# Fidelity D & D Bancorp Inc: Form 10-Q for the period ended Jun 30, 2009

- Company: [Fidelity D & D Bancorp Inc](/companies/fdbc.md) (CIK 1098151)
- Form: 10-Q
- Filed: 2009-08-12
- Accepted by EDGAR: Aug 12, 2009, 12:26 ET
- Period: 2009-06-30
- Accession: 0001104659-09-049175
- Inline XBRL: no
- Main document: https://www.sec.gov/Archives/edgar/data/1098151/000110465909049175/a09-18516_110q.htm
- All documents and exhibits: https://www.sec.gov/Archives/edgar/data/1098151/000110465909049175/

## Management's discussion and analysis

As filed, 60,473 characters.

The following is management’s discussion and analysis of the significant changes in the consolidated financial condition of the Company as of June 30, 2009 compared to December 31, 2008 and the results of operations for the three- and six month periods ended June 30, 2009 and 2008. Current performance may not be indicative of future results. This discussion should be read in conjunction with the Company’s 2008 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;
- volatilities in the securities market;
- deteriorating economic conditions;
- effects of deterioration of economic conditions on customers, specifically the effect on loan customers ability to repay their loans;
- 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 and investment securities values may adversely affect our business;
- changes in accounting principles, policies or guidelines may cause our financial condition to be perceived differently;
- 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; and
- 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 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, sales of other real estate (ORE) properties and from other-than-temporary-impairment (OTTI) charges on investment securities. 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 properties.

### Comparison of the results of operations

### Three and six months ended June 30, 2009 and 2008

### Overview

Net income for the second quarter of 2009 was $912,000 compared to $1,204,000 recorded in the same quarter of 2008. Diluted earnings per share were $0.44 and $0.59 for each of the respective quarters. For the six months ended June 30, 2009, net income was $1,737,000, or $0.84 per share compared to $2,293,000, or $1.11 per share for the six months ended June 30, 2008. The decrease in net income, in the quarterly comparison, was due to a reduction of net interest income and increases in the provision for loan losses and non-interest expenses, partially offset by an increase in non-interest income. The decline in net income in the first half of 2009 compared to the first half of 2008 was caused by an increase in the provision for loans losses, an increase in non-interest expenses and a non-cash OTTI charge of $326,000 related to the Company’s investment portfolio that did not occur during the first half of 2008. These items were partially offset by higher gains from the sales of mortgage loans in the three- and six- month periods ended June 30, 2009 compared to the same period of 2008. For the six months ended June 30, 2009, net income excluding the OTTI charge would have been $1,952,000, or $0.94 per share. The following table reconciles net income as reported to pro forma net operating income for the periods indicated:

|  | Three months ended June 30, 2009 Amount | Per share | 2008 Amount | Per share | Six months ended June 30, 2009 Amount | Per share | 2008 Amount | Per share |
| --- | ---: | ---: | ---: | ---: | ---: | ---: | ---: | ---: |
| Net income, as reported | $912,153 | $0.44 | $1,203,946 | $0.59 | $1,737,211 | $0.84 | $2,292,893 | $1.11 |
| Other-than-temporary impairment | 570 | 0.00 | — | — | 326,095 | 0.15 | — | — |
| Tax effect | (194) | (0.00) | — | — | (110,872) | (0.05) | — | — |
| Net operating earnings | $912,529 | $0.44 | $1,203,946 | $0.59 | $1,952,434 | $0.94 | $2,292,893 | $1.11 |

Return on average assets (ROA) and return on average shareholders’ equity (ROE) were 0.65% and 7.63%, respectively, for the three months ended June 30, 2009 compared to 0.83% and 8.73%, respectively, for the same period in 2008. For the six months ended June 30, 2009, ROA and ROE were 0.62% and 7.33%, respectively, compared to 0.78% and 8.26% for the same period in 2008. The decrease in both ROA and ROE is attributable to lower net income.

#### Net interest income and interest sensitive assets / liabilities

Net interest income decreased $202,000, or 4%, to $4,741,000 for the second quarter of 2009, from $4,943,000 recorded in the same period of 2008. The decline in net interest income was principally due to a combination of: a 70 basis point decline in yields from earning-assets, mostly in the commercial loan and investment portfolios partially offset by a decrease in rates paid on deposits and lower balances of interest-bearing liabilities mostly from a reduction of $10,000,000 in long-term Federal Home Loan Banks (FHLB) advances and short-term borrowings. The decline in FHLB advances were supplanted by growth in average deposits which were used to help reduce dependence on short-term borrowings.

During the second quarter of 2009, the Company’s tax-equivalent margin and spread were 3.70% and 3.28%, respectively, compared to 3.71% and 3.18% during the second quarter of 2008. The improvement in spread was caused by a greater reduction in rates paid on interest-bearing liabilities than the lower yields earned on interest-earning assets. Rates paid on interest-bearing liabilities declined 75 basis points compared to a decline in yield of 65 basis points.

For the six months ended June 30, 2009, net interest income improved 1%, or, $75,000 compared to the six months ended June 30, 2008. The Company’s tax-equivalent margin and spread improved to 3.71% and 3.27%, respectively, from 3.54% and 2.97% during the same period of 2008. The improvements were largely from lower balances of interest-bearing liabilities — most notably from lower long-and short-term borrowings. Rates paid on deposits declined 94 basis points compared to lower yields from earning-assets of 58 basis points.

The current interest rate environment has not materially changed since year-end 2008; however, it is much different than a year ago. The interest rate environment was considerably lower during the first half of 2009 compared to 2008, albeit the treasury yield curve is somewhat steeper today. The lower rates have caused assets to price and re-price at significantly lower levels thereby pressuring earning-yields downward. Increased prepayment activity in asset portfolios, thereby shortening the duration of interest-earning assets as well as increased activity in loan refinancing all contribute to lower portfolio yields. However, the steepness of the curve has enabled the Company to help mitigate the lower yields earned from its asset portfolios. To manage the interest rate margin to acceptable levels, the Company’s Asset Liability Management (ALM) team meets regularly to discuss interest rate risk and when deemed necessary adjusts interest rates on deposits and repurchase agreements and when necessary uses lower costing wholesale funding sources. The actions of the ALM team have helped minimize the effect rate changes have had on interest income so that net interest income is not materially and disproportionately impacted during this lower yield environment. During the first quarter of 2009, the Company sold $10.8 million of lower yielding mortgage loans and used the proceeds to pay off the aforementioned FHLB advance that was scheduled to mature in the second quarter of 2009. The Company’s proactive attention to interest rate risk should continue to help contain the Company’s net interest income at acceptable levels.

