Fidelity D & D Bancorp (FDBC) 10-Q 2005 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

FOR QUARTER ENDED SEPTEMBER 30, 2005

COMMISSION FILE NUMBER: 333-90273

FIDELITY D & D BANCORP, INC.

STATE OF INCORPORATION:	IRS EMPLOYER IDENTIFICATION NO:
PENNSYLVANIA	23-3017653

PRINCIPAL OFFICE:

BLAKELY & DRINKER ST.

DUNMORE, PENNSYLVANIA 18512

TELEPHONE:

570-342-8281

The Company (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 Company was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

ý  YES    o  NO

The Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).

o  YES    ý  NO

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

o  YES    ý  NO

The number of outstanding shares of Common Stock of Fidelity D & D Bancorp, Inc. on October 31, 2005, the latest practicable date, was 1,851,024 shares.

FIDELITY D & D BANCORP, INC.

Form 10-Q September 30, 2005

Index

Part I. Financial information
Item 1.	Financial Statements:
	Consolidated Balance Sheets as of September 30, 2005 and December 31, 2004
	Consolidated Statements of Income for the three and nine months ended September 30, 2005 and 2004
	Consolidated Statements of Changes in Shareholders’ Equity for the nine months ended September 30, 2005 and 2004
	Consolidated Statements of Cash Flows for the nine months ended September 30, 2005 and 2004
	Notes to Consolidated Financial Statements
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosure about Market Risk
Item 4.	Controls and Procedures
Part II. Other Information
Item 1.	Legal Proceedings
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds
Item 3.	Defaults upon Senior Securities
Item 4.	Submission of Matters to a Vote of Security Holders
Item 5.	Other Information
Item 6.	Exhibits
Signatures
Exhibit index

2

FIDELITY D & D BANCORP, INC.

Consolidated Balance Sheets

As of September 30, 2005 and December 31, 2004

	September 30, 2005				December 31, 2004
	(unaudited)				(audited)
ASSETS
Cash and due from banks	$		10,855,055		$	9,013,060
Interest-bearing deposits with financial institutions	106,763				1,203,334
Total cash and cash equivalents	10,961,818				10,216,394
Available-for-sale securities	104,503,869				112,612,513
Held-to-maturity securities	2,224,161				3,056,305
Federal Home Loan Bank Stock	4,409,800				4,568,700
Loans and leases, net (allowance for loan losses of $6,034,549 in 2005 and $5,987,798 in 2004)	390,338,304				381,546,375
Loans available-for-sale (fair value $702,356 in 2005 and $582,141 in 2004)	697,456				576,378
Bank premises and equipment, net	10,671,310				11,163,292
Cash surrender value of bank-owned life insurance	7,816,244				7,613,437
Other assets	4,748,463				3,385,790
Accrued interest receivable	1,959,704				1,722,850
Foreclosed assets held for sale	103,382				213,104
Total assets	$	538,434,511			$		536,675,138
LIABILITIES
Deposits
Non-interest-bearing	$	70,331,584			$	65,357,535
Certificates of deposit of $100,000 or more	86,893,558				93,986,033
Other interest-bearing deposits	212,191,121				206,271,767
Total deposits	369,416,263				365,615,335
Accrued interest payable and other liabilities	6,067,621				3,039,809
Short-term borrowings	44,026,811				50,534,046
Long-term debt	70,536,586				71,119,188
Total liabilities	490,047,281				490,308,378
SHAREHOLDERS’ EQUITY
Preferred stock authorized 5,000,000 shares with no par value; none issued	—				—
Capital stock authorized 10,000,000 shares with no par value; issued and outstanding 1,851,024 shares in 2005 and 1,839,572 shares in 2004	10,471,172				10,072,134
Retained earnings	38,628,530				36,396,027
Accumulated other comprehensive loss	(712,472			)	(101,401			)
Total shareholders’ equity	48,387,230				46,366,760
Total liabilities and shareholders’ equity	$		538,434,511		$	536,675,138

3

FIDELITY D & D BANCORP, INC.

Consolidated Statements of Income

(unaudited)

	Three Months Ended						Nine Months Ended
	September 30, 2005			September 30, 2004			September 30, 2005			September 30, 2004
Interest income
Interest and fees on loans:
Taxable	$	6,012,028		$	5,386,418		$	17,414,848		$	16,260,004
Nontaxable	120,630			75,264			335,159			233,780
Leases	7,056			34,089			39,851			126,435
Interest-bearing deposits with financial institutions	3,263			1,861			12,234			4,071
Investment securities:
US Government agencies	861,777			1,064,878			2,693,019			3,356,887
States and political subdivisions (non-taxable)	156,931			114,858			397,491			366,564
Other securities	162,285			59,303			461,043			155,235
Federal funds sold	—			1,028			47,427			11,238
Total interest income	7,323,970			6,737,699			21,401,072			20,514,214
Interest expense
Certificates of deposit of $100,000 or more	722,680			700,172			2,096,344			2,301,440
Other deposits	1,023,540			903,016			2,881,871			2,873,866
Securities sold under repurchase agreements	148,677			119,240			486,794			323,501
Other short- and long-term borrowings and other	1,066,817			997,357			2,979,854			2,973,383
Total interest expense	2,961,714			2,719,785			8,444,863			8,472,190
Net interest income	4,362,256			4,017,914			12,956,209			12,042,024
Provision for loan losses	300,000			450,000			680,000			1,700,000
Net interest income after provision for loan losses	4,062,256			3,567,914			12,276,209			10,342,024
Other income:
Service charges on deposit accounts	689,435			554,394			1,961,966			1,620,614
Gain (loss) on:
Investment securities	—			—			2,643			9,497
Loans	8,468			61,065			1,011			155,452
Leased assets	22,626			(50,690		)	(11,328		)	(205,876		)
Foreclosed assets held-for-sale	41,472			4,102			33,861			(4,116		)
Write-down lease residual	—			—			(220,000		)	—
Fees, other service charges and other income	466,186			579,867			1,334,154			1,590,469
Total other income	1,228,187			1,148,738			3,102,307			3,166,040
Other operating expenses:
Salaries and employee benefits	1,755,611			1,745,107			5,251,730			5,193,127
Premises and equipment	750,266			690,847			2,221,742			2,128,474
Advertising	127,709			158,193			407,517			303,385
Professional fees and services	290,619			273,447			1,086,537			872,023
Other	666,582			790,200			1,801,437			1,974,520
Total other operating expenses	3,590,787			3,657,794			10,768,963			10,471,529
Income before provision for income taxes	1,699,656			1,058,858			4,609,553			3,036,535
Provision for income taxes	405,311			245,346			1,160,011			677,223
Net income	$		1,294,345	$	813,512		$	3,449,542		$	2,359,312
Per share data:
Net income - basic	$		0.70	$	0.45		$	1.87		$	1.29
Net income - diluted	$		0.70	$	0.45		$	1.87		$	1.29
Dividends	$		0.22	$	0.22		$	0.66		$	0.66

4

FIDELITY D & D BANCORP, INC.

Consolidated Statements of Changes in Shareholders’ Equity

For the Nine Months Ended September 30, 2005 and 2004

	Capital stock				Treasury stock					Retained			Accumulated other comprehensive
	Shares	Amount			Shares		Amount			earnings			income (loss)			Total
Balance, December 31, 2003 (audited)	1,828,270	$	9,698,879		(5,227	)	$	(196,048	)	$	34,641,976		$	(212,908	)	$	43,931,899
Comprehensive income:
Net income										2,359,312						2,359,312
Change in net unrealized holding gains (losses) on available-for-sale securities, net, net of reclassification adjustments													363,620			363,620
Comprehensive income																2,722,932
Reissued treasury stock through Employee Stock Purchase Plan		(8,329		)	1,635		61,370									53,041
Dividends reinvested through Dividend Reinvestment Plan	7,192	243,615			3,592		134,678									378,293
Dividends declared										(1,206,621		)				(1,206,621		)
Balance, September 30, 2004 (unaudited)	1,835,462	$	9,934,165		—		$	—		$	35,794,667		$	150,712		$	45,879,544
Balance, December 31, 2004 (audited)	1,839,572	$	10,072,134		—		$	—		$	36,396,027		$	(101,401	)	$	46,366,760
Comprehensive income:
Net income										3,449,542						3,449,542
Change in net unrealized holding gains (losses) on available-for-sale securities, net, net of reclassification adjustments													(611,071		)	(611,071		)
Comprehensive income																2,838,471
Stock issued through Employee Stock Purchase Plan	1,031	31,671														31,671
Dividends reinvested through Dividend Reinvestment Plan	10,421	367,367														367,367
Dividends declared										(1,217,039		)				(1,217,039		)
Balance, September 30, 2005 (unaudited)	1,851,024	$	10,471,172		—		$	—		$	38,628,530		$	(712,472	)	$	48,387,230

5

FIDELITY D & D BANCORP, INC.

Consolidated Statements of Cash Flows

(unaudited)

	Nine Months Ended
	September 30, 2005			September 30, 2004
Cash flows from operating activities:
Net income	$	3,449,542		$	2,359,312
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation	880,897			911,171
Amortization of securities (net of accretion)	180,449			441,223
Provision for loan losses	680,000			1,700,000
Deferred income tax	(184,956		)	(594,889		)
Write-down of foreclosed assets held-for-sale	50,451			121,789
Write-down lease residual	220,000			—
Increase in cash surrender value of life insurance	(202,807		)	(240,365		)
Gain on sale of investment securities	(2,643		)	(9,497		)
Gain on sale of loans	(1,011		)	(155,452		)
(Gain) loss on sale of foreclosed assets held-for-sale	(33,861		)	4,116
Loss on sale of leased assets	11,328			205,876
Loss on disposal of equipment	589			3,661
Amortization of loan servicing rights	71,871			71,078
Change in:
Accured interest receivable	(236,854		)	(265,828		)
Other assets	(861,362		)	80,950
Accrued interest payable and other liabilities	221,490			(146,708		)
Net cash provided by operating activities	4,243,123			4,486,437
Cash flows from investing activities:
Held-to-maturity securities:
Proceeds from maturities, calls and paydowns	827,760			1,445,868
Available-for-sale securities:
Proceeds from sales	19,282,027			3,850,562
Proceeds from maturities, calls and paydowns	11,934,551			19,920,791
Purchases	(24,207,222		)	(11,080,552		)
Net decrease FHLB stock	158,900			11,300
Proceeds from sale of loans available-for-sale	1,561,456			15,491,238
Net increase in loans and leases	(9,770,169		)	(8,648,029		)
Proceeds from sale of leased assets	766,598			753,007
Acquisition of bank premises and equipment	(389,504		)	(187,993		)
Proceeds from sale of foreclosed assets held-for-sale	444,814			411,514
Net cash provided by investing activities	609,211			21,967,706
Cash flows from financing activities:
Net increase in noninterest-bearing deposits	4,974,049			1,222,968
Net decrease in certificates of deposit of $100,000 or more	(7,092,475		)	(13,648,229		)
Net increase (decrease) in other interest-bearing deposits	5,919,354			(13,587,583		)
Net decrease in short-term borrowings	(6,507,235		)	(10,267,020		)
Net (decrease) increase in long-term borrowings	(582,602		)	4,434,483
Dividends paid, net of dividend reinvestment	(849,672		)	(828,328		)
Proceeds from employee stock purchase plan	31,671			53,041
Net cash used in financing activities	(4,106,910		)	(32,620,668		)
Net increase (decrease) in cash and cash equivalents	745,424			(6,166,525		)
Cash and cash equivalents, beginning	10,216,394			19,231,601
Cash and cash equivalents, ending	$	10,961,818		$	13,065,076

6

FIDELITY D & D BANCORP, INC.

