory agencies have adopted final guidelines for
      establishing standards for safeguarding nonpublic personal information about
      customers that implement provisions of the Gramm-Leach-Bliley Act of 1999 or
      “GLBA,” which establishes a comprehensive framework to permit affiliations among
      commercial banks, insurance companies, securities firms, and other financial
      service providers by revising and expanding the BHCA framework. Specifically,
      the Information Security Guidelines established by the GLBA require each
      financial institution, under the supervision and ongoing oversight of its Board
      of Directors or an appropriate committee thereof, to develop, implement and
      maintain a comprehensive written information security program designed to ensure
      the security and confidentiality of customer information, to protect against
      anticipated threats or hazards to the security or integrity of such information;
      and to protect against unauthorized access to or use of such information that
      could result in substantial harm or inconvenience to any customer. The federal
      banking regulators have issued guidance for banks on response programs for
      unauthorized access to customer information. This guidance, among other things,
      requires notice to be sent to customers whose “sensitive information” has been
      compromised if unauthorized use of this information is “reasonably possible.”
Various states have enacted legislation concerning breaches of data security
      and
      various bills requiring consumer notice of data security breaches are being
      considered by Congress.





*Privacy.* The
      GLBA
      requires financial institutions to implement policies and procedures regarding
      the disclosure of nonpublic personal information about consumers to
      nonaffiliated third parties. In general, the statute requires financial
      institutions to explain to consumers their policies and procedures regarding
      the
      disclosure of such nonpublic personal information, and, unless otherwise
      required or permitted by law, financial institutions are prohibited from
      disclosing such information except as provided in their policies and procedures.





*USA
      Patriot Act.* The
      USA
      Patriot Act of 2001, designed to deny terrorists and others the ability to
      obtain anonymous access to the U.S. financial system, has significant
      implications for depository institutions, broker-dealers, mutual funds,
      insurance companies and businesses of other types involved in the transfer
      of
      money. The USA Patriot Act, together with the implementing regulations of
      various federal regulatory agencies, have caused financial institutions,
      including banks, to adopt and implement additional, or amend existing, policies
      and procedures with respect to, among other things, anti-money laundering
      compliance, suspicious activity and currency transaction reporting, customer
      identity verification and customer risk analysis. The statute and its underlying
      regulations also permit information sharing for counter-terrorist purposes
      between federal law enforcement agencies and financial institutions, as well
      as
      among financial institutions, subject to certain conditions, and require the
      FRB
      (and other federal banking agencies) to evaluate the effectiveness of an
      applicant and a target institution in combating money laundering activities
      when
      considering applications filed under Section 3 of the BHCA or under the Bank
      Merger Act. In 2006, final regulations under the USA Patriot Act were issued
      requiring financial institutions, including the Bank, to take additional steps
      to monitor their correspondent banking and private banking relationships as
      well
      as their relationships with “shell banks.” Management believes that the Company
      is in compliance with all the requirements prescribed by the USA Patriot Act
      and
      all applicable final implementing regulations.





*The
      Community Reinvestment Act* .
      The
      Community Reinvestment Act ("CRA") requires lenders to identify the communities
      served by the institution's offices and other deposit taking facilities and
      to
      make loans and investments and provide services that meet the credit needs
      of
      these communities. Regulatory agencies examine each of the banks and rate such
      institutions’ compliance with CRA as "Outstanding", "Satisfactory", "Needs to
      Improve," or "Substantial Noncompliance". Failure of an institution to receive
      at least a "Satisfactory" rating could inhibit such institution or its holding
      company from undertaking certain activities, including engaging in activities
      newly permitted as a financial holding company under the GLBA and acquisitions
      of other financial institutions. The FRB must take into account the record
      of
      performance of banks in meeting the credit needs of the entire community served,
      including low-and moderate-income neighborhoods. The Bank has achieved a rating
      of Outstanding on its most recent examination. New Hampshire also has enacted
      substantially similar community reinvestment requirements. The federal banking
      agencies adopted less burdensome CRA requirements, effective in 2006, for
“intermediate - small banks,” which are banks with $250 million or more, but
      less than $1 billion in total assets, under which such banks, including Northway
      Bank, will be examined using only two tests, a Lending Test and a new Community
      Development Test, and will be relieved of certain data collection and reporting
      requirements.





**Competition**





The
      banking industry in the United States, which includes commercial banks, savings
      and loan associations, mutual savings banks, capital stock savings banks, credit
      unions, and bank and savings and loan holding companies, is part of the broader
      financial services industry which includes insurance companies, mutual funds,
      and the brokerage industry, among others. In recent years, intense market
      demands and economic pressures have eroded once clearly defined industry
      classifications and have forced financial services institutions to diversify
      their services, increase returns on deposits, and become more cost-effective
      as
      a result of competition with one another and with new types of financial
      services companies, including non-bank competitors.





The
      Company’s banking subsidiary faces significant competition in its markets from
      commercial banks, savings banks, credit unions, consumer finance companies,
      insurance companies, "non-bank banks," mutual funds, government agencies,
      investment management companies, investment advisors, brokers and investment
      bankers. In addition, increasing consolidation within the banking and financial
      services industry, as well as increased competition from larger regional and
      out-of-state banking organizations and non-bank providers of various financial
      services, may adversely affect the Company’s ability to achieve its financial
      goals. Federal banking laws permit adequately capitalized bank holding companies
      to venture across state lines to offer banking services through bank
      subsidiaries to a wider geographic market. Consequently, it is possible for
      large organizations to enter many new markets including the markets served
      by
      the Company. Certain of these competitors, by virtue of their size and
      resources, may enjoy certain efficiencies and competitive advantages over the
      Company in pricing, delivery, and marketing of their products and services.
      The
      Company’s long-term success depends on the ability of the Company’s banking
      subsidiary to compete successfully with other financial institutions in their
      service areas. It is not possible to assess what impact these changes in the
      regulatory environment will have on the Company. Many of these large competitors
      have significantly more financial resources, larger market share and greater
      name recognition in the market areas served by the Company and its banking
      subsidiaries.





The
      Bank
      competes in this environment by providing a broad range of financial services,
      competitive interest rates and a personal level of service that, combined,
      tend
      to retain the loyalty of its customers in its market areas against competitors
      with far larger resources. To a lesser extent, convenience of branch locations
      and hours of operations are also considered competitive advantages of the Bank.





**Employees**





As
      of
      December 31, 2006 the Company has 249 full-time equivalent employees. The
      Company considers its employee relations to be good.





**Website
      Access to Company Reports**





The
      Company’s annual reports on Form 10-K, quarterly reports on Form 10-Q, current
      reports on Form 8-K, and all amendments to those reports are available free
      of
      charge on the Company’s website at www.northwaybank.com as soon
      as reasonably practicable after such material is electronically filed with
      or
      furnished to the Securities and Exchange Commission. Also, copies of the
      Company’s annual report on Form 10-K, including the exhibits thereto, will be
      made available, free of charge, upon written request.





**Table
          of Contents**


ITEM
      1A. RISK FACTORS





*Our
      business is largely dependent upon the hospitality industry* .
      A
      number of our loan customers are in the hospitality industry. The hospitality
      industry is dependent on personal discretionary spending levels. As a result,
      the hospitality industry may be adversely impacted by economic trends, including
      recession and increased unemployment. Additionally, unforeseen events including
      acts of terrorism, war, increases in fuel prices, travel-related accidents
      and
      unusual weather patterns also may adversely affect the hospitality industry.
      As
      a result, our business also is likely to be adversely affected by those events.





*Fluctuations
      in interest rates may negatively impact the business of our Bank.* Our
      Bank’s main source of income from operations is net interest income, which is
      equal to the difference between the interest income received on interest-earning
      assets (usually loans and investment securities) and the interest expense
      incurred in connection with interest-bearing liabilities (usually deposits
      and
      borrowings). These rates are highly sensitive to many factors beyond our
      control, including general economic conditions, both domestic and foreign,
      and
      the monetary and fiscal policies of various governmental and regulatory
      authorities. Our bank’s net interest income can be affected significantly by
      changes in market interest rates. Changes in relative interest rates may reduce
      our Bank’s net interest income as the difference between interest income and
      interest expense decreases. As a result, our Bank’s have adopted asset and
      liability management policies to minimize the potential adverse effects of
      changes in interest rates on net interest income, primarily by altering the
      mix
      and maturity of loans, investments and funding sources. However, even with
      these
      policies in place, a change in interest rates can impact our results of
      operations or financial condition.





An
      increase in interest rates could also have a negative impact on our bank’s
      results of operations by reducing the ability of borrowers to repay their
      current loan obligations, which could not only result in increased loan
      defaults, foreclosures and write-offs, but also necessitate further increases
      in
      the banks’ allowance for loan losses.





*Our
      allowance for loan losses may not be adequate to cover actual
      losses* .
      We make
      various assumptions and judgments about the collectibility of our loan portfolio
      and provide an allowance for potential loan losses based on several factors.
      If
      our assumptions are incorrect, our allowance for loan losses may be insufficient
      to cover our actual losses, which would have an adverse effect on our results
      of
      operations, and may cause us to increase the allowance in the future.





*Changes
      in the securities market may adversely impact our results of
      operations.* In
      recent years the securities market has experienced significant volatility and
      will likely continue to experience volatility as a result of, among other
      things, global economic and political conditions. Declines in equity prices,
      as
      well as declines in the performance of certain sectors or specific companies,
      may result in a corresponding decline in the value of Company-held securities.
      Any decline in the value of Company-held securities may decrease our earnings.





*Our
      loans are concentrated in certain areas of New Hampshire and adverse conditions
      in those markets could adversely affect our operations.* We
      are
      exposed to real estate and economic factors in the northern and central areas
      of
      New Hampshire, as virtually the entire loan portfolio is concentrated among
      borrowers in these markets. Further, because a substantial portion of the loan
      portfolio is secured by real estate in this area, the value of the associated
      collateral is also subject to regional real estate market conditions. Adverse
      economic, political or business developments or natural hazards may affect
      these
      areas and the ability of property owners in these areas to make payments of
      principal and interest on the underlying mortgages. If these regions experience
      adverse economic, political or business conditions, we would likely experience
      higher rates of loss and delinquency on these mortgage loans than if the loans
      were more geographically diverse.





*If
      we
      do not maintain net income growth, the market price of our common stock could
      be
      adversely affected.* Our
      return on shareholders’ equity and other measures of profitability, which affect
      the market price of our common stock, depend in part on our continued growth
      and
      expansion. Our growth strategy has two principal components—internal growth and
      external growth. Our ability to generate internal growth is affected by the
      competitive factors described below as well as by the primarily rural
      characteristics and related demographic features of the markets we serve. Our
      ability to continue to identify and invest in suitable acquisition candidates
      on
      acceptable terms is crucial to our external growth. In pursuing acquisition
      opportunities, we may be in competition with other companies having similar
      growth strategies. As a result, we may not be able to identify or acquire
      promising acquisition candidates on acceptable terms. Competition for these
      acquisitions could result in increased acquisition prices and a diminished
      pool
      of acquisition opportunities. An inability to find suitable acquisition
      candidates at reasonable prices could slow our growth rate and have a negative
      effect on the market price of our common stock.





*We
      experience strong competition within our markets, which may impact our
      profitability.* Competition
      in the banking and financial services industry is strong. In our market areas,
      we compete for loans and deposits with local independent banks, thrift
      institutions, savings institutions, mortgage brokerage firms, credit unions,
      finance companies, mutual funds, insurance companies and brokerage and
      investment banking firms operating locally as well as nationally. Many of these
      competitors have substantially greater resources and lending limits than those
      of our subsidiaries and may offer services that our subsidiaries do not or
      cannot provide. Our long-term success depends on the ability of the Bank to
      compete successfully with other financial institutions in their service areas.
      Because we maintain a smaller staff and have fewer financial and other resources
      than larger institutions with which we compete, we may be limited in our ability
      to attract customers. If we are unable to attract and retain customers, we
      may
      be unable to sustain growth in the loan portfolio and our results of operations
      and financial condition may otherwise be negatively impacted.





*Our
      cost of funds for banking operations may increase as a result of general
      economic conditions, interest rates and competitive pressures.* Our
      banking subsidiary has traditionally obtained funds principally through deposits
      and borrowings. As a general matter, deposits are a less costly source of funds
      than borrowings because interest rates paid for deposits are typically less
      than
      interest rates charged for borrowings. If, as a result of general economic
      conditions, market interest rates, competitive pressures or otherwise, the
      value
      of deposits at our banking subsidiary decreases relative to our overall banking
      operations, we may have to rely more heavily on borrowings as a source of funds
      in the future.





*Our
      banking business is highly regulated.* Bank
      holding companies and state-chartered banks operate in a highly regulated
      environment and are subject to supervision, regulation and examination by
      various federal and state bank regulatory agencies, as well as other
      governmental agencies in the states in which they operate. Federal and state
      laws and regulations govern numerous matters including changes in the ownership
      or control of banks and BHCs, maintenance of adequate capital and the financial
      condition of a financial institution, permissible types, amounts and terms
      of
      extensions of credit and investments, permissible non-banking activities, the
      level of reserves against deposits and restrictions on dividend payments. The
      FDIC possesses cease and desist powers to prevent or remedy unsafe or unsound
      practices or violations of law by banks subject to their regulation, and the
      FRB
      possesses similar powers with respect to BHCs. These and other restrictions
      limit the manner in which we may conduct business and obtain financing. There
      can be no assurance that any modification of these laws and regulations, or
      new
      legislation that may be enacted, in the future will not make compliance more
      difficult or expensive, restrict our ability to originate, broker or sell loans
      or otherwise adversely affect our operations. See “Supervision and Regulation”
on page 4 of this report.





**Table
          of Contents**


Furthermore,
      our business is also affected by the economic, fiscal and monetary policies
      of
      the United States and its agencies and regulatory authorities, particularly
      the
      FRB. The economic and fiscal policies of various governmental entities and
      the
      monetary policies of the FRB may affect the interest rates our bank subsidiaries
      must offer to attract deposits and the interest rates they must charge on loans,
      as well as the manner in which they offer deposits and make loans. These
      economic, fiscal and monetary policies have had, and are expected to continue
      to
      have, significant effects on the operating results of depository institutions
      generally, including our bank subsidiaries.





*We
      could be held responsible for environmental liabilities of properties we acquire
      through foreclosure.* If
      we are
      forced to foreclose on a defaulted mortgage loan to recover our investment,
      we
      may be subject to environmental liabilities related to the underlying real
      property. Hazardous substances or wastes, contaminants, pollutants or sources
      thereof may be discovered on properties during our ownership or after a sale
      to
      a third party. The amount of environmental liability could exceed the value
      of
      the real property. There can be no assurance that we would not be fully liable
      for the entire cost of any removal and clean-up on an acquired property, that
      the cost of removal and clean-up would not exceed the value of the property,
      or
      that we could recoup any of the costs from any third party.





*To
      the extent that we acquire other companies or branches in the future, our
      business may be negatively impacted by certain risks inherent with such
      acquisitions.* Although
      we do not have an aggressive acquisition strategy, we have acquired, and in
      the
      future, will continue to consider the acquisition of, branches of other
      financial services companies. To the extent that we acquire branches in the
      future, our business may be negatively impacted by certain risks inherent with
      such acquisitions. These risks include the following:





·
            The
                risk that the acquired business will not perform in accordance with
                management’s expectations;


·
            The
                risk that difficulties will arise in connection with the integration
                of
                the operations of the acquired business with the operation of our
                businesses;


·
            The
                risk that management will divert its attention from other aspects
                of our
                business;


·
            The
                risk that we may lose key employees of the acquired business;
                and


·
            The
                risks associated with entering into geographic and product markets
                in
                which we have limited or no direct prior
                experience.





*Due
      to the nature of our business, we may be subject to litigation from time to
      time, some of which may not be covered by insurance.* Through
      our bank subsidiary, we operate in a highly regulated industry, and as a result,
      are subject to various regulations related to disclosures to our customers,
      our
      lending practices, and other fiduciary responsibilities. From time-to-time,
      we
      have been, and may become, subject to legal actions relating to our operations
      that have had, or could, involve claims for substantial monetary damages.
      Although we maintain insurance, the scope of this coverage may not provide
      us
      with full, or even partial, coverage in any particular case. As a result, a
      judgment against us in any such litigation could have a material adverse effect
      on our financial condition and results of operation.





*Changes
      in tax legislation could have a material impact on our results of operations.
      C* hanges
      in
      tax legislation could have a material impact on our results of operations.





ITEM
      2. PROPERTIES





The
      Company operates 20 branch offices, one commercial lending and administration
      facility and one administration facility that are located in the central and
      northern New Hampshire communities of Berlin, Conway (four offices), Gorham
      (two
      offices), Groveton, Littleton, West Ossipee, West Plymouth, Plymouth, Campton,
      Ashland, North Woodstock, Tilton (two offices), Franklin, Laconia, Belmont
      (two
      offices), and Pittsfield. Sixteen of these offices are located on properties
      the
      Company owns. The Company leases six of its branches under contracts that expire
      between June 30, 2007 and December 31, 2015. Furthermore, four of the leases
      have an option to renew for an additional five years. Seventeen of the Company’s
      branches have drive-up facilities and all are equipped with automated teller
      machines.





ITEM
      3. LEGAL PROCEEDINGS





The
      Company is not a party to, nor are any of its subsidiaries the subject of,
      any
      material pending legal proceedings, other than ordinary routine litigation
      incidental to the business.





ITEM
      4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY
      HOLDERS





No
      matters were submitted to a vote of security holders during the quarter ended
      December 31, 2006.





**PART
      II**





ITEM
      5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER
      MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES





The
      Company’s common stock is traded on The Nasdaq Stock Market, Inc.’s National
      Market under the symbol “NWFI”. The following table sets forth, for the periods
      indicated, the high and low closing sale prices for the common stock, as
      reported by The Nasdaq National Market, and the dividends paid on the common
      stock:





Price
                Per Share
            DividendsLow
            High
            Per
                Share2006
            4thQuarter
            $32.41
            $33.64
            $0.203rdQuarter
            32.41
            34.38
            0.202ndQuarter
            34.72
            38.05
            0.201stQuarter
            33.28
            37.61
            0.182005
            4thQuarter
            $31.59
            $35.31
            $0.183rdQuarter
            30.27
            35.56
            0.182ndQuarter
            29.61
            33.77
            0.181stQuarter
            32.37
            35.24
            0.17








**Table
          of Contents**


The
      Company intends to continue to pay dividends on a quarterly basis subject to,
      among other things, the financial condition and earnings of the Company, capital
      requirements, and other factors, including applicable governmental regulations.
      No dividends will be payable unless declared by the Board of Directors and
      then
      only to the extent funds are legally available for the payment of such
      dividends.





On
      March
      1, 2007, the closing sales price of the common stock on the Nasdaq National
      Market was $31.37 per share. As of such date, there were approximately 1,100
      holders of record of the Company common stock.





The
      following table sets forth, for the periods indicated, information regarding
      stock repurchases:


Period
              Total
                  Number of Shares Purchased
              Average
                  Price Paid per Share
              Total
                  Number of Shares Purchased as Part of Publicly Announced
                  Program
              Maximum
                  Number of Shares that May Yet Be Purchased Under the Plan(1)October
                  1, 2006 to October 31, 2006
              -
              -
              -
              75,515November
                  1, 2006 to November 30, 2006
              -
              -
              -
              75,515December
                  1, 2006 to December 31, 2006
              -
              -
              -
              75,515Total
              -
              -
              -




(1) On
      July
      26, 1999, the Board of Directors authorized the repurchase of up to 175,000
      shares of common stock for use in the company’s common stock repurchase program.
      Under this repurchase program, the Company will repurchase shares on the open
      market or in private transactions from time to time, depending on market
      conditions. The repurchase program does not have an expiration
      date.





The
      following graph compares the cumulative total stockholder return on Northway’s
      common stock (assuming $100 was invested on September 30, 1997, the date when
      Northway’s common stock became publicly traded, and all dividends were
      reinvested) against (i) the cumulative total return of the S&P Composite 500
      Stock Index, and (ii) the NASDAQ Bank Stock Index.





12/31/02
            
            12/31/03
            
            12/31/04
            
            12/31/05
            
            12/31/06NWFI
            
            $
            115.50
            
            $
            129.67
            
            $
            129.16
            
            $
            131.97
            
            $
            131.65S&P
                500
            
            
            90.66
            
            
            114.58
            
            
            124.88
            
            
            128.63
            
            
            146.15NASDAQ
                Bank Stocks
            
            
            107.11
            
            
            139.17
            
            
            154.47
            
            
            147.77
            
            
            164.04





**Table
          of
          Contents**


ITEM
      6. SELECTED FINANCIAL DATA





The
      following table sets forth the selected consolidated financial information
      of
      the Company for the five years in the period ended December 31, 2006. This
      selected consolidated financial information should be read in conjunction with
      “Management’s Discussion and Analysis of Financial Condition and Results of
      Operations” appearing under Item 7 of this report and “Financial Statements and
      Supplementary Data” appearing under Item 8 of this report.





At
                or for the years ended December 31,
            
            2006
            
            2005
            
            2004
            
            2003
            
            2002($000
                Omitted, except per share data)*Balance
                Sheet Data:*Total
                assets
            
            $
            650,877
            
            $
            632,734
            
            $
            638,418
            
            $
            609,216
            
            $
            598,945Securities
                available-for-sale, at fair value
            
            
            127,789
            
            
            103,244
            
            
            101,133
            
            
            68,082
            
            
            87,776Loans,
                net of unearned income
            
            
            462,230
            
            
            460,373
            
            
            474,706
            
            
            473,619
            
            
            445,773Allowance
                for loan losses
            
            
            5,581
            
            
            5,150
            
            
            5,204
            
            
            5,036
            
            
            4,920Other
                real estate owned
            
            
            -
            
            
            196
            
            
            -
            
            
            175
            
            
            22Goodwill
            
            
            10,577
            
            
            10,152
            
            
            10,152
            
            
            10,152
            
            
            10,152Core
                deposit intangibles, net
            
            
            2,178
            
            
            1,995
            
            
            2,949
            
            
            3,903
            
            
            4,857Deposits
            
            
            484,677
            
            
            464,456
            
            
            475,359
            
            
            463,307
            
            
            476,194Long-term
                debt
            
            
            73,620
            
            
            105,620
            
            
            98,620
            
            
            87,620
            
            
            66,620Stockholders’
                equity
            
            
            52,149
            
            
            50,250
            
            
            49,510
            
            
            47,872
            
            
            44,266*Income
                Statement Data:*Net
                interest and dividend income
            
            $
            22,202
            
            $
            23,176
            
            $
            22,846
            
            $
            23,050
            
            $
            21,664Provision
                for loan losses
            
            
            465
            
            
            75
            
            
            495
            
            
            805
            
            
            900Noninterest
                income
            
            
            5,871
            
            
            3,996
            
            
            5,097
            
            
            5,375
            
            
            3,396Noninterest
                expense
            
            
            23,741
            
            
            23,582
            
            
            22,394
            
            
            22,136
            
            
            20,035Net
                income
            
            
            3,215
            
            
            2,673
            
            
            3,388
            
            
            3,617
            
            
            2,598*Per
                Common Share Data:*Net
                income - basic
            
            $
            2.15
            
            $
            1.78
            
            $
            2.26
            
            $
            2.40
            
            $
            1.71Net
                income - assuming dilution
            
            
            2.14
            
            
            1.77
            
            
            2.24
            
            
            2.39
            
            
            1.71Cash
                dividends declared
            
            
            0.78
            
            
            0.71
            
            
            0.68
            
            
            0.68
            
            
            0.68Book
                value
            
            
            34.97
            
            
            33.70
            
            
            32.93
            
            
            31.92
            
            
            29.19Tangible
                book value
            
            
            26.28
            
            
            25.39
            
            
            24.02
            
            
            22.30
            
            
            19.07*Selected
                Ratios:*Return
                on average assets
            
            
            0.51
            %
            
            0.43
            %
            
            0.54
            %
            
            0.59
            %
            
            0.49
            %Return
                on average equity
            
            
            6.24
            
            
            5.33
            
            
            6.97
            
            
            7.82
            
            
            5.86Dividend
                payout
            
            
            36.21
            
            
            39.96
            
            
            30.10
            
            
            28.28
            
            
            39.65Average
                equity to average assets
            
            
            8.12
            
            
            7.99
            
            
            7.75
            
            
            7.61
            
            
            8.33


**Table
          of
          Contents**


ITEM
      7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
      AND RESULTS OF OPERATIONS





The
      purpose of this discussion is to focus on significant changes in the financial
      condition and results of operations of the Company. It is intended to supplement
      and highlight information contained in the accompanying consolidated financial
      statements and the selected financial data presented elsewhere in this report.
      The discussion set forth below contains certain statements that may be
      considered “forward-looking statements.” Forward-looking statements involve
      risks, uncertainties and other factors that may cause the Company’s actual
      results to materially differ from those projected in the forwarding-looking
      statements. For further information regarding forward-looking statements, you
      should review the discussion under the caption “FORWARD-LOOKING STATEMENTS” on
      page 1 of this report.








