Attached files

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EX-31.1 - CERTIFICATION OF CHIEF EXECUTIVE OFFICER - CITIZENS FINANCIAL SERVICES INCceocert.htm
EX-32.1 - SECTION 1350 CERTIFICATION OF CHIEF EXECUTIVE OFFICER - CITIZENS FINANCIAL SERVICES INCcertceo.htm
EX-32.2 - SECTION 1350 CERTIFICATION OF CHIEF FINANCIAL OFFICER - CITIZENS FINANCIAL SERVICES INCcertcfo.htm
EX-31.2 - CERTIFICATION OF CHIEF FINANCIAL OFFICER - CITIZENS FINANCIAL SERVICES INCcfocert.htm
EX-23 - CONSENT OF SR SNODGRASS CERTIFIED PUBLIC ACCOUNTANTS - CITIZENS FINANCIAL SERVICES INCsnodgrassconsent.htm
EX-21 - LIST OF SUBSIDIARIES - CITIZENS FINANCIAL SERVICES INCsubsidiaries.htm


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

FORM 10-K
(Mark One)

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

For the fiscal year ended
 
     December 31, 2009

or
 
 
     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
     000-13222

CITIZENS FINANCIAL SERVICES, INC.
(Exact name of registrant as specified in its charter)
Pennsylvania
 
23-2265045
State or other jurisdiction of
incorporation or organization
 
(I.R.S. Employer
Identification No.)
15 South Main Street, Mansfield, Pennsylvania
 
16933
(Address of principal executive offices)
 
(Zip Code)
Registrant’s telephone number, including area code
(570) 662-2121
         
Securities registered pursuant to Section 12(b) of the Act:
None
 
         
Securities registered pursuant to Section 12(g) of the Act:
         
Common Stock, par value $1.00 per share
(Title of class)
 
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
  Yes       No

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
  Yes       No

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       No

Indicate by check mark whether the registrant has submitted electronically and posted on its website, 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       No


Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.
                  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  o                                                                                     Accelerated filer  £
 
 
Non-accelerated filer  o                                                                           Smaller reporting company  
 
(Do not check if a smaller reporting company)


Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).
      Yes       No


State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter. $53,368,585 as of June 30, 2009.

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date. 2,869,854 as of March 1, 2010

DOCUMENTS INCORPORATED BY REFERENCE

Certain information required by Part III is incorporated by reference to the Registrant’s Definitive Proxy Statement for the 2009 Annual Meeting of Shareholders.



 
II

 

 

 
Citizens Financial Services, Inc.
Form 10-K
INDEX
 
Page
PART I
 
ITEM 1 – BUSINESS
1 – 4
ITEM 1A – RISK FACTORS
5 – 8
ITEM 1B – UNRESOLVED STAFF COMMENTS
8
ITEM 2 – PROPERTIES
8
ITEM 3 – LEGAL PROCEEDINGS
8
ITEM 4 – [RESERVED]
8
PART II
 
ITEM 5 – MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
9 – 10
ITEM 6 – SELECTED FINANCIAL DATA
11
ITEM 7 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS  OF OPERATION
12 – 38
ITEM 7A – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
38
ITEM 8 – FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
39 – 75
ITEM 9 – CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
76
ITEM 9A(T) – CONTROLS AND PROCEDURES
76
ITEM 9B – OTHER INFORMATION
76
PART III
 
ITEM 10 – DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
77
ITEM 11 – EXECUTIVE COMPENSATION
77
ITEM 12 – SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
77 – 78
ITEM 13 – CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
78
ITEM 14 – PRINCIPAL ACCOUNTING FEES AND SERVICES
78
PART IV
 
ITEM 15 – EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
79 – 80
SIGNATURES
81

 
III

 


 
PART I
 
 

 
 
ITEM 1 – BUSINESS.
 
 
CITIZENS FINANCIAL SERVICES, INC.
 
Citizens Financial Services, Inc. (the “Company”), a Pennsylvania corporation, was incorporated on April 30, 1984. The Company is registered with the Board of Governors of the Federal Reserve System (“FRB”) as a bank holding company under the Bank Holding Company Act of 1956, as amended.  Simultaneous with establishment of the Company in 1984, First Citizens National Bank (the “Bank”) became a wholly-owned subsidiary of the Company.   The Company is subject to regulation, supervision and examination by the FRB.  In general, the Company is limited to owning or controlling banks and engaging in such other bank related activities.
 
Our Company is primarily engaged in the ownership and management of the Bank and its wholly-owned insurance agency subsidiary.
 
FIRST CITIZENS NATIONAL BANK
 
The Bank’s main office is located at 15 South Main Street, Mansfield, (Tioga County) Pennsylvania.  The Bank’s primary market area consists of the Pennsylvania Counties of Bradford, Potter and Tioga in North Central Pennsylvania.  It also includes Allegany, Steuben, Chemung and Tioga Counties in Southern New York.  The economy is diversified and includes manufacturing industries, wholesale and retail trade, service industries, family farms and the production of natural resources of gas and timber.  We are dependent geographically upon the economic conditions in north central Pennsylvania and the southern tier of New York.  In addition to the main office, the Bank has 16 other full service branch offices in its market area.
 
The Bank is a full-service bank engaging in a broad range of banking activities and services for individual, business, governmental and institutional customers.  These activities and services principally include checking, savings, time and deposit accounts; real estate, commercial, industrial, residential and consumer loans; and a variety of other specialized financial services.  The Trust and Investment division of the Bank offers a full range of client investment, estate and retirement services through the Bank’s wholly owned insurance agency subsidiary, First Citizens Insurance Agency, Inc.
 
As of December 31, 2009, the Bank employed 158 full time employees and 26 part-time employees, resulting in 169 full time equivalent employees at our corporate offices and other banking locations.
 
COMPETITION
 
The banking industry in the Bank’s service area continues to be extremely competitive, both among commercial banks and with financial service providers such as consumer finance companies, thrifts, investment firms, mutual funds, insurance companies, credit unions and internet banks.  The increased competition has resulted from changes in the legal and regulatory guidelines as well as from economic conditions.  Mortgage banking firms, financial companies, financial affiliates of industrial companies, brokerage firms, retirement fund management firms and even government agencies provide additional competition for loans and other financial services.  The Bank is generally competitive with all competing financial institutions in its service area with respect to interest rates paid on time and savings deposits, service charges on deposit accounts and interest rates charged on loans.
 
Additional information related to our business and competition is included in Part II, Item 7, “Management's Discussion and Analysis of Financial Condition and Results of Operations”.
 
SUPERVISION AND REGULATION

GENERAL
 
The Company is registered as a bank holding company and is subject to supervision and regulation by the Board of Governors of the Federal Reserve System under the Bank Holding Company Act of 1956, as amended.  The Company is considered a bank holding company.  Bank holding companies are required to file periodic reports with and are subject to examination by the Federal Reserve Board.  The Federal Reserve Board has issued regulations under the Bank Holding Company Act that require a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks.  As a result, the Federal Reserve Board, pursuant to such regulations, may require the Company to stand ready to use its resources to provide adequate capital funds to its bank subsidiary during periods of financial stress or adversity.

1

The Bank Holding Company Act prohibits the Company from acquiring direct or indirect control of more than 5% of the outstanding shares of any class of voting stock, or substantially all of the assets of, any bank, or from merging or consolidating with another bank holding company, without prior approval of the Federal Reserve Board.  Additionally, the Bank Holding Company Act prohibits the Company from engaging in or from acquiring ownership or control of more than 5% of the outstanding shares of any class of voting stock of any company engaged in a non-banking business, unless such business has been determined by the Federal Reserve Board to be so closely related to banking as to be a proper incident thereto or, for financial holding companies, to be financial in nature or incidental thereto.
 
The Bank is a national bank and a member of the Federal Reserve System, and its deposits are insured (up to applicable limits) by the Federal Deposit Insurance Corporation (the “FDIC”).  The Bank is subject to regulation and examination by the Office of the Comptroller of the Currency (OCC), and to a much lesser extent, the Federal Reserve Board and the FDIC.  The Bank is also subject to requirements and restrictions under federal and state law, including requirements to maintain reserves against deposits, and the interest that may be charged on loans, and limitations on the types of investments that may be made and the types of services that may be offered.  The Bank is subject to extensive regulation and reporting requirements in a variety of areas, including helping to prevent money laundering, to preserve financial privacy and to properly report late payments, defaults and denials of loan applications.  The Community Reinvestment Act requires the Bank to help meet the credit needs of the entire community where the Bank operates, including low and moderate income neighborhoods.  The Bank's rating under the Community Reinvestment Act, assigned by the Comptroller of the Currency pursuant to an examination of the Bank, is important in determining whether the bank may receive approval for, or utilize certain streamlined procedures in, applications to engage in new activities.  The Bank’s present CRA rating is “Satisfactory.”  Various consumer laws and regulations also affect the operations of the Bank.  In addition to the impact of regulation, commercial banks are affected significantly by the actions of the Federal Reserve Board as it attempts to control the money supply and credit availability in order to influence the economy.

CAPITAL ADEQUACY GUIDELINES
 
Bank holding companies are required to comply with the Federal Reserve Board's risk-based capital guidelines.  The required minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) is 8%.  At least half of the total capital is required to be “Tier 1 capital,” consisting principally of common shareholders' equity, less certain intangible assets.  The remainder (“Tier 2 capital”) may consist of certain preferred stock, a limited amount of subordinated debt, certain hybrid capital instruments and other debt securities, and a limited amount of the general loan loss allowance.  The risk-based capital guidelines are required to take adequate account of interest rate risk, concentration of credit risk, and risks of nontraditional activities.
 
In addition to the risk-based capital guidelines, the Federal Reserve Board requires a bank holding company to maintain a leverage ratio of a minimum level of Tier 1 capital (as determined under the risk-based capital guidelines) equal to 3% of average total consolidated assets for those bank holding companies which have the highest regulatory examination ratings and are not contemplating or experiencing significant growth or expansion.  All other bank holding companies are required to maintain a ratio of at least 1% above the stated minimum.  The Bank is subject to largely similar capital requirements adopted by the OCC.

PROMPT CORRECTIVE ACTION RULES
 
The federal banking agencies have regulations defining the levels at which an insured institution would be considered “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” and “critically undercapitalized.”  Institutions that are classified as undercapitalized, significantly undercapitalized or critically undercapitalized are subject to various supervision measures based on the degree of undercapitalization.  The applicable federal bank regulator for a depository institution could, under certain circumstances, reclassify a “well-capitalized” institution as “adequately capitalized” or require an “adequately capitalized” or “undercapitalized” institution to comply with supervisory actions as if it were in the next lower category.  Such a reclassification could be made if the regulatory agency determines that the institution is in an unsafe or unsound condition (which could include unsatisfactory examination ratings).  The Bank satisfies the criteria to be classified as “well capitalized” within the meaning of applicable regulations.

REGULATORY RESTRICTIONS ON DIVIDENDS

2

The Bank may not, under the National Bank Act, declare a dividend without approval of the OCC, unless the dividend to be declared by the Bank's Board of Directors does not exceed the total of:  (i) the Bank's net profits for the current year to date, plus (ii) its retained net profits for the preceding two current years, less any required transfers to surplus.  In addition, the Bank can only pay dividends to the extent that its retained net profits (including the portion transferred to surplus) exceed its bad debts.  The Federal Reserve Board, the OCC and the FDIC have formal and informal policies which provide that insured banks and bank holding companies should generally pay dividends only out of current operating earnings, with some exceptions.  The Prompt Corrective Action Rules, described above, further limit the ability of banks to pay dividends, because banks which are not classified as well capitalized or adequately capitalized may not pay dividends and no dividend may be paid which would make the Bank undercapitalized after the dividend. Those rules also authorize the Federal Reserve Board to prohibit a bank holding company from paying dividends under certain circumstances if its subsidiary bank is undercapitalized.
 
Under these policies and subject to the restrictions applicable to the Bank, the Bank could have declared, during 2009, without prior regulatory approval, aggregate dividends of approximately $10.9 million, plus net profits earned to the date of such dividend declaration.

BANK SECRECY ACT
 
Under the Bank Secrecy Act (BSA), banks and other financial institutions are required to retain records to assure that the details of financial transactions can be traced if investigators need to do so.  Banks are also required to report most cash transactions in amounts exceeding $10,000 made by or on behalf of their customers.  Failure to meet BSA requirements may expose the Bank to statutory penalties, and a negative compliance record may affect the willingness of regulating authorities to approve certain actions by the Bank requiring regulatory approval, including new branches.

INSURANCE OF DEPOSIT ACCOUNTS
 
The Bank’s deposits are insured up to applicable limits by the Deposit Insurance Fund (DIF) of the FDIC.  The Deposit Insurance Fund is the successor to the Bank Insurance Fund and the Savings Association Insurance Fund, which were merged in 2006.
 
Under the FDIC’s risk-based assessment system, insured institutions are assigned to one of four risk categories based on supervisory evaluations, regulatory capital levels and certain other factors, with less risky institutions paying lower assessments.  An institution’s assessment rate depends upon the category to which it is assigned.  For calendar 2008, assessments ranged from five to forty-three basis points of each institution’s deposit assessment base.  Due to losses incurred by the DIF in 2008 as a result of failed institutions, and anticipated future losses, the FDIC adopted an across the board seven basis point increase in the assessment range for the first quarter of 2009.  The FDIC made further refinements to its risk-based assessment that were effective April 1, 2009 and that effectively made the range seven to 771/2 basis points.  The FDIC may adjust rates uniformly from one quarter to the next, except that no adjustment can deviate more than three basis points from the base scale without notice and comment rulemaking.  No institution may pay a dividend if in default of the FDIC assessment.
 