Notes to Consolidated Financial Statements

(unaudited)

1. Nature of operations and critical accounting policies

Principles of consolidation

The accompanying unaudited consolidated financial statements of Fidelity D & D Bancorp, Inc., and its wholly owned subsidiary, The Fidelity Deposit and Discount Bank (the Bank or collectively, the Company) have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) for interim financial information and with the instructions to this Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of the information and footnote disclosures required by GAAP for complete financial statements.  In the opinion of Management, all normal recurring adjustments necessary for a fair presentation of the financial condition and results of operations for the periods have been included.  All significant inter-company balances and transactions have been eliminated in consolidation.  Prior period amounts have been reclassified, when necessary, to conform to the current period’s presentation.

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 reported periods.  Actual results could differ from those estimates.  For additional information and disclosures required under GAAP, please refer to the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.

Nature of operations

The Bank is a commercial bank chartered in the Commonwealth of Pennsylvania and a wholly owned subsidiary of the Company.  Having commenced operations in 1903, the Bank provides a full range of traditional banking services, trust services and alternative financial products from its main office located in Dunmore and other branches throughout Lackawanna and Luzerne counties.

Management is responsible for the fairness, integrity and objectivity of the unaudited financial statements included in this report.  Management prepared the unaudited financial statements in accordance with GAAP.  In meeting its responsibility for the financial statements, Management depends on the Company’s accounting systems and related internal controls.  These systems and controls are designed to provide reasonable, but not absolute, assurance that the financial records accurately reflect the transactions of the Company, the Company’s assets are safeguarded and that financial statements present fairly the financial condition and results of operations of the Company.

In the opinion of Management, the consolidated balance sheets as of September 30, 2005 and December 31, 2004 and the related consolidated statements of income for each of the three and nine month periods ended September 30, 2005 and September 30, 2004 and changes in shareholders’ equity and cash flows for each of the nine months ended September 30, 2005 and September 30, 2004 present fairly the financial condition and results of operations of the Company.  All material adjustments required for a fair presentation have been made.  These adjustments are of a normal recurring nature.  There have been no material changes in accounting principles, practices or in the method of application and there have been no retroactive adjustments during these periods.  The results of operations for interim periods are not necessarily indicative of the results of operations for the entire year.

This Quarterly Report on Form 10-Q should be read in conjunction with the Company’s audited financial statements for the year ended December 31, 2004 and the notes included therein, included within the Company’s Annual Report filed on Form 10-K.

Critical accounting policies

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

7

A material estimate that is particularly susceptible to significant change is the determination of the allowance for loan losses (the allowance).  Management believes that the allowance, as of September 30, 2005, is adequate and reasonable.  Given the subjective nature of identifying and valuing loan losses, it is likely that well-informed individuals could make materially different assumptions and could, therefore, calculate a materially different allowance value.  While Management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in the future.  In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance.  Such agencies may require the Company to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination.

Other material estimates include the determinations of fair values of the Company’s investment securities and loans classified as available-for-sale (AFS).  The Company receives estimated fair values of investment securities from an independent valuation service.  In developing these fair values, the valuation service uses estimates of cash flows based on historical performance of similar instruments in similar interest rate environments.  Based on experience, Management is aware that estimated fair values of investment securities tend to vary among valuation services.  Accordingly, when selling investment securities, Management typically obtains price quotes from more than one source.  The majority of the Company’s investment securities are classified as AFS.  AFS securities are carried at fair market value on the consolidated balance sheet, with unrealized gains and losses, net of income tax, reported as a separate component of shareholders’ equity in accumulated other comprehensive income (loss).

The fair market value of residential mortgage loans, classified as AFS, is obtained from the Federal National Mortgage Association (FNMA). The fair value of Small Business Administration (SBA) loans, classified as AFS, is obtained from an outside pricing source. To determine the fair market value of student loans, classified as AFS, the Bank uses the pricing obtained from the most recent student loans sold from its AFS portfolio. The market to which the Bank sells mortgage and other loans is restricted and price quotes from other sources are typically not obtained. As of September 30, 2005, the Company’s portfolio of loans AFS was comprised of residential mortgage loans and student loans. At December 31, 2004, the portfolio was comprised of only student loans.

2. Earnings per share

Basic earnings per share (EPS) is computed using the weighted-average number of shares of common stock outstanding. Diluted EPS is computed in the same manner as basic EPS but reflects the potential dilution of common stock equivalents. Dilution would occur if Company-issued “in-the-money” stock options were exercised and converted into common stock. Stock options are in-the-money if the market value of the underlying stock is greater than the option’s exercise or strike price. The Company uses the treasury stock method to determine the dilutive effect of its unexercised stock options. Under this method, the proceeds received from shares issued in a hypothetical exercise of stock options are assumed to be used to purchase treasury stock.

The following data illustrates the amounts used in computing EPS and the effects on income and the weighted-average number of shares of potentially dilutive common stock for the nine months ended September 30, 2005 and 2004:

8

					Weighted-average
	Income				common shares
September 30, 2005	numerator				denominator		EPS
Basic EPS	$			3,449,542	1,844,792		$		1.87
Dilutive effect of potential common stock:
Stock options:
Exercise of options outstanding					7,700
Hypothetical share repurchase at $35.50					(7,224	)
Diluted EPS	$	3,449,542			1,845,268		$	1.87
September 30, 2004
Basic EPS	$		2,359,312		1,828,814		$		1.29
Dilutive effect of potential common stock:
Stock options:
Exercise of options outstanding					5,100
Hypothetical share repurchase at $35.00					(4,517	)
Diluted EPS	$	2,359,312			1,829,397		$	1.29

3. Stock plans

The Company uses the intrinsic value method of accounting for stock-based compensation plans, under Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees (APB No. 25), and as permitted by Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation (SFAS No. 123).  Under the intrinsic value method, compensation cost is measured by the excess of the quoted market price of the stock, as of the grant date (or other measurement date) over the stock’s exercise price.  Since all options issued under the Company’s stock-based compensation plans had an exercise price equal to the quoted market value of the underlying common stock on the date of grant, the stock is deemed to have no intrinsic value.  Accordingly, no compensation cost is recorded.

The alternative fair value method of accounting for stock-based compensation provided under SFAS No. 123 requires the use of option valuation models, such as the Black-Scholes option pricing model.  The Black-Scholes option pricing model was not developed for use in valuing stock options granted under employer stock option plans.  Rather, the Black-Scholes option pricing model was developed for use in estimating the fair market value of short-term options traded in organized exchanges.  Options traded in organized exchanges have no vesting restrictions and are fully transferable.  In addition, option valuation models require the input of highly subjective assumptions including the expected or implied volatility of the options underlying stock.  Since the options granted under the Company’s stock option plans have characteristics significantly different from those of marketable options and because changes in the subjective input assumptions can materially impact the estimated fair market value, in Management’s opinion, the existing valuation models do not necessarily provide a reliable single measure of the fair market value of its employee stock options at the time of grant.

In December 2004, the Financial Accounting Standards Board issued SFAS 123(R) which replaces SFAS 123, and supersedes APB No. 25.  SFAS 123(R) requires that the cost of share-based payment transactions (including those with employees and non-employees) be recognized in the financial statements.  SFAS 123(R) applies to all share-based payment transactions in which an entity acquires goods or services by issuing (or offering to issue) its shares, share options, or other equity instruments (except for those held by an ESOP) or by incurring liabilities (1) in amounts based (even in part) on the price of the entity’s shares or other equity instruments, or (2) that require (or may require) settlement by the issuance of an entity’s shares or other equity instruments.  Public entities such as the Company are not required to apply SFAS 123(R) until the beginning of the first interim reporting period or fiscal year beginning after December 31, 2005.  The Company does not plan early implementation of the provisions of SFAS 123(R).

In 2004 and for the first nine months of 2005, the Company did not grant stock options under any of its stock plans.

9

Item 2:Management’s Discussion and Analysis of Results of Operations and Financial Condition

The following is Management’s discussion and analysis of the significant changes in the consolidated financial condition of the Company as of September 30, 2005 compared to December 31, 2004 and the results of operations for the three and nine month periods ended September 30, 2005 compared to the respective periods ended September 30, 2004.  Current performance may not be indicative of future results. This discussion should be read in conjunction with the Company’s 2004 Annual Report filed on Form 10-K.

Forward looking statements

This Quarterly Report on Form 10-Q contains a number of forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, or the Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act.  These statements may be identified by the use of the words “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “outlook,” “plan,” “potential,” “predict,” “project,” “should,” “will,” “would” and similar terms and phrases, including references to assumptions.  Forward looking statements include risks and uncertainties.

Forward-looking statements are based on various assumptions and analyses made by us in light of Management’s experience and its perception of historical trends, current conditions and expected future developments, as well as other factors it believes are appropriate under the circumstances.  These statements are not guarantees of future performance and are subject to risks, uncertainties and other factors (many of which are beyond our control) that could cause actual results to differ materially from future results expressed or implied by such forward-looking statements.  These factors include, without limitation, the following:

•the timing and occurrence or non-occurrence of events may be subject to circumstances beyond our control;

•there may be increases in competitive pressure among financial institutions or from non-financial institutions;

•changes in the interest rate environment may reduce interest margins;

•changes in deposit flows, loan demand or real estate values may adversely affect our business;

•changes in accounting principles, policies or guidelines may cause our financial condition to be perceived differently;

•general economic conditions, either nationally or locally in some or all areas in which we do business, or conditions in the securities markets or the banking industry may be less favorable than we currently anticipate;

•legislative or regulatory changes may adversely affect our business;

•technological changes may be more rapid, difficult or expensive than we anticipate;

•success or consummation of new business initiatives may be more difficult or expensive than we anticipate; or

•acts of war, terrorism or natural disaster.

Management cautions readers not to place undue reliance on forward-looking statements, which reflect analyses only as of the date of this document.  We have no obligation to update any forward-looking statements to reflect events or circumstances after the date of this document.  Readers should review the risk factors described in other documents that we file or furnish, from time to time, with the Securities and Exchange Commission, including Annual Reports to Shareholders, Annual Reports filed on Form 10-K and other current reports filed or furnished on Form 8-K.