**OVERVIEW
      OF PERFORMANCE**





The
      Company derives substantially all of its revenue and income from community
      bank-related activities. The Bank operates as a typical community banking
      institution and does not engage in any specialized finance or capital markets
      activities. Northway functions primarily as the holder of stock of its
      subsidiary and assists in the management of the operations of its subsidiary
      as
      appropriate.





The
      principal components of the Company’s income sources are net interest and
      dividend income. Net interest and dividend income is the difference between
      interest, dividends and fee income received on interest earning assets, such
      as
      loans and investments, and the interest expense paid on interest bearing
      liabilities, such as deposits and borrowed funds. Our other sources of income
      include revenues from sales of securities, deposit account service fees and
      fee-based services, such as debit card fees, ATM fees and alternative investment
      income.





Economic
      and industry factors that could cause the Company’s financial performance to
      differ from expected results include changes in applicable federal and state
      regulations, changes in the hospitality industry on which the Company’s business
      is largely dependent, interest rate volatility, significant changes in loan
      losses which may affect the Company’s allowance for loan losses and the related
      provision for loan losses, and changes in the securities market that would
      affect the performance of the Company’s investment portfolio. Management
      evaluates each of these factors on an ongoing basis to determine their impact
      and to effect any strategies necessary to mitigate these risks.





The
      Company reported net income of $3,215,000, or $2.15 basic earnings per common
      share, in 2006 compared to net income of $2,673,000, or $1.78 basic earnings
      per
      common share, in 2005 and $3,388,000, or $2.26 basic earnings per common share,
      in 2004. Return on average equity was 6.24% in 2006, compared to 5.33% in 2005
      and 6.97% in 2004. Return on average assets was 0.51% in 2006, compared to
      0.43%
      in 2005 and 0.54% in 2004.




On
      April
      7, 2006, the Company acquired from Washington Mutual Bank the former Providian
      National Bank branches located in Tilton and Belmont, New Hampshire. This
      transaction included the purchase of approximately $8,192,000 in loan balances,
      net of discount, and the acquisition of deposits, net of deposit assumption
      premium, totaling approximately $27,779,000, for which the Company paid a
      deposit assumption premium of 6.30%. See NOTE 11 to the Consolidated Financial
      Statements.





During
      2006, the Company recorded a decrease in net interest and dividend income of
      $974,000, as an increase in the cost of interest bearing liabilities of 0.92%
      was only partially offset by an increase in the yield on earning assets of
      0.65%
      and an increase in average earning assets of $9,026,000. During 2006, interest
      income increased $3,863,000 due primarily to an improvement in the yield on
      loans as well as an increase in both the yield and average balances of
      investments. Interest expense increased $4,837,000 due primarily to an increase
      in interest bearing liabilities of $10,079,000 as well as a shift in liabilities
      from savings and NOW accounts, a less expensive source of funds, into
      certificates of deposits and securities sold under agreements to repurchase,
      more costly sources of funds. The provision for loan losses increased $390,000
      as the total provision for 2006 was $465,000 compared to $75,000 for 2005.
      The
      increase in the provision for loan losses was the result of the ongoing review
      of the adequacy of the allowance for loan losses. Noninterest income, excluding
      securities gains, increased $930,000 from last year due primarily to an increase
      in overdraft income, debit card fees and one-time favorable items relating
      to
      the resolution of a significant loan relationship workout as well as unwind
      fee
      income from a FHLBB symmetrical advance. During 2006, the Company realized
      net
      securities gains of $394,000 compared to net securities losses of $551,000
      for
      the prior year. The 2005 net losses were the result of the restructuring of
      the
      investment portfolio as well as the sale of corporate bonds at a loss of
      $499,000. Noninterest expense increased $159,000 over the prior year.


**Table
          of Contents**




During
      2005, the Company recorded an increase in net interest and dividend income
      of
      $330,000, as an increase in the average yield on earning assets of 0.33% and
      an
      increase in average earning assets of $2,079,000 was only partially offset
      by an
      increase in the cost of interest bearing liabilities of 0.31%. During 2005,
      interest income increased $1,827,000 due primarily to an improvement in the
      yield on loans as well as an increase in investment balances. Partially
      offsetting this, interest expense increased $1,497,000 as money market and
      certificates of deposit rates increased, keeping pace with the rise in interest
      rates. The Company recorded a reduction in the provision for loan losses of
      $420,000 as the total provision for 2005 was $75,000 compared to $495,000 for
      2004. The decrease in the provision for loan losses was the result of an ongoing
      review of the adequacy of the allowance for loan losses. Noninterest income,
      excluding securities gains, increased $203,000 from last year due primarily
      to
      improvements in overdraft income, commissions on alternative investments and
      debit card fees, which was partially offset by decreases in gains on sales
      of
      loans and loan fees. During 2005, the Company realized net securities losses
      totaling $551,000 compared to net securities gains of $753,000 for the prior
      year. These net losses in 2005 were the result of the restructuring of the
      investment portfolio as well as the sale of corporate bonds at a loss of
      $499,000. Noninterest expense increased $1,188,000 due primarily to one-time
      costs of $1,161,000 associated with the merger of the two banks.








**NET
      INTEREST AND DIVIDEND INCOME ANALYSIS**





Fluctuations
      in interest rates as well as changes in volume and mix of income earning assets
      and interest bearing liabilities can materially impact net interest and dividend
      income, the principal source of our income. The discussion of net interest
      and
      dividend income is presented on a taxable equivalent basis, unless otherwise
      noted, to facilitate performance comparisons among various taxable and
      tax-exempt assets.





The
      table
      below under the caption “Consolidated Average Balances, Interest and Dividend
      Income/Expense and Average Yields/Rates,” presents the average balances, income
      earned or interest paid, and average yields earned or rates paid on the
      Company’s assets and liabilities for the years ended December 31, 2006, 2005,
      and 2004.





Net
      interest and dividend income for 2006 decreased $487,000, or 2%, compared to
      2005. Interest and dividend income increased $4,350,000, or 13%, in 2006
      compared to 2005. Rising interest rates and a shift in the loan mix resulted
      in
      an improvement on the yield on loans of 0.65%. Further the average balance
      on
      investments increased $14,266,000 and the yield on investments increased 0.66%
      resulting in an improvement in investment income of $1,419,000.





The
      increase in interest income was more than offset by an increase in interest
      expense of $4,837,000, or 54%, in 2006 compared to 2005. Interest expense
      increased due primarily to an increase in the cost of interest bearing
      liabilities of 0.92%. This increase was the result of an increase in rates
      paid
      on money market accounts, certificates of deposit, securities sold under
      agreements to repurchase, FHLB advances and junior subordinated debentures.
      These rates increased as a result of the increase in interest rates during
      2006.
      Further, the Company experienced a shift in liabilities from lower costing
      savings and NOW accounts into money markets, certificates of deposit and
      securities sold under agreements to repurchase, more expensive sources of funds.





Net
      interest and dividend income for 2005 increased $489,000, or 2%, compared to
      2004. Interest and dividend income increased $1,986,000, or 7%, in 2005 compared
      to 2004. Rising interest rates resulted in an improvement in the yield on loans
      of 0.42% which was partially offset by a decline in average balances of
      $19,824,000, resulting in an increase in interest and fees on loans of $821,000.
      Further, the average balance of investments increased $23,097,000 resulting
      in
      an improvement in investment income of $966,000.





In
      2005
      the increase in interest income was partially offset by an increase in interest
      expense of $1,497,000, or 20%, in 2005 compared to 2004. Interest expense
      increased due primarily to an increase in the cost of interest bearing
      liabilities of 0.31%. This increase was the result of an increase in rates
      paid
      on money market accounts, certificates of deposit, securities sold under
      agreements to repurchase, and junior subordinated debentures. These rates
      increased as a result of the increase in general interest rates during 2005.





The
      trend
      in net interest and dividend income is commonly evaluated in terms of average
      rates using net interest margin and interest rate spread. The net interest
      margin is computed by dividing fully taxable equivalent net interest and
      dividend income by average total earning assets. This ratio represents the
      difference between the average yield returned on average earning assets and
      the
      average rate paid for all funds used to support those earning assets, including
      both interest bearing and noninterest bearing sources of funds. The net interest
      margin decreased 0.14% to 3.92% in 2006 after having increased 0.07% to 4.06%
      in
      2005. The decrease in the net interest margin for 2006 was a direct result
      of
      the increase in the cost of interest bearing liabilities, which increase was
      only partially offset by an increase in the yield on earning assets. The
      increase in the net interest margin for 2005 was a direct result of the increase
      in the yield on earning assets, which increase was only partially offset by
      the
      increase in the cost of funds.




The
      interest rate spread measures the difference between the average yield on
      earning assets and the average rate paid on interest bearing liabilities. The
      interest rate spread eliminates the impact of noninterest bearing funds and
      gives a direct perspective on the effect of interest rate fluctuations. During
      2006, the net interest rate spread decreased 0.27% to 3.53% as the cost of
      interest bearing liabilities increased 0.92% and was only partially offset
      by an
      increase in the yield on earning assets of 0.65% During 2005, the net interest
      rate spread increased 0.02% to 3.80% as the yield on earning assets increased
      0.33% and was only partially offset by an increase in the cost of interest
      bearing liabilities of 0.31%.





See
      the
      tables below under the captions “Consolidated Average Balances, Interest and
      Dividend Income/Expense and Average Yields/Rates” and “Consolidated Rate/Volume
      Variance Analysis” for more information.








**Table
          of Contents**


**PROVISION
      FOR LOAN LOSSES**





The
      provision for loan losses represents the annual cost of providing an allowance
      for losses inherent in the loan portfolio. The size of the provision for each
      year is determined by management based upon many factors, including loan growth,
      net charge-offs, changes in the composition of the loan portfolio,
      delinquencies, management’s assessment of loan portfolio quality, the value of
      collateral and general economic factors.




The
      provision for loan losses was $465,000 in 2006, an increase of $390,000 from
      the
      provision recorded in 2005. The provision for loan losses was $75,000 in 2005,
      a
      decrease of $420,000 from the provision recorded in 2004. The provision for
      each
      of the three years was based upon a review of the adequacy of the allowance
      for
      loan losses, which is conducted on a quarterly basis. This review is based
      upon
      many factors, including the risk characteristics of the portfolio, trends in
      loan delinquencies, and an assessment of existing economic conditions. In
      addition, various regulatory agencies, as part of their examination process,
      review the Company’s allowances for loan losses and such review may result in
      changes to the allowance based on judgments different from those of management.





The
      increase in the 2006 provision was due in large part to an increase in
      commercial loans, especially large hospitality loans, which require a higher
      risk weighting in the allowance for loan loss calculation. The decrease in
      the
      2005 provision was due in part to a reduction in average loans of $19,824,000,
      which was primarily the result of a decrease in average indirect installment
      loans which declined $53,234,000.





Although
      management utilizes its best judgment in providing for losses, there can be
      no
      assurance that the Company will not have to change its provision for loan losses
      in subsequent periods. Management will continue to monitor the allowance for
      loan losses and modify the provision to the allowance for loan losses as
      appropriate. For additional information regarding estimates in the assessment
      of
      the allowance for loan losses see “Application of Critical Accounting Policies”
below.


**Table
          of
          Contents**


**CONSOLIDATED
      AVERAGE BALANCES, INTEREST AND DIVIDEND INCOME/EXPENSE**


**AND
      AVERAGE YIELDS/RATES**


($000
      Omitted)


For
      the
      Year Ended December 31,





2006
            
            2005
            
            2004Average
              Balance
            
            Income/
              Expense
            
            Average
              Yield/
              Rate
            
            Average
              Balance
            
            Income/
              Expense
            
            Average
              Yield/
              Rate
            
            Average
              Balance
            
            Income/
              Expense
            
            Average
              Yield/
              RateAssetsInterest
                earning assets:Federal
                funds sold
            
            $
            4,151
            
            $
            200
            
            
            4.82
            %
            $
            9,383
            
            $
            322
            
            
            3.43
            %
            $
            10,564
            
            $
            125
            
            
            1.18
            %Interest
                bearing deposits
            
            
            198
            
            
            8
            
            
            4.04
            
            
            130
            
            
            3
            
            
            2.31
            
            
            143
            
            
            1
            
            
            0.70Securities
                (1) (2)
            
            
            123,599
            
            
            6,069
            
            
            4.91
            
            
            109,333
            
            
            4,650
            
            
            4.25
            
            
            86,236
            
            
            3,684
            
            
            4.27Loans,
                net (3) (4)
            
            
            463,965
            
            
            30,690
            
            
            6.61
            
            
            464,041
            
            
            27,642
            
            
            5.96
            
            
            483,865
            
            
            26,821
            
            
            5.54Total
                interest earning assets (5)
            
            
            591,913
            
            
            36,967
            
            
            6.25
            
            
            582,887
            
            
            32,617
            
            
            5.60
            
            
            580,808
            
            
            30,631
            
            
            5.27Cash
                and due from banks
            
            
            13,008
            
            
            
            
            
            
            
            
            14,942
            
            
            
            
            
            
            
            
            15,637Allowance
                for loan losses
            
            
            (5,341
            )
            
            
            
            
            
            
            
            (5,254
            )
            
            
            
            
            
            
            
            (5,104
            )Premises
                and equipment, net
            
            
            12,934
            
            
            
            
            
            
            
            
            13,453
            
            
            
            
            
            
            
            
            13,444Other
                assets
            
            
            22,071
            
            
            
            
            
            
            
            
            21,750
            
            
            
            
            
            
            
            
            22,574Total
                assets
            
            $
            634,585
            
            
            
            
            
            
            
            $
            627,778
            
            
            
            
            
            
            
            $
            627,359LiabilitiesInterest
                bearing liabilities:Regular
                savings
            
            $
            69,304
            
            
            178
            
            
            0.26
            
            $
            81,534
            
            
            201
            
            
            0.25
            
            $
            85,319
            
            
            220
            
            
            0.26NOW
                and super NOW
            
            
            85,785
            
            
            279
            
            
            0.33
            
            
            96,713
            
            
            356
            
            
            0.37
            
            
            97,170
            
            
            334
            
            
            0.34Money
                market accounts
            
            
            67,986
            
            
            1,701
            
            
            2.50
            
            
            68,398
            
            
            767
            
            
            1.12
            
            
            65,286
            
            
            460
            
            
            0.70Certificates
                of deposit
            
            
            173,706
            
            
            6,207
            
            
            3.57
            
            
            135,751
            
            
            2,769
            
            
            2.04
            
            
            140,614
            
            
            2,136
            
            
            1.52Securities
                sold under agreements to repurchase
            
            
            22,559
            
            
            672
            
            
            2.98
            
            
            8,836
            
            
            183
            
            
            2.07
            
            
            8,611
            
            
            87
            
            
            1.01FHLB
                advances
            
            
            66,408
            
            
            2,896
            
            
            4.36
            
            
            84,437
            
            
            3,189
            
            
            3.78
            
            
            80,744
            
            
            3,115
            
            
            3.86Junior
                subordinated debentures
            
            
            20,620
            
            
            1,832
            
            
            8.88
            
            
            20,620
            
            
            1,463
            
            
            7.10
            
            
            20,620
            
            
            1,079
            
            
            5.23Total
                interest bearing liabilities
            
            
            506,368
            
            
            13,765
            
            
            2.72
            
            
            496,289
            
            
            8,928
            
            
            1.80
            
            
            498,364
            
            
            7,431
            
            
            1.49Noninterest
                bearing deposits
            
            
            72,883
            
            
            
            
            
            
            
            
            77,845
            
            
            
            
            
            
            
            
            76,915Other
                liabilities
            
            
            3,775
            
            
            
            
            
            
            
            
            3,466
            
            
            
            
            
            
            
            
            3,475Total
                liabilities
            
            
            583,026
            
            
            
            
            
            
            
            
            577,600
            
            
            
            
            
            
            
            
            578,754Stockholders'
                equity
            
            
            51,559
            
            
            
            
            
            
            
            
            50,178
            
            
            
            
            
            
            
            
            48,605Total
                liabilities and stockholders' equity
            
            $
            634,585
            
            
            
            
            
            
            
            $
            627,778
            
            
            
            
            
            
            
            $
            627,359Net
                interest and dividend income (6)
            
            
            
            
            $
            23,202
            
            
            
            
            
            
            
            $
            23,689
            
            
            
            
            
            
            
            $
            23,200Interest
                rate spread (7)
            
            
            
            
            
            
            
            
            3.53
            %
            
            
            
            
            
            
            
            3.80
            %
            
            
            
            
            
            
            
            3.78
            %Net
                interest margin (8)
            
            
            
            
            
            
            
            
            3.92
            %
            
            
            
            
            
            
            
            4.06
            %
            
            
            
            
            
            
            
            3.99
            %





(1)
            Reported
                on a tax equivalent basis. Reported interest on securities of $5,432,000,
                $4,465,000 and $3,582,000 was adjusted by $637,000, $185,000 and
                $102,000,
                for 2006, 2005 and 2004, respectively, to reflect the tax equivalent
                adjustment.


(2)
            Average
                balances are calculated using the adjusted cost
                basis.


(3)
            Reported
                on a tax equivalent basis. Reported interest and fees on loans of
                $30,327,000, $27,314,000 and $26,569,000 was adjusted by $364,000,
                $328,000 and $252,000 for 2006, 2005 and 2004, respectively, to reflect
                the tax equivalent adjustment.


(4)
            Net
                of unamortized cost/unearned income. Includes loans held for sale
                and
                nonperforming loans.


(5)
            Reported
                on a tax equivalent basis. Reported interest and dividend income
                of
                $35,967,000, $32,104,000 and $30,277,000 was adjusted by $1,000,000,
                $513,000 and $354,000 for 2006, 2005 and 2004, respectively, to reflect
                the tax equivalent adjustment.


(6)
            Reported
                on a tax equivalent basis. Reported net interest and dividend income
                of
                $22,202,000, $23,176,000 and $22,846,000 was adjusted by $1,000,000,
                $513,000 and $354,000 for 2006, 2005 and 2004, respectively, to reflect
                the tax equivalent adjustment.


(7)
            Interest
                rate spread equals the yield on interest earning assets minus the
                rate
                paid on interest bearing
                liabilities.


(8)
            The
                net interest margin equals net interest and dividend income divided
                by
                total average interest earning
                assets.


**Table
          of
          Contents**


**CONSOLIDATED
      RATE/VOLUME VARIANCE ANALYSIS** **(1)**





($000
                Omitted)2006
                Compared to 2005
              Increase
                (Decrease) Due to Change in
            2005
                Compared to 2004
              Increase
                (Decrease) Due to Change inVolume
            
            
            Rate
            
            
            Mix
            
            
            Total
            
            
            Volume
            
            
            Rate
            
            
            Mix
            
            
            TotalInterest
                and dividend income:Federal
                funds sold
            
            $
            (180
            )
            $
            130
            
            $
            (72
            )
            $
            (122
            )
            $
            (14
            )
            $
            238
            
            $
            (27
            )
            $
            197Interest
                bearing deposits
            
            
            2
            
            
            2
            
            
            1
            
            
            5
            
            
            -
            
            
            2
            
            
            -
            
            
            2Securities
            
            
            607
            
            
            718
            
            
            94
            
            
            1,419
            
            
            987
            
            
            (16
            )
            
            (5
            )
            
            966Loans,
                net
            
            
            (5
            )
            
            3,053
            
            
            -
            
            
            3,048
            
            
            (1,099
            )
            
            2,002
            
            
            (82
            )
            
            821Total
                interest and dividend income
            
            
            424
            
            
            3,903
            
            
            23
            
            
            4,350
            
            
            (126
            )
            
            2,226
            
            
            (114
            )
            
            1,986Interest
                expense:Regular
                savings
            
            
            (30
            )
            
            8
            
            
            (1
            )
            
            (23
            )
            
            (10
            )
            
            (9
            )
            
            -
            
            
            (19
            )NOW
                and super NOW
            
            
            (40
            )
            
            (42
            )
            
            5
            
            
            (77
            )
            
            (2
            )
            
            24
            
            
            -
            
            
            22Money
                market accounts
            
            
            (5
            )
            
            945
            
            
            (6
            )
            
            934
            
            
            22
            
            
            272
            
            
            13
            
            
            307Certificates
                of deposit
            
            
            774
            
            
            2,082
            
            
            582
            
            
            3,438
            
            
            (74
            )
            
            732
            
            
            (25
            )
            
            633Securities
                sold under agreements to repurchase
            
            
            284
            
            
            80
            
            
            125
            
            
            489
            
            
            2
            
            
            91
            
            
            3
            
            
            96FHLB
                advances
            
            
            (681
            )
            
            493
            
            
            (105
            )
            
            (293
            )
            
            143
            
            
            (66
            )
            
            (3
            )
            
            74Junior
                subordinated debentures
            
            
            -
            
            
            369
            
            
            -
            
            
            369
            
            
            -
            
            
            384
            
            
            -
            
            
            384Total
                interest expense
            
            
            302
            
            
            3,935
            
            
            600
            
            
            4,837
            
            
            81
            
            
            1,428
            
            
            (12
            )
            
            1,497Net
                interest and dividend income
            
            $
            122
            
            $
            (32
            )
            $
            (577
            )
            $
            (487
            )
            $
            (207
            )
            $
            798
            
            $
            (102
            )
            $
            489





(1)
            Reported
                on a tax equivalent basis.





**NONINTEREST
      INCOME**





Noninterest
      income consists of revenues generated from a broad range of financial services
      and activities, including fee-based services and income earned through
      securities sales.





The
      following table sets forth the components of the Company’s noninterest
      income:





($000
                Omitted)
              Years
                Ended December 31,2006
            
            
            2005
            
            
            2004Service
                charges and fees on deposit accounts
            
            $
            2,837
            
            $
            2,430
            
            $
            2,229Gain
                (loss) on sales of securities available-for-sale, net
            
            
            394
            
            
            (551
            )
            
            753Debit
                card fees
            
            
            557
            
            
            456
            
            
            372Gain
                on sales of loans, net
            
            
            137
            
            
            260
            
            
            374Other
            
            
            1,946
            
            
            1,401
            
            
            1,369Total
                noninterest income
            
            $
            5,871
            
            $
            3,996
            
            $
            5,097





Fee
      income from service charges and fees on deposit accounts increased 17% in 2006,
      9% in 2005 and 33% in 2004. The improvement in 2006 was due primarily to an
      increase in overdraft income due to a 20% increase in the insufficient funds
      (“NSF”) per item fees in May 2006 as well as the impact of the two branches
      acquired April 7, 2006. The improvement in 2005 was due primarily to an increase
      in overdraft income due to the full year impact of the introduction of Bounce
      ProtectionTM, an overdraft privilege program, in April 2004. The improvement in
      2004 was due principally to increases in the per item insufficient fund fee
      as
      the Company introduced new fee schedules in December 2003. In addition, 2004
      overdraft income was positively impacted by the introduction of Bounce
      ProtectionTM.


**Table
          of
          Contents**


During
      2006, the Company recognized a net gain on sales of securities of $394,000
      compared to a net loss on sales of securities of $551,000 in 2005 and a net
      gain
      on sales of securities of $753,000 in 2004. Securities gains in 2006 were
      primarily the result of an improved equity market in 2006. Securities losses
      in
      2005 were primarily due to the restructuring of the investment portfolio, which
      resulted in the sale of U.S. Government Agency bonds at a loss, as well as
      the
      sale of corporate bonds at a loss of $499,000. Securities gains in 2004 were
      the
      result of improved market conditions for investment securities. Securities
      gains, net, in 2006 included $440,000 of net gains on sales of equity securities
      compared to $117,000 and $253,000 in 2005 and 2004, respectively. Net losses
      on
      the sales of debt securities totaled $46,000 in 2006 compared to net losses
      of
      $668,000 in 2005 and net gains of $500,000 in 2004.





