Penseco Financial Services (PFNS) 10-Q 2010 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

__________________

FORM 10-Q

__________________

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

SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2010

OR

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

SECURITIES EXCHANGE ACT OF 1934

__________________

Commission file number 000-23777

PENSECO FINANCIAL SERVICES CORPORATION

Incorporated pursuant to the laws of Pennsylvania

__________________

Internal Revenue Service — Employer Identification No. 23-2939222

150 North Washington Avenue, Scranton, Pennsylvania 18503-1848

(570) 346-7741

__________________

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 x     No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes ¨     No ¨

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.

Large accelerated filer  ¨	Accelerated filer  x
Non-accelerated filer  ¨ (Do not check if a smaller reporting company)	Smaller reporting company  ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨     No x
The total number of shares of the registrant’s Common Stock, $0.01 par value, outstanding on July 23, 2010 was 3,276,079.

                                                                  ;                         

PENSECO FINANCIAL SERVICES CORPORATION

		Page
Part I — FINANCIAL INFORMATION
Item 1.Unaudited Financial Statements - Consolidated
Balance Sheets:
	June 30, 2010	3
	December 31, 2009	3
Statements of Income:
	Three Months Ended June 30, 2010	4
	Three Months Ended June 30, 2009	4
	Six Months Ended June 30, 2010	5
	Six Months Ended June 30, 2009	5
Statements of Changes in Stockholders’ Equity:
	Three Months Ended June 30, 2010	6
	Three Months Ended June 30, 2009	6
	Six Months Ended June 30, 2010	7
	Six Months Ended June 30, 2009	7
Statements of Cash Flows:
	Six Months Ended June 30, 2010	8
	Six Months Ended June 30, 2009	8
Notes to Unaudited Consolidated Financial Statements		9
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	22
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	40
Item 4.	Controls and Procedures	40
Part II — OTHER INFORMATION
Item 1.	Legal Proceedings	41
Item 1A.	Risk Factors	41
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	41
Item 3.	Defaults Upon Senior Securities	41
Item 4.	Removed and Reserved	41
Item 5.	Other Information	41
Item 6.	Exhibits	41
Signatures

2

PART I. FINANCIAL INFORMATION,  Item 1 —  Financial Statements

PENSECO FINANCIAL SERVICES CORPORATION

CONSOLIDATED BALANCE SHEETS

(unaudited)

(in thousands, except share and per share amounts)

	June 30,		December 31,
	2010		2009
ASSETS
Cash and due from banks	$	11,316	$	11,100
Interest bearing balances with banks		2,197		2,274
Federal funds sold		-		-
Cash and Cash Equivalents		13,513		13,374
Investment securities:
Available-for-sale, at fair value		153,764		155,481
Held-to-maturity (fair value of $43,371
and $49,054, respectively)		41,040		46,851
Total Investment Securities		194,804		202,332
Loans, net of unearned income		609,736		603,970
Less: Allowance for loan losses		6,500		6,300
Loans, Net		603,236		597,670
Bank premises and equipment		13,033		12,396
Other real estate owned		1,269		528
Accrued interest receivable		3,951		4,317
Goodwill		26,398		26,398
Cash surrender value of life insurance		14,644		14,380
Other assets		11,536		11,932
Total Assets	$	882,384	$	883,327
LIABILITIES
Deposits:
Non-interest bearing	$	108,202	$	109,855
Interest bearing		546,066		535,579
Total Deposits		654,268		645,434
Other borrowed funds:
Repurchase agreements		18,435		18,168
Short-term borrowings		13,311		27,430
Long-term borrowings		67,525		68,094
Accrued interest payable		1,196		1,317
Other liabilities		6,541		5,487
Total Liabilities		761,276		765,930
STOCKHOLDERS' EQUITY
Common stock; $ .01 par value, 15,000,000 shares authorized,
3,276,079 shares issued and outstanding		33		33
Surplus		48,865		48,865
Retained earnings		71,330		68,086
Accumulated other comprehensive income		880		413
Total Stockholders' Equity		121,108		117,397
Total Liabilities and Stockholders' Equity	$	882,384	$	883,327
(See accompanying Notes to Unaudited Consolidated Financial Statements)

3

PENSECO FINANCIAL SERVICES CORPORATION

CONSOLIDATED STATEMENTS OF INCOME

(unaudited)

(in thousands, except share and per share amounts)

	Three Months Ended		Three Months Ended
	June 30, 2010		June 30, 2009
INTEREST INCOME
Interest and fees on loans	$	8,608	$	8,727
Interest and dividends on investments:
U.S. Treasury securities and U.S. Agency obligations		704		872
States & political subdivisions		1,094		1,133
Other securities		12		8
Interest on Federal funds sold		-		-
Interest on balances with banks		2		3
Total Interest Income		10,420		10,743
INTEREST EXPENSE
Interest on time deposits of $100,000 or more		532		482
Interest on other deposits		886		1,441
Interest on other borrowed funds		679		780
Total Interest Expense		2,097		2,703
Net Interest Income		8,323		8,040
Provision for loan losses		537		235
Net Interest Income After Provision for Loan Losses		7,786		7,805
NON-INTEREST INCOME
Trust department income		337		375
Service charges on deposit accounts		563		481
Merchant transaction income		875		841
Brokerage fee income		92		79
Other fee income		413		331
Bank-owned life insurance income		130		132
Other operating income		172		218
Realized gains (losses) on securities, net		291		314
Total Non-Interest Income		2,873		2,771
NON-INTEREST EXPENSES
Salaries and employee benefits		3,092		3,249
Expense of premises and fixed assets		835		817
Merchant transaction expenses		639		605
Merger related costs		-		215
FDIC insurance assessments		370		��284
Other operating expenses		1,869		1,762
Total Non-Interest Expenses		6,805		6,932
Income before income taxes		3,854		3,644
Applicable income taxes		838		775
Net Income	$	3,016	$	2,869
Earnings per Common Share
(Based on weighted average shares outstanding of 3,276,079)	$	0.92	$	0.88
Cash Dividends Declared Per Common Share	$	0.42	$	0.42
(See accompanying Notes to Unaudited Consolidated Financial Statements)

4

PENSECO FINANCIAL SERVICES CORPORATION

CONSOLIDATED STATEMENTS OF INCOME

(unaudited)

(in thousands, except share and per share amounts)

	Six Months Ended		Six Months Ended
	June 30, 2010		June 30, 2009
INTEREST INCOME
Interest and fees on loans	$	17,294	$	15,011
Interest and dividends on investments:
U.S. Treasury securities and U.S. Agency obligations		1,423		1,750
States & political subdivisions		2,233		1,994
Other securities		23		22
Interest on Federal funds sold		-		-
Interest on balances with banks		4		6
Total Interest Income		20,977		18,783
INTEREST EXPENSE
Interest on time deposits of $100,000 or more		965		760
Interest on other deposits		1,860		2,384
Interest on other borrowed funds		1,378		1,601
Total Interest Expense		4,203		4,745
Net Interest Income		16,774		14,038
Provision for loan losses		865		1,231
Net Interest Income After Provision for Loan Losses		15,909		12,807
NON-INTEREST INCOME
Trust department income		717		685
Service charges on deposit accounts		1,095		820
Merchant transaction income		2,069		2,049
Brokerage fee income		162		196
Other fee income		763		618
Bank-owned life insurance income		252		211
Other operating income		233		288
Realized gains (losses) on securities, net		293		314
Total Non-Interest Income		5,584		5,181
NON-INTEREST EXPENSES
Salaries and employee benefits		6,265		5,727
Expense of premises and fixed assets		1,785		1,608
Merchant transaction expenses		1,450		1,462
Merger related costs		-		1,550
FDIC insurance assessments		636		445
Other operating expenses		3,706		3,264
Total Non-Interest Expenses		13,842		14,056
Income before income taxes		7,651		3,932
Applicable income taxes		1,654		622
Net Income	$	5,997	$	3,310
Weighted average shares outstanding		3,276,079		2,712,040
Earnings per Common Share	$	1.83	$	1.22
Cash Dividends Declared Per Common Share	$	0.84	$	0.84
(See accompanying Notes to Unaudited Consolidated Financial Statements)

5

PENSECO FINANCIAL SERVICES CORPORATION

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY

THREE MONTHS ENDED JUNE 30, 2010 AND 2009

(unaudited)

(in thousands, except per share amounts)

	Common Stock		Surplus		Retained Earnings			Accumulated Other Comprehensive Income			Total Stockholders' Equity
Balance, March 31, 2009	$	21	$	10,819	$	64,284		$	(1,793	)	$	73,331
Fair value of consideration exchanged in merger		12		38,046		-			-			38,058
Comprehensive income:
Net income		-		-		2,869			-			2,869
Other comprehensive income, net of tax
Unrealized gains on securities, net of
reclassification adjustment		-		-		-			331			331
Other comprehensive income									331			331
Comprehensive income												3,200
Cash dividends declared ($0.42 per share)		-		-		(1,376	)		-			(1,376	)
Balance, June 30, 2009	$	33	$	48,865	$	65,777		$	(1,462	)	$	113,213
Balance, March 31, 2010	$	33	$	48,865	$	69,691		$	503		$	119,092
Comprehensive income:
Net income		-		-		3,016			-			3,016
Other comprehensive income, net of tax
Unrealized gains on securities, net of
reclassification adjustment		-		-		-			377			377
Other comprehensive income									377			377
Comprehensive income												3,393
Cash dividends declared ($0.42 per share)		-		-		(1,377	)		-			(1,377	)
Balance, June 30, 2010	$	33	$	48,865	$	71,330		$	880		$	121,108
(See accompanying Notes to Unaudited Consolidated Financial Statements)

6

PENSECO FINANCIAL SERVICES CORPORATION

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY

SIX MONTHS ENDED JUNE 30, 2010 AND 2009

(unaudited)

(in thousands, except per share amounts)

	Common Stock		Surplus		Retained Earnings			Accumulated Other Comprehensive Income			Total Stockholders' Equity
Balance, December 31, 2008	$	21	$	10,819	$	64,745		$	(1,943	)	$	73,642
Fair value of consideration exchanged in merger		12		38,046		-			-			38,058
Comprehensive income:
Net income		-		-		3,310			-			3,310
Other comprehensive income, net of tax
Unrealized gains on securities, net of
reclassification adjustment		-		-		-			481			481
Other comprehensive income									481			481
Comprehensive income												3,791
Cash dividends declared ($0.84 per share)		-		-		(2,278	)		-			(2,278	)
Balance, June 30, 2009	$	33	$	48,865	$	65,777		$	(1,462	)	$	113,213
Balance, December 31, 2009	$	33	$	48,865	$	68,086		$	413		$	117,397
Fair value of consideration exchanged in merger		-		-		-			-			-
Comprehensive income:
Net income		-		-		5,997			-			5,997
Other comprehensive income, net of tax
Unrealized gains on securities, net of
reclassification adjustment		-		-		-			467			467
Other comprehensive income									467			467
Comprehensive income												6,464
Cash dividends declared ($0.84 per share)		-		-		(2,753	)		-			(2,753	)
Balance, June 30, 2010	$	33	$	48,865	$	71,330		$	880		$	121,108
(See accompanying Notes to Unaudited Consolidated Financial Statements)

7

PENSECO FINANCIAL SERVICES CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

(in thousands)

	Six Months Ended			Six Months Ended
	June 30, 2010			June 30, 2009
OPERATING ACTIVITIES
Net Income	$	5,997		$	3,310
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		530			464
Provision for loan losses		865			1,231
Deferred income tax provision (benefit)		171			(381	)
Amortization of securities, (net of accretion)		230			221
Net realized (gains) losses on securities		(293	)		(314	)
Loss (gain) loss on other real estate		13			5
Decrease (increase) in interest receivable		366			465
(Increase) decrease in cash surrender value of life insurance		(264	)		(211	)
Decrease (increase) in other assets		225			603
Increase (decrease) in income taxes payable		1,654			470
(Decrease) increase in interest payable		(121	)		(76	)
(Decrease) increase in other liabilities		(707	)		1,156
Net cash provided (used) by operating activities		8,666			6,943
INVESTING ACTIVITIES
Purchase of investment securities available-for-sale		(12,693	)		(33,892	)
Purchase of investment securities to be held-to-maturity		-			-
Proceeds from sales and maturities of investment securities available-for-sale		13,654			24,526
Proceeds from sales and maturities of investment securities held-to-maturity		2,124			1,175
Proceeds from repayments of investment securities available-for-sale		1,589			1,996
Proceeds from repayments of investment securities held-to-maturity		3,622			5,149
Net loans (originated) repaid		(7,349	)		13,388
Proceeds from other real estate		33			32
Investment in premises and equipment		(1,167	)		(713	)
Net cash received (paid) in merger		-			(12,645	)
Net cash (used) provided by investing activities		(187	)		(984	)
FINANCING ACTIVITIES
Net (decrease) increase in demand and savings deposits		(5,510	)		25,738
Net proceeds (payments) on time deposits		14,344			11,797
Increase (decrease) in repurchase agreements		267			(4,055	)
Net (decrease) increase in short-term borrowings		(14,119	)		(27,970	)
Increase in long-term borrowings		6,300			1,000
Payments on long-term borrowings		(6,869	)		(6,181	)
Cash dividends paid		(2,753	)		(2,278	)
Net cash (used) provided by financing activities		(8,340	)		(1,949	)
Net increase (decrease) in cash and cash equivalents		139			4,010
Cash and cash equivalents at January 1		13,374			9,355
Cash and cash equivalents at June 30	$	3,513		$	13,365
The Company paid interest and income taxes of $4,324 and $0 and $4,557 and $89
for the six months ended June 30, 2010 and 2009, respectively.
(See accompanying Notes to Unaudited Consolidated Financial Statements)

8

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

For the Quarter Ended June 30, 2010

(unaudited)

These Notes to Unaudited Consolidated Financial Statements reflect events subsequent to December 31, 2009, the date of the most recent Report of Independent Registered Public Accounting Firm, through the date of this Quarterly Report on Form 10-Q. These Notes to Unaudited Consolidated Financial Statements should be read in conjunction with Parts I and II of this Report and the Company’s Annual Report on Form 10-K for the year ended December 31, 2009, which was filed with the Securities and Exchange Commission (SEC) on March 12, 2010.

