Pavilion Bancorp (PVLN) 10-Q 2006 Q3 Quarterly report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
——————————

FORM 10-Q

[X]     QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006

or

[__]     TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934

——————————

Commission File #000-30521

PAVILION BANCORP, INC.
(Exact name of registrant as specified in its charter)

Michigan
(State or Other Jurisdiction of
Incorporation or Organization) 38-3088340
(I.R.S. Employer
Identification No.)

135 East Maumee Street, Adrian, Michigan 49221
(Address of Principal Executive Offices, including Zip Code)

Registrant’s telephone number, including area code: (517) 265-5144, Fax (517) 265-3926

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for shorter periods that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes [X]             No [__]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” (in Rule 12b-2 of the Exchange Act). (Check one:)

Large Accelerated Filer   [__]             Accelerated Filer [__]             Non-Accelerated Filer [X]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 126-2 of the Exchange Act).

Yes [__]             No [X]

As of November 10, 2006 there were 731,408 outstanding shares of the registrant’s common stock, no par value.

Page 1

CROSS REFERENCE TABLE

ITEM NO.	DESCRIPTION	PAGE NO.
	PART I - FINANCIAL INFORMATION
Item 1	Financial Statements (Condensed and Unaudited)
	(a)     Report of Independent Registered Public Accounting Firm	3
	(b)     Condensed Consolidated Balance Sheets	4
	(c)     Condensed Consolidated Statements of Income	5
	(d)     Condensed Consolidated Statements of Changes in Shareholders' Equity	6
	(e)     Condensed Consolidated Statements of Cash Flows	7
	(f)     Notes to Condensed Consolidated Financial Statements	8
Item 2	Management's Discussion and Analysis of
	Financial Condition and Results of Operations	14
Item 3	Quantitative and Qualitative Disclosures About Market Risk	24
Item 4	Controls and Procedures	25
	PART II -OTHER INFORMATION
Item 1	Legal Proceedings	25
Item 1.A.	Risk Factors	25
Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	25
Item 3	Defaults Upon Senior Securities	25
Item 4	Submission of Matters to a Vote of Security Holders	26
Item 5	Other Information	26
Item 6	Exhibits	26
Signatures		27
Exhibit Index		28

Page 2

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Shareholders and Board of Directors
Pavilion Bancorp, Inc.
Adrian, Michigan

We have reviewed the condensed consolidated balance sheet of Pavilion Bancorp, Inc. (the “Corporation”) as of September 30, 2006, and the related condensed consolidated statements of income, shareholders’ equity, and cash flows for the three and nine month periods ended September 30, 2006 and 2005, included in the Corporation’s SEC Form 10-Q. These interim financial statements are the responsibility of the Corporation’s management.

We conducted our reviews in accordance with the standards established by the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures to financial data and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with auditing standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our reviews, we are not aware of any material modifications that should be made to the condensed consolidated interim financial statements for them to be in conformity with generally accepted accounting principles in the United States of America.

/s/ Plante & Moran, PLLC

Auburn Hills, Michigan
November 8, 2006

Page 3

PART I
FINANCIAL INFORMATION

ITEM 1- FINANCIAL STATEMENTS

CONDENSED CONSOLIDATED BALANCE SHEETS
(000’s omitted)

	September 30, 2006 (unaudited)			December 31, 2005
ASSETS
Cash and due from banks	$	10,536		$	11,308
Federal funds sold		4,364			-
Total cash and cash equivalents		14,900			11,308
Securities available for sale		24,005			25,407
Federal Home Loan Bank, Freddie Mac, FNMA stock		2,279			2,795
Federal Reserve Bank stock		630			630
Loans held for sale		615			927
Loans receivable, net of allowance for loan and lease losses		242,510			234,915
Premises and equipment, net		7,363			6,135
Accrued interest receivable		2,186			1,651
Mortgage servicing rights		2,670			2,898
Other assets		1,272			1,215
Total assets	$	298,430		$	287,881
LIABILITIES AND SHAREHOLDERS' EQUITY
Deposits
Noninterest bearing	$	49,212		$	45,353
Interest bearing		184,107			165,395
Total deposits		233,319			210,748
Federal funds purchased		-			9,000
Repurchase agreements		12,751			13,663
Federal Home Loan Bank advances		13,685			16,901
Accrued interest payable		875			667
Other liabilities		2,148			2,529
Subordinated debentures		5,000			5,000
Common stock in ESOP subject to repurchase obligation		2,817			2,989
Total liabilities		270,595			261,497
Shareholders' equity
Common stock and paid-in capital, no par value: shares issued and
and outstanding: 731,408 at September 30, 2006; 735,379 at
December 31, 2005		10,691			10,724
Retained earnings		17,313			15,963
Accumulated other comprehensive loss		(169	)		(303	)
Total shareholders' equity		27,835			26,384
Total liabilities and shareholders' equity	$	298,430		$	287,881

See accompanying notes to the condensed consolidated financial statements

Page 4

CONDENSED CONSOLIDATED STATEMENTS OF
INCOME (unaudited)
(000’s omitted, except per share data)

	Three months ended September 30,				Nine months ended September 30,
	2006		2005		2006		2005
Interest and dividend income
Loans receivable, including fees	$	4,627	$	3,928	$	13,083	$	10,883
Debt securities:
Taxable		182		192		547		590
Tax - exempt		22		31		71		106
Dividend income		38		39		127		107
Federal funds sold and other		49		6		190		70
Total interest and dividend income		4,918		4,196		14,018		11,756
Interest expense
Deposits		1,439		916		3,885		2,308
Subordinated debentures		117		94		331		261
Other borrowed funds		363		246		920		493
Total interest expense		1,919		1,256		5,136		3,062
Net interest income		2,999		2,940		8,882		8,694
Provision for loan losses		120		105		225		285
Net interest income after provision for loan losses		2,879		2,835		8,657		8,409
Noninterest income
Service charges and fees		349		354		1,005		978
Net gains on sale of loans		213		356		776		1,112
Loan servicing fees, net of amortization		24		4		78		275
Other		133		87		413		274
		719		801		2,272		2,639
Noninterest expense
Compensation and employee benefits		1,392		1,687		4,850		5,512
Occupancy and equipment		383		351		1,108		1,060
Professional services		126		152		399		556
Marketing		23		70		113		180
Outside service fees		268		254		818		795
Postage and delivery services		63		74		215		239
Director and shareholders		47		43		157		163
Loan and collection		81		82		228		243
Other		152		226		397		537
		2,535		2,939		8,285		9,285
Income before income taxes		1,063		697		2,644		1,763
Income taxes		280		220		766		563
Net income	$	783	$	477	$	1,878	$	1,200
Net earnings per share
Basic	$	1.06	$	0.65	$	2.55	$	1.50
Diluted	$	1.06	$	0.65	$	2.54	$	1.49
Dividends per share	$	0.24	$	0.24	$	0.72	$	0.72

See accompanying notes to condensed consolidated financial statements

Page 5

PAVILION BANCORP, INC.
CONDENSED  CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
(unaudited)
For the periods ended September 30, 2005 and 2006

(000's omitted)	Common Stock Paid-In Capital			Retained Earnings			Accumulated Other Comprehensive Income/(Loss)			Total Shareholders' Equity
Balance January 1, 2005	$	10,190		$	21,713		$	(46	)	$	31,857
Comprehensive income:
Net income		-			1,200			-			1,200
Unrealized (losses) on securities
available for sale		-			-			(241	)
Tax effect		-			-			82
Total other comprehensive loss		-			-			(159	)		(159	)
Total comprehensive income		-			-						1,041
Change in common stock subject to repurchase		(110	)		-			-			(110	)
Stock repurchase and retirement		(1,566	)		(6,952	)		-			(8,518	)
Stock option expense		12			-			-			12
Stock options exercised		530			-			-			530
Cash dividends - $0.72 per share		-			(558	)		-			(558	)
Balance September 30, 2005	$	9,056		$	15,403		$	(205	)	$	24,254
Balance January 1, 2006	$	10,724		$	15,963		$	(303	)	$	26,384
Comprehensive income:
Net income		-			1,878			-			1,878
Unrealized gain on securities
available for sale		-			-			203
Tax effect		-			-			(69	)
Total other comprehensive income		-			-			134			134
Total comprehensive income		-			-						2,012
Change in common stock subject to repurchase		(88	)		-			-			(88	)
Stock option expense		17			-			-			17
Stock options exercised		38			-			-			38
Cash dividends - $0.72 per share		-			(528	)		-			(528	)
Balance September 30, 2006	$	10,691		$	17,313		$	(169	)	$	27,835

