form10-k2008.htm
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K
(Mark One)

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

For the fiscal year ended
 
     December 31, 2008

or

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

For the transition period from
 
to
 

Commission file number
     000-13222

CITIZENS FINANCIAL SERVICES, INC.
(Exact name of registrant as specified in its charter)
Pennsylvania
 
23-2265045
State or other jurisdiction of
incorporation or organization
 
(I.R.S. Employer
Identification No.)
15 South Main Street, Mansfield, Pennsylvania
 
16933
(Address of principal executive offices)
 
(Zip Code)
Registrant’s telephone number, including area code
(570) 662-2121
         
Securities registered pursuant to Section 12(b) of the Act:
None
 
         
Securities registered pursuant to Section 12(g) of the Act:
         
Common Stock, par value $1.00 per share
(Title of class)

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

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
  Yes       No

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.
                                 
 

 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
 
Large accelerated filer  o                                                                                     Accelerated filer  £
 
 
Non-accelerated filer  o                                                                           Smaller reporting company  
 
(Do not check if a smaller reporting company)


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


State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter. $54,961,808 as of June 30, 2008.

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date. 2,847,371 as of February 18, 2009

DOCUMENTS INCORPORATED BY REFERENCE

Certain information required by Part III is incorporated by reference to the Registrant’s Definitive Proxy Statement for the 2009 Annual Meeting of Shareholders.

 
II

 
 
Citizens Financial Services, Inc.
Form 10-K
INDEX
 
Page
PART I
 
ITEM 1 – BUSINESS
1 – 5
ITEM 1A – RISK FACTORS
6 – 8
ITEM 1B – UNRESOLVED STAFF COMMENTS
8
ITEM 2 – PROPERTIES
8
ITEM 3 – LEGAL PROCEEDINGS
8
ITEM 4 – SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
8
PART II
 
ITEM 5 – MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
9 – 10
ITEM 6 – SELECTED FINANCIAL DATA
11
ITEM 7 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS  OF OPERATION
12 – 34
ITEM 7A – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
34
ITEM 8 – FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
35 – 70
ITEM 9 – CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND  FINANCIAL DISCLOSURE
71
ITEM 9A(T) – CONTROLS AND PROCEDURES
71
ITEM 9B– OTHER INFORMATION
71
PART III
 
ITEM 10 – DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
72
ITEM 11 – EXECUTIVE COMPENSATION
72
ITEM 12 – SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
72 – 73
ITEM 13 – CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
73
ITEM 14 – PRINCIPAL ACCOUNTING FEES AND SERVICES
73
PART IV
 
ITEM 15 – EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
74 – 75
SIGNATURES
76

 
III

 


 
PART I
 
 
ITEM 1 – BUSINESS.
 
CITIZENS FINANCIAL SERVICES, INC.
 
Citizens Financial Services, Inc. (the “Company”), a Pennsylvania corporation, was incorporated on April 30, 1984. The Company is registered with the Board of Governors of the Federal Reserve System (“FRB”) as a bank holding company under the Bank Holding Company Act of 1956, as amended.  Simultaneous with establishment of the Company in 1984, First Citizens National Bank (the “Bank”) became a wholly-owned subsidiary of the Company.   The Company is subject to regulation, supervision and examination by the FRB.  In general, the Company is limited to owning or controlling banks and engaging in such other activities as are properly incident thereto.
 
Our Company is primarily engaged in the ownership and management of the Bank and its wholly-owned insurance agency subsidiary.
 
FIRST CITIZENS NATIONAL BANK
 
The Bank was created as a result of the merger of Citizens National Bank of Blossburg, Pennsylvania with and into The First National Bank of Mansfield in 1970.  Upon consummation of the merger, the Bank had 2 offices and served Tioga County, Pennsylvania.  In 1971, the Bank expanded its operations into Potter County through the acquisition of the Grange National Bank, which had offices in Ulysses and Genesee, Pennsylvania.  As previously discussed, the Bank became the wholly-owned subsidiary of Citizens Financial Services, Inc. in 1984.  On November 16, 1990, the Company acquired Star Savings and Loan Association, originally organized as a Pennsylvania state-chartered mutual savings and loan association in 1899, and converted it into a Pennsylvania state-chartered permanent reserve fund stock savings and loan association on March 27, 1986. On December 31, 1991, the Star Savings and Loan Association merged with and into the Bank.  On April 20, 1996, the Bank purchased two branch offices of Meridian Bank in Canton and Gillett, Pennsylvania.  In October 1996, the Bank opened an office in the Weis Supermarket in Wellsboro, Pennsylvania.  In August of 2000, the Bank opened an office in the Wal-Mart Super-center in Mansfield, Pennsylvania.  On October 27, 2000, the Bank purchased six branch offices of Sovereign Bank in Bradford County, Pennsylvania.  In February 2001, the Bank consolidated two of the six Sovereign branches.  On June 4, 2004, two branches of The Legacy Bank in Bradford County, Pennsylvania were purchased and the Bank consolidated two of its existing branches to maximize efficiencies.  On December 17, 2005, the Hannibal branch of the Fulton Savings Bank in Hannibal, New York was acquired.  Simultaneous with the purchase, the branch was relocated to Wellsville, New York (Allegany County) and opened for business on December 19, 2005.  On November 21, 2008, the Mansfield, Pennsylvania branch of The Elmira Savings Bank was acquired.
 
The Bank’s main office is located at 15 South Main Street, Mansfield, (Tioga County) Pennsylvania.  The Bank’s primary market area consists of the Pennsylvania Counties of Bradford, Potter and Tioga in North Central Pennsylvania.  It also includes Allegany, Steuben, Chemung and Tioga Counties in Southern New York.  The economy is diversified and includes manufacturing industries, wholesale and retail trade, service industries, family farms and the production of natural resources of gas and timber.  We are dependent geographically upon the economic conditions in north central Pennsylvania and the southern tier of New York.  In addition to the main office, the Bank has 16 other full service branch offices in its market area.
 
The Bank is a full-service bank engaging in a broad range of banking activities and services for individual, business, governmental and institutional customers.  These activities and services principally include checking, savings, time and deposit accounts; real estate, commercial, industrial, residential and consumer loans; and a variety of other specialized financial services.  The Trust and Investment division offers a full range of client investment, estate and retirement services through the Bank’s wholly owned insurance agency subsidiary, First Citizens Insurance Agency, Inc.
 
As of December 31, 2008, the Bank employed 159 full time employees and 29 part-time employees, resulting in 169 full time equivalent employees at our corporate offices and other banking locations.
 
COMPETITION
 
The banking industry in the Bank’s service area continues to be extremely competitive, both among commercial banks and with financial service providers such as consumer finance companies, thrifts, investment firms, mutual funds, insurance companies, credit unions and internet banks.  The increased competition has resulted from changes in the legal and regulatory guidelines as well as from economic conditions.  Mortgage banking firms, financial companies, financial affiliates of industrial companies, brokerage firms, retirement fund management firms and even government agencies provide additional competition for loans and other financial services.  The Bank is generally competitive with all competing financial institutions in its service area with respect to interest rates paid on time and savings deposits, service charges on deposit accounts and interest rates charged on loans.
 
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Additional information related to our business and competition is included in Part II, Item 7, “Management's Discussion and Analysis of Financial Condition and Results of Operations”.
 
SUPERVISION AND REGULATION

GENERAL

The Company is registered as a bank holding company and is subject to supervision and regulation by the Board of Governors of the Federal Reserve System under the Bank Holding Company Act of 1956, as amended.  The Company is considered a bank holding company.  Bank holding companies are required to file periodic reports with and are subject to examination by the Federal Reserve Board.  The Federal Reserve Board has issued regulations under the Bank Holding Company Act that require a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks.  As a result, the Federal Reserve Board, pursuant to such regulations, may require the Company to stand ready to use its resources to provide adequate capital funds to its bank subsidiary during periods of financial stress or adversity.

The Bank Holding Company Act prohibits the Company from acquiring direct or indirect control of more than 5% of the outstanding shares of any class of voting stock, or substantially all of the assets of, any bank, or from merging or consolidating with another bank holding company, without prior approval of the Federal Reserve Board.  Additionally, the Bank Holding Company Act prohibits the Company from engaging in or from acquiring ownership or control of more than 5% of the outstanding shares of any class of voting stock of any company engaged in a non-banking business, unless such business has been determined by the Federal Reserve Board to be so closely related to banking as to be a proper incident thereto or, for financial holding companies, to be financial in nature or incidental thereto.

The Bank is a national bank and a member of the Federal Reserve System, and its deposits are insured (up to applicable limits) by the Federal Deposit Insurance Corporation (the “FDIC”).  The Bank is subject to regulation and examination by the Office of the Comptroller of the Currency (OCC), and to a much lesser extent, the Federal Reserve Board and the FDIC.  The Bank is also subject to requirements and restrictions under federal and state law, including requirements to maintain reserves against deposits, and the interest that may be charged on loans, and limitations on the types of investments that may be made and the types of services that may be offered.  The Bank is subject to extensive regulation and reporting requirements in a variety of areas, including helping to prevent money laundering, to preserve financial privacy and to properly report late payments, defaults and denials of loan applications.  The Community Reinvestment Act requires the Bank to help meet the credit needs of the entire community where the Bank operates, including low and moderate income neighborhoods.  The Bank's rating under the Community Reinvestment Act, assigned by the Comptroller of the Currency pursuant to an examination of the Bank, is important in determining whether the bank may receive approval for, or utilize certain streamlined procedures in, applications to engage in new activities.  The Bank’s present CRA rating is “Satisfactory.”  Various consumer laws and regulations also affect the operations of the Bank.  In addition to the impact of regulation, commercial banks are affected significantly by the actions of the Federal Reserve Board as it attempts to control the money supply and credit availability in order to influence the economy.

CAPITAL ADEQUACY GUIDELINES

Bank holding companies are required to comply with the Federal Reserve Board's risk-based capital guidelines.  The required minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) is 8%.  At least half of the total capital is required to be “Tier 1 capital,” consisting principally of common shareholders' equity, less certain intangible assets.  The remainder (“Tier 2 capital”) may consist of certain preferred stock, a limited amount of subordinated debt, certain hybrid capital instruments and other debt securities, and a limited amount of the general loan loss allowance.  The risk-based capital guidelines are required to take adequate account of interest rate risk, concentration of credit risk, and risks of nontraditional activities.

In addition to the risk-based capital guidelines, the Federal Reserve Board requires a bank holding company to maintain a leverage ratio of a minimum level of Tier 1 capital (as determined under the risk-based capital guidelines) equal to 3% of average total consolidated assets for those bank holding companies which have the highest regulatory examination ratings and are not contemplating or experiencing significant growth or expansion.  All other bank holding companies are required to maintain a ratio of at least 1% above the stated minimum.  The Bank is subject to identical capital requirements adopted by the OCC.

2


PROMPT CORRECTIVE ACTION RULES

The federal banking agencies have regulations defining the levels at which an insured institution would be considered “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.”  Institutions that are classified as undercapitalized, significantly undercapitalized or critically undercapitalized are subject to various supervision measures based on the degree of undercapitalization.  The applicable federal bank regulator for a depository institution could, under certain circumstances, reclassify a “well-capitalized” institution as “adequately capitalized” or require an “adequately capitalized” or “undercapitalized” institution to comply with supervisory actions as if it were in the next lower category.  Such a reclassification could be made if the regulatory agency determines that the institution is in an unsafe or unsound condition (which could include unsatisfactory examination ratings).  The Bank satisfies the criteria to be classified as “well capitalized” within the meaning of applicable regulations.

REGULATORY RESTRICTIONS ON DIVIDENDS

The Bank may not, under the National Bank Act, declare a dividend without approval of the OCC, unless the dividend to be declared by the Bank's Board of Directors does not exceed the total of:  (i) the Bank's net profits for the current year to date, plus (ii) its retained net profits for the preceding two current years, less any required transfers to surplus.  In addition, the Bank can only pay dividends to the extent that its retained net profits (including the portion transferred to surplus) exceed its bad debts.  The Federal Reserve Board, the OCC and the FDIC have formal and informal policies which provide that insured banks and bank holding companies should generally pay dividends only out of current operating earnings, with some exceptions.  The Prompt Corrective Action Rules, described above, further limit the ability of banks to pay dividends, because banks which are not classified as well capitalized or adequately capitalized may not pay dividends and no dividend may be paid which would make the Bank undercapitalized after the dividend.

Under these policies and subject to the restrictions applicable to the Bank, the Bank could have declared, during 2008, without prior regulatory approval, aggregate dividends of approximately $8.1 million, plus net profits earned to the date of such dividend declaration.

BANK SECRECY ACT
 
Under the Bank Secrecy Act (BSA), banks and other financial institutions are required to retain records to assure that the details of financial transactions can be traced if investigators need to do so.  Banks are also required to report most cash transactions in amounts exceeding $10,000 made by or on behalf of their customers.  Failure to meet BSA requirements may expose the Bank to statutory penalties, and a negative compliance record may affect the willingness of regulating authorities to approve certain actions by the Bank requiring regulatory approval, including new branches.

