Citizens & Northern Corp - 10-K annual report

 

 

(Exact name of Registrant as specified in its charter)

570-724-3411
(Registrant’s telephone number including area code)

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to section 12(g) of the Act: None

Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes o No þ

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

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 þ No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

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

Large accelerated filer o Accelerated filer þ Non-accelerated filer o

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

The aggregate market value of the registrant’s common stock held by non-affiliates at June 30, 2006, the registrant’s most recently completed second fiscal quarter, was $190,710,304.

The number of shares of common stock outstanding at February 22, 2007 was 8,292,759.

Portions of the registrant’s proxy statement for the annual meeting of its shareholders to be held April 17, 2007 are incorporated by reference into Parts III and IV of this report.

 

Citizens & Northern Corporation (“Corporation”) is a holding company whose principal activity is community banking. The Corporation’s principal office is located in Wellsboro, Pennsylvania. The largest subsidiary is Citizens & Northern Bank (“C&N Bank”). In the third quarter 2005, the Corporation completed the acquisition of Canisteo Valley Corporation and its subsidiary, First State Bank, a New York State chartered commercial bank with offices in Canisteo and South Hornell, NY. The acquisition of Canisteo Valley Corporation and First State Bank permits expansion of Citizens & Northern Corporation’s banking operations into communities located in the southern tier of New York State, in close proximity to many of the northern Pennsylvania branch locations. Management considers the New York State branches to be part of the same community banking operating segment as the Pennsylvania locations; however, the separate New York State charter for First State Bank has been maintained because of certain regulatory advantages. The Corporation’s other wholly-owned subsidiaries are Citizens & Northern Investment Corporation and Bucktail Life Insurance Company (“Bucktail”). Citizens & Northern Investment Corporation was formed in 1999 to engage in investment activities. Bucktail reinsures credit and mortgage life and accident and health insurance on behalf of the Bank.

In December 2006, the Corporation, along with Citizens Bancorp, Inc. (“Citizens”), announced the signing of an Agreement and Plan of Merger. Citizens is the parent company of Citizens Trust Company (“CTC”), a commercial bank with offices in the Pennsylvania communities of Coudersport, Emporium and Port Allegany. As of December 31, 2006, Citizens reported total assets of $144.4 million. Under the terms of the Agreement and Plan of Merger, Citizens will merge into the Corporation, and CTC will merge into C&N Bank. In the aggregate, 50% of the shares of Citizens common stock will be purchased for cash and 50% of the shares of Citizens common stock will be exchanged for shares of Corporation common stock. Based on the number of Citizens common shares outstanding on December 31, 2006, and the last trading price of the Corporation’s common stock in 2006, the total purchase consideration is valued at approximately $29 million. The transaction, which has been approved by the Board of Directors of both companies, is expected to be completed during the second quarter 2007. Consummation of the Merger is subject to approval by Citizens’ shareholders, regulatory approvals and other customary conditions of closing.

C&N Bank is a Pennsylvania banking institution that was formed by the consolidation of Northern National Bank of Wellsboro and Citizens National Bank of Towanda on October 1, 1971. Subsequent mergers included: First National Bank of Ralston in May 1972; Sullivan County National Bank in October 1977; Farmers National Bank of Athens in January 1984; and First National Bank of East Smithfield in May 1990. C&N Bank has held its current name since May 6, 1975, at which time C&N Bank changed its charter from a national bank to a Pennsylvania bank.

C&N Bank and First State Bank (collectively, the “Banks”) provide an extensive range of banking services, including deposit and loan products for personal and commercial customers. C&N Bank also maintains a trust division that provides a wide range of financial services, such as 401(k) plans, retirement planning, estate planning, estate settlements and asset management. In January 2000, C&N Bank formed a subsidiary, C&N Financial Services Corporation (“C&NFSC”). C&NFSC is a licensed insurance agency that provides insurance products to individuals and businesses. In 2001, C&NFSC added a broker-dealer division, which offers mutual funds, annuities, educational savings accounts and other investment products through registered agents. C&NFSC’s operations are not significant in relation to the total operations of the Corporation.

All phases of the Banks’ business are competitive. The Banks primarily compete in Tioga, Bradford, Sullivan and Lycoming counties in Pennsylvania, and Steuben and Allegany counties in New York. The Banks compete with local commercial banks headquartered in our market area as well as other commercial banks with branches in our market area. Some of the banks that have branches in the Banks’ market area are larger in overall size than the Banks. With respect to lending activities and attracting deposits, the Banks also compete with savings banks, savings and loan associations, insurance companies, regulated small loan companies and credit unions. Also, the Banks compete with mutual funds for deposits. C&N Bank competes with insurance companies, investment counseling firms, mutual funds and other business firms and individuals for trust, investment management, brokerage and insurance services. The Banks are generally competitive with all financial institutions in our service area with respect to interest rates paid on time and savings deposits, service charges on deposit accounts and interest rates charged on loans. The Banks serve a diverse customer base, and are not economically dependent on any small group of customers or on any individual industry.

Major initiatives over the last 5 years included the following:

At December 31, 2006, C&N Bank had total assets of $1,063,970,000, total deposits of $725,983,000, net loans outstanding of $659,370,000 and 346 full-time equivalent employees. At December 31, 2006, First State Bank had total assets of $42,889,000, total deposits of $35,241,000, net loans outstanding of $19,930,000 and 20 full-time equivalent employees.

Most of the activities of the Corporation and its subsidiaries are regulated by federal or state agencies. The primary regulatory relationships are described as follows:

A copy of the Corporation’s annual report on Form 10-K, quarterly reports on Form 10-Q, current events reports on Form 8-K, and amendments to these reports, will be furnished without charge upon written request to the Corporation’s Treasurer at P.O. Box 58, Wellsboro, PA 16901. Copies of these reports will be furnished as soon as reasonably possible, after they are filed electronically with the Securities and Exchange Commission. The information is also available through the Corporation’s web site at www.cnbankpa.com.

The Corporation is subject to the many risks and uncertainties applicable to all banking companies, as well as risks specific to the Corporation’s geographic locations. Although the Corporation seeks to effectively manage risks, and maintains a level of equity that exceeds the banking regulatory agencies’ thresholds for being considered “well capitalized” (see Note 21 to the consolidated financial statements), management cannot predict the future and cannot eliminate the possibility of credit, operational or other losses. Accordingly, actual results may differ materially from management’s expectations. Some of the Corporation’s significant risks and uncertainties are discussed below.

