Edgar Filing: CITIZENS & NORTHERN CORP

Unassociated Document

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2011

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

For the transition period from _______________ to _________________________.

Commission file number: 000-16084

CITIZENS & NORTHERN CORPORATION

(Exact name of Registrant as specified in its charter)

PENNSYLVANIA	23-2451943
(State or other jurisdiction of	(I.R.S. Employer
incorporation or organization)	Identification No.)

90-92 MAIN STREET, WELLSBORO, PA 16901

(Address of principal executive offices) (Zip code)

570-724-3411

(Registrant's telephone number including area code)

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

Yes x No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§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 x 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 definition 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 ¨ 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

Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date.

Common Stock ($1.00 par value)

12,138,191 Shares Outstanding on November 3, 2011

CITIZENS & NORTHERN CORPORATION

Index

Part I. Financial Information

Item 1. Financial Statements

Consolidated Balance Sheet (Unaudited) – September 30, 2011 and December 31, 2010		Page 3

Consolidated Statement of Operations (Unaudited) - Three Months and Nine Months Ended September 30, 2011 and 2010		Page 4

Consolidated Statement of Cash Flows (Unaudited) - Nine Months Ended September 30, 2011 and 2010		Page 5

Consolidated Statement of Changes in Stockholders’ Equity (Unaudited) - Nine Months Ended September 30, 2011 and 2010		Page 6

Notes to Unaudited Consolidated Financial Statements		Pages 7 – 34

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations		Pages 35 – 53

Item 3. Quantitative and Qualitative Disclosures About Market Risk		Pages 53 – 56

Item 4. Controls and Procedures		Page 56

Part II. Other Information		Pages 57 – 58

Signatures		Page 59

Exhibit 31.1. Rule 13a-14(a)/15d-14(a) Certification - Chief Executive Officer		Page 60

Exhibit 31.2. Rule 13a-14(a)/15d-14(a) Certification - Chief Financial Officer		Page 61

Exhibit 32. Section 1350 Certifications		Page 62

PART 1 - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEET (Unaudited)	September 30,			December 31,
(In Thousands Except Share Data)	2011			2010

ASSETS
Cash and due from banks:
Noninterest-bearing	$	20,608		$	16,840
Interest-bearing		35,146			29,461
Total cash and cash equivalents		55,754			46,301
Available-for-sale securities, at fair value		472,113			443,956
Loans held for sale		1,218			5,247

Loans receivable		705,879			730,411
Allowance for loan losses		(8,177	)		(9,107	)
Loans, net		697,702			721,304
Bank-owned life insurance		20,761			21,822
Accrued interest receivable		5,144			4,960
Bank premises and equipment, net		19,372			22,636
Foreclosed assets held for sale		1,596			537
Deferred tax asset, net		7,927			16,054
Intangible asset - Core deposit intangibles		240			326
Intangible asset - Goodwill		11,942			11,942
Other assets		18,285			21,503
TOTAL ASSETS	$	1,312,054		$	1,316,588

LIABILITIES
Deposits:
Noninterest-bearing	$	177,326		$	158,767
Interest-bearing		818,404			845,581
Total deposits		995,730			1,004,348
Short-term borrowings		19,234			18,413
Long-term borrowings		128,024			148,495
Accrued interest and other liabilities		7,856			6,388
TOTAL LIABILITIES		1,150,844			1,177,644

STOCKHOLDERS' EQUITY
Preferred stock, $1,000 par value; authorized 30,000 shares; $1,000 liquidation preference per share; no shares issued at September 30, 2011 and December 31, 2010		0			0
Common stock, par value $1.00 per share; authorized 20,000,000 shares in 2011 and 2010; issued 12,447,219 at September 30, 2011 and 12,408,212 at December 31, 2010		12,447			12,408
Paid-in capital		67,322			66,648
Retained earnings		78,085			65,920
Treasury stock, at cost; 306,589 shares at September 30, 2011 and 254,614 shares at December 31, 2010		(5,128	)		(4,431	)
Sub-total		152,726			140,545
Accumulated other comprehensive income (loss):
Unrealized gains (losses) on available-for-sale securities		8,787			(1,351	)
Defined benefit plans		(303	)		(250	)
Total accumulated other comprehensive income (loss)		8,484			(1,601	)
TOTAL STOCKHOLDERS' EQUITY		161,210			138,944
TOTAL LIABILITIES & STOCKHOLDERS' EQUITY	$	1,312,054		$	1,316,588

The accompanying notes are an integral part of these unaudited consolidated financial statements.