INSURANCE OF DEPOSIT ACCOUNTS
 
The deposits of the Bank are insured up to applicable limits by the Deposit Insurance Fund of the FDIC.  The Deposit Insurance Fund is the successor to the Bank Insurance Fund and the Savings Association Insurance Fund, which were merged in 2006.  Under the FDIC’s risk-based assessment system, insured institutions are assigned to one of four risk categories based on supervisory evaluations, regulatory capital levels and certain other factors.  An institution’s assessment rate depends upon the category to which it is assigned, with less risky institutions paying lower assessments.
 
For 2008, assessments ranged from five to forty-three basis points of assessable deposits.  Due to losses incurred by the Deposit Insurance Fund from failed institutions in 2008, and anticipated future losses, the FDIC has adopted, pursuant to a Restoration Plan to replenish the fund, an across the board seven basis point increase in the assessment range for the first quarter of 2009.  The FDIC has adopted further refinements to its risk-based
assessment system that are effective April 1, 2009 and would effectively make the range seven to 77 1/2 basis points.  The FDIC may adjust the scale uniformly from one quarter to the next, except that no adjustment can deviate more than three basis points from the base scale without notice and comment rulemaking.  No institution may pay a dividend if in default of the federal deposit insurance assessment.  The Federal Deposit Insurance Corporation has also adopted an interim final rule that would impose a special emergency assessment of up to 20 basis points of assessable deposits, as of June 30, 2009, in order to cover the losses to the Deposit Insurance Fund.
 
Due to the recent difficult economic conditions, deposit insurance per account owner has been raised to $250,000 for all types of accounts until January 1, 2010.  In addition, the FDIC adopted an optional Temporary Liquidity Guarantee Program by which, for a fee, non-interest bearing transaction accounts would receive unlimited insurance coverage until December 31, 2009 and certain senior unsecured debt issued by institutions and their holding companies between October 13, 2008 and June 30, 2009 would be guaranteed by the FDIC through June 30, 2012.  The Bank made the business decision to participate in the unlimited non-interest bearing transaction account coverage and the Bank and the Company opted to participate in the unsecured debt guarantee program.
 
3

 
The Federal Deposit Insurance Reform Act of 2005 (“Reform Act”) provided a one-time credit for eligible institutions based on their assessment base as of December 31, 1996.  Subject to certain limitations, credits could be used beginning in 2007 to offset assessments until exhausted.  The Bank’s one-time credit approximated $335,000, of which $126,000 was utilized in 2007 and the remaining $209,000 in 2008.  The Reform Act also provided for the possibility that the FDIC may pay dividends to insured institutions once the Deposit Insurance fund reserve ratio equals or exceeds 1.35% of estimated insured deposits.

In addition to the assessment for deposit insurance, institutions are required to make payments on bonds issued in the late 1980s by the Financing Corporation to recapitalize a predecessor deposit insurance fund.  That payment is established quarterly and during the calendar year ending December 31, 2008 averaged 1.12 basis points of assessable deposits.

The FDIC has authority to increase insurance assessments.  A significant increase in insurance premiums would likely have an adverse effect on the operating expenses and results of operations of the Bank.  Management cannot predict what insurance assessment rates will be in the future.

Insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC or the OCC.  The management of the Bank does not know of any practice, condition or violation that might lead to termination of deposit insurance.

EFFECT OF GOVERNMENT MONETARY POLICIES
 
The earnings and growth of the banking industry are affected by the credit policies of monetary authorities, including the Federal Reserve System.  An important function of the Federal Reserve System is to regulate the national supply of bank credit in order to control recessionary and inflationary pressures.  Among the instruments of monetary policy used by the Federal Reserve to implement these objectives are open market activities in U.S. Government Securities, changes in the discount rate on member bank borrowings and changes in reserve requirements against member bank deposits.  These operations are used in varying combinations to influence overall economic growth and indirectly, bank loans, securities, and deposits.  These variables may also affect interest rates charged on loans or paid on deposits.  The monetary policies of the Federal Reserve authorities have had a significant effect on the operating results of commercial banks in the past and are expected to continue to have such an effect in the future.
 
In view of the changing conditions in the national economy and in the money markets, as well as the effect of actions by monetary and fiscal authorities including the Federal Reserve System, no prediction can be made as to possible changes in interest rates, deposit levels, loan demand or their effect on the business and earnings of the Company and the Bank.   Additional information is included under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing in this Annual Report on Form 10-K.
 
RECENT LEGISLATION

Troubled Asset Relief Program.  On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (“EESA”) was enacted establishing the Troubled Asset Relief Program (“TARP”).  On October 14, 2008, Treasury announced its intention to inject capital into U.S. financial institutions under the TARP Capital Purchase Program (“CPP”) and since has injected capital into many financial institutions.  The Board of Directors of the Company determined not to participate in the CPP.

Temporary Liquidity Guarantee Program. On November 21, 2008, the Board of Directors of the FDIC adopted a final rule relating to the Temporary Liquidity Guarantee Program (“TLG Program”).  The TLG Program was announced by the FDIC on October 14, 2008, preceded by the determination of systemic risk by Treasury, as an initiative to counter the system-wide crisis in the nation’s financial sector. Under the TLG Program the FDIC will (i) guarantee, through the earlier of maturity or June 30, 2012, certain newly issued senior unsecured debt issued by participating institutions and (ii) provide full FDIC deposit insurance coverage for non-interest bearing transaction deposit accounts, Negotiable Order of Withdrawal accounts paying less than 0.5% interest per annum and Interest on Lawyers Trust Accounts held at participating FDIC-insured institutions through December 31, 2009. Coverage under the TLG Program was available for the first 30 days without charge. The fee assessment for coverage of senior unsecured debt ranges from 50 basis points to 100 basis points per annum, depending on the initial maturity of the debt. The fee assessment for deposit insurance coverage is 10 basis points per quarter on amounts in covered accounts exceeding $250,000. The Company elected to participate in both guarantee programs.
 
4

 
American Recovery and Reinvestment Act of 2009. On February 17, 2009, the American Recovery and Reinvestment Act of 2009 (“ARRA”) was enacted.  The ARRA, commonly known as the economic stimulus or economic recovery package, includes a wide variety of programs intended to stimulate the economy and provide for extensive infrastructure, energy, health, and education needs.  In addition, ARRA imposes certain new executive compensation and corporate expenditure limits on all current and future TARP recipients until the institution has repaid Treasury, which is now permitted under ARRA without penalty and without the need to raise new capital, subject to Treasury’s consultation with the recipient’s appropriate regulatory agency.
 
Future Legislation.  Various legislation affecting financial institutions and the financial industry is from time to time introduced in Congress.  Such legislation may change banking statutes and the operating environment of the Company and its subsidiaries in substantial and unpredictable ways, and could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance depending upon whether any of this potential legislation will be enacted, and if enacted, the effect that it or any implementing regulations, would have on the financial condition or results of operations of the Company or any of its subsidiaries. With the recent enactments of EESA and ARRA, the nature and extent of future legislative and regulatory changes affecting financial institutions is very unpredictable at this time.
 
5

 
ITEM 1A – RISK FACTORS.
 
Changes in interest rates could reduce our income, cash flows and asset values.
 
Our income and cash flows and the value of our assets depend to a great extent on the difference between the interest rates we earn on interest-earning assets, such as loans and investment securities, and the interest rates we pay on interest-bearing liabilities such as deposits and borrowings.  These rates are highly sensitive to many factors which are beyond our control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Board of Governors of the Federal Reserve System. Changes in monetary policy, including changes in interest rates, will influence not only the interest we receive on our loans and investment securities and the amount of interest we pay on deposits and borrowings but will also affect our ability to originate loans and obtain deposits and the value of our investment portfolio.  If the rate of interest we pay on our deposits and other borrowings increases more than the rate of interest we earn on our loans and other investments, our net interest income, and therefore our earnings, could be adversely affected.  Our earnings also could be adversely affected if the rates on our loans and other investments fall more quickly than those on our deposits and other borrowings.
 
The current economic environment poses significant challenges for us and could adversely affect our financial condition and results of operations.
 
We currently are operating in a challenging and uncertain economic environment, both nationally and in the local markets that we serve. Financial institutions continue to be affected by sharp declines in financial and real estate values.  Continued declines in real estate values and home sales, and an increase in the financial stress on borrowers stemming from an uncertain economic environment, including rising unemployment, could have an adverse effect on our borrowers or their customers, which could adversely impact the repayment of the loans we have made. The overall deterioration in economic conditions also could subject us to increased regulatory scrutiny. In addition, a prolonged recession, or further deterioration in local economic conditions, could result in an increase in loan delinquencies; an increase in problem assets and foreclosures; and a decline in the value of the collateral for our loans.  Furthermore, a prolonged recession or further deterioration in local economic conditions could drive the level of loan losses beyond the level we have provided for in our loan loss allowance, which could necessitate our increasing our provision for loans losses, which would reduce our earnings.  Additionally, the demand for our products and services could be reduced, which would adversely impact our liquidity and the level of revenues we generate.
 
Our financial condition and results of operations would be adversely affected if our allowance for loan losses is not sufficient to absorb actual losses or if we are required to increase our allowance.
 
Despite our underwriting criteria, we may experience loan delinquencies and losses.  In order to absorb losses associated with nonperforming loans, we maintain an allowance for loan losses based on, among other things, historical experience, an evaluation of economic conditions, and regular reviews of delinquencies and loan portfolio quality.  Determination of the allowance inherently involves a high degree of subjectivity and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes.  At any time there are likely to be loans in our portfolio that will result in losses but that have not been identified as nonperforming or potential problem credits. We cannot be sure that we will be able to identify deteriorating credits before they become nonperforming assets or that we will be able to limit losses on those loans that are identified. We may increase our allowance for loan losses based on our regular review of delinquencies and loan portfolio quality, or for any of several other reasons.  Bank regulators, in reviewing our loan portfolio as part of a regulatory examination, may request that we increase our allowance for loan losses.  Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may require an increase in our allowance.  In addition, if charge-offs in future periods exceed our allowance for loan losses, we will need additional increases in our allowance for loan losses.  Any increases in our allowance for loan losses will result in a decrease in our net income and, possibly, our capital, and may materially affect our results of operations in the period in which the allowance is increased.
 
If we conclude that the decline in value of any of our investment securities is other than temporary, we are required to write down the value of that security through a charge to earnings.
 
We review our investment securities portfolio monthly and 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 are required to write down the value of that security through a charge to earnings. As of December 31, 2008, our investment portfolio included available for sale investment securities with a carrying value of $171.4 million and an estimated fair value of $174.1 million, which included unrealized losses on 47 securities totaling $1.4 million.  Changes in the expected cash flows of these securities and/or prolonged price declines may result in our concluding in future periods that the impairment of these securities is other than temporary, which would require a charge to earnings to write down theses securities to their fair value. Any charges for other-than-temporary impairment would not impact cash flow, tangible capital or liquidity.
 
6

 
Future FDIC assessments will hurt our earnings.
 
In February 2009, the FDIC adopted an interim final rule imposing a special assessment on all insured institutions due to recent bank and savings association failures.  The interim final rule would impose an emergency assessment of up to 20 basis points of assessable deposits as of June 30, 2009.  The assessment will be collected on September 30, 2009.  The special assessment will negatively impact the Company’s earnings by up to $1,100,000 and the Company expects that non-interest expense will increase by up to $1,800,000 in 2009 compared to 2008 due to this increase in FDIC insurance.  In addition, the interim rule would also permit the FDIC to impose additional emergency special assessments after June 30, 2009, of up to 10 basis points per quarter if necessary to maintain public confidence in federal deposit insurance or as a result of deterioration in the deposit insurance fund reserve ratio due to institution failures.  Any additional emergency special assessment imposed by the FDIC will further hurt the Company’s earnings.
 
The market price of our common stock may be materially adversely affected by market volatility.
 
Many publicly traded financial services companies have recently experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance or prospects of such companies.  We may experience market fluctuations that are not directly related to our operating performance but are influenced by the market’s perception of the state of the financial services industry in general and, in particular, the market’s assessment of general credit quality conditions, including default and foreclosure rates in the industry.
 
Competition may decrease our growth or profits.
 
We face substantial competition in all phases of our operations from a variety of different competitors, including commercial banks, savings and loan associations, mutual savings banks, credit unions, consumer finance companies, factoring companies, leasing companies, insurance companies and money market mutual funds.  There is very strong competition among financial services providers in our principal service area.  Our competitors may have greater resources, higher lending limits or larger branch systems than we do.  Accordingly, they may be able to offer a broader range of products and services as well as better pricing for those products and services than we can.
 
In addition, some of the financial services organizations with which we compete are not subject to the same degree of regulation as is imposed on federally insured financial institutions.  As a result, those non-bank competitors may be able to access funding and provide various services more easily or at less cost than we can, adversely affecting our ability to compete effectively.
 
