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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

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

For the quarterly period ended March 31, 2011

OR

 

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

 

 

Commission file number 000-23777

 

 

PENSECO FINANCIAL SERVICES CORPORATION

Incorporated pursuant to the laws of Pennsylvania

 

 

Internal Revenue Service — Employer Identification No. 23-2939222

150 North Washington Avenue, Scranton, Pennsylvania 18503-1848

(570) 346-7741

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     Yes  ¨    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer   ¨    Accelerated filer   x
Non-accelerated filer   ¨  (Do not check if a smaller reporting company)    Smaller reporting company   ¨

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

The total number of shares of the registrant’s Common Stock, $0.01 par value, outstanding on May 1, 2011 was 3,276,079.

 

 

 


Table of Contents

PENSECO FINANCIAL SERVICES CORPORATION

 

     Page  
Part I — FINANCIAL INFORMATION   

Item 1.

   Unaudited Financial Statements - Consolidated   
   Balance Sheets:   
       March 31, 2011      3   
       December 31, 2010      3   
   Statements of Income:   
       Three Months Ended March 31, 2011      4   
       Three Months Ended March 31, 2010      4   
   Statements of Changes in Stockholders’ Equity:   
       Three Months Ended March 31, 2011      5   
       Three Months Ended March 31, 2010      5   
   Statements of Cash Flows:   
       Three Months Ended March 31, 2011      6   
       Three Months Ended March 31, 2010      6   
   Notes to Unaudited Consolidated Financial Statements      7   

Item 2.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations      26   

Item 3.

   Quantitative and Qualitative Disclosures About Market Risk      40   

Item 4.

   Controls and Procedures      41   
Part II — OTHER INFORMATION   

Item 1.

   Legal Proceedings      41   

Item 1A.

   Risk Factors      41   

Item 2.

   Unregistered Sales of Equity Securities and Use of Proceeds      41   

Item 3.

   Defaults Upon Senior Securities      41   

Item 4.

   Removed and Reserved      41   

Item 5.

   Other Information      41   

Item 6.

   Exhibits      41   
Signatures      42   

 

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PART I. FINANCIAL INFORMATION, Item 1 — Financial Statements

PENSECO FINANCIAL SERVICES CORPORATION

CONSOLIDATED BALANCE SHEETS

(unaudited)

(in thousands, except share and per share amounts)

 

     March 31,     December 31,  
     2011     2010  

ASSETS

    

Cash and due from banks

   $ 9,710      $ 11,585   

Interest bearing balances with banks

     15,824        2,634   

Federal funds sold

     —          —     
                

Cash and Cash Equivalents

     25,534        14,219   

Investment securities:

    

Available-for-sale, at fair value

     169,844        173,297   

Held-to-maturity (fair value of $40,036 and $45,218, respectively)

     38,720        43,747   
                

Total Investment Securities

     208,564        217,044   

Loans, net of unearned income

     611,021        615,105   

Less: Allowance for loan losses

     6,800        6,500   
                

Loans, Net

     604,221        608,605   

Bank premises and equipment

     13,391        13,406   

Other real estate owned

     883        803   

Accrued interest receivable

     3,422        3,809   

Goodwill

     26,398        26,398   

Cash surrender value of life insurance

     15,500        15,380   

Federal Home Loan Bank stock

     5,778        6,082   

Other assets

     10,566        10,341   
                

Total Assets

   $ 914,257      $ 916,087   
                

LIABILITIES

    

Deposits:

    

Non-interest bearing

   $ 113,551      $ 113,391   

Interest bearing

     586,930        577,641   
                

Total Deposits

     700,481        691,032   

Other borrowed funds:

    

Repurchase agreements

     19,942        19,394   

Short-term borrowings

     508        8,688   

Long-term borrowings

     64,711        68,835   

Accrued interest payable

     1,106        1,128   

Other liabilities

     4,234        5,088   
                

Total Liabilities

     790,982        794,165   
                

STOCKHOLDERS’ EQUITY

    

Common stock; $ .01 par value, 15,000,000 shares authorized, 3,276,079 shares issued and outstanding

     33        33   

Surplus

     48,865        48,865   

Retained earnings

     75,697        74,304   

Accumulated other comprehensive income

     (1,320     (1,280
                

Total Stockholders’ Equity

     123,275        121,922   
                

Total Liabilities and Stockholders’ Equity

   $ 914,257      $ 916,087   
                

(See accompanying Notes to Unaudited Consolidated Financial Statements)

 

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PENSECO FINANCIAL SERVICES CORPORATION

CONSOLIDATED STATEMENTS OF INCOME

(unaudited)

(in thousands, except share and per share amounts)

 

     Three Months Ended
March 31, 2011
     Three Months Ended
March 31, 2010
 

INTEREST INCOME

     

Interest and fees on loans

   $ 8,342       $ 8,686   

Interest and dividends on investments:

     

U.S. Treasury securities and U.S. Agency obligations

     815         719   

States & political subdivisions

     867         1,139   

Other securities

     14         11   

Interest on Federal funds sold

     —           —     

Interest on balances with banks

     2         2   
                 

Total Interest Income

     10,040         10,557   
                 

INTEREST EXPENSE

     

Interest on time deposits of $100,000 or more

     370         433   

Interest on other deposits

     892         974   

Interest on other borrowed funds

     635         699   
                 

Total Interest Expense

     1,897         2,106   
                 

Net Interest Income

     8,143         8,451   

Provision for loan losses

     369         328   
                 

Net Interest Income After Provision for Loan Losses

     7,774         8,123   
                 

NON-INTEREST INCOME

     

Trust department income

     398         380   

Service charges on deposit accounts

     472         532   

Merchant transaction income

     1,242         1,194   

Brokerage fee income

     56         70   

Other fee income

     378         350   

Bank-owned life insurance income

     120         122   

Other operating income

     630         61   

Realized gains (losses) on securities, net

     8         2   
                 

Total Non-Interest Income

     3,304         2,711   
                 

NON-INTEREST EXPENSES

     

Salaries and employee benefits

     3,525         3,173   

Expense of premises and fixed assets

     1,021         950   

Merchant transaction expenses

     833         811   

FDIC insurance assessments

     242         266   

Other operating expenses

     1,829         1,837   
                 

Total Non-Interest Expenses

     7,450         7,037   
                 

Income before income taxes

     3,628         3,797   

Applicable income taxes

     859         816   
                 

Net Income

   $ 2,769       $ 2,981   
                 

Earnings per Common Share

     

(Based on weighted average shares outstanding of 3,276,079)

   $ 0.85       $ 0.91   

Cash Dividends Declared Per Common Share

   $ 0.42       $ 0.42   

(See accompanying Notes to Unaudited Consolidated Financial Statements)

 

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PENSECO FINANCIAL SERVICES CORPORATION

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

THREE MONTHS ENDED MARCH 31, 2011 AND 2010

(unaudited)

(in thousands, except per share amounts)

 

     Common
Stock
     Surplus      Retained
Earnings
    Accumulated
Other
Comprehensive
Income
    Total
Stockholders’
Equity
 

Balance, December 31, 2009

   $ 33       $ 48,865       $ 68,086      $ 413      $ 117,397   

Comprehensive income:

            

Net income

     —           —           2,981        —          2,981   

Other comprehensive income, net of tax

            

Unrealized gains on securities, net of reclassification adjustment

     —           —           —          90        90   
                        

Other comprehensive income

             90        90   
                  

Comprehensive income

               3,071   

Cash dividends declared ($0.42 per share)

     —           —           (1,376     —          (1,376
                                          

Balance, March 31, 2010

   $ 33       $ 48,865       $ 69,691      $ 503      $ 119,092   
                                          

Balance, December 31, 2010

   $ 33       $ 48,865       $ 74,304      $ (1,280   $ 121,922   

Comprehensive income:

            

Net income

     —           —           2,769        —          2,769   

Other comprehensive income, net of tax

            

Unrealized losses on securities, net of reclassification adjustment

     —           —           —          (40     (40
                        

Other comprehensive income

             (40     (40
                  

Comprehensive income

               2,729   

Cash dividends declared ($0.42 per share)

     —           —           (1,376     —          (1,376
                                          

Balance, March 31, 2011

   $ 33       $ 48,865       $ 75,697      $ (1,320   $ 123,275   
                                          

(See accompanying Notes to Unaudited Consolidated Financial Statements)

 

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PENSECO FINANCIAL SERVICES CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

(in thousands)

 

     Three Months Ended     Three Months Ended  
     March 31, 2011     March 31, 2010  

OPERATING ACTIVITIES

    

Net Income

   $ 2,769      $ 2,981   

Adjustments to reconcile net income to net cash provided by operating activities:

    

Depreciation

     283        266   

Provision for loan losses

     369        328   

Deferred income tax provision (benefit)

     72        94   

Amortization of securities, (net of accretion)

     121        130   

Net realized (gains) losses on securities

     (8     (2

Loss (gain) on other real estate

     —          13   

Decrease (increase) in interest receivable

     387        450   

(Increase) decrease in cash surrender value of life insurance

     (120     (134

(Increase) decrease in other assets

     (297     (1,107

Increase (decrease) in income taxes payable

     859        816   

(Decrease) increase in interest payable

     (22     (17

(Decrease) increase in other liabilities

     (1,341     (907
                

Net cash provided (used) by operating activities

     3,072        2,911   
                

INVESTING ACTIVITIES

    

Purchase of investment securities available-for-sale

     (5,255     (3,122

Purchase of investment securities to be held-to-maturity

     —          —     

Proceeds from sales and maturities of investment securities available-for-sale

     7,541        3,102   

Proceeds from sales and maturities of investment securities held-to-maturity

     2,895        —     

Proceeds from repayments of investment securities available-for-sale

     1,015        649   

Proceeds from repayments of investment securities held-to-maturity

     2,109        3,621   

Net loans repaid (originated)

     3,889        (1,554

Proceeds from other real estate

     —          33   

Investment in premises and equipment

     (268     (571

Net cash received (paid) in merger

     —          —     
                

Net cash provided (used) by investing activities

     11,926        2,158   
                

FINANCING ACTIVITIES

    

Net increase (decrease) in demand and savings deposits

     9,376        (2,991

Net proceeds (payments) on time deposits

     73        6,084   

Increase (decrease) in repurchase agreements

     548        1,027   

Net (decrease) increase in short-term borrowings

     (8,180     (1,442

Increase in long-term borrowings

     —          —     

Payments on long-term borrowings

     (4,124     (4,803

Cash dividends paid

     (1,376     (1,376
                

Net cash (used) provided by financing activities

     (3,683     (3,501
                

Net increase (decrease) in cash and cash equivalents

     11,315        1,568   

Cash and cash equivalents at January 1

     14,219        13,374   
                

Cash and cash equivalents at March 31

   $ 25,534      $ 14,942   
                

The Company paid interest and income taxes of $1,919 and $200 and $2,123 and $0

for the three months ended March 31, 2011 and 2010, respectively.

(See accompanying Notes to Unaudited Consolidated Financial Statements)

 

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NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

For the Quarter Ended March 31, 2011

(unaudited)

These Notes to Unaudited Consolidated Financial Statements reflect events subsequent to December 31, 2010, the date of the most recent Report of Independent Registered Public Accounting Firm, through the date of this Quarterly Report on Form 10-Q. These Notes to Unaudited Consolidated Financial Statements should be read in conjunction with Parts I and II of this Report and the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, which was filed with the Securities and Exchange Commission (SEC) on March 14, 2011.

FORWARD LOOKING INFORMATION

This Quarterly Report on Form 10-Q contains forward-looking statements that are based on assumptions and may describe future plans, strategies and expectations of Penseco Financial Services Corporation. These forward-looking statements are generally identified by use of the words “believe,” “expect,” “intend,” “anticipate,” “estimate,” “project” or similar expressions. Penseco Financial Services Corporation’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations of Penseco Financial Services Corporation and its subsidiary include, but are not limited to, changes in interest rates, national and regional economic conditions, legislative and regulatory changes, monetary and fiscal policies of the U.S. government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality and composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in Penseco Financial Services Corporation’s market area, changes in real estate market values in Penseco Financial Services Corporation’s market area, changes in relevant accounting principles and guidelines and inability of third party service providers to perform. Additional factors that may affect our results are discussed in Part II, Item 1A to this Quarterly Report on Form 10-Q titled “Risk Factors”.

These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Except as required by applicable law or regulation, Penseco Financial Services Corporation does not undertake, and specifically disclaims any obligation, to release publicly the result of any revisions that may be made to any forward-looking statements to reflect events or circumstances after the date of the statements or to reflect the occurrence of anticipated or unanticipated events.

Unless the context indicates otherwise, all references in this Quarterly Report to “Company,” “we,” “us” and “our” refer to Penseco Financial Services Corporation and its direct and indirect subsidiaries.

NOTE 1 — Principles of Consolidation

Penseco Financial Services Corporation is a financial holding company incorporated under the laws of Pennsylvania. It is the parent company of Penn Security Bank and Trust Company (Bank), a Pennsylvania state chartered bank.

The Financial Statements of the Company have been consolidated with those of its wholly-owned subsidiary, Penn Security Bank and Trust Company, eliminating all intercompany items and transactions.

The accounting policies of the Company conform with accounting principles generally accepted in the United States of America (GAAP) and with general practices within the banking industry.

On April 1, 2009, the Company completed its acquisition of Old Forge Bank (the “Merger”) in a cash and stock transaction valued at approximately $55.5 million. The Merger was accounted for using the acquisition method of accounting and, accordingly, the assets and liabilities of Old Forge Bank have been recorded at their respective fair values on the date the Merger was completed.