FORWARD LOOKING INFORMATION

This Quarterly Report on Form 10-Q contains forward-looking statements that are based on assumptions and may describe future plans, strategies and expectations of Penseco Financial Services Corporation. These forward-looking statements are generally identified by use of the words “believe,” “expect,” “intend,” “anticipate,” “estimate,” “project” or similar expressions. Penseco Financial Services Corporation’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations of Penseco Financial Services Corporation and its subsidiary include, but are not limited to, changes in interest rates, national and regional economic conditions, legislative and regu latory changes,  monetary and fiscal policies of the U.S. government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality and composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in Penseco Financial Services Corporation’s market area, changes in real estate market values in Penseco Financial Services Corporation’s market area, changes in relevant accounting principles and guidelines and inability of third party service providers to perform. Additional factors that may affect our results are discussed in Part II, Item 1A to this Quarterly Report on Form 10-Q titled “Risk Factors”.

These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Except as required by applicable law or regulation, Penseco Financial Services Corporation does not undertake, and specifically disclaims any obligation, to release publicly the result of any revisions that may be made to any forward-looking statements to reflect events or circumstances after the date of the statements or to reflect the occurrence of anticipated or unanticipated events.

Unless the context indicates otherwise, all references in this Annual Report to “Company,” “we,” “us” and “our” refer to Penseco Financial Services Corporation and its subsidiary.

NOTE 1 — Principles of Consolidation

Penseco Financial Services Corporation is a financial holding company incorporated under the laws of Pennsylvania. It is the parent company of Penn Security Bank and Trust Company (Bank), a Pennsylvania state chartered bank.

Intercompany transactions have been eliminated in preparing the consolidated financial statements.

The accounting policies of the Company conform with accounting principles generally accepted in the United States of America (GAAP) and with general practices within the banking industry.

On April 1, 2009, the Company completed its acquisition of Old Forge Bank in a cash and stock transaction valued at approximately $55.5 million (the “Merger”). The Merger was accounted for using the acquisition method of accounting and, accordingly, the assets and liabilities of Old Forge Bank have been recorded at their respective fair values on the date the Merger was completed. The Merger was effected by the issuance of 1,128,079 shares of Company common stock to former Old Forge Bank shareholders. Each share of Old Forge Bank common stock was exchanged for 2.9012 shares of Company common stock, with any fractional shares as a result of the exchange paid to Old Forge Bank shareholders in cash based on $35.255 per share of Company stock.

NOTE 2 — Basis of Presentation

The unaudited consolidated financial statements have been prepared in accordance with the instructions to SEC Form 10-Q and GAAP for interim financial information. In the opinion of management, all adjustments that are of a normal recurring nature and are considered necessary for a fair presentation have been included. They are not, however, necessarily indicative of the results of consolidated operations for a full year or any other period.

9

All information is presented in thousands of dollars, except share and per share amounts.

For further information, refer to the consolidated financial statements and accompanying notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.

NOTE 3 — Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for losses on loans and the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the allowances for losses on loans and foreclosed real estate, management obtains independent appraisals for significant properties.

NOTE 4 — Investment Securities

Investments in securities are classified in two categories and accounted for as follows:

Securities Held-to-Maturity  Bonds, notes, debentures and mortgage-backed securities for which the Company has the positive intent and ability to hold to maturity are reported at cost, adjusted for amortization of premiums and accretion of discounts computed on the straight-line basis, which approximates the interest method, over the remaining period to maturity.

Securities Available-for-Sale  Bonds, notes, debentures, mortgage-backed securities and certain equity securities not classified as securities to be held to maturity are carried at fair value with unrealized holding gains and losses, net of tax, reported as a net amount in a separate component of stockholders’ equity until realized.

The amortization of premiums on mortgage-backed securities is done based on management's estimate of the lives of the securities, adjusted, when necessary, for advanced prepayments in excess of those estimates.

Realized gains and losses on the sale of securities available-for-sale are determined using the specific identification method and are reported as a separate component of other income in the Statements of Income. Unrealized gains and losses are included as a separate item in computing comprehensive income.

Investments are evaluated periodically to determine whether a decline in their value is other than temporary. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other than temporary. The term “other than temporary” is not intended to indicate that the decline is permanent. It indicates that the prospects for a near term recovery of value are not necessarily favorable, or that there is a lack of evidence to support fair values equal to, or greater than, the carrying value of the investment. Once a decline in value is determined to be other than temporary, the value of the security is reduced and a corresponding charge to earnings is recognized.

The amortized cost and fair value of investment securities at June 30, 2010 and December 31, 2009 are as follows:

Available-for-Sale
			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
June 30, 2010	Cost		Gains		Losses		Value
U.S. Agency securities	$	59,184	$	816	$	-	$	60,000
Mortgage-backed securities		15,417		898		-		16,315
States & political subdivisions		63,801		1,958		46		65,713
Corporate securities		4,117		6		4		4,119
Total Debt Securities		142,519		3,678		50		146,147
Equity securities		7,062		622		67		7,617
Total Available-for-Sale	$	149,581	$	4,300	$	117	$	153,764

10

Available-for-Sale
			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
December 31, 2009	Cost		Gains		Losses		Value
U.S. Agency securities	$	54,165	$	595	$	65	$	54,695
Mortgage-backed securities		16,999		568		-		17,567
States & political subdivisions		74,060		1,784		411		75,433
Total Debt Securities		145,224		2,947		476		147,695
Equity securities		6,780		1,006		-		7,786
Total Available-for-Sale	$	152,004	$	3,953	$	476	$	155,481
Held-to-Maturity
			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
June 30, 2010	Cost		Gains		Losses		Value
Mortgage-backed securities	$	20,010	$	1,636	$	-	$	21,646
States & political subdivisions		21,030		695		-		21,725
Total Held-to-Maturity	$	41,040	$	2,331	$	-	$	43,371
			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
December 31, 2009	Cost		Gains		Losses		Value
Mortgage-backed securities	$	23,700	$	1,281	$	-	$	24,981
States & political subdivisions		23,151		922		-		24,073
Total Held-to-Maturity	$	46,851	$	2,203	$	-	$	49,054

Equity securities at June 30, 2010 and December 31, 2009 consisted primarily of other financial institutions’ stock and Federal Home Loan Bank of Pittsburgh (FHLB) stock, which is a required investment in order for the Company to participate in a FHLB line of credit program. The FHLB stock is stated at par value as it is restricted to purchases and sales with the FHLB. The FHLB indefinitely suspended its stock repurchase and dividend payments during December 2008. Based on current financial information available, management does not believe the FHLB stock value is impaired as of June 30, 2010.

The amortized cost and fair value of debt securities at June 30, 2010 by contractual maturity are shown in the following table. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

June 30, 2010	Available-for-Sale				Held-to-Maturity
	Amortized		Fair		Amortized		Fair
	Cost		Value		Cost		Value
Due in one year or less:
U.S. Agency securities	$	23,570	$	23,903	$	-	$	-
After one year through five years:
U.S. Agency securities		35,614		36,097		-		-
States & political subdivisions		300		308		-		-
Corporate securities		4,117		4,119		-		-
After five year through ten years:
States & political subdivisions		2,005		2,121		11,803		12,135
After ten years:
States & political subdivisions		61,496		63,284		9,227		9,590
Subtotal		127,102		129,832		21,030		21,725
Mortgage-backed securities		15,417		16,315		20,010		21,646
Total Debt Securities	$	142,519	$	146,147	$	41,040	$	43,371

11

The gross fair value and unrealized losses of the Company's investments aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at June 30, 2010 and December 31, 2009, are as follows:

	Less than twelve months				Twelve months or more				Totals
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
June 30, 2010	Value		Losses		Value		Losses		Value		Losses
States & political subdivisions	$	1,605	$	32	$	696	$	14	$	2,301	$	46
Corporate securities		3,093		4		-		-		3,093		4
Equities		199		67		-		-		199		67
Total	$	4,897	$	103	$	696	$	14	$	5,593	$	117

	Less than twelve months				Twelve months or more				Totals
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
December 31, 2009	Value		Losses		Value		Losses		Value		Losses
U.S. Agency securities	$	14,259	$	65	$	-	$	-	$	14,259	$	65
States & political subdivisions		9,212		383		3,817		28		13,029		411
Total	$	23,471	$	448	$	3,817	$	28	$	27,288	$	476

The table at June 30, 2010 includes fifteen (15) securities that have unrealized losses for less than twelve months and two (2) securities that have been in an unrealized loss position for twelve or more months. The table at December 31, 2009, includes fourteen (14) securities that have unrealized losses for less than twelve months and ten (10) securities that have been in an unrealized loss position for twelve or more months.

U.S. Agency Securities

The unrealized losses on the Company’s investments in U.S. Agency securities were caused by interest rate fluctuations. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the par value of the investment. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at June 30, 2010.

States and Political Subdivisions

The unrealized losses on the Company’s investments in states and political subdivisions were caused by interest rate fluctuations and not credit quality. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the par value of the investment. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at June 30, 2010.

Corporate Securities  

The unrealized losses on the Company's investments in corporate securities were caused primarily by interest rate fluctuations and other market conditions. The Company's investment in corporate securities consists of corporate bonds guaranteed by the Federal Deposit Insurance Corporation (FDIC). The Company has analyzed its corporate security portfolio and determined that the market value fluctuation in this equity security is consistent with the broader market and not a cause for recognition of a current loss. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their cost bases, the Company does not consider those investments to be other-than-temporarily impaired at June 30, 2010.

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Marketable Equity Securities

The unrealized losses on the Company's investments in marketable equity securities were caused primarily by interest rate fluctuations and other market conditions. The Company's investments in marketable equity securities consist primarily of investments in common stock of companies in the financial services industry. The Company has analyzed its equity portfolio and determined that the market value fluctuation in these equity securities is consistent with the broader market and not a cause for recognition of a current loss. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their cost bases, the Company does not consider those investments to be other-than-temporarily impaired at June 30, 2010.

NOTE 5 — Loan Portfolio

Details regarding the Company’s loan portfolio on June 30, 2010 and December 31, 2009 are as follows:

	June 30,		December 31,
As of:	2010		2009
Loans secured by real estate:
Construction and land development	$	29,611	$	32,910
Secured by 1-4 family residential properties:
Revolving, open-end loans		30,948		31,674
Secured by first liens		239,756		240,615
Secured by junior liens		20,333		21,840
Secured by multi-family properties		7,434		3,969
Secured by non-farm, non-residential properties		180,296		171,995
Commercial and industrial loans to U.S. addressees		30,760		30,743
Loans to individuals for household, family and
other personal expenditures:
Credit card and related plans		3,282		3,365
Other (installment and student loans, etc.)		53,562		56,426
Obligations of states & political subdivisions		9,270		6,873
All other loans		4,486		3,562
Gross Loans		609,738		603,972
Less:  Unearned income on loans		2		2
Loans, net of unearned income	$	609,736	$	603,970

The Company does not engage in any sub-prime or Alt-A credit lending. Therefore, the Company is not subject to any credit risks associated with such loans. The Company’s loan portfolio consists primarily of residential and commercial mortgage loans secured by properties located in Northeastern Pennsylvania and subject to conservative underwriting standards.