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):

| Assets Interest-earning assets: | Three months ended: June 30, 2009 Average balance | Interest | Yield / rate | June 30, 2008 Average balance | Interest | Yield / rate |
| --- | ---: | ---: | ---: | ---: | ---: | ---: |
| Loans and leases | $428,079 | $6,529 | 6.12% | $407,208 | $6,904 | 6.82% |
| Investments | 94,535 | 1,113 | 4.72 | 141,728 | 1,834 | 5.20 |
| Federal funds sold | 10,793 | 7 | 0.24 | 1,268 | 7 | 2.21 |
| Interest-bearing deposits | 1,419 | — | 0.10 | 118 | 1 | 2.37 |
| Total interest-earning assets | 534,826 | 7,649 | 5.74 | 550,322 | 8,746 | 6.39 |
| Non-interest-earning assets | 28,615 |  |  | 35,317 |  |  |
| Total assets | $563,441 |  |  | $585,639 |  |  |
| **Liabilities and shareholders’ equity** |  |  |  |  |  |  |
| Interest-bearing liabilities: |  |  |  |  |  |  |
| Other interest-bearing deposits | $217,249 | $550 | 1.02% | $197,552 | $852 | 1.73% |
| Certificates of deposit | 172,573 | 1,588 | 3.69 | 180,925 | 1,980 | 4.40 |
| Borrowed funds | 42,578 | 569 | 5.36 | 70,896 | 825 | 4.68 |
| Repurchase agreements | 9,837 | 8 | 0.33 | 10,234 | 13 | 0.53 |
| Total interest-bearing liabilities | 442,237 | 2,715 | 2.46 | 459,607 | 3,670 | 3.21 |
| Non-interest-bearing deposits | 68,909 |  |  | 65,591 |  |  |
| Other non-interest-bearing liabilities | 4,373 |  |  | 5,005 |  |  |
| Shareholders’ equity | 47,922 |  |  | 55,436 |  |  |
| Total liabilities and shareholders’ equity | $563,441 |  |  | $585,639 |  |  |
| Net interest income / interest rate spread |  | $4,934 | 3.28% |  | $5,076 | 3.18% |
| Net interest margin |  |  | 3.70% |  |  | 3.71% |

| Assets Interest-earning assets: | Six months ended: June 30, 2009 Average balance | Interest | Yield / rate | June 30, 2008 Average balance | Interest | Yield / rate |
| --- | ---: | ---: | ---: | ---: | ---: | ---: |
| Loans and leases | $433,412 | $13,263 | 6.17% | $409,151 | $13,832 | 6.80% |
| Investments | 98,488 | 2,372 | 4.86 | 138,110 | 3,690 | 5.37 |
| Federal funds sold | 6,145 | 7 | 0.24 | 6,721 | 91 | 2.73 |
| Interest-bearing deposits | 773 | — | 0.12 | 135 | 2 | 2.69 |
| Total interest-earning assets | 538,818 | 15,642 | 5.85 | 554,117 | 17,615 | 6.39 |
| Non-interest-earning assets | 29,027 |  |  | 34,743 |  |  |
| Total assets | $567,845 |  |  | $588,860 |  |  |
| **Liabilities and shareholders’ equity** |  |  |  |  |  |  |
| Interest-bearing liabilities: |  |  |  |  |  |  |
| Other interest-bearing deposits | $212,270 | $1,119 | 1.06% | $194,424 | $1,946 | 2.01% |
| Certificates of deposit | 172,922 | 3,210 | 3.74 | 185,263 | 4,119 | 4.47 |
| Borrowed funds | 52,387 | 1,371 | 5.28 | 69,796 | 1,722 | 4.96 |
| Repurchase agreements | 10,098 | 17 | 0.33 | 12,803 | 81 | 1.27 |
| Total interest-bearing liabilities | 447,677 | 5,717 | 2.58 | 462,286 | 7,868 | 3.42 |
| Non-interest-bearing deposits | 68,498 |  |  | 66,048 |  |  |
| Other non-interest-bearing liabilities | 3,873 |  |  | 4,730 |  |  |
| Shareholders’ equity | 47,797 |  |  | 55,796 |  |  |
| Total liabilities and shareholders’ equity | $567,845 |  |  | $588,860 |  |  |
| Net interest income / interest rate spread |  | $9,925 | 3.27% |  | $9,747 | 2.97% |
| Net interest margin |  |  | 3.71% |  |  | 3.54% |

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 Company’s loan 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 Company’s Special Asset Committee meets periodically to review problem loans and leases. The committee is comprised of 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.

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; and
- changes in credit concentrations.

The provision for loan loss was $300,000 for the second quarter of 2009 and $725,000 for the six month period ending June 30, 2009, as compared to $125,000 for the same 2008 quarter and six month periods. A provision for loan loss was required due to internally classified credit downgrades, weakening economic conditions, plus commercial loan growth during the second quarter of 2009.

The allowance for loan losses was $5,216,000 at June 30, 2009 compared to $4,189,000 at June 30, 2008. For a further discussion on the allowance for loan losses, see “Allowance for loan losses” under the caption “Comparison of financial condition at June 30, 2009 and December 31, 2008”, below.

#### Other income

In the second quarter of 2009, other (non-interest) income increased $193,000, or 15%, to $1,458,000 from $1,265,000 recorded in second quarter of 2008. The increase was the result of higher volumes of mortgage origination / refinance activity that has been prevalent throughout 2009. Most fixed-rate mortgage loan originations are sold into the secondary market with gains of $328,000 recognized during the current year quarter compared to $60,000 recognized during the same 2008 quarter. A decrease in the volume of deposit overdraft transactions has resulted in an $89,000 decline in service charges on deposit accounts for the three months ended June 30, 2009 compared to the three months ended June 30, 2008.

For the six months ended June 30, 2009, other income improved by $210,000, or 8%, compared to the six months ended June 30, 2008. In the first half of 2009, the Company sold $74,148,000 of residential mortgage loans and recognized gains of $818,000. Included in these sales were $10,838,000 of loans transferred from the loan and lease portfolio to loans AFS during the first quarter of the current year and simultaneously sold. Partially offsetting this gain was a non-cash OTTI charge of $326,000 from the investment portfolio. The OTTI charge is related to the Company’s investment in a pooled trust preferred security. The carrying value of this security was further written down to its fair market value during the first half of 2009 as management has deemed the additional impairment to be other-than-temporary. There was no similar OTTI charge during the first half of 2008. Service charges from deposit accounts declined $220,000, or 15%, due to lower volumes of overdraft transactions.

#### Other operating expenses

For the quarter ended June 30, 2009, other (non-interest) expenses increased $294,000, or 7%, compared to the quarter ended June 30, 2008. In the second quarter of 2009, the Company’s FDIC insurance premium was $321,000 greater than the premium incurred in the 2008 quarter. The increase was caused by the $255,000, 5 basis points on total assets less tier I capital, special assessment imposed by the FDIC to all member-insured banks on June 30, 2009. The increase in premises and equipment is from added depreciation expense for the new West Scranton branch expansion project that opened in the third quarter of 2008, property insurance and increased equipment maintenance in information technology.

For the six months ended June 30, 2009, non-interest related expenses increased $563,000, or 6%, compared to the six months ended June 30, 2008. The previously mentioned FDIC special assessment and increased premiums contributed to $383,000 of the increase. The 2% increase in salary and benefits was due to a full six month of operations of the Company’s

West Scranton branch that was not operational until the third quarter of 2008, a Company’s executive officer was re-employed during the middle of the first quarter of 2008 compared to a full six-month impact in the current year, higher commissions earned on production by our financial services staff, increased health care and partially offset by lower stock-based compensation. The increase in premises and equipment is from depreciation expense for the new West Scranton branch. An increase in the level of ORE, as a result of our efforts to resolve non-performing assets, resulted in a $126,000 increase in the costs associated with foreclosure and the resultant operating costs of property ownership.

#### Provision for income taxes

The provision for income taxes for the three- and six- months ended June 30, 2009 was lower compared to the same periods in 2008 primarily from lower pretax income.