See accompanying notes to the condensed consolidated financial statements

Page 6

CONDENSED CONSOLIDATED STATEMENTS OF
CASH FLOWS (unaudited)
(000’s omitted)

	Nine months ended September 30,
	2006			2005
Cash Flows from operating activities
Net income	$	1,878		$	1,200
Adjustments to reconcile net income to
net cash from operating activities
Depreciation		516			501
Stock option expense		17			12
Provision for loan losses		225			285
Amortization on securities available for sale		19			24
Loss on disposal of assets		-			28
Loss on sales of securities		9			-
Amortization of mortgage servicing rights		637			440
Origination of mortgage loans held for sale		(33,821	)		(48,347	)
Proceeds from sales of mortgage loans held for sale		34,500			48,314
Net gains on sale of mortgage loans		(776	)		(1,112	)
Net change in:
Deferred loan origination fees		(6	)		(11	)
Accrued interest receivable		(535	)		(412	)
Other assets		(332	)		193
Accrued interest payable		208			461
Other liabilities		(449	)		(2,324	)
Net cash provided by (used in) operating activities		2,090			(748	)
Cash flows from investing activities
Securities available for sale:
Maturities, calls and principal payments		1,584			4,680
Sales of securities available for sale		990			-
Purchases		(996	)		(3,165	)
Redemption (purchase) of Federal Home Loan Bank stock		516			(57	)
Purchase of Federal Reserve Bank stock		-			(120	)
Net premises and equipment expenditures		(1,745	)		(537	)
Net increase in loans		(7,585	)		(25,651	)
Recoveries on loans charged-off		46			61
Net cash used in investing activities		(7,190	)		(24,789	)
Cash flows from financing activities
Net change in deposits		22,571			28,113
Net change in short term borrowings		(9,912	)		9,905
Proceeds from Federal Home Loan Bank advances		32,400			3,000
Repayments of Federal Home Loan Bank advances		(35,616	)		(2,681	)
Stock repurchased		-			(8,518	)
Repurchase of ESOP/401k shares		(260	)		-
Stock options exercised		38			530
Dividends paid		(529	)		(808	)
Net cash from financing activities		8,692			29,541
Net increase in cash and cash equivalents		3,592			4,004
Cash and cash equivalents at beginning of period		11,308			11,700
Cash and cash equivalents at end of period	$	14,900		$	15,704
Transfer from:
Loans to foreclosed real estate	$	275		$	295
Cash paid for:
Interest	$	4,927		$	2,601
Income taxes	$	853		$	2,351

See accompanying notes to condensed consolidated financial statements

Page 7

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

NOTE 1 – PRINCIPLES OF CONSOLIDATION AND NATURE OF OPERATIONS

The accounting and reporting policies of Pavilion Bancorp, Inc. (the “Company”) and its wholly-owned subsidiary, Bank of Lenawee (the “Bank”), conform to accounting principles generally accepted in the United States of America and to general practice within the banking industry. The following describes the significant accounting and reporting policies which are employed in the preparation of the consolidated financial statements.

Basis of Financial Statement Presentation
The accompanying unaudited consolidated interim financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and with the instructions to Form 10-Q. Accordingly, certain information and disclosures required by the accounting principles generally accepted in the United States of America for complete financial statements are not included herein. The interim financial statements should be read in conjunction with the financial statements of Pavilion Bancorp, Inc. and the notes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2005.

All adjustments, consisting of normal recurring adjustments, which in the opinion of management are necessary for a fair presentation of the results of operations and cash flows, have been made. The results of operations for the nine months ended September 30, 2006 are not necessarily indicative of the results that may be expected for the year ended December 31, 2006.

Principles of Consolidation: The consolidated financial statements include the accounts of the Company, the Bank and the Bank’s wholly-owned subsidiaries, Pavilion Mortgage Company and Pavilion Financial Services, Inc. All significant intercompany balances and transactions have been eliminated in consolidation.

Nature of Operations and Industry Segments: The Company is a one-bank holding company which conducts limited business activities. The Bank performs the majority of business activities.

The Bank provides a full range of banking services to individuals, agricultural businesses, commercial businesses and light industries located in its service area. The Bank maintains a diversified loan portfolio, including loans to individuals for home mortgages, automobiles and personal expenditures, and loans to business enterprises for current operations and expansion. The Bank offers a variety of deposit products, including checking accounts, savings accounts, money market accounts, individual retirement accounts and certificates of deposit. Pavilion Mortgage Company originates personal mortgage loans, and the majority of the mortgage loans originated are sold on the secondary market. Pavilion Financial Services, Inc. owns an interest in a title insurance agency. While the Company monitors the revenue stream of various Company products and services, operations are managed and financial performance is evaluated on a Company-wide basis. Accordingly, all of the Company’s banking operations are considered by management to be aggregated into one operating segment. The principal markets for the Bank’s financial services are the communities in which the Bank is located and the areas immediately surrounding these communities. The Bank serves these markets through its offices located in Lenawee and Hillsdale Counties in Michigan.

Recent Accounting Developments:

Servicing of Financial Assets
In March 2006, the Financial Accounting Standards Board issued SFAS No. 156, Accounting for Servicing of Financial Assets, an amendment of FASB Statement No. 140. SFAS No. 156 requires an entity to recognize a servicing asset or liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract. It requires all separately recognized servicing assets and servicing liabilities to be initially measured at fair value. SFAS No. 156 permits an entity to choose either an amortization or fair value measurement method for each class of separately recognized servicing assets and servicing liabilities. It also permits a one-time reclassification of available-for-sale securities to trading securities with recognized servicing rights. Lastly, it requires separate presentation of servicing assets and servicing liabilities. Adoption of the initial measurement provision of this statement is permitted as of the beginning of an entity’s fiscal year, provided the entity has not yet issued financial statements, including interim financial statements, for any period of that fiscal year. Had the new standard been adopted on January 1, 2006, the Company’s retained earnings would have increased by approximately $1.1 million, net of tax.

Page 8

Accounting for Uncertainty in Income Taxes
In July 2006, the Financial Accounting Standards Board issued FIN No. 48, Accounting for Uncertainty in Income Taxes. This interpretation clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes. This interpretation requires that the Company recognize in the financial statements, the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. This interpretation is effective for fiscal years beginning after December 15, 2006 and would be recognized with the cumulative effect of the change in accounting principle recorded as an adjustment to beginning retained earnings. Adoption of this interpretation is not expected to have a material effect on the results of operations or financial condition of the Company.

Establishing Standards on Measuring Fair Value
In September 2006, the FASB issued SFAS No. 157 “Fair Value Measurements.” SFAS No. 157 defines fair value, establishes a framework for measuring fair value in accordance with U.S. GAAP, and expands disclosures about fair value measurements. The statement clarifies that the exchange price is the price in an orderly transaction between market participants to sell an asset or transfer a liability at the measurement date. The statement emphasizes that fair value is a market-based measurement and not an entity-specific measurement. The statement establishes a fair value hierarchy used in fair value measurements and expands the required disclosures of assets and liabilities measured at fair value. Management will be required to adopt this statement beginning in 2008. The adoption of this standard is not expected to have a material impact on the Company’s financial condition, results of operations or liquidity.

