UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2007

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the transition period from                  to                 

Commission file number: 333-90273

FIDELITY D & D BANCORP, INC.

 

Address of principal executive offices:

BLAKELY & DRINKER ST.

DUNMORE, PENNSYLVANIA 18512

TELEPHONE:

570-342-8281

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 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subjected to such filing requirements for the past 90 days.

x YES    o NO

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

Large accelerated filer o   Accelerated filer o   Non-accelerated filer x

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

o YES    x NO

The number of outstanding shares of Common Stock of Fidelity D & D Bancorp, Inc. at April 30, 2007, the latest practicable date, was 2,063,357 shares.

FIDELITY D & D BANCORP, INC.

Form 10-Q March 31, 2007

Index

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

 

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PART I — Financial Information

Item 1: Financial Statements

FIDELITY D & D BANCORP, INC. AND SUBSIDIARY

Consolidated Balance Sheets

		March 31, 2007			December 31, 2006
		(unaudited)			(audited)
Assets:
Cash and due from banks		$	14,339,563		$	13,732,137
Interest-bearing deposits with financial institutions		96,175			68,711
Total cash and cash equivalents		14,435,738			13,800,848
Available-for-sale securities		99,921,920			98,841,364
Held-to-maturity securities		1,369,657			1,569,372
Federal Home Loan Bank Stock		3,598,600			3,795,100
Loans and leases, net (allowance for loan losses of $5,359,758 in 2007 and $5,444,303 in 2006)		417,225,015			417,199,048
Loans available-for-sale (fair value $371,990 in 2007; $123,156 in 2006)		370,750			122,000
Bank premises and equipment, net		10,941,355			11,324,465
Cash surrender value of bank owned life insurance		8,254,777			8,177,961
Other assets		5,609,660			4,788,105
Accrued interest receivable		2,614,412			2,502,576
Foreclosed assets held for sale		284,058			197,149
Total assets		$	564,625,942		$	562,317,988
Liabilities:
Deposits:
Interest-bearing		$	342,443,261		$	336,592,620
Non-interest-bearing		71,623,735			73,741,975
Total deposits		414,066,996			410,334,595
Accrued interest payable and other liabilities		3,985,911			4,179,170
Short-term borrowings		31,607,966			33,656,150
Long-term debt		62,331,630			62,536,210
Total liabilities		511,992,503			510,706,125
Shareholders’ equity:
Preferred stock authorized 5,000,000 shares with no par value; none issued		—			—
Capital stock authorized 10,000,000 shares with no par value; issued and outstanding 2,063,357 shares in 2007 and 2,057,433 shares in 2006		18,914,490			18,702,537
Retained earnings		34,465,335			33,874,118
Accumulated other comprehensive loss		(746,386		)	(964,792		)
Total shareholders’ equity		52,633,439			51,611,863
Total liabilities and shareholders’ equity		$	564,625,942		$	562,317,988

 

See notes to consolidated financial statements

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FIDELITY D & D BANCORP, INC. AND SUBSIDIARY

Consolidated Statements of Income

(unaudited)

		Three Months Ended
		March 31, 2007			March 31, 2006
Interest income:
Loans and leases:
Taxable		$	7,175,029		$	6,498,618
Nontaxable		109,517			132,158
Interest-bearing deposits with financial institutions		2,792			2,537
Investment securities:
U.S. government agency and corporations		919,288			885,182
States and political subdivisions (nontaxable)		124,839			141,044
Other securities		245,899			198,410
Federal funds sold		54,452			35,488
Total interest income		8,631,816			7,893,437
Interest expense:
Deposits		3,334,023			2,396,906
Securities sold under repurchase agreements		115,457			135,449
Other short-term borrowings and other		73,073			61,962
Long-term debt		805,073			1,068,811
Total interest expense		4,327,626			3,663,128
Net interest income		4,304,190			4,230,309
Provision for loan losses		—			75,000
Net interest income after provision for loan losses		4,304,190			4,155,309
Other income:
Service charges on deposit accounts		632,317			631,727
Gain (loss) on sale of:
Loans		36,725			14,985
Investment securities		—			(168		)
Premises and equipment		96,557			1,560
Leased assets		—			15,054
Foreclosed assets held for sale		15,128			405
Fees and other service charges		432,936			465,262
Total other income		1,213,663			1,128,825
Other expenses:
Salaries and employee benefits		2,134,977			2,006,814
Premises and equipment		805,825			800,851
Advertising		159,005			128,373
Other		1,013,236			986,712
Total other expenses		4,113,043			3,922,750
Income before provision for income taxes		1,404,810			1,361,384
Provision for income taxes		360,459			329,753
Net income		$	1,044,351		$	1,031,631
Per share data:
Net income - basic		$	0.51		$	0.51
Net income - diluted		$	0.51		$	0.50
Dividends		$	0.22		$	0.22

 