### Comparison of financial condition at

### June 30, 2009 and December 31, 2008

#### Overview

Consolidated assets declined $15,265,000, or 3%, during the six months ended June 30, 2009. The decline was caused by a $39,249,000, or 43%, reduction in total borrowings, partially offset by a $20,561,000, or 4%, increase in total deposits. The reduction in borrowings was from implementing a de-leveraging strategy, during the first quarter that used the proceeds from the sale of residential mortgage loans to reduce a FHLB advance that was scheduled to mature during the second quarter of 2009. The increase in deposits was used to reduce overnight borrowings and fund commercial loan growth.

#### Investment securities

At the time of purchase, management 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. Most of the securities purchased are classified as AFS even though there is no immediate intent to sell them. The AFS designation affords management the flexibility to sell securities and position the balance sheet in response to capital levels, liquidity needs or changes in market conditions. Securities AFS are carried at fair value in the consolidated balance sheet with an adjustment to shareholders’ equity, net of tax, presented under the caption “Accumulated other comprehensive income (loss).” Securities designated as HTM are carried at amortized cost and represent debt securities that the Company has the ability and intent to hold until maturity.

As of June 30, 2009, the carrying value of investment securities totaled $77,319,000, or 14% of total assets, compared to $84,187,000, or 15% of total assets, at December 31, 2008. At June 30, 2009, approximately 14% of the carrying value of the investment portfolio was comprised of mortgage-backed securities that amortize and provide monthly cash flow. Agency, municipal and corporate bonds comprised 40%, 35% and 11%, respectively, of the investment portfolio at June 30, 2009.

During the six months ended June 30, 2009, total investments decreased $6,868,000, net of a $1,444,000 decline in the market value of AFS investments. The investment securities are comprised of HTM and AFS securities with carrying values of $843,000 and $76,014,000, respectively. As of June 30, 2009, the AFS debt securities were recorded with a net unrealized loss in the amount of $14,964,000 and equity securities were recorded with an unrealized net gain of $140,000.

A comparison of investment securities at June 30, 2009 and December 31, 2008 is as follows (dollars in thousands):

|  | June 30, 2009 Amount% |  | December 31, 2008 Amount% |  |
| --- | ---: | ---: | ---: | ---: |
| U.S. government agencies | $30,632 | 39.6 | $43,507 | 51.6 |
| Mortgage-backed securities | 10,604 | 13.7 | 12,439 | 14.8 |
| State & municipal subdivisions | 27,358 | 35.4 | 17,553 | 20.9 |
| Pooled trust preferred securities | 8,263 | 10.7 | 10,260 | 12.2 |
| Equity securities | 462 | 0.6 | 428 | 0.5 |
| Total investments | $77,319 | 100.0 | $84,187 | 100.0 |

Quarterly, management performs a review of the investment portfolio to determine the cause of declines in the fair value of each security. The Company uses inputs provided by independent third parties to determine the fair value of its investment securities portfolio. Inputs provided by the third party are reviewed and corroborated by management. Evaluations of the causes of the unrealized losses are performed to determine whether impairment, if any, is temporary or other-than-temporary. Considerations such as the Company’s intent and ability to hold the securities to maturity, recoverability of the invested amounts over the intended holding period, the length of time and the severity in pricing decline below cost, the interest rate environment, receipts of amounts contractually due and whether or not there is an active market for the security, for example, are applied, along with the financial condition of the issuer for management to make a realistic judgment of the probability that the Company will be unable to collect all amounts (principal and interest) due in determining whether a security is other-than-temporarily impaired. If a decline in value is deemed to be other-than-temporary, the amortized cost of the security is reduced by the credit impairment amount and a corresponding charge to earnings is recognized. If at the time of sale, call or maturity the proceeds exceed the security’s amortized cost, the impairment charge may be fully or partially recovered.

During 2008 and today, uncertainty in the financial markets increased the volatility in fair value estimates for the securities in our investment portfolio. Compared to year-end 2008, the fair values of securities have declined. Management believes these changes were due mainly to interest rate changes and liquidity problems in the financial markets, not deterioration in the creditworthiness of the issuers.

At June 30, 2009 and December 31, 2008, the securities with the most significant reductions in fair value and associated estimated unrealized losses were in the Company’s corporate bond portfolio consisting of pooled trust preferred securities issued by banks, thrifts and insurance companies.

Except for the pooled trust preferred securities, fair values of the other investment securities are determined by prices provided by a third-party vendor, who is a provider of financial market data, analytics and related services to financial institutions. For the pooled trust preferred securities portfolio, management was unable to obtain readily attainable and realistic pricing from market traders due to a lack of active market participants and therefore management has determined that the market for these securities is inactive.

The Company owns 13 tranches of pooled trust preferred securities. The market for these securities at June 30, 2009 is inactive and markets for similar securities were also not active. The inactivity was evidenced first by a significant widening of the bid-ask spread in the brokered markets in which pooled trust preferred securities trade and then by a significant decrease in the volume of trades relative to historical levels. The new issue market is also inactive as no new pooled trust preferred securities have been issued since 2007. There are currently very few market participants who are willing and / or able to transact for these securities. Given the conditions in the debt markets today and the absence of observable transactions in the secondary and new issue markets, we determined:

- The few observable transactions and market quotations that were available were not reliable for purposes of determining fair value at June 30, 2009,
- An income valuation approach (present value technique) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs will be equally or more representative of fair value than the market approach valuation technique used at prior measurement dates, and
- The pooled preferred trust securities are classified within Level 3 of the fair value hierarchy because significant adjustments are required to determine fair value at the measurement date. Our pooled preferred trust securities valuations were prepared by an independent third party. Their approach to determine fair value involved the following:
- Data about the issue structure as defined in the indenture and the underlying collateral were collected,
- The credit quality of the collateral is estimated using average probability of default values for each issuer (adjusted for rating levels and stressed to reflect the current environment),
- The default probabilities also considered the potential for 50% correlation among issuers within the same industry (e.g. banks with other banks) and 30% correlation between industries (e.g. banks vs. insurance),
- The loss given default was assumed to be 100%,
- The cash flows were forecast at no prepayments and zero recovery for the underlying collateral and applied to each tranche to determine the resulting distribution among the securities,
- The expected cash flows were discounted at 300 basis points over Libor to calculate the present value of the security,
- The effective discount rates on an overall basis range from 3.28% to 16.73% and are highly dependent upon the credit quality of the collateral, the relative position of the tranche in the capital structure of the security and the prepayment assumptions, and
- The calculations were modeled in ten thousand scenarios using a Monte Carlo engine to establish a distribution of intrinsic values and the average was used for valuation purposes.

Based on the technique described, the Company determined that as of June 30, 2009, the fair value of one pooled trust preferred security, PreTSL VII, had declined $326,000 below its amortized cost basis and since the present value of the security’s expected cash flows was insufficient to recover the entire amortized cost basis, the security is deemed to have experienced credit related other-than-temporarily impairment and the full amount was charged to current earnings as a component of other income in the consolidated income statement for the six months ended June 30, 2009. Excluding the impairment, the market value of the Company’s investment in pooled trust preferred securities has declined by $6,040,000 since December 31, 2008. The Company closely monitors the pooled trust preferred securities market and performs collateral sufficiency and cash flow analyses on at least a quarterly basis. Future analyses could yield results that may indicate further impairment has occurred and therefore require additional write-downs and corresponding other-than-temporary charges to current earnings. There were no OTTI charges recorded during the first six months of 2008.