NOTE 6 — Loan Servicing

The Company generally retains the right to service mortgage loans sold to third parties. The cost allocated to the mortgage servicing rights retained has been recognized as a separate asset and is amortized in proportion to and over the period of estimated net servicing income.

Mortgage servicing rights are evaluated for impairment based on the fair value of those rights. Fair values are estimated using discounted cash flows based on current market rates of interest and expected future prepayment rates. For purposes of measuring impairment, the rights must be stratified by one or more predominant risk characteristics of the underlying loans. The Company stratifies its capitalized mortgage servicing rights based on the product type, interest rate and term of the underlying loans. The amount of impairment recognized is the amount, if any, by which the amortized cost of the rights for each stratum exceed the fair value.

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NOTE 7 — Goodwill

Goodwill represents the excess of the purchase price over the underlying fair value of merged entities. Goodwill is assessed for impairment at least annually and as triggering events occur. In making this assessment, management considers a number of factors including, but not limited to, operating results, business plans, economic projections, anticipated future cash flows, and current market data. There are inherent uncertainties related to these factors and management’s judgment in applying them to the analysis of goodwill impairment. Changes in economic and operating conditions, as well as other factors, could result in goodwill impairment in future periods. Management has determined that the carrying value of goodwill is not impaired at June 30, 2010.

NOTE 8 — Other Intangible Assets

Intangible assets include the premium assigned to the core deposit relationships acquired in the Merger. The core deposit intangible is being amortized over ten years on a sum-of-the-years-digits basis. Amortization expense is expected to be as follows:

June 30,
2011	$	322
2012		286
2013		249
2014		212
2015		175
2016 and thereafter		332
	$	1,576

NOTE 9 — Long-Term Debt

The loans from the Federal Home Loan Bank of Pittsburgh are secured by a general collateral pledge of the Company’s assets. The Company has agreed to maintain sufficient qualifying collateral to fully secure the borrowings below.

A summary of long-term debt, including amortizing principal and interest payments, at June 30, 2010 is as follows:

Monthly Installment			Fixed Rate	Maturity Date	Balance
Amortizing loans
$		29	1.84%	08/28/12	$          728
		90	3.10%	02/28/13	2,763
		430	3.74%	03/13/13	13,467
		18	2.66%	08/28/14	842
		67	3.44%	03/02/15	3,465
		13	3.48%	03/31/15	705
		10	3.83%	04/02/18	814
		186	4.69%	03/13/23	21,441
	Total amortizing				44,225
Non-amortizing loans
			2.61%	08/30/10	1,000
			2.88%	02/28/11	2,000
			3.27%	02/29/12	2,000
			3.49%	02/28/13	7,000
			2.89%	11/28/14	2,000
			2.58%	05/18/15	6,300
			3.32%	11/27/15	3,000
	Total non-amortizing				23,300
	Total long-term debt				$     67,525

14

Aggregate maturities of long-term debt at June 30, 2010 are as follows:

June 30,	Principal
2011	$	11,458
2012		10,775
2013		14,160
2014		2,686
2015		10,608
Thereafter		17,838
	$	67,525

NOTE 10 — Employee Benefit Plans

The Company provides, among other benefits, a defined benefit pension plan, currently under curtailment, a post-retirement benefit plan for eligible employees and a Long-Term Incentive Plan.

The components of the net periodicbenefit cost are as follows:

	Pension Benefits						Other Benefits
Six months ended June 30,	2010			2009			2010		2009
Service cost	$	-		$	-		$	2	$	2
Interest cost		355			350			10		10
Expected return on plan assets		(440	)		(410	)		-		-
Amortization of prior service cost		-			-			4		4
Amortization of net loss (gain)		28			98			-		-
Net periodic pension cost	$	(57	)	$	38		$	16	$	16

Effective June 22, 2008 the Company curtailed its defined benefit pension plan. The Company previously disclosed in its financial statements for the year ended December 31, 2009 that it did not expect to contribute to its pension plan but expected to contribute $35 to its post-retirement plan during 2010. Readers should refer to the Company’s Annual Report on Form 10-K for 2009 for further details on the Company’s defined benefit pension plan. The actuarially computed information on the plan curtailment, as to the pension obligation and funded status, was disclosed in the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2008, as filed with the SEC on August 7, 2008.

The Company sponsors a 401(k) profit sharing plan for all eligible employees. The Company’s profit sharing expense for the six months ended June 30, 2010 and 2009 was $261 and $208 respectively.

Under the 2008 Long-Term Incentive Plan, the Company granted restricted stock awards during the six months ended June 30, 2010 and 2009 valued at $0 and $75 respectively.

NOTE 11 — Regulatory Matters

The Company and the Bank are subject to various regulatory capital requirements administered by the Federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory—and possibly additional discretionary - actions by regulators that, if undertaken, could have a direct material effect on the Company and the Bank’s Consolidated Financial Statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Company and the Bank’s capital amounts and classifications are also subject to qualitative judgments by the regulators about comp onents, risk weightings and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the Capital Adequacy table on the following page) of Tier I and

15

Total Capital to risk-weighted assets and of Tier I Capital to average assets (Leverage ratio). The table also presents the Company’s actual capital amounts and ratios. Management believes, as of June 30, 2010, that the Company and the Bank meet all capital adequacy requirements to which they are subject.

As of June 30, 2010 and December 31, 2009, the most recent regulatory notifications categorized the Company and Bank as “well capitalized” under the regulatory framework for prompt corrective action. To be categorized as “well capitalized”, the Company must maintain minimum Tier I Capital, Total Capital and Leverage ratios as set forth in the Capital Adequacy table. There are no conditions or events since that notification that management believes have changed the Company’s categorization by the FDIC.

The Company and Bank are also subject to minimum capital levels, which could limit the payment of dividends, although the Company and Bank currently have capital levels which are in excess of minimum capital level ratios required.

The Pennsylvania Banking Code restricts capital funds available for payment of dividends to the retained earnings of the Bank. The balances in the capital stock and surplus accounts are unavailable for dividends.

In addition, the Bank is subject to restrictions imposed by Federal law on certain transactions with the Company’s affiliates. These transactions include extensions of credit, purchases of or investments in stock issued by the affiliate, purchases of assets subject to certain exceptions, acceptance of securities issued by an affiliate as collateral for loans, and the issuance of guarantees, acceptances, and letters of credit on behalf of affiliates. These restrictions prevent the Company’s affiliates from borrowing from the Bank unless the loans are secured by obligations of designated amounts. Further, the aggregate of such transactions by the Bank with a single affiliate is limited in amount to 10 percent of the Bank’s capital stock and surplus, and the aggregate of such transactions with all affiliates is limited t o 20 percent of the Bank’s capital stock and surplus. The Federal Reserve System has interpreted “capital stock and surplus” to include undivided profits.

Actual							Regulatory Requirements
							For Capital								To Be
							Adequacy Purposes								"Well Capitalized"
As of June 30, 2010	Amount		Ratio				Amount				Ratio				Amount			Ratio
Total Capital (to Risk Weighted Assets)
PFSC (Company)	$	96,288		16.58	%	>	$	46,452		>		8.0	%	>	$	58,065	>		10.0	%
PSB (Bank)	$	93,167		16.06	%	>	$	46,398		>		8.0	%	>	$	57,997	>		10.0	%
Tier 1 Capital (to Risk Weighted Assets)
PFSC (Company)	$	89,788		15.46	%	>	$	23,226		>		4.0	%	>	$	34,839	>		6.0	%
PSB (Bank)	$	86,667		14.94	%	>	$	23,199		>		4.0	%	>	$	34,798	>		6.0	%
Tier 1 Capital (to Average Assets)
PFSC (Company)	$	89,788		10.53	%	>	$		*	>		*		>	$	42,628	>		5.0	%
PSB (Bank)	$	86,667		10.22	%	>	$		*	>		*		>	$	42,417	>		5.0	%

PFSC - *3.0% ($25,577), 4.0% ($34,102) or 5.0% ($42,628) depending on the bank's CAMELS Rating and other regulatory risk factors.

PSB - *3.0% ($25,450), 4.0% ($33,933) or 5.0% ($42,417) depending on the bank's CAMELS Rating and other regulatory risk factors.

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Actual							Regulatory Requirements
							For Capital								To Be
							Adequacy Purposes								"Well Capitalized"
As of December 31, 2009	Amount		Ratio				Amount				Ratio				Amount			Ratio
Total Capital (to Risk Weighted Assets)
PFSC (Company)	$	95,492		16.90	%	>	$	45,198		>		8.0	%	>	$	56,497	>		10.0	%
PSB (Bank)	$	92,077		16.31	%	>	$	45,170		>		8.0	%	>	$	56,463	>		10.0	%
Tier 1 Capital (to Risk Weighted Assets)
PFSC (Company)	$	89,192		15.79	%	>	$	22,599		>		4.0	%	>	$	33,898	>		6.0	%
PSB (Bank)	$	85,777		15.19	%	>	$	22,585		>		4.0	%	>	$	33,878	>		6.0	%
Tier 1 Capital (to Average Assets)
PFSC (Company)	$	89,192		11.48	%	>	$		*	>		*		>	$	38,846	>		5.0	%
PSB (Bank)	$	85,777		11.09	%	>	$		*	>		*		>	$	38,658	>		5.0	%

PFSC - *3.0% ($22,308), 4.0% ($31,077) or 5.0% ($38,846) depending on the bank's CAMELS Rating and other regulatory risk factors.

PSB - *3.0% ($23,195), 4.0% ($30,926) or 5.0% ($38,658) depending on the bank's CAMELS Rating and other regulatory risk factors.

NOTE 12 — Merger

An Agreement and Plan of Merger (the Agreement) by and between the Company, the Bank and Old Forge Bank, was entered into on December 5, 2008. The Agreement provided for, among other things, the Company to acquire 100% of the outstanding common shares of Old Forge Bank through a two-step merger transaction (the Merger). The Company consummated the acquisition of Old Forge Bank on April 1, 2009, at which time Old Forge Bank was merged with and into the Bank. Following the Merger, the Bank continues to operate as a banking subsidiary of the Company.

Shareholders of Old Forge Bank were entitled to receive the merger consideration in either cash or shares of Company common stock, or any combination thereof, subject to certain limitations and allocation procedures set forth in the Agreement. The per share amount was calculated from the cash consideration and the value of the stock consideration based on the Company’s closing price of the Company’s common stock over a fixed period of time, as provided for in the Agreement.

Old Forge Bank was an independent $215 million community bank, operating from three locations in Lackawanna and Luzerne Counties of Pennsylvania. As a result of the Merger, the Company is now an $883 million financial institution serving Northeastern Pennsylvania from 12 locations. Management of the Company believes that the combined entity is in a more favorable position to compete with local and regional banks in the marketplace.

There was approximately $26.4 million of goodwill created in the Merger, largely based on the Company’s evaluation of the business growth opportunities inherent in the Old Forge Bank customer base, as well as operating synergies and economy of scale resulting from the Merger. None of the goodwill is expected to be deductible for income tax purposes.

The following table summarizes the consideration paid for Old Forge Bank and the identifiable assets acquired and liabilities assumed on the acquisition date.

	April 1, 2009
Consideration
Cash	$	17,405
Common Stock issued – 1,128,079 shares   of the Company, net of issuance costs of $184		38,058
Fair value of consideration transferred	$	55,463

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The fair value of the 1,128,079 common shares of the Company issued as part of the consideration paid to former Old Forge Bank shareholders was $38,058, determined by use of the weighted average price of Company common shares traded on March 31, 2009 ($33.90 per share). The Company believes that the weighted average price of the Company’s common stock traded on March 31, 2009 is the best indication of value since the Company’s common stock is not a heavily traded security.

Acquisition-related costs recorded in the income statement of the acquirer for the year ended December 31, 2009.	$	1,550
Acquisition-related costs recorded as an offset to surplus of the acquirer as of December 31, 2009.	$	184
Recognized amounts of identifiable assets acquired and liabilities assumed on April 1, 2009 are:
Cash	$	4,760
Investments	$	32,095
Loans		159,949
Property and equipment		1,576
Core Deposit Intangible		2,027
All other assets		12,193
Identifiable Assets		212,600
Deposits		177,018
Borrowings		5,000
All other liabilities		1,517
Identifiable Liabilities		183,535
Identifiable net assets		29,065
Goodwill		26,398
Total consideration transferred	$	55,463

The fair value of the financial assets acquired included loans receivable with a gross amortized cost basis of $166,348 at April 1, 2009.