General

The Company’s results of operations depend primarily on its net interest income.  Net interest income is the difference between interest income and interest expense.  Interest income is generated from yields on interest-earning assets which consist principally of loans and investment securities.  Interest expense is incurred from rates paid on interest-bearing

10

liabilities which consist of deposits and borrowings.  Net interest income is determined by the Company’s interest rate spread (i.e., the difference between the yields earned on its interest-earning assets and the rates paid on its interest-bearing liabilities) and the relative amounts of interest-earning assets and interest-bearing liabilities.  The interest rate spread is influenced by the overall interest rate environment, the composition and characteristics of interest-earning assets and interest-bearing liabilities and by the competition in our marketplace.  The interest rate spread and the changes in the interest rate spread, from period-to-period, is also influenced by differences in the maturity and re-pricing characteristics of assets compared to the maturity and re-pricing characteristics of the liabilities that fund them.

The Company’s profitability is also affected by the level of its non-interest income and expenses, provision for loan losses and provision for income taxes.  Non-interest income consists of service charges on the Bank’s loan and deposit products, trust and asset management service fees, net gains or losses from sales of leases, securities and loans AFS and increases in the cash surrender value of the bank-owned life insurance.  Non-interest expense consists of compensation and related employee benefit expenses, occupancy, equipment, data processing, advertising, marketing, professional fees, insurance and other operating overhead.

The Company’s profitability is significantly affected by general economic and competitive conditions, changes in market interest rates, government policies and actions of regulatory authorities.  The Company’s loan portfolio is comprised principally of commercial and commercial real estate loans.  The properties underlying the Company’s mortgages are concentrated in northeastern Pennsylvania.  Credit risk, which represents the possibility of the Company not recovering amounts due from its borrowers, is significantly related to local economic conditions in the areas the properties are located as well as the Company’s loan underwriting standards.  Economic conditions affect the market value of the underlying collateral as well as the levels of occupancy of multi-family dwellings and levels of adequate cash flow and revenue generation from other income-producing commercial properties.

COMPARISON OF FINANCIAL CONDITION AT

SEPTEMBER 30, 2005 AND DECEMBER 31, 2004

Overview

Consolidated assets increased $1,759,000 or 0.3%, during the nine months ended September 30, 2005 to $538,435,000.  The increase resulted from increases in total deposits of $3,801,000, accrued expenses and other liabilities of $3,028,000 and total stockholders’ equity of $2,020,000.   These items were partially offset by a decrease in total borrowings of $7,090,000.  Since December 31, 2004, the carrying value of total loans increased $8,913,000 and cash and cash equivalents increased $745,000.  The carrying value of the Bank’s investment portfolio declined $8,940,000.  The increase in shareholders’ equity was attributable to earnings net of dividends declared of $2,233,000, an increase in common stock of $399,000, partially offset by a $611,000 net unrealized holding loss on AFS securities recorded in other comprehensive income (loss).

A comparison of selected balance sheet information as of September 30, 2005 and December 31, 2004 follows:

Investment securities

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

At the time of purchase, the Bank classifies investment securities into one of three categories: trading, AFS or held-to- maturity (HTM).  To date, Management has not purchased any securities for trading purposes.  Management classifies most securities as AFS even though it has no immediate intent to sell them.  The AFS designation affords Management the flexibility to sell securities and adjust or restructure the balance sheet in response to capital levels, liquidity needs, structuring strategies and/or changes in market conditions.  Securities AFS are carried at net fair market value in the

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consolidated balance sheet with an adjustment to shareholders’ equity, net of tax, which is presented under the caption “Accumulated other comprehensive income (loss).”  Securities designated as HTM are carried at amortized cost.

During the second quarter, the Bank restructured approximately $19.5 million of investment securities holdings to enhance current earnings while simultaneously addressing the interest rate risk in the portfolio from the continued flattening of the treasury yield curve.  The restructuring included the sale and purchase of securities that re-allocated the diversification away from heavily weighted mortgage-backed securities.  At September 30, 2005, approximately 45.4% of the carrying value of the investment portfolios was comprised of mortgage-backed securities that amortize and provide monthly cash flow, compared to 55.7% at December 31, 2004.  Also at September 30, 2005, agency and municipal bonds comprised 30.3% and 14.4%, respectively, of the investment portfolios.  The carrying value of investment securities totaled $106,728,000 or 19.8% of total assets as of September 30, 2005 compared to $115,669,000 or 21.6% as of December 31, 2004.  At September 30, 2005, the portfolio is comprised of HTM and AFS securities with carrying values of $2,224,000 and $104,504,000, respectively.

At September 30, 2005, the AFS debt securities were recorded with a net unrealized loss in the amount of $1,246,000.  The increase in the unrealized loss is due to the relative increase in the interest rate environment which has an inverse relationship with the market values of debt securities.  Also at September 30, 2005, AFS equity securities were recorded in the amount of $445,000 including an unrealized gain in the amount of $166,000.

The amortized cost and fair value of investment securities HTM and AFS at September 30, 2005 consisted of the following (dollars in thousands):

	Amortized		Gross unrealized		Gross unrealized		Fair
	cost		gains		losses		value
Held-to-maturity securities:
Mortgage-backed securities	$	2,224	$	65	$	—	$	2,289
Available-for-sale securities:
U.S. government agencies and corporations	33,001		1		643		32,359
Obligations of states and municipal subdivisions	15,339		124		58		15,405
Corporate bonds	10,023		44		14		10,053
Mortgage-backed securities	46,942		14		714		46,242
Sub total	105,305		183		1,429		104,059
Equity securities	279		166		—		445
Total available-for-sale	105,584		349		1,429		104,504
Total securities	$	107,808	$	414	$	1,429	$	106,793

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The amortized cost and fair value of investments HTM and AFS by contractual maturity at September 30, 2005 are as follows (dollars in thousands):

	Amortized		Market
	cost		value
Held-to-maturity securities:
Mortgage-backed securities	$	2,224	$	2,289
Available-for-sale securities:
Debt securities:
One year or less	120		120
One through five years	7,310		7,139
Five through ten years	24,127		23,798
Over ten years	26,806		26,760
Total debt securities	58,363		57,817
Mortgage-backed securities	46,942		46,242
Equity securities	279		445
Total available-for-sale	105,584		104,504
Total securities	$	107,808	$	106,793

Expected maturities will differ from contractual maturities because issuers and borrowers may have the right to call or repay obligations with or without call or prepayment penalty. Federal agency and municipal securities are included based on their original stated maturity. Mortgage-backed securities, which are based on weighted-average lives and subject to monthly principal pay-downs, are listed in total. Equity securities, which have no stated maturity, are carried at the lower of cost or fair market value.

Loans available - for- sale (AFS)

Generally, upon origination, certain residential mortgages, the guaranteed portions of SBA loans and student loans may be classified as AFS.  In the event of market interest rate increases, fixed-rate loans and loans not immediately scheduled to re-price would no longer produce yields consistent with the current market.  In a declining interest rate environment, the Bank would be exposed to prepayment risk and, as rates on adjustable rate loans decrease, interest income would be negatively affected.  To better manage prepayment and interest rate risk, loans that meet these conditions may be classified as AFS.  Consideration is also given to the Company’s current liquidity position and expected future liquidity needs.  Loans AFS are carried at the lower of cost or estimated fair value.  If the fair market values of these loans fall below their amortized cost, the loan is written down by the difference with a corresponding charge to current earnings.  Subsequent appreciation, if any, is credited to current earnings but only to the extent of previous write-downs.

At September 30, 2005, loans AFS amounted to $697,000 with a corresponding fair value of $703,000, compared to $576,000 and $582,000, respectively at December 31, 2004.  For the nine months ended September 30, 2005, residential and student loans with principal balances of $878,000 and $682,000, respectively were sold into the secondary market with combined net gains of approximately $16,000 being recognized.  At September 30, 2005 the balance of loans AFS consisted of $413,000 of residential mortgages and $285,000 of student loans.  At December 31, 2004, the entire balance of loans AFS consisted of student loans.

Loans and leases

The Bank originates commercial and commercial real estate loans, residential, consumer, home equity and construction loans.  The relative volume of originations is dependent upon customer demand, current interest rates and the perception and duration of future interest rate levels.  The Bank focuses its efforts, whenever possible, on the expansion of variable-rate portfolios of residential and consumer loans as well as commercial loans, along with fixed-rate residential real estate loans.  The broad spectrum of products provides diversification which helps manage, to an extent, interest

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rate risk and credit concentration risk.  Credit risk is further managed through underwriting policies and procedures and loan monitoring practices.  Interest rate risk is managed using various asset/liability modeling techniques and analyses.  The interest rates on most commercial loans are adjustable with reset intervals of five years or less.  Whenever practical, the Bank originates variable-rate loans.

The majority of our loan portfolio is collateralized, at least in part, by real estate in the greater Lackawanna and Luzerne counties of Pennsylvania.  Commercial lending activities generally involve a greater degree of credit risk than residential lending because they typically have larger balances and are more affected by adverse conditions in the economy.  Because payments on loans secured by commercial and commercial real estate often depend upon the successful operation and management of the properties and the businesses which operate from within them, repayment of such loans may be affected by factors outside the borrower’s control.  Such factors may include adverse conditions in the real estate market, the economy, the industry or changes in government regulations.  As such, commercial loans require more ongoing evaluation and monitoring which occurs with the Bank’s credit administration and outsourced loan review functions.

During the first quarter of 2005, the Bank established a reserve for estimated impairment from the future sales of its leased vehicles which was netted against the gross amount of direct finance leasing.  The estimated impairment was based on the historical sales performance of terminated leases which are typically sold below their residual value.  The balance of the Bank’s leased vehicles should mature or payoff during the remainder of 2005.  As of September 30, 2005, the Company expects the current balance of the reserve to be adequate to absorb the remaining anticipated losses.  Currently, the Company does not anticipate re-entering the direct finance lease business when the current agreements expire in 2005.

Loans, net of unearned income of $396,373,000 at September 30, 2005 increased $8,839,000 from $387,534,000 at December 31, 2004.  The increase was from successful implementation and marketing strategies for residential mortgages and consumer home equity installment lending partially offset by a decline in commercial loans and run-off of receivables from the Bank’s auto leasing business.  The decrease in commercial lending was primarily from a sold loan participation during the first quarter of 2005 and the maturity of an automobile dealer’s floor plan note that was not renewed. 