The FDIC imposed on each insured institution a special emergency assessment of five basis points of total assets minus tier 1 capital, as of June 30, 2009 (capped at ten basis points of an institution’s deposit assessment base on the same date) in order to cover losses to the Deposit Insurance Fund.  That special assessment was collected on September 30, 2009.  The FDIC provided for similar special assessments during the last fiscal two quarters of 2009, if deemed necessary.  However, in lieu of further special assessments, the FDIC required insured institutions to prepay estimated quarterly risk-based assessments for the fourth quarter of 2009 through the fourth quarter of 2012.  The estimated assessments, which include an assumed annual assessment base increase of 5%, were recorded as a prepaid expense asset as of December 30, 2009.
 
Due to the recent difficult economic conditions, deposit insurance per account owner has been raised to $250,000 for all types of accounts until January 1, 2014.  In addition, the FDIC adopted an optional Temporary Liquidity Guarantee Program by which, for a fee, noninterest bearing transaction accounts would receive unlimited insurance coverage until December 31, 2009, subsequently extended until June 30, 2010.  Certain senior unsecured debt issued by institutions and their holding companies between specified time frames could also be guaranteed by the FDIC through June 30, 2012, or in some cases, December 31, 2012.  The Bank made a business decision to participate in the unlimited noninterest bearing transaction account coverage and the Bank and the Company opted to participate in the unsecured debt guarantee program.
 
In addition to the assessment for deposit insurance, institutions are required to make payments on bonds issued in the late 1980s by the financing corporation to recapitalize a predecessor deposit insurance funds.  That payment is established quarterly and for the four quarters ended December 31, 2009 averaged 1.06 basis points of assessable deposits.
 
The FDIC has authority to increase insurance assessments.  A significant increase in insurance premiums would likely have an adverse effect on the operating expenses and results of operations of the Bank.  Management cannot predict what insurance assessment rates will be in the future.

3

 
Insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC or the OCC.  The management of the Bank does not know of any practice, condition or violation that might lead to termination of deposit insurance.
 
 EFFECT OF GOVERNMENT MONETARY POLICIES
 
The earnings and growth of the banking industry are affected by the credit policies of monetary authorities, including the Federal Reserve System.  An important function of the Federal Reserve System is to regulate the national supply of bank credit in order to control recessionary and inflationary pressures.  Among the instruments of monetary policy used by the Federal Reserve to implement these objectives are open market activities in U.S. Government Securities, changes in the discount rate on member bank borrowings and changes in reserve requirements against member bank deposits.  These operations are used in varying combinations to influence overall economic growth and indirectly, bank loans, securities, and deposits.  These variables may also affect interest rates charged on loans or paid on deposits.  The monetary policies of the Federal Reserve authorities have had a significant effect on the operating results of commercial banks in the past and are expected to continue to have such an effect in the future.
 
In view of the changing conditions in the national economy and in the money markets, as well as the effect of actions by monetary and fiscal authorities including the Federal Reserve System, no prediction can be made as to possible changes in interest rates, deposit levels, loan demand or their effect on the business and earnings of the Company and the Bank.   Additional information is included under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing in this Annual Report on Form 10-K.
 
RECENT LEGISLATION
 
Troubled Asset Relief Program.  On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (“EESA”) was enacted establishing the Troubled Asset Relief Program (“TARP”).  On October 14, 2008, Treasury announced its intention to inject capital into U.S. financial institutions under the TARP Capital Purchase Program (“CPP”) and since has injected capital into many financial institutions.  The Board of Directors of the Company determined not to participate in the CPP.
 
American Recovery and Reinvestment Act of 2009. On February 17, 2009, the American Recovery and Reinvestment Act of 2009 (“ARRA”) was enacted.  The ARRA, commonly known as the economic stimulus or economic recovery package, includes a wide variety of programs intended to stimulate the economy and provide for extensive infrastructure, energy, health, and education needs.  In addition, ARRA imposes certain new executive compensation and corporate expenditure limits on all current and future TARP recipients until the institution has repaid Treasury, which is now permitted under ARRA without penalty and without the need to raise new capital, subject to Treasury’s consultation with the recipient’s appropriate regulatory agency.
 
Future Legislation.  Various legislation affecting financial institutions and the financial industry is from time to time introduced in Congress.  Such legislation may change banking statutes and the operating environment of the Company and its subsidiaries in substantial and unpredictable ways, and could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance depending upon whether any of this potential legislation will be enacted, and if enacted, the effect that it or any implementing regulations, would have on the financial condition or results of operations of the Company or any of its subsidiaries. With the recent enactments of EESA and ARRA, the nature and extent of future legislative and regulatory changes affecting financial institutions is very unpredictable at this time.
 
In particular, the Obama Administration has proposed, and the Congress is considering, legislation that would restructure the regulation of depository institutions.  Proposals range from the merger of the Office of Thrift Supervision, which regulates federal savings associations, with the OCC, to the creation of an independent federal agency that would assume the regulatory responsibilities of the Office of Thrift Supervision, FDIC, OCC and Federal Reserve Board.  The federal savings association charter would be eliminated and federal associations required to become banks under some proposals, although others would grandfather existing charters.  Also proposed is the creation of a new federal agency to administer and enforce consumer and fair lending laws, a function that is now performed by the depository institution regulators.  The federal preemption of state laws currently accorded federally chartered depository institutions would be reduced under certain proposals as well.
Enactment of any of these proposals could revise the regulatory structure imposed on the Company and Bank, which could result in more stringent regulation.  At this time, management has no way of predicting the contents of any final legislation, or whether any legislation will be enacted at all.
 
 
4


ITEM 1A – RISK FACTORS.
 
Changing interest rates may decrease our earnings and asset values.
 
Our net interest income is the interest we earn on loans and investments less the interest we pay on our deposits and borrowings.  Our net interest margin is the difference between the yield we earn on our assets and the interest rate we pay for deposits and our other sources of funding.  Changes in interest rates—up or down—could adversely affect our net interest margin and, as a result, our net interest income.  Although the yield we earn on our assets and our funding costs tend to move in the same direction in response to changes in interest rates, one can rise or fall faster than the other, causing our net interest margin to expand or contract.  Our liabilities tend to be shorter in duration than our assets, so they may adjust faster in response to changes in interest rates.  As a result, when interest rates rise, our funding costs may rise faster than the yield we earn on our assets, causing our net interest margin to contract until the asset yields catch up.   Changes in the slope of the “yield curve”—or the spread between short-term and long-term interest rates—could also reduce our net interest margin.  Normally, the yield curve is upward sloping, meaning short-term rates are lower than long-term rates.  Because our liabilities tend to be shorter in duration than our assets, when the yield curve flattens or even inverts, we could experience pressure on our net interest margin as our cost of funds increases relative to the yield we can earn on our assets.
 
Changes in interest rates also affect the value of the Bank’s interest-earning assets, and in particular the Bank’s securities portfolio.  Generally, the value of fixed-rate securities fluctuates inversely with changes in interest rates.  Unrealized gains and losses on securities available for sale are reported as a separate component of equity, net of tax.  Decreases in the fair value of securities available for sale resulting from increases in interest rates could have an adverse effect on shareholders’ equity.
 
A continuation of recent turmoil in the financial markets could have an adverse effect on our financial position or results of operations.
 
Since 2008, United States and global financial markets have experienced severe disruption and volatility, and general economic conditions have declined significantly. Adverse developments in credit quality, asset values and revenue opportunities throughout the financial services industry, as well as general uncertainty regarding the economic, industry and regulatory environment, have had a marked negative impact on the industry.  Dramatic declines in the U.S. housing market over the past two years, with falling home prices, increasing foreclosures and increasing unemployment, have negatively affected the credit performance of mortgage loans and resulted in significant write-downs of asset values by many financial institutions. The United States and the governments of other countries have taken steps to try to stabilize the financial system, including investing in financial institutions, and have also been working to design and implement programs to improve general economic conditions. Notwithstanding the actions of the United States and other governments, these efforts may not succeed in restoring industry, economic or market conditions and may result in adverse unintended consequences.  Factors that could continue to pressure financial services companies, including the Company, are numerous and include (i) worsening credit quality, leading among other things to increases in loan losses and reserves, (ii) continued or worsening disruption and volatility in financial markets, leading to, among other things, continuing reductions in asset values, (iii)  capital and liquidity concerns regarding financial institutions generally, (iv) limitations resulting from or imposed in connection with governmental actions intended to stabilize or provide additional regulation of the financial system, or (v) recessionary conditions that are deeper or last longer than currently anticipated.
 
Higher loan losses could require us to increase our allowance for loan losses through a charge to earnings.
 
When we loan money we incur the risk that our borrowers do not repay their loans. We reserve for loan losses by establishing an allowance through a charge to earnings. The amount of this allowance is based on our assessment of loan losses inherent in our loan portfolio. The process for determining the amount of the allowance is critical to our financial results and condition. It requires subjective and complex judgments about the future, including forecasts of economic or market conditions that might impair the ability of our borrowers to repay their loans. We might underestimate the loan losses inherent in our loan portfolio and have loan losses in excess of the amount reserved. We might increase the allowance because of changing economic conditions. For example, in a rising interest rate environment, borrowers with adjustable-rate loans could see their payments increase. There may be a significant increase in the number of borrowers who are unable or unwilling to repay their loans, resulting in our charging off more loans and increasing our allowance. In addition, when real estate values decline, the potential severity of loss on a real estate-secured loan can increase significantly, especially in the case of loans with high combined loan-to-value ratios. The recent decline in the national economy and the local economies of the areas in which the loans are concentrated could result in an increase in loan delinquencies, foreclosures or repossessions resulting in increased charge-off amounts and the need for additional loan loss allowances in future periods. In addition, our determination as to the amount of our allowance for loan losses is subject to review by our primary regulator, the Office of the Comptroller of the Currency, as part of its examination process, which may result in the establishment of an additional allowance based upon the judgment of the Office of the Comptroller of the Currency after a review of the information available at the time of its examination. Our allowance for loan losses amounted to $4.9 million, or 1.07% of total loans outstanding and 72.36% of nonperforming loans, at December 31, 2009. Our allowance for loan losses at December 31, 2009 may not be sufficient to cover future loan losses. A large loss could deplete the allowance and require increased provisions to replenish the allowance, which would decrease our earnings. In addition, at December 31, 2009, we had 9 loan relationships that were performing according to their original terms with outstanding balances that exceeded $3.0 million. However, the deterioration of one or more of these loans could result in a significant increase in our nonperforming loans and our provision for loan losses, which would negatively impact our results of operations.
 
5

Our emphasis on commercial real estate, agricultural and construction lending may expose us to increased lending risks.
 
At December 31, 2009, we had $134.0 million in loans secured by commercial real estate, $19.5 million in agricultural loans and $5.6 million in construction loans.  Commercial real estate loans, agricultural and construction loans represented 29.4%, 4.3% and 1.2%, respectively, of our loan portfolio.  At December 31, 2009, we had $2.9 million of reserves specifically allocated to these loan types.  While commercial real estate, agricultural  and construction loans are generally more interest rate sensitive and carry higher yields than do residential mortgage loans, these types of loans generally expose a lender to greater risk of non-payment and loss than single-family residential mortgage loans because repayment of the loans often depends on the successful operation of the property, the income stream of the borrowers and, for construction loans, the accuracy of the estimate of the property’s value at completion of construction and the estimated cost of construction.  Such loans typically involve larger loan balances to single borrowers or groups of related borrowers compared to single-family residential mortgage loans.
 
If we conclude that the decline in value of any of our investment securities is other than temporary, we are required to write down the value of that security through a charge to earnings.
 
We review our investment securities portfolio monthly and at each quarter-end reporting period to determine whether the fair value is below the current carrying value. When the fair value of any of our investment securities has declined below its carrying value, we are required to assess whether the decline is other than temporary. If we conclude that the decline is other than temporary, we are required to write down the value of that security through a charge to earnings. As of December 31, 2009, our investment portfolio included available for sale investment securities with a carrying value of $193.6 million and an estimated fair value of $198.6 million, which included unrealized losses on 33 securities totaling $400,000.  Changes in the expected cash flows of these securities and/or prolonged price declines may result in our concluding in future periods that the impairment of these securities is other than temporary, which would require a charge to earnings to write down theses securities to their fair value. Any charges for other-than-temporary impairment would not impact cash flow, tangible capital or liquidity.
 
The Company’s financial condition and results of operations are dependent on the economy in the Bank’s market area.
 
The Bank’s market area consists of the Pennsylvania Counties of Bradford, Potter and Tioga in North Central Pennsylvania and Allegany, Steuben, Chemung and Tioga Counties in Southern New York.  As of December 31, 2009, management estimates that more than 93% of deposits and 84% of loans came from its market area.  Because of the Bank’s concentration of business activities in its market area, the Company’s financial condition and results of operations depend upon economic conditions in its market area.  Adverse economic conditions in our market area could reduce our growth rate, affect the ability of our customers to repay their loans and generally affect our financial condition and results of operations.  Conditions such as inflation, recession, unemployment, high interest rates and short money supply and other factors beyond our control may adversely affect our profitability.  We are less able than a larger institution to spread the risks of unfavorable local economic conditions across a large number of diversified economies.  Any sustained period of increased payment delinquencies, foreclosures or losses caused by adverse market or economic conditions in the States of Pennsylvania and New York could adversely affect the value of our assets, revenues, results of operations and financial condition.  Moreover, we cannot give any assurance we will benefit from any market growth or favorable economic conditions in our primary market areas if they do occur.
 