CONSOLIDATED STATEMENT OF OPERATIONS	3 Months Ended					Fiscal Year To Date
(In Thousands, Except Per Share Data) (Unaudited)	Sept. 30,			Sept. 30,		9 Months Ended Sept. 30,
	2011			2010		2011			2010
	(Current)			(Prior Year)		(Current)			(Prior Year)
INTEREST INCOME
Interest and fees on loans	$	10,799		$	11,153	$	32,521		$	33,112
Interest on balances with depository institutions		13			26		45			102
Interest on loans to political subdivisions		372			395		1,119			1,192
Interest on trading securities		0			0		0			1
Income from available-for-sale and held-to-maturity securities:
Taxable		2,784			2,641		8,326			8,425
Tax-exempt		1,285			1,223		3,860			3,588
Dividends		64			57		187			194
Total interest and dividend income		15,317			15,495		46,058			46,614
INTEREST EXPENSE
Interest on deposits		1,775			2,916		6,610			9,131
Interest on short-term borrowings		6			15		20			166
Interest on long-term borrowings		1,327			1,708		4,122			5,638
Total interest expense		3,108			4,639		10,752			14,935
Net interest income		12,209			10,856		35,306			31,679
(Credit) provision for loan losses		(37	)		189		(198	)		472
Net interest income after (credit) provision for loan losses		12,246			10,667		35,504			31,207
OTHER INCOME
Service charges on deposit accounts		1,230			1,166		3,586			3,449
Service charges and fees		218			191		643			594
Trust and financial management revenue		785			876		2,608			2,605
Interchange revenue from debit card transactions		490			427		1,427			1,226
Net gains from sale of loans		263			275		677			478
Increase in cash surrender value of life insurance		127			121		381			352
Insurance commissions, fees and premiums		66			65		192			186
Impairment loss on limited partnership investment		0			0		(948	)		0
Other operating income		820			441		1,661			1,480
Sub-total		3,999			3,562		10,227			10,370
Total other-than-temporary impairment losses on available-for-sale securities		0			0		0			(381	)
Portion of (gain) loss recognized in other comprehensive loss (before taxes)		0			0		0			(52	)
Net impairment losses recognized in earnings		0			0		0			(433	)
Realized gains on available-for-sale securities, net		26			388		2,028			1,198
Net realized gains on available-for-sale securities		26			388		2,028			765
Total other income		4,025			3,950		12,255			11,135
OTHER EXPENSES
Salaries and wages		3,451			3,354		10,321			9,631
Pensions and other employee benefits		1,020			980		3,344			2,902
Occupancy expense, net		641			654		2,038			2,004
Furniture and equipment expense		498			500		1,435			1,610
FDIC Assessments		174			382		688			1,201
Pennsylvania shares tax		345			305		984			916
Other operating expense		1,923			1,907		5,299			5,518
Total other expenses		8,052			8,082		24,109			23,782
Income before income tax provision		8,219			6,535		23,650			18,560
Income tax provision		2,230			1,671		6,423			4,389
Net income		5,989			4,864		17,227			14,171
U.S Treasury preferred dividends		0			729		0			1,474
NET INCOME AVAILABLE TO COMMON SHAREHOLDERS	$	5,989		$	4,135	$	17,227		$	12,697
Net income per share – basic	$	0.49		$	0.34	$	1.42		$	1.05
Net income per share – diluted	$	0.49		$	0.34	$	1.42		$	1.05

The accompanying notes are an integral part of these unaudited consolidated financial statements.