The following table sets forth the composition of the loan portfolio at September 30, 2005 and December 31, 2004:

	September 30, 2005		December 31, 2004
Commercial and commercial real estate	$	212,046,121	$		221,968,137
Residential real estate	99,800,950		91,294,401
Consumer and home equity	71,625,825		61,487,608
Real estate construction	12,043,129		10,620,472
Direct financing leases	858,189		2,211,978
Gross loans	396,374,214		387,582,596
Less:
Unearned discount	1,361		48,423
Allowance for loan losses	6,034,549		5,987,798
Net loans	390,338,304		381,546,375
Loans available-for-sale	697,456		576,378
Total loans	$	391,035,760	$	382,122,753

Allowance for loan losses

Management continually evaluates the credit quality of the Bank’s loan portfolio and, on a quarterly basis, performs a formal review of the adequacy of the allowance for loan losses (the allowance).  The allowance reflects management’s best estimate of the amount of credit losses in the loan portfolio.  Management’s judgment is based on the evaluation of individual loans, past experience, the assessment of current economic conditions and other relevant factors including the amounts and timing of cash flows expected to be received on impaired loans.  Those estimates may be susceptible to significant change.  The provision for loan losses represents the amount necessary to maintain an appropriate allowance. Loan losses are charged directly against the allowance when loans are deemed to be uncollectible.  Recoveries on previously charged-off loans are added to the allowance when received.

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Management applies two primary components during the loan review process to determine the adequacy of allowance levels.  The two components consist of a specific loan loss allocation, for loans that are deemed impaired, and a general loan loss allocation for those loans where a specific loss has not been allocated.  The methodology to analyze the adequacy of the allowance is as follows:

•Identification of specific problem loans by loan category;

•Calculation of specific allowances required based on collateral and other persuasive evidence;

•Identification of loans collateralized by cash and cash equivalents;

•Determination of remaining homogenous pools by loan category and eliminating loans collateralized by cash and cash equivalents and eliminating loans with specific loss allocations;

•Application of historical loss percentages (three-year average) to pools to determine the allowance allocation; and

•Application of qualitative factor adjustment percentages to historical losses for trends or changes in the loan portfolio.

Allocation of the allowance for different categories of loans is based on the methodology as explained above.  A key element of the methodology to determine the allowance is the Company’s credit risk evaluation process, which includes credit risk-grading of individual commercial loans.  Commercial loans are assigned credit risk grades based on the Company’s assessment of conditions that affect the borrower’s ability to meet its contractual obligations under the loan agreement.  That process includes reviewing borrowers’ current financial information, historical payment experience, credit documentation, public information and other information specific to each individual borrower.  The changes in the allocations from period to period are based upon reviews of the loan and lease portfolios.

Net charge-offs for the nine months ended September 30, 2005 were $633,000, compared to $588,000, for the same period in 2004.  Net charge-offs of commercial loans were $588,000 for the nine months ended September 30, 2005 compared to $176,000 in the first nine months of 2004.  Real estate mortgage net charge-offs declined to $11,000 for the first nine months of 2005 compared to $220,000 in the first nine months of 2004.  Consumer loan net charge-offs were $34,000 for the first nine months of 2005 compared to $146,000 for the same 2004 period.  There were no lease financing charge-offs or recoveries during the current period.  Some deterioration in the credit quality of various non-performing commercial loans caused an increase of commercial loan charge-offs during the nine months ended September 30, 2005 compared to the same 2004 period. Improvement in the credit quality and collection effort helped to reduce the real estate and consumer charge-offs.  In addition, recoveries for the 2005 period include $115,000 from the sale of previously charged-off loans.

Management believes that the current balance in the allowance for loans losses of $6,035,000 is sufficient to withstand the identified potential credit quality issues that may arise and are inherent to the portfolio.  Management is unaware of any potential problem loans that have not been reviewed.  Potential problem loans are those where there is known information that leads Management to believe repayment of principal and/or interest is in jeopardy and the loans are neither on non-accrual status nor past due 90 days or more.  However, there could be instances which become identified during the year that may require additional charge-offs and/or increases to the allowance.  The ratio of allowance for loan losses to total loans was 1.52% at September 30, 2005 compared 1.54% at December 31, 2004 and 1.59% September 30, 2004.

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The following tables set forth the activity in the allowance for loan losses and certain key ratios for the period indicated:

	As of and for the		As of and for the		As of and for the
	nine months ended		year ended		nine months ended
	September 30, 2005		December 31, 2004		September 30, 2004
Balance at beginning of period	$	5,987,798	$	4,996,966	$	4,996,966
Provision charged to operations	680,000		2,150,000		1,700,000
Charge-offs:
Commercial	940,911		775,252		380,900
Real estate	20,875		266,324		229,087
Consumer	183,659		480,462		298,253
Lease financing	—		84,902		69,210
Total	1,145,445		1,606,940		977,450
Recoveries:
Commercial	352,413		226,082		205,183
Real estate	9,698		20,039		9,000
Consumer	150,085		178,727		152,543
Lease financing	—		22,924		22,724
Total	512,196		447,772		389,450
Net charge-offs	633,249		1,159,168		588,000
Balance at end of period	$	6,034,549	$	5,987,798	$	6,108,966
Total loans, end of period	$	397,070,309	$	388,110,551	$	383,185,529

	As of and for the			As of and for the			As of and for the
	nine months ended			year ended			nine months ended
	September 30, 2005			December 31, 2004			September 30, 2004
Net charge-offs to:
Loans, end of period	0.16		%	0.30		%	0.15		%
Allowance for loan losses	10.49		%	19.36		%	9.63		%
Provision for loan losses	93.12		%	53.91		%	34.59		%
Allowance for loan losses to:
Total loans	1.52		%	1.54		%	1.59		%
Non-accrual loans	64.47		%	60.46		%	62.14		%
Non-performing loans	60.26		%	57.24		%	59.39		%
Net charge-offs	9.53		x	5.17		x	10.39		x
Loans 30-89 days past due and still accruing	$	2,396,798		$	4,316,453		$	3,791,855
Loans 90 days past due and accruing	$	654,084		$	557,492		$	455,872
Non-accrual loans	$	9,360,643		$	9,904,276		$	9,831,170
Allowance for loan losses to loans 90 days or more past due and accruing	9.23		x	10.75		x	13.40		x

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Non-performing assets

The Bank defines non-performing assets as accruing loans past due 90 days or more, non-accrual loans, restructured loans, other real estate owned and repossessed assets.  As of September 30, 2005, non-performing assets represented 1.88% of total assets compared to 1.99% at December 31, 2004 and 1.95% at September 30, 2004.

The non-accrual loan balance declined $544,000 during the first nine months of 2005, and was down by $471,000 compared to September 30, 2004.  The balance of non-accrual loans fluctuates upward and downward depending mostly on delinquency status, pay downs, charge-offs, a history of satisfactory repayments during the period a loan is classified as non-accrual and acquisition through foreclosure.  During the nine months ended September 30, 2005, $3,952,000 of loans classified as non-accrual, including capitalized expenditures, were added to non-accrual, partially offset by payoffs or pay downs of $2,441,000, charge offs of $999,000, transfers to the Bank’s portfolio of other real estate owned (OREO) of $246,000 and $810,000 of loans that have returned to performing status.

Non-performing loans which includes non-accrual loans and accruing loans past due 90 days or more decreased $447,000 to $10,015,000 since December 31, 2004.  While loans past due 90 days or more increased by $97,000, this increase was more than offset by non-accrual loans declining $544,000.   The ratio of non-performing loans to end of period net loans declined 18 basis points to 2.56%, during the nine month period ended September 30, 2005, compared to 2.74% as of December 31, 2004.  As of September 30, 2004, the ratio of non-performing loans to net loans was 2.73%.

Foreclosed assets held for sale includes OREO and repossessed assets.  OREO represents two properties that have been foreclosed upon and transferred from loans.  Both of the properties are currently under agreements for sale. Repossessed assets represent indirect auto loans, the payments of which have become delinquent and the vehicles repossessed.

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

	September 30, 2005			December 31, 2004			September 30, 2004
Loans past due 90 days or more and accruing	$	654,084		$	557,492		$	455,872
Non-accrual loans	9,360,643			9,904,276			9,831,170
Total non-performing loans	10,014,727			10,461,768			10,287,042
Restructured loans	—			—			—
Other real estate owned	77,750			163,000			277,804
Repossessed assets	25,632			50,104			47,365
Total non-performing assets	$	10,118,109		$	10,674,872		$	10,612,211
Net loans including AFS	$	391,035,760		$	382,122,753		$	377,076,563
Total assets	$	538,434,511		$	536,675,138		$	545,171,022
Non-accrual loans to net loans	2.39		%	2.59		%	2.61		%
Non-performing assets to net loans, foreclosed real estate and repossessed assets	2.59		%	2.79		%	2.81		%
Non-performing assets to total assets	1.88		%	1.99		%	1.95		%
Non-performing loans to net loans	2.56		%	2.74		%	2.73		%

Accrued interest receivable and other assets

The increase in accrued interest receivable of $237,000 or 13.7% from December 31, 2004 to September 30, 2005 was due to the timing of cash receipts on interest-earning asset balances.  The increase in other assets of $1,363,000 was due primarily an increase in construction in process for expenditures associated with the Bank’s branch expansion plans.  Generally, upon completion, these expenditures will be transferred to bank premises and equipment at which time depreciation will begin.

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Deposits

The Bank is a community-based commercial financial institution and offers a variety of deposit accounts with a range of interest rates and terms.  Deposit products consist of passbook and statement savings accounts, NOW, money market, demand deposit and certificates of deposit accounts.  The flow of deposits is significantly influenced by general economic conditions, changes in prevailing interest rates, pricing and competition.  Most of the Bank’s deposits are obtained from the communities surrounding its 12 branch offices.  We attempt to attract and retain deposit customers via sales and marketing efforts with new products, quality service, competitive rates and long-standing customer relationships.

To determine deposit product interest rates, the Bank considers local competition, market yields and the rates charged for alternative sources of funding such as borrowings.  Although we have experienced a continued intense competition for deposits, we have not increased rates significantly as we only consider cost effective strategies while operating in a rising interest rate environment.

