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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-Q
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|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2009
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
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Commission file number 000-23777
PENSECO FINANCIAL SERVICES CORPORATION
Incorporated pursuant to the laws of Pennsylvania
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Internal Revenue Service -- Employer Identification No. 23-2939222
150 North Washington Avenue, Scranton, Pennsylvania 18503-1848
(570) 346-7741
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Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes |X| No |_|
Indicate by check mark whether the registrant has submitted electronically and
posted on its corporate Web site, if any, every Interactive Date File required
to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section
232.405 of this chapter) during the preceding 12 months (or for such shorter
period that the registrant was required to submit and post such files).
Yes |_| No |_|
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
the definitions of "large accelerated filer," "accelerated filer" and "smaller
reporting company" in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer |_|
Accelerated filer |X|
Non-accelerated filer |_| (Do not check if a smaller reporting company)
Smaller reporting company |_|
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act).
Yes |_| No |X|
The total number of shares of the registrant's Common Stock, $0.01 par value,
outstanding on July 31, 2009 was 3,276,079.
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PENSECO FINANCIAL SERVICES CORPORATION
PAGE
----
PART I -- FINANCIAL INFORMATION
Item 1. Unaudited Financial Statements - Consolidated
Balance Sheets:
June 30, 2009......................................................... 3
December 31, 2008..................................................... 3
Statements of Income:
Three Months Ended June 30, 2009...................................... 4
Three Months Ended June 30, 2008...................................... 4
Six Months Ended June 30, 2009........................................ 5
Six Months Ended June 30, 2008........................................ 5
Statements of Changes in Stockholders' Equity:
Three Months Ended June 30, 2009....................................... 6
Three Months Ended June 30, 2008....................................... 6
Six Months Ended June 30, 2009......................................... 7
Six Months Ended June 30, 2008......................................... 7
Statements of Cash Flows:
Six Months Ended June 30, 2009........................................ 8
Six Months Ended June 30, 2008........................................ 8
Notes to Unaudited Consolidated Financial Statements..................... 9
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations....................................... 23
Item 3. Quantitative and Qualitative Disclosures About Market
Risk............................................................ 39
Item 4. Controls and Procedures........................................... 40
PART II -- OTHER INFORMATION
Item 1. Legal Proceedings................................................. 40
Item 1A. Risk Factors..................................................... 40
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds....... 43
Item 3. Defaults Upon Senior Securities................................... 43
Item 4. Submission of Matters to a Vote of Security Holders............... 43
Item 5. Other Information................................................. 44
Item 6. Exhibits.......................................................... 44
Signatures.................................................................. 45
2
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PART I. FINANCIAL INFORMATION, ITEM 1 -- FINANCIAL STATEMENTS
PENSECO FINANCIAL SERVICES CORPORATION
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<Table>
<Caption>
June 30, December 31,
2009 2008
------------ ------------
ASSETS
Cash and due from banks $ 11,112 $ 7,246
Interest bearing balances with banks 2,253 2,109
Federal funds sold - -
------------ ------------
Cash and Cash Equivalents 13,365 9,355
Investment securities:
Available-for-sale, at fair value 135,102 94,996
Held-to-maturity (fair value of $58,278
and $64,678, respectively) 56,063 62,484
------------ ------------
Total Investment Securities 191,165 157,480
Loans, net of unearned income 586,693 441,148
Less: Allowance for loan losses 6,050 5,275
------------ ------------
Loans, Net 580,643 435,873
Bank premises and equipment 12,216 10,391
Other real estate owned 687 -
Accrued interest receivable 4,058 3,518
Goodwill 26,398 -
Cash surrender value of life insurance 14,121 7,684
Other assets 11,470 4,666
------------ ------------
Total Assets $854,123 $628,967
============ ============
LIABILITIES
Deposits:
Non-interest bearing $ 97,805 $ 72,456
Interest bearing 541,473 352,269
------------ ------------
Total Deposits 639,278 424,725
Other borrowed funds:
Repurchase agreements 25,100 29,155
Short-term borrowings 1,234 24,204
Long-term borrowings 67,539 72,720
Accrued interest payable 1,382 1,118
Other liabilities 6,377 3,403
------------ ------------
Total Liabilities 740,910 555,325
------------ ------------
STOCKHOLDERS' EQUITY
Common stock; $ .01 par value, 15,000,000
shares authorized, 3,276,079 shares issued
and outstanding at June 30, 2009 and
2,148,000 shares issued and outstanding at
December 31, 2008 33 21
Surplus 48,865 10,819
Retained earnings 65,777 64,745
Accumulated other comprehensive income (1,462) (1,943)
------------ ------------
Total Stockholders' Equity 113,213 73,642
------------ ------------
Total Liabilities and Stockholders' Equity $854,123 $628,967
============ ============
</Table>
(See accompanying Notes to Unaudited Consolidated Financial Statements)
3
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PENSECO FINANCIAL SERVICES CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<Table>
<Caption>
Three Months Three Months
Ended Ended
June 30, 2009 June 30, 2008
----------------- -----------------
INTEREST INCOME
Interest and fees on loans $ 8,727 $ 6,436
Interest and dividends on investments:
U.S. Treasury securities and U.S.
Agency obligations 872 1,100
States & political subdivisions 1,133 836
Other securities 8 69
Interest on Federal funds sold - -
Interest on balances with banks 3 23
------------- -------------
Total Interest Income 10,743 8,464
------------- -------------
INTEREST EXPENSE
Interest on time deposits of $100,000
or more 482 355
Interest on other deposits 1,441 1,424
Interest on other borrowed funds 780 1,018
------------- -------------
Total Interest Expense 2,703 2,797
------------- -------------
Net Interest Income 8,040 5,667
Provision for loan losses 235 216
------------- -------------
Net Interest Income After Provision
for Loan Losses 7,805 5,451
------------- -------------
NON-INTEREST INCOME
Trust department income 375 382
Service charges on deposit accounts 481 396
Merchant transaction income 841 935
Brokerage income 79 169
Other fee income 331 320
Bank-owned life insurance income 132 80
Other operating income 218 82
VISA mandatory share redemption - -
Realized gains (losses) on securities, net 314 -
------------- -------------
Total Non-Interest Income 2,771 2,364
------------- -------------
NON-INTEREST EXPENSES
Salaries and employee benefits 3,249 2,509
Expense of premises and fixed assets 817 667
Merchant transaction expenses 605 703
Merger related costs 215 -
Other operating expenses 2,046 1,578
------------- -------------
Total Non-Interest Expenses 6,932 5,457
------------- -------------
Income before income taxes 3,644 2,358
Applicable income taxes 775 430
------------- -------------
Net Income $ 2,869 $ 1,928
============= =============
Weighted average shares outstanding 3,276,079 2,148,000
Earnings per Common Share $ 0.88 $ 0.89
Cash Dividends Declared Per Common Share $ 0.42 $ 0.41
</Table>
(See accompanying Notes to Unaudited Consolidated Financial Statements)
4
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PENSECO FINANCIAL SERVICES CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<Table>
<Caption>
Six Months Ended Six Months Ended
June 30, 2009 June 30, 2008
----------------- -----------------
INTEREST INCOME
Interest and fees on loans $ 15,011 $ 13,097
Interest and dividends on investments:
U.S. Treasury securities and U.S.
Agency obligations 1,750 2,005
States & political subdivisions 1,994 1,672
Other securities 22 143
Interest on Federal funds sold - -
Interest on balances with banks 6 34
------------- -------------
Total Interest Income 18,783 16,951
------------- -------------
INTEREST EXPENSE
Interest on time deposits of $100,000
or more 760 806
Interest on other deposits 2,384 2,957
Interest on other borrowed funds 1,601 1,944
------------- -------------
Total Interest Expense 4,745 5,707
------------- -------------
Net Interest Income 14,038 11,244
Provision for loan losses 1,231 451
------------- -------------
Net Interest Income After Provision
for Loan Losses 12,807 10,793
------------- -------------
NON-INTEREST INCOME
Trust department income 685 747
Service charges on deposit accounts 820 659
Merchant transaction income 2,049 2,119
Brokerage income 196 351
Other fee income 618 617
Bank-owned life insurance income 211 158
Other operating income 288 118
VISA mandatory share redemption - 1,213
Realized gains (losses) on securities, net 314 -
------------- -------------
Total Non-Interest Income 5,181 5,982
------------- -------------
NON-INTEREST EXPENSES
Salaries and employee benefits 5,727 4,924
Expense of premises and fixed assets 1,608 1,435
Merchant transaction expenses 1,462 1,605
Merger related costs 1,550 -
Other operating expenses 3,709 2,551
------------- -------------
Total Non-Interest Expenses 14,056 10,515
------------- -------------
Income before income taxes
3,932 6,260
Applicable income taxes 622 1,375
------------- -------------
Net Income $ 3,310 $ 4,885
============= =============
Weighted average shares outstanding 2,712,040 2,148,000
Earnings per Common Share $ 1.22 $ 2.27
Cash Dividends Declared Per Common Share $ 0.84 $ 0.82
</Table>
(See accompanying Notes to Unaudited Consolidated Financial Statements)
5
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PENSECO FINANCIAL SERVICES CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
THREE MONTHS ENDED JUNE 30, 2009 AND 2008
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<Table>
<Caption>
Accumulated
Other Total
Common Retained Comprehensive Stockholders'
Stock Surplus Earnings Income Equity
-------- ------- -------- ------------- -------------
Balance, March 31, 2008 $ 21 $10,819 $61,773 $ (416) $ 72,197
Comprehensive income:
Net income - - 1,928 - 1,928
Other comprehensive income, net of tax
Unrealized losses on securities, net of
reclassification adjustment - - - (1,298) (1,298)
Minimum pension liability adjustment - - - 445 445
------------- -------------
Other comprehensive income (853) (853)
-------------
Comprehensive income 1,075
Cash dividends declared ($0.41 per share) - - (881) - (881)
-------- ------- -------- ------------- -------------
Balance, June 30, 2008 $ 21 $10,819 $62,820 $ (1,269) $ 72,391
======== ======= ======== ============= =============
Balance, March 31, 2009 21 10,819 64,284 (1,793) 73,331
Fair value of consideration exchanged in merger 12 38,046 - - 38,058
Comprehensive income:
Net income - - 2,869 - 2,869
Other comprehensive income, net of tax
Unrealized gains on securities, net of
reclassification adjustment - - - 331 331
------------- -------------
Other comprehensive income 331 331
-------------
Comprehensive income 3,200
Cash dividends declared ($0.42 per share) - - (1,376) - (1,376)
-------- ------- -------- ------------- -------------
Balance, June 30, 2009 $ 33 $48,865 $65,777 $ (1,462) $113,213
======== ======= ======== ============= =============
</Table>
(See accompanying Notes to Unaudited Consolidated Financial Statements)
6
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PENSECO FINANCIAL SERVICES CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
SIX MONTHS ENDED JUNE 30, 2009 AND 2008
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<Table>
<Caption>
Accumulated
Other Total
Common Retained Comprehensive Stockholders'
Stock Surplus Earnings Income Equity
-------- ------- -------- ------------- -------------
Balance, March 31, 2008 $ 21 $10,819 $59,697 $ (822) $ 69,715
Comprehensive income:
Net income - - 4,885 - 4,885
Other comprehensive income, net of tax
Unrealized losses on securities, net of
reclassification adjustment - - - (892) (892)
Minimum pension liability adjustment - - - 445 445
------------- -------------
Other comprehensive income (447) (447)
-------------
Comprehensive income 4,438
Cash dividends declared ($0.82 per share) - - (1,762) - (1,762)
-------- ------- -------- ------------- -------------
Balance, June 30, 2008 $ 21 $10,819 $62,820 $ (1,269) $ 72,391
======== ======= ======== ============= =============
Balance, December 31, 2008 21 10,819 64,745 (1,943) 73,642
Fair value of consideration exchanged in merger 12 38,046 - - 38,058
Comprehensive income:
Net income - - 3,310 - 3,310
Other comprehensive income, net of tax
Unrealized gains on securities, net of
reclassification adjustment - - - 481 481
------------- -------------
Other comprehensive income 481 481
-------------
Comprehensive income 3,791
Cash dividends declared ($0.84 per share) - - (2,278) - (2,278)
-------- ------- -------- ------------- -------------
Balance, June 30, 2009 $ 33 $48,865 $65,777 $ (1,462) $113,213
======== ======= ======== ============= =============
</Table>
(See accompanying Notes to Unaudited Consolidated Financial Statements)
7
<Page>8
PENSECO FINANCIAL SERVICES CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)
<Table>
<Caption>
Six Months Six Months
Ended Ended
June 30, 2009 June 30, 2008
--------------- --------------
OPERATING ACTIVITIES
Net income $ 3,310 $ 4,885
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation 464 417
Provision for loan losses 1,231 451
Deferred income tax (benefit) provision (381) 13
Amortization of securities, (net of accretion) 221 148
Gain on VISA mandatory share redemption - (1,213)
Net realized (gains) losses on securities (314) -
(Gain) loss on other real estate 5 -
Decrease (increase) in interest receivable 465 (83)
(Increase) decrease in cash surrender value of life
insurance (211) (157)
(Increase) decrease in other assets 603 (936)
(Decrease) increase in income taxes payable 470 1,386
(Decrease) increase in interest payable (76) (75)
Increase (decrease) in other liabilities 1,156 (800)
----------- ----------
Net cash (used) provided by operating activities 6,943 4,036
----------- ----------
INVESTING ACTIVITIES
Purchase of investment securities available-for-sale (33,892) (38,465)
Proceeds from sales and maturities of investment
securities available-for-sale 24,534 6,282
Purchase of investment securities to be
held-to-maturity - -
Proceeds from repayments of investment securities
available-for-sale 1,996 5,000
Proceeds from repayments of investment securities
held-to-maturity 6,316 3,306
Net loans repaid (originated) 13,388 (18,105)
Proceeds from other real estate 32 -
Investment in premises and equipment (713) (186)
Net cash received (paid) in merger (12,645) -
----------- ----------
Net cash (used) provided by investing activities (984) (42,168)
----------- ----------
FINANCING ACTIVITIES
Net increase (decrease) in demand and savings
deposits 25,738 15,864
Net (payments) proceeds on time deposits 11,797 4,632
Increase (decrease) in repurchase agreements (4,055) 17,884
Net increase (decrease) in short-term borrowings (27,970) (12,747)
Increase in long-term borrowings 1,000 27,000
Repayments of long-term borrowings (6,181) (5,159)
Cash dividends paid (2,278) (1,761)
----------- ----------
Net cash provided (used) by financing activities (1,949) 45,713
----------- ----------
Net increase (decrease) in cash and cash
equivalents 4,010 7,581
Cash and cash equivalents at January 1 9,355 11,644
----------- ----------
Cash and cash equivalents at June 30 $ 13,365 $ 19,225
=========== ==========
</Table>
The Company paid interest and income taxes of $4,557 and $89 and 5,782 and
$1,928, for the six months ended June 30, 2009 and 2008, respectively.
(See accompanying Notes to Unaudited Consolidated Financial Statements)
8
<Page>9
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE QUARTER ENDED JUNE 30, 2009
(UNAUDITED)
These Notes to Unaudited Consolidated Financial Statements reflect events
subsequent to December 31, 2008, the date of the most recent Report of
Independent Registered Public Accounting Firm, through the date of this
Quarterly Report on Form 10-Q. These Notes to Unaudited Consolidated Financial
Statements should be read in conjunction with Parts I and II of this Report and
the Company's Annual Report on Form 10-K for the year ended December 31, 2008,
which was filed with the Securities and Exchange Commission (SEC) on March 16,
2009.
FORWARD LOOKING INFORMATION
This Quarterly Report on Form 10-Q contains forward-looking statements that are
based on assumptions and may describe future plans, strategies and expectations
of Penseco Financial Services Corporation. These forward-looking statements are
generally identified by use of the words "believe," "expect," "intend,"
"anticipate," "estimate," "project" or similar expressions. Penseco Financial
Services Corporation's ability to predict results or the actual effect of future
plans or strategies is inherently uncertain. Factors which could have a material
adverse effect on the operations of Penseco Financial Services Corporation and
its subsidiary include, but are not limited to, changes in interest rates,
national and regional economic conditions, legislative and regulatory changes,
monetary and fiscal policies of the U.S. government, including policies of the
U.S. Treasury and the Federal Reserve Board, the quality and composition of the
loan or investment portfolios, demand for loan products, deposit flows,
competition, demand for financial services in Penseco Financial Services
Corporation's market area, changes in real estate market values in Penseco
Financial Services Corporation's market area, changes in relevant accounting
principles and guidelines and inability of third party service providers to
perform. Additional factors that may affect our results are discussed in Item 1A
to this Quarterly Report on Form 10-Q titled "Risk Factors".
