UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2008

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                    .

CITIZENS & NORTHERN CORPORATION

(Exact name of Registrant as specified in its charter)

PENNSYLVANIA		23-2451943
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

90-92 MAIN STREET, WELLSBORO, PA 16901

570-724-3411

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 subject to such filing requirements for the past 90 days. Yes þ No o

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

Large accelerated filer o		Accelerated filer þ		Non-accelerated filer   o (Do not check if a smaller reporting company)		Smaller Reporting Company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o No þ

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

Common Stock ($1.00 par value)		8,964,262 Shares Outstanding on October 31, 2008

 

 

CITIZENS & NORTHERN CORPORATION — FORM 10-Q

CITIZENS & NORTHERN CORPORATION
Index

Part I. Financial Information
Item 1. Financial Statements
Consolidated Balance Sheet — September 30, 2008 and December 31, 2007		Page 3
Consolidated Statement of Income — Three Months and Nine Months Ended September 30, 2008 and 2007		Page 4
Consolidated Statement of Cash Flows — Nine Months Ended September 30, 2008 and 2007		Pages 5 and 6
Notes to Consolidated Financial Statements		Pages 7 through 15
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		Pages 16 through 34
Item 3. Quantitative and Qualitative Disclosures About Market Risk		Pages 35 through 38
Item 4. Controls and Procedures		Pages 38 through 39
Part II. Other Information		Pages 39 through 42
Signatures		Page 42
Exhibit 31.1. Rule 13a-14(a)/15d-14(a) Certification - Chief Executive Officer		Page 43
Exhibit 31.2. Rule 13a-14(a)/15d-14(a) Certification - Chief Financial Officer		Page 44
Exhibit 32. Section 1350 Certifications		Page 45
EX-31.1
EX-31.2
EX-32

CITIZENS & NORTHERN CORPORATION — FORM 10-Q

PART I — FINANCIAL INFORMATION

		September 30,				December 31,
		2008				2007
(In Thousands Except Share Data)		(Unaudited)				(Note)
ASSETS
Cash and due from banks:
Noninterest-bearing		$	21,777			$	21,892
Interest-bearing			1,383				9,769
Total cash and cash equivalents			23,160				31,661
Trading securities			1,630				2,980
Available-for-sale securities			417,761				432,755
Held-to-maturity securities			407				409
Loans, net			748,909				727,082
Bank-owned life insurance			22,119				21,539
Accrued interest receivable			5,846				5,714
Bank premises and equipment, net			26,500				27,796
Foreclosed assets held for sale			312				258
Intangible asset — Core deposit intangibles			964				1,378
Intangible asset — Goodwill			12,014				12,032
Other assets			29,275				20,142
TOTAL ASSETS		$	1,288,897			$	1,283,746
LIABILITIES
Deposits:
Noninterest-bearing		$	126,649			$	125,485
Interest-bearing			729,927				713,018
Total deposits			856,576				838,503
Dividends payable			2,149				2,134
Short-term borrowings			52,650				40,678
Long-term borrowings			249,395				259,454
Accrued interest and other liabilities			6,053				5,196
TOTAL LIABILITIES			1,166,823				1,145,965
STOCKHOLDERS’ EQUITY
Common stock, par value $1.00 per share; authorized 20,000,000 shares in 2008 and 2007; issued 9,284,148 in 2008 and 9,193,192 in 2007			9,284				9,193
Stock dividend distributable			—				1,571
Paid-in capital			44,215				42,494
Retained earnings			97,723				96,628
Unamortized stock compensation			(71	)			(56	)
Treasury stock, at cost; 338,730 shares at September 30, 2008 and 303,058 shares at December 31, 2007			(5,815	)			(4,992	)
Sub-total			145,336				144,838
Accumulated other comprehensive loss:
Unrealized losses on available-for-sale securities			(23,149	)			(6,654	)
Defined benefit plans			(113	)			(403	)
Total accumulated other comprehensive loss			(23,262	)			(7,057	)
TOTAL STOCKHOLDERS’ EQUITY			122,074				137,781
TOTAL LIABILITIES & STOCKHOLDERS’ EQUITY		$	1,288,897			$	1,283,746

The accompanying notes are an integral part of these consolidated financial statements.

Note: The balance sheet at December 31, 2007 has been derived from the audited financial statements at that date but does not include all the information and notes required by U.S. generally accepted accounting principles for complete financial statements.

CITIZENS & NORTHERN CORPORATION — FORM 10-Q

Consolidated Statement of Income

		3 Months Ended								Fiscal Year To Date
		Sept. 30,				Sept. 30,				9 Months Ended Sept. 30,
		2008				2007				2008				2007
(In Thousands, Except Per Share Data) (Unaudited)		(Current)				(Prior Year)				(Current)				(Prior Year)
INTEREST INCOME
Interest and fees on loans		$	12,255			$	12,929			$	36,836			$	36,889
Interest on loans to political subdivisions			406				369				1,116				1,072
Interest on balances with depository institutions			9				16				27				74
Interest on federal funds sold			42				50				116				200
Interest on trading securities			19				27				62				46
Income from available-for-sale and held-to-maturity securities:
Taxable			4,815				3,777				14,574				10,945
Tax-exempt			828				677				2,267				2,076
Dividends			201				213				650				691
Total interest and dividend income			18,575				18,058				55,648				51,993
INTEREST EXPENSE
Interest on deposits			4,557				6,437				14,941				18,780
Interest on short-term borrowings			218				432				761				1,397
Interest on long-term borrowings			2,699				1,682				8,152				5,053
Total interest expense			7,474				8,551				23,854				25,230
Interest margin			11,101				9,507				31,794				26,763
Provision for loan losses			141				—				669				229
Interest margin after provision for loan losses			10,960				9,507				31,125				26,534
OTHER INCOME
Trust and financial management revenue			845				885				2,697				2,506
Service charges on deposit accounts			1,191				709				3,240				1,824
Service charges and fees			208				177				569				501
Insurance commissions, fees and premiums			77				108				246				368
Increase in cash surrender value of life insurance			190				196				580				515
Other operating income			551				802				2,372				1,895
Total other income before net losses on available-for-sale securities			3,062				2,877				9,704				7,609
Net losses on available-for-sale securities			(4,483	)			(68	)			(5,460	)			(79	)
Total other income			(1,421	)			2,809				4,244				7,530
OTHER EXPENSES
Salaries and wages			3,892				3,741				11,319				10,769
Pensions and other employee benefits			1,082				1,032				3,312				3,190
Occupancy expense, net			689				668				2,160				1,954
Furniture and equipment expense			692				708				1,982				2,104
Pennsylvania shares tax			292				236				876				707
Other operating expense			2,089				2,306				5,808				6,403
Total other expenses			8,736				8,691				25,457				25,127
Income before income tax provision			803				3,625				9,912				8,937
Income tax (credit) provision			(209	)			777				2,031				1,695
NET INCOME		$	1,012			$	2,848			$	7,881			$	7,242
PER SHARE DATA:
Net income — basic		$	0.11			$	0.32			$	0.88			$	0.83
Net income — diluted		$	0.11			$	0.32			$	0.88			$	0.83
Dividend per share		$	0.24			$	0.24			$	0.72			$	0.72
Number of shares used in computation — basic			8,957,774				8,986,822				8,965,230				8,743,490
Number of shares used in computation — diluted			8,986,253				8,994,805				8,985,211				8,756,013

The accompanying notes are an integral part of these consolidated financial statements.