Credit Risk from Lending Activities — A significant source of risk is the possibility that losses will be sustained because borrowers, guarantors and related parties may fail to perform in accordance with the terms of their loan agreements. Most of the Corporation’s loans are secured, but some loans are unsecured. With respect to secured loans, the collateral securing the repayment of these loans may be insufficient to cover the obligations owed under such loans. Collateral values may be adversely affected by changes in economic, environmental and other conditions, including declines in the value of real estate, changes in interest rates, changes in monetary and fiscal policies of the federal government, wide-spread disease, terrorist activity, environmental contamination and other external events. In addition, collateral appraisals that are out of date or that do not meet industry recognized standards may create the impression that a loan is adequately collateralized when it is not. The Corporation has adopted underwriting and credit monitoring procedures and policies, including regular reviews of appraisals and borrower financial statements, that management believes are appropriate to mitigate the risk of loss. Also, as discussed further in the “Provision and Allowance for Loan Losses” section of Management’s Discussion and Analysis, the Corporation attempts to estimate the amount of losses that may be inherent in the portfolio through a quarterly evaluation process that includes several members of management and that addresses specifically identified problem loans, as well as other quantitative data and qualitative factors. Such risk management and accounting policies and procedures, however, may not prevent unexpected losses that could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity.

Interest Rate Risk — Business risk arising from changes in interest rates is an inherent factor in operating a banking organization. The Corporation’s assets are predominantly long-term, fixed rate loans and debt securities. Funding for these assets comes principally from shorter-term deposits and borrowed funds. Accordingly, there is an inherent risk of lower future earnings or decline in fair value of the Corporation’s financial instruments when interest rates change. Significant fluctuations in interest rates could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity. For additional information regarding interest rate risk, see Part II, Item 7A, “Quantitative and Qualitative Disclosures About Market Risk.”

Equity Securities Risk - The Corporation’s equity securities portfolio consists primarily of investments in stocks of banks and bank holding companies, mainly based in Pennsylvania. Investments in bank stocks are subject to the risk factors affecting the banking industry, and that could cause a general market decline in the value of bank stocks. Also, losses could occur in individual stocks held by the Corporation because of specific circumstances related to each bank. Further, because of the concentration of its holdings in Pennsylvania banks, these investments could decline in value if there were a downturn in the state’s economy. These factors could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity. For additional information regarding equity securities risk, see Part II, Item 7A, “Quantitative and Qualitative Disclosures About Market Risk.”

Breach of Information Security and Technology Dependence — The Corporation relies on software, communication, and information exchange on a variety of computing platforms and networks and over the Internet. Despite numerous safeguards, the Corporation cannot be certain that all of its systems are entirely free from vulnerability to attack or other technological difficulties or failures. The Corporation relies on the services of a variety of vendors to meet its data processing and communication needs. If information security is breached or other technology difficulties or failures occur, information may be lost or misappropriated, services and operations may be interrupted and the Corporation could be exposed to claims from customers. Any of these results could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity.

Limited Geographic Diversification — The Corporation grants commercial, residential and personal loans to customers primarily in the Pennsylvania Counties of Tioga, Bradford, Sullivan and Lycoming, and in Steuben and Allegany Counties in New York State. Although the Corporation has a diversified loan portfolio, a significant portion of its debtors’ ability to honor their contracts is dependent on the local economic conditions within the region. Deterioration in economic conditions could adversely affect the quality of the Corporation’s loan portfolio and the demand for its products and services, and accordingly, could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity.

Growth Strategy – In recent years, the Corporation has expanded its operations by adding new branches in Lycoming County, Pennsylvania, and by acquiring Canisteo Valley Corporation in the southern tier of New York State. Also, as described in Item 1, in December 2006, the Corporation entered into an agreement to acquire Citizens Bancorp, Inc., a banking company with total assets of approximately $144.4 million as of December 31, 2006. Management expects the acquisition of Citizens Bancorp, inc. to close in 2007. The Corporation’s future financial performance will depend on its ability to execute its strategic plan and manage its future growth. Failure to execute these plans could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity.

Competition — All phases of the Corporation’s business are competitive. Some competitors are much larger in total assets and capitalization than the Corporation, have greater access to capital markets and can offer a broader array of financial services. There can be no assurance that the Corporation will be able to compete effectively in its markets. Furthermore, developments increasing the nature or level of competition could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity.

Government Regulation and Monetary Policy — The Corporation and the banking industry are subject to extensive regulation and supervision under federal and state laws and regulations. The restrictions imposed by such laws and regulations limit the manner in which the Corporation conducts its business, undertakes new investments and activities and obtains financing. These regulations are designed primarily for the protection of the deposit insurance funds and consumers and not to benefit the Corporation’s shareholders. Financial institution regulation has been the subject of significant legislation in recent years and may be the subject of further significant legislation in the future, none of which is in the control of the Corporation. Significant new laws or changes in, or repeals of, existing laws could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity. Further, federal monetary policy, particularly as implemented through the Federal Reserve System, significantly affects short-term interest rates and credit conditions, and any unfavorable change in these conditions could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity.

Bank Secrecy Act and Related Laws and Regulations — These laws and regulations have significant implications for all financial institutions. They increase due diligence requirements and reporting obligations for financial institutions, create new crimes and penalties, and require the federal banking agencies, in reviewing merger and other acquisition transactions, to consider the effectiveness of the parties to such transactions in combating money laundering activities. Even innocent noncompliance and inconsequential failure to follow the regulations could result in significant fines or other penalties, which could have a material adverse impact on the Corporation’s financial condition, results of operations or liquidity.

Not applicable.

The Banks owns each of their properties, except for the facility located at 2 East Mountain Avenue, South Williamsport, which is leased. All of the properties are in good condition. None of the owned properties are subject to encumbrance.

A listing of properties is as follows:

The Corporation and the Banks are involved in various legal proceedings incidental to their business. Management believes the aggregate liability, if any, resulting from such pending and threatened legal proceedings will not have a material, adverse effect on the Corporation’s financial condition or results of operations.

During the fourth quarter of 2006, no matters were submitted to a vote of security holders, through the solicitation of proxies or otherwise.