Accounting for Defined Benefit Pension and Other Postretirement Plans
In September 2006, the FASB issued SFAS No. 158 “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.” SFAS No. 158 amends SFAS No. 87, 88, 106, and 123(R). SFAS No. 158 requires an employer to recognize in its statement of financial position an asset for a plan’s overfunded status or a liability for a plan’s underfunded status. Secondly, it requires employers to measure the plan assets and obligations that determine its funded status as of the end of the fiscal year. Lastly, employers are required to recognize changes in the funded status of the defined benefit pension or postretirement plan in the year that the changes occur with the changes reported in comprehensive income. The standard is required to be adopted by entities beginning with fiscal years ending after December 15, 2006. The Company is a participant in a multi-employer defined benefit plan, which is not within the scope of this pronouncement. This standard is not expected to have an impact on the Company’s financial condition, results of operations or liquidity.

Quantifying Financial Statement Misstatements
In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 108 (“SAB 108”). SAB 108 expresses the view of the SEC regarding the process of quantifying financial statement misstatements. This statement focuses on addressing the diversity in practice of quantifying financial statement misstatements. The statement addresses the two techniques commonly used in practice in accumulating and quantifying misstatements, the “Rollover Approach” and the “Iron Curtain Approach.” The standard is required to be adopted by the Company on January 1, 2007. The adoption of this standard is not expected to have a material impact on financial condition, results of operations or liquidity.

NOTE 2 – STOCK BASED COMPENSATION
In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), “Share-Based Payment,” which requires that compensation costs related to share-based payment transactions be recognized in the financial statements. SFAS 123R eliminates the alternative to use the intrinsic method of accounting provided for in Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” which generally resulted in no compensation expense recorded in the financial statements related to the grant of stock options to employees or directors if certain conditions were met.

Page 9

On January 1, 2006, the Company adopted SFAS 123R using the modified prospective method. SFAS 123R requires all share-based payments to employees or non-employee directors, including stock options, to be recognized as expense in the consolidated statement of earnings based on their fair values. Prior to SFAS 123R, only certain pro forma disclosures were required. The amount of compensation is measured at fair value of the options when granted, and this cost is expensed over the required service period, which is normally the vesting period of the options. SFAS 123R applies to awards granted or modified after January 1, 2006 or any unvested awards outstanding at December 31, 2005. Consequently, compensation cost is recorded for prior option grants that vest on or after January 1, 2006, the date of adoption.

At September 30, 2006, the Company has two stock compensation plans. Stock option plans are used to reward directors and certain executive officers and provide them with an additional equity interest. Options are issued for 10 year periods and vest over five years. Additionally, the options that are awarded to a director will become fully vested when an active director reaches the age of 62. Prior to adoption of SFAS 123R, the Company accounted for those plans under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. Minimal stock-based employee compensation related to the Stock Option Plans was reflected in net earnings, as substantially all options granted under the Stock Option Plans had an exercise price equal to the market value of the underlying common stock on the date of grant.

The fair value concepts were not changed significantly in SFAS No. 123R; however, in adopting this Standard, companies must choose among alternative valuation models and amortization assumptions. The Company has elected to continue to use the Black-Scholes option pricing model and straight-line amortization of compensation expense over the requisite service period of the grant.

The summary of option activity under the Plan as of September 30, 2006, and changes during the nine months then ended is presented below:

Options	Shares			Weighted Average Exercise Price		Weighted Average Remaining Contractual Term		Aggregate Intrinsic Value
Outstanding, January 1, 2006		30,791		$	45.56
Granted		-			-
Exercised		(1,386	)		17.65
Forfeited or expired		-			-
Outstanding, September 30, 2006		29,405		$	46.88		5.4	$	112,543
Options exercisable, end of period		25,331		$	45.44		5.0	$	112,543

The aggregate intrinsic value in the table above represents the total pretax intrinsic value (i.e., the difference between the Company’s closing stock price on the last trading day of third quarter 2006 and the exercise price, times the number of shares) that would have been received by the option holders had all option holders exercised their options on September 30, 2006. Out of the money options (options that have an exercise price that exceeds market value) are excluded from the computation as they are assumed to have no intrinsic value. This amount changes based on the fair market value of the Company’s stock.

The summary of the status of the Company’s nonvested shares as of September 30, 2006, and changes during the nine months then ended, is presented below:

Nonvested Shares	Shares			Weighted Average Grant Date Fair Value
Nonvested at January 1, 2006		5,692		$	13.86
Granted		-			-
Vested		(1,618	)		14.23
Forfeited		-			-
Nonvested at September 30, 2006		4,074		$	13.71

Page 10

Options outstanding and exercisable at September 30, 2006 were as follows:

	Outstanding						Exercisable
Range of Exercise Prices	Number		Weighted Average Remaining Contractual Life		Weighted Average Exercise Price		Number		Weighted Average Exercise Price
$17.00 - $24.00		3,339		1.0	$	23.36		3,339	$	23.36
$34.00 - $42.00		4,851		2.9	$	38.64		4,851	$	38.64
$48.00 - $52.00		15,965		6.1	$	49.66		13,991	$	49.57
$55.00 - $61.00		5,250		8.3	$	61.00		3,150	$	61.00
Outstanding at period end		29,405		5.4	$	46.88		25,331	$	45.44

The following table illustrates the effect on net income and earnings per share as of and for the three and nine months ended September 30, 2006 and 2005 if the Company had applied the fair value recognition provisions of SFAS No. 123, to stock-based compensation (in thousands, except per share data)

	For the three months ended September 30,						For the nine months ended September 30,
	2006			2005			2006			2005
Net income as reported	$	783		$	477		$	1,878		$	1,200
Add: Stock-based compensation expense included in reported net income, net of related tax effects		4			1			11			8
Deduct: Total stock-based compensation expense determined under fair value based method for all awards, net of related tax effects		(4	)		(22	)		(11	)		(70	)
Pro forma net income	$	783		$	456		$	1,878		$	1,138
Basic earnings per share - As reported	$	1.06		$	0.65		$	2.55		$	1.50
Basic earnings per share - Pro forma	$	1.06		$	0.61		$	2.55		$	1.42
Diluted earnings per share - As reported	$	1.06		$	0.65		$	2.54		$	1.49
Diluted earnings per share - Pro forma	$	1.06		$	0.61		$	2.54		$	1.41

As of September 30, 2006, there was $29,000, net of tax, of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the Plans. This cost is expected to be fully amortized in four years, with half of the total amortization cost being recognized within the next 18 months.

Page 11

NOTE 3 — EARNINGS PER SHARE

Earnings per common share have been computed based on the following for the three and nine months ended September 30, 2006 and 2005 (000’s omitted, except antidilutive stock options):

	Three months ended September 30,				Nine months ended September 30,
	2006		2005		2006		2005
Net income	$	783	$	477	$	1,878	$	1,200
Average number of common shares outstanding used to calculate basic earnings per share		734		735		736		802
Effect of dilutive options		2		3		2		5
Average number of common shares outstanding used to calculate diluted earnings per common share		736		738		738		807
Number of antidilutive stock options excluded from the diluted earnings per share computation		21,215		5,250		21,215		5,250

NOTE 4 – LOANS RECEIVABLE

Loans receivable consist of the following (000’s omitted):

	September 30, 2006			December 31, 2005
Commercial	$	131,379		$	125,378
Agricultural		40,932			38,778
Residential mortgage		30,742			28,113
Residential construction		9,578			11,902
Home equity lines of credit		19,805			20,693
Consumer		12,833			12,734
		245,269			237,598
Less: allowance for loan and lease losses		(2,759	)		(2,683	)
Loans receivable, net	$	242,510		$	234,915

Activity in the allowance for loan and lease losses for the three and nine months ended September 30, are as follows (000’s omitted):

	Three months ended September 30,						Nine months ended September 30,
	2006			2005			2006			2005
Balance at beginning of period	$	2,694		$	2,649		$	2,683		$	2,495
Charge-offs		(56	)		(47	)		(195	)		(121	)
Recoveries		1			13			46			61
Provision for loan losses		120			105			225			285
Balance at end of period	$	2,759		$	2,720		$	2,759		$	2,720

Page 12

NOTE 5 — STANDBY AND COMMERCIAL LETTERS OF CREDIT AND FINANCIAL GUARANTEES

The Bank is a party to credit-related financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit, and commercial letters of credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet.