The table below illustrates the fair value adjustments made to the amortized cost basis in order to present the fair value of the loans acquired.

Gross amortized cost basis at April 1, 2009	$	166,348
Market rate adjustment		640
Credit fair value adjustment in pools of homogeneous loans		(5,648	)
Credit fair value adjustment on distressed loans		(1,391	)
Fair value of purchased loans at April 1, 2009	$	159,949

 

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Pro Forma Income Statement
For the Six Months Ended June 30, 2009
	Penseco
	Financial Services			Old Forge
	Corporation			Bank							Pro Forma
($ = 000's)	6/30/2009			6/30/2009			Adjustments				6/30/2009
INTEREST INCOME
Interest and fees on loans	$	15,011		$	2,524			184		(a)	$	17,719
Interest and dividends on investments		3,766			377			(30	)	(b)		4,113
Interest on Federal funds sold		-			1							1
Interest on balances with banks		6			-							6
Total Interest Income		18,783			2,902			154				21,839
INTEREST EXPENSE
Interest on deposits		3,144			897			(92	)	(c)		3,949
Interest on borrowed funds		1,601			9							1,610
Total Interest Expense		4,745			906			(92	)			5,559
Net Interest Income		14,038			1,996			246				16,280
Provision for loan losses		1,231			75							1,306
Net Interest Income After Provision
for Loan Losses		12,807			1,921			246				14,974
NON-INTERST INCOME
Service charges on deposits		820			80							900
Other non-interest income		4,047			97							4,144
Realized gains (losses) on securities		314			-							314
Total Non-Interest Income		5,181			177							5,358
NON-INTEREST EXPENSES
Salaries and employee benefits		5,727			696							6,423
Expense of premises and equipment		1,608			146							1,754
Other non-interest expenses		5,171			428			61		(d)		5,660
Total Non-Interest Expenses		12,506			1,270			61				13,837
Income before income taxes		5,482			828			185				6,495
Applicable income taxes		1,010			315			63				1,388
Net Income	$	4,472	(f)	$	513	(f)	$	122			$	5,107
Earnings Per Common Share	$	2.08		$	0.92					(e)	$	1.56

Footnotes:

(a) Amortization of loan fair value adjustment

(b) Opportunity cost of cash paid to Old Forge Bank shareholders at 0.70% rate

(c) Amortization of certificate of deposit fair value adjustment

(d) Amortization of core deposit intangible over a 10 year period using the sum of the years digits method

(e) Pro Forma EPS based on weighted average shares outstanding of 3,276,079

(f) Excludes merger related costs of $1,550,000 and $451,000 and related tax effect incurred by Penseco and Old Forge Bank, respectively

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Note 13 – Fair Value Measurements

The following table sets forth the Company’s financial assets that were accounted for at fair value and are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

Level I - Quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access at the measurement date.

Level II- Observable inputs other than Level I prices, such as quoted prices for similar assets or liabilities in active markets; quoted prices in markets that are not active for identical or similar assets or liabilities; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level III- Unobservable inputs that are supported by little or no market activity and significant to the fair value of the assets or liabilities that are developed using the reporting entities’ estimates and assumptions, which reflect those that market participants would use.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

A description of the valuation methodologies used for financial assets measured at fair value on a recurring basis, as well as the classification of the assets pursuant to the valuation hierarchy, are as follows:

Securities Available-for-Sale

Securities classified as available-for-sale are reported using Level I, Level II and Level III inputs. Level I instruments generally include equity securities valued in accordance with quoted market prices in active markets. Level II instruments include U.S. government agency obligations, state and municipal bonds, mortgage-backed securities and corporate bonds. For these securities, the Company obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond's terms and conditions, among other things. Level III instruments include certain non-public equity securities and real esta te sold under contract. See Note 4 – Investment Securities for additional information.

Assets and liabilities measured at fair value on a recurring basis are summarized below:

	June 30, 2010
	Level I		Level II		Level III		Total
Assets:
Securities available-for-sale	$	7,617	$	146,147	$	-	$	153,764

Assets Measured at Fair Value on a Nonrecurring Basis

Disclosure of non-financial assets and non-financial liabilities became effective January 1, 2009. Certain non-financial assets and non-financial liabilities, measured at fair value on a non-recurring basis, include foreclosed assets, goodwill and intangible assets.

A description of the valuation methodologies and classification levels used for non-financial assets and non-financial liabilities measured at fair value on a nonrecurring basis are listed below.

Goodwill and Other Identifiable Intangibles

The Company employs general industry practices in evaluating the fair value of its goodwill and other identifiable intangibles. The Company calculates the fair value, with the assistance of a third party specialist, using a combination of the following valuation methods: dividend discount analysis under the income approach, which calculates the present value of all excess cash flows plus the present value of a terminal value and market multiples (pricing ratios) under the market approach. Management has performed its initial review of goodwill and other identifiable intangibles and concluded no impairment had occurred.

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Other Real Estate Owned

At June 30, 2010, other real estate owned was adjusted to fair values with any impairment charge, included in earnings for the year. Foreclosed real estate, which is considered to be non-financial assets, has been valued using a market approach. The values were determined using market prices of similar real estate assets, which the Company considered to be Level II inputs.

Certain assets measured at fair value on a non-recurring basis as of June 30, 2010 are presented below:

	Fair Value Measurement Using
	Quoted Prices in Active Markets for Identical Assets/Liabilities		Significant Other Observable Inputs		Significant Unobservable Inputs		Balance June 30, 2010
	Level I		Level II		Level III		Total
Assets
Core deposit intangible	$	-	$	-	$	1,576	$	1,576
Goodwill		-		-		26,398		26,398
Other real-estate owned		-		1,269		-		1,269
Total non-financial assets	$	-	$	1,269	$	27,974	$	29,243

A reconciliation of items in Level III is as follows:

	Non-Financial Assets
	Core deposit intangible			Goodwill		Real estates sold under contract			Total
Balance, December 31, 2009	$	1,751		$	26,398	$	123		$	28,272
Amortization of core deposit intangible		(175	)		-		-			(175	)
Payments received on real estate sold		-			-		(123	)		(123	)
Balance, June 30, 2010	$	1,576		$	26,398	$	-		$	27,974

Disclosures about Fair Value of Financial Instruments

General Accepted Accounting Principles (GAAP) require disclosure of the estimated fair value of an entity’s assets and liabilities considered to be financial instruments. For the Company, as for most financial institutions, the majority of its assets and liabilities are considered financial instruments. However, many such instruments lack an available trading market, as characterized by a willing buyer and seller engaging in an exchange transaction. Also, it is the Company’s general practice and intent to hold its financial instruments to maturity and not to engage in trading or sales activities, except for certain loans and investments. Therefore, the Company had to use significant estimates and present value calculations to prepare this disclosure.

Changes in the assumptions or methodologies used to estimate fair values may materially affect the estimated amounts. Also, management is concerned that there may not be reasonable comparability between institutions due to the wide range of permitted assumptions and methodologies in the absence of active markets. This lack of uniformity gives rise to a high degree of subjectivity in estimating financial instrument fair values.

Estimated fair values have been determined by the Company using the best available data and an estimation methodology suitable for each category of financial instruments. The estimation methodologies used at June 30, 2010 and December 31, 2009 are outlined below. The methodologies for estimating the fair value of financial assets and financial liabilities that are measured at fair value on a recurring or non-recurring basis are discussed in the fair value measurements section above. The estimated fair value approximates carrying value for cash and cash equivalents, accrued interest and the cash surrender value of life insurance policies. The methodologies for other financial assets and financial liabilities are discussed below:

21

Short-term financial instruments

The carrying value of short-term financial instruments including cash and due from banks, federal funds sold, interest-bearing deposits in banks and other short-term investments and borrowings, approximates the fair value of these instruments. These financial instruments generally expose the Company to limited credit risk and have no stated maturities or have short-term maturities with interest rates that approximate market rates.

Investment securities held-to-maturity

The estimated fair values of investment securities held to maturity are based on quoted market prices, provided by independent third parties that specialize in those investment sectors. If quoted market prices are not available, estimated fair values are based on quoted market prices of comparable instruments.

Loans

The loan portfolio, net of unearned income, has been valued by a third party specialist using quoted market prices, if available. When market prices were not available, a credit risk based present value discounted cash flow analysis was utilized. The primary assumptions utilized in this analysis are the discount rate based on the libor curve, adjusted for credit risk, and prepayment estimates based on factors such as refinancing incentives, age of the loan and seasonality. These assumptions were applied by loan category and different spreads were applied based upon prevailing market rates by category.

Deposits

The estimated fair values of demand deposits (i.e., interest and non-interest bearing checking accounts, savings and money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). The fair value for certificates of deposit was calculated by an independent third party by discounting contractual cash flows using current market rates for instruments with similar maturities, using a credit based risk model. The carrying amount of accrued interest receivable and payable approximates fair value.

Long-term borrowings

The amounts assigned to long-term borrowings was based on quoted market prices, when available, or were based on discounted cash flow calculations using prevailing market interest rates for debt of similar terms.

The carrying and fair values of certain financial instruments were as follows:

	June 30, 2010						December 31, 2009
	Carrying Amount			Fair Value			Carrying Amount			Fair Value
Cash and cash equivalents	$	13,513		$	13,513		$	13,374		$	13,374
Investment securities available- for-sale		153,764			153,764			155,481			155,481
Investment securities held-to-maturity		41,040			43,371			46,851			49,054
Loans, net		603,236			615,665			597,670			606,814
Cash surrender value of life insurance		14,644			14,644			14,380			14,380
Demand deposits		434,005			434,005			439,515			439,515
Time deposits		220,263			222,332			205,919			208,205
Short-term borrowings		31,746			31,746			45,598			45,598
Long-term borrowings		67,525			71,034			68,094			69,853
Standby Letters of Credit	$	(162	)	$	(162	)	$	(161	)	$	(161	)

PART I.  FINANCIAL INFORMATION,  Item 2 —  

 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

The following commentary provides an overview of the financial condition and significant changes in the results of operations of Penseco Financial Services Corporation (the “Company”) and its subsidiary, Penn Security Bank and Trust Company (the “Bank”), at June 30, 2010 and for the three and six month periods ended June 30, 2010

22

and June 30, 2009. All information is presented in thousands of dollars, except as indicated. The Company consummated the acquisition of Old Forge Bank on April 1, 2009 (the “Merger”). Therefore, the operating results for Old Forge Bank for the three month period ended March 31, 2009 are not included herein. See Note 12 of the “Notes to Consolidated Financial Statements” for the presentation of the pro forma results of the Company for the six months ended June 30, 2009.

Critical Accounting Policies

The preparation of financial statements in conformity with generally accepted accounting principles (GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Provision (allowance) for possible loan losses - The provision for loan losses is based on past loan loss experience, management's evaluation of the potential loss in the current loan portfolio under current economic conditions and such other factors as, in management's best judgment, deserve current recognition in estimating loan losses. The annual provision for loan losses charged to operating expense is that amount which is sufficient to bring the balance of the allowance for possible loan losses to an adequate level to absorb anticipated losses.

Actuarial assumptions associated with pension, post-retirement and other employee benefit plans - These assumptions include discount rate, rate of future compensation increases and expected return on plan assets.

Income taxes - The calculation of the provision for federal income taxes is complex and requires the use of estimates and judgments. Deferred federal income tax assets or liabilities represent the estimated impact of temporary differences between the recognition of assets and liabilities under GAAP, and how such assets and liabilities are recognized under the federal tax code. The Company uses an estimate of future earnings to support management’s position that the benefit of the deferred tax assets will be realized. If future income should prove non-existent or less than the amount of the deferred tax assets within the tax years to which they may be applied, the asset may not be realized and net income will be reduced. Deferred tax assets are described further in Note 17 of the “Notes to Consolidated Financial Statements&# 8221; in the Company’s most recent Annual Report on Form 10-K.

The Company and its subsidiary file income tax and other returns in the U.S Federal jurisdiction, Pennsylvania state jurisdiction and local jurisdictions.

Management evaluated the Company’s tax positions and concluded that the aggregate liabilities related to taxes are appropriately reflected in the consolidated financial statements. With few exceptions, the Company is no longer subject to income tax examinations by the U.S. Federal, state or local tax authorities for years before 2006.

