# Fidelity D & D Bancorp Inc: Form 10-K for the period ended Dec 31, 2009

- Company: [Fidelity D & D Bancorp Inc](/companies/fdbc.md) (CIK 1098151)
- Form: 10-K
- Filed: 2010-03-08
- Accepted by EDGAR: Mar 8, 2010, 15:49 ET
- Period: 2009-12-31
- Accession: 0001144204-10-012006
- Inline XBRL: no
- Main document: https://www.sec.gov/Archives/edgar/data/1098151/000114420410012006/v176540_10k.htm
- All documents and exhibits: https://www.sec.gov/Archives/edgar/data/1098151/000114420410012006/

## Business

As filed, 5,591 characters.

Fidelity D & D Bancorp, Inc. (the Company) was incorporated in the Commonwealth of Pennsylvania, on August 10, 1999, and is a bank holding company, whose wholly-owned state chartered commercial bank is The Fidelity Deposit and Discount Bank (the Bank) (collectively, the Company). The Company is headquartered at Blakely and Drinker Streets in Dunmore, Pennsylvania.

The Bank has offered a full range of traditional banking services since it commenced operations in 1903. The Bank has a personal and corporate trust department and also provides alternative financial and insurance products with asset management services. A full list of services provided by the Bank is detailed in the section entitled “Products and Services” contained within the 2009 Annual Report to Shareholders, incorporated by reference. The service area is comprised of the Borough of Dunmore and the surrounding communities within Lackawanna and Luzerne counties in Northeastern Pennsylvania.

The banking business is highly competitive, and the profitability of the Company depends principally upon the Company’s ability to compete in its market area. Competition includes, among other sources, the following:

|  |  |  |  |
| --- | --- | --- | --- |
| § | local community banks | § | insurance companies |
| § | savings banks | § | money market funds |
| § | regional banks | § | mutual funds |
| § | credit unions | § | small loan companies |
| § | savings & loans | § | other financial service companies |

The Company has been able to compete effectively with other financial institutions by emphasizing technology and customer service, including local decision making on loans. These efforts enabled the Company to establish long-term customer relationships and build customer loyalty by providing products and services designed to address their specific needs.

There are no concentrations of loans that, if lost, would have a materially adverse effect on the continued business of the Company. The Company’s loan portfolio does not have a material concentration within a single industry or group of related industries that are vulnerable to the risk of a near-term severe impact. However, the Company’s success is dependent, to a significant degree, on economic conditions in Northeastern Pennsylvania, especially Lackawanna and Luzerne counties which the Company defines as its primary market area. The banking industry is affected by general economic conditions including the effects of inflation, recession, unemployment, real estate values, trends in national and global economies and other factors beyond the Company’s control. An economic recession or a delayed economic recovery over a prolonged period of time in the Company’s primary market area could cause an increase in the level of the Company’s non-performing assets and loan losses, and thereby cause operating losses, impairment of liquidity and erosion of capital. We cannot assure you that adverse changes in the local economy would not have a material effect on the Company’s future consolidated financial condition, results of operations and cash flows. Refer to Item 1A, “Risk Factors” for material risks and uncertainties that management believes affect the Company.

The Company had 185 full-time equivalent employees on December 31, 2009, which includes exempt officers, exempt, non-exempt and part-time employees.

Federal and state banking laws contain numerous provisions that affect various aspects of the business and operations of the Company and the Bank. The Company is subject to, among others, the regulations of the Securities and Exchange Commission (the SEC) and the Federal Reserve Board (the FRB) and the Bank is subject to, among others, the regulations of the Pennsylvania Department of Banking and the Federal Deposit Insurance Corporation (the FDIC). Refer to Part II, Item 7 “Supervision and Regulation” for descriptions of and references to applicable statutes and regulations which are not intended to be complete descriptions of these provisions or their effects on the Company or the Bank. They are summaries only and are qualified in their entirety by reference to such statutes and regulations. Applicable regulations relate to, among other things:

|  |  |  |  |
| --- | --- | --- | --- |
| § | operations | § | consolidation |
| § | securities | § | reserves |
| § | risk management | § | dividends |
| § | consumer compliance | § | branches |
| § | mergers | § | capital adequacy |

Annually, the Bank is examined by the Pennsylvania Department of Banking and/or the FDIC. The last examination was conducted by the FDIC as of December 31, 2008.

The Company’s website address is http://www.bankatfidelity.com. The Company makes available through this website the annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K and amendments to those reports as soon as reasonably practical after filing with the SEC. You may read and copy any materials filed with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at (202) 551-8090. The SEC also maintains an internet site that contains reports, proxy and information statements and other information about the Company at http://www.sec.gov.

The Company’s accounting policies and procedures are designed to comply with accounting principles generally accepted in the United States of America (GAAP). Refer to “Critical Accounting Policies,” which are incorporated by reference in Part II, Item 7.

## Risk factors

As filed, 30,729 characters.

An investment in the Company’s common stock is subject to risks inherent to the Company’s business. The material risks and uncertainties that management believes affect the Company are described below. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this report. The risks and uncertainties described below are not the only ones facing the Company. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair the Company’s business operations. This report is qualified in its entirety by these risk factors.

If any of the following risks actually occur, the Company’s financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of the Company’s common stock could decline significantly, and you could lose all or part of your investment.

### Risks Related to the Company’s Business

*The Company’s business is subject to interest rate risk and variations in interest rates may negatively affect its financial performance.*

Changes in the interest rate environment may reduce profits. The Company’s earnings and cash flows are largely dependent upon its net interest income. Net interest income is the difference between the interest earned on loans, securities and other interest-earning assets, and interest paid on deposits, borrowings and other interest-bearing liabilities. As prevailing interest rates change, net interest spreads are affected by the difference between the maturities and re-pricing characteristics of interest-earning assets and interest-bearing liabilities. In addition, loan volume and yields are affected by market interest rates on loans, and rising interest rates generally are associated with a lower volume of loan originations. An increase in the general level of interest rates may also adversely affect the ability of certain borrowers to pay the interest on and principal of their obligations. Accordingly, changes in levels of market interest rates could materially adversely affect the Company’s net interest spread, asset quality, loan origination volume and overall profitability.

#### The Company is subject to lending risk.

There are inherent risks associated with the Company’s lending activities. These risks include, among other things, the impact of changes in interest rates and changes in the economic conditions in the markets where the Company operates as well as those across the Commonwealth of Pennsylvania and the United States. Increases in interest rates and/or weakening economic conditions could adversely impact the ability of borrowers to repay outstanding loans or the value of the collateral securing these loans. The Company is also subject to various laws and regulations that affect its lending activities. Failure to comply with applicable laws and regulations could subject the Company to regulatory enforcement action that could result in the assessment of significant civil money penalties against the Company.

Commercial, commercial real estate and real estate construction loans are generally viewed as having more risk of default than residential real estate loans or consumer loans. These types of loans are also typically larger than residential real estate loans and consumer loans. Because these loans generally have larger balances than residential real estate loans and consumer loans, the deterioration of one or a few of these loans could cause a significant increase in non-performing loans. An increase in non-performing loans could result in a net loss of earnings from these loans, an increase in the provision for possible loan losses and an increase in loan charge-offs, all of which could have a material adverse effect on the Company’s financial condition and results of operations.

#### The Company’s allowance for possible loan losses may be insufficient.

The Company maintains an allowance for possible loan losses, which is a reserve established through a provision for possible loan losses charged to expense, that represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The allowance, in the judgment of management, is necessary to reserve for estimated loan losses and risks inherent in the loan portfolio. The level of the allowance reflects management’s continuing evaluation of industry concentrations; specific credit risks; loan loss experience; current loan portfolio quality; present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. The determination of the appropriate level of the allowance for possible loan losses inherently involves a high degree of subjectivity and requires the Company to make significant estimates of current credit risks and future trends, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of the Company’s control, may require an increase in the allowance for possible loan losses. In addition, bank regulatory agencies periodically review the Company’s allowance for loan losses and may require an increase in the provision for possible loan losses or the recognition of further loan charge-offs, based on judgments different than those of management. In addition, if charge-offs in future periods exceed the allowance for possible loan losses, the Company will need additional provisions to increase the allowance for possible loan losses. Any increases in the allowance for loan losses will result in a decrease in net income and capital and may have a material adverse effect on the Company’s financial condition and results of operations.

*The Company may need or be compelled to raise additional capital in the future, but that capital may not be available when it is needed and on terms favorable to current shareholders.*

Federal banking regulators require the Company and Bank to maintain adequate levels of capital to support their operations. These capital levels are determined and dictated by law, regulation and banking regulatory agencies. In addition, capital levels are also determined by the Company’s management and board of directors based on capital levels that they believe are necessary to support the Company’s business operations. The Company is evaluating its present and future capital requirements and needs, is developing a comprehensive capital plan and is analyzing capital raising alternatives, methods and options. Even if the Company succeeds in meeting the current regulatory capital requirements, the Company may need to raise additional capital in the near future to support possible loan losses during future periods or to meet future regulatory capital requirements.

Further, the Company’s regulators may require it to increase its capital levels. If the Company raises capital through the issuance of additional shares of its common stock or other securities, it would likely dilute the ownership interests of current investors and would likely dilute the per-share book value and earnings per share of its common stock. Furthermore, it may have an adverse impact on the Company’s stock price. New investors may also have rights, preferences and privileges senior to the Company’s current shareholders, which may adversely impact its current shareholders. The Company’s ability to raise additional capital will depend on conditions in the capital markets at that time, which are outside its control, and on its financial performance. Accordingly, the Company cannot assure you of its ability to raise additional capital on terms and time frames acceptable to it or to raise additional capital at all. If the Company cannot raise additional capital in sufficient amounts when needed, its ability to comply with regulatory capital requirements could be materially impaired. Additionally, the inability to raise capital in sufficient amounts may adversely affect the Company’s operations, financial condition and results of operations.

*If we conclude that the decline in value of any of our investment securities is other than temporary, we will be required to write down the credit-related portion of the impairment of that security through a charge to earnings.*

We review our investment securities portfolio at each quarter-end reporting period to determine whether the fair value is below the current carrying value. When the fair value of any of our investment securities has declined below its carrying value, we are required to assess whether the decline is other than temporary. If we conclude that the decline is other than temporary, we will be required to write down the credit-related portion of the impairment of that security through a charge to earnings. As of December 31, 2009, the book value of the Company’s pooled trust preferred securities was $18,794,000 with an estimated fair value of $5,242,000. Changes in the expected cash flows of these securities and/or prolonged price declines have resulted and may result in our concluding in future periods that there is additional impairment of these securities that is other than temporary, which would require a charge to earnings for the portion of the impairment that is deemed to be-credit-related. Due to the complexity of the calculations and assumptions used in determining whether an asset, such as pooled trust preferred securities, is impaired, the impairment disclosed may not accurately reflect the actual impairment in the future.

*The Company is subject to environmental liability risk associated with lending activities.*

A significant portion of the Company’s loan portfolio is secured by real property. During the ordinary course of business, the Company may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, the Company may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require the Company to incur substantial expense and may materially reduce the affected property’s value or limit the Company’s ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase the Company’s exposure to environmental liability. Although the Company has policies and procedures to perform an environmental review before initiating any foreclosure action on real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on the Company’s financial condition and results of operations.

*The Company’s profitability depends significantly on economic conditions in the Commonwealth of Pennsylvania and the local region in which it conducts business.*

The Company’s success depends primarily on the general economic conditions of the Commonwealth of Pennsylvania and the specific local markets in which the Company operates. Unlike larger national or other regional banks that are more geographically diversified, the Company provides banking and financial services to customers primarily in Lackawanna and Luzerne Counties in Northeastern Pennsylvania. The local economic conditions in these areas have a significant impact on the demand for the Company’s products and services as well as the ability of the Company’s customers to repay loans, the value of the collateral securing loans and the stability of the Company’s deposit funding sources. A significant decline in general economic conditions, caused by inflation, recession, acts of terrorism, an outbreak of hostilities or other international or domestic occurrences, unemployment, changes in securities markets or other factors could impact these local economic conditions and, in turn, have a material adverse effect on the Company’s financial condition and results of operations.

*There is no assurance that the Company will be able to successfully compete with others for business.*

The Company competes for loans, deposits and investment dollars with numerous regional and national banks and other community banking institutions, as well as other kinds of financial institutions and enterprises, such as securities firms, insurance companies, savings associations, credit unions, mortgage brokers and private lenders. Many competitors have substantially greater resources than the Company does, and operate under less stringent regulatory environments. The differences in resources and regulations may make it more difficult for the Company to compete profitably, reduce the rates that it can earn on loans and on its investments, increase the rates it must offer on deposits and other funds, and adversely affect its overall financial condition and earnings.

#### The Company is subject to extensive government regulation and supervision.

The Company, primarily through the Bank, is subject to extensive federal and state regulation and supervision. Banking regulations are primarily intended to protect depositors’ funds, federal deposit insurance funds and the banking system as a whole, not shareholders. These regulations affect the Company’s lending practices, capital structure, investment practices, dividend policy and growth, among other things. Federal or commonwealth regulatory agencies continually review banking laws, regulations and policies for possible changes. Changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could affect the Company in substantial and unpredictable ways. Such changes could subject the Company to additional costs, limit the types of financial services and products the Company may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a material adverse effect on the Company’s business, financial condition and results of operations. While the Company has policies and procedures designed to prevent any such violations, there can be no assurance that such violations will not occur.

#### The Company’s controls and procedures may fail or be circumvented.

Management regularly reviews and updates the Company’s internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of the Company’s controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on the Company’s business, results of operations and financial condition.

*New lines of business or new products and services may subject the Company to additional risks.*

From time-to-time, the Company may implement new lines of business or offer new products and services within existing lines of business. There are substantial risks and uncertainties associated with these efforts, particularly in instances where the markets are not fully developed. In developing and marketing new lines of business and/or new products and services the Company may invest significant time and resources. Initial timetables for the introduction and development of new lines of business and/or new products or services may not be achieved and price and profitability targets may not prove feasible. External factors, such as compliance with regulations, competitive alternatives, and shifting market preferences, may also impact the successful implementation of a new line of business or a new product or service. Furthermore, any new line of business and/or new product or service could have a significant impact on the effectiveness of the Company’s system of internal controls. Failure to successfully manage these risks in the development and implementation of new lines of business or new products or services could have a material adverse effect on the Company’s business, results of operations and financial condition.

*The Company’s future acquisitions could dilute your ownership and may cause it to become more susceptible to adverse economic events.*

The Company may use its common stock to acquire other companies or make investments in banks and other complementary businesses in the future. The Company may issue additional shares of common stock to pay for future acquisitions, which would dilute your ownership interest in the Company. Future business acquisitions could be material to the Company, and the degree of success achieved in acquiring and integrating these businesses into the Company could have a material effect on the value of the Company’s common stock. In addition, any acquisition could require it to use substantial cash or other liquid assets or to incur debt. In those events, it could become more susceptible to economic downturns and competitive pressures.

#### The Company may not be able to attract and retain skilled people.

The Company’s success depends, in large part, on its ability to attract and retain key people. Competition for the best people in most activities engaged in by the Company can be intense and the Company may not be able to hire people or to retain them. The unexpected loss of services of one or more of the Company’s key personnel could have a material adverse impact on the Company’s business because of their skills, knowledge of the Company’s market, years of industry experience and the difficulty of promptly finding qualified replacement personnel.

*The Company’s information systems may experience an interruption or breach in security.*

The Company relies heavily on communications and information systems to conduct its business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in the Company’s customer relationship management, general ledger, deposit, loan and other systems. While the Company has policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of its information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of the Company’s information systems could damage the Company’s reputation, result in a loss of customer business, subject the Company to additional regulatory scrutiny, or expose the Company to civil litigation and possible financial liability, any of which could have a material adverse effect on the Company’s financial condition and results of operations.

#### The Company continually encounters technological change.

The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. The Company’s future success depends, in part, upon its ability to address the needs of its customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in the Company’s operations. Many of the Company’s competitors have substantially greater resources to invest in technological improvements. The Company may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to its customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on the Company’s business and, in turn, the Company’s financial condition and results of operations.

*The Company is subject to claims and litigation pertaining to fiduciary responsibility.*

From time-to-time, customers make claims and take legal action pertaining to the Company’s performance of its fiduciary responsibilities. Whether customer claims and legal action related to the Company’s performance of its fiduciary responsibilities are founded or unfounded, if such claims and legal actions are not resolved in a manner favorable to the Company, they may result in significant financial liability and/or adversely affect the market perception of the Company and its products and services as well as impact customer demand for those products and services. Any financial liability or reputation damage could have a material adverse effect on the Company’s business, which, in turn, could have a material adverse effect on the Company’s financial condition and results of operations.