See Notes to Consolidated Financial Statements

4

FIDELITY D & D BANCORP, INC. AND SUBSIDIARY

Consolidated Statements of Changes in Shareholders’ Equity

For the three months ended March 31, 2007 and 2006

										Accumulated other
		Capital stock					Retained			comprehensive
		Shares		Amount			earnings			income (loss)			Total
Balance, December 31, 2005 (audited)		1,854,217		$	10,594,901		$	39,363,461		$	(1,112,333	)	$	48,846,029
Cumulative effect of change in accounting principle, net of tax							(343,717		)				(343,717		)
Total comprehensive income:
Net income							1,031,631						1,031,631
Change in net unrealized holding losses on available-for-sale securities, net of reclassification adjustment and tax effects										(698,263		)	(698,263		)
Comprehensive income													333,368
Issuance of common stock through Employee Stock Purchase Plan		1,571		48,151									48,151
Dividends reinvested through Dividend Reinvestment Plan		3,620		141,180									141,180
Stock-based compensation expense				21,913									21,913
Cash dividends declared							(449,060		)				(449,060		)
Stock dividend declared		185,394		7,462,100			(7,469,548		)				(7,448		)
Balance, March 31, 2006 (unaudited)		2,044,802		$	18,268,245		$	32,132,767		$	(1,810,596	)	$	48,590,416
Balance, December 31, 2006 (audited)		2,057,433		$	18,702,537		$	33,874,118		$	(964,792	)	$	51,611,863
Total comprehensive income:
Net income							1,044,351						1,044,351
Change in net unrealized holding losses on available-for-sale securities, net of reclassification adjustment and tax effects										159,150			159,150
Change in cash flow hedge intrinsic value										59,256			59,256
Comprehensive income													1,262,757
Issuance of common stock through Employee Stock Purchase Plan		2,266		67,820									67,820
Dividends reinvested through Dividend Reinvestment Plan		3,658		137,175									137,175
Stock-based compensation expense				6,958									6,958
Cash dividends declared							(453,134		)				(453,134		)
Balance, March 31, 2007 (unaudited)		2,063,357		$	18,914,490		$	34,465,335		$	(746,386	)	$	52,633,439

 

See Notes to Consolidated Financial Statements

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FIDELITY DEPOSIT & DISCOUNT BANCORP, INC. AND SUBSIDIARY

Consolidated Statements of Cash Flows

(unaudited)

		Three Months Ended
		March 31, 2007			March 31, 2006
Cash flows from operating activities:
Net income		$	1,044,351		$	1,031,631
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation, amortization and accretion		294,105			340,178
Provision for loan losses		—			75,000
Deferred income tax (benefit) expense		(63,692		)	91,443
Stock-based compensation expense		6,958			21,913
Loss from investment in limited partnership		20,100			22,500
Proceeds from sale of loans available-for-sale		3,998,013			1,777,954
Originations of loans available-for-sale		(4,210,038		)	(2,287,637		)
Increase in cash surrender value of life insurance		(76,816		)	(70,409		)
Net gain on sale of loans		(36,725		)	(14,985		)
Net loss on sale of investment securities		—			168
Net gain on sale of foreclosed assets held-for-sale		(15,128		)	(405		)
Net gain on disposal of premises and equipment		(96,557		)	(1,560		)
Change in:
Accrued interest receivable		(111,836		)	(226,778		)
Other assets		(301,492		)	(516,168		)
Accrued interest payable and other liabilities		(192,854		)	158,053
Net cash provided by operating activities		258,389			400,898
Cash flows from investing activities:
Held-to-maturity securities:
Proceeds from maturities, calls and principal pay-downs		199,356			85,055
Available-for-sale securities:
Proceeds from sales		—			1,537,336
Proceeds from maturities, calls and principal pay-downs		4,187,592			1,542,173
Purchases		(4,943,639		)	(22,776,490		)
Net decrease (increase) in FHLB stock		196,500			(70,800		)
Net increase in loans and leases		(270,967		)	(7,385,044		)
Proceeds from sale of premises and equipment		247,008			1,560
Acquisition of bank premises and equipment		(643,661		)	(155,489		)
Proceeds from sale of foreclosed assets held-for-sale		172,814			—
Net cash used in investing activities		(854,997		)	(27,221,699		)
Cash flows from financing activities:
Net increase in deposits		3,732,401			29,005,634
Net decrease in short-term borrowings		(2,048,184		)	(1,350,461		)
Repayments of long-term debt		(204,580		)	(2,674,840		)
Proceeds from employee stock purchase plan		67,820			48,151
Dividends paid, net of dividends reinvested		(315,959		)	(307,880		)
Cash payments in lieu of fractional shares on stock dividend		—			(7,448		)
Net cash provided by financing activities		1,231,498			24,713,156
Net increase (decrease) in cash and cash equivalents		634,890			(2,107,645		)
Cash and cash equivalents, beginning		13,800,848			12,594,540
Cash and cash equivalents, ending		$	14,435,738		$	10,486,895

 

See notes to consolidated financial statements

6

FIDELITY D & D BANCORP, INC.

Notes to Consolidated Financial Statements

(unaudited)

1.             Nature of operations and critical accounting policies

Nature of operations

The Fidelity Deposit and Discount Bank (the Bank) is a commercial bank chartered in the Commonwealth of Pennsylvania and a wholly-owned subsidiary of Fidelity D & D Bancorp, Inc. (the Company or collectively, the Company).  Having commenced operations in 1903, the Bank is committed to provide superior customer service, while offering a full range of banking products and financial and trust services, to both our consumer and commercial customers from its main office located in Dunmore and other branches throughout Lackawanna and Luzerne counties.

Principles of consolidation

The accompanying unaudited consolidated financial statements of the Company and the Bank have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) for interim financial information and with the instructions to this Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of the information and footnote disclosures required by GAAP for complete financial statements.  In the opinion of management, all normal recurring adjustments necessary for a fair presentation of the financial condition and results of operations for the periods have been included.  All significant inter-company balances and transactions have been eliminated in consolidation.  Prior period amounts are reclassified when necessary to conform to the current period’s presentation.

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

Management is responsible for the fairness, integrity and objectivity of the unaudited financial statements included in this report.  Management prepared the unaudited financial statements in accordance with GAAP.  In meeting its responsibility for the financial statements, management depends on the Company’s accounting systems and related internal controls.  These systems and controls are designed to provide reasonable, but not absolute, assurance that the financial records accurately reflect the transactions of the Company, the Company’s assets are safeguarded and that the financial statements present fairly the financial condition and results of operations of the Company.