Trades of the Corporation’s stock are executed through various brokers who maintain a market in the Corporation’s stock. Effective January 13, 2005, the Corporation’s stock began to be listed on the NASDAQ Capital Markets (formerly known as NASDAQ SmallCap) with the trading symbol CZNC. Previously, the Corporation’s stock was available through the Over-The-Counter Bulletin Board. As of December 31, 2006, there were 2,422 shareholders of record of the Corporation’s common stock.

The following table sets forth the high and low sales prices of the common stock during 2006 and 2005.

In addition to the cash dividends reflected in the table above, the Corporation declared a 1% stock dividend in the 4^th quarter of each year presented, which was issued in January of the following year.

While the Corporation expects to continue its policy of regular quarterly dividend payments, future dividend payments will depend upon maintenance of a strong financial condition, future earnings and capital and regulatory requirements. Also, the Corporation, C&N Bank and First State Bank are subject to restrictions on the amount of dividends that may be paid without approval of banking regulatory authorities. These restrictions are described in Note 21 to the consolidated financial statements.

Set forth below is a chart comparing the Corporation’s cumulative return to stockholders against the cumulative return of the Russell 2000 and a Peer Group Index of similar banking organizations selected by the Corporation for the five year period commencing December 31, 2001 and ended December 31, 2006. The index values are market-weighted dividend-reinvestment numbers which measure the total return for investing $100.00 five years ago. This meets Securities & Exchange Commission requirements for showing dividend reinvestment share performance over a five year period and measures the return to an investor for placing $100.00 into a group of bank stocks and reinvesting any and all dividends into the purchase of more of the same stock for which dividends were paid.

COMPARISON OF 5 YEAR CUMULATIVE RETURN

The C&N peer group consists of banks headquartered in Pennsylvania with total assets of $500 million to $1.3 billion. This peer group consists of ACNB Corporation, Gettysburg; American Bank Incorporated, Allentown; AmeriServ Financial, Inc., Johnstown; Bryn Mawr Bank Corporation, Bryn Mawr; CNB Financial Corporation, Clearfield; Citizens Financial Services, Inc., Mansfield; Comm Bankcorp, Inc., Clarks Summit; Ephrata National Bank, Ephrata; Fidelity D & D Bancorp, Inc., Dunmore; First Chester County Corp., West Chester; First Keystone Corporation, Berwick; First National Community Bankcorp, Inc., Dunmore; Franklin Financial Services Corporation, Chambersburg; IBT Bancorp, Inc., Irwin; Leesport Financial Corp., Wyomissing; Orrstown Financial Services, Inc., Shippensburg; Penns Woods Bancorp, Inc., Williamsport; Penseco Financial Services Corporation, Scranton; PSB Bancorp, Inc., Philadelphia; QNB Corp., Quakertown; Republic First Bancorp, Inc. ; Philadelphia; FNB Bankcorp, Inc., Newtown; Palm Bancorp, Palmerton; Tower Bancorp, Inc., Greencastle; Codorus Valley Bancorp, Inc., York; Union National Financial Corporation, Lancaster, and DNB Financial Corporation, Downingtown.

The data for this graph was obtained from SNL Financial L.C.

The following table sets forth information concerning the Stock Incentive Plan and Independent Directors Stock Incentive Plan, both of which have been approved by the Corporation’s shareholders. The figures shown in the table below are as of December 31, 2006.

More details related to the Corporation’s equity compensation plans are provided in Notes 1 and 15 to the consolidated financial statements.

During the 3-month period ended December 31, 2006, the Corporation issued 420 shares of common stock held in treasury upon the exercise of stock options by a director under the Corporation’s equity compensation plans. The exercise price was $17.00 per share and resulted in cash proceeds to the Corporation of $7,140. Treasury shares were issued upon exercise of options by a small number of employees and directors in reliance upon the private placement exemption from registration under Section 4(2) of the Securities Act of 1933.

On August 24, 2006, the Corporation announced the extension of a plan, through August 31, 2007, that permits repurchase of shares of its outstanding common stock. There were no share repurchases during the fourth quarter 2006. As of December 31, 2006, the maximum additional value available for purchases under this program is $10,666,392.

Certain statements in this section and elsewhere in this Annual Report on Form 10-K are forward-looking statements. Citizens & Northern Corporation and its wholly-owned subsidiaries (collectively, the Corporation) intend such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Reform Act of 1995. Forward-looking statements, which are not historical facts, are based on certain assumptions and describe future plans, business objectives and expectations, and are generally identifiable by the use of words such as, “should”, “likely”, “expect”, “plan”, “anticipate”, “target”, “forecast”, and “goal”. These forward-looking statements are subject to risks and uncertainties that are difficult to predict, may be beyond management’s control and could cause results to differ materially from those expressed or implied by such forward-looking statements. Factors which could have a material, adverse impact on the operations and future prospects of the Corporation include, but are not limited to, the following:

These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements.

Net income in 2006 was $11,986,000, or $1.44 per share – basic and $1.43 per share – diluted. Net income for 2006 was down from $1.55 per share – basic and $1.54 per share – diluted in 2005. In 2006, the trends of the past few years that have negatively impacted the Corporation’s earnings results continued, as the yield curve moved from flat to inverted, and noninterest expense continued to increase.

The net interest margin decreased $1,733,000, or 4.9%, in 2006 as compared to 2005. The flat or inverted yield curve, along with competitive pressures, caused interest rates paid on liabilities (mainly deposits and borrowings) to increase more than the rates of interest earned on loans and investment securities. Further, the flat or inverted yield curve resulted in limited opportunities to earn a positive spread from maintaining borrowed funds and holding investment securities. Accordingly, the Corporation sold securities and repaid borrowings throughout much of 2006. The balance of available-for-sale securities was $70,633,000 lower at December 31, 2006 than one year earlier, and the December 31, 2006 balance of short-term and long-term borrowings was $40,023,000 lower than one year earlier.

Noninterest expense increased $2,652,000 (9.2%) in 2006 over 2005. Much of the increase in noninterest expense in 2006 has been attributable to operations and start-up costs in new markets, including the First State Bank offices (Canisteo and South Hornell) in New York State, and the Jersey Shore and Old Lycoming Township offices in Pennsylvania.