NOTE 2 — Basis of Presentation

The unaudited consolidated financial statements have been prepared in accordance with the instructions to SEC Form 10-Q and GAAP for interim financial information. In the opinion of management, all adjustments that are of a normal recurring nature and are considered necessary for a fair presentation have been included. They are not, however, necessarily indicative of the results of consolidated operations for a full year or any other period.

All information is presented in thousands of dollars, except share and per share amounts.

 

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For further information, refer to the consolidated financial statements and accompanying notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

NOTE 3 — Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses and the valuation of other real estate owned acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the allowances for loan losses and other real estate owned, management obtains independent appraisals for significant properties.

NOTE 4 — Reclassifications

Certain prior year amounts have been reclassified to conform to the current year presentation.

NOTE 5 — Investment Securities

Investments in securities are classified in two categories and accounted for as follows:

Securities Held-to-Maturity Bonds, notes, debentures and mortgage-backed securities for which the Company has the positive intent and ability to hold to maturity are reported at cost, adjusted for amortization of premiums and accretion of discounts computed on the straight-line basis, which approximates the interest method, over the remaining period to maturity.

Securities Available-for-Sale Bonds, notes, debentures, mortgage-backed securities and certain equity securities not classified as securities to be held to maturity are carried at fair value with unrealized holding gains and losses, net of tax, reported as a net amount in a separate component of stockholders’ equity until realized.

The amortization of premiums on mortgage-backed securities is done based on management’s estimate of the lives of the securities, adjusted, when necessary, for advanced prepayments in excess of those estimates.

Realized gains and losses on the sale of securities available-for-sale are determined using the specific identification method and are reported as a separate component of other income in the Statements of Income. Unrealized gains and losses are included as a separate item in computing comprehensive income.

Investments are evaluated periodically to determine whether a decline in their value is other than temporary. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other than temporary. The term “other than temporary” is not intended to indicate that the decline is permanent. It indicates that the prospects for a near term recovery of value are not necessarily favorable, or that there is a lack of evidence to support fair values equal to, or greater than, the carrying value of the investment. Once a decline in value is determined to be other than temporary, the value of the security is reduced and a corresponding charge to earnings is recognized.

The amortized cost and fair value of investment securities at March 31, 2011 and December 31, 2010 are as follows:

 

Available-for-Sale

 

 
             Gross      Gross         
     Amortized      Unrealized      Unrealized      Fair  

March 31, 2011

   Cost      Gains      Losses      Value  

U.S. Agency securities

   $ 76,409       $ 469       $ 451       $ 76,427   

Mortgage-backed securities

     24,657         660         85         25,232   

States & political subdivisions

     62,355         1,039         585         62,809   

Corporate securities

     4,057         14         —           4,071   
                                   

Total Debt Securities

     167,478         2,182         1,121         168,539   

Equity securities

     760         586         41         1,305   
                                   

Total Available-for-Sale

   $ 168,238       $ 2,768       $ 1,162       $ 169,844   
                                   

 

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Available-for-Sale

 

December 31, 2010

   Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
     Fair
Value
 

U.S. Agency securities

   $ 78,993       $ 620       $ 319       $ 79,294   

Mortgage-backed securities

     25,686         709         25         26,370   

States & political subdivisions

     62,381         839         662         62,558   

Corporate securities

     4,077         13         —           4,090   
                                   

Total Debt Securities

     171,137         2,181         1,006         172,312   

Equity securities

     494         540         49         985   
                                   

Total Available-for-Sale

   $ 171,631       $ 2,721       $ 1,055       $ 173,297   
                                   

 

Held-to-Maturity

 

  

March 31, 2011

   Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
     Fair
Value
 

Mortgage-backed securities

   $ 26,741       $ 1,153       $ 80       $ 27,814   

States & political subdivisions

     11,979         243         —           12,222   
                                   

Total Held-to-Maturity

   $ 38,720       $ 1,396       $ 80       $ 40,036   
                                   

 

Held-to-Maturity

 

  

December 31, 2010

   Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
     Fair
Value
 

Mortgage-backed securities

   $ 28,877       $ 1,161       $ 24       $ 30,014   

States & political subdivisions

     14,870         334         —           15,204   
                                   

Total Held-to-Maturity

   $ 43,747       $ 1,495       $ 24       $ 45,218   
                                   

Equity securities at March 31, 2011 and December 31, 2010 consisted primarily of other financial institutions’ stock.

The amortized cost and fair value of debt securities at March 31, 2011 by contractual maturity are shown in the following table. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

March 31, 2011

   Available-for-Sale      Held-to-Maturity  
     Amortized      Fair      Amortized      Fair  
     Cost      Value      Cost      Value  

Due in one year or less:

           

U.S. Agency securities

   $ 16,165       $ 16,296       $ —         $ —     

Corporate securities

     4,057         4,071         —           —     

After one year through five years:

           

U.S. Agency securities

     60,244         60,131         —           —     

States & political subdivisions

     65         70         —           —     

Corporate securities

     —           —           —           —     

After five years through ten years:

           

States & political subdivisions

     3,561         3,687         6,628         6,780   

After ten years:

           

States & political subdivisions

     58,729         59,052         5,351         5,442   
                                   

Subtotal

     142,821         143,307         11,979         12,222   

Mortgage-backed securities

     24,657         25,232         26,741         27,814   
                                   

Total Debt Securities

   $ 167,478       $ 168,539       $ 38,720       $ 40,036   
                                   

 

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The gross fair value and unrealized losses of the Company’s investments aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at March 31, 2011 and December 31, 2010 are as follows:

 

     Less than twelve months      Twelve months or more      Totals  

March 31, 2011

   Fair
Value
     Unrealized
Losses
     Fair
Value
     Unrealized
Losses
     Fair
Value
     Unrealized
Losses
 

U.S. Agency securities

   $ 33,514       $ 451       $ —         $ —         $ 33,514       $ 451   

Mortgage-backed securities

     24,657         165         —           —           24,657         165   

States & political subdivisions

     20,595         501         716         84         21,311         585   

Equities

     149         2         311         39         460         41   
                                                     

Total

   $ 78,915       $ 1,119       $ 1,027       $ 123       $ 79,942       $ 1,242   
                                                     
     Less than twelve months      Twelve months or more      Totals  

December 31, 2010

   Fair
Value
     Unrealized
Losses
     Fair
Value
     Unrealized
Losses
     Fair
Value
     Unrealized
Losses
 

U.S. Agency securities

   $ 28,662       $ 319       $ —         $ —         $ 28,662       $ 319   

Mortgage-backed securities

     25,554         49         —           —           25,554         49   

States & political subdivisions

     23,627         582         721         80         24,348         662   

Equities

     186         49         —           —           186         49   
                                                     

Total

   $ 78,029       $ 999       $ 721       $ 80       $ 78,750       $ 1,079   
                                                     

The table at March 31, 2011, includes forty-one (41) securities that have unrealized losses for less than twelve months and nine (9) securities that have been in an unrealized loss position for twelve or more months. The table at December 31, 2010, includes fifty-one (51) securities that have unrealized losses for less than twelve months and two (2) securities that have been in an unrealized loss position for twelve or more months.

U.S. Agency Securities

The unrealized losses on the Company’s investments in U.S. Agency securities were caused by interest rate fluctuations. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the par value of the investment. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at March 31, 2011.

Mortgage-backed Securities

The unrealized losses on the Company’s investments in mortgage-backed securities were caused by interest rate fluctuations. The contractual cash flows of these investments are guaranteed by an agency of the U.S. Government. Accordingly, it is expected that these securities would not be settled at a price less than the amortized cost of the Company’s investment. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at March 31, 2011.

States and Political Subdivisions

The unrealized losses on the Company’s investments in states and political subdivisions were caused by interest rate fluctuations and not credit quality. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the par value of the investment. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, the Company does not consider those investments to be other-than-temporarily impaired at March 31, 2011.

 

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Table of Contents

Marketable Equity Securities

The unrealized losses on the Company’s investments in marketable equity securities were caused primarily by interest rate fluctuations and other market conditions. The Company’s investments in marketable equity securities consist primarily of investments in common stock of companies in the financial services industry. The Company has analyzed its equity portfolio and determined that the market value fluctuation in these equity securities is consistent with the broader market and not a cause for recognition of a current loss. Because the Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their cost bases, the Company does not consider those investments to be other-than-temporarily impaired at March 31, 2011.

NOTE 6 — Loan Portfolio

Details regarding the Company’s loan portfolio during the periods indicated are as follows:

 

As of:

   March 31,
2011
     December 31,
2010
 

Loans secured by real estate:

     

Construction and land development

     

Residential real estate

   $ 8,122       $ 7,799   

Commercial real estate

     21,662         28,345   

Secured by 1-4 family residential properties:

     

Revolving, open-end loans

     32,701         33,102   

Secured by first liens

     226,383         225,105   

Secured by junior liens

     21,312         21,233   

Secured by multi-family properties

     9,823         8,062   

Secured by non-farm, non-residential properties

     170,976         179,619   

Commercial and industrial loans to U.S. addressees

     38,969         36,190   

Loans to individuals for household, family and other personal expenditures:

     

Credit card and related plans

     3,159         3,327   

Other (installment and student loans, etc.)

     50,935         52,536   

Obligations of states & political subdivisions

     16,882         9,882   

All other loans

     10,098         9,906   
                 

Gross Loans

     611,022         615,106   

Less: Unearned income on loans

     1         1   
                 

Loans, net of unearned income

   $ 611,021       $ 615,105   
                 

The Company has not engaged in any sub-prime residential mortgage lending. Therefore, the Company is not subject to any credit risks associated with such loans. The Company’s loan portfolio consists primarily of residential and commercial mortgage loans secured by properties located in Northeastern Pennsylvania and subject to conservative underwriting standards.

 

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Age Analysis of Past Due Loans

As of March 31, 2011

 

     30-59
Days
Past Due
     60-89
Days
Past Due
     Greater
Than 90
Days
     Total
Past Due
     Current      Total Loans      Recorded
Investment
> 90 Days
and
Accruing
 

Commercial

   $ 49       $ 86       $ 1,154       $ 1,289       $ 64,660       $ 65,949       $ —     

Commercial real estate:

                    

Commercial real estate construction

     —           —         $ 1,040         1,040         20,622         21,662         —     

Commercial real estate - other

     634         —         $ 280         914         170,062         170,976         85   

Consumer:

                    

Consumer - credit card

     12         13       $ 26         51         3,108         3,159         26   

Consumer - other

     15         5       $ —           20         8,690         8,710         —     

Consumer - auto

     125         18       $ 40         183         28,871         29,054         34   

Student loans - TERI

     109         33       $ 61         203         6,090         6,293         —     

Student loans - other

     260         56       $ 60         376         6,501         6,877         60   

Residential:

                    

Residential - prime

     3,790         48       $ 3,380         7,218         291,123         298,341         903   
                                                              

Total

   $ 4,994       $ 259       $ 6,041       $ 11,294       $ 599,727       $ 611,021       $ 1,108   
                                                              

Credit Quality Indicators. As part of the on-going monitoring of the credit quality of the Company’s loan portfolio, management tracks certain credit quality indicators including trends related to (i) loan delinquency, (ii) the level of classified commercial loans, (iii) net charge-offs, (iv) non-performing loans (see details above) and (v) the general economic conditions in the Company’s market area.

The Company utilizes a risk grading matrix to assign a risk grade to each of its commercial loans. Loans are graded on a scale of 1 to 8. A description of the general characteristics of the 8 risk grades is as follows:

Pass 1 (Minimal Risk)

This classification includes loans which are fully secured by liquid collateral or loans to very high quality borrowers who demonstrate exceptional credit fundamentals, including stable and predictable profit margins and cash flows, strong liquidity, a conservative balance sheet, superior asset quality and good management with an excellent track record.

Pass 2 (Average Risk)

This classification includes loans which have no identifiable risk of collection and conform in all aspects to the Bank’s policies and procedures as well as federal and state regulations. Documentation exceptions are minimal and in the process of correction and not of a type that could subsequently introduce loan loss risk.

Pass 3 (Acceptable Risk)

This classification includes loans to borrowers of acceptable credit quality and risk. Such borrowers are differentiated from Pass 2 in terms of secondary sources of repayment or they are of lesser stature in other key credit metrics in that they may be over-leveraged, under capitalized, inconsistent in performance or in an industry that is known to have a higher level of risk, volatility, or susceptibility to weaknesses in the economy.

Pass 4 (Watch List)

This classification is intended to be utilized on a temporary basis for pass grade borrowers where a significant risk-modifying action is anticipated in the near term. It is assigned to loans where, for example, the financial condition of the company has taken a negative turn and may be temporarily strained; borrowers may exhibit excessive growth, declining earnings, strained cash flow, increasing leverage and/or weakening market position that indicate above average risk. Interim losses and/or adverse trends may occur, but not to the level that would affect the Bank’s position and cash flow may be weak but minimally acceptable.

 

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Table of Contents

Criticized 5 (Other Assets Especially Mentioned)

This classification is also intended to be temporary and includes loans to borrowers whose credit quality has clearly deteriorated and are at risk of further decline unless active measures are taken to correct the situation.

Classified 6 (Substandard)

This classification includes loans with well-defined weaknesses which are inadequately protected by current net worth, repayment capacity or pledged collateral of the borrower. Loans are substandard when they have one or more weaknesses that could jeopardize debt repayment and/or liquidation, primarily resulting in the possibility that the Bank may sustain some loss if the deficiencies are not corrected.