*Severe weather, natural disasters, acts of war or terrorism and other external events could significantly impact the Company’s business.*

Severe weather, natural disasters, acts of war or terrorism and other adverse external events could have a significant impact on the Company’s ability to conduct business. Such events could affect the stability of the Company’s deposit base, impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue and/or cause the Company to incur additional expenses. Severe weather or natural disasters, acts of war or terrorism or other adverse external events may occur in the future. Although management has established disaster recovery policies and procedures, the occurrence of any such event could have a material adverse effect on the Company’s business, which, in turn, could have a material adverse effect on the Company’s financial condition and results of operations.

*We currently have an Interim Chief Executive Officer while we search for a permanent Chief Executive Officer.*

During the third quarter of 2009 our President and Chief Executive Officer resigned. As a result, the board of directors formed a CEO search committee and is currently conducting a search. While we expect to recruit a new CEO no later than the end of the second quarter of 2010, we cannot assure you that the process will be concluded by then. Further, until we find a permanent CEO, we may be unable to successfully manage and grow the business; and, our business, financial condition and profitability may suffer. We believe each member of our senior management team is important to our success and the unexpected loss of any of these persons could impair our day-to-day operations as well as our strategic direction.

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.

### Risks Associated with the Company’s Common Stock

#### The Company’s stock price can be volatile.

Stock price volatility may make it more difficult for you to resell your common stock when you want and at prices you find attractive. The Company’s stock price can fluctuate significantly in response to a variety of factors including, among other things:

- Actual or anticipated variations in quarterly results of operations.
- Recommendations by securities analysts.
- Operating and stock price performance of other companies that investors deem comparable to the Company.
- News reports relating to trends, concerns and other issues in the financial services industry.
- Perceptions in the marketplace regarding the Company and/or its competitors.
- New technology used, or services offered, by competitors.
- Significant acquisitions or business combinations, strategic partnerships, joint ventures or capital commitments by or involving the Company or its competitors.
- Failure to integrate acquisitions or realize anticipated benefits from acquisitions.
- Changes in government regulations.
- Geopolitical conditions such as acts or threats of terrorism or military conflicts.

General market fluctuations, industry factors and general economic and political conditions and events, such as economic slowdowns or recessions, interest rate changes or credit loss trends, could also cause the Company’s stock price to decrease regardless of operating results.

*The trading volume in the Company’s common stock is less than that of other larger financial services companies.*

The Company’s common stock is listed for trading on the over-the-counter bulletin board and the trading volume in its common stock is less than that of other larger financial services companies. A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of willing buyers and sellers of the Company’s common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which the Company has no control. Given the lower trading volume of the Company’s common stock, significant sales of the Company’s common stock, or the expectation of these sales, could cause the Company’s stock price to fall.

### Risks Associated with the Company’s Industry

*Future governmental regulation and legislation could limit the Company’s future growth.*

The Company is a registered bank holding company, and its subsidiary bank is a depository institution whose deposits are insured by the FDIC. As a result, the Company is subject to various regulations and examinations by various regulatory authorities. In general, statutes establish the corporate governance and eligible business activities for the Company, certain acquisition and merger restrictions, limitations on inter-company transactions such as loans and dividends, capital adequacy requirements, requirements for anti-money laundering programs and other compliance matters, among other regulations. The Company is extensively regulated under federal and state banking laws and regulations that are intended primarily for the protection of depositors, federal deposit insurance funds and the banking system as a whole. Compliance with these statutes and regulations is important to the Company’s ability to engage in new activities and consummate additional acquisitions.

In addition, the Company is subject to changes in federal and state tax laws as well as changes in banking and credit regulations, accounting principles and governmental economic and monetary policies. The Company cannot predict whether any of these changes may adversely and materially affect it. Federal and state banking regulators also possess broad powers to take supervisory actions as they deem appropriate. These supervisory actions may result in higher capital requirements, higher insurance premiums and limitations on the Company’s activities that could have a material adverse effect on its business and profitability. While these statutes are generally designed to minimize potential loss to depositors and the FDIC insurance funds, they do not eliminate risk, and compliance with such statutes increases the Company’s expense, requires management’s attention and can be a disadvantage from a competitive standpoint with respect to non-regulated competitors.

*The earnings of financial services companies are significantly affected by general business and economic conditions.*

The Company’s operations and profitability are impacted by general business and economic conditions in the United States and abroad. These conditions include short-term and long-term interest rates, inflation, money supply, political issues, legislative and regulatory changes, fluctuations in both debt and equity capital markets, broad trends in industry and finance, and the strength of the U.S. economy and the local economies in which the Company operates, all of which are beyond the Company’s control. Deterioration in economic conditions could result in an increase in loan delinquencies and non-performing assets, decreases in loan collateral values and a decrease in demand for the Company’s products and services, among other things, any of which could have a material adverse impact on the Company’s financial condition and results of operations.

*Financial services companies depend on the accuracy and completeness of information about customers and counterparties.*

In deciding whether to extend credit or enter into other transactions, the Company may rely on information furnished by or on behalf of customers and counterparties, including financial statements, credit reports and other financial information. The Company may also rely on representations of those customers, counterparties or other third parties, such as independent auditors, as to the accuracy and completeness of that information. Reliance on inaccurate or misleading financial statements, credit reports or other financial information could have a material adverse impact on the Company’s business and, in turn, the Company’s financial condition and results of operations.

#### Consumers may decide not to use banks to complete their financial transactions.

Technology and other changes are allowing parties to complete financial transactions that historically have involved banks through alternative methods. For example, consumers can now maintain funds that would have historically been held as bank deposits in brokerage accounts or mutual funds. Consumers can also complete transactions such as paying bills and/or transferring funds directly without the assistance of banks. The process of eliminating banks as intermediaries, known as “disintermediation,” could result in the loss of fee income, as well as the loss of customer deposits and the related income generated from those deposits. The loss of these revenue streams and the lower cost deposits as a source of funds could have a material adverse effect on the Company’s financial condition and results of operations.

## Properties

As filed, 2,890 characters.

As of December 31, 2009, the Company operated 11 full-service banking offices, of which four were owned and seven were leased. None of the lessors of the properties leased by the Company are affiliated with the Company and all of the properties are located in the Commonwealth of Pennsylvania. The Company is headquartered at its owner-occupied main branch located on the corner of Blakely and Drinker Streets in Dunmore, PA.

The following table provides information with respect to the principal properties from which the Bank conducts business:

| Location | Owned / leased\* | Type of use | Full service | Drive-thru | ATM |
| --- | --- | --- | --- | --- | --- |
| Drinker & Blakely Sts., Dunmore, PA | Owned | Main Branch (1) (2) | x | x | x |
| 111 Green Ridge St., Scranton, PA | Leased | Green Ridge Branch (2) | x | x | x |
| 1311 Morgan Hwy., Clarks Summit, PA | Leased | Abington Branch (3) | x | x | x |
| 1232 Keystone Industrial Park Rd., Dunmore, PA | Owned | Keystone Industrial Park Branch | x | x | x |
| 338 North Washington Ave., Scranton, PA | Owned | Financial Center Branch (4) | x |  | x |
| 4010 Birney Ave., Moosic, PA | Leased | Moosic Branch | x | x | x |
| 801 Wyoming Ave., West Pittston, PA | Leased | West Pittston Branch | x |  | x |
| 1598 Main St., Peckville, PA | Leased | Peckville Branch | x | x | x |
| 247 Wyoming Ave., Kingston, PA | Leased | Kingston Branch | x | x | x |
| 511 Scranton-Carbondale Hwy., Eynon, PA | Leased | Eynon Branch | x | x | x |
| 400 S. Main St., Scranton, PA | Owned | West Scranton Branch(2) | x | x | x |

10

\*All of the owned properties are free of encumbrances

(1) Executive and administrative, commercial lending, trust and asset management services are located at this facility.

(2) This office has two automated teller machines (ATMs).

(3) In addition, there is a banking facility located in the Clarks Summit State Hospital. The office is leased from the hospital under a lease-for-service-provided agreement with service limited to employees and patients of the hospital.

(4) Executive, mortgage and consumer lending, finance and operational offices are located in this building. A portion of the building is leased to a non-related entity.

The Bank maintains several free-standing 24-hour ATMs located at the following locations in Pennsylvania:

- 139 Wyoming Ave., Scranton (former location of the Bank’s Scranton branch)
- Marywood University, 2300 Adams Ave., Nazareth and Regina Halls, Scranton
- Snö Mountain Ski Resort, 1000 Montage Mountain Rd., Moosic
- Shoppes at Montage, 1035 Shoppes Blvd., Moosic

During 2009, the Company closed its Scranton branch office located at 139 Wyoming Avenue, Scranton.

Other real estate owned includes all foreclosed properties listed for sale. Upon possession, foreclosed properties are recorded on the Company’s balance sheet at the lower of cost or fair value.

## Legal proceedings

As filed, 668 characters.

The nature of the Company’s business generates some litigation involving matters arising in the ordinary course of business. However, in the opinion of the Company after consulting with legal counsel, no legal proceedings are pending, which, if determined adversely to the Company or the Bank, would have a material effect on the Company’s undivided profits or financial condition. No legal proceedings are pending other than ordinary routine litigation incidental to the business of the Company and the Bank. In addition, to management’s knowledge, no governmental authorities have initiated or contemplated any material legal actions against the Company or the Bank.

## Management's discussion and analysis

As filed, 151,801 characters.

### Critical accounting policies

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

A material estimate that is particularly susceptible to significant change relates to the determination of the allowance for loan losses. Management believes that the allowance for loan losses at December 31, 2009 is adequate and reasonable. Given the subjective nature of identifying and valuing loan losses, it is likely that well-informed individuals could make 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 the future. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may require the Company to recognize adjustments to the allowance based on their judgment of information available to them at the time of their examination.

Another material estimate is the calculation of fair values of the Company’s investment securities. Except for the Company’s investment in corporate bonds, consisting of pooled trust preferred securities, fair values on 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, 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 the market for these securities to be inactive. In order to determine the fair value of the pooled trust preferred securities, management relied on the use of an income valuation approach (present value technique) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs, the results of which are more representative of fair value than the market approach valuation technique used for the other investment securities.

Based on experience, management is aware that estimated fair values of investment securities tend to vary among valuation services. Accordingly, when selling investment securities, price quotes may be obtained from more than one source. As described in Notes 1 and 3 of the consolidated financial statements, the majority of the Company’s investment securities are classified as available-for-sale (AFS). AFS securities are carried at fair value on the consolidated balance sheets, with unrealized gains and losses, net of income tax, reported separately within shareholders’ equity through accumulated other comprehensive income (loss).

The fair value of residential mortgage loans, classified as AFS, is obtained from the Federal National Mortgage Association (FNMA) or the Federal Home Loan Bank (FHLB). Generally, the market to which the Company sells mortgages it originates for sale is restricted and price quotes from other sources are not typically obtained. On occasion, the Company may transfer loans from the loan and lease portfolio to loans AFS. Under these rare circumstances, pricing may be obtained from other entities and the loans are transferred at the lower of cost or market value and simultaneously sold. For a further discussion on the accounting treatment of AFS loans, see the section entitled “Loans available-for-sale,” contained within management’s discussion and analysis. As of December 31, 2009 and 2008, loans classified as AFS consisted of residential mortgages.

All significant accounting policies are contained in Note 1, “Nature of Operations and Summary of Significant Accounting Policies”, within the notes to consolidated financial statements and incorporated by reference in Part II, Item 8.

The following discussion and analysis presents the significant changes in the financial condition and in the results of operations of the Company as of December 31, 2009 and December 31, 2008 and for each of the years then ended. This discussion should be read in conjunction with the consolidated financial statements and notes thereto included in Part II, Item 8 of this report.

### Comparison of Financial Condition as of December 31, 2009

### and 2008 and Results of Operations for each of the Years then Ended

### Financial Condition

### Overview

The national economy by some estimates may be improving, but the state of the housing, real estate markets and capital markets continue to feel the downward pressure of the recession-stricken financial environment that began its downward spiral over a year ago. Capital constraints and asset quality concerns will restrict asset growth. The sluggish recovery has suppressed the availability of commercial and consumer credit, continued to contain residential real estate at relatively low values, propelled the rate of home foreclosures and sustained a level of unemployment not seen for decades. In an effort to stimulate the economy, among other things, the Federal Open Market Committee (FOMC) has not adjusted the short-term federal funds rate which had remained near zero percent during 2009. While lower rates certainly do help funding costs, their effect can be unfavorable to floating-rate asset yields and re-financed fixed-rate assets thereby pressuring margins. The shape of the interest rate yield curve continued to be positively sloped throughout 2009 but the interest rate environment was considerably lower in 2009 compared to 2008. The shape of the yield curve may present opportunities. However the local economy is not insulated from the disruptions, volatility and slow recovery that has negatively impacted the national economy and that situation will continue to require the Company, like all banks, to operate in a difficult, financially unstable economic landscape. The management team and steering committees of the Company are prepared to address the issues at hand and will implement strategies to navigate through these uncertain times.

Consolidated assets decreased $19,702,000, or 3%, during the year ended December 31, 2009 to $556,017,000. The decline was the result of decreased total borrowings of $41,597,000, or 46%, and a decrease in total shareholders’ equity of $3,286,000, or 7%, partially offset by a 6%, or $25,682,000 increase in deposits. The decline in borrowings resulted from a combination of deposit growth and balance sheet de-leveraging. Shareholders' equity declined due to the net loss recorded for the year ended December 31, 2009 and the declaration of cash dividends plus the reduction in intrinsic value from expiration of the cash flow hedge.

The following table is a comparison of condensed balance sheet accounts and percentage to total assets at December 31, 2009, 2008 and 2007 (dollars in thousands):

| Assets: | 2009 Amount | Percent | 2008 Amount | Percent | 2007 Amount | Percent |
| --- | ---: | ---: | ---: | ---: | ---: | ---: |
| Cash and cash equivalents | $8,328 | 1.5% | $12,771 | 2.2% | $10,409 | 1.8% |
| Investment securities | 76,530 | 13.8 | 84,188 | 14.6 | 122,984 | 20.9 |
| Federal Home Loan Bank Stock | 4,781 | 0.9 | 4,781 | 0.8 | 3,303 | 0.6 |
| Loans and leases, net | 424,345 | 76.3 | 436,291 | 75.8 | 422,252 | 71.9 |
| Bank premises and equipment | 15,362 | 2.8 | 16,056 | 2.8 | 12,965 | 2.2 |
| Life insurance cash surrender value | 9,117 | 1.6 | 8,808 | 1.5 | 8,489 | 1.4 |
| Other assets | 17,554 | 3.1 | 12,824 | 2.3 | 7,011 | 1.2 |
| Total assets | $556,017 | 100.0% | $575,719 | 100.0% | $587,413 | 100.0% |
| **Liabilities:** |  |  |  |  |  |  |
| Total deposits | $458,994 | 82.6% | $433,312 | 75.3% | $425,708 | 72.5% |
| Short-term borrowings | 16,533 | 3.0 | 38,130 | 6.6 | 39,656 | 6.7 |
| Long-term debt | 32,000 | 5.8 | 52,000 | 9.0 | 62,709 | 10.7 |
| Other liabilities | 2,815 | 0.4 | 3,316 | 0.6 | 4,149 | 0.7 |
| Total liabilities | 510,342 | 91.8 | 526,758 | 91.5 | 532,222 | 90.6 |
| Shareholders' equity | 45,675 | 8.2 | 48,961 | 8.5 | 55,191 | 9.4 |
| Total liabilities and shareholders' equity | $556,017 | 100.0% | $575,719 | 100.0% | $587,413 | 100.0% |

A comparison of net changes in selected balance sheet categories as of December 31, are as follows:

|  | Assets% |  | Earning assets\*% |  | Deposits% |  | Short-term borrowings% |  | Other borrowings% |  |
| --- | ---: | ---: | ---: | ---: | ---: | ---: | ---: | ---: | ---: | ---: |
| 2009 | $(19,701,726) | (3) | $(26,475,299) | (5) | $25,682,526 | 6 | $(21,596,597) | (57) | $(20,000,000) | (38) |
| 2008 | (11,693,558) | (2) | (22,808,541) | (4) | 7,603,571 | 2 | (1,526,650) | (4) | (10,708,677) | (17) |
| 2007 | 25,094,567 | 4 | 26,073,807 | 5 | 15,373,766 | 4 | 6,000,204 | 18 | 172,467 | - |
| 2006 | 18,257,290 | 3 | 21,202,050 | 4 | 30,835,955 | 8 | 4,883,153 | 17 | (21,167,978) | (25) |
| 2005 | 7,385,560 | 1 | 2,784,580 | 1 | 13,883,305 | 4 | (21,761,049) | (43) | 12,585,000 | 18 |

\* Earning assets exclude: loans and securities placed on non-accrual status.