In the opinion of management, the consolidated balance sheets as of March 31, 2007 and December 31, 2006 and the related consolidated statements of income for the three-month periods ended March 31, 2007 and 2006 and changes in shareholders’ equity and cash flows for the three month periods ended March 31, 2007 and 2006 present fairly the financial condition and results of operations of the Company.  All material adjustments required for a fair presentation have been made.  These adjustments are of a normal recurring nature.

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

Critical accounting policies

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

A material estimate that is particularly susceptible to significant change is the determination of the allowance for loan losses (the allowance).  Management believes that the allowance, as of March 31, 2007, is adequate and reasonable.  Given the subjective nature of identifying and valuing loan losses, it is likely that well-informed individuals could make materially different assumptions and could, therefore, calculate a materially different allowance value.  While management uses available information to recognize losses on loans, changes in economic conditions may necessitate

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revisions in the future.  In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance.  Such agencies may require the Company to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination.

Another material estimate is the calculation of fair values of the Company’s investment securities.  The Company receives estimated fair values of investment securities from an independent valuation service.  In developing these fair values, the valuation service uses estimates of cash flows, based on historical performance of similar instruments in similar interest rate environments.  Based on experience, management is aware that estimated fair values of investment securities tend to vary among valuation services.  Accordingly, when selling investment securities, management may obtain price quotes from more than one source.  Available-for-sale (AFS) securities are carried at fair value on the consolidated balance sheet, with unrealized gains and losses, net of income tax, reported separately within shareholders’ equity through accumulated other comprehensive income (loss).

The fair value of residential mortgage loans, classified as AFS, is obtained from the Federal National Mortgage Association  or the Pennsylvania Housing Finance Authority.  To determine the fair value of student loans, classified as AFS, the Bank uses the pricing obtained from the most recent student loans sold from its AFS portfolio.  From time-to-time, the Bank may originate Small Business Administration (SBA) loans AFS.  The fair value of SBA loans, classified as AFS, is obtained from an outside pricing source.  The market to which the Bank sells mortgage and other loans is restricted and price quotes from other sources are not typically obtained.  As of March 31, 2007 and December 31, 2006, the AFS loan portfolio consisted of residential mortgages and student loans.

2.             Earnings per share

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

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

The following table illustrates the data used in computing basic EPS and a reconciliation to derive at the components of diluted EPS for the periods indicated:

 

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3.             Stock plans

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

The Company has two stock-based compensation plans (the stock option plans).  The stock option plans were shareholder-approved and permit the grant of share-based compensation awards to its directors, key officers and certain other employees.  The Company believes that these stock option plans better align the interest of its directors, key officers and employees with the interest of its shareholders.  The Company further believes that the granting of share-based awards, under the provisions of the stock option plans, is necessary to retain the knowledge base, continuity and expertise of its directors, key officers and certain employees.

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

The Company has also established the 2000 Stock Incentive Plan and has reserved 55,000 shares of its un-issued capital stock for issuance under the plan.  Under the 2000 Stock Incentive Plan, key officers and certain other employees are eligible to be awarded qualified stock options to purchase the Company’s common stock at the fair market value on the date of grant.  No stock options were awarded during the first quarter of 2007.  During the first quarter of 2006, 2,200 stock options were issued under this plan at a grant-date fair value of $6.21 per share.  The options vest over a six month period and for the three months ended March 31, 2006 approximately $7,000 of stock-based compensation expense was recorded and is included as a component of salaries and employee benefits in the consolidated statements of income.  As of March 31, 2007, there were 5,830 unexercised stock options outstanding under this plan.

In addition to the two stock option plans above, the Company has established the 2002 Employee Stock Purchase Plan (the ESPP) and has reserved 110,000 shares of its un-issued capital stock for issuance under the plan.  The plan was designed to promote broad-based employee ownership of the Company’s stock.  Under the 2002 ESPP, employees may have automatic payroll deductions to purchase the Company’s capital stock at a discounted price based on the fair market value of the Company’s capital stock on either the commencement date or termination date.  At March 31, 2007, 8,317 shares have been issued under the ESPP.  The ESPP is considered a compensatory plan and, as such, is required to comply with the provisions of SFAS 123R.  The Company recognizes compensation expense on its ESPP Plan on the date the shares are purchased.  For the three months ended March 31, 2007 and 2006, compensation expense related to the ESPP approximated $7,000 and $15,000, respectively, and is included as a component of salaries and employee benefits in the consolidated statements of income.

4.             Derivative instruments

As part of the Company’s overall interest rate risk management strategy, the Company has adopted a policy whereby the Company may periodically use derivative instruments to minimize significant fluctuations in earnings caused by interest rate volatility.  This interest rate risk management strategy entails the use of interest rate floors, caps and swaps.  During the fourth quarter of 2006, the Company entered into a three-year interest rate floor derivative agreement on $20,000,000 notional value of its prime-based loan portfolio.  The transaction required the payment of a premium by the Company to the seller for the right to receive payments in the event national prime drops below a pre-determined level (strike rate), essentially converting floating rate loans to fixed rate loans when prime drops below the contractual strike rate.  When purchased, the Company recorded an asset representing the fair value of the hedge at the time of purchase.  The Company has designated this agreement as a cash flow hedge pursuant to SFAS No. 133.  Accordingly, the change in the fair value of the instrument related to the hedge’s intrinsic value, or approximately $59,000, is recorded as a component of OCI in the consolidated statement of changes in shareholders’ equity and the portion of the change in fair value related to the time value expiration, or approximately $51,000, is recorded in the consolidated statements of income as a reduction of interest income.  No gain or loss has been recognized in earnings due to hedge ineffectiveness as of March 31, 2007.  As of March 31, 2007, the Company does not expect to reclassify any amount from OCI to earnings over the next twelve months and no hedge has been discontinued.  Also, as of March 31, 2007, the fair value of the derivative contract approximated $233,000 and is a

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component of other assets in the consolidated balance sheet.