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The following table represents the components of deposits as of September 30, 2005 and December 31, 2004:

	September 30, 2005				December 31, 2004			Dollar change				Percent change
Non-interest-bearing deposits
Personal	$	31,445,829			$	28,927,588		$		2,518,241		8.71	%
Non-personal	31,191,738				29,248,882			1,942,856				6.64	%
Public funds	1,232,581				2,479,373			(1,246,792			)	-50.29	%
Bank checks	6,461,436				4,701,692			1,759,744				37.43	%
Total	$	70,331,584			$	65,357,535		$		4,974,049		7.61	%
Total deposits of $100,000 or greater
Personal	$	56,231,071			$	61,694,837		$		(5,463,766	)	-8.86	%
Non-personal	17,435,376				17,749,896			(314,520			)	-1.77	%
Public funds	8,690,629				9,023,956			(333,327			)	-3.69	%
IRA’s	4,536,482				5,517,344			(980,862			)	-17.78	%
Total	$	86,893,558			$	93,986,033		$		(7,092,475	)	-7.55	%
Other interest-bearing deposits
Time deposits less than $100,000:
Personal	$	61,391,784			$	66,918,765		$		(5,526,981	)	-8.26	%
Non-personal	3,563,118				4,024,801			(461,683			)	-11.47	%
Public funds	232,785				662,876			(430,091			)	-64.88	%
IRA’s	17,331,121				19,090,551			(1,759,430			)	-9.22	%
sub total	82,518,808				90,696,993			(8,178,185			)	-9.02	%
NOW accounts	59,579,838				41,421,525			18,158,313				43.84	%
Money market deposits	18,464,331				27,606,102			(9,141,771			)	-33.12	%
Savings and clubs	51,628,144				46,547,147			5,080,997				10.92	%
Total	$	212,191,121			$	206,271,767		$		5,919,354		2.87	%
Total deposits
Noninterest-bearing deposits	$	70,331,584			$	65,357,535		$		4,974,049		7.61	%
Interest-bearing deposits	299,084,679				300,257,800			(1,173,121			)	-0.39	%
Total	$	369,416,263			$	365,615,335		$		3,800,928		1.04	%
Public funds
Noninterest-bearing	$	1,232,581			$	2,479,373		$	(1,246,792		)	-50.29	%
Certificates of deposit	8,923,414				9,686,832			(763,418			)	-7.88	%
NOW accounts	27,330,921				8,406,827			18,924,094				225.10	%
Money market deposits	580,390				4,710,720			(4,130,330			)	-87.68	%
Savings and clubs	888,320				1,266,834			(378,514			)	-29.88	%
Total	$		38,955,626		$	26,550,586		$	12,405,040			46.72	%
Total assets	$		538,434,511		$	536,675,138
Total deposits to total assets	68.61			%	68.13		%
Public funds to total deposits	10.55			%	7.26		%
Public funds to total assets	7.23			%	4.95		%

Total deposits increased $3,801,000 or 1.0% during the nine months ended September 30, 2005 to $369,416,000.  The increase in total deposits was primarily due to an $18,158,000 or 43.8% increase in NOW accounts caused by the receipt and retention of deposits from the public sector including deposits from a municipal customer who formerly used the Bank’s daily-sweep repurchase agreements.  In addition, savings accounts increased $5,080,000 or 10.9% due mostly to the continued success from marketing our new savings product programs.  Demand deposit accounts (DDA’s) increased $4,974,000 or 7.6% during the first nine months of 2005.  Partially offsetting these increases was the continued time deposit outflow, which experienced a decline of $15,271,000 or 8.4% during the nine months ended September 30, 2005, and a decline in money market accounts of $9,142,000 or 33.1% during the same period.  Management believes the decrease in money markets as well as time deposit accounts is due in part to the growth from the Bank’s new savings options, the decrease from the public sector and to the outflow to other alternative financial products.  While Management, along with the Bank’s Asset/Liability Committee, continues to monitor deposit interest rates in our communities, it remains poised to offer deposit rates that are prudent to producing meaningful interest rate spreads.

Total average interest-bearing deposits decreased $15,031,000 or 4.7% from $316,528,000, at December 31, 2004 to

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$301,497,000 at September 30, 2005.  The average deposit decline included a reduction in total time deposits of $28,559,000.  Management’s tactical plan is to continue to monitor but not actively participate in the current competitive pricing pressure across the entire spectrum of time deposits and will allow high-cost longer termed time deposits to continue to run-off in favor of promoting and growing its short-term time deposits and its lower costing transaction and savings account programs.  Through continued success in marketing efforts, the average balance of these transaction and savings accounts increased by approximately $13,528,000 during the first nine months of 2005.

Public funds continue to be a relatively constant source of deposits and now represent $38,955,000 or 10.6% of total deposits at September 30, 2005, up from $26,551,000 or 7.3% at December 31, 2004.  The Bank is able to maintain public funds due to long established relationships and competitive product pricing.  Public fund deposits are sensitive to the operating demands and business cycles of the various public entities as well as the forever-changing political landscape.  Accordingly, the Bank could experience significant shifts and outflows of these balances throughout the year.

Borrowings

Borrowings totaled $114,563,000 at September 30, 2005 compared to $121,653,000 at December 31, 2004.

Borrowings are used as a complement to deposit generation as an alternative funding source whereby the Bank will borrow from the Federal Home Loan Bank of Pittsburgh (FHLB) for asset growth and liquidity needs.  Borrowings included $70,537,000 and $71,119,000 in long-term advances from the FHLB at September 30, 2005 and December 31, 2004, respectively.  Also included in borrowings is short-term customer repurchase (repos) agreements of $31,438,000 and $40,684,000, at September 30, 2005 and December 31, 2004, respectively.  Repos are non-insured low-cost interest-bearing liabilities that have a security interest in qualified investment securities of the Bank.  Repos offered are either fixed-term or a daily-sweep product of the Bank.  The balance in customer repos can fluctuate daily because the daily-sweep product is dependent on the level of available funds in depositor accounts.  In addition, short-term borrowings may include overnight balances which the Bank may require from time-to-time to fund daily liquidity needs.  As of September 30, 2005, the balance in this account was $11,570,000 compared to $8,760,000 at December 31, 2004.

The combined short- and long-term weighted-average interest rate on borrowings increased to 4.17% at September 30, 2005 compared to 3.57% at December 31, 2004.  The increase in interest rates resulted primarily from increases in short-term and overnight rates due to the Federal Open Market Committee (FOMC) actions.

Accrued interest payable and other liabilities

Accrued interest payable and other liabilities doubled to $6,068,000 during the nine months ended September 30, 2005.   The increase was principally caused by the Bank’s recognition of a purchase obligation in the amount of $2,808,000 caused by a participant’s non-renewal notification of a loan participation agreement.  This transaction settled on October 18, 2005.  Accrued interest payable increased $67,000 while other liabilities and accrued expenses increased $154,000.  Both changes represent fluctuations from normal business transactions.

COMPARISON OF RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED

SEPTEMBER 30, 2005 AND SEPTEMBER 30, 2004

Overview

Net income for the third quarter of 2005 was $1,294,000, an increase of $480,000 or 59% from the $814,000 recorded in the same quarter of 2004.  Diluted earnings per share for the same period improved $0.25 from $0.45 for the three months ended September 30, 2004 to $0.70 for the three months ended September 30, 2005.

The quarter-to-quarter improvement in net income was primarily from the results of increases in net interest and non-interest income and decreases in the provision for loan losses and non-interest expense.  The provision for income taxes increased during the comparable periods due to improved earnings.

Return on average assets and return on average equity were 0.96% and 10.62%, respectively, for the three months ended September 30, 2005 compared to 0.60% and 7.29%, respectively, for the same period in 2004.  The improvement in these ratios is principally due to the improved earnings.

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Net interest income

Net interest income is the Company’s primary source of earnings and is influenced primarily by the amount, distribution and re-pricing characteristics of its interest-earning assets and interest-bearing liabilities as well as the relative levels and movements of interest rates.

Net interest income increased $344,000, or 9%, to $4,362,000 for the third quarter of 2005, from $4,018,000 recorded in the same period of 2004.  Interest income increased by approximately $586,000 in the third quarter 2005 compared to the third quarter of 2004.  The increase was primarily attributable to a 50 basis point increase in the book yield earned on the Bank’s interest-earning assets, to 5.76%, for the three months ended September 30, 2005 compared to 5.26% for the three months ended September 30, 2004.  The effect of the increase in book yield more than offset reduced income from the effect of a $5,095,000 decrease in average interest-earning assets that occurred during the respective period.  The Bank’s diverse portfolio of interest earning-assets should continue to benefit from the effect of the rising interest rate environment.  The book yield on the Bank’s loan portfolio increased 49 basis points due to increases in the national prime rate, the bench mark rate to which floating rate loans originate and re-price to, and the pricing of new loan originations.  The increase in rate more than offset the effect of a decline in average balances and netted a $644,000 increase in interest income from the loan portfolio for the third quarter of 2005 compared to the same quarter in 2004.  The investment securities portfolio experienced a 26 basis point increase in its book yield in the third quarter of 2005 compared to the second quarter of 2004.  However, because of a $14,088,000 decline in average balance, this portfolio’s interest income declined by approximately $58,000 in the third quarter of 2005 compared to the same 2004 quarter.

During the third quarter of 2005, interest expense increased $242,000 to $2,962,000 from $2,720,000 for the same 2004 quarter.  The increasing rate environment has necessitated the need for the Bank to increase offering rates on various deposit products as well as recognition of higher interest charges from repurchase agreements (repos) and other borrowing sources.  Rates paid on average interest-bearing liabilities increased 30 basis points and offset the effect of an $11,761,000 decline in the average balances upon which they are paid.  The continued decline in average balances in certificate of deposit accounts (CD’s) compounded with increases in low-cost transaction and savings account balances should help strengthen the Bank’s performance.  Compared to the third quarter of 2004, the Bank experienced an increase in the average balances of lower-costing transaction and savings accounts and a decrease in the average balances of CD’s and repos during the third quarter of 2005.  The growth in the savings accounts was caused by the success of the Bank’s continued efforts in the promotion of new savings products.  The decrease in average balances of repos was caused by the cyclical nature of the sweep account and preference for exiting the repo product in favor of one of the Bank’s alternative interest-bearing checking accounts as was the case for a municipal customer.  In the near-term, Management’s focus will be to continue to attract and retain low-cost transaction and short-term CD accounts.

For the third quarter of 2005, the Bank’s tax-equivalent spread and margin increased 23 and 33 basis points, respectively, to 3.03% and 3.55% compared to 2.80% and 3.22% for the third quarter of 2004.  The increase in spread and margin is the result of the impact the increasing rate environment has had on the performance of the Bank’s portfolio of interest-earning assets.  Increases in rates at the short end of the relatively flat yield curve will continue to pressure the Bank’s interest rate spread and margin as the competition for deposits will continue to intensify.  However, any periodic increases in national prime should continue to bolster the performance of the Bank’s interest income.