These risks and uncertainties should be considered in evaluating forward-looking
statements and undue reliance should not be placed on such statements. Except as
required by applicable law or regulation, Penseco Financial Services Corporation
does not undertake, and specifically disclaims any obligation, to release
publicly the result of any revisions that may be made to any forward-looking
statements to reflect events or circumstances after the date of the statements
or to reflect the occurrence of anticipated or unanticipated events.
Unless the context indicates otherwise, all references in this Quarterly Report
to "Company," "we," "us" and "our" refer to Penseco Financial Services
Corporation and its subsidiary.
NOTE 1 -- PRINCIPLES OF CONSOLIDATION
Penseco Financial Services Corporation is a financial holding company
incorporated under the laws of Pennsylvania. It is the parent company of Penn
Security Bank and Trust Company (Bank), a Pennsylvania state chartered bank.
Intercompany transactions have been eliminated in preparing the consolidated
financial statements.
The accounting policies of the Company conform with accounting principles
generally accepted in the United States of America and with general practices
within the banking industry.
NOTE 2 -- BASIS OF PRESENTATION
The unaudited consolidated financial statements have been prepared in accordance
with the instructions to SEC Form 10-Q and generally accepted accounting
principles for interim financial information. In the opinion of management, all
adjustments that are of a normal recurring nature and are considered necessary
for a fair presentation have been included. They are not, however, necessarily
indicative of the results of consolidated operations for a full year or any
other period.
All information is presented in thousands of dollars, except per share amounts.
For further information, refer to the consolidated financial statements and
accompanying notes included in the Company's Annual Report on Form 10-K for the
year ended December 31, 2008.
9
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NOTE 3 -- USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
Material estimates that are particularly susceptible to significant change
relate to the determination of the allowance for losses on loans and the
valuation of real estate acquired in connection with foreclosures or in
satisfaction of loans. In connection with the determination of the allowances
for losses on loans and foreclosed real estate, management obtains independent
appraisals for significant properties.
NOTE 4 -- INVESTMENT SECURITIES
Investments in securities are classified in two categories and accounted for as
follows:
Securities Held-to-Maturity Bonds, notes, debentures and mortgage-backed
- ---------------------------
securities for which the Company has the positive intent and ability to hold to
maturity are reported at cost, adjusted for amortization of premiums and
accretion of discounts computed on the straight-line basis, which approximates
the interest method, over the remaining period to maturity.
Securities Available-for-Sale Bonds, notes, debentures, mortgage-backed
- -----------------------------
securities and certain equity securities not classified as securities to be
held-to-maturity are carried at fair value with unrealized gains and losses, net
of tax, reported as a net amount in a separate component of stockholders' equity
until realized.
The amortization of premiums on mortgage-backed securities is done based on
management's estimate of the lives of the securities, adjusted, when necessary,
for advanced prepayments in excess of those estimates.
Realized gains and losses on the sale of securities available-for-sale are
determined using the specific identification method and are reported as a
separate component of other income in the Statements of Income. Unrealized gains
and losses are included as a separate item in computing comprehensive income.
The amortized cost and fair value of investment securities at June 30, 2009 and
December 31, 2008 are as follows:
<Table>
<Caption>
AVAILABLE-FOR-SALE
Gross Gross
Amortized Unrealized Unrealized Fair
June 30, 2009 Cost Gains Losses Value
- ------------------------------------------------------------------------------------------
U.S. Agency securities $ 38,404 $ 778 $ - $ 39,182
Mortgage-backed securities 18,886 491 - 19,377
States & political subdivisions 69,176 858 1,220 68,814
- ------------------------------------------------------------------------------------------
Total Debt Securities 126,466 2,127 1,220 127,373
Equity securities 7,566 843 680 7,729
- ------------------------------------------------------------------------------------------
Total Available-for-Sale $134,032 $2,970 $1,900 $135,102
- ------------------------------------------------------------------------------------------
</Table>
<Table>
<Caption>
AVAILABLE-FOR-SALE
Gross Gross
Amortized Unrealized Unrealized Fair
December 31, 2009 Cost Gains Losses Value
- ------------------------------------------------------------------------------------------
U.S. Agency securities $ 25,221 $ 919 $ - $ 26,140
Mortgage-backed securities 20,873 392 16 21,249
States & political subdivisions 41,726 514 1,460 40,780
- ------------------------------------------------------------------------------------------
Total Debt Securities 87,820 1,825 1,476 88,169
Equity securities 6,835 623 631 6,827
- ------------------------------------------------------------------------------------------
Total Available-for-Sale $94,655 $2,448 $2,107 $ 94,996
- ------------------------------------------------------------------------------------------
</Table>
10
<Page>11
HELD-TO-MATURITY
<Table>
<Caption>
Gross Gross
Amortized Unrealized Unrealized Fair
June 30, 2009 Cost Gains Losses Value
- ------------------------------------------------------------------------------------------
Mortgage-backed securities $ 28,005 $ 932 $ - $ 28,937
States & political subdivisions 28,058 1,294 11 29,341
- ------------------------------------------------------------------------------------------
Total Held-to-Maturity $ 56,063 $2,226 $ 11 $ 58,278
- ------------------------------------------------------------------------------------------
</Table>
<Table>
<Caption>
HELD-TO-MATURITY
Gross Gross
Amortized Unrealized Unrealized Fair
December 30, 2009 Cost Gains Losses Value
- ------------------------------------------------------------------------------------------
Mortgage-backed securities $ 33,254 $ 661 $ 2 $ 33,913
States & political subdivisions 29,230 1,558 23 30,765
- ------------------------------------------------------------------------------------------
Total Held-to-Maturity $ 62,484 $2,219 $ 25 $64,678
- ------------------------------------------------------------------------------------------
</Table>
Equity securities at June 30, 2009 and December 31, 2008 consisted primarily of
other financial institutions' stock and Federal Home Loan Bank of Pittsburgh
(FHLB) stock, which is a required investment in order for the Company to
participate in a FHLB available line of credit program. The FHLB stock is stated
at par value as it is restricted to purchases and sales with the FHLB. The FHLB
indefinitely suspended its stock repurchase and dividend payments during
December 2008. Based on current financial information available, management does
not believe the FHLB stock value is impaired as of June 30, 2009.
The amortized cost and fair value of debt securities at June 30, 2009 by
contractual maturity are shown below. Expected maturities may differ from
contractual maturities because borrowers may have the right to call or prepay
obligations with or without call or prepayment penalties.
<Table>
<Caption>
June 30, 2009 Available-for-Sale Held-to-Maturity
- -----------------------------------------------------------------------------------------
Amortized Fair Amortized Fair
Cost Value Cost Value
- -----------------------------------------------------------------------------------------
Due in one year or less:
U.S. Agency securities $ 9,113 $ 9,187 $ - $ -
States & political subdivisions 45 46 - -
After one year through five years:
U.S. Agency securities 26,755 27,453 - -
States & political subdivisions 320 333 - -
After five year through ten years:
U.S. Agency securities 2,536 2,542 - -
States & political subdivisions 1,163 1,238 4,861 5,080
After ten years:
States & political subdivisions 67,648 67,197 23,197 24,261
- ------------------------------------------------------------------------------------------
Subtotal 107,580 107,996 28,058 29,341
Mortgage-backed securities 18,886 19,377 28,005 28,937
- ------------------------------------------------------------------------------------------
Total Debt Securities $126,466 $127,373 $56,063 $58,278
- ------------------------------------------------------------------------------------------
</Table>
11
<Page>12
The gross fair value and unrealized losses of the Company's investments
aggregated by investment category and length of time that individual securities
have been in a continuous unrealized loss position, at June 30, 2009 and
December 31, 2008, are as follows:
<Table>
<Caption>
Less than
twelve months Twelve months or more Totals
--------------------- --------------------- ---------------------
Fair Unrealized Fair Unrealized Fair Unrealized
June 30, 2009 Value Losses Value Losses Value Losses
- -----------------------------------------------------------------------------------------------------------
U.S. Agency securities $ - $ - $ - $ - $ - $ -
States & political subdivisions 17,294 343 18,178 888 35,472 1,231
Equities - - 999 680 999 680
- -----------------------------------------------------------------------------------------------------------
Total $17,294 $ 343 $19,177 $1,568 $36,471 $1,911
- -----------------------------------------------------------------------------------------------------------
</Table>
<Table>
<Caption>
Less than
twelve months Twelve months or more Totals
--------------------- --------------------- ---------------------
Fair Unrealized Fair Unrealized Fair Unrealized
December 31, 2009 Value Losses Value Losses Value Losses
- -----------------------------------------------------------------------------------------------------------
Mortgage-backed securities $ - $ - $5,351 $ 18 $ 5,351 $ 18
States & political subdivisions 21,569 1,247 1,409 236 22,978 1,483
Equities 37 15 395 616 432 631
- -----------------------------------------------------------------------------------------------------------
Total $21,606 $1,262 $7,155 $ 870 $28,761 $2,132
- -----------------------------------------------------------------------------------------------------------
</Table>
The table at June 30, 2009 includes twenty-one (21) securities that have
unrealized losses for less than twelve months and forty-three (43) securities
that have been in an unrealized loss position for twelve or more months. The
table at December 31, 2008 includes forty-two (42) securities that have
unrealized losses for less than twelve months and twenty (20) securities that
have been in an unrealized loss position for twelve or more months. The Company
has analyzed its investment portfolio and determined that the market value
fluctuation in these securities is consistent with the broader market and not a
cause for recognition of a current loss.
U.S. AGENCY SECURITIES
The unrealized losses on the Company's investments in U.S. Agency securities
were caused by interest rate fluctuations. The contractual terms of these
investments do not permit the issuer to settle the securities at a price less
than the par value of the investment. Because the Company has the ability and
intent to hold these investments until a recovery of amortized cost, which may
be maturity, the Company does not consider these investments to be
other-than-temporarily impaired at June 30, 2009.
MORTGAGE-BACKED SECURITIES
The unrealized losses on the Company's investments in mortgage-backed securities
were caused by interest rate fluctuations. The contractual cash flows of these
investments are guaranteed by an agency of the U.S. government. Accordingly, it
is expected that these securities would not be settled at a price less than the
amortized cost of the Company's investment. Because the decline in market value
is attributable to changes in interest rates and not credit quality, and because
the Company has the ability and intent to hold these investments until a
recovery of amortized cost, which may be maturity, the Company does not consider
these investments to be other-than-temporarily impaired at June 30, 2009.
STATES AND POLITICAL SUBDIVISIONS
The unrealized losses on the Company's investments in states and political
subdivisions were caused by interest rate fluctuations. The contractual terms of
these investments do not permit the issuer to settle the securities at a price
less than the par value of the investment. Because the Company has the ability
and intent to hold these investments until a recovery of amortized cost, which
may be maturity, the Company does not consider these investments to be
other-than-temporarily impaired at June 30, 2009.
12
<Page>13
MARKETABLE EQUITY SECURITIES
The unrealized losses on the Company's investments in marketable equity
securities were caused primarily by interest rate fluctuations and other market
conditions. The Company's investments in marketable equity securities consist
primarily of investments in common stock of companies in the financial services
industry. The Company has analyzed its equity portfolio and determined that the
market value fluctuation in these equity securities is consistent with the
broader market and not a cause for recognition of a current loss. Because the
Company has the ability and intent to hold these investments for a reasonable
period of time sufficient for a forecasted recovery of cost, the Company does
not consider these investments to be other-than-temporarily impaired at June 30,
2009.
NOTE 5 -- LOAN PORTFOLIO
Details regarding the Company's loan portfolio on June 30, 2009 and December 31,
2008 are as follows:
<Table>
<Caption>
June 30, December 31,
As of: 2009 2008
- ---------------------------------------------------------------------------------
Real estate - construction and land development $ 28,828 $ 21,949
Real estate mortgages 460,980 355,528
Commercial 24,866 27,793
Credit card and related plans 3,235 3,272
Installment and other 61,473 28,135
Obligations of states & political subdivisions 7,311 4,471
- ---------------------------------------------------------------------------------
Loans, net of unearned income 586,693 441,148
Less: Allowance for loan losses 6,050 5,275
- ---------------------------------------------------------------------------------
Loans, net $580,643 $435,873
- ---------------------------------------------------------------------------------
</Table>
The Company does not engage in any sub-prime or Alt-A credit lending. Therefore,
the Company is not subject to any credit risks associated with such loans. The
Company's loan portfolio consists primarily of residential and commercial
mortgage loans secured by properties located in Northeastern Pennsylvania and
subject to conservative underwriting standards.
NOTE 6 -- LOAN SERVICING
The Company generally retains the right to service mortgage loans sold to third
parties. The cost allocated to the mortgage servicing rights retained has been
recognized as a separate asset and is amortized in proportion to and over the
period of estimated net servicing income.
Mortgage servicing rights are evaluated for impairment based on the fair value
of those rights. Fair values are estimated using discounted cash flows based on
current market rates of interest and expected future prepayment rates. For
purposes of measuring impairment, the rights must be stratified by one or more
predominant risk characteristics of the underlying loans. The Company stratifies
its capitalized mortgage servicing rights based on the product type, interest
rate and term of the underlying loans. The amount of impairment recognized is
the amount, if any, by which the amortized cost of the rights for each stratum
exceed the fair value.
NOTE 7 -- GOODWILL
Goodwill represents the excess of the purchase price over the underlying fair
value of merged entities. The Company accounts for goodwill in accordance with
SFAS No. 142, "Goodwill and Other Intangible Assets," and goodwill is assessed
for impairment at least annually and as triggering events occur. In making this
assessment, management considers a number of factors including, but not limited
to, operating results, business plans, economic projections, anticipated future
cash flows, and current market data. There are inherent uncertainties related to
these factors and management's judgment in applying them to the analysis of
goodwill impairment. Changes in economic and operating conditions, as well as
other factors, could result in goodwill impairment in future periods.
13
<Page>14
NOTE 8 -- OTHER INTANGIBLE ASSETS
Intangible assets include premiums from purchases of core deposit relationships
acquired in the Merger (see Note 13). The core deposit intangible is being
amortized over ten years on a sum-of-the-years-digits basis. Amortization
expense for the next five years is expected to be as follows:
June 30,
--------
2010 $ 237
2011 213
2012 189
2013 164
2014 140
NOTE 9 -- LONG-TERM DEBT
A summary of the Company's long-term debt at June 30, 2009 is as follows:
<Table>
<Caption>
Fixed
Monthly Installment Rate Maturity Date Balance
- ------------------------------------------------------------
Amortizing loans
$ 253 3.22% 03/15/10 $ 2,246
90 3.10% 02/28/13 3,741
430 3.74% 03/13/13 18,031
67 3.44% 03/02/15 4,138
13 3.48% 03/31/15 839
10 3.83% 04/02/18 902
186 4.69% 03/13/23 22,642
- ------------------------------------------------------------
Total amortizing 52,539
- ------------------------------------------------------------
Non-amortizing loans
2.62% 08/31/09 1,000
2.61% 03/01/10 1,000
1.71% 03/02/10 1,000
2.61% 08/30/10 1,000
2.88% 02/28/11 2,000
3.27% 02/29/12 2,000
3.49% 02/28/13 7,000
- ------------------------------------------------------------
Total non-amortizing 15,000
- ------------------------------------------------------------
Total long-term debt $67,539
- ------------------------------------------------------------
</Table>
The loans are secured by a general collateral pledge of the Company.
The Company has agreed to maintain sufficient qualifying collateral to fully
secure the above borrowings.
Aggregate maturities of long-term debt at June 30, 2009 are as follows:
<Table>
<Caption>
June 30, Principal
----------- ---------
2010 $12,884
2011 $10,932
2012 $10,237
2013 $13,898
2014 $ 2,477
Thereafter $17,111
---------
$67,539
=========
</Table>
14
<Page>15
NOTE 10 -- EMPLOYEE BENEFIT PLANS
The Company provides a defined benefit pension plan, currently under
curtailment, and a post-retirement benefit plan for eligible employees.
The components of the net periodic benefit cost are as follows:
<Table>
<Caption>
Pension Benefits Other Benefits
---------------------------------------
Six months ended June 30, 2009 2008 2009 2008
- -------------------------------------------------------------------------------
Service cost $ - $ 202 $ 2 $ 2
Interest cost 350 408 10 10
Expected return on plan assets (410) (510) - -
Amortization of prior service cost - - 4 4
Amortization of net loss (gain) 98 70 - -
- -------------------------------------------------------------------------------
Net periodic pension cost 38 170 16 16
- -------------------------------------------------------------------------------
</Table>
Contributions
- -------------
Effective June 22, 2008 the Company curtailed its defined benefit pension plan.