5.             Recent accounting pronouncements

In July 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109 (FIN 48).  FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement 109, Accounting for Income Taxes.  FIN 48 is effective for the year ended December 31, 2007.

The Company has evaluated its material tax positions as of March 31, 2007, and does not expect the adoption of this interpretation to have an immediate effect on its consolidated financial statements.  Under the “more-likely-than-not” threshold guidelines, the Company believes no significant uncertain tax positions exist, either individually or in the aggregate, that would give rise to the non-recognition of an existing tax benefit.  In periods subsequent to March 31, 2007, determinations of potentially adverse material tax positions will be evaluated to determine whether an uncertain tax position may have previously existed or has been originated.  In the event an adverse tax position is determined to exist, penalty and interest will be accrued, in accordance with the Internal Revenue Service guidelines, and recorded as a component of other expenses in the Company’s consolidated statements of income.

As of March 31, 2007, there were no unrecognized tax benefits that, if recognized, would significantly affect the Company’s effective tax rate.  Also, as of March 31, 2007, there were no penalties and interest recognized in the consolidated statements of income as a result of the adoption of FIN 48, nor does the Company foresee a change in its material tax positions that would give rise to the non-recognition of a an existing tax benefit during the forthcoming twelve months.

Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following is management’s discussion and analysis of the significant changes in the consolidated financial condition of the Company as of March 31, 2007 compared to December 31, 2006 and the results of operations for the three months ended March 31, 2007 and March 31, 2006.  Current performance may not be indicative of future results.  This discussion should be read in conjunction with the Company’s 2006 Annual Report filed on Form 10-K.

Forward-looking statements

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

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

·                  the timing and occurrence or non-occurrence of events may be subject to circumstances beyond our control;

·                  there may be increases in competitive pressure among financial institutions or from non-financial institutions;

·                  changes in the interest rate environment may reduce interest margins;

·                  changes in deposit flows, loan demand or real estate values may adversely affect our business;

·                  changes in accounting principles, policies or guidelines may cause our financial condition to be perceived differently;

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·                  general economic conditions, either nationally or locally in some or all areas in which we do business, or conditions in the securities markets or the banking industry may be less favorable than we currently anticipate;

·                  legislative or regulatory changes may adversely affect our business;

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

·                  success or consummation of new business initiatives may be more difficult or expensive than we anticipate;

·                  acts of war or terrorism; or

·                  natural disaster.

Management cautions readers not to place undue reliance on forward-looking statements, which reflect analyses only as of the date of this document.  We have no obligation to update any forward-looking statements to reflect events or circumstances after the date of this document.

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

General

The Company’s principal revenues are derived from interest, dividends and fees earned on its interest-earning assets, which are comprised of loans, securities and other short-term investments.  The Company’s principal expenses consist of interest paid on its interest-bearing liabilities, which are comprised of deposits, short-and long-term borrowings and operating and general expenses.  The Company’s profitability depends primarily on its net interest income. Net interest income is the difference between interest income and interest expense.  Interest income is generated from yields on interest-earning assets which consist principally of loans and investment securities. Interest expense is incurred from rates paid on interest-bearing liabilities, which consist of deposits and borrowings. Net interest income is dependent upon the interest-rate spread (i.e., the difference between the yields earned on its interest-earning assets and the rates paid on its interest-bearing liabilities) and the relative amounts of interest-earning assets and interest-bearing liabilities.  The interest rate spread is significantly impacted by: changes in interest rates and market yield curves and their related impact on cash flows; the composition and characteristics of interest-earning assets and interest-bearing liabilities; differences in the maturity and re-pricing characteristics of assets compared to the maturity and re-pricing characteristics of the liabilities that fund them and by the competition in our marketplace.

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

The Company’s profitability is significantly affected by general economic and competitive conditions, changes in market interest rates, government policies and actions of regulatory authorities.  The Company’s loan portfolio is comprised principally of commercial and commercial real estate loans.  The properties underlying the Company’s mortgages are concentrated in Northeastern Pennsylvania.  Credit risk, which represents the possibility of the Company not recovering amounts due from its borrowers, is significantly related to local economic conditions in the areas the properties are located as well as the Company’s underwriting standards.  Economic conditions affect the market value of the underlying collateral as well as the levels of adequate cash flow and revenue generation from income-producing commercial and multi-family properties.

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COMPARISON OF RESULTS OF OPERATIONS

THREE MONTHS ENDED MARCH 31, 2007 AND MARCH 31, 2006

Overview

Net income for the first quarter of 2007 was $1,044,000, or a slight increase compared to $1,032,000 recorded in the same quarter in 2006.  Diluted earnings per share were $0.51 and $0.50 for each of the respective periods.  The increase in net income was the result of increases in net interest income, non-interest income and a decrease in the provision for loan losses, partially offset by increases in non-interest expense and the provision for income taxes.

Return on average assets (ROA) and return on average shareholders’ equity (ROE) were 0.75% and 8.12%, respectively, for the three months ended March 31, 2007 compared to 0.75% and 8.51%, respectively, for the same period in 2006.  The change in ROE was caused by higher average equity in the current period fueled by higher retained earnings.