CITIZENS & NORTHERN CORPORATION — FORM 10-Q

Consolidated Statement of Cash Flows

		9 Months Ended
		Sept. 30,				Sept. 30,
(In Thousands) (Unaudited)		2008				2007
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income		$	7,881			$	7,242
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses			669				229
Net losses on available-for-sale securities			5,460				79
Gain on sale of foreclosed assets, net			(46	)			(76	)
Loss on disposition of premises and equipment			—				145
Depreciation expense			2,174				2,125
Accretion and amortization on securities, net			136				274
Accretion and amortization on loans, deposits and borrowings, net			(314	)			(158	)
Increase in cash surrender value of life insurance			(580	)			(515	)
Stock-based compensation			274				231
Amortization of core deposit intangibles			414				289
Net increase in trading securities			(1,722	)			(2,515	)
Increase in accrued interest receivable and other assets			(1,708	)			(1,099	)
Increase in accrued interest payable and other liabilities			1,067				482
Net Cash Provided by Operating Activities			13,705				6,733
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from acquisition of Citizens Bancorp, Inc., net			—				29,941
Proceeds from maturity of held-to-maturity securities			2				4
Proceeds from sales of available-for-sale securities			22,682				91,088
Proceeds from calls and maturities of available-for-sale securities			44,525				27,235
Purchase of available-for-sale securities			(79,737	)			(85,847	)
Purchase of Federal Home Loan Bank of Pittsburgh stock			(2,629	)			(4,655	)
Redemption of Federal Home Loan Bank of Pittsburgh stock			3,299				4,977
Net (increase) decrease in loans			(22,706	)			1,483
Purchase of premises and equipment			(878	)			(2,157	)
Return of principal on limited partnership investment			34				238
Proceeds from sale of foreclosed assets			374				478
Net Cash (Used in) Provided by Investing Activities			(35,034	)			62,785
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase (decrease) in deposits			18,045				(32,615	)
Net increase (decrease) in short-term borrowings			11,972				(2,805	)
Proceeds from long-term borrowings			29,703				42,500
Repayments of long-term borrowings			(39,592	)			(74,927	)
Purchase of treasury stock			(1,567	)			(950	)
Sale of treasury stock			154				88
Dividends paid			(5,887	)			(6,115	)
Net Cash Provided by (Used in) Financing Activities			12,828				(74,824	)
DECREASE IN CASH AND CASH EQUIVALENTS			(8,501	)			(5,306	)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD			31,661				27,159
CASH AND CASH EQUIVALENTS, END OF PERIOD		$	23,160			$	21,853

The accompanying notes are an integral part of these consolidated financial statements.

CITIZENS & NORTHERN CORPORATION — FORM 10-Q

Consolidated Statement of Cash Flows

		9 Months Ended
		Sept. 30,				Sept. 30,
(In Thousands) (Unaudited) (Continued)		2008				2007
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Assets acquired through foreclosure of real estate loans		$	382			$	417
Securities transferred from trading to available-for-sale			3,072				—
Interest paid			24,097				25,278
Income taxes paid			3,492				1,977
ACQUISITION OF CITIZENS BANCORP, INC.:
Cash and cash equivalents received			—				44,264
Cash paid for acquisition			—				(14,323	)
Net cash received on acquisition		$	—			$	29,941
NONCASH ASSETS RECEIVED, LIABILITIES ASSUMED AND EQUITY ISSUED FROM ACQUISITION OF CITIZENS BANCORP, INC.:
Assets received:
Available for sale securities		$	—			$	26,426
Loans			—				60,151
Bank-owned life insurance			—				4,433
Premises and equipment			—				5,243
Foreclosed assets			—				107
Intangible asset — core deposit intangible			—				1,487
Intangible asset — goodwill			—				9,263
Other assets			—				1,567
Total noncash assets received		$	—			$	108,677
Liabilities assumed and equity issued:
Deposits		$	—			$	99,636
Short-term borrowings			—				1,426
Long-term borrowings			—				22,753
Other liabilities			—				735
Equity issued, net			—				14,068
Total noncash liabilities assumed and equity issued		$	—			$	138,618

The accompanying notes are an integral part of these consolidated financial statements.

CITIZENS & NORTHERN CORPORATION — FORM 10-Q

Notes to Consolidated Financial Statements

1. BASIS OF INTERIM PRESENTATION

The financial information included herein, with the exception of the consolidated balance sheet dated December 31, 2007, is unaudited; however, such information reflects all adjustments (consisting solely of normal recurring adjustments) that are, in the opinion of management, necessary for a fair presentation of the financial position, results of operations and cash flows for the interim periods.

Results reported for the three-month and nine-month periods ended September 30, 2008 might not be indicative of the results for the year ending December 31, 2008.

This document has not been reviewed or confirmed for accuracy or relevance by the Federal Deposit Insurance Corporation or any other regulatory agency.

2. PER SHARE DATA

Net income per share is based on the weighted-average number of shares of common stock outstanding. The number of shares used in calculating net income and cash dividends per share reflects the retroactive effect of stock dividends for all periods presented. The following data shows the amounts used in computing net income per share and the weighted average number of shares of dilutive stock options. As shown in the table that follows, diluted earnings per share is computed using weighted average common shares outstanding, plus weighted-average common shares available from the exercise of all dilutive stock options, less the number of shares that could be repurchased with the proceeds of stock option exercises based on the average share price of the Corporation’s common stock during the period.

						Weighted-
						Average				Earnings
		Net				Common				Per
		Income				Shares				Share
Nine Months Ended September 30, 2008
Earnings per share — basic		$	7,881,000				8,965,230			$	0.88
Dilutive effect of potential common stock arising from stock options:
Exercise of outstanding stock options							145,729
Hypothetical share repurchase at $19.88							(125,748	)
Earnings per share — diluted		$	7,881,000				8,985,211			$	0.88
Nine Months Ended September 30, 2007
Earnings per share — basic		$	7,242,000				8,743,490			$	0.83
Dilutive effect of potential common stock arising from stock options:
Exercise of outstanding stock options							109,329
Hypothetical share repurchase at $20.50							(96,806	)
Earnings per share — diluted		$	7,242,000				8,756,013			$	0.83

CITIZENS & NORTHERN CORPORATION — FORM 10-Q

						Weighted-
						Average				Earnings
		Net				Common				Per
		Income				Shares				Share
Quarter Ended September 30, 2008
Earnings per share — basic		$	1,012,000				8,957,774			$	0.11
Dilutive effect of potential common stock arising from stock options:
Exercise of outstanding stock options							174,332
Hypothetical share repurchase at $21.41							(145,853	)
Earnings per share — diluted		$	1,012,000				8,986,253			$	0.11
Quarter Ended September 30, 2007
Earnings per share — basic		$	2,848,000				8,986,822			$	0.32
Dilutive effect of potential common stock arising from stock options:
Exercise of outstanding stock options							108,115
Hypothetical share repurchase at $18.93							(100,132	)
Earnings per share — diluted		$	2,848,000				8,994,805			$	0.32

3. COMPREHENSIVE INCOME

Comprehensive income is the total of (1) net income, and (2) all other changes in equity from non-stockholder sources, which are referred to as other comprehensive income. The components of comprehensive (loss) income, and the related tax effects, are as follows:

		3 Months Ended								9 Months Ended
		Sept. 30,								Sept. 30,
(In Thousands)		2008				2007				2008				2007
Net income		$	1,012			$	2,848			$	7,881			$	7,242
Unrealized (losses) gains on available-for-sale securities:
Unrealized holding (losses) gains on available-for-sale securities			(15,623	)			(2,333	)			(30,452	)			(6,026	)
Reclassification adjustment for losses realized in income			4,483				68				5,460				79
Other comprehensive loss on available-for-sale securities before income tax			(11,140	)			(2,265	)			(24,992	)			(5,947	)
Income tax related to unrealized loss on available-for-sale securities			3,788				770				8,497				2,022
Other comprehensive loss on available-for-sale securities			(7,352	)			(1,495	)			(16,495	)			(3,925	)
Unfunded pension and postretirement obligations:
Amortization of net transition obligation, prior service cost, net actuarial loss and gain from settlement of pension plan included in net periodic benefit cost, and additional reduction in unfunded liability from settlement of pension plan			444				11				455				33
Income tax related to other comprehensive gain			(164	)			(3	)			(165	)			(12	)
Other comprehensive gain on unfunded retirement obligations			280				8				290				21
Total comprehensive (loss) income		$	(6,060	)		$	1,361			$	(8,324	)		$	3,338

CITIZENS & NORTHERN CORPORATION — FORM 10-Q

4. SECURITIES

The Corporation’s trading assets at September 30, 2008 and December 31, 2007 were composed exclusively of municipal bonds. Gains and losses from trading activities are included in other operating income in the consolidated statement of income as follows (in thousands):

		3 Months Ended								Fiscal Year To Date
		Sept. 30,				Sept. 30,				9 Months Ended Sept. 30,
		2008				2007				2008				2007
Gross realized gains		$	20			$	46			$	60			$	52
Gross realized losses			—				—				(63	)			—
Net change in unrealized gains/losses			(140	)			1				(141	)			(76	)
Net (losses) gains		$	(120	)		$	47			$	(144	)		$	(24	)
Income tax (credit) provision related to net losses		$	(41	)		$	16			$	(49	)		$	(8	)

Amortized cost and fair value of available-for-sale and held-to-maturity securities at September 30, 2008 are summarized as follows:

		September 30, 2008
						Gross				Gross
						Unrealized				Unrealized
		Amortized				Holding				Holding				Fair
(In Thousands)		Cost				Gains				Losses				Value
AVAILABLE-FOR-SALE SECURITIES:
Obligations of other U.S. Government agencies		$	15,500			$	243			$	—			$	15,743
Obligations of states and political subdivisions			75,925				113				(6,781	)			69,257
Mortgage-backed securities			170,978				506				(1,418	)			170,066
Collateralized mortgage obligations			70,449				5				(3,758	)			66,696
Other securities			98,780				102				(24,740	)			74,142
Total debt securities			431,632				969				(36,697	)			395,904
Marketable equity securities			21,209				2,948				(2,300	)			21,857
Total		$	452,841			$	3,917			$	(38,997	)		$	417,761
HELD-TO-MATURITY SECURITIES:
Obligations of the U.S. Treasury		$	305			$	14			$	—			$	319
Obligations of other U.S. Government agencies			100				4				—				104
Mortgage-backed securities			2				—				—				2
Total		$	407			$	18			$	—			$	425

CITIZENS & NORTHERN CORPORATION — FORM 10-Q

The following table presents gross unrealized losses and fair value of available-for-sale investments aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at September 30, 2008:

September 30, 2008

		Less Than 12 Months								12 Months or More								Total
		Fair				Unrealized				Fair				Unrealized				Fair				Unrealized
(In Thousands)		Value				Losses				Value				Losses				Value				Losses
AVAILABLE-FOR-SALE SECURITIES:
Obligations of other U.S. Government agencies		$	—			$	—			$	—			$	—			$	—			$	—
Obligations of states and political subdivisions			32,939				(2,834	)			24,598				(3,947	)			57,537				(6,781	)
Mortgage-backed securities			112,319				(1,282	)			7,280				(136	)			119,599				(1,418	)
Collateralized mortgage obligations			47,665				(1,956	)			17,985				(1,802	)			65,650				(3,758	)
Other securities			32,058				(11,280	)			35,021				(13,460	)			67,079				(24,740	)
Total debt securities			224,981				(17,352	)			84,884				(19,345	)			309,865				(36,697	)
Marketable equity securities			3,587				(663	)			5,838				(1,637	)			9,425				(2,300	)
Total temporarily impaired available-for-sale securities		$	228,568			$	(18,015	)		$	90,722			$	(20,982	)		$	319,290			$	(38,997	)

Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic 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 Corporation to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.

In addition to the effects of volatility in interest rates on individual debt securities, management believes valuations of debt securities at September 30, 2008 have been negatively impacted by events affecting the overall credit markets during the last quarter of 2007 and the first nine months of 2008. There have been widespread disruptions to the normal operation of bond markets. Particularly with regard to trust-preferred securities (which comprise most of the balance in “Other securities” in the table above), trading volume has been limited and consisted almost entirely of sales by distressed sellers.

Trust-preferred securities are very long-term (usually 30-year maturity) instruments with characteristics of both debt and equity, mainly issued by banks. Most of the Corporation’s investments in trust-preferred securities are of pooled issues, each made up of 30 or more companies with geographic and size diversification. Almost all of the Corporation’s pooled trust-preferred securities are comprised of debt issued by banking companies, with lesser amounts issued by insurance companies and real estate investment trusts. Management believes trust-preferred valuations have been negatively affected by concerns that the underlying banks and other companies may have significant exposure to losses from sub-prime mortgages, defaulted collateralized debt obligations or other concerns. Several of the Corporation’s trust-preferred securities were downgraded by Moody’s during the third quarter 2008, with five securities falling to ratings of less than investment grade. Further, Moody’s and Fitch have placed all of the pooled trust-preferred securities on “Ratings Watch Negative,” meaning that an initial or further downgrade may be possible in the foreseeable future. In the first nine months of 2008, some of the issuers of trust-preferred securities that are included in the Corporation’s pooled investments have elected to defer payment of interest on these obligations (trust-preferred securities typically permit deferral of quarterly interest payments for up to five years), and some issuers have defaulted. Trust-preferred securities are structured so that the issuers pay more interest into the trusts than would be required for pass through to the investors in the rated notes (such as the Corporation), with the excess used to cover administrative and other expenses, and to provide a cushion for some protection against the risk of loss for investors in the rated notes.

As of September 30, 2008, management evaluated the pooled trust-preferred securities for other-than-temporary impairment by estimating the cash flows a market participant would expect to receive from each security, taking into account estimated levels of deferrals and defaults by the underlying issuers. In determining cash flows, management assumed all issuers currently deferring or in default would make no future payments, and assigned estimated future default levels for the remaining issuers in each security based on financial strength ratings assigned by a national ratings service. Management calculated the present value of each security based on the current book yield, adjusted for future changes in 3-month LIBOR (which is the index rate on the Corporation’s adjustable rate pooled trust-

CITIZENS & NORTHERN CORPORATION — FORM 10-Q

preferred securities) based on the applicable forward curve. For most of the pooled trust-preferred securities, the present value determined on that basis had not declined from management’s previous assumptions used to determine book value, and accordingly, impairment was deemed temporary. However, for three of the securities, the present values declined, and the Corporation wrote the historical cost basis down to estimated fair value, resulting in other-than-temporary impairment charges totaling $4,289,000 (pretax). Management’s estimates of cash flows used to evaluate other-than-temporary impairment of pooled trust-preferred securities were based on sensitive assumptions, and market participants might use substantially different assumptions, which could produce different conclusions for each security. Management’s calculations of fair values of pooled trust-preferred securities are described in Note 5.