The Bank’s exposure to credit loss is represented by the contractual amount of these commitments. The Bank follows the same credit policies in making commitments as it does for on-balance-sheet instruments.

The total contractual amounts of commercial and standby letters of credit and financial guarantees were $2.4 million and $3.1 million at September 30, 2006 and December 31, 2005, respectively.

Page 13

ITEM 2 — MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This discussion provides information about the consolidated financial condition and results of operations of the Company as of September 30, 2006 and for the three and nine month periods ended September 30, 2006 and 2005 and should be read in conjunction with the Company’s Condensed Consolidated Financial Statements and the notes thereto, appearing in Part 1, Item 1 of this document.

Forward-Looking Statements
This discussion and analysis of financial condition and results of operations and other sections of this Form 10-Q contain forward looking statements that are based on management’s beliefs, assumptions, current expectations, estimates and projections about the financial services industry, the economy and about the Company itself. Words such as “anticipates”, “believes”, “estimates”, “expects”, “forecasts”, “foresee”, “intends”, “is likely”, “plans”, “projects”, variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions (“Future Factors”) that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecast in such forward-lookingstatements. Furthermore, the Company undertakes no obligation to update, amend or clarify forward-looking statements, whether as a result of new information, future events or otherwise. Future Factors include:

• changes in interest rates and interest rate relationships;

• demand for products and services;

• the degree of competition by traditional and non-traditional competitors;

• changes in banking regulations;

• changes in tax laws;

• changes in prices, levies and assessments;

• the impact of technology, governmental and regulatory policy changes;

• the outcome of pending and future litigation and contingencies;

• trends in customer behavior as well as their ability to repay loans; and

• changes in the national and local economies.

These are representative of the Future Factors that could cause a difference between an actual outcome and a forward-looking statement.

Critical Accounting Policies
Certain of the Company’s accounting policies are important to the portrayal of the Company’s financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Estimates associated with these policies are susceptible to material changes as a result of changes in facts and circumstances. Facts and circumstances which could affect these judgments include, but without limitation, changes in interest rates, in the performance of the economy or in the financial condition of borrowers. Management believes that its critical accounting policies include valuation of the allowance for loan and lease losses, fair value of securities and other financial instruments, the valuation of mortgage servicing rights and deferred tax and tax provision estimates. The Company’s critical accounting policies are described in the financial section of its 2005 Annual Report.

Financial Overview
Total assets increased by $10.5 million or 3.7% from December 31, 2005 to September 30, 2006. Cash and cash equivalents increased $3.6 million or 31.8%. Loans receivable, net of the allowance for loan and lease losses, increased by $7.6 million or 3.2% from December 31, 2005 to September 30, 2006. Investment securities available for sale decreased $1.4 million or 5.5% from December 31, 2005 to September 30, 2006. Total deposits increased $22.6 million or 10.7% from December 31, 2005 to September 30, 2006. Borrowed funds decreased $13.2 million or 33.2%. Basic earnings per share (“EPS”) for the three and nine months ended September 30, 2006 were $1.06 per share and $2.55 per share, respectively. For the same periods in 2005 basic EPS were $0.65 and $1.50, respectively. Fully diluted EPS for the three and nine months ended September 30, 2006 were $1.06 per share and $2.54 per share, respectively. For the same periods in 2005 fully diluted EPS were $0.65 and $1.49 per share, respectively.

Page 14

FINANCIAL CONDITION

Investments
Total investments securities available-for-sale decreased 5.5%, or $1.4 million, to $24.0 million at September 30, 2006, compared to $25.4 million at December 31, 2005. The decrease in investment securities is attributable to maturities and repayments on investments. Equity investment in the Federal Home Loan Bank of Indianapolis (“FHLBI”) decreased $500,000 or 18.5% to $2.3 million at September 30, 2006 compared to $2.8 million at December 31, 2005. Investment in Federal Reserve Bank (“FRB”) stock remains unchanged at $630,000 as of September 30, 2006 and December 31, 2005. The Company had no held-to-maturity securities as of September 30, 2006 or December 31, 2005.

Loans
The following table summarizes the Bank’s loan portfolio and loan mix at September 30, 2006 and December 31, 2005:

Consolidated Loans Outstanding

(000's omitted)	September 30, 2006						December 31, 2005
	Amount			Percent of Loans			Amount			Percent of Loans
Commercial	$	131,379			53.6	%	$	125,378			52.8	%
Agricultural		40,932			16.7	%		38,778			16.3	%
Residential mortgage		30,742			12.5	%		28,113			11.8	%
Residential construction		9,578			3.9	%		11,902			5.0	%
Home equity lines of credit		19,805			8.1	%		20,693			8.7	%
Consumer		12,833			5.2	%		12,734			5.4	%
Total loans receivable		245,269			100.0	%		237,598			100.0	%
Less: allowance for loan and lease losses		(2,759	)					(2,683	)
Loans receivable, net	$	242,510					$	234,915

During the first nine months of 2006, loans, net of allowance for loan and lease losses, increased $7.6 million, or 3.2%. The mix of the loan portfolio continues to remain relatively unchanged from the prior year. The commercial and agricultural loan portfolios increased by $6.0 million or 4.8% and $2.1 million or 5.6%, respectively. The increase in the commercial portfolio is due to business development efforts. The increase in the agricultural portfolio is related to seasonal draws on lines as well as an increase in the number of agricultural loans. The residential mortgage loan portfolio grew by $2.6 million or 9.4% due to increased demand for bridge loans as well as real estate development efforts. The residential construction loan portfolio decreased approximately $2.3 million, or 19.5%, and is consistent with the slowing in the real estate market. Home equity lines of credit decreased approximately $0.9 million, or 4.3%, as customers look to move from variable rate home equity lines to more fixed rate mortgage products. Consumer loans increased slightly in the first nine months of 2006 as well, as new loans have outpaced repayments. Management expects the loan portfolios in the fourth quarter to decrease as demand for loans slows and lines of credit are repaid prior to the end of the calendar year.

Page 15

Off-Balance Sheet Items
The following is a summary of outstanding commitments by the Bank to grant loans, unfunded commitments under lines of credit and letters of credit at September 30, 2006 and December 31, 2005:

(000's omitted)	September 30, 2006		December 31, 2005
Loan Category:
Commitments to originate or refinance loans	$	14,076	$	7,370
Unfunded commitments under lines of credit		61,047		61,242
Commercial and standby letters of credit		2,423		3,051
Total	$	77,546	$	71,663

Outstanding commitments to originate or refinance loans increased $6.7 million, or 90.5%, to $14.1 million at September 30, 2006 from $7.4 million at December 31, 2005. This increase in commitments to originate or refinance loans is due primarily to increased loan demand coupled with continued business development activities. Unfunded commitments under lines of credit decreased $0.2 million or 0.3% to $61.0 million as of September 30, 2006 from $61.2 million at December 31, 2005. This decrease in the unfunded level is primarily due to increased draw activity on existing lines of credit, which has reduced the amount available for draw. Commercial and standby letters of credit have decreased approximately $0.7 million or 20.6% to $2.4 million as of September 30, 2006 down from $3.1 million as of December 31, 2005. Management does not expect that all commitments will result in funded loans.