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The following table sets forth, a comparison of average balance sheet amounts and their corresponding tax-equivalent interest income and expense and annualized tax-equivalent yield and cost for the periods indicated (dollars in thousands):

	Three months ended						Nine months ended						Year ended
	September 30,						September 30,						December 31,
	2005			2004			2005			2004			2004
Average interest-earning assets:
Loans and leases	$	390,829		$	381,227		$	387,754		$	387,981		$	387,292
Investments	113,632			127,720			115,842			134,180			132,130
Federal funds sold	—			308			2,451			1,572			1,530
Interest-bearing deposits	400			701			650			651			637
Total	$	504,861		$	509,956		$	506,697		$	524,384		$	521,589
Average interest-bearing liabilities:
Other interest-bearing deposits	$	128,830		$	110,946		$	124,853		$	110,741		$	111,325
Certificates of deposit	170,893			197,586			176,644			210,437			205,203
Borrowed funds	84,309			76,668			78,909			78,103			78,318
Repurchase agreements	29,686			40,279			37,029			41,071			41,695
Total	$	413,718		$	425,479		$	417,435		$	440,352		$	436,541
Interest income:
Loans and leases	$	6,202		$	5,535		$	17,963		$	16,741		$	22,431
Investments(1)	1,270			1,301			3,773			4,078			5,385
Federal funds sold	—			1			47			11			17
Interest-bearing deposits	3			2			12			4			6
Total	$	7,475		$	6,839		$	21,795		$	20,834		$	27,839
Interest expense:
Other interest-bearing deposits	$	419		$	186		$	1,006		$	547		$	742
Certificates of deposit	1,327			1,418			3,972			4,628			5,994
Borrowed funds	1,067			997			2,980			2,973			3,980
Repurchase agreements	149			119			487			324			464
Total	$	2,962		$	2,720		$	8,445		$	8,472		$	11,180
Net interest income	$	4,513		$	4,119		$	13,350		$	12,362		$	16,659
Yield on average interest-earning assets	5.87		%	5.34		%	5.75		%	5.31		%	5.34		%
Rate on average interest-bearing liabilities	2.84		%	2.54		%	2.70		%	2.57		%	2.56		%
Net interest spread	3.03		%	2.80		%	3.05		%	2.74		%	2.78		%
Net interest margin	3.55		%	3.22		%	3.52		%	3.15		%	3.19		%

(1)The 2004 tax equivalent calculations were adjusted to eliminate the effect attributable to the dividend from the Federal Home Loan Bank.

In the table above, interest income was adjusted to a tax-equivalent basis to recognize the income from the various tax-exempt assets as if the interest was fully taxable.  This treatment allows a uniform comparison among the yields on interest-earning assets.  The calculations were computed on a fully tax-equivalent basis using the corporate federal tax rate of 34%.  Net interest spread represents the difference between the yield on interest-earning assets and the rate on interest-bearing liabilities.  Net interest margin represents the ratio of net interest income to total average interest-earning assets.

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Provision for loan losses

The provision for loan losses represents the necessary amount to charge against current earnings, the purpose of which is to increase the allowance for loan losses to a level that represents Management’s best estimate of known and inherentlosses in the Bank’s loan portfolio.  Loans and leases determined to be uncollectible are charged-off against the allowance for loan losses.

The required amount of the provision for loan losses, based upon the adequate level of the allowance for loan losses, is subject to ongoing analysis of the loan portfolio. The Bank maintains a Special Asset Committee which meets periodically to review problem loans and leases. The committee is comprised of Bank management, including the credit administration officer, loan workout officers and collection personnel.  The committee reports quarterly to the Credit Administration Committee of the Board of Directors.

Management continuously reviews the risks inherent in the loan and lease portfolio.  Specific factors used to evaluate the adequacy of the loan loss provision during the formal process include:

•Specific loans that could have loss potential

•Levels of and trends in delinquencies and non-accrual loans

•Levels of and trends in charge-offs and recoveries

•Trends in volume and terms of loans

•Changes in risk selection and underwriting standards

•Changes in lending policies, procedures and practices

•Experience, ability and depth of lending personnel

•National and local economic trends and conditions

•Changes in credit concentrations

The provision for loan losses was $300,000, for the three months ended September 30, 2005, compared to $450,000 for the three months ended September 30, 2004.  The decrease in the provision for loan losses were due to increased recoveries along with the reduced charge-off level of non-performing loans, which consist of loans past due 90 days or more and non-accrual loans.  In addition, certain non-accrual loan balances were reduced and therefore require a reduced level of allowance for loan losses.  The balance of non-performing loans declined by $272,000 to $10,015,000 at September 30, 2005 compared to $10,287,000 at September 30, 2004.  The non-accrual component of non-performing loans decreased $471,000 during that period.  Further, the balance of delinquent loans past due less than 90 days declined by $1,395,000 to $2,397,000 at September 30, 2005 compared to $3,792,000 at September 30, 2004.  The Bank’s enhanced collection department staff has become more aggressive in the collection of delinquent balances thereby preventing larger volumes of past due accounts from migrating to non-performing status which in turn necessitates a lower allowance for loan losses.

Other income

Other (non-interest) income consists of service charges or fees collected on the Bank’s various deposit and loan products, net mortgage servicing revenue, fees from trust, asset management and other financial services, the increase in the cash surrender value of bank-owned life insurance (BOLI), the net realized gains and losses from the sales of investment securities, loans, leased assets and foreclosed assets held for sale and other various classifications of non-interest related income.

Total other income increased $79,000, or 7% for the three months ended September 30, 2005 compared to the same period in 2004.  Service charges on deposit accounts grew by $135,000 or 24% due to the heightened effort to better manage the collection of overdraft and service fees along with increased electronic banking related revenue.  Sales of loans into the secondary market have declined significantly in 2005 as compared to 2004.  The Bank has been absent of a sizable AFS loan portfolio since the restructure of the combined loan portfolio and resulting transfer of loans AFS to the HTM portfolio in the latter part of 2004.  For the first time in 2005, the Bank sold mortgage loans, into the secondary market, during the third quarter.  While operating in an increasing rate environment, the Bank will be more poised to sell newly originated fixed-rate residential mortgages.  The losses from sales of leased assets have also declined as a result of the establishment of a lease loss reserve, during the first quarter of 2005.  See below, “Other income,” under the caption “Comparison of Results of Operations for the Nine months Ended September 30, 2005 and September 30, 2004” for further discussion on the lease loss reserve.  The $37,000 improvement from the sale of foreclosed property was due to insurance proceeds received, from a claim and the subsequent sale of the land.  Fees, other service charges and other non-interest related income decreased $114,000 or 20% principally from reduced trust

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and financial services fees, a decrease in loan servicing charges and a reduction of the benefit crediting rates to the cash surrender value of BOLI during the third quarter of 2005 compared to the same period of 2004.

Other operating expenses

Other (non-interest) expenses decreased $67,000, or 2% for the three months ended September 30, 2005 compared to the same period in 2004.  Other expenses declined $124,000 or 16% due primarily to a reduction in the recognition of settlement expenses.  The Bank established a settlement reserve in 2004 for future obligations related to certain retirement benefits.  During the third quarter of 2005, the reserve was increased by approximately $58,000 due to increased medical insurance premiums and a decrease in the discount rate used to calculate future benefit costs.  This compares to $198,000 recognized in the third quarter of 2004.  This was partially offset by increased collection expenses incurred caused by the sustained and aggressive pursuit of non-performing assets.  Advertising decreased during the third quarter of 2005 compared to the third quarter of 2004 because more of the sales campaigns, initiatives, programs and sponsorships were concentrated in the first half of the year which the Bank has determined to be more representative of its marketing cycle.  Compared to the third quarter of 2004, premises and equipment expenses are up due to increased depreciation and increased equipment maintenance.  Professional service fees increased due to increased fees related to the Bank’s continued activities related to Sarbanes-Oxley §404 compliance process.

Income tax provision

An increase in pre-tax income of $641,000 resulted in an increased tax provision of $160,000 in the third quarter of 2005 compared to the third 2004 quarter.  The effective federal income tax rate was 23.8% and 23.1% for the respective quarters.  The effective tax rate increase is attributable to a decrease in combined tax-free income as a ratio to total pre-tax income.

COMPARISON OF RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDED

SEPTEMBER 30, 2005 AND SEPTEMBER 30, 2004

Overview

Net income for the nine months ended September 30, 2005 was $3,450,000, an increase of $1,091,000 or 46% from the $2,359,000 recorded for the nine months ended September 30, 2004.  Diluted earnings per share for the same period improved $0.58 from $1.29 for the nine months ended September 30, 2004 to $1.87 for the nine months ended September 30, 2005.

The period improvement in net income was primarily from the result of an increase in net interest income and a decrease in the provision for loan losses.   These items were partially offset by a decrease in non-interest income and increases in non-interest expense and the provision for income taxes.

Return on average assets and return on average equity were 0.86% and 9.73%, respectively, for the nine months ended September 30, 2005 compared to 0.57% and 7.11%, respectively, for the same period in 2004.  The improvement in these ratios is primarily due to improved earnings.

Net interest income

Net interest income increased $914,000, or 8%, to $12,956,000 for the nine months ended September 30, 2005, from $12,042,000 recorded for the nine months ended September 30, 2004.  The increase was primarily due to a 42 basis point increase in the book yield earned on the Bank’s interest-earning assets, to 5.65%, for the nine months ended September 30, 2005 compared to 5.23% for the first nine months of 2004.  The increase in yield more than offset reduced income from the effect of a $17,687,000 decrease in average interest-earning assets.  The periodic increases in the national prime rate resulted in a 41 basis point increase in yield from the Bank’s loan portfolio during the nine months ended September 30, 2005 compared to the same 2004 period.  During the same period, the average earning balances of the loan portfolio decreased modestly.  The investment securities portfolio registered a 24 basis point increase in book yield during the nine months ended September 30, 2005 compared to same 2004 period; however, a $18,338,000 decline in their average balances has more than offset the income effect of the increase in yield and has resulted in a decline in interest income in the investment securities portfolio of $327,000.

For the nine months ended September 30, 2005, total interest expense decreased $27,000 to $8,445,000 from $8,472,000 for the same 2004 period.  Despite a 13 basis point increase in the combined rate paid on average interest-bearing liabilities, interest expense declined due to a $22,917,000 net decrease in the average balances of interest-bearing liabilities

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during the first nine months of 2005 compared to the same 2004 period.  A $33,793,000 decreases in average balances of CD’s were the primary factor in the net average balance decrease.  The decrease in average CD balances were partially offset by lower costing savings and transaction accounts which increased by approximately $14,112,000 in the first nine months of 2005 compared to the same period of 2004.

For the nine months ended September 30, 2005, the Bank’s tax-equivalent spread and margin increased 31 and 37 basis points, respectively, to 3.05% and 3.52% compared to 2.74% and 3.15% for the nine months ended September 30, 2004.  The increase in spread and margin is primarily due the increase in the interest rate environment currently favoring the Bank’s interest-earning assets and a decrease in average interest-bearing liabilities.  Notwithstanding a flat interest rate yield curve, a continuance of increases in national prime coupled with prolonged success in the Bank’s ability to continue to attract lower costing transaction and savings account should have a positive effect on the performance of the Bank’s interest rate spread and margin.

Provision for loan losses

The provision for loan losses was $680,000, for the nine months ended September 30, 2005, compared to $1,700,000 for the nine months ended September 30, 2004.  The substantial reduction in the provision for loan losses is based upon Management’s assessment of the current loan portfolio.  Many of the non-performing loans from the 2004 period have been provided for in the allowance and some have been written down, therefore, additional provisions at prior levels was no longer deemed necessary.   In addition, our collections department has been working diligently on past due and delinquent loans.  This has resulted in the level of total past due loans over 30 days declining by $1,197,000 to $3,051,000 at September 30, 2005 compared to $4,248,000 at September 30, 2004.  During the same period, non-accrual loans also declined by $470,000 to $9,361,000 from $9,831,000.