Debit
      card fees were $557,000 in 2006 compared to $456,000 in 2005 and $372,000 in
      2004. The $101,000 increase in debit card fees in 2006 and $84,000 in 2005
      reflects the increase in debit card usage over the past several
      years.





Gains
      on
      sales of loans, net, decreased $123,000 in 2006 compared to 2005 as gains on
      sales of mortgage loans declined $52,000 to $77,000 and the Company recorded
      no
      gain on the sale of commercial loans in 2006 compared to $68,000 in 2005. Gains
      on sales of loans, net, decreased $114,000 in 2005 compared to 2004. Gains
      on
      sales of mortgage loans remained relatively unchanged at $112,000 from the
      prior
      year. Gains on sales of commercial loans declined $109,000 during 2004 as the
      Company sold a portfolio of commercial loans guaranteed by the Small Business
      Administration for a gain of $178,000. Gains on sales of loans, net, decreased
      $48,000 in 2004 compared to 2003. Gains on sales of mortgage loans decreased
      $228,000 as the Company opted to retain a greater portion of fixed rate
      mortgages in portfolio in 2004 compared to 2003. This was partially offset
      by
      the Company’s sale of a portfolio of commercial loans guaranteed by the Small
      Business Administration for a gain of $178,000 in 2004.





Other
      noninterest income (sources of which include credit card merchant income, ATM
      fees, loan fees, safe deposit fees and commissions on alternative investment
      products) increased $545,000, or 39%, to $1,946,000 in 2006 following an
      increase of $32,000, or 2%, to $1,401,000 in 2005 and a decrease of $72,000,
      or
      5%, to $1,369,000 in 2004. The increase in 2006 was due primarily to an increase
      in income from alternative investment products, an increase in the valuation
      of
      the cash surrender value of a company-owned life insurance and several one-time
      favorable items relating to the recapture of prior years’ interest and expenses
      on the payoff of a large commercial loan workout totaling $100,000, gains on
      sale of OREO property of $86,000 as well as an unwind fee of $84,000 from the
      redemption of a FHLBB symmetrical advance. The increase in 2005 was due
      primarily to an increase in income from alternative investments products as
      well
      as an increase in debit card income. The decrease in 2004 compared to 2003
      was
      due primarily to the recognition of approximately $191,000 in other loan fees
      resulting from transactions with Federal Home Loan Mortgage Corporation
      (“FHLMC”). This decrease was partially offset by the introduction of alternative
      investment products offered by the Company, which increased fee income by
      approximately $126,000.





**NONINTEREST
      EXPENSE**





Total
      noninterest expense increased $159,000, or 1%, during 2006 following an increase
      of $1,188,000, or 5%, during 2005 and an increase $258,000, or 1%, during 2004.
      During 2006, noninterest expense was impacted by the expenses associated with
      the acquisition of the two branches in April 2006 as well as increased fees
      paid
      to our outsourced marketing firm. The increase in expenses during 2005 is due
      primarily to one-time expenses of $1,161,000 resulting from the merger of the
      Company’s two subsidiary banks. The increase in expenses during 2004 was due
      primarily to an increase in salaries and employee benefits.





The
      following table sets forth information relating to the Company's noninterest
      expense during the periods indicated:





($000
                Omitted)
              Years
                Ended December 31,2006
            
            
            2005
            
            
            2004Salaries
                and employee benefits
            
            $
            12,252
            
            $
            11,633
            
            $
            12,058Office
                occupancy and equipment
            
            
            4,190
            
            
            4,282
            
            
            3,873Amortization
                of core deposit intangibles
            
            
            1,051
            
            
            954
            
            
            954Professional
                fees
            
            
            1,026
            
            
            1,179
            
            
            907Marketing
            
            
            726
            
            
            757
            
            
            326Stationery
                and supplies
            
            
            365
            
            
            647
            
            
            429Telecommunications
            
            
            455
            
            
            619
            
            
            595Other
            
            
            3,676
            
            
            3,511
            
            
            3,252Total
                noninterest expense
            
            $
            23,741
            
            $
            23,582
            
            $
            22,394





The
      merger related expenses, which totaled $1,161,000 for 2005, consisted primarily
      of advertising expense of $386,000, stationery and supplies of $337,000,
      equipment expense of $141,000, professional fees of $83,000, legal fees of
      $81,000 and state transfer tax of $71,000. These one-time costs related to
      marketing the Northway brand, replacing all existing forms, replacing all
      existing signage, transfer of real estate, and all necessary legal and computer
      systems issues related to the merger. These expenses are included in the table
      above in the appropriate expense categories.





Salaries
      and employee benefits increased $619,000, or 5%, from 2005 to 2006 and decreased
      $425,000, or 4%, from 2004 to 2005. The increase in 2006 was attributable
      primarily to increases in health and dental insurance, pension expense and
      the
      Supplemental Employee Retirement Plan (“SERP ) as well as one-time separation
      expenses from the centralization of consumer lending. The decrease in 2005
      was
      due primarily to a focus on staffing levels, an increase in SFAS No. 91 credits
      associated with deferred loan origination costs, and a decrease in the expense
      related to the SERP. The increase in 2004 reflected staff additions in
      connection with the expansion of the retail franchise, increased lending
      activities and normal salary and wage increases. Also, during 2004, the Company
      recorded a liability to deferred compensation related to the SERP. Refer to
      NOTE
      15 to the Consolidated Financial Statements for a further discussion regarding
      the SERP.





**Table
          of Contents**


Office
      occupancy and equipment expense decreased $92,000 from 2005 to 2006. Further,
      2005 included one-time merger related expenses of $141,000. The primary reason
      for the decrease of $233,000, net of merger related expenses, was the decrease
      in occupancy depreciation expense, leases and property maintenance partially
      offset by an increase in equipment depreciation and maintenance expense. Office
      occupancy and equipment expenses increased $268,000, net of merger related
      expenses of $141,000, during 2005 compared to 2004. The increase in 2005 was
      due
      primarily to increases in building maintenance costs as well as one-time
      expenses associated with the write-down of leasehold improvements associated
      with the closure of two supermarket branch facilities.





The
      amortization of core deposit intangibles increased $97,000 from 2005 to 2006
      due
      to the core deposit intangibles amortization associated with the two branches
      acquired in April 2006. There was no change from 2004 to 2005.





Marketing
      expense increased $355,000, net of merger related expenses of $386,000, during
      2006 compared to 2005. During 2006, the Company expanded upon its relationship
      with an outsourced marketing firm, in connection with an effort to increase
      deposit balances. Telecommunications expenses decreased $164,000 from 2005
      to
      2006 due to a change in service providers.





**INCOME
      TAX EXPENSE**





The
      Company recognized $652,000, $842,000 and $1,666,000 in income tax expense
      for
      the years ended December 31, 2006, 2005 and 2004, respectively. The effective
      tax rate was 16.9% for 2006, 24.0% for 2005 and 33.0% for 2004. For additional
      information relating to income taxes, see NOTE 15 to the Consolidated Financial
      Statements.





**ASSETS**





Total
      assets increased $18,143,000, or 3%, to $650,877,000 at December 31, 2006
      compared to $632,734,000 at December 31, 2005. The following is a summary of
      significant balance sheet changes.





($000
                Omitted)
              December
                312006
            
            2005
            
            $
                Change
            
            %
                ChangeTotal
                assets
            
            $
            650,877
            
            $
            632,734
            
            $
            18,143
            
            
            2.9
            %Earning
                assets
            
            
            602,320
            
            
            582,558
            
            
            19,762
            
            
            3.4Federal
                funds sold
            
            
            8,755
            
            
            14,775
            
            
            (6,020
            )
            
            (40.7
            )Securities
                available-for-sale, at fair value(1)
            
            
            131,571
            
            
            108,785
            
            
            22,786
            
            
            21.0Loans,
                net of unamortized cost/unearned income
            
            
            462,230
            
            
            460,373
            
            
            1,857
            
            
            0.4Deposits
            
            
            484,677
            
            
            464,456
            
            
            20,221
            
            
            4.4Borrowings
            
            
            110,117
            
            
            114,983
            
            
            (4,866
            )
            
            (4.2
            )Stockholders’
                equity
            
            
            52,149
            
            
            50,250
            
            
            1,899
            
            
            3.8





(1)
            Includes
                Federal Home Loan Bank stock





The
      increase in earning assets of $19,762,000 was due primarily to an increase
      in
      securities available-for-sale partially offset by a decrease in federal funds
      sold. The increase in earning assets was accompanied by an increase in deposits
      which was partially offset by a decrease in borrowings.








**SECURITIES
      AVAILABLE-FOR-SALE**





The
      Company’s securities are classified into one of two categories based on
      management’s intent to hold the securities: (i) “held-to-maturity” securities,
      or (ii) securities “available-for-sale.” Securities designated to be
      held-to-maturity are reported at amortized cost. Securities classified as
      available-for-sale are required to be reported at fair value with unrealized
      gains and losses, net of taxes, excluded from earnings and shown separately
      as a
      component of stockholders’ equity. At December 31, 2006 and 2005 the Company had
      no securities designated as held-to-maturity.





The
      following table summarizes the Company's securities portfolio at December 31,
      2006 and 2005 showing amortized cost and fair value for each
      category:





($000
                Omitted)
              December
                31,2006
            
            2005Amortized
              Cost
            
            Fair
              Value
            
            Amortized
              Cost
            
            Fair
              ValueSecurities
                available-for-sale:U.S.
                Treasury and U.S. government agency securities
            
            $
            47,738
            
            $
            47,063
            
            $
            48,728
            
            $
            47,751Mortgage-backed
                securities
            
            
            40,905
            
            
            40,615
            
            
            24,704
            
            
            23,931Collateralized
                mortgage obligations
            
            
            6
            
            
            6
            
            
            8
            
            
            8Marketable
                equity securities
            
            
            3,364
            
            
            3,617
            
            
            2,695
            
            
            2,809Corporate
                bonds
            
            
            3,517
            
            
            3,522
            
            
            5,541
            
            
            5,569Asset
                backed securities
            
            
            4,974
            
            
            4,968
            
            
            -
            
            
            -State
                and political subdivision bonds and notes
            
            
            27,784
            
            
            27,998
            
            
            23,396
            
            
            23,176Total
                securities available-for-sale
            
            $
            128,288
            
            $
            127,789
            
            $
            105,072
            
            $
            103,244





**Table
          of Contents**


Total
      securities available-for-sale increased $24,545,000 during 2006 to $127,789,000
      as a result of the growth in funding sources. The Company purchased
      mortgage-backed securities, asset backed securities and state and political
      subdivision bonds and notes.





The
      net
      unrealized loss on securities available-for-sale was $499,000 at December 31,
      2006 compared to a net unrealized loss of $1,828,000 at December 31, 2005 due
      primarily to the continued level of low interest rates, which increases the
      value of our security holdings. At December 31, 2006, the net unrealized loss
      on
      debt securities was $752,000 and the net unrealized gain on marketable equity
      securities was $253,000. At December 31, 2005, the net unrealized loss on debt
      securities was $1,942,000 and the net unrealized gain on marketable equity
      securities was $114,000.





At
      December 31, 2006, the Company’s investment in equity securities totaled
      $3,617,000. This amount is net of a market value adjustment of $253,000, of
      which the full amount was reflected as a reduction in accumulated other
      comprehensive loss in stockholders’ equity.





The
      Company has a general policy of purchasing investment grade securities and
      U.S.
      government securities to minimize credit risk. All securities, however, carry
      interest rate risk, which affect their market values such that as market yields
      increase, the value of the Company's securities decline and vice versa.
      Additionally, mortgage-backed securities carry prepayment risk whereby expected
      yields may not be achieved due to the inability to reinvest proceeds from
      prepayment at comparable yields. Moreover, such mortgage-backed securities
      may
      not benefit from price appreciation in periods of declining rates to the same
      extent as the remainder of the portfolio.





A
      portion
      of the securities portfolio is pledged to secure public deposits, securities
      sold under agreements to repurchase, FHLB advances and treasury, tax and loan
      accounts. Refer to NOTE 3 to the Consolidated Financial Statements for a further
      discussion of pledging of securities.





**LOANS**





Gross
      loans increased $1,662,000, or 0.4%, to $461,951,000 at December 31, 2006
      compared to December 31, 2005. This increase was due primarily to an increase
      in
      commercial real estate, residential real estate, commercial and installment
      loans , which was partially offset by a decrease in indirect installment loans
      of $33,507,000. Gross loans decreased $14,523,000, or 3%, to $460,289,000 at
      December 31, 2005 compared to December 31, 2004. This decrease was due primarily
      to a decrease in indirect installment loans of $54,299,000, which was partially
      offset by increases in residential real estate, commercial real estate,
      construction loans and installment loans. The following table presents the
      composition of the loan portfolio as of December 31, 2006 and 2005:




($000 Omitted)2006
            
            
            Percent
              of
                Total
            
            
            2005
            
            
            Percent
              of
                TotalReal
                estate:Residential
            
            $
            167,172
            
            
            36.2
            %
            $
            158,729
            
            
            34.5
            %Commercial
            
            
            158,464
            
            
            34.3
            
            
            143,456
            
            
            31.1Construction
            
            
            10,700
            
            
            2.3
            
            
            13,241
            
            
            2.9Commercial
            
            
            33,569
            
            
            7.3
            
            
            27,349
            
            
            6.0Installment
            
            
            42,489
            
            
            9.2
            
            
            35,786
            
            
            7.8Indirect
                installment
            
            
            28,714
            
            
            6.2
            
            
            62,221
            
            
            13.5Other
            
            
            20,843
            
            
            4.5
            
            
            19,507
            
            
            4.2$
            461,951
            
            
            100.0
            %
            $
            460,289
            
            
            100.0
            %





During
      2006, the loan portfolio mix continued to shift as runoff from the indirect
      installment loan portfolio was redeployed into residential real estate,
      commercial real estate, commercial and installment loans. Further, during 2006
      the Company purchased loans totaling $8,192,000, net of discount, as part of
      the
      branch acquisition. These loans were comprised of commercial real estate,
      residential mortgage loans and consumer loans. Residential real estate loans
      increased to account for 36.2% of the portfolio from 34.5% at December 31,
      2005
      due in part to the decision to retain high credit quality fixed-rate mortgages
      in the portfolio rather than sell in the secondary market. Commercial real
      estate and construction loans now comprise 34.3% and 2.3%, respectively of
      total
      loans compared to 31.1% and 2.9%, respectively at December 31, 2005 due to
      the
      continued efforts of our seasoned commercial lenders. Installment loans comprise
      9.2% of the loan portfolio compared to 7.8% a year ago due primarily to an
      increase in fixed rate home improvement loans. Indirect installment loans,
      which
      originations were discontinued in August 2004, now comprise 6.2% of total loans
      compared to 13.5% at December 31, 2005.





Commercial
      real estate loans consist of loans secured by income producing and
      owner-occupied commercial real estate and commercial loans consist of loans
      that
      are either unsecured or are secured by inventories, receivables or other
      corporate assets, and some are additionally secured by a guarantee of the
      federal Small Business Administration. Commercial real estate and commercial
      loans increased by $21,228,000 in 2006 as compared to 2005. The Company
      continues to emphasize commercial real estate and commercial loans in order
      to
      enhance earnings and maintain the balance of its portfolio.





Residential
      real estate loans increased by $8,443,000, a 5% increase from 2005, compared to
      an increase of $11,396,000, or 8%, in 2005 compared to 2004. The Company
      originates both fixed-rate and adjustable-rate residential loans for its
      portfolio. Some fixed-rate residential loans are originated for sale to
      investors in the secondary market. The increase in residential real estate
      loans
      in 2006 resulted primarily from the Company’s decision to retain a greater
      percentage of fixed-rate residential mortgage loans.





During
      2006, installment loan balances increased $6,703,000, or 19%, from 2005,
      compared to an increase of $6,441,000, or 22%, in 2005 compared to 2004.
      Indirect installment loans decreased by $33,507,000, or 54%, in 2006 compared
      to
      a decrease of $54,299,000, or 47%, in 2005.





**Table
          of Contents**


**NONPERFORMING
      ASSETS**





Nonperforming
      assets were $3,714,000, or 0.57%, of total assets, at December 31, 2006 compared
      to $3,321,000, or 0.53% of total assets, at December 31, 2005, an increase
      of
      $393,000, or 12%. Nonperforming assets are comprised primarily of nonaccrual
      loans, other chattels owned and real estate acquired by foreclosure or a similar
      conveyance of title. The accrual of interest on a loan is discontinued when
      there is reasonable doubt as to its collectibility or whenever the payment
      of
      principal or interest is more than 90 days past due. However, there are loans
      within this nonaccrual classification that provide periodic payments, but which
      have a weakness with respect to the collateral securing the loan.





At
      December 31, 2006, nonaccrual loans totaled $3,698,000, or 0.80% of total loans,
      compared to $3,013,000, or 0.66% of total loans, in 2005. At December 31, 2006
      the Company had no other real estate owned compared to $196,000 at December
      31,
      2005 Other chattels owned decreased $96,000 to $16,000 at December 31, 2006
      compared to $112,000 at December 31, 2005.





At
      December 31, 2006, gross interest income that would have been recorded for
      the
      year had the loans been current in accordance with their original terms totaled
      approximately $393,000. During the year ended December 31, 2006, the Company
      recognized interest income on these non-accrual loans of $353,000.




**ALLOWANCE
      FOR LOAN LOSSES**





The
      Company maintains an allowance for loan losses to absorb losses inherent in
      the
      existing loan portfolio. When a loan, or portion thereof, is considered
      uncollectible, it is charged against the allowance. Recoveries of amounts
      previously charged-off are added to the allowance when collected. The adequacy
      of the allowance for loan losses is evaluated on a regular basis by management.
      Factors considered in evaluating the adequacy of the allowance include previous
      loss experience, current economic conditions and their effect on borrowers
      and
      the market area in general, and the performance of individual credits in
      relation to the contract terms. In addition various federal and state regulatory
      agencies, as an integral part of their examination process, periodically review
      the adequacy of the Company’s allowance for loan losses. For additional
      information regarding estimates in the assessment of the allowance for loan
      losses see “Application of Critical Accounting Policies-Allowance for Loan
      Losses” below.





The
      Company’s allowance for loan losses increased $431,000 from December 31, 2005 to
      $5,581,000, or 1.21% of total loans, at December 31, 2006.





The
      following table sets forth the activity of the allowance for loan losses for
      the
      periods indicated:





($000
                Omitted)
              Years
                Ended December 31,2006
            
            
            2005
            
            
            2004Beginning
                allowance
            
            $
            5,150
            
            $
            5,204
            
            $
            5,036Provision
                for loan losses
            
            
            465
            
            
            75
            
            
            495Loans
                charged-off
            
            
            (332
            )
            
            (415
            )
            
            (665
            )Recoveries
                on loans previously charged-off
            
            
            298
            
            
            286
            
            
            338Net
                charge-offs
            
            
            (34
            )
            
            (129
            )
            
            (327
            )Ending
                allowance
            
            $
            5,581
            
            $
            5,150
            
            $
            5,204Allowance
                as a percentage of loans outstanding
            
            
            1.21
            %
            
            1.12
            %
            
            1.10
            %Allowance
                as a percentage of nonperforming loans
            
            
            150.92
            
            
            170.93
            
            
            181.51Net
                charge-offs as a percentage of average loans
            
            
            0.01
            
            
            0.03
            
            
            0.07








**DEPOSITS**





Total
      deposits at December 31, 2006 were $484,677,000, an increase of $20,221,000,
      or
      4%, compared to $464,456,000 at December 31, 2005. The increase in deposits
      was
      due primarily to the deposits acquired, net of premium, of $29,438,000 in April
      2006. Certificates of deposit increased $46,610,000 and were partially offset
      by
      decreases in demand, savings, NOW and money market deposits of $26,389,000.





The
      following table sets forth the components of deposits for the periods
      indicated:





($000
                Omitted)
              December
                31,2006
            
            
            2005Demand
            
            $
            72,054
            
            $
            77,436Regular
                savings, NOWand
                money market
            
            
            217,682
            
            
            238,689Time
            
            
            194,941
            
            
            148,331Total
                deposits
            
            $
            484,677
            
            $
            464,456





At
      December 31, 2006, time deposits of $100,000 or more are scheduled to mature
      as
      follows:





($000
                Omitted)3
                months or less
            
            $
            17,084Over
                3 to 6 months
            
            
            24,461Over
                6 to 12 months
            
            
            13,054Over
                12 months
            
            
            1,077$
            55,676





**Table
          of
          Contents**





**BORROWINGS**





At
      December 31, 2006 short-term borrowings consisted of securities sold under
      agreements to repurchase of $36,497,000 compared to $9,363,000 for 2005.





Long-term
      debt in 2006 consists of FHLB term advances of $53,000,000 as well as
      $20,620,000 of junior subordinated debentures, compared to $85,000,000 of FHLB
      term advances and $20,620,000 of junior subordinated debentures in 2005. Two
      of
      the long-term term FHLB advances are callable quarterly with their next call
      dates in March and December 2007. The decrease in FHLB advances is the result
      of
      the maturity and redemption of $56,000,000 in advances partially offset by
      new
      advances totaling $24,000,000.





Junior
      subordinated debentures consist of two issues of floating rate trust preferred
      securities acquired during April and July 2002 in the amount of $7,217,000
      and
      $13,403,000, respectively, due in 2032. These trust preferred securities were
      offered for the purpose of providing capital to the subsidiary bank to ensure
      adequate capital following branch acquisitions and for general corporate
      purposes. As of December 31, 2006, of the $20,620,000 principal amount
      outstanding, $17,209,000 qualified as Tier 1 capital and $3,411,000 was
      allocated to Tier 2 capital.





See
      NOTES
      9 and 10 to the Consolidated Financial Statements for additional information
      regarding the Company’s borrowings.





The
      following table sets forth certain information concerning the Company’s
      borrowings at the dates indicated:





($000
                Omitted)
              December
                31,2006
            
            2005Short-term
                borrowings
            
            $
            36,497
            
            $
            9,363Long-term
                debt
            
            
            73,620
            
            
            105,620$
            110,117
            
            $
            114,983





At
      December 31, 2006, long-term debt is scheduled to mature as
      follows:


($000
                Omitted)Less
                than one year
            
            $
            13,000After
                one year through three years
            
            
            19,000After
                three year through five years
            
            
            7,000Over
                five years
            
            
            34,620$
            73,620








**OFF-BALANCE
      SHEET ARRANGEMENTS**





The
      Company is party to financial instruments with off-balance sheet risk in the
      normal course of business to meet the financing needs of its customers and
      to
      reduce its own exposure to fluctuations in interest rates. These financial
      instruments include commitments to originate loans and standby letters of
      credit. The instruments involve, to varying degrees, elements of credit and
      interest rate risk in excess of the amount recognized in the balance sheet.
      The
      amounts of those instruments reflect the extent of involvement the Company
      has
      in particular classes of financial instruments.





The
      Company’s exposure to credit loss in the event of nonperformance by the other
      party to the financial instrument for loan commitments and standby letters
      of
      credit is represented by the contractual amount of those instruments. The
      Company uses the same credit policies in making commitments and conditional
      obligations as it does for balance sheet instruments.





Financial
      instruments with off-balance sheet credit risk at December 31, 2006 and 2005
      totaled $92,220,000 and $81,970,000, respectively.





See
      NOTE
      17 to the Consolidated Financial Statements for additional information regarding
      off-balance sheet arrangements.


**Table
          of
          Contents**





**CAPITAL**





The
      Company's stockholders’ equity serves to support growth and provide depositors
      and other creditors protection against loss. Equity capital represents the
      stockholders’ investment in the Company. Management strives to maintain an
      optimal level of capital on which an attractive return to the stockholders
      will
      be realized over both the short-term and long-term, while serving depositors’
and creditors’ needs.





The
      Company must also observe the minimum requirements enforced by the federal
      banking regulators. There are three capital requirements that banks and bank
      holding companies must meet: Tier 1 capital, total capital (combination of
      Tier
      1 capital and Tier 2 capital), and leverage (Tier 1 capital to average assets)
      ratios. Tier 1 capital consists of stockholders’ equity, net of intangible
      assets as well as a portion of junior subordinated debentures. Tier 2 capital
      consists of a limited amount of allowance for loan losses and the portion of
      junior subordinated debentures not allocated to Tier 1 capital. Tier 1 capital,
      total capital and leverage ratios do not include any adjustments for unrealized
      gains and losses relating to securities available-for-sale except net unrealized
      losses relating to marketable equity securities. The minimum requirements for
      the leverage ratio, risk-based Tier 1 capital and risk-based total capital
      are
      4%, 4% and 8%, respectively. As of December 31, 2006 and 2005, the Bank was
“well capitalized” as defined under FDIC regulations.