CONSOLIDATED STATEMENT OF CASH FLOWS	Nine Months Ended September 30,
(In Thousands) (Unaudited)	2011			2010
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	17,227		$	14,171
Adjustments to reconcile net income to net cash provided by operating activities:
(Credit) provision for loan losses		(198	)		472
Realized gains on available-for-sale securities, net		(2,028	)		(765	)
Gain on sale of foreclosed assets, net		(8	)		(113	)
Depreciation expense		1,584			1,787
Gain on disposition of premises and equipment		(324	)		(442	)
Accretion and amortization on securities, net		1,045			1,740
Accretion and amortization on loans, deposits and borrowings, net		(27	)		(179	)
Amortization of mortgage servicing rights		48			0
Impairment loss on limited partnership interest		948			0
Increase in cash surrender value of life insurance		(381	)		(352	)
Stock-based compensation		386			50
Amortization of core deposit intangibles		86			132
Deferred income taxes		2,936			6,360
Gains on sales of mortgage loans, net		(677	)		(478	)
Origination of mortgage loans for sale		(15,166	)		(19,228	)
Proceeds from sales of mortgage loans		19,683			19,516
Net decrease in trading securities		0			1,045
Decrease in accrued interest receivable and other assets		888			3,543
Increase (decrease) in accrued interest payable and other liabilities		1,280			(238	)
Net Cash Provided by Operating Activities		27,302			27,021
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from maturity of held-to-maturity securities		0			300
Proceeds from sales of available-for-sale securities		16,696			51,528
Proceeds from calls and maturities of available-for-sale securities		79,813			137,313
Purchase of available-for-sale securities		(108,327	)		(219,143	)
Redemption of Federal Home Loan Bank of Pittsburgh stock		1,164			0
Net decrease (increase) in loans		22,150			(5,615	)
Proceeds from bank-owned life insurance		1,442			1,442
Purchase of premises and equipment		(666	)		(595	)
Proceeds from disposition of premises and equipment		3,060			100
Purchase of investment in limited liability entity		(200	)		0
Return of principal on limited liability entity investments		93			49
Proceeds from sale of foreclosed assets		640			1,100
Net Cash Provided by (Used in) Investing Activities		15,865			(33,521	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net (decrease) increase in deposits		(8,632	)		56,711
Net increase (decrease) in short-term borrowings		821			(20,827	)
Repayments of long-term borrowings		(20,471	)		(37,453	)
Redemption of US Treasury preferred stock and warrant		0			(26,840	)
Purchase of treasury stock		(983	)		0
Sale of treasury stock		16			0
Tax benefit from compensation plans		48			29
US Treasury preferred dividends paid		0			(952	)
Common dividends paid		(4,513	)		(3,008	)
Net Cash Used in Financing Activities		(33,714	)		(32,340	)
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		9,453			(38,840	)
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR		46,301			92,065
CASH AND CASH EQUIVALENTS, END OF PERIOD	$	55,754		$	53,225
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Assets acquired through foreclosure of real estate loans	$	1,691		$	644
Interest paid	$	10,817		$	15,280
Income taxes paid (refunded)	$	2,300		$	(3,781	)

The accompanying notes are an integral part of these unaudited consolidated financial statements.

Consolidated Statement of Changes in Stockholders' Equity
Nine Months Ended September 30, 2011 and 2010
(In Thousands Except Per Share Data)												Accum. Other
(Unaudited)	Preferred			Common		Paid-in			Retained			Comprehensive			Treasury
	Stock			Stock		Capital			Earnings			Income (Loss)			Stock			Total
Nine Months Ended September 30, 2011:
Balance, December 31, 2010	$	0		$	12,408	$	66,648		$	65,920		$	(1,601	)	$	(4,431	)	$	138,944
Comprehensive income:
Net income										17,227									17,227
Unrealized gain on securities, net of reclassification and tax													10,138						10,138
Other comprehensive loss related to defined benefit plans													(53	)					(53	)
Total comprehensive income																			27,312
Cash dividends declared on common stock, $.42 per share										(5,110	)								(5,110	)
Shares issued for dividend reinvestment plan					39		558												597
Treasury stock purchased																(983	)		(983	)
Shares issued from treasury related to exercise of stock options							(3	)								19			16
Restricted stock granted							(272	)								272			0
Forfeiture of restricted stock							5									(5	)		0
Stock-based compensation expense							386												386
Tax benefit from employee benefit plan										48									48
Balance, September 30, 2011	$	0		$	12,447	$	67,322		$	78,085		$	8,484		$	(5,128	)	$	161,210
Nine Months Ended September 30, 2010:
Balance, December 31, 2009	$	25,749		$	12,374	$	66,726		$	53,027		$	(891	)	$	(4,575	)	$	152,410
Comprehensive income:
Net income										14,171									14,171
Unrealized gain on securities, net of reclassification and tax													4,915						4,915
Other comprehensive income related to defined benefit plans													138						138
Total comprehensive income																			19,224
Accretion of discount associated with U.S. Treasury preferred stock		691								(691	)								0
Cash dividends on U.S. Treasury preferred stock										(783	)								(783	)
Redemption of U.S. Treasury preferred stock		(26,440	)																(26,440	)
Redemption of U.S. Treasury warrant							(400	)											(400	)
Cash dividends declared on common stock, $.27 per share										(3,273	)								(3,273	)
Shares issued for dividend reinvestment plan					23		242												265
Restricted stock granted							(159	)								159			0
Forfeiture of restricted stock							15									(15	)		0
Stock-based compensation expense							50												50
Tax benefit from employee benefit plan										29									29
Balance, September 30, 2010	$	0		$	12,397	$	66,474		$	62,480		$	4,162		$	(4,431	)	$	141,082