Fair Value Measurements – Fair values of financial instruments are estimated using relevant market information and other assumptions. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayment speeds and other factors. Changes in assumptions or in market conditions could significantly affect the estimates. Fair value measurements are classified within one of three levels within a valuation hierarchy based on the transparency of inputs to each valuation as of the fair value measurement date. The three levels are defined as follows:

Level I – quoted prices (unadjusted) for identical assets or liabilities in active markets.

Level II – inputs include quoted prices for similar assets and liabilities in active markets, quoted prices of identical or similar assets or liabilities in markets that are not active, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

Level III – inputs that are unobservable and significant to the fair value measurement. Financial instruments are considered Level III when values are determined using pricing models, discounted cash flow methodologies, or similar techniques, and at least one significant model assumption or input is unobservable.

Other-than-temporary impairment of investments - Investments are evaluated periodically to determine whether a decline in their value is other than temporary. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other than temporary. The term “other-than-temporary” is not intended to indicate that the decline is permanent. It indicates that the prospects for a near term recovery of value are not necessarily favorable, or that there is a lack of evidence to support fair values equal to, or greater than, the carrying value of the investment. Once a decline in value is

23

determined to be other than temporary, the value of the security is reduced and a corresponding charge to earnings is recognized.

Premium amortization - The amortization of premiums on mortgage-backed securities is done based on management's estimate of the lives of the securities, adjusted, when necessary, for advanced prepayments in excess of those estimates.

Loans purchased – Loans purchased as a result of the Merger were recorded at the acquisition date fair value.  Management made three different types of fair value adjustments in order to record the loans at fair value. An interest rate fair value adjustment was made comparing current weighted average rates of the acquired loans to stated market rates of similar loan types. A general credit fair value adjustment was made on similar loan types based on historical loss projections plus a discount for the weak economic environment. A specific credit fair value adjustment was made to loans identified by management as being problematic. The specific loans have been discounted by management based on collateral values and expected cash flows. The interest rate and general credit fair value adjustments are being accreted over an eight year period based on a sum-of-the-years-digits basis. The specific credit fair value adjustment is reduced only when cash flows are received.

Loan servicing rights – Mortgage servicing rights are evaluated for impairment based on the fair value of those rights. Fair values are estimated using discounted cash flows based on current market rates of interest and current expected future prepayment rates. For purposes of measuring impairment, the rights must be stratified by one or more predominant risk characteristics of the underlying loans. The Company stratifies its capitalized mortgage servicing rights based on the product type, interest rate and term of the underlying loans. The amount of impairment recognized is the amount, if any, by which the amortized cost of the rights for each stratum exceed the fair value.

Time deposits – Time deposits acquired through the Merger have been recorded at their acquisition date fair value.  The fair value of time deposits represents the present value of the time deposits’ expected contractual payments discounted by market rates for similar deposits. The fair value adjustment is amortized monthly based a level yield methodology.

Core deposit intangible – The fair value assigned to the core deposit intangible asset represents the future economic benefit of the potential cost savings from acquiring core deposits in the Merger compared to the cost of obtaining alternative funding, such as brokered deposits, from market sources. Management utilized an income approach to present value the expected after tax cash flow benefits of the acquired core deposits. The core deposit intangible is being amortized over ten years on a sum-of-the-years-digits basis.

Goodwill – Goodwill arose in connection with the Merger. It is reviewed by management for possible impairment at least annually or more frequently upon the occurrence of an event or when circumstances indicate that its carrying amount exceeds fair value. Management has obtained a professional evaluation of the Company value as of December 31, 2009. The evaluation disclosed that the fair value of the Company stock is approximately 43% above book value, considering both income and market approaches. Market conditions that could negatively impact the value of goodwill in the future are essentially those Risk Factors discussed in Part 1A of the Company’s most recent Annual Report on Form 10-K. Based on the above, management has determined that the carrying value of goodwill has not been impaired at June 30, 2010.

Non-GAAP Financial Measures

Certain financial measures for 2009 contained in this Form 10-Q exclude costs related to the Company’s acquisition of Old Forge Bank on April 1, 2009. Financial measures which exclude the above referenced items have not been determined in accordance with GAAP and are therefore non-GAAP financial measures. Management of the Company believes that investors’ understanding of the Company’s performance is enhanced by disclosing these non-GAAP financial measures as a reasonable basis for comparison of the Company’s ongoing results of operations. These non-GAAP measures should not be considered a substitute for GAAP-basis measures and results. Our non-GAAP measures may not be comparable to non-GAAP measures of other companies. The Non-GAAP Reconciliation Schedule provides a reconciliation of these non-GAAP financial me asures to the most closely analogous measure determined in accordance with GAAP.

Merger costs of $215 and $1,550 in the three months and six months ended June 30, 2009, respectively, related to the acquisition of Old Forge Bank consist primarily of investment banking costs, system conversion costs, valuation services, legal and accounting fees and severance payments.

24

NON-GAAP RECONCILIATION SCHEDULE

PENSECO FINANCIAL SERVICES CORPORATION

(unaudited)

(in thousands)

The following tables present the reconciliation of non-GAAP financial measures to reported GAAP financial measures.

	Three Months Ended
	June 30,
	2010			2009			Change
Net interest income after provision for loan losses	$	7,786		$	7,805		$	(19	)
Non-interest income		2,873			2,771			102
Non-interest expense		(6,805	)		(6,932	)		127
Income tax (provision) benefit		(838	)		(775	)		(63	)
Net income		3,016			2,869			147
Adjustments
Non-interest expense
Merger related costs		-			215			(215	)
Total Adjustments pre-tax		-			215			(215	)
Income tax provision (benefit)1		-			73			(73	)
After tax adjustments to GAAP		-			142			(142	)
Adjusted net income	$	3,016		$	3,011		$	5
Return on Average Assets		1.37	%		1.42	%
Return on Average Equity		10.00	%		10.49	%
Dividend Payout Ratio		45.65	%		45.65	%

 

1 Income tax effect calculation is 34% except for the portion of the merger costs that are non-deductible.

Return on average equity (ROE) and return on average assets (ROA) for the three months ended June 30, 2010 was 10.00% and 1.37%, respectively. ROE was 10.00% (10.49% excluding the Merger costs) and ROA was 1.35% (1.42% excluding the Merger costs) for the same period last year. The dividend payout ratio was 45.65% and was 47.73% (45.65% excluding the Merger costs) for the same period last year.

	Six Months Ended
	June 30,
	2010			2009			Change
Net interest income after provision for loan losses	$	15,909		$	12,807		$	3,102
Non-interest income		5,584			5,181			403
Non-interest expense		(13,842	)		(14,056	)		214
Income tax benefit (provision)		(1,654	)		(622	)		(1,032	)
Net income		5,997			3,310			2,687
Adjustments
Non-interest expense
Merger related costs		-			1,550			(1,550	)
Total Adjustments pre-tax		-			1,550			(1,550	)
Income tax provision (benefit)2		-			527			(527	)
After tax adjustments to GAAP		-			1,023			(1,023	)
Adjusted net income	$	5,997		$	4,333		$	1,664
Return on Average Assets		1.36	%		1.17	%
Return on Average Equity		10.02	%		9.15	%
Dividend Payout Ratio		45.90	%		52.50	%

 

2 Income tax effect calculation is 34% except for the portion of the merger costs that are non-deductible.

25

Return on average equity (ROE) and return on average assets (ROA) for the six months ended June 30, 2010 was 10.02% and 1.36%, respectively. ROE was 6.99% (9.15% excluding the Merger costs) and ROA was 0.89% (1.17% excluding the Merger costs) for the same period last year. The dividend payout ratio was 45.90% and was 68.85% (52.50% excluding the Merger costs) for the same period last year.

Executive Summary

The Company reported an increase in net income of $147 for the three months ended June 30, 2010 to $3,016 or $0.92 per share compared with $2,869 or $0.88 per share from the year ago period. Pre-provision net interest income increased $283 or 3.5%. Net interest income, after provision for loan losses, decreased $19 or 0.2% during the 2010 period, partly from a $302 increase in the provision for loan losses, along with reduced interest and fees on loans, investment income and reduced interest expense from lower funding costs. The ratio of the allowance for loan losses to total loans stood at 1.07% and 1.03% as of June 30, 2010 and 2009, respectively. Non-interest income increased $102 or 3.7% primarily as a result of higher service charges on deposit accounts and other fee income. Non-interest expenses decreased $127 or 1.8%, mainly fro m a reduction of $215 in costs associated with the Merger and reduced salaries and employee benefits expenses, offset by increased operating expenses and increased FDIC insurance assessments of $86.

The Company reported an increase in net income of $2,687 for the six months ended June 30, 2010 to $5,997 or $1.83 per share compared with $3,310 or $1.22 per weighted average share from the year ago period. The increase in net income was primarily attributed to a reduction of $366 in the provision for loan losses and a reduction of $1,550 in Merger related costs associated with the acquisition of Old Forge Bank. Net interest income, after provision for loan losses, increased $3,102 or 24.2% for the six months ended June 30, 2010 largely due to increased interest and fees on loans as a result of the Merger which was completed on April 1, 2009, offset by a reduction in deposit costs.

Net income from core operations (“operating earnings”), which is a non-GAAP measure of net income, increased $1,664 for the six months ended June 30, 2010 to $5,997 compared to $4,333 for the same period of 2009. Operating earnings for the six months ended June 30, 2010 have been positively impacted by the Merger. A reconciliation of the non-GAAP financial measures of operating earnings, operating return on assets, operating return on equity and dividend payout ratio are described within the non-GAAP reconciliation schedule included within this Quarterly Report on Form 10-Q.

Net income from accretion and amortization of acquisition date fair value adjustments included in the financial results during the period indicated are as follows:

	Six Months Ended
	June 30, 2010
Homogeneous loan pools	$	497
Time deposits		163
Core deposit intangible expense		(175	)
Net income from acquisition fair value adjustment	$	485

Accretion of the loan pools credit fair value adjustment and market rate fair value adjustment is calculated on a sum-of-the-years-digits basis over an eight year period. The fair value market rate adjustment of the time deposits is amortized monthly based on a level yield methodology over five years. The core deposit intangible is being amortized over ten years on a sum-of-the-years-digits basis.

Net Interest Income and Net Interest Margin

Net interest income, the principal component of the Company’s earnings, is defined as the difference between interest and fees earned on interest-earning assets and interest paid on deposits and other borrowings. Average earning assets are composed primarily of loans and investments while deposits, short-term and long-term borrowings represent interest-bearing liabilities. Variations in the volume and mix of these assets and liabilities, as well as changes in the yields earned and rates paid, are determinants of changes in net interest income.

26

Net interest income before provision for loan losses increased $283 or 3.5% to $8,323 for the three months ended June 30, 2010 compared to $8,040 for the three months ended June 30, 2009. The average yield on interest earning assets decreased 36 basis points or 6.2%.

The net interest margin represents the Company’s net yield on its average interest earning assets and is calculated as net interest income divided by average interest earning assets. In the three months ended June 30, 2010, net interest margin increased 1 basis point to 4.14% from 4.13% in the same period of 2009.

Total average interest earning assets and average interest bearing funds increased during the three months ended June 30, 2010 and 2009, respectively. Average interest earning assets increased $26.6 million or 3.4%, from $778.0 million in 2009 to $804.6 million in 2010 and average interest bearing funds increased $12.9 million, or 2.1%, from $627.4 million to $640.3 million for the same period. Average long-term borrowings decreased a net of $3.2 million or 4.7% during the three months ended June 30, 2010 from year ago levels. As a percentage of average assets, average earning assets, including bank-owned life insurance (BOLI) remained relatively unchanged for the three months ended June 30, 2010 and 2009, respectively.

Changes in the mix of both interest earning assets and funding sources also impacted net interest income in the three months ended June 30, 2010 and 2009. Average loans as a percentage of average interest earning assets decreased from 75.9% in 2009 to 75.5% in 2010. Average investments increased $11.0 million year over year and increased as a percentage of interest earning assets to 24.1% at June 30, 2010 from 23.5% at June 30, 2009. Average short-term investments, federal funds sold and interest bearing balances with banks, decreased as a percentage of average assets to 0.3% at June 30, 2010 from 0.6% at June 30, 2009. Average time deposits increased $14.3 million or 7.1% from $202.0 million or 32.2% of interest bearing liabilities in 2009 to $216.3 million or 33.8% of interest bearing liabilities for the 2010 period. In addition, dur ing the three months ended June 30, 2010, average repurchase agreements decreased $6.5 million, average short-term borrowings decreased $2.7 million and average long-term borrowings decreased $3.2 million or 4.7% when compared to the prior year period.