The
      following table sets forth the Company’s risk-based capital and leverage
      ratios:





($000
                Omitted)
              December
                31,2006
            
            2005Risk-adjusted
                assets
            
            $
            416,735
            
            $
            426,731Tier
                1 capital (to average assets)
            
            
            9.31
            %
            
            8.96
            %Tier
                1 capital (to risk weighted assets)
            
            
            14.02
            
            
            13.07Total
                capital (to risk weighted assets)
            
            
            15.95
            
            
            15.24





Total
      stockholders’ equity includes a $1,256,000 negative adjustment for accumulated
      other comprehensive loss, net of tax, at December 31, 2006 and a $1,104,000
      negative adjustment for accumulated other comprehensive loss, net of tax, at
      December 31, 2005. At December 31, 2006 this adjustment was comprised of a
      net
      unrealized loss on securities available-for-sale, net of taxes, of $301,000,
      a
      $1,382,000 unrealized loss on pension valuation, net of tax and a $427,000
      unrealized credit on prior pension service cost. At December 31, 2005, this
      adjustment was comprised solely of a net unrealized loss on securities
      available-for-sale, net of taxes.





The
      Company intends to continue to pay dividends on a quarterly basis subject to
      the
      financial condition and earnings of the Company, capital requirements, and
      other
      factors, including applicable governmental regulations. No dividends will be
      payable unless declared by the Board of Directors and then only to the extent
      funds are legally available for the payment of such dividends.





**APPLICATION
      OF CRITICAL ACCOUNTING POLICIES**





The
      Company’s accounting policies are more fully described in NOTE 1 of the
      Consolidated Financial Statements. As disclosed in NOTE 1, the preparation
      of
      financial statements in conformity with generally accepted accounting principles
      requires management to make estimates and assumptions about future events that
      affect the amounts reported in the financial statements and accompanying notes.
      Actual results could differ significantly from those estimates. The Company
      believes that the following discussion addresses the Company’s most critical
      accounting policies, which are those that are most important to the portrayal
      of
      the Company’s financial condition and results of operations and require
      management’s most difficult, subjective and complex judgments.





Allowance
      for Loan Losses .
      The
      allowance for loan losses, which is established through a charge to the
      provision for loan losses, is estimated at the Bank based on estimates of losses
      related to customer loan balances. In establishing the appropriate provisions,
      the Company makes assumptions with respect to the future collectibility of
      customer loan balances. The Company’s assumptions are based on an individual
      assessment of the customer’s credit quality as well as subjective factors and
      trends, including the credit rating of the loans. Generally, these individual
      credit assessments occur prior to the inception of the credit exposure and
      at
      regular reviews during the life of the exposure and consider (a) the customer’s
      ability to meet and sustain their financial commitments; (b) a customer’s
      current and projected financial condition; (c) the positive or negative effects
      of the current and projected industry outlook; and (d) the economy in general.
      Once the Company considers all of these factors, a determination is made as
      to
      the probability of default. An appropriate provision is made, which takes into
      account the severity of the likely loss on the outstanding loan balances based
      on the Company’s experience in collecting these amounts. The Company’s level of
      allowance for loan losses fluctuates depending upon all of the factors mentioned
      above. The use of different estimates or assumptions could produce different
      provisions for loan losses.


**Table
          of
          Contents**


Goodwill
      and Core Deposit Intangibles .
      Effective January 1, 2002, the Company adopted Statement of Financial Accounting
      Standards No. 142 (“SFAS No. 142”), “Goodwill and Other Intangible Assets.”
Under SFAS No. 142, the Company is required to perform annual impairment tests
      of its goodwill and intangible assets and more frequently in certain
      circumstances. The Company has elected to test for goodwill and intangible
      asset
      impairment in the fourth quarter of each year. In that goodwill is carried
      on
      the books of the Bank and the Company owns 100% of its outstanding stock, there
      is no market value for its common stock. The Company utilizes a multiple of
      earnings approach in analyzing the valuation of goodwill. Core deposit
      intangibles are carried on the books of the Bank as well. The valuation of
      core
      deposit intangibles incorporate deposits acquired compared with current deposit
      levels, considers deposit outflow assumptions made at acquisition as well as
      other factors.





The
      most
      recent impairment test of goodwill and core deposit intangibles indicated that
      no adjustments were required. The Company cannot predict the occurrence of
      certain future events that might adversely affect the reported value of goodwill
      and core deposit intangibles that totaled $10,577,000 and $2,178,000,
      respectively, at December 31 2006. Such events include, but are not limited
      to,
      strategic decisions made in response to economic and competitive conditions,
      the
      impact of the economic environment on the Company’s customer base, or the impact
      of changes in federal and state laws and regulations.





Pension
      Benefits .
      The
      Company maintains a trusteed non-contributory pension plan (the “Plan”) covering
      substantially all full-time employees. Several statistical and other factors,
      which attempt to anticipate future events, are used in calculating the expense
      and liability related to the Plan. Key factors include assumptions about the
      expected rates of return on plan assets and discount rates. The Company
      considers market conditions, including changes in investment returns and
      interest rates, in making these assumptions.





The
      Company determines the expected long-term rate of return on plan assets based
      on
      the building block method, which consists of aggregating the expected rates
      of
      return for each component of the plan’s asset mix. Plan assets are comprised
      primarily of mutual funds including bond funds, US equity funds, international
      equity funds, real estate funds and short-term money market funds. The Company
      uses historic plan asset returns combined with current market conditions to
      estimate the rate of return. The expected rate of return on plan assets is
      a
      long-term assumption and generally does not change annually. The discount rate
      reflects the market rate for high-quality fixed income debt instruments on
      the
      Company’s annual measurement date (December 31) and is subject to change each
      year.





Unrecognized
      actuarial gains and losses are being recognized to net periodic pension expense
      over approximately
      a 17-year period, which
      represents the expected remaining service life of the employee group.
      Unrecognized actuarial gains and losses arise from several factors including
      experience and assumption changes in the obligations and from the difference
      between expected returns and actual returns on plan assets. These unrecognized
      losses will be systematically recognized as an increase in future net periodic
      pension expense and a decrease in accumulated other comprehensive loss in
      accordance with FAS 87, “Employers’ Accounting for Pensions, ” as amended by
      SFAS 158, “Employer’s Accounting for Defined Benefit Pension and Other
      Postretirement Plans - an amendment of FASB Statements No. 87, 88, 106, and
      132(R).”





The
      actuarial assumptions used by the Company in determining its pension benefits
      may differ materially from actual results due to changing market and economic
      conditions, higher or lower withdrawal rates or longer or shorter life spans
      of
      the participants. While the Company believes that the assumptions used are
      appropriate, differences in actual experience or changes in assumptions may
      materially affect the Company’s financial position or results of
      operations.





Mortgage
      Servicing Rights (MSR or MSRs). Servicing assets are recognized as separate assets when rights are acquired
      through purchase or through sale of financial assets. Capitalized servicing
      rights are reported in other assets and are amortized into noninterest income
      in
      proportion to, and over the period of, the estimated future net servicing income
      of the underlying financial assets. Servicing assets are evaluated for
      impairment based upon the fair value of the rights as compared to amortized
      cost. Impairment is determined by stratifying rights by predominant
      characteristics, such as interest rates and original loan terms (primarily
      15
      and 30 year). Fair value is determined using prices for similar assets with
      similar characteristics, when available, or based upon discounted cash flows
      using market-based assumptions. In periods of falling market interest rates,
      accelerated loan prepayment speeds can adversely impact the fair value of these
      mortgage-servicing rights relative to their book value. In the event that the
      fair value of these assets were to increase in the future, the Company can
      recognize the increased fair value to the extent of the impairment allowance
      but
      cannot recognize an asset in excess of its amortized book value. When the book
      value of an individual stratum exceeds its fair value, an impairment reserve
      must be recognized. Future changes in management's assessment of the impairment
      of these servicing assets, as a result of changes in observable market data
      relating to market interest rates, loan prepayment speeds, and other factors,
      could impact the Company's financial condition and results of operations either
      positively or adversely.




**MARKET
      RISK**





Market
      risk is the risk of loss in a financial instrument arising from adverse changes
      in market rates and prices, such as interest rates, foreign currency exchange
      rates, commodity prices and equity prices. The Company’s primary market risk
      exposure is interest rate risk. The ongoing monitoring and management of this
      risk is an important component of the Company's asset/liability management
      process which is governed by policies established by the Company’s Boards of
      Directors that are reviewed and approved annually. The Board of Directors
      delegates responsibility for carrying out the asset/liability management
      policies to the Company's Asset Liability Committee (“ALCO”). In this capacity
      ALCO develops guidelines and strategies impacting the Company's asset/liability
      management-related activities based upon estimated market risk sensitivity,
      policy limits and overall market interest rate levels/trends.





Interest
      Rate Risk





Interest
      rate risk represents the sensitivity of earnings to changes in market interest
      rates. As interest rates change, the interest income and interest expenses
      associated with the Company's financial instruments also change, thereby
      impacting net interest income ("NII"), the primary component of the Company's
      earnings. ALCO utilizes the results of a detailed and dynamic simulation model
      to quantify the estimated exposure of NII to sustained interest rate changes.
      While ALCO routinely monitors simulated NII sensitivity over a rolling 2-year
      horizon, it also utilizes additional tools to monitor potential longer-term
      interest rate risk.





The
      simulation model captures the impact of changing interest rates on the interest
      income received and interest expense paid on all interest-earning assets and
      interest--bearing liabilities reflected on the Company's balance sheet. The
      Company uses computer simulations to determine the impact on net interest income
      of various interest rate scenarios, balance sheet trends and strategies. These
      simulations incorporate assumptions about balance sheet dynamics such as loan
      and deposit growth, loan and deposit pricing, changes in funding mix, and asset
      and liability repricing and maturity characteristics. Simulations based on
      numerous assumptions are run under various interest rate scenarios to determine
      the impact on net interest income and capital. From these scenarios, interest
      rate risk is quantified and appropriate strategies are developed and
      implemented.





**Table
          of Contents**


This
      sensitivity analysis is compared to ALCO policy limits which specify a maximum
      tolerance level for NII exposure over a 1-year horizon given both an immediate
      300 basis point, or 3%, upward and downward shift in interest rates. Given
      the
      current level of interest rates, the Company has modeled an upward shift in
      rates of 200 basis points and a downward shift in rates of 200 basis points.
      Using an immediate rate shock simulation where interest rates increase 200
      basis
      points, the December 31, 2006 earnings simulation model projects that net
      interest income for the twelve months ending December 31, 2007 would decrease
      by
      an amount equal to approximately 7.33%. In addition, utilizing an immediate
      rate
      shock simulation where interest rates decrease 200 basis points, the December
      31, 2006 earnings simulation model projects that net interest income for the
      twelve months ending December 31, 2007 would increase by an amount equal to
      approximately 1.06%.





Using
      an
      immediate rate shock simulation where interest rates increase 200 basis points,
      the December 31, 2006 earnings simulation model projects that net interest
      income for the twelve months ending December 31, 2008 would decrease by an
      amount equal to approximately 4.57%. In addition, utilizing an immediate rate
      shock simulation where interest rates decrease 200 basis points, the December
      31, 2006 earnings simulation model projects that net interest income for the
      twelve months ending December 31, 2008 would decrease by an amount equal to
      approximately 6.44%. The projected results are within Company’s ALCO policy
      limits for both years.





The
      preceding sensitivity analysis does not represent a Company forecast and should
      not be relied upon as being indicative of expected operating results. These
      hypothetical estimates are based upon numerous assumptions including, among
      others, the nature and timing of interest rate levels, yield curve shape,
      prepayments on loans and securities, deposit decay rates, pricing decisions
      on
      loans and deposits, and reinvestment/replacement of asset and liability
      cashflows-. The assumptions differed in each of the periods included in the
      sensitivity analysis above. While assumptions are developed based upon current
      economic and local market conditions, the Company cannot make any assurances
      as
      to the predictive nature of these assumptions, including how customer
      preferences or competitor influences might change.





The
      most
      significant factors affecting the changes in market risk exposure during 2006
      compared to 2005 was the decrease in interest rates, changes in the yield curve,
      the shift in loan mix from indirect installment loans to commercial and
      commercial real estate loans, the aggregate increase in securities
      available-for-sale, the increase in total deposits, and increase in short-term
      borrowings and the decrease in long-term debt.





**LIQUIDITY
      RISK**





Liquidity
      risk management involves the Company’s ability to raise funds in order to meet
      its existing and anticipated financial obligations. These obligations are the
      withdrawal of deposits on demand or at contractual maturity, the repayment
      of
      debt as it matures, the ability to fund new and existing loan commitments and
      the ability to take advantage of new business opportunities. Liquidity may
      be
      provided through amortization, maturity or sale of assets such as loans and
      securities available-for-sale, liability sources such as increased deposits,
      utilization of the FHLB credit facility, purchased or other borrowed funds,
      and
      access to the capital markets. Liquidity targets are subject to change based
      on
      economic and market conditions and are controlled and monitored by ALCO. At
      the
      bank level, liquidity is managed by measuring the net amount of marketable
      assets after deducting pledged assets, plus lines of credit, primarily with
      the
      FHLB, which are available to fund liquidity requirements. Management then
      measures the adequacy of that aggregate amount relative to the aggregate amount
      of liabilities deemed to be sensitive or volatile. These include brokered
      deposits, deposits in excess of $100,000, term deposits with short maturities,
      and credit commitments outstanding.





Additionally,
      the Company requires cash for various operating needs including dividends to
      stockholders, the purchase of treasury stock, capital injections to the Bank,
      and the payment of general corporate expenses. The primary sources of liquidity
      for the Company are dividends from the Bank and reimbursement for services
      performed on behalf of the Bank. Additionally, the Company may utilize outside
      sources of funding such as the issuance of the trust preferred
      securities.





Cash
      and
      cash equivalents decreased $4,554,000 during 2006. Cash used in investing
      activities totaled $22,503,000 with lending activities using $1,188,000, net,
      and investment activities using $17,874,000, net. Cash provided by financing
      activities totaled $12,532,000. This cash consisted of an increase in deposits
      of $18,562,000, an increase in repurchase agreements of $27,134,000, advances
      of
      $24,000,000 from the FHLB advances offset by the repayment of maturing FHLB
      advances and redemption of FHLB advances in the amount of $56,000,000. The
      net
      cash provided by operating activities totaled $5,417,000 and consisted primarily
      of net income of $3,215,000 and a decrease in other assets and other
      liabilities, net.





**Table
          of Contents**


**CAPITAL
      EXPENDITURES AND COMMITMENTS**





During
      2006, the Company incurred approximately $3,441,000 in capital expenditures,
      which included real estate acquired in the branch acquisition, significant
      building improvements at several of our branch locations, the purchase of remote
      capture software to allow for more efficient processing of daily work, and
      normal replacement of, or upgrades in, existing property and
      equipment.





During
      2005, the Company incurred approximately $1,257,000 in capital expenditures,
      which included new signage related to the name change and merger of PNB into
      the
      Bank, ATM upgrades, security camera upgrades, renovations to the Belmont
      facility, renovations to the Berlin facility due to the relocation of item
      processing, as well as the normal replacement of, or upgrades in, existing
      property and equipment. During 2005, the Company disposed of assets with a
      total
      net book value of approximately $1,747,000, which consisted primarily of the
      West Plymouth branch facility.





The
      Company’s estimated capital expenditures for 2007 total $600,000. They include
      network upgrades, ATM purchases and various equipment and software
      upgrades.





**CONTRACTUAL
      OBLIGATIONS**





The
      table
      below contains information on the Company’s contractual obligations as of the
      fiscal year ended December 31, 2006:





($000
                Omitted)Contractual
                Obligations
            
            
            Total
            
            
            Less
                Than
              One
                Year
            
            
            One
                to Three
              Years
            
            
            Three
                to Five
              Years
            
            
            More
                than
              Five
                YearsFHLB
                advances
            
            $
            53,000
            
            $
            13,000
            
            $
            19,000
            
            $
            7,000
            
            $
            14,000Junior
                subordinated debentures
            
            
            20,620
            
            
            -
            
            
            -
            
            
            -
            
            
            20,620Total
            
            $
            73,620
            
            $
            13,000
            
            $
            19,000
            
            $
            7,000
            
            $
            34,620





ITEM
      7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
      RISK





Information
      regarding quantitative and qualitative disclosures about market risk is included
      in “Management’s Discussion and Analysis of Financial Condition and Results of
      Operations” appearing under Item 7 of this report and is hereby incorporated by
      reference in this Item 7A.


**Table
          of
          Contents**


ITEM
      8. FINANCIAL STATEMENTS AND SUPPLEMENTARY
      DATA








**CONSOLIDATED
      STATEMENTS OF INCOME**





($000
                Omitted, Except Per Share Data)FOR
                THE YEAR ENDED DECEMBER 31,
            
            
            2006
            
            
            2005
            
            
            2004Interest
                and dividend incomeInterest
                and fees on loans
            
            $
            30,327
            
            $
            27,314
            
            $
            26,569Interest
                on debt securities available-for-sale:Taxable
            
            
            3,946
            
            
            3,843
            
            
            3,201Tax-exempt
            
            
            1,149
            
            
            299
            
            
            142Dividends
            
            
            337
            
            
            323
            
            
            239Interest
                on federal funds sold
            
            
            200
            
            
            322
            
            
            125Interest
                on interest-bearing deposits
            
            
            8
            
            
            3
            
            
            1Total
                interest and dividend income
            
            
            35,967
            
            
            32,104
            
            
            30,277Interest
                expenseInterest
                on deposits
            
            
            8,365
            
            
            4,092
            
            
            3,150Interest
                on short-term borrowings
            
            
            811
            
            
            257
            
            
            110Interest
                on long-term debt
            
            
            4,589
            
            
            4,579
            
            
            4,171Total
                interest expense
            
            
            13,765
            
            
            8,928
            
            
            7,431Net
                interest and dividend income
            
            
            22,202
            
            
            23,176
            
            
            22,846Provision
                for loan losses
            
            
            465
            
            
            75
            
            
            495Net
                interest and dividend income after provision for loan
                losses
            
            
            21,737
            
            
            23,101
            
            
            22,351Noninterest
                incomeService
                charges and fees on deposit accounts
            
            
            2,837
            
            
            2,430
            
            
            2,229Gain
                (loss) on sales of securities available-for-sale, net
            
            
            394
            
            
            (551
            )
            
            753Debit
                card fees
            
            
            557
            
            
            456
            
            
            372Gain
                on sales of loans, net
            
            
            137
            
            
            260
            
            
            374Other
            
            
            1,946
            
            
            1,401
            
            
            1,369Total
                noninterest income
            
            
            5,871
            
            
            3,996
            
            
            5,097Noninterest
                expenseSalaries
                and employee benefits
            
            
            12,252
            
            
            11,633
            
            
            12,058Office
                occupancy and equipment
            
            
            4,190
            
            
            4,282
            
            
            3,873Amortization
                of core deposit intangibles
            
            
            1,051
            
            
            954
            
            
            954Other
            
            
            6,248
            
            
            6,713
            
            
            5,509Total
                noninterest expense
            
            
            23,741
            
            
            23,582
            
            
            22,394Income
                before income tax expense
            
            
            3,867
            
            
            3,515
            
            
            5,054Income
                tax expense
            
            
            652
            
            
            842
            
            
            1,666Net
                income
            
            $
            3,215
            
            $
            2,673
            
            $
            3,388Basic
                earnings per common share
            
            $
            2.15
            
            $
            1.78
            
            $
            2.26Earnings
                per common share assuming dilution
            
            $
            2.14
            
            $
            1.77
            
            $
            2.24


See
      Notes
      to Consolidated Financial Statements


**Table
          of
          Contents**


**CONSOLIDATED
      BALANCE SHEETS**





($000
                Omitted)AS
                OF DECEMBER 31,
            
            
            2006
            
            
            2005AssetsCash
                and cash equivalentsCash
                and due from banks and interest-bearing deposits
            
            $
            16,053
            
            $
            14,587Federal
                funds sold
            
            
            8,755
            
            
            14,775Total
                cash and cash equivalents
            
            
            24,808
            
            
            29,362Securities
                available-for-sale, at fair value
            
            
            127,789
            
            
            103,244Federal
                Home Loan Bank stock
            
            
            3,782
            
            
            5,541Loans
                held-for-sale
            
            
            263
            
            
            453Loans,
                net before allowance for loan losses
            
            
            462,230
            
            
            460,373Less:
                allowance for loan losses
            
            
            5,581
            
            
            5,150Net
                loans
            
            
            456,649
            
            
            455,223Premises
                and equipment, net
            
            
            13,749
            
            
            11,735Other
                real estate owned
            
            
            -
            
            
            196Goodwill
            
            
            10,577
            
            
            10,152Core
                deposit intangibles, net
            
            
            2,178
            
            
            1,995Other
                assets
            
            
            11,082
            
            
            14,833Total
                assets
            
            $
            650,877
            
            $
            632,734Liabilities
                and Stockholders’ EquityLiabilitiesDepositsDemand
            
            $
            72,054
            
            $
            77,436Regular
                savings, NOW and money market deposit accounts
            
            
            217,682
            
            
            238,689Certificates
                of deposit (in denominations of $100,000 or more)
            
            
            55,676
            
            
            28,297Other
                time
            
            
            139,265
            
            
            120,034Total
                deposits
            
            
            484,677
            
            
            464,456Short-term
                borrowings
            
            
            36,497
            
            
            9,363Long-term
                debt
            
            
            73,620
            
            
            105,620Other
                liabilities
            
            
            3,934
            
            
            3,045Total
                liabilities
            
            
            598,728
            
            
            582,484Stockholders'
                equityPreferred
                stock, $1.00 par value; 1,000,000 shares authorized; none
                issued
            
            
            -
            
            
            -Common
                stock, $1.00 par value; 9,000,000 shares authorized; 1,731,969 shares
                issued and 1,491,174 shares outstanding in 2006 and 2005
            
            
            1,732
            
            
            1,732Surplus
            
            
            2,064
            
            
            2,064Retained
                earnings
            
            
            56,140
            
            
            54,089Treasury
                stock (240,795 shares at December 31, 2006 and 2005)
            
            
            (6,531
            )
            
            (6,531
            )Accumulated
                other comprehensive loss, net of tax
            
            
            (1,256
            )
            
            (1,104
            )Total
                stockholders’ equity
            
            
            52,149
            
            
            50,250Total
                liabilities and stockholders’ equity
            
            $
            650,877
            
            $
            632,734


See
      Notes
      to Consolidated Financial Statements


**Table
          of
          Contents**


**CONSOLIDATED
      STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY**





($000
                Omitted)Common
              Stock
            
            
            Additional
              Paid-In
              Capital
            
            
            Retained
              Earnings
            
            
            Treasury
              Stock
            
            
            Accumulated
              Other
              Comprehensive
              Income
                (Loss)1
            
            
            Total
              Stockholders'
              EquityBalance
                at December 31, 2003
            
            $
            1,732
            
            $
            2,088
            
            $
            50,116
            
            $
            (6,213
            )
            $
            149
            
            $
            47,872Net
                income - 2004
            
            
            -
            
            
            -
            
            
            3,388
            
            
            -
            
            
            -
            
            
            3,388Net
                change in unrealized gain (loss) on securities available-for-sale,
                net of
                tax
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (889
            )
            
            (889
            )Net
                change in unfunded pension accumulated benefit obligation, net of
                tax
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            49
            
            
            49Exercise
                of stock options, net of tax benefit
            
            
            -
            
            
            (13
            )
            
            -
            
            
            123
            
            
            -
            
            
            110Cash
                dividends declared ($0.68 per share)
            
            
            -
            
            
            -
            
            
            (1,020
            )
            
            -
            
            
            -
            
            
            (1,020
            )Balance
                at December 31, 2004
            
            
            1,732
            
            
            2,075
            
            
            52,484
            
            
            (6,090
            )
            
            (691
            )
            
            49,510Net
                income - 2005
            
            
            -
            
            
            -
            
            
            2,673
            
            
            -
            
            
            -
            
            
            2,673Net
                change in unrealized loss on securities available-for-sale, net of
                tax
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (1,085
            )
            
            (1,085
            )Net
                change in unfunded pension accumulated benefit obligation, net of
                tax
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            672
            
            
            672Exercise
                of stock options, net of tax benefit
            
            
            -
            
            
            (11
            )
            
            -
            
            
            122
            
            
            -
            
            
            111Treasury
                stock purchased
            
            
            -
            
            
            -
            
            
            -
            
            
            (563
            )
            
            -
            
            
            (563
            )Cash
                dividends declared ($0.71 per share)
            
            
            -
            
            
            -
            
            
            (1,068
            )
            
            -
            
            
            -
            
            
            (1,068
            )Balance
                at December 31, 2005
            
            
            1,732
            
            
            2,064
            
            
            54,089
            
            
            (6,531
            )
            
            (1,104
            )
            
            50,250Net
                income - 2006
            
            
            -
            
            
            -
            
            
            3,215
            
            
            -
            
            
            -
            
            
            3,215Net
                change in unrealized loss on securities available-for-sale, net of
                tax
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            803
            
            
            803Net
                change in unrecognized loss on pension valuation, net of
                tax
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (1,382
            )
            
            (1,382
            )Net
                change in unrecognized pension prior service credit, net of tax
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            427
            
            
            427Cash
                dividends declared ($0.78 per share)
            
            
            -
            
            
            -
            
            
            (1,164
            )
            
            -
            
            
            -
            
            
            (1,164
            )Balance
                at December 31, 2006
            
            $
            1,732
            
            $
            2,064
            
            $
            56,140
            
            $
            (6,531
            )
            $
            (1,256
            )
            $
            52,149





1
            Accumulated
                other comprehensive loss as of December 31, 2006 consists of net
                unrealized holding losses on available-for-sale securities of $301,
                net of
                taxes, net unrealized loss on pension valuation of $1,382, net of
                taxes,
                and a net credit for prior service on pension of $427, net of tax
                benefit.
                Accumulated other comprehensive loss as of December 31, 2005 consists
                of
                net unrealized holding losses on available-for-sale securities of
                $1,104,
                net of taxes. Accumulated other comprehensive loss at December 31,
                2004
                consists of net holding losses on available-for-sale securities of
                $19,
                net of taxes, and net unrealized holding losses on unfunded pension
                accumulated obligation of $672, net of
                taxes.