The Company previously disclosed in its financial statements for the year ended
December 31, 2008 that it did not expect to contribute to its pension plan but
expected to contribute $18 to its post-retirement plan during 2009. The
actuarial calculations of required contributions for 2009 were revised to $468
and $32, respectively, as to its pension and post-retirement plans. As of July
15, 2009, $0 has been contributed to the pension plan for 2009, due to the use
of a portion of the Funding Standard Carryover Balance to satisfy the
installments required to date, and $16 was contributed to the post retirement
plan. Readers should refer to the Company's Annual Report on Form 10-K for
further details on the Company's defined benefit pension plan. The actuarially
computed information on the plan curtailment, as to the pension obligation and
funded status, was disclosed in the Company's quarterly report on Form 10-Q for
the six month period ended June 30, 2008, as filed with the SEC on August 7,
2008.
Effective July 1, 2008, the Company began to sponsor a new 401(k) profit sharing
plan for all eligible employees. The Company's profit sharing expense for the
six months ended June 30, 2009 was $208.
NOTE 11 -- REGULATORY MATTERS
The Company and the Bank are subject to various regulatory capital requirements
administered by Federal banking agencies. Failure to meet minimum capital
requirements can initiate certain mandatory--and possibly additional
discretionary--actions by regulators that, if undertaken, could have a direct
material effect on the Company and the Bank's Consolidated Financial Statements.
Under capital adequacy guidelines and the regulatory framework for prompt
corrective action, the Company and the Bank must meet specific capital
guidelines that involve quantitative measures of their assets, liabilities, and
certain off-balance sheet items as calculated under regulatory accounting
practices. The Company and the Bank's capital amounts and classifications are
also subject to qualitative judgments by the regulators about components, risk
weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy
require the Company and the Bank to maintain minimum amounts and ratios (set
forth in the Capital Adequacy table on the following page) of Tier I and Total
Capital to risk-weighted assets and of Tier I Capital to average assets
(Leverage ratio). The table also presents the Company's actual capital amounts
and ratios. Management believes, as of June 30, 2009, that the Company and the
Bank meet all capital adequacy requirements to which they are subject.
As of June 30, 2009, the most recent notification from the Federal Deposit
Insurance Corporation (FDIC) categorized the Company as "well capitalized" under
the regulatory framework for prompt corrective action. To be categorized as
"well capitalized", the Company must maintain minimum Tier I Capital, Total
Capital and Leverage ratios as set forth in the Capital Adequacy table. There
are no conditions or events since that notification that management believes
have changed the Company's categorization by the FDIC.
The Company and Bank are also subject to minimum capital levels, which could
limit the payment of dividends,
15
<Page>16
although the Company and Bank currently have capital levels which are in excess
of minimum capital level ratios required.
The Pennsylvania Banking Code restricts capital funds available for payment of
dividends to the retained earnings of the Bank. The balances in the capital
stock and surplus accounts are unavailable for dividends.
In addition, the Bank is subject to restrictions imposed by Federal law on
certain transactions with the Company's affiliates. These transactions include
extensions of credit, purchases of or investments in stock issued by an
affiliate, purchases of assets subject to certain exceptions, acceptance of
securities issued by an affiliate as collateral for loans, and the issuance of
guarantees, acceptances, and letters of credit on behalf of affiliates. These
restrictions prevent the Company's affiliates from borrowing from the Bank
unless the loans are secured by obligations of designated amounts. Further, the
aggregate of such transactions by the Bank with a single affiliate is limited in
amount to 10 percent of the Bank's Capital Stock and Surplus, and the aggregate
of such transactions with all affiliates is limited to 20 percent of the Bank's
Capital Stock and Surplus. The Federal Reserve System has interpreted "Capital
Stock and Surplus" to include undivided profits.
<Table>
<Caption>
Actual Regulatory Requirements
- ---------------------------------------------------------- ------------------------------------------------
For Capital To Be
Adequacy Purposes "Well Capitalized"
----------------- ------------------
As of June 30, 2009 Amount Ratio Amount Ratio Amount Ratio
- ------------------------------------------- ---------------------------------------------------------------------
Total Capital (to Risk Weighted Assets)
PFSC (Company) $92,230 16.70% > $44,176 > 8.0% > $55,220 > 10.0%
- - - -
PSB (Bank) $88,832 16.10% > $44,138 > 8.0% > $55,173 > 10.0%
- - - -
Tier 1 Capital (to Risk Weighted Assets)
PFSC (Company) $86,180 15.61% > $22,088 > 4.0% > $33,132 > 6.0%
- - - -
PSB (Bank) $82,782 15.00% > $22,069 > 4.0% > $33,104 > 6.0%
- - - -
Tier 1 Capital (to Average Assets)
PFSC (Company) $86,180 12.11% > * > * > $35,595 > 5.0%
- - - -
PSB (Bank) $82,782 11.69% > * > * > $35,414 > 5.0%
- - - -
</Table>
PFSC - *3.0% ($21,357), 4.0% ($28,476) or 5.0% ($35,595) depending on the bank's
CAMELS Rating and other regulatory risk factors.
PSB - *3.0% ($21,248), 4.0% ($28,331) or 5.0% ($35,414) depending on the bank's
CAMELS Rating and other regulatory risk factors.
<Table>
<Caption>
Actual Regulatory Requirements
- ---------------------------------------------------------- ------------------------------------------------
For Capital To Be
Adequacy Purposes "Well Capitalized"
----------------- ------------------
As of December 30, 2009 Amount Ratio Amount Ratio Amount Ratio
- -------------------------------------------------------------------------------------------------------------------
Total Capital (to Risk Weighted Assets)
PFSC (Company) $80,630 19.81% > $32,570 > 8.0% > $40,712 > 10.0%
- - - -
PSB (Bank) $77,275 19.03% > $32,486 > 8.0% > $40,607 > 10.0%
- - - -
Tier 1 Capital (to Risk Weighted Assets)
PFSC (Company) $75,544 18.56% > $16,285 > 4.0% > $24,427 > 6.0%
- - - -
PSB (Bank) $72,197 17.78% > $16,243 > 4.0% > $24,364 > 6.0%
- - - -
Tier 1 Capital (to Average Assets)
PFSC (Company) $75,544 12.26% > * > * > $30,813 > 5.0%
- - - -
PSB (Bank) $72,197 11.73% > * > * > $30,765 > 5.0%
- - - -
</Table>
PFSC - *3.0% ($18,488), 4.0% ($24,651) or 5.0% ($30,813) depending on the bank's
CAMELS Rating and other regulatory risk factors.
PSB - *3.0% ($18,459), 4.0% ($24,612) or 5.0% ($30,765) depending on the bank's
CAMELS Rating and other regulatory risk factors.
16
<Page>17
NOTE 12 -- FAIR VALUE MEASUREMENTS
Effective January 1, 2008, the Company adopted SFAS No. 157, which, among other
things, requires enhanced disclosures about assets and liabilities carried at
fair value. SFAS No. 157 establishes a hierarchal disclosure framework
associated with the level of pricing observability utilized in measuring assets
and liabilities at fair value. The three broad levels defined by SFAS No. 157
hierarchy are as follows:
Level I: Quoted prices are available in active markets for identical assets or
liabilities as of the record date.
Level II: Pricing inputs are other than quoted prices in active markets, which
are either directly or indirectly observable as of the reported date.
The nature of these assets and liabilities include items for which
quoted prices are available but traded less frequently, and items
that are fair valued using other financial instruments, the
parameters of which can be directly observed.
Level III: Assets and liabilities that have little to no pricing observability
as of the reported date. These items do not have two-way markets and
are measured using management's best estimate of fair value, where
the inputs into the determination of fair value require significant
management judgment or estimation.
The following table presents the assets reported on the Consolidated Statements
of Financial Condition at their fair value as of June 30, 2009 by level within
the fair value hierarchy. As required by SFAS No. 157, financial assets and
liabilities are classified in their entirety based on the lowest level of input
that is significant to the fair value measurement.
<Table>
<Caption>
June 30, 2009
---------------------------------------------
Level I Level II Level III Total
---------- ---------- --------- ----------
Assets:
Securities available-for-sale $7,679 $127,373 $ 50 $135,102
Other real estate owned - 560 127 687
</Table>
Level III classifications increased by $127 due to the addition of $129 in real
estate sold under contract resulting from the Old Forge Bank merger, less
payments of $2 received during the quarter ended June 30, 2009.
NOTE 13 -- MERGER
An Agreement and Plan of Merger (the Agreement) by and between the Company, the
Bank and Old Forge Bank, was entered into on December 5, 2008. The Agreement
provided for, among other things, the Company to acquire 100% of the outstanding
common shares of Old Forge Bank through a two-step merger transaction (the
Merger). The Company consummated the acquisition of Old Forge Bank on April 1,
2009. Old Forge Bank was merged with and into the Bank. Following the Merger,
the Bank continues to operate as a banking subsidiary of the Company.
Shareholders of Old Forge Bank were entitled to receive the merger consideration
in either cash or shares of Company common stock, or any combination thereof,
subject to certain limitations and allocation procedures set forth in the
Agreement. The per share amount was calculated from the cash consideration and
the value of the stock consideration based on the Company's closing price of the
Company's common stock over a fixed period of time, as provided for in the
Agreement.
Old Forge Bank was an independent $215 million community bank, operating from
three locations in Lackawanna and Luzerne Counties of Pennsylvania. As a result
of the Merger, the Company is now an $854 million financial institution serving
Northeastern Pennsylvania from 12 locations. Management of the Company believes
that the combined entity is in a more favorable position to compete with local
and regional banks in the marketplace.
There was approximately $26.4 million of goodwill created in the Merger, largely
based on the Company's evaluation of the business growth opportunities inherent
in the Old Forge Bank customer base, as well as operating synergies and economy
of scale resulting from the Merger. None of the goodwill is expected to be
deductible for income tax purposes.
The following table summarizes the consideration paid for Old Forge Bank and the
identifiable assets acquired and liabilities assumed at acquisition date.
17
<Page>18
<Table>
<Caption>
April 1, 2009
-------------
Consideration
- -------------
Cash $ 17,405
Common Stock issued - 1,128,079 shares
of the Company, net of issuance costs of $184 38,058
---------
Fair value of consideration transferred $ 55,463
=========
</Table>
The fair value of the 1,128,079 common shares of the Company issued as part of
the consideration paid to former Old Forge Bank shareholders was $38,058,
determined by use of the weighted average price of Company shares traded on
March 31, 2009 ($33.90 per share). The Company believes that the weighted
average price of the Company stock traded on March 31, 2009 is the best
indication of value since the Company's common stock is not a heavily traded
security.
Acquisition-related costs recorded in the income
statement of the acquirer for the six months
ended June 30, 2009. $ 1,550
Acquisition-related costs recorded as an offset to
surplus of the acquirer as of June 30, 2009. $ 184
Recognized amounts of identifiable assets acquired
and liabilities assumed on April 1, 2009 are:
Cash $ 4,760
Investments 32,095
Loans 159,949
Property and equipment 1,576
Core Deposit Intangible 2,027
All other assets 12,193
-----------
Identifiable Assets 212,600
-----------
Deposits 177,018
Borrowings 5,000
All other liabilities 1,517
-----------
Identifiable Liabilities 183,535
-----------
Identifiable net assets 29,065
Goodwill 26,398
-----------
Total consideration transferred $ 55,463
===========
The fair value of the financial assets acquired included loans receivable with a
gross amortized cost basis of $166,348 at April 1, 2009. The table below
illustrates the fair value adjustments made to the amortized cost basis in order
to present the fair value of the loans acquired.