Based on the Corporation’s ability and intent to hold its debt securities for the foreseeable future, and management’s assessment of the creditworthiness of the issuers, management believes impairment of the Corporation’s debt securities at September 30, 2008, after adjustment for the write-downs of pooled trust-preferred securities described above, to be temporary.

Unrealized losses on marketable equity securities are mainly from investments in common stocks of banking corporations. Management evaluated equity securities held as of September 30, 2008. Upon evaluation, it was determined that equity securities issued by five banking corporations were other-than-temporarily impaired, including one security that management deemed worthless. Management’s assessment that these securities were other-than-temporarily impaired was based on a large amount of unrealized loss, poor and rapidly deteriorating financial conditions reflected in published financial reports for each entity, and in some cases, publicly announced endeavors to issue additional shares of stock that would dilute the Corporation’s ownership interest. These securities were written down to current fair value at September 30, 2008, and the Corporation recognized a pretax loss in the third quarter 2008 of $458,000, including $24,000 from writing down the worthless security. For the nine months ended September 30, 2008, pretax other-than-temporary impairment losses on bank stocks totaled $1,878,000, including losses totaling $216,000 from the worthless security. As of September 30, 2008, management believes the impairment of the Corporation’s other marketable equity securities to be temporary.

5. ASSETS MEASURED AT FAIR VALUE ON A RECURRING BASIS

The Corporation measures certain assets at fair value on a recurring basis. Fair value is defined as the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date. Statement of Financial Accounting Standards No. 157 establishes a framework for measuring fair value that includes a hierarchy used to classify the inputs used in measuring fair value. The hierarchy prioritizes the inputs used in determining valuations into three levels. The level in the fair value hierarchy within which the fair value measurement falls is determined based on the lowest level input that is significant to the fair value measurement. The levels of the fair value hierarchy are as follows:

Level 1 — Fair value is based on unadjusted quoted prices in active markets that are accessible to the Corporation for identical assets. These generally provide the most reliable evidence and are used to measure fair value whenever available.

Level 2 — Fair value is based on significant inputs, other than Level 1 inputs, that are observable either directly or indirectly for substantially the full term of the asset through corroboration with observable market data. Level 2 inputs include quoted market prices in active markets for similar assets, quoted market prices in markets that are not active for identical or similar assets and other observable inputs.

Level 3 — Fair value is based on significant unobservable inputs. Examples of valuation methodologies that would result in Level 3 classification include option pricing models, discounted cash flows and other similar techniques.

CITIZENS & NORTHERN CORPORATION — FORM 10-Q

At September 30, 2008, assets measured at fair value on a recurring basis and the valuation methods used are as follows:

						September 30, 2008
		Quoted				Market Values Based on:
		Prices				Other
		in Active				Observable				Unobservable				Total
		Markets				Inputs				Inputs				Fair
(In Thousands)		(Level 1)				(Level 2)				(Level 3)				Value
AVAILABLE-FOR-SALE SECURITIES:
Obligations of other U.S. Government agencies		$	—			$	15,743			$	—			$	15,743
Obligations of states and political subdivisions			2,026				67,231				—				69,257
Mortgage-backed securities			10,065				160,001				—				170,066
Collateralized mortgage obligations			—				66,696				—				66,696
Other securities			—				10,898				63,244				74,142
Total debt securities			12,091				320,569				63,244				395,904
Marketable equity securities			21,857				—				—				21,857
Total available-for-sale securities			33,948				320,569				63,244				417,761
TRADING SECURITIES,
Obligations of states and political subdivisions			—				1,630				—				1,630
Total		$	33,948			$	322,199			$	63,244			$	419,391

Management determined there were virtually no trades of pooled trust-preferred securities in the third quarter 2008, except for a limited number of transactions that took place as a result of bankruptcies, forced liquidations or similar circumstances. Also, in management’s judgment, there were no available quoted market prices in active markets for assets sufficiently similar to the Corporation’s pooled trust-preferred securities to be reliable as observable inputs. Accordingly, at September 30, 2008, the Corporation changed its method of valuing pooled trust-preferred securities from a Level 2 methodology that had been used in prior periods, based on price quotes received from pricing services, to a Level 3 methodology, using discounted cash flows.

At September 30, 2008, management calculated the fair values of pooled trust-preferred securities by applying discount rates to estimated cash flows for each security. Management used the cash flow estimates for each security determined using the process described in Note 4. Management used discount rates considered reflective of a market participant’s expectations regarding the extent of credit and liquidity risk inherent in the securities. In establishing the discount rates, management considered: (1) the implied discount rates as of the end of 2007, prior to the market for trust-preferred securities becoming inactive; (2) adjustment to the year-end 2007 discount rates for the change in the spread between indicative market rates (3-month LIBOR, for most of the Corporation’s securities) over corresponding risk-free rates (3-month U.S. Treasury Bill, for most of the Corporation’s securities) as of September 30, 2008; and (3) an additional adjustment — an increase of 2% in the discount rate — for liquidity risk. Management considered the additional 2% increase in the discount rate necessary in order to give some consideration to price estimates based on trades made under distressed conditions, as reported by brokers and pricing services. Management’s estimates of cash flows and discount rates used to calculate fair values of pooled trust-preferred securities were based on sensitive assumptions, and market participants might use substantially different assumptions, which could result in calculations of fair values that would be substantially different than the amounts calculated by management.

CITIZENS & NORTHERN CORPORATION — FORM 10-Q

Following is a reconciliation of activity for assets (pooled trust-preferred securities) measured at fair value based on significant unobservable information:

		3 Months Ended								Fiscal Year To Date
		Sept. 30,				Sept. 30,				9 Mos. Ended Sept. 30,
(In Thousands)		2008				2007				2008				2007
Balance, beginning of period		$	—			$	—			$	—			$	—
Transfers			73,018				—				73,018				—
Purchases, issuances and settlements			13				—				13				—
Unrealized (losses) included in earnings			(4,289	)			—				(4,289	)			—
Unrealized (losses) included in other comprehensive income			(5,498	)			—				(5,498	)			—
Balance, end of period		$	63,244			$	—			$	63,244			$	—

Losses included in earnings are from the September 30, 2008 other-than-temporary impairment analysis of securities, as described in Note 4, and are included in net losses on available-for-sale securities in the consolidated statement of income.

6. DEFINED BENEFIT PLANS

The Corporation sponsors a defined benefit health care plan that provides postretirement medical benefits and life insurance to employees who meet certain age and length of service requirements. This plan contains a cost-sharing feature, which causes participants to pay for all future increases in costs related to benefit coverage. Accordingly, actuarial assumptions related to health care cost trend rates do not affect the liability balance at September 30, 2008 and December 31, 2007, and will not affect the Corporation’s future expenses. The Corporation uses a December 31 measurement date for the postretirement plan.