Classified 7 (Doubtful)

This classification includes loans that have all weaknesses inherent in the substandard category and where collection or liquidation in full is highly improbable. The possibility of loss is high, but because of certain important and reasonably specific pending factors, its classification as an estimated loss is deferred until its more exact status may be determined.

Classified 8 (Loss)

This classification includes loans considered uncollectible and of such little value that continuance as bankable assets is not warranted and, therefore, should be charged-off. This classification does not mean that the loans have absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off these assets even though partial recovery may be affected in the future.

Credit Quality Indicators as of March 31, 2011

Corporate Credit Exposure

Credit Risk Profile by Credit Worthiness Category

 

     Commercial      Commercial Real Estate
Construction
     Commercial Real Estate -
Other
 

Pass / Watch

   $ 63,704       $ 19,201       $ 148,356   

Criticized

     781         1,412         13,665   

Substandard

     1,464         1,049         8,955   
                          

Total

   $ 65,949       $ 21,662       $ 170,976   
                          

Consumer Credit Exposure

Credit Risk Profile by Payment Activity

 

     Residential - Real Estate  

Performing

   $ 294,961   

Non Performing

     3,380   
        

Total

   $ 298,341   
        

Credit Risk Profile by Payment Activity

 

     Consumer - Credit
Card
     Consumer -
Other
     Consumer -
Auto
     Student Loans -
TERI
     Student Loans -
Other
 

Performing

   $ 3,133       $ 8,710       $ 29,014       $ 6,232       $ 6,817   

Nonperforming

     26         —           40         61         60   
                                            

Total

   $ 3,159       $ 8,710       $ 29,054       $ 6,293       $ 6,877   
                                            

 

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Table of Contents

Impaired Loans. Loans are considered impaired when, based on current information and events, it is probable the Company will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments. Impairment is evaluated in total for smaller-balance loans of a similar nature and on an individual loan basis for other loans. If a loan is impaired, a specific valuation allowance is allocated, if necessary, so that the loan is reported net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Interest payments on impaired loans are typically applied to principal unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Impaired loans, or portions thereof, are charged off when deemed uncollectible.

Impaired Loans

For the Period Ended March 31, 2011

 

     Recorded
Investment
     Unpaid
Principal
Balance
     Related
Allowance
     Average
Recorded
Investment
     Interest
Income
Recognized
 

With no related allowance recorded:

              

Commercial Real Estate

   $ 195       $ 195       $ —         $ 195       $ —     

Commercial

     —           —           —           —           —     

Consumer - TERI

     61         61         —           61         —     

Consumer - other

     —           —           —           —           —     

Consumer - auto

     6         6         —           6         —     

Residential - Real Estate

     269         269         —           369         —     

With an allowance recorded:

              

Commercial real estate construction

     1,040         1,040         200         1,040         —     

Commercial real estate - other

     —           —           —           —           —     

Commercial

     1,617         1,617         932         1,398         4   

Residential Real Estate

     2,208         2,208         294         1,800         —     
                                            

Total:

   $ 5,396       $ 5,396       $ 1,426       $ 4,869       $ 4   
                                            

Commercial Real Estate

   $ 1,235       $ 1,235       $ 200       $ 1,235       $ —     

Commercial

   $ 1,617       $ 1,617       $ 932       $ 1,398       $ 4   

Consumer

   $ 67       $ 67       $ —         $ 67       $ —     

Residential Real Estate

   $ 2,477       $ 2,477       $ 294       $ 2,169       $ —     

Non-Accrual and Past Due Loans. Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on non-accrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. Loans may be placed on non-accrual status regardless of whether or not such loans are considered past due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal due. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured with the minimum of a six month positive payment history.

 

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Table of Contents

Period-end non-accrual loans, segregated by class of loans, is as follows:

 

March 31,

   2011  

Commercial

   $ 1,154   

Commercial real estate:

  

Commercial real estate construction

     1,040   

Commercial real estate - other

     195   

Consumer:

  

Student loans - TERI

     61   

Student loans - other

     —     

Consumer - other

     —     

Consumer - auto

     6   

Residential:

  

Residential real estate

     2,477   
        

Total

   $ 4,933   
        

The Allowance for Credit Losses and Recorded Investment in Loans for the period ended March 31, 2011 is as follows:

 

     Commercial      Commercial
Real Estate
     Consumer     Residential     Credit Card     Unallocated      Total  

Allowance for credit losses:

                 

Beginning balance 12/31/10

   $ 1,957       $ 2,067       $ 1,380      $ 753      $ 343      $ —         $ 6,500   

Charge-offs

     —           —           (34     (61     (20     —           (115

Recoveries

     —           1         26        18        1        —           46   

Provision

     90         94         72        78        35        —           369   
                                                           

Ending balance 03/31/11

   $ 2,047       $ 2,162       $ 1,444      $ 788      $ 359      $ —         $ 6,800   

Ending balance: Individually evaluated for impairment

     932         200         —          294        —             1,426   
                                                           

Ending balance: Collectively evaluated for impairment

   $ 1,115       $ 1,962       $ 1,444      $ 494      $ 359      $ —         $ 5,374   
                                                           

Ending balance: Loans acquired with deteriorated credit quality

   $ —         $ —         $ —        $ —        $ —        $ —         $ —     
                                                           

Loans:

                 

Ending balance

   $ 65,949       $ 192,638       $ 50,934      $ 298,341      $ 3,159      $ —         $ 611,021   
                                                           

Ending balance: Individually evaluated for impairment

     1,617         1,235         67        2,477        —          —           5,396   
                                                           

Ending balance: Collectively evaluated for impairment

   $ 64,332       $ 191,403       $ 50,867      $ 295,864      $ 3,159      $ —         $ 605,625   
                                                           

Ending balance: Loans acquired with deteriorated credit quality

   $ —         $ —         $ —        $ —        $ —        $ —         $ —     
                                                           

NOTE 7 — Loan Servicing

The Company generally retains the right to service mortgage loans sold to third parties. The cost allocated to the mortgage servicing rights retained has been recognized as a separate asset and is amortized in proportion to and over the period of estimated net servicing income.

Mortgage servicing rights are evaluated for impairment based on the fair value of those rights. Fair values are estimated using discounted cash flows based on current market rates of interest and expected future prepayment rates. For purposes of measuring impairment, the rights must be stratified by one or more predominant risk characteristics of the underlying loans. The Company stratifies its capitalized mortgage servicing rights based on the product type, interest rate and term of the underlying loans. The amount of impairment recognized is the amount, if any, by which the amortized cost of the rights for each stratum exceed the fair value.

 

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Table of Contents

NOTE 8 — Goodwill

Goodwill represents the excess of the purchase price over the underlying fair value of merged entities. Goodwill is assessed for impairment at least annually and as triggering events occur. In making this assessment, management considers a number of factors including, but not limited to, operating results, business plans, economic projections, anticipated future cash flows, and current market data. There are inherent uncertainties related to these factors and management’s judgment in applying them to the analysis of Goodwill impairment. Changes in economic and operating conditions, as well as other factors, could result in Goodwill impairment in future periods.

NOTE 9 — Other Intangible Assets

Intangible assets include the premium assigned to the core deposit relationships acquired in the Merger. The core deposit intangible is being amortized over ten years on a sum-of-the-years-digits basis. Amortization expense is expected to be as follows:

 

March 31,

      

2012

   $ 295   

2013

     258   

2014

     221   

2015

     184   

2016

     148   

2017 and thereafter

     221   
        
   $ 1,327   
        

NOTE 10 — Long-Term Debt

The loans from the Federal Home Loan Bank of Pittsburgh are secured by a general collateral pledge of the Company’s assets. The Company has agreed to maintain sufficient qualifying collateral to fully secure the borrowings below.

A summary of long-term debt, including amortizing principal and interest payments, at March 31, 2011 is as follows:

 

Monthly Installment

   Fixed Rate     Maturity Date      Balance  

Amortizing loans

       

$    29

     1.84     08/28/12       $ 479   

      90

     3.10     02/28/13         2,009   

    430

     3.74     03/13/13         9,930   

      18

     2.66     08/28/14         697   

      67

     3.44     03/02/15         2,945   

      13

     3.48     03/31/15         601   

      10

     3.83     04/02/18         747   

    186

     4.69     03/13/23         20,503   
                         

Total amortizing

          37,911   
             

Non-amortizing loans

  

     3.27     02/29/12         2,000   
     3.49     02/28/13         7,000   
     2.89     11/28/14         2,000   
     2.58     05/18/15         6,300   
     3.32     11/27/15         3,000   
     2.36     09/22/17         6,500   
                         

Total non-amortizing

  

     26,800   
             

Total long-term debt

  

   $ 64,711   
             

 

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Table of Contents

Aggregate maturities of long-term debt at March 31, 2011 are as follows:

 

March 31,

   Principal  

2012

   $ 10,695   

2013

     15,729   

2014

     2,659   

2015

     4,577   

2016

     10,981   

Thereafter

     20,070   
        
   $ 64,711   
        

NOTE 11 — Employee Benefit Plans

The Company provides, among other benefits, a defined benefit pension plan, currently under curtailment, a 401(k) profit sharing plan for all eligible employees, a post-retirement benefit plan for eligible employees and a Long-Term Incentive Plan.

The components of the net periodic benefit cost are as follows:

 

     Pension Benefits     Other Benefits  

Three months ended March 31,

   2011     2010     2011      2010  

Service cost

   $ —        $ —        $ 2       $ 1   

Interest cost

     175        178        6         5   

Expected return on plan assets

     (226     (220     —           —     

Amortization of prior service cost

     —          —          2         2   

Amortization of net loss (gain)

     21        15        —           —     
                                 

Net periodic pension cost

   $ (30   $ (27   $ 10       $ 8   
                                 

The Company previously disclosed in its financial statements for the year ended December 31, 2010 that it did not expect to contribute to its pension plan but expected to contribute $40 to its post-retirement plan during 2011. Readers should refer to the Company’s Annual Report on Form 10-K for 2010 for further details on the Company’s defined benefit pension plan.

The Company sponsors a 401(k) profit sharing plan for all eligible employees. The Company’s profit sharing expense for the three months ended March 31, 2011 and 2010 was $108 and $132 respectively.

The Company granted restricted stock awards during the three months ended March 31, 2011 valued at $56. There were no awards during the three months ended March 31, 2010.

NOTE 12 — Regulatory Matters

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

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the Capital Adequacy table on the following page) of Tier 1 and Total Capital to risk-weighted assets and of Tier 1 Capital to average assets (Leverage ratio). The table also presents the Company’s actual capital amounts and ratios. Management believes, as of March 31, 2011, that the Company and the Bank meet all capital adequacy requirements to which they are subject.

 

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Table of Contents

As of June 30, 2010, the most recent regulatory notifications categorized the Bank as “well capitalized” under the regulatory framework for prompt corrective action. To be categorized as “well capitalized”, the Bank must maintain minimum Tier 1 Capital, Total Capital and Leverage ratios as set forth in the Capital Adequacy table. There are no conditions or events since that notification that management believes have changed the Company’s categorization by the FDIC.

The Company and Bank are also subject to minimum capital levels, which could limit the payment of dividends, although the Company and Bank currently have capital levels which are in excess of minimum capital level ratios required.

The Pennsylvania Banking Code restricts capital funds available for payment of dividends to the retained earnings of the Bank. The balances in the capital stock and surplus accounts are unavailable for dividends.

In addition, the Bank is subject to restrictions imposed by Federal law on certain transactions with the Company’s affiliates. These transactions include extensions of credit, purchases of or investments in stock issued by the affiliate, purchases of assets subject to certain exceptions, acceptance of securities issued by an affiliate as collateral for loans, and the issuance of guarantees, acceptances, and letters of credit on behalf of affiliates. These restrictions prevent the Company’s affiliates from borrowing from the Bank unless the loans are secured by obligations of designated amounts. Further, the aggregate of such transactions by the Bank with a single affiliate is limited in amount to 10 percent of the Bank’s Capital Stock and Surplus, and the aggregate of such transactions with all affiliates is limited to 20 percent of the Bank’s capital stock and surplus. The Federal Reserve System has interpreted “capital stock and surplus” to include undivided profits.

 

Actual

           Regulatory Requirements  
                         For Capital
Adequacy Purposes
           To Be
“Well Capitalized”
 

As of March 31, 2011

   Amount      Ratio            Amount            Ratio            Amount             Ratio  

Total Capital (to Risk Weighted Assets)

                          

PFSC (Company)

   $ 100,691         16.88     >       $ 47,726        >         8.0     >         N/A         >         N/A   
                                                  

PSB (Bank)

   $ 96,985         16.28     >       $ 47,674        >         8.0     >       $ 59,592         >         10.0
                                                  

Tier 1 Capital (to Risk Weighted Assets)

                          

PFSC (Company)

   $ 93,645         15.70     >       $ 23,863        >         4.0     >         N/A         >         N/A   
                                                  

PSB (Bank)

   $ 90,185         15.13     >       $ 23,837        >         4.0     >       $ 35,755         >         6.0
                                                  

Tier 1 Capital (to Average Assets)

                          

PFSC (Company)

   $ 93,645         10.59     >       $       >         *        >         N/A         >         N/A   
                                                  

PSB (Bank)

   $ 90,185         10.25     >       $       >         *        >       $ 43,974         >         5.0
                                                  

PFSC - *3.0% ($26,517), 4.0% ($35,356) or 5.0% ($44,195) depending on the bank’s CAMELS Rating and other regulatory risk factors.