Gross amortized costs basis at April 1, 2009 $ 166,348
Market rate adjustment 640
Credit fair value adjustment in pools of homogeneous loans (5,648)
Credit fair value adjustment on distressed loans (1,391)
---------
Fair value of purchased loans at April 1, 2009 $ 159,949
=========
18
<Page>19
PRO FORMA BALANCE SHEET
As of December 31, 2008
<Table>
<Caption>
Penseco
Financial Services Old Forge
Corporation Bank Pro Forma
($ = 000's) 12/31/2008 12/31/2008 Eliminations Marks/Costs Adjustments 12/31/2008
- ------------------------------------------------------------------------------------------------------------------------
ASSETS
Cash and Equivalents $ 9,355 $ 4,275 $ 13,630
Securities 157,480 40,033 197,513
Gross Loans 441,148 169,789 (7,828)(d) 603,109
Loan Loss Reserves (5,275) (1,429) 1,429 (a) (5,275)
Goodwill - - 26,398 (j) 26,398
Other Intangibles 41 150 (150)(b) 2,027 (k) 2,068
Buildings and Furniture,
Fixtures & Equipment 10,391 1,701 (132)(e) 11,960
Other Assets 15,827 8,743 1,853 (f) (17,405)(i) 9,018
-------- -------- ---------
TOTAL ASSETS $628,967 $223,262 $858,421
======== ======== =========
LIABILITIES
Deposits $424,725 $180,458 929(g) 606,112
Borrowings 126,079 7,500 133,579
Other Liabilities 4,521 1,825 684(h) 7,030
-------- -------- ---------
TOTAL LIABILITIES 555,325 189,783 746,721
STOCKHOLDERS' EQUITY
Common Equity 73,642 33,479 (33,479)(c) 38,058 (l) 111,700
-------- -------- ---------
Total Equity 73,642 33,479 111,700
-------- -------- ---------
TOTAL LIABILITIES & EQUITY $628,967 $223,262 $858,421
======== ======== =========
</Table>
FOOTNOTES:
- --------------------------------------------------------------------------------
(a) Elimination of loan loss reserve
(b) Elimination of Old Forge Bank's intangible assets
(c) Elimination of Old Forge Bank's common equity
(d) Fair value adjustment for loans
(e) Buildings and Furniture, Fixtures & Equipment fair value adjustment
(f) Deferred tax adjustments related to fair value adjustment
(g) Fair value adjustment for certificates of deposits
(h) Fair value adjustment for unrecorded contingent liability
(i) Escrowed purchase price related to cash component
(j) Goodwill created in the transaction
(k) Fair value adjustment for core deposit intangible
(l) Purchase price related to the equity interest transferred
19
<Page>20
PRO FORMA INCOME STATEMENT
For the Three Months Ended June 30, 2008
<Table>
<Caption>
Penseco
Financial Services Old Forge
Corporation Bank Pro Forma
($ = 000's) 6/30/2008 6/30/2008 Adjustments 6/30/2008
- ----------------------------------------------------------------- --------- ----------- ---------
INTEREST INCOME
Interest and fees on loans $ 6,436 $ 2,498 184 (a) $ 9,118
Interest and dividends on investments 2,005 445 (30) (b) 2,420
Interest on Federal funds sold - 11 11
Interest on balances with banks 23 4 27
- -------------------------------------------------------------------------------------------------------------
Total Interest Income 8,464 2,958 154 11,576
- -------------------------------------------------------------------------------------------------------------
INTEREST EXPENSE
Interest on deposits 1,779 1,089 (143) (c) 2,725
Interest on borrowed funds 1,018 28 1,046
- -------------------------------------------------------------------------------------------------------------
Total Interest Expense 2,797 1,117 (143) 3,771
- -------------------------------------------------------------------------------------------------------------
Net Interest Income 5,667 1,841 297 7,805
Provision for loan losses 216 75 291
- -------------------------------------------------------------------------------------------------------------
Net Interest Income After Provision
for Loan Losses 5,451 1,766 297 7,514
- -------------------------------------------------------------------------------------------------------------
NON-INTEREST INCOME
Service charges on deposits 396 85 481
Other non-interest income 1,968 94 2,062
Realized gains (losses) on securities - 15 15
- -------------------------------------------------------------------------------------------------------------
Total Non-Interest Income 2,364 194 2,558
- -------------------------------------------------------------------------------------------------------------
NON-INTEREST EXPENSES
Salaries and employee benefits 2,509 735 3,244
Expense of premises and equipment 667 138 805
Other non-interest expenses 2,281 393 61 (d) 2,735
- -------------------------------------------------------------------------------------------------------------
Total Non-Interest Expenses 5,457 1,266 61 6,784
- -------------------------------------------------------------------------------------------------------------
Income before income taxes 2,358 694 236 3,288
Applicable income taxes 430 139 80 649
- -------------------------------------------------------------------------------------------------------------
Net Income $ 1,928 (f) $ 555 (f) $ 156 $ 2,639
=============================================================================================================
Earnings Per Common Share $ 0.89 $ 0.99 (e) $ 0.81
</Table>
FOOTNOTES:
- --------------------------------------------------------------------------------
(a) Amortization of loan fair value adjustment
(b) Opportunity cost of cash paid to Old Forge Bank shareholders at 0.70% rate
(c) Amortization of certificate of deposit fair value adjustment
(d) Amortization of core deposit intangible over a 10 year period using the
sum of the years digits method
(e) Pro Forma EPS based on Pro Forma shares outstanding of 3,276,079
(f) Excludes merger related costs of $1,550,000 and $451,000 and related tax
effect incurred by Penseco and Old Forge Bank, respectively
20
<Page>21
PRO FORMA INCOME STATEMENT
For the Six Months Ended June 30, 2009
<Table>
<Caption>
Penseco
Financial Services Old Forge
Corporation Bank Pro Forma
($ = 000's) 6/30/2009 6/30/2009 Adjustments 6/30/2009
- ----------------------------------------------------------------- --------- ----------- ---------
INTEREST INCOME
Interest and fees on loans $ 15,011 $ 2,524 184 (a) $ 17,119
Interest and dividends on investments 3,766 377 (30) (b) 4,113
Interest on Federal funds sold - 1 1
Interest on balances with banks 6 - 6
- -------------------------------------------------------------------------------------------------------------
Total Interest Income 18,783 2,902 154 21,839
- -------------------------------------------------------------------------------------------------------------
INTEREST EXPENSE
Interest on deposits 3,144 897 (92) (c) 3,949
Interest on borrowed funds 1,601 9 1,610
- -------------------------------------------------------------------------------------------------------------
Total Interest Expense 4,745 906 (92) 5,559
- -------------------------------------------------------------------------------------------------------------
Net Interest Income 14,038 1,996 246 16,280
Provision for loan losses 1,231 75 1,306
- -------------------------------------------------------------------------------------------------------------
Net Interest Income After Provision
for Loan Losses 12,807 1,921 246 14,974
- -------------------------------------------------------------------------------------------------------------
NON-INTERST INCOME
Service charges on deposits 820 80 900
Other non-interest income 4,047 97 4,144
Realized gains (losses) on securities 314 - 314
- -------------------------------------------------------------------------------------------------------------
Total Non-Interest Income 5,181 177 5,358
- -------------------------------------------------------------------------------------------------------------
NON-INTEREST EXPENSES
Salaries and employee benefits 5,727 696 6,423
Expense of premises and equipment 1,608 146 1,754
Other non-interest expenses 5,171 428 61 (d) 5,660
- -------------------------------------------------------------------------------------------------------------
Total Non-Interest Expenses 12,506 1,270 61 13,837
- -------------------------------------------------------------------------------------------------------------
Income before income taxes 5,482 828 185 6,495
Applicable income taxes 1,010 315 63 1,388
- -------------------------------------------------------------------------------------------------------------
Net Income $ 4,472 (f) $ 513 (f) $ 122 $ 5,107
=============================================================================================================
Earnings Per Common Share $ 2.08 $ 0.92 (e) $ 1.56
</Table>
FOOTNOTES:
- --------------------------------------------------------------------------------
(a) Amortization of loan fair value adjustment
(b) Opportunity cost of cash paid to Old Forge Bank shareholders at 0.70% rate
(c) Amortization of certificate of deposit fair value adjustment
(d) Amortization of core deposit intangible over a 10 year period using the
sum of the years digits method
(e) Pro Forma EPS based on weighted average shares outstanding of 3,276,079
(f) Excludes merger related costs of $1,550,000 and $451,000 and related tax
effect incurred by Penseco and Old Forge Bank, respectively
21
<Page>22
PRO FORMA INCOME STATEMENT
For the Six Months Ended June 30, 2008
<Table>
<Caption>
Penseco
Financial Services Old Forge
Corporation Bank Pro Forma
($ = 000's) 6/30/2008 6/30/2008 Adjustments 6/30/2008
- ----------------------------------------------------------------- --------- ----------- ---------
INTEREST INCOME
Interest and fees on loans $ 13,097 $ 5,094 367 (a) $ 18,558
Interest and dividends on investments 3,820 889 (61) (b) 4,648
Interest on Federal funds sold - 31 31
Interest on balances with banks 34 5 39
Total Interest Income 16,951 6,019 306 23,276
- -------------------------------------------------------------------------------------------------------------
INTEREST EXPENSE
Interest on deposits 3,763 2,264 (235) (c) 5,792
Interest on borrowed funds 1,944 29 1,973
- -------------------------------------------------------------------------------------------------------------
Total Interest Expense 5,707 2,293 (235) 7,765
- -------------------------------------------------------------------------------------------------------------
Net Interest Income 11,244 3,726 541 15,511
Provision for loan losses 451 150 601
- -------------------------------------------------------------------------------------------------------------
Net Interest Income After Provision
for Loan Losses 10,793 3,576 541 14,910
- -------------------------------------------------------------------------------------------------------------
NON-INTEREST INCOME
Service charges on deposits 659 195 854
Other non-interest income 5,323 185 5,508
Realized gains (losses) on securities - 18 18
- -------------------------------------------------------------------------------------------------------------
Total Non-Interest Income 5,982 398 6,380
- -------------------------------------------------------------------------------------------------------------
NON-INTEREST EXPENSES
Salaries and employee benefits 4,924 1,445 6,369
Expense of premises and equipment 1,435 272 1,707
Other non-interest expenses 4,156 783 122 (d) 5,061
- -------------------------------------------------------------------------------------------------------------
Total Non-Interest Expenses 10,515 2,500 122 13,137
- -------------------------------------------------------------------------------------------------------------
Income before income taxes 6,260 1,474 419 8,153
Applicable income taxes 1,375 289 142 1,806
- -------------------------------------------------------------------------------------------------------------
Net Income $ 4,885 (f) $ 1,185 (f) $ 277 $ 6,347
=============================================================================================================
Earnings Per Common Share $ 2.27 $ 2.12 (e) $ 1.94
</Table>
FOOTNOTES:
- --------------------------------------------------------------------------------
(a) Amortization of loan fair value adjustment
(b) Opportunity cost of cash paid to Old Forge Bank shareholders at 0.70% rate
(c) Amortization of certificate of deposit fair value adjustment
(d) Amortization of core deposit intangible over a 10 year period using the
sum of the years digits method
(e) Pro Forma EPS based on Pro Forma shares outstanding of 3,276,079
(f) Excludes merger related costs of $1,550,000 and $451,000 and related tax
effect incurred by Penseco and Old Forge Bank, respectively
22
<Page>23
PART 1. FINANCIAL INFORMATION, ITEM 2 --
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
The following commentary provides an overview of the financial condition and
significant changes in the results of operations of Penseco Financial Services
Corporation (the "Company") and its subsidiary, Penn Security Bank and Trust
Company (the "Bank"), at June 30, 2009 and for the three and six month periods
ended June 30, 2009 and June 30, 2008. All information is presented in thousands
of dollars, except as indicated. The Company consummated the acquisition of Old
Forge Bank on April 1, 2009 (the Merger). Therefore, the operating results for
Old Forge Bank for the three month period ended March 31, 2009 is not included
herein.
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
Provision (allowance) for possible loan losses - The provision for loan losses
is based on past loan loss experience, management's evaluation of the potential
loss in the current loan portfolio under current economic conditions and such
other factors as, in management's best judgment, deserve current recognition in
estimating loan losses. The annual provision for loan losses charged to
operating expense is that amount which is sufficient to bring the balance of the
allowance for possible loan losses to an adequate level to absorb anticipated
losses.
Actuarial assumptions associated with pension, post-retirement and other
employee benefit plans - These assumptions include discount rate, rate of future
compensation increases and expected return on plan assets.
Provision for income taxes - Management believes that the assumptions and
judgments used to record tax related assets or liabilities have been
appropriate.
Fair value of certain investment securities - Fair value of investment
securities are based on quoted market prices.
Premium amortization - The amortization of premiums on mortgage-backed
securities is done based on management's estimate of the lives of the
securities, adjusted, when necessary, for advanced prepayments in excess of
those estimates.
Loans purchased - Loans purchased as a result of the Merger were recorded at the
acquisition date fair value. Management made three different types of fair value
adjustments in order to record the loans at fair value. An interest rate fair
value adjustment was made comparing current weighted average rates of the
acquired loans to stated market rates of similar loan types. A general credit
fair value adjustment was made on similar loan types based on historical loss
projections plus a discount for the weak economic environment. A specific credit
fair value adjustment was made to loans identified by management as being
problematic. The specific loans have been discounted by management based on
collateral values and expected cash flows. The interest rate and general credit
fair value adjustments are being accreted over an eight year period based on a
sum-of-the-years-digits basis. The specific credit fair value adjustment is
reduced only when cash flows are received.
Loan servicing rights - Mortgage servicing rights are evaluated for impairment
based on the fair value of those rights. Fair values are estimated using
discounted cash flows based on current market rates of interest and current
expected future prepayment rates. For purposes of measuring impairment, the
rights must be stratified by one or more predominant risk characteristics of the
underlying loans. The Company stratifies its capitalized mortgage servicing
rights based on the product type, interest rate and term of the underlying
loans. The amount of impairment recognized is the amount, if any, by which the
amortized cost of the rights for each stratum exceed the fair value.
23
<Page>24
Time Deposits - Time Deposits acquired through the Merger have been recorded at
their acquisition date fair value. The fair value of time deposits represents
the present value of the time deposits expected contractual payments discounted
by market rates for similar deposits. The fair value adjustment is amortized
monthly based a level yield methodology.
Core Deposit Intangible - The fair value assigned to the core deposit intangible
asset represents the future economic benefit of the potential cost savings from
acquiring core deposits in the Merger compared to the cost of obtaining
alternative funding such as brokered deposits from market sources. Management
utilized an income approach to present value the expected after tax cash flow
benefits of the acquired core deposits.
MERGER AND ACQUISITIONS
On April 1, 2009, the Company completed the Merger with Old Forge Bank in a cash
and stock transaction valued at approximately $55.5 million. The Merger is
accounted for using the acquisition method of accounting and, accordingly, the
assets and liabilities of Old Forge Bank have been recorded at their respective
fair values on the date the Merger was completed. The Merger was effected by the
issuance of 1,128,079 shares of Company common stock to Old Forge Bank. Each
share of Old Forge Bank common stock was exchanged for 2.9012 shares of Company
common stock, with any fractional shares as a result of the exchange, paid to
Old Forge Bank shareholders in cash based on $35.255 per share of Company stock.
NON-GAAP FINANCIAL MEASURES
Certain financial measures contained in this Form 10-Q with respect to the three
months and six months ended June 30, 2009 exclude the decrease of the liability
accrual related to VISA's covered litigation provision as well as the gain from
the mandatory redemption of a portion of the Company's class B shares in VISA.
Also, as to the three months and six months ended June 30, 2008, these financial
measures exclude Merger related costs related to the acquisition of Old Forge
Bank on April 1, 2009. Financial measures which exclude the above referenced
items have not been determined in accordance with generally accepted accounting
principles ("GAAP") and are therefore non-GAAP financial measures. Management of
the Company believes that investors' understanding of the Company's performance
is enhanced by disclosing these non-GAAP financial measures as a reasonable
basis for comparison of the Company's ongoing results of operations. These
non-GAAP measures should not be considered a substitute for GAAP-basis measures
and results. Our non-GAAP measures may not be comparable to non-GAAP measures of
other companies. The attached Non-GAAP Reconciliation Schedule provides a
reconciliation of these non-GAAP financial measures to the most closely
analogous measure determined in accordance with GAAP.
In March 2008, VISA, Inc. (VISA) completed its initial public offering. The Bank
and certain other VISA member banks are shareholders in VISA. Following the
initial public offering, the Company received $1.2 million in proceeds from the
offering, as a mandatory partial redemption of 28,351 shares, reducing the
Company's holdings from 73,333 to 44,982 shares of Class B common stock. Using
proceeds from this offering, VISA established a $3.0 billion escrow account to
cover the resolution of pending litigation and related claims. The partial
redemption proceeds of $1.2 million are reflected in other non-interest income
in the first quarter of 2008.
The remaining unredeemed shares of VISA Class B common stock are restricted and
may not be transferred until the later of (1) three years from the date of the
initial public offering or (2) the period of time necessary to resolve the
covered litigation. The current conversion ratio of 0.5824 was established for
the conversion rate of Class B shares into Class A shares. If the funds in the
escrow account are insufficient to settle all the covered litigation, VISA may
sell additional Class A shares, use the proceeds to settle litigation, and
further reduce the conversion ratio. If funds remain in the escrow account after
all litigation is settled, the Class B conversion ratio will be increased to
reflect that surplus. As of June 30, 2009, the value of the Class A shares was
$62.26 per share. The value of unredeemed Class A equivalent shares owned by the
Company was $1.6 million as of June 30, 2009, and has not yet been reflected in
the accompanying financial statements.
In connection with VISA's establishment of the litigation escrow account, the
Company reversed $497 reserve in the first quarter of 2008, reflected as a
reduction of other non-interest expense. This reserve was created in the fourth
24
<Page>25
quarter of 2007, pending completion of the VISA, Inc. initial public offering as
a charge to other non-interest expense.
Merger costs of $215 and $1,550 in the three months and six months ended June
30, 2009, respectively, related to the acquisition of Old Forge Bank consist
primarily of investment banking costs, system conversion costs, valuation
services, legal and accounting fees and severance payments.
NON-GAAP RECONCILIATION SCHEDULE
PENSECO FINANCIAL SERVICES CORPORATION
(UNAUDITED)
(IN THOUSANDS)
The following tables present the reconciliation of non-GAAP financial measures
to reported GAAP financial measures.
<Table>
<Caption>
Three Months Ended
June 30,
2009 2008 Change
----------- --------- -----------
Net interest income after provision for loan losses $ 7,805 $ 5,451 $ 2,354
Non-interest income 2,771 2,364 407
Non-interest expense (6,932) (5,457) (1,475)
Income tax benefit (provision) (775) (430) (345)
----------- --------- -----------
Net income 2,869 1,928 941
ADJUSTMENTS
- -----------
Non-interest income
Gain on mandatory redemption of VISA, Inc.
class B common stock - - -
Non-interest expense
Merger related costs 215 - 215
Covered litigation provision - - -
----------- --------- -----------
Total Adjustments pre-tax 215 - 215
Income tax provision (benefit) 73 - 73
----------- --------- -----------
After tax adjustments to GAAP 142 - 142
----------- --------- -----------
Adjusted net income $ 3,011 $ 1,928 $ 1,083
=========== ========= ===========
Return on Average Assets 1.42% 1.25%
Return on Average Equity 10.49% 10.53%
Dividend Payout Ratio 45.65% 46.07%
</Table>
Return on average equity (ROE) and return on average assets (ROA) for the three
months ended June 30, 2009 was 10.00% (10.49% excluding the Merger costs) and
1.35% (1.42% excluding the Merger costs), respectively. ROE was 10.53% and ROA
was 1.25% for the same period last year. The dividend payout ratio was 47.73%
(45.65% excluding the Merger costs) and was 46.07% for the same period last
year.
25
<Page>26
NON-GAAP RECONCILIATION SCHEDULE
PENSECO FINANCIAL SERVICES CORPORATION
(UNAUDITED)
(IN THOUSANDS)
The following tables present the reconciliation of non-GAAP financial measures
to reported GAAP financial measures.
<Table>
<Caption>
Six Months Ended
June 30,
2009 2008 Change
----------- --------- -----------
Net interest income after provision for loan losses $ 12,807 $ 10,793 $ 2,014
Non-interest income 5,181 5,982 (801)
Non-interest expense (14,056) (10,515) (3,541)
Income tax benefit (provision) (622) (1,375) 753
----------- --------- -----------
Net income 3,310 4,885 (1,575)
ADJUSTMENTS
- -----------
Non-interest income
Gain on mandatory redemption of VISA, Inc.
class B common stock - (1,213) 1,213
Non-interest expense
Merger related costs 1,550 - 1,550
Covered litigation provision - (497) 497
----------- --------- -----------
Total Adjustments pre-tax 1,550 (1,710) 3,260
Income tax provision (benefit) 527 (581) 1,108
----------- --------- -----------
After tax adjustments to GAAP 1,023 (1,129) 2,152
----------- --------- -----------
Adjusted net income $ 4,333 $ 3,756 $ 577
=========== ========= ===========
Return on Average Assets 1.17% 1.24%
Return on Average Equity 9.15% 10.45%
Dividend Payout Ratio 52.50% 46.86%
</Table>
Return on average equity (ROE) and return on average assets (ROA) for the six
months ended June 30, 2009 was 6.99% (9.15% excluding the Merger costs) and .89%
(1.17% excluding the Merger costs), respectively. ROE was 13.59% (10.45%
excluding the VISA IPO impact) and ROA was 1.62% (1.24% excluding the VISA IPO
impact) for the same period last year. The dividend payout ratio was 68.85%
(52.50% excluding the Merger costs) and was 36.12% (46.86% excluding the VISA
IPO impact) for the same period last year.