Shifts in the interest rate environment and competitive factors affected the rates paid for funds as well as the yields earned on assets. The investment securities tax equivalent yield decreased 79 basis points from 5.68% for the three months ended June 30, 2009 to 4.89% for the three months ended June 30, 2010. Also, average loan yields decreased 25 basis points from 5.91% for the three months ended June 30, 2009 to 5.66% for the three months ended June 30, 2010.

The average time deposit costs decreased 58 basis points from 2.51% for the three months ended June 30, 2009 to 1.93% for the three months ended June 30, 2010. In addition, the average cost of money market accounts decreased 55 basis points from 1.15% for the three months ended June 30, 2009 to 0.60% for the three months ended June 30, 2010.

27

Distribution of Assets, Liabilities and Stockholders’ Equity / Interest Rates and Interest Differential

The table below presents average balances, interest income on a fully taxable equivalent basis and interest expense, as well as average rates earned and paid on the Company’s major asset and liability items for the three months ended June 30, 2010 and June 30, 2009.

	June 30, 2010							June 30, 2009
ASSETS	Average		Revenue/		Yield/			Average		Revenue/		Yield/
	Balance		Expense		Rate			Balance		Expense		Rate
Investment Securities
Available-for-sale:
U.S. Agency obligations	$	70,743	$	450		2.54	%	$	59,519	$	517		3.47	%
States & political subdivisions		72,164		816		6.85	%		58,292		755		7.85	%
Federal Home Loan Bank stock		6,402		-		-			6,330		-		-
Other		2,679		12		1.79	%		1,490		8		2.15	%
Held-to-maturity:
U.S. Agency obligations		20,777		254		4.89	%		29,273		355		4.85	%
States & political subdivisions		21,208		278		7.94	%		28,059		378		8.16	%
Loans, net of unearned income:
Real estate mortgages		329,096		4,305		5.23	%		340,371		4,797		5.64	%
Commercial real estate		176,038		2,259		5.13	%		156,079		2,068		5.30	%
Commercial		31,669		517		6.53	%		26,117		354		5.42	%
Consumer and other		71,038		1,527		8.60	%		67,847		1,508		8.89	%
Federal funds sold		-		-		-			-		-		-
Interest on balances with banks		2,787		2		0.29	%		4,649		3		0.26	%
Total Interest Earning Assets/
Total Interest Income		804,601	$	10,420		5.46	%		778,026	$	10,743		5.82	%
Cash and due from banks		10,243							11,334
Bank premises and equipment		12,759							12,351
Accrued interest receivable		3,779							3,919
Goodwill		26,398							26,398
Cash surrender value of life insurance		14,567							14,054
Other assets		13,632							10,433
Less:  Allowance for loan losses		6,412							6,405
Total Assets	$	879,567						$	850,110
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits:
Demand-Interest bearing	$	69,986	$	84		0.48	%	$	68,242	$	132		0.77	%
Savings		114,906		81		0.28	%		111,265		116		0.42	%
Money markets		141,897		212		0.60	%		141,500		407		1.15	%
Time - Over $100		94,343		532		2.26	%		69,730		482		2.76	%
Time - Other		121,931		509		1.67	%		132,256		786		2.38	%
Federal funds purchased		7,026		10		0.57	%		1,918		3		0.63	%
Repurchase agreements		18,319		41		0.90	%		24,752		96		1.55	%
Short-term borrowings		6,535		8		0.49	%		9,204		13		0.56	%
Long-term borrowings		65,334		620		3.80	%		68,547		668		3.90	%
Total Interest Bearing Liabilities/
Total Interest Expense		640,277	$	2,097		1.31	%		627,414	$	2,703		1.72	%
Demand - Non-interest bearing		110,746							100,603
All other liabilities		7,950							7,296
Stockholders' equity		120,594							114,797
Total Liabilities and
Stockholders' Equity	$	879,567						$	850,110
Interest Spread						4.15	%						4.10	%
Net Interest Income			$	8,323						$	8,040
FINANCIAL RATIOS
Net interest margin						4.14	%						4.13	%
Return on average assets						1.37	%						1.35	%
Return on average equity						10.00	%						10.00	%
Average equity to average assets						13.71	%						13.50	%
Dividend payout ratio						45.65	%						47.73	%

28

Net interest income before provision for loan losses increased $2,736 or 19.5% to $16,774 for the six months ended June 30, 2010, compared to $14,038 for the six months ended June 30, 2009. The average yield on interest earning assets decreased 25 basis points or 4.4%.

The net interest margin represents the Company’s net yield on its average interest earning assets and is calculated as net interest income divided by average interest earning assets. For the six months ended June 30, 2010, net interest margin was 4.16%, an increase of 9 basis points from 4.07% in the same period of 2009.

Total average interest earning assets and average interest bearing funds increased for the six months ended June 30, 2010 as compared to the six months ended June 30, 2009. Average interest earning assets increased $116.4 million or 16.9%, from $689.7 million in 2009 to $806.1 million in 2010 and average interest bearing funds increased $91.2 million, or 16.5%, from $552.9 million to $644.1 million for the same period. As a percentage of average assets, average earning assets, including BOLI, decreased to 93.2% for the six months ended June 30, 2010 from 94.6% for the year ago period.

Changes in the mix of both interest earning assets and funding sources also impacted net interest income in the six months ended June 30, 2010 and 2009. Average loans as a percentage of average interest earning assets increased from 74.5% in 2009 to 75.2% in 2010. Average investments increased $24.6 million year over year and decreased as a percentage of average interest earning assets to 24.5% at June 30, 2010 from 25.0% at June 30, 2009. Average short-term investments, federal funds sold and interest bearing balances with banks, decreased as a percentage of average assets to 0.3% at June 30, 2010 from 0.5% at June 30, 2009. Average time deposits increased $56.1 million or 35.8% from 28.3% of interest bearing liabilities in 2009 to 33.0% of interest bearing liabilities for the 2010 period. In addition, during the six months ended June 30, 2010, average federal funds purchased increased $4.0 million, average repurchase agreements decreased $8.7 million, average short-term borrowings increased $1.4 million and average long-term borrowings decreased $4.3 million when compared to the prior year period.

Shifts in the interest rate environment and competitive factors affected the rates paid for funds as well as the yields earned on assets. The investment securities tax equivalent yield decreased 65 basis points from 5.55% for the six months ended June 30, 2009 to 4.90% for the six months ended June 30, 2010. Also, average loan yields decreased 14 basis points, from 5.85% for the six months ended June 30, 2009 to 5.71% for the same period of 2010.

The average time deposit costs decreased 71 basis points from 2.62% for the six months ended June 30, 2009 to 1.91% for the six months ended June 30, 2010, along with the average cost of money market accounts decreasing 46 basis points from 1.09% for the six months ended June 30, 2009 to 0.63% for the six months ended June 30, 2010.

29

Distribution of Assets, Liabilities and Stockholders’ Equity / Interest Rates and Interest Differential

The table below presents average balances, interest income on a fully taxable equivalent basis and interest expense, as well as average rates earned and paid on the Company’s major asset and liability items for the six months ended June 30, 2010 and June 30, 2009.

	June 30, 2010							June 30, 2009
ASSETS	Average		Revenue/		Yield/			Average		Revenue/		Yield/
	Balance		Expense		Rate			Balance		Expense		Rate
Investment Securities
Available-for-sale:
U.S. Agency obligations	$	71,038	$	906		2.55	%	$	56,061	$	1,015		3.62	%
States & political subdivisions		73,803		1,660		6.82	%		49,708		1,229		7.49	%
Federal Home Loan Bank stock		6,402		-		-			5,949		-		-
Other		2,302		23		2.00	%		1,375		22		3.20	%
Held-to-maturity:
U.S. Agency obligations		21,730		517		4.76	%		30,905		735		4.76	%
States & political subdivisions		21,896		573		7.93	%		28,644		765		8.09	%
Loans, net of unearned income:
Real estate mortgages		330,390		8,749		5.30	%		307,334		8,770		5.71	%
Commercial real estate		174,155		4,452		5.11	%		128,939		3,508		5.44	%
Commercial		30,123		1,030		6.84	%		25,535		698		5.47	%
Consumer and other		71,535		3,063		8.56	%		51,781		2,035		7.86	%
Federal funds sold		-		-		-			-		-		-
Interest on balances with banks		2,773		4		0.29	%		3,474		6		0.35	%
Total Interest Earning Assets/
Total Interest Income		806,147	$	20,977		5.49	%		689,705	$	18,783		5.74	%
Cash and due from banks		10,389							9,700
Bank premises and equipment		12,577							11,435
Accrued interest receivable		3,834							3,609
Goodwill		26,398							13,199
Cash surrender value of life insurance		14,497							10,884
Other assets		13,202							7,698
Less:  Allowance for loan losses		6,328							5,830
Total Assets	$	880,716						$	740,400
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits:
Demand-Interest bearing	$	69,690	$	178		0.51	%	$	60,125	$	189		0.63	%
Savings		113,551		164		0.29	%		93,114		191		0.41	%
Money markets		142,872		449		0.63	%		130,147		712		1.09	%
Time - Over $100		88,765		965		2.17	%		54,244		760		2.80	%
Time - Other		123,818		1,069		1.73	%		102,209		1,292		2.53	%
Repurchase agreements		18,447		83		0.90	%		27,148		204		1.50	%
Federal funds purchased		7,872		22		0.56	%		3,921		11		0.56	%
Short-term borrowings		13,372		26		0.39	%		12,012		34		0.57	%
Long-term borrowings		65,698		1,247		3.80	%		69,985		1,352		3.86	%
Total Interest Bearing Liabilities/
Total Interest Expense		644,085	$	4,203		1.31	%		552,905	$	4,745		1.72	%
Demand - Non-interest bearing		109,103							86,808
All other liabilities		7,866							6,002
Stockholders' equity		119,662							94,685
Total Liabilities and
Stockholders' Equity	$	880,716						$	740,400
Interest Spread						4.18	%						4.02	%
Net Interest Income			$	16,774						$	14,038
FINANCIAL RATIOS
Net interest margin						4.16	%						4.07	%
Return on average assets						1.36	%						0.89	%
Return on average equity						10.02	%						6.99	%
Average equity to average assets						13.59	%						12.79	%
Dividend payout ratio						45.90	%						68.85	%

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Investments

The Company’s investment portfolio has primarily two functions: To provide liquidity and to contribute to earnings. To provide liquidity the Company may invest in short-term securities such as Federal funds sold, interest bearing deposits with banks, U.S. Treasury securities and U.S. Agency securities all with maturities of one year or less. These funds are invested short-term to ensure the availability of funds to meet customer demand for credit needs. The Company enhances interest income by securing long-term investments within its investment portfolio, by means of U.S. Treasury securities, U.S. Agency securities, municipal securities and mortgage-backed securities, generally with maturities greater than one year. The Company’s mortgage-backed securities portfolio does not contain any sub-prime or Alt-A credits.

Investments in securities are classified in two categories and accounted for as follows:

Securities Held-to-Maturity  Bonds, notes, debentures and mortgage-backed securities for which the Company has the positive intent and ability to hold to maturity are reported at cost, adjusted for amortization of premiums and accretion of discounts computed on the straight-line basis, which approximates the interest method, over the remaining period to maturity.

Securities Available-for-Sale  Bonds, notes, debentures, mortgage-backed securities and certain equity securities not classified as securities to be held to maturity are carried at fair value with unrealized holding gains and losses, net of tax, reported as a net amount in a separate component of stockholders’ equity until realized.

The amortization of premiums on mortgage-backed securities is done based on management's estimate of the lives of the securities, adjusted, when necessary, for advanced prepayments in excess of those estimates.

Realized gains and losses on the sale of securities available-for-sale are determined using the specific identification method and are reported as a separate component of other income in the Statements of Income. Unrealized gains and losses are included as a separate item in computing comprehensive income.

Investments are evaluated periodically to determine whether a decline in their value is other than temporary. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other than temporary. The term “other than temporary” is not intended to indicate that the decline is permanent. It indicates that the prospects for a near term recovery of value are not necessarily favorable, or that there is a lack of evidence to support fair values equal to, or greater than, the carrying value of the investment. Once a decline in value is determined to be other than temporary, the value of the security is reduced and a corresponding charge to earnings is recognized.

Federal Home Loan Bank Stock Impairment Evaluation

The Company's banking subsidiary, Penn Security Bank, is required to maintain certain amounts of FHLB stock in order to participate in a FHLB line of credit program. The FHLB stock is stated at par value as it is restricted to purchases and sales with the FHLB. FHLB stock is less liquid than other tradable equity securities and the fair value is equal to cost. No impairment write-downs have been recorded on FHLB stock during 2010 or 2009.