PSB - *3.0% ($26,384), 4.0% ($35,179) or 5.0% ($43,974) depending on the bank’s CAMELS Rating and other regulatory risk factors.

 

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Actual

           Regulatory Requirements  
                         For Capital
Adequacy Purposes
           To Be
“Well Capitalized”
 

As of December 31, 2010

   Amount      Ratio            Amount             Ratio            Amount             Ratio  

Total Capital (to Risk Weighted Assets)

                           

PFSC (Company)

   $ 98,220         16.42     >       $ 47,852         >         8.0     >         N/A         >         N/A   
                                                   

PSB (Bank)

   $ 94,455         15.81     >       $ 47,808         >         8.0     >       $ 59,760         >         10.0
                                                   

Tier 1 Capital (to Risk Weighted Assets)

                           

PFSC (Company)

   $ 91,499         15.30     >       $ 23,926         >         4.0     >         N/A         >         N/A   
                                                   

PSB (Bank)

   $ 87,955         14.72     >       $ 23,904         >         4.0     >       $ 35,856         >         6.0
                                                   

Tier 1 Capital (to Average Assets)

                           

PFSC (Company)

   $ 91,499         10.68     >       $ *         >         *        >         N/A         >         N/A   
                                                   

PSB (Bank)

   $ 87,955         10.32     >       $ *         >         *        >       $ 42,607         >         5.0
                                                   

PFSC - *3.0% ($25,696), 4.0% ($34,261) or 5.0% ($42,826) depending on the bank’s CAMELS Rating and other regulatory risk factors.

PSB - *3.0% ($25,564), 4.0% ($34,086) or 5.0% ($42,607) depending on the bank’s CAMELS Rating and other regulatory risk factors.

NOTE 13 — Merger

An Agreement and Plan of Merger (the “Agreement”) by and between the Company, the Bank and Old Forge Bank, was entered into on December 5, 2008. The Agreement provided for, among other things, the Company to acquire 100% of the outstanding common shares of Old Forge Bank through a two-step merger transaction. The Company consummated the acquisition of Old Forge Bank on April 1, 2009, at which time Old Forge Bank was merged with and into the Bank. Following the Merger, the Bank continues to operate as a banking subsidiary of the Company.

There was approximately $26.4 million of goodwill created in the Merger, largely based on the Company’s evaluation of the business growth opportunities inherent in the Old Forge Bank customer base, as well as operating synergies and economy of scale resulting from the Merger. None of the goodwill is expected to be deductible for income tax purposes.

The table below illustrates the fair value adjustments made to the amortized cost basis in order to present the fair value of the loans acquired.

 

Gross amortized cost basis at April 1, 2009

   $ 166,348   

Market rate adjustment

     640   

Credit fair value adjustment in pools of homogeneous loans

     (5,648

Credit fair value adjustment on distressed loans

     (1,391
        

Fair value of purchased loans at April 1, 2009

   $ 159,949   
        

In connection with its acquisition of Old Forge Bank, the Company acquired loans with evidence of credit deterioration that have been accounted for under ASC 310-30. As part of the Company’s acquisition of Old Forge Bank, the acquired loan portfolio of Old Forge Bank was evaluated based on risk characteristics and other credit and market criteria to determine a credit adjustment to the fair value of the loans acquired. The acquired loan balance was reduced by the aggregate amount of the credit fair value adjustment for both homogeneous pools and specific loans in determining the fair value of the loans. The credit fair value adjustment accounted for acquired loans deemed to require a specific allocation in accordance with Accounting Standard Codification 310-30-30, previously known as Statement of Position (SOP) 03-3, “Accounting for Certain Loans Acquired in a Transfer.” These loans are accounted for in the credit fair value adjustment considering the portion of the loan balance that has been deemed uncollectible based on management’s expectations of future cash flows for each respective loan. Based on management’s evaluation of the acquired loan portfolio of Old Forge Bank, six loans with a carrying value of $2,151 exhibited credit quality deterioration resulting in a credit fair value adjustment of $1,391. As of March 31, 2011, there were a total of two loans remaining with a carrying value of $228 with a credit fair value adjustment of $228. As of December 31, 2010, there were a total of two loans remaining with a carrying value of $229 with a credit fair value adjustment of $229. As of March 31, 2010, there were a total of four loans remaining with a carrying value of $1,936 with a credit fair value adjustment of $1,305. There is no accretable yield for the specific loans accounted for under Accounting Standard Codification 310-30-30. There were no significant prepayment estimates by Management in the determination of contractual cash flows and cash flows expected to be collected.

 

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Changes in the credit fair value adjustment on specific loans purchased are as follows:

 

Three Months Ended March 31, 2011

 
     Carrying
Value
    Credit
Fair Value
Adjustment
    Net
Amount
 

Balance, December 31, 2010

      

Residential Mortgages

   $ —        $ —        $ —     

Commercial

     229        229        —     

Consumer / Other

     —          —          —     
                        
     229        229        —     

Charge-offs

      

Residential Mortgages

     —          —          —     

Commercial

     —          —          —     

Consumer / Other

     —          —          —     
                        

Total Charge-offs

     —          —          —     

Loans transferred to other real estate owned

      

Residential Mortgages

     —          —          —     

Commercial

     —          —          —     

Consumer / Other

     —          —          —     
                        

Total loans transferred to other real estate owned

     —          —          —     

Payments

      

Residential Mortgages

     —          —          —     

Commercial

     (1     (1     —     

Consumer / Other

     —          —          —     
                        

Total Payments

     (1     (1     —     
                        

Balance, March 31, 2011

   $ 228      $ 228      $ —     
                        

 

Three Months Ended March 31, 2010

 
     Carrying
Value
    Credit
Fair Value
Adjustment
    Net
Amount
 

Balance, December 31, 2009

      

Residential Mortgages

   $ —        $ —        $ —     

Commercial

     1,966        1,307        659   

Consumer / Other

     —          —          —     
                        
     1,966        1,307        659   

Charge-offs

      

Residential Mortgages

     —          —          —     

Commercial

     —          —          —     

Consumer / Other

     —          —          —     
                        

Total Charge-offs

     —          —          —     

Loans transferred to other real estate owned

      

Residential Mortgages

     —          —          —     

Commercial

     —          —          —     

Consumer / Other

     —          —          —     
                        

Total loans transferred to other real estate owned

     —          —          —     

Payments

      

Residential Mortgages

     —          —          —     

Commercial

     (30     (2     (28

Consumer / Other

     —          —          —     
                        

Total Payments

     (30     (2     (28
                        

Balance, March 31, 2010

   $ 1,936      $ 1,305      $ 631   
                        

 

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Table of Contents

Note 14 – Fair Value Measurements

The following table sets forth the Company’s financial assets that were accounted for at fair value and are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

Level I - Quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access at the measurement date.

Level II - Observable inputs other than Level I prices, such as quoted prices for similar assets or liabilities in active markets; quoted prices in markets that are not active for identical or similar assets or liabilities; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level III - Unobservable inputs that are supported by little or no market activity and significant to the fair value of the assets or liabilities that are developed using the reporting entities’ estimates and assumptions, which reflect those that market participants would use.

Assets and Liabilities Measured at Fair Value on a Recurring Basis

A description of the valuation methodologies used for financial assets measured at fair value on a recurring basis, as well as the classification of the assets pursuant to the valuation hierarchy, are as follows:

Securities Available-for-Sale

Securities classified as available-for-sale are reported using Level I, Level II and Level III inputs. Level I instruments generally include equity securities valued in accordance with quoted market prices in active markets. Level II instruments include U.S. government agency obligations, state and municipal bonds, mortgage-backed securities and corporate bonds. For these securities, the Company obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U.S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayment speeds, credit information and the bond’s terms and conditions, among other things. Level III instruments include certain non-public equity securities and real estate sold under contract. See Note 5 – Investment Securities for additional information.

Assets and liabilities measured at fair value on a recurring basis are summarized as follows:

 

     March 31, 2011  
     Level I      Level II      Level III      Total  

Assets:

           

Securities available-for-sale

           

U.S. Agency securities

   $ —         $ 76,427       $ —         $ 76,427   

Mortgage-backed securities:

           

Residential

     —           25,232         —           25,232   

States & political subdivisions:

           

Bank qualified tax exempt

     —           62,809         —           62,809   

Corporate securities:

           

Aaa credit rating

     —           4,071         —           4,071   

Equity securities:

           

Financial services industry

     1,305         —           —           1,305   
                                   

Total securities available-for-sale

   $ 1,305       $ 168,539       $ —         $ 169,844   
                                   

 

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Table of Contents
     December 31, 2010  
     Level I      Level II      Level III      Total  

Assets:

           

Securities available-for-sale

           

U.S. Agency securities

   $ —         $ 79,294       $ —         $ 79,294   

Mortgage-backed securities:

           

Residential

     —           26,370         —           26,370   

States & political subdivisions:

           

Bank qualified tax exempt

     —           62,558         —           62,558   

Corporate securities:

           

Aaa credit rating

     —           4,090         —           4,090   

Equity securities:

           

Financial services industry

     985         —           —           985   
                                   

Total securities available-for-sale

   $ 985       $ 172,312       $ —         $ 173,297   
                                   

Assets Measured at Fair Value on a Nonrecurring Basis

Certain non-financial assets and non-financial liabilities, measured at fair value on a non-recurring basis, include foreclosed and non-performing assets, goodwill and other intangible assets.

A description of the valuation methodologies and classification levels used for non-financial assets and non-financial liabilities measured at fair value on a nonrecurring basis are listed as follows:

Goodwill and Other Identifiable Intangibles

The Company employs general industry practices in evaluating the fair value of its goodwill and other identifiable intangibles. The Company calculates the fair value, with the assistance of a third party specialist, using a combination of the following valuation methods: dividend discount analysis under the income approach, which calculates the present value of all excess cash flows plus the present value of a terminal value and market multiples (pricing ratios) under the market approach. Management performed a review of goodwill and other identifiable intangibles as of December 31, 2010. Goodwill and other identifiable intangibles were not evaluated during the three months ended March 31, 2011 as a result of management’s determination that no evidence of impairment was present during the period.

Impaired Loans

At March 31, 2011 certain impaired loans were remeasured and reported at fair value through a specific valuation allowance allocation of the allowance for loan losses based upon the fair value of the underlying collateral and the evaluation of expected future cash flows. Impaired loans with a carrying value of $5,396 were reduced by a specific valuation allowance allocation totaling $1,426, to a total reported fair value of $3,970 based on collateral valuations utilizing Level III valuation inputs.

Federal Home Loan Bank Stock

Federal Home Loan Bank of Pittsburgh (FHLB) stock is a required investment in order for the Company to participate in a FHLB line of credit program. The FHLB stock is stated at par value as it is restricted to purchases and sales with the FHLB. The FHLB had indefinitely suspended its stock repurchase and dividend payments during December 2008. During the first quarter of 2011, the FHLB repurchased $304 of capital stock which represented 5.0% of the Bank’s $6,082 investment. Based on current financial information available, management does not believe the FHLB stock value is impaired as of March 31, 2011.

Other Real Estate Owned

Foreclosed real estate, which is considered to be a non-financial asset, has been valued using a market approach. The values were determined using market prices of similar real estate assets, which the Company considered to be Level II inputs.

 

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Certain assets measured at fair value on a non-recurring basis as of March 31, 2011 is as follows:

 

     Fair Value Measurement Using  
     Quoted Prices in
Active Markets for
Identical

Assets/Liabilities
     Significant
Other
Observable
Inputs
     Significant
Unobservable
Inputs
     Balance
March 31,
2011
 
     Level I      Level II      Level III      Total  

Assets

           

Core deposit intangible

   $ —         $ —         $ 1,327       $ 1,327   

Goodwill

     —           —           26,398         26,398   

Impaired loans

     —           —           5,396         5,396   

Federal Home Loan Bank stock

     —           —           5,778         5,778   

Other real-estate owned

     —           883         —           883   
                                   

Total non-financial assets

   $ —         $ 883       $ 38,899       $ 39,782   
                                   

Certain assets measured at fair value on a non-recurring basis as of December 31, 2010 is as follows:

 

     Fair Value Measurement Using  
     Quoted Prices in
Active Markets for
Identical

Assets/Liabilities
     Significant
Other
Observable
Inputs
     Significant
Unobservable
Inputs
     Balance
December 31,
2010
 
     Level I      Level II      Level III      Total  

Assets

           

Core deposit intangible

   $ —         $ —         $ 1,410       $ 1,410   

Goodwill

     —           —           26,398         26,398   

Impaired loans

     —           —           4,493         4,493   

Federal Home Loan Bank stock

     —           —           6,082         6,082   

Other real-estate owned

     —           803         —           803   
                                   

Total non-financial assets

   $ —         $ 803       $ 38,383       $ 39,186   
                                   

A reconciliation of items in Level III for the period ended March 31, 2011 is as follows:

 

     Core
deposit
intangible
    Goodwill      Impaired
Loans
    Federal Home
Loan Bank
Stock
    Total  

Balance December 31, 2010

   $ 1,410      $ 26,398       $ 4,493      $ 6,082      $ 38,383   

Amortization of core deposit intangible

     (83     —           —          —          (83

Increase in impaired loans

     —          —           1,043        —          1,043   

Decrease in impaired loans

     —          —           (102     —          (102

Payments received

     —          —           (38     (304     (342
                                         

Balance March 31, 2011

   $ 1,327      $ 26,398       $ 5,396      $ 5,778      $ 38,899   
                                         

A reconciliation of items in Level III for the year ended December 31, 2010 is as follows:

 

     Core
deposit
intangible
    Goodwill      Impaired
Loans
    Federal
Home Loan
Bank Stock
    Real estate
sold under
contract
    Total  

Balance December 31, 2009

   $ 1,751      $ 26,398       $ —        $ 6,402      $ 123      $ 34,674   

Amortization of core deposit intangible

     (341     —           —          —          —          (341

Increase in impaired loans

     —          —           5,073        —          —          5,073   

Decrease in impaired loans

     —          —           (580     —          —          (580

Payments received

     —          —           —          (320     (123     (443
                                                 

Balance December 31, 2010

   $ 1,410      $ 26,398       $ 4,493      $ 6,082      $ —        $ 38,383   
                                                 

 

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Table of Contents

Disclosures about Fair Value of Financial Instruments

General Accepted Accounting Principles require disclosure of the estimated fair value of an entity’s assets and liabilities considered to be financial instruments. For the Company, as for most financial institutions, the majority of its assets and liabilities are considered financial instruments. However, many such instruments lack an available trading market, as characterized by a willing buyer and seller engaging in an exchange transaction. Also, it is the Company’s general practice and intent to hold its financial instruments to maturity and not to engage in trading or sales activities, except for certain loans and investments. Therefore, the Company had to use significant estimates and present value calculations to prepare this disclosure.