### Deposits

The Bank is a community-based commercial financial institution, member FDIC, which offers a variety of deposit products with varying ranges of interest rates and terms. Deposit products include savings, clubs, 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 which can range 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. To determine deposit product interest rates, the Company considers local competition, spreads to earning-asset yields, liquidity position and rates charged for alternative sources of funding such as borrowings which include repurchase agreements. Though the Company tends to experience intense competition for deposits, more so during this prolonged low interest-rate environment, the interest rate setting strategy also includes consideration of the Company’s balance sheet structure and cost effective strategies that are mindful of the current economic landscape.

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

|  | 2009 Amount | Percent | 2008 Amount | Percent |
| --- | ---: | ---: | ---: | ---: |
| Money market | $91,488 | 19.9% | $96,738 | 22.3% |
| NOW | 62,031 | 13.5 | 50,124 | 11.6 |
| Savings and clubs | 86,335 | 18.8 | 41,326 | 9.5 |
| Certificates of deposit | 139,502 | 30.5 | 173,681 | 40.1 |
| CDARS | 8,748 | 1.9 | - | - |
| Total interest-bearing | 388,104 | 84.6 | 361,869 | 83.5 |
| Non-interest bearing | 70,890 | 15.4 | 71,443 | 16.5 |
| Total deposits | $458,994 | 100.0% | $433,312 | 100.0% |

During the first quarter of 2009, the Company began to use the Certificate of Deposit Account Registry Service (CDARS) reciprocal program 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 with varying terms and interest rates, originated in the Company’s own markets, are exchanged for deposits of 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 placed with network institutions, the Company receives from network institutions deposits that are approximately equal in amount and contain similar terms as those placed for our customers. Deposits the Company receives, or reciprocal deposits, from other institutions are considered brokered deposits by regulatory definitions. As of December 31, 2009, CDARS represented $8,748,000, or 2%, of total deposits.

Total deposits increased $25,682,000, or 6%, during 2009 to $458,994,000. The increase stems from growth in savings and clubs of $45,009,000 and NOW accounts of $11,907,000, partially offset by declines in CDs including CDARS of $25,431,000, net and money market accounts of $5,250,000. Generally, deposits are obtained from consumers and businesses within the communities that surround the Company’s 11 branch offices and all deposits are insured by the FDIC up to the full extent permitted by law. In an effort to grow and retain core deposits, the Company introduced innovative options to its variety of deposit products. Most notably, in 2009 the Company created special savings account offerings tailored to the needs of both business and non-business customers. This creativity resulted in savings account balances that more than doubled by the end of 2009 compared to December 31, 2008. The Company’s niche is developing, promoting and bringing creative deposit-related ideas to the market during times that are best suited for the customer and for the Company. This in conjunction with superior customer service contributed to the overall net increase in deposits.

Including CDARS, the maturity distribution of certificates of deposit at December 31, 2009 is as follows (dollars in thousands):

|  | Three months or less | Three to six months | Six to twelve months | Over twelve months | Total |
| --- | ---: | ---: | ---: | ---: | ---: |
| CDs of $100,000 or more | $19,883 | $5,197 | $7,992 | $21,867 | $54,939 |
| CDs of less than $100,000 | 17,817 | 8,157 | 17,980 | 40,609 | 84,563 |
| CDARS | - | 740 | 4,088 | 3,920 | 8,748 |
| Total CDs | $37,700 | $14,094 | $30,060 | $66,396 | $148,250 |

17

Including CDARS, approximately 55% of the CDs are scheduled to mature within one year. Renewing CDs may re-price to lower or higher 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 negative impact of the unpredictable interest rate environment, management deployed strategies that diversified the deposit mix across the entire continuum of new and existing deposit products.

### Short-term borrowings

In addition to deposits, other funding sources available to the Company are overnight funds purchased from the Federal Home Loan Bank of Pittsburgh (FHLB), fed funds purchased from correspondent banks and repurchase agreements with individuals, businesses and public entities. The Company uses overnight funding for asset growth, deposit run-off and short-term liquidity needs.

Repurchase agreements are non-insured interest-bearing liabilities that have a perfected security interest in qualified investments of the Company. The FDIC Depositor Protection Act of 2009 requires banks to provide a perfected security interest to the purchasers of uninsured repurchase agreements. Repurchase agreements 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 funds are transferred, or swept, into an interest-bearing overnight repurchase agreement account. Due to the constant flow of funds in to and out of the sweep product, their balances tend to be somewhat volatile, mimicking the likes of a DDA deposit account. Customer liquidity is the typical cause for variances in repurchase agreements, which during 2009 declined $3,665,000 from $11,412,000 at December 31, 2008 to $7,747,000 as of December 31, 2009.

Overnight borrowings and repurchase agreements are included with short-term borrowings on the consolidated balance sheets. For a further discussion on short-term borrowings, see Note 7, “Short-Term Borrowings”, contained in the notes to consolidated financial statements in Part II, Item 8.

### Long-term debt

Long-term debt consists of borrowings from the FHLB. The weighted-average rate in effect on funds borrowed at December 31, 2009 was 5.11% compared to 5.35% as of December 31, 2008. The 2009 weighted-average rate was 61 basis points below the tax-equivalent yield of 5.72% earned from the Company’s portfolio of average interest-earning assets for the year ended December 31, 2009. Rates on the $32,000,000 balances of long-term advances are currently fixed but are structured to adjust quarterly should market interest rates increase beyond the issues’ original or strike rates. Significant prepayment penalties are attached to the borrowings thereby creating a disincentive from paying off the higher cost advances. However, in the event underlying market rates drift above the rates currently paid on these borrowings, the fixed-rate would convert to a floating rate advance and at that time, the Company would have the option to repay or to renegotiate the converted advance rate. During the third quarter of 2009, $10,000,000 of convertible select advances with a weighted-average interest rate of 6.12%, scheduled to mature in 2010, were paid off. At the time of pay-off, the Company incurred $505,000 of prepayment interest costs that are included as a component of interest expense in the consolidated statement of income for the year ended December 31, 2009. This deleveraging allowed the Company access to higher available liquidity and to strengthen regulatory capital ratios. Due to the relatively high-costing nature of these advances, the strategy was immediately accretive to future earnings. As of December 31, 2009, the Company had the ability to borrow an additional $138,346,000 from the FHLB.

### Investments

The Company’s investment policy is designed to complement its lending activities, generate a favorable return without incurring undue interest rate and credit risk, manage interest rate sensitivity, provide monthly cash flow and manage liquidity at acceptable levels. In establishing investment strategies, the Company considers its business, growth or restructuring plans, the economic environment, the interest rate sensitivity position, the types of securities held, permissible purchases, credit quality, maturity and re-pricing terms, call or average-life intervals and investment concentrations. The policy prescribes permissible investment categories that meet the policy standards and management is responsible for structuring and executing the specific investment purchases within these policy parameters. Management buys and sells investment securities from time-to-time depending on market conditions, business trends, liquidity needs, capital levels and structuring strategies. Investment security purchases provide a way to quickly invest excess liquidity in order to generate additional earnings. The Company generally earns a positive interest spread by assuming interest rate risk and using deposits and/or borrowings to purchase securities with longer maturities.

At the time of purchase, management classifies investment securities into one of three categories: trading, available-for-sale (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 their net fair values in the consolidated balance sheets with an adjustment to shareholders’ equity, net of tax, presented under the caption “Accumulated other comprehensive income (loss).” As of December 31, 2009, AFS debt securities were recorded with an unrealized net loss of $14,038,000 while equity securities were recorded with an unrealized net gain of $107,000. Investment securities designated as HTM represent debt securities that the Company has the ability and intent to hold until maturity and are carried at amortized cost. As of December 31, 2009 and December 31, 2008, the aggregate fair value of securities HTM exceeded their respective aggregate amortized cost by $56,000 and $31,000, respectively.

As of December 31, 2009, the carrying value of investment securities totaled $76,530,000, or 14% of total assets, compared to $84,187,000, or 15% of total assets at December 31, 2008. At December 31, 2009, approximately 19% of the carrying value of the investment portfolio was comprised of U.S. Government Sponsored Enterprise residential mortgage-backed securities (MBS – GSE residential) that amortize and provide monthly cash flow. Agency Government Sponsored Enterprise (Agency – GSE) securities, municipal general obligations and corporate bonds comprised 43%, 30% and 7%, respectively, of the investment portfolio at December 31, 2009.

A comparison of total investment securities as of December 31 follows:

|  | 2009 Amount | Percent | 2008 Amount | Percent |
| --- | ---: | ---: | ---: | ---: |
| Agency - GSE | $33,132,301 | 43.3% | $43,507,359 | 51.7% |
| MBS - GSE residential | 14,456,037 | 18.9 | 12,438,721 | 14.8 |
| State & municipal subdivisions | 23,270,289 | 30.4 | 17,552,729 | 20.8 |
| Pooled trust preferred securities | 5,241,844 | 6.8 | 10,260,196 | 12.2 |
| Equity securities - financial services | 429,527 | 0.6 | 428,574 | 0.5 |
| Total | $76,529,998 | 100.0% | $84,187,579 | 100.0% |

The distribution of debt securities by stated maturity date at December 31, 2009 is as follows:

|  | One year or less | One through five years | Five through ten years | More than ten years | Total |
| --- | ---: | ---: | ---: | ---: | ---: |
| Agency - GSE | $- | $- | $6,939,700 | $26,192,601 | $33,132,301 |
| MBS - GSE residential | - | 46,579 | 487,049 | 13,922,409 | 14,456,037 |
| State & municipal subdivisions | - | - | 592,410 | 22,677,879 | 23,270,289 |
| Pooled trust preferred securities | - | - | - | 5,241,844 | 5,241,844 |
| Total debt securities | $- | $46,579 | $8,019,159 | $68,034,733 | $76,100,471 |

The tax-equivalent yield on debt securities by stated maturity date at December 31, 2009 is as follows:

|  | One year or less | One through five years | Five through ten years | More than ten years | Total |
| --- | ---: | ---: | ---: | ---: | ---: |
| Agency - GSE | -% | -% | 3.32% | 5.02% | 4.67% |
| MBS - GSE residential | - | 6.00 | 6.04 | 4.76 | 4.81 |
| State & municipal subdivisions | - | - | 5.60 | 6.22 | 6.21 |
| Pooled trust preferred securities | - | - | - | 1.69 | 1.69 |
| Total debt securities | -% | 6.00% | 3.65% | 4.54% | 4.46% |

In the above table, the book yields on state & municipal subdivisions were adjusted to a tax-equivalent basis using the corporate federal tax rate of 34%. In addition, average yields on securities AFS are based on amortized cost and do not reflect unrealized gains or losses.

Uncertainty continues to prevail in the financial markets which has increased the volatility in fair value estimates for the securities in the Company’s investment portfolio. Other than pooled trust preferred securities, fair values of the Company’s investment securities have improved since year-end 2008. Management believes fair value changes are due mainly to the interest rate environment, instability in the capital markets, limited trading activity and illiquid conditions in the financial markets, not deterioration in the creditworthiness of the issuers. Nearly all of the securities in the portfolio have fixed rates or have predetermined scheduled rate changes, and many have call features that allow the issuer to call the security at par before its stated maturity without penalty. As of December 31, 2009, the debt securities with unrealized losses have depreciated 25.9% compared to 27.4% at December 31, 2008. The most significant component of the $14.0 million net unrealized loss in the AFS debt securities portfolio was $13.6 million from the Company’s investments in corporate bonds consisting of collateralized debt obligation (CDO) securities that are backed by pooled trust preferred securities issued by banks, thrifts and insurance companies.

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 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.

The Company owns 13 tranches of pooled trust preferred securities (PreTSLs). The market for these securities and other issues of PreTSLs at December 31, 2009 was not active. The inactivity was evidenced first by a significant widening of the bid-ask spread in the brokered markets in which PreTSLs trade, then by a significant decrease in the volume of trades relative to historical levels and the lack of a new-issue market 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, management has made the following observations and has determined:

- The few observable transactions and market quotations that were available were not reliable for purposes of determining fair value at December 31, 2009,
- An income valuation approach (present value technique) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs are equally or more representative of fair value than the market approach valuation technique, and
- The PreTSLs securities are classified within “Level 3” (as defined in current accounting guidance and explained in Note 12, “Fair Value of Financial Instruments and Derivatives” of the consolidated financial statements) of the fair value hierarchy because significant adjustments are required to determine fair value at the measurement date. The valuations of the Company’s PreTSLs were prepared by an independent third party and corroborated by management. The 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 issuer-specific probability of default values,
- 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, or amount of cash lost to the investor when a debt asset defaults, was assumed to be 100% (no recovery) based upon Moody’s research. This replicates the historically high default loss levels on trust preferred instruments,
- The cash flows were forecast for the underlying collateral and applied to each tranche to determine the resulting distribution among the securities. This ascertains which investors are paid and which investors incur losses. Thus, these cash flow projections capture the credit risk,
- The expected cash flows utilize no prepayments and were discounted utilizing three-month LIBOR as the risk-free rate for the base case and then added a 300bp liquidity premium as the discount rate to calculate the present value of the security,
- The effective discount rates on an overall basis range from 9.84% to 341.92% and are highly dependent upon the credit quality of the collateral, the relative position of the tranche within the capital structure of the security and the prepayment assumptions, and
- The calculations were modeled in several 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 December 31, 2009, the fair value of five PreTSL securities: VII, IX, XV, XVI and XXV had declined $8,014,000 in total below their amortized cost basis and since the present value of the security’s expected cash flows were insufficient to recover the entire amortized cost basis, the securities are deemed to have experienced credit related other-than-temporary impairment in the amount of $3,300,000 which was charged to current earnings as a component of other income in the consolidated statement of income for the year ended December 31, 2009. This compares to $436,000 of impairment charges recorded for the year ended December 31, 2008. There were no other-than-temporary impairment charges recorded in 2007. The Company closely monitors the pooled trust preferred securities market and performs collateral sufficiency and cash flow analyses on a quarterly basis. Future analyses could yield results that may indicate further impairment has occurred and would therefore require additional write-downs and corresponding other-than-temporary charges to current earnings.

### 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 level of borrowings declines to a predetermined level. In addition, the Company normally earns a return or dividend on the amount invested. In order to preserve its capital level, in December 2008 the FHLB announced that it had suspended the payment of dividends and excess capital stock repurchasing. That decision was based on the FHLB’s analysis and consideration of certain negative market trends and the impact those trends will have on their financial condition. Based on the financial results of the FHLB for the year-ended December 31, 2009 and 2008, 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 a 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. There can be no assurance, however, that future negative changes to the financial condition of the FHLB may not require the Company to recognize an impairment charge with respect to such holdings. The Company will continue to monitor the financial condition of the FHLB and assess its future ability to resume normal dividend payments and stock redemption activities.

### 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. As part of the overall strategy to serve the business community in which it operates, the Company is focused on developing and implementing products and services to the broad spectrum of businesses that operate in our marketplace. The Company’s goals center on building relationships by providing credit and non-credit products and services, continuing to diversify its loan portfolio and utilizing participations to reduce risk in larger credit transactions. Especially in today’s economy, the Company, in providing credit to existing and new customers, has implemented policies and procedures to reduce the associated risk. The risks associated with interest rates are being managed by utilizing floating versus long-term fixed rates and exploring programs where we can match our cost of funds.

Gross loans and leases decreased $10,255,000, or 2%, from $440,953,000 at December 31, 2008, to $430,698,000 at December 31, 2009. Gross loans represented 77% of total assets at December 31, 2009 and December 31, 2008, respectively.

In 2009, the Company originated $32,686,000 of commercial and CRE loans, $13,809,000 of residential mortgage loans and $20,602,000 of consumer loans. This compares to $47,864,000, $23,111,000 and $21,354,000, respectively, in 2008. Included in mortgage loans is $8,307,000 of real estate construction lines in 2009 and $9,476,000 in 2008. In addition for 2009, the Company originated lines of credit in the amounts of $35,296,000 for commercial borrowers and $13,260,000 in home equity and other consumer lines of credit.

The Company’s origination, for portfolio, activity declined 27% in 2009 compared to 2008. Because of the low interest rate environment, borrowers’ sentiment was to procure and refinance to low, fixed-rate mortgage loans; an activity that dominated housing lending throughout 2009. To manage interest rate risk, the Company sells these loans into the secondary market rather than for portfolio retention. The decline in the commercial and CRE originations was due to weak economic conditions and the related strict underwriting practices that the Company employs to help ensure against possible future losses.

#### Commercial and commercial real estate loans:

For 2009 the Company further implemented the concept of reinforcing and building relationships. Commercial lenders have become relationship managers and have the knowledge to deal with loans, deposits and referrals to other areas of the bank such as trust and asset management. The commercial and CRE loan portfolio increased to $263,514,000 from $245,480,000, or 7%, during 2009. Deposits associated with lending, whether they are retail or commercial, have benefited from the emphasis on relationships and not just loans.