Other income

Total other income decreased $64,000, or 2% for the nine months ended September 30, 2005 compared to the same period in 2004.  During the first quarter the Bank recognized an estimated impairment charge of $220,000 in anticipation of projected realized losses from the future sales of its leased vehicles.  The estimated losses were based on the historical performance of terminated lease contracts that were typically sold below their residual value.  The balance of the Bank’s leased vehicles should mature or pay-off during 2005.  Service charges on deposit accounts grew by $341,000 or 21% due to the improved collection of account maintenance and overdraft fees charged to customers as well as improvements in revenue from electronic banking.  For the nine months ended September 30, 2005, the Bank recorded a $1,000 net gain from the sales of loans AFS, compared to $155,000 for the nine months ended September 30, 2004.  The $154,000 variance was due primarily to the 2004 balance sheet restructure that resulted, in part, in the sale of a sizable portfolio of profitable mortgage loans into the secondary market.  Fees, other service charges and other non-interest related income decreased $256,000 or 16% in the first nine months of 2005, principally from reduced benefit crediting rates to the cash surrender value of the BOLI and from decreased fees from both trust and financial services.

 Other operating expenses

Other expenses increased $297,000 or 3% for the nine months ended September 30, 2005 compared to the same period in 2004.  Professional service fees increased $215,000, or 25% due to increased fees related to the Bank’s required independent financial audits, Sarbanes-Oxley §404 compliance process, the cost for the Bank-wide participation in management skills development and sales training programs and increased FDIC assessments.  Advertising expenses for the first nine months of 2005 increased $104,000 or 34% from the same period in of 2004.  The Bank has concentrated its marketing effort with added initiatives for Bank product, use of alternative media advertising, bank-wide signage, new demographic related research tools, a new website and more Bank sponsored events than in the prior year.  Variances in other operating expenses, for the comparable periods included a decrease in settlement expense accruals and increases in ancillary training expense for the management skills and sales training programs, an increase in Pennsylvania shares tax and an increase in OREO and collection related expenses.

Income tax provision

Income before provision for income taxes increased $1,573,000 for the nine months ended September 30, 2005 compared to the nine months ended September 30, 2004.  As a result, the Bank’s income tax provision increased $483,000 during the same period.  The effective federal income tax rate was 25.2% and 22.3% for the respective periods.  The effective tax rate increase is attributable to a lower proportion of combined tax-free interest income to total pre-tax earnings.

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Item 3.Quantitative and Qualitative Disclosure about Market Risk

Management of interest rate risk and market risk analysis

The Company is subject to the interest rate risks inherent in our lending, investing and financing activities.  Fluctuations of interest rates will impact interest income and interest expense along with affecting market values of all interest-earning assets and interest-bearing liabilities, except for those assets or liabilities with a short-term remaining to maturity.  Interest rate risk management is an integral part of the asset/liability management process.  The Company has instituted certain procedures and policy guidelines to manage the interest rate risk position.  Those internal policies enable the Company to react to changes in market rates to protect net interest income from significant fluctuations.  The primary objective in managing interest rate risk is to minimize the adverse impact of changes in interest rates on net interest income along with creating an asset/liability structure that maximizes earnings.

Asset/Liability Management:  One major objective of the Company when managing the rate sensitivity of its assets and liabilities is to stabilize net interest income.  The management of and authority to assume interest rate risk is the responsibility of the Company’s Asset/Liability Committee (ALCO), which is comprised of senior management and Board members.  ALCO meets quarterly to monitor the ratio of interest sensitive assets to interest sensitive liabilities.  The process to review interest rate risk is a regular part of managing the Company.  Consistent policies and practices of measuring and reporting interest rate risk exposure, particularly regarding the treatment of non-contractual assets and liabilities, are in effect.  In addition, there is an annual process to review the interest rate risk policy with the Board of Directors which includes limits on the impact to earnings from shifts in interest rates.

Interest Rate Risk Measurement: Interest rate risk is monitored through the use of three complementary measures:  static gap analysis, earnings at risk simulation and economic value at risk simulation.  While each of the interest rate risk measurements has limitations, taken together they represent a reasonably comprehensive view of the magnitude of interest rate risk in the Company and the distribution of risk along the yield curve, the level of risk through time and the amount of exposure to changes in certain interest rate relationships.

Static Gap: The ratio between assets and liabilities re-pricing in specific time intervals is referred to as an interest rate sensitivity gap.  Interest rate sensitivity gaps can be managed to take advantage of the slope of the yield curve as well as forecasted changes in the level of interest rate changes.

To manage this interest rate sensitivity position, an asset/liability model called ‘cumulative gap analysis’ is used to monitor the difference in the volume of the Company’s interest sensitive assets and liabilities that mature or re-price within given periods.  A positive gap (asset sensitive) indicates that more assets re-price during a given period compared to liabilities, while a negative gap (liability sensitive) has the opposite effect.  The Company employs computerized net interest income simulation modeling to assist in quantifying interest rate risk exposure.  This process measures and quantifies the impact on net interest income through varying interest rate changes and balance sheet compositions.  The use of this model assists the ALCO to gauge the effects of the interest rate changes on interest sensitive assets and liabilities in order to determine what impact these rate changes will have upon the net interest spread.

At September 30, 2005, the Company maintained a one-year cumulative negative gap of $2,083,000 million or -0.39% of total assets.  The effect of this negative gap position provided a mismatch of assets and liabilities, which may expose the Bank to an increased interest rate risk position during a period of increasing interest rates.  Conversely, in a decreasing interest rate environment, net income could be positively affected because more liabilities will re-price downward during a one-year period.

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The following table illustrates the Company’s interest sensitivity gap position at September 30, 2005 (dollars in thousands):

	3 months				3 through					1 through				Over
	or less				12 months					3 years				3 years							Total
Cash and cash equivalents	$	134			$		—			$	—			$				10,828			$			10,962
Investment securities(1)(2)	8,025				14,172					28,000				56,531							106,728
Loans(2)	130,619				69,434					89,570				101,413							391,036
Fixed and other assets	—				7,816					—				21,893							29,709
Total assets	$	138,778			$		91,422			$	117,570			$				190,665			$	538,435
Total cumulative assets	$	138,778			$		230,200			$	347,770			$					538,435
Non-interest bearing transaction deposits(3)	$		—		$		7,027			$	19,343			$			43,963				$		70,333
Interest-bearing transaction deposits(3)	24,046				52,813					41,755				11,057							129,671
Time deposits	32,989				71,899					43,636				20,888							169,412
Repurchase agreements	21,158				3,939					6,340				—							31,437
Short-term borrowings	12,589				—					—				—							12,589
Long-term debt	5,206				617					1,646				63,068							70,537
Other liabilities	—				—					—				6,069							6,069
Total liabilities	$		95,988		$		136,295			$	112,720			$	145,045						$		490,048
Total cumulative liabilities	$		95,988		$		232,283			$	345,003			$	490,048
Interest sensitivity gap	$		42,790		$			(44,873	)	$	4,850			$	45,620
Cumulative gap	$		42,790		$	(2,083			)	$		2,767		$		48,387
Cumulative gap to total assets	7.95			%	-0.39				%	0.51			%	8.99						%

⁽¹⁾Includes net unrealized gains/losses on securities AFS.

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

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

Certain shortcomings are inherent in the method of analysis presented in the above table.  Although certain assets and liabilities may have similar maturities or periods of re-pricing, they may react in different degrees to changes in market interest rates.  The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types of assets and liabilities may lag behind changes in market interest rates.  Certain assets, such as adjustable-rate mortgages, have features which restrict changes in interest rates on a short-term basis and over the life of the loan.  In the event of a change in interest rates, prepayment and early withdrawal levels may deviate significantly from those assumed in calculating the table.  The ability of many borrowers to service their adjustable-rate debt may decrease in the event of an interest rate increase.

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

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

Economic Value at Risk: Earnings at risk simulation measure the short-term risk in the balance sheet.  Economic value (or portfolio equity) at risk measures the long-term risk by finding the net present value of the future cash flows from

27

the Company’s existing assets and liabilities.  The ALCO examines this ratio quarterly utilizing an increase and decrease of 200 basis points in interest rates simulation model.  The ALCO recognizes that, in some instances, this ratio may contradict the “earnings at risk” ratio.

The following table illustrates the simulated impact of 200 basis points upward or downward movement in interest rates on net interest income, net income and the change in economic value (portfolio equity).  This analysis assumed that interest-earning asset and interest-bearing liability levels at September 30, 2005 remained constant.  The impact of the rate movements was developed by simulating the effect of the rate change over a twelve-month period from the September 30, 2005 levels:

	Rates +200		Rates -200
Earnings at risk:
Percent change in:
Net interest income	5.8	%	(14.1	)%
Net income	15.0		(35.3	)
Economic value at risk:
Percent change in:
Economic value of equity	(17.6	)	(7.9	)
Economic value of equity as a percent of book assets	(1.9	)	(0.9	)

Economic value has the most meaning when viewed within the context of risk-based capital.  Therefore, the economic value may change beyond the Company’s policy guideline for a short period of time as long as the risk-based capital ratio, after adjusting for the excess equity exposure, is greater than 10%.  At September 30, 2005, the Company’s total risk-based capital ratio was 13.7%.

The table below summarizes estimated changes in net interest income over a twelve-month period beginning October 1, 2005, under alternate interest rate scenarios using the income simulation model described above:

	Net interest		Dollar			Percent
Change in interest rates	income		variance			variance
	(dollars in thousands)
+200 basis points	$	20,206	$	1,100		5.8	%
+100 basis points	19,655		549			2.9
Flat rate	19,106		—			—
-100 basis points	18,110		(996		)	(5.2	)
-200 basis points	16,411		(2,695		)	(14.1	)

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

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Liquidity

Liquidity management ensures that adequate funds will be available to meet customers’ needs for borrowings, deposit withdrawals and maturities and normal operating expenses of the Bank.  Current sources of liquidity are cash and cash equivalents, asset maturities and pay downs within one year, loans and investments AFS, growth of core deposits, growth of repurchase agreements, increase of other borrowed funds from correspondent banks and issuance of capital stock.  Although regularly scheduled investment and loan payments are dependable sources of daily funds, the sale of loans and investment securities AFS, deposit activity, and investment and loan prepayments are significantly influenced by general economic conditions and the level of interest rates.