The accompanying notes are an integral part of these unaudited consolidated financial statements.

Notes to Unaudited Consolidated Financial Statements

1. BASIS OF INTERIM PRESENTATION

The consolidated financial information included herein, with the exception of the consolidated balance sheet dated December 31, 2010, is unaudited. Such information reflects all adjustments (consisting solely of normal recurring adjustments) that are, in the opinion of management, necessary for a fair presentation of the financial position, results of operations, cash flows and changes in stockholders’ equity for the interim periods; however, the information does not include all disclosures required by accounting principles generally accepted in the United States of America (“U.S. GAAP”) for a complete set of financial statements. Certain 2010 information has been reclassified for consistency with the 2011 presentation.

Operating results reported for the three-month and nine-month periods ended September 30, 2011 might not be indicative of the results for the year ending December 31, 2011. The Corporation evaluates subsequent events through the date of filing with the Securities and Exchange Commission.

2. PER COMMON SHARE DATA

Net income per share is based on the weighted-average number of shares of common stock outstanding. The following data show the amounts used in computing basic and diluted net income per share. As shown in the table that follows, diluted earnings per share is computed using weighted average common shares outstanding, plus weighted-average common shares available from the exercise of all dilutive stock options, less the number of shares that could be repurchased with the proceeds of stock option exercises based on the average share price of the Corporation's common stock during the period.

	Net Income		Weighted-
	Available		Average			Earnings
	to Common		Common			Per
	Shareholders		Shares			Share
Nine Months Ended September 30, 2011
Earnings per common share – basic	$	17,227,000		12,167,563		$	1.42
Dilutive effect of potential common stock arising from stock options:
Exercise of outstanding stock options				92,786
Hypothetical share repurchase at $15.57				(89,738	)
Earnings per common share – diluted	$	17,227,000		12,170,611		$	1.42

Nine Months Ended September 30, 2010
Earnings per common share – basic and diluted	$	12,697,000		12,125,142		$	1.05

Quarter Ended September 30, 2011
Earnings per common share – basic	$	5,989,000		12,150,910		$	0.49
Dilutive effect of potential common stock arising from stock options:
Exercise of outstanding stock options				91,843
Hypothetical share repurchase at $15.56				(88,892	)
Earnings per common share – diluted	$	5,989,000		12,153,861		$	0.49

Quarter Ended September 30, 2010
Earnings per common share – basic and diluted	$	4,135,000		12,136,516		$	0.34

Stock options and a warrant that were anti-dilutive were excluded from net income per share calculations. Weighted-average common shares available from anti-dilutive instruments totaled 224,651 shares in the nine-month period ended September 30, 2011, 424,179 shares in the nine months ended September 30, 2010, 223,463 shares in the third quarter 2011 and 362,738 shares in the third quarter 2010. All instruments for 2010 were anti-dilutive.