**CONSOLIDATED
      STATEMENTS OF COMPREHENSIVE INCOME**





($000
                Omitted)FOR
                THE YEAR ENDED DECEMBER 31,
            
            
            2006
            
            
            2005
            
            
            2004Net
                income
            
            $
            3,215
            
            $
            2,673
            
            $
            3,388Other
                comprehensive income (loss)Net
                unrealized holding gains (losses) on securities
                available-for-sale
            
            
            1,723
            
            
            (2,347
            )
            
            (720
            )Reclassification
                adjustment for realized (gains) losses in net income
            
            
            (394
            )
            
            551
            
            
            (753
            )Net
                unrealized gains (losses) on securities
            
            
            1,329
            
            
            (1,796
            )
            
            (1,473
            )Pension
                valuation adjustment
            
            
            (2,289
            )
            
            -
            
            
            -Pension
                prior service credit adjustment
            
            
            708
            
            
            -
            
            
            -Minimum
                pension liability adjustment
            
            
            -
            
            
            1,018
            
            
            74Other
                comprehensive income (loss)
            
            
            (252
            )
            
            (778
            )
            
            (1,399
            )Income
                tax benefit
            
            
            (100
            )
            
            (365
            )
            
            (559
            )Other
                comprehensive loss, net of tax
            
            
            (152
            )
            
            (413
            )
            
            (840
            )Comprehensive
                income
            
            $
            3,063
            
            $
            2,260
            
            $
            2,548


See
      Notes
      to Consolidated Financial Statements


**Table
          of
          Contents**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**





($000
                Omitted)FOR
                THE YEAR ENDED DECEMBER 31,
            
            
            2006
            
            
            2005
            
            
            2004Cash
                flows from operating activities:Net
                income
            
            $
            3,215
            
            $
            2,673
            
            $
            3,388Adjustments
                to reconcile net income to net cash provided by operating
                activities:Provision
                for loan losses
            
            
            465
            
            
            75
            
            
            495Depreciation
                and amortization
            
            
            2,426
            
            
            2,367
            
            
            2,369Deferred
                income tax (benefit) expense
            
            
            (358
            )
            
            (4
            )
            
            43(Gain)
                loss on sales of securities available-for-sale, net
            
            
            (394
            )
            
            551
            
            
            (753
            )Loss
                on sale, disposal and write-down of premises and equipment
            
            
            52
            
            
            57
            
            
            9Amortization
                of premiums and accretion of discounts on securities, net
            
            
            21
            
            
            54
            
            
            90Change
                in unearned income/unamortized cost, net
            
            
            (195
            )
            
            (190
            )
            
            (141
            )Accretion
                of discount on loans acquired
            
            
            (149
            )
            
            (140
            )
            
            (160
            )(Gains)
                losses on sales of other real estate owned and other personal property,
                net
            
            
            (68
            )
            
            -
            
            
            9Net
                decrease (increase) in loans held-for-sale
            
            
            190
            
            
            (142
            )
            
            200Net
                change in other assets and other liabilities
            
            
            212
            
            
            (999
            )
            
            587Net
                cash provided by operating activities
            
            
            5,417
            
            
            4,302
            
            
            6,136Cash
                flows from investing activities:Proceeds
                from sales of securities available-for-sale
            
            
            11,459
            
            
            16,002
            
            
            16,964Proceeds
                from maturities of securities available-for-sale
            
            
            16,688
            
            
            17,315
            
            
            25,690Purchases
                of securities available-for-sale
            
            
            (47,990
            )
            
            (40,829
            )
            
            (76,515
            )Purchases
                of Federal Home Loan Bank stock
            
            
            -
            
            
            (26
            )
            
            (810
            )Proceeds
                from sales of Federal Reserve Bank stock
            
            
            -
            
            
            365
            
            
            -Redemption
                of Federal Home Loan Bank stock
            
            
            1,759
            
            
            -
            
            
            -Capital
                distribution on investment in limited partnership
            
            
            210
            
            
            -
            
            
            -Loan
                originations and principal collections, net
            
            
            6,112
            
            
            13,345
            
            
            (7,142
            )Recoveries
                of previously charged-off loans
            
            
            298
            
            
            286
            
            
            338Loans
                acquired in branch transactions
            
            
            (8,192
            )
            
            -
            
            
            -Proceeds
                from sale of commercial loans
            
            
            -
            
            
            -
            
            
            5,088Proceeds
                from sales of and payments received on other real estate
                owned
            
            
            264
            
            
            25
            
            
            -Proceeds
                from sales of and payments received on other personal
                property
            
            
            330
            
            
            652
            
            
            604Premises
                and equipment acquired in branch transactions
            
            
            (507
            )
            
            -
            
            
            -Additions
                to premises and equipment, net of disposals
            
            
            (2,934
            )
            
            496
            
            
            (2,267
            )Purchase
                of company owned life insurance policies
            
            
            -
            
            
            -
            
            
            (400
            )Net
                cash (used by) provided by investing activities
            
            
            (22,503
            )
            
            7,631
            
            
            (38,450
            )Cash
                flows from financing activities:Net
                (decrease) increase in deposits
            
            
            (9,217
            )
            
            (10,903
            )
            
            12,052Deposits
                assumed in branch transactions, net of assumption premiums
            
            
            27,779
            
            
            -
            
            
            -Net
                increase (decrease) in short-term borrowings
            
            
            27,134
            
            
            (1,905
            )
            
            3,867Advances
                from Federal Home Loan Bank (FHLB)
            
            
            24,000
            
            
            13,000
            
            
            20,000Repayment
                of FHLB advances
            
            
            (56,000
            )
            
            (6,000
            )
            
            (9,000
            )Exercise
                of stock options
            
            
            -
            
            
            99
            
            
            99Purchases
                of treasury stock
            
            
            -
            
            
            (563
            )
            
            -Cash
                dividends paid
            
            
            (1,164
            )
            
            (1,068
            )
            
            (1,020
            )Net
                cash provided by (used in) financing activities
            
            
            12,532
            
            
            (7,340
            )
            
            25,998Net
                (decrease) increase in cash and cash equivalents
            
            
            (4,554
            )
            
            4,593
            
            
            (6,316
            )Cash
                and cash equivalents at beginning of year
            
            
            29,362
            
            
            24,769
            
            
            31,085Cash
                and cash equivalents at end of year
            
            $
            24,808
            
            $
            29,362
            
            $
            24,769





See
      Notes
      to Consolidated Financial Statements


**Table
          of
          Contents**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS (CONTINUED)**





($000
                Omitted)FOR
                THE YEAR ENDED DECEMBER 31,
            
            
            2006
            
            
            2005
            
            
            2004Supplemental
                disclosures of cash flows:Interest
                paid
            
            $
            13,728
            
            $
            8,662
            
            $
            7,519Income
                taxes paid
            
            
            860
            
            
            1,106
            
            
            2,090Loans
                transferred to other real estate owned
            
            
            -
            
            
            231
            
            
            -Loans
                transferred to other personal property
            
            
            235
            
            
            682
            
            
            603Amount
                due from customer for pending municipal security maturity
            
            
            -
            
            
            3,000
            
            
            -





See
      Notes
      to Consolidated Financial Statements


**Table
          of
          Contents**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**NOTE
      1 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**





***Nature
      of Operations***





Northway
      is a bank holding company formed in 1997 under the laws of New Hampshire and
      is
      registered under the Bank Holding Company Act of 1956. Northway’s only business
      activity has been to own all of the shares of, and provide management, capital
      and operational support to Northway Bank (“Bank”), formerly known as The Berlin
      City Bank, and its Delaware statutory business trusts Northway Capital Trust
      I
      and Northway Capital Trust II. On October 1, 2005 The Berlin City Bank was
      renamed Northway Bank and The Pemigewasset National Bank of Plymouth, New
      Hampshire was merged into Northway Bank. The Company’s headquarters are in
      Berlin, New Hampshire. The banking subsidy is engaged principally in the
      business of attracting deposits from the general public and investing those
      deposits in securities, commercial loans, real estate loans, and consumer loans.





***Basis
      of Presentation***





The
      consolidated financial statements include the accounts of the Company and its
      wholly-owned subsidiary. All significant intercompany accounts and transactions
      have been eliminated in the consolidation.





Northway
      Capital Trust I and Northway Capital Trust II, affiliates of the Company, were
      formed to sell capital securities to the public through a third party trust
      pool. In accordance with FASB Interpretation No. 46, “Consolidation of Variable
      Interest Entities” (“FIN 46”), these affiliates have not been included in the
      consolidated financial statements.





The
      accounting and reporting policies of the Company conform to accounting
      principles generally accepted in the United States of America and to general
      practices within the banking industry.





In
      preparing the financial statements, management is required to make estimates
      and
      judgments that affect the reported amounts of assets and liabilities as of
      the
      dates of the consolidated balance sheets, and income and expense for the
      periods. Actual results could differ from those estimates. Material estimates
      that are particularly susceptible to change in the near-term relate to the
      determination of the allowance for loan losses.




***Reclassifications***





Certain
      amounts in the prior years’ financial statements have been reclassified to
      conform with the current year’s presentation.





***Cash
      and Cash Equivalents***





For
      purposes of the statement of cash flows, cash and cash equivalents include
      cash
      and due from banks, interest-bearing deposits, and federal funds
      sold.




***Securities***





Debt
      securities that the Company has the positive intent and ability to hold to
      maturity are classified as held-to-maturity and reported at amortized cost;
      if
      debt and equity securities are bought and held principally for the purpose
      of
      selling in the near term they would be classified as trading and reported at
      fair value, with unrealized gains and losses included in earnings; and debt
      and
      equity securities not classified as either held-to-maturity or trading are
      classified as available-for-sale and reported at fair value, with unrealized
      gains and losses excluded from earnings and reported as a separate component
      of
      stockholders’ equity, net of estimated income taxes. At this time, the Company
      has not established a trading account.





Premiums
      and discounts are amortized and accreted primarily on the level yield method
      over the contractual life of the securities adjusted for expected
      prepayments.





If
      a
      decline in the fair value below the adjusted cost basis of an investment is
      judged to be other than temporary, the cost basis of the investment is written
      down to fair value as the new cost basis and the amount of the write-down is
      included in noninterest expense.





Gains
      and
      losses on sales of securities available-for-sale are recognized at the time
      of
      the sale on a specific identification basis.


**Table
          of
          Contents**


***Loans
      Held-for-Sale***





Loans
      held-for-sale are generally identified as such at origination and are stated
      at
      the lower of aggregate cost or market. Market value is based on outstanding
      investor commitments. When loans are sold, a gain or loss is recognized to
      the
      extent that the sale proceeds exceed or are less than the carrying value of
      the
      loans. Gains and losses are determined using the specific identification method.
      All loans sold are without recourse to the Company.





***Loans***





Loans
      are
      carried at the principal amounts outstanding, net of any unearned income or
      unamortized cost, premiums on originated loans and discounts on acquired loans.
      Unearned income and unamortized cost includes loan origination fees, net of
      direct loan origination costs. This income or expense is deferred and recognized
      as adjustments to loan income over the contractual life of the related notes
      using a method the result of which approximates that of the interest
      method.





Loans
      are
      placed on nonaccrual when payment of principal or interest is considered to
      be
      in doubt or is past due 90 days or more. The Company may choose to place a
      loan
      on nonaccrual status due to payment delinquency or uncertain collectibility,
      while not classifying the loan as impaired, if (i) it is probable that the
      Company will collect all amounts due in accordance with the contractual terms
      of
      the loan or (ii) the loan is not a commercial, commercial real estate or an
      individually significant mortgage or consumer loan. Previously accrued income
      on
      nonaccrual loans that has not been collected is reversed from current income,
      and subsequent cash receipts are recorded as income if principal on the loans
      is
      deemed collectible. Loans are returned to accrual status when collection of
      all
      contractual principal and interest is reasonably assured and there has been
      sustained repayment performance.





The
      Company’s loans are primarily secured by real estate in New Hampshire. In
      addition, other real estate owned is located in this market. Accordingly, the
      ultimate collectibility of a substantial portion of the Company’s loan portfolio
      and the recovery of other real estate owned are susceptible to changing
      conditions in this market.





***Allowance
      for Loan Losses***





The
      allowance for loan losses is maintained at a level considered adequate by
      management on the basis of many factors including the risk characteristics
      of
      the portfolio, trends in loan delinquencies and an assessment of existing
      economic conditions. Additions to the allowance are charged to earnings;
      realized losses, net of recoveries, are charged directly to the
      allowance.





While
      management uses available information in establishing the allowance for loan
      losses, future additions to the allowance may be necessary if economic
      conditions differ substantially from the estimates used in making the
      evaluations. In addition, various regulatory agencies, as an integral part
      of
      their examination process, periodically review the Company’s allowance for loan
      losses. Such agencies may require the Company to recognize additions to the
      allowance based on judgments different from those of management.





Commercial,
      commercial real estate and individually significant mortgage and consumer loans
      are considered impaired, and are placed on nonaccrual, when it is probable
      that
      the Company will not be able to collect all amounts due according to the
      contractual terms of the loan agreement. Mortgage and consumer loans, which
      are
      not individually significant, are measured for impairment collectively. Loans
      that experience insignificant payment delays and insignificant shortfalls in
      payment amounts generally are not classified as impaired. The amount of
      impairment for all impaired loans is determined by the difference between the
      present value of the expected cash flows related to the loan, using the original
      contractual interest rate, and its recorded value, or, as a practical expedient
      in the case of collateralized loans, the difference between the fair value
      of
      the collateral and the recorded amount of the loan.





When
      foreclosure is probable, impairment is measured based on the fair value of
      the
      collateral.





***Servicing
      Assets***





Servicing
      assets are recognized as separate assets when rights are acquired through
      purchase or through sale of financial assets. Capitalized servicing rights
      are
      reported in other assets and are amortized into noninterest income in proportion
      to, and over the period of, the estimated future net servicing income of the
      underlying financial assets. Servicing assets are evaluated for impairment
      based
      upon the fair value of the rights as compared to amortized cost. Impairment
      is
      determined by stratifying rights by predominant characteristics, such as
      interest rates and terms. Fair value is determined using prices for similar
      assets with similar characteristics, when available, or based upon discounted
      cash flows using market-based assumptions. Impairment is recognized through
      a
      valuation allowance for an individual stratum, to the extent that fair value
      is
      less than the capitalized amount for the stratum.





***Premises
      and Equipment***





Premises
      and equipment are carried at cost less accumulated depreciation. Depreciation
      is
      computed on the straight-line method over the estimated useful lives of the
      respective assets. Estimated lives are thirty-nine years for buildings, ten
      to
      fifteen years for building improvements and three to seven years for furniture
      and equipment.




Amortization
      of leasehold improvements is accumulated on a straight-line basis over the
      lesser of the term of the respective lease or the asset’s useful life, not to
      exceed ten years.




***Other
      Real Estate Owned***





Other
      real estate owned is comprised of properties acquired either through foreclosure
      proceedings or acceptance of a deed in lieu of foreclosure, and for which the
      Company has taken physical possession. The Company classifies loans as
      repossessed or foreclosed if the Company receives physical possession of the
      debtor’s assets, regardless of whether or not foreclosure proceedings take
      place.





Assets
      acquired through foreclosure or a similar conveyance of title are initially
      recorded at the lower of the carrying value of the loan or the fair value,
      less
      estimated costs to sell, of the property constructively or actually received.
      Gains and losses upon disposition are reflected in the statement of income
      as
      realized.





**Table
          of Contents**


***Advertising***





The
      Company directly expenses costs associated with advertising as they are
      incurred.





***Income
      Taxes***





The
      Company uses the asset and liability method of accounting for income taxes.
      Under the asset and liability method, deferred tax assets and liabilities are
      recognized for the future tax consequences attributable to differences between
      the financial statement carrying amounts of existing assets and liabilities
      and
      the respective tax bases and operating loss and tax credit carry forwards.
      Deferred tax assets and liabilities are measured using enacted tax rates
      expected to apply to taxable income in the years in which those temporary
      differences are expected to be recovered or settled. The effect on deferred
      tax
      assets and liabilities of a change in tax rates is recognized in income in
      the
      period that includes the enactment date.





***Stock-Based
      Compensation***





At
      December 31, 2006, the Company has a stock-based employee compensation plan
      which is described more fully in NOTE 16. Effective January 1, 2006, the Company
      adopted Statement of Financial Accounting Standards No. 123 (revised 2004)
      “Share-Based Payment” (“SFAS 123R”). This Statement revised SFAS No. 123,
“Accounting for Stock Based Compensation” and superceded Accounting Principles
      Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and
      its related implementation guidance. SFAS 123R requires that the cost resulting
      from all share-based payment transactions be recognized in the financial
      statements and establishes fair value as the measurement objective in accounting
      for share-based payment arrangements. No compensation expense was recognized
      for
      the twelve months ended December 31, 2006 related to SFAS 123R. Prior to January
      1, 2006, the Company accounted for the plan under the recognition and
      measurement principles of APB Opinion No. 25. No stock-based employee
      compensation cost had been recognized during periods prior to January 1, 2006
      for its fixed stock option plans.


The
      following table illustrates the effect on net income and earnings per share
      if
      the Company had applied the fair value recognition provisions of SFAS 123R
      to
      stock-based employee compensation during the years ended December 31, 2005
      and
      2004.





($000
                Omitted, Except Per Share Data)2005
            
            
            2004Net
                income
            
            
            As
                reported
            
            $
            2,673
            
            $
            3,388Deduct:
                Total stock-based employee compensation expense determined under
                fair
                value based methods awards, net of related tax effects
            
            
            
            
            
            -
            
            
            -Pro
                forma
            
            $
            2,673
            
            $
            3,388Earnings
                per common share
            
            
            As
                reported
            
            $
            1.78
            
            $
            2.26Pro
                forma
            
            
            1.78
            
            
            2.26Earnings
                per common share
            
            
            As
                reported
            
            $
            1.77
            
            $
            2.24(assuming
                dilution)
            
            
            Pro
                forma
            
            
            1.77
            
            
            2.24





***Earnings
      Per Share***





Basic
      earnings per share (“EPS”) excludes dilution and is computed by dividing income
      available to common stockholders by the weighted-average number of common shares
      outstanding for the period. Diluted EPS, if applicable, reflects the potential
      dilution that could occur if securities or other contracts to issue common
      stock
      were exercised or converted into common stock or resulted in the issuance of
      common stock that then shared in the earnings of the entity.





Earnings
      per common share have been computed based on the following:


($000
                Omitted, Shares Reported in Millions)
              Years
                Ended December 31,2006
            
            
            2005
            
            
            2004Net
                income
            
            $
            3,215
            
            $
            2,673
            
            $
            3,388Less:
                Preferred stock dividends
            
            
            -
            
            
            -
            
            
            -Net
                income applicable to common stock
            
            $
            3,215
            
            $
            2,673
            
            $
            3,388Average
                number of common shares outstanding
            
            
            1,492.3
            
            
            1,502.1
            
            
            1,500.1Effect
                of dilutive options
            
            
            9.1
            
            
            9.3
            
            
            11.6Average
                number of common shares outstanding used to calculate diluted earnings
                per
                common share
            
            
            1,501.4
            
            
            1,511.4
            
            
            1,511.7





**Table
          of Contents**


***Recent
      Accounting Pronouncements***





In
      February 2006, the Financial Accounting Standards Board (FASB) issued SFAS
      No.
      155, "Accounting for Certain Hybrid Instruments" (SFAS 155), which permits,
      but
      does not require, fair value accounting for any hybrid financial instrument
      that
      contains an embedded derivative that would otherwise require bifurcation in
      accordance with SFAS 133. The statement also subjects beneficial interests
      issued by securitization vehicles to the requirements of SFAS 133. The statement
      is effective as of January 1, 2007. The adoption of SFAS 155 is not expected
      to
      have a material impact on the Company’s financial condition, results of
      operations or cash flow.





In
      March
      2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial
      Assets- an amendment of FASB Statement No. 140” (SFAS 156). SFAS 156 requires an
      entity to recognize a servicing asset or servicing liability each time it
      undertakes an obligation to service a financial asset by entering into a
      servicing contract in specific situations. Additionally, the servicing asset
      or
      servicing liability shall be initially measured at fair value; however, an
      entity may elect the “amortization method” or “fair value method” for subsequent
      balance sheet reporting periods. SFAS 156 is effective as of an entity’s first
      fiscal year beginning after September 15, 2006. Early adoption is permitted
      as
      of the beginning of an entity’s fiscal year, provided the entity has not yet
      issued financial statements, including interim financial statements, for any
      period of that fiscal year. The Company does not expect the adoption of this
      statement to have a material impact on its financial condition, results of
      operations or cash flows.





In
      September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements" (SFAS
      157). SFAS 157 defines fair value, establishes a framework for measuring fair
      value under generally accepted accounting principles (GAAP) and enhances
      disclosures about fair value measurements. SFAS 157 retains the exchange price
      notion and clarifies that the exchange price is the price that would be received
      for an asset or paid to transfer a liability (an exit price) in an orderly
      transaction between market participants on the measurement date. SFAS 157 is
      effective for the Company’s consolidated financial statements for the year
      beginning on January 1, 2008, with earlier adoption permitted. The Company
      does
      not expect the adoption of this statement to have a material impact on its
      financial condition, results of operations or cash flows.





In
      September 2006, the FASB issued SFAS No. 158, “Employer’s Accounting for Defined
      Benefit Pension and other Postretirement Plans - an amendment of FASB Statements
      No. 87, 88, 106, and 132(R)” (SFAS 158). SFAS 158 requires 1) the recognition of
      an asset or liability for the over-funded or under-funded status of a defined
      benefit plan, 2) the recognition of actuarial gains and losses and prior service
      costs and credits in other comprehensive income, 3) measurement of plan assets
      and benefit obligations as of the employer’s balance sheet date, rather than at
      interim measurement dates as currently allowed, and 4) disclosure of additional
      information concerning actuarial gains and losses and prior service costs and
      credits recognized in other comprehensive income. This statement is effective
      for financial statements with fiscal years ending after December 15, 2006.
      The adoption of this Statement did not have a material impact on the Company’s
      financial position, result of operations or cash flows.