At September 30, 2005, the Company maintained $10,962,000 in cash and cash equivalents. The Company also had $104,504,000 in investments AFS and $697,000 of loans AFS. This combined total of $105,201,000 represented approximately 20% of total assets at September 30, 2005. In addition, as of September 30, 2005, the Company had approximately $79,396,000 available to borrow from the FHLB. Management believes that the present level of liquidity remains strong and adequate for current operations.

Capital

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

Capital is fundamental to support our continued growth. In addition, the Company and Bank are subject to various regulatory capital requirements. Regulatory capital is defined in terms of Tier I capital (shareholders’ equity plus the allowable portion of the minority interest in equity of subsidiaries, minus unrealized gains or plus unrealized losses on AFS, and minus certain intangible assets), Tier II capital (which includes the allowable portion of the allowance for loan losses, minority interest in equity of subsidiaries and subordinated debt), and total capital (Tier I plus Tier II). Risk-based capital ratios are expressed as percentages of risk-weighted assets.  Risk-weighted assets are determined by assigning various weights to all assets and off-balance sheet financial instruments, such as letters of credit and loan commitments, based on associated risk.  Regulators have also adopted minimum Tier I leverage ratio standards, which measure the ratio of Tier I capital to total average quarterly assets.

Quantitative measures, established by regulation to ensure capital adequacy, require the Company to maintain minimum amounts and ratios of total and Tier I capital to risk-weighted assets, and of Tier I capital to average assets.  Capital is evaluated in relation to total assets and the risk associated with those assets.  As of September 30, 2005, the Company exceeds all capital adequacy requirements to which it is subject.

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The following table depicts the capital amounts and ratios of the Company and the Bank as of September 30, 2005:

	Actual				For capital adequacy purposes				To be well capitalized under prompt corrective action provisions
	Amount		Ratio		Amount		Ratio		Amount		Ratio
Total capital (to risk-weighted assets)
Consolidated	$	54,106,517	13.66	%	$	31,687,810	8.00	%	N/A		N/A
Bank	$	53,795,990	13.58	%	$	31,689,700	8.00	%	$	39,612,125	10.00	%
Tier I capital (to risk-weighted assets)
Consolidated	$	49,067,311	12.39	%	$	15,843,905	4.00	%	N/A		N/A
Bank	$	48,825,793	12.33	%	$	15,844,850	4.00	%	$	23,767,275	6.00	%
Tier I Capital (to average assets)
Consolidated	$	49,067,311	9.20	%	$	21,338,264	4.00	%	N/A		N/A
Bank	$	48,825,793	9.16	%	$	21,320,158	4.00	%	$	26,650,197	5.00	%

Item 4.Controls and Procedures

The Company maintains controls and procedures designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission. Based upon their evaluation of those controls and procedures as of the end of the period covered by this report, the Chief Executive Officer and Chief Financial Officer of the Company concluded that the Company’s disclosure controls and procedures were adequate. There have been no changes to the Company’s internal control over financial reporting during the third quarter of 2005.

PART II. Other Information

Item 1.         Legal Proceedings

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

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

                          None

Item 3.        Default upon Senior Securities

                          None

Item 4.         Submission of Matters to a Vote of Security Holders

                          None

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Item 5.         Other Information

                          None

Item 6.       Exhibits

      Exhibits

3(i)Amended and Restated Articles of Incorporation of Registrant. Incorporated by reference to Exhibit 3(i) to Registrant’s Registration Statement No. 333-90273 on Form S-4, filed with the SEC on November 3, 1999 and as amended on April 6, 2000.

3(ii)Bylaws of Registrant. Incorporated by reference to Exhibit 3(ii) to Registrant’s Registration Statement No. 333-90273 on Form S-4, filed with the SEC on November 3, 1999 and as amended on April 6, 2000.

10.11998 Independent Directors Stock Option Plan of The Fidelity Deposit and Discount Bank, as assumed by Registrant. Incorporated by reference to Exhibit 10.1 to Registrant’s Registration Statement No. 333-90273 on Form S-4, filed with the SEC on November 3, 1999 and as amended on April 6, 2000.

10.21998 Stock Incentive Plan of The Fidelity Deposit and Discount Bank, as assumed by Registrant. Incorporated by reference to Exhibit 10.2 of Registrant’s Registration Statement No. 333-90273 on Form S-4, filed with the SEC on November 3, 1999 and as amended on April 6, 2000.

10.3Form of Deferred Compensation Plan of The Fidelity Deposit and Discount Bank. Incorporated by reference to Exhibit 10.3 to Registrant’s Registration Statement No.333-45668 on Form S-1, filed with the SEC on September 12, 2000 and as amended on October 11, 2000.

10.4Registrant’s 2000 Dividend Reinvestment Plan. Incorporated by reference to Exhibit 4 to Registrant’s Registration Statement No. 333-45668 on Form S-1, filed with the SEC on September 12, 2000 and as amended by Pre-Effective Amendment No. 1 on October 11, 2000, by Post-Effective Amendment No. 1 on May 30, 2001 and by Post-Effective Amendment No 2 on July  7, 2005.

10.5Registrant’s 2000 Independent Directors Stock Option Plan. Incorporated by reference to Exhibit 4.3 to Registrant’s Registration Statement No. 333-64356 on Form S-8 filed with the SEC on July 2, 2001.

10.6Registrant’s 2000 Stock Incentive Plan. Incorporated by reference to Exhibit 4.4 to Registrant’s Registration Statement No. 333-64356 on Form S-8 filed with the SEC on July 2, 2001.

10.7Registrant’s 2002 Employee Stock Purchase Plan. Incorporated by reference to Appendix A to Registrant’s Definitive Proxy Statement filed with the SEC on March 28, 2002.

10.8Employment Agreement between Registrant, The Fidelity Deposit and Discount Bank and Steven C. Ackmann, dated June 21, 2004. Incorporated by reference to Exhibit 99.1 to Registrant’s Current Report on Form 8-K filed with the SEC on June 24, 2004.

10.9Complete Settlement Agreement and General Release between Michael F. Marranca, Registrant and The Fidelity Deposit and Discount Bank, dated July 30, 2004.  Incorporated by reference to Exhibit 99.1 to Registrant’s Current Report on Form 8-K filed with the SEC on August 10, 2004.

10.10Change of Control and Severance Agreement between James T. Gorman, Registrant and The Fidelity Deposit and Discount Bank, dated September 19, 2005.  Incorporated by reference to Exhibit 99.1 to Registrant’s Current Report on Form 8-K filed with the SEC on September 22, 2005.

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11Statement regarding computation of earnings per share. Included herein in Note 2 “Earnings per Share”, contained within the Notes to Consolidated Financial Statements, and incorporated herein by reference.

31.1Rule 13a-14(a) Certification of Principal Executive Officer, filed herewith.

31.2          Rule 13a-14(a) Certification of Principal Financial Officer, filed herewith.

32.1Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350,  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, filed herewith.

32.2Certification of Principal Financial Officer pursuant to 18 U.S.C. Section 1350  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, filed herewith.

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

FIDELITY D & D BANCORP, INC.

Date:	November 10, 2005	/s/	Steven C. Ackmann
			Steven C. Ackmann,
			President and Chief Executive Officer

Date:	November 10, 2005	/s/	Salvatore R. DeFrancesco, Jr.
			Salvatore R. DeFrancesco, Jr.,
			Treasurer and Chief Financial Officer

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Exhibit Index

		Page
3(i)	Amended and Restated Articles of Incorporation ofRegistrant. Incorporated by reference to Exhibit 3(i) to Registrant’s Registration Statement No. 333-90273 on Form S-4, filed with the SEC on November 3, 1999 and as amended on April 6, 2000.	*
3(ii)	Bylaws of Registrant. Incorporatedby reference to Exhibit 3 (ii) to Registrant’s Registration Statement No. 333-90273 on Form S-4, filed with the SEC on November 3, 1999 and as amended on April 6, 2000.	*
10.1	1998 Independent Directors StockOption Plan of The Fidelity Deposit and Discount Bank, as assumed by Registrant. Incorporated by reference to Exhibit 10.1 to Registrant’s Registration Statement No. 333-90273 on Form S-4, filed with the SEC on November 3, 1999 and as amended on April 6, 2000.	*
10.2	1998 Stock Incentive Plan of The Fidelity Deposit and Discount Bank, as assumed by Registrant. Incorporated by reference to Exhibit 10.2 of Registrant’s Registration Statement No. 333-90273 on Form S-4, filed with the SEC on Nov. 3, 1999 and as amended on April 6, 2000.	*
10.3	Form of Deferred Compensation Plan of The Fidelity Deposit and Discount Bank. Incorporated by reference to Exhibit 10.3 to Registrant’s Registration Statement No. 333-45668 on Form S-1, filed with the SEC on September 12, 2000 and as amended on October 11, 2000.	*
10.4	Registrant’s 2000 Dividend Reinvestment Plan. Incorporated by reference to Exhibit 4 to Registrant’s Registration Statement No. 333-45668 on Form S-1, filed with the SEC on September 12, 2000 and as amended by Pre-Effective Amendment No. 1 on October 11, 2000, by Post-Effective Amendment No. 1 on May 30, 2001 and by Post-Effective Amendment No 2 on July 7, 2005.	*
10.5	Registrant’s 2000 Independent Directors Stock Option Plan. Incorporated by reference to Exhibit 4.3 to Registrant’s Registration Statement No. 333-64356 on Form S-8 filed with the SEC on July 2, 2001.	*
10.6	Registrant’s 2000 Stock Incentive Plan. Incorporated by reference to Exhibit 4.4 to Registrant’s Registration Statement No. 333-64356 on Form S-8 filed with the SEC on July 2, 2001.	*

34

10.7	Registrant’s 2002 Employee Stock Purchase Plan. Incorporated by reference to Appendix A to Registrant’s Definitive Proxy Statement filed with the SEC on March 28, 2002.	*
10.8	Employment Agreement between Registrant, The Fidelity Deposit and Discount Bank and Steven C. Ackmann, dated June 21, 2004. Incorporated by reference to Exhibit 99.1 to Registrant’s Current Report on Form 8-K filed with the SEC on June 24, 2004.	*
10.9	Complete Settlement Agreement and General Release between Michael F. Marranca, Registrant and The Fidelity Deposit and Discount Bank, dated July 30, 2004. Incorporated by reference to Exhibit 99.1 to Registrant’s Current Report on Form 8-K filed with the SEC on August 10, 2004.	*
10.10	Change of Control and Severance Agreement between James T. Gorman, Registrant and the Fidelity Deposit and Discount Bank, dated September 19, 2005. Incorporated by reference to Exhibit 99.1 to Registrant’s Current Report on Form 8-K filed with the SEC on September 22, 2005.	*
11	Statement regarding computation of earnings per share. Included herein.	8
31.1	Rule 13a-14(a) Certification of Principal Executive Officer.	36
31.2	Rule 13a-14(a) Certification of Principal Financial Officer.	37
32.1	Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.	38
32.2	Certification of Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.	39

* - Incorporated by Reference

35