Gains related to sales of credit card loans totaled $340,000 in 2006 and $1,906,000 in 2005. In the fourth quarter 2005, the Corporation sold the C&N Bank credit card receivables, and recorded a gain of $1,906,000. After the sale, the Corporation continued to provide servicing of credit cards for a portion of 2006, and was subject to possible losses associated with credit card receivables sold with recourse. In the fourth quarter 2006, the Corporation recorded an additional gain of $325,000 for the difference between the initial estimates of post-sale servicing expenses and recourse losses, and the actual amounts incurred. Also in 2006, the Corporation sold First State Bank’s credit card portfolio for a gain of $15,000.

Net realized gains from sales of securities amounted to $5,046,000 in 2006, an increase of $3,244,000 over 2005. Most of the gains realized in 2006 have been from sales of bank stocks. Also, in the fourth quarter 2005, C&N had net losses from sales of securities of $586,000. The fourth quarter 2005 losses were mainly from sales of debt securities that were purchased in 2003 and 2004, when market yields were lower than in 2005.

The provision for loan losses was $672,000 in 2006, down from $2,026,000 in 2005. In 2006, negotiations and workout of a few large, commercial loans were completed, resulting in charge-offs that were significantly less than the estimated allowances that had been previously established.

Net income in 2005 totaled $12,984,000, or $1.55 per share – basic, and $1.54 per share – diluted. Net income per share for 2005 was down from $1.78 per share – basic and $1.77 per share – diluted in 2004. As in 2006, the Corporation’s lower 2005 earnings than had been realized in 2004 resulted mainly from the flattening yield curve and a significant increase in noninterest expense, along with other factors. Despite substantial loan growth in 2005, the net interest margin increased only slightly in 2005 over 2004 (as noted in the “Net Interest Margin” section of Management’s Discussion and Analysis, when calculated on a fully taxable equivalent basis, net interest income was lower by $651,000 in 2005 than in 2004). Similar to 2006, management decided to shrink the investment portfolio and repay borrowings in 2005. Accordingly, the December 31, 2005 balance of available-for-sale securities was $47,787,000 lower than the year-end 2004 balance, and the December 31, 2005 balance of short-term and long-term borrowings was $38,066,000 lower than year-end 2004.

Noninterest expense increased $2,961,000 (11.4%) in 2005 over 2004. Total salaries and benefit expenses increased $1,483,000, or 10.1% in 2005 over 2004, primarily due to new hires to accommodate expansion into new branches and for several support functions. Furniture and equipment expense increased $859,000, or 47.6%, mainly due to depreciation and maintenance costs associated with the new core banking software system, which was implemented in the fourth quarter 2004.

The provision for loan losses increased $626,000 in 2005 over 2004, mainly due to estimates of possible future charge-offs on several large commercial loans, as well as volume-related increases in the portions of the provision determined based on historical net charge-off and subjective factors.

As referenced above, in the fourth quarter 2005 the Corporation realized a gain from the sale of credit card receivables of $1,906,000. Also in the fourth quarter 2005, the Corporation had net losses from sales of securities of $586,000, contributing to a $1,075,000 reduction in net securities gains in 2005 as compared to 2004.

In looking ahead to 2007, it is important to consider the Corporation’s prospects in light of the environment and activity of the past few years. The historically long (over 2 years) flat and inverted yield curve has challenged the Corporation’s ability to achieve earnings growth. Despite this challenging environment, the Corporation has continued to implement its strategic plan by opening four new C&N Bank branches and acquiring the two New York State (First State Bank) branches, during this time frame. Further, the Corporation has experienced significant increases in its operating costs as a result of acquiring and implementing a new core banking software system late in 2004, added personnel to keep up with increases in regulatory burden and built a new administrative building to house the higher numbers of employees. All of these issues – the yield curve, branches with less than “mature” market share and operating expense pressures – are expected to continue in 2007, and management expects that it will be difficult to generate earnings at a level much greater in 2007 than was realized in 2006.

While management acknowledges the challenges cited above, there are many reasons for long-term optimism going into 2007. The Lycoming County offices have contributed significantly to loan and deposit growth over the past few years, and management anticipates continued growth in that market. In the fourth quarter 2006, two new lenders were hired with the expectation for increased commercial and consumer business in the New York State market. The Trust and Financial Management Group has grown Assets Under Management to $517,775,000 at December 31, 2006, an increase of 23.8% since the end of 2005, and increased revenue by 15.4% in 2006 over 2005. Management is focused on this area of noninterest revenue in an effort to reduce reliance on the net interest margin, and believes the prospects for continued growth in this area are encouraging.

In December 2006, the Corporation signed a definitive merger agreement with Citizens Bancorp, Inc. (“Citizens”) of Coudersport. Citizens is the parent company of Citizens Trust Company (“CTC”), a commercial bank with offices in the Pennsylvania communities of Coudersport, Emporium and Port Allegany. As of December 31, 2006, Citizens reported total assets of $144.4 million. The agreement provides for Citizens to merge into the Corporation, and CTC to merge into C&N Bank. In the aggregate, 50% of the shares of Citizens common stock will be purchased for cash and 50% of the shares of Citizens common stock will be exchanged for shares of Corporation common stock. The estimated total purchase consideration is valued at approximately $29 million. Management expects the transaction to be completed during the second quarter 2007. Consummation of the merger is subject to approval by Citizens’ shareholders, regulatory approvals and other customary conditions of closing.

Management believes the prospects for both organizations, and the addition of Citizens’ management group to the Corporation’s team will result in increased opportunities for the combined organization. In 2007, management anticipates start-up and duplicate operating costs will result in the transaction being slightly dilutive to earnings per share; however, in 2008, management expects the impact of the transaction on earnings to be accretive.

Another major variable that affects the Corporation’s earnings is securities gains and losses. Management’s decisions regarding sales of securities are based on a variety of factors, with the overall goal of maximizing portfolio return over a long-term horizon. It is difficult to predict, with any reasonable degree of certainty, the amount of net securities gains and losses that will be realized in 2007.

Total capital purchases for 2007 are estimated at $2.5-$3 million, with renovations of existing facilities and computer equipment and software the largest planned categories of expenditure. This would be the Corporation’s lowest total capital purchases amount since 2002 (with the exception of the Citizens acquisition), as management has no current plans to build or acquire new branches in 2007.

The presentation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect many of the reported amounts and disclosures. Actual results could differ from these estimates.