Increased and/or special Federal Deposit Insurance Corporation assessments will hurt our earnings
 
The recent economic recession has caused a high level of bank failures, which has dramatically increased FDIC resolution costs and led to a significant reduction in the balance of the Deposit Insurance Fund. As a result, the FDIC has significantly increased the initial base assessment rates paid by financial institutions for deposit insurance. Increases in the base assessment rate have increased our deposit insurance costs and negatively impacted our earnings. In addition, in May 2009, the FDIC imposed a special assessment on all insured institutions. Our special assessment, which was reflected in earnings for the quarter ended June 30, 2009, was $330,000. In lieu of imposing an additional special assessment, the FDIC required all institutions to prepay their assessments for the fourth quarter of 2009 and all of 2010, 2011 and 2012. Additional increases in the base assessment rate or additional special assessments would negatively impact our earnings.
 
The Company and the Bank operate in a highly regulated environment and may be adversely affected by changes in laws and regulations.
 
6

The Bank is subject to extensive regulation, supervision and examination by the Office of the Comptroller of the Currency, our chartering authority, and by the Federal Deposit Insurance Corporation, as insurer of its deposits.  The Company is subject to regulation and supervision by the Federal Reserve Board.  Such regulation and supervision govern the activities in which an institution and its holding company may engage, and are intended primarily for the protection of the insurance fund and for the depositors and borrowers of the Bank.  The regulation and supervision by the Office of the Comptroller of the Currency, the Federal Reserve Board and the Federal Deposit Insurance Corporation are not intended to protect the interests of investors in the Company’s common stock.  Regulatory authorities have extensive discretion in their supervisory and enforcement activities, including the imposition of restrictions on our operations, the classification of our assets and determination of the level of our allowance for loan losses.  Any change in such regulation and oversight, whether in the form of regulatory policy, regulations, legislation or supervisory action, may have a material impact on our operations.
 
Proposed regulatory reform may have a material impact on our operations.
 
The Obama Administration has published a comprehensive regulatory reform plan that is intended to modernize and protect the integrity of the United States financial system and has offered, and the House of Representatives and Senate are currently considering, proposed legislation to accomplish these reforms.  The Administration has also proposed the creation of a new federal agency, the Consumer Financial Protection Agency, that would be dedicated to protecting consumers in the financial products and services market.  The creation of this agency could result in new regulatory requirements and raise the cost of regulatory compliance.  In addition, legislation stemming from the reform plan could require changes in regulatory capital requirements, loan loss provisioning practices, and compensation practices.  If implemented, the foregoing regulatory reforms may have a material impact on our operations.  However, because the final legislation may differ significantly from the reform plan proposed by the President, we cannot determine the specific impact of any regulatory reform at this time.
 
Strong competition within the Bank’s market area could hurt profits and slow growth.
 
The Bank faces intense competition both in making loans and attracting deposits.  This competition has made it more difficult for the Bank to make new loans and at times has forced the Bank to offer higher deposit rates.  Price competition for loans and deposits might result in the Bank earning less on loans and paying more on deposits, which would reduce net interest income.  Competition also makes it more difficult to increase loans and deposits.  As of June 30, 2009, which is the most recent date for which information is available, we held 33.0% of the deposits in Bradford, Potter and Tioga Counties, Pennsylvania , which was the second largest share of deposits out of eight financial institutions with offices in the area, and 5.2% of the deposits in Allegany County, New York, which was the fourth largest share of deposits out of five financial institutions with offices in this area.  Competition also makes it more difficult to hire and retain experienced employees.  Some of the institutions with which the Bank competes have substantially greater resources and lending limits than the Bank has and may offer services that the Bank does not provide.  Management expects competition to increase in the future as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry.  The Bank’s profitability depends upon its continued ability to compete successfully in its market area.
 
We rely on our management and other key personnel, and the loss of any of them may adversely affect our operations.
 
We are and will continue to be dependent upon the services of our executive management team. In addition, we will continue to depend on our ability to retain and recruit key commercial loan officers. The unexpected loss of services of any key management personnel or commercial loan officers could have an adverse effect on our business and financial condition because of their skills, knowledge of our market, years of industry experience and the difficulty of promptly finding qualified replacement personnel.
 
Environmental liability associated with lending activities could result in losses.
 
In the course of our business, we may foreclose on and take title to properties securing our loans.  If hazardous substances were discovered on any of these properties, we could be liable to governmental entities or third parties for the costs of remediation of the hazard, as well as for personal injury and property damage.  Many environmental laws can impose liability regardless of whether we knew of, or were responsible for, the contamination.  In addition, if we arrange for the disposal of hazardous or toxic substances at another site, we may be liable for the costs of cleaning up and removing those substances from the site even if we neither own nor operate the disposal site.  Environmental laws may require us to incur substantial expenses and may materially limit use of properties we acquire through foreclosure, reduce their value or limit our ability to sell them in the event of a default on the loans they secure.  In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability.
 
Failure to implement new technologies in our operations may adversely affect our growth or profits.
 
The market for financial services, including banking services and consumer finance services, is increasingly affected by advances in technology, including developments in telecommunications, data processing, computers, automation, Internet-based banking and telebanking. Our ability to compete successfully in our markets may depend on the extent to which we are able to exploit such technological changes. However, we can provide no assurance that we will be able properly or timely to anticipate or implement such technologies or properly train our staff to use such technologies.  Any failure to adapt to new technologies could adversely affect our business, financial condition or operating results. 
 
7

Our ability to pay dividends is limited by law.
 
Our ability to pay dividends to our shareholders largely depends on our receipt of dividends from the Bank. The amount of dividends that the Bank may pay to us is limited by federal laws and regulations. We also may decide to limit the payment of dividends even when we have the legal ability to pay them in order to retain earnings for use in our business.
 
Federal and state banking laws, our articles of incorporation and our by-laws may have an anti-takeover effect.
 
Federal law imposes restrictions, including regulatory approval requirements, on persons seeking to acquire control over us.  Pennsylvania law also has provisions that may have an anti-takeover effect.  These provisions may serve to entrench management or discourage a takeover attempt that shareholders consider to be in their best interest or in which they would receive a substantial premium over the current market price.
 
ITEM 1B – UNRESOLVED STAFF COMMENTS.
 
Not applicable.
 
ITEM 2 – PROPERTIES.
 
The headquarters of the Company and Bank are located at 15 South Main Street, Mansfield, Pennsylvania. The building contains the central offices of the Company and Bank. Our bank owned fifteen banking facilities and leased three other facilities as of December 31, 2009.  All buildings owned by the Bank are free of any liens or encumbrances.
 
The net book value of owned properties and leasehold improvements totaled $11,421,586 as of December 31, 2009.  The properties are adequate to meet the needs of the employees and customers. We have equipped all of our facilities with current technological improvements for data and word processing.
 
ITEM 3 - LEGAL PROCEEDINGS.
 
The Company is not involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business.  Such routine legal proceedings in the aggregate are believed by management to be immaterial to the Company's financial condition or results of operations.

ITEM 4 – [RESERVED]
 

 
8

 

 
PART II
 
ITEM 5 - MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
 
The Company's stock is not listed on any stock exchange, but it is quoted on the OTC Bulletin Board under the trading symbol CZFS.  Prices presented in the table below are bid prices between broker-dealers published by the OTC Bulletin Board and the Pink Sheets Electronic Quotation Service.  The prices do not include retail markups or markdowns or any commission to the broker-dealer.  The bid prices do not necessarily reflect prices in actual transactions.  Cash dividends are declared on a quarterly basis and are summarized in the table below (also see dividend restrictions in Note 14 of the consolidated financial statements).
 
 
Dividends
   
Dividends
 
2009
declared
2008
declared
 
High
Low
per share
High
Low
per share
First quarter
 $      19.80
 $      16.93
 $      0.240
 $      21.78
 $      17.87
 $      0.230
Second quarter
         22.77
         18.32
         0.245
         23.27
         20.05
         0.235
Third quarter
         24.00
         20.79
         0.245
         24.50
         21.25
         0.235
Fourth quarter
         25.30
         23.05
         0.300
         21.00
         17.25
         0.290
 
The Company has paid dividends since April 30, 1984, the effective date of our formation as a bank holding company. The Company's Board of Directors intends to continue the dividend payment policy; however, future dividends necessarily depend upon earnings, financial condition, appropriate legal restrictions and other factors in existence at the time the Board of Directors considers a dividend policy. Cash available for dividend distributions to stockholders of the Company comes from dividends paid to the Company by the Bank. Therefore, restrictions on the ability of the Bank to make dividend payments are directly applicable to the Company.  See “Note 14 – Regulatory Matters” to the consolidated financial statements.
 
Under the Pennsylvania Business Corporation Law of 1988, the Company may pay dividends only if, after payment, the Company would be able to pay debts as they become due in the usual course of our business and total assets will be greater than the sum of total liabilities.  The Federal Reserve Board has issued a policy statement regarding the payment of dividends by bank holding companies.  In general, the Federal Reserve Board’s policies provide that dividends should be paid only out of current earnings and only if the prospective rate of earnings retention by the bank holding company appears consistent with the organization’s capital needs, asset quality, and overall financial condition.  The Federal Reserve Board’s policies also require that a bank holding company serve as a source of financial strength to its subsidiary banks by standing ready to use available resources to provide adequate capital funds to those banks during periods of financial stress or adversity and by maintaining the financial flexibility and capital-raising capacity to obtain additional resources for assisting its subsidiary banks where necessary.  Furthermore, the Federal Reserve Board has authority to prohibit a bank holding company from paying a capital distribution where a subsidiary bank is undercapitalized. These regulatory policies could affect the ability of the Company to pay dividends or otherwise engage in capital distributions.
 
The Company distributed a 1% stock dividend on July 31, 2009 to all shareholders of record as of July 17, 2009.
 
As of February 9, 2010, the Company had approximately 1,528 stockholders of record.  The computation of stockholders of record excludes individual participants in securities positions listings. The following table presents information regarding the Company’s stock repurchases during the three months ended December 31, 2009:
 
 
9



 
Period
Total Number of Shares (or units Purchased)
Average Price Paid per Share (or Unit)
Total Number of Shares (or Units) Purchased as Part of Publicly Announced Plans of Programs
Maximum Number (or Approximate Dollar Value) of Shares (or Units) that May Yet Be Purchased Under the Plans or Programs (1) (2)
         
10/1/09 to 10/31/09
                                -
                              -
                                         -
                               54,505
11/1/09 to 11/30/09
-
-
                                  -
                               54,505
12/1/09 to 12/31/09
                            3,780
$25.09
3,780
                               50,725
Total
3,780
$25.09
                                  3,780
                               50,725
 

 
(1)  
On January 7, 2006, the Company announced that the Board of Directors authorized the Company to repurchase up to 140,000 shares.  The repurchases will be conducted through open-market purchases or privately negotiated transactions and will be made from time to time depending on market conditions and other factors.  No time limit was placed on the duration of the share repurchase program.  Any repurchased shares will be held as treasury stock and will be available for general corporate purposes.
 
(2)  
On November 17, 2009, the Board of Directors authorized a Voluntary Shareholder Buy-Back Program under which shareholders owning less than 100 shares of the Company could voluntarily sell their shares to the Company at a purchase price of $26.00 per share. The program expired on February 4, 2010. Under this program, 343 shares were purchased during the 4th quarter of 2009
 
 
10


ITEM 6 - SELECTED FINANCIAL DATA.
 
The following table sets forth certain financial data as of and for each of the years in the five year period ended December 31, 2009:

 
 
(in thousands, except share data)
2009
2008
2007
2006
2005
Interest income
 $     38,615
 $     37,238
 $    36,024
 $     32,851
 $     28,699
Interest expense
        13,231
        14,058
        16,922
        14,953
        11,000
Net interest income
        25,384
        23,180
        19,102
        17,898
        17,699
Provision for loan losses
              925
              330
             365
              330
                60
Net interest income after provision
         
  for loan losses
        24,459
        22,850
        18,737
        17,568
        17,639
Non-interest income
          5,708
          5,245
          5,114
          4,712
          4,688
Investment securities gains (losses), net
              139
         (4,089)
              (29)
                  4
                   -
Non-interest expenses
        17,759
        15,877
        15,314
        15,027
        15,387
Income before provision for income taxes
        12,547
          8,129
          8,508
          7,257
          6,940
Provision for income taxes
          2,683
          1,224
          1,772
          1,457
          1,666
Net income
 $       9,864
 $       6,905
 $       6,736
 $       5,800
 $       5,274
           
Return on Assets (net income to average total assets)
1.42%
1.13%
1.16%
1.05%
1.04%
Return on Equity (net income to average total equity)
17.65%
13.51%
14.38%
13.21%
12.63%
Dividend Payout Ratio (dividends declared divided by net income)
29.92%
40.77%
37.86%
42.10%
44.28%
Equity to Asset Ratio (average equity to average total assets,
8.02%
8.33%
8.10%
7.98%
8.20%
  excluding other comprehensive income)
         
           
Per share data:
         
Net income (1)
 $         3.43
 $         2.40
 $         2.33
 $         1.98
 $         1.78
Cash dividends (1)
             1.03
             0.98
            0.89
             0.83
             0.79
Book value (1) (2)
          20.71
          18.34
          16.96
          15.58
          14.57
           
Total investments
 $  198,582
 $  174,139
 $  120,802
 $  109,743
 $  102,602
Loans, net (3)
      451,496
      428,436
     419,182
      410,897
      379,139
Total assets (3)
      729,477
      668,612
     591,029
      572,168
      529,241
Total deposits (3)
      605,559
      546,680
     456,028
      446,515
      429,799
Stockholders' equity
        61,527
        52,770
        48,528
        43,500
        41,561
           
(1) Amounts were adjusted to reflect stock dividends.
         