We may be adversely affected by government regulation.
 
The banking industry is heavily regulated. Banking regulations are primarily intended to protect the federal deposit insurance funds and depositors, not shareholders. Changes in the laws, regulations, and regulatory practices affecting the banking industry may increase our costs of doing business or otherwise adversely affect us and create competitive advantages for others. Regulations affecting banks and financial services companies undergo continuous change, and we cannot predict the ultimate effect of these changes, which could have a material adverse effect on our profitability or financial condition.
 
In addition to these banking laws and regulations, we are also subject to the Securities Exchange Act of 1934, as amended, and the rules and regulations issued thereunder.  Moreover, we are subject to the provisions of the Sarbanes-Oxley Act of 2002 (SOX) and the rules and regulations issued thereunder by the Securities and Exchange Commission (“SEC”).  These laws and regulations impose, among other things, significant responsibilities on officers, auditors, boards of directors and audit committees. Our expenses related to services rendered by our accountants, legal counsel and consultants have increased and may continue to increase in order to ensure compliance with these laws and regulations.
 
Under Section 404 of SOX, we were required to conduct a comprehensive review and assessment of the adequacy of our existing systems and controls as of the end of 2008 and our auditors will have to attest to our assessment beginning with the twelve months ended December 31, 2009.  This resulted in additional expenses in 2008 and will result in further expenses in succeeding years that may adversely affect our results of operations.  In a SOX 404 review, we could uncover deficiencies or material weaknesses in existing systems and controls. If that is the case, we would have to take the necessary steps to correct any deficiencies or material weaknesses, which may be costly and may strain our management resources.   We also would be required to disclose any such material weaknesses, which could adversely affect the market price of our common stock. 
 
We rely on our management and other key personnel, and the loss of any of them may adversely affect our operations.
 
We are and will continue to be dependent upon the services of our executive management team. In addition, we will continue to depend on our ability to retain and recruit key commercial loan officers. The unexpected loss of services of any key management personnel or commercial loan officers could have an adverse effect on our business and financial condition because of their skills, knowledge of our market, years of industry experience and the difficulty of promptly finding qualified replacement personnel.
 
7

 
Environmental liability associated with lending activities could result in losses.
 
In the course of our business, we may foreclose on and take title to properties securing our loans.  If hazardous substances were discovered on any of these properties, we could be liable to governmental entities or third parties for the costs of remediation of the hazard, as well as for personal injury and property damage.  Many environmental laws can impose liability regardless of whether we knew of, or were responsible for, the contamination.  In addition, if we arrange for the disposal of hazardous or toxic substances at another site, we may be liable for the costs of cleaning up and removing those substances from the site even if we neither own nor operate the disposal site.  Environmental laws may require us to incur substantial expenses and may materially limit use of properties we acquire through foreclosure, reduce their value or limit our ability to sell them in the event of a default on the loans they secure.  In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability.
 
Failure to implement new technologies in our operations may adversely affect our growth or profits.
 
The market for financial services, including banking services and consumer finance services, is increasingly affected by advances in technology, including developments in telecommunications, data processing, computers, automation, Internet-based banking and telebanking. Our ability to compete successfully in our markets may depend on the extent to which we are able to exploit such technological changes. However, we can provide no assurance that we will be able properly or timely to anticipate or implement such technologies or properly train our staff to use such technologies.  Any failure to adapt to new technologies could adversely affect our business, financial condition or operating results. 
 
Our ability to pay dividends is limited by law.
 
Our ability to pay dividends to our shareholders largely depends on our receipt of dividends from the Bank. The amount of dividends that the Bank may pay to us is limited by federal laws and regulations. We also may decide to limit the payment of dividends even when we have the legal ability to pay them in order to retain earnings for use in our business.
 
Federal and state banking laws, our articles of incorporation and our by-laws may have an anti-takeover effect.
 
Federal law imposes restrictions, including regulatory approval requirements, on persons seeking to acquire control over us.  Pennsylvania law also has provisions that may have an anti-takeover effect.  These provisions may serve to entrench management or discourage a takeover attempt that shareholders consider to be in their best interest or in which they would receive a substantial premium over the current market price.
 
 
ITEM 1B – UNRESOLVED STAFF COMMENTS.
 
Not applicable.
 
ITEM 2 – PROPERTIES.
 
The headquarters of the Company and Bank are located at 15 South Main Street, Mansfield, Pennsylvania. The building contains the central offices of the Company and Bank. Our bank owned sixteen banking facilities and leased two other facilities as of December 31, 2008.  Subsequent to December 31, 2008, one facility was sold and leased back.  All buildings owned by the Bank are free of any liens or encumbrances.
 
The net book value of owned properties and leasehold improvements totaled $11,996,639 as of December 31, 2008.  The properties are adequate to meet the needs of the employees and customers. We have equipped all of our facilities with current technological improvements for data and word processing.
 
ITEM 3 - LEGAL PROCEEDINGS.
 
The Company is not involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business.  Such routine legal proceedings in the aggregate are believed by management to be immaterial to the Company's financial condition or results of operations.
 
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
 
During the quarter ended December 31, 2008, no matters were submitted to vote of security holders through a solicitation of proxies or otherwise.

 
8

 
 
PART II
 
ITEM 5 - MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
 
The Company's stock is not listed on any stock exchange, but it is quoted on the OTC Bulletin Board under the trading symbol CZFS.  Prices presented in the table below are bid prices between broker-dealers published by the OTC Bulletin Board and the Pink Sheets Electronic Quotation Service.  The prices do not include retail markups or markdowns or any commission to the broker-dealer.  The bid prices do not necessarily reflect prices in actual transactions.  Cash dividends are declared on a quarterly basis and are summarized in the table below (also see dividend restrictions in Note 13 of the consolidated financial statements).
 
 
Dividends
   
Dividends
 
2008
paid
2007
paid
 
High
Low
per share
High
Low
per share
First quarter
 $      21.78
 $      17.87
 $      0.230
 $    22.57
 $     21.04
 $        0.220
Second quarter
         23.27
         20.05
         0.235
       23.52
        20.94
           0.225
Third quarter
         24.50
         21.25
         0.235
       22.75
        20.25
           0.225
Fourth quarter
         21.00
         17.25
         0.290
       21.75
        19.35
           0.230
 
The Company has paid dividends since April 30, 1984, the effective date of our formation as a bank holding company. The Company's Board of Directors intends to continue the dividend payment policy; however, future dividends necessarily depend upon earnings, financial condition, appropriate legal restrictions and other factors in existence at the time the Board of Directors considers a dividend policy. Cash available for dividend distributions to stockholders of the Company comes from dividends paid to the Company by the Bank. Therefore, restrictions on the ability of the Bank to make dividend payments are directly applicable to the Company.  See “Note 13 – Regulatory Matters” to the consolidated financial statements.
 
Under the Pennsylvania Business Corporation Law of 1988, the Company may pay dividends only if, after payment, the Company would be able to pay debts as they become due in the usual course of our business and total assets will be greater than the sum of total liabilities.  The Federal Reserve Board has issued a policy statement regarding the payment of dividends by bank holding companies.  In general, the Federal Reserve Board’s policies provide that dividends should be paid only out of current earnings and only if the prospective rate of earnings retention by the bank holding company appears consistent with the organization’s capital needs, asset quality, and overall financial condition.  The Federal Reserve Board’s policies also require that a bank holding company serve as a source of financial strength to its subsidiary banks by standing ready to use available resources to provide adequate capital funds to those banks during periods of financial stress or adversity and by maintaining the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks where necessary.  Furthermore, the Federal Reserve Board has authority to prohibit a bank holding company from paying a capital distribution where a subsidiary bank is undercapitalized. These regulatory policies could affect the ability of the Company to pay dividends or otherwise engage in capital distributions.
 
The Company distributed a 1% stock dividend on July 25, 2008 to all shareholders of record as of July 11, 2008.
 
As of February 11, 2009, the Company had approximately 1,535 stockholders of record.  The computation of stockholders of record excludes individual participants in securities positions listings. The following table presents information regarding the Company’s stock repurchases during the three months ended December 31, 2008:
 
9

 

Period
Total Number of Shares (or units Purchased)
Average Price Paid per Share (or Unit)
Total Number of Shares (or Units) Purchased as Part of Publicly Announced Plans of Programs
Maximum Number (or Approximate Dollar Value) of Shares (or Units) that May Yet Be Purchased Under the Plans or Programs (1)
         
10/1/08 to 10/31/08
                                -
                              -
                                         -
                               65,643
11/1/08 to 11/30/08
                         1,066
$19.98
                                  1,066
                               64,577
12/1/08 to 12/31/08
                            277
$19.50
                                     277
                               64,300
Total
                         1,343
$19.88
                                  1,343
                               64,300
 
On January 7, 2006, the Company announced that the Board of Directors authorized the Company to repurchase up to 140,000 shares.  The repurchases will be conducted through open-market purchases or privately negotiated transactions and will be made from time to time depending on market conditions and other factors.  No time limit was placed on the duration of the share repurchase program.  Any repurchased shares will be held as treasury stock and will be available for general corporate purposes.
 
10

 
ITEM 6 - SELECTED FINANCIAL DATA.
 
The following table sets forth certain financial data as of and for each of the years in the five year period ended December 31, 2008:
 
(in thousands, except share data)
2008
2007
2006
2005
2004
Interest income
 $     37,238
 $    36,024
 $     32,851
 $     28,699
 $   26,606
Interest expense
        14,058
        16,922
        14,953
        11,000
         9,235
Net interest income
        23,180
        19,102
        17,898
        17,699
       17,371
Provision for loan losses
              330
             365
              330
                60
                  -
Net interest income after provision
         
  for loan losses
        22,850
        18,737
        17,568
        17,639
       17,371
Non-interest income
          5,245
          5,114
          4,712
          4,688
         4,527
Investment securities gains (losses), net
         (4,089)
              (29)
                  4
                   -
           (235)
Non-interest expenses
        15,877
        15,314
        15,027
        15,387
       14,922
Income before provision for income taxes
          8,129
          8,508
          7,257
          6,940
         6,741
Provision for income taxes
          1,224
          1,772
          1,457
          1,666
         1,474
Net income
 $       6,905
 $       6,736
 $       5,800
 $       5,274
 $      5,267
           
Return on Assets (net income to average total assets)
1.13%
1.16%
1.05%
1.04%
1.09%
Return on Equity (net income to average total equity)
13.51%
14.38%
13.21%
12.63%
13.40%
Dividend Payout Ratio (dividends declared divided by net income)
40.77%
37.86%
42.10%
44.28%
41.90%
Equity to Asset Ratio (average equity to average total assets,
8.33%
8.10%
7.98%
8.20%
8.15%
  excluding other comprehensive income)
         
           
Per share data:
         
Net income (1)
 $         2.42
 $         2.35
 $         2.00
 $         1.79
 $        1.78
Cash dividends (1)
             0.99
            0.90
             0.84
             0.79
           0.75
Book value (1) (2)
          18.52
          17.13
          15.73
          14.71
         13.77
           
Total investments
 $  174,139
 $  120,802
 $  109,743
 $  102,602
 $   95,747
Loans, net (3)
      428,436
     419,182
      410,897
      379,139
    355,774
Total assets (3)
      668,612
     591,029
      572,168
      529,241
    499,347
Total deposits (3)
      546,680
     456,028
      446,515
      429,799
    419,074
Stockholders' equity
        52,770
        48,528
        43,500
        41,561
       40,789
           
(1) Amounts were adjusted to reflect stock dividends.
         
(2) Calculation excludes accumulated other comprehensive income.
   
(3) Amounts in 2004 reflect the acquisition of branches in the second quarter of 2004.
     
     Amounts in 2005 reflect the branch acquisition in the fourth quarter of 2005.
       
    Amounts in 2008 reflect the branch acquisition in the fourth quarter of 2008.
       
 
11

 
ITEM 7 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION.
 
CAUTIONARY STATEMENT
 
Forward-looking statements may prove inaccurate. We have made forward-looking statements in this document, and in documents that we incorporate by reference, that are subject to risks and uncertainties. Forward-looking statements include information concerning possible or assumed future results of operations of the Company, the Bank, First Citizens Insurance Agency, Inc. or the Company on a consolidated basis. When we use words such as “believes,” “expects,” “anticipates,” or similar expressions, we are making forward-looking statements.  For a variety of reasons, actual results could differ materially from those contained in or implied by forward-looking statements:
 
 
·
Interest rates could change more rapidly or more significantly than we expect.
 
·
The economy could change significantly in an unexpected way, which would cause the demand for new loans and the ability of borrowers to repay outstanding loans to change in ways that our models do not anticipate.
 
·
The stock and bond markets could suffer a significant disruption, which may have a negative effect on our financial condition and that of our borrowers, and on our ability to raise money by issuing new securities.
 
·
It could take us longer than we anticipate implementing strategic initiatives designed to increase revenues or manage expenses, or we may be unable to implement those initiatives at all.
 