On July 15, 2009, an issuer in several of the pooled trust preferred securities that the Company owns announced its intent to defer future payment of interest on its pooled trust preferred securities. After performing initial analysis of the impact of this deferral on cash flow projections, management believes that it is possible for this event to negatively impact the cash flow projections on two of the pooled trust preferred securities owned by the Company. As of June 30, 2009, the Company’s investment in these two securities, PreTSL V and PreTSL VII, amounted to $276,000 and $777,000 with corresponding fair values of $259,000 and $406,000, respectively. It appears that these securities’ credit enhanced subordinate collateral will not be sufficient to cover the interest due and therefore it is possible that the Company may be required to charge additional credit related OTTI to current earnings during the third quarter of 2009. Management is in the process of evaluating the impact of this event.

At June 30, 2009, the AFS debt securities portfolio was carried with a net unrealized loss of $14,964,000 compared to a net unrealized loss of $13,486,000 at December 31, 2008. Management believes the cause of the unrealized losses is related to changes in interest rates or the limited trading activity due to recent debt market illiquid conditions and is not directly or fully related to credit quality, which is consistent with its past experience. In addition, the Company has no intent to sell the securities and it is more likely than not that the Company will not be required to sell the securities before recovery of its amortized cost basis. As of June 30, 2009, the Company has the ability and intent to hold its investments for a period of time sufficient for the fair value of the securities to recover, which may be at maturity. For a further discussion on the investment securities portfolio, see note 3, “Investment securities” of the notes to the consolidated financial statements in Part I, Item I, herein.

#### Federal Home Loan Bank Stock

Investment in FHLB stock is required for membership in the organization and is carried at cost since there is no market value available. The amount the Company is required to invest is dependent upon the relative size of outstanding borrowings the Company has with the FHLB. Excess stock is typically repurchased from the Company at par if the borrowings decline to a predetermined level. Throughout most of 2008, the Company earned a return or dividend on the amount invested. In late December 2008, the FHLB announced that it had suspended the payment of dividends and the repurchase of excess capital stock to preserve its capital level. That decision was based on FHLB’s analysis and consideration of certain negative market trends and the impact those trends had on their financial condition. Based on the financial results of the FHLB for the year-ended December 31, 2008 and the first quarter of 2009, management believes that the suspension of both the dividend payments and excess capital stock repurchase is temporary in nature. Management further believes that the FHLB will continue to be the primary source of wholesale liquidity for both short- and long-term funding and has concluded that its investment in FHLB stock is not other-than-temporarily impaired. The Company will continue to monitor the financial condition of the FHLB quarterly to assess its ability to resume these activities in the future.

#### Loans available-for-sale (AFS)

Generally, upon origination, certain residential mortgages 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 Company would be exposed to prepayment risk and, as rates decrease, interest income could be negatively affected. Consideration is given to the Company’s current liquidity position and projected future liquidity needs. To better manage prepayment and interest rate risk, loans that meet these conditions may be classified as AFS. The carrying value of loans AFS is at the lower of cost or estimated fair value. If the fair values of these loans fall below their original cost, the difference is written down and charged to current earnings. Subsequent appreciation in the portfolio is credited to current earnings but only to the extent of previous write-downs.

Loans AFS at June 30, 2009 amounted to $2,288,000 with a corresponding fair value of $2,308,000, compared to $84,000 and $85,000, respectively, at December 31, 2008. During the six months ended June 30, 2009, residential mortgage loans with principal balances of $73,329,000 were sold into the secondary market with net gains of approximately $818,000 recognized. Included in the sale was $10,838,000 of residential loans transferred from the loan and lease portfolio during the first quarter of 2009.

#### Loans and leases

The Company originates commercial and industrial (commercial) and commercial real estate (CRE) loans, residential mortgages, 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 broad spectrum of products provides diversification that helps manage, to an extent, interest rate 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 the Company’s loan portfolio is collateralized, at least in part, by real estate in Lackawanna and Luzerne Counties of Pennsylvania. Commercial lending activities generally involve a greater degree of credit risk than consumer 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.

The composition of the loan portfolio at June 30, 2009 and December 31, 2008, is summarized as follows (dollars in thousands):

| Real estate: | June 30, 2009 Amount% |  | December 31, 2008 Amount% |  | Variance% |  |
| --- | ---: | ---: | ---: | ---: | ---: | ---: |
| Commercial | $181,990 | 42.8 | $164,772 | 37.4 | $17,218 | 10.4 |
| Residential | 72,059 | 17.0 | 98,510 | 22.3 | (26,451) | (26.9) |
| Contruction | 8,568 | 2.0 | 11,427 | 2.6 | (2,859) | (25.0) |
| Commercial and industrial | 79,002 | 18.5 | 80,708 | 18.3 | (1,706) | (2.1) |
| Consumer | 83,122 | 19.6 | 85,091 | 19.3 | (1,969) | (2.3) |
| Direct financing leases | 403 | 0.1 | 444 | 0.1 | (41) | (9.2) |
| Gross loans | 425,144 | 100.0 | 440,952 | 100.0 | $(15,808) | (3.6) |
| Allowance for loan losses | (5,216) |  | (4,745) |  |  |  |
| Net loans | $419,928 |  | $436,207 |  |  |  |

Gross loans decreased from $440,952,000, as of December 31, 2008 to $425,144,000 at June 30, 2009. The decline was predominately from the transfer from the loan and lease portfolio, to the AFS portfolio, and simultaneous sale of $10,838,000 of residential mortgage loans during the first quarter of 2009. The balance of the decline is mostly from net pay-downs during the first half of 2009 as borrowers’ sentiment, during this low-rate environment, is to re-finance their existing mortgage and home equity debt into new mortgage loans. Most of the mortgage loans that were originated in the first half of 2009 were sold on a servicing-retained basis. New commercial business and relationship emphasis has resulted in an increase in commercial real estate loans of $17,218,000, or 10%.

#### Allowance for loan losses

Management continually evaluates the credit quality of the Company’s loan 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.

Management applies two primary components during the loan review process to determine proper allowance levels. The two components are a 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 impaired loans by loan category;
- calculation of specific allowances where required for the impaired loans based on collateral and other objective and quantifiable evidence;
- determination of homogenous pools by loan category and eliminating the impaired loans;
- application of historical loss percentages (five-year average) to pools to determine the allowance allocation; and
- application of qualitative factor adjustment percentages for trends or estimated future 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 allocations in the commercial loan portfolio from period to period are based upon the credit risk grading system and from periodic reviews of the loan and lease portfolios.

Each quarter, management performs an assessment of the allowance and the provision for loan losses. The Company’s Special Assets Committee meets quarterly and the applicable lenders discuss each relationship under review and reach a consensus on the appropriate estimated loss amount based on Statement of Financial Accounting Standards No. 114, “*Accounting by Creditors for Impairment of a Loan,”* (SFAS 114). The Special Assets Committee’s focus is on ensuring the pertinent facts are considered and the SFAS 114 reserve amounts are reasonable. The assessment process includes the review of all loans on a non-accruing basis as well as a review of certain loans to which the lenders or the Company’s Credit Administration function have assigned a criticized or classified risk rating.