EXECUTIVE SUMMARY
Penseco Financial Services Corporation reported an increase in net income of
$941 or 48.8% for the three months ended June 30, 2009 to $2,869 or $.88 per
share compared with $1,928 or $.89 per share from the year ago period. The
increase in net income was primarily attributed to the Merger with Old Forge
Bank, which was completed on April 1, 2009. Net interest income increased $2,373
or 41.9% largely due to an increased loan portfolio of $144.7 million from Old
Forge Bank. Core net income increased $1,083 or 56.2% due to higher earning
assets related to the Merger with Old Forge Bank. Non-interest income increased
$407 or 17.2% partly from service charges on deposit accounts and higher
operating income. The Company realized security gains of $314, primarily from
the sale of Old Forge Bank securities which was reinvested in higher credit
quality securities. Offsetting this increase was higher total non-interest
expenses of $1,475 or 27.0% mainly from higher salary and benefits expenses and
operating expenses, primarily merger costs and a special one time FDIC insurance
assessment of $242. Return on average assets and return on average equity was
1.35% and 10.00% for the three months ending June 30, 2009, respectively versus
1.25% and 10.53% for the same period last year.
The Company reported a decrease in net income of $1,575 for the six months ended
June 30, 2009 to $3,310 or $1.22 per weighted average share compared with $4,885
or $2.27 per share from the year ago period. The decrease in net income was
primarily attributed to $1,550 of merger related costs associated with the
acquisition of Old Forge Bank, along with the first quarter 2008 one time
positive impact of $1,710 related to Visa International's Initial
26
<Page>27
Public Offering. Net interest income, after provision for loan losses, increased
$2,014 or 18.7% largely due to increased interest and fees on loans and reduced
interest expense from lower deposit costs. Core net income increased $577 or
15.4% due to increases in earning assets. The Company increased the provision
for potential loan losses by $780 due to the softness in the economy. As of June
30, 2009 there are no significant loans as to which management has serious doubt
about their collectibility.
Net income from accretion and amortization of acquisition date fair value
adjustments included in the three months ended and six months ended June 30,
2009 financial results.
Homogeneous loan pools $ 184
Time deposits 143
Core deposit intangible expense (61)
---------
Net income from acquisition fair value adjustment $ 266
---------
Accretion of the loan pools credit fair value adjustment and market rate fair
value adjustment is calculated on a sum-of-the-year-digits basis over an eight
year period. The fair value market rate adjustment of the time deposits is
amortized monthly based on a level yield methodology. The core deposit
intangible is being amortized over ten years on a sum-of-the-years-digits basis.
NET INTEREST INCOME AND NET INTEREST MARGIN
Net interest income, the largest contributor to the Company's earnings, is
defined as the difference between interest income on assets and the cost of
funds supporting those assets. Average earning assets are composed primarily of
loans and investments while deposits, short-term and long-term borrowings
represent interest-bearing liabilities. Variations in the volume and mix of
these assets and liabilities, as well as changes in the yields earned and rates
paid, are determinants of changes in net interest income.
Net interest income before provision for loan losses increased $2,373 or 41.9%
to $8,040 for the three months ended June 30, 2009 compared to $5,667 for the
three months ended June 30, 2008. The average yield on interest earning assets
decreased 24 basis points.
The net interest margin represents the Company's net yield on its average
interest earning assets and is calculated as net interest income divided by
average interest earning assets. In the three months ended June 30, 2009, net
interest margin increased 27 basis points to 4.13% from 3.86% in the same period
of 2008.
Total average interest earning assets and average interest bearing funds
increased during the three months ended June 30, 2009 as compared to 2008.
Average interest earning assets increased $190.7 million or 32.5%, from $587.3
million in 2008 to $778.0 million in 2009 and average interest bearing funds
increased $159.4 million, or 34.1%, from $468.0 million to $627.4 million for
the same period. Average long-term borrowings decreased a net of $10.5 million
or 13.3% during the three months ended June 30, 2009 from year ago levels.
Average earning assets, including Bank-Owned Life Insurance (BOLI), decreased to
93.2% for the three months ended June 30, 2009 from 96.4% for the year ago
period.
Changes in the mix of both interest earning assets and funding sources also
impacted net interest income in the three months ended June 30, 2009 and 2008.
Average loans as a percentage of average interest earning assets increased from
70.4% in 2008 to 75.9% in 2009. Average investments increased $13.9 million but
decreased to 23.5% from 28.8% as a percentage of interest earning assets.
Interest bearing balances with banks decreased $.3 million to $4.6 million from
$4.9 million. Average time deposits increased $93.6 million to $202.0 million
from $108.4 million; average long-term borrowings decreased $10.5 million, and
repurchase agreements decreased $12.7 million or 33.9% to $24.8 million compared
to $37.5 million for the year ago period.
Shifts in the interest rate environment and competitive factors affected the
rates paid for funds as well as the yields earned on assets. The investment
securities tax equivalent yield decreased 8 basis points from 5.76% for the
three months ended June 30, 2008 to 5.68% for the three months ended June 30,
2009. Average loan yields decreased 32 basis points, from 6.23% for the three
months ended June 30, 2008 to 5.91% for the three months ended June 30, 2009.
The average time deposit costs decreased 134 basis points from 3.85% for the
three months ended June 30, 2008 to 2.51% for the three months ended June 30,
2009. In addition, the average cost of money market accounts decreased 74 basis
points from 1.89% for the three months ended June 30, 2008 to 1.15% for the
three months ended June 30, 2009.
27
<Page>28
DISTRIBUTION OF ASSETS, LIABILITIES AND STOCKHOLDERS' EQUITY/INTEREST RATES AND
INTEREST DIFFERENTIAL
The table below presents average balances, interest income on a fully taxable
equivalent basis and interest expense, as well as average rates earned and paid
on the Company's major asset and liability items for the three months ended June
30, 2009 and June 30, 2008.
<Table>
<Caption>
- ---------------------------------------------------------------------------------------------------------------
JUNE 30, 2009 JUNE 30, 2008
ASSETS AVERAGE REVENUE/ YIELD/ AVERAGE REVENUE/ YIELD/
BALANCE EXPENSE RATE BALANCE EXPENSE RATE
- ---------------------------------------------------------------------------------------------------------------
Investment Securities
Available-for-sale:
U.S. Agency obligations $ 59,519 $ 517 3.47% $ 54,708 $ 670 4.90%
States & politicalsubdivisions 58,292 755 7.85% 41,115 448 6.60%
Federal Home Loan Bank stock 6,330 - - 4,733 46 3.89%
Other 1,490 8 2.15% 3,035 23 3.03%
Held-to-maturity:
U.S. Agency obligations 29,273 355 4.85% 36,311 430 4.74%
States & political subdivisions 28,059 378 8.16% 29,237 388 8.04%
Loans, net of unearned income:
Real estate mortgages 340,371 4,797 5.64% 266,310 4,037 6.06%
Commercial real estate 156,079 2,068 5.30% 86,626 1,364 6.30%
Commercial 26,117 354 5.42% 24,384 413 6.77%
Consumer and other 67,847 1,508 8.89% 35,909 622 6.93%
Federal funds sold - - - - - -
Interest on balances with banks 4,649 3 0.26% 4,903 23 1.88%
- ---------------------------------------------------------------------------------------------------------------
Total Interest Earning Assets/
Total Interest Income 778,026 $10,743 5.82% 587,271 $8,464 6.06%
- ---------------------------------------------------------------------------------------------------------------
Cash and due from banks 11,334 10,197
Bank premises and equipment 12,351 9,139
Accrued interest receivable 3,919 3,299
Goodwill 26,398 -
Cash surrender value of life insurance 14,054 7,476
Other assets 10,433 4,671
Less: Allowance for loan losses 6,405 4,933
- ---------------------------------------------------------------------------------------------------------------
TOTAL ASSETS $850,110 $617,120
- ---------------------------------------------------------------------------------------------------------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits:
Demand-Interest bearing $ 68,242 $ 132 0.77% $ 54,413 $ 104 0.76%
Savings 111,265 116 0.42% 76,082 106 0.56%
Money markets 141,500 407 1.15% 111,071 526 1.89%
Time - Over $100 69,730 482 2.76% 36,649 355 3.87%
Time - Other 132,256 786 2.38% 71,773 688 3.83%
Federal funds purchased 1,918 3 0.63% - - -
Repurchase agreements 24,752 96 1.55% 37,488 253 2.70%
Short-term borrowings 9,204 13 0.56% 1,505 9 2.39%
Long-term borrowings 68,547 668 3.90% 79,044 756 3.83%
- ---------------------------------------------------------------------------------------------------------------
Total Interest Bearing Liabilities/
Total Interest Expense 627,414 $ 2,703 1.72% 468,025 $2,797 2.39%
- ---------------------------------------------------------------------------------------------------------------
Demand - Non-interest bearing 100,603 70,721
All other liabilities 7,296 5,114
Stockholders' equity 114,797 73,260
- ---------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES AND
STOCKHOLDERS' EQUITY $850,110 $617,120
- ---------------------------------------------------------------------------------------------------------------
Interest Spread 4.10% 3.67%
- ---------------------------------------------------------------------------------------------------------------
Net Interest Income $ 8,040 $5,667
- ---------------------------------------------------------------------------------------------------------------
FINANCIAL RATIOS
Net interest margin 4.13% 3.86%
Return on average assets 1.35% 1.25%
Return on average equity 10.00% 10.53%
Average equity to average assets 13.50% 11.87%
Dividend payout ratio 47.73% 46.07%
- ---------------------------------------------------------------------------------------------------------------
</Table>
28
<Page>29
Net interest income before provision for loan losses increased $2,794 or 24.8%
to $14,038 for the six months ended June 30, 2009, compared to $11,244 for the
six months ended June 30, 2008. The average yield on interest earning assets
decreased 47 basis points, largely from the Federal Reserve Bank lowering its
target for the federal funds rate to 25 basis points from the fall of 2008.
The net interest margin represents the Company's net yield on its average
interest earning assets and is calculated as net interest income divided by
average interest earning assets. For the six months ended June 30, 2009, net
interest margin was 4.07% increasing 15 basis points from 3.92% in the same
period of 2008.
Total average interest earning assets and average interest bearing funds
increased for the six months ended June 30, 2009 as compared to the six months
ended June 30, 2008. Average interest earning assets increased $115.6 million or
20.1%, from $574.1 million in 2008 to $689.7 million in 2009 and average
interest bearing funds increased $96.8 million, or 21.2%, from $456.1 million to
$552.9 million for the same period. As a percentage of average assets, average
earning assets, including BOLI, decreased to 94.6% for the six months ended June
30, 2009 from 96.3% for the year ago period.
Changes in the mix of both interest earning assets and funding sources also
impacted net interest income in the six months ended June 30, 2009 and 2008.
Average loans as a percentage of average interest earning assets increased from
71.5% in 2008 to 74.5% in 2009, due in part to the Merger with Old Forge Bank.
Average investments increased $12.2 million year over year and decreased as a
percentage of average assets to 25.0% at June 30, 2009 from 27.9% at June 30,
2008. Average short-term investments, federal funds sold and interest bearing
balances with banks, remained flat with year ago levels. Average time deposits
increased $48.6 million or 45.0% from 23.7% of interest bearing liabilities in
2008 to 28.3% in 2009. During the six months ended June 30, 2009, average
federal funds purchased increased $3.9 million; average repurchase agreements
decreased $3.4 million; average short-term borrowings increased $3.3 million and
average long-term borrowings decreased $1.2 million.
Shifts in the interest rate environment and competitive factors affected the
rates paid for funds as well as the yields earned on assets. The investment
securities tax equivalent yield decreased 29 basis points from 5.84% for the six
months ended June 30, 2008 to 5.55% for the six months ended June 30, 2009.
Also, average loan yields decreased 53 basis points, from 6.38% for the six
months ended June 30, 2008 to 5.85% for the same period of 2008.
The average time deposit costs decreased 141 basis points from 4.03% for the six
months ended September 30, 2008 to 2.62% for the six months ended June 30, 2009,
along with the average cost of money market accounts decreasing 103 basis points
from 2.12% for the six months ended June 30, 2008 to 1.09% for the six months
ended June 30, 2009.
29
<Page>30
DISTRIBUTION OF ASSETS, LIABILITIES AND STOCKHOLDERS' EQUITY/INTEREST RATES AND
INTEREST DIFFERENTIAL
The table below presents average balances, interest income on a fully taxable
equivalent basis and interest expense, as well as average rates earned and paid
on the Company's major asset and liability items for the six months ended June
30, 2009 and June 30, 2008.
<Table>
<Caption>
- ---------------------------------------------------------------------------------------------------------------
JUNE 30, 2009 JUNE 30, 2008
ASSETS AVERAGE REVENUE/ YIELD/ AVERAGE REVENUE/ YIELD/
BALANCE EXPENSE RATE BALANCE EXPENSE RATE
- ---------------------------------------------------------------------------------------------------------------
Investment Securities
Available-for-sale:
U.S. Agency obligations $ 56,061 $ 1,015 3.62% $ 45,349 $ 1,140 5.03%
States & political subdivisions 49,708 1,229 7.49% 40,855 896 6.65%
Federal Home Loan Bank stock 5,949 - - 4,809 94 3.91%
Other 1,375 22 3.20% 2,885 49 3.40%
Held-to-maturity:
U.S. Agency obligations 30,905 735 4.76% 37,270 865 4.64%
States & political subdivisions 28,644 765 8.09% 29,238 776 8.04%
Loans, net of unearned income:
Real estate mortgages 307,334 8,770 5.71% 264,659 8,136 6.15%
Commercial real estate 128,939 3,508 5.44% 85,520 2,808 6.57%
Commercial 25,535 698 5.47% 24,045 857 7.13%
Consumer and other 51,781 2,035 7.86% 36,287 1,296 7.14%
Federal funds sold - - - - - -
Interest on balances with banks 3,474 6 0.35% 3,192 34 2.13%
- ---------------------------------------------------------------------------------------------------------------
Total Interest Earning Assets/
Total Interest Income 689,705 $18,783 5.74% 574,109 $16,951 6.21%
- ---------------------------------------------------------------------------------------------------------------
Cash and due from banks 9,700 10,049
Bank premises and equipment 11,435 9,198
Accrued interest receivable 3,609 3,317
Goodwill 13,199 -
Cash surrender value of life insurance 10,884 7,436
Other assets 7,698 4,720
Less: Allowance for loan losses 5,830 4,818
- ---------------------------------------------------------------------------------------------------------------
TOTAL ASSETS $740,400 $604,011
- ---------------------------------------------------------------------------------------------------------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits:
Demand-Interest bearing $ 60,125 $ 189 0.63% $ 53,424 $ 216 0.81%
Savings 93,114 191 0.41% 76,943 237 0.62%
Money markets 130,147 712 1.09% 107,355 1,136 2.12%
Time - Over $100 54,244 760 2.80% 38,390 806 4.20%
Time - Other 102,209 1,292 2.53% 69,496 1,368 3.94%
Federal funds purchased 3,921 11 0.56% - - -
Repurchase agreements 27,148 204 1.50% 30,571 407 2.66%
Short-term borrowings 12,012 34 0.57% 8,670 149 3.44%
Long-term borrowings 69,985 1,352 3.86% 71,228 1,388 3.90%
- ---------------------------------------------------------------------------------------------------------------
Total Interest Bearing Liabilities/
Total Interest Expense 552,905 4,745 1.72% 456,077 5,707 2.50%
- ---------------------------------------------------------------------------------------------------------------
Demand - Non-interest bearing 86,808 70,784
All other liabilities 6,002 5,264
Stockholders' equity 94,685 71,886
- ---------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $740,400 $604,011
- ---------------------------------------------------------------------------------------------------------------
Interest Spread 4.02% 3.71%
- ---------------------------------------------------------------------------------------------------------------
Net Interest Income $14,038 $11,244
- ---------------------------------------------------------------------------------------------------------------
FINANCIAL RATIOS
Net interest margin 4.07% 3.92%
Return on average assets 0.89% 1.62%
Return on average equity 6.99% 13.59%
Average equity to average assets 12.79% 11.90%
Dividend payout ratio 68.85% 36.12%
- ---------------------------------------------------------------------------------------------------------------
</Table>
30
<Page>31
INVESTMENTS
The Company's investment portfolio has primarily two functions: To provide
liquidity and to contribute to earnings. To provide liquidity the Company may
invest in short-term securities such as Federal funds sold, interest bearing
deposits with banks, U.S. Treasury securities and U.S. Agency securities all
with maturities of one year or less. These funds are invested short-term to
ensure the availability of funds to meet customer demand for credit needs. The
Company enhances interest income by securing long-term investments within its
investment portfolio, by means of U.S. Treasury securities, U.S. Agency
securities, municipal securities and mortgage-backed securities, generally with
maturities greater than one year. The Company's mortgage-backed securities
portfolio does not contain any sub-prime or Alt-A credits.