*Residential real estate loans:*

Residential real estate loans declined $27,509,000, or 28%, to $71,001,000 in 2009. During the first quarter of 2009, the Company transferred $10,838,000 of residential mortgage loans to the AFS portfolio, which were simultaneously sold. From time-to-time, management will evaluate the composition of the residential loan portfolio and based upon liquidity needs, interest rate risk and other considerations may transfer loans to the AFS portfolio, at the lower of cost or market value. The balance of the residential real estate mortgage decline is mostly from net pay-downs during 2009 as borrowers’ desire, during this low-rate environment, is to re-finance their existing mortgage and home equity debt into new lower rate mortgage loans. Operating in a lower interest rate environment throughout 2009 that continues into 2010, the Company expects continued prepayment and refinance activity from its mortgage banking services, albeit on a much smaller scale.

#### Consumer loans:

Despite reduced origination, compared to December 31, 2008, the consumer loan portfolio remained relatively unchanged as of December 31, 2009. The Company’s success in the development and implementation of promotional campaigns for prime-based home equity lines of credit, which customers find to be attractive in low interest rate environments, resulted in more lines, more line usage and lower installment balances. This in addition to a new relationship with an automobile dealership during the latter part of 2008 helped stabilize the size of the consumer loan portfolio.

#### Real estate construction loans:

Real estate construction loans decreased $1,302,000, or 11%, at December 31, 2009 compared to December 31, 2008. These loans fund residential and commercial construction projects and then convert to a residential mortgage or to a commercial real estate loan usually within one year from the origination date. Generally, the converted loans will bear similar terms as the terms during the construction period.

#### Direct financing leases:

The balance represents tax-free leasing arrangements provided to municipal customers. The Company has not originated new direct finance leasing and for the past several years, the activity represented scheduled run-off.

A comparison of domestic loans at December 31, for the five previous periods is as follows:

| Real estate: | 2009 | 2008 | 2007 | 2006 | 2005 |
| --- | ---: | ---: | ---: | ---: | ---: |
| Commercial | $186,726,196 | $164,772,236 | $143,596,397 | $158,446,052 | $158,566,841 |
| Residential | 71,001,298 | 98,510,562 | 116,978,378 | 112,742,692 | 103,920,613 |
| Construction | 10,125,354 | 11,426,978 | 10,703,249 | 13,369,712 | 14,198,858 |
| Commercial and industrial | 76,787,809 | 80,707,756 | 72,461,485 | 59,767,164 | 57,721,756 |
| Consumer | 85,689,831 | 85,091,205 | 81,998,093 | 77,729,520 | 74,070,328 |
| Direct financing leases | 367,169 | 443,957 | 511,178 | 588,211 | 650,348 |
| Gross loans | 430,697,657 | 440,952,694 | 426,248,780 | 422,643,351 | 409,128,744 |
| Less: |  |  |  |  |  |
| Allowance for loan losses | 7,573,603 | 4,745,234 | 4,824,401 | 5,444,303 | 5,984,649 |
| Net loans | $423,124,054 | $436,207,460 | $421,424,379 | $417,199,048 | $403,144,095 |
| Loans available-for-sale | $1,221,365 | $84,000 | $827,250 | $122,000 | $428,584 |

22

A comparison of gross loans by percent at year-end for the five previous periods is as follows:

| Real estate: | 2009 | 2008 | 2007 | 2006 | 2005 |
| --- | ---: | ---: | ---: | ---: | ---: |
| Commercial | 43.3% | 37.4% | 33.7% | 37.5% | 38.8% |
| Residential | 16.5 | 22.3 | 27.5 | 26.7 | 25.4 |
| Construction | 2.4 | 2.6 | 2.5 | 3.2 | 3.5 |
| Commercial and industrial | 17.8 | 18.3 | 17.0 | 14.1 | 14.1 |
| Consumer | 19.9 | 19.3 | 19.2 | 18.4 | 18.1 |
| Direct financing leases | 0.1 | 0.1 | 0.1 | 0.1 | 0.1 |
| Gross loans | 100.0% | 100.0% | 100.0% | 100.0% | 100.0% |

The following table sets forth the maturity distribution of select components of the loan portfolio at December 31, 2009. Excluded from the table are residential real estate loans, consumer loans and direct financing leases (dollars in thousands):

|  | One year or less | One to five years | More than five years | Total |
| --- | ---: | ---: | ---: | ---: |
| Commercial and CRE | $27,130 | $50,854 | $185,530 | $263,514 |
| Real estate construction | 10,125 | - | - | 10,125 |
| Total | $37,255 | $50,854 | $185,530 | $273,639 |

Real estate construction loans are included in the one-year or less category since, by their nature, these loans are converted into residential and CRE loans within one year from the date the real estate construction loan was consummated. Upon conversion, the residential and CRE loans would normally mature after five years.

The following table sets forth the greater than one year sensitivity changes in interest rates for performing commercial and CRE loans at December 31, 2009 (dollars in thousands):

|  | One to five years | More than five years | Total |
| --- | ---: | ---: | ---: |
| Fixed interest rate | $33,564 | $37,822 | $71,386 |
| Variable interest rate | 81,718 | 53,186 | 134,904 |
| Total | $115,282 | $91,008 | $206,290 |

Non-refundable fees or costs associated with all loan originations are deferred. Using the principal reduction method, the deferral is released as charges or credits to loan interest income over the life of the loan.

There are no concentrations of loans to a number of borrowers engaged in similar activities exceeding 10% of total loans that are not otherwise disclosed as a category in the tables above. There are no concentrations of loans that, if resulted in a loss, would have a material adverse effect on the business of the Company. The Company’s loan portfolio does not have a material concentration within a single industry or group of related industries that is vulnerable to the risk of a near-term severe negative business impact.

### Loans available-for-sale

Upon origination, certain residential mortgages are classified as AFS. In the event market rates increase, fixed-rate loans and adjustable-rate 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 on adjustable-rate loans decrease, interest income would be negatively affected. Consideration is given to the Company’s current liquidity position and projected future liquidity needs. To better manage interest rate and prepayment risk, loans meeting 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 loans AFS fall below their original cost, the difference is written down and charged to current earnings. Any subsequent appreciation in the portfolio is credited to current earnings but only to the extent of previous write-downs.

Loans AFS as of December 31, 2009 were $1,221,000 with a corresponding fair value of $1,233,000 compared to $84,000 and $85,000, respectively, at December 31, 2008. During 2009, the Company originated $87,896,000 of residential mortgages AFS, compared to $14,754,000 in 2008. The higher volume in 2009 was a function of the low interest rate environment which spawned refinance activity of existing home debt. During 2009, residential mortgage loans with principal balances of $98,213,000 were sold into the secondary market and recognized net gains of approximately $1,060,000, compared to $46,969,000 and $261,000, respectively during 2008. Included in the 2009 sale was $10,838,000 of residential mortgage loans transferred from the loan and lease portfolio during the first quarter of 2009 compared to $28,103,000 in the early part of 2008. The Company does not expect residential mortgage loan origination activity to continue at the 2009 pace.

The Company retains mortgage servicing rights (MSRs) on loans sold into the secondary market. MSRs are retained so that the Company can continue the personal relationships it has established with its customers. At December 31, 2009 and 2008, the servicing portfolio balance of sold residential mortgage loans was $157,516,000 and $95,856,000, respectively.

### 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;
- specific loans that could have potential loss;
- 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 (three-year average) to pools to determine the allowance allocation; and
- application of qualitative factor adjustment percentages to historical losses for trends or changes in the loan portfolio. Qualitative factor adjustments include:
- 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.

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. Upon review, the commercial loan credit risk grade is revised or reaffirmed as the case may be. The credit risk grades may be changed at any time management feels an upgrade or downgrade may be warranted. The credit risk grades for the commercial loan portfolio are taken into account in the reserve methodology and loss factors are applied based upon the credit risk grades. The loss factors applied are based upon the Company’s historical experience as well as what we believe to be best practices and common industry standards. Historical experience reveals there is a direct correlation between the credit risk grades and loan charge-offs. 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 current accounting guidelines. The Special Assets Committee’s focus is on ensuring the pertinent facts are considered and the reserve amounts pursuant to the accounting principles 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 twelve months ending December 31, 2009, were $2,221,000, compared to $1,019,000 in the twelve months of 2008. The higher level of charge-offs recorded in the year primarily resulted from the write-down of impaired loans to current fair value. Commercial real estate loan net charge-offs of $842,000 were recorded during the twelve months ending December 31, 2009 versus $547,000 at December 31, 2008. Commercial and industrial loan net charge-offs were $948,000 for the twelve months ending December 31, 2009 compared to net charge-offs of $107,000 in the same period of 2008. Residential real estate loan net charge-offs totaled $9,000 for the twelve months ending December 31, 2009 compared to $45,000 in the like period of 2008. Consumer loan net charge-offs of $422,000 were recorded during the twelve months ending December 31, 2009 versus $320,000 at December 31, 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.

The allowance for loan losses was $7,574,000 at December 31, 2009, an increase of $2,829,000 from December 31, 2008. The increase in the allowance was primarily driven by a migration of commercial loan credit risk ratings from pass to classified status, higher loan charge-offs, and a generally weaker economic outlook.

Management believes that the current balance in the allowance for loan losses of $7,574,000 is sufficient to withstand the identified potential credit quality issues that may arise and others unidentified but inherent to the portfolio. 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 nor past due 90 days or more. Given continuing pressure on property values and the generally uncertain economic backdrop, there could be additional instances which become identified in future periods that may require additional charge-offs and/or increases to the allowance. At December 31, 2009 the ratio of the allowance for loans losses was increased to 1.75% of loans compared to 1.08% at December 31, 2008. The 30-89 day past due loans at December 31, 2009 were $5,173,000 compared to $1,858,000 at December 31, 2008. The increase in the 30-89 day past due loans can be attributed to a general decline in economic conditions, along with rising unemployment and diminishing real estate values, each having an impact on borrowers’ ability to make their payments in a timely fashion.

The following table sets forth the activity in the allowance for loan losses and certain key ratios for the periods indicated (dollars in thousands):

|  | 2009 | 2008 | 2007 | 2006 | 2005 |
| --- | ---: | ---: | ---: | ---: | ---: |
| Balance at beginning of period | $4,745 | $4,824 | $5,444 | $5,985 | $5,988 |
| Charge-offs: |  |  |  |  |  |
| Real estate: |  |  |  |  |  |
| Commercial | 844 | 565 | - | 31 | 463 |
| Residential | 9 | 45 | 90 | 109 | 21 |
| Commercial and industrial | 983 | 168 | 376 | 630 | 614 |
| Consumer | 433 | 351 | 256 | 285 | 288 |
| Lease financing | - | - | - | - | 8 |
| Total | 2,269 | 1,129 | 722 | 1,055 | 1,394 |
| Recoveries: |  |  |  |  |  |
| Real estate: |  |  |  |  |  |
| Commercial | 2 | 18 | 2 | 27 | 275 |
| Residential | - | - | 125 | 1 | 11 |
| Commercial and industrial | 35 | 61 | 16 | 37 | 120 |
| Consumer | 11 | 31 | 19 | 124 | 155 |
| Total | 48 | 110 | 162 | 189 | 561 |
| Net charge-offs | 2,221 | 1,019 | 560 | 866 | 833 |
| Provision (credit) for loan losses | 5,050 | 940 | (60) | 325 | 830 |
| Balance at end of period | $7,574 | $4,745 | $4,824 | $5,444 | $5,985 |
| Net charge-offs to average net loans outstanding | 0.51% | 0.24% | 0.13% | 0.21% | 0.22% |
| Allowance for loan losses to net charge-offs | 3.41 x | 4.66 x | 8.62 x | 6.29 x | 7.18 x |
| Allowance for loan losses to total loans | 1.75% | 1.08% | 1.13% | 1.29% | 1.46% |
| Loans 30 - 89 days past due and accruing | $5,173 | $1,858 | $4,698 | $2,571 | $1,609 |
| Loans 90 days or more past due and accruing | $555 | $604 | $26 | $81 | $197 |
| Non-accruing loans | $12,329 | $3,493 | $3,811 | $3,358 | $9,453 |
| Allowance for loan losses to loans 90 days or more past due and accruing | 13.65 x | 7.85 x | 189.41 x | 67.54 x | 30.39 x |
| Allowance for loan losses to non-accruing loans | 0.61 x | 1.36 x | 1.27 x | 1.62 x | 0.63 x |
| Allowance for loan losses to non-performing loans | 0.59 x | 1.16 x | 1.26 x | 1.58 x | 0.62 x |
| Average net loans | $432,642 | $416,438 | $419,586 | $412,523 | $385,800 |

25

The allowance for loan losses can generally absorb losses throughout the loan and lease portfolios. However, in some instances an allocation is made for specific loans or groups of loans. Allocation of the allowance for loan losses for different categories of loans is based on the methodology used by the Company, as previously explained. The changes in the allocations from year-to-year are based upon year-end reviews of the loan and lease portfolios.

Allocation of the allowance among major categories of loans for the past five years is summarized in the following table. This table should not be interpreted as an indication that charge-offs in future periods will occur in these amounts or proportions, or that the allocation indicates future charge-off trends. The portion of the allowance designated as unallocated is within the Company’s policy guidelines.

|  |  |  |  |  |  |
| --- | ---: | ---: | ---: | ---: | ---: |
|  | **2009%** | **2008%** | **2007%** | **2006%** | **2005%** |
| Category |  |  |  |  |  |
| Real estate: |  |  |  |  |  |
| Commercial | $4,045,046 53.3% | $1,930,511 40.7% | $1,989,267 41.2% | $2,586,967 47.5% | $2,969,168 49.6% |
| Residential | 880,401 11.6 | 710,981 15.0 | 636,899 13.2 | 578,117 10.6 | 595,092 9.9 |
| Construction | 72,105 1.0 | 67,141 1.4 | 52,634 1.1 | 59,617 1.1 | 59,953 1.0 |
| Commercial and industrial | 1,639,872 21.7 | 929,548 19.6 | 990,105 20.5 | 962,903 17.7 | 1,066,782 17.8 |
| Consumer | 840,660 11.1 | 973,356 20.5 | 960,505 19.9 | 1,157,091 21.2 | 1,180,175 19.7 |
| Direct financing leases | - - | 6,837 0.1 | 9,355 0.2 | 14,058 0.3 | 14,828 0.3 |
| Unallocated | 95,519 1.3 | 126,860 2.7 | 185,636 3.9 | 85,550 1.6 | 98,651 1.7 |
| Total | $7,573,603 100.0% | $4,745,234 100.0% | $4,824,401 100.0% | $5,444,303 100.0% | $5,984,649 100.0% |

The allocation of the allowance for the commercial loan portfolio which is comprised of commercial real estate loans and commercial and industrial loans, accounted for approximately 75%, or $5,685,000 of the total allowance for loan losses at December 31, 2009. Collateral values were prudently calculated to provide a conservative and realistic value supporting these loans. The allocations to the other categories of loans are adequate compared to the actual three-year historical net charge-offs. Approximately $793,000, or 11%, of the allowance is specifically allocated to individual impaired loans.

### Non-performing assets

The Company defines non-performing assets as accruing loans past due 90 days or more, non-accrual loans, troubled debt restructured loans (TDRs), other real estate owned (ORE), repossessed assets and non-accrual investment securities. As of December 31, 2009, non-performing assets represented 2.58% of total assets compared to 0.96% at December 31, 2008.

The following table sets forth non-performing assets at December 31 (dollars in thousands):

|  | 2009 | 2008 | 2007 | 2006 | 2005 |
| --- | ---: | ---: | ---: | ---: | ---: |
| Net loans, including loans available-for-sale | $424,345 | $436,291 | $422,252 | $417,321 | $403,573 |
| Loans past due 90 days or more and accruing | $555 | $604 | $26 | $81 | $197 |
| Non-accrual loans | 12,329 | 3,493 | 3,811 | 3,358 | 9,453 |
| Total non-performing loans | 12,884 | 4,097 | 3,837 | 3,439 | 9,650 |
| Restructured loans | - | - | - | - | - |
| Other real estate owned | 887 | 1,451 | 107 | 197 | - |
| Non-accrual securities | 583 | - | - | - | - |
| Repossessed assets | - | - | - | - | 19 |
| Total non-performing assets | $14,354 | $5,548 | $3,944 | $3,636 | $9,669 |
| Non-accrual loans to net loans | 2.91% | 0.80% | 0.90% | 0.80% | 2.34% |
| Non-performing loans to net loans | 3.04% | 0.94% | 0.91% | 0.82% | 2.39% |
| Non-performing assets to total assets | 2.58% | 0.96% | 0.67% | 0.65% | 1.78% |

26

The composition of non-performing loans as of December 31, 2009 is as follows (dollars in thousands):

| Real estate: | Gross loan balances | Past due 90 days or more and still accruing | Non- accrual loans | Total non- performing loans | % of gross loans |
| --- | ---: | ---: | ---: | ---: | ---: |
| Commercial | $186,726 | $103 | $7,382 | $7,485 | 4.01% |
| Residential | 71,001 | 387 | 3,865 | 4,253 | 5.99% |
| Construction | 10,125 | - | - | - | - |
| Commercial and industrial | 76,788 | 12 | 726 | 738 | 0.96% |
| Consumer | 85,690 | 52 | 355 | 408 | 0.48% |
| Direct financing leases | 367 | - | - | - | - |
| Total | $430,698 | $555 | $12,329 | $12,884 | 2.99% |

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 commercial loans are placed on non-accrual status when management has determined that payment of all contractual principal and interest is in doubt or the loan is past due 90 days or more as to principal and interest, unless well-secured and in the process of collection. Consumer loans secured by real estate and residential mortgage loans are placed on non-accrual status at 120 days past due as to principal and interest, and, unsecured consumer loans are charged-off when the loan is 90 days or more past due as to principal and interest. Securities are placed on non-accrual status when principal has been impaired and the receipt of cash interest has ceased. Uncollected accrued interest is reversed and charged against interest income when loans and securities are placed on non-accrual status.