The Corporation’s defined benefit pension plan was frozen and terminated, effective December 31, 2007. In the third quarter 2008, the Corporation funded and settled substantially all of its obligations under the Plan. The following table reconciles the funding status of the defined benefit pension plan for the nine months ended September 30, 2008:

(In Thousands)
CHANGE IN BENEFIT OBLIGATION:
Benefit obligation at beginning of year		$	12,035
Service cost			29
Interest cost			446
Actuarial (gain)			(496	)
Benefits paid			(495	)
Funding and settlement of plan obligations			(11,519	)
Benefit obligation at September 30, 2008		$	—
CHANGE IN PLAN ASSETS:
Fair value of plan assets at beginning of year		$	11,428
Actual return on plan assets			243
Employer contribution			343
Plan participants’ contributions			—
Benefits paid			(495	)
Funding and settlement of plan obligations			(11,519	)
Fair value of plan assets at September 30, 2008		$	—
Funded status at September 30, 2008		$	—

CITIZENS & NORTHERN CORPORATION — FORM 10-Q

The components of net periodic benefit costs from these defined benefit plans are as follows:

		Pension								Postretirement
		Nine Months Ended								Nine Months Ended
		Sept. 30,								Sept. 30,
(In Thousands)		2008				2007				2008				2007
Service cost		$	29			$	512			$	52			$	55
Interest cost			446				525				59				52
Expected return on plan assets			(230	)			(689	)			—				—
Amortization of transition (asset) obligation			(17	)			(17	)			27				27
Amortization of prior service cost			—				6				7				—
Recognized net actuarial loss			—				34				—				2
Net periodic benefit cost, excluding pension plan settlement			228				371				145				136
(Gain) on pension plan settlement			(71	)			—				—				—
Total net periodic benefit cost		$	157			$	371			$	145			$	136

		Pension								Postretirement
		Three Months Ended								Three Months Ended
		Sept. 30,								Sept. 30,
(In Thousands)		2008				2007				2008				2007
Service cost		$	9			$	170			$	17			$	18
Interest cost			148				175				20				17
Expected return on plan assets			(77	)			(230	)			—				—
Amortization of transition (asset) obligation			(5	)			(5	)			9				9
Amortization of prior service cost			—				2				2				—
Recognized net actuarial loss			—				11				—				1
Net periodic benefit cost, excluding pension plan settlement			75				123				48				45
(Gain) on pension plan settlement			(71	)			—				—				—
Total net periodic benefit cost		$	4			$	123			$	48			$	45

In the first nine months of 2008, the Corporation funded postretirement contributions totaling $44,000, with estimated annual postretirement contributions of $59,000 expected in 2008 for the full year.

7. STOCK-BASED COMPENSATION PLANS

In January 2008, the Corporation granted options to purchase a total of 83,257 shares of common stock through its Stock Incentive and Independent Directors Stock Incentive Plans. In January 2007, the Corporation granted options to purchase a total of 43,385 shares of common stock. The exercise price for the 2008 awards is $17.50 per share, and the exercise price for the 2007 awards is $22.325 per share, based on the market price as of the date of each grant. The Corporation records stock option expense based on estimated fair value calculated using an option valuation model.

CITIZENS & NORTHERN CORPORATION — FORM 10-Q

In calculating the fair value, the Corporation utilized the Black-Scholes option-pricing model. The calculated fair value of each option granted, and significant assumptions used in the calculations, are as follows:

		2008				2007
Fair value of each option granted		$	3.15			$	4.46
Volatility			23	%			23	%
Expected option lives		9 Years				8 Years
Risk-free interest rate			4.05	%			4.69	%
Dividend yield			3.74	%			3.61	%

In calculating the estimated fair value of stock option awards, management based its estimates of volatility and dividend yield on the Corporation’s experience over the immediately prior period of time consistent with the estimated lives of the options. The risk-free interest rate was based on the published yield of zero-coupon U.S. Treasury strips with an applicable maturity as of the grant dates. The 9-year expected option life used for 2008 awards, and 8-year expected option life used for 2007 awards, was based on management’s estimates of the average term for all options issued under both plans. For the 2008 and 2007 awards, management assumed a 23% forfeiture rate for options granted under the Stock Incentive Plan, and a 0% forfeiture rate for the Directors Stock Incentive Plan. These estimated forfeiture rates were determined based on the Corporation’s historical experience.

Also, the Corporation awarded a total of 5,062 shares in January 2008 and 6,529 shares in January 2007 of restricted stock under the Stock Incentive and Independent Directors Stock Incentive Plans. Compensation cost related to restricted stock is recognized based on the market price of the stock at the grant date over the vesting period.

Total stock-based compensation expense is as follows:

		3 Months Ended								Fiscal Year To Date
		Sept. 30,				Sept. 30,				9 Months Ended Sept. 30,
(In Thousands)		2008				2007				2008				2007
Stock options		$	—			$	—			$	209			$	156
Restricted stock			18				—				65				75
Total		$	18			$	—			$	274			$	231

Stock option expense has been recognized over the six-month vesting period for both the 2008 and 2007 awards.

8. CONTINGENCIES

In the normal course of business, the Corporation may be subject to pending and threatened lawsuits in which claims for monetary damages could be asserted. In management’s opinion, the Corporation’s financial position and results of operations would not be materially affected by the outcome of such pending legal proceedings.

CITIZENS & NORTHERN CORPORATION — FORM 10-Q

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Certain statements in this section and elsewhere in this quarterly report on Form 10-Q are forward-looking statements. Citizens & Northern Corporation and its wholly-owned subsidiaries (collectively, the Corporation) intend such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Reform Act of 1995. Forward-looking statements, which are not historical facts, are based on certain assumptions and describe future plans, business objectives and expectations, and are generally identifiable by the use of words such as, “should”, “likely”, “expect”, “plan”, “anticipate”, “target”, “forecast”, and “goal”. These forward-looking statements are subject to risks and uncertainties that are difficult to predict, may be beyond management’s control and could cause results to differ materially from those expressed or implied by such forward-looking statements. Factors which could have a material, adverse impact on the operations and future prospects of the Corporation include, but are not limited to, the following:

•		changes in monetary and fiscal policies of the Federal Reserve Board and the U. S. Government, particularly related to changes in interest rates
•		changes in management’s assessment regarding the realization of future cash flows on securities, as well as the determination of whether securities are other-than-temporarily impaired
•		changes in general economic conditions
•		legislative or regulatory changes
•		downturn in demand for loan, deposit and other financial services in the Corporation’s market area
•		increased competition from other banks and non-bank providers of financial services
•		technological changes and increased technology-related costs
•		changes in accounting principles, or the application of generally accepted accounting principles.

These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements.

REFERENCES TO 2008 AND 2007

Unless otherwise noted, all references to “2008” in the following discussion of operating results are intended to mean the nine months ended September 30, 2008, and similarly, references to “2007” relate to the nine months ended September 30, 2007.

EARNINGS OVERVIEW

Net income in 2008 was $7,881,000 in the first nine months of 2008, as compared to $7,242,000 in 2007. Net income per share was $0.88 (basic and diluted), for the first nine months of 2008 compared to $0.83 per share (basic and diluted) for 2007, an increase of 6.0% in diluted net income per share. Return on average equity increased to 7.88% for 2008, up from 7.02% in 2007.