A material estimate that is particularly susceptible to significant change is the determination of the allowance for loan losses. Management believes that the allowance for loan losses is adequate and reasonable. The Corporation’s methodology for determining the allowance for loan losses is described in a separate section later in Management’s Discussion and Analysis. Given the very subjective nature of identifying and valuing loan losses, it is likely that well-informed individuals could make materially different assumptions, and could, therefore calculate a materially different allowance value. While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in future years. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation’s allowance for loan losses. Such agencies may require the Corporation to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination.

Another material estimate is the calculation of fair values of the Corporation’s debt securities. The Corporation receives estimated fair values of debt securities from an independent valuation service, or from brokers. In developing these fair values, the valuation service and the brokers use estimates of cash flows, based on historical performance of similar instruments in similar interest rate environments. Based on experience, management is aware that estimated fair values of debt securities tend to vary among brokers and other valuation services. Accordingly, when selling debt securities, management typically obtains price quotes from more than one source. As described in Note 1 to the consolidated financial statements, the large majority of the Corporation’s securities are classified as available-for-sale. Accordingly, these securities are carried at fair value on the consolidated balance sheet, with unrealized gains and losses excluded from earnings and reported separately through accumulated other comprehensive income (included in stockholders’ equity).

The Corporation’s primary source of operating income is represented by the net interest margin. The net interest margin is equal to the difference between the amounts of interest income and interest expense. Tables I, II and III include information regarding the Corporation’s net interest margin in 2006, 2005 and 2004. In each of these tables, the amounts of interest income earned on tax-exempt securities and loans have been adjusted to a fully taxable-equivalent basis. Accordingly, the net interest margin amounts presented in these tables exceed the amounts presented in the consolidated financial statements. The discussion that follows is based on amounts in the Tables.

On a fully taxable-equivalent basis, net interest income fell 6.4%, to $36,105,000 in 2006 from $38,567,000 in 2005. As reflected in Table III, interest rate changes had the effect of decreasing net interest income $3,327,000 in 2006 as compared to 2005, as rising short-term interest rates caused increases in interest expense. Table III also shows that volume changes had the effect of increasing net interest income $865,000 in 2006 over 2005. The major components of the increase in net interest income from volume changes in 2006 were an increase of $2,958,000 attributable to loan growth and a decrease in interest expense of $2,392,000 related to lower long-term borrowings, partially offset by $3,386,000 lower interest income from a lower volume of available-for-sale securities. As presented in Table II, the “Interest Rate Spread” (excess of average rate of return on interest-bearing assets over average cost of funds on interest-bearing liabilities) shrunk to 2.90% in 2006 from 3.22% in 2005.

In 2005, the net interest margin was $38,567,000, down $651,000, or 1.7%, from 2004. Similar to 2006’s results, Table III shows that interest rate changes caused a decrease in net interest income of $2,310,000 in 2005 compared to 2004, while volume changes (mainly attributable to loan growth) increased net interest income $1,659,000. As shown in Table II, the Interest Rate Spread of 3.22% in 2005 was down from 3.43% in 2004.

INTEREST INCOME AND EARNING ASSETS

Interest income totaled $66,879,000 in 2006, or 4.1% higher than in 2005. Interest and fees from loans increased $4,749,000, or 11.8%, while income from available-for-sale securities decreased $2,334,000, or 9.8%. The majority of the increase in interest income resulted from higher loan volume, along with an increase in the average rate earned on loans, which more than offset the effect of the lower average volume of available-for-sale securities.

Total average gross loans increased 7.2% in 2006 over 2005, to $662,714,000 from $618,344,000. While loan growth was not at the 10% or more levels experienced for each of the immediately prior several years, loan demand has remained good for both commercial and mortgage loans throughout the Corporation’s market area. In addition, the acquisition of First State Bank, which was added to the Corporation’s balance sheet for the final 4 months of 2005, contributed to the increase in average loans in 2006 compared to 2005. Excluding First State Bank, average total deposits increased 5.0% in 2006 compared to 2005. The average rate of return on loans was 6.81% in 2006, up from 6.53% in 2005.

As indicated in Table II, total average available-for-sale securities in 2006 fell to $385,119,000, a decrease of $57,406,000 or 13.0% from 2005. Proceeds from sales and maturities of securities have been used, in part, to help fund loans and pay off borrowings. Within the available-for-sale securities portfolio, the average balance of municipal bonds shrunk to $89,981,000 in 2006 from $123,295,000 in 2005. Management decided to reduce the Corporation’s investment in municipal bonds in order to reduce the alternative minimum tax liability. Also, because short-term interest rates have been rising faster than long-term rates, there have been only limited opportunities to purchase mortgage-backed securities or other taxable bonds at spreads sufficient to justify the applicable interest rate risk. The average rate of return on available-for-sale securities was 5.55% for 2006, up from 5.35% in 2005.

Similar to 2006, in 2005 the average balance of loans grew while available-for-sale securities fell. As reflected in Table II, total average gross loans increased 12.2% in 2005 over 2004, to $618,344,000 from $551,352,000. The acquisition of loans from First State Bank contributed 1.4% of the growth in average loans. The average yield on loans was 6.53% in 2005, up slightly from the average yield for 2004 of 6.47%. The total average balance of available-for-sale securities decreased 8.3% in 2005 as compared to 2004, for the same reasons as the portfolio continued to shrink in 2006 (as discussed above). The average rate of return on available-for-sale securities of 5.35% for in 2005 was slightly lower than the 5.41% generated in 2004.

INTEREST EXPENSE AND INTEREST-BEARING LIABILITIES

Interest expense rose $5,087,000, or 19.8%, to $30,774,000 in 2006 from $25,687,000 in 2005. Table II shows that the overall cost of funds on interest-bearing liabilities rose to 3.44% in 2006, from 2.81% in 2005.

From Table II, you can calculate that total average deposits (interest-bearing and noninterest-bearing) increased 6.9% to $750,982,000 in 2006 from $702,404,000 in 2005. The most significant increases in average deposits by categories were $21,961,000 for interest checking accounts (47.3%), $18,295,000 for certificates of deposit (9.3%), and $14,304,000 (16.3%) for demand deposit accounts. Average money market account balances decreased $9,219,000, or 4.9%, in 2006 as compared to 2005, as some depositors’ have moved balances to higher-rate certificates of deposit or withdrawn funds to invest in equities. Most of the increase in interest checking balances is attributable to one local governmental customer, for which the Corporation became the primary depository institution in September 2005. In addition, the acquisition of First State Bank contributed significantly to the increase in average deposits in 2006 compared to 2005. Excluding First State Bank, average total deposits increased 3.7% in 2006 compared to 2005.