·
Acquisitions and dispositions of assets could affect us in ways that management has not anticipated.
 
·
We may become subject to new legal obligations or the resolution of litigation may have a negative effect on our financial condition.
 
·
We may become subject to new and unanticipated accounting, tax, or regulatory practices or requirements.
 
·
We could experience greater loan delinquencies than anticipated, adversely affecting our earnings and financial condition.  We could also experience greater losses than expected due to the ever increasing volume of information theft and fraudulent scams impacting our customers and the banking industry.
 
·
We could lose the services of some or all of our key personnel, which would negatively impact our business because of their business development skills, financial expertise, lending experience, technical expertise and market area knowledge.
 
Except as required by applicable law and regulation, we assume no obligation to update or revise any forward-looking statements after the date on which they are made.
 
INTRODUCTION
 
The following is management’s discussion and analysis of the significant changes in the results of operations, capital resources and liquidity presented in its accompanying consolidated financial statements for the Company. Our Company’s consolidated financial condition and results of operations consist almost entirely of the Bank’s financial condition and results of operations. Management’s discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes. Except as noted, tabular information is presented in thousands of dollars.
 
Our Company currently engages in the general business of banking throughout our service area of Potter, Tioga and Bradford counties in North Central Pennsylvania and Allegany, Steuben, Chemung and Tioga counties in Southern New York. We maintain our central office in Mansfield, Pennsylvania. Presently we operate 17 banking facilities.  In Pennsylvania, these offices are located in Mansfield, Blossburg, Ulysses, Genesee, Wellsboro, Troy, Sayre, Canton, Gillett, Millerton, LeRaysville, Towanda, the Wellsboro Weis Market store and the Mansfield Wal-Mart Super Center.  In New York, our office is in Wellsville.
  
On November 21, 2008, the Bank acquired the Mansfield, Pennsylvania branch of the Elmira Savings Bank, ESB.  The acquisition provided the Bank with approximately 40% of the deposit market share in Tioga County (see Note 18 to the consolidated financial statements).
 
Risk identification and management are essential elements for the successful management of the Company.  In the normal course of business, the Company is subject to various types of risk, including interest rate, credit, liquidity and regulatory risk.
 
Interest rate risk is the sensitivity of net interest income and the market value of financial instruments to the direction and frequency of changes in interest rates.  Interest rate risk results from various re-pricing frequencies and the maturity structure of the financial instruments owned by the Company.  The Company uses its asset/liability and funds management policies to control and manage interest rate risk.
 
12

 
Credit risk represents the possibility that a customer may not perform in accordance with contractual terms.  Credit risk results from loans with customers and the purchasing of securities.  The Company’s primary credit risk is in the loan portfolio.  The Company manages credit risk by adhering to an established credit policy and through a disciplined evaluation of the adequacy of the allowance for loan losses.  Also, the investment policy limits the amount of credit risk that may be taken in the investment portfolio.
 
Liquidity risk represents the inability to generate or otherwise obtain funds at reasonable rates to satisfy commitments to borrowers and obligations to depositors.  The Company has established guidelines within its asset/liability and funds management policy to manage liquidity risk.  These guidelines include, among other things, contingent funding alternatives.
 
Regulatory risk represents the possibility that a change in law, regulations or regulatory policy may have a material effect on the business of the Company and its subsidiary.  We can not predict what legislation might be enacted or what regulations might be adopted, or if adopted, the effect thereof on our operations.  We can not anticipate additional requirements or additional compliance efforts regarding the Bank Secrecy Act or USA Patriot Act, or regulatory burdens regarding the ever increasing information theft and fraudulent activities impacting our customers and the banking industry in general.
 
Readers should carefully review the risk factors described in other documents our Company files with the SEC, including the annual reports on Form 10-K, the quarterly reports on Form 10-Q and any current reports on Form 8-K filed by us.

TRUST AND INVESTMENT SERVICES
 
Our Investment and Trust Services Division is committed to helping our customers meet their financial goals.  The Trust Division offers professional trust administration, investment management services, estate planning and administration, custody of securities and individual retirement accounts.  Assets held by the Bank in a fiduciary or agency capacity for its customers are not included in the consolidated financial statements since such items are not assets of the Bank.  As of December 31, 2008, non-deposit investment products under management totaled $34.5 million.  Additionally, as summarized in the table below, the Trust Department had assets under management as of December 31, 2008 and 2007 of $74.3 million and $94.4 million, respectively.  The decrease is primarily due to a decline in the fair value of plan assets given the overall market decline in equity securities and mutual funds during 2008.

(market values - in thousands)
2008
2007
INVESTMENTS:
   
Bonds
 $         20,842
 $         21,081
Stock
            14,771
            23,014
Savings and Money Market Funds
            10,068
              9,907
Mutual Funds
            26,614
            38,177
Mortgages
              1,070
              1,098
Real Estate
                 978
                 978
Miscellaneous
                     1
                   12
Cash
                     3
                 106
TOTAL
 $         74,347
 $         94,373
ACCOUNTS:
   
Trusts
            24,345
            30,306
Guardianships
                 857
                 682
Employee Benefits
            26,722
            34,944
Investment Management
            21,995
            27,791
Custodial
                 428
                 650
TOTAL
 $         74,347
 $         94,373

13

 
Our Financial Consultants offer full service brokerage services throughout the Bank’s market area.  Appointments can be made at any Bank branch.  The Financial Consultants provide financial planning and help our customers achieve their financial goals with their choice of mutual funds, annuities, health and life insurance.  These products are made available through our insurance subsidiary, First Citizens Insurance Agency, Inc.

RESULTS OF OPERATIONS
 
Net income for the twelve months ended December 31, 2008 was $6,905,000, which represents an increase of $169,000, or 2.5%, when compared to the 2007 related period.  Net income for the twelve months ended December 31, 2007 totaled $6,736,000, an increase of $936,000 from the 2006 related period.  Earnings per share were $2.42, $2.35 and $2.00 for the years ended 2008, 2007 and 2006, respectively.
 
The following table sets forth certain performance ratios of our Company for the periods indicated:


 
2008
2007
2006
Return on Assets (net income to average total assets)
1.13%
1.16%
1.05%
Return on Equity (net income to average total equity)
13.51%
14.38%
13.21%
Dividend Payout Ratio (dividends declared divided by net income)
40.76%
37.86%
42.10%
Equity to Asset Ratio (average equity to average total assets, excluding other comprehensive income)
8.33%
8.10%
7.98%

Net income is influenced by five key components: net interest income, non-interest income, non-interest expenses, provision for loan losses and the provision for income taxes.

Net Interest Income
 
The most significant source of revenue is net interest income; the amount of interest earned on interest-earning assets exceeding interest incurred on interest-bearing liabilities.  Factors that influence net interest income are changes in volume of interest-earning assets and interest-bearing liabilities as well as changes in the associated interest rates.
 
The following table sets forth our Company’s average balances of, and the interest earned or incurred on, each principal category of assets, liabilities and stockholders’ equity, the related rates, net interest income and rate “spread” created (dollars in thousands):

14

 
     
Analysis of Average Balances and Interest Rates (1)
   
    2008   2007   2006
 
Average
 
Average
Average
 
Average
Average
 
Average
 
Balance (1)
Interest
Rate
Balance (1)
Interest
Rate
Balance (1)
Interest
Rate
 
$
$
%
$
$
%
$
$
%
ASSETS
                 
Short-term investments:
                 
   Interest-bearing deposits at banks
          7,118
           57
0.80
        102
            5
5.10
           4
           -
5.14
Total short-term investments
          7,118
           57
0.80
        102
            5
5.10
           4
           -
5.14
Investment securities:
                 
  Taxable
        99,872
       5,013
5.02
    95,417
      4,702
4.93
    86,198
     3,892
4.52
  Tax-exempt (3)
        36,016
       2,235
6.21
    24,173
      1,451
6.00
    22,952
     1,368
5.96
  Total investment securities
      135,888
       7,248
5.33
  119,590
      6,153
5.14
  109,150
     5,260
4.82
Loans:
                 
  Residential mortgage loans
      211,958
     15,726
7.42
  211,171
    15,640
7.41
  209,305
   14,842
7.09
  Commercial & agricultural loans
      156,873
     11,872
7.57
  147,921
    11,740
7.94
  134,813
   10,353
7.68
  Loans to state & political subdivisions
        47,766
       2,998
6.28
    45,259
      2,751
6.08
    43,642
     2,604
5.97
  Other loans
        11,849
       1,079
9.11
    12,426
      1,150
9.25
    12,747
     1,141
8.95
  Loans, net of discount (2)(3)(4)
      428,446
     31,675
7.39
  416,777
    31,281
7.51
  400,507
   28,940
7.23
Total interest-earning assets
      571,452
     38,980
6.82
  536,469
    37,439
6.98
  509,661
   34,200
6.71
Cash and due from banks
          9,548
   
     9,299
   
     9,093
   
Bank premises and equipment
        12,390
   
    12,773
   
    12,415
   
Other assets
        19,756
   
    18,832
   
    18,610
   
Total non-interest earning assets
        41,694
   
    40,904
   
    40,118
   
Total assets
      613,146
   
  577,373
   
  549,779
   
LIABILITIES AND STOCKHOLDERS' EQUITY
               
Interest-bearing liabilities:
                 
  NOW accounts
      106,694
       1,314
     1.23
    95,098
      2,026
     2.13
    85,481
     1,638
     1.92
  Savings accounts
        41,494
         153
     0.37
    38,443
        137
     0.36
    39,170
       130
     0.33
  Money market accounts
        45,073
         828
     1.84
    50,189
      1,787
     3.56
    45,717
     1,464
     3.20
  Certificates of deposit
      242,751
       9,197
     3.79
  225,590
      9,413
     4.17
  218,019
     8,453
     3.88
Total interest-bearing deposits
      436,012
     11,492
     2.64
  409,320
    13,363
     3.26
  388,387
   11,685
     3.01
Other borrowed funds
        64,858
       2,566
     3.96
    66,525
      3,559
     5.35
    63,635
     3,268
     5.14
Total interest-bearing liabilities
      500,870
     14,058
     2.81
  475,845
    16,922
     3.56
  452,022
   14,953
     3.31
Demand deposits
        54,438
   
    48,981
   
    49,324
   
Other liabilities
          6,735
   
     6,783
   
     4,757
   
Total non-interest-bearing liabilities
        61,173
   
    55,764
   
    54,081
   
Stockholders' equity
        51,103
   
    45,764
   
    43,676
   
Total liabilities & stockholders' equity
      613,146
   
  577,373
   
  549,779
   
Net interest income
 
     24,922
   
    20,517
   
   19,247
 
Net interest spread (5)
   
4.01%
   
3.42%
   
3.40%
Net interest income as a percentage
                 
  of average interest-earning assets
   
4.36%
   
3.82%
   
3.78%
Ratio of interest-earning assets
                 
  to interest-bearing liabilities
   
     1.14
   
     1.13
   
     1.13
                   
(1) Averages are based on daily averages.
                 
(2) Includes loan origination and commitment fees.
               
(3) Tax exempt interest revenue is shown on a tax equivalent basis for proper comparison using
       
    a statutory federal income tax rate of 34%.
               
(4) Income on non-accrual loans is accounted for on a cash basis, and the loan balances are included in interest-earning assets.
 
(5) Interest rate spread represents the difference between the average rate earned on interest-earning assets
     
    and the average rate paid on interest-bearing liabilities.
               