The majority of the increase non-performing assets for the period is attributed to non-accruing commercial business loans, non-accruing real estate loans in the process of foreclosure and non-accruing investment securities. During the period $583,000 of corporate bonds consisting of pooled trust preferred securities were moved to non-accrual status. There were no non-accrual securities prior to 2009. For a further discussion the Company’s securities portfolio, see Note 3, “Investment Securities”, within the notes to the consolidated financial statements, and incorporated by reference in Part II, Item 8, and the section entitled, “Investments”, contained within management’s discussion and analysis. Most of the non-accruing loans are collateralized, thereby mitigating the Company’s potential for loss. In 2008, non-performing loans were $4,097,000 and $12,884,000 at year-end 2009. The increase occurred mainly in the commercial loan portfolio as several local borrowers were unable to meet their contractual repayment obligations as a result of the weakened economic conditions. Action plans for the resolution of each of the Company’s non-performing loans have been developed, monitored and are periodically updated as needed. There were no repossessed assets at December 31, 2009 or 2008. ORE at December 31, 2009 consisted of three properties which are listed for sale with realtors. ORE at year-end 2008, consisted of four properties. The non-accrual loans aggregated $12,329,000 at December 31, 2009 and were $3,493,000 at December 31, 2008. During 2009, approximately $12,492,000 of loans were placed in non-accrual status. These were partially offset by reductions or payoffs of $1,131,000, charge-offs of $1,979,000, $469,000 of transfers to ORE and $77,000 of loans that returned to performing status. Loans past due 90 days or more and accruing totaled $555,000 at December 31, 2009 compared to $604,000, at December 31, 2008. The percentage of non-performing assets to total assets was 2.58% at December 31, 2009, an increase from 0.96% at December 31, 2008, primarily due to the transfer of loans and investments to non-performing status. Non-performing loans to net loans were 3.04% at December 31, 2009, and 0.94% at December 31, 2008.

Repossessed assets consist of previously financed vehicles held-for-sale. Subsequent to the loan or lease maturity, the borrower or lessee defaulted on their contract and the Company repossessed the unit. Repossessed assets are sold through either a private or public sale and any deficiency balance from the sale of the asset is charged to the allowance for loan losses. There were no repossessed assets or troubled debt restructured loans at December 31, 2009 or December 31, 2008.

Payments received on non-accrual loans are recognized on a cash basis. Payments are first applied against the outstanding principal balance, then to the recovery of any charged-off loan amounts. Any excess is treated as a recovery of interest income. During 2009, the Company collected approximately $31,000 of interest income recognized on the cash basis. If the non-accrual loans that were outstanding as of December 31, 2009 had been performing in accordance with their original terms, the Company would have recognized interest income with respect to such loans of $365,000 for the year ended December 31, 2009.

### Bank premises and equipment, net

Net of accumulated depreciation and disposals, premises and equipment decreased $695,000. The Company purchased premises and equipment or transferred assets from construction in process, a component of other assets in the consolidated balance sheet, of approximately $908,000 in total during 2009 compared to $4,489,000 in 2008. The 2008 amount includes construction and completion of the Company’s West Scranton branch expansion project. There were no expansion projects in 2009.

### Foreclosed assets held-for-sale

#### Other Real Estate Owned

ORE was $887,000 at December 31, 2009 consisting of three properties, all of which were listed for sale with realtors. At December 31, 2008 ORE consisted of four properties at an aggregate value of $1,451,000.

### Cash surrender value of bank owned life insurance

The Company maintains bank owned life insurance (BOLI) for a chosen group of employees, namely its officers, where the Company is the owner and sole beneficiary of the policies. BOLI is classified as a non-interest earning asset. Increases in the cash surrender value are recorded as components of non-interest income. The BOLI is profitable from the appreciation of the cash surrender values of the pool of insurance and its tax-free advantage to the Company. This profitability is used to offset a portion of current and future employee benefit costs. The BOLI can be liquidated if necessary with associated tax costs. However, the Company intends to hold this pool of insurance, because it provides income that enhances the Company’s capital position. Therefore, the Company has not provided for deferred income taxes on the earnings from the increase in cash surrender value.

### Other assets

Other assets increased 61% to $14,416,000 as of December 31, 2009 from $8,930,000 at December 31, 2008. The increase was caused predominately by the recent federal mandate that banks pre-fund their three-year estimated FDIC insurance premium. The prepaid FDIC insurance premium will be released as a charge to earnings over the next three years. Contributing to the increase in other assets was additional deferred tax assets from current year impairment losses in the securities AFS portfolio. Partially offsetting these increases was a reduction in the carrying amount of the Company’s derivative contract which expired in the fourth quarter of 2009. For a further discussion on the Company’s derivative contract, see Note 12, “Fair Value of Financial Instruments and Derivatives” of the consolidated financial statements, in Part II, Item 8.

### Results of Operations

### Earnings Summary

The Company’s results of operations depend primarily on 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 determined by the Company’s interest rate spread (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 non-interest income and expenses, provision for loan losses and provision for income taxes. Non-interest income consists mostly of service charges on the Bank’s deposit and loan products, trust and asset management service fees, increases in the cash surrender value of the bank owned life insurance, net gains or losses from the sales of loans, securities and foreclosed properties held-for-sale, write-down to market value of foreclosed properties held-for-sale and from credit related other-than-temporary impairment charges from 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 where 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.

### Overview

For the year ended 2009, the Company incurred a net loss of $1,400,000, or $0.67 per diluted share, compared to net income of $3,636,000, or $1.76 per share, for the year ended December 31, 2008. For the year ended December 31, 2009, the Company’s return on average assets (ROA) and return on average shareholders’ equity (ROE) were -0.25% and -2.91% compared to 0.62% and 6.81%, respectively, for the year ended December 31, 2008. The current year included a non-operating, non-cash, after-tax charge of $2,178,000 related to other-than-temporary impairment in the Company’s security AFS portfolio compared to $288,000 for the year ended December 31, 2008. In addition, during 2009, the Company recorded a provision for loan losses in the amount of $5,050,000 compared to $940,000 in 2008. The provision for loan losses in 2009 was recorded to reinforce and fund the allowance for loan losses for heightened credit risks from a weakened economy and declining real estate values as well as an increase in the commercial real estate loan portfolio. Further contributing to the lower net income was lower net interest income of $165,000 and $1,030,000, or 6%, of higher non-interest expenses. During 2009, the Company paid off long-term debt and incurred $505,000 of prepayment interest costs which are included as a component of interest expense in the consolidated income statement for the year ended December 31, 2009. Higher FDIC insurance premiums contributed to the increase in non-interest expense in 2009 compared to 2008. The decline in ROA and ROE was caused by the decrease in net income.

### Net interest income

The following table sets forth a comparison of average balances of assets and liabilities and their related net tax equivalent yields and rates for 2009, 2008 and 2007 (dollars in thousands):

| Assets Interest earning assets | 2009 Average balance | Interest | Yield / rate | 2008 Average balance | Interest | Yield / rate | 2007 Average balance | Interest | Yield / rate |
| --- | ---: | ---: | ---: | ---: | ---: | ---: | ---: | ---: | ---: |
| **Interest-bearing deposits** | $562 | $1 | 0.10% | $233 | $3 | 1.36% | $184 | $9 | 4.81% |
| **Investments:** |  |  |  |  |  |  |  |  |  |
| Agency - GSE | 36,842 | 1,769 | 4.80 | 49,034 | 2,576 | 5.25 | 34,682 | 1,724 | 4.97 |
| MBS - GSE residential | 11,072 | 618 | 5.58 | 35,294 | 1,833 | 5.19 | 51,781 | 2,540 | 4.91 |
| State and municipal | 24,278 | 1,610 | 6.63 | 15,813 | 1,014 | 6.41 | 12,267 | 780 | 6.36 |
| Other | 25,988 | 475 | 1.83 | 25,967 | 1,252 | 4.82 | 17,487 | 1,175 | 6.72 |
| **Total investments** | 98,180 | 4,472 | 4.56 | 126,108 | 6,675 | 5.29 | 116,217 | 6,219 | 5.35 |
| **Loans:** |  |  |  |  |  |  |  |  |  |
| Commercial and CRE | 261,842 | 15,829 | 6.05 | 231,721 | 15,869 | 6.85 | 220,968 | 16,458 | 7.45 |
| Consumer | 65,916 | 4,559 | 6.92 | 71,089 | 4,872 | 6.85 | 68,395 | 4,625 | 6.76 |
| Residential real estate | 104,481 | 5,787 | 5.54 | 117,547 | 6,985 | 5.94 | 134,869 | 8,360 | 6.20 |
| Direct financing leases | 403 | 25 | 6.12 | 477 | 29 | 6.15 | 549 | 34 | 6.16 |
| **Total loans** | 432,642 | 26,200 | 6.06 | 420,834 | 27,755 | 6.60 | 424,781 | 29,477 | 6.94 |
| **Federal funds sold** | 4,603 | 11 | 0.25 | 3,342 | 91 | 2.73 | 1,948 | 103 | 5.28 |
| Total interest-earning assets | 535,987 | 30,684 | 5.72% | 550,517 | 34,524 | 6.27% | 543,130 | 35,808 | 6.59% |
| Non-interest earning assets | 29,289 |  |  | 33,301 |  |  | 32,328 |  |  |
| **Total Assets** | $565,276 |  |  | $583,818 |  |  | $575,458 |  |  |
| **Liabilities and shareholders' equity** |  |  |  |  |  |  |  |  |  |
| Interest-bearing liabilities |  |  |  |  |  |  |  |  |  |
| **Deposits:** |  |  |  |  |  |  |  |  |  |
| Savings | $53,690 | $404 | 0.75% | $38,425 | $331 | 0.86% | $41,055 | $511 | 1.24% |
| NOW | 62,090 | 197 | 0.32 | 59,130 | 616 | 1.04 | 67,489 | 1,837 | 2.72 |
| MMDA | 106,115 | 1,624 | 1.53 | 93,465 | 2,460 | 2.63 | 84,000 | 3,658 | 4.35 |
| CDs \< $100,000 | 101,286 | 3,217 | 3.18 | 98,410 | 4,052 | 4.12 | 94,420 | 4,173 | 4.42 |
| CDs \> $100,000 | 63,436 | 2,435 | 3.84 | 80,389 | 3,638 | 4.53 | 66,998 | 3,168 | 4.73 |
| Clubs | 1,687 | 19 | 1.14 | 1,764 | 21 | 1.19 | 1,908 | 23 | 1.21 |
| **Total interest-bearing deposits** | 388,304 | 7,896 | 2.03 | 371,583 | 11,118 | 2.99 | 355,870 | 13,370 | 3.76 |
| **Repurchase agreements** | 8,743 | 28 | 0.32 | 12,074 | 103 | 0.85 | 19,580 | 465 | 2.38 |
| **Borrowed funds** | 45,979 | 2,873 | 6.25 | 74,530 | 3,463 | 4.65 | 71,573 | 3,825 | 5.34 |
| Total interest-bearing liabilities | 443,026 | 10,797 | 2.44% | 458,187 | 14,684 | 3.20% | 447,023 | 17,660 | 3.95% |
| Non-interest bearing deposits | 70,285 |  |  | 67,717 |  |  | 70,606 |  |  |
| Non-interest bearing liabilities | 3,828 |  |  | 4,503 |  |  | 4,499 |  |  |
| Total liabilities | 517,139 |  |  | 530,407 |  |  | 522,128 |  |  |
| Shareholders' equity | 48,137 |  |  | 53,411 |  |  | 53,330 |  |  |
| **Total liabilities and shareholders' equity** | $565,276 |  |  | $583,818 |  |  | $575,458 |  |  |
| Net interest income |  | $19,887 |  |  | $19,840 |  |  | $18,148 |  |
| Net interest spread |  |  | 3.28% |  |  | 3.07% |  |  | 2.64% |
| Net interest margin |  |  | 3.71% |  |  | 3.60% |  |  | 3.34% |

30

In the preceding table, interest income was adjusted to a tax-equivalent basis, using the corporate federal tax rate of 34%, to recognize the income from tax-exempt interest-earning assets as if the interest was taxable. This treatment allows a uniform comparison between yields on interest-earning assets. Loans include loans AFS and non-accrual loans but exclude the allowance for loan losses. Securities include non-accrual securities. Average balances are based on amortized cost and do not reflect net unrealized gains or losses. Net interest margin is calculated by dividing net interest income by total average interest-earning assets.

Changes in net interest income are a function of both changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities. The following table presents the extent to which changes in interest rates and changes in volumes of interest-earning assets and interest-bearing liabilities have affected the Company’s interest income and interest expense during the periods indicated. Information is provided in each category with respect to (1) the changes attributable to changes in volume (changes in volume multiplied by the prior period rate), (2) the changes attributable to changes in interest rates (changes in rates multiplied by prior period volume) and (3) the net change. The combined effect of changes in both volume and rate has been allocated proportionately to the change due to volume and the change due to rate. Tax-exempt income was not converted to a tax-equivalent basis on the rate/volume analysis (dollars in thousands):

| Interest income: Loans and leases: | Years ended December 31, 2009 compared to 2008 Increase (decrease) due to Volume | Rate | Total | 2008 compared to 2007 Volume | Rate | Total |
| --- | ---: | ---: | ---: | ---: | ---: | ---: |
| Residential real estate | $(744) | $(454) | $(1,198) | $(1,040) | $(336) | $(1,376) |
| Commercial and CRE | 1,912 | (1,992) | (80) | 766 | (1,305) | (539) |
| Consumer | (362) | 45 | (317) | 178 | 66 | 244 |
| Total loans and leases | 806 | (2,401) | (1,595) | (96) | (1,575) | (1,671) |
| Investment securities, interest-bearing deposits and Federal funds sold | (1,159) | (1,298) | (2,457) | 564 | (211) | 353 |
| Total interest income | (353) | (3,699) | (4,052) | 468 | (1,786) | (1,318) |
| Interest expense: |  |  |  |  |  |  |
| Deposits: |  |  |  |  |  |  |
| Certificates of deposit greater than $100,000 | (700) | (503) | (1,203) | 611 | (141) | 470 |
| Other | 790 | (2,809) | (2,019) | 81 | (2,803) | (2,722) |
| Total deposits | 90 | (3,312) | (3,222) | 692 | (2,944) | (2,252) |
| Other interest-bearing liabilities | (1,525) | 860 | (665) | (206) | (518) | (724) |
| Total interest expense | (1,435) | (2,452) | (3,887) | 486 | (3,462) | (2,976) |
| Net interest income | $1,082 | $(1,247) | $(165) | $(18) | $1,676 | $1,658 |

The interest rate yield curve remained positively sloped in 2009, but at unprecedented low levels. The FOMC has not adjusted the short-term federal funds rate which has remained near zero percent during 2009. Similarly, at 3.25%, the national prime interest rate remained constant throughout 2009. National prime is a benchmark rate banks use to set rates on various lending and other interest-sensitive products. Operating in a very low interest rate environment will continue to present challenges in the coming year for all banks. In today’s markets, funding longer-termed assets with shorter-termed liabilities solely for higher spread is not a prudent means of managing interest rate risk as this strategy is detrimental to future earnings when rates begin to rise and asset duration lengthens. Therefore, operating in this low interest rate environment will continue to suppress significant asset growth.

While national prime has remained at 3.25% throughout 2009, the weighted-average national prime rate decreased 184 basis points, from 5.09%, in 2008. The effect of this decrease has been to exert extreme downward pressure on yields of the Company’s interest-earning assets. With rate-cutting beginning in January 2008, this pressure existed with increasing momentum throughout 2009. The Company was able to more than offset this pressure by periodically adjusting rates on its interest-bearing deposits. In response to the swift downward shift in rates, the Company’s asset / liability committee assessed, among other things, the impact the interest rate movements have had on its earning assets. Where necessary, rate adjustments to interest-bearing deposits and repurchase agreements were implemented and high-costing long-term wholesale funding sources were paid off, all of which helped minimize the effect rate changes have had on net interest income. The committee meets frequently and has successfully implemented rate setting strategies to help mitigate the interest rate risk inherent in the balance sheet and has been able to preserve its net interest margin to acceptable levels.