Total charge-offs net of recoveries for the six months ending June 30, 2009, were $254,000, compared to $761,000 in the first half of 2008. The higher level of charge-offs recorded in the previous year resulted primarily from the resolution of an impaired commercial real estate loan and the partial charge-off of a commercial real estate loan for which specific reserves had been allocated. Commercial real estate loan net charge-offs of $9,000 were recorded during the six months ending June 30, 2009 versus $535,000 at June 30, 2008. Commercial and industrial loan net charge-offs were $116,000 for the six months ending June 30, 2009 compared to net recoveries of $25,000 in the same period of 2008. Residential real estate loan net charge-offs totaled $3,000 for the six months ending June 30, 2009 compared to $32,000 in the like period of 2008. Consumer loan net charge-offs of $126,000 were recorded during the six months ending June 30, 2009 versus $218,000 at June 30, 2008. For a discussion on the provision for loan losses, see the “Provision for loan losses,” located in the results of operations section of management’s discussion and analysis contained herein. For a discussion on the provision for loan losses, see the “Provision for loan losses,” located in the results of operations section of management’s discussion and analysis contained herein.

Management believes that the current balance in the allowance for loan losses of $5,216,000 is sufficient to withstand the identified potential credit quality issues that may arise and others unidentified but are inherent to the portfolio. At June 30, 2009, management was 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 currently neither on non-accrual status or past due 90 days or more. However, there could be certain instances which become identified over the upcoming year that may require additional charge-offs and/or increases to the allowance. The ratio of allowance for loan losses to total loans was 1.22% at June 30, 2009 compared to 1.00% at June 30, 2008.

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 six months ended June 30, 2009 | As of and for the twelve months ended December 31, 2008 | As of and for the six months ended June 30, 2008 |
| --- | ---: | ---: | ---: |
| Balance at beginning of period | $4,745,234 | $4,824,401 | $4,824,401 |
| Provision charged to operations | 725,000 | 940,000 | 125,000 |
| Charge-offs: |  |  |  |
| Real estate: |  |  |  |
| Commercial | 24,932 | 565,193 | 553,193 |
| Residential | 3,158 | 44,800 | 31,870 |
| Commercial and industrial | 118,520 | 168,021 | 33,836 |
| Consumer | 133,617 | 350,856 | 236,797 |
| Total | 280,227 | 1,128,870 | 855,696 |
| Recoveries: |  |  |  |
| Real estate: |  |  |  |
| Commercial | 15,808 | 18,020 | 18,020 |
| Residential | — | 97 | 50 |
| Commercial and industrial | 2,075 | 61,233 | 58,462 |
| Consumer | 7,846 | 30,353 | 18,334 |
| Total | 25,729 | 109,703 | 94,866 |
| Net charge-offs | 254,498 | 1,019,167 | 760,830 |
| Balance at end of period | $5,215,736 | $4,745,234 | $4,188,571 |
| Total loans, end of period | $427,432,128 | $441,036,694 | $418,650,319 |

| Net charge-offs to: | As of and for the six months ended June 30, 2009 | As of and for the twelve months ended December 31, 2008 | As of and for the six months ended June 30, 2008 |
| --- | ---: | ---: | ---: |
| Loans, end of period | 0.06% | 0.23% | 0.18% |
| Allowance for loan losses | 4.88% | 21.48% | 18.16% |
| Provision for loan losses | 0.35 x | 1.08 x | 6.09 x |
| Allowance for loan losses to: |  |  |  |
| Total loans | 1.22% | 1.08% | 1.00% |
| Non-accrual loans | 0.70 x | 1.36 x | 1.14 x |
| Non-performing loans | 0.69 x | 1.16 x | 1.09 x |
| Net charge-offs | 20.49 x | 4.66 x | 5.51 x |
| Loans 30-89 days past due and still accruing | $2,360,786 | $1,858,481 | $2,199,056 |
| Loans 90 days past due and accruing | $180,800 | $604,140 | $177,431 |
| Non-accrual loans | $7,398,505 | $3,493,169 | $3,667,929 |
| Allowance for loan losses to loans 90 days or more past due and accruing | 28.85 x | 7.85 x | 23.61 x |

#### Non-performing assets

The Company defines non-performing assets as accruing loans past due 90 days or more, non-accrual loans, restructured loans, other real estate owned (ORE) and repossessed assets. As of June 30, 2009, non-performing assets represented 1.57% of total assets compared to 0.79% at June 30, 2008. The increase was driven by the higher level of non-accrual loans and ORE at June 30, 2009.

In the review of loans for both delinquency and collateral sufficiency, management concluded that there were a number of loans that lacked the ability to repay in accordance with contractual terms. The decision to place loans or leases on a non-accrual status is made on an individual basis after considering factors pertaining to each specific loan.

The majority of the non-performing assets for the period are attributed to non-accruing commercial real estate loans, non-accruing residential real estate loans and ORE. Most of the loans are collateralized, thereby mitigating the Company’s potential for loss. At June 30, 2009 non-performing loans were $7,579,000 compared to $4,097,000 at December 31, 2008. During the first quarter of this year, the Company was notified by a customer of a significant adverse business event causing management to place the customer’s $3,300,000 loan relationship on non-accrual status. Management does not expect this will have a material impact on income going forward. Action plans for the resolution of each of the Company’s non-performing loans have been developed and are periodically updated as needed. There were no restructured loans or repossessed assets at June 30, 2009 or at December 31, 2008. ORE at June 30, 2009 was $1,199,000 and consisted of four properties of which two had an agreement to sell. At June 30, 2009, the non-accrual loans aggregated $7,399,000 as compared to $3,493,000 at December 31, 2008. Additions to the non-accrual component of the non-performing assets totaling $5,009,000 were made during the first six months of the year. These were partially offset by reductions or payoffs of $681,000, charge-offs of $213,000, $132,000 of transfers to ORE and $77,000 of loans that returned to performing status. Loans past due 90 days or more and accruing declined to $181,000 at June 30, 2009, from $604,000, at December 31, 2008. Non-performing loans to net loans were 1.80% at June 30, 2009, and 0.94% at December 31, 2008. The percentage of non-performing assets to total assets was 1.57% at June 30, 2009, an increase from 0.96% at December 31, 2008, primarily due to the aforementioned increase in the non-accrual loans component.

The 30-89 day past due loans at June 30, 2009 were $2,361,000 and $1,858,000 at December 31, 2008.

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

|  | June 30, 2009 | December 31, 2008 | June 30, 2008 |
| --- | ---: | ---: | ---: |
| Loans past due 90 days or more and accruing | $180,800 | $604,140 | $177,431 |
| Non-accrual loans | 7,398,505 | 3,493,169 | 3,667,929 |
| Total non-performing loans | 7,579,305 | 4,097,309 | 3,845,360 |
| Other real estate owned | 1,199,060 | 1,450,507 | 897,036 |
| Total non-performing assets | $8,778,365 | $5,547,816 | $4,742,396 |
| Net loans including AFS | $422,216,392 | $436,291,460 | $414,461,748 |
| Total assets | $560,454,208 | $575,718,997 | $598,563,896 |
| Non-accrual loans to net loans | 1.75% | 0.80% | 0.88% |
| Non-performing assets to net loans, foreclosed real estate and repossessed assets | 2.07% | 1.27% | 1.14% |
| Non-performing assets to total assets | 1.57% | 0.96% | 0.79% |
| Non-performing loans to net loans | 1.80% | 0.94% | 0.93% |

#### Foreclosed assets held-for-sale

Foreclosed assets held-for-sale, consisting of ORE, was $1,199,000 at June 30, 2009 comprised of four properties, two of which were under an agreement to be sold. The remaining two properties are listed for sale with a realtor.