Pre-tax losses from available-for-sale securities totaled $5,460,000 in the first nine months of 2008, as compared to $79,000 in the first nine months of 2007. Securities losses in 2008 included the effects of other-than-temporary impairment (“OTTI”) charges on pooled trust-preferred securities totaling $4,289,000 and bank stocks totaling $1,878,000. Excluding the after-tax impact of losses on available-for-sale securities, diluted net income per share for the nine months ended September 30, 2008 would have been $1.28, or 54.2% higher than the corresponding amount for the first nine months of 2007.

Pooled trust-preferred securities are long-term instruments, mainly issued by banks, with 30 or more companies included in each pool. The OTTI charges on pooled trust-preferred securities resulted from management’s assessment that it is unlikely all previously anticipated principal and interest will be received on three of the securities. Accordingly, management wrote down the cost basis of these three securities to their estimated fair values as of September 30, 2008. After the impact of the OTTI charges, C&N’s cost basis in pooled trust-preferred securities totaled $86.6 million, and the estimated fair value at September 30, 2008 was $63.2 million.

CITIZENS & NORTHERN CORPORATION — FORM 10-Q

Other significant changes in the components of earnings for the first nine months of 2008, as compared to the same period in 2007, were as follows:

	•		The interest margin increased by $5,031,000, or 18.8% in 2008. The improved interest margin includes the impact of the Citizens Bancorp, Inc. acquisition, which was effective May 1, 2007, compared to the full year-to-date period of 2008. In addition, the interest margin has been positively impacted by lower short-term market interest rates, which have reduced interest rates paid on deposits and borrowings, and by higher earnings on the investment portfolio resulting from higher average total holdings of securities.
	•		Noninterest income, excluding securities gains (losses) increased $2,095,000, or 27.5%. Service charges on deposit accounts increased $1,416,000, or 77.6%, as a result of growth in deposit volumes from the Citizens Bancorp acquisition, as well as higher fees associated with a new overdraft privilege program. Also, in 2008, noninterest income included a gain of $533,000 from redemption of restricted shares of Visa, resulting from Visa’s initial public offering. Trust and Financial Management revenue increased $191,000, or 7.6%, mainly as a result of the addition of Citizens Bancorp.
	•		The provision for loan losses was $669,000 in 2008, or $440,000 higher than the first nine months of 2007.

Third Quarter 2008:

Third quarter 2008 earnings were significantly impacted by OTTI losses on securities, as discussed above, including pre-tax losses from OTTI charges on pooled trust-preferred securities of $4,289,000 and bank stocks of $458,000. Diluted net income per share for the third quarter 2008 was $0.11. Excluding the impact of losses on available-for-sale securities, diluted net income per share for the third quarter 2008 would have been $0.44, as compared to $0.32 in the third quarter 2007. The net interest margin was $1,594,000, or 16.8%, higher in the third quarter 2008 than in the third quarter 2007.

Third quarter 2008 diluted net income per share, excluding losses from available-for-sale securities, is $0.04 lower than corresponding second quarter 2008 results. Although the net interest margin increased $452,000 in the third quarter 2008 over the prior quarter, the provision for loan losses increased $517,000, and noninterest expenses increased $479,000. The Corporation benefited from a negative provision for loan losses in the second quarter 2008 of $376,000, resulting from receipt of a payoff on a commercial loan for which an allowance had been established. In the third quarter 2008, increases in noninterest expense included professional fees and severance costs associated with organizational restructuring activities designed to generate future improvements in efficiency and profitability, as well as increases in FDIC insurance costs and charitable contributions.

TABLE I — QUARTERLY FINANCIAL DATA

		Sept. 30,				June 30,				Mar. 31,				Dec. 31,				Sept. 30,				June 30,				Mar. 31,
(In Thousands)		2008				2008				2008				2007				2007				2007				2007
Interest income		$	18,575			$	18,373			$	18,700			$	18,228			$	18,058			$	17,692			$	16,243
Interest expense			7,474				7,724				8,656				8,679				8,551				8,679				8,000
Interest margin			11,101				10,649				10,044				9,549				9,507				9,013				8,243
Provision for loan losses			141				(376	)			904				300				—				—				229
Interest margin after provision for loan losses			10,960				11,025				9,140				9,249				9,507				9,013				8,014
Other income			3,062				3,155				3,487				2,831				2,877				2,644				2,088
Net (losses) gains on available-for-sale securities			(4,483	)			(867	)			(110	)			206				(68	)			(1,172	)			1,161
Other expenses			8,736				8,257				8,464				8,156				8,691				8,189				8,247
Income before income tax provision			803				5,056				4,053				4,130				3,625				2,296				3,016
Income tax provision			(209	)			1,303				937				948				777				360				558
Net income		$	1,012			$	3,753			$	3,116			$	3,182			$	2,848			$	1,936			$	2,458
Net income per share — basic		$	0.11			$	0.42			$	0.35			$	0.35			$	0.32			$	0.22			$	0.29
Net income per share — diluted		$	0.11			$	0.42			$	0.35			$	0.35			$	0.32			$	0.22			$	0.29

CITIZENS & NORTHERN CORPORATION — FORM 10-Q

The number of shares used in calculating net income per share for each quarter presented in Table I reflect the retroactive effect of stock dividends.

Prospects for the Remainder of 2008

Despite substantial write-downs of securities, earnings have increased for the first nine months of 2008 over the same period in 2007, and there are many factors pointing to continued good operating results in the fourth quarter 2008. The largest area of concern for the remainder of 2008 is the potential need to record more losses from the securities portfolio, as described in more detail below.

Because current economic conditions are volatile, management and the Corporation’s Board of Directors are considering raising more capital in the fourth quarter 2008 by issuing preferred stock to enable participation in the TARP Capital Purchase Program (described in more detail in the “Stockholders’ Equity and Capital Adequacy” section of Management’s Discussion and Analysis). The additional capital that could become available under the TARP Capital Purchase Program would provide some protection in case additional securities losses occur, or if local economic conditions worsen and the Corporation begins to experience higher levels of loan losses than it has experienced in the first nine months of 2008. Further, the additional capital may position the Corporation to improve profitability through increased lending, acquisitions or other means. Based on the Corporation’s risk-weighted assets as of September 30, 2008, the total amount of preferred stock issued could be as high as $26.5 million. The Corporation’s ability to participate in the TARP Capital Purchase Program is dependent on: (1) shareholder approval of an amendment to the Articles of Incorporation to permit issuance of the preferred shares, and (2) approval by banking regulatory agencies and the Treasury Department.

As described in more detail in Item 3, Quantitative and Qualitative Disclosures About Market Risk, the Corporation is liability sensitive, meaning that its sources of funds (mainly deposits and borrowings) tend to re-price more quickly on average when interest rates change than do its earning assets (mainly loans and available-for-sale debt securities). Accordingly, the Corporation tends to generate lower earnings when short-term interest rates rise and higher earnings when short-term rates fall. With reductions in the Fed Funds target rate (which has fallen from 5.25% in August 2007 to its early-November 2008 level of 1%), the Corporation has experienced overall reductions in its cost of funds and improvement in its net interest margin over the course of 2008.