(2) Calculation excludes accumulated other comprehensive income and unrecognized pension cost.
   
(3) Amounts in 2005 reflect the branch acquisition in the fourth quarter of 2005. Amounts in 2008 reflect the branch acquisition in the fourth quarter of 2008.
 
11

 
ITEM 7 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION.
 
CAUTIONARY STATEMENT
 
Forward-looking statements may prove inaccurate. We have made forward-looking statements in this document, and in documents that we incorporate by reference, that are subject to risks and uncertainties. Forward-looking statements include information concerning possible or assumed future results of operations of the Company, the Bank, First Citizens Insurance Agency, Inc. or the Company on a consolidated basis. When we use words such as “believes,” “expects,” “anticipates,” or similar expressions, we are making forward-looking statements.  For a variety of reasons, actual results could differ materially from those contained in or implied by forward-looking statements:
 
 
·
Interest rates could change more rapidly or more significantly than we expect.
 
·
The economy could change significantly in an unexpected way, which would cause the demand for new loans and the ability of borrowers to repay outstanding loans to change in ways that our models do not anticipate.
 
·
The stock and bond markets could suffer a significant disruption, which may have a negative effect on our financial condition and that of our borrowers, and on our ability to raise money by issuing new securities.
 
·
It could take us longer than we anticipate implementing strategic initiatives designed to increase revenues or manage expenses, or we may be unable to implement those initiatives at all.
 
·
Acquisitions and dispositions of assets could affect us in ways that management has not anticipated.
 
·
We may become subject to new legal obligations or the resolution of litigation may have a negative effect on our financial condition.
 
·
We may become subject to new and unanticipated accounting, tax, or regulatory practices or requirements.
 
·
We could experience greater loan delinquencies than anticipated, adversely affecting our earnings and financial condition.  We could also experience greater losses than expected due to the ever increasing volume of information theft and fraudulent scams impacting our customers and the banking industry.
 
·
We could lose the services of some or all of our key personnel, which would negatively impact our business because of their business development skills, financial expertise, lending experience, technical expertise and market area knowledge.
 
Except as required by applicable law and regulation, we assume no obligation to update or revise any forward-looking statements after the date on which they are made.
 
INTRODUCTION
 
The following is management’s discussion and analysis of the significant changes in financial condition, the results of operations, capital resources and liquidity presented in its accompanying consolidated financial statements for the Company. Our Company’s consolidated financial condition and results of operations consist almost entirely of the Bank’s financial condition and results of operations. Management’s discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes. Except as noted, tabular information is presented in thousands of dollars.
 
Our Company currently engages in the general business of banking throughout our service area of Potter, Tioga and Bradford counties in North Central Pennsylvania and Allegany, Steuben, Chemung and Tioga counties in Southern New York. We maintain our central office in Mansfield, Pennsylvania. Presently we operate 18 banking facilities, 17 of which operate as bank branches.  In Pennsylvania, these offices are located in Mansfield, Blossburg, Ulysses, Genesee, Wellsboro, Troy, Sayre, Canton, Gillett, Millerton, LeRaysville, Towanda, the Wellsboro Weis Market store and the Mansfield Wal-Mart Super Center.  In New York, our office is in Wellsville.
 
On November 21, 2008, the Bank acquired the Mansfield, Pennsylvania branch of the Elmira Savings Bank, ESB.  The acquisition provided the Bank with approximately 40% of the deposit market share in Tioga County (see Note 18 to the consolidated financial statements).
 
Risk identification and management are essential elements for the successful management of the Company.  In the normal course of business, the Company is subject to various types of risk, including interest rate, credit, liquidity and regulatory risk.
 
Interest rate risk is the sensitivity of net interest income and the market value of financial instruments to the direction and frequency of changes in interest rates.  Interest rate risk results from various re-pricing frequencies and the maturity structure of the financial instruments owned by the Company.  The Company uses its asset/liability and funds management policies to control and manage interest rate risk.
 
12

Credit risk represents the possibility that a customer may not perform in accordance with contractual terms.  Credit risk results from loans with customers and the purchasing of securities.  The Company’s primary credit risk is in the loan portfolio.  The Company manages credit risk by adhering to an established credit policy and through a disciplined evaluation of the adequacy of the allowance for loan losses.  Also, the investment policy limits the amount of credit risk that may be taken in the investment portfolio.
 
Liquidity risk represents the inability to generate or otherwise obtain funds at reasonable rates to satisfy commitments to borrowers and obligations to depositors.  The Company has established guidelines within its asset/liability and funds management policy to manage liquidity risk.  These guidelines include, among other things, contingent funding alternatives.
 
Reputational risk, or the risk to our business, earnings, liquidity, and capital from negative public opinion, could result from our actual or alleged conduct in a variety of areas, including legal and regulatory compliance, lending practices, corporate governance, litigation, ethical issues, or inadequate protection of customer information. We expend significant resources to comply with regulatory requirements. Failure to comply could result in reputational harm or significant legal or remedial costs. Damage to our reputation could adversely affect our ability to retain and attract new customers, and adversely impact our earnings and liquidity.
 
Regulatory risk represents the possibility that a change in law, regulations or regulatory policy may have a material effect on the business of the Company and its subsidiary.  We can not predict what legislation might be enacted or what regulations might be adopted, or if adopted, the effect thereof on our operations.  We can not anticipate additional requirements or additional compliance efforts regarding the Bank Secrecy Act or USA Patriot Act, or regulatory burdens regarding the ever increasing information theft and fraudulent activities impacting our customers and the banking industry in general.
 
Readers should carefully review the risk factors described in other documents our Company files with the SEC, including the annual reports on Form 10-K, the quarterly reports on Form 10-Q and any current reports on Form 8-K filed by us.
 
TRUST AND INVESTMENT SERVICES
 
Our Investment and Trust Services Division is committed to helping our customers meet their financial goals.  The Trust Division offers professional trust administration, investment management services, estate planning and administration, custody of securities and individual retirement accounts.  Assets held by the Bank in a fiduciary or agency capacity for its customers are not included in the consolidated financial statements since such items are not assets of the Bank.  As of December 31, 2009, non-deposit investment products under management totaled $46.2 million.  Additionally, as summarized in the table below, the Trust Department had assets under management as of December 31, 2009 and 2008 of $85.9 million and $74.3 million, respectively. The increase is primarily due to an increase in the fair value of plan assets given the overall market increase in equity securities and mutual funds during 2009.

13

 

(market values - in thousands)
        2009
2008
INVESTMENTS:
   
Bonds
 $         21,007
 $         20,842
Stock
            18,754
            14,771
Savings and Money Market Funds
            10,396
            10,068
Mutual Funds
            34,001
            26,614
Mortgages
                 836
              1,070
Real Estate
                 931
                 978
Miscellaneous
                     8
                     1
Cash
                      -
                     3
TOTAL
 $         85,933
 $         74,347
ACCOUNTS:
   
Trusts
            27,478
            24,345
Guardianships
                 552
                 857
Employee Benefits
            31,781
            26,722
Investment Management
            25,678
            21,995
Custodial
                 444
                 428
TOTAL
 $         85,933
 $         74,347
 

 Our Financial Consultants offer full service brokerage services throughout the Bank’s market area.  Appointments can be made at any Bank branch.  The Financial Consultants provide financial planning and help our customers achieve their financial goals with their choice of mutual funds, annuities, health and life insurance.  These products are made available through our insurance subsidiary, First Citizens Insurance Agency, Inc.

RESULTS OF OPERATIONS
 
Net income for the twelve months ended December 31, 2009 was $9,864,000, which represents an increase of $2,959,000, or 42.9%, when compared to the 2008 related period.  Net income for the twelve months ended December 31, 2008 totaled $6,905,000, an increase of $169,000 from the 2007 related period.  Earnings per share were $3.43, $2.40 and $2.33 for the years ended 2009, 2008 and 2007, respectively.
 
The following table sets forth certain performance ratios of our Company for the periods indicated:

 
2009
2008
2007
Return on Assets (net income to average total assets)
1.42%
1.13%
1.16%
Return on Equity (net income to average total equity)
17.65%
13.51%
14.38%
Dividend Payout Ratio (dividends declared divided by net income)
29.92%
40.77%
37.86%
Equity to Asset Ratio (average equity to average total assets, excluding other comprehensive income)
8.02%
8.33%
8.10%
 
 
Net income is influenced by five key components: net interest income, provision for loan losses, non-interest income, non-interest expenses, and the provision for income taxes.

Net Interest Income
 
The most significant source of revenue is net interest income; the amount of interest earned on interest-earning assets exceeding interest incurred on interest-bearing liabilities.  Factors that influence net interest income are changes in volume of interest-earning assets and interest-bearing liabilities as well as changes in the associated interest rates.
 
14

The following table sets forth our Company’s average balances of, and the interest earned or incurred on, each principal category of assets, liabilities and stockholders’ equity, the related rates, net interest income and rate “spread” created (dollars in thousands):
 
Analysis of Average Balances and Interest Rates (1)
     
 
2009
2008
 
2007
 
 
Average
 
Average
Average
 
Average
Average
 
Average
 
Balance (1)
Interest
Rate
Balance (1)
Interest
Rate
Balance (1)
Interest
Rate
(dollars in thousands)
$
$
%
$
$
%
$
$
%
ASSETS
                 
Short-term investments:
                 
   Interest-bearing deposits at banks
       21,496
           43
0.20
        7,118
         57
0.80
           102
         5
5.10
Total short-term investments
       21,496
           43
0.20
        7,118
         57
0.80
           102
         5
5.10
Investment securities:
                 
  Taxable
     131,620
     6,072
4.61
      99,872
    5,013
5.02
      95,417
   4,702
4.93
  Tax-exempt (3)
       51,588
     3,325
6.45
      36,016
    2,235
6.21
      24,173
   1,451
6.00
  Total investment securities
     183,208
     9,397
5.13
    135,888
    7,248
5.33
    119,590
   6,153
5.14
Loans:
                 
  Residential mortgage loans
     203,526
   14,743
7.24
    211,958
  15,726
7.42
    211,171
 15,640
7.41
  Commercial & agricultural loans
     182,326
   12,606
6.91
    156,873
  11,872
7.57
    147,921
 11,740
7.94
  Loans to state & political subdivisions
       46,415
     2,844
6.13
      47,766
    2,998
6.28
      45,259
   2,751
6.08
  Other loans
       11,484
     1,020
8.88
      11,849
    1,079
9.11
      12,426
   1,150
9.25
  Loans, net of discount (2)(3)(4)
     443,751
   31,213
7.03
    428,446
  31,675
7.39
    416,777
 31,281
7.51
Total interest-earning assets
     648,455
   40,653
6.27
    571,452
  38,980
6.82
    536,469
 37,439
6.98
Cash and due from banks
          9,315
   
        9,548
   
        9,299
   
Bank premises and equipment
       11,876
   
      12,390
   
      12,773
   
Other assets
       27,408
   
      19,756
   
      18,832
   
Total non-interest earning assets
       48,599
   
      41,694
   
      40,904
   
Total assets
     697,054
   
    613,146
   
    577,373
   
LIABILITIES AND STOCKHOLDERS' EQUITY
               
Interest-bearing liabilities:
                 
  NOW accounts
     123,225
        971
       0.79
    106,694
    1,314
      1.23
      95,098
   2,026
     2.13
  Savings accounts
       46,457
        147
       0.32
      41,494
       153
      0.37
      38,443
      137
     0.36
  Money market accounts
       42,186
        337
       0.80
      45,073
       828
      1.84
      50,189
   1,787
     3.56
  Certificates of deposit
     305,777
     9,767
       3.19
    242,751
    9,197
      3.79
    225,590
   9,413
     4.17
Total interest-bearing deposits
     517,645
   11,222
       2.17
    436,012
  11,492
      2.64
    409,320
 13,363
     3.26
Other borrowed funds
       58,133
     2,009
       3.46
      64,858
    2,566
      3.96
      66,525
   3,559
     5.35
Total interest-bearing liabilities
     575,778
   13,231
       2.30
    500,870
  14,058
      2.81
    475,845
 16,922
     3.56
Demand deposits
       56,628
   
      54,438
   
      48,981
   
Other liabilities
          8,754
   
        6,735
   
        6,783
   
Total non-interest-bearing liabilities
       65,382
   
      61,173
   
      55,764
   
Stockholders' equity
       55,894
   
      51,103
   
      45,764
   
Total liabilities & stockholders' equity
     697,054
   
    613,146
   
    577,373
   
Net interest income
 
   27,422
   
  24,922
   
 20,517
 
Net interest spread (5)
   
3.97%
   
4.01%
   
3.42%
Net interest income as a percentage
                 
  of average interest-earning assets
   
4.23%
   
4.36%
   
3.82%
Ratio of interest-earning assets
                 
  to interest-bearing liabilities
   
       1.13   
   
      1.14   
   
     1.13
                   
(1) Averages are based on daily averages.
               