Net interest income and interest sensitive assets / liabilities

Net interest income increased $74,000 to $4,304,000 for the first quarter of 2007, from $4,230,000 recorded in the same period of 2006.  The increase was principally due to the restoration of some large commercial loans from non-performing to performing status during the second half of 2006.  During the first quarter of 2007, the yield on the commercial loan portfolio increased 60 basis points compared to the first quarter of 2006.  In addition, all other categories of earning assets were either originated or re-priced at higher rates in the first quarter of 2007 compared to the first quarter of 2006.  Partially offsetting the effect interest rates had on interest-earning assets was an increase in interest expense of $664,000, or 18%, caused mostly by increases in rates paid on interest-bearing deposits.  The blended rate paid on all interest-bearing deposits increased 87 basis points in the current year quarter compared to the comparative quarter of 2006.  The increase in rates paid was due to deposit-gathering strategies and competitive pressure in conjunction with the prolonged inverted-shaped interest rate yield curve.  The average balance of total interest-bearing deposits increased $24,600,000 during the first quarter of 2007 compared to the same quarter of 2006 and is also $14,600,000 higher on average than the average for the full year 2006.  The Bank will continue its quest to raise deposit levels and reduce its dependency on high-cost borrowings.  Interest expense on borrowings and repurchase agreements declined $273,000 due mostly to lower average-balances.  Average balances of borrowings declined almost $19,800,000.

During the first quarter of 2007, the Bank’s tax-equivalent margin and spread were 3.36% and 2.66%, respectively, compared to 3.34% and 2.77% during the first quarter of 2006.  The decline in spread was from interest costs outpacing the yields earned on assets.  The two basis point improvement in margin is from a slightly higher net interest income in the first quarter of 2007 compared to the first quarter of 2006.

The inverted treasury yield curve will continue to pressure the Bank’s net interest income performance.  However, our successful deposit gathering strategies, debt reduction, and improved credit quality of the Bank’s earning assets will help position the Bank to optimize net interest income during this challenging rate environment and should be further enhanced when the shape of the yield curve returns to a more normal slope.

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The following table sets forth, a comparison of average balance sheet amounts and their corresponding fully tax-equivalent (FTE) interest income and expense and annualized tax-equivalent yield and cost for the periods indicated (dollars in thousands):

 

In the table above, interest income was adjusted to a tax-equivalent basis to recognize the income from the various tax-exempt assets as if the interest was fully taxable.  This treatment allows a uniform comparison among the yields on interest-earning assets.  The calculations were computed on a fully tax-equivalent basis using the corporate federal tax rate of 34%.  Net interest spread represents the difference between the yield on interest-earning assets and the rate on interest-bearing liabilities.  Net interest margin represents the ratio of net interest income to total average interest-earning assets.

Provision for loan losses

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

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

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

·                  Specific loans that could have loss potential

·                  Levels of and trends in delinquencies and non-accrual loans

·                  Levels of and trends in charge-offs and recoveries

·                  Trends in volume and terms of loans

·                  Changes in risk selection and underwriting standards

·                  Changes in lending policies, procedures and practices

·                  Experience, ability and depth of lending management

·                  National and local economic trends and conditions

·                  Changes in credit concentrations

The Bank’s non-performing loans declined year-over-year by $5,476,000 to $3,520,000 at March 31, 2007 compared to $8,996,000 at March 31, 2006.  The non-accrual component of non-performing loans showed a $5,666,000 decline in the same period as the Bank continues to make progress in moving non-performing loans to performing status.

There was no provision for loan losses made at March 31, 2007 while $75,000 was provided for the March 31, 2006 period.  After taking into account charge-offs and recoveries during the period, the allowance was $5,360,000 at March 31, 2007 compared to $5,716,000 at March 31, 2006.  Both the decrease in the provision for loan losses and the level of the allowance were driven by the decrease in the non-performing loans mentioned above.  Our Special Assets Department continues to make progress carrying out exit strategies and/or resolution plans for each of the non-performing loans.

Other income

Total other (non-interest) income improved $85,000, or 8%, for the three months ended March 31, 2007 compared to the three months ended March 31, 2006.  The current year quarter includes a $97,000 gain from the sale of an owned commercial facility previously leased to a non-related third party.

Other operating expenses

For the first quarter ended March 31, 2007, other (non-interest) expenses increased $190,000, or 5%, compared to the same 2006 quarter.  Salaries and related employee benefits increased $128,000, or 6%, due to annual merit pay increases and interim recognition of performance-based incentives.  The increase in advertising was caused by our first-time winter deposit-gathering campaign which included costs for direct mail, point-of-sale promotional material and premiums.  The increase in the other component of other operating expense included increases in professional service and collection fees partially offset by decreases in office supplies, ATM expenses, and overdraft management service fees.

Income tax provision

The provision for income taxes increased $31,000 in the first quarter of 2007 compared to the respective 2006 quarter.  The increase was due to a combination of $43,000 in additional pre-tax income and a decrease in tax-free interest income from municipal securities, tax-free loans and earnings from the BOLI, collectively representing a smaller component of pre-tax earnings in 2007 compared to 2006.

COMPARISON OF FINANCIAL CONDITION AT

MARCH 31, 2007 AND DECEMBER 31, 2006

Overview

Consolidated assets increased $2,308,000 during the three months ended March 31, 2007.  Contributing to the net asset increase were increases in total deposits of $3,732,000 and shareholders’ equity of $1,022,000 partially offset by a reduction in combined short- and long-term borrowings of $2,253,000.

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Investment securities

At the time of purchase, the Bank classifies investment securities into one of three categories: trading, AFS or held-to- maturity (HTM).  To date, management has not purchased any securities for trading purposes.  Management classifies most securities as AFS even though it has no immediate intent to sell them.  The AFS designation affords management the flexibility to sell securities and adjust the balance sheet in response to capital levels, liquidity needs, structuring strategies and/or changes in market conditions.  Securities AFS are carried at net fair market value in the consolidated balance sheet with an adjustment to stockholders’ equity, net of tax, which is presented under the caption “Accumulated other comprehensive income (loss).”  Securities designated as HTM are carried at amortized cost.