15


Tax exempt interest revenue is shown on a tax-equivalent basis for proper comparison using a statutory, federal income tax rate of 34%.  For purposes of the comparison, as well as the discussion that follows, this presentation facilitates performance comparisons between taxable and tax-free assets by increasing the tax-free income by an amount equivalent to the Federal income taxes that would have been paid if this income were taxable at the Company’s 34% Federal statutory rate.  Accordingly, tax equivalent adjustments for investments and loans have been made accordingly to the previous table for the years ended December 31, 2008, 2007 and 2006, respectively:

 
2008
2007
2006
Interest and dividend income
     
    from investment securities (non-tax adjusted)
 $          6,528
 $          5,626
 $        4,750
Tax equivalent adjustment
                777
                532
              510
Interest and dividend income
     
    from investment securities (tax equivalent basis)
 $          7,305
 $          6,158
 $        5,260
       
       
 
2008
2007
2006
Interest and fees on loans (non-tax adjusted)
 $        30,710
 $        30,398
 $      28,101
Tax equivalent adjustment
                965
                883
              839
Interest and fees on loans (tax equivalent basis)
 $        31,675
 $        31,281
 $      28,940
       
       
 
2008
2007
2006
Total interest income
 $        37,238
 $        36,024
 $      32,851
Total interest expense
           14,058
           16,922
         14,953
Net interest income
           23,180
           19,102
         17,898
Total tax equivalent adjustment
             1,742
             1,415
           1,349
Net interest income (tax equivalent basis)
 $        24,922
 $        20,517
 $      19,247

16

 
The following table shows the tax-equivalent effect of changes in volume and rates on interest income and expense (in thousands):
 
Analysis of Changes in Net Interest Income on a Tax-Equivalent Basis (1)
 

 
 2008 vs. 2007 (1)
 2007 vs. 2006 (1)
 
 Change in
 Change
 Total
 Change in
 Change
 Total
 
 Volume
 in Rate
 Change
 Volume
 in Rate
 Change
Interest Income:
           
Short-term investments:
           
  Interest-bearing deposits at banks
 $             53
 $             (1)
 $            52
 $             5
 $              -
 $             5
Investment securities:
           
  Taxable
              223
               88
             311
            436
             374
            810
  Tax-exempt
              733
               51
             784
              73
               10
              83
Total investment securities
              956
             139
          1,095
            509
             384
            893
Loans:
           
  Residential mortgage loans
               58
               28
               86
            133
             665
            798
  Commercial & agricultural loans
              568
            (436)
             132
          1,031
             356
         1,387
  Loans to state & political subdivisions
              155
               92
             247
              97
               50
            147
  Other loans
              (53)
              (18)
              (71)
             (26)
               35
               9
Total loans, net of discount
              728
            (334)
             394
          1,235
          1,106
         2,341
Total Interest Income
           1,737
            (196)
          1,541
          1,749
          1,490
         3,239
Interest Expense:
           
Interest-bearing deposits:
           
  NOW accounts
              289
         (1,001)
            (712)
            195
             193
            388
  Savings accounts
               11
                5
               16
               (3)
               10
               7
  Money Market accounts
             (167)
            (792)
            (959)
            150
             173
            323
  Certificates of deposit
           1,029
         (1,245)
            (216)
            301
             659
            960
Total interest-bearing deposits
           1,162
         (3,033)
         (1,871)
            643
          1,035
         1,678
Other borrowed funds
              (87)
            (906)
            (993)
            152
             139
            291
Total interest expense
           1,075
         (3,939)
         (2,864)
            795
          1,174
         1,969
Net interest income
 $           662
 $        3,743
 $        4,405
 $          954
 $          316
 $       1,270

 (1) The portion of total change attributable to both volume and rate changes, which cannot be separated, has been allocated proportionally to the change due to volume and the change due to rate prior to allocation.

2008 vs. 2007
 
Tax equivalent net interest income for 2008 was $24,922,000 compared with $20,517,000 for 2007, an increase of $4,405,000 or 21.5%.  The increased volume of interest earning assets of $35.0 million generated an increase in interest income of $1,737,000.  The average rate on interest earning assets decreased from 6.98% in 2007 to 6.82% in 2008, which had the effect of decreasing interest income by $196,000.
 
Total tax equivalent interest income from investment securities increased $1,095,000 in 2008 from 2007.  The average balance of investment securities increased $16.3 million, which had an effect of increasing interest income by $956,000 due to volume.  Of this amount, $733,000 is from income on tax-exempt investment securities, where the average balance increased $11.8 million from 2007.  The average tax-effected yield on our investment portfolio increased from 5.14% in 2007 to 5.33% in 2008.  This had the effect of increasing interest income by $139,000 due to rate.  The Company’s strategy in 2008 was to increase the size and duration of our investment portfolio, given the opportunity that general market conditions provided, resulting in an increase in the overall yield on our investments.
 
Loan income increased $394,000 in 2008 from 2007.  The average balance of our loan portfolio increased by $11.7 million in 2008 compared to 2007 resulting in an increase in interest income of $728,000 due to volume.  Offsetting this was a decrease in yield on total loans from 7.51% in 2007 to 7.39% in 2008 resulting in a decrease in interest income of $334,000 due to rate.
 
17

 
Interest income on residential mortgage loans increased only $86,000.  The average balance increased only $787,000 as issues facing the economy, financial markets and unemployment rates significantly impacted loan demand.  The Company continues to strive on being the top mortgage lender within our service area by providing competitive products and exemplary service to our customers.
 
During 2008, the Federal Reserve decreased the federal funds rate by 425 basis points.  This decrease as well as competitive pressures impacted loan yields, particularly yields on commercial and agricultural loans.  The average yield on commercial and agricultural loans decreased from 7.94% in 2007 to 7.57% in 2008, decreasing interest income by $436,000 due to rate.  The average balance of commercial and agricultural loans increased $9.0 million, increasing interest income $568,000 due to volume.
 
Total interest expense decreased $2,864,000 in 2008 compared to 2007.  The average balance of interest bearing liabilities increased $25.0 million from 2007 to 2008.  This had the effect of increasing interest expense by $1,075,000 due to volume.  The average rate paid on interest bearing liabilities decreased from 3.56% to 2.81% due to decreasing interest rates caused by the current economic climate.  This resulted in a $3,939,000 decrease in interest expense due to rate.  Balances most affected were those that were indexed to a specific market rate.
 
As noted above, the federal funds rate decreased 425 basis points during 2008.  This had an impact on the rates paid on short term deposits, top tier money market and NOW accounts, and on short term borrowing rates particularly from the Federal Home Loan Bank.  The Company’s liabilities, including borrowings and deposits, are shorter in nature and are more sensitive to short-term changes in interest rates.  Our ability to decrease rates paid on short term liabilities faster than the average rates earned on interest earning assets resulted in an improvement in our net interest spread.  Our net interest spread for 2008 was 4.01% compared to 3.42% in 2007.  The current economic situation has resulted in a more normal yield curve suggesting that our margin should remain consistent or near its current level.   Should short-term and/or long-term interest rates move in such a way that results in a flattened or inverted yield curve, we would anticipate pressure on our margin.

2007 vs. 2006
 
Tax equivalent net interest income for 2007 was $20,517,000 compared with $19,247,000 for 2006, an increase of $1,270,000 or 6.6%.  The increased volume of interest earning assets of $26.8 million generated an increase in interest income of $1,749,000.  The average rate on interest earning assets increased from 6.71% in 2006 to 6.98% in 2007, which had the effect of increasing interest income by $1,490,000.
 
Total tax equivalent interest income from investment securities increased $893,000 in 2007 from 2006.  The average balance of investment securities increased $10.4 million, which had an effect of increasing interest income by $509,000 due to volume.  The average tax-effected yield on our investment portfolio increased from 4.82% in 2006 to 5.14% in 2007.  This had the effect of increasing interest income by $384,000 due to rate.
 
Loan income increased $2,341,000 in 2007 from 2006.  Commercial and agricultural loans were the primary drivers as income from these loans increased $1,387,000 over 2006.  The increase due to volume was $1,031,000 as the average balance of commercial and agricultural loans increased $13.1 million or 9.7%.  The average rate increased from 7.68% to 7.94%, increasing interest income $356,000 due to rate.
 
Residential mortgage loan income increased $798,000.  The increase due to volume was $133,000, as the average balance increased $1.9 million.  During 2007, overall rates increased on 1 to 4 family residential mortgages due to various economic conditions, including well publicized credit issues facing the banking industry.  Although we were not directly impacted by sub-prime credit concerns facing other institutions, the average rate earned on our residential mortgage loan portfolio increased from 7.09% to 7.41%.  This had the effect of increasing interest income by $665,000.
 
Total interest expense increased $1,969,000 in 2007 compared to 2006.  This is attributable to an increase in the average balance of interest bearing liabilities, which increased $23.8 million.  This had the effect of increasing interest expense by $795,000.  The average rate paid on interest bearing liabilities increased from 3.31% to 3.56%.  This is primarily due to increased average balances in state and political deposits which are more sensitive to market changes in interest rates.  The overall increase in the average rate had the effect of increasing interest expense by $1,174,000.
 
During the second half of 2007, the Federal Reserve decreased the federal funds rate 100 basis points.  This had an impact on the rates paid on short term deposits, top tier money market and NOW accounts, and on short term borrowing rates particularly from the Federal Home Loan Bank.  Because the average rates paid on our short term liabilities decreased faster than the average rate earned on interest earning assets has resulted in a slight improvement in our net interest spread from 3.40% in 2006 to 3.42%.
 
18

 
Non-interest Income

The following table reflects non-interest income by major category for the periods ended December 31 (dollars in thousands):


 
2008
2007
2006
Service charges
 $          3,489
 $          3,210
 $          3,140
Trust
                561
                520
                487
Brokerage and insurance
                240
                132
                260
Investment securities (losses) gains, net
            (4,089)
                 (29)
                    4
Gains on sales of foreclosed properties
                  81
                396
                  80
Earnings on bank owned life insurance
                362
                331
                304
Other
                512
                525
                441
Total
 $          1,156
 $          5,085
 $          4,716


 
 2008/2007
 2007/2006
 
Change
Change
 
Amount
%
Amount
%
Service charges
 $             279
                 8.7
 $               70
                 2.2
Trust
                  41
                 7.9
                  33
                 6.8
Brokerage and insurance
                108
               81.8
               (128)
              (49.2)
Investment securities (losses) gains, net
            (4,060)
                    n/a
                 (33)
n/a
Gains on sales of foreclosed properties
               (315)
              (79.5)
                316
             395.0
Earnings on bank owned life insurance
                  31
                 9.4
                  27
                 8.9
Other
                 (13)
                (2.5)
                  84
               19.0
Total
 $         (3,929)
              (77.3)
 $             369
                 7.8
 
2008 vs. 2007
 
Non-interest income decreased $3,929,000 in 2008 from 2007, or 77.3%.  Most notable, we recorded investment security losses totaling $4,089,000 compared with a $29,000 loss in 2007.  As a result of actions taken by the U.S. Treasury Department and the Federal Housing Financing Agency with respect to the Federal Home Loan Mortgage Corporation (“Freddie Mac”) and deteriorating credit and liquidity conditions in the third quarter of 2008, we recorded a non-recurring $2,336,000 million other than temporary impairment charge related to our investment in Freddie Mac preferred stock and a $1,796,000 other than temporary impairment charge on a Lehman Brothers corporate bond.  The Lehman Brothers corporate bond was subsequently sold in the fourth quarter of 2008.
 
Service charge income increased by $279,000 in 2008 compared to 2007.    Service charge fees charged to customers for non-sufficient funds increased by $162,000.  Additionally, we increased ATM and related check card fee income by $113,000 compared to last year as the Company continues to promote efforts to increase usage of debit cards by retail customers.
 
Brokerage and insurance revenue increased by $108,000 in 2008, while trust revenues increased 7.9% to $561,000 during 2008.  The Company’s continued efforts on hiring experienced professionals who strive to provide quality service and meet customers’ needs resulted in improved revenues.
 
Gains on sales of foreclosed properties decreased by $315,000 in 2008 compared to 2007 primarily due to a pre-tax gain of $381,000 recognized on a large commercial property that was sold in the second quarter of 2007.

19

 
2007 vs. 2006
 
Non-interest income increased $369,000 in 2007 from 2006, or 7.8%.  Service charge income increased by $70,000 in 2007 compared to 2006.  ATM and related check card fee income increased $90,000 from last year.  Service charge fees charged to customers for non-sufficient funds increased by $15,000.  Offsetting these increases was a $40,000 decrease in statement fees, primarily due to the competitive environment for attracting and retaining commercial deposit customers and increased earnings credits with our account analysis product on commercial deposits.
 
Trust revenues increased by 6.8% to $520,000 during 2007 compared to 2006.  This increase was offset by a decrease in brokerage and insurance revenue of $128,000.
 
Gains on sales of foreclosed properties increased by $316,000 in 2007 compared to 2006 primarily due to a pre-tax gain of $381,000 recognized on a large commercial property that was sold in the second quarter of 2007, as mentioned above.
 
Investment securities losses of $29,000 were realized in 2007 due to restructuring the investment portfolio in order to improve future yields.

Non-interest Expenses

The following tables reflect the breakdown of non-interest expense and professional fees for the periods ended December 31 (dollars in thousands):

 
2008
2007
2006
Salaries and employee benefits
 $         8,725
 $         8,386
 $         8,026
Occupancy
            1,162
            1,151
            1,123
Furniture and equipment
               479
               539
               593
Professional fees
               625
               645
               551
Amortization of intangibles
               145
               144
               252
Other
            4,741
            4,449
            4,482
Total
 $       15,877
 $       15,314
 $       15,027

 
 2008/2007
 2007/2006
 
Change
Change
 
Amount
%
Amount
%
Salaries and employee benefits
 $            339
                4.0
 $            360
                4.5
Occupancy
                 11
                1.0
                 28
                2.5
Furniture and equipment
               (60)
            (11.1)
               (54)
              (9.1)
Professional fees
               (20)
              (3.1)
                 94
              17.1
Amortization of intangibles
                   1
                0.7
             (108)
            (42.9)
Other
               292
                6.6
               (33)
              (0.7)
Total
 $            563
                3.7
 $            287
                1.9

20

 
 
2008
2007
2006
Other professional fees
 $           316
 $           367
 $           296
Legal fees
              129
              111
              115
Examinations and audits
              180
              167
              140
Total
 $           625
 $           645
 $           551

 
 2008/2007
 2007/2006
 
Change
Change
 
Amount
%
Amount
%
Other professional fees
 $            (51)
            (13.9)
 $             71
             24.0
Legal fees
                18
             16.2
                 (4)
              (3.5)
Examinations and audits
                13
               7.8
                27
             19.3
Total
 $            (20)
              (3.1)
 $             94
             17.1

2008 vs. 2007
 
Non-interest expenses for 2008 totaled $15,877,000 which represents an increase of $563,000, or 3.7%, compared with 2007 costs of $15,314,000.  Much of the increase is attributable to salary and benefit costs increasing $339,000. Base salaries and related payroll taxes increased $191,000 primarily due to merit increases.  The year to date full time equivalent staffing was 169 employees for 2008 compared to 170 employees for 2007.  Incentive costs increased $249,000 compared to 2007 primarily due to the attainment of certain corporate goals and objectives, as well as the implementation of a supplemental employee retirement plan for key management.  Insurance costs for employees increased by $70,000 attributable to a significant increase in insurance premiums.  Pension expense decreased by $187,000 compared to 2007.  Effective January 1, 2008, the Company modified its defined benefit pension plan resulting in a reduction in expense.
 