(2) Includes loan origination and commitment fees.
               
(3) Tax exempt interest revenue is shown on a tax equivalent basis for proper comparison using
       
       a statutory federal income tax rate of 34%.
           
(4) Income on non-accrual loans is accounted for on a cash basis, and the loan balances are included in interest-earning assets.
   
(5) Interest rate spread represents the difference between the average rate earned on interest-earning assets
   
      and the average rate paid on interest-bearing liabilities.
             

15

Tax exempt interest revenue is shown on a tax-equivalent basis for proper comparison using a statutory, federal income tax rate of 34%.  For purposes of the comparison, as well as the discussion that follows, this presentation facilitates performance comparisons between taxable and tax-free assets by increasing the tax-free income by an amount equivalent to the Federal income taxes that would have been paid if this income were taxable at the Company’s 34% Federal statutory rate.  Accordingly, tax equivalent adjustments for investments and loans have been made accordingly to the previous table for the years ended December 31, 2009, 2008 and 2007, respectively:


 
2009
2008
2007
Interest and dividend income
     
    from investment securities (non-tax adjusted)
 $          8,310
 $          6,528
 $        5,626
Tax equivalent adjustment
             1,130
                777
              532
Interest and dividend income
     
    from investment securities (tax equivalent basis)
 $          9,440
 $          7,305
 $        6,158
       
       
 
2009
2008
2007
Interest and fees on loans (non-tax adjusted)
 $        30,305
 $        30,710
 $      30,398
Tax equivalent adjustment
                908
                965
              883
Interest and fees on loans (tax equivalent basis)
 $        31,213
 $        31,675
 $      31,281
       
       
 
2009
2008
2007
Total interest income
 $        38,615
 $        37,238
 $      36,024
Total interest expense
           13,231
           14,058
         16,922
Net interest income
           25,384
           23,180
         19,102
Total tax equivalent adjustment
             2,038
             1,742
           1,415
Net interest income (tax equivalent basis)
 $        27,422
 $        24,922
 $      20,517

The following table shows the tax-equivalent effect of changes in volume and rates on interest income and expense (in thousands):


16



Analysis of Changes in Net Interest Income on a Tax-Equivalent Basis (1)
 
 
 2009 vs. 2008 (1)
 2008 vs. 2007 (1)
 
 Change in
 Change
 Total  
 Change in
 Change
 Total  
 
Volume   
 in Rate
 Change
 Volume  
 in Rate
 Change
Interest Income:
           
Short-term investments:
           
  Interest-bearing deposits at banks
 $            (22)
 $              8
 $           (14)
 $           53
 $             (1)
 $           52
Investment securities:
           
  Taxable
           1,421
            (362)
          1,059
            223
               88
            311
  Tax-exempt
           1,001
               89
          1,090
            733
               51
            784
Total investment securities
           2,422
            (273)
          2,149
            956
             139
         1,095
Total investment income
           2,400
            (265)
          2,135
          1,009
             138
         1,147
Loans:
           
  Residential mortgage loans
             (617)
            (366)
            (983)
              58
               28
              86
  Commercial & agricultural loans
           1,571
            (837)
             734
            568
            (436)
            132
  Loans to state & political subdivisions
              (84)
              (70)
            (154)
            155
               92
            247
  Other loans
              (32)
              (27)
              (59)
             (53)
              (18)
             (71)
Total loans, net of discount
              838
         (1,300)
            (462)
            728
            (334)
            394
Total Interest Income
           3,238
         (1,565)
          1,673
          1,737
            (196)
         1,541
Interest Expense:
           
Interest-bearing deposits:
           
  NOW accounts
              258
            (601)
            (343)
            289
         (1,001)
           (712)
  Savings accounts
               33
              (39)
               (6)
              11
                5
              16
  Money Market accounts
              (50)
            (441)
            (491)
           (167)
            (792)
           (959)
  Certificates of deposit
           1,440
            (870)
             570
          1,029
         (1,245)
           (216)
Total interest-bearing deposits
           1,681
         (1,951)
            (270)
          1,162
         (3,033)
        (1,871)
Other borrowed funds
             (251)
            (306)
            (557)
             (87)
            (906)
           (993)
Total interest expense
           1,430
         (2,257)
            (827)
          1,075
         (3,939)
        (2,864)
Net interest income
 $        1,808
 $          692
 $        2,500
 $          662
 $        3,743
 $       4,405

 (1) The portion of total change attributable to both volume and rate changes, which cannot be separated, has been allocated proportionally to the change due to volume and the change due to rate prior to allocation.
 
2009 vs. 2008
 
Tax equivalent net interest income for 2009 was $27,422,000 compared with $24,922,000 for 2008, an increase of $2,500,000 or 10.0%.  The increased volume of interest earning assets of $77.0 million generated an increase in interest income of $3,238,000.  The average rate on interest earning assets decreased from 6.82% in 2008 to 6.27% in 2009, which had the effect of decreasing interest income by $1,565,000.
 
Total tax equivalent interest income from investment securities increased $2,149,000 in 2009 from 2008.  The average balance of investment securities increased $47.3 million, which had an effect of increasing interest income by $2,422,000 due to volume.  The average balance of taxable securities increased $31.7 million while tax-exempt securities increased by $15.6 million, which had the effect of increasing interest income by $1,421,000 and $1,001,000, respectively.  The average tax-effected yield on our investment portfolio decreased from 5.33% in 2008 to 5.13% in 2009.  This had the effect of decreasing interest income by $273,000 due to rate.  The Company’s strategy in 2009 was to invest available funds primarily in shorter, one-time callable agencies that offer higher coupon rates and are likely to be called as well as two to four year agency bullet structures.    During 2009, we purchased $64.1 million of U.S. agency obligations.  While this strategy resulted in a decrease in the overall yield on our investments, it was implemented to stabilize the effective duration and average life of the portfolio in an upward rate environment and to take advantage of the steepness in the yield curve.  The shorter term investments, while having lower yields, will provide sufficient cash flows that will permit reinvestment opportunities as market conditions improve.  As a means to balance this strategy, we also purchased $18.5 million of 15 to 20 year municipal bonds in order to obtain higher yields.
17

Loan income decreased $462,000 in 2009 from 2008.  The average balance of our loan portfolio increased by $15.3 million in 2009 compared to 2008 resulting in an increase in interest income of $838,000 due to volume.  Offsetting this was a decrease in yield on total loans from 7.39% in 2008 to 7.03% in 2009 resulting in a decrease in interest income of $1,300,000 due to rate.
 
Interest income on residential mortgage loans decreased $983,000, of which $617,000 was due to volume and $366,000 was due to rate. The average balance decreased $8.4 million due to the economic recession, higher unemployment rates and other negative economic factors that resulted in lower loan demand for non-conforming residential mortgages and home equity lines. With this said, the Company continues to strive to be the top mortgage lender within our service area by providing competitive products and exemplary service to our customers. During 2009, conforming loans totaling $21,716,000 were closed and sold due to the historically low residential mortgage rates offered during 2009. The average balance of commercial and agricultural loans increased $25.5 million from 2008 to 2009 primarily due to our emphasis to grow this segment of the loan portfolio. This had the positive impact of $1,571,000 on total interest income due to volume. Offsetting this, the average yield on commercial and agricultural loans decreased from 7.57% in 2008 to 6.91% in 2009, decreasing interest income by $837,000 due to rate. The decreasing yield was the result of competitive pressures to obtain and retain quality credits in the current economic environment.
 
Total interest expense decreased $827,000 in 2009 compared to 2008.  The decrease is primarily attributable to change in rate from 2.81% in 2008 to 2.30% in 2009, which had the effect of decreasing interest expense by $2,257,000. The actions of the Federal Reserve and current economic downturn had the effect of decreasing our short-term borrowing costs as well as rates on deposit products, including shorter-term certificates of deposit and rate sensitive NOW and money market accounts. The average balance of interest bearing liabilities increased $74.9 million from 2008 to 2009.  This had the effect of increasing interest expense by $1,430,000 due to volume.
 
The average balance of certificates of deposit increased $63.0 million causing an increase in interest expense of $1,440,000.  Offsetting the increase in average balance was a decrease in the rate on certificates of deposit from 3.79% to 3.19% resulting in a decrease in interest expense of $870,000.  The average balance of NOW accounts also increased $16.5 million accounting for an increase of $258,000 in interest expense. The change in rate from 123 basis points to 79 basis points, contributed to an offset in interest expense of $601,000 resulting in an overall decrease of $343,000. The average balance of Money Market accounts decreased $2.9 million accounting for a decrease of $50,000 in interest expense. The change in rate from 184 basis points to 80 basis points also contributed to an offset in interest expense of $441,000 resulting in an overall decrease of $491,000.  The average balance of borrowed funds decreased by $6.7 million, resulting in a decrease in interest expense of $251,000.  The average interest rate paid on borrowed funds also decreased by 50 basis points accounting for a decrease in interest expense of $306,000 due to rate. 
 
Our net interest spread for 2009 was 3.97% compared to 4.01% in 2008.  The current economic situation has resulted in a relatively steep yield curve. Should short-term and/or long-term interest rates move in such a way that results in a flattened or inverted yield curve, we would anticipate pressure on our margin.
 
2008 vs. 2007
 
Tax equivalent net interest income for 2008 was $24,922,000 compared with $20,517,000 for 2007, an increase of $4,405,000 or 21.5%.  The increased volume of interest earning assets of $35.0 million generated an increase in interest income of $1,737,000.  The average rate on interest earning assets decreased from 6.98% in 2007 to 6.82% in 2008, which had the effect of decreasing interest income by $196,000.
 
Total tax equivalent interest income from investment securities increased $1,095,000 in 2008 from 2007.  The average balance of investment securities increased $16.3 million, which had an effect of increasing interest income by $956,000 due to volume.  Of this amount, $733,000 was from income on tax-exempt investment securities, where the average balance increased $11.8 million from 2007.  The average tax-effected yield on our investment portfolio increased from 5.14% in 2007 to 5.33% in 2008.  This had the effect of increasing interest income by $139,000 due to rate.  The Company’s strategy in 2008 was to increase the size and duration of our investment portfolio, given the opportunity that general market conditions provided, which resulted in an increase in the overall yield on our investments.
 
Loan income increased $394,000 in 2008 from 2007.  The average balance of our loan portfolio increased by $11.7 million in 2008 compared to 2007 resulting in an increase in interest income of $728,000 due to volume.  Offsetting this was a decrease in yield on total loans from 7.51% in 2007 to 7.39% in 2008 resulting in a decrease in interest income of $334,000 due to rate.
 
Interest income on residential mortgage loans increased only $86,000.  The average balance increased only $787,000 as issues facing the economy, financial markets and unemployment rates significantly impacted loan demand.
18

During 2008, the Federal Reserve decreased the federal funds rate by 425 basis points.  This decrease as well as competitive pressures impacted loan yields, particularly yields on commercial and agricultural loans.  The average yield on commercial and agricultural loans decreased from 7.94% in 2007 to 7.57% in 2008, decreasing interest income by $436,000 due to rate.  The average balance of commercial and agricultural loans increased $9.0 million, increasing interest income $568,000 due to volume.
 
Total interest expense decreased $2,864,000 in 2008 compared to 2007.  The average balance of interest bearing liabilities increased $25.0 million from 2007 to 2008.  This had the effect of increasing interest expense by $1,075,000 due to volume.  The average rate paid on interest bearing liabilities decreased from 3.56% to 2.81% due to decreasing interest rates.  This resulted in a $3,939,000 decrease in interest expense due to rate.  Balances most affected were those that were indexed to a specific market rate.
 
As noted above, the federal funds rate decreased 425 basis points during 2008.  This had an impact on the rates paid on short term deposits, top tier money market and NOW accounts, and on short term borrowing rates particularly from the Federal Home Loan Bank.  The Company’s liabilities, including borrowings and deposits, are shorter in nature and are more sensitive to short-term changes in interest rates.  Our ability to decrease rates paid on short term liabilities faster than the average rates earned on interest earning assets resulted in an improvement in our net interest spread.  Our net interest spread for 2008 was 4.01% compared to 3.42% in 2007.

PROVISION FOR LOAN LOSSES
 
For the year ended December 31, 2009, we recorded a provision for loan losses of $925,000, which represents an increase of $595,000 over the same time period in 2008.  This is the result of current economic conditions and an increase in non-performing loans as of December 31, 2009, which have impacted management's quarterly review of the allowance for loan losses (see also “Financial Condition – Allowance for Loan Losses and Credit Quality Risk”).