Investments in securities are classified in two categories and accounted for as
follows:
Securities Held-to-Maturity Bonds, notes, debentures and mortgage-backed
- ---------------------------
securities for which the Company has the positive intent and ability to hold to
maturity are reported at cost, adjusted for amortization of premiums and
accretion of discounts computed on the straight-line basis, which approximates
the interest method, over the remaining period to maturity.
Securities Available-for-Sale Bonds, notes, debentures, mortgage-backed
- -----------------------------
securities and certain equity securities not classified as securities to be held
to maturity are carried at fair value with unrealized holding gains and losses,
net of tax, reported as a net amount in a separate component of stockholders'
equity until realized.
The amortization of premiums on mortgage-backed securities is done based on
management's estimate of the lives of the securities, adjusted, when necessary,
for advanced prepayments in excess of those estimates.
Realized gains and losses on the sale of securities available-for-sale are
determined using the specific identification method and are reported as a
separate component of other income in the Statements of Income. Unrealized gains
and losses are included as a separate item in computing comprehensive income.
DEPOSITS
The Company is largely dependent on its core deposit base to fund operations.
Management has competitively priced its deposit products in checking, savings,
money market and time deposits to provide a stable source of funding.
As general interest rates in the economy change, there is migration of some
deposits among investment options as customers seek increased yields.
Historically, such changes in the Company's deposit base have been minimal.
PROVISION FOR LOAN LOSSES
The provision for loan losses represents management's determination of the
amount necessary to bring the allowance for loan losses to a level that
management considers adequate to reflect the risk of future losses inherent in
the Company's loan portfolio. The process of determining the adequacy of the
allowance is necessarily judgmental and subject to changes in external
conditions. The allowance for loan losses reflects management's judgment as to
the level considered appropriate to absorb such losses based upon a review of
many factors, including historical loss experience, adverse situations that may
affect a borrower's ability to repay (including the timing of future payments),
economic conditions and trends, loan portfolio volume and mix, loan performance
trends, the value and adequacy of collateral, and the Company's internal credit
review process. Accordingly, there can be no assurance that existing levels of
the allowance will ultimately prove adequate to cover actual loan losses. The
quarterly provision for loan losses charged to operating expense is that amount
which is sufficient to bring the balance of the allowance for possible loan
losses to an adequate level to absorb anticipated losses. Based on this ongoing
evaluation, management determines the provision necessary to maintain an
appropriate allowance.
The provision for loan losses increased $19 from $216 for the three months ended
June 30, 2008 to $235 for the three months ended June 30, 2009, mainly due to
the management's more conservative valuation of the loan portfolio for loan
losses in response to recent economic conditions. Loans charged off totaled $237
and recoveries were $2 for the three months ended June 30, 2009. In the same
period of 2008, loans charged off totaled $12 and recoveries were $11. For the
six months ended June 30, 2009, the provision for loan losses was $1,231, an
increase from $451 in the first six months of 2008. Loans charged-off totaled
$459 and recoveries were $3 for the six months
31
<Page>32
ended June 30, 2009. In the same period of 2008, loans charged off totaled $27
and recoveries were $16. At June 30, 2009 the allowance for loan losses was
$6,050, or 1.03% of gross loans compared to $5,140 or 1.22% of gross loans at
June 30, 2008.
NON-INTEREST INCOME
The following table sets forth information by category of non-interest income
for the Company for the three months ended June 30, 2009 and June 30, 2008,
respectively:
<Table>
<Caption>
June 30, June 30,
Three Months Ended: 2009 2008
- -------------------------------------------------------------------
Trust department income $ 375 $ 382
Service charges on deposit accounts 481 396
Merchant transaction income 841 935
Brokerage income 79 169
Other fee income 331 320
Bank-owned life insurance income 132 80
Other operating income 218 82
VISA mandatory share redemption - -
Realized gains (losses) on securities, net 314 -
- -------------------------------------------------------------------
Total Non-Interest Income $2,771 $2,364
===================================================================
</Table>
Total non-interest income increased $407 or 17.2% to $2,771 for the three months
ended June 30, 2009, compared with $2,364 for the same period in 2008. Service
charges on deposit accounts increased $85 or 21.5% primarily due to the
increased number of accounts and increased service charge activity. Merchant
transaction income decreased $94 or 10.1% due to lower transaction volume mainly
from continued softness in the economy. Brokerage fee income decreased $90 or
53.3% mostly due to the decline in the overall market. Bank-owned life insurance
income increased $52 or 65.0% due to the Old Forge Bank merger. Other operating
income increased $136 largely due to gains on the sale of low yielding long-term
fixed rate real estate loans. The majority of the Old Forge Bank securities
portfolio was sold during the second quarter of 2009 netting gains of $302, with
the proceeds reinvested into higher quality securities.
The following table sets forth information by category of non-interest income
for the Company for six months ended June 30, 2009 and June 30, 2008,
respectively:
<Table>
<Caption>
June 30, June 30,
Six Months Ended: 2009 2008
- -------------------------------------------------------------------
Trust department income $ 685 $ 747
Service charges on deposit accounts 820 659
Merchant transaction income 2,049 2,119
Brokerage income 196 351
Other fee income 618 617
Bank-owned life insurance income 211 158
Other operating income 288 118
VISA mandatory share redemption - 1,213
Realized gains (losses) on securities, net 314 -
- -------------------------------------------------------------------
Total Non-Interest Income $5,181 $5,982
===================================================================
</Table>
Total non-interest income decreased $801 or 13.4% to $5,181 during the first
half of 2009 from $5,982 for the same period of 2008. The lower non-interest
income was primarily attributed to a one time gain of $1,213 related to the Visa
IPO during first quarter of 2008. Service charges on deposit accounts increased
$161 or 24.4%. Merchant transaction income decreased $70 or 3.3%, mainly due to
lower transaction volume from continued softness in the economy. Brokerage fee
income decreased $155 or 44.2% mostly due to the decline in the overall market.
Bank-owned life insurance income increased $53 or 33.5% due to the Old Forge
Bank merger. Other operating income increased $170 or 144.1% largely due to
gains on the sale of low yielding long-term fixed rate real estate loans. The
majority of the Old Forge Bank securities portfolio was sold during the second
quarter of 2009 netting gains of $302, with the proceeds reinvested into higher
quality securities.
32
<Page>33
NON-INTEREST EXPENSES
The following table sets forth information by category of non-interest expenses
for the Company for the three months ended June 30, 2009 and June 30, 2008,
respectively:
<Table>
<Caption>
June 30, June 30,
Three Months Ended: 2009 2008
- -------------------------------------------------------------------
Salaries and employee benefits $ 3,249 $ 2,509
Expense of premises and fixed assets 817 667
Merchant transaction expenses 605 703
Merger related costs 215 -
Other operating expenses 2,046 1,578
- -------------------------------------------------------------------
Total Non-Interest Expenses $ 6,932 $ 5,457
===================================================================
</Table>
Total non-interest expenses increased $1,475 or 27.0% to $6,932 for the three
months ended June 30, 2009 compared with $5,457 for the same period of 2008.
Salaries and employee benefits expense increased $740 or 29.5% due to additional
staff from the Old Forge Bank acquisition. Expense of premises and fixed assets
increased $150 or 22.5%. Merchant transaction expenses decreased $98 or 13.9%
due to lower transaction volume from the softness in the economy. Merger related
costs of $215 consist of severance payments and stay bonuses to key employees of
Old Forge Bank to help with the transition and conversion process. Other
operating expenses increased $468 or 29.7% partly from a higher one time FDIC
special assessment cost of $242, increased shares tax of $96 and higher legal
and professional expenses.
The following table sets forth information by category of non-interest expenses
for the Company for the six months ended June 30, 2009 and June 30, 2008,
respectively:
<Table>
<Caption>
June 30, June 30,
Six Months Ended: 2009 2008
- -------------------------------------------------------------------
Salaries and employee benefits $ 5,727 $ 4,924
Expense of premises and fixed assets 1,608 1,435
Merchant transaction expenses 1,462 1,605
Merger related costs 1,550 -
Other operating expenses 3,709 2,551
- -------------------------------------------------------------------
Total Non-Interest Expenses $14,056 $10,515
===================================================================
</Table>
Total non-interest expenses increased $3,541 or 33.7% to $14,056 during the
first half of 2009 compared with $10,515 for the same period of 2008. Salaries
and employee benefits expense increased $803 or 16.3% mainly due to increased
salaries resulting from additional employees as a result of the Merger with Old
Forge Bank. Premises and fixed assets expense increased $173 or 12.1% due to
additional depreciation and increased occupancy expense in part due to the Old
Forge Bank merger. Merchant transaction expenses decreased $143 or 8.9% due to
lower transaction volume. Merger related costs of $1,550 consist of computer and
equipment upgrades of $606, investment banking, valuation services, legal and
accounting fees of $429, severance payments of $450 and stay bonuses of $65.
Other operating expenses increased $1,158 or 45.4% due to the reversal in the
first quarter of 2008 of the $497 VISA litigation accrual recorded by the
Company in the fourth quarter of 2007, offset by an increase in advertising
expenses, professional services and increased general operating expenses and a
one time FDIC special assessment cost of $385.
INCOME TAXES
Applicable income taxes increased $345 for the three months ended June 30, 2009
due to overall higher income. Also, applicable income taxes decreased $753 or
54.8% during the first half of 2009 primarily due to the $1,550 of merger costs
associated with the Old Forge Bank merger, a higher provision for loan losses in
2009 and a one time gain on the VISA IPO during the six months ended June 30,
2008.
33
<Page>34
LOAN PORTFOLIO
Details regarding the Company's loan portfolio on June 30, 2009 and December 31,
2008 are as follows:
<Table>
<Caption>
June 30, December 31,
As of: 2009 2008
- ---------------------------------------------------------------------------------
Real estate - construction and land development $ 28,828 $ 21,949
Real estate mortgages 460,980 355,528
Commercial 24,866 27,793
Credit card and related plans 3,235 3,272
Installment and other 61,473 28,135
Obligations of states & political subdivisions 7,311 4,471
- ---------------------------------------------------------------------------------
Loans, net of unearned income 586,693 441,148
Less: Allowance for loan losses 6,050 5,275
- ---------------------------------------------------------------------------------
Loans, net $580,643 $435,873
=================================================================================
</Table>
The Company does not engage in any sub-prime or Alt-A credit lending. Therefore,
the Company is not subject to any credit risks associated with such loans. The
Company's loan portfolio primarily consists of residential and commercial
mortgage loans, secured by properties located in Northeastern Pennsylvania and
subject to conservative underwriting standards.
The following table presents the components of the allowance for credit losses
as of June 30, 2009 and December 31, 2008:
<Table>
<Caption>
June 30, December 31,
2009 2008
----------------------------
Allowance for loan losses $ 6,050 $ 5,275
Credit fair value adjustment on purchased loans 6,725 -
--------- --------
Allowance for credit losses $12,775 $ 5,275
========= =========
</Table>
The allowance for loan loss as a percentage of loans was 1.03% at June 30, 2009,
compared to 1.20% at December 31, 2008. The decrease is a result of eliminating
the allowance for loan loss and incorporating a credit fair value adjustment on
purchased loans. As a result, the allowance for credit losses, which included
the allowance for loan loss and the credit fair value adjustment on loans
purchased, provides an allowance for credit loss as a percentage of period end
loans of 2.15% at June 30, 2009. The evaluation of credit fair value adjustment
on purchased loans was made in accordance accounting standards as described
below.
The increase in mortgage loans of $112.3 million between December 31, 2008 and
June 30, 2009 is predominately mortgage loans acquired in the Merger. The
mortgage loan portfolio continues to be the largest component of the loan
portfolio, representing 83.5% and 85.6% of total loans at June 30, 2009 and
December 31, 2008, respectively. However, due to deteriorating economic
conditions and continued recessionary conditions resulting in lower levels of
loan demand, we expect that loan growth may be slower than historically
expected.
The increase in installment and other loans between December 31, 2008 and June
30, 2009 is primarily due to the purchase of the indirect loan portfolio of Old
Forge Bank.
LOAN QUALITY
The lending activities of the Company are guided by the comprehensive lending
policy established by the Board of Directors. Loans must meet criteria which
include consideration of the character, capacity and capital of the borrower,
collateral provided for the loan, and prevailing economic conditions. Due to the
consistent application of conservative underwriting standards, the Company's
loan quality has remained strong during the current general economic downturn.
The Company has not engaged in any sub-prime credit lending and is therefore,
not subject to the credit risks associated with such loans.
Regardless of credit standards, there is risk of loss inherent in every loan
portfolio. The allowance for loan losses is an amount that management believes
will be adequate to absorb possible losses on existing loans that may become
uncollectible, based on evaluations of the collectibility of the loans. The
evaluations take into consideration such
34
<Page>35
factors as change in the nature and volume of the loan portfolio, overall
portfolio quality, review of specific problem loans, industry experience,
collateral value and current economic conditions that may affect the borrower's
ability to pay. Management believes that the allowance for loan losses was
adequate as of June 30, 2009. While management uses available information to
recognize losses on loans, future additions to the allowance may be necessary
based on changes in economic conditions. In addition, various regulatory
agencies, as an integral part of their examination process, periodically review
the Company's allowance for loan losses. Such agencies may require the Company
to recognize additions to the allowance based on their judgment of information
available to them at the time of their examination
The allowance for loan losses is increased by periodic charges against earnings
as a provision for loan losses, and decreased periodically by charge-offs of
loans (or parts of loans) management has determined to be uncollectible, net of
actual recoveries on loans previously charged-off.
NON-PERFORMING ASSETS
The following table sets forth information regarding non-accrual loans and loans
past due 90 days or more and still accruing interest:
<Table>
<Caption>
June 30, December 31, June 30,
As of: 2009 2008 2008
- ---------------------------------------------------------------------------------------------
Non-accrual loans $ 2,731 $ 1,454 $ 550
Other real estate owned 560 - -
- ---------------------------------------------------------------------------------------------
Total non-performing assets $ 3,291 $ 1,454 $ 550
=============================================================================================
Loans past due 90 days or more and accruing:
Secured by real estate 754 810 442
Guaranteed student loans 223 203 236
Credit card loans 6 17 9
Commercial - 119 -
Other loans to individuals for household,
family, and other personal expenditures 2 4 -
- ---------------------------------------------------------------------------------------------
Total loans past due 90 days or more
and accruing $ 985 $ 1,153 $ 687
=============================================================================================
</Table>
<Table>
<Caption>
June 30, December 31, June 30,
2009 2008 2008
----------- ------------- ------------
Allowance for loan losses $ 6,050 $ 5,275 $ 5,140
Credit fair value adjustment on loans purchased 6,725 - -
----------- ------------- ------------
Allowance for credit losses $ 12,775 $ 5,275 $ 5,140
=========== ============= ============
Non-performing assets to total assets 0.39% 0.23% 0.09%
Non-performing loans to period end loans 0.47% 0.33% 0.13%
Allowance for loan losses to period end loans 1.03% 1.20% 1.22%
Allowance for credit losses to period end loans 2.15% 1.20% 1.22%
Allowance for loan losses to non-performing loans 221.53% 362.79% 934.55%
Allowance for credit losses to non-performing loans 467.77% 362.79% 934.55%
</Table>
Non-accrual loans increased $2,181 to $2,731 at June 30, 2009 from $550 at June
30, 2008 due to the softness in the economy. Management is actively monitoring
these accounts. Also, non-accrual loans have increased $1,277 from $1,454 at
December 31, 2008.
Loans are generally placed on a non-accrual status when principal or interest is
past due 90 days and when payment in full is not anticipated. When a loan is
placed on non-accrual status, all interest previously accrued but not collected
is charged against current income. Loans are returned to accrual status when
past due interest is collected and the collection of future principal and
interest is probable.