3. COMPREHENSIVE INCOME

Comprehensive income is the total of (1) net income, and (2) all other changes in equity from non-stockholder sources, which are referred to as other comprehensive income. The components of comprehensive income, and the related tax effects, are as follows:

(In Thousands)	3 Months Ended						9 Months Ended
	September 30,						September 30,
	2011			2010			2011			2010
Net income	$	5,989		$	4,864		$	17,227		$	14,171

Unrealized gains on available-for-sale securities:
Unrealized holding gains on available-for-sale securities		5,310			4,467			17,384			8,191
Reclassification adjustment for gains realized in income		(26	)		(388	)		(2,028	)		(765	)
Other comprehensive gain before income tax		5,284			4,079			15,356			7,426
Income tax related to other comprehensive gain		1,796			1,370			5,218			2,511
Other comprehensive gain on available-for-sale securities		3,488			2,709			10,138			4,915

Unfunded pension and postretirement obligations:
Change in items from defined benefit plans included in accumulated other comprehensive income		0			16			(122	)		168
Amortization of net transition obligation, prior service cost and net actuarial loss included in net periodic benefit cost		14			13			41			40
Other comprehensive gain (loss) before income tax		14			29			(81	)		208
Income tax related to other comprehensive gain (loss)		4			9			(28	)		70
Other comprehensive gain (loss) on unfunded retirement obligations		10			20			(53	)		138

Net other comprehensive gain		3,498			2,729			10,085			5,053

Total comprehensive income	$	9,487		$	7,593		$	27,312		$	19,224

The Corporation recognized other comprehensive income of $52,000 before income tax ($34,000 after income tax) related to available-for-sale debt securities for which a portion of an other-than-temporary impairment (OTTI) loss has been recognized in earnings in the nine months ended September 30, 2010, with no other comprehensive income in the third quarter 2010.

4. FAIR VALUE MEASUREMENTS AND FAIR VALUES OF FINANCIAL INSTRUMENTS

The Corporation measures certain assets at fair value on a recurring basis. Fair value is defined as the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date. FASB ASC topic 820, “Fair Value Measurements and Disclosures” (formerly Statement of Financial Accounting Standards No. 157) establishes a framework for measuring fair value that includes a hierarchy used to classify the inputs used in measuring fair value. The hierarchy prioritizes the inputs used in determining valuations into three levels. The level in the fair value hierarchy within which the fair value measurement falls is determined based on the lowest level input that is significant to the fair value measurement. The levels of the fair value hierarchy are as follows:

Level 1 – Fair value is based on unadjusted quoted prices in active markets that are accessible to the Corporation for identical assets. These generally provide the most reliable evidence and are used to measure fair value whenever available.

Level 2 – Fair value is based on significant inputs, other than Level 1 inputs, that are observable either directly or indirectly for substantially the full term of the asset through corroboration with observable market data. Level 2 inputs include quoted market prices in active markets for similar assets, quoted market prices in markets that are not active for identical or similar assets and other observable inputs.

Level 3 – Fair value is based on significant unobservable inputs. Examples of valuation methodologies that would result in Level 3 classification include option pricing models, discounted cash flows and other similar techniques.

At September 30, 2011 and December 31, 2010, assets measured at fair value on a recurring basis and the valuation methods used are as follows:

			September 30, 2011
			Market Values Based on:
	Quoted Prices		Other
	in Active		Observable		Unobservable		Total
	Markets		Inputs		Inputs		Fair
(In Thousands)	(Level 1)		(Level 2)		(Level 3)		Value

AVAILABLE-FOR-SALE SECURITIES:
Obligations of U.S. Government agencies	$	0	$	34,250	$	0	$	34,250
Obligations of states and political subdivisions:
Tax-exempt		0		132,545		0		132,545
Taxable		0		13,354		0		13,354
Mortgage-backed securities		0		121,967		0		121,967
Collateralized mortgage obligations, Issued by U.S. Government agencies		0		146,002		0		146,002
Corporate bonds		0		1,001		0		1,001
Trust preferred securities issued by individual institutions		0		8,181		0		8,181
Collateralized debt obligations:
Pooled trust preferred securities - senior tranches		0		0		7,103		7,103
Other collateralized debt obligations		0		660		0		660
Total debt securities		0		457,960		7,103		465,063
Marketable equity securities		7,050		0		0		7,050
Total available-for-sale securities		7,050		457,960		7,103		472,113
Servicing rights		0		0		346		346
Total assets measured at fair value on a recurring basis	$	7,050	$	457,960	$	7,449	$	472,459

			December 31, 2010
			Market Values Based on:
	Quoted Prices		Other
	in Active		Observable		Unobservable		Total
	Markets		Inputs		Inputs		Fair
(In Thousands)	(Level 1)		(Level 2)		(Level 3)		Value