Changes in the assumptions or methodologies used to estimate fair values may materially affect the estimated amounts. Also, management is concerned that there may not be reasonable comparability between institutions due to the wide range of permitted assumptions and methodologies in the absence of active markets. This lack of uniformity gives rise to a high degree of subjectivity in estimating financial instrument fair values.

Estimated fair values have been determined by the Company using the best available data and an estimation methodology suitable for each category of financial instruments. The estimation methodologies used at March 31, 2011 and December 31, 2010 are outlined below. The methodologies for estimating the fair value of financial assets and financial liabilities that are measured at fair value on a recurring or non-recurring basis are discussed in the fair value measurements section above. The estimated fair value approximates carrying value for cash and cash equivalents, accrued interest and the cash surrender value of life insurance policies. The methodologies for other financial assets and financial liabilities are discussed below:

Short-term financial instruments

The carrying value of short-term financial instruments including cash and due from banks, federal funds sold, interest-bearing deposits in banks and other short-term investments and borrowings, approximates the fair value of these instruments. These financial instruments generally expose the Company to limited credit risk and have no stated maturities or have short-term maturities with interest rates that approximate market rates.

Investment securities held-to-maturity

The estimated fair values of investment securities held-to-maturity are based on quoted market prices provided by independent third parties that specialize in those investment sectors. If quoted market prices are not available, estimated fair values are based on quoted market prices of comparable instruments.

Loans

The loan portfolio, net of unearned income, has been valued by a third party specialist using quoted market prices, if available. When market prices were not available, a credit risk based present value discounted cash flow analysis was utilized. The primary assumptions utilized in this analysis are the discount rate based on the LIBOR curve, adjusted for credit risk, and prepayment estimates based on factors such as refinancing incentives, age of the loan and seasonality. These assumptions were applied by loan category and different spreads were applied based upon prevailing market rates by category.

Deposits

The estimated fair values of demand deposits (i.e., interest and non-interest bearing checking accounts, savings and money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). The fair value for certificates of deposit was calculated by an independent third party by discounting contractual cash flows using current market rates for instruments with similar maturities, using a credit based risk model. The carrying amount of accrued interest receivable and payable approximates fair value.

Long-term borrowings

The amounts assigned to long-term borrowings were based on quoted market prices, when available, or based on discounted cash flow calculations using prevailing market interest rates for debt of similar terms.

 

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Table of Contents

The carrying and fair values of certain financial instruments are as follows:

 

     March 31, 2011     December 31, 2010  
     Carrying
Amount
    Fair
Value
    Carrying
Amount
    Fair
Value
 

Cash and cash equivalents

   $ 25,534      $ 25,534      $ 14,219      $ 14,219   

Investment securities held-to-maturity

     38,720        40,036        43,747        45,218   

Loans, net

     604,221        613,966        608,605        620,040   

Cash surrender value of life insurance

     15,500        15,500        15,380        15,380   

Demand deposits

     451,344        451,344        441,968        441,968   

Time deposits

     249,137        251,570        249,064        251,779   

Short-term borrowings

     20,450        20,450        28,082        28,082   

Long-term borrowings

     64,711        66,965        68,835        71,309   

Standby Letters of Credit

   $ (169   $ (169   $ (164   $ (164

 

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Table of Contents

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

The following commentary provides an overview of the financial condition and significant changes in the results of operations of Penseco Financial Services Corporation (the “Company”) and its subsidiary, Penn Security Bank and Trust Company (the “Bank”), at March 31, 2011 and for the three month periods ended March 31, 2011 and March 31, 2010. All information is presented in thousands of dollars, except as indicated.

Critical Accounting Policies

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Provision (allowance) for loan losses - The allowance for loan losses is based on past loan loss experience, management’s evaluation of the probable loss in the current loan portfolio under current economic conditions and such other factors as, in management’s best judgment, merit recognition in estimating loan losses. The provision for loan losses charged to operating expense is that amount which is sufficient to bring the balance of the allowance for loan losses to an adequate level to absorb probable losses.

Actuarial assumptions associated with pension, post-retirement and other employee benefit plans - These assumptions include discount rate, rate of future compensation increases and expected return on plan assets.

Income taxes - The calculation of the provision for federal income taxes is complex and requires the use of estimates and judgments. Deferred federal income tax assets or liabilities represent the estimated impact of temporary differences between the recognition of assets and liabilities under GAAP, and how such assets and liabilities are recognized under the federal tax code. The Company uses an estimate of future earnings to support management’s position that the benefit of the deferred tax assets will be realized. If projected income is not recognized, at all or in the amounts predicted, the amount of the deferred tax assets within the tax years to which they may be applied, the asset may not be realized and net income will be reduced. Deferred tax assets are described further in Note 18 of the “Notes to Consolidated Financial Statements” in the Company’s most recent Annual Report on Form 10-K.

Management evaluated the Company’s tax positions and concluded that the aggregate liabilities related to taxes are appropriately reflected in the consolidated financial statements. With few exceptions, the Company is no longer subject to income tax examinations by the U.S. Federal, state or local tax authorities for years before 2007.

Fair Value Measurements – Fair values of financial instruments are estimated using relevant market information and other assumptions. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayment speeds and other factors. Changes in assumptions or in market conditions could significantly affect the estimates. Fair value measurements are classified within one of three levels within a valuation hierarchy based on the transparency of inputs to each valuation as of the fair value measurement date. The three levels are defined as follows:

Level I – quoted prices (unadjusted) for identical assets or liabilities in active markets.

Level II – inputs include quoted prices for similar assets and liabilities in active markets, quoted prices of identical or similar assets or liabilities in markets that are not active, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

Level III – inputs that are unobservable and significant to the fair value measurement. Financial instruments are considered Level III when values are determined using pricing models, discounted cash flow methodologies, or similar techniques, and at least one significant model assumption or input is unobservable.

Other-than-temporary impairment of investments - Investments are evaluated periodically to determine whether a decline in their value is other-than-temporary. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other-than-temporary. The term “other-than-temporary” is not intended to indicate that the decline is permanent. It indicates that the prospects for a near term recovery of value are not necessarily favorable, or that there is a lack of evidence to support fair values equal to, or greater than, the carrying value of the investment. Once a decline in value is determined to be other-than-temporary, the value of the security is reduced and a corresponding charge to earnings is recognized.

 

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Premium amortization - The amortization of premiums on mortgage-backed securities is done based on management’s estimate of the lives of the securities, adjusted, when necessary, for advanced prepayments in excess of those estimates.

Loans purchased – Loans purchased in the Merger were recorded at the acquisition date fair value. Management made three different types of fair value adjustments in order to record the loans at fair value. An interest rate fair value adjustment was made comparing current weighted average rates of the acquired loans to stated market rates of similar loan types. A general credit fair value adjustment was made on similar loan types based on historical loss projections plus a discount for the weak economic environment. A specific credit fair value adjustment was made to loans identified by management as being problematic. The specific loans have been discounted by management based on collateral values and expected cash flows. The interest rate and general credit fair value adjustments are being accreted over an eight year period based on a sum-of-the-years-digits basis. The specific credit fair value adjustment is reduced only when cash flows are received or loans are charged-off or transferred to other real estate owned.

Loan servicing rights – Mortgage servicing rights are evaluated for impairment based on the fair value of those rights. Fair values are estimated using discounted cash flows based on current market rates of interest and current expected future prepayment rates. For purposes of measuring impairment, the rights must be stratified by one or more predominant risk characteristics of the underlying loans. The Company stratifies its capitalized mortgage servicing rights based on the product type, interest rate and term of the underlying loans. The amount of impairment recognized is the amount, if any, by which the amortized cost of the rights for each stratum exceeds the fair value.

Time deposits – Time deposits acquired through the Merger have been recorded at their acquisition date fair value. The fair value of time deposits represents the present value of the time deposits’ expected contractual payments discounted by market rates for similar deposits. The fair value adjustment is amortized monthly based on a level yield methodology.

Repurchase agreements - The Company also offers repurchase agreements as an alternative to conventional savings deposits for its customers. The repurchase agreements are accounted for as a collateralized borrowing with a one day maturity and are collateralized by U.S. Agency securities.

Core deposit intangible – The fair value assigned to the core deposit intangible asset represents the future economic benefit of the potential cost savings from acquiring core deposits in the Merger compared to the cost of obtaining alternative funding, such as brokered deposits, from market sources. Management utilized an income approach to present value the expected after tax cash flow benefits of the acquired core deposits. The core deposit intangible is being amortized over ten years on a sum-of-the-years-digits basis.

Goodwill – Goodwill is reviewed by management for possible impairment at least annually or more frequently upon the occurrence of an event or when circumstances indicate that its carrying amount exceeds fair value. Management has obtained a professional valuation of the Company value as of December 31, 2010. As a result of such valuation, goodwill was determined to be not impaired at December 31, 2010. Market conditions that could negatively impact the value of goodwill in the future are essentially those Risk Factors discussed in Part 1A of the Company’s most recent Annual Report on Form 10-K.

Comparison of Operating Results

 

     Three Months Ended March 31,  
     2011     2010  

Interest Income

   $ 10,040      $ 10,557   

Interest Expense

     1,897        2,106   
                

Net Interest Income

     8,143        8,451   

Non-Interest Income

     3,304        2,711   

Total Revenue

   $ 13,344      $ 13,268   

Non-Interest Expense

     7,450        7,037   

Net Income

   $ 2,769      $ 2,981   

Net Interest Margin

     3.87     4.19

ROA

     1.21     1.35

ROE

     8.96     10.04

 

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The Company reported net income for the three months ended March 31, 2011 of $2,769 or $0.85 per weighted average share compared with $2,981 or $0.91 per weighted average share from the year ago period, a decrease of $212 or 7.1%. Pre-provision net interest income decreased $308 or 3.6%. Net interest income, after provision for loan losses, decreased $349 or 4.3% during the 2011 period, due to a decrease in total interest income of $517 or 4.9% and a $41 increase in the provision for loan losses, partially offset by reduced interest expense of $209 or 9.9% from lower funding costs. The decrease in total interest income was primarily attributable to decreases in interest and fees on loans and interest and dividends on investments, due to weak loan demand and investment cash flows being reinvested into historically low short-term yields. Non-interest income increased $593 or 21.9% primarily as a result of the reversal of a contingent liability recorded in connection with the Merger. Non-interest expenses increased $413 or 5.9%, mainly due to increased salaries and employee benefits of $352 reflecting merit increases in salaries of existing personnel and increased staffing for loan production and monitoring asset quality.

Net income from core operations, which excludes the reversal of a contingent liability recorded in connection with the Merger, decreased $542 for the three months ended March 31, 2011 to $2,439 compared to $2,981 for the same period in 2010. Net income from core operations is a non-GAAP measure of net income. A reconciliation of the net income from core operations and disclosure of the non-GAAP return on assets, return on equity and dividend payout ratio derived from that measure are described in the non-GAAP reconciliation included in this Quarterly Report on Form 10-Q.

The following table reflects net income from accretion and amortization, net of taxes, of acquisition date fair value adjustments relating to the Merger included in the Company’s financial results during the periods indicated are as follows:

 

     Three Months Ended  
     March 31,
2011
    March 31,
2010
 

Homogeneous loan pools

   $ 151      $ 175   

Time deposits

     30        58   

Core deposit intangible expense

     (55     (61
                

Net income from acquisition fair value adjustment

   $ 126      $ 172   
                

Accretion of the loan pools credit fair value adjustment and market rate fair value adjustment is calculated on a sum-of-the-years-digits basis over an eight year period. The fair value market rate adjustment of the time deposits is amortized monthly based on a level yield methodology over five years. The core deposit intangible is being amortized over ten years on a sum-of-the-years-digits basis.

 

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Net Interest Income and Net Interest Margin

Net interest income, the principal component of the Company’s earnings, is defined as the difference between interest and fees earned on interest-earning assets and interest paid on deposits and other borrowings. Average earning assets are composed primarily of loans and investments while deposits, short-term and long-term borrowings represent interest-bearing liabilities. Variations in the volume and mix of these assets and liabilities, as well as changes in the yields earned and rates paid, are determinants of changes in net interest income.