As market rates fell along with national prime, loan originations, renewing commercial and residential loans and lines of credit continued to price below the average 2009 portfolio yields. In addition, the decrease in the Treasury yields and other capital market rates, which largely began during the second half of 2008, has had and could continue to have an unfavorable impact on the Company’s total 2009 and 2010 investment portfolio yield. The relative and predominantly lower interest rate environment of 2008 and 2009 had a negative impact on the Company’s interest-earning assets. Total interest income declined 12%, or $4,052,000 from $33,961,000 in 2008 to $29,909,000 in 2009 and further caused the tax-equivalent yield on earning assets to decrease 55 basis points. The Company should continue to experience a period of sliding yields on its interest-earning assets during 2010, in what has become a sustained low interest rate environment.

Interest expense decreased $3,887,000, or 26%, from $14,684,000 in 2008 to $10,797,000 in 2009. The lower interest rate environment that has dominated the economy over the last two years required the Company to periodically reduce offering rates on both its deposit and repurchase agreement products. Though the Company recorded a net increase in average interest-bearing deposits, interest expense on deposits declined by $3,223,000 in 2009 compared to 2008 caused by a 96 basis point decline on rates paid. The effect of the $16,721,000 net increase in average interest-bearing deposits was an additional $90,000 in interest expense. In an effort to maintain reasonable interest rate spreads to its earning-assets, the Company’s asset / liability committee reduced rates paid on CDs as well as rates paid on transactional deposits. In today’s environment, rates on CD’s should naturally price lower as they mature. Whether or not the Company can continue to reduce rates on deposits that are currently priced at unprecedented low levels, to maintain its interest rate spread will be predicated on the interest rate environment, liquidity position and competition. Interest expense on borrowings, including repurchase agreements, declined $665,000 during 2009, mostly from the $31,882,000 decline in average balances. During 2009, the Company paid off $10,000,000 of high-costing long-term debt and incurred $505,000 of prepayment interest costs that are included as a component of interest expense in the consolidated statement of income for the year ended December 31, 2009.

The resulting performance that the mix of the Company’s interest-sensitive assets and liabilities and the varying effects the severity of the yield curve slope has had during 2009, combined with the early pay off of high-costing long-term debt, caused net interest income to decrease $165,000, or 1%, from $19,277,000 in 2008 to $19,112,000 in 2009. On a tax-equivalent basis, the net interest rate spread increased 21 basis points from 3.07% to 3.28% and the tax-equivalent margin improved 11 basis points, from 3.60% in 2008 to 3.71% in 2009, respectively.

### 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. Management continuously reviews the risks inherent in the loan and lease portfolio. Loans and leases determined to be uncollectible are charged-off against the allowance for loan losses. The required amount of the provision for loan losses, based upon the adequate level of the allowance for loan losses, is subject to ongoing analysis of the loan portfolio. The 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.

Provisions for loan losses of $5,050,000 were made for the year ended December 31, 2009. In 2008, provisions of $940,000 were made. The $5,050,000 provision for loan losses was recorded due to credit quality deterioration ensuing from the declines in economic conditions during 2009. This increase in the provision compared to 2008 was due to the increased levels of credit downgrades, net charge-offs, and an increase in the level of non-performing loans. A portion was also allocated to safeguard against possible future losses due to weaker economic conditions.

### Other income

For the year ended December 31, 2009, total other income was $2,417,000, or 53%, less than the $4,578,000 recorded during the year ended December 31, 2008. In 2009, a non-cash other-than-temporary impairment (OTTI) charge of $3,300,000 was recorded compared to $436,000 recorded for the year ended December 31, 2008. For both years, the OTTI charges were related to the Company’s investment in pooled trust preferred securities. The carrying values of these securities were written down to their fair values as management has deemed the impairment to be other-than-temporary. For a further discussion on the Company’s investment in pooled trust preferred securities see Note 3, “Investment Securities”, within the notes to the consolidated financial statements, and incorporated by reference in Part II, Item 8, and the section entitled, “Investments”, contained within management’s discussion and analysis. Service charges on deposit related accounts declined $271,000, or 9%, in 2009 compared to 2008. This decline was the result of lower volumes of overdraft transactions. Further contributing to the decline in other income in 2009, the Company wrote down to fair value, the carrying amount of its investment in two foreclosed assets held-for-sale by a total of $178,000. There were no similar write-downs in 2008. The assets represent two commercial real estate properties acquired in foreclosure during 2008. The current year subsequent write-downs were based on sales indications received by the Company that were less than the carrying value of the properties. Partially offsetting these declines in other income were increased gains from mortgage banking services which increased by $799,000 in the year-over-year comparison and higher levels of loan and financial services fee income.

### Other expenses

For the year ended December 31, 2009, other operating expenses grew $1,030,000, or 6%, from $18,211,000 for the year ended December 31, 2008 to $19,241,000 for the 2009 year. The higher operating expenses include a $1,046,000 increase in FDIC insurance premiums, or nearly nine times the 2008 assessment. With the requirement for the FDIC to shore up the insurance reserve, the Company expects to continue to incur relatively high FDIC insurance premiums over the next several years. In conjunction with the Company’s branch expansion project in 2008, depreciation on premises and equipment increased $305,000, or 6%, from a full year of expense. Partially offsetting the increased FDIC premiums and branch expansion related expenses were lower employee salary and benefit costs and less expenses from advertising. The reduced salary and benefits is from fewer full-time equivalent employees in 2009 compared to 2008. The decline in advertising was due to expansion projects and the related promotion costs consummated in 2008 that did not recur in 2009. Other expenses also increased by higher collection and ORE expenses associated with more legal, maintenance and other costs associated with the property foreclosure process.

The ratios of non-interest expense less non-interest income to average assets (expense ratio) at December 31, 2009 and 2008 were 2.37% and 2.25%, respectively. The overhead expense ratio, which excludes OTTI and gains from securities sales, drifted upward due mostly to lower average assets and to a lesser extent, higher net non-interest expenses.

As the Company enters 2010, management expects certain expenses to rise above or remain at above-normal, inflationary-only prone increases. In 2009, the Company’s FDIC costs, grew nearly nine times the 2008 level. In 2010, the Company will continue to experience high premiums and does not expect these coverage costs to recede in the near future. In addition, the deterioration of real estate values, a lackluster environment for commercial business expansion and the potential for contraction of existing businesses and those whose operations have been negatively affected by the current economic climate, could result in additional legal costs associated with collection efforts as well as higher maintenance costs for existing and potentially more properties acquired in foreclosure. The management team of the Company is poised to minimize losses and expenses associated with these activities, however there is no assurance that such activity will not occur.

### Provision for income taxes

The Company’s pre tax loss in 2009 compared to pretax income in 2008 was the cause of a credit for income taxes in 2009 compared to a provision for income taxes in 2008.

### Comparison of Financial Condition as of December 31, 2008

### and 2007 and Results of Operations for each of the Years then Ended

### Financial Condition

### Overview

Consolidated assets decreased $11,694,000, or 2%, during the year ended December 31, 2008 to $575,719,000. The decline was the result of decreases in total borrowings of $12,235,000, or 12%, and a decrease in total shareholders’ equity of $6,231,000 partially offset by a 2%, or $7,604,000 increase in deposits. The decline in shareholders’ equity was primarily from increased unrealized net losses in the securities AFS portfolio, the declaration of cash dividends and the repurchase of the Company’s capital stock (treasury stock). During 2008, the carrying amount of the investment portfolios declined by $38,797,000, or 32%, while the loan portfolios increased $14,040,000, or 3% to $436,291,000 as of December 31, 2008. Other increases included premises and equipment, the net deferred tax asset, bank owned life insurance, FHLB stock, the carrying value of the derivative contract and prepaid expenses. Cash increased $2,362,000 since 2007.

### Deposits

Total deposits increased $7,604,000, or 2%, during 2008 to $433,312,000. The growth in deposits was mostly from increases in money markets of $8,846,000 and DDAs of $6,647,000, or 10% each, partially offset by declines in NOW and certificates of deposit accounts of $4,571,000 and $4,519,000, respectively. The majority of the increase in DDAs was from a temporary deposit from a corporate trust account which had since been withdrawn. The West Scranton branch office, that had opened during the third quarter of 2008 and the related bank-wide promotions, superior customer service, increased deposit business from our existing and new commercial customers all contributed to the net increase in deposits. The continued increases in money market accounts that the Company had experienced were from success in our deposit-gathering strategies in conjunction with promotional interest rates tailored to depositors’ needs. We attributed the decline in certificate of deposit accounts to the lower and highly volatile interest rate environment that existed at December 31, 2008 when compared to the prior year.

### Short-term borrowings

During 2008, repurchase agreements declined to $9,092,000 from $20,504,000 at December 31, 2007. At December 31, 2008 and 2007, sweep accounts represented 93% and 62%, respectively, of total repurchase agreements. The low interest rate environment had caused our customers to seek higher rates in alternative products and as such the balances in the term-repurchase agreements declined by about 91%.

### Long-term debt

The weighted-average rate in effect on funds borrowed at December 31, 2008, was 5.35% compared to 5.26% as of December 31, 2007. The 2008 weighted-average rate was 92 basis points below the tax-equivalent yield of 6.27% on the Company’s portfolio of average interest-earning assets for the year ended December 31, 2008. Rates on $42,000,000 of the total long-term advances were fixed but would adjust quarterly had market rates increased beyond the issues’ original or strike rates. Significant prepayment penalties are attached to the borrowings which thereby created a significant disincentive from paying off the relatively high cost advances. However, in the event that the underlying market rates drifted above the rates that were paid on these borrowings, the FHLB rate would have converted to a floating rate and the Company would have had the option, at that time, to repay or to renegotiate the converted advance rate. During December 2008, a $10,000,000 capped floating-rate long-term advance was paid off early.

### Investments

As of December 31, 2008 and December 31, 2007, the aggregate fair value of securities HTM exceeded their respective aggregate amortized cost by $31,000 and $33,000, respectively. Total investments decreased $38,797,000 in 2008, including an $11,893,000 decline in the market value of AFS investments. During 2008, the Company sold approximately $48.4 million of MBS – GSE residential and Agency – GSE securities, the proceeds of which were used to pay-down long-term debt, fund loan growth and fund the expansion of the Company’s branch network. The carrying value of investment securities, at December 31, 2008, was $84,188,000, or 15% of total assets compared to $122,984,000, or 21%, as of December 31, 2007.

The tax-equivalent yield on debt securities by stated maturity date at December 31, 2008, was as follows:

|  | One year or less | One through five years | Five through ten years | More than ten years | Total |
| --- | ---: | ---: | ---: | ---: | ---: |
| Agency - GSE | -% | -% | 5.07% | 5.87% | 5.74% |
| MBS - GSE residential | - | - | 6.01 | 5.44 | 5.45 |
| State & municipal subdivisions | - | - | 5.47 | 5.90 | 5.83 |
| Pooled trust preferred securities | - | - | - | 4.00 | 4.00 |
| Total debt securities | -% | -% | 5.21% | 5.35% | 5.34% |

### Loans and leases

Gross loans and leases increased $14,704,000, or 3%, from $426,249,000 at December 31, 2007, to $440,953,000 at December 31, 2008. Gross loans represented 77% and 73% of total assets at December 31, 2008 and December 31, 2007, respectively.

In 2008, the Company originated $47,864,000 of commercial loans, $23,111,000 of residential mortgage loans and $21,354,000 of consumer loans. This compares to $32,919,000, $24,032,000 and $28,062,000, respectively, in 2007. Included in mortgage loans is $9,476,000 of real estate construction lines in 2008 and $12,515,000 in 2007. In addition for 2008, the Company originated lines of credit in the amounts of $50,664,000 for commercial borrowers and $11,866,000 in home equity and other consumer lines of credit.

The Company’s origination activity increased 9% in 2008 over 2007 despite operating in a very difficult economy. Only the residential real estate portfolio recorded a decline compared to 2007 which was more than offset by growth in commercial lending. A new senior lender was hired which enabled the Company to grow its commercial and CRE portfolio.

#### Commercial and Commercial Real Estate Loans:

Originations in commercial and commercial real estate were relatively strong, as they fully exceeded scheduled principal curtailments and pre-payments, which thereby resulted in a commercial loan increase of $29,422,000 to $245,480,000 from $216,058,000, or 14% during 2008. During most of 2008, the Company bolstered the origination activities in the commercial loan business. Commercial lending successfully restructured its team of commercial loan officers led by the experienced newly hired senior lender. This team had effectively penetrated our markets and successfully developed new business relationships and re-kindled relationships with our existing commercial customer base.

*Residential Real Estate Loans:*

Residential real estate loans declined $18,468,000, or 16%, to $98,511,000 in 2008. In the beginning of 2008, the Company transferred approximately $28,103,000 to the loans AFS portfolio. The loans were subsequently sold. Excluding this transfer, the residential real estate loan portfolio would have grown $6,900,000 as origination activity exceeded maturities and pay-downs.

#### Consumer Loans:

Though consumer loan originations were lower in 2008 compared to 2007, this sector increased $3,093,000, or 4%, during the year. The increase was mainly from lower principal pay-downs and increased draw activity from customers who accessed their home equity available credit. During 2008, the Company established a new relationship with a local automobile dealership which provided increased origination activity in consumer lending.

#### Real Estate Construction Loans:

Real estate construction loans increased $724,000, or 7%, at December 31, 2008 compared to December 31, 2007. The increase in 2008 was caused by more commercial construction projects that had not yet converted to permanent financing.

### Loans available-for-sale

Loans AFS at December 31, 2008 were $84,000 with a corresponding fair value of $85,000 compared to $827,000 and $843,000, respectively, at December 31, 2007. During 2008, residential mortgages with principal balances of $46,969,000 were sold into the secondary market and recognized net gains of approximately $261,000. Included in the sale were $28,103,000 of residential loans transferred from the loan and lease portfolio.

At December 31, 2008 and 2007, the servicing portfolio balance of sold residential mortgage loans was $95,856,000 and $61,023,000, respectively.

### Allowance for loan losses

Total charge-offs, net of recoveries, for the year ended December 31, 2008, were $1,019,000, compared to $560,000 in 2007. The majority of the increase occurred in the commercial portfolio and was attributable to non-performing loan dispositions and write-downs before transfers to ORE. Combined consumer loan and lease financing net charge-offs increased from $237,000 at December 31, 2007 to $320,000 through December 31, 2008. Commercial loan net charge-offs were $358,000 for the year 2007 compared to $654,000 for 2008. Mortgage loans showed net charge-offs of $45,000 in 2008 compared to net recoveries of $35,000 in 2007.

### Non-performing assets

The majority of non-performing assets for the period were attributed to non-accruing commercial business loans and non-accruing real estate loans in the process of foreclosure. Most of these loans were collateralized, thereby mitigating the Company’s potential for loss. In 2007, non-performing loans were $3,837,000 compared to $4,097,000 at year-end 2008. There were no repossessed assets at December 31, 2008 or 2007. ORE at December 31, 2008 consisted of four properties of which one had an agreement to sell pending at that time. ORE at year-end 2007 consisted of one property which was subsequently sold. The Special Assets Committee had developed specific action plans for each of the Company’s non-performing loans. During 2008, several of those plans were brought to a conclusion resulting in repayments of non-performing loans. The non-accrual loans aggregated $3,493,000 at December 31, 2008, a reduction of $318,000 from year-end 2007. During 2008, approximately $4,946,000 of loans were placed in non-accrual status. These were partially offset by reductions or payoffs of $2,426,000, charge-offs of $916,000, $1,562,000 of transfers to ORE and $360,000 of loans that returned to performing status. Loans past due 90 days or more and accruing totaled $604,000 at December 31, 2008 compared to $26,000, at December 31, 2007. The majority of the increase was attributable to one residential mortgage migrating to the over 90 day category. Non-accrual loans were reduced by 8% to $3,493,000. The ORE balance rose from $107,000 to $1,450,000. This sizeable increase was a result of the collections process as the collateral securing non-accruing loans was taken in the foreclosure process. These three items comprise the non-performing assets of $5,548,000 at December 31, 2008. The percentage of non-performing assets to total assets was 0.96% at December 31, 2008, an increase from 0.67% at December 31, 2007, primarily due to the aforementioned ORE increase. Non-performing loans to net loans were 0.94% at December 31, 2008, and 0.91% at December 31, 2007. The 30-89 day past due loans at December 31, 2008 were $1,858,000 reduced from $4,698,000 at December 31, 2007. Contributing to the reduction was the repayment of previously delinquent loans and others which had been brought current.

During 2008, the Company collected approximately $311,000 of interest income recognized on the cash basis. If the non-accrual loans that were outstanding as of December 31, 2008 had been performing in accordance with their original terms, the Company would have recognized interest income with respect to such loans of $250,000 for the year ended December 31, 2008.