**NOTE
      2 CASH AND DUE FROM BANKS**





At
      December 31, 2006, there was $64,000, which was subject to withdrawals and
      usage
      restrictions to satisfy the reserve requirements of the Federal Reserve Bank.
      There was no cash and due from bank balances at December 31, 2005 subject to
      withdrawals and usage restrictions to satisfy the reserve requirements of the
      Federal Reserve Bank.





**NOTE
      3 SECURITIES AVAILABLE-FOR-SALE**





The
      amortized cost, gross unrealized gains, gross unrealized losses, and fair value
      of securities at December 31, 2006 and 2005 follows:


($000
                Omitted)Amortized
              Cost
            
            
            Gross
              Unrealized
              Gains
            
            
            Gross
              Unrealized
              Losses
            
            
            Fair
              ValueDecember
                31, 2006U.S.
                Treasury and other U.S. government agency securities
            
            $
            47,738
            
            $
            50
            
            $
            725
            
            $
            47,063Marketable
                equity securities
            
            
            3,364
            
            
            311
            
            
            58
            
            
            3,617Mortgage-backed
                securities
            
            
            40,905
            
            
            310
            
            
            600
            
            
            40,615Collateralized
                mortgage obligations
            
            
            6
            
            
            -
            
            
            -
            
            
            6Corporate
                bonds
            
            
            3,517
            
            
            10
            
            
            5
            
            
            3,522Asset
                backed securities
            
            
            4,974
            
            
            -
            
            
            6
            
            
            4,968State
                and political subdivision bonds and notes
            
            
            27,784
            
            
            221
            
            
            7
            
            
            27,998$
            128,288
            
            $
            902
            
            $
            1,401
            
            $
            127,789





December
                31, 2005U.S.
                Treasury and other U.S. government agency securities
            
            $
            48,728
            
            $
            -
            
            $
            977
            
            $
            47,751Marketable
                equity securities
            
            
            2,695
            
            
            178
            
            
            64
            
            
            2,809Mortgage-backed
                securities
            
            
            24,704
            
            
            1
            
            
            774
            
            
            23,931Collateralized
                mortgage obligations
            
            
            8
            
            
            -
            
            
            -
            
            
            8Corporate
                bonds
            
            
            5,541
            
            
            37
            
            
            9
            
            
            5,569State
                and political subdivision bonds and notes
            
            
            23,396
            
            
            45
            
            
            265
            
            
            23,176$
            105,072
            
            $
            261
            
            $
            2,089
            
            $
            103,244





**Table
          of
          Contents**


The
      contractual maturity distribution of investments in debt obligations at December
      31, 2006 follows:





($000
                Omitted)Within
              One
              Year
            
            
            Over
                One Through
              Five
              Years
            
            
            After
                Five Through
              Ten
              Years
            
            
            Over
              Ten
              Years
            
            
            Total
              Amortized
              CostU.S.
                Treasury and other U.S. government agency securities
            
            $
            6,300
            
            $
            30,455
            
            $
            10,983
            
            $
            -
            
            $
            47,738Mortgage-backed
                securities
            
            
            -
            
            
            20
            
            
            -
            
            
            40,885
            
            
            40,905Collateralized
                mortgage obligations
            
            
            -
            
            
            -
            
            
            -
            
            
            6
            
            
            6Corporate
                bonds
            
            
            1,508
            
            
            2,009
            
            
            -
            
            
            -
            
            
            3,517Asset
                backed securities
            
            
            -
            
            
            -
            
            
            -
            
            
            4,974
            
            
            4,974State
                and political subdivision bonds and notes
            
            
            1,506
            
            
            996
            
            
            -
            
            
            25,282
            
            
            27,784Total
                amortized cost
            
            $
            9,314
            
            $
            33,480
            
            $
            10,983
            
            $
            71,147
            
            $
            124,924Fair
                value
            
            $
            9,262
            
            $
            32,935
            
            $
            10,916
            
            $
            71,059
            
            $
            124,172





Actual
      maturities of state and political subdivision bonds and notes, mortgage-backed
      securities and collateralized mortgage obligations will differ from the
      maturities presented because borrowers have the right to prepay obligations
      without prepayment penalties.





For
      the
      years ended December 31, 2006, 2005 and 2004, proceeds from the sales of
      securities available-for-sale amounted to $11,459,000, $16,002,000 and
      $16,964,000, respectively. An analysis of gross realized gains and losses on
      sales of securities available-for-sale during the years ended December 31,
      follows:





($000
                Omitted)2006
            
            2005
            
            2004Realized
              Gains
            
            
            Realized
              Losses
            
            
            
            Realized
              Gains
            
            
            Realized
              Losses
            
            
            
            Realized
              Gains
            
            
            Realized
              LossesMarketable
                equity securities
            
            $
            480
            
            $
            40
            
            
            $
            221
            
            $
            104
            
            
            $
            402
            
            $
            149U.S.
                Treasury and other U.S. government agency securities
            
            
            -
            
            
            49
            
            
            
            -
            
            
            200
            
            
            
            5
            
            
            -Mortgage-backed
                securities
            
            
            -
            
            
            -
            
            
            
            12
            
            
            11
            
            
            
            -
            
            
            -Corporate
                bonds
            
            
            3
            
            
            -
            
            
            
            30
            
            
            499
            
            
            
            539
            
            
            50State
                and political subdivision bonds and notes
            
            
            -
            
            
            -
            
            
            
            -
            
            
            -
            
            
            
            6
            
            
            -$
            483
            
            $
            89
            
            
            $
            263
            
            $
            814
            
            
            $
            952
            
            $
            199





The
      tax
      provision (benefit) applicable to these net realized gains/(losses) amounted
      to
      $156,000, (218,000) and $298,000 for 2006, 2005, and 2004,
      respectively.





Securities
      with a carrying amount totaling $91,155,000 and $73,651,000 were pledged to
      secure public deposits, securities sold under agreements to repurchase, FHLB
      advances and treasury, tax and loan accounts at December 31, 2006 and 2005,
      respectively





The
      aggregate fair value and unrealized losses of securities that have been in
      a
      continuous unrealized loss position for less than twelve months and for twelve
      months or more, and are not other than temporarily impaired, are as follows
      as
      of December 31, 2006:





($000
                Omitted)Less
                than 12 Months
            
            12
                Months or Longer
            
            TotalFair
              Value
            
            Unrealized
              Losses
            
            Fair
              Value
            
            Unrealized
              Losses
            
            Fair
              Value
            
            Unrealized
              LossesU.S.
                Treasury and other U.S. government agency securities
            
            $
            -
            
            $
            -
            
            $
            38,030
            
            $
            725
            
            $
            38,030
            
            $
            725Marketable
                equity securities
            
            
            525
            
            
            58
            
            
            -
            
            
            -
            
            
            525
            
            
            58Mortgage-backed
                securities
            
            
            -
            
            
            -
            
            
            25,048
            
            
            600
            
            
            25,048
            
            
            600Corporate
                bonds
            
            
            -
            
            
            -
            
            
            1,503
            
            
            5
            
            
            1,503
            
            
            5Asset
                backed securities
            
            
            4,968
            
            
            6
            
            
            -
            
            
            -
            
            
            4,968
            
            
            6State
                and political subdivision bonds and notes
            
            
            3,497
            
            
            7
            
            
            -
            
            
            -
            
            
            3,497
            
            
            7Total
                temporarily impaired securities
            
            $
            8,990
            
            $
            71
            
            $
            64,581
            
            $
            1,330
            
            $
            73,571
            
            $
            1,401




At
      December 31, 2006, securities with a total fair value of $73,571,000 were in
      a
      loss position. These securities included twenty U.S. government agency
      securities with a fair value of $38,030,000 and an unrealized loss of $725,000.
      These securities had an unrealized loss due to the current interest rate
      environment. As these securities are guaranteed by U.S. government agencies
      such
      as FHLB, FHLMC or FNMA there is no credit risk associated with them. These
      securities are not other-than-temporarily impaired as the Company has the
      ability and the intent to hold these securities until recovery to cost basis.





**Table
          of Contents**


Mortgage-backed
      securities with a fair value of $25,048,000 had an unrealized loss of $600,000
      at December 31, 2006. As with the U.S. government agency securities, these
      securities have an unrealized loss due to the current interest rate environment.
      As all of these mortgage-backed securities are guaranteed by U.S. government
      agencies such as FHLMC, GNMA or FNMA there is no credit risk associated with
      them. These securities have not been classified as other-than-temporarily
      impaired as the Company has the ability and intent to hold these securities
      until recovery to cost basis.





Eight
      marketable equity securities with a fair value of $525,000 had an unrealized
      loss of $58,000 at December 31, 2006. Marketable equity securities are subject
      to internal testing on a quarterly basis to determine impairment. Testing
      includes review of industry analyst reports, credit ratings, sector analysis
      and
      earnings projections. Based upon the December 31, 2006 review, these securities
      were not determined to be other-than-temporarily impaired.





One
      corporate bond security with a fair value of $1,503,000 had an unrealized loss
      of $5,000 at December 31, 2006. Corporate bond securities are subject to
      internal testing on a quarterly basis to determine other-than-temporary
      impairment. Based upon the December 31, 2006 review, this security was not
      determined to be other-than-temporarily impaired.





One
      asset-backed security with a fair value of $4,968,000 had an unrealized loss
      of
      $6,000 at December 31, 2006. Asset-backed securities are subject to internal
      testing on a quarterly basis to determine other-than-temporary impairment.
      Based
      upon the December 31, 2006 review, this security was not determined to be
      other-than-temporarily impaired.





Eight
      state and political subdivision securities with a fair value of $3,497,000
      had
      an unrealized loss of $7,000 at December 31, 2006. As all of these state and
      political subdivision securities are guaranteed by municipalities there is
      minimal credit risk associated with them. These securities have not been
      classified as other-than-temporarily impaired as the Company has the ability
      to
      hold these securities until recovery to cost basis.





**NOTE
      4 LOANS**





Loan
      balances were comprised of the following:





($000
                Omitted)December
                31,
            
            2006
            
            2005Real
                estate:Residential
            
            $
            167,172
            
            $
            158,729Commercial
            
            
            158,464
            
            
            143,456Construction
            
            
            10,700
            
            
            13,241Commercial
            
            
            33,569
            
            
            27,349Installment
            
            
            42,489
            
            
            35,786Indirect
                installment
            
            
            28,714
            
            
            62,221Other
            
            
            20,843
            
            
            19,507Total
                loans
            
            
            461,951
            
            
            460,289Unamortized
                cost
            
            
            279
            
            
            84Allowance
                for loan losses
            
            
            (5,581
            )
            
            (5,150
            )Total
                unamortized cost and allowance for loan losses
            
            
            (5,302
            )
            
            (5,066
            )Net
                loans
            
            $
            456,649
            
            $
            455,223





Total
      loans above are net of unearned discount on loans acquired in the amount of
      $181,000 and $275,000 at December 31, 2006 and 2005, respectively. In addition,
      total loans above are net of unamortized premium on indirect installment loans
      originated in the amount of $234,000 and $789,000 at December 31, 2006 and
      2005,
      respectively.


**Table
          of
          Contents**


Loans
      are
      made in the ordinary course of business to directors, executive officers, and
      their immediate families and to organizations in which such persons have more
      than a 10% ownership interest. These loans are made on substantially the same
      terms, including interest rate and collateral, as those prevailing at the same
      time for comparable transactions with unrelated persons and did not involve
      more
      than the normal risk of collectibility or present other unfavorable features.
      Total loans to such persons and their companies amounted to $571,000 as of
      December 31, 2006. During 2006, principal payments were $203,000 and principal
      advances amounted to $230,000.





The
      Company’s lending activities are conducted principally in New Hampshire.
      Although the loan portfolio is diversified, a portion of its debtors’ ability to
      repay is dependent upon the economic conditions prevailing in New Hampshire.
      The
      Company maintains significant credit relationships with borrowers in the hotel
      and motel industry. The aggregate loan balances to these industries totaled
      $71,874,000 at December 31, 2006 and $67,152,000 at December 31,
      2005.





Loans
      serviced for others are not included in the accompanying consolidated balance
      sheets. The unpaid principal balances of these loans total $36,225,000 and
      $39,219,000 at December 31, 2006 and 2005, respectively. The Company sold
      $5,965,000 of mortgage loans in 2006 and $9,132,000 of mortgage loans in
      2005.





The
      Company capitalized $77,000 and $79,000 of servicing rights and amortized
      $115,000 and $144,000 of total servicing rights in 2006 and 2005, respectively.
      The impairment valuation allowance of mortgage servicing rights was reduced
      by
      $0 and $3,000 in 2006 and 2005, respectively. Impairment of mortgage servicing
      rights is assessed based on the fair value of those rights. Fair values are
      estimated using discounted cash flows based on a current market interest rate.
      The amount of the impairment recognized is the amount by which the capitalized
      mortgage servicing rights exceed their fair value. At December 31, 2006 and
      2005, respectively, the carrying amount of servicing rights was $198,000 and
      $236,000, and is included in other assets. At December 31, 2006 and 2005,
      respectively, the fair value of servicing rights was $417,000 and
      $389,000.





Restructured,
      accruing loans entered into prior to the adoption of SFAS No. 114 and 118 are
      not required to be reported as impaired loans unless such loans are not
      performing in accordance with the restructured terms at adoption of SFAS No.
      114. Restructured, accruing loans entered into subsequent to the adoption of
      these statements are reported as impaired loans. In the year subsequent to
      restructure these loans may be removed from the impaired loan disclosure
      provided that the loan bears a market rate of interest at the time of
      restructure and is performing under the restructured terms.





At
      December 31, 2006 and 2005, the Company had no loans restructured in a troubled
      debt restructuring before January 1, 1995, the effective date of SFAS No.
      114.





At
      December 31, 2006 and 2005, nonperforming loans totaled $3,698,000 and
      $3,013,000, respectively. No nonperforming loans were past due 90 days or more
      and still accruing interest at December 31, 2006 and 2005.





The
      recorded investment in loans that are considered to be impaired under SFAS
      No.
      114 was $2,666,000 and $2,082,000 at December 31, 2006 and 2005, respectively,
      for which the related allowance for loan losses is $0 for both years. All of
      the
      Company’s impaired loans are collateralized and therefore all impaired loans are
      measured by the difference between the fair value of the collateral and the
      recorded amount of the loan. The average recorded investment in impaired loans
      during the twelve months ended December 31, 2006 and 2005 was approximately
      $2,787,000 and $2,147,000, respectively. For the twelve months ended December
      31, 2006 and 2005 the Company recognized interest income on impaired loans
      of
      $231,000 and $88,000, respectively, which was recognized using the cash-basis
      method of income recognition.








**NOTE
      5 ALLOWANCE FOR LOAN LOSSES**





Changes
      in the allowance for loan losses for the years ended December 31,
      follows:


($000
                Omitted)2006
            
            2005
            
            2004Balance
                at beginning of year
            
            $
            5,150
            
            $
            5,204
            
            $
            5,036Provision
                for loan losses
            
            
            465
            
            
            75
            
            
            495Recoveries
                on loans previously
              charged-off
            
            
            298
            
            
            286
            
            
            338Loans
                charged-off
            
            
            (332
            )
            
            (415
            )
            
            (665
            )Balance
                at end of year
            
            $
            5,581
            
            $
            5,150
            
            $
            5,204








**NOTE
      6 PREMISES AND EQUIPMENT**





A
      summary
      of premises and equipment follows:


($000
                Omitted)
              December
                31,2006
            
            2005Land
            
            $
            2,610
            
            $
            2,455Buildings
            
            
            11,033
            
            
            9,718Leasehold
                improvements
            
            
            601
            
            
            120Construction
                in progress
            
            
            381
            
            
            129Equipment
            
            
            10,166
            
            
            9,35924,791
            
            
            21,781Less
                accumulated depreciation and amortization
            
            
            11,042
            
            
            10,046$
            13,749
            
            $
            11,735





**Table
          of Contents**


Depreciation
      expense for the years ended December 31, 2006, 2005 and 2004 amounted to
      $1,375,000, $1,413,000 and $1,415,000, respectively.





The
      Company leases six of its branch locations and an automobile under
      non-cancelable operating leases. In addition, the Company leases one storage
      facility under a non-cancelable lease. Minimum lease payments in future periods
      under non-cancelable operating leases at December 31, 2006 are as
      follows:





($000
                Omitted)2007
            
            $
            2202008
            
            
            1152009
            
            
            852010
            
            
            852011
            
            
            91Thereafter
            
            
            397$
            993








The
      terms
      of two of the leases provide that the Company can, at the end of the current
      five-year term, renew the lease under one five-year option. The terms of two
      additional leases provide that the Company can, at the end of a ten-year term,
      renew the lease under two five-year options. All branch leases contain a
      provision that the Company shall pay its pro-rata share of operating costs.
      Additionally, two of the leases require that the Company pay all real estate
      taxes. The automobile lease contains a purchase option at the end of the lease
      term.





Rent
      expense for the years ended December 31, 2006, 2005, and 2004 amounted to
      $263,000, $359,000 and $404,000, respectively.








**NOTE
      7 OTHER REAL ESTATE OWNED**





Other
      real estate owned consists of real estate acquired by foreclosure or a similar
      conveyance of title. At December 31, 2006, the Company had no other real estate
      owned. At December 31, 2005 other real estate owned was comprised of commercial
      real estate of $196,000.





Sales
      of
      other real estate owned by the Company resulted in gains of $68,000 for the
      year
      ended December 31, 2006.





There
      were no write-downs on other real estate owned for the years ended December
      31,
      2006, 2005, and 2004.


**Table
          of
          Contents**





**NOTE
      8 DEPOSITS**





The
      aggregate amount of maturities for time deposits as of December 31, 2006 for
      each of the following five years is as follows:





($000
                Omitted)2007
            
            $
            186,2962008
            
            
            5,6892009
            
            
            1,4692010
            
            
            7692011
            
            
            718$
            194,941





Deposits
      from related parties held by the Bank at December 31, 2006 and 2005 amounted
      to
      $5,234,000 and $3,785,000, respectively.








**NOTE
      9 SHORT-TERM BORROWINGS**





Short-term
      borrowings consist of securities sold under agreements to repurchase. The
      securities sold under agreements to repurchase as of December 31, 2006 and
      2005
      are securities sold on a short term basis by the Company that have been
      accounted for not as sales but as borrowings. The underlying securities
      associated with securities sold under agreements to repurchase are under the
      control of the Company. The purchasers have agreed to sell to the Company
      substantially identical securities at the maturity of the
      agreements.





**NOTE
      10 LONG-TERM DEBT**





Long-term
      debt at December 31, 2006 and 2005 consisted of FHLB advances of $53,000,000
      and
      $85,000,000, respectively, as well as $20,620,000 of junior subordinated
      debentures, for each year.





As
      of
      December 31, 2006, contractual principal payments due under long-term debt,
      which consists of FHLB advances and junior subordinated debentures, are as
      follows:





($000
                Omitted)2007
            
            $
            13,0002008
            
            
            14,0002009
            
            
            5,0002010
            
            
            5,0002012
                and years thereafter
            
            
            36,620$
            73,620





The
      FHLB
      long-term debt consisted of fourteen separate advances. Two of these advances
      are callable with the following rates and terms ($000 Omitted):





Amount
            
            Rate
            
            Maturity
                Date
            
            Next
                Call Date$
                5,000
            
            5.91
            %
            12/17/09
            
            03/19/07
                and quarterly thereafter14,000
            
            4.50
            
            12/27/13
            
            12/29/08
                and quarterly thereafter$19,000





One
      advance, totaling $10,000,000 with a maturity date of May 9, 2008 and an
      interest rate of 5.31% reprices monthly to the 4-week weighted average money
      market yield, as published by the FHLB, plus 10 basis points.





The
      remaining eleven advances, totaling $24,000,000, are at rates ranging from
      2.35%
      to 6.11% with a weighted average rate of 3.79%.


**Table
          of Contents**




The
      $20,620,000 of junior subordinated debentures consists of the following two
      issues:





On
      April
      10, 2002, the Company completed the private placement of $7,217,000 aggregate
      liquidation amount of floating rate trust preferred securities (the “Trust I
      Capital Securities”) issued by its Delaware statutory business trust, Northway
      Capital Trust I (“Capital Trust I”). The Trust I Capital Securities were sold to
      a pooled investment vehicle. The proceeds from the sale of the Trust I Capital
      Securities, which included the proceeds from the sale by Capital Trust I of
      its
      common securities to the Company, were invested in Floating Rate Junior
      Subordinated Debt Securities of the Company due 2032 (the “Trust I Junior
      Subordinated Debt”), which were issued pursuant to an Indenture, dated April 10,
      2002, between the Company and Wilmington Trust Company, as Trustee. Both the
      Trust I Capital Securities and the Trust I Junior Subordinated Debt have a
      floating rate, which resets semi-annually, equal to six-month LIBOR plus 3.70%,
      with a ceiling of 11.00% for the first five years. Currently, the interest
      rate
      on these securities is 9.089%. Payments of distributions and other amounts
      due
      on the Trust I Capital Securities are irrevocably guaranteed by the Company,
      to
      the extent that Capital Trust I has funds available for the payments of such
      distributions, pursuant to a Guarantee Agreement, dated April 10, 2002, between
      the Company and Wilmington Trust Company, as Guarantee Trustee. The Trust I
      Junior Subordinated Debt and the Trust I Capital Securities may be redeemed
      at
      the option of the Company on fixed semi-annual dates beginning on April 22,
      2007.





On
      July
      11, 2002, the Company completed the private placement of $13,403,000 aggregate
      liquidation amount of floating rate trust preferred securities (the “Trust II
      Capital Securities”) issued by its Delaware statutory business trust, Northway
      Capital Trust II (the “Capital Trust II”). The Trust II Capital Securities were
      sold to a pooled investment vehicle. The proceeds from the sale of the Trust
      II
      Capital Securities, which include the proceeds from the sale by Capital Trust
      II
      of its common securities to the Company, were invested in Floating Rate Junior
      Subordinated Debt Securities of the Company due 2032 (the “Trust II Junior
      Subordinated Debt”), which were issued pursuant to an Indenture, dated July 11,
      2002, between the Company and Wilmington Trust Company, as Trustee. Both the
      Trust II Capital Securities and the Trust II Junior Subordinated Debt have
      a
      floating rate, which resets quarterly, equal to three-month LIBOR plus 3.65%,
      with a ceiling of 12.50% for the first five years. Currently, the interest
      rate
      on these securities is 9.01%. Payments of distributions and other amounts due
      on
      the Trust II Capital Securities are irrevocably guaranteed by the Company,
      to
      the extent that Capital Trust II has funds available for the payments of such
      distributions, pursuant to a Guarantee Agreement, dated July 11, 2002, between
      the Company and Wilmington Trust Company, as Guarantee Trustee. The Trust II
      Junior Subordinated Debt and the Trust II Capital Securities may be redeemed
      at
      the option of the Company on fixed quarterly dates beginning on July 7,
      2007.





**NOTE
      11 ACQUISITIONS**





On
      April
      7, 2006, the Company acquired certain assets and assumed the deposits of two
      branch offices of Washington Mutual Bank located in Laconia and Belmont, New
      Hampshire. This acquisition has allowed the Company to expand its market area
      further in Belknap County. Deposits assumed totaled $29,438,000 for which the
      Company paid a deposit purchase premium of 6.30%. In addition, the Company
      acquired certain loans associated with the branches totaling $8,192,000. As
      a
      result of this purchase, the Company made the following entries to record this
      transaction:





($000
                Omitted)Cash
            
            $
            19,130Loans
            
            
            8,192Goodwill
            
            
            425Core
                deposit intangible
            
            
            1,234Equipment
            
            
            49Land
                and buildings
            
            
            458Other
                assets
            
            
            28Building
                and equipment expense
            
            
            1Deposits
            
            
            
            
            $
            29,438Other
                liabilities
            
            
            
            
            
            74Miscellaneous
                income
            
            
            
            
            
            5$
            29,517
            
            $
            29,517





This
      transaction was accounted for using the purchase method of accounting. The
      results of operations of the acquired branches are included in the 2006
      consolidated statements of income of the Company from the date of the
      transaction.





The
      cost
      of the acquired branch offices exceeded the fair value of the assets acquired
      and liabilities assumed by $1,659,000. Of this amount, $1,234,000 was assigned
      to core deposit intangible and $425,000 was recorded as goodwill. All of the
      goodwill was deductible for tax purposes. The core deposit intangible of
      $1,234,000 is being amortized to noninterest expense over fourteen years using
      the sum-of-the-years'-digits method.