Net interest income before provision for loan losses decreased $308 or 3.6% to $8,143 for the three months ended March 31, 2011 compared to $8,451 for the three months ended March 31, 2010. The average yield on interest earning assets decreased 53 basis points or 9.6%.

The net interest margin represents the Company’s net yield on its average interest earning assets and is calculated as net interest income divided by average interest earning assets. In the three months ended March 31, 2011, net interest margin decreased 32 basis points to 3.87% from 4.19% in the same period of 2010.

Total average interest earning assets and average interest bearing funds increased from the three months ended March 31, 2010. Average interest earning assets increased $32.9 million or 4.1%, from $807.7 million in 2010 to $840.6 million in 2011 and average interest bearing funds increased $21.5 million, or 3.3%, from $647.9 million to $669.4 million for the same period. As a percentage of average assets, average earning assets, including bank-owned life insurance (BOLI) remained relatively unchanged for the three months ended March 31, 2011 and 2010, respectively.

Changes in the mix of both interest earning assets and funding sources also impacted net interest income in the three months ended March 31, 2011 and 2010. Average loans as a percentage of average interest earning assets decreased slightly from 74.9% in 2010 to 73.2% in 2011. Average investments increased $19.3 million year over year as well as a percentage of interest earning assets to 25.4% at March 31, 2011 from 24.0% at March 31, 2010. Average short-term investments, federal funds sold, FHLB stock and interest bearing balances with banks, increased as a percentage of average assets to 1.4% at March 31, 2011 from 1.1% at March 31, 2010. Average time deposits increased $39.7 million or 19.0% from $208.9 million or 32.2% of interest bearing liabilities in 2010 to $248.6 million or 37.1% of interest bearing liabilities for the 2011 period. In addition, during the three months ended March 31, 2011, average federal funds purchased decreased $8.7 million and average short-term borrowings decreased $18.0 million.

Shifts in the interest rate environment and competitive factors affected the rates paid for funds as well as the yields earned on assets. The investment securities tax equivalent yield decreased 104 basis points from 5.06% for the three months ended March 31, 2010 to 4.02% for the three months ended March 31, 2011. Also, average loan yields decreased 33 basis points from 5.75% for the three months ended March 31, 2010 to 5.42% for the three months ended March 31, 2011.

The average time deposit costs decreased 41 basis points from 1.90% for the three months ended March 31, 2010 to 1.49% for the three months ended March 31, 2011. In addition, the average cost of money market accounts decreased 15 basis points from 0.66% for the three months ended March 31, 2010 to 0.51% for the three months ended March 31, 2011.

Interest expense in for the three months ended March 31, 2011 totaled $1,897, compared to $2,106 in 2010, a decrease of $209 or 9.9%. The average rate paid on interest-bearing liabilities for the three months ended March 31, 2011 decreased to 1.13%, compared to 1.30% in 2010. Average interest-bearing liabilities increased $21.5 or 3.3% to $669.4 from $647.9 in 2010. Average savings deposits increased $2.5 or 2.2%. Average time deposits increased $39.7 or 19.0% for the three months ended March 31, 2011 due primarily to the issuance of brokered certificates of deposit. Average time deposits represented 37.1% of average interest-bearing liabilities at March 31, 2011, compared to 32.2% at March 31, 2010. Average demand non-interest bearing deposits increased $7.4 or 6.9%.

Historically low interest rates will begin to stress our margin as funding costs have reached a low point and asset yields continue to price downward. The Dodd-Frank financial reform bill passed in 2010 will reduce revenue and increase compliance and regulatory costs.

 

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Distribution of Assets, Liabilities and Stockholders’ Equity / Interest Rates and Interest Differential

The table below presents average balances, interest income on a fully taxable equivalent basis and interest expense, as well as average rates earned and paid on the Company’s major asset and liability items for the three months ended March 31, 2011 and March 31, 2010.

 

     March 31, 2011     March 31, 2010  
ASSETS    Average      Revenue/      Yield/     Average      Revenue/      Yield/  
     Balance      Expense      Rate     Balance      Expense      Rate  

Investment Securities

                

Available-for-sale:

                

U.S. Agency obligations

   $ 105,401       $ 533         2.02   $ 71,333       $ 456         2.56

States & political subdivisions

     62,637         712         6.89     75,442         844         6.78

Other

     5,038         14         1.11     1,925         11         2.29

Held-to-maturity:

                

U.S. Agency obligations

     27,790         282         4.06     22,683         263         4.64

States & political subdivisions

     12,443         155         7.55     22,584         295         7.92

Loans, net of unearned income:

                

Real estate mortgages

     318,396         4,110         5.16     331,684         4,444         5.36

Commercial real estate

     174,345         2,134         4.90     172,271         2,193         5.09

Commercial

     38,559         571         5.92     28,577         513         7.18

Consumer and other

     84,185         1,527         7.26     72,032         1,536         8.53

Federal funds sold

     —           —           —          —           —           —     

Federal Home Loan Bank stock

     5,957         —           —          6,402         —           —     

Interest on balances with banks

     5,893         2         0.14     2,760         2         0.29
                                                    

Total Interest Earning Assets/Total Interest Income

     840,644       $ 10,040         4.99     807,693       $ 10,557         5.52
                                                    

Cash and due from banks

     10,381              10,535         

Bank premises and equipment

     13,438              12,395         

Accrued interest receivable

     3,395              3,888         

Goodwill

     26,398              26,397         

Cash surrender value of life insurance

     15,427              14,428         

Other assets

     11,652              12,772         

Less: Allowance for loan losses

     6,479              6,243         
                            

Total Assets

   $ 914,856            $ 881,865         
                            

LIABILITIES AND STOCKHOLDERS’ EQUITY

                

Deposits:

                

Demand-Interest bearing

   $ 70,154       $ 72         0.41   $ 69,393       $ 94         0.54

Savings

     114,726         77         0.27     112,197         82         0.29

Money markets

     147,306         186         0.51     143,846         237         0.66

Time - Over $100

     84,077         370         1.76     83,187         433         2.08

Time - Other

     164,555         557         1.35     125,705         561         1.79

Federal funds purchased

     —           —           —          8,718         12         0.55

Repurchase agreements

     19,228         24         0.50     18,575         42         0.90

Short-term borrowings

     2,212         3         0.54     20,208         18         0.36

Long-term borrowings

     67,101         608         3.62     66,063         627         3.80
                                                    

Total Interest Bearing Liabilities/Total Interest Expense

     669,359       $ 1,897         1.13     647,892       $ 2,106         1.30
                                                    

Demand - Non-interest bearing

     114,873              107,460         

All other liabilities

     7,008              7,782         

Stockholders’ equity

     123,616              118,731         
                            

Total Liabilities and Stockholders’ Equity

   $ 914,856            $ 881,865         
                                        

Interest Spread

           3.86           4.22
                                        

Net Interest Income

      $ 8,143            $ 8,451      
                            

FINANCIAL RATIOS

                

Net interest margin

           3.87           4.19

Return on average assets

           1.21           1.35

Return on average equity

           8.96           10.04

Average equity to average assets

           13.51           13.46

Dividend payout ratio

           49.41           46.15
                            

 

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Provision for Loan Losses

The provision for loan losses represents the charge to operating expense necessary to maintain the allowance for loan losses at a level which management determines is adequate to absorb probable losses inherent in the Company’s loan portfolio.

The local economy continued to experience the effects of our nation’s economic downturn. The local housing market remained weak and the unemployment rate in Scranton/Wilkes-Barre metropolitan area was 9.4% at March 31, 2011. The Company continues to proactively evaluate probable loan losses and address delinquent loans by, among other things, obtaining current appraisals of collateral and increasing communication with clients.

The Bank’s process for determining the allowance for loan and lease losses (ALLL) is based on a comprehensive, well documented and consistently applied analysis of its loan portfolio. This analysis considers all significant factors that affect the collectability of the loans within our portfolio and supports the credit losses estimated by this process. Our ALLL methodology includes procedures for a review by a party who is independent of the Bank’s credit approval and ALLL estimation processes.

The Bank follows its systematic methodology in accordance with the FFIEC Interagency Policy Statements, as amended, and GAAP in assessing the adequacy of its allowance for loan losses. Under GAAP, the adequacy of the allowance for loan losses is determined based on the provisions of FASB ASC 310 for loans specifically identified to be individually evaluated for impairment and the requirements of FASB ASC 450 for large groups of smaller balance homogeneous loans to be collectively evaluated for impairment. Loans are identified by the Bank’s rating system, past due reports, watch list and sensitivity to economic factors and are then collectively evaluated for impairment compared to other loans utilizing standard criteria. Consideration is given to current local economic conditions which the Company continues to classify as recessionary.

Our historical analysis of loss factors, which utilizes a rolling twenty quarters, was refined in the third quarter of 2010 to assign greater weight to the four quarters of the previous five years that reflected the greatest loan loss allowances. This change in our methodology is designed to better address deterioration in local economic conditions. In addition, and in view of the concentration of the Bank’s loan portfolio in real estate - over 80% of the portfolio is secured by real estate mainly in the counties in which the Bank operates - the Bank also took into account the decline in real estate sales and new construction in our market area and the drop in real estate values within the market area. Our provision for loan losses for the quarter ended March 31, 2011 was allocated somewhat evenly to the commercial and industrial, commercial real estate, residential real estate and consumer portfolio. Reference should be made to the information about the Company’s provision for loan losses under the heading “General Notes to Financial Statements – Note 6 – Loan Portfolio”.

Based on this methodology, management made a provision of $369 for loan losses for the period ended March 31, 2011, compared to a $328 provision for the comparable prior year period. The amount and number of charge-offs and foreclosures during the periods indicated below are as follows:

 

At:

   March 31,
2011
    December 31,
2010
    March 31,
2010
 

Provision for loan losses

   $ 369      $ 1,999      $ 328   

Allowance for loan losses to non-performing loans

     137.84     161.13     286.47

Non-performing loans to period end loans

     0.81     0.66     0.38

Ratio of charged-off loans to average loans

     0.02     0.30     0.02

Ratio of foreclosed loans to average loans

     0.01     0.19     0.10

 

At:

   March 31,
2011
            December 31,
2010
            March 31,
2010
        
     Amount      (#)      Amount      (#)      Amount      (#)  

Charge-offs

   $ 115         15       $ 1,838         102       $ 131         19   

Foreclosures completed

     80         3         1,183         6         578         3   

Non-performing loans

     4,933         79         4,034         70         2,269         45   

 

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The Company had one commercial loan whose terms had been modified in a troubled debt restructuring as of March 31, 2011 and December 31, 2010; monthly payments were lowered to accommodate the borrower’s financial needs for a period of time.

The following table presents loans whose terms were modified in a TDR at the dates indicated below:

 

      March 31,
2011
     December 31,
2010
 

Restructured Loans on Accrual Status and Not Past Due 90 Days or More

   $ —         $ —     

Restructured Loans Included in Non-Accrual Loans or Accruing Loans Past Due 90 Days or More

     394         401   
                 

Total Restructured Loans

   $ 394       $ 401   
                 

The Company believes that the judgments used in establishing the allowance for loan losses are based on reliable information. In assessing the adequacy of the allowance for loan losses, management considers how well prior estimates have related to actual experience. The Company continually monitors the risk elements, historical rates and other data used in establishing the allowance on a periodic basis. Based on this ongoing evaluation, management determines the provision necessary to maintain an appropriate allowance.

The methodology of determining the adequacy of the allowance is necessarily judgmental and subject to changes in external conditions. Accordingly, there can be no assurance that existing levels of the allowance will ultimately prove adequate to cover actual loan losses. Although management uses available information to establish the appropriate level of the allowance for loan losses, future additions or reductions to the allowance may be necessary, based on estimates that are susceptible to change, as a result of changes in economic conditions and other factors. As a result, our allowance for loan losses may not be sufficient to cover actual loan losses, and future provisions for loan losses could materially adversely affect the Company’s operating results. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may require the Company to recognize adjustments to the allowance based on their judgments about information available to them at the time of their examination.

There are also no particular risk elements in the local economy that put a group or category of loans at increased risk, however, the Company has increased its portfolio of commercial loans, which typically bear a higher risk. These loans are typically secured by real estate to minimize this risk. At March 31, 2011, management believes the allowance for loan losses is adequate to absorb probable loan losses inherent in the loan portfolio.

Non-Interest Income

The following table sets forth information by category of non-interest income for the Company for the three months ended March 31, 2011 and March 31, 2010, respectively:

 

Three Months Ended:

   March 31,
2011
     March 31,
2010
 

Trust department income

   $ 398       $ 380   

Service charges on deposit accounts

     472         532   

Merchant transaction income

     1,242         1,194   

Brokerage fee income

     56         70   

Other fee income

     378         350   

Bank-owned life insurance income

     120         122   

Other operating income

     630         61   

Realized gains (losses) on securities, net

     8         2   
                 

Total Non-Interest Income

   $ 3,304       $ 2,711   
                 

Total non-interest income increased $593 or 21.9%, to $3,304 for the three months ended March 31, 2011, compared with $2,711 for the same period in 2010. Service charges on deposit accounts decreased $60 or 11.3%, primarily due to decreased overdraft activity. Merchant transaction income increased $48 or 4.0%, due to the increased volume of merchant transactions primarily from new business. Brokerage fee income decreased $14 or 20.0%, mostly due to a lower volume of investor activity. Other fee income increased $28 or 8.0%, mainly due to increased debit card discounts of $27 related to the increased number of new accounts and organic growth. Other operating income increased $569 largely due to the reversal of a contingent liability of $500 recorded in connection with the Old Forge Bank acquisition and gains on the sale of low-yielding long-term fixed rate real estate loans of $48. Realized gains (losses) on securities, net, increased $6 as a result of investment securities being called.