At March 31, 2007, the carrying value of investment securities totaled $101,292,000, or 18% of total assets compared to $100,411,000 or 18% of total assets at December 31, 2006.  At March 31, 2007, approximately 41% of the carrying value of the investment portfolio was comprised of mortgage-backed securities that amortize and provide monthly cash flow.  Agency, corporate and municipal bonds comprised 32%, 15% and 12%, respectively, of the investment portfolio at March 31, 2007.

As illustrated in the following table of amortized cost and fair market value of investment securities, the portfolio is comprised of HTM and AFS securities with carrying values of $1,370,000 and $99,922,000, respectively.  At March 31, 2007, the AFS debt securities were recorded with a net unrealized loss in the amount of $1,405,000 and equity securities were recorded with an unrealized gain of $183,000 (dollars in thousands):

 

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The amortized cost and fair value of debt securities at March 31, 2007 by contractual maturity are as follows (dollars in thousands):

 

Expected maturities will differ from contractual maturities because issuers and borrowers may have the right to call or repay obligations with or without call or prepayment penalty.  Federal agency and municipal securities are included based on their original stated maturity.  Mortgage-backed securities, which are based on weighted-average lives and subject to monthly principal pay-downs, are listed in total.

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

At March 31, 2007, the AFS debt securities portfolio was carried at a net unrealized loss of $1,405,000 compared to a net unrealized loss of $1,656,000 at December 31, 2006, or an improvement of $251,000.  A large portion of the unrealized losses was for a continuous period of more than 12 months.  However, management believes the cause of these unrealized losses is directly related to changes in market interest rates.  As of March 31, 2007, however, most all of the deterioration of the AFS debt portfolio is from investments that are guaranteed by the U.S. government or one of its agencies.  In analyzing an issuer’s financial condition, management considers whether the securities are issued by the U.S. government, its agencies or other governments, whether downgrades by bond rating agencies have occurred and, if necessary, reviews of the issuer’s financial condition.  Because the decline in market values is attributable to changes in interest rates and not credit quality, and the Company has the ability and intent to hold those securities until recovery of fair value, which may be maturity, management views these unrealized losses to be temporary.

The current interest rate environment, essentially a sustaining period of yield curve inversion, continues to preclude structured investment portfolio growth.  As such, the Company will attempt to replace investment securities that mature, pay-down, are called or amortize with bonds that provide incremental earnings above the Bank’s funding sources.  In addition, cash flows from investments may be used to repay debt and fund growth in the loan portfolio.

Loans available-for-sale (AFS)

Generally, upon origination, certain residential mortgages, the guaranteed portions of Small Business Administration loans and student loans are classified as AFS.  In the event of market rate increases, fixed-rate loans and loans not immediately scheduled to re-price would no longer produce yields consistent with the current market.  In a declining interest rate environment, the Bank would be exposed to prepayment risk and, as rates on adjustable rate loans decrease, interest income would be negatively affected.  To better manage prepayment and interest rate risk, loans that meet these conditions may be considered for sale in the secondary market.  Consideration is also given to the Company’s current liquidity position and expected future liquidity needs.  Loans AFS are carried at the lower of cost or estimated fair value.  If the fair values of these

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loans fall below their amortized cost, the difference is written down and charged to current earnings.  Subsequent appreciation in the portfolio, if any, is credited to current earnings but only to the extent of previous write-downs.

At March 31, 2007, loans AFS amounted to $371,000 with a corresponding fair value of $372,000, compared to $122,000 and $123,000, respectively, at December 31, 2006.  During the first quarter of 2007, residential mortgage and student loans with principal balances of $3,982,000 were sold into the secondary market with combined net gains of approximately $37,000 recognized.

Loans and leases  

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

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

Gross loans, of $422,585,000 at March 31, 2007 were essentially unchanged from December 31, 2006.  The composition of the loan portfolio at March 31, 2007 and December 31, 2006, is summarized as follows:

 

Allowance for loan losses

Management continually evaluates the credit quality of the Bank’s loan and lease portfolio and performs a formal review of the adequacy of the allowance for loan losses (the allowance), on a quarterly basis.  The allowance reflects management’s best estimate of the amount of credit losses in the loan portfolio.  Management’s judgment is based on the evaluation of individual loans, past experience, the assessment of current economic conditions and other relevant factors including the amounts and timing of cash flows expected to be received on impaired loans.  Those estimates may be susceptible to significant change.  The provision for loan losses represents the amount necessary to maintain an appropriate allowance.  Loan losses are charged directly against the allowance when loans are deemed to be uncollectible.  Recoveries from previously charged-off loans are added to the allowance when received.

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

·                  Identification of specific problem loans by loan category;

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

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

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

·                  Application of qualitative factor adjustment percentages to historical losses for trends or changes in the loan portfolio.

Allocation of the allowance for different categories of loans is based on the methodology as explained above.  A key element of the methodology to determine the allowance is the Company’s credit risk evaluation process, which includes credit risk grading of individual commercial loans.  Commercial loans are assigned credit risk grades based on the Company’s assessment of conditions that affect the borrower’s ability to meet its contractual obligations under the loan agreement.  That process includes reviewing borrowers’ current financial information, historical payment experience, credit documentation, public information and other information specific to each individual borrower.  The changes in the allocations from period to period are based upon the credit risk grading assigned from periodic reviews of the loan and lease portfolios.

Net charge-offs for the three months ended March 31, 2007 were $85,000, compared to $343,000 for the same period in 2006.  There were net recoveries of commercial loans of $6,000 for the three months ended March 31, 2007 compared to net charge-offs of $188,000 for the same three months of 2006.  There were no commercial loan charge-offs in the first three months of 2007 with recoveries of $6,000.  By comparison, in the first three months of 2006 there were gross commercial loan charge-offs of $213,000 and recoveries of $25,000.  Real estate mortgages had net recoveries of $12,000 in the first three months of 2007 as compared to net charge-offs of $32,000 in the first three months of 2006.  Consumer loan net charge-offs were $102,000 in the quarter ended March 31, 2007 as compared to $124,000 for the same quarter of 2006.