Credit Quality
The Bank continues to monitor the asset quality of the loan portfolio utilizing the Chief Credit Officer who, combined with external loan review specialists, periodically submits reports to the Chief Executive Officer, Chief Financial Officer, Chief Lending Officer and to the Board of Directors regarding the credit quality of each loan portfolio. This review is independent of the loan approval process. Also, management continues to monitor delinquencies, nonperforming assets and potential problem loans to assess the continued quality of the Bank’s loan portfolios.

Nonperforming loans are comprised of (1) loans accounted for on a nonaccrual basis, (2) loans contractually past due 90 days or more as to interest or principal payments (but not included in the nonaccrual loans in (1) above) and (3) other nonperforming loans including real estate held for redemption, which is classified within (1) or (2) above dependent upon the respective collateralized position. The aggregate amount of nonperforming loans, in thousands of dollars, is shown in the table below. The Bank’s classifications of nonperforming loans are generally consistent with loans identified as impaired.

The chart below shows the composition of the Bank’s nonperforming assets by type as of September 30, 2006 and 2005, and December 31, 2005.

(000's omitted)	September 30, 2006			December 31, 2005			September 30, 2005
Non-accruing loans past due	$	1,640		$	1,104		$	667
Loans past due 90 days or more still accruing		606			672			497
Total nonperforming loans		2,246			1,776			1,164
Other real estate		315			549			587
Total nonperforming assets	$	2,561		$	2,325		$	1,751
Nonperforming loans as a percent of total loans		0.92	%		0.75	%		0.50	%
Nonperforming assets as a percent of total assets		0.86	%		0.81	%		0.75	%
Nonperforming loans as a percent of the allowance for
loan and lease losses		81.41	%		66.19	%		42.79	%

At September 30, 2006, total nonperforming assets increased by $236,000 or 10.2% from December 31, 2005. The Bank is closely monitoring and managing nonperforming loans to determine and implement corrective action to improve the quality of nonperforming assets. Non-accruing loans increased $0.5 million to $1.6 million as of September 30, 2006 up from $1.1 million as of December 31, 2005. Of this increase, approximately $600,000 went into nonaccrual status in June 2006. The increase was primarily in residential real estate loans, and management believes the Bank is adequately reserved on these loans. Loans past due 90 days and still accruing are loans that management considers to be adequately collateralized to support continued accrual of interest. Nonperforming assets as a percentage of total assets have increased to 0.86% at September 30, 2006 compared to 0.81% at December 31, 2005. The increase relates primarily to the increase in non-accruing loans discussed above. Nonperforming loans as a percentage of the allowance for loan and lease losses increased to 81.41% as of September 30, 2006 compared to 66.19% and 42.79% as of December 31, 2005 and September 30, 2005, respectively. As discussed above, the increase in nonperforming loans is primarily in residential real estate loans, for which management believes that the Bank is adequately reserved. Approximately $596,000 of the nonperforming loans at September 30, 2006 represents agricultural loans that are partially guaranteed by the Farm Service Agency and management believes that they are adequately reserved.

Page 16

The activity in the allowance for loan and lease losses for the three months ended September 30, 2006 and 2005 and the nine months ended September 30, 2006 and 2005 is presented in the following table:

	Three months ended September 30,						Nine months ended September 30,
	2006			2005			2006			2005
Beginning balance	$	2,694		$	2,649		$	2,683		$	2,495
Loan charge-offs		(56	)		(47	)		(195	)		(121	)
Loan recoveries		1			13			46			61
Net loan charge-offs		(55	)		(34	)		(149	)		(60	)
Provision for loan losses		120			105			225			285
Ending balance	$	2,759		$	2,720		$	2,759		$	2,720
Net charge-off rate		0.09	%		0.06	%		0.08	%		0.04	%

The Bank decreased its funding of provision for loan losses during the first nine months of 2006 over the same period in 2005 based on management’s assessment of the adequacy of the allowance for loan and lease losses. The total loan portfolio has increased to $245.3 million as of September 30, 2006 compared to $233.0 million outstanding as of September 30, 2005. Management is continuing to monitor credits with the increase in the level of non-performing loans. Management discusses problem credits in periodic loan committee meetings. Problem credits are also monitored by the Board of Directors during monthly reviews of watch list. Management is actively calling on past due loans before the loans reach 30 days past due. Management is also proactively calling on troubled industry clients, including construction contractors, manufacturing, etc. Management believes that the level of allowance is appropriate given the present credit quality of the portfolio.

The Bank maintains an allowance for loan and lease losses believed to be sufficient to absorb estimated probable credit losses inherent in the loan portfolio, recognizing the imprecision inherent in the process of estimating credit losses. The allowance represents management’s estimate of probable net loan charge-offs in the portfolio at each balance sheet date. The allowance contains provisions for probable losses that have been identified relating to specific borrowing relationships as well as probable losses believed to be inherent in the loan portfolio without specific identification of loan relationships.

The amount of provision for loan losses recognized by the Bank is based on management’s evaluation as to the amounts required to maintain an allowance adequate to provide for potential losses inherent in the loan portfolio. The level of the allowance is dependent upon the total amount of classified loans, past due and non-performing loans, historical charge-off experience, general economic conditions and management’s assessment of potential losses based upon internal credit evaluation of the loan portfolio and particular loans. In determining the provision for loan losses, management first determines the estimated allowance required for any specifically identified classified loans. Management then estimates potential charge-offs based on historical experience. Management also evaluates the general loan portfolio for credit risk based upon, but not limited to, the criteria noted above, and allocates an amount believed to be sufficient to cover estimated loan charge-offs inherent in the general loan portfolio. Management may then add, at its discretion, an allocation amount to adjust for current economic conditions, any additional perceived credit risk in the portfolio and any other information that management considers relevant.

Page 17

Deposits and Borrowed Funds
Total deposits increased $22.6 million or 10.7% during the first nine months to $233.3 million at September 30, 2006 from $210.7 million at December 31, 2005. Noninterest-bearing deposits increased $3.9 million, or 8.5% to $49.2 million at September 30, 2006 from $45.3 million at December 31, 2005. Interest-bearing deposits increased $18.7 million, or 11.3% to $184.1 million at September 30, 2006 from $165.4 million at December 31, 2005. Specifically, certificates of deposit (“CD’s”) with balances of $100,000 and greater (Jumbo CD’s) increased $16.1 million, or 29.3%, to $71.2 million at September 30, 2006 from $55.1 million at December 31, 2005. The increase in Jumbo CD’s is attributable to a greater amount of local municipal deposits obtained through a competitive bidding process. Generally, municipal CD’s have shorter maturity lengths and thus can reprice more often than longer term CD’s. Certificates of Deposit with balances under $100,000 increased $4.7 million, or 13.0%, to $41.6 million at September 30, 2006 from $36.9 million at December 31, 2005. This increase is the result of business development efforts within the local communities. Other interest-bearing deposits, including savings and NOW accounts, decreased $2.1 million, or 3.0% to $71.3 million at September 30, 2006 from $73.4 at December 31, 2005. Management believes that this decrease represents a normal business fluctuation.

Borrowed funds decreased by $13.2 million, or 33.2%, to $26.4 million at September 30, 2006 from $39.6 million at December 31, 2005. The increased level of deposits was used to fund the repayments of other borrowings.

Capital
During the first nine months of 2006, equity capital increased by $1.5 million, reflecting current year earnings as well as the exercise of stock options. The number of outstanding shares at December 31, 2005 of 735,379 decreased to 731,408 at September 30, 2006, as a result of the redemption and retirement of shares from the Company’s ESOP/401k plan. The Bank continues to maintain sufficient risk-based capital levels to remain categorized as “well-capitalized” under federal regulatory requirements. “Well capitalized” institutions are eligible for reduced FDIC premiums, and also enjoy other reduced regulatory restrictions. Management monitors the capital levels of the Company and the Bank to provide for current and future business opportunities.