Other expenses increased $292,000 over last year mainly due to branch acquisition costs, an increase in the FDIC assessment and operational charge offs.
 
Furniture and equipment expenses decreased $60,000 mainly due to a reduction in depreciation expense from assets that became fully depreciated during the year.
 
Due to the FDIC’s across the board assessment increase, along with the proposed 20 basis point special assessment, our FDIC insurance expense is expected to increase by up to $1,800,000 in 2009.

2007 vs. 2006
 
Non-interest expenses for 2007 increased $287,000, or 1.9%, compared with 2006.  Salary and benefit costs increased $360,000, which includes an increase in base salaries of $111,000 primarily due to merit increases.  The year to date full time equivalent staffing was 170 employees for 2007 compared to 172 employees for 2006.  Incentive costs for employees increased by $236,000 due primarily to the attainment of certain corporate goals and objectives.
 
Professional fees increased by $94,000 due to various consulting arrangements including an evaluation of our employee pension and incentive plans as well as increased internal control testing requirements related to SOX regulations.
 
We experienced decreases in furniture and equipment expenses and amortization of intangibles.  Amortization expense decreased $108,000 due to a core deposit intangible from a previous acquisition that became fully amortized in March 2006.  Furniture and equipment expense decreased $54,000 mainly due to depreciation expense from assets becoming fully depreciated.  Also, during the second quarter of 2007 we recorded a $100,000 write-down of one of our bank properties.

Provision For Income Taxes
 
The provision for income taxes was $1,224,000 during 2008, $1,772,000 during 2007 and $1,457,000 for the 2006 related periods.   The effective tax rates for 2008, 2007 and 2006 were 15.1%, 20.8% and 20.1%, respectively.
 
Income before the provision for income taxes decreased by $379,000 in 2008 compared to 2007, while the provision for income taxes decreased by $548,000 when compared to 2007.  We have successfully managed our effective tax rate by remaining invested in tax-exempt municipal loans and bonds.  As such, the provision was impacted in 2008 by an increase in tax exempt bond and loan revenue.  Additionally, the Emergency Economic Stabilization Act of 2008 (“EESA”) was signed into law on October 3, 2008.  The EESA included a provision which will allow the loss on the Freddie Mac preferred stock to be treated as an ordinary loss.  Management will continue to monitor and manage our effective tax rate.   
 
21

 
We are also involved in three limited partnership agreements that established low-income housing projects in our market area.  For tax purposes, we have recognized $738,000 out of a total $913,000 in tax credits from one project and $263,000 out of a total $385,000 in tax credits on the second project.  In 2005, we entered into a third limited partnership for a low-income housing project for senior citizens in our Sayre market area, which was completed at the end of 2006. Beginning in 2007, we have recognized $105,000 out of a total of $574,000 tax credits. $766,000 in tax credits remain and will be taken over the next eight years.    

FINANCIAL CONDITION
 
The following table presents ending balances (dollars in millions), growth and the percentage change during the past two years:

 
 2008
 
 %
 2007
 
 %
 2006
 
 Balance
 Increase
 Change
 Balance
 Increase
 Change
 Balance
 Total assets
 $        668.6
 $           77.6
           13.1
 $      591.0
 $           18.8
             3.3
 $      572.2
 Total investments
           174.1
              53.3
           44.1
         120.8
              11.1
           10.1
         109.7
 Total loans, net
           428.4
                9.2
             2.2
         419.2
                8.3
             2.0
         410.9
 Total deposits
           546.7
              90.7
           19.9
         456.0
                9.5
             2.1
         446.5
 Total stockholders' equity
             52.8
                4.3
             8.9
           48.5
                5.0
           11.5
           43.5

Cash and Cash Equivalents
 
Cash and cash equivalents totaled $19.9 million at December 31, 2008 compared with $10.4 million at December 31, 2007.  We believe the Company’s liquidity needs are satisfied by the current balance of cash and cash equivalents, readily available access to traditional funding sources, Federal Home Loan Bank financing, federal funds lines with correspondent banks, brokered certificates of deposit and the portion of the investment and loan portfolios that mature within one year.  These sources of funds should permit us to meet cash obligations and off-balance sheet commitments as they come due.

Investments

2008
 
The Company’s investment portfolio increased by $53,337,000, or 44.1%, during the past year.  During 2008, we purchased approximately $42.1 million of mortgage-backed securities, $12.7 million of U.S. agency obligations, and $15.4 million of municipal bonds.  Offsetting the purchases were $11.5 million of principal repayments and $3.5 million in maturities that occurred during 2008.  Due to unusually wide credit spreads to treasuries, significant market opportunity existed to grow our investment portfolio during the latter half of 2008.  In doing so, the effective yield on our portfolio for 2008 improved to 5.33% compared to 5.14% for 2007 on a tax equivalent basis.  The market value of our investment portfolio increased approximately $2.4 million in 2008 due to  a decrease in interest rates and the realization of loss due to the Freddie Mac write-down and the sale of the Lehman Brothers corporate bond.

2007
 
The Company’s investment portfolio increased by $11,059,000, or 10.1%, in 2007.  During 2007, we purchased approximately $21.2 million of mortgage-backed securities, $12.4 million of U.S. agency obligations, and $8.4 million of municipal bonds.  Offsetting the purchases were $18.9 million in sales, $11.2 million of principal repayments and $2.2 million in maturities that occurred during 2007.  We increased the balance in our investment portfolio during 2007 primarily due to market opportunities related to fluctuations in the Treasury curve and the resulting impact on bond yields.  In doing so, the effective yield on our portfolio for 2007 improved to 5.14% compared to 4.82% for 2006 on a tax equivalent basis.  The market value of our investment portfolio increased approximately $1.4 million in 2007.
 
22

 
The following table shows the year-end composition of the investment portfolio for the five years ended December 31 (dollars in thousands):

 
2008
% of
2007
% of
2006
% of
2005
% of
2004
% of
 
Amount
Total
Amount
Total
Amount
Total
Amount
Total
Amount
Total
Available-for-sale:
                   
  U. S. Agency securities
 $      28,942
      16.6
 $   17,236
      14.3
 $   16,651
    15.2
 $   12,754
    12.5
 $     5,812
      6.1
  Obligations of state & political
                   
     subdivisions
         44,132
      25.3
      30,844
      25.4
      22,562
    20.5
      22,612
    22.0
        7,452
      7.8
  Corporate obligations
           5,296
        3.0
        7,813
        6.5
        7,997
      7.3
        8,627
      8.4
        8,935
      9.3
  Mortgage-backed securities
         95,407
      54.8
      62,642
      51.9
      59,875
    54.6
      55,852
    54.4
      70,449
    73.6
  Equity securities
              362
        0.3
        2,267
        1.9
        2,658
      2.4
        2,757
      2.7
        3,099
      3.2
Total
 $    174,139
    100.0
 $ 120,802
    100.0
 $ 109,743
  100.0
 $ 102,602
  100.0
 $   95,747
  100.0

The expected principal repayments (amortized cost) and average weighted yields for the investment portfolio as of December 31, 2008, are shown below (dollars in thousands). Expected principal repayments, which include prepayment speed assumptions for mortgage-backed securities, are significantly different than the contractual maturities detailed in Note 3 of the consolidated financial statements. Yields on tax-exempt securities are presented on a fully taxable equivalent basis, assuming a 34% tax rate.
 
     
After One Year
After Five Years
       
 
One Year or Less
to Five years
to Ten Years
After Ten Years
Total
 
Amortized
Yield
Amortized
Yield
Amortized
Yield
Amortized
Yield
Amortized
Yield
 
Cost
%
Cost
%
Cost
%
Cost
%
Cost
%
Available-for-sale securities:
                   
  U.S. Agency securities
 $     12,348
     4.6
 $      13,840
     5.7
 $        1,440
     5.5
 $             -
        -
 $      27,628
     5.2
  Obligations of state & political
                   
    subdivisions
         3,659
     6.0
         18,964
     6.2
         19,795
     6.7
         1,770
     6.6
         44,188
     6.4
  Corporate obligations
                -
        -
                 -
        -
          5,964
     5.6
                -
        -
          5,964
     5.6
  Mortgage-backed securities
        15,460
     4.6
         45,153
     5.0
         23,477
     5.7
         8,947
     6.4
         93,037
     5.2
Total available-for-sale
 $     31,467
     4.8
 $      77,957
     5.4
 $      50,676
     6.1
 $     10,717
        -
 $    170,817
     5.6


 Approximately 64% of the amortized cost of debt securities is expected to mature, call or pre-pay within five years or less.  Our Company expects that earnings from operations, the high liquidity level of the available-for-sale securities, growth of deposits and the availability of borrowings from the Federal Home Loan Bank and other third party banks will be sufficient to meet future liquidity needs.  There are no securities from a single issuer representing more than 10% of stockholders’ equity.

Loans
 
Historically, our loan customers have been located in North Central Pennsylvania and Southern New York. We originate loans primarily through direct loans to our existing customer base, with new customers generated by referrals from real estate brokers, building contractors, attorneys, accountants and existing customers.
 
All lending is governed by a lending policy that is developed and maintained by us and approved by the Board of Directors. Our Company’s real estate loan lending policy generally permits the Bank to lend up to 80% of the appraised value or purchase price (whichever is lower) on owner-occupied residential property, when secured by the first mortgage on the property. Home equity lines of credit or second mortgage loans are generally originated subject to maximum mortgage liens against the property of 85% of the current appraised value. The maximum term for mortgage loans is 30 years for one-to-four family residential property and 20 years for commercial and vacation property.

23

 
2008

Total loans grew $9.4 million in 2008 from a balance of $423.4 million at the end of 2007 to $432.8 million at the end of 2008.  Total loans grew 2.2% in 2008 compared with a 2.1% loan growth rate in 2007.
 
Commercial real estate loans increased $7.4 million in 2008 or 7.3% while commercial and other loans increased $3.3 million, or 9.5%.  State and political subdivision loans also increased by $3.0 million, or 6.6%.  While not compromising credit quality, our strong team of seasoned business development officers enabled the Company to grow our high quality, commercial loan portfolio and achieve organic loan growth.  Commercial loan demand is subject to significant competitive pressures, the yield curve and the strength of the overall local, regional and national economy.
 
Residential real estate loans decreased $2.7 million primarily due to the lack of loan demand in the residential real estate market.  Additionally, consumer loans decreased by $1.4 million, or 10.9%.  Increasing unemployment rates, recessionary pressures, a softening economy, tightened credit standards, low consumer confidence, and the depressed financial markets have all had a negative impact on our loan growth.  Despite the decrease in loan demand, mortgage lending continues to be one of our primary focuses, as residential real estate loans totaled $199.1 million and comprised 46.0% of the loan portfolio as of the end of the year compared to 47.7% as of December 31, 2007.  One of our primary goals is to continue being the premier mortgage lender in our market area, with a variety of mortgage products available for our customers.  We expect residential real estate loan demand to increase as the economy improves.  During 2008, $4.4 million in conforming mortgage loans were originated and sold in the secondary market through Freddie Mac and Fannie Mae, providing nearly $52,000 of income in origination fees and premiums on loans sold.

2007
 
Total loans grew $8.6 million, or 2.1% in 2007 from a balance of $414.8 million at the end of 2006 to $423.4 million at the end of 2006.  The primary increases were in commercial real estate, construction, and commercial and other loans which increased $6.3, $4.3, and $1.9 million, respectively.  Residential loans decreased $4.2 million, or 2.0% from 2006.  The overall loan growth in 2007 of 2.1% compares to the 8.4% loan growth in 2006.
 