NON-INTEREST INCOME
 
The following table reflects non-interest income by major category for the periods ended December 31 (dollars in thousands):


 
2009
2008
2007
Service charges
 $          3,612
 $          3,489
 $          3,210
Trust
                521
                561
                520
Brokerage and insurance
                284
                240
                132
Investment securities gains (losses), net
                139
            (4,089)
                 (29)
Gains on loans sold
                430
                  84
                134
Earnings on bank owned life insurance
                492
                362
                331
Other
                369
                509
                787
Total
 $          5,847
 $          1,156
 $          5,085

 
                           2009/2008
                         2008/2007
 
                          Change
                         Change
 
Amount
%
Amount
%
Service charges
 $             123
                 3.5
 $             279
                 8.7
Trust
                 (40)
                (7.1)
                  41
                 7.9
Brokerage and insurance
                  44
               18.3
                108
               81.8
Investment securities gains, (losses), net
             4,228
 -
            (4,060)
 -
Gains on loans sold
                346
             411.9
                 (50)
              (37.3)
Earnings on bank owned life insurance
                130
               35.9
                  31
                 9.4
Other
               (140)
              (27.5)
               (278)
              (35.3)
Total
 $          4,691
             405.8
 $         (3,929)
              (77.3)

 
19

2009 vs. 2008
 
Non-interest income increased $4,691,000 in 2009 from 2008, or 405.8%.  We recorded investment securities gains totaling $139,000 compared with a $4,089,000 loss in 2008.  In the third quarter of 2008, we recorded a non-recurring $2,336,000 million other than temporary impairment charge related to our investment in Freddie Mac preferred stock and a $1,796,000 other than temporary impairment charge on a Lehman Brothers corporate bond.  The Lehman Brothers corporate bond was subsequently sold in the fourth quarter of 2008. During 2009, we elected to sell an agency bond that was likely to be called, several higher coupon mortgage-backed securities that were prepaying very quickly, and two corporate bonds for total gains of $253,000. These gains were offset by losses incurred on the sales of three municipal securities and the sale of certain bank equity securities totaling $60,000. Additionally, we recorded an additional $54,000 other than temporary impairment charge on our Freddie Mac preferred stock.
 
Service charge income increased by $123,000 in 2009 compared to 2008 and continues to be the Company’s primary source of non-interest income. Service charge fees related to customers’ usage of their debit cards increased by $87,000, statement service charges increased by $9,000 and fees charges to customers for non-sufficient funds increased by $27,000. Management is currently evaluating regulatory changes, specifically to Regulation E, regarding fees charged to customers for non-sufficient funds, which could impact the level of fees that the Company realizes.
 
Gains on loans sold increased $346,000 compared to last year, which is the result of the amount of refinancing due to favorable rates in the secondary markets during the economic downturn.  Earnings on bank owned life insurance (BOLI) increased from $362,000 in 2008 to $492,000 in 2009.  In the fourth quarter of 2008, we invested an additional $3.4 million based upon an analysis of new employees and updated future employee benefit costs, resulting in additional BOLI income.  Brokerage and insurance revenue increased by $44,000 in 2009, as we continue to increase the principal amounts invested through us by our customers. Trust income decreased by $40,000 in 2009 due to the economy’s downturn and the affect it has had on the values of trust assets under management for the first half of 2009.  Other income decreased $140,000 primarily due to a decrease in rental income from other real estate owned properties as well a decrease in the gain from the sale of these properties in 2009 compared with last year.
 
2008 vs. 2007
 
Non-interest income decreased $3,929,000 in 2008 from 2007, or 77.3%.  Most notable, we recorded investment security losses totaling $4,089,000 compared with a $29,000 loss in 2007, which was due to the non-recurring, other than temporary impairment charges recorded in the third quarter of 2008 totaling $4.1 million.
 
Service charge income increased by $279,000 in 2008 compared to 2007.    Service charge fees charged to customers for non-sufficient funds increased by $162,000.  Additionally, we increased ATM and related check card fee income by $113,000 compared to last year as the Company continued to promote efforts to increase usage of debit cards by retail customers.
 
Brokerage and insurance revenue increased by $108,000 in 2008, while trust revenues increased 7.9% to $561,000 during 2008.  Gains on sales of foreclosed properties decreased by $315,000 in 2008 compared to 2007 primarily due to a pre-tax gain of $381,000 recognized on a large commercial property that was sold in the second quarter of 2007.

Non-interest Expenses
 
The following tables reflect the breakdown of non-interest expense and professional fees for the periods ended December 31 (dollars in thousands):

 
2009
2008
2007
Salaries and employee benefits
 $         9,472
 $         8,725
 $         8,386
Occupancy
            1,179
            1,162
            1,151
Furniture and equipment
               437
               479
               539
Professional fees
               660
               625
               645
Amortization of intangibles
               160
               145
               144
FDIC insurance
            1,200
               156
                 54
ORE expenses
               447
               224
               103
Other
            4,204
            4,361
            4,292
Total
 $       17,759
 $       15,877
 $       15,314

20

 
 
 
                               2009/2008
                                   2008/2007
 
                              Change
                                 Change
 
Amount
%
Amount
%
Salaries and employee benefits
 $            747
                8.6
 $            339
                4.0
Occupancy
                 17
                1.5
                 11
                1.0
Furniture and equipment
               (42)
              (8.8)
               (60)
            (11.1)
Professional fees
                 35
                5.6
               (20)
              (3.1)
Amortization of intangibles
                 15
              10.3
                   1
                0.7
FDIC insurance
            1,044
            669.2
               102
            188.9
ORE expenses
               223
              99.6
               121
            117.5
Other
             (157)
              (3.6)
                 69
                1.6
Total
 $         1,882
              11.9
 $            563
                3.7

 
2009
2008
2007
Other professional fees
 $           299
 $           316
 $           367
Legal fees
              129
              129
              111
Examinations and audits
              232
              180
              167
Total
 $           660
 $           625
 $           645

 
                                           2009/2008
                                    2008/2007
 
                                         Change
                                    Change
 
Amount
%
Amount
%
Other professional fees
 $            (17)
              (5.4)
 $            (51)
            (13.9)
Legal fees
                   -
                  -
                18
             16.2
Examinations and audits
                52
             28.9
                13
               7.8
Total
 $             35
               5.6
 $            (20)
              (3.1)
 
2009 vs. 2008
 
Non-interest expenses for 2009 totaled $17,759,000 which represents an increase of $1,882,000, or 11.9%, compared with 2008 costs of $15,877,000.  Much of the increase is attributable to salary and benefit costs which increased $747,000.  Base salaries and related payroll taxes increased $262,000, primarily due to merit increases.  Full time equivalent staffing was 169 employees for 2009 and 2008. Incentive costs increased $165,000 compared to 2008 primarily due to the attainment of certain corporate goals and objectives.  Insurance costs for employees increased by $101,000 attributable to a significant increase in insurance premiums.  Pension expense increased by $229,000 compared to 2008, mostly attributable to a significant decline in the market value of plan assets during 2008 and the impact it had on the actuarial calculation of pension costs for 2009.
 
FDIC Insurance increased $1,044,000 in 2009 primarily due to an increase in our FDIC deposit insurance assessments and a five basis point special assessment based on assets as of June 30, 2009, which was related to the continued failing of many banks across the country. The impact of the special assessment was approximately $330,000. Also, in 2008 we recognized approximately $209,000 in credits as a result of the Federal Deposit Insurance Reform Act of 2005.  Credits related to this legislation were fully utilized by the end of 2008 with no remaining credits available for 2009.  In lieu of imposing an additional special assessment, the FDIC required all institutions to prepay their assessments for the fourth quarter of 2009 and all of 2010, 2011 and 2012. These prepayments will be recognized as a charge to operations over the applicable three year period. Due to the uncertainty involving many financial institutions insured by the FDIC Insurance, the Company cannot predict whether the prepayment made in December 2009 will be enough to cover its future obligations through 2012 or whether an additional assessment will be required.
 
Expenses related with other real estate owned properties increased $223,000 from 2008 to 2009. This increase is the result of a general increase in non-performing assets, with a significant component related to a customer with properties in New York State that have significant real estate taxes associated with them.
21

Furniture and equipment expenses decreased $42,000 mainly due to a reduction in depreciation expense from assets that became fully depreciated during the year.
 
Exams and audits expenses increased by $52,000 due to general increases and $18,000 of costs incurred related to our audit of internal controls for Sarbanes Oxley.  Although the audit requirement was delayed later in 2009 until 2010,  audit fees and related expenses were already incurred.
 
2008 vs. 2007
 
Non-interest expenses for 2008 totaled $15,877,000 which represented an increase of $563,000, or 3.7%, compared with 2007 costs of $15,314,000.  Much of the increase was attributable to salary and benefit costs increasing $339,000. Base salaries and related payroll taxes increased $191,000 primarily due to merit increases.  The year to date full time equivalent staffing was 169 employees for 2008 compared to 170 employees for 2007.  Incentive costs increased $249,000 compared to 2007 primarily due to the attainment of certain corporate goals and objectives, as well as the implementation of a supplemental employee retirement plan for key management.  Insurance costs for employees increased by $70,000 attributable to a significant increase in insurance premiums.  Pension expense decreased by $187,000 compared to 2007.  Effective January 1, 2008, the Company modified its defined benefit pension plan resulting in a reduction in expense.
 
Other expenses increased $292,000 over 2007 mainly due to branch acquisition costs, an increase in the FDIC assessment and operational charge offs.
 
Furniture and equipment expenses decreased $60,000 mainly due to a reduction in depreciation expense from assets that became fully depreciated during the year.

Provision For Income Taxes
 
The provision for income taxes was $2,683,000 during 2009, $1,224,000 during 2008 and $1,772,000 for the 2007 related periods.   The effective tax rates for 2009, 2008 and 2007 were 21.4% 15.1% and 20.8%, respectively. The tax rate for 2008 was impacted by the Emergency Economic Stabilization Act of 2008, which permitted the write-down of the Freddie Mac preferred stock to be treated as an ordinary loss, allowing a tax benefit of approximately $1,000,000.
 
Income before the provision for income taxes increased by $4,418,000 in 2009 compared to 2008, while the provision for income taxes increased by $1,459,000 when compared to 2008, the majority of which is attributable to the tax treatment of the Freddie Mac preferred stock discussed above. We have managed our effective tax rate by remaining invested in tax-exempt municipal loans and bonds.  As such, the provision was impacted in 2009 by an increase in tax exempt bond and loan revenue.     
 
We are also involved in three limited partnership agreements that established low-income housing projects in our market area.  For tax purposes, we have recognized $845,000 out of a total $913,000 in tax credits from one project, $308,000 out of a total $385,000 in tax credits on the second project and $172,000 out of a total of $574,000 tax credits on the third project.  $547,000 in tax credits remain and will be taken over the next seven years.    
 
FINANCIAL CONDITION
 
The following table presents ending balances (dollars in millions), growth and the percentage change during the past two years:

 
    2009
 
      %
    2008
 
      %
    2007
 
 Balance
 Increase
 Change
 Balance
 Increase
 Change
 Balance
 Total assets
 $        729.5
 $           60.9
             9.1
 $      668.6
 $           77.6
           13.1
 $      591.0
 Total loans, net
           451.5
              23.1
             5.4
         428.4
                9.2
             2.2
         419.2
 Total investments
           198.6
              24.5
           14.1
         174.1
              53.3
           44.1
         120.8
 Total deposits
           605.6
              58.9
           10.8
         546.7
              90.7
           19.9
         456.0
 Total stockholders' equity
             61.5
                8.7
           16.5
           52.8
                4.3
             8.9
           48.5


22

Cash and Cash Equivalents
 
Cash and cash equivalents totaled $31.4 million at December 31, 2009 compared with $19.9 million at December 31, 2008. The increase in cash and cash equivalents is the result of the Company’s deposit growth and cash flows from the investment portfolio, as discussed in more detail below. Management actively measures and evaluates its liquidity through our Asset – Liability committee and believes its liquidity needs are satisfied by the current balance of cash and cash equivalents, readily available access to traditional funding sources, Federal Home Loan Bank financing, federal funds lines with correspondent banks, brokered certificates of deposit and the portion of the investment and loan portfolios that mature within one year.  Management expects that these sources of funds will permit us to meet cash obligations and off-balance sheet commitments as they come due.

Investments
 
2009
 
The Company’s investment portfolio increased by $24,443,000, or 14.1%, during the past year.  During 2009, we purchased approximately $61.4 million U.S. agency obligations, $7.4 million of mortgage-backed securities, $18.5 million of state and local obligations and $125,000 of equity securities, which help offset the $29.0 million of principal repayments and $25.1 million of calls and maturities that occurred during the year. We also selectively sold $10.7 million of bonds and equities at a net gain of $193,000. We also recorded an additional $54,000 other than temporary impairment charge on our Freddie Mac preferred stock. The market value of our investment portfolio increased approximately $2.2 million in 2009 due to market fluctuations. Significant market recoveries were seen in our mortgage backed securities, state and local obligations and our corporate bonds. Excluding our short term investments consisting of monies held primarily at the Federal Reserve, the effective yield on our investment portfolio for 2009 was 5.13% compared to 5.33% for 2008 on a tax equivalent basis.
 
As mentioned above and seen in the table below, due to the economic downturn and the lowering of interest rates, we have experienced significant prepayments of our mortgage backed securities of $29.0 million and calls on our agency bonds of $25.1 million.  Due to the amount of cash flow from the investment portfolio as well as an increase in deposits and a lack of opportunities in other investment types, our strategy has been to reinvest funds mainly in short-term agency bonds via purchases of $61.4 million and longer-term municipal bond purchases of $18.5 million.  We believe this strategy will enable us to reinvest cash flows in the next one to four years with improved investment opportunities.

2008
 
The Company’s investment portfolio increased $53,337,000, or 44.1%, during 2008.  During 2008, we purchased approximately $42.1 million of mortgage-backed securities, $12.7 million of U.S. agency obligations, and $15.4 million of municipal bonds.  Offsetting the purchases were $11.5 million of principal repayments and $3.5 million in maturities that occurred during 2008.  Due to unusually wide credit spreads to treasuries, significant market opportunity existed to grow our investment portfolio during the latter half of 2008.  In doing so, the effective yield on our portfolio for 2008 improved to 5.33% compared to 5.14% for 2007 on a tax equivalent basis.  The market value of our investment portfolio increased approximately $2.4 million in 2008 due to a decrease in interest rates and the realization of loss due to the Freddie Mac write-down and the sale of the Lehman Brothers corporate bond.
 