RESULTS OF OPERATIONS

Net Income
Net income for the three months ended September 30, 2006 increased $306,000, or 64.2% to $783,000 compared to $477,000 for the same period in 2005. Basic earnings per share (“EPS”) attributable to continuing operations for the three months ended September 30, 2006 were $1.06 compared to $0.65 for the same period in 2005. Diluted EPS for the three months ended September 30, 2006 were $1.06 compared to $0.65 for the same period in 2005.

Net income for the nine months ended September 30, 2006 increased $0.7 million, or 56.5% to $1.9 million compared to $1.2 million for the same period in 2005. Basic earnings per share (“EPS”) attributable to continuing operations for the nine months ended September 30, 2006 were $2.55 compared to $1.50 for the same period in 2005. Diluted EPS for the nine months ended September 30, 2006 were $2.54 compared to $1.49 for the same period in 2005.

Page 18

Net Interest Margin
Following are the net interest margin calculations for the three and nine months ended September 30, 2006 and 2005:

	Three months ended
	September 30, 2006							September 30, 2005
(000's omitted)	Average Outstanding Balance		Interest Earned/ Paid		Yield/ Rate			Average Outstanding Balance		Interest Earned/ Paid		Yield/ Rate
Interest-earning assets:
Loans receivable (1)	$	243,218	$	4,627		7.55	%	$	226,547	$	3,928		6.88	%
Securities available for sale (3)		24,088		204		3.36	%		26,355		223		3.36	%
Federal funds sold		3,515		48		5.42	%		640		5		3.10	%
Equity securities (2)		3,022		38		5.00	%		3,275		39		4.72	%
Interest-earning balances with
other financial institutions		104		1		3.81	%		59		1		6.72	%
Total interest-earning assets		273,947		4,918		7.12	%		256,876		4,196		6.48	%
Noninterest-earning assets:
Cash and due from financial
institutions		8,204							11,069
Premises and equipment, net		6,707							5,631
Other assets		6,051							6,504
Total assets	$	294,909						$	280,080
Interest-bearing liabilities:
Interest-bearing demand deposits	$	46,167		228		1.96	%	$	43,322		124		1.14	%
Savings deposits		27,090		27		0.40	%		31,185		28		0.36	%
Time deposits		103,816		1,184		4.52	%		95,388		764		3.18	%
Subordinated debentures		5,000		117		9.28	%		5,000		94		7.46	%
Other borrowings		32,803		363		4.39	%		26,414		246		3.69	%
Total int.-bearing liabilities		214,876		1,919		3.54	%		201,309		1,256		2.48	%
Demand deposits		46,867							43,147
Other liabilities		6,029							7,327
Total liabilities		267,772							251,783
Shareholders' equity		27,137							28,297
Total liabilities and shareholders'
equity	$	294,909						$	280,080
Net interest income			$	2,999						$	2,940
Interest rate spread (4)						3.58	%						4.00	%
Net interest margin (5)						4.34	%						4.54	%
Ratio of interest-earning assets
to interest-bearing liabilities		1.27							1.28

Page 19

	Nine months ended
	September 30, 2006							September 30, 2005
(000's omitted)	Average Outstanding Balance		Interest Earned/ Paid		Yield/ Rate			Average Outstanding Balance		Interest Earned/ Paid		Yield/ Rate
Interest-earning assets:
Loans receivable (1)	$	237,354	$	13,083		7.37	%	$	216,257	$	10,883		6.73	%
Securities available for sale (3)		24,492		618		3.37	%		27,740		696		3.35	%
Federal funds sold		4,934		183		4.96	%		3,482		67		2.57	%
Equity securities (2)		3,289		127		5.16	%		3,199		107		4.47	%
Interest-earning balances with
other financial institutions		186		7		5.03	%		165		3		2.43	%
Total interest-earning assets		270,255		14,018		6.93	%		250,843		11,756		6.27	%
Noninterest-earning assets:
Cash and due from financial
institutions		9,093							10,839
Premises and equipment, net		6,528							5,628
Other assets		5,879							6,459
Total assets	$	291,755						$	273,769
Interest-bearing liabilities:
Interest-bearing demand deposits	$	46,505		630		1.81	%	$	51,348		427		1.11	%
Savings deposits		28,479		78		0.37	%		31,858		83		0.35	%
Time deposits		102,913		3,177		4.13	%		84,980		1,798		2.83	%
Subordinated debentures		5,000		331		8.85	%		5,000		261		6.98	%
Other borrowings		30,018		920		4.10	%		18,056		493		3.65	%
Total int.-bearing liabilities		212,915		5,136		3.23	%		191,242		3,062		2.14	%
Demand deposits		45,969							42,427
Other liabilities		5,805							7,740
Total liabilities		264,689							241,409
Shareholders' equity		27,066							32,360
Total liabilities and shareholders'
equity	$	291,755						$	273,769
Net interest income			$	8,882						$	8,694
Interest rate spread (4)						3.70	%						4.13	%
Net interest margin (5)						4.39	%						4.63	%
Ratio of interest-earning assets
to interest-bearing liabilities		1.27							1.31

(1) Non-accrual loans and overdrafts are included in the average balances of loans.

(2) Includes Federal Home Loan Bank and Federal Reserve Bank stock.

(3) Interest income on tax-exempt securities has not been adjusted to a taxable equivalent basis.

(4) Interest rate spread is the difference between rates of interest-earning assets and rates of interest paid on interest-bearing liabilities

(5) Net interest margin is the net interest income divided by average interest-earning assets.

The yield on interest-earning assets increased for the quarter ended September 30, 2006 to 7.12% from 6.48% as compared to the same period in the prior year. Much of the increase was due to increases in the yield in the loan portfolio with the prime rate changes within the last twelve months. The yield on loans receivable increased to 7.55% for the three months ended September 30, 2006 from 6.88% for the same period in 2005. The consumer loan portfolio had the greatest increase in yield as it is primarily a variable rate portfolio followed by the commercial lending portfolio which also has a significant portion of variable rate loans.

Page 20

The Company’s interest rate spread decreased for the three months ended September 30, 2006 to 3.58% from 4.00% for the same period in 2005. This decrease is due to the increase in the rates paid on interest-bearing liabilities, which increased to 3.54% for the three months ended September 30, 2006 from 2.48% for the same period in 2005, which was expected with the increasing rate environment. Rate increases within the deposit categories were driven by increases in short-term interest rates as well as competition within the local market to maintain and attract customers.

The yield on interest-earning assets increased for the nine months ended September 30, 2006 to 6.93% from 6.27% for the same period in 2005. The increase primarily was in the yield on loans receivable which increased to 7.37% for the nine months ended September 30, 2006 from 6.73% for the same period in 2005. As indicated above, much of this increase was due to the increases to the prime lending rate within the last twelve months.

The Company’s interest rate spread decreased for the nine months ended September 30, 2006 to 3.70% from 4.13% for the same period in 2005. This decrease is due primarily to the increase in the rates paid on interest-bearing liabilities, which increased to 3.23% for the nine months ended September 30, 2006 from 2.14% for the same period in 2005, which was expected with the increasing rate environment as well as of the influence of competition within the local market. In addition, the variable rate paid on the subordinated debentures continues to increase and is at a coupon rate of 9.17% as of September 30, 2006. The subordinated debentures are eligible for call as of December 8, 2006, and the Company has elected to redeem the subordinated debentures on that date. Management is presently evaluating lower cost options for funding to replace these funds. As a result of the redemption, the Company will recognize approximately $140,000 of unamortized deferred costs as an expense at the time of redemption. Management believes that the costs incurred as a result of the redemption will be more than offset by the reduction in interest expense. The Company’s net interest margin remains relatively strong compared to our peers.

Noninterest Income
Total non-interest income decreased $82,000 or 10.2% to $719,000 for the three months ended September 30, 2006 compared to $801,000 for the same period in 2005. Service charges on deposit accounts decreased $5,000. A decline in gains on residential mortgage loan sales accounted for approximately $143,000 of the decrease, which was consistent with a decrease in mortgage banking activity. Loan servicing fees, net of amortization, increased $20,000 due to increases in the loan servicing portfolio. Other income increased $46,000 due primarily to fee income earned on Merchant Visa services.