**Table
          of
          Contents**





**NOTE
      12 GOODWILL AND OTHER INTANGIBLE ASSETS**





At
      December 31, 2006, the Company has goodwill and core deposit intangibles
      totaling $12,755,000. Core deposit intangibles are being amortized over their
      useful lives and both core deposit intangibles and goodwill are tested for
      impairment at least annually.





The
      changes in the carrying amount of goodwill and core deposit intangibles for
      the
      years ended December 31, 2006 and 2005 are as follows:


($000
                Omitted)Goodwill
            
            Core
                Deposit
              IntangiblesBalance,
                December 31, 2004
            
            $
            10,152
            
            $
            2,949Amortization
                expense
            
            
            -
            
            
            (954
            )Balance,
                December 31, 2005
            
            
            10,152
            
            
            1,995Branch
                acquisition
            
            
            425
            
            
            1,234Amortization
                expense
            
            
            -
            
            
            (1,051
            )Balance,
                December 31, 2006
            
            $
            10,577
            
            $
            2,178





Estimated
      annual amortization expense:


($000
                Omitted)Core
                Deposit
              Intangibles2007
            
            $
            4762008
            
            
            4642009
            
            
            4532010
            
            
            2272011
            
            
            1092012
                and thereafter
            
            
            449





The
      following table reflects the gross carrying amount and accumulated amortization
      of core deposit intangibles as of December 31, 2006:


($000
                Omitted)Gross
              Carrying
              Amount
            Accumulated
              Amortization
            Net
              Carrying
              AmountCore
                deposit intangibles
            $6,566
            $4,388
            $2,178





Management
      reviews the carrying amount of intangible assets on an ongoing basis, taking
      into consideration any events and circumstances that might have diminished
      such
      amount. During 2006 and 2005, the Company reviewed the carrying amount of
      intangible assets and determined that no impairment write-down was
      required.








**NOTE
      13 REGULATORY MATTERS**





The
      Company and the Bank are subject to various regulatory capital requirements
      administered by the federal banking agencies. Failure to meet minimum capital
      requirements can initiate certain mandatory, and possibly additional
      discretionary actions by regulators that, if undertaken, could have a direct
      material effect on the Company’s and the Bank’s financial statements. Under
      capital adequacy guidelines and the regulatory framework for prompt corrective
      action, the Company and the Bank must meet specific capital guidelines that
      involve quantitative measures of their assets, liabilities and certain
      off-balance sheet items as calculated under regulatory accounting practices.
      The
      capital amounts and classifications are also subject to qualitative judgments
      by
      the regulators about components, risk weightings and other factors.





Quantitative
      measures established by regulation to ensure capital adequacy require the
      Company and the Bank to maintain minimum amounts and ratios (set forth in the
      table below) of total and Tier 1 capital (as defined in the regulations) to
      risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average
      assets (as defined). As of December 31, 2006, the most recent notification
      from
      the FDIC categorized the Bank as “well-capitalized” under the regulatory
      framework for prompt corrective action. To be categorized as “well-capitalized”
the Bank must maintain total risk-based, Tier 1 risk-based and Tier 1 leverage
      ratios above regulatory prescribed minimum levels. There are no conditions
      or
      events since that notification that management believes have changed the Bank’s
      category. Management believes, as of December 31, 2006 and 2005, that the
      Company and the Bank meet all capital adequacy requirements to which they are
      subject.





**Table
          of Contents**


These
      minimum capital amounts and ratios, as well as the Company’s and Bank’s actual
      capital amounts and ratios, are presented in the following table:


($000
                Omitted)Actual
            
            For
                Capital
              Adequacy
              Purposes
            
            To
                Be Well Capitalized
              Under
                Prompt Corrective Action
              ProvisionsAmount
            Ratio
            
            Amount
            Ratio
            
            Amount
            RatioAs
                of December 31, 2006Tier
                1 capital (to average assets)Northway
                Financial, Inc.
            $58,432
            9.31
            %
            $25,102
            34.00
            %
            N/ANorthway
                Bank
            51,653
            8.30
            
            24,887
            34.00
            
            $31,109
            35.00
            %Total
                capital (to risk weighted assets)Northway
                Financial, Inc.
            66,464
            15.95
            
            33,339
            38.00
            
            N/ANorthway
                Bank
            56,796
            13.82
            
            32,885
            38.00
            
            41,107
            310.00Tier
                1 capital (to risk weighted assets)Northway
                Financial, Inc.
            58,432
            14.02
            
            16,669
            34.00
            
            N/ANorthway
                Bank
            51,653
            12.57
            
            16,443
            34.00
            
            24,664
            36.00As
                of December 31, 2005Tier
                1 capital (to average assets)Northway
                Financial, Inc.
            $55,765
            8.96
            
            $24,888
            34.00
            
            N/ANorthway
                Bank
            50,450
            8.19
            
            24,644
            34.00
            
            $30,806
            35.00Total
                capital (to risk weighted assets)Northway
                Financial, Inc.
            65,025
            15.24
            
            34,138
            38.00
            
            N/ANorthway
                Bank
            55,673
            13.25
            
            33,623
            38.00
            
            42,029
            310.00Tier
                1 capital (to risk weighted assets)Northway
                Financial, Inc.
            55,765
            13.07
            
            17,069
            34.00
            
            N/ANorthway
                Bank
            50,450
            12.00
            
            16,812
            34.00
            
            25,217
            36.00





Federal
      regulations prohibit banking companies from paying dividends on their stock
      if
      the effect would cause stockholders' equity to be reduced below applicable
      regulatory capital requirements or if such declaration and payment would
      otherwise violate regulatory requirements.





As
      of
      December 31, 2006, the Bank is restricted from declaring dividends to the
      Company in an amount greater than approximately $23,900,000, as such declaration
      would decrease capital below the Bank’s required minimum level of regulatory
      capital.








**NOTE
      14 OTHER NONINTEREST EXPENSE**





The
      following table sets for information relating to the Company’s other noninterest
      expense for the years ended December 31:





($000
                Omitted)2006
            
            2005
            
            2004Professional
                fees
            
            $
            1,026
            
            $
            1,179
            
            $
            907Marketing
            
            
            726
            
            
            757
            
            
            326Stationery
                and supplies
            
            
            365
            
            
            647
            
            
            429Telecommunications
            
            
            455
            
            
            619
            
            
            595Other
            
            
            3,676
            
            
            3,511
            
            
            3,252$
            6,248
            
            $
            6,713
            
            $
            5,509


**Table
          of
          Contents**


**NOTE
      15 FEDERAL AND STATE TAXES**





The
      components of federal and state tax expense for the years ended December 31,
      are
      as follows:





($000
                Omitted)2006
            
            2005
            
            2004CurrentFederal
            
            $
            1,010
            
            $
            820
            
            $
            1,289State
            
            
            -
            
            
            26
            
            
            3341,010
            
            
            846
            
            
            1,623DeferredFederal
            
            
            (363
            )
            
            2
            
            
            44State
            
            
            5
            
            
            (6
            )
            
            (1
            )(358
            )
            
            (4
            )
            
            43Total
            
            $
            652
            
            $
            842
            
            $
            1,666





The
      temporary differences (the differences between the financial statement carrying
      amounts of existing assets and liabilities and their respective tax bases)
      that
      give rise to significant portions of the net deferred income tax asset at
      December 31, are as follows:





($000
                Omitted)2006
            
            2005Deferred
                income tax assetsAllowance
                for loan losses
            
            $
            2,234
            
            $
            2,072Interest
                on nonaccrual loans
            
            
            16
            
            
            46Unrealized
                holding loss on securities available-for-sale
            
            
            198
            
            
            724Capital
                loss carryforward
            
            
            -
            
            
            24Pension
                unfunded status valuation adjustment
            
            
            626
            
            
            -Amortization
                of goodwill and core deposit intangible
            
            
            -
            
            
            3Supplemental
                pension
            
            
            416
            
            
            325Other
            
            
            10
            
            
            93,500
            
            
            3,203Deferred
                income tax liabilitiesDepreciation
            
            
            (557
            )
            
            (621
            )Amortization
                of goodwill and core deposit intangible
            
            
            (86
            )
            
            -Prepaid
                pension
            
            
            (286
            )
            
            (454
            )Mortgage
                and consumer servicing rights
            
            
            (79
            )
            
            (94
            )(1,008
            )
            
            (1,169
            )Deferred
                income tax asset, net
            
            $
            2,492
            
            $
            2,034





The
      primary sources of recovery of the deferred income tax asset are taxes paid
      that
      are available for carryback and the expectation that the deductible temporary
      differences will reverse during periods in which the Company generates taxable
      income.





Total
      income tax expense for the years ended December 31, 2006, 2005 and 2004 differs
      from the "expected" federal income tax expense at the 34% statutory rate for
      the
      following reasons:





2006
            
            2005
            
            2004Expected
                federal income taxes
            
            
            34.0
            %
            
            34.0
            %
            
            34.0
            %Interest
                on municipal securities available-for-sale and municipal
                loans
            
            
            (16.8
            )
            
            (9.4
            )
            
            (4.5
            )State
                tax expense, net of federal benefit
            
            
            0.1
            
            
            0.4
            
            
            4.3Other
            
            
            (0.4
            )
            
            (1.0
            )
            
            (0.8
            )Effective
                tax rates
            
            
            16.9
            %
            
            24.0
            %
            
            33.0
            %


**Table
          of
          Contents**


**NOTE
      16 EMPLOYEE BENEFITS**





*Pension
      Plan* ****





The
      Company maintains a trusteed non-contributory pension plan (the “Plan”) covering
      substantially all full-time employees. Assuming retirement at age 65 after
      30
      years or more of service, the benefits are computed as the sum of one percent
      of
      final average earnings up to a covered compensation limit, plus 0.65 percent
      of
      final average earnings in excess of covered compensation, times years of
      service, up to 30. Final average earnings are defined as the five consecutive
      years out of the employee’s last ten years of employment during which
      compensation is highest. The amounts contributed to the Plan are determined
      annually on the basis of (a) the maximum amount that can be deducted for federal
      income tax purposes or (b) the amount certified by a consulting actuary as
      necessary to avoid an accumulated funding deficiency as defined by the Employee
      Retirement Income Security Act of 1974. Contributions are intended to provide
      not only benefits attributed to service to date but also for those expected
      to
      be earned in the future.





The
      following table sets forth information about the Plan as of December 31, using
      a
      measurement date of December 31, and for the years then ended:


($000
                Omitted)2006
            
            2005
            
            2004Accumulated
                benefit obligation at the end of the year
            
            $
            5,863
            
            $
            4,986
            
            $
            5,475Change
                in projected benefit obligationProjected
                benefit obligation at beginning of year
            
            $
            6,590
            
            $
            5,805
            
            $
            4,901Service
                cost
            
            
            519
            
            
            515
            
            
            481Interest
                cost
            
            
            371
            
            
            346
            
            
            303Actuarial
                (gain) loss
            
            
            (344
            )
            
            235
            
            
            233Benefits
                paid
            
            
            (169
            )
            
            (311
            )
            
            (113
            )Projected
                benefit obligation at end of year
            
            
            6,967
            
            
            6,590
            
            
            5,805Change
                in plan assetsFair
                value of plan assets at beginning of year
            
            
            5,730
            
            
            4,601
            
            
            3,652Actual
                return on plan assets
            
            
            680
            
            
            295
            
            
            401Employer
                contributions
            
            
            -
            
            
            1,145
            
            
            661Administrative
                expense
            
            
            (15
            )
            
            -
            
            
            -Benefits
                paid
            
            
            (169
            )
            
            (311
            )
            
            (113
            )Fair
                value of plan assets at end of year
            
            
            6,226
            
            
            5,730
            
            
            4,601Funded
                status at end of year
            
            $
            (741
            )
            
            (
                860
            )
            
            (1,204
            )Unrecognized
                net actuarial loss
            
            
            
            
            
            2,989
            
            
            2,803Unrecognized
                prior service credit
            
            
            
            
            
            (792
            )
            
            (877
            )Net
                amount recognized
            
            
            
            
            $
            1,337
            
            $
            722Amounts
                recognized in the Statement of Financial PositionPrepaid
                benefit cost
            
            $
            -
            
            $
            1,337
            
            $
            722Accrued
                benefit liability
            
            
            -
            
            
            -
            
            
            (1,018
            )Unfunded
                pension liability
            
            
            (741
            )
            
            -
            
            
            -Total
            
            $
            (741
            )
            $
            1,337
            
            $
            (296
            )Amounts
                recognized in accumulated other comprehensive incomePension
                liability adjustment
            
            $
            -
            
            $
            -
            
            $
            1,018Prior
                service credit
            
            
            (708
            )
            
            -
            
            
            -Net
                loss
            
            
            2,289
            
            
            -
            
            
            -Total
            
            $
            1,581
            
            $
            -
            
            $
            1,018


**Table
          of
          Contents**


The
      following table illustrates the incremental effect of applying SFAS No. 158
      on
      individual line items in the balance sheet as of December 31, 2006:





($000
                Omitted)Before
                Application of SFAS No. 158
            
            Adjustments
            
            After
                Application of SFAS No. 158Prepaid
                benefit cost
            
            $
            840
            
            $
            (840
            )
            $
            -Deferred
                income taxes
            
            
            1,866
            
            
            626
            
            
            2,492Total
                assets
            
            
            651,091
            
            
            (214
            )
            
            650,877Liability
                for pension benefits
            
            
            -
            
            
            741
            
            
            741Total
                liabilities
            
            
            597,987
            
            
            741
            
            
            598,728Accumulated
                other comprehensive loss
            
            
            (301
            )
            
            (955
            )
            
            (1,256
            )Total
                stockholders’ equity
            
            
            53,104
            
            
            (955
            )
            
            52,149




Components
                of net periodic benefit cost and other amounts recognized in other
                comprehensive loss
            
            2006
            
            2005
            
            2004Service
                cost
            
            $
            519
            
            $
            515
            
            $
            481Interest
                cost
            
            
            371
            
            
            346
            
            
            303Expected
                return on plan assets
            
            
            (451
            )
            
            (384
            )
            
            (288
            )Amortization
                of prior service cost
            
            
            (85
            )
            
            (85
            )
            
            (84
            )Amortization
                of net actuarial loss
            
            
            143
            
            
            138
            
            
            141Recognized
                transition amount
            
            
            -
            
            
            -
            
            
            (1
            )Net
                periodic benefit cost
            
            
            497
            
            $
            530
            
            $
            552Other
                changes in plan assets and benefit obligations recognized in other
                comprehensive loss*Net
                gain for period
            
            
            (558
            )Amortization
                of prior service credit
            
            
            85Amortization
                of net loss
            
            
            (143
            )Total
            
            
            (616
            )Total
                recognized in net period pension cost and other comprehensive
                loss*
            
            $
            (119
            )*This
                section illustrates the reconciliation items if FAS 158 were in effect
                at
                December 31, 2005





The
      estimated prior service credit and net loss that will be accreted and amortized
      from accumulated other comprehensive loss into net periodic benefit cost over
      the year ended December 31, 2007 are $84,000 and $100,000,
      respectively.





Assumptions
                used to determine benefit obligations and benefit cost as of and
                for the
                years ending December 31,
            
            2006
            
            2005
            
            2004Discount
                rate:Benefit
                obligation
            
            6.00
            %
            5.75
            %
            6.00
            %Benefit
                cost
            
            5.75
            
            6.00
            
            6.25Long-term
                rate of return on plan assets
            
            8.00
            
            8.00
            
            8.00Rate
                of compensation increase
            
            3.50
            
            3.50
            
            3.50





The
      expected long-term rate of return for the plan’s total assets is based on the
      expected return of asset categories identified below, weighted based on the
      target allocations for each class. Equity funds are expected to return 8% to
      10%
      over the long-term and bond funds and short-term money markets are expected
      to
      return between 4% and 6%.


**Table
          of
          Contents**




The
      Company’s pension plan actual asset allocations by asset category are as
      follows:





Plan
                Assets at December 31,Asset
              Category
            
            2006
            
            2005
            
            2004Mutual
                funds:Bond
                funds
            
            29.0
            %
            32.7
            %
            32.6
            %Equity
                securities
            
            51.0
            
            42.5
            
            43.6Real
                estate funds
            
            7.0
            
            8.5
            
            9.4Short-term
                money market
            
            13.0
            
            16.3
            
            14.4Total
            
            100.0
            %
            100.0
            %
            100.0
            %





The
      investment policy, as established by the Company, is to provide for a moderate
      growth of capital with a moderate level of volatility by investing assets per
      the target allocations as follows:





Asset
              Category
            
            2006
            
            2005
            
            2004Mutual
                funds:Bond
                funds
            
            25-45
            %
            40-60
            %
            40-60
            %Equity
                securities
            
            45-65
            
            30-50
            
            30-50Real
                estate funds
            
            0-15
            
            0-15
            
            0-15Other
            
            0-25
            
            -
            
            -





The
      assets will be re-allocated quarterly to meet the above target allocations.
      The
      investment policy is reviewed on an annual basis, under the advisement of the
      Company’s certified investment advisor, to determine if the policy should be
      changed.





The
      plan
      assets do not include any Company common stock at December 31, 2006 and
      2005.





The
      Company expects to contribute $435,000 to its pension plan in 2007.





Estimated
      future benefit payments, which reflect future service, as appropriate, are
      as
      follows for the years ended December 31:





($000
                Omitted)2007
            $
                1692008
            1942009
            2242010
            2352011
            2622012-2016
            1,827





*401(k)
      Plan*





The
      Company offers a contributory 401(k) Plan. Under the Northway Financial, Inc.
      401(k) and Profit Sharing Plan (the “401K Plan”) employees must have attained
      age 21, completed six months of service and be credited with 1,000 hours of
      service in order to participate. Employees of the Company are eligible to
      participate. Under the 401K Plan, the Company matches 50 percent of the first
      4
      percent of employee contributions. Total 401(k) matching expense in 2006, 2005
      and 2004 amounted to $151,000, $139,000 and $143,000, respectively, and Profit
      Sharing contribution expense for 2006, 2005, and 2004 was $0, $0, and $38,000,
      respectively.





*Supplemental
      Executive Retirement Plan (SERP)*





Effective
      May 29, 2003, the existing Executive Life program sponsored by the Company
      was
      terminated and replaced with a SERP in which Mr. Woodward participates. The
      existing Split Dollar Life Insurance policy designed to support the Executive
      Life program is now fully owned by Northway. This policy will be maintained
      by
      Northway and is used as the benchmark for the SERP.





The
      total
      retirement SERP benefit is as follows: Upon Mr. Woodward’s termination of
      employment for reasons other than death or for cause, the account balance is
      paid out to him in ten (10) equal annual installments on the first day of the
      month following the month in which employment is terminated. Upon death after
      retirement, the unpaid account balance, if any, is paid out in a lump sum to
      the
      named beneficiary. During retirement, an additional retirement payment, based
      on
      the policy gains associated with the prior calendar year, will also be paid
      on
      an annual basis until the executive’s death. In the event of Mr. Woodward’s
      death while employed by the Company, the SERP permits a death benefit of
      $2,000,000 be paid to his beneficiary.





**Table
          of Contents**


*Stock-Based
      Compensation*





The
      Board
      of Directors (the “Committee”) administers the 1999 Stock Option and Grant Plan
      (the “1999 Plan”) which is described below.





Under
      the
      1999 Plan, the Committee may select the individuals to whom awards may from
      time
      to time be granted; determine the time or times of grant; and determines the
      extent, if any, of incentive stock options, non-qualified stock options,
      restricted stock awards, unrestricted stock awards, performance share awards,
      or
      any combination of the foregoing.





The
      1999
      Plan expires in February 2009. The aggregate number of shares of the Company’s
      common stock which may be issued upon the exercise of options granted under
      the
      1999 Plan is 175,000. The option price is fixed by the Committee at the time
      of
      the grant and may not be less than 100 percent of the fair market value of
      the
      stock, as determined by the Committee, in good faith as of the grant date.
      Each
      option may be exercised at such times as shall be determined by the Committee
      at
      or after the grant date; provided, however, that no option may be exercised
      ten
      years after the date of grant. The fair value of each option granted is
      estimated on grant date using the Black-Scholes option pricing model.





A
      summary
      of the status of the Company’s 1999 Plan as of December 31, 2006, 2005 and 2004
      and changes during the years then ended is presented below:





2006
            
            2005
            
            2004Shares
            
            Weighted
              Average
              Exercise
              Price
            
            Shares
            
            Weighted
              Average
              Exercise
              Price
            
            Shares
            
            Weighted
              Average
              Exercise
              PriceOutstanding,
                beginning of year
            
            
            34,000
            
            $
            25.00
            
            
            38,000
            
            $
            24.96
            
            
            42,000
            
            $
            24.93Exercised
            
            
            -
            
            
            
            
            
            (4,000
            )
            
            24.64
            
            
            (4,000
            )
            
            24.64Forfeited
            
            
            (3,500
            )
            
            28.00
            
            
            -
            
            
            
            
            
            -Outstanding,
                end of year
            
            
            30,500
            
            
            24.65
            
            
            34,000
            
            
            25.00
            
            
            38,000
            
            
            24.96Options
                exercisable at year-end
            
            
            30,500
            
            
            
            
            
            34,000
            
            
            
            
            
            38,000





The
      following table summarizes information about fixed stock options outstanding
      as
      of December 31, 2006:





Options
                Outstanding
            
            Options
                ExercisableWeighted
              Average
              Exercise
              Price
            
            
            Number
              Outstanding
              as
                of
              12/31/06
            
            
            Weighted
              Average
              Remaining
              Contractual
              Life
            
            
            
            Number
              Exercisable
              as
                of
              12/31/06
            
            
            Weighted
              Average
              Exercise
              Price$
            28.00
            
            
            11,500
            
            
            2.50
                years
            
            
            
            11,500
            
            $
            28.0022.63
            
            
            19,000
            
            
            3.63
                years
            
            
            
            19,000
            
            
            22.6324.65
            
            
            30,500
            
            
            3.20
                years
            
            
            
            30,500
            
            
            24.65








*Change
      in Control*





The
      Company and its subsidiary have entered into Key Employee agreements with
      specific Executive Officers as well as other Senior Officers of the Company.
      These agreements provide for payments, under certain circumstances, to the
      officer upon the officer’s termination after a change in control. Payments will
      be made under these agreements upon the officer’s termination or resignation in
      connection with certain specified actions adverse to the officer’s employment
      status after a change in control. The amount of such payments ranges from 1.0
      to
      1.5 times such officer’s annual compensation.


**Table
          of
          Contents**


**NOTE
      17 FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK**





The
      Company is party to financial instruments with off-balance sheet risk in the
      normal course of business to meet the financing needs of its customers and
      to
      reduce its own exposure to fluctuations in interest rates. These financial
      instruments include commitments to originate loans and standby letters of
      credit. The instruments involve, to varying degrees, elements of credit and
      interest rate risk in excess of the amount recognized in the consolidated
      balance sheets. The amounts of those instruments reflect the extent of
      involvement the Company has in particular classes of financial
      instruments.





The
      Company’s exposure to credit loss in the event of nonperformance by the other
      party to the financial instrument for loan commitments and standby letters
      of
      credit is represented by the contractual amount of those instruments. The
      Company uses the same credit policies in making commitments and conditional
      obligations as it does for on-balance sheet instruments.





Financial
      instruments with off-balance sheet credit risk at December 31, are as follows:




($000
                Omitted)2006
            
            2005Financial
                instrument whose contract amounts represent credit risk:Unadvanced
                portions of home equity loans
            
            $
            17,691
            
            $
            18,761Unadvanced
                portions of lines of credit
            
            
            21,424
            
            
            14,485Unadvanced
                portions of commercial real estate loans
            
            
            17,421
            
            
            17,381Unadvanced
                portions of Bounce ProtectionTM
            
            
            13,667
            
            
            11,294Commitments
                to originate all other loans
            
            
            20,742
            
            
            19,971Commitments
                to originate municipal notes
            
            
            972
            
            
            -Standby
                letters of credit
            
            
            303
            
            
            78Total
            
            $
            92,220
            
            $
            81,970





Commitments
      to originate loans and municipal notes, unadvanced portions of home equity
      loans, lines of credit and commercial real estate loans are agreements to lend
      to a customer provided there is no violation of any condition established in
      the
      contract. Commitments generally have fixed expiration dates or other termination
      clauses and may require payment of a fee. Since many of the commitments are
      expected to expire without having been drawn upon, the total commitment amounts
      do not necessarily represent future cash requirements. The Company evaluates
      each customer’s creditworthiness on a case-by-case basis. The amount of
      collateral obtained, if deemed necessary by the Company upon extension of
      credit, is based on management’s credit evaluation of the borrower.