The combined average total short-term and long-term borrowed funds decreased $54,571,000 to $244,683,000 in 2006 from $299,254,000 in 2005. As discussed earlier in Management’s Discussion and Analysis, because the yield curve has been flat or inverted, the Corporation’s opportunities have been limited for earning a positive spread by purchasing or holding investment securities as compared to interest costs associated with maintaining borrowed funds. Accordingly, the Corporation has been paying off borrowings as they mature, or rolling them over at terms of less than one year. The pace of such changes or trends is reflected in the Corporation’s consolidated balance sheet, as total short-term borrowings increased to $49,258,000 at December 31, 2006 from $34,734,000 at December 31, 2005, while total long-term borrowings decreased to $179,182,000 at December 31, 2006 from $232,205,000 at December 31, 2005.

In 2005, interest expense rose $3,081,000, or 13.6% over 2004. The overall cost of funds on interest-bearing liabilities rose to 2.81% in 2005, from 2.53% in 2004. In Table II, you can see that rising short-term interest rates caused increases in the average rates incurred on money market accounts, certificates of deposit, interest checking accounts and short-term borrowings. Helping to offset some of the impact of rising short-term market rates were passbook Individual Retirement Accounts (IRAs), for which the average rate fell to 3.46% from 3.75%, and long-term borrowings, for which the average rate fell to 3.47% from 3.55%. In the first quarter 2004, the average rate paid on the majority of the Corporation’s IRAs was 5%, which was the “floor” on 18-month variable IRAs that existed prior to October 1, 2003. Effective April 1, 2004, the floor on those IRAs fell to 3%, and the Corporation’s variable IRA rate ranged from 3.25% to 3.60% over the remainder of 2004 and 2005. The decrease in average rate incurred on long-term borrowings resulted from repayment of borrowings originated in earlier interest rate cycles at higher rates.

As you can calculate from Table II, total average deposits (interest-bearing and noninterest-bearing) increased to $702,404,000 in 2005 from $669,307,000 in 2004, an increase of 4.9%. Fluctuations in deposits of nonprofit and municipal customers impacted average deposit balances significantly in 2005, as the Corporation both lost and gained customers with average balances exceeding $10 million. The acquisition of deposits from First State Bank contributed $13,405,000, or 2.0%, of the increase in average deposits.

Total noninterest income increased $2,012,000, or 17.7%, in 2006 compared to 2005. The largest change within this category is related to securities gains, which increased $3,244,000, and which are discussed in the Earnings Overview section of Management’s Discussion and Analysis. The gains related to sale of credit card loans, which decreased $1,566,000 in 2006 as compared to 2005, is also discussed in the Earnings Overview section. Other items of significance are as follows:

Total noninterest income increased $1,545,000, or 15.8%, in 2005 as compared to 2004. The gain from sale of credit card loans, and reduced amount of net realized security gains in 2005 as compared to 2004 are discussed in the Earnings Overview section of Management’s Discussion and Analysis. Other items of significance are as follows:

Total noninterest expense increased $2,652,000, or 9.2%, in 2006 over 2005, and $2,961,000, or 11.4%, in 2005 over 2004. Increased levels of expenses in 2006 and 2005 resulted mainly from expansion, as the Corporation opened or acquired new offices in Jersey Shore, PA (August 2005), Canisteo and South Hornell, NY (August 2005) and Old Lycoming Township, PA (March 2006). Also, the Corporation built a new administrative office in Wellsboro, PA, which opened in March 2006.

Salaries and wages increased $1,322,000, or 10.7%, in 2006 over 2005. The increase in salaries expense relates primarily to the increase in the number of full-time equivalent employees, which has averaged 10% higher since August of 2005. For 2006, new branch operations at Jersey Shore, Old Lycoming Township and New York State added $612,000 to salaries expense.

Pension and other employee benefits increased $527,000, or 14.0%, in 2006 over 2005. The increase in number of people and covered compensation is the primary reason for the increase. In the aggregate, total pensions and other employee benefits expense, as a percentage of salaries and wages, was 31.2% in 2006, up from 30.3% in 2005 and 2004. Note 15 to the consolidated financial statements provides information concerning some of the larger expenses within this category, including the defined benefit pension and postretirement health plans, the 401(k)/ESOP and the supplemental executive retirement plan.

Occupancy expense increased $444,000, or 23.8%, in 2006 compared to 2005. The increase in total occupancy costs in 2006 includes $288,000 for the Jersey Shore, Old Lycoming and New York State locations, and $213,000 for the new administration building in Wellsboro.

Other (noninterest) expense increased $253,000 or 3.4% in 2006 compared to 2005. The increase in other expenses includes an increase of $420,000 for the New York State locations in 2006, including $128,000 for the amortization of the core deposit intangible. In addition, in the second quarter 2006, other expense included a one-time charge of $168,000 for impairment of leasehold improvements from early termination of a property lease. Included in the 2005 total is $462,000 for non-payroll related expenses associated with the credit card operation, which was sold in the fourth quarter 2005.

Salaries and wages increased $1,135,000, or 10.1%, in 2005 over 2004. The increase in salaries expense in 2005 was primarily a reflection of a greater number of employees, resulting from expansion into new branches and the addition of new employees for support functions.

Pensions and other employee benefit expenses increased $348,000, or 10.2%, in 2005 over 2004. Increases in numbers of employees drove up expenses for health insurance, contributions to the savings and retirement (401(k)) plan and payroll taxes. Helping to mitigate some of the expense increases within this category were reductions in expense associated with the defined benefit plan and professional fees related to employee benefit plan matters.

Occupancy expense increased $201,000, or 12.1%, in 2005 over 2004, primarily as a result of higher depreciation and maintenance costs associated with new facilities.

Furniture and equipment expense increased $868,000, or 48.1%, in 2005 over 2004. Depreciation expense within this category increased $586,000, to $1,601,000 in 2005 from $1,015,000 in 2004, including an increase of $468,000 in 2005 from the new core banking software system that was placed in service during the fourth quarter 2004. Similarly, maintenance and repair expense within this category increased $241,000 in 2005 over 2004, primarily because of inclusion of a full year of maintenance costs associated with the new core banking software system of approximately $377,000 in 2005, up from 2 months’ of costs totaling $60,000 in 2004.