Management believes that the current balance in the allowance for loans losses of $5,360,000 is sufficient to withstand the identified potential credit quality issues that may arise and are inherent to the portfolio.  Currently, management is unaware of any potential problem loans that have not been reviewed.  Potential problem loans are those where there is known information that leads management to believe repayment of principal and/or interest is in jeopardy and the loans are neither on non-accrual status nor past due 90 days or more.  However, there could be instances which become identified over the year that may require additional charge-offs and/or increases to the allowance.  The ratio of allowance for loan losses to total loans was 1.27% at March 31, 2007 compared to 1.29% at December 31, 2006 and 1.37% at March 31, 2006.

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The following tables set forth the activity in the allowance for loan losses and certain key ratios for the period indicated:

		As of and for the			As of and for the			As of and for the
		three months ended			twelve months ended			three months ended
		March 31, 2007			December 31, 2006			March 31, 2006
Balance at beginning of period		$	5,444,303		$	5,984,649		$	5,984,649
Provision charged to operations		—			325,000			75,000
Charge-offs:
Commercial		—			660,471			213,093
Residential real estate		1,585			109,164			31,626
Consumer		109,657			285,379			137,334
Lease financing		—			—			—
Total		111,242			1,055,014			382,053
Recoveries:
Commercial		5,723			64,173			25,576
Residential real estate		13,563			532			30
Consumer		7,411			124,763			13,071
Lease financing		—			200			200
Total		26,697			189,668			38,877
Net charge-offs		84,545			865,346			343,176
Balance at end of period		$	5,359,758		$	5,444,303		$	5,716,473
Total loans, end of period		$	422,955,523		$	422,765,351		$	416,096,315

 

		As of and for the			As of and for the			As of and for the
		three months ended			twelve months ended			three months ended
		March 31, 2007			December 31, 2006			March 31, 2006
Net charge-offs to:
Loans, end of period		0.02		%	0.20		%	0.08		%
Allowance for loan losses		1.58		%	15.89		%	6.00		%
Provisions for loan losses		—		x	2.66		x	4.58		x
Allowance for loan losses to:
Total loans		1.27		%	1.29		%	1.37		%
Non-accrual loans		1.69		x	1.62		x	0.65		x
Non-performing loans		1.52		x	1.58		x	0.64		x
Net charge-offs		63.40		x	6.29		x	16.66		x
Loans 30-89 days past due and still accruing		$	4,482,637		$	2,570,825		$	1,180,974
Loans 90 days past due and accruing		$	347,200		$	80,603		$	156,640
Non-accrual loans		$	3,172,782		$	3,357,718		$	8,838,950
Allowance for loan losses to loans 90  days or more past due and accruing		15.44		x	67.54		x	36.49		x

 

The increase in the 30-89 days past due category as of March 31, 2007 was caused by a few loans that migrated beyond 30 days.  These loans are secured and are expected to be brought current during the second quarter of 2007.

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Non-performing assets

The Bank defines non-performing assets as accruing loans past due 90 days or more, non-accrual loans, restructured loans, other real estate owned and repossessed assets.  As of March 31, 2007, non-performing assets represented 0.67% of total assets compared to 0.65% at December 31, 2006 and 1.60% at March 31, 2006.

The non-accrual loans declined by $185,000 during the first three months of 2007 to $3,173,000.  There were additions to the non-accrual loans totaling $363,000 during the first three months of 2007.  These additions were offset by payoffs or pay downs of $133,000, $93,000 of loans returned to accruing status, charge-offs of $76,000 and $245,000 of loans that were transferred to other real estate owned.

Other real estate owned at quarter end March 31, 2007 totaled $284,000 consisting of two residential properties that were foreclosed upon and transferred to other real estate from loans.   Both properties are under contracts for sale.  There were no repossessed assets at quarter end March 31, 2007.

Non-performing loans were $3,520,000 at March 31, 2007, an increase of $82,000 from year-end 2006, but a substantial decline of $5,476,000 compared to March 31, 2006.  Although the decline occurred substantially in the commercial loans, reductions occurred in the residential real estate and consumer portfolios as well.  The Special Assets Department had developed specific action plans for each of the Bank’s non-performing loans.  During calendar year 2006, several of those plans came to a conclusion resulting in a substantial reduction of the non-performing loans.  The ratio of non-accrual loans to net loans declined by 139 basis points to 0.76%, at March 31, 2007 when compared to 2.15% at March 31, 2006.  It was also down slightly from the year-end ratio of 0.80%.  At March 31, 2007, the ratio of non-performing loans to net loans was 0.84% compared to 0.82% at December 31, 2006 and 2.19% at March 31, 2006.

The following table sets forth non-performing assets data as of the period indicated:

 

Other assets

The increase in other assets of $822,000, or 17%, from December 31, 2006 to March 31, 2007 was principally due to increased prepaid expenses that are periodically charged to current earnings when the expense is incurred plus increased capitalized construction costs for activities related to the Company’s branch expansion projects.

Deposits

The Bank is a community-based commercial financial institution that offers a variety of deposit accounts with a range of interest rates and terms.  Deposit products include passbook and statement savings accounts, interest-bearing checking (NOW), money market, non-interest bearing, or demand deposit accounts (DDAs), and certificates of deposit accounts.  The

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flow of deposits is significantly influenced by general economic conditions, changes in prevailing interest rates, pricing and competition.  Most of the Bank’s deposits are obtained from the communities surrounding its 12 branch offices.  The Bank attempts to attract and retain deposit customers via sales and marketing efforts with new products, quality service, competitive rates, and maintaining long-standing customer relationships.  To determine deposit product interest rates, the Bank considers local competition, market yields and the rates charged for alternative sources of funding such as borrowings.  To be competitive in our markets and continue to bolster our deposit base, we have increased rates on most deposit products; however, we have not increased rates above market rates, as we only consider cost effective rate-setting tactics in all interest rate environments.