AVAILABLE-FOR-SALE SECURITIES:
Obligations of U.S. Government agencies	$	0	$	44,247	$	0	$	44,247
Obligations of states and political subdivisions:
Tax-exempt		4,574		115,301		0		119,875
Taxable		1,125		6,542		0		7,667
Mortgage-backed securities		0		118,386		0		118,386
Collateralized mortgage obligations, Issued by U.S. Government agencies		9,117		121,709		0		130,826
Corporate bonds		0		1,027		0		1,027
Trust preferred securities issued by individual institutions		0		7,838		0		7,838
Collateralized debt obligations:
Pooled trust preferred securities - senior tranches		0		0		7,400		7,400
Other collateralized debt obligations		0		681		0		681
Total debt securities		14,816		415,731		7,400		437,947
Marketable equity securities		6,009		0		0		6,009
Total available-for-sale securities		20,825		415,731		7,400		443,956
Servicing rights		0		0		204		204
Total assets measured at fair value on a recurring basis	$	20,825	$	415,731	$	7,604	$	444,160

Debt securities with a fair value of $14,816,000 at December 31, 2010 were transferred from Level 1 to Level 2 in the first quarter 2011 in the table above. These securities were purchased in the month of December 2010, and their fair values at December 31, 2010 were determined based on the Corporation’s purchase prices. The fair values of these securities were determined at September 30, 2011 based on price estimates provided by an independent valuation service based on Level 2 inputs.

Management determined there have been few trades of pooled trust-preferred securities since the first half of 2008, except for a limited number of transactions that have taken place as a result of bankruptcies, forced liquidations or similar circumstances. Also, in management’s judgment, there were no available quoted market prices in active markets for assets sufficiently similar to the Corporation’s pooled trust-preferred securities to be reliable as observable inputs. Accordingly, in the third quarter of 2008, the Corporation changed its method of valuing pooled trust-preferred securities from a Level 2 methodology that had been used in prior periods, based on price quotes received from pricing services, to a Level 3 methodology, using discounted cash flows.

Management has calculated the fair value of the Corporation’s senior tranche pooled trust-preferred security by applying a discount rate to the estimated cash flows. In 2011, management’s estimate of cash flows from the senior tranche security changed significantly from the estimates in previous years based on the level and timing of assumed prepayments that changed for some of the underlying issuers. Management used the cash flow estimates determined using the process described in Note 5 for evaluating pooled trust-preferred securities for other-than-temporary impairment (OTTI). Management used a discount rate considered reflective of a market participant’s expectations regarding the extent of credit and liquidity risk inherent in the security. In establishing the discount rate, management considered: (1) the implied discount rate as of the end of 2007, prior to the market for trust-preferred securities becoming inactive; (2) adjustment to the year-end 2007 discount rate for the change in the spread between indicative market rates over corresponding risk-free rates; and (3) an additional adjustment – an increase of 2% in the discount rate – for liquidity risk. Management considered the additional 2% increase in the discount rate necessary in order to give some consideration to price estimates based on trades made under distressed conditions, as reported by brokers and pricing services. Management’s estimate of cash flows and the discount rate used to calculate the fair value of the pooled trust-preferred security were based on sensitive assumptions, and market participants might use substantially different assumptions, which could result in calculations of a fair value that would be substantially different than the amount calculated by management.

Following is a reconciliation of activity for available-for-sale securities measured at fair value based on significant unobservable information:

	3 Months Ended						Fiscal Year To Date
	Sept. 30,			Sept. 30,			9 Months Ended Sept. 30,
	2011			2010			2011			2010
	(Current)			(Prior Year)			(Current)			(Prior Year)
Balance, beginning of period	$	7,207		$	8,240		$	7,400		$	9,114
Accretion and amortization, net		0			(20	)		(34	)		(235	)
Proceeds from sales and calls		(24	)		(284	)		(2,109	)		(808	)
Realized gains, net		24			284			99			284
Unrealized losses included in earnings		0			0			0			(423	)
Unrealized (losses) gains included in other comprehensive income		(104	)		20			1,747			308
Balance, end of period	$	7,103		$	8,240		$	7,103		$	8,240

Unrealized losses included in earnings are from the Corporation’s other-than-temporary impairment analysis of securities, as described in Note 5, and are included in net impairment losses recognized in earnings in the consolidated statement of operations.