35
<Page>36
Loans on which the accrual of interest has been discontinued or reduced amounted
to $2,731 at June 30, 2009, up from $1,454 at December 31, 2008 and $550 at
June 30, 2008. If interest on those loans had been accrued, such income would
have been $336 and $28 for the six months ended June 30, 2009 and June 30, 2008,
respectively. Interest income on those loans, which is recorded only when
received, amounted to $35 and $15 at June 30, 2009 and June 30, 2008,
respectively. There were no commitments to lend additional funds to individuals
whose loans are in non-accrual status.
Management's process for evaluating the adequacy of the allowance for loan
losses includes reviewing each month's loan committee reports which list all
loans that do not meet certain internally developed criteria as to collateral
adequacy, payment performance, economic conditions and overall credit risk.
These reports also address the current status and actions in process on each
listed loan. From this information, adjustments are made to the allowance for
loan losses. Such adjustments include both specific loss allocation amounts and
general provisions by loan category based on present and past collection
experience, nature and volume of the loan portfolio, overall portfolio quality,
and current economic conditions that may affect the borrower's ability to pay.
As of June 30, 2009 there were no significant loans as to which management had
serious doubt about their collectibility. During the second quarter of 2008, the
Company was notified that The Education Resources Institute, Inc. (TERI), a
guarantor of a portion of our student loan portfolio, had filed for
reorganization under Chapter 11 of the Federal Bankruptcy Act. Currently, the
Company holds $8.2 million of TERI loans out of a total student loan portfolio
of $19.4 million. The Company does not anticipate that TERI's bankruptcy filing
will significantly impact the Company's financial statements. These loans are
placed on non-accrual status when they become more than 90 days past due. At
June 30, 2009 there was $93,966 in such loans placed on non-accrual status.
Most of the Company's lending activity is with customers located in the
Company's geographic market area and repayment thereof is affected by economic
conditions in this market area.
LOAN LOSS EXPERIENCE
The following tables present the Company's loan loss experience during the
periods indicated:
<Table>
<Caption>
June 30, June 30,
Three Months Ended: 2009 2008
- ---------------------------------------------------------------------
Balance at beginning of period $ 6,050 $ 4,925
Charge-offs:
Real estate mortgages 146 -
Commercial and all others - -
Credit card and related plans 22 4
Installment loans 69 8
- ---------------------------------------------------------------------
Total charge-offs 237 12
- ---------------------------------------------------------------------
Recoveries:
Real estate mortgages - -
Commercial and all others - 10
Credit card and related plans - 1
Installment loans 2 -
- ---------------------------------------------------------------------
Total recoveries 2 11
- ---------------------------------------------------------------------
Net charge-offs (recoveries) 235 1
- ---------------------------------------------------------------------
Provision charged to operations 235 216
- ---------------------------------------------------------------------
Balance at End of Period $ 6,050 $ 5,140
=====================================================================
Ratio of net charge-offs (recoveries)
to average loans outstanding 0.040% 0.000%
=====================================================================
</Table>
36
<Page>37
<Table>
<Caption>
June 30, June 30,
Six Months Ended: 2009 2008
- ---------------------------------------------------------------------
Balance at beginning of period $ 5,275 $ 4,700
Charge-offs:
Real estate mortgages 308 -
Commercial and all others - -
Credit card and related plans 37 14
Installment loans 114 13
- ---------------------------------------------------------------------
Total charge-offs 459 27
- ---------------------------------------------------------------------
Recoveries:
Real estate mortgages - -
Commercial and all others - 13
Credit card and related plans 1 3
Installment loans 2 -
- ---------------------------------------------------------------------
Total recoveries 3 16
- ---------------------------------------------------------------------
Net charge-offs (recoveries) 456 11
- ---------------------------------------------------------------------
Provision charged to operations 1,231 451
- ---------------------------------------------------------------------
Balance at End of Period $ 6,050 $ 5,140
=====================================================================
Ratio of net charge-offs (recoveries)
to average loans outstanding 0.089% 0.003%
=====================================================================
</Table>
Management's process for evaluating the adequacy of the allowance for loan
losses includes reviewing each month's loan committee reports which list all
loans that do not meet certain internally developed criteria as to collateral
adequacy, payment performance, economic conditions and overall credit risk.
These reports also address the current status and actions in process on each
listed loan. From this information, adjustments are made to the allowance for
loan losses. Such adjustments include both specific loss allocation amounts and
general provisions by loan category based on present and past collection
experience, nature and volume of the loan portfolio, overall portfolio quality,
and current economic conditions that may affect the borrower's ability to pay.
The allowance for loan loss as a percentage of loans was 1.03% at June 30, 2009,
compared to 1.20% at December 31, 2008. The decrease is a result of eliminating
the allowance for loan loss and incorporating a credit fair value adjustment on
purchased loans. As a result, the allowance for credit losses, which included
the allowance for loan loss and the credit fair value adjustment on loans
purchased, provides an allowance for credit loss as a percentage of period end
loans of 2.15% at June 30, 2009. The evaluation of credit fair value adjustment
on purchased loans was made in accordance accounting standards as described
below.
An adjustment was made to reflect the elimination of Old Forge Bank's allowance
for loan loss required by applying purchase accounting under FAS 141R. As a
result, the purchased loan portfolio was evaluated based on risk characteristics
and other credit and market data by loan type to determine a credit risk
component to the fair value of loans purchased. The purchased loan balance was
reduced by the aggregate amount of the credit component in determining the fair
market value of loans purchased. The credit component does not account for
purchased loans that are deemed to be impaired under Statement of Position 03-3,
"Accounting for Certain Loans or Debt Securities Acquired in a Transfer" (SOP
03-3). SOP 03-3 addresses the accounting for the differences between contractual
cash flows and cash flows expected to be collected from an investor's initial
investment in loans, including those acquired in a business combination, if
those differences are attributable, at least in part, to credit quality
considerations and a credit quality fair value adjustment. We evaluated the
purchased loan portfolio and identified seven (7) loans that met the criteria
under SOP 03-3. Accordingly, these loans were written down at the date of the
Merger to the amount of cash flows that are expected to be collected on each of
these loans.
Determining the level of the allowance for probable loan loss at any given point
in time is difficult, particularly during uncertain economic periods. We must
make estimates using assumptions and information that is often subjective and
changing rapidly. The review of the loan portfolio is a continuing process in
light of a changing economy and the dynamics of the banking and regulatory
environment. In management's opinion, the allowance for
37
<Page>38
loan loss was adequate to meet probable incurred loan losses at June 30, 2009.
There can be no assurance, however, that we will not sustain loan losses in
future periods that could be greater than the size of the allowance at June 30,
2009. Management believes that the allowance for loan loss is appropriate based
on applicable accounting standards.
The allowance for loan losses at June 30, 2009 was $6,050 or 1.03% of total
loans compared to $5,140 or 1.22% of total loans at June 30, 2008. Management
believes the loan loss reserve is adequate. The reserve for credit losses,
which includes the loan loss reserve plus a credit discount for loans acquired
in the Old Forge Bank merger, equaled 2.15% of total loans at June 30, 2009.
The allowance for loan losses is allocated as follows:
<Table>
<Caption>
As of: June 30, 2009 December 31, 2008 June 30, 2008
- -------------------------------------------------------------------------------------------
Amount % * Amount % * Amount % *
- -------------------------------------------------------------------------------------------
Real estate mortgages $1,200 83% $1,200 86% $1,200 86%
Commercial and all others 4,000 4% 3,275 6% 3,340 6%
Credit card and related plans 325 1% 300 1% 300 1%
Personal installment loans 525 12% 500 7% 300 7%
- -------------------------------------------------------------------------------------------
Total $6,050 100% $5,275 100% $5,140 100%
- -------------------------------------------------------------------------------------------
</Table>
* Percent of loans in each category to total loans
LIQUIDITY
The objective of liquidity management is to maintain a balance between sources
and uses of funds in such a way that the cash requirements of customers for
loans and deposit withdrawals are met in the most economical manner. Management
monitors its liquidity position continuously in relation to trends of loans and
deposits for short-term as well as long-term requirements. Liquid assets are
monitored on a daily basis to assure maximum utilization. Management also
manages its liquidity requirements by maintaining an adequate level of readily
marketable assets and access to short-term funding sources. Management does not
foresee any adverse trends in liquidity.
The Company remains in a highly liquid condition both in the short and long
term. Sources of liquidity include the Company's U.S. Agency bond portfolios,
additional deposits, earnings, overnight loans to and from other companies
(Federal Funds) and lines of credit at the Federal Reserve Bank and the Federal
Home Loan Bank (FHLB). The Company is not a party to any commitments, guarantees
or obligations that could materially affect its liquidity.
The Company offers collateralized repurchase agreements, which have a one day
maturity, as an alternative deposit option for its customers. The Company also
has long-term debt outstanding to the FHLB, which was used to purchase a Freddie
Mac pool of residential mortgages, as described earlier in this report. At June
30, 2009 the Company had $145,816 of available borrowing capacity with the FHLB
and a Borrower-In-Custody (BIC) line of credit of $13,655 with the Federal
Reserve Bank of Philadelphia.
The Company is a separate legal entity from the Bank and must provide for its
own liquidity. In addition to its operating expenses, the Company is responsible
for paying any dividends declared to its shareholders. The Company's primary
source of income is dividends received from the Bank. The amount of dividends
that the Bank may declare and pay to the Company is generally restricted under
Pennsylvania law to the retained earnings of the Bank. At June 30, 2009, the
Company had liquid assets of $3.4 million.
COMMITMENTS AND CONTINGENT LIABILITIES
In the normal course of business, there are outstanding commitments and
contingent liabilities, created under prevailing terms and collateral
requirements such as commitments to extend credit, financial guarantees and
letters of credit, which are not reflected in the accompanying Financial
Statements. The Company does not anticipate any losses as a result of these
transactions. These instruments involve, to varying degrees, elements of credit
and interest rate risk in excess of the amount recognized in the Balance Sheets.
The contract or notional amounts of those instruments reflect the extent of
involvement the Company has in particular classes of financial instruments.
Commitments to extend credit are agreements to lend to a customer as long as
there is no violation of any condition established in the contract. Commitments
generally have expiration dates of one year or less or other termination
38
<Page>39
clauses and may require payment of a fee. Since many of the commitments are
expected to expire without being drawn upon, the total commitment amounts do not
necessarily represent future cash requirements.
Standby letters of credit are conditional commitments issued to guarantee the
performance of a customer to a third party. The credit risk involved in issuing
letters of credit is essentially the same as that involved in extending loan
facilities to customers.
At June 30, 2009 the Bank has entered into contracts for the renovation of
various branches, in the aggregate amount of $1,909, approximately $158 of which
had been disbursed as of June 30, 2009.
RELATED PARTIES
The Company does not have any material transactions involving related persons or
entities, other than traditional banking transactions, which are made on the
same terms and conditions as those prevailing at the time for comparable
transactions with unrelated parties. At June 30, 2009, the Bank has issued
standby letters of credit for the accounts of related parties in the amount of
$8,007.
CAPITAL RESOURCES
A strong capital position is important to the continued profitability of the
Company and promotes depositor and investor confidence. The Company's capital
provides a basis for future growth and expansion and also provides additional
protection against unexpected losses.
Additional sources of capital would come from retained earnings from the
operations of the Company and from the sale of additional shares of common
stock. Management has no plans to offer additional shares of common stock at
this time.
The Company's total risk-based capital ratio was 16.70% at June 30, 2009. The
Company's risk-based capital ratio is more than the 10.00% ratio that Federal
regulators use as the "well capitalized" threshold under the Federal prompt
corrective action regulations. This is the current criteria which the FDIC uses
in determining the lowest insurance rate for deposit insurance. The Company's
risk-based capital ratio is more than double the 8.00% minimum threshold, which
determines whether a company is "adequately capitalized".
PART 1. FINANCIAL INFORMATION, ITEM 3 --
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company currently does not enter into derivative financial instruments,
which include futures, forwards, interest rate swaps, option contracts and other
financial instruments with similar characteristics. However, the Company is
party to traditional financial instruments with off-balance sheet risk in the
normal course of business to meet the financing needs of its customers. These
financial instruments include commitments to extend credit, financial guarantees
and letters of credit. These traditional instruments involve to varying degrees,
elements of credit and interest rate risk in excess of the amount recognized in
the Consolidated Balance Sheets.
Commitments to extend credit are agreements to lend to a customer as long as
there is no violation of any condition established in the contract. Commitments
generally have fixed expiration dates or other termination clauses and may
require payment of a fee. Standby letters of credit are conditional commitments
issued to guarantee the performance of a customer to a third party up to a
stipulated amount and with specified terms and conditions.
Commitments to extend credit and standby letters of credit are not recorded as
an asset or liability by the Company until the instrument is exercised.
The Company's exposure to market risk is reviewed on a regular basis by its
Asset/Liability Committee. Interest rate risk is the potential of economic
losses due to future interest rate changes. These economic losses can be
reflected as a loss of future net interest income and/or a loss of current fair
market values. The objective is to measure the effect on net interest income and
to adjust the balance sheet to minimize the inherent risk while at the same time
maximizing income. Management realizes certain risks are inherent and that the
goal is to identify and minimize the risks. Tools used by management include the
standard GAP report and an interest rate shock simulation report. The Company
has no market risk sensitive instruments held for trading purposes. It appears
the Company's market risk is reasonable at this time.
39
<Page>40
For a discussion of the Company's asset and liability management policies, as
well as the potential impact of interest rate changes upon the market value of
the Company's financial instruments, see Item 7A in the Company's Annual Report
on Form 10-K for the year ended December 31, 2008. Management, as part of its
regular practices, performs periodic reviews of the impact of interest rate
changes upon net interest income and market value of the Company's portfolio
equity. Based on, among other factors, such reviews, management believes that
there have been no material changes in the market risk of the Company's asset
and liability position since December 31, 2008.
PART 1. FINANCIAL INFORMATION, ITEM 4 --
CONTROLS AND PROCEDURES
Under the supervision and with the participation of our management, including
our Chief Executive Officer and Controller, we conducted an evaluation of our
disclosure controls and procedures, as such term is defined under Rule 13a-15(e)
under the Securities Exchange Act of 1934. Based upon this evaluation, our Chief
Executive Officer and our Controller (our Principal Financial Officer) concluded
that our disclosure controls and procedures were effective as of the end of the
period covered by this quarterly report.
The Company continually assesses the adequacy of its internal control over
financial reporting and enhances its controls in response to internal control
assessments, and internal and external audit and regulatory recommendations.
Management maintains a comprehensive system of controls intended to ensure that
transactions are executed in accordance with management's authorization, assets
are safeguarded, and financial records are reliable. Management also takes steps
to see that information and communication flows are effective and to monitor
performance, including performance of internal control procedures.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate due to changes in conditions, or that the degree of compliance with
the policies or procedures may deteriorate.
There have been no substantive changes in the internal control over financial
reporting during the quarter ended June 30, 2009 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
None.
ITEM 1A -- RISK FACTORS
In addition to the other information set forth in this report, you should
carefully consider the factors discussed below, which could materially affect
our business, financial condition or future results. The risks described below
are not the only risks that the Company faces. Additional risks and
uncertainties not currently known to us or that we currently deem to be
immaterial also may materially adversely affect our business, financial
condition and/or operating results.
RISKS RELATED TO OUR BUSINESS
CREDIT RISK
CHANGES IN THE CREDIT QUALITY OF OUR LOAN PORTFOLIO MAY IMPACT THE LEVEL OF OUR
ALLOWANCE FOR LOAN LOSSES.
We make various judgments about the collectibility of our loans, including the
creditworthiness of our borrowers and the value of the real estate and other
assets serving as collateral for our loans. In determining the amount of the
allowance for loan losses, we review our loans and our loan loss and delinquency
experience, and we evaluate economic conditions. If our judgments are incorrect,
our allowance for loan losses may not be sufficient to cover
40
<Page>41
future losses, which will result in additions to our allowance through increased
provisions for loan losses. In addition, bank regulators periodically review our
allowance for loan losses and may require us to increase our provision for loan
losses or recognize further loan charge-offs. Increased provisions for loan
losses would increase our expenses and reduce our profits.
Nonetheless, to the best of management's knowledge, there are also no particular
risk elements in the local economy that put a group or category of loans at
increased risk. The Company does not engage in any sub-prime or Alt-A credit
lending. Therefore, the Company is not subject to any credit risks associated
with such loans.
Also, the Company is not dependent upon a single customer, or a few customers,
the loss of one or more of which would have a material adverse effect on its
operations. The operations and earnings of the Corporation are also not
materially affected by seasonal changes.