Compared to December 31, 2006 total deposits increased $3,700,000, or slightly less than 1%, during the three months ended March 31, 2007.  The growth in total deposits was primarily due to increases in money market and NOW accounts of $8,200,000, or 11%, and $4,900,000, or 8%, respectively.  The $13,100,000 increase in these two accounts was due to the continued success in the implementation of deposit-gathering strategies in conjunction with increased promotional interest rates.  The decline in certificates of deposits was due to the reduction in the public sector partially offset by growth in personal and non-personal certificates.

The following table represents the major components of deposits as of March 31, 2007 and December 31, 2006:

 

Certificates of deposit, of $100,000 or more aggregated $54,600,000 and $63,000,000 at March 31, 2007 and December 31, 2006, respectively.

Borrowings

Borrowings are used as a complement to deposit generation as an alternative funding source whereby the Bank will borrow under customer repurchase agreements in the local market and advances from the Federal Home Loan Bank of Pittsburgh (FHLB) and correspondent banks for asset growth and liquidity needs.  Borrowings included $62,332,000 and $62,536,000 in long-term advances from the FHLB at March 31, 2007 and December 31, 2006, respectively.  Also included in borrowings were short-term repurchase agreements of $16,900,000 and $22,224,000, as of the respective periods.  Repurchase agreements are non-insured interest-bearing liabilities that have a security interest in qualified investment securities of the Bank and are offered in both sweep and fixed-term products.  A sweep account is designed to ensure that, on a daily basis, an attached DDA is adequately funded and excess DDA funds are transferred, or swept into an overnight interest-bearing repurchase agreement account.  The balance in customer repurchase agreement accounts can fluctuate daily because the daily sweep product is dependent on the level of available funds in depositor accounts.  In addition, short-term borrowings may include overnight balances which the Bank may require from time-to-time to fund daily liquidity needs.  As of March 31, 2007, the Bank had $14,000,000 in overnight balances compared to $10,400,000 at December 31, 2006.

Item 3.  Quantitative and Qualitative Disclosure About Market Risk

Management of interest rate risk and market risk analysis

The Company is subject to the interest rate risks inherent in our lending, investing and financing activities.  Fluctuations of interest rates will impact interest income and interest expense along with affecting market values of all interest-earning assets and interest-bearing liabilities, except for those assets or liabilities with a short term remaining to maturity.  Interest rate risk management is an integral part of the asset/liability management process.  The Company has instituted certain procedures and policy guidelines to manage the interest rate risk position.  Those internal policies enable the Company to

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react to changes in market rates to protect net interest income from significant fluctuations.  The primary objective in managing interest rate risk is to minimize the adverse impact of changes in interest rates on net interest income along with creating an asset/liability structure that maximizes earnings.

Asset/Liability Management.  One major objective of the Company when managing the rate sensitivity of its assets and liabilities is to stabilize net interest income.  The management of and authority to assume interest rate risk is the responsibility of the Company’s Asset/Liability Committee (ALCO), which is comprised of senior management and members of the Board of Directors.  ALCO meets quarterly to monitor the relationship of interest sensitive assets to interest sensitive liabilities.  The process to review interest rate risk is a regular part of managing the Company.  Consistent policies and practices of measuring and reporting interest rate risk exposure, particularly regarding the treatment of non-contractual assets and liabilities, are in effect.  In addition, there is an annual process to review the interest rate risk policy with the Board of Directors which includes limits on the impact to earnings from shifts in interest rates.

Interest Rate Risk Measurement.  Interest rate risk is monitored through the use of three complementary measures:  static gap analysis, earnings at risk simulation and economic value at risk simulation.  While each of the interest rate risk measurements has limitations, taken together they represent a reasonably comprehensive view of the magnitude of interest rate risk in the Company and the distribution of risk along the yield curve, the level of risk through time and the amount of exposure to changes in certain interest rate relationships.

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

To manage this interest rate sensitivity gap position, an asset/liability model commonly known as cumulative gap analysis is used to monitor the difference in the volume of the Company’s interest sensitive assets and liabilities that mature or re-price within given periods.  A positive gap (asset sensitive) indicates that more assets will re-price during a given period compared to liabilities, while a negative gap (liability sensitive) has the opposite effect.  The Company employs computerized net interest income simulation modeling to assist in quantifying interest rate risk exposure.  This process measures and quantifies the impact on net interest income through varying interest rate changes and balance sheet compositions.  The use of this model assists the ALCO to gauge the effects of the interest rate changes on interest sensitive assets and liabilities in order to determine what impact these rate changes will have upon the net interest spread.  At March 31, 2007, the Company maintained a negative one-year cumulative gap of $72,000,000 or -12.7% of total assets.  The effect of this negative gap position provided a mismatch of assets and liabilities which may expose the Bank to interest rate risk during periods of rising interest rates.  Conversely, in a declining interest rate environment, net interest income could be positively impacted because more liabilities than assets will re-price downward during a one-year period.

Certain shortcomings are inherent in the method of analysis discussed above and presented in the next table.  Although certain assets and liabilities may have similar maturities or periods of re-pricing, they may react in different degrees to changes in market interest rates.  The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types of assets and liabilities may lag behind changes in market interest rates.  Certain assets, such as adjustable-rate mortgages, have features which restrict changes in interest rates on a short-term basis and over the life of the asset.  In the event of a change in interest rates, prepayment and early withdrawal levels may deviate significantly from those assumed in calculating the table.  The ability of many borrowers to service their adjustable-rate debt may decrease in the event of an interest rate increase.

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