Assets measured at fair value on a nonrecurring basis include impaired commercial loans and foreclosed real estate assets held for sale. All of the Corporation’s impaired commercial loans for which a valuation allowance was necessary at September 30, 2011 and December 31, 2010 were valued based on the estimated amount of net proceeds from liquidation of real estate and other collateral, or based on the estimated present value of cash flows to be received. The Corporation considers the fair value of such impaired commercial loans to be based on unobservable inputs (Level 3), and the balance of impaired loans for which a valuation allowance was recorded, net of allowance for loan losses, was $2,415,000 at September 30, 2011 and $3,169,000 at December 31, 2010. Similarly, the carrying values of foreclosed real estate assets held for sale were based on unobservable inputs (Level 3), with a balance of $1,596,000 at September 30, 2011 and $537,000 at December 31, 2010.

Certain of the Corporation’s financial instruments are not measured at fair value in the consolidated financial statements. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument. Certain financial instruments and all nonfinancial instruments are excluded from disclosure requirements. Therefore, the aggregate fair value amounts presented may not represent the underlying fair value of the Corporation.

The Corporation used the following methods and assumptions in estimating fair value disclosures for financial instruments:

CASH AND CASH EQUIVALENTS - The carrying amounts of cash and short-term instruments approximate fair values.

SECURITIES - Fair values for securities, excluding restricted equity securities, are based on quoted market prices or other methods as described above. The carrying value of restricted equity securities approximates fair value based on applicable redemption provisions.

LOANS HELD FOR SALE - Fair values of loans held for sale are determined based on applicable sales price available under the Federal Home Loan Banks’ MPF Xtra program.

LOANS - Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, commercial real estate, residential mortgage and other consumer. Each loan category is further segmented into fixed and adjustable rate interest terms and by performing and nonperforming categories. The fair value of performing loans is calculated by discounting contractual cash flows, adjusted for estimated prepayments based on historical experience, using estimated market discount rates that reflect the credit and interest rate risk inherent in the loans. Fair value of nonperforming loans is based on recent appraisals or estimates prepared by the Corporation’s lending officers.

SERVICING RIGHTS – The fair value of servicing rights, included in other assets in the consolidated balance sheet, is determined through a discounted cash flow valuation. Significant inputs include expected net servicing income, the discount rate and the expected life of the underlying loans.

DEPOSITS - The fair value of deposits with no stated maturity, such as noninterest-bearing demand deposits, savings, money market and interest checking accounts, is (by definition) equal to the amount payable on demand at September 30, 2011 and December 31, 2010. The fair value of all other deposit categories is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities. The fair value estimates of deposits do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market, commonly referred to as the core deposit intangible.

BORROWED FUNDS - The fair value of borrowings is estimated using discounted cash flow analyses based on rates currently available to the Corporation for similar types of borrowing arrangements.

ACCRUED INTEREST - The carrying amounts of accrued interest receivable and payable approximate fair values.

OFF-BALANCE SHEET COMMITMENTS - The Corporation has commitments to extend credit and has issued standby letters of credit. Standby letters of credit are conditional guarantees of performance by a customer to a third party. Estimates of the fair value of these off-balance sheet items were not made because of the short-term nature of these arrangements and the credit standing of the counterparties.

The estimated fair values, and related carrying amounts, of the Corporation’s financial instruments are as follows:

(In Thousands)	September 30, 2011				December 31, 2010
	Carrying		Fair		Carrying		Fair
	Amount		Value		Amount		Value
Financial assets:
Cash and cash equivalents	$	55,754	$	55,754	$	46,301	$	46,301
Available-for-sale securities		472,113		472,113		443,956		443,956
Restricted equity securities		7,123		7,123		8,286		8,286
Loans held for sale		1,218		1,218		5,247		5,249
Loans, net		697,702		703,299		721,304		728,744
Accrued interest receivable		5,144		5,144		4,960		4,960
Servicing rights		346		346		204		204

Financial liabilities:
Deposits		995,730		1,000,179		1,004,348		1,012,247
Short-term borrowings		19,234		18,965		18,413		18,240
Long-term borrowings		128,024		147,369		148,495		171,877
Accrued interest payable		351		351		430		430