The provision for loan losses for the first nine months of 2008 was $669,000, including a charge to earnings of $141,000 in the third quarter, a credit of $376,000 in the second quarter and a charge to earnings of $904,000 in the first quarter. Issues related to larger commercial borrowers significantly affect the Corporation’s provision for loan losses in any particular period. Accordingly, the amount of loan loss provision for the remainder of 2008 will depend substantially on the credit status of the commercial portfolio. Although management is concerned about the condition of the national economy and the potential for problems in our market area, to date the Corporation has not experienced significant deterioration in loan delinquencies, nor a noticeable change in volume of activity related to troubled debts or foreclosures. The Corporation has not originated interest only mortgages, loans without documentation of the borrowers’ sources of income or net worth, or other types of subprime mortgage loans that have received negative publicity in 2007 and 2008.

Benefits under the Corporation’s defined benefit pension plan were frozen, and a decision was made to terminate the Plan, effective December 31, 2007. Earlier in 2008, management expected the Corporation to realize a loss from settlement of the defined benefit pension plan at the time it would be required to fund the final amounts necessary to extinguish its obligations under the Plan. However, the cost of the annuities purchased to settle obligations to retired participants receiving benefits was substantially less than anticipated, and the Corporation had a gain of $71,000 from settlement of the Plan in the third quarter 2008. As reflected in Note 6 to the consolidated financial statements, in the first nine months of 2008, the Corporation recorded expense from the defined benefit plan of $228,000, excluding the gain from settlement. For the year ended December 31, 2007, when a significant amount of service cost was still accruing, expense from the defined benefit plan (excluding a loss from curtailment of $77,000) totaled $495,000. Also in 2008, employer matching contributions under the Corporation’s Employee Savings & Retirement Plan (a 401(k) plan), were increased, which will result in an estimated increase in expense of $150,000 for the year. Going forward, management expects the net impact of terminating the defined benefit plan and increasing the Savings & Retirement Plan contributions to be lower ongoing employee benefit expenses.

A major variable that affects the Corporation’s earnings is securities gains and losses. In the first nine months of 2008, the Corporation reported realized losses from available-for-sale securities of $5,460,000, including the effect of pretax write-downs of impaired trust-preferred securities by $4,289,000 and bank stocks by $1,878,000. The Corporation’s losses from trust-preferred securities and bank stocks stem from the much-publicized economic

CITIZENS & NORTHERN CORPORATION — FORM 10-Q

problems affecting the national and international economy, which have particularly hurt the banking industry. Although management believes these conditions to be cyclical, opportunities for realized gains from bank stocks are expected to be limited in the fourth quarter 2008, and (after the effect of the write-downs) the Corporation has significant unrealized losses on its holdings of trust-preferred securities as of September 30, 2008. Management has reviewed its holdings of bank stocks, trust-preferred securities and other securities as of September 30, 2008, and concluded that — with the exception of the trust-preferred securities and bank stocks that have been written down through earnings — the remaining unrealized losses are considered temporary. Notes 4 and 5 to the consolidated financial statements provide more detail concerning the Corporation’s processes for evaluating securities for other-than-temporary impairment, and for valuation of trust-preferred securities. Management will continue to closely monitor the status of impaired securities in the fourth quarter 2008.

CRITICAL ACCOUNTING POLICIES

The presentation of financial statements in conformity with U.S. generally accepted accounting principles 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. Management believes that the allowance for loan losses is adequate and reasonable. The Corporation’s methodology for determining the allowance for loan losses is described in a separate section later in Management’s Discussion and Analysis. Given the very 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 revisions in future years. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation’s allowance for loan losses. Such agencies may require the Corporation 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 Corporation’s debt securities. For most of the Corporation’s debt securities, the Corporation receives estimated fair values of debt securities from an independent valuation service, or from brokers. In developing fair values, the valuation service and the brokers use 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 debt securities tend to vary among brokers and other valuation services. Accordingly, when selling debt securities, management typically obtains price quotes from more than one source.

As described in Note 5 to the consolidated financial statements, at September 30, 2008, the Corporation changed its method of valuing pooled trust-preferred securities from a Level 2 methodology that had been used in prior periods, based on price quotes received from pricing services, to a Level 3 methodology, using discounted cash flows. At September 30, 2008, management calculated the fair values of pooled trust-preferred securities by applying discount rates to estimated cash flows for each security. Management estimated the cash flows a market participant would expect to receive from each security, taking into account estimated levels of deferrals and defaults by the underlying issuers, and used discount rates considered reflective of a market participant’s expectations regarding the extent of credit and liquidity risk inherent in the securities. Management’s estimates of cash flows and discount rates used to calculate fair values of pooled trust-preferred securities were based on sensitive assumptions, and market participants might use substantially different assumptions, which could result in calculations of fair values that would be substantially different than the amounts calculated by management.

As described in Note 4 to the consolidated financial statements, management evaluates securities for other-than-temporary impairment. In making that 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 Corporation to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Management’s estimates of cash flows used to evaluate other-than-temporary impairment of pooled trust-preferred securities are based on sensitive assumptions, and market participants might use substantially different assumptions, which could produce different conclusions for each security. Also, management’s assessments of the likelihood and potential for recovery in value of equity securities (mainly, bank stocks) are subjective, and based on sensitive assumptions.

CITIZENS & NORTHERN CORPORATION — FORM 10-Q

NET INTEREST MARGIN

The Corporation’s primary source of operating income is represented by the net interest margin. The net interest margin is equal to the difference between the amounts of interest income and interest expense. Tables II, III and IV include information regarding the Corporation’s net interest margin for 2008 and 2007. In each of these tables, the amounts of interest income earned on tax-exempt securities and loans have been adjusted to a fully taxable-equivalent basis. Accordingly, the net interest margin amounts reflected in these tables exceed the amounts presented in the consolidated financial statements. The discussion that follows is based on amounts in the related Tables.

The fully taxable equivalent net interest margin was $33,374,000 in 2008, which is $5,181,000 (18.4%) higher than in 2007. As shown in Table IV, net increases in volume had the effect of increasing net interest income $1,807,000 in 2008 over 2007, and interest rate changes had the effect of increasing net interest income $3,374,000. Increases in the volume of earning assets and interest-bearing liabilities were significantly affected by the acquisition of Citizens Trust Company on May 1, 2007. The most significant components of the volume changes in interest income in 2008 were an increase of $4,040,000 attributable to growth in the available-for-sale securities portfolio and an increase of $975,000 attributable to loan growth. The most significant volume change in interest expense in 2008 was an increase of $2,927,000 resulting from an increase in long-term borrowings. As presented in Table III, the “Interest Rate Spread” (excess of average rate of return on earning assets over average cost of funds on interest-bearing liabilities) was 3.23% in the first nine months of 2008, as compared to 2.92% for the year ended December 31, 2007 and 2.89% in the first nine months of 2007.

INTEREST INCOME AND EARNING ASSETS

Interest income totaled $57,228,000 in 2008, an increase of 7.1% over 2007. Income from available-for-sale securities increased $3,890,000, or 26.6%, and interest and fees from loans increased $22,000, or 0.1%. As indicated in Table III, total average available-for-sale securities in 2008 rose to $447,354,000, an increase of $99,737,000, or 28.7% from 2007. Throughout much of 2007, proceeds from sales and maturities of securities were used, in part, to help fund loans and pay off borrowings. In December 2007, the Corporation purchased approximately $86,152,000 in mortgage-backed securities in connection with two repurchase agreements. During 2008, the Corporation has increased its holdings of mortgage-backed securities and municipal bonds as securities became available at attractive prices. The average rate of return on available-for-sale securities was 5.53% for 2008, down from the 5.65% return for the year ended December 31, 2007 and 5.62% in the first nine months of 2007.