### Bank premises and equipment, net

Net of accumulated depreciation and disposals, premises and equipment increased $3,091,000. During 2008, the Company purchased or transferred from construction in process approximately $4,489,000 compared to $3,293,000 in 2007. The increase was principally from the construction and completion of the Company’s West Scranton branch expansion project.

### Foreclosed assets held-for-sale

#### Other real estate owned

ORE was $1,451,000 at December 31, 2008 consisting of four properties, one of which was under an agreement to be sold. The three remaining properties were listed for sale with a realtor. The one residential property which was owned at year end 2007 was sold.

### Other assets

Other assets more than doubled in 2008 to $8,930,000 compared to 2007. The increase was caused predominately by the increase in the net deferred tax asset of $4,046,000 as a result of additional unrealized losses in the securities AFS portfolio. Also contributing to the increase in other assets was an increase in the fair value of the Company’s derivative contract.

### Results of Operations

### Earnings Summary

Net income for the year ended December 31, 2008 was $3,636,000, compared to $4,612,000 for the year ended December 31, 2007. During the same periods, diluted earnings per common share was $1.76 and $2.23, respectively. For the year ended December 31, 2008, the Company’s return on average assets (ROA) and return on average shareholders’ equity (ROE) were 0.62% and 6.81% compared to 0.80% and 8.65%, respectively, for the year ended December 31, 2007. 2008 included a non-operating, non-cash, after-tax charge of $288,000 related to an other-than-temporary impairment (OTTI) in the Company’s security AFS portfolio that did not occur in 2007. In addition, during 2008, the Company recorded a provision for loan losses in the amount of $940,000 compared to a credit for loan losses of $60,000 in 2007. The provision for loan losses in 2008 was recorded in anticipation of credit quality deterioration ensuing from accelerated declines in economic conditions during the fourth quarter of 2008, in addition to growth in the commercial loan portfolio. Further contributing to the lower net income were lower non-interest interest income and higher non-interest expenses. These items were partially offset by an improvement in net interest income of $1,658,000, or 9%, to $19,277,000 in 2008 compared to $17,619,000 in 2007. The decline in ROA and ROE was caused by the decrease in net income.

### Net interest income

The slope of the yield curve returned to a more normal, positive slope in 2008 compared to 2007, but at unprecedented low levels. In several efforts to stimulate a recessing economy, the FOMC reduced short-term interest rates seven times during 2008, in intervals ranging from 25 to 75 basis points, sometimes occurring twice in a single month. In response to these actions, the national prime rate also decreased during 2008. National prime, the benchmark rate banks use to set rates on various lending and other interest sensitive products, decreased seven times for a total decrease of 400 basis points from 7.25% at December 31, 2007 to 3.25% at December 31, 2008.

While national prime decreased 400 basis points, the weighted-average national prime rate decreased to 5.09% in 2008 compared to 8.05% in 2007. The effect of this average decrease was to exert extreme downward pressure on yields of the Company’s interest-earning assets. With rate cutting beginning in January 2008, this pressure existed with increasing momentum throughout all of 2008. The Company was able to more than offset this pressure by periodically adjusting rates on its interest-bearing deposits. Where necessary, rate adjustments to interest-bearing deposit and repurchase agreements were implemented and wholesale funding sources were utilized, all of which helped minimize the effect rate changes had on net interest income. The Company’s ALM committee met frequently and successfully implemented rate setting strategies to mitigate the interest rate risk inherent in the balance sheet and was able to preserve its net interest margin while always mindful of our customers’ needs.

As expected the relative and predominantly lower interest rate environment of 2008 continued to have a negative impact on the Company’s interest-earning assets. Total interest income declined 4%, or $1,318,000 from $35,279,000 in 2007 to $33,961,000 in 2008 and further caused the tax-equivalent yield on earning assets to decrease 32 basis points. Interest expense decreased $2,976,000, or 17%, from $17,660,000 in 2007 to $14,684,000 in 2008. Though the Company recorded a net increase in average interest-bearing liabilities, due to deposit growth, interest expense on deposits declined by almost $3,000,000 in 2008 compared to 2007 caused by a 77 basis point decline on rates paid. The effect of the $15,713,000 increase in average interest-bearing deposits was an additional $692,000 in interest expense. In an effort to maintain reasonable interest rate spreads to its earning-assets, throughout 2008 the Company’s asset / liability committee has reduced rates paid on CDs as well as rates paid on transactional deposits. Interest expense on borrowings, including repurchase agreements, declined $724,000 during 2008, mostly from lower rates.

As a result of the mix of the Company’s interest-sensitive assets and liabilities and the varying effects the severity of the yield curve slope had during 2008, net interest income increased $1,658,000, or 9%, from $17,619,000 in 2007 to $19,277,000 in 2008. On a tax-equivalent basis, the net interest rate spread increased 43 basis points from 2.64% to 3.07% and the tax-equivalent margin improved 26 basis points, from 3.34% in 2007 to 3.60% in 2008, respectively. The improvement in spread and margin were due largely to lower rates paid on interest-bearing liabilities and more net interest income.

### Provision for loan losses

Provisions for loan losses of $940,000 were made for the year ended December 31, 2008. In 2007, the Company did not need to make provisions and reduced the allowance for loan losses due to a reduced level of internally criticized and classified loans. The $940,000 provision for loan losses was recorded for anticipated credit quality deterioration, ensuing from accelerated declines in economic conditions during the fourth quarter of 2008, together with providing for over $30 million of commercial loan growth throughout 2008. The provision increase occurred to reinforce and fund the allowance for loan losses balance as of December 31, 2008 to safeguard against possible future losses. The allowance for loan losses was $4,745,000 at December 31, 2008, and was $4,824,000 at December 31, 2007.

### Other income

For the year ended December 31, 2008, total other income was $4,578,000, $627,000, or 12% less than the $5,205,000 recorded during the year ended December 31, 2007. In 2008, a non-cash OTTI charge of $436,000 was recorded. There was no similar charge in 2007. The OTTI charge was related to the Company’s investment in a pooled preferred term security and a common stock equity position in FNMA. The carrying values of these securities were written down to their fair values during the third and fourth quarters of 2008 as management had deemed the impairment to be other-than-temporary. Service charges on deposit related accounts declined $106,000, or 4%, in 2008 compared to 2007. Most of this decline was the result of lower volumes of overdraft transactions. During 2008, the Company recorded net losses from the disposal of premises and equipment of $36,000 compared to net gains of $98,000 recorded in 2007, or an adverse impact of approximately $134,000. The loss in 2008 was from the disposal of unused, obsolete capital equipment while in 2007 gains included the sales of two commercial facilities previously leased to non-related third parties. Further contributing to the non-interest income decline in 2008 were the gains recorded from the sale of foreclosed properties in 2007 of $144,000 compared to $43,000 in 2008. Partially offsetting these adverse changes in non-interest income were: $101,000 more gains from the sales of residential mortgages into the secondary market; fees earned from the Company’s trust services business and an increase in the cash surrender value of BOLI.

### Other expense

For the year ended December 31, 2008, other operating expenses grew $1,574,000, or 9%, from $16,637,000 for the year ended December 31, 2007. Merit and performance-based incentive increases, branch expansion and the related employee benefits, health care, and wider participation in the Company’s 401(k) plan caused salaries and employee benefit costs to rise $1,164,000, or 13%, for the twelve months ended December 31, 2008 compared to the same period in 2007. Occupancy related expenses, a component of premises and equipment, increased $95,000, or 3%, due to a full year of depreciation and amortization on the Green Ridge branch relocation and the 2008 opening of the West Scranton branch. Branch expansion activities also included more advertising and marketing, up $33,000, or 5%, and other increased overhead including: office supplies, postage, data processing and FDIC premiums. Other expenses were also increased by higher collection and ORE expenses associated with more legal and foreclosure costs.

The ratios of non-interest expense less non-interest income to average assets (expense ratio) at December 31, 2008 and 2007 were 2.25% and 2.01%, respectively. The overhead expense ratio of the Company drifted upward due to higher non-interest expenses.

### Provision for income taxes

Income before provision for income taxes in 2008 decreased $1,543,000 from 2007. The effective federal income tax rate was 22.7% and 26.2% for the years ending December 31, 2008 and 2007, respectively. The decrease in the effective tax rate is attributable to the decrease in pre-tax income.

### Off-Balance Sheet Arrangements and Contractual Obligations

The Company is a party to financial instruments with off-balance sheet risk in the normal course of business in order to meet the financing needs of its customers and in connection with the overall interest rate management strategy. These instruments involve, to a varying degree, elements of credit, interest rate and liquidity risk. In accordance with GAAP, these instruments are either not recorded in the consolidated financial statements or are recorded in amounts that differ from the notional amounts. Such instruments primarily include lending commitments, lease obligations and derivative instruments. For a further discussion on the Company’s derivative instrument, see Note 1, “Nature of Operations and Summary of Significant Accounting Policies”, and Note 12, “Fair Value of Financial Instruments and Derivatives”, contained within the notes to consolidated financial statements in Part II, Item 8.

Lending commitments include commitments to originate loans and commitments to fund unused lines of credit. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.

In addition to lending commitments, the Company has contractual obligations related to operating lease commitments. Operating lease commitments are obligations under various non-cancelable operating leases on buildings and land used for office space and banking purposes.

The following table presents, as of December 31, 2009, the Company’s significant determinable contractual obligations and significant commitments by payment date. The payment amounts represent those amounts contractually due to the recipient, excluding interest (dollars in thousands):

| Contractual obligations: | One year or less | Over one year through three years | Over three years through five years | Over five years | Total |
| --- | ---: | ---: | ---: | ---: | ---: |
| Certificates of deposit \* | $81,854 | $54,794 | $10,015 | $1,587 | $148,250 |
| Long-term debt | 11,000 | 5,000 | - | 16,000 | 32,000 |
| Repurchase agreements | 7,747 | - | - | - | 7,747 |
| Operating leases | 357 | 695 | 670 | 3,493 | 5,215 |
| Significant commitments: |  |  |  |  |  |
| Letters of credit | 2,169 | 6,105 | - | 772 | 9,046 |
| Loan commitments \*\* | 17,652 | - | - | - | 17,652 |
| Total | $120,779 | $66,594 | $10,685 | $21,852 | $219,910 |

\* Includes certificates in the CDARS program.

\*\* Available credit to borrowers in the amount of $61,713 is excluded from the above table since, by its nature, the borrowers may not have the need for additional funding, and, therefore, the credit may or may not be disbursed by the Company.

### Related Party Transactions

Information with respect to related parties is contained in Note 15, “Related Party Transactions”, within the notes to the consolidated financial statements, and incorporated by reference in Part II, Item 8.

### Impact of Accounting Standards and Interpretations

Information with respect to the impact of accounting standards is contained in Note 18, “Recent Accounting Pronouncements”, within the notes to the consolidated financial statements, and incorporated by reference in Part II, Item 8.

### Impact of Inflation and Changing Prices

The consolidated financial statements and notes thereto presented herein have been prepared in accordance with GAAP, which requires the measurement of the Company’s financial condition and results of operations in terms of historical dollars without considering the changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of our operations. Unlike industrial businesses, most all of the Company’s assets and liabilities are monetary in nature. As a result, interest rates have a greater impact on our performance than do the effects of general levels of inflation as interest rates do not necessarily move in the same direction or, to the same extent, as the price of goods and services.

### Capital Resources

The Company is 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 financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company must meet specific capital guidelines that involve quantitative measures of the Company’s assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk-weightings and other factors.

Under these guidelines, assets and certain off-balance sheet items are assigned to broad risk categories, each with prescribed risk weightings. The appropriate risk-weighting, pursuant to regulatory guidelines, required an increase in the weights applied to securities that are rated below investment grade, thereby inflating the total risk-weighted assets. The resulting capital ratios represent capital as a percentage of total risk-weighted assets and certain off-balance sheet items. 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%. Additional information with respect to capital requirements is contained in Note 14, “Regulatory Matters”, within the notes to the consolidated financial statements, and incorporated by reference in Part II, Item 8.

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 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.

In January 2010, the DRP was amended to authorize and issue not more than 300,000 shares of common stock of the Company. The DRP provides shareholders with a convenient and economical method of investing cash dividends payable upon the common stock and the opportunity to make voluntary optional cash payments to purchase additional shares of the Company’s common stock. Participants pay no brokerage commissions or service charges when they acquire additional shares of common stock through the DRP. In addition, until further notice and action of the Company’s Board of Directors, shareholders who participate in the DRP may use their cash dividends and optional cash payments to purchase additional shares of stock directly from the Company at 90% of the fair market value of the common stock on the investment date. To the extent that additional shares are purchased directly from the Company under the DRP, the Company will receive additional funds for its general corporate purposes. Post-Effective Amendment No. 1 to Form S-3, Registration Statement No. 333-152806 was filed with the SEC on January 25, 2010.

During the year-ended December 31, 2009, total shareholders' equity decreased $3,240,000, or 9%, due principally from the recorded net loss, the declaration of cash dividends and the expiration of the Company’s cash flow hedge and the related adjustment for its remaining intrinsic value. Conversely, shareholders’ equity was enhanced by stock issued from the Company’s Employee Stock Purchase and Dividend Reinvestment Plans. The Company’s primary source (use) of capital during the previous five years has been from the retention of equity in undistributed earnings of the Bank, as reflected below:

|  | Net (loss) income | Cash dividends declared | Earnings retained |
| --- | ---: | ---: | ---: |
| 2009 | $(1,400,205) | $2,078,171 | $(3,478,376) |
| 2008 | 3,635,948 | 2,068,680 | 1,567,268 |
| 2007 | 4,611,572 | 1,921,533 | 2,690,039 |
| 2006 | 4,125,283 | 1,801,361 | 2,323,922 |
| 2005 | 4,591,697 | 1,624,263 | 2,967,434 |

39

As of December 31, 2009, the Company reported a net unrealized loss of $9,194,000, net of tax, from the securities AFS portfolio including $6,126,000 of non-credit related OTTI recorded in 2009 compared to a net unrealized loss of $8,831,000 as of December 31, 2008. Other than the Company’s investment in corporate bonds consisting of pooled trust preferred securities, the unrealized loss position has improved from December 31, 2008. However, the prolonged economic slump 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. Nonetheless, there is no assurance that future unrealized losses will not be recognized on the Company’s portfolio of investment securities. Additional information with respect to the investment portfolio and a discussion on the related decline in fair value, is contained in Note 3, “Investment Securities”, within the notes to the consolidated financial statements, and incorporated by reference in Part II, Item 8, and the section entitled, “Investments”, in management’s discussion and analysis.

### Liquidity

Liquidity management ensures that adequate funds will be available to meet customers’ needs for borrowings, deposit withdrawals and maturities and normal operating expenses of the Company. Current sources of liquidity are cash and cash equivalents, asset maturities and pay-downs within one year, loans and investments AFS, growth of core deposits, growth of repurchase agreements, increases of other borrowed funds from correspondent banks and issuance of capital stock. Although regularly scheduled investment and loan payments are a dependable source 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 interest rate environment. During a declining interest rate environment, 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, prepayments from interest-sensitive assets tend to decelerate causing cash flow from mortgage loans and the MBS – GSE residential securities portfolio to decrease. Rising interest rates may also cause deposit inflow to 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.

During the year ended December 31, 2009, the Company used approximately $4.4 million of cash. During this period, the Company’s operations provided approximately $11.8 million, primarily from the sales of mortgages AFS net of originations. Included in the sales were approximately $10.8 million of residential mortgage loans that were transferred to the loan AFS portfolio. Cash provided by investing activities was generated from the sales of securities and ORE properties. The combined $12.7 million generated from operations and financing along with deposit growth from financing activities was used to pay cash dividends, reduce overnight borrowings and de-leverage the balance sheet by the pay down and non-renewal of long-term debt.

As of December 31, 2009, the Company maintained $8,328,000 in cash and cash equivalents and $77,043,000 of investments and loans AFS. In addition, as of December 31, 2009, the Company had approximately $138,346,000 available to borrow from the FHLB, $30,000,000 available from other correspondent banks and $960,000 from the Discount Window of the Federal Reserve Bank. This combined total of $254,677,000 represented 46% of total assets at December 31, 2009. Management believes this level of liquidity to be strong and adequate to support current operations. Included in the $30,000,000 availability from correspondent banks is $20,000,000 from one bank whose credit facility expired on January 1, 2010. The correspondent bank provides liquidity to the Company in the form of short-term overnight borrowings. In February 2010, the Company renewed the relationship for $15,000,000. The $5,000,000 reduction of available funds from this relationship will not have a significant effect on the Company’s liquidity position. For a discussion on the Company’s significant determinable contractual obligations and significant commitments, see “Off-Balance Sheet Arrangements and Contractual Obligations,” above.