The FHLB indefinitely suspended its stock repurchase and dividend payments during December 2008. A reduction in the level of core earnings resulting from lower short-term interest rates, the increased cost of maintaining liquidity and constrained access to the debt markets at attractive rates and maturities are the main reasons the FHLB cited as significant for the decision to suspend dividends and the repurchase of excess capital stock. Accounting guidance indicates that investors should recognize impairment in FHLB Pittsburgh capital stock if it is determined that it is not probable that the Bank will ultimately recover the par value of its shares. An investor in FHLB Pittsburgh must determine whether impairment exists based on its long-term performance, the severity and duration of declines in the market value of its net assets related to its capital stock amount, its commitment to make payments required by law or regulation and the level of such payments in relation to its operating performance, the impact of legislation and regulatory changes and its liquidity. Based on current financial information available, management does not believe the FHLB stock value is impaired as of June 30, 2010.

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Deposits

The Company is largely dependent on its core deposit base to fund operations. Management has competitively priced its deposit products in checking, savings, money market and time deposits to provide a stable source of funding.

As general interest rates in the economy change, there is migration of some deposits among investment options as customers seek increased yields. Historically, such changes in the Company’s deposit base have been minimal.

Provision for Loan Losses

The provision for loan losses represents management’s determination of the amount necessary to bring the allowance for loan losses to a level that management considers adequate to reflect the risk of future losses inherent in the Company’s loan portfolio.

The provision for loan losses increased $302 from $235 for the three months ended June 30, 2009 to $537 for the three months ended June 30, 2010, based on management’s ongoing valuation of the loan portfolio. Loans charged off totaled $542 and recoveries were $5 for the three months ended June 30, 2010. In the same period of 2009, loans charged off totaled $237 and recoveries were $2. For the six months ended June 30, 2010, the provision for loan losses was $865, a decrease from $1,231 in the first six months of 2009. Loans charged-off totaled $673 and recoveries were $8 for the six months ended June 30, 2010. In the same period of 2009, loans charged off totaled $459 and recoveries were $3. The allowance for loan losses at June 30, 2010 was $6,500 or 1.07% of total loans compared to $6,300 or 1.04% of total loans at Decembe r 31, 2009 and $6,050 or 1.03% of total loans at June 30, 2009.

The components of the allowance for credit losses are as follows:

	June 30,			December 31,			June 30,
	2010			2009			2009
Allowance for loan losses	$	6,500		$	6,300		$	6,050
Credit fair value adjustment on purchased loans		5,192			5,795			6,725
Allowance for credit losses	$	11,692		$	12,095		$	12,775
Allowance for credit losses to period end loans		1.90	%		1.98	%		2.17	%

The Company believes that the judgments used in establishing the allowance for loan losses are based on reliable information. In assessing the sufficiency of the allowance for loan losses, management considers how well prior estimates have related to actual experience. The Company continually monitors the risk elements, historical rates and other data used in establishing the allowance on a periodic basis. The quarterly provision for loan losses charged to operating expense is that amount which is sufficient to bring the balance of the allowance for possible loan losses to an adequate level to absorb anticipated losses. Based on this ongoing evaluation, management determines the provision necessary to maintain an appropriate allowance.

Although management uses available information to establish the appropriate level of the allowance for loan losses, future additions or reductions to the allowance may be necessary based on estimates that are susceptible to change as a result of changes in economic conditions and other factors. As a result, our allowance for loan losses may not be sufficient to cover actual loan losses, and future provisions for loan losses could materially adversely affect the Company’s operating results. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may require the Company to recognize adjustments to the allowance based on their judgments about information available to them at the time of their examination.

There are also no particular risk elements in the local economy that put a group or category of loans at increased risk, however, the Company has increased its portfolio of commercial loans, which typically bear a higher risk.

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These loans are typically secured by real estate to minimize this risk. At June 30, 2010 management believes the loan loss reserve is adequate to manage the risk inherent in the loan portfolio due to today’s economic environment.

The process of determining the adequacy of the allowance is necessarily judgmental and subject to changes in external conditions. Accordingly, there can be no assurance that existing levels of the allowance will ultimately prove adequate to cover actual loan losses.

Non-Interest Income

The following table sets forth information by category of non-interest income for the Company for the three months ended June 30, 2010 and June 30, 2009, respectively:

	June 30,		June 30,
Three Months Ended:	2010		2009
Trust department income	$	337	$	375
Service charges on deposit accounts		563		481
Merchant transaction income		875		841
Brokerage fee income		92		79
Other fee income		413		331
Bank-owned life insurance income		130		132
Other operating income		172		218
Realized gains (losses) on securities, net		291		314
Total Non-Interest Income	$	2,873	$	2,771

Total non-interest income increased $102 or 3.7% to $2,873 for the three months ended June 30, 2010, compared with $2,771 for the same period in 2009. Trust department income decreased $38 or 10.1% due to a decrease in the market value of trust assets. Service charges on deposit accounts increased $82 or 17.0% primarily due to the increased number of accounts and increased service charge activity. Brokerage fee income increased $13 or 16.5% mostly due to the volume of investor activity. Other fee income increased $82 or 24.8% mainly from increased debit card discounts related to the increased number of accounts. Other operating income decreased $46 or 21.1% largely due to a reduction of gains on the sale of low yielding long-term fixed rate real estate loans.

The following table sets forth information by category of non-interest income for the Company for the six months ended June 30, 2010 and June 30, 2009, respectively:

	June 30,		June 30,
Six Months Ended:	2010		2009
Trust department income	$	717	$	685
Service charges on deposit accounts		1,095		820
Merchant transaction income		2,069		2,049
Brokerage fee income		162		196
Other fee income		763		618
Bank-owned life insurance income		252		211
Other operating income		233		288
Realized gains (losses) on securities, net		293		314
Total Non-Interest Income	$	5,584	$	5,181

Total non-interest income increased $403 or 7.8% to $5,584 for the six months ended June 30, 2010, compared with $5,181 for the same period in 2009. Trust department income increased $32 or 4.7% due to increased business. Service charges on deposit accounts increased $275 or 33.5% primarily due to the increased number of accounts and increased service charge activity. Brokerage fee income decreased $34 or 17.3% mostly due to a lower volume of investor activity. Other fee income increased $145 or 23.5% mainly from increased debit card discounts related to the increased number of accounts. Bank-owned life insurance income increased $41 or 19.4% due to the Merger. Other operating income decreased $55 or 19.1% largely due to a reduction of gains on the sale of low yielding long-term fixed rate real estate loans.

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Non-Interest Expenses

The following table sets forth information by category of non-interest expenses for the Company for the three months ended June 30, 2010 and June 30, 2009, respectively:

	June 30,		June 30,
Three Months Ended:	2010		2009
Salaries and employee benefits	$	3,092	$	3,249
Expense of premises and fixed assets		835		817
Merchant transaction expenses		639		605
Merger related costs		-		215
FDIC insurance assessments		370		284
Other operating expenses		1,869		1,762
Total Non-Interest Expenses	$	6,805	$	6,932

Total non-interest expenses decreased $127 or 1.8% to $6,805 for the three months ended June 30, 2010 compared with $6,932 for the same period of 2009. Salaries and employee benefits expense decreased $157 or 4.8% mainly due to reduced pension expense and unemployment taxes. Merchant transaction expenses increased $34 or 5.6% due to higher transaction volume. Merger related costs, which consisted in 2009 of severance payments and stay bonuses to key employees of Old Forge Bank to help with the transition and conversion process, decreased $215. FDIC insurance assessments increased $86 or 30.3% in 2010. Other operating expenses increased $107 or 6.1% mostly from amortization of core deposit intangible expense of $83 and increased general operating expenses.

The following table sets forth information by category of non-interest expenses for the Company for the six months ended June 30, 2010 and June 30, 2009, respectively:

	June 30,		June 30,
Six Months Ended:	2010		2009
Salaries and employee benefits	$	6,265	$	5,727
Expense of premises and fixed assets		1,785		1,608
Merchant transaction expenses		1,450		1,462
Merger related costs		-		1,550
FDIC insurance assessments		636		445
Other operating expenses		3,706		3,264
Total Non-Interest Expenses	$	13,842	$	14,056

Total non-interest expenses decreased $214 or 1.5% to $13,842 for the six months ended June 30, 2010 compared with $14,056 for the same period of 2009. Salaries and employee benefits expense increased $538 or 9.4% mainly due to increased salaries resulting from additional employees as a result of the Merger. Expense of premises and fixed assets increased $177 or 11.0% due to information technology system upgrades along with additional depreciation as a result of the Merger. Merger related costs decreased $1,550, which consisted in 2009 of computer and equipment upgrades of $606, investment banking, valuation services, legal and accounting fees of $429, severance payments of $450 and stay bonuses of $65. FDIC insurance assessments increased $191 or 42.9% in 2010. Other operating expenses increased $442 or 13.5% partly from amortization of core deposit intangible expense of $175, increased professional services of $105, increased advertising of $48, along with increased general operating expenses.

Income Taxes

Applicable income taxes increased $63 or 8.1% for the three months ended June 30, 2010 due to overall higher income and the effect of $215 of costs associated with the Merger recorded in the second quarter of 2009. Also, applicable income taxes increased $1,032 or 165.9% during the first six months of 2010 primarily due to the effect of $1,550 of costs associated with the Merger recorded during the first six months of 2009, along with overall higher income.

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Loan Portfolio

Details regarding the Company’s loan portfolio on June 30, 2010 and December 31, 2009 are as follows:

	June 30,		December 31,
As of:	2010		2009
Real estate - construction and land development	$	29,611	$	32,910
Real estate mortgages		478,767		470,093
Commercial		30,760		30,743
Credit card and related plans		3,282		3,365
Installment and other		58,046		59,986
Obligations of states & political subdivisions		9,270		6,873
Loans, net of unearned income		609,736		603,970
Less:  Allowance for loan losses		6,500		6,300
Loans, net	$	603,236	$	597,670

The Company does not engage in any sub-prime or Alt-A credit lending. Therefore, the Company is not subject to any credit risks associated with such loans. The Company’s loan portfolio primarily consists of residential and commercial mortgage loans, secured by properties located in Northeastern Pennsylvania and subject to conservative underwriting standards.

The mortgage loan portfolio continues to be the largest component of the loan portfolio, representing 83.4% and 83.3% of total loans at June 30, 2010 and December 31, 2009, respectively. However, recent economic conditions and recessionary concerns have resulted in lower levels of loan demand. Accordingly, we expect that loan growth may be slower than historically expected.

Loan Quality

The lending activities of the Company are guided by the comprehensive lending policy established by the Board of Directors. Loans must meet criteria which include consideration of the character, capacity and capital of the borrower, collateral provided for the loan, and prevailing economic conditions. Due to the consistent application of conservative underwriting standards, the Company’s loan quality has remained strong during the current general economic downturn. The Company has not engaged in any sub-prime credit lending and is therefore, not subject to the credit risks associated with such loans.

Regardless of credit standards, there is risk of loss inherent in every loan portfolio. The allowance for loan losses is an amount that management believes will be adequate to absorb possible losses on existing loans that may become uncollectible, based on evaluations of the collectibility of the loans. The evaluations take into consideration such factors as change in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, industry experience, collateral value and current economic conditions that may affect the borrower’s ability to pay. Management believes that the allowance for loan losses is adequate. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may require the Company to recognize additions to the allowance based on their judgment of information available to them at the time of their examination.

The allowance for loan losses is increased by periodic charges against earnings as a provision for loan losses, and decreased periodically by charge-offs of loans (or parts of loans) management has determined to be uncollectible, net of actual recoveries on loans previously charged-off.

The allowance for loan loss as a percentage of loans was 1.07% at June 30, 2010, compared to 1.04% at December 31, 2009 and 1.03% at June 30, 2009. The allowance for credit losses, which includes the allowance for loan loss and the credit fair value adjustment on loans purchased, provides an allowance for credit loss as a percentage of period end loans of 1.90% at June 30, 2010 compared to 1.98% at December 31, 2009 and 2.17% at June 30, 2009. The evaluation of credit fair value adjustment on purchased loans was made in accordance with current accounting standards for business combinations.