 

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Non-Interest Expenses

The following table sets forth information by category of non-interest expenses for the Company for the three months ended March 31, 2011 and March 31, 2010, respectively:

 

Three Months Ended:

   March 31,
2011
     March 31,
2010
 

Salaries and employee benefits

   $ 3,525       $ 3,173   

Expense of premises and fixed assets

     1,021         950   

Merchant transaction expenses

     833         811   

FDIC insurance assessments

     242         266   

Other operating expenses

     1,829         1,837   
                 

Total Non-Interest Expenses

   $ 7,450       $ 7,037   
                 

Total non-interest expenses increased $413 or 5.9%, to $7,450 for the three months ended March 31, 2011 compared with $7,037 for the same period in 2010. Salaries and employee benefits expense increased $352 or 11.1%, due primarily to merit increases in salaries of existing personnel and increased staffing for loan production and monitoring asset quality. Expense of premises and fixed assets increased $71 or 7.5% largely due to increased occupancy expenses and additional depreciation from branch renovations. Merchant transaction expenses increased $22 or 2.7% due to the increased volume of merchant transactions. FDIC insurance assessments decreased $24 or 9.0% in 2011.

Income Taxes

Applicable income taxes increased $43 or 5.3% due to higher taxable income for the three months ended March 31, 2011.

Investments

The Company’s investment portfolio has two primary functions: to provide liquidity and to contribute to earnings. To provide liquidity, the Company may invest in short-term securities such as Federal funds sold, interest bearing deposits with banks, U.S. Treasury securities and U.S. Agency securities all with maturities of one year or less. These funds are invested short-term to ensure the availability of funds to meet customer demand for credit needs. The Company enhances interest income by securing long-term investments within its investment portfolio, by means of U.S. Treasury securities, U.S. Agency securities, municipal securities and mortgage-backed securities, generally with maturities greater than one year. The Company’s mortgage-backed securities portfolio does not contain any sub-prime or Alt-A credits.

The following table presents the carrying value, by security type and by maturity, for the Company’s investment portfolio during the periods indicated:

 

     March 31, 2011      December 31, 2010  

U.S. Agency obligations

   $ 128,400       $ 134,541   

States & political subdivisions

     74,788         77,428   

Corporate securities

     4,071         4,090   
                 

Total Debt Securities

     207,259         216,059   

Equity Securities

     1,305         985   
                 

Total Investment Securities

   $ 208,564       $ 217,044   
                 

Federal Home Loan Bank Stock Impairment Evaluation

The Company’s banking subsidiary, Penn Security Bank, is required to maintain certain amounts of Federal Home Loan Bank, or FHLB, stock in order to participate in a FHLB line of credit program. The FHLB stock is stated at par value as it is restricted to purchases and sales with the FHLB. FHLB stock is less liquid than other tradable equity securities and the fair value is equal to cost. No impairment write-downs have been recorded on FHLB stock during 2011 or 2010.

 

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The FHLB had suspended its stock repurchase and dividend payments during December 2008. A reduction in the level of core earnings resulting from lower short-term interest rates, the increased cost of maintaining liquidity and constrained access to the debt markets at attractive rates and maturities are the main reasons the FHLB cited as significant for the decision to suspend dividends and the repurchase of excess capital stock. Accounting guidance indicates that investors should recognize impairment in FHLB Pittsburgh capital stock if it is determined that it is not probable that the Bank will ultimately recover the par value of its shares. An investor in FHLB Pittsburgh must determine whether impairment exists based on its long-term performance, the severity and duration of declines in the market value of its net assets related to its capital stock amount, its commitment to make payments required by law or regulation and the level of such payments in relation to its operating performance, the impact of legislation and regulatory changes and its liquidity. During the first quarter of 2011, the FHLB repurchased $304 of capital stock which represented 5.0% of the Bank’s $6,082 investment. Also, during 2010, the Company received $320 of capital stock which represented 5.0% of the Bank’s $6,402 investment at that time. Based on current financial information available, management does not believe the FHLB stock value is impaired as of March 31, 2011.

Loan Portfolio

Details regarding the Company’s loan portfolio at the dates indicated are as follows:

 

     March 31,
2011
     December 31,
2010
 

Commercial Secured by Real Estate

   $ 192,638       $ 207,964   

Residential Real Estate

     298,341         295,301   

Commercial and Industrial

     38,969         36,190   

Consumer

     54,093         55,862   

State & Political Subdivisions

     16,882         9,882   

All Other

     10,098         9,906   
                 

Loans net of Unearned Income

   $ 611,021       $ 615,105   
                 

There were no purchased loans as of March 31, 2011 other than loan participations with local banks. Originations of new loans are primarily in loans secured by real estate with an emphasis on commercial loans.

The Company has not engaged in any sub-prime residential mortgage lending. Therefore, the Company is not subject to any credit risks associated with such loans. The Company’s loan portfolio consists primarily of residential and commercial mortgage loans secured by properties located in Northeastern Pennsylvania and subject to conservative underwriting standards.

Loans secured by real estate continue to be the largest component of the loan portfolio, representing 80% and 82% of total loans at March 31, 2011 and December 31, 2010, respectively. Recent economic conditions and recessionary concerns have resulted in lower levels of loan demand. Accordingly, we expect that loan growth may be slower than historically expected.

Loan Quality

The lending activities of the Company are guided by the comprehensive lending policy established by the Board of Directors. Loans must meet certain criteria relating to the character, capacity and capital of the borrower, collateral provided for the loan, and prevailing economic conditions. Due to the consistent application of conservative underwriting standards, the Company’s loan quality has remained strong during the current general economic downturn.

Regardless of credit standards, there is risk of loss inherent in every loan portfolio. The allowance for loan losses is an amount that management believes will be adequate to absorb probable losses on existing loans that may become uncollectible, based on evaluations of the collectability of the loans. The evaluations take into consideration such factors as change in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, industry experience, collateral value and current economic conditions that may affect the borrower’s ability to pay. Management believes that the allowance for loan losses was adequate as of March 31, 2011. While management uses available information to estimate probable losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may require the Company to recognize additions to the allowance based on their judgment of information available to them at the time of their examination.

 

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The allowance for loan losses is increased by periodic charges against earnings as a provision for loan losses, and decreased periodically by charge-offs of loans (or parts of loans) management has determined to be uncollectible, net of actual recoveries on loans previously charged-off.

The allowance for loan loss as a percentage of loans was 1.11% at March 31, 2011, compared to 1.06% at December 31, 2010 and 1.07% at March 31, 2010.

Market Area

Our market area has been affected by the economic decline that has affected the U.S. economy as a whole. The unemployment rate for the Scranton/Wilkes-Barre metropolitan area was 9.4% at March 31, 2011. Although this unemployment rate reflected a modest improvement compared to the regional unemployment rate at December 31, 2010, it is still the highest unemployment rate among Pennsylvania’s 14 metro areas and remains above the national unemployment rate of 8.8%. The high unemployment rate can be attributed to a gradual decline in manufacturing in Northeastern Pennsylvania, and much like the rest of the country, a slowdown in construction of residential and commercial property.

Improved labor conditions and a drop in unemployment did little to affect the foreclosure rate for the Scranton/Wilkes-Barre metropolitan area. In January 2011, foreclosure actions hit a new high, rising to 3.3% of all mortgaged properties. Although the pace of foreclosures has decreased, one of the strengths of the Northeastern Pennsylvania housing market is that it was not impacted by the loss of home equity that has affected the rest of the country. The Case-Shiller House Price Index for Northeastern Pennsylvania has not changed from December 2010. High unemployment in Northeastern Pennsylvania will continue to put pressure on the local economy and on our loan portfolio. We believe that our focus on identifying borrowers who are facing cash flow problems before they are unable to make their payments will significantly improve our ability to help these borrowers through difficult times.

Non-Performing Assets

Non-performing assets consist of non-accrual loans and other real estate owned. The following table sets forth information regarding non-performing assets and loans past due 90 days or more and still accruing interest as of the dates indicated:

 

As of:

   March 31,
2011
     December 31,
2010
     March 31,
2010
 

Non-accrual loans

        

Residential real estate

   $ 2,477       $ 1,579       $ 1,506   

Commercial real estate

     1,235         1,385         416   

Commercial loans

     1,154         977         167   

Consumer loans

     67         93         180   
                          

Total non-performing loans

   $ 4,933       $ 4,034       $ 2,269   
                          

Other real estate owned

     883         803         937   
                          

Total non-performing assets

   $ 5,816       $ 4,837       $ 3,206   
                          

Loans past due 90 days or more and accruing:

        

Secured by real estate

   $ 988       $ 1,236       $ 1,362   

Guaranteed student loans

     60         268         117   

Credit card loans

     26         20         12   

Commercial loans

     —           100         —     

Consumer loans

     34         6         2   
                          

Total loans past due 90 days or more and accruing

   $ 1,108       $ 1,630       $ 1,493   
                          

Loans are generally placed on a non-accrual status when principal or interest is past due 90 days and when payment in full is not anticipated. When a loan is placed on non-accrual status, all interest previously accrued but not collected is charged against current income. Loans are returned to accrual status when past due interest is collected and the collection of future principal and interest is probable.

During the second quarter of 2008, the Company was notified that The Education Resources Institute, Inc. (TERI), a guarantor of a portion of our student loan portfolio, had filed for reorganization under Chapter 11 of the Federal Bankruptcy Act. As of March 31, 2011, the Company had $7,279 of TERI loans out of a total student loan portfolio of $16,011. The Company does not anticipate that TERI’s bankruptcy filing will significantly impact the Company’s financial statements. These loans are placed on non-accrual status when they become more than 90 days past due. As of March 31, 2011 there was $61 of such loans placed on non-accrual status.

 

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Loans on which the accrual of interest has been discontinued or reduced amounted to $4,933 or 0.81% of loans at March 31, 2011, representing an increase of $2,664 from $2,269 or 0.38% of loans at March 31, 2010 and an increase of $899 from $4,034 or 0.66% of loans at December 31, 2010. The 2011 increase in non-accrual residential real estate loans is due to the continued high unemployment rate, both locally and nationally, and the effects of the slow economy on customers’ ability to repay loans, and delays at the county level in acquiring properties through foreclosure. The Company applies a conservative valuation of the property in assessing collectability, and historically has had a low charge-off ratio. Therefore, the Company believes adequate allowances have been provided. The 2010 increase can be attributed primarily to three commercial borrowers which are well secured and under continuous monitoring by Management. In each case the Bank has taken a charge-off or provided a specific reserve as reflected in the current recorded loan balance in the applicable financial statements. If interest on those loans had been accrued, such income would have been $91 and $43 for the three months ended March 31, 2011 and March 31, 2010, respectively. Interest income on those loans, which is recorded only when received, amounted to $0 for the three months ended March 31, 2011 and March 31, 2010. There are no commitments to lend additional funds to individuals whose loans are in non-accrual status.

Real estate loans of $988 that are past due 90 days or more and still accruing are primarily 1-4 family residential loans with favorable loan-to-value ratios and in the process of collection.

Management’s process for evaluating the adequacy of the allowance for loan losses includes reviewing each month’s loan committee reports which list all loans that do not meet certain internally developed criteria as to collateral adequacy, payment performance, economic conditions and overall credit risk. These reports also address the current status and actions in process on each listed loan. From this information, adjustments are made to the allowance for loan losses. Such adjustments include both specific loss allocation amounts and general provisions by loan category based on present and past collection experience, nature and volume of the loan portfolio, overall portfolio quality, and current economic conditions that may affect the borrower’s ability to pay.

As of March 31, 2011, the Company had total impaired loans of $5,396. Management performed an evaluation of expected future cash flows, including the anticipated cash flow from the sale of collateral, and compared that to the carrying amount of the impaired loans. Based on these evaluations, the Company determined that a reserve of $1,426, included in the allowance for loan losses, was required against impaired loans at March 31, 2011.

Most of the Company’s lending activity is with customers located in the Company’s geographic market area and repayment thereof is affected by economic conditions in this market area.

Loan Loss Experience

The following table presents the Company’s loan loss experience during the periods indicated:

 

Three Months Ended:

   March 31,
2011
    March 31,
2010
 

Balance at beginning of period

   $ 6,500      $ 6,300   

Charge-offs:

    

Residential real estate mortgages

     61        4   

Commercial real estate and all others

     —          —     

Credit card and related plans

     20        11   

Installment loans

     34        116   
                

Total charge-offs

     115        131   
                

Recoveries:

    

Residential real estate mortgages

     18        —     

Commercial real estate and all others

     1        —     

Credit card and related plans

     1        —     

Installment loans

     26        3   
                

Total recoveries

     46        3   
                

Net charge-offs (recoveries)

     69        128   
                

Provision charged to operations

     369        328   
                

Balance at End of Period

   $ 6,800      $ 6,500   
                

Ratio of net charge-offs (recoveries) to average loans outstanding

     0.01     0.02
                

 

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The allowance for loan losses at March 31, 2011 was $6,800 or 1.11% of total loans compared to $6,500 or 1.06% of total loans at December 31, 2010 and $6,500 or 1.07% of total loans at March 31, 2010.