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 decided to participate the Transaction Account Guarantee (TAG) component of the TLGP. Under the TAG, 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, have a temporary unlimited guarantee from the FDIC which was originally scheduled to expire on December 31, 2009. To assure an orderly phase out of the TAG component of the TLGP, the FDIC has extended the program, on a voluntary basis to June 30, 2010. Participation in the extended program required the assessment of a higher premium – from 15 to 25 basis points depending on pre-determined risk factors assigned to financial institutions. To protect the deposit base, the Company opted to extend its participation in the TAG program. Under the program, through June 30, 2010, all noninterest-bearing transaction accounts will continue to be fully guaranteed by the FDIC for the entire account balance. The Company, rated with the lowest tier 1 risk factor, was assessed 15 basis points and as a result will incur $42,000 of additional FDIC premiums to voluntarily participate in the TAG extension program. Coverage under the TAG program 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.

### 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, collectively, 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 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 December 31, 2009 the Company maintained a one-year cumulative gap of positive $35.1 million, or 6.3%, of total assets. The effect of this positive gap position provided a mismatch of assets and liabilities which may expose the Company 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 will 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 reflects the re-pricing of the balance sheet or “gap” position at December 31, 2009 (dollars in thousands):

|  | Three months or less | Three to twelve months | One to three years | Over three years | Total |
| --- | ---: | ---: | ---: | ---: | ---: |
| Cash and cash equivalents | $117 | $- | $- | $8,211 | $8,328 |
| Investment securities (1)(2) | 16,665 | 2,005 | 24,022 | 38,619 | 81,311 |
| Loans (2) | 133,949 | 53,600 | 105,175 | 131,621 | 424,345 |
| Fixed and other assets | - | 9,117 | - | 32,916 | 42,033 |
| Total assets | $150,731 | $64,722 | $129,197 | $211,367 | $556,017 |
| Total cumulative assets | $150,731 | $215,453 | $344,650 | $556,017 |  |
| Non-interest-bearing transaction deposits (3) | $- | $7,090 | $19,495 | $44,306 | $70,891 |
| Interest-bearing transaction deposits | 63,917 | - | 66,621 | 109,315 | 239,853 |
| Certificates of deposit | 38,439 | 43,415 | 54,814 | 11,583 | 148,251 |
| Repurchase agreements | 7,747 | - | - | - | 7,747 |
| Short-term borrowings | 8,786 | - | - | - | 8,786 |
| Long-term debt | - | 11,000 | - | 21,000 | 32,000 |
| Other liabilities | - | - | - | 2,815 | 2,815 |
| Total liabilities | $118,889 | $61,505 | $140,930 | $189,019 | $510,343 |
| Total cumulative liabilities | $118,889 | $180,394 | $321,324 | $510,343 |  |
| Interest sensitivity gap | $31,842 | $3,217 | $(11,733) | $22,348 |  |
| Cumulative gap | $31,842 | $35,059 | $23,326 | $45,674 |  |
| Cumulative gap to total assets | 5.7% | 6.3% | 4.2% | 8.2% |  |

(1) Includes FHLB stock and the net unrealized gains/losses on available-for-sale securities.

(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 were included in the periods in which they are scheduled to be repaid based on scheduled amortization. For amortizing loans and MBS – GSE residential, annual prepayment rates are assumed reflecting historical experience as well as management’s knowledge and experience of its loan products.

(3) The Company’s demand and savings accounts were 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 an immediate 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 assumed that interest-earning asset and interest-bearing liability levels at December 31, 2009 remained constant. The impact of the rate movements was developed by simulating the effect of the rate change over a twelve-month period from the December 31, 2009 levels:

| Earnings at risk: Percent change in: | Rates +200 | Rates -200 |
| --- | ---: | ---: |
| Net interest income | 3.9% | 0.4% |
| Net income | 14.3 | 1.0 |
| Economic value at risk: |  |  |
| Percent change in: |  |  |
| Economic value of equity | (42.0) | (2.0) |
| Economic value of equity as a percent of total assets | (3.5) | (0.2) |

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 December 31, 2009, the Company’s risk-based capital ratio was 11.4%.

The table below summarizes estimated changes in net interest income over a twelve-month period beginning January 1, 2010, 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 | $21,637 | $803 | 1.3% |
| +100 basis points | 21,015 | 181 | 1.6 |
| Flat rate | 20,834 | - | - |
| -100 basis points | 21,086 | 252 | 3.1 |
| -200 basis points | 20,912 | 78 | 5.1 |

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. MBS – GSE residential securities and amortizing loans are scheduled based on their anticipated cash flow including estimated prepayments. For investment securities, the Company uses a third-party service to provide cash flow estimates in the various rate environments. Savings, money market and interest-bearing checking accounts do not have stated maturities or re-pricing terms and can be withdrawn or re-price 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 Company’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 that when utilized would be 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 Company’s derivative contract, see Note 1, “Nature of Operations and Summary of Significant Accounting Policies”, and Note 12, “Fair Value of Financial Instruments and Derivatives”, contained within the notes to consolidated financial statements in Part II, Item 8.

### Supervision and Regulation

The following is a brief summary of the regulatory environment in which the Company and the Bank operate and is not designed to be a complete discussion of all statutes and regulations affecting such operations, including those statutes and regulations specifically mentioned herein. Changes in the laws and regulations applicable to the Company and the Bank can affect the operating environment in substantial and unpredictable ways. We cannot accurately predict whether legislation will ultimately be enacted, and if enacted, the ultimate effect that legislation or implementing regulations would have on our financial condition or results of operations. While banking regulations are material to the operations of the Company and the Bank, it should be noted that supervision, regulation and examination of the Company and the Bank are intended primarily for the protection of depositors, not shareholders.

### Recent Legislation and Rulemaking

***Emergency Economic Stabilization Act of 2008 and American Recovery and Reinvestment Act of 2009.*** In response to the financial crises affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions, on October 3, 2008, the Emergency Economic Stabilization Act of 2008 (the “EESA”) was signed into law and subsequently amended by the American Recovery and Reinvestment Act of 2009 on February 17, 2009. Under the authority of the EESA, as amended, the United States Department of the Treasury (the “Treasury”) created the Troubled Asset Relief Program (“TARP”) Capital Purchase Program and through this program invested in financial institutions by purchasing preferred stock and warrants to purchase either common stock or additional shares of preferred stock. As of December 31, 2009, the Treasury will not make additional investments under the TARP Capital Purchase Program but is considering continuing a similar program for banks under $10 billion in assets under a different program.

The EESA, as amended, also included a provision for a temporary increase in FDIC insurance coverage from $100,000 to $250,000 per depositor through December 31, 2009. In May 2009, Congress extended the increased coverage until December 31, 2013. After that time, the per depositor coverage will return to $100,000.

***FDIC Rulemaking.*** On November 26, 2008, the FDIC issued the final rule regarding the Temporary Liquidity Guarantee Program enabling the FDIC to temporarily provide a 100% guarantee of the senior debt of all FDIC-insured institutions and their holding companies under the Debt Guarantee Program as well as deposits in non-interest bearing transaction deposit accounts under the Transaction Account Guarantee Program. Coverage under the Debt Guarantee Program and the Transaction Account Guarantee Program was available until November 12, 2008 without charge and thereafter at a cost of 75 basis points per annum for senior unsecured debt and 10 basis points per annum for non-interest bearing transaction deposits. Institutions may continue to participate in the Transaction Account Guarantee Program until June 30, 2010.

On November 12, 2009, the Board of Directors of the FDIC adopted rulemaking that requires insured institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012. Each institution recorded the entire amount of its prepaid assessment as a prepaid expense (asset) as of December 31, 2009. As of December 31, 2009, and each quarter thereafter, each institution records an expense (charge to earnings) for its regular quarterly assessment for the quarter and an offsetting credit to the prepaid assessment until the asset is exhausted. Once the asset is exhausted, the institution records an accrued expense payable each quarter for the assessment payment, which will be paid in arrears to the FDIC at the end of the following quarter. If the prepaid assessment is not exhausted by December 30, 2014, any remaining amount will be returned to the depository institution. The FDIC also voted to adopt a uniform three-basis point increase in assessment rates effective on January 1, 2011.

***Financial Services Regulatory Relief Act of 2006.*** This federal act amends several federal banking laws to reduce redundant and costly regulatory burden. Among its many provisions, the act allows the payment of interest on certain reserve balances of depository institutions that are held at the Federal Reserve beginning in year 2011, requires banking regulatory agencies to streamline reports of condition and clarifies the authority of home and host state regulators with respect to supervision of interstate branches. The act was signed into law in October 2006.

***Federal Deposit Insurance Reform Act of 2005 and the Federal Deposit Insurance Reform Conforming Amendments Act of 2005.*** These federal acts were signed into law in February 2006 to amend the Federal Deposit Insurance Act. These laws enact FDIC and banking industry deposit insurance reform proposals by amendments including: increasing the coverage for retirement accounts to $250,000 and indexing the coverage limit for retirement accounts to inflation as with the general deposit insurance coverage limit; merging the Bank Insurance Fund (BIF) and the Savings Association Insurance Fund (SAIF) into a new fund, the Deposit Insurance Fund (DIF); establishing a percentage range within which the FDIC Board of Directors may set the FDIC’s Designated Reserve Ratio (DRR); allowing the FDIC to manage the pace at which the DRR varies within this range; eliminating the restrictions on premium rates based on the DRR and granting the FDIC Board the discretion to price deposit insurance according to risk for all insured institutions at all times.

***Sarbanes-Oxley Act of 2002.*** In July, 2002, the Sarbanes-Oxley Act of 2002 was enacted. The stated goals of the Act are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies, and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws.

The Act is the most far-reaching U.S. securities legislation enacted in decades. The Act generally applies to all companies, both U.S. and non-U.S., that file or are required to file periodic reports with the Securities and Exchange Commission under the Securities Exchange Act of 1934.

The Act includes very specific additional disclosure requirements and corporate governance rules, requires the SEC and securities exchanges to adopt extensive additional disclosure, corporate governance and other related rules and mandates further studies of certain issues by the SEC. The Act adds new obligations and restrictions on directors and senior executives of public companies, such as requiring certification of financial statements, and new audit committee procedures. The Act represents significant federal involvement in matters traditionally left to state regulatory systems such as the regulation of the accounting profession, and to state corporate law such as the relationship between a board of directors and management and between a board of directors and its committees.

***USA PATRIOT Act of 2001.*** The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (USA PATRIOT Act) was signed into law in October 2001. The USA PATRIOT Act broadened the application of anti-money laundering regulations to apply to additional types of financial institutions, such as broker-dealers, and strengthened the ability of the U.S. government to detect and prosecute international money laundering and the financing of terrorism. The principal provisions of Title III of the USA PATRIOT Act require that regulated financial institutions, including banks: (1) establish an anti-money laundering program that includes training and audit components; (2) comply with regulations regarding the verification of the identity of any person seeking to open an account; (3) take additional required precautions with regard to non-U.S. owned accounts; and (4) perform certain verification and certification of money laundering risk for their foreign correspondent banking relationships. The USA PATRIOT Act also expanded the conditions under which funds in a U.S. inter-bank account may be subject to forfeiture and increased the penalties for violation of anti-money laundering regulations. Failure of a financial institution to comply with the USA PATRIOT Act’s requirements could have serious legal and reputational consequences for the institution. The Bank has adopted policies, procedures and controls to address compliance with the requirements of the USA PATRIOT Act under the existing regulations and will continue to revise and update its policies, procedures and controls to reflect changes required by the USA PATRIOT Act and implementing regulations.

As part of the USA PATRIOT Act, Congress adopted the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001 (IML Act). The IML Act amended the Bank Secrecy Act and adopted certain additional measures that increase the obligation of financial institutions, including the Bank, to identify their customers, watch for and report upon suspicious transactions, respond to requests for information by federal banking regulatory authorities and law enforcement agencies, and share information with other financial institutions. The Secretary of the Treasury has adopted several regulations to implement these provisions. The Bank is also barred from dealing with foreign “shell” banks. In addition, the IML Act expands the circumstances under which funds in a bank account may be forfeited. The IML Act also amended the Bank Holding Company Act and the Bank Merger Act to require the federal banking regulatory authorities to consider the effectiveness of a financial institution’s anti-money laundering activities when reviewing an application to expand operations. The Bank has in place a Bank Secrecy Act compliance program.

***Gramm-Leach-Bliley Act of 1999.*** This law authorized cross-industry affiliations between banks, securities firms, insurance companies and other financial service providers. This was landmark legislation that repealed the Glass-Steagall Act which since the 1930’s had prohibited such affiliations. Among other provisions, the Act provided new authority for banks and created a revised framework for regulating affiliated financial services institutions.

***Regulation W.*** Transactions between a bank and its “affiliates” are quantitatively and qualitatively restricted under the Federal Reserve Act. The Federal Deposit Insurance Act applies Sections 23A and 23B to insured nonmember banks in the same manner and to the same extent as if they were members of the Federal Reserve System. In 2002, the Federal Reserve Board issued Regulation W, which became effective in 2003. Regulation W codifies prior regulations under Sections 23A and 23B of the Federal Reserve Act and interpretative guidance with respect to affiliate transactions.

Regulation W incorporates the exemption from the affiliate transaction rules but expands the exemption to cover the purchase of any type of loan or extension of credit from an affiliate. Affiliates of a bank include, among other entities, the Bank’s holding company and companies that are under common control with the Bank. The Company is considered to be an affiliate of the Bank.

### Future Federal and State Legislation and Rulemaking

From time-to-time, various types of federal and state legislation have been proposed that could result in additional regulations and restrictions on the business of the Company and the Bank. We cannot predict whether legislation will be adopted, or if adopted, how the new laws would affect our business. As a consequence, we are susceptible to legislation that may increase the cost of doing business. Management believes that the effect of any current legislative proposals on the liquidity, capital resources and the results of operations of the Company and the Bank will be minimal.

It is possible that there will be regulatory proposals which, if implemented, could have a material effect upon our liquidity, capital resources and results of operations. In addition, the general cost of compliance with numerous federal and state laws does have, and in the future may have, a negative impact on our results of operations. As with other banks, the status of the financial services industry can affect the Bank. Consolidations of institutions are expected to continue as the financial services industry seeks greater efficiencies and market share. Bank management believes that such consolidations may enhance the Bank’s competitive position as a community bank.

### Future Outlook

Based upon the uncertain economic outlook that has affected the financial and capital markets, the uncertainty in the housing and real estate arena, deterioration in asset and collateral values, tightened credit, high rate of foreclosures, high unemployment and the inability to predict when and by how much interest rates will change and whether rates will continue to fall or begin to rise, the Company recognizes that there are challenges ahead. The Company is prepared to meet these challenges and feels future earnings will be significantly impacted by its ability to react to changes in the interest rates.

The Company will continue to monitor interest rate sensitivity of its interest-earning assets and interest-bearing liabilities to minimize any adverse effects on future earnings. The Company’s commitment to remain a community based organization is very strong. Our intention is to cautiously grow while increasing our base of core deposits and maintain risk-based regulatory capital ratios above “well capitalized” limits. Review and implementation of policies and procedures along with adding innovative products and services will continue. These steps are designed to provide our customers with confidence that the Company is doing everything possible to maximize their banking experience which in turn will increase shareholder value.

## Market risk

As filed, 278 characters.

The information required by 7A is set forth at Item 7, under “Liquidity” and “Management of interest rate risk and market risk analysis,” contained within management’s discussion and analysis of financial condition and results of operations and incorporated herein by reference.

## Controls and procedures

As filed, 3,321 characters.

As of the end of the period covered by this Annual Report on Form 10-K, an evaluation was carried out by the Company’s management, with the participation of its Interim President and Chief Executive Officer and the 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 Interim President and Chief Executive Officer and the 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 SEC has extended the deadline for non-accelerated filers, such as the Company, for an auditor attestation on internal control over financial reporting to fiscal years ending after June 15, 2010. Furthermore, the Company made no 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 December 31, 2009.

### Management’s Report on Internal Control Over Financial Reporting

Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control over financial reporting is a process designed under the supervision of the Company’s Interim President and Chief Executive Officer and the Chief Financial Officer, and implemented in conjunction with management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company’s consolidated financial statements for external purposes in accordance with generally accepted accounting principles.

There are inherent limitations in the effectiveness of any internal control, including the possibility of human error and the circumvention or overriding of controls. Accordingly, even effective internal control can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, the effectiveness of internal control may vary over time.

Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2009. This assessment was based on criteria for effective internal control over financial reporting described in “Internal Control – Integrated Framework,” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this assessment, management determined that, as of December 31, 2009, the Company maintained effective internal control over financial reporting.

This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to temporary rules of the SEC that permit the Company to provide only management’s report in this annual report.

Filed Mar 8, 2010.
Source: SEC EDGAR, the filing index for accession 0001144204-10-012006. Last ingested by Listed: Nov 6, 2026, 18:40 ET. No prices; not investment advice.