The following table shows the year-end composition of the investment portfolio for the five years ended December 31 (dollars in thousands):
 
 
   2009
% of
   2008
% of
   2007
% of
   2006
% of
   2005
% of
 
Amount
Total
Amount
Total
Amount
Total
Amount
Total
Amount
Total
Available-for-sale:
                   
  U. S. Agency securities
 $      65,223
      32.8
 $   28,942
      16.6
 $   17,236
    14.3
 $   16,651
    15.2
 $   12,754
    12.5
  Obligations of state & political
                   
     subdivisions
         59,574
      30.0
      44,132
      25.3
      30,844
    25.4
      22,562
    20.5
      22,612
    22.0
  Corporate obligations
           3,166
        1.6
        5,296
        3.0
        7,813
      6.5
        7,997
      7.3
        8,627
      8.4
  Mortgage-backed securities
         70,194
      35.3
      95,407
      54.8
      62,642
    51.9
      59,875
    54.6
      55,852
    54.4
  Equity securities
              425
        0.3
           362
        0.2
        2,267
      1.9
        2,658
      2.4
        2,757
      2.7
Total
 $    198,582
    100.0
 $ 174,139
    100.0
 $ 120,802
  100.0
 $ 109,743
  100.0
 $ 102,602
  100.0

23

The expected principal repayments (amortized cost) and average weighted yields for the investment portfolio as of December 31, 2009, are shown below (dollars in thousands). Expected principal repayments, which include prepayment speed assumptions for mortgage-backed securities, are significantly different than the contractual maturities detailed in Note 3 of the consolidated financial statements. Yields on tax-exempt securities are presented on a fully taxable equivalent basis, assuming a 34% tax rate.

     
After One Year
After Five Years
       
 
One Year or Less
to Five years
to Ten Years
After Ten Years
Total
 
Amortized
Yield
Amortized
Yield
Amortized
Yield
Amortized
Yield
Amortized
Yield
 
     Cost
   %
     Cost
   %
     Cost
   %
     Cost
   %
     Cost
   %
Available-for-sale securities:
                   
  U.S. Agency securities
 $     26,221
     3.0
 $       36,916
     2.8
 $        1,446
     5.5
 $               -
        -
 $       64,583
     2.9
  Obligations of state & political
 
 
 
 
 
 
 
 
 
 
    subdivisions
         4,456
     6.3
          23,393
     6.2
         30,163
     6.5
              639
     6.4
          58,651
     6.4
  Corporate obligations
                -
        -
                  -
        -
          2,998
     5.6
                  -
        -
           2,998
     5.6
  Mortgage-backed securities
        20,420
     4.3
          42,316
     5.1
          4,290
     5.6
                  -
        -
          67,026
     4.9
Total available-for-sale
 $     51,097
     3.8
 $     102,625
     4.5
 $      38,897
     6.3
 $           639
     6.4
 $     193,258
     4.7

Approximately 79.5% of the amortized cost of debt securities is expected to mature, call or pre-pay within five years or less.  Our Company expects that earnings from operations, the high liquidity level of the available-for-sale securities, growth of deposits and the availability of borrowings from the Federal Home Loan Bank and other third party banks will be sufficient to meet future liquidity needs.  There are no securities from a single issuer representing more than 10% of stockholders’ equity.
 
Loans
 
The Bank’s lending efforts are focused within its market area located in North Central Pennsylvania and Southern New York. We originate loans primarily through direct loans to our existing customer base, with new customers generated by referrals from real estate brokers, building contractors, attorneys, accountants and existing customers.  The Bank offers a variety of loans although historically most of our lending has focused on real estate loans including residential, commercial, agricultural, and construction loans.  As of December 31, 2009, approximately 77% of our loan portfolio consisted of real estate loans.  All lending is governed by a lending policy that is developed and maintained by us and approved by the Board of Directors.
 
Residential mortgage loans generally are written for terms of up to 25 years at a fixed rate or one, three, and five year adjustable rate mortgages.  Loan to value ratios are usually 80% or less with exceptions for individuals with excellent credit and low debt to income and/or high net worth. Adjustable rate mortgages are tied to a margin above the Comparable Federal Home Loan Bank of Pittsburgh borrowing rate.  Home equity loans are written with terms of up to 15 years at fixed rates.  Home equity lines of credit are variable rate loans tied to the Prime Rate generally with a ten year draw period followed by a ten year repayment period. Home equity loans are typically written with a maximum 80% loan to value.
 
Commercial real estate loan terms are generally 20 years or less with one to five year adjustable rates.  The adjustable rates are tied to a margin above the Comparable Federal Home Loan Bank of Pittsburgh borrowing rate with a maximum loan to value ratio of 80%. Where feasible, the Bank works with the United States Department of Agriculture’s (USDA) guaranteed loan program to offset risk and to further promote economic growth is our market area.  During 2009, we originated $6.4 million in USDA guaranteed commercial real estate loans.
 
Agriculture, and particularly dairy farming, is an important industry in our market area. Therefore the Bank has developed an agriculture lending team with significant experience that has a thorough understanding of this industry. Agricultural loans focus on character, cash flow and collateral, while also taking into account the particular risks of the industry.  Loan terms are generally 20 years or less with one to five year adjustable rates.  The adjustable rates are tied to a margin above the Comparable Federal Home Loan Bank of Pittsburgh borrowing rate with a maximum loan to value of 80%. The Bank is a preferred lender under the USDA’s Farm Service Agency (FSA) and participates in the FSA guaranteed loan program.
24

The Bank, as part of its commitment to the communities it serves, is an active lender for projects by our local municipalities and school districts. These loans range from short term bridge financing to 20 year term loans for specific projects. These loans are typically written at rates that adjust at least every five years.
 
2009
 
Total loans grew $23.6 million in 2009 from a balance of $432.8 million at the end of 2008 to $456.4 million at the end of 2009.  Total loans grew 5.4% in 2009 compared with a 2.2% loan growth rate in 2008.
 
Commercial real estate loans increased $26.2 million in 2009 or 24.3% while commercial and other loans increased $6.1 million, or 16.2%.  Agricultural loans increased $2.4 million in 2009 or 14.2%.  The growth in commercial real estate, agricultural real estate and other commercial loans, despite the recession, reflects the Company’s focus on commercial lending as a means to increase loan growth and obtain deposits from farmers and small businesses throughout our market area.  We believe we have a strong team of experienced professionals that enable us to meet the needs of these customers within our service area.  Commercial loan demand is subject to significant competitive pressures, the yield curve and the strength of the overall local, regional and national economy.
 
Residential real estate loans decreased $4.1 million, while construction loans decreased $5.5 million or 49.5%. There has been a decrease in loan demand for residential real estate, construction and consumer loans due to several economic factors.  Recessionary pressures, higher unemployment, and a depressed housing market have had a negative impact on nonconforming, residential real estate mortgage and home equity loan growth.  Conversely, loan demand for conforming mortgages, which the Company sells on the secondary market, has increased dramatically. We have sold $21.7 million of loans in the secondary market compared to $4.5 million in 2008, an increase of $17.2 million.  Residential mortgage lending is a principal business activity and our Company continues to offer a variety of competitively priced conforming, nonconforming and home equity mortgages that positions us a leading mortgage lender in our service area.

2008
 
Total loans grew $9.4 million, or 2.2%, in 2008 from a balance of $423.4 million at the end of 2007 to $432.8 million at the end of 2008.  Commercial real estate loans increased $7.4 million in 2008 or 7.3% while commercial and other loans increased $3.3 million, or 9.5%.  State and political subdivision loans also increased by $3.0 million, or 6.6%.
 
Residential real estate loans decreased $2.7 million primarily due to the lack of loan demand in the residential real estate market.  Additionally, consumer loans decreased by $1.4 million, or 10.9%.  The economic recession which began during 2008, included increasing unemployment rates, a softening economy, tightened credit standards, low consumer confidence, and depressed financial markets all of which had a negative impact on our loan growth.  Residential real estate loans totaled $199.1 million and comprised 46.0% of the loan portfolio as of December 31, 2008 compared to 47.7% as of December 31, 2007.  During 2008, $4.4 million in conforming mortgage loans were originated and sold in the secondary market through Freddie Mac and Fannie Mae, providing nearly $52,000 of income in origination fees and premiums on loans sold.


25

 
 
Five Year Breakdown of Loans by Type as of December 31,
 

 
2009
2008
2007
2006
2005
(dollars in thousands)
     Amount
     %
  Amount
    %
   Amount
     %
  Amount
   %
    Amount
    %
Real estate:
                   
  Residential
 $   194,989
    42.7
 $  199,118
    46.0
 $  201,861
    47.7
 $  206,059
    49.7
 $  195,628
    51.1
  Commercial
      133,953
    29.4
     107,740
    24.9
     100,380
    23.7
       94,122
    22.7
       82,128
    21.5
  Agricultural
        19,485
      4.3
       17,066
      3.9
       16,891
      4.0
       17,054
      4.1
       12,991
      3.4
  Construction
          5,619
      1.2
       11,118
      2.6
       11,330
      2.7
         7,027
      1.7
         7,245
      1.9
Loans to individuals
                   
  for household,
                   
  family and other purchases
        11,895
      2.6
       11,651
      2.7
       13,082
      3.1
       12,482
      3.0
       13,017
      3.4
Commercial and other loans
        44,101
      9.7
       37,968
      8.8
       34,664
      8.2
       32,766
      7.9
       29,260
      7.6
State & political subdivision loans
        46,342
    10.1
       48,153
    11.1
       45,171
    10.6
       45,263
    10.9
       42,534
    11.1
Total loans
      456,384
  100.0
     432,814
  100.0
     423,379
  100.0
     414,773
  100.0
     382,803
  100.0
Less allowance for loan losses
          4,888
 
         4,378
 
         4,197
 
         3,876
 
         3,664
 
Net loans
 $   451,496
 
 $  428,436
 
 $  419,182
 
 $  410,897
 
 $  379,139
 

 
 2009/2008
2008/2007
 
Change
Change
 
     Amount
     %
     Amount
     %
Real estate:
       
  Residential
 $     (4,129)
    (2.1)
 $    (2,743)
    (1.4)
  Commercial
        26,213
    24.3
         7,360
      7.3
  Agricultural
          2,419
    14.2
            175
      1.0
  Construction
        (5,499)
  (49.5)
          (212)
    (1.9)
Loans to individuals
       
  for household,
       
  family and other purchases
             244
      2.1
       (1,431)
  (10.9)
Commercial and other loans
          6,133
    16.2
         3,304
      9.5
State & political subdivision loans
        (1,811)
    (3.8)
         2,982
      6.6
Total loans
 $     23,570
      5.4
 $      9,435
      2.2
 
The following table shows the maturity of state and political subdivision loans, commercial and agricultural loans and commercial loans secured by real estate as of December 31, 2009, classified according to the sensitivity to changes in interest rates within various time intervals (in thousands).  The table does not include any estimate of prepayments which significantly shorten the average life of all loans and may cause our actual repayment experience to differ from that shown below.  Demand loans having no stated schedule of repayments and no stated maturity are reported as due in one year or less.  The amounts shown below exclude net deferred loan costs or fees.


26


 
Commercial,
   
 
municipal,
Real estate
 
 
agricultural
construction
Total
Maturity of loans:
     
  One year or less
 $             8,869
 $                    -
 $             8,869
  Over one year through five years
              32,860
                   305
              33,165
  Over five years
            202,152
                5,314
            207,466
Total
 $         243,881
 $             5,619
 $         249,500
Sensitivity of loans to changes in interest
     
   rates - loans due after December 31, 2010:
     
  Predetermined interest rate
 $           35,886
 $                985
 $           36,871
  Floating or adjustable interest rate
            199,126
                4,634
            203,760
Total
 $         235,012
 $             5,619
 $         240,631

Allowance For Loan Losses and Credit Quality Risk
 
The allowance for loan losses is maintained at a level, which in management’s judgment is adequate to absorb probable future loan losses inherent in the loan portfolio.  The provision for loan losses is charged against current income.  Loans deemed not collectable are charged-off against the allowance while subsequent recoveries increase the allowance.  The following table presents an analysis of the change in the allowance for loan losses for the years ended December 31, 2009, 2008, 2007, 2006 and 2005:
 
 
December 31,
 
2009
2008
2007
2006
2005
Balance
         
  at beginning of period
 $          4,378
 $          4,197
 $          3,876
 $          3,664
 $          3,919
Charge-offs:
         
  Real estate:
         
     Residential
                  76
                  31
                  64
                  37
                  43
     Commercial
                236
                  36
                    6
                  86
                  61
     Agricultural
                    1
                  20
                     -
                     -
                     -
  Loans to individuals for household,
         
    family and other purchases
                  80
                  44
                103
                103
                168
  Commercial and other loans
                153
                115
                  13
                  64
                100
Total loans charged-off
                546
                246
                186
                290
                372
Recoveries:
         
  Real estate:
 
 
     
     Residential
                    1
                    6
                    2
                    6
                    2
     Commercial
                    1
                     -
                  79
                115
                    3
     Agricultural
                     -
                  20
                     -
                     -
                     -
  Loans to individuals for household,
         
    family and other purchases
                  52
                  19
                  52
                  39
                  12
  Commercial and other loans
                  77
                  52
                    9
                  12
                  40
Total loans recovered
                131
                  97
                142
                172
                  57
           