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The components of the allowance for credit losses are as follows:

	June 30,			December 31,			June 30,
	2010			2009			2009
Allowance for loan losses	$	6,500		$	6,300		$	6,050
Credit fair value adjustment on purchased loans		5,192			5,795			6,725
Allowance for credit losses	$	11,692		$	12,095		$	12,775
Allowance for credit losses to period end loans		1.90	%		1.98	%		2.17	%

Non-Performing Assets

The following table sets forth information regarding non-accrual loans and loans past due 90 days or more and still accruing interest:

		June 30,			December 31,			June 30,
As of:		2010			2009			2009
Non-accrual loans
Secured by real estate	$	2,104		$	1,945		$	1,650
Commercial loans		569			199			941
Consumer loans		149			195			140
Total non-performing loans	$	2,822		$	2,339		$	2,731
Other real estate owned		1,269			405			560
Total non-performing assets	$	4,091		$	2,744		$	3,291
Loans past due 90 days or more and accruing:
Secured by real estate	$	555		$	1,456		$	754
Guaranteed student loans		185			218			223
Credit card loans		26			9			6
Commercial loans		-			-			-
Consumer loans		26			14			2
Total loans past due 90 days or more and accruing	$	792		$	1,697		$	985
Non-performing loans to period end loans		0.46	%		0.39	%		0.47	%
Total loans past due 90 days or more and accruing to period end loans		0.13	%		0.28	%		0.17	%
Non-performing assets to period end assets		0.46	%		0.31	%		0.39	%

Loans are generally placed on a non-accrual status when principal or interest is past due 90 days and when payment in full is not anticipated. When a loan is placed on non-accrual status, all interest previously accrued but not collected is charged against current income. Loans are returned to accrual status when past due interest is collected and the collection of future principal and interest is probable.

Loans on which the accrual of interest has been discontinued or reduced amounted to $2,822 or 0.46% of loans at June 30, 2010, representing an increase of $91 from $2,731 or 0.47% of loans at June 30, 2009 and an increase of $483 from $2,339 or 0.39% of loans at December 31, 2009. If interest on those loans had been accrued, such income would have been $369 and $336 for the six months ended June 30, 2010 and June 30, 2009, respectively. Interest income on those loans, which is recorded only when received, amounted to $61 and $35 for the six months ended June 30, 2010 and June 30, 2009, respectively. There are no commitments to lend additional funds to individuals whose loans are in non-accrual status.

Management’s process for evaluating the adequacy of the allowance for loan losses includes reviewing each month’s loan committee reports which list all loans that do not meet certain internally developed criteria as to collateral adequacy, payment performance, economic conditions and overall credit risk. These reports also address the current status and actions in process on each listed loan. From this information, adjustments are made to the

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allowance for loan losses. Such adjustments include both specific loss allocation amounts and general provisions by loan category based on present and past collection experience, nature and volume of the loan portfolio, overall portfolio quality, and current economic conditions that may affect the borrower’s ability to pay.

During the second quarter of 2008, the Company was notified that The Education Resources Institute, Inc. (TERI), a guarantor of a portion of our student loan portfolio, had filed for reorganization under Chapter 11 of the Federal Bankruptcy Act. At June 30, 2010, the Company had $7.6 million of TERI loans out of a total student loan portfolio of $17.4 million. The Company does not anticipate that TERI’s bankruptcy filing will significantly impact the Company’s financial statements. These loans are placed on non-accrual status when they become more than 90 days past due. At June 30, 2010 there was $66 of such loans placed on non-accrual status.

Most of the Company’s lending activity is with customers located in the Company’s geographic market area and repayment thereof is affected by economic conditions in this market area.

The Company has seen an increase in the ratio of non-performing assets to period end assets which is 0.46% at June 30, 2010 and 0.39% at June 30, 2009, as well as an increase in the ratio of net charge-offs to average loans which is 0.11% for the six months ended June 30, 2010 compared to 0.09% for the six months ended June 30, 2009.

For other real estate owned, management obtains independent appraisals for significant properties and makes an adequate provision for loan loss adjustment.

Loan Loss Experience

The following tables present the Company’s loan loss experience during the periods indicated:

	June 30,			June 30,
Three Months Ended:	2010			2009
Balance at beginning of period	$	6,500		$	6,050
Charge-offs:
Real estate mortgages		8			146
Commercial and all others		416			-
Credit card and related plans		27			22
Installment loans		91			69
Total charge-offs		542			237
Recoveries:
Real estate mortgages		1			-
Commercial and all others		-			-
Credit card and related plans		1			-
Installment loans		3			2
Total recoveries		5			2
Net charge-offs (recoveries)		537			235
Provision charged to operations		537			235
Balance at End of Period	$	6,500		$	6,050
Ratio of net charge-offs (recoveries)
to average loans outstanding		0.09	%		0.04	%

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	June 30,			June 30,
Six Months Ended:	2010			2009
Balance at beginning of period	$	6,300		$	5,275
Charge-offs:
Real estate mortgages		12			308
Commercial and all others		416			-
Credit card and related plans		38			37
Installment loans		207			114
Total charge-offs		673			459
Recoveries:
Real estate mortgages		1			-
Commercial and all others		-			-
Credit card and related plans		1			1
Installment loans		6			2
Total recoveries		8			3
Net charge-offs (recoveries)		665			456
Provision charged to operations		865			1,231
Balance at End of Period	$	6,500		$	6,050
Ratio of net charge-offs (recoveries)
to average loans outstanding		0.11	%		0.09	%

The allowance for loan losses at June 30, 2010 was $6,500 or 1.07% of total loans compared to $6,300 or 1.04% of total loans at December 31, 2009 and $6,050 or 1.03% of total loans at June 30, 2009.

The allowance for loan losses is allocated as follows:

As of:	June 30, 2010				December 31, 2009				June 30, 2009
	Amount		%	*	Amount		%	*	Amount		%	*
Real estate mortgages	$	1,200	83	%	$	1,200	86	%	$	1,200	83	%
Commercial and all others		4,200	5	%		4,000	6	%		4,000	4	%
Credit card and related plans		350	1	%		350	1	%		325	1	%
Personal installment loans		750	11	%		750	7	%		525	12	%
Total	$	6,500	100	%	$	6,300	100	%	$	6,050	100	%
* Percent of loans in each category to total loans

Liquidity

The objective of liquidity management is to maintain a balance between sources and uses of funds in such a way that the cash requirements of customers for loans and deposit withdrawals are met in the most economical manner. Management monitors its liquidity position continuously in relation to trends of loans and deposits for short-term as well as long-term requirements. Liquid assets are monitored on a daily basis to assure maximum utilization. Management also manages its liquidity requirements by maintaining an adequate level of readily marketable assets and access to short-term funding sources. Management does not foresee any adverse trends in liquidity.

The Company remains in a highly liquid condition both in the short and long term. Sources of liquidity include the Company’s U.S. Agency bond portfolios, additional deposits, earnings, overnight loans to and from other companies (Federal Funds) and lines of credit at the Federal Reserve Bank and the Federal Home Loan Bank (FHLB). The Company is not a party to any commitments, guarantees or obligations that could materially affect its liquidity.

The Company offers collateralized repurchase agreements, which have a one day maturity, as an alternative deposit option for its customers. The Company also has long-term debt outstanding to the FHLB, which was used to

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purchase a Freddie Mac pool of residential mortgages. At June 30, 2010 the Company had $226,306 of available borrowing capacity with the FHLB, a Borrower-In-Custody (BIC) line of credit of $19,046 with the Federal Reserve Bank of Philadelphia, available borrowing capacity at the Discount Window of $36,952, an overnight Federal funds line of credit of $19,000 with PNC Bank and an overnight Federal funds line of credit of $5,000 with Wells Fargo.

The Company is a separate legal entity from the Bank and must provide for its own liquidity. In addition to its operating expenses, the Company is responsible for paying any dividends declared to its shareholders. The Company’s primary source of income is dividends received from the Bank. The amount of dividends that the Bank may declare and pay to the Company is generally restricted under Pennsylvania law to the retained earnings of the Bank.

Commitments and Contingent Liabilities

In the normal course of business, there are outstanding commitments and contingent liabilities, created under prevailing terms and collateral requirements such as commitments to extend credit, financial guarantees and letters of credit, which are not reflected in the accompanying Financial Statements. The Company does not anticipate any losses as a result of these transactions. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the Balance Sheets.

The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.

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

Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.

Related Parties

The Company does not have any material transactions involving related persons or entities, other than traditional banking transactions, which are made on the same terms and conditions as those prevailing at the time for comparable transactions with unrelated parties. At June 30, 2010, the Bank has issued standby letters of credit for the accounts of related parties in the amount of $7,785.

Capital Resources

A strong capital position is important to the continued profitability of the Company and promotes depositor and investor confidence. The Company’s capital provides a basis for future growth and expansion and also provides additional protection against unexpected losses.

Additional sources of capital would come from retained earnings from the operations of the Company and from the sale of additional shares of common stock. Management has no plans to offer additional shares of common stock at this time.

The Company’s total risk-based capital ratio was 16.58% at June 30, 2010. The Company’s risk-based capital ratio is more than the 10.00% ratio that Federal regulators use as the “well capitalized” threshold under the Federal prompt corrective action regulations. This is the current criteria which the FDIC uses in determining the lowest insurance rate for deposit insurance. The Company’s risk-based capital ratio is more than double the 8.00% minimum threshold, which determines whether a company is “adequately capitalized”. Under these rules, the Company could significantly increase its assets and still comply with these capital requirements without the necessity of increasing its equity capital.

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PART I.  FINANCIAL INFORMATION,  Item 3 —  

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company currently does not enter into derivative financial instruments, which include futures, forwards, interest rate swaps, option contracts and other financial instruments with similar characteristics. However, the Company is party to traditional financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, financial guarantees and letters of credit. These traditional instruments involve to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the Consolidated Balance Sheets.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party up to a stipulated amount and with specified terms and conditions.

Commitments to extend credit and standby letters of credit are not recorded as an asset or liability by the Company until the instrument is exercised.

The Company’s exposure to market risk is reviewed on a regular basis by the Asset/Liability Committee. Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximizing income. Management realizes certain risks are inherent and that the goal is to identify and minimize the risks. Tools used by management include the standard GAP report and an interest rate shock simulation report. The Company has no market risk sensitive instruments held for trading purposes. It appears the Company’s market risk is reasonable at this time .

For a discussion of the Company’s asset and liability management policies, as well as the potential impact of interest rate changes upon the market value of the Company’s financial instruments, see Item 7A in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009. Management, as part of its regular practices, performs periodic reviews of the impact of interest rate changes upon net interest income and market value of the Company’s portfolio equity. Based on, among other factors, such reviews, management believes that there have been no material changes in the market risk of the Company’s asset and liability position since December 31, 2009.

PART I.  FINANCIAL INFORMATION,  Item 4 —  

CONTROLS AND PROCEDURES

Under the supervision and with the participation of our management, including our Chief Executive Officer and Finance Division Head, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) under the Securities Exchange Act of 1934. Based upon this evaluation, our Chief Executive Officer and our Finance Division Head concluded that our disclosure controls and procedures were effective as of the end of the period covered by this quarterly report.

The Company continually assesses the adequacy of its internal control over financial reporting and enhances its controls in response to internal control assessments, and internal and external audit and regulatory recommendations. No change in internal control over financial reporting during the quarter ended June  30, 2010 have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.

Management maintains a comprehensive system of controls intended to ensure that transactions are executed in accordance with management's authorization, assets are safeguarded, and financial records are reliable. Management also takes steps to see that information and communication flows are effective and to monitor performance, including performance of internal control procedures.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become

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inadequate due to changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

PART II. OTHER INFORMATION

Item 1   — Legal Proceedings

None.

Item 1A — Risk Factors

There are no material changes to the risk factors set forth in Part I, Item 1A, “Risk Factors,” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2009, which was filed with the Securities and Exchange Commission (SEC) on March 12, 2010. Please refer to that section for disclosures regarding the risks and uncertainties related to the company’s business.

Item 2   — Unregistered Sales of Equity Securities and Use of Proceeds

None.

Item 3   — Defaults Upon Senior Securities

None.

Item 4   — Removed and Reserved

Item 5   — Other Information

None.

Item 6   — Exhibits

31           Rule 13a-14(a) / 15-d-4(a) Certifications

32           Section 1350 Certifications

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

PENSECO FINANCIAL SERVICES CORPORATION

By:  /s/ Craig W. Best

Craig W. Best

President and CEO

(Principal Executive Officer

Dated:  August 5, 2010

PENSECO FINANCIAL SERVICES CORPORATION

By:  /s/ Patrick Scanlon

Patrick Scanlon

Senior Vice President, Finance Division Head

(Principal Financial Officer

Dated:  August 5, 2010

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