#### Other assets

Pending receivable of securities purchases of $2,632,000 was the primary cause of other assets to increase $3,684,000, or 41%, during the first half of 2009. The purchases, which included agency and municipal obligations, settled in July 2009. Further contributing to the increase in other assets, the Company’s deferred tax asset increased $358,000 on further declines in the investment portfolio and mortgage servicing rights increased $436,000 due to high volume of mortgage real estate sales that the Company normally sells into the secondary market on a serving-retained basis.

#### Deposits

The Bank is a community-based commercial financial institution, member FDIC, which offers a variety of deposit accounts with varying ranges of interest rates and terms. Deposit products include savings accounts, interest-bearing checking (NOW), money market, non-interest bearing checking (DDAs) and certificates of deposit accounts. Certificates of deposit accounts, or CDs, are deposits with stated maturities ranging from seven days to ten years. The flow of deposits is significantly influenced by general economic conditions, changes in prevailing interest rates, pricing and competition. Most of the Company’s deposits are obtained from the communities surrounding its 12 branch offices and are insured by the FDIC up to the full extent permitted by law. The Bank attempts to attract and retain deposit customers via sales and marketing efforts, new products, quality service, competitive rates and maintaining long-standing customer relationships. To determine deposit product interest rates, the Company considers local competition, market yields and the rates charged for alternative sources of funding such as borrowings. Though we continue to experience intense competition for deposits, our rate-setting strategy includes consideration of liquidity needs, balance sheet structure and cost effective strategies that are mindful of the current interest rate environment.

Compared to December 31, 2008 total deposits grew $20,561,000, or 5%, during the six month period ending June 30, 2009. The growth in total deposits was due to increases in money market, NOW and savings accounts of $17,115,000, or 18%, $6,919,000, or 14%, and $3,159,000, or 8%, respectively, partially offset by lower DDA and CD balances. The opening of the West Scranton branch during the third quarter of 2008 and bank-wide money market promotions that the Company attempts to customize to personal and non-personal needs of our customers contributed to growth in deposits during the first half of 2009. On July 20, 2009, the Company closed its Wyoming Avenue, Scranton branch and consolidated with the Financial Center branch located on North Washington Avenue, Scranton. The consolidation is not expected to have a material effect on the Company’s deposits.

The following table represents the components of deposits as of the date indicated:

|  | June 30, 2009 Amount% |  | December 31, 2008 Amount% |  |
| --- | ---: | ---: | ---: | ---: |
| Money market | $113,852,919 | 25.1 | $96,738,006 | 22.3 |
| NOW | 57,042,434 | 12.5 | 50,123,744 | 11.6 |
| Savings and club | 44,485,585 | 9.8 | 41,326,616 | 9.5 |
| Certificates of deposit | 162,400,639 | 35.8 | 173,680,915 | 40.1 |
| CDARS | 6,588,600 | 1.5 | — | — |
| Total interest-bearing | 384,370,177 | 84.7 | 361,869,281 | 83.5 |
| Non-interest-bearing | 69,503,187 | 15.3 | 71,442,651 | 16.5 |
| Total deposits | $453,873,364 | 100.0 | $433,311,932 | 100.0 |

Certificates of deposit of $100,000 or more aggregated $62,800,000 and $74,250,000 at June 30, 2009 and December 31, 2008, respectively. Certificates of deposit of $250,000 or more aggregated $22,334,000 and $35,108,000 at June 30, 2009 and December 31, 2008.

During the first quarter of 2009, the Company began to use the Certificate of Deposit Account Registry Service (CDARS) in order to obtain FDIC insurance protection for customers who have large deposits that at times exceed the FDIC maximum amount of $250,000. In the CDARS program, deposits are sold at varying terms and interest rates, are originated in our own market place and are placed with other financial institutions that are members in the CDARS network. By placing these deposits in other participating institutions, the deposits of our customers are fully insured by the FDIC. In return for deposits we place with network institutions, we can receive from network institutions deposits that are approximately equal in amount of what was placed for our customers. Deposits that we receive, or reciprocal deposits, from other institutions are considered brokered deposits. As of June 30, 2009, CDARS represented $6,589,000, or 2%, of total deposits.

Approximately 51% of total CDs are scheduled to mature in 2009. Renewing CDs may re-price to market rates depending on the direction of interest rate movements, the shape of the yield curve, competition, the rate profile of the maturing accounts and depositor preference for alternative products. To help reduce the financial impact of the unpredictable and highly volatile interest rate environment, management will deploy prudent strategies that will diversify the deposit mix across the entire spectrum of products offered. Although we continue to experience intense competition for deposits, we have not adjusted rates above market levels as we consider cost effective strategies as well as relationship retention and development when setting interest rates on deposit accounts.

#### 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, advances from the Federal Home Loan Bank of Pittsburgh (FHLB) and other correspondent banks for asset growth and liquidity needs. Repurchase agreements are non-insured interest-bearing liabilities that have a security interest in qualified investment securities of the Bank and are offered through a sweep product. 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 to fund daily liquidity needs. Overnight balances and repurchase agreements are components of short-term borrowings and FHLB advances are components of long-term debt on the consolidated balance sheets.

The following table represents the components of borrowings as of June 30, 2009 and December 31, 2008 (dollars in thousands):

|  | June 30, 2009 Amount% |  | December 31, 2008 Amount% |  |
| --- | ---: | ---: | ---: | ---: |
| Overnight borrowings | $— | — | $25,668 | 28.5 |
| Repurchase agreements | 7,895 | 15.5 | 11,412 | 12.6 |
| Demand note, U.S. Treasury | 985 | 1.9 | 1,050 | 1.2 |
| FHLB advances | 42,000 | 82.6 | 52,000 | 57.7 |
| Total borrowings | $50,880 | 100.0 | $90,130 | 100.0 |

Borrowings have decreased $39,250,000, or 44%, during the six months ended June 30, 2009. Overnight borrowings and FHLB advances have declined as a result of the Company’s balance sheet de-leveraging and deposit generation. The reduction in repurchase agreements was caused by a combination of pricing and the volatile nature of the sweep product.

#### Accrued interest payable and other liabilities

The $3,261,000 increase in accrued expenses and other liabilities stems from the securities purchase commitments that settled in July 2009.

## Market risk

As filed, 22,933 characters.

#### Management of interest rate risk and market risk analysis

The Company is subject to the interest rate risks inherent in its 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 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 time intervals. A positive gap (asset sensitive) indicates that more assets will mature or 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 June 30, 2009 the Bank maintained a one-year cumulative gap of positive $16.5 million, or 2.95%, of total assets. The effect of this positive gap position provided a mismatch of assets and liabilities which may expose the Bank to interest rate risk during periods of falling interest rates. Conversely, in an increasing interest rate environment, net interest income could be positively impacted because more assets than liabilities would re-price upward during the 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.