For the nine months ended September 30, 2006, total non-interest income declined 13.9% to $2.3 million, compared to $2.6 million for the same period in 2005. The most significant decrease was in the net gains on sale of loans, which decreased 30.2% or $336,000 due to a reduction in mortgage volume. Mortgage loan sales were down approximately 28.6% in the first nine months of 2006 compared to the same period in 2005, as the volume from mortgage production has been significantly reduced due to the continued rise in rates for the mortgage loan products in 2006 and a slowing of the local real estate market. Loan servicing fees, net of amortization decreased $197,000 for the first nine months of the year due to increased levels of amortization of the mortgage servicing asset. Service charges and fees on deposit accounts increased $27,000 for the first nine months of 2006 compared to the same period in 2005 with the increase in transactional deposit accounts. Other income increased $139,000 for the first nine months of 2006 due primarily to fee income earned on Merchant Visa services, as discussed above.

Noninterest Expense
For the three months ended September 30, 2006, total non-interest expense decreased $404,000 or 13.7% to $2.5 million from $2.9 million for the same period in 2005. The most significant decrease was in compensation and employee benefits, which was down $295,000 for the three months ended September 30, 2006 compared to the same period in 2005, due in large part to the cost savings associated with Reduction-in-Force plans (“RIF) which were developed with the goal of increasing operational efficiency. The Bank eliminated various staff positions in the first quarters of 2006 and 2005. Occupancy and equipment expenses increased by $32,000 or 9.1% to $383,000, up from $351,000 for the same period in 2005. This increase is primarily related to the costs associated with the new branch that was opened in the first quarter of 2006. Professional services expense decreased by $26,000 or 17.1% to $126,000 down from $152,000 for the same period in 2005. This is due to a decrease in legal and consulting costs in the third quarter of 2006 as compared with 2005. Marketing expense has decreased $47,000 or 67.1% to $23,000 down from $70,000 for the same period in 2005 and other noninterest expense decreased approximately $74,000 or 32.7% over the prior year due largely to cost reduction efforts in these areas.

Page 21

Noninterest expense for the nine months ended September 30, 2006 was $8.3 million, compared to $9.3 million for the same period in 2005, a decrease of approximately $1.0 million or 10.8%. Compensation and employee benefits decreased $662,000 or 12.0%, to $4.9 million for the nine months ended September 30, 2006 compared to $5.5 million for the same period in 2005. As discussed above, the first quarters of both 2006 and 2005 were impacted by Reduction-in-Force plans (“RIF”), in which the Bank eliminated various staff positions in an effort to improve the Bank’s operational efficiency. In certain circumstances, severance packages were provided to employees affected by the RIF which increased compensation cost. The aggregate cost of the RIF plans were approximately $210,000 and $264,000 for 2006 and 2005, respectively, and were accrued for as of March 31^st of the respective years. The decrease seen in the first nine months of 2006 was due in large part to the cost savings associated with the aforementioned RIF’s. Occupancy and equipment costs remained relatively consistent at $1.1 million for the nine months ended September 30, 2006 and 2005, respectively. Fees for professional services decreased approximately $157,000 or 28.2% to $399,000 in the first nine months of 2006 compared to $556,000 for the same period in 2005. The nine months ended September 30, 2005 included higher than expected costs associated with the Company’s auditing firms for services related to contingency planning, Sarbanes-Oxley compliance and additional work related to the Company’s 2005 annual report as well as costs associated with the tender offer completed in the second quarter of 2005. Marketing expense decreased $67,000 or 37.2%, to $113,000 for the nine months ended September 30, 2006 compared to $180,000 for the same period in 2005. Other outside services increased $23,000 or 2.9% to $818,000 for the nine months ended September 30, 2006 compared to $795,000 for the same period in 2005. Other operating expenses decreased approximately $140,000, or 26.1%, for the nine months ended September 30, 2006 to $397,000 compared to $537,000 for the same period in 2005. This decrease is due to management’s focus on cost reductions.

Federal Income Tax
The provision for federal income tax was $280,000 or 26.3% of pretax income for the three month period ended September 30, 2006, compared to $220,000 or 31.6% for the same period in 2005. The increase in the income tax provision reflects the increase in net income generated in the three months ended September 30, 2006 versus the same period in 2005. The reduction in the effective tax rate is the result of absorption of some of the prior year over accrual of the federal income tax liability. The provision for federal income tax was $766,000 or 29.0% of pretax income from continuing operations for the nine month period ended September 30, 2006, compared to $563,000 or 31.9% for the same period in 2005. The cause of the increase in income tax provision for the nine months ended September 30, 2006 is substantially the same as noted above. The difference between the statutory rate and the effective tax rate is due primarily to tax-exempt municipal income and non-deductible expenses.

Liquidity and Capital Resources
Liquidity is the ability to meet current and future financial obligations, including the ability to have funds available to respond to the needs of depositors and borrowers as well as maintaining the flexibility to take advantage of investment opportunities. The Company’s primary sources of funds consist of deposit inflows, loan repayments, maturities and sales of investment securities and borrowings from the FHLBI. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition.

Liquidity management is both a daily and long-term responsibility of management. The Company adjusts its investments in liquid assets based upon management’s assessment of (1) expected loan demand, (2) expected deposit flows, (3) yields available on interest-earning deposits and securities, and (4) the objectives of its asset/liability management program. Excess liquid assets are invested generally in interest-earning overnight deposits and short- and immediate-term U.S. Government and agency obligations.

The Company’s most liquid assets are cash and short-term investments. The levels of these assets are dependent on the Company’s operating, financing, lending and investing activities during any given period. At September 30, 2006, cash and short-term investments totaled $14.9 million and securities classified as available for sale totaled $24.0 million. However, available-for-sale securities with a market value of $13.7 million were pledged as collateral for Treasury Tax & Loan accounts and repurchase agreements and therefore were not available for liquidity needs. The amortized cost of the available-for-sale securities was more than the fair value at quarter end, primarily as the result of increasing interest rates, which resulted in an unrealized loss of $256,000 within the investment portfolio. This unrealized loss, however, is normal given interest rate changes and does not represent a permanent impairment of value to the investment portfolio. The unrealized losses were 5% or less of their respective amortized cost basis. Management does not consider such an unrealized loss a material risk to the Company’s capital. Management does not believe the sale of any of the Company’s securities would materially affect the overall financial condition of the Company. Management believes it has sufficient liquidity and sources to meet its obligations without the sale of securities.

Page 22

Financing activities consist primarily of activity in deposit accounts, overnight borrowings from our correspondent banks and FHLBI advances. The Bank experienced a net increase in total deposits of $22.6 million for the nine months ended September 30, 2006. Deposit flows are affected by the overall level of interest rates, products offered by the Bank and its local competitors as well as other factors.

The Bank’s borrowing position decreased during the first nine months of 2006 from $39.6 million at December 31, 2005 compared to the balance of $26.4 million as of September 30, 2006. As of September 30, 2006, the Bank had the ability to borrow a total of $15.3 million from the FHLBI based upon the amount of collateral pledged, of which $13.7 million was outstanding at that date. In addition to the FHLBI, the Bank had available borrowings on a line-of-credit of $10 million from a correspondent bank, which had not been drawn upon as of September 30, 2006. The Bank also had outstanding advances on repurchase agreements totaling $12.8 million at September 30, 2006, based on the collateral pledged. Additional advances could be obtained through repurchase agreements provided additional collateral is pledged. Repurchase agreements are terminable upon demand.

At September 30, 2006, the Bank had outstanding commitments to fund loans of $14.1 million, of which $10.9 million had fixed interest rates. The Bank believes that it will have sufficient funds available to meet its current loan commitments. Loan commitments, in recent periods, have been funded through liquidity and through FHLBI borrowings. Based on the foregoing, the Company considers its liquidity and capital resources sufficient to meets its outstanding short-term and long-term needs.