Net loans charged-off
                415
                149
                  44
                118
                315
Provision charged to expense
                925
                330
                365
                330
                  60
Balance at end of year
 $          4,888
 $          4,378
 $          4,197
 $          3,876
 $          3,664
           
Loans outstanding at end of period
 $      456,384
 $      432,814
 $      423,379
 $      414,773
 $      382,803
Average loans outstanding, net
 $      442,921
 $      423,382
 $      411,927
 $      400,507
 $      371,147
Non-performing assets:
         
    Non-accruing loans
 $            5,871
 $            2,202
 $            1,915
 $            1,668
 $            1,898
    Accrual loans - 90 days or more past due
                 884
                 383
                 275
               1,690
                 337
      Total non-performing loans
 $            6,755
 $            2,585
 $            2,190
 $            3,358
 $            2,235
    Foreclosed assets held for sale
                 302
                 591
                 203
                 758
                 619
      Total non-performing assets
 $            7,057
 $            3,176
 $            2,393
 $            4,116
 $            2,854
Net charge-offs to average loans
0.09%
0.04%
0.01%
0.03%
0.08%
Allowance to total loans
1.07%
1.01%
0.99%
0.93%
0.96%
Allowance to total non-performing loans
72.36%
169.36%
191.64%
115.43%
163.94%
Non-performing loans as a percent of loans
         
   net of unearned income
1.48%
0.60%
0.52%
0.81%
0.58%
Non-performing assets as a percent of loans
         
  net of unearned income
1.55%
0.73%
0.57%
0.99%
0.75%
 

27

The Company utilizes a disciplined and thorough loan review process based upon our internal loan policy approved by the Company’s Board of Directors.  The purpose of the review is to assess loan quality, analyze delinquencies, identify problem loans, evaluate potential charge-offs and recoveries, and assess general overall economic conditions in the markets served.  An external independent loan review is performed on our commercial portfolio semi-annually for the Company.  As part of this review, our underwriting process and loan grading system is evaluated.
 
Management believes it uses the best information available to make such determinations and that the allowance for loan losses is adequate as of December 31, 2009.  However, future adjustments could be required if circumstances differ substantially from assumptions and estimates used in making the initial determination.  A prolonged downturn in the economy, continued high unemployment rates, significant changes in the value of collateral and delays in receiving financial information from borrowers could result in increased levels of non-performing assets, charge-offs, loan loss provisions and reduction in income.  Additionally, bank regulatory agencies periodically examine the Bank’s allowance for loan losses.  The banking agencies could require the recognition of additions to the allowance for loan losses based upon their judgment of information available to them at the time of their examination.
 
On a monthly basis, problem loans are identified and updated primarily using internally prepared past due reports.  Based on data surrounding the collection process of each identified loan, the loan may be added or deleted from the monthly watch list.  The watch list includes loans graded special mention, substandard, doubtful, and loss, as well as additional loans that management may choose to include.  Watch list loans are continually monitored going forward until satisfactory conditions exist that allow management to upgrade and remove the loan from the watchlist.  In certain cases, loans may be placed on non-accrual status or charged-off based upon management’s evaluation of the borrower’s ability to pay.  All commercial loans, which include commercial real estate, agricultural real estate, state and political subdivision loans and other commercial loans, on non-accrual are evaluated quarterly for impairment.
 
The adequacy of the allowance for loan losses is subject to a formal, quarterly analysis by management of the Company.  In order to better analyze the risks associated with the loan portfolio, the entire portfolio is divided into several categories.  As stated above, loans on non-accrual status are specifically reviewed for impairment and given a specific reserve, if appropriate.  Loans evaluated and not found to be impaired are included with other performing loans, by category, by their respective homogenous pools.  Five year average historical loss factors are calculated for each pool and applied to the performing portion of the loan category. The historical loss factors for both reviewed and homogeneous pools are adjusted based upon the following qualitative factors:

·  
Level of and trends in charge-offs and recoveries
·  
Trends in volume, terms and nature of the loan portfolio
·  
Effects of any changes in risk selection and underwriting standards and any other changes in lending and recovery policies, procedures and practices
·  
Changes in the quality of the Company’s loan review system
·  
Experience, ability and depth of lending management and other relevant staff
·  
National, state, regional and local economic trends and business conditions
·  
Industry conditions including the effects of external factors such as competition, legal, and regulatory requirements on the level of estimated credit losses.
·  
Existence and effect of any credit concentrations, and changes in the level of such concentrations
 
28

The balance in the allowance for loan losses was $4,888,000 or 1.07% of total loans as of December 31, 2009 as compared to $4,378,000 or 1.01% of loans as of December 31, 2008.  The $510,000 increase is a result of a $925,000 provision for loan losses less net charge-offs of $415,000.  The following table shows the distribution of the allowance for loan losses and the percentage of loans compared to total loans by loan category (dollars in thousands) as of December 31:
 
                              2009
                          2008
                              2007
                              2006
                                2005
 
Amount
%
Amount
%
Amount
%
Amount
%
Amount
%
Real estate loans:
                   
  Residential
 $         801
      42.7
 $       694
      46.0
 $       599
      47.7
 $       614
      49.7
 $       493
      51.1
  Commercial, agricultural
         2,864
      33.6
       2,303
      28.8
       2,128
      27.7
       1,676
      26.8
       1,551
      24.9
  Construction
              20
        1.2
              5
        2.6
              -
        2.7
              -
        1.7
              -
        1.9
Loans to individuals
                   
   for household,
                   
   family and other purchases
            131
        2.6
          449
        2.7
          424
        3.1
          734
        3.0
          542
        3.4
Commercial and other loans
            918
        9.7
          807
        8.8
          736
        8.2
          582
        7.9
          484
        7.6
State & political subdivision loans
              93
      10.1
            19
      11.1
            22
      10.6
            22
      10.9
            21
      11.1
Unallocated
              61
 N/A
          101
 N/A
          288
 N/A
          248
 N/A
          573
 N/A
Total allowance for loan losses
 $      4,888
    100.0
 $    4,378
    100.0
 $    4,197
    100.0
 $    3,876
    100.0
 $    3,664
    100.0
 

The following table identifies amounts of loans contractually past due 30 to 90 days and non-performing loans by loan category, as well as the change from December 31, 2008 to December 31, 2009 in non-performing loans (dollars in thousands).  Non-performing loans include those loans that are contractually past due 90 days or more and non-accrual loans.  Interest does not accrue on non-accrual loans.  Subsequent cash payments received are applied to the outstanding principal balance or recorded as interest income, depending upon management's assessment of its ultimate ability to collect principal and interest.
 
 
December 31, 2009
 
December 31, 2008
   
Non-Performing Loans
   
Non-Performing Loans
 
30 - 90 Days
90 Days Past
Non-
Total Non-
 
30 - 90 Days
90 Days Past
Non-
Total Non-
(in thousands)
Past Due
Due Accruing
accrual
Performing
 
Past Due
Due Accruing
accrual
Performing
Real estate:
                 
  Residential
 $             1,629
 $                  75
 $          775
 $              850
 
 $            1,041
 $             267
 $           689
 $           957
  Commercial
               1,558
                   635
1,863
2,498
 
                  819
                114
           1,453
1,567
  Agricultural
                    75
                       -
2,094
2,094
 
                  240
                    -
                 -
                 -
  Construction
                      -
                       -
749
749
 
                      -
                    -
                 -
                 -
Loans to individuals for household,
               
  family and other purchases
                    88
                     10
36
46
 
                  129
                   2
                 -
2
Commercial and other loans
                  610
                   164
354
518
 
                  112
                    -
               60
60
Total nonperforming loans
 $             3,960
 $                 884
 $       5,871
 $           6,755
 
 $            2,341
 $             383
 $        2,202
 $        2,586
 
29

     
 
                         Change in Non-Performing Loans
 
 December 31, 2009 / 2008
(in thousands)
Amount
%
Real estate:
   
  Residential
 $              (107)
                 (11.2)
  Commercial
                  931
                  59.4
  Agricultural
               2,094
 -
  Construction
                  749
 -
Loans to individuals for household,
 
  family and other purchases
                    44
              2,200.0
Commercial and other loans
                  458
                 763.3
Total nonperforming loans
 $             4,169
                 161.2

For the year ended December 31, 2009 we recorded a provision for loan losses of $925,000 which compares to $330,000 for the same period in 2008, an increase of $595,000 or 180.0%.  The significant increase is attributable to current economic conditions, an increase in non-performing loans as of December 31, 2009 and an increased level of charge-offs compared with the prior year.  Non-performing loans increased $4.2 million, or 161.2%, from December 31, 2008 mainly due to the following:

·  
An agricultural customer with total loans of $3.0 million, $2.3 million of which is an agricultural real estate loan and $700,000 is a related construction loan.  The current economic struggles of dairy farmers, caused primarily from decreased milk prices, have created cash flow difficulties for this customer.  While we are hopeful that increased milk prices would significantly improve cash flows for this borrower and return them to current status, there is no certainty that this will occur.  Without a sizable and sustained increase in milk prices, we will need to rely upon the collateral for repayment of interest and principal.  A real estate appraisal was completed in October, 2009, which together with a collateral analysis on equipment and livestock, resulted in an updated collateral value of approximately $4.0 million.  Based upon this analysis, management determined not to allocate a specific reserve to this loan.
·  
A real estate rental property with loans of $700,000 was placed on non-accrual due to inadequate cash flows.  This loan was evaluated and found to be impaired and was subsequently written down in the third quarter of 2009 by $175,000, to the net realizable value.
·  
A commercial real estate property with a loan balance of $500,000 was past due 90 days as of December 31, 2009.  The downturn in the economy has impacted commercial development activity and has negatively affected the customer’s cash flow.
 
We have not experienced the significant decrease in the collateral values of local residential, commercial or agricultural real estate loan portfolios as seen in other parts of the country during this current economic downturn.  Real estate market values in our service area did not realize the significant, and sometimes speculative, increases as seen in other parts of the country prior to the current economic downturn.  As such, the collateral value of our real estate loans has not significantly deteriorated with the downturn.  In addition, our market area is predominately centered in the Marcellus Shale natural gas exploration and drilling area. These natural gas exploration and drilling activities have significantly impacted the overall interest in real estate in our market area due to the related lease and royalty revenues associated with it.  The natural gas activities have had a positive impact on the value of local real estate.  Due to the relatively stable or increasing collateral values in our service area, management determined not to increase the provision for loan losses and allowance for loan losses at the same magnitude as the increase in non-performing loans.

Bank Owned Life Insurance
 
In 2008 and 2003 the Company purchased $3.4 and $7.0 million, respectively, of bank owned life insurance to offset future employee benefit costs.  The Bank is the sole beneficiary on the policies, and will provide the Bank with an asset that will generate earnings to partially offset the current costs of benefits, and eventually (at the death of the insured’s) provide partial recovery of cash outflows associated with the benefits.  As of December 31, 2009 and 2008, the cash surrender value of the life insurance was $12.7 and $12.2 million, respectively.  The change in cash surrender value, net of purchases, is recognized in the results of operations.  The amounts recorded as non-interest income totaled $492,000, $362,000 and $331,000 in 2009, 2008 and 2007, respectively.  The Company evaluates annually the risks associated with the life insurance policies, including limits on the amount of coverage and an evaluation of the various carriers’ credit ratings.
30


Other Assets

2009
 
Other assets increased 19.6% in 2009 to $9.7 million.  The majority of this increase is the result of increases in prepaid federal depository insurance and regulatory stock of $2,814,000 and $586,000, respectively, offset by a decrease in the deferred income tax asset of $1,288,000. The increase in the prepaid federal depository insurance was the result of actions taken by the FDIC, which are described above. The increase in regulatory stock was due to purchases made to meet the requirements of the Federal Home Loan Bank of Pittsburgh (the “FHLB”) and correspondent banks. The majority of the decrease in the deferred income tax asset was the result of the activity related to the change in unrealized gains on investments, goodwill amortization and the change in the pension obligation.


2008
 
Other assets decreased 6.2% in 2008 to $8.1 million.  The majority of this decrease is the result of a decrease in regulatory stock of $1,438,000 offset by an increase in the deferred income tax asset of $594,000. The decrease in regulatory stock was the result of a sale of stock in excess of the requirements of the FHLB. The majority of the increase in the deferred income tax asset was the result of the activity related to the change in unrealized gains on investments, goodwill amortization, change in the pension obligation and the allowance for losses on available for sale securities. .

Deposits

2009
 
As can be seen in the tables below, total deposits increased $58.9 million in 2009, or 10.8%.  The increase in deposits is due to several reasons.  Our market has been positively impacted from the Marcellus Shale oil and gas exploration activities and we have developed products specifically targeting those that have benefited from this activity.  Furthermore, the overall turbulence and volatility of the financial markets on a national and local level has resulted in customers seeking stability with strong, local community banks. Furthermore, our financial performance, reputation as a strong, local community bank, acquisitions of local competitors from institutions outside of our general market area and the fact that the Company did not participate in the Troubled Asset Relief Program Capital Purchase Program has positioned the Company as a leading financial institution within our service area.
 
Non-interest bearing deposits increased $4.5 million, or 8.1% in 2009.  As a percent to total, non-interest bearing deposits totaled 9.9% as of the end of 2009, which compares to 10.2% at the end of 2008.  In order to manage our overall cost of funds, the C