The following table illustrates the Company’s interest sensitivity gap position at June 30, 2009 (dollars in thousands):

|  | Interest sensitivity gap at June 30, 2009 Three months or less | Three to twelve months | One to three years | Over three years | Total |
| --- | ---: | ---: | ---: | ---: | ---: |
| Cash and cash equivalents | $4,634 | $— | $— | $10,936 | $15,570 |
| Investment securities (1)(2) | 24,499 | 4,509 | 15,373 | 37,720 | 82,101 |
| Loans (2) | 119,890 | 64,396 | 99,761 | 138,169 | 422,216 |
| Fixed and other assets | — | 8,962 | — | 31,605 | 40,567 |
| Total assets | $149,023 | $77,867 | $115,134 | $218,430 | $560,454 |
| Total cumulative assets | $149,023 | $226,890 | $342,024 | $560,454 |  |
| Non-interest bearing transaction deposits (3) | $— | $6,950 | $19,113 | $43,440 | $69,503 |
| Interest-bearing transaction deposits (3) | 62,771 | — | 58,018 | 94,592 | 215,381 |
| Time deposits | 55,402 | 76,365 | 29,190 | 8,032 | 168,989 |
| Repurchase agreements | 7,895 | — | — | — | 7,895 |
| Short-term borrowings | 986 | — | — | (1) | 985 |
| Long-term debt | — | — | 21,000 | 21,000 | 42,000 |
| Other liabilities | — | — | — | 6,578 | 6,578 |
| Total liabilities | $127,054 | $83,315 | $127,321 | $173,641 | $511,331 |
| Total cumulative liabilities | $127,054 | $210,369 | $337,690 | $511,331 |  |
| Interest sensitivity gap | $21,969 | $(5,448) | $(12,187) | $44,789 |  |
| Cumulative gap | $21,969 | $16,521 | $4,334 | $49,123 |  |
| Cumulative gap to total assets | 3.92% | 2.95% | 0.77% | 8.76% |  |

(1) Includes FHLB stock and the net unrealized gains/losses on securities AFS.

(2) Investments and loans are included in the earlier of the period in which interest rates were next scheduled to adjust or the period in which they are due. In addition, loans are included in the periods in which they are scheduled to be repaid based on scheduled amortization. For amortizing loans and mortgage-backed securities, annual prepayment rates are assumed reflecting historical experience as well as management’s knowledge and experience of its loan products.

(3) The Bank’s demand and savings accounts are generally subject to immediate withdrawal. However, management considers a certain amount of such accounts to be core accounts having significantly longer effective maturities based on the retention experiences of such deposits in changing interest rate environments. The effective maturities presented are the recommended maturity distribution limits for non-maturing deposits based on historical deposit studies.

*Earnings at Risk and Economic Value at Risk Simulations.* The Company recognizes that more sophisticated tools exist for measuring the interest rate risk in the balance sheet that extend beyond static re-pricing gap analysis. Although it will continue to measure its re-pricing gap position, the Company utilizes additional modeling for identifying and measuring the interest rate risk in the overall balance sheet. The ALCO is responsible for focusing on “earnings at risk” and “economic value at risk”, and how both relate to the risk-based capital position when analyzing the interest rate risk.

*Earnings at Risk.* Earnings at risk simulation measures the change in net interest income and net income should interest rates rise and fall. The simulation recognizes that not all assets and liabilities re-price one-for-one with market rates (e.g., savings rate). The ALCO looks at “earnings at risk” to determine income changes from a base case scenario under an increase and decrease of 200 basis points in interest rate simulation models.

*Economic Value at Risk.* Earnings at risk simulation measures the short-term risk in the balance sheet. Economic value (or portfolio equity) at risk measures the long-term risk by finding the net present value of the future cash flows from the Company’s existing assets and liabilities. The ALCO examines this ratio quarterly utilizing an increase and decrease of 200 basis points in interest rate simulation models. The ALCO recognizes that, in some instances, this ratio may contradict the “earnings at risk” ratio.

The following table illustrates the simulated impact of 200 basis points upward or downward movement in interest rates on net interest income, net income and the change in the economic value (portfolio equity). This analysis assumes that interest-earning asset and interest-bearing liability levels at June 30, 2009 remain constant. The impact of the rate movements was developed by simulating the effect of rates changing over a twelve-month period from the June 30, 2009 levels:

| Earnings at risk: Percent change in: | Rates +200 | Rates -200 |
| --- | ---: | ---: |
| Net interest income | 0.7% | 4.5% |
| Net income | 3.7 | 17.0 |
| Economic value at risk: |  |  |
| Percent change in: |  |  |
| Economic value of equity | (31.6) | 0.2 |
| Economic value of equity as a percent of book assets | (2.7) | 0.0 |

Economic value has the most meaning when viewed within the context of risk-based capital. Therefore, the economic value may normally change beyond the Company’s policy guideline for a short period of time as long as the risk-based capital ratio (after adjusting for the excess equity exposure) is greater than 10%. At June 30, 2009, the Company’s risk-based capital ratio was 11.7%.

The table below summarizes estimated changes in net interest income over a twelve-month period beginning July 1, 2009 under alternate interest rate scenarios using the income simulation model described above (dollars in thousands):

| Change in interest rates | Net interest income | $% variance | variance |
| --- | ---: | ---: | ---: |
| +200 basis points | $19,793 | $141 | 0.7% |
| +100 basis points | 19,574 | (78) | (0.4) |
| Flat rate | 19,652 | — | — |
| -100 basis points | 20,189 | 537 | 2.7 |
| -200 basis points | 20,540 | 888 | 4.5 |

Simulation models require assumptions about certain categories of assets and liabilities. The models schedule existing assets and liabilities by their contractual maturity, estimated likely call date or earliest re-pricing opportunity. Mortgage-backed securities and amortizing loans are scheduled based on their anticipated cash flow including estimated prepayments. For investment securities, the Bank uses a third-party service to provide cash flow estimates in the various rate environments. Savings, money market and NOW accounts do not have a stated maturity or re-pricing term and can be withdrawn or re-priced at any time. This may impact the margin if more expensive alternative sources of deposits are required to fund loans or deposit runoff. Management projects the re-pricing characteristics of these accounts based on historical performance and assumptions that it believes reflect their rate sensitivity. The model reinvests all maturities, repayments and prepayments for each type of asset or liability into the same product for a new like term at current product interest rates provided by management. As a result, the mix of interest-earning assets and interest bearing-liabilities is held constant.

*Derivative Financial Instruments.* As part of the Bank’s overall interest rate risk 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. In October 2006, the Bank entered into an interest rate floor derivative agreement on $20,000,000 notional value of its prime-based loan portfolio. The purpose of the hedge is to help protect the Bank’s interest income in the event interest rates decline below a pre-determined contractual interest rate. The strategy is reflected in the scenarios for earnings and economic value at risk and the net interest income in the two immediately preceding tables. For a further discussion on the Bank’s derivative contract, see note 4, “Derivative instruments,” contained within the notes to consolidated financial statements in Part I, Item 1.

#### Liquidity

Liquidity management ensures that adequate funds will be available to meet loan and investment commitments, deposit withdrawals and maturities and normal operating requirements of the Bank. Current sources of liquidity are cash and cash equivalents, asset maturities, calls and principal repayments, loans and investments AFS, growth of core deposits, growth of repurchase agreements, increases in other borrowed funds from correspondent banks and issuance of capital stock. Although regularly scheduled investment and loan payments are dependable sources of daily funds, the sales of both loans and investments AFS, deposit activity and investment and loan prepayments are significantly influenced by general economic conditions and the level of interest rates. During declining interest rate environments, prepayments from interest-sensitive assets tend to accelerate and provide significant liquidity which can be used to invest in other interest-earning assets but at lower market rates. Conversely, in a period of rising interest rates, prepayment from interest-sensitive assets tend to decelerate causing cash flow from mortgage loans and mortgage-backed securities portfolio to decrease. Deposit inflow may accelerate and be invested at higher market interest rates. The Company closely monitors activity in the capital markets and takes appropriate action to ensure that the liquidity levels are adequate for funding, investing and operating activities.