The average balance of gross loans increased 2.5% to $742,018,000 in 2008 from $723,794,000 in the first nine months of 2007. Excluding the acquisition of Citizens Trust Company, the balance of residential mortgages has remained nearly unchanged in 2008, and there has been a modest decrease in the balance of consumer loans. Growth in the loan portfolio has come primarily from several large loans made to commercial and non-profit entities. The average rate of return on loans was 6.92% in 2008, down from the 7.10% return for the year ended December 31, 2007 and 7.10% in the first nine months of 2007.

INTEREST EXPENSE AND INTEREST-BEARING LIABILITIES

Interest expense decreased $1,376,000, or 5.5%, to $23,854,000 in 2008 from $25,230,000 in 2007. Table III shows that the overall cost of funds on interest-bearing liabilities fell to 3.14% in 2008, from 3.70% for the year ended December 31, 2007 and 3.72% in the first nine months of 2007.

From Table III, you can calculate that total average deposits (interest-bearing and noninterest-bearing) increased 4.3%, to $843,950,000 in 2008 from $809,001,000 in the first nine months of 2007. The average rates incurred on deposit accounts have decreased significantly in the first nine months of 2008 as compared to the first nine months of 2007. The decreases in rates reduced interest expense on deposits by $4,347,000.

The combined average total short-term and long-term borrowed funds increased $84,680,000 to $296,215,000 in 2008 from $211,535,000 in the first nine months of 2007. In December 2007, the Corporation entered into two repurchase agreements totaling $80,000,000; the proceeds were used to purchase mortgage-backed securities as described above. The average rate on long-term borrowings was 4.25% in 2008, up from 4.11% in the first nine months of 2007.

CITIZENS & NORTHERN CORPORATION — FORM 10-Q

TABLE II — ANALYSIS OF INTEREST INCOME AND EXPENSE

		Nine Months Ended
		September 30,								Increase/
(In Thousands)		2008				2007				(Decrease)
INTEREST INCOME
Available-for-sale securities:
Taxable		$	15,206			$	11,618			$	3,588
Tax-exempt			3,308				3,006				302
Total available-for-sale securities			18,514				14,624				3,890
Held-to-maturity securities, Taxable			18				18				—
Trading securities			90				66				24
Interest-bearing due from banks			27				74				(47	)
Federal funds sold			116				200				(84	)
Loans:
Taxable			36,836				36,889				(53	)
Tax-exempt			1,627				1,552				75
Total loans			38,463				38,441				22
Total Interest Income			57,228				53,423				3,805
INTEREST EXPENSE
Interest checking			794				1,485				(691	)
Money market			3,265				4,535				(1,270	)
Savings			249				256				(7	)
Certificates of deposit			6,978				8,085				(1,107	)
Individual Retirement Accounts			3,650				4,413				(763	)
Other time deposits			5				6				(1	)
Short-term borrowings			761				1,397				(636	)
Long-term borrowings			8,152				5,053				3,099
Total Interest Expense			23,854				25,230				(1,376	)
Net Interest Income		$	33,374			$	28,193			$	5,181

Note: Interest income from tax-exempt securities and loans has been adjusted to a fully tax-equivalent basis, using the Corporation’s marginal federal income tax rate of 34%.

CITIZENS & NORTHERN CORPORATION — FORM 10-Q

Table IIl — Analysis of Average Daily Balances and Rates

		9 Months								Year								9 Months
		Ended				Rate of				Ended				Rate of				Ended				Rate of
		9/30/2008				Return/				12/31/2007				Return/				9/30/2007				Return/
		Average				Cost of				Average				Cost of				Average				Cost of
(Dollars in Thousands)		Balance				Funds %				Balance				Funds %				Balance				Funds %
EARNING ASSETS
Available-for-sale securities, at amortized cost:
Taxable		$	380,650				5.34	%		$	290,743				5.49	%		$	285,215				5.45	%
Tax-exempt			66,704				6.62	%			62,065				6.43	%			62,402				6.44	%
Total available-for-sale securities			447,354				5.53	%			352,808				5.65	%			347,617				5.62	%
Held-to-maturity securities, Taxable			408				5.89	%			412				5.83	%			412				5.84	%
Trading securities			1,972				6.10	%			1,665				5.89	%			1,541				5.73	%
Interest-bearing due from banks			1,302				2.77	%			1,864				4.67	%			2,058				4.81	%
Federal funds sold			6,135				2.53	%			4,017				5.25	%			5,091				5.25	%
Loans:
Taxable			708,714				6.94	%			696,667				7.13	%			691,194				7.14	%
Tax-exempt			33,304				6.53	%			32,602				6.46	%			32,600				6.37	%
Total loans			742,018				6.92	%			729,269				7.10	%			723,794				7.10	%
Total Earning Assets			1,199,189				6.37	%			1,090,035				6.62	%			1,080,513				6.61	%
Cash			20,111								19,485								19,488
Unrealized gain/loss on securities			(20,535	)							(324	)							553
Allowance for loan losses			(8,875	)							(8,697	)							(8,662	)
Bank premises and equipment			27,305								26,767								26,337
Intangible Asset — Core Deposit Intangible			1,182								1,287								1,239
Intangible Asset — Goodwill			12,026								8,864								7,810
Other assets			51,148								41,487								40,462
Total Assets		$	1,281,551							$	1,178,904							$	1,167,740
INTEREST-BEARING LIABILITIES
Interest checking		$	81,302				1.30	%		$	75,488				2.42	%		$	75,576				2.63	%
Money market			192,528				2.27	%			183,178				3.29	%			183,798				3.30	%
Savings			66,859				0.50	%			62,976				0.54	%			62,702				0.55	%
Certificates of deposit			239,971				3.88	%			242,822				4.44	%			242,189				4.46	%
Individual Retirement Accounts			137,785				3.54	%			131,158				4.50	%			130,099				4.54	%
Other time deposits			1,474				0.45	%			1,283				0.55	%			1,467				0.55	%
Short-term borrowings			39,904				2.55	%			48,373				3.98	%			47,266				3.95	%
Long-term borrowings			256,311				4.25	%			170,229				4.17	%			164,269				4.11	%
Total Interest-bearing Liabilities			1,016,134				3.14	%			915,507				3.70	%			907,366				3.72	%
Demand deposits			124,031								115,350								113,170
Other liabilities			7,892								9,378								9,697
Total Liabilities			1,148,057								1,040,235								1,030,233
Stockholders’ equity, excluding other comprehensive income/loss			147,445								140,035								138,299
Other comprehensive income/loss			(13,951	)							(1,366	)							(792	)
Total Stockholders’ Equity			133,494								138,669								137,507
Total Liabilities and Stockholders’ Equity		$	1,281,551							$	1,178,904							$	1,167,740
Interest Rate Spread							3.23	%							2.92	%							2.89	%
Net Interest Income/Earning Assets							3.72	%							3.51	%							3.49	%