MARKET RISK
CHANGES IN INTEREST RATES COULD AFFECT OUR INVESTMENT VALUES AND NET INTEREST
INCOME WHICH COULD HURT OUR PROFITS.
At June 30, 2009, the Company owned approximately $135.1 million of marketable
securities available for sale. These securities are carried at fair value on the
consolidated balance sheets. Unrealized gains or losses on these securities,
that is, the difference between the fair value and the amortized cost of these
securities, are reflected in stockholders' equity, net of deferred taxes. As of
June 30, 2009, the Company's available for sale marketable securities portfolio
had a net unrealized gain, net of taxes, of $.7 million. The fair value of the
Company's available for sale marketable securities is subject to interest rate
change, which would not affect recorded earnings, but would increase or decrease
comprehensive income and stockholders' equity.
The principal component of the Company's earnings is net interest income, which
is the difference between interest and fees earned on interest-earning assets
and interest paid on deposits and other borrowings. The most significant impact
on net interest income between periods is derived from the interaction of
changes in the volume of and rates earned or paid on interest-earning assets and
interest-bearing liabilities. The volume of earning dollars in loans and
investments, compared to the volume of interest-bearing liabilities represented
by deposits and borrowings, combined with the spread, produces the changes in
net interest income between periods.
The Company continually monitors the relationship of its interest rate sensitive
assets and liabilities through its Asset/Liability Committee.
STRONG COMPETITION WITHIN OUR MARKET COULD HURT OUR PROFITS AND INHIBIT GROWTH.
The Bank operates in a competitive environment in which it must share its market
with many local independent banks as well as several banks which are affiliates
or branches of very large regional holding companies. The Bank encounters
competition from diversified financial institutions, ranging in size from small
banks to the nationwide banks operating in its region. The competition includes
commercial banks, savings and loan associations, credit unions, other lending
institutions and mortgage originators.
The principal competitive factors among the Company's competitors can be grouped
into two categories: pricing and services. In the Company's primary service
area, interest rates on deposits, especially time deposits, and interest rates
and fees charged to customers on loans are very competitive. From a service
perspective, the Bank competes in areas such as convenience of location, types
of services, service costs and banking hours. Our profitability depends on our
continued ability to compete successfully in our market area.
COMPLIANCE RISK
WE OPERATE IN A HIGHLY REGULATED ENVIRONMENT AND MAY BE ADVERSELY AFFECTED BY
CHANGES IN LAWS AND REGULATIONS.
The Company is registered as a financial holding company under the Bank Holding
Company Act of 1956, as amended, and, as such, is subject to supervision and
regulation by the Board of Governors of the Federal Reserve System ("FRB"). The
Company is required to file annual and quarterly reports of its operations with
the FRB.
41
<Page>42
As a financial holding company, the Company is permitted to engage in
banking-related activities as authorized by the FRB, directly or through
subsidiaries or by acquiring companies already established in such activities
subject to the FRB regulations relating to those activities.
Our banking subsidiary, Penn Security Bank and Trust Company, as a Pennsylvania
state-chartered financial institution, is subject to supervision, regulation and
examination by the Commonwealth of Pennsylvania Department of Banking and by the
Federal Deposit Insurance Corporation (the "FDIC"), which insures the Bank's
deposits to the maximum extent permitted by law.
Any change in such regulation and oversight, whether in the form of regulatory
policy, regulations, legislation or supervisory actions, may have a material
impact on our operations.
OPERATIONAL RISK
A CONTINUATION OF RECENT TURMOIL IN THE FINANCIAL MARKETS COULD HAVE AN ADVERSE
EFFECT ON THE FINANCIAL POSITION OR RESULTS OF OPERATIONS.
In recent periods, United States and global markets, as well as general economic
conditions, have been disrupted and volatile. Concerns regarding the financial
strength of financial institutions have led to distress in credit markets and
issues relating to liquidity among financial institutions. Some financial
institutions around the world have failed; others have been forced to seek
acquisition partners. The United States and other governments have taken steps
to try to stabilize the financial system, including investing in financial
institutions. The Company has not applied for and is not participating in any
government sponsored Capital Purchase Programs. Our company's financial
condition and results of operations could be adversely affected by (1) continued
disruption and volatility in financial markets, (2) continued capital and
liquidity concerns regarding financial institutions generally and our
counterparties specifically, including the Federal Home Loan Bank, (3)
limitations resulting from governmental action in an effort to stabilize or
provide additional regulation of the financial system, or (4) recessionary
conditions that are deeper or last longer than currently anticipated. Further,
there can be no assurance that action by federal and state legislatures, and
governmental agencies and regulators, including the enacted legislation
authorizing the U.S. government to invest in financial institutions, or changes
in tax policy, will help stabilize the U.S. financial system and any such
action, including changes to existing legislation or policy, could have an
adverse effect on the financial conditions or results of operations of the
Company.
SPECIAL FDIC ASSESSMENTS WILL HURT OUR EARNINGS.
Beginning in late 2008, the economic environment caused higher levels of bank
failures, which dramatically increased FDIC resolution costs and led to a
significant reduction in the Deposit Insurance Fund. As a result, the FDIC has
significantly increased the initial base assessment rates paid by financial
institutions for deposit insurance. The base assessment rate was increased by
seven basis points (7 cents for every $100 of deposits) for the first quarter of
2009. Effective April 1, 2009, initial base assessment rates were changed to
range from 12 basis points to 45 basis points across all risk categories with
possible adjustments to these rates based on certain debt-related components.
These increases in the base assessment rate will increase our deposit insurance
costs and negatively impact our earnings. In addition, in May 2009, the FDIC
imposed a special assessment on all insured institutions due to recent bank and
savings association failures. The emergency assessment amounts to 5 basis points
on each institution's assets minus Tier 1 capital as of June 30, 2009, subject
to a maximum equal to 10 basis points times the institution's assessment base.
The assessment will be collected on September 30, 2009. Based on our assets and
Tier 1 capital as of March 31, 2009, our special assessment would be
approximately $385. The special assessment will negatively impact our earnings.
In addition, the FDIC may impose additional emergency special assessments after
June 30, 2009, of up to 5 basis points per quarter on each institution's assets
minus Tier 1 capital if necessary to maintain public confidence in federal
deposit insurance or as a result of deterioration in the deposit insurance fund
reserve ratio due to institution failures. The earliest possible date for
imposing any such additional special assessment is September 30, 2009, with
collection on December 30, 2009. The latest date possible for imposing any such
additional special assessment is December 31, 2009, with collection on March 30,
2010. Any additional emergency special assessment imposed by the FDIC will
further hurt our earnings.
42
<Page>43
THE COMPANY NEEDS TO CONTINUALLY ATTRACT AND RETAIN QUALIFIED PERSONNEL FOR ITS
OPERATIONS.
High quality customer service, as well as efficient and profitable operations,
is dependent on the Company's ability to attract and retain qualified
individuals for key positions within the organization. The Company has
successfully recruited several individuals for management positions in recent
years. As of June 30, 2009, the Company employed 222 full-time equivalent
employees. The employees of the Company are not represented by any collective
bargaining group. Management of the Company considers relations with its
employees to be good.
OUR OPERATIONS COULD BE AFFECTED IF WE DO NOT HAVE ACCESS TO MODERN AND RELIABLE
TECHNOLOGY.
The Company operates in a highly-automated environment, wherein almost all
transactions are processed by computer software to produce results. To remain
competitive, the Company must continually evaluate the adequacy of its data
processing capabilities and make revisions as needed.
The Company regularly tests its ability to restore data capabilities in the
event of a natural disaster, sustained power failure or other inability to
utilize its primary systems.
LIQUIDITY RISK
INCREASED NEEDS FOR DISBURSEMENT OF FUNDS ON LOANS AND DEPOSITS CAN AFFECT OUR
LIQUIDITY.
The objective of liquidity management is to maintain a balance between sources
and uses of funds in such a way that the cash requirements of customers for
loans and deposit withdrawals are met in the most economical manner. Management
monitors its liquidity position continuously in relation to trends of loans and
deposits for short-term as well as long-term requirements. Liquid assets are
monitored on a daily basis to assure maximum utilization. Management also
manages its liquidity requirements by maintaining an adequate level of readily
marketable assets and access to short-term funding sources. Management does not
foresee any adverse trends in liquidity.
OUR FUTURE PENSION PLAN COSTS AND CONTRIBUTIONS COULD BE UNFAVORABLY IMPACTED BY
THE FACTORS THAT ARE USED IN THE ACTUARIAL CALCULATIONS.
Our costs for the non-contributory defined benefit pension plans are dependent
upon a number of factors, such as the rates of return on plan assets, discount
rates, the level of interest rates used to measure the required minimum funding
levels of the plans, future government regulation and our required or voluntary
contributions made to the plans. Without sustained growth in the pension
investments over time to increase the value of our plan assets and depending
upon the other factors impacting our costs as listed above, we could be required
to fund our plans with higher amounts of cash than are anticipated by our
actuaries. Such increased funding obligations could have a material impact on
our liquidity by reducing our cash flows.
ITEM 2 -- UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
ITEM 3 -- DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4 -- SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Annual Meeting of Shareholders of Penseco Financial Services Corporation
was held on May 5, 2009.
The results of the items submitted for a vote are as follows:
The following four Directors, whose term will expire in 2013, were elected:
<Table>
<Caption>
Number of votes Number of votes Number of
cast for director cast against director votes not cast
----------------- --------------------- --------------
Richard E. Grimm 1,780,914 25,851 341,235
James B. Nicholas 1,788,927 17,838 341,235
Sandra C. Phillips 1,788,870 17,895 341,235
Robert J. Mellow 1,676,370 130,395 341,235
</Table>
43
<Page>44
The following Director, whose term will expire in 2012, was elected:
<Table>
<Caption>
Number of votes Number of votes Number of
cast for director cast against director votes not cast
----------------- --------------------- --------------
Joseph G. Cesare 1,783,560 23,205 341,235
</Table>
Amendments to the Company's Bylaws to (i) provide that the number of Company
directors shall be fixed from time to time by resolution of the Board of
Directors; (ii) eliminate the restriction that the Company's Board of Directors
cannot increase the size of the Board by more than two directors in any one
year; and (iii) provide that directors appointed to fill a newly created vacancy
on the Board of Directors may serve until the remainder of the term to which
they are appointed rather than until the next annual meeting of shareholders
were approved as set forth below:
Votes for 1,613,250
Votes against 174,431
Votes abstained 19,083
Votes not cast 341,236
The ratification of the appointment of McGrail Merkel Quinn and Associates
as independent registered public accounting firm for the year ending December
31, 2009.
Votes for 1,790,298
Votes against 8,762
Votes abstained 7,704
Votes not cast 341,236
ITEM 5 -- OTHER INFORMATION
None.
ITEM 6 -- EXHIBITS
31 Rule 13a-14(a) / 15-d-4(a) Certifications
32 Section 1350 Certifications
44
<Page>45
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
PENSECO FINANCIAL SERVICES CORPORATION
By /s/ Craig W. Best
------------------------------
Craig W. Best
President and CEO
(Principal Executive Officer)
Dated: August 10, 2009
By /s/ Patrick Scanlon
------------------------------
Patrick Scanlon
Senior Vice President, Finance Division Head
(Principal Financial Officer)
Dated: August 10, 2009
45
<Page>46
EXHIBIT 31
CERTIFICATIONS
I, Craig W. Best, certify that:
1. I have reviewed this Quarterly Report on Form 10-Q of Penseco Financial
Services Corporation;
2. Based on my knowledge, this report does not contain any untrue statement of a
material fact or omit to state a material fact necessary to make the statements
made, in light of the circumstances under which such statements were made, not
misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material respects the
financial condition, results of operations and cash flows of the registrant as
of, and for, the periods presented in this report;
4. The registrant's other certifying officer(s) and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial
reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the
registrant and have:
a) Designed such disclosure controls and procedures, or caused such disclosure
controls and procedures to be designed under our supervision, to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this report is being prepared;
b) Designed such internal control over financial reporting, or caused such
internal control over financial reporting to be designed under our supervision,
to provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles;
c) Evaluated the effectiveness of the registrant's disclosure controls and
procedures and presented in this report our conclusions about the effectiveness
of the disclosure controls and procedures, as of the end of the period covered
by this report based on such evaluation; and
d) Disclosed in this report any change in the registrant's internal control over
financial reporting that occurred during the registrant's most recent fiscal
quarter (the registrant's fourth fiscal quarter in the case of an annual report)
that has materially affected, or is reasonably likely to materially affect, the
registrant's internal control over financial reporting; and
5. The registrant's other certifying officer and I have disclosed, based on our
most recent evaluation of internal control over financial reporting, to the
registrant's auditors and the audit committee of the registrant's board of
directors (or persons performing the equivalent functions):
a) All significant deficiencies and material weaknesses in the design or
operation of internal control over financial reporting which are reasonably
likely to adversely affect the registrant's ability to record, process,
summarize and report financial information; and
b) Any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal control over
financial reporting.
Date: August 10, 2009
/s/ Craig W. Best
------------------------------
Craig W. Best
President and CEO
(Principal Executive Officer)
46
<Page>47
I, Patrick Scanlon, certify that:
1. I have reviewed this Quarterly Report on Form 10-Q of Penseco Financial
Services Corporation;
2. Based on my knowledge, this report does not contain any untrue statement of a
material fact or omit to state a material fact necessary to make the statements
made, in light of the circumstances under which such statements were made, not
misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material respects the
financial condition, results of operations and cash flows of the registrant as
of, and for, the periods presented in this report;
4. The registrant's other certifying officer(s) and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial
reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the
registrant and have:
a) Designed such disclosure controls and procedures, or caused such disclosure
controls and procedures to be designed under our supervision, to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this report is being prepared;
b) Designed such internal control over financial reporting, or caused such
internal control over financial reporting to be designed under our supervision,
to provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles;
c) Evaluated the effectiveness of the registrant's disclosure controls and
procedures and presented in this report our conclusions about the effectiveness
of the disclosure controls and procedures, as of the end of the period covered
by this report based on such evaluation; and
d) Disclosed in this report any change in the registrant's internal control over
financial reporting that occurred during the registrant's most recent fiscal
quarter (the registrant's fourth fiscal quarter in the case of an annual report)
that has materially affected, or is reasonably likely to materially affect, the
registrant's internal control over financial reporting; and
5. The registrant's other certifying officer and I have disclosed, based on our
most recent evaluation of internal control over financial reporting, to the
registrant's auditors and the audit committee of the registrant's board of
directors (or persons performing the equivalent functions):
a) All significant deficiencies and material weaknesses in the design or
operation of internal control over financial reporting which are reasonably
likely to adversely affect the registrant's ability to record, process,
summarize and report financial information; and
b) Any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal control over
financial reporting.
Date: August 10, 2009
/s/ Patrick Scanlong
------------------------------
Patrick Scanlon
Senior Vice President, Finance
Division Head
(Principal Financial Officer)
47
<Page>48
EXHIBIT 32
CERTIFICATION OF PERIODIC FINANCIAL REPORT PURSUANT TO SECTION 906 OF THE
SARBANES-OXLEY ACT OF 2002
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (subsection (a) and
(b) of Section 1350, Chapter 63 of Title 18, United States Code), the
undersigned officer of Penseco Financial Services Corporation (the "Company")
certifies to his knowledge that:
(1) The Quarterly Report on Form 10-Q of the Company for the quarter ended
June 30, 2009 (the "Form 10-Q") fully complies with the requirements of
Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (the
"Act") ; and
(2) The information contained in the Form 10-Q fairly presents, in all
material respects, the financial conditions and results of operations
of the Company as for the dates and for the periods referred to in the
Form 10-Q.
/s/ Craig W. Best
-----------------------------
Craig W. Best
President and CEO
(Principal Executive Officer)
August 10, 2009
CERTIFICATION OF PERIODIC FINANCIAL REPORT PURSUANT TO SECTION 906 OF THE
SARBANES-OXLEY ACT OF 2002
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (subsection (a) and
(b) of Section 1350, Chapter 63 of Title 18, United States Code), the
undersigned officer of Penseco Financial Services Corporation (the "Company")
certifies to his knowledge that:
(1) The Quarterly Report on Form 10-Q of the Company for the quarter ended
June 30, 2009 (the "Form 10-Q") fully complies with the requirements of
Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (the
"Act") ; and
(2) The information contained in the Form 10-Q fairly presents, in all
material respects, the financial conditions and results of operations
of the Company as for the dates and for the periods referred to in the
Form 10-Q.
/s/ Patrick Scanlon
-----------------------------
Patrick Scanlon
Senior Vice President, Finance
Division Head
(Principal Financial Officer)
August 10, 2009