Unadvanced
      portions of Bounce ProtectionTM represent the unused portion of the Bank’s
      overdraft privilege program.





Standby
      letters of credit are conditional commitments issued by the Company to guarantee
      the performance by a customer to a third party. The credit risk involved in
      issuing letters of credit is essentially the same as that involved in extending
      loan commitments to customers. As of December 31, 2006 and 2005, the maximum
      potential amount of the Company’s obligation was $303,000 and $78,000,
      respectively, for financial and standby letters of credit. The Company’s
      outstanding letters of credit generally have a term of less than one year.
      If a
      letter of credit is drawn upon, the Company may seek recourse through the
      customer’s underlying line of credit. If the customer’s line of credit is also
      in default, the Company may take possession of the collateral, if any, securing
      the line of credit.





**Table
          of
          Contents**





**NOTE
      18 FAIR VALUE OF FINANCIAL INSTRUMENTS**





The
      following methods and assumptions were used by the Company in estimating its
      fair value disclosures for financial instruments:





Cash
      and
      cash equivalents: The carrying amounts reported in the consolidated balance
      sheets for cash and cash equivalents approximates the fair value of those
      assets.





Securities:
      Fair values for securities are based on quoted market prices, where available.
      If quoted market prices are not available, fair values are based on quoted
      market prices of comparable instruments.





FHLB
      Stock: The carrying amount reported in the consolidated balance sheets for
      FHLB
      Stock approximates its fair value. If redeemed, the Company will receive an
      amount equal to the par value of the stock.





Loans
      held-for-sale: Fair values for loans held-for-sale are estimated based on
      outstanding investor commitments, or in the absence of such commitments, are
      based on current investor yield requirements.





Loans:
      For variable-rate loans that reprice frequently and with no significant change
      in credit risk, fair values are based on carrying values. The fair values for
      other loans are estimated using discounted cash flow analyses, using interest
      rates currently being offered for loans with similar terms to borrowers of
      similar credit quality. The fair values of nonaccrual loans was estimated using
      discounted cash flow analyses or the estimated fair value of the underlying
      collateral where applicable.





Accrued
      interest receivable: The carrying value of accrued interest receivable
      approximates its fair value because of the short-term nature of this financial
      instrument.





Deposits:
      The fair value of demand deposits (e.g. NOW and super NOW checking, noninterest
      bearing checking, regular savings, money market accounts and mortgagors’ escrow
      accounts) are, by definition, equal to the amount payable on demand at the
      reporting date (i.e. their carrying amounts). Fair values for certificates
      of
      deposit are estimated using a discounted cash flow technique that applies
      interest rates currently being offered on certificates to a schedule of
      aggregated expected monthly maturities of time deposits.





Short-term
      borrowings: The carrying value of short-term borrowings approximates its fair
      value because of the short-term nature of these financial
      instruments.





Long-term
      debt: The fair values of long-term debt are determined by discounting the
      anticipated future cash payments by using the rates currently available to
      the
      Company for debt with similar terms and remaining maturities.





Junior
      subordinated debentures: The fair values of junior subordinated debentures
      are
      based on quoted market prices, where available. If quoted market prices are
      not
      available, fair values are based on quoted market prices of comparable
      instruments.





Off-balance
      sheet instruments: The fair value of commitments to originate loans is estimated
      using the fees currently charged to enter similar agreements, taking into
      account the remaining terms of the agreements and the present creditworthiness
      of the counterparties. For fixed-rate loan commitments and the unadvanced
      portion of loans, fair value also considers the difference between current
      levels of interest rates and the committed rates. The fair value of letters
      of
      credit is based on fees currently charged for similar agreements or on the
      estimated cost to terminate them or otherwise settle the obligation with the
      counterparties at the reporting date. See NOTE 17 for further
      information.





The
      estimated fair values of the Company’s financial instruments are as
      follows:


($000
                Omitted)December
                31,2006
            
            2005CarryingAmount
            
            EstimatedFair
                Value
            
            CarryingAmount
            
            EstimatedFair
                ValueFinancial
                assets:Cash
                and cash equivalents
            
            $
            24,808
            
            $
            24,808
            
            $
            29,362
            
            $
            29,362Securities
                available-for-sale
            
            
            127,789
            
            
            127,789
            
            
            103,244
            
            
            103,244FHLB
                stock
            
            
            3,782
            
            
            3,782
            
            
            5,541
            
            
            5,541Loans
                held-for-sale
            
            
            263
            
            
            268
            
            
            453
            
            
            461Loans,
                net
            
            
            456,649
            
            
            445,550
            
            
            455,223
            
            
            445,529Accrued
                interest receivable
            
            
            2,941
            
            
            2,941
            
            
            2,614
            
            
            2,614


Financial
                liabilities:Deposits
            
            $
            484,677
            
            $
            484,266
            
            $
            464,456
            
            $
            463,159Short-term
                borrowings
            
            
            36,497
            
            
            36,497
            
            
            9,363
            
            
            9,363Long-term
                debt
            
            
            53,000
            
            
            51,900
            
            
            85,000
            
            
            84,296Junior
                subordinated debentures
            
            
            20,620
            
            
            20,646
            
            
            20,620
            
            
            20,908





The
      carrying amounts of financial instruments shown in the above table are included
      in the consolidated balance sheets under the indicated captions except that
      accrued interest receivable is included with other assets and junior
      subordinated debentures are included with long-term debt.





At
      December 31, 2006 and 2005 all the Company’s financial instruments were held for
      purposes other than trading.





***Limitations***





Fair
      value estimates are made at a specific point in time, based on relevant market
      information and information about the financial instrument. These estimates
      do
      not reflect any premium or discount that could result from offering for sale
      at
      one time the Company’s entire holdings of a particular financial instrument.
      Because no market exists for some of the Company’s financial instruments, fair
      value estimates are based on judgments regarding future expected loss
      experience, cash flows, current economic conditions, risk characteristics,
      and
      other factors. These estimates are subjective in nature and involve
      uncertainties and matters of significant judgment and therefore cannot be
      determined with precision. Changes in assumptions and changes in the loan,
      debt
      and interest rate markets could significantly affect the estimates. Further,
      the
      income tax ramifications related to the realization of the unrealized gains
      and
      losses can have a significant effect on the fair value estimates and have not
      been considered. The fair value amounts presented do not represent the
      underlying value of the Company because fair values of certain other financial
      instruments, assets and liabilities have not been determined.





**Table
          of Contents**


**NOTE
      19 CONDENSED PARENT ONLY FINANCIAL STATEMENTS**





Condensed
      financial statements of Northway Financial, Inc. (Parent Company only) as of
      December 31, 2006 and 2005 and for the three years ended December 31, 2006
      follow:





***Balance
      Sheets***




($000
                Omitted)2006
            
            2005AssetsCash
                and cash equivalents
            
            $
            5,182
            
            $
            3,780Investment
                in subsidiary, Northway Bank
            
            
            64,126
            
            
            61,517Investment
                in unconsolidated subsidiaries, Northway Capital Trust I &
                II
            
            
            620
            
            
            620Equipment,
                net
            
            
            960
            
            
            1,571Due
                from subsidiary
            
            
            145
            
            
            540Other
                assets
            
            
            4,126
            
            
            4,751Total
                assets
            
            $
            75,159
            
            $
            72,779Liabilities
                and stockholders’ equityAccrued
                expenses
            
            $
            541
            
            $
            540Other
                liabilities
            
            
            1,849
            
            
            1,369Junior
                subordinated debentures
            
            
            20,620
            
            
            20,620Total
                liabilities
            
            
            23,010
            
            
            22,529Stockholders’
                equity:Common
                stock
            
            
            1,732
            
            
            1,732Additional
                paid-in capital
            
            
            2,064
            
            
            2,064Retained
                earnings
            
            
            56,140
            
            
            54,089Treasury
                stock
            
            
            (6,531
            )
            
            (6,531
            )Accumulated
                other comprehensive loss
            
            
            (1,256
            )
            
            (1,104
            )Total
                stockholders’ equity
            
            
            52,149
            
            
            50,250Total
                liabilities and stockholders’ equity
            
            $
            75,159
            
            $
            72,779







**Statements
                of Income**
            
            ($000
                Omitted)2006
            
            2005
            
            2004Income:Dividends
                from subsidiary
            
            $
            2,210
            
            $
            2,036
            
            $
            2,030Interest
                income
            
            
            210
            
            
            120
            
            
            48Management
                fee income from subsidiary
            
            
            1,913
            
            
            8,750
            
            
            9,576Other
            
            
            290
            
            
            202
            
            
            1784,623
            
            
            11,108
            
            
            11,832Expense:Interest
                expense
            
            
            1,832
            
            
            1,463
            
            
            1,079Salaries
                and employee benefits
            
            
            940
            
            
            5,536
            
            
            5,715Office
                occupancy and equipment expense
            
            
            611
            
            
            1,137
            
            
            1,268Professional
                fees
            
            
            257
            
            
            661
            
            
            777Other
            
            
            104
            
            
            1,417
            
            
            1,8333,744
            
            
            10,214
            
            
            10,672Income
                before income tax benefit and equity in undistributed net income
                of
                subsidiary
            
            
            879
            
            
            894
            
            
            1,160Income
                tax benefit
            
            
            (531
            )
            
            (438
            )
            
            (345
            )Income
                before equity in undistributed net income of subsidiary
            
            
            1,410
            
            
            1,332
            
            
            1,505Equity
                in undistributed net income of subsidiary
            
            
            1,805
            
            
            1,341
            
            
            1,883Net
                income
            
            $
            3,215
            
            $
            2,673
            
            $
            3,388








**Table
          of Contents**





***Statements
      of Cash Flows***


($000
                Omitted)2006
            
            2005
            
            2004Cash
                flows from operating activities:Net
                income
            
            $
            3,215
            
            $
            2,673
            
            $
            3,388Adjustments
                to reconcile net income to net cash provided by operating
                activities:Depreciation
                and amortization
            
            
            597
            
            
            630
            
            
            603Decrease
                in amount due from subsidiary
            
            
            395
            
            
            268
            
            
            170Increase
                in other assets
            
            
            411
            
            
            (622
            )
            
            (305
            )Increase
                in accrued expenses and other liabilities
            
            
            (261
            )
            
            4
            
            
            535Loss
                on disposal of assets
            
            
            14
            
            
            2
            
            
            -Undistributed
                net income of subsidiary
            
            
            (1,805
            )
            
            (1,341
            )
            
            (1,883
            )Net
                cash provided by operating activities
            
            
            2,566
            
            
            1,614
            
            
            2,508Cash
                flows from investing activities:Capital
                contributions to subsidiary
            
            
            -
            
            
            -
            
            
            -Additions
                to premises and equipment
            
            
            -
            
            
            (145
            )
            
            (869
            )Purchase
                of company owned life insurance
            
            
            -
            
            
            -
            
            
            (400
            )Net
                cash used by investing activities
            
            
            -
            
            
            (
                145
            )
            
            (1,269
            )Cash
                flows from financing activities:Exercise
                of stock options
            
            
            -
            
            
            99
            
            
            99Purchases
                of treasury stock
            
            
            -
            
            
            (563
            )
            
            -Cash
                dividends paid
            
            
            (1,164
            )
            
            (1,068
            )
            
            (1,020
            )Net
                cash used by financing activities
            
            
            (1,164
            )
            
            (1,532
            )
            
            (
                921
            )Net
                (decrease) increase in cash and cash equivalents
            
            
            1,402
            
            
            (63
            )
            
            318Cash
                and cash equivalents at beginning of year
            
            
            3,780
            
            
            3,843
            
            
            3,525Cash
                and cash equivalents at end of year
            
            $
            5,182
            
            $
            3,780
            
            $
            3,843





**Table
          of
          Contents**





**QUARTERLY
      RESULTS OF OPERATIONS (UNAUDITED)**





Summarized
      quarterly financial data for 2006 and 2005 follows:


($000
                Omitted, except earnings per share)2006
                Quarters EndedMar
                31
            
            Jun
                30
            
            Sep
                30
            
            Dec
                31Interest
                and dividend income
            
            $
            8,543
            
            $
            8,937
            
            $
            9,179
            
            $
            9,308Interest
                expense
            
            
            2,901
            
            
            3,293
            
            
            3,623
            
            
            3,948Net
                interest and dividend income
            
            
            5,642
            
            
            5,644
            
            
            5,556
            
            
            5,360Provision
                for loan losses
            
            
            105
            
            
            120
            
            
            120
            
            
            120Noninterest
                income
            
            
            1,572
            
            
            1,324
            
            
            1,507
            
            
            1,468Noninterest
                expense
            
            
            5,699
            
            
            5,921
            
            
            5,904
            
            
            6,217Income
                before taxes
            
            
            1,410
            
            
            927
            
            
            1,039
            
            
            491Income
                tax expense (benefit)
            
            
            330
            
            
            171
            
            
            185
            
            
            (
                34
            )Net
                income
            
            $
            1,080
            
            $
            756
            
            $
            854
            
            $
            525Basic
                earnings per common share
            
            $
            0.72
            
            $
            0.51
            
            $
            0.57
            
            $
            0.35Earnings
                per common share assuming dilution
            
            $
            0.72
            
            $
            0.50
            
            $
            0.57
            
            $
            0.35


2005
                Quarters EndedMar
                31
            
            Jun
                30
            
            Sep
                30
            
            Dec
                31Interest
                and dividend income
            
            $
            7,833
            
            $
            7,742
            
            $
            8,177
            
            $
            8,352Interest
                expense
            
            
            1,896
            
            
            2,068
            
            
            2,342
            
            
            2,622Net
                interest and dividend income
            
            
            5,937
            
            
            5,674
            
            
            5,835
            
            
            5,730Provision
                for loan losses
            
            
            75
            
            
            -
            
            
            -
            
            
            -Noninterest
                income
            
            
            987
            
            
            1,295
            
            
            1,337
            
            
            377Noninterest
                expense
            
            
            5,612
            
            
            5,752
            
            
            5,946
            
            
            6,272Income
                before taxes
            
            
            1,237
            
            
            1,217
            
            
            1,226
            
            
            (165
            )Income
                tax expense (benefit)
            
            
            414
            
            
            313
            
            
            349
            
            
            (
                234
            )Net
                income
            
            $
            823
            
            $
            904
            
            $
            877
            
            $
            69Basic
                earnings per common share
            
            $
            0.55
            
            $
            0.60
            
            $
            0.58
            
            $
            0.05Earnings
                per common share assuming dilution
            
            $
            0.54
            
            $
            0.60
            
            $
            0.58
            
            $
            0.05









**Table
          of
          Contents**











**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**








Shatswell,
      MacLeod & Company, P.C.


Certified
      Public Accountants


83
      Pine
      Street


West
      Peabody, Massachusetts 01960





The
      Board
      of Directors and Stockholders


Northway
      Financial, Inc.


Berlin,
      New Hampshire





We
      have
      audited the accompanying consolidated balance sheets of Northway Financial,
      Inc.
      and Subsidiaries as of December 31, 2006 and 2005 and the related consolidated
      statements of income, comprehensive income, changes in stockholders’ equity and
      cash flows for each of the years in the three-year period ended December 31,
      2006. These consolidated financial statements are the responsibility of the
      Company’s management. Our responsibility is to express an opinion on these
      consolidated financial statements based on our audits.





We
      conducted our audits in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether the
      consolidated financial statements are free of material misstatement. The Company
      is not required to have, nor were we engaged to perform, an audit of its
      internal control over financial reporting. Our audit included consideration
      of
      internal control over financial reporting as a basis for designing audit
      procedures that are appropriate in the circumstances, but not for the purpose
      of
      expressing an opinion on the effectiveness of the Company’s internal control
      over financial reporting. Accordingly, we express no such opinion. An audit
      includes examining, on a test basis, evidence supporting the amounts and
      disclosures in the consolidated financial statements. An audit also includes
      assessing the accounting principles used and significant estimates made by
      management, as well as evaluating the overall consolidated financial statement
      presentation. We believe that our audits provide a reasonable basis for our
      opinion.





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the consolidated financial position of Northway
      Financial, Inc. and Subsidiaries as of December 31, 2006 and 2005 and the
      results of their operations and their cash flows for each of the years in the
      three-year period ended December 31, 2006, in conformity with accounting
      principles generally accepted in the United States of America.

















SHATSWELL,
      MacLEOD & COMPANY,
      P.C.





West
      Peabody, Massachusetts


January
      26, 2007











**Table
          of
          Contents**





ITEM
      9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
      AND FINANCIAL DISCLOSURE





None.





ITEM
      9A. CONTROLS AND PROCEDURES





The
      Company’s management, with the participation of the Company’s Chief Executive
      Officer and Chief Financial Officer, has evaluated the effectiveness of the
      Company’s disclosure controls and procedures as of December 31, 2006. Based on
      that evaluation, the Company’s Chief Executive Officer and Chief Financial
      Officer concluded that the Company’s disclosure controls and procedures were
      effective as of December 31, 2006. There were no changes in the Company’s
      internal control over financial reporting during the fourth quarter 2006 that
      has materially affected, or is reasonably likely to materially affect, the
      Company’s internal control over financial reporting.





ITEM
      9B. OTHER INFORMATION





None


**PART
      III**








ITEM
      10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE
      GOVERNANCE





Information
      required by this item is incorporated by reference to the information in the
      Company’s definitive proxy statement to be delivered in connection with its 2007
      Annual Meeting of Stockholders.





ITEM
      11. EXECUTIVE COMPENSATION





The
      information required by this item is incorporated by reference to the
      information set forth in the Company’s definitive proxy statement to be
      delivered in connection with its 2007 Annual Meeting of
      Stockholders.








ITEM
      12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
      MANAGEMENT AND RELATED STOCKHOLDER MATTERS





The
      information required by this item is incorporated by reference to the
      information in the Company’s definitive proxy statement to be delivered in
      connection with its 2007 Annual Meeting of Stockholders.








ITEM
      13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR
      INDEPENDENCE





The
      information required by this item is incorporated by reference to the
      information in the Company’s definitive proxy statement to be delivered in
      connection with its 2007 Annual Meeting of Stockholders.








ITEM
      14. PRINCIPAL ACCOUNTANT FEES AND SERVICES





The
      information required by this item is incorporated by reference to the
      information in the Company’s definitive proxy statement to be delivered in
      connection with its 2007 Annual Meeting of Stockholders.


**Table
          of
          Contents**





ITEM
      15 EXHIBITS AND FINANCIAL STATEMENT
      SCHEDULES





(a)
      (1)
      The following financial statements are filed as part of this Report on Form
      10-K:


Report
      of
      Independent Registered Public Accounting Firm


Consolidated
      Statements of Income for the years ended December 31, 2006, 2005 and
      2004


Consolidated
      Balance Sheets as of December 31, 2006 and 2005


Consolidated
      Statements of Changes in Stockholders’ Equity for the years ended December 31,
      2006, 2005, and 2004


Consolidated
      Statements of Comprehensive Income for the years ended December 31, 2006, 2005
      and 2004


Consolidated
      Statements of Cash Flows for the years ended December 31, 2006, 2005 and
      2004


Notes
      to
      Consolidated Financial Statements





(2) Financial Statement Schedules:


None




(3)
      The Exhibits which are
      filed with this report or which are incorporated herein by reference are set
      forth in the Exhibit


Index. The Exhibit Index is incorporated herein by reference.







**Table
          of
          Contents**





**SIGNATURES**





Pursuant
      to requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934,
      the Registrant has duly caused this Report to be signed on its behalf by the
      undersigned, thereunto duly authorized.





NORTHWAY
      FINANCIAL, INC.





March
      22,
      2007    BY: /S/
      William J. Woodward


William
      J. Woodward


Chairman
      of the Board, President & Chief Executive
      Officer





Pursuant
      to the requirements of the Securities Exchange Act of 1934, this report has
      been
      signed below by the following persons on behalf of the registrant and in the
      capacities and on the dates indicated.





Signature
            Title
            Date/S/
                William J. Woodward
              William
                J. Woodward
            Chairman
                of the Board, President, and CEO (Principal Executive
                Officer)
            March
                22, 2007/S/
                Richard P. Orsillo
              Richard
                P. Orsillo
            Senior
                Vice President and Chief Financial Officer (Principal Financial and
                Accounting Officer)
            March
                22, 2007/S/
                John H. Noyes
              John
                H. Noyes
            Director
            March
                27, 2007/S/
                Barry J. Kelley
              Barry
                J. Kelley
            Director
            March
                22, 2007/S/
                Randall G. Labnon
              Randall
                G. Labnon
            Director
            March
                26, 2007/S/
                Brien L. Ward
              Brien
                L. Ward
            Director
            March
                22, 2007/S/
                Arnold P. Hanson, Jr.
              Arnold
                P. Hanson, Jr.
            Director
            March
                22, 2007/S/
                Frederick C. Anderson
              Frederick
                C. Anderson
            Director
            March
                27, 2007/S/
                Stephen G. Boucher
              Stephen
                G. Boucher
            Director
            March
                26, 2007/S/
                Fletcher W. Adams
              Fletcher
                W. Adams
            Director
            March
                27, 2007





**Table
          of
          Contents**








**INDEX
      OF EXHIBITS**





Exhibit
      Number  Description
      of Exhibit





2.1
            
            Agreement
                and Plan of Merger, dated as of March 14, 1997, by and among Northway
                Financial, Inc., The Berlin City Bank, Pemi Bancorp, Inc. and Pemigewasset
                National Bank (the "Merger Agreement") (incorporated by reference
                to
                Exhibit 2.1 to Registration Statement No.
                333-33033).





3.1
            
            Amended
                and Restated Articles of Incorporation of Northway Financial, Inc.
                (incorporated by reference to Exhibit 3.1 to Registration Statement
                No.
                333-33033).





3.2
            
            By-laws
                of Northway Financial, Inc. (incorporated by reference to Exhibit
                3.2 to
                the Company’s Annual Report on Form 10-K for the year ended
                2005).





4
            
            Form
                of Certificate representing the Company Common Stock (reference is
                also
                made to Exhibits 3.1 and 3.2) (incorporated by reference to Exhibit
                4 to
                Registration Statement No.
                333-33033).





10.1
            
            Employment
                Agreement for William J. Woodward (incorporated by reference to Exhibit
                10.1 to the Company’s Annual Report on Form 10-K for the year ended
                2005).(2)





10.2
            
            Amendment
                to the Employment Agreement for William J. Woodward (incorporated
                by
                reference to Exhibit 10.3 to the Company’s Annual Report on Form 10-K for
                the year ended 2005).(2)





10.3
            
            Northway
                Financial, Inc. 1999 Stock Option and Grant Plan (incorporated by
                reference to


Exhibit
                4.1 to Registration Statement No. 333-83571 dated July 23,1999).(2)





10.4
            
            Form
                of Key Employee Agreement (incorporated by reference to Exhibit 10.7
                to
                the Company’s Annual Report on Form 10-K for the year ended
                2005).(2)





10.5
            
            Supplemental
                Executive Retirement Plan. (incorporated by reference to Exhibit
                10.8 to
                the Company’s Annual Report on Form 10-K for the year ended
                2003).





11
            
            Statement
                re: Computation of Per Share Earnings(1)





14
            
            Code
                of Ethics(1)





21
            
            List
                of Subsidiaries(1)





23
            
            Consent
                of Shatswell, MacLeod & Company, P.C.(1)





31.1
            Certification
                of President of Northway Financial, Inc., pursuant to rules 13(a)-15(e)
                and 15d-15(e), as adopted pursuant to Section 302 of the Sarbanes-Oxley
                Act of 2002.(1)





31.2
            Certification
                of Chief Financial Officer of Northway Financial, Inc., pursuant
                to rules
                13(a)-15(e) and 5d-15(e), as adopted pursuant to Section 302 of the
                Sarbanes-Oxley Act of 2002.(1)





32.1
            Certification
                of President of Northway Financial, Inc., pursuant to 18 U.S.C. Section
                1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
                of
                2002.(1)





32.2
            Certification
                of Chief Financial Officer of Northway Financial, Inc., pursuant
                to 18
                U.S.C. Section 1350, as adopted pursuant to Section 906 of the
                Sarbanes-Oxley Act of 2002.(1)





(1)  Filed
      herewith.


( 2)  Management
      contract or compensatory plan required to be filed as an exhibit to this form
      pursuant to Item 15(a) of this report.