For the six months ended June 30, 2009, the Company generated approximately $2.8 million of cash. During this period, the Company’s operations provided approximately $11.7 million primarily from the sales of mortgages AFS net of originations and the investing activities provided approximately $10.4 million from pay-downs of loans and bonds and from the sale of foreclosed properties held-for-sale. Partially offsetting these cash generators was a use of $19.3 million in financing activities, mostly from the pay-down of total borrowings net of deposit growth. As of June 30, 2009, the Company maintained $15.6 million of cash and cash equivalents, $76.5 million of investments AFS and $2.3 million of loans AFS. In addition, as of June 30, 2009 the Company had approximately $168.0 million available to borrow from the FHLB and $30.0 million available from other correspondent banks. This combined total of $292.4 million represented 52% of total assets at June 30, 2009. Management believes this level of liquidity to be strong and adequate to support current operations.

Management identified over $20 million in large municipal and corporate deposits that may depart over the next six months and if so, will be replaced with borrowings.

In October 2008, the FDIC announced the Temporary Liquidity Guarantee Program (TLGP) to strengthen confidence and encourage liquidity in the banking system. Among other things, this new program provides full deposit insurance coverage for non-interest bearing deposit transaction accounts in FDIC-insured institutions regardless of the dollar amount. To protect its depositors, the Company is participating in the TLGP. Under the TLGP, all depositors who hold funds in non-interest bearing accounts, or interest-bearing accounts with an interest rate of 0.50% or less, including the Lawyers Trust Accounts, will have a temporary unlimited guarantee from the FDIC until December 31, 2009. TLGP may be extended into 2010 with a higher premium — as much as 50 basis points. Management has not assessed if the Company will elect the extension and take on the much higher costs. The coverage of the TLGP is in addition to and separate from coverage available under the FDIC’s general deposit insurance rules, which insures accounts up to $250,000 until the end of 2013 unless extended.

#### Capital

During the six months ended June 30, 2009, shareholders’ equity increased modestly, or $162,000, due principally from net income generated during the period and issuance of common stock via the Company’s Employee Stock Purchase and Dividend Reinvestment Plans partially offset by increased unrealized net losses in the securities AFS portfolio, the declaration of cash dividends and a decline in the intrinsic value of the Company’s cash flow hedge.

As of June 30, 2009, the Company reported a net unrealized loss of $9,785,000, net of tax, from the securities AFS portfolio compared to a net unrealized loss of $8,831,000 as of December 31, 2008. The increase in the unrealized loss during the first half of 2009 was caused by the prolonged economic downturn which has created uncertainty and in certain circumstances illiquidity in the financial and capital markets and has had a sizable negative impact on the fair value estimates for securities in banks’ investment portfolios. Management believes these changes are due mainly to liquidity problems in the financial markets and to a lesser extent the deterioration in the creditworthiness of the issuers. For a further discussion on the fair value determination of the Company’s investment portfolio, see “Investment securities” under the caption “Comparison of financial condition at June 30, 2009 and December 31, 2008” of Part 1, Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations;” and notes 3 and 5, “Investment securities” and “Fair value measurement” in the notes to the consolidated financial statements, incorporated by reference in Part I, Item 1.

During the second quarter of 2008, the Company’s Board of Directors announced its intent to initiate a capital stock repurchase program covering up to 50,000 shares of its outstanding capital stock. The repurchased shares would become treasury stock and could be available for issuance under the Company’s various stock-based compensation, employee stock purchase and dividend reinvestment (DRP) plans and for general corporate purposes. The repurchases may be made from time-to-time in open-market transactions, subject to availability, pursuant to safe harbor rule 10b-18 under the Securities Exchange Act of 1934. Management has temporarily suspended repurchase plan activity as a prudent means, in light of the current economic pressures on banking, to preserve and grow the Company’s capital base. Since the program’s inception, the Company has reacquired (at $27.83 per share) and reissued (at $21.11 per share) 17,500 shares to participants in the Company’s DRP.

The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s and the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk-weightings and other factors. Prompt corrective action provisions are not applicable to bank holding companies.

Under these guidelines, assets and certain off-balance sheet items are assigned to broad risk categories, each with appropriate weights. The resulting capital ratios represent capital as a percentage of total risk-weighted assets and certain off-balance sheet items. The appropriate risk-weighting, pursuant to regulatory guidelines, required an increase in the risk-weighting of securities that were recently rated below investment grade, thus significantly inflating the total risk-weighted assets. Compared to December 31, 2008, the total capital and Tier I capital ratios were reduced by the increase in risk-weighted assets. The guidelines require all banks and bank holding companies to maintain a minimum ratio of total risk-based capital to total risk-weighted assets (Total Risk Adjusted Capital) of 8%, including Tier I capital to total risk-weighted assets (Tier I Capital) of 4% and Tier I capital to average total assets (Leverage Ratio) of at least 4%. As of June 30, 2009, the Company and the Bank met all capital adequacy requirements to which it was subject.

The following table depicts the capital amounts and ratios of the Company and the Bank as of June 30, 2009:

| Total capital (to risk-weighted assets) | Actual Amount | Ratio |  | For capital adequacy purposes Amount |  | Ratio |  | To be well capitalized under prompt corrective action provisions Amount |  | Ratio |
| --- | ---: | ---: | --- | ---: | --- | ---: | --- | ---: | --- | ---: |
| Consolidated | $63,822,538 | 11.7% | \> | $43,735,644 | \> | 8.0% |  | N/A |  | N/A |
| Bank | $63,408,547 | 11.6% | \> | $43,725,036 | \> | 8.0% | \> | $54,656,295 | \> | 10.0% |
| Tier I capital |  |  |  |  |  |  |  |  |  |  |
| (to risk-weighted assets) |  |  |  |  |  |  |  |  |  |  |
| Consolidated | $58,543,758 | 10.7% | \> | $21,867,822 | \> | 4.0% |  | N/A |  | N/A |
| Bank | $58,192,706 | 10.7% | \> | $21,862,518 | \> | 4.0% | \> | $32,793,777 | \> | 6.0% |
| Tier I capital |  |  |  |  |  |  |  |  |  |  |
| (to average assets) |  |  |  |  |  |  |  |  |  |  |
| Consolidated | $58,543,758 | 10.4% | \> | $22,504,276 | \> | 4.0% |  | N/A |  | N/A |
| Bank | $58,192,706 | 10.4% | \> | $22,488,506 | \> | 4.0% | \> | $28,110,633 | \> | 5.0% |

## Controls and procedures

As filed, 1,071 characters.

As of the end of the period covered by this Quarterly Report on Form 10-Q, an evaluation was carried out by the Company’s management, with the participation of its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures, as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934. Based on such evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are designed to ensure that information required to be disclosed in the reports the Company files or furnishes under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and regulations, and are operating in an effective manner. The Company made no significant changes in its internal controls over financial reporting or in other factors that materially affected, or are reasonably likely to materially affect, these controls during the last fiscal quarter ended June 30, 2009.

## Risk factors

As filed, 201 characters.

Management of the Company does not believe there have been any material changes in risk factors that were disclosed in the Form 10-K filed with the Securities and Exchange Commission on March 12, 2009.

Filed Aug 12, 2009.
Source: SEC EDGAR, the filing index for accession 0001104659-09-049175. Last ingested by Listed: Nov 6, 2026, 18:40 ET. No prices; not investment advice.