Commercial real estate loans increased $6.3 million in 2007 or 6.6% while construction real estate loans increased $4.3 million, or 61.2%.  Residential real estate loans decreased $4.2 million primarily due to the lack of loan demand in the residential real estate market.  Residential real estate loans totaled $201.9 million and comprised 47.7% of the loan portfolio as of the end of the year.  In 2007, $6.7 million in conforming mortgage loans were originated and sold in the secondary market through Freddie Mac and Fannie Mae, providing nearly $83,000 of income in origination fees and premiums on loans sold.
 
Five Year Breakdown of Loans by Type as of December 31,
 
 
2008
2007
2006
2005
2004
(dollars in thousands)
Amount
%
Amount
%
Amount
%
Amount
%
Amount
%
Real estate:
                   
  Residential
 $   199,118
    46.0
 $  201,861
    47.7
 $  206,059
    49.7
 $  195,628
    51.1
 $  189,803
    52.8
  Commercial
      107,740
    24.9
     100,380
    23.7
       94,122
    22.7
       82,128
    21.5
       75,228
    20.9
  Agricultural
        17,066
      3.9
       16,891
      4.0
       17,054
      4.1
       12,991
      3.4
       11,564
      3.2
  Construction
        11,118
      2.6
       11,330
      2.7
         7,027
      1.7
         7,245
      1.9
         7,282
      2.0
Loans to individuals
                   
  for household,
                   
  family and other purchases
        11,651
      2.7
       13,082
      3.1
       12,482
      3.0
       13,017
      3.4
       12,657
      3.5
Commercial and other loans
        37,968
      8.8
       34,664
      8.2
       32,766
      7.9
       29,260
      7.6
       28,069
      7.8
State & political subdivision loans
        48,153
    11.1
       45,171
    10.6
       45,263
    10.9
       42,534
    11.1
       35,090
      9.8
Total loans
      432,814
  100.0
     423,379
  100.0
     414,773
  100.0
     382,803
  100.0
     359,693
  100.0
Less allowance for loan losses
          4,378
 
         4,197
 
         3,876
 
         3,664
 
         3,919
 
Net loans
 $   428,436
 
 $  419,182
 
 $  410,897
 
 $  379,139
 
 $  355,774
 
 
24


 
 
 2008/2007
2007/2006
 
Change
Change
 
Amount
%
Amount
%
Real estate:
       
  Residential
 $     (2,743)
    (1.4)
 $    (4,198)
    (2.0)
  Commercial
          7,360
      7.3
         6,258
      6.6
  Agricultural
             175
      1.0
          (163)
    (1.0)
  Construction
           (212)
    (1.9)
         4,303
    61.2
Loans to individuals
       
  for household,
       
  family and other purchases
        (1,431)
  (10.9)
            600
      4.8
Commercial and other loans
          3,304
      9.5
         1,898
      5.8
State & political subdivision loans
          2,982
      6.6
            (92)
    (0.2)
Total loans
 $       9,435
      2.2
 $      8,606
      2.1

The following table shows the maturity of state and political subdivision loans, commercial and agricultural loans and commercial loans secured by real estate as of December 31, 2008, classified according to the sensitivity to changes in interest rates within various time intervals (in thousands).  The table does not include any estimate of prepayments which significantly shorten the average life of all loans and may cause our actual repayment experience to differ from that shown below.  Demand loans having no stated schedule of repayments and no stated maturity are reported as due in one year or less.  The amounts shown below exclude net deferred loan costs or fees.
 
 
Commercial,
   
 
municipal,
Real estate
 
 
agricultural
construction
Total
Maturity of loans:
     
  One year or less
 $             9,965
 $                    -
 $             9,965
  Over one year through five years
              29,290
                     65
              29,355
  Over five years
            171,672
              11,053
            182,725
Total
 $         210,927
 $           11,118
 $         222,045
Sensitivity of loans to changes in interest
     
   rates - loans due after December 31, 2009:
     
  Predetermined interest rate
 $           43,074
 $             2,831
 $           45,905
  Floating or adjustable interest rate
            157,888
                8,287
            166,175
Total
 $         200,962
 $           11,118
 $         212,080

Loan Quality and Provision For Loan Losses
 
As discussed previously, the loan portfolio contains a large portion of real estate secured loans (generally residential home mortgages, mortgages on small business properties, etc.), consumer installment loans and other commercial loans.  Footnote 4 of the consolidated financial statements provides further details on the composition of the loan portfolio.
 
The following table indicates the level of non-performing assets over the past five years ended December 31 (dollars in thousands).  We did not have any troubled debt restructurings at the dates presented.

25

 

 
2008
2007
2006
2005
2004
Non-performing loans:
         
  Non-accruing loans, exclusive of impaired loans
 $          580
 $          827
 $          478
 $          867
 $          722
  Impaired loans
          1,622
          1,088
          1,190
          1,031
          1,061
  Accrual loans - 90 days or
         
    more past due
             383
             275
          1,690
             337
             437
Total non-performing loans
          2,585
          2,190
          3,358
          2,235
          2,220
Foreclosed assets held for sale
             591
             203
             758
             619
             712
Total non-performing assets
 $       3,176
 $       2,393
 $       4,116
 $       2,854
 $       2,932
Non-performing loans as a percent of loans
         
   net of unearned income
0.60%
0.52%
0.81%
0.58%
0.62%
Non-performing assets as a percent of loans
         
  net of unearned income
0.73%
0.57%
0.99%
0.75%
0.82%

 The following table presents an analysis of the allowance for loan losses for the five years ending December 31 (dollars in thousands):
 
                                                     Summary of Loan Loss Experience
 
2008
2007
2006
2005
2004
Balance
         
  at beginning of period
 $          4,197
 $          3,876
 $          3,664
 $          3,919
 $          3,620
Charge-offs:
         
  Real estate-mortgage
                  87
                  70
                  37
                  43
                110
  Loans to individuals for household,
         
    family and other purchases
                  44
                111
                118
                168
                  70
  Commercial and other loans
                115
                    5
                135
                161
                135
Total loans charged-off
                246
                186
                290
                372
                315
Recoveries:
         
  Real estate-mortgage
                  26
                  81
                    6
                    2
                     -
  Loans to individuals for household,
         
    family and other purchases
                  19
                  57
                  44
                  12
                  25
  Commercial and other loans
                  52
                    4
                122
                  43
                299
Total loans recovered
                  97
                142
                172
                  57
                324
           
Net loans charged-off (recovered)
                149
                  44
                118
                315
                   (9)
Provision charged to expense
                330
                365
                330
                  60
                     -
Increase related to acquisition
                     -
                     -
                     -
                     -
                290
Balance at end of year
 $          4,378
 $          4,197
 $          3,876
 $          3,664
 $          3,919
           
Loans outstanding at end of year
 $      432,814
 $      423,379
 $      414,773
 $      382,803
 $      359,693
Average loans outstanding, net
 $      423,382
 $      411,927
 $      400,507
 $      371,147
 $      338,836
Net charge-offs to average loans
0.04%
0.01%
0.03%
0.08%
0.00%
Year-end allowance to total loans
1.01%
0.99%
0.93%
0.96%
1.09%
Year-end allowance to total
         
    non-performing loans
169.36%
191.64%
115.43%
163.94%
176.53%
 
26

 
As detailed in the preceding table, the percent of non-performing loans to total loans increased slightly from .52% to .60% as of the end of December, 2008.  Foreclosed assets held for sale increased by $388,000, to $591,000, which is average compared to the prior four years.  Total loans charged-off in 2008 totaled $246,000, an increase of $60,000 compared to last year.  Total loans recovered were $97,000, resulting in a net charge-off for the year of $149,000 compared to $44,000 in 2007.  $330,000 was charged to the provision in 2008 compared to $365,000 in 2007.  During 2007, there were $186,000 of loans charged-off while $142,000 of loans were recovered, resulting in a net charge-off of $44,000.
 
Other than those disclosed above, we do not believe there are any loans classified for regulatory purposes as loss, doubtful, substandard, special mention or otherwise, which will result in losses or have a material impact on future operations, liquidity or capital reserves. We are not aware of any other information that causes us to have serious doubts as to the ability of borrowers in general to comply with repayment terms.

Allowance For Loan Losses
 
The allowance is maintained at a level, which in management’s judgment is adequate to absorb probable future loan losses inherent in the loan portfolio.  The amount of the allowance is determined by a formal analysis of delinquencies, large problem credits, non-accrual loans, local economic conditions, trends in the loan portfolio and historic and projected losses.  As part of this evaluation, the loan portfolio is divided into several categories in order to appropriately measure the risks within the portfolio.  These categories are loans classified on the Watch List, residential mortgages, commercial loans and consumer loans.
 
Historical loss factors are calculated for consumer, residential mortgage, and commercial loans for the past seven years.  The five year average historical loss factor for each category is applied to the performing portion of the loan category.  For Watch List loans, the losses are calculated using regulatory guidelines and are based on historical losses.  These historical factors, for both the Watch List and homogeneous loan pools, are adjusted based on the following qualitative factors:
 
§  
Level of delinquencies and non-accruals
§  
Trends in volume and terms of loans
§  
Experience, ability and depth of management
§  
National and local economic trends and conditions
§  
Concentration of credit
§  
Changes in the quality of the Company’s loan review system
§  
Industry conditions including the effects of external factors such as competition, legal, and regulatory requirements, on the level of estimated credit losses

  While we evaluate all of this information quarterly, future adjustments to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the evaluation. In addition, various regulatory agencies, as an integral part of their examination process, review our Company’s allowance for loan losses. These agencies may require us to recognize changes to the allowance based on their evaluation of information available to them. We believe that the current allowance is adequate to offset any exposure that may exist for loans that are under secured or loans that might not be collectible.
 
The accrual of interest income on loans is discontinued when, in the opinion of management, there exists doubt as to the ability to collect interest.  Payments received on non-accrual loans are applied to the outstanding principal balance or recorded as interest income, depending upon our assessment of our ability to collect principal and interest.  Loans are returned to the accrual status when factors indicating doubtful collectability cease to exist.

Allocation of the Allowance for Loan Losses
The allocation of the allowance for loan losses is our determination of the amounts necessary for concentrations and changes in mix and volume of the loan portfolio.  The unallocated portion of the allowance is based upon our assessment of general and specific economic conditions within our market. This allocation is more uncertain and considers risk factors that may not be reflected in our historical loss factors.
 
The following table shows the distribution of the allowance for loan losses and the percentage of loans compared to total loans by loan category (dollars in thousands):
 
27


 
 
2008
2007
2006
2005
2004
 
Amount
%
Amount
%
Amount
%
Amount
%
Amount
%
Real estate loans:
                   
  Residential
 $         694
      46.0
 $       599
      47.7
 $       614
      49.7
 $       493
      51.1
 $       392
      52.8
  Commercial, agricultural
         2,303
      28.8
       2,128
      27.7
       1,676
      26.8
       1,551
      24.9
       1,591
      24.1
  Construction
               5
        2.6
              -
        2.7
              -
        1.7
              -
        1.9
              -
        2.0
Loans to individuals
                   
   for household,
                   
   family and other purchases
            449
        2.7
          424
        3.1
          734
        3.0
          542
        3.4
          463
        3.5
Commercial and other loans
            807
        8.8
          736
        8.2
          582
        7.9
          484
        7.6
          515
        7.8
State & political subdivision loans
              19
      11.1
            22
      10.6
            22
      10.9
            21
      11.1
            18
        9.8
Unallocated
            101
 N/A
          288
 N/A
          248
 N/A
          573
 N/A
          940
 N/A
Total allowance for loan losses
 $      4,378
    100.0
 $    4,197
    100.0
 $    3,876
    100.0
 $    3,664
    100.0
 $    3,919
    100.0

Bank Owned Life Insurance
 
In 2003 the Company purchased $7.0 million of bank owned life insurance to offset future employee benefit costs.  The Bank is the sole beneficiary on the policies, and will provide the Bank with an asset that will generate earnings to partially offset the current costs of benefits, and eventually (at the death of the insured’s) provide partial recovery of cash outflows associated with the benefits.  During the fourth quarter of 2008, we increased our investment in bank owned life insurance by approximately $3.4 million based upon an analysis of new employees and updated future employee benefit costs.  As of December 31, 2008 and 2007, the cash surrender value of the life insurance was $12.2 and $8.4 million, respectively.  The change in cash surrender value, net of purchases, is recognized in the results of operations.  The amounts recorded as non-interest income totaled $362,000, $331,000 and $304,000 in 2008, 2007 and 2006, respectively.  The Company evaluates annually the risks associated with the life insurance policies, including limits on the amount of coverage and an evaluation of the various carriers’ credit ratings.

Deposits

2008
 
As can be seen in the tables below, total deposits increased $90.7 million in 2008, or 19.9%.  The increase in deposits is due to several reasons.  Our market has been positively impacted from oil and gas exploration activities and we have developed products specifically targeting those that have benefited from this activity.  Furthermore, the overall turbulence and volatility of the financial markets has resulted in customers seeking stability from familiar local banks.  Also, on November 21, 2008, our Company gained approximately $16.9 million in deposits from a local branch acquisition (see Note 18 to the consolidated financial statements).
 