The allowance for loan losses is allocated as follows:

 

As of:

   March 31, 2011            December 31, 2010            March 31, 2010        
     Amount      %     *      Amount      %     *      Amount      %     *  

Residential real estate

   $ 788         49      $ 800         48      $ 800         51  

Commercial real estate and all others

     4,209         42        4,000         40        4,000         39  

Credit card and related plans

     359         1        350         1        350         1  

Personal installment loans

     1,444         8        1,350         11        1,350         9  
                                                           

Total

   $ 6,800         100      $ 6,500         100      $ 6,500         100  
                                                           

 

* Percent of loans in each category to total loans

Our non-performing loans increased from $2,269 at March 31, 2010 to $4,933 at March 31, 2011. As of March 31, 2011, our non-performing loans were comprised of seventy-nine loans of which sixteen loans were in excess of one hundred thousand dollars in size and the remainder of which were less than one hundred thousand dollars each. As of March 31, 2010, our non-performing loans were comprised of forty-five loans of which six loans are in excess of one hundred thousand dollars and the remainder of which are less than one hundred thousand dollars. The increase in the non-performing loans can be attributed, to a large extent, to the following factors: (1) the addition of a large land development credit and two commercial loans, (2) the continuing deterioration in the economic conditions both locally and regionally, and (3) the widely depressed housing and real estate construction market.

The decrease in asset quality has been addressed by maintaining an adequate loss allowance. As of March 31, 2011, the total of the allowance for loan losses was $6,800. The level of loan loss coverage reflects management’s conservative view of the local economic conditions and an appropriate increase in the allowance for loan losses. As a result of the economic conditions in our market area and the increase in non-performing loans, management has undertaken the following actions beginning in 2009:

 

 

Adjusted the credit policy in 2009 to lower the maximum loan-to-value ratios on commercial real estate loans and certain consumer loans;

 

 

Hired a former bank examiner in February 2010 to perform loan reviews on a full time basis and to enhance our allowance for loan loss methodology for implementation in the third quarter of 2010 which did not have any appreciable impact on the required level on loan loss allowance;

 

 

Contracted with a credit professional in March 2010 to assess the soundness of the small business underwriting function as well as the appropriateness of the Company’s established methodology for determining the allowance for loan losses;

 

 

As a result of the local and national weakness in the real estate industry, and to mitigate or prevent loan loss, the Bank orders a current appraisal of the collateral securing such loan after it is 90 days delinquent to assess the current loan to value ratio.

Deposits

Details regarding the Company’s deposit portfolio at the dates indicated are as follows:

 

     March 31,
2011
     December 31,
2010
 

Demand - Non-interest bearing

   $ 113,551       $ 113,391   

Demand - Interest bearing

     68,382         70,989   

Savings

     118,168         113,382   

Money markets

     151,243         144,206   

Time - Over $100,000

     83,776         85,404   

Time - Other

     165,361         163,660   
                 

Total

   $ 700,481       $ 691,032   
                 

 

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As of March 31, 2011, the Company had Certificate of Deposit Account Registry Service (“CDARS”) reciprocal deposits in the amount of $19.7 million. The Company also issues brokered certificates of deposit from time to time as an alternative to wholesale funding. As of March 31, 2011, the dollar amount of brokered deposits, exclusive of CDARS reciprocal deposits, was $49.5 million or 7.1% of total deposits, compared to $51.3 million or 7.4% at December 31, 2010.

The Company is largely dependent on its core deposit base to fund operations. Management has competitively priced its deposit products in checking, savings, money market and time deposits to provide a stable source of funding.

As general interest rates in the economy change, some deposits migrate towards investment with higher anticipated yields.

Liquidity

The objective of liquidity management is to maintain a balance between sources and uses of funds in such a way that the cash requirements of customers for loans and deposit withdrawals are met in the most economical manner. Management monitors its liquidity position continuously in relation to trends of loans and deposits for short-term as well as long-term requirements. Liquid assets are monitored on a daily basis to assure maximum utilization. Management also manages its liquidity requirements by maintaining an adequate level of readily marketable assets and access to short-term funding sources. Management does not foresee any adverse trends in liquidity.

The Company remains in a highly liquid condition both in the short and long term. Sources of liquidity include the Company’s U.S. Agency bond portfolios, additional deposits, earnings, overnight loans to and from other companies (Federal Funds) and lines of credit at the Federal Reserve Bank and the Federal Home Loan Bank (FHLB). The Company is not a party to any commitments, guarantees or obligations that could materially affect its liquidity.

The Company offers collateralized repurchase agreements, which have a one day maturity, as an alternative deposit option for its customers. The repurchase agreements are accounted for as a collateralized borrowing with a one day maturity and are collateralized by U.S. Agency securities. The Company also has long-term debt outstanding to the FHLB, which was used to purchase a Freddie Mac pool of residential mortgages. At March 31, 2011 the Company had $237,819 of available borrowing capacity with the FHLB, a Borrower-In-Custody (BIC) line of credit of $23,863 with the Federal Reserve Bank of Philadelphia, available borrowing capacity at the Discount Window of $30,389, an overnight Federal funds line of credit of $19,000 with PNC Bank and an overnight Federal funds line of credit of $5,000 with Wells Fargo.

The Company is a separate legal entity from the Bank and must provide for its own liquidity. In addition to its operating expenses, the Company is responsible for paying any dividends declared to its shareholders. The Company’s primary source of income is dividends received from the Bank. The amount of dividends that the Bank may declare and pay to the Company is generally restricted under Pennsylvania law to the retained earnings of the Bank.

Commitments and Contingent Liabilities

In the normal course of business, there are outstanding commitments and contingent liabilities, created under prevailing terms and collateral requirements such as commitments to extend credit, financial guarantees and letters of credit, which are not reflected in the accompanying Financial Statements. The Company does not anticipate any losses as a result of these transactions. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the Balance Sheets.

The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have expiration dates of one year or less or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.

Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.

During 2010 the Bank had executed purchase agreements in the amount of one million dollars for land in Scranton, Pennsylvania, to be used for construction of a new branch facility. The Bank has received regulatory approval for the establishment of this new branch office.

 

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Related Parties

The Company does not have any material transactions involving related persons or entities, other than traditional banking transactions, which are made on the same terms and conditions as those prevailing at the time for comparable transactions with unrelated parties. At March 31, 2011, the Bank has issued standby letters of credit for the accounts of related parties in the amount of $7,785.

Capital Resources

A strong capital position is important to the continued profitability of the Company and promotes depositor and investor confidence. The Company’s capital provides a basis for future growth and expansion and also provides additional protection against unexpected losses.

Additional sources of capital would come from retained earnings from the operations of the Company and from the sale of additional shares of common stock. Management has no plans to offer additional shares of common stock at this time.

The Company’s total risk-based capital ratio was 16.88% at March 31, 2011. The Company’s risk-based capital ratio is more than the 10.00% ratio that Federal regulators use as the “well capitalized” threshold under the Federal prompt corrective action regulations. This is the current criteria which the FDIC uses in determining the lowest insurance rate for deposit insurance. The Company’s risk-based capital ratio is more than double the 8.00% minimum threshold, which determines whether a company is “adequately capitalized”. Under these rules, the Company could significantly increase its assets and still comply with these capital requirements without the necessity of increasing its equity capital.

Non-GAAP Financial Measures

Core Earnings Calculation

Certain financial measures reported herein exclude the effect of the reversal of a contingent liability recorded in the Merger. Management of the Company believes that investors’ understanding of the Company’s performance is enhanced by disclosing these non-GAAP financial measures as a reasonable basis for comparison of the Company’s ongoing results of operations. These non-GAAP measures should not be considered a substitute for GAAP-basis measures and results. Our non-GAAP measures may not be comparable to non-GAAP measures of other companies. The Non-GAAP Reconciliation Schedule provides a disclosure of these non-GAAP financial measures to the most closely analogous measure determined in accordance with GAAP.

The following table presents the reconciliation of non-GAAP financial measures to reported GAAP financial measures.

 

    

Three Months Ended

March 31,

       
     2011     2010     Change  

Net interest income after provision for loan losses

   $ 7,774      $ 8,123      $ (349

Non-interest income

     3,304        2,711        593   

Non-interest expense

     (7,450     (7,037     (413

Income tax (provision) benefit

     (859     (816     (43
                        

Net income

     2,769        2,981        (212

Adjustments

      

Non-interest income

      

Reversal of a contingent liability

     (500     —          (500
                        

Total adjustments pre-tax

     (500     —          (500

Income tax provision (benefit)

     170        —          170   
                        

After tax adjustments to GAAP

     (330     —          (330
                        

Adjusted “net income from core operations”

   $ 2,439      $ 2,981      $ (542
                        

Adjusted Return on Average Assets

     1.07     1.35  

Adjusted Return on Average Equity

     7.89     10.04  

Adjusted Dividend Payout Ratio

     56.76     46.15  

 

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Return on average equity (ROE) and return on average assets (ROA) for the three months ended March 31, 2011 was 8.96% (7.89% excluding the reversal of a contingent liability) and 1.21% (1.07% excluding the reversal of a contingent liability), respectively. ROE was 10.04% and ROA was 1.35% for the same period last year. The dividend payout ratio was 49.41% (56.76% excluding the reversal of a contingent liability) for the three months ended March 31, 2011 and 46.15% for the same period last year.

Allowance for Loan Losses and Credit Fair Value Adjustment

The Company has provided for anticipated loan losses through the allowance for loan losses and a credit fair value adjustment on loans acquired, as shown below:

 

     March 31,     December 31,     March 31,  
     2011     2010     2010  

Loans, net of unearned income

   $ 611,021      $ 615,105      $ 604,815   

Credit fair value adjustment on purchased loans

     3,290        3,579        5,483   
                        

Total adjusted loans

   $ 614,311      $ 618,684      $ 610,298   
                        
     March 31,     December 31,     March 31,  
     2011     2010     2010  

Allowance for loan losses

   $ 6,800      $ 6,500      $ 6,500   

Credit fair value adjustment on purchased loans

     3,290        3,579        5,483   
                        

Total allowance

   $ 10,090      $ 10,079      $ 11,983   
                        

Total allowance to adjusted loans

     1.64     1.63     1.96

Management believes that the above information, as to the Company’s evaluation of probable credit losses and its effect on results of operations and financial condition, is useful to investors.

Item 3. Quantitative and Qualitative Disclosure About Market Risk

The Company currently does not enter into derivative financial instruments, which include futures, forwards, interest rate swaps, option contracts and other financial instruments with similar characteristics. However, the Company is party to traditional financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, financial guarantees and letters of credit. These traditional instruments involve to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the Consolidated Balance Sheets.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party up to a stipulated amount and with specified terms and conditions.

Commitments to extend credit and standby letters of credit are not recorded as an asset or liability by the Company until the instrument is exercised.

The Company’s exposure to market risk is reviewed on a regular basis by the Asset/Liability Committee. Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximizing income. Management realizes certain risks are inherent and that the goal is to identify and minimize the risks. Tools used by management include the standard GAP report and an interest rate shock simulation report. The Company has no market risk sensitive instruments held for trading purposes. It appears the Company’s market risk is reasonable at this time.

For a discussion of the Company’s asset and liability management policies, as well as the potential impact of interest rate changes upon the market value of the Company’s financial instruments, see Item 7A in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010. Management, as part of its regular practices, performs periodic reviews of the impact of interest rate changes upon net interest income and market value of the Company’s portfolio equity. Based on, among other factors, such reviews, management believes that there have been no material changes in the market risk of the Company’s asset and liability position since December 31, 2010.

 

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Item 4. Controls and Procedures

Under the supervision and with the participation of the Company’s management, including our Chief Executive Officer and Finance Division Head, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) under the Securities Exchange Act of 1934. Based upon this evaluation, the Company’s Chief Executive Officer and the Company’s Finance Division Head concluded that our disclosure controls and procedures were effective as of the end of the period covered by this quarterly report.

No changes in our internal control over financial reporting occurred during the quarter ended March 31, 2011 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1 — Legal Proceedings

None.

Item 1A — Risk Factors

There are no material changes to the risk factors set forth in Part I, Item 1A, “Risk Factors,” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, which was filed with the Securities and Exchange Commission (SEC) on March 14, 2011. Please refer to that section for disclosures regarding the risks and uncertainties related to the company’s business.

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

None.

Item 3 — Defaults Upon Senior Securities

None.

Item  4 — Removed and Reserved

Item 5 — Other Information

None.

Item 6 — Exhibits

 

  3.1.1 Amendment to Articles of Incorporation of Penseco Financial Services Corporation, dated March 10, 2011 (incorporated by reference to Exhibit 3.1.2 of the Registrant’s annual report on Form 10-K filed with the SEC on March 14, 2011)

 

  10.1 Employment Agreement, dated January 3, 2011, among Penseco Financial Services Corporation, Penn Security Bank & Trust, and Craig W. Best (incorporated by reference to Exhibit 10.1 of the Registrant’s current report on Form 8-K filed with the SEC on January 7, 2011)

 

  31 Rule 13a-14(a) / 15-d-4(a) Certifications

 

  32 Section 1350 Certifications

 

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SIGNATURES

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

 

PENSECO FINANCIAL SERVICES CORPORATION
By  

/s/ CRAIG W. BEST

  Craig W. Best
  President and CEO
  (Principal Executive Officer)
Dated: May 9, 2011
By  

/s/ PATRICK SCANLON

  Patrick Scanlon
  Senior Vice President, Finance Division Head
  (Principal Financial Officer)
Dated: May 9, 2011

 

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