Other operating expense increased $451,000, or 6.4%, in 2005 over 2004. Most of the line items within this category increased in 2005, in part due to expansion into more locations and the resulting higher volume of transactions and costs. Total other operating expense incurred by Canisteo Valley Corporation and First State Bank in the final 4 months of 2005 totaled $281,000, or 4.0% of the total increase. The most significant increases within this category were: (1) expenses associated with maintaining and preparing other real estate properties for sale, which increased $210,000 in 2005 to $304,000; (2) attorney fees, which increased $164,000 in 2005 to $203,000, mainly because of collection activities on a large commercial credit, and (3) Bucktail expenses, which increased $117,000 to $323,000, due to a larger volume of claims. Helping to reduce the overall increase in this category was a decrease in professional fees of $530,000, to $215,000 in 2005. In 2004, the Corporation incurred a significant amount of professional fees expense associated with the core banking system conversion.

The income tax provision was $2,772,000, or 18.8% of pre-tax income, in 2006, as compared to 17.7% in 2005 and 16.1% in 2004. The increases in the tax provision/pre-tax income rate in 2006 and 2005 reflected lower average holdings of tax-exempt securities. Management decided to reduce the Corporation’s investment in municipal bonds in order to reduce the alternative minimum tax liability in 2006 and 2005. A more complete analysis of income taxes is presented in Note 16 to the consolidated financial statements.

Significant changes in the average balances of the Corporation’s earning assets and interest-bearing liabilities are described in the Net Interest Margin section of Management’s Discussion and Analysis. That discussion provides useful information regarding changes in the Corporation’s balance sheet over the 2-year period ended December 31, 2006, including discussions of available-for-sale securities, loans, deposits and borrowings. The acquisition of Canisteo Valley Corporation was effective at the end of August 2005. That transaction was an all-cash acquisition, which had the effect of increasing the Corporation’s assets and liabilities. At December 31, 2006, total consolidated assets of Canisteo Valley Corporation amounted to $42,954,000, including net loans of $19,929,000, while deposits totaled $35,160,000. Other significant balance sheet items — the allowance for loan losses and stockholders’ equity — are discussed in separate sections of Management’s Discussion and Analysis.

Table VI shows the composition of the investment portfolio at December 31, 2006, 2005 and 2004. Comparison of the amortized cost totals of available-for-sale securities at each year-end presented reflects a reduction from $459,123,000 at December 31, 2004 to $420,185,000 at December 31, 2005, and then a further reduction to $353,954,000 at December 31, 2006. Management’s decision to reduce the size of the securities portfolio has been attributable to 2 primary factors: (1) substantial loan growth, and (2) the need to manage interest rate risk within acceptable parameters. Specifically, in light of the flat yield curve, the opportunities have been very limited for earning a positive spread from maintaining borrowed funds and holding investment securities, and because there is almost no difference between short-term and long-term rates, the Corporation faces the risk that excessive holdings of long-term, fixed rate securities could result in future losses or diminished net interest margin results when the yield curve “normalizes.” Accordingly, management has utilized proceeds from principal repayments and sales of securities to help fund loan growth. The Corporation’s liquidity position is discussed in a separate section of Management’s Discussion and Analysis, and interest rate risk is discussed in more detail in Part II, Item 7A.

The balance of loans outstanding has grown substantially over the past 4 years. As reflected in Table VII, the year-end balance of loans, net of the allowance for loan losses, increased 5.3% as of December 31, 2006 compared to the previous year-end, and grew by more than 10% in each of the 3 years before 2006. Table VIII presents a table of loan maturities. Fixed rate loans are included in Table VIII based on their contractually scheduled principal repayments, while variable rate loans are included based on contractual principal repayments, with the remaining balance reflected in the Table as of the date of the next change in rate. Table VIII shows that the majority ($489,206,000 or 71%) of the loan portfolio is fixed rate, including $184,410,000 or 27% fixed rate beyond 5 years. This substantial investment in long-term, fixed rate loans is one of the major concerns management attempts to address through interest rate risk management practices. See Part II, Item 7A for a more detailed discussion of the Corporation’s interest rate risk.

Total capital purchases for 2007 are estimated at approximately $2.5-$3 million. In light of the Corporation’s strong capital position and ample sources of liquidity, management does not expect capital expenditures to have a material, detrimental effect on the Corporation’s financial condition in 2007. The overall impact on the Corporation’s earnings in 2007 and thereafter will depend on the Corporation’s ability to build market share and produce profitable results from those locations, and how long that will take.

The allowance for loan losses is maintained at a level which, in management’s judgment, is adequate to absorb credit losses inherent in the loan portfolio. The amount of the allowance is based on management’s evaluation of the collectibility of the loan portfolio. In evaluating collectibility, management considers a number of factors, including the status of specific impaired loans, trends in historical loss experience, delinquency trends, credit concentrations, comparison of historical loan loss data to that of other financial institutions and economic conditions within the Corporation’s market area. Allowances for impaired loans are determined based on collateral values or the present value of estimated cash flows. The allowance is increased by a provision for loan losses, which is charged to expense, and reduced by charge-offs, net of recoveries. The discussion that follows explains management’s current processes for estimating the allowance for loan losses, and provides information concerning the provision for loan losses in 2006 and the valuation of the allowance at December 31, 2006 and in recent prior years.

There are two major components of the allowance — (1) Statement of Financial Accounting Standards (SFAS) 114 allowances — on larger loans, mainly commercial purpose, determined on a loan-by-loan basis; and (2) SFAS 5 allowances — estimates of losses incurred on the remainder of the portfolio, determined based on collective evaluation of impairment for various categories of loans. SFAS 5 allowances include a portion based on historical net charge-off experience, and a portion based on evaluation of qualitative factors.

Each quarter, management performs a detailed assessment of the allowance and provision for loan losses. A management committee called the Watch List Committee performs this assessment. Quarterly, the Watch List Committee and the applicable Lenders discuss each loan relationship under review, and reach a consensus on the appropriate SFAS 114 estimated loss amount for the quarter. The Watch List Committee’s focus is on ensuring that all pertinent facts have been considered, and that the SFAS 114 loss amounts are reasonable. The assessment process includes review of certain loans reported on the “Watch List.” All loans, which Lenders or the Credit Administration staff has assigned a risk rating of Special Mention, Substandard, Doubtful or Loss, are included in the Watch List. The scope of loans evaluated individually for impairment (SFAS 114 evaluation) include all loan relationships greater than $200,000 for C&N Bank loans, and $50,000 for First State Bank, for which there is at least one extension of credit graded Substandard, Doubtful or Loss. Also, loan

relationships less than $200,000 in the aggregate, but with an estimated loss of $100,000 or more, are individually evaluated for impairment.