5. SECURITIES

Amortized cost and fair value of available-for-sale securities at September 30, 2011 and December 31, 2010 are summarized as follows:

			September 30, 2011
			Gross		Gross
			Unrealized		Unrealized
	Amortized		Holding		Holding			Fair
(In Thousands)	Cost		Gains		Losses			Value

Obligations of U.S. Government agencies	$	33,459	$	791	$	0		$	34,250
Obligations of states and political subdivisions:
Tax-exempt		130,537		3,782		(1,774	)		132,545
Taxable		13,080		282		(8	)		13,354
Mortgage-backed securities		116,314		5,653		0			121,967
Collateralized mortgage obligations, Issued by U.S. Government agencies		143,275		2,774		(47	)		146,002
Corporate bonds		1,000		1		0			1,001
Trust preferred securities issued by individual institutions		7,015		1,211		(45	)		8,181
Collateralized debt obligations:
Pooled trust preferred securities - senior tranches		7,914		0		(811	)		7,103
Other collateralized debt obligations		660		0		0			660
Total debt securities		453,254		14,494		(2,685	)		465,063
Marketable equity securities		5,548		1,698		(196	)		7,050
Total	$	458,802	$	16,192	$	(2,881	)	$	472,113

			December 31, 2010
			Gross		Gross
			Unrealized		Unrealized
	Amortized		Holding		Holding			Fair
(In Thousands)	Cost		Gains		Losses			Value

Obligations of U.S. Government agencies	$	44,005	$	270	$	(28	)	$	44,247
Obligations of states and political subdivisions:
Tax-exempt		127,210		546		(7,882	)		119,874
Taxable		7,808		1		(141	)		7,668
Mortgage-backed securities		113,176		5,381		(171	)		118,386
Collateralized mortgage obligations, Issued by U.S. Government agencies		131,040		869		(1,083	)		130,826
Corporate bonds		1,000		27		0			1,027
Trust preferred securities issued by individual institutions		6,535		1,694		(391	)		7,838
Collateralized debt obligations:
Pooled trust preferred securities - senior tranches		9,957		0		(2,557	)		7,400
Other collateralized debt obligations		681		0		0			681
Total debt securities		441,412		8,788		(12,253	)		437,947
Marketable equity securities		4,589		1,496		(76	)		6,009
Total	$	446,001	$	10,284	$	(12,329	)	$	443,956

The following table presents gross unrealized losses and fair value of available-for-sale securities with unrealized loss positions that are not deemed to be other-than-temporarily impaired, aggregated by length of time that individual securities have been in a continuous unrealized loss position at September 30, 2011 and December 31, 2010:

September 30, 2011	Less Than 12 Months					12 Months or More					Total
(In Thousands)	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
	Value		Losses			Value		Losses			Value		Losses

Obligations of states and political subdivisions:
Tax-exempt	$	9,055	$	(702	)	$	24,904	$	(1,072	)	$	33,959	$	(1,774	)
Taxable		699		(8	)		0		0			699		(8	)
Collateralized mortgage obligations, Issued by U.S. Government agencies		8,399		(45	)		5,316		(2	)		13,715		(47	)
Trust preferred securities issued by individual institutions		0		0			955		(45	)		955		(45	)
Collateralized debt obligations:
Pooled trust preferred securities - senior tranches		0		0			7,103		(811	)		7,103		(811	)
Total debt securities		18,153		(755	)		38,278		(1,930	)		56,431		(2,685	)
Marketable equity securities		1,413		(137	)		96		(59	)		1,509		(196	)
Total temporarily impaired available-for-sale securities	$	19,566	$	(892	)	$	38,374	$	(1,989	)	$	57,940	$	(2,881	)

December 31, 2010	Less Than 12 Months					12 Months or More					Total
(In Thousands)	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
	Value		Losses			Value		Losses			Value		Losses

Obligations of U.S. Government agencies	$	10,230	$	(28	)	$	0	$	0		$	10,230	$	(28	)
Obligations of states and political subdivisions:
Tax-exempt		53,119		(2,533	)		28,622		(5,349	)		81,741		(7,882	)
Taxable		6,542		(141	)		0		0			6,542		(141