The Company is subject to various regulatory capital requirements administered by the Federal Deposit Insurance Corporation including a risk-based capital measure. The risk-based capital guidelines include both a definition of capital and a framework for calculating risk-weighted assets by assigning balance sheet assets and off-balance sheet items to broad risk categories.

Page 23

At September 30, 2006 and December 31, 2005, the Company and the Bank exceeded all regulatory minimum capital requirements. Beginning in the first quarter of 2006, the Company became exempt from the Capital Guidelines, as the Board of Governors of the Federal Reserve System increased the asset size threshold from $150 million to $500 million in consolidated assets for determining whether a Bank Holding Company may qualify for an exemption from the Capital Guidelines. Under the revised regulatory financial reporting requirements, the Company will only be required to file parent-only financial data on a semi-annual basis. This change only impacts the Company and the Bank will continue to file necessary regulatory reports. The Bank continues to maintain sufficient risk-based capital levels to remain categorized as “well-capitalized” under federal regulatory requirements.

	Actual					Minimum Required For Capital Adequacy Purposes				Minimum Required to be Well-Capitalized Under Prompt Corrective Action Regulations
	Amount		Ratio			Amount		Ratio		Amount		Ratio
September 30, 2006
Total Capital (to risk weighted assets)
Bank of Lenawee	$	35.5		13.5	%	$	21.0		>=8.0%	$	26.3		>=10.0%
Tier 1 Capital (to risk weighted assets)
Bank of Lenawee	$	32.8		12.5	%	$	10.5		>=4.0%	$	15.8		>=6.0%
Tier 1 Capital (to average assets)
Bank of Lenawee	$	32.8		11.1	%	$	11.8		>=4.0%	$	14.7		>=5.0%
December 31, 2005
Total Capital (to risk weighted assets)
Consolidated	$	37.3		15.2	%	$	19.6		>=8.0%		n/a		n/a
Bank of Lenawee	$	33.3		13.7	%	$	19.4		>=8.0%	$	24.3		>=10.0%
Tier 1 Capital (to risk weighted assets)
Consolidated	$	34.7		14.1	%	$	9.8		>=4.0%		n/a		n/a
Bank of Lenawee	$	30.6		12.6	%	$	9.7		>=4.0%	$	14.5		>=6.0%
Tier 1 Capital (to average assets)
Consolidated	$	34.7		12.4	%	$	11.2		>=4.0%		n/a		n/a
Bank of Lenawee	$	30.6		10.7	%	$	11.5		>=4.0%	$	14.3		>=5.0%

ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company’s primary market risk exposure is interest rate risk and liquidity risk. All of the Company’s transactions are denominated in U.S. dollars with no specific foreign exchange exposure. The Company has a limited exposure to commodity prices related to agricultural loans. Any impacts that changes in foreign exchange rates and commodity prices would have on interest rates are assumed to be insignificant.

Interest rate risk (IRR) is the exposure of a banking organization’s financial condition to adverse movements in interest rates. Accepting this risk can be an important source of profitability and shareholder value; however, excessive levels of IRR could pose a significant threat to our earnings and capital base. Accordingly, effective risk management that maintains IRR at prudent levels is essential to the Company’s safety and soundness. The Board of Directors has instituted a policy setting limits on the amount of interest rate risk that may be assumed. Management provides information to the Board of Directors on a monthly basis detailing interest rate risk estimates and activities to control such risk.

Evaluating a financial institution’s exposure to changes in interest rates includes assessing both the adequacy of the management process used to control IRR and the organization’s quantitative level of exposure. When assessing the IRR management process, the Company seeks to ensure that appropriate policies, procedures, management information systems and internal controls are in place to maintain IRR at prudent levels with consistency and continuity. Evaluating the quantitative level of IRR exposure requires the Company to assess the existing and potential future effects of changes in interest rates on its consolidated financial condition, including capital adequacy, earnings, liquidity, and, where appropriate, asset quality.

Page 24

The Company has not experienced a material change in its financial instruments that are sensitive to changes in interest rates since December 31, 2005, which information can be located in the Company’s annual report on Form 10-K.

ITEM 4 - CONTROLS AND PROCEDURES

(a) Evaluation of Disclosure Controls and Procedures. As of September 30, 2006, an evaluation was performed under the supervision and with the participation of the Company’s management, including the Chief Executive Officer (CEO) and Chief Financial Officer (CFO), of the effectiveness of the design and operation of the Company’s disclosure controls and procedures [(as defined in Exchange Act Rules 13a – 15(e) and 15d – 15(e))]. Based on that evaluation, the Company’s management, including the CEO and CFO, concluded that the Company’s disclosure controls and procedures were adequate and effective as of September 30, 2006, to ensure that material information relating to the Company would be made known to them by others within the Company, particularly during the period in which this Form 10-Q was being prepared.

(b) Changes in Internal Controls. During the period covered by this report, there have been no changes in the Company’s internal control over financial reporting that have materially affected or are reasonably likely to materially affect the Company’s internal control over financial reporting.

PART II
OTHER INFORMATION

ITEM 1 - LEGAL PROCEEDINGS
The Company is not involved in any material legal proceedings. The Company’s wholly-owned subsidiary, Bank of Lenawee, is involved in ordinary routine litigation incident to its business; however, no such proceedings are expected to result in any material adverse effect on the operations or earnings of the Bank. Neither the Bank nor the Company are involved in any proceedings to which any director, principal officer, affiliate thereof, or person who owns of record or beneficially five percent (5%) or more of the outstanding stock of the Company or the Bank, or any associate of the foregoing, is a party or has a material interest adverse to the Company or the Bank.

ITEM 1A - RISK FACTORS
There have been no material changes in the risk factors applicable to the Company from those disclosed in its annual report on Form 10-K for the year ended December 31, 2005.

Page 25

ITEM 2 - UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

(c) During the three-month period ended September 30, 2006, the Company repurchased the following shares of its common stock:

Period	(a) Total Number of Shares Purchased		(b) Average Price Paid per Share		(c) Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs		(d) Maximum Number (or Approximate Dollar Value) of Shares that May Yet Be Purchased Under the Plans or Programs
June 1 - June 30, 2006		0		N/A		N/A		N/A
August 1 - August 31, 2006		5,357(1)		$48.50		0		N/A
Sept. 1 - Sept. 30, 2006		0		N/A		N/A		N/A

(1) These shares of common stock were purchased by the Company in satisfaction of its obligation under its Employee Stock Ownership and 401(k) Savings Plan to repurchase shares of common stock distributed to a Plan participant upon request by such participant. Pursuant to the terms of the Plan, the price paid by the Company is the most recent appraised value of the Company's common stock.

ITEM 3 - DEFAULTS UPON SENIOR SECURITIES - None

Page 26

ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - None

ITEM 5 - OTHER INFORMATION — None

ITEM 6 - EXHIBITS

Listing of Exhibits (numbered as in Item 601 of Regulation S-K):

31.1 Certificate of the Chief Executive Officer of Pavilion Bancorp, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2 Certificate of the Chief Financial Officer of Pavilion Bancorp, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1 Certificate of the Chief Executive Officer and the Chief Financial Officer of Pavilion Bancorp, Inc. pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

Page 27

SIGNATURES

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

Date: November 10, 2006





Date: November 10, 2006 Pavilion Bancorp, Inc.


/s/ Richard J. DeVries
——————————————
Richard J. DeVries
President and Chief Executive Officer


/s/ Mark D. Wolfe
——————————————
Mark D. Wolfe
Chief Financial Officer

Page 28

EXHIBIT INDEX

Exhibit Description

31.1 Certificate of the Chief Executive Officer of Pavilion Bancorp, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2 Certificate of the Chief Financial Officer of Pavilion Bancorp, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1 Certificate of the Chief Executive Officer and the Chief Financial Officer of Pavilion Bancorp, Inc. pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

Page 29