The Banks also engage consulting firms, at least annually, to perform independent credit reviews of large credit relationships. Management gives substantial consideration to the classifications and recommendations of the independent credit reviewers in determining the allowance for loan losses.

The SFAS 5 component of the allowance includes estimates of losses incurred on loans that have not been individually evaluated for impairment. Management uses loan categories included in the Call Report (a quarterly report filed by FDIC-insured banks) to identify categories of loans with similar risk characteristics, and multiplies the loan balances for each category as of each quarter-end by two different factors to determine the SFAS 5 allowance amounts. These two factors are based on: (1) historical net charge-off experience, and (2) qualitative factors. The sum of the allowance amounts calculated for each risk category, including both the amount based on historical net charge-off experience and the amount based on evaluation of qualitative factors, is equal to the total SFAS 5 component of the allowance.

The historical net charge-off portion of the SFAS 5 allowance component is calculated by the Accounting Department as of the end of the applicable quarter. For each loan classification category used in the Call Report, the Accounting Department multiplies the outstanding balance as of the quarter-end (excluding loans individually evaluated for impairment) by the ratio of net charge-offs to average quarterly loan balances for the previous three calendar years. Prior to the fourth quarter 2005, C&N Bank had utilized the ratio of net charge-offs to average balances over a five-year period in calculating the historical loan loss experience portion of the allowance portfolio. Management made the change to the three-year assumption, which had very little effect on the allowance valuation as of December 31, 2005, mainly because management believes net charge-off experience over a 3-year period may be more representative of losses existing in the portfolio as of the balance sheet date.

Effective in the second quarter 2005, management began to calculate the effects of specific qualitative factors criteria to determine a percentage increase or decrease in the SFAS 5 allowance, in relation to the historical net charge-off percentage. The qualitative factors analysis involves assessment of changes in factors affecting the portfolio, to provide for estimated differences between losses currently inherent in the portfolio and the amounts determined based on recent historical loss rates and from identification of losses on specific individual loans. A management committee called the Qualitative Factors Committee meets quarterly, near the end of the final month of each quarter. The Qualitative Factors Committee discusses several qualitative factors, including economic conditions, lending policies, changes in the portfolio, risk profile of the portfolio, competition and regulatory requirements, and other factors, with consideration given to how the factors affect three distinct parts of the loan portfolio: Commercial, Mortgage and Consumer. During or soon after completion of the meeting, each member of the Committee prepares an update to his or her recommended percentage adjustment for each qualitative factor, and average qualitative factor adjustments are calculated for Commercial, Mortgage and Consumer loans. The Accounting Department multiplies the outstanding balance as of the quarter-end (excluding loans individually evaluated for impairment) by the applicable qualitative factor percentages, to determine the portion of the SFAS 5 allowance attributable to qualitative factors.

The allocation of the allowance for loan losses table (Table X) includes the SFAS 114 component of the allowance on the line item called “Impaired Loans.” As of December 31, 2006 and 2005, SFAS 5 estimated losses, including both the portion determined based on historical net charge-off results, as well as the portion based on management’s assessment of qualitative factors, are allocated in Table X to the applicable categories of commercial, consumer mortgage and consumer loans. In periods prior to 2005, the portion of the allowance determined by management’s subjective assessment of economic conditions and other factors (which is now calculated using the qualitative factors criteria described above) was reflected completely in the unallocated component of the allowance. Primarily as a result of this change in process, Table X shows a reduction in the unallocated portion of the allowance to $24,000 at December 31, 2006 and $0 at December 31, 2005 from $2,578,000 at December 31, 2004.

The allowance for loan losses was $8,201,000 at December 31, 2006, down slightly from the December 31, 2005 balance of $8,361,000. As shown in Table IX, net charge-offs in 2006 totaled $832,000, as compared to $829,000 in 2005 and $710,000 in 2004. Table IX also shows the provision for loan losses totaled $672,000 in 2006, down from $2,026,000 in 2005 and $1,400,000 in 2004. In the second quarter 2006, settlements were reached related to two large commercial loan relationships that had previously been classified as impaired. Total second quarter 2006 charge-offs related to these two relationships were $568,000, or approximately $450,000 less than the estimated valuation allowance amounts that had been previously recorded. These lower-than-anticipated charge-off levels contributed to a reduction in the provision for loan losses in 2006. Relatedly, the comparatively high provision for loan losses in 2005 resulted primarily from increases in SFAS 114 estimated losses that were recorded related to these loans. The total amount of the provision for loan losses in each year is determined based on the amount required to maintain an appropriate allowance in light of all of the factors described above.

Table XI presents information related to past due and impaired loans. As of December 31, 2006, total impaired loans amounted to $8,011,000, down slightly from $8,216,000 at December 31, 2005 and $8,261,000 at December 31, 2004, but much higher than the levels of impaired loans in 2003 and 2002. Nonaccrual loans totaled $8,506,000 at December 31, 2006, up from $6,365,000 at December 31, 2005 and $7,796,000 at December 31, 2004. Over the period 2004-2006, there have been a few large commercial relationships that have required significant monitoring and workout efforts. In the third quarter 2006, management identified three commercial loan relationships with outstanding balances totaling approximately $3,300,000 that were moved to nonaccrual status and classified as impaired (and which continue to be classified as nonaccrual and impaired as of December 31, 2006). As of December 31, 2006, the SFAS 114 valuation allowance related to one of these relationships is $400,000. The third quarter 2006 increases in impaired and nonaccrual loans followed reductions in the second quarter, mainly because of the settlements of the two large commercial loan relationships referred to above. Management believes it has been conservative in its decisions concerning identification of impaired loans, estimates of loss and nonaccrual status. However, the actual losses realized from these relationships could vary materially from the allowances calculated as of December 31, 2006. Management continues to closely monitor its commercial loan relationships for possible credit losses, and will adjust its estimates of loss and decisions concerning nonaccrual status, if appropriate.

Tables IX through XII present historical data related to the allowance for loan losses.