Non-interest bearing deposits increased $4.6 million, or 9.0% in 2008.  As a percent to total, non-interest bearing deposits totaled 10.2% as of the end of 2008, which compares to 11.2% at the end of 2007.  In order to manage our overall cost of funds, the Company continues to focus on adding low cost deposits by having a free checking product available for retail customers and being one of the few banks within our market to pay interest on a senior checking product.  Additionally, our business development officers and branch personnel are focused on providing outstanding customer service and developing larger deposit relationships with our commercial customers.
 
NOW accounts increased by $15.5 million, or 15.5%, and savings deposits increased $6.5 million, or 17.0%, since the end of 2007.  Most of the increase in NOW accounts is due to state and local governmental agencies as well as $4.7 million coming from the aforementioned branch acquisition.  Money market deposit accounts decreased by $9.6 million in 2008, a decrease of 18.8%, due mostly to customers seeking higher deposit rates since the Federal Reserve’s actions have decreased short term rates significantly.
 
Certificates of deposit increased $73.8 million, or 34.2% from 2007 primarily due to the reasons mentioned above.  Approximately $20 million of the growth came from oil and gas exploration activities.  The branch acquisition accounted for $11.3 million in growth.
 
28

 
Our deposit growth funded our growth in loans of $9.4 million, our growth in investments of $53.3 million, and enabled us to decrease our borrowed funds by $19.1 million while providing us with liquidity in this challenging economy.

2007
 
Total deposits increased $9.5 million in 2007, or 2.1%.  Non-interest bearing deposits increased $2.4 million.  As a percent to total, non-interest bearing deposits totaled 11.2% as of the end of 2007, which compared to 10.9% at the end of 2006.  NOW accounts increased by $13.8 million, or 16.0% since the end of 2006.  Most of the increase in NOW accounts was due to state  and local governmental agencies.  Similarly, money market deposit accounts also increased by $5.3 million in 2007, an increase of 11.6%, due to state and local governmental agencies.
 
Certificates of deposit decreased $12.4 million, or 5.4% from 2006 primarily due to the maturity of $10.3 million of brokered certificates of deposit as of December 31, 2007.  As the Federal Reserve decreased short-term interest rates during the latter half of 2007, funding alternatives resulted in less expensive borrowing costs.
 
The following table shows the breakdown of deposits by deposit type (dollars in thousands):


 
2008
2007
2006
 
Amount
%
Amount
%
Amount
%
Non-interest-bearing deposits
 $       55,545
     10.2
 $       50,944
     11.2
 $       48,509
     10.9
NOW accounts
        115,338
     21.1
          99,862
     21.9
          86,067
     19.3
Savings deposits
          44,447
       8.1
          37,996
       8.3
          37,637
       8.4
Money market deposit accounts
          41,752
       7.6
          51,398
     11.3
          46,066
     10.3
Certificates of deposit
        289,598
     53.0
        215,828
     47.3
        228,236
     51.1
Total
 $     546,680
   100.0
 $     456,028
   100.0
 $     446,515
   100.0
 
         
 
 2008/2007
 2007/2006
 
Change
Change
 
Amount
%
Amount
%
Non-interest-bearing deposits
 $         4,601
       9.0
 $         2,435
       5.0
NOW accounts
          15,476
     15.5
          13,795
     16.0
Savings deposits
            6,451
     17.0
               359
       1.0
Money market deposit accounts
          (9,646)
   (18.8)
            5,332
     11.6
Certificates of deposit
          73,770
     34.2
        (12,408)
     (5.4)
Total
 $       90,652
     19.9
 $         9,513
       2.1

Remaining maturities of certificates of deposit of $100,000 or more are as follows (dollars in thousands):

 
2008
2007
2006
3 months or less
 $         5,462
 $       9,489
 $       8,714
Over 3 months through 6 months
          13,706
          9,628
        14,697
Over 6 months through 12 months
          26,554
        11,226
        16,604
Over 12 months
          50,297
        27,794
        27,897
Total
 $       96,019
 $     58,137
 $     67,912
As a percent of total
     
  certificates of deposit
33.16%
26.94%
29.76%

29

 
Deposits by type of depositor are as follows (dollars in thousands):

 
2008
2007
2006
 
Amount
%
Amount
%
Amount
%
Individual, partnerships
           
  & corporations
 $      465,234
       85.1
 $    382,968
      84.0
 $    386,314
      86.5
United States government
             2,069
         0.4
              752
        0.1
           1,591
        0.4
State & political subdivisions
           79,377
       14.5
         72,308
      15.9
         58,610
      13.1
Total
 $      546,680
     100.0
 $    456,028
    100.0
 $    446,515
    100.0

Borrowed Funds

2008
 
Borrowed funds decreased $19.1 million during 2008, a decrease of 23.8%.  As of December 31, 2008 we had $46.0 million of term loans with the Federal Home Loan Bank compared with $51.7 million outstanding as of December 31, 2007 (see Note 9 of the consolidated financial statements for additional information).  During 2008, $36.7 million of term loans matured.  We strategically replaced these funds with $31.0 million of new term loans at various maturities as a means of reducing our cost of funds, given the lower interest rates that prevailed during 2008.  The significant increase in our deposits also resulted in a reduction in short term borrowings from the Federal Home Loan Bank from $13.9 million as of December 31, 2007 to $0 at December 31, 2008.

2007
 
Borrowed funds increased $4.6 million during 2007, an increase of 6.0%.  This increase was primarily due to an increase in term loans from the Federal Home Loan Bank (see Note 9 of the consolidated financial statements for additional information).  This increase, along with the $9.5 million increase in deposits was used to fund growth in loans and investment securities of $8.6 million and $11.1 million, respectively.

Stockholders’ Equity

We evaluate stockholders’ equity in relation to total assets and the risk associated with those assets. The greater the capital resources, the greater the likelihood of meeting our cash obligations and absorbing unforeseen losses. For these reasons, capital adequacy has been, and will continue to be, of paramount importance.
 
Our Board of Directors determines our dividend rate after considering our capital requirements, current and projected net income, and other factors. In 2008 and 2007, the Company paid out 40.8% and 37.9% of net income in dividends, respectively.
 
For the year ended December 31, 2008, the total number of common shares outstanding was 2,847,371. For comparative purposes, outstanding shares for prior periods were adjusted for the July, 2008 stock dividend in computing earnings and cash dividends per share as detailed in Note 1 of the consolidated financial statements.  During 2008, we also purchased 11,928 shares of treasury stock at a weighted average cost of $22.65 per share.
 
There are currently three federal regulatory measures of capital adequacy. The Company’s ratios meet the regulatory standards for well capitalized for 2008 and 2007, as detailed in Note 13 of the consolidated financial statements.

2008
 
Stockholders’ equity increased 8.7% in 2008 to $52.8 million.  Excluding accumulated other comprehensive income, which is the after-tax effect of unrealized holding gains and losses on available-for-sale securities, additional pension obligation and unrealized loss on interest rate swap, stockholders’ equity increased $3.9 million, or 7.9%.  This increase is due to net income of $6,905,000, offset by cash dividends of $2,815,000 and purchase of treasury stock of $271,000.  Total equity was approximately 7.9% of total assets as of December 31, 2008, compared to 8.2% of total assets as of December 31, 2007.

30

2007
 
Stockholders’ equity increased by 11.6% in 2007 to $48.5 million.  Excluding accumulated other comprehensive income, stockholders’ equity increased $3.6 million, or 8.0%.  This increase was due to net income of $6,736,000 offset by cash dividends of $2,550,000 and purchase of treasury stock of $567,000.

 
LIQUIDITY
 
Liquidity is a measure of the Company’s ability to efficiently meet normal cash flow requirements of both borrowers and depositors. Liquidity is needed to meet depositors’ withdrawal demands, extend credit to meet borrowers’ needs, provide funds for normal operating expenses and cash dividends, and fund future capital expenditures.
 
To maintain proper liquidity, we use funds management policies along with our investment policies to assure we can meet our financial obligations to depositors, credit customers and stockholders.  Management monitors liquidity by reviewing loan demand, investment opportunities, deposit pricing and the cost and availability of borrowing funds.  The Company’s historical activity in this area can be seen in the Consolidated Statement of Cash Flows from investing and financing activities.
 
Cash generated by operating activities, investing activities and financing activities influences liquidity management. The most important source of funds is the deposits that are primarily core deposits (deposits from customers with other relationships). Short-term debt from the Federal Home Loan Bank supplements the Company’s availability of funds as well as lines of credit arrangements with corresponding banks.  Other sources of short-term funds include brokered CDs and the sale of loans, if needed.
 
The Company’s use of funds is shown in the investing activity section of the Consolidated Statement of Cash Flows, where the net loan activity is detailed. Other significant uses of funds are capital expenditures, purchase of loans and acquisition premiums. Surplus funds are then invested in investment securities.
 
Capital expenditures in 2008 totaled $1,132,000, which included:
§  
New branch office in process in Troy totaling $674,000.
§  
Land, building, and equipment associated with branch acquisition totaling $296,000.
§  
New equipment associated with merchant and branch capture totaling $77,000.
§  
Upgrades to data processing and security equipment totaling $73,000.
 
Capital expenditures were $529,000 in 2007, which included:
§  
Various building improvements totaling $243,000.
§  
Upgrades to data processing and security equipment totaling $154,300.
§  
New software for Trust services and other software purchases for new product implementation totaling approximately $67,000.
§  
Bank vehicle purchases totaling $65,000.
 
These expenditures will allow us to support our growth over the next decade, create greater operating efficiency and provide the customer with higher quality banking services.   
 
The Company achieves additional liquidity primarily from temporary or short-term investments in the Federal Home Loan Bank of Pittsburgh, investments that mature in less than one year and expected principal repayments from mortgage backed securities.  The Company also has a maximum borrowing capacity at the Federal Home Loan Bank of approximately $236 million, inclusive of any outstanding amounts, as an additional source of liquidity.  The Company also had a federal fund line with a third party provider in the amount of $12,000,000 as of December 31, 2008.  Subsequent to year end, an additional federal fund line was established with another correspondent bank in the amount of $10,000,000.  Both federal fund lines are unsecured.
 
Apart from those matters described above, management does not currently believe that there are any current trends, events or uncertainties that would have a material impact on capital.
 
INTEREST RATE AND MARKET RISK MANAGEMENT
 
The objective of interest rate sensitivity management is to maintain an appropriate balance between the stable growth of income and the risks associated with maximizing income through interest sensitivity imbalances and the market value risk of assets and liabilities.
31

Because of the nature of our operations, we are not subject to foreign currency exchange or commodity price risk and, since the Company has no trading portfolio, it is not subject to trading risk.
 
The primary factors that make assets interest-sensitive include adjustable-rate features on loans and investments, loan repayments and investment maturities. The primary components of interest-sensitive liabilities include maturing certificates of deposit, IRA certificates of deposit, repurchase agreements and short-term borrowings. Savings deposits, NOW accounts and money market investor accounts are considered core deposits and are not short-term interest sensitive (except for the top-tier money market investor and NOW accounts which are paid current market interest rates).
 
The following table shows the cumulative static gap (at amortized cost) for various time intervals (dollars in thousands):


Maturity or Re-pricing of Company Assets and Liabilities as of December 31, 2008
               
 
Within
Four to
One to
Two to
Three to
Over
 
 
Three
Twelve
Two
Three
Five
Five
 
 
Months
Months
Years
Years
Years
Years
Total
Interest-earning assets:
             
Interest-bearing deposits at banks
 $    10,164
 $              -
 $             -
 $             -
 $             -
 $             -
 $   10,164
Investment securities
         7,753
       14,911
      31,665
      14,316
      51,574
      51,143
    171,362
Residential mortgage loans
       25,125
       49,729
      46,578
      36,056
      43,499
        9,249
    210,236
Commercial and farm loans
       45,546
       21,780
      27,444
      22,302
      36,065
        9,637
    162,774
Loans to state & political subdivisions
         2,952
         2,782
      10,194
        3,498
      22,650
        6,077
      48,153
Other loans
         3,168
         2,719
        2,461
        1,457
        1,199
           647
      11,651
Total interest-earning assets
 $    94,708
 $    91,921
 $ 118,342
 $   77,629
 $ 154,987
 $   76,753
 $ 614,340
Interest-bearing liabilities:
             
NOW accounts
 $    61,783
 $              -
 $             -
 $             -
 $             -
 $   53,555
 $ 115,338
Savings accounts
                 -
                 -
                -
                -
                -
      44,447
      44,447
Money Market accounts
       30,170
                 -
                -
                -
                -
      11,582
      41,752
Certificates of deposit
       26,942
     106,103
      66,559
      49,217
      36,713
        4,064
    289,598
Short-term borrowing
         5,786
                 -
                -
                -
                -
                -
        5,786
Long-term borrowing
       14,528
       11,010
        3,858
        7,022
      19,000
                -
      55,418
Total interest-bearing liabilities
 $  139,209