Citizens & Northern Corp - 10-Q quarterly report FY

 

(Exact name of Registrant as specified in its charter)

90-92 MAIN STREET, WELLSBORO, PA 16901
(Address of principal executive offices) (Zip code)

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

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

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

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

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

 

 

(In Thousands Except Share Data)

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

Note: The balance sheet at December 31, 2007 has been derived from the audited financial statements at that date but does not include all the information and notes required by U.S. generally accepted accounting principles for complete financial statements.

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

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

The financial information included herein, with the exception of the consolidated balance sheet dated December 31, 2007, is unaudited; however, such information reflects all adjustments (consisting solely of normal recurring adjustments) that are, in the opinion of management, necessary for a fair presentation of the financial position, results of operations and cash flows for the interim periods.

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

The Corporation’s trading assets at March 31, 2008 were composed exclusively of municipal bonds. In the first quarter 2008, the gain on trading activities included in earnings totaled $19,000. This amount included $35,000 in net realized gains and $16,000 in net unrealized losses. In the first quarter 2007, the realized gain on trading activities included in earnings totaled $6,000. There were no unrealized gains or losses on trading securities in the first quarter 2007. Gains and losses from trading activities are included in Other Operating Income in the consolidated income statement.

Amortized cost and fair value of available-for-sale and held-to-maturity securities at March 31, 2008 are summarized as follows:

The following table presents gross unrealized losses and fair value of available-for-sale investments aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at March 31, 2008.

Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market conditions warrant such evaluation. Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Corporation to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.

In addition to the effects of volatility in interest rates on individual debt securities, management believes valuations of debt securities at March 31, 2008 have been negatively impacted by events affecting the overall credit markets during the last quarter of 2007 and the first quarter of 2008. There have been widespread disruptions to the normal operation of bond markets. Particularly with regard to trust-preferred securities (which comprise most of the balance in “Other securities” in the table above), trading volume has been limited and consisted almost entirely of sales by distressed sellers. As a result, quoted market prices on many securities have been substantially depressed without regard to the attributes specific to each security.

Although not directly related to the specific securities held by the Corporation, these events have been impacting market prices for municipal bonds and trust-preferred securities. Management believes municipal bond valuations have been negatively impacted by reported financial problems by some of the largest companies that insure municipal bond offerings. Trust-preferred securities are very long-term (usually 30-year maturity) instruments with characteristics of both debt and equity, mainly issued by banks. Most of the Corporation’s investments in trust-preferred securities are of pooled issues, each made up of 30 or more companies with geographic and size diversification. Almost all of the Corporation’s pooled trust-preferred securities are comprised of debt issued by banking companies, with lesser amounts issued by insurance companies and real estate investment trusts. Management believes trust-preferred valuations have been negatively affected by concerns that the underlying banks

and other companies may have significant exposure to losses from sub-prime mortgages, defaulted collateralized debt obligations or other concerns. In the first quarter of 2008, management has reviewed and discussed the Corporation’s individual holdings of municipal bonds and trust-preferred securities with its investment advisors, and has concluded that no downgrades or deterioration in the credit quality of the securities have occurred that would warrant an other- than-temporary impairment charge to the income statement. Based on the Corporation’s ability and intent to hold its debt securities for the foreseeable future, and management’s assessment of the creditworthiness of the issuers, management believes the Corporation’s debt securities at March 31, 2008 were not other-than-temporarily impaired.

Unrealized losses on marketable equity securities are mainly from investments in common stocks of banking corporations. Management believes that recent declines in market prices of many bank stocks have been caused by media reports regarding sub-prime mortgage losses and similar events that have mainly affected mortgage banking operations and very large financial institutions.

Management evaluated equity securities held as of March 31, 2008. Upon evaluation, it was determined that an equity security issued by a regional banking corporation was other-than-temporarily impaired. The investment was written down to the current market value at March 31, 2008, and the Corporation recognized a pretax loss of $249,000. Management believes the impairment of the Corporation’s other marketable equity securities to be temporary.

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

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

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

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

At March 31, 2008, assets measured at fair value on a recurring basis and the valuation methods used are as follows:

The Corporation has a noncontributory defined benefit pension plan for all employees meeting certain age and length of service requirements. Benefits are based primarily on years of service and the average annual compensation during the highest five consecutive years within the final ten years of employment.

On October 18, 2007, the Corporation’s Board of Directors adopted amendments to the defined benefit pension plan to freeze and terminate the Plan, effective December 31, 2007. The Corporation expects to fund and settle its obligations under the Plan sometime in 2008.

In addition, the Corporation sponsors a defined benefit health care plan that provides postretirement medical benefits and life insurance to employees who meet certain age and length of service requirements. This plan contains a cost-sharing feature, which causes participants to pay for all future increases in costs related to benefit coverage. Accordingly, actuarial assumptions related to health care cost trend rates do not affect the liability balance at March 31, 2008 and December 31, 2007, and will not affect the Corporation’s future expenses.

The Corporation uses a December 31 measurement date for its plans. In 2007, the Corporation assumed the Citizens Trust Company Retirement Plan, a defined benefit pension plan for which benefit accruals and participation were frozen in 2002. The Corporation used a September 30 measurement date for this plan in 2007, and will change to a December 31 measurement date in 2008. The Citizens Trust Company Retirement Plan is not significant in comparison to the other defined benefit plans, and information related to that plan is not included in the table that follows.

The components of net periodic benefit costs from these defined benefit plans are as follows:

The Corporation has not made a contribution to the defined benefit pension plan in the first quarter 2008, and the timing and amount of its contribution in 2008 will depend on requirements to fund its final obligations under the terminated plan. At this time, the Corporation cannot estimate the amount of contribution required for the defined benefit pension plan in 2008. In the first quarter 2008, the Corporation funded postretirement contributions totaling $15,000, with estimated annual postretirement contributions of $51,000 expected in 2008 for the full year.

In January 2008, the Corporation granted options to purchase a total of 83,257 shares of common stock through its Stock Incentive and Independent Directors Stock Incentive Plans. In January 2007, the Corporation granted options

to purchase a total of 43,385 shares of common stock. The exercise price for the 2008 awards is $17.50 per share, and the exercise price for the 2007 awards is $22.325 per share, based on the market price as of the date of each grant. The Corporation records stock option expense based on estimated fair value calculated using an option valuation model. The Corporation recorded total stock option expense of $118,000 in the first quarter 2008 and $79,000 in the first quarter 2007. The Corporation expects total stock option expense for the year ending December 31, 2008 to be approximately $209,000, and total stock option expense for the year ended December 31, 2007 was $156,000.

In calculating the fair value, the Corporation utilized the Black-Scholes option-pricing model. The calculated fair value of each option granted, and significant assumptions used in the calculations, are as follows:

In calculating the estimated fair value of stock option awards, management based its estimates of volatility and dividend yield on the Corporation’s experience over the immediately prior period of time consistent with the estimated lives of the options. The risk-free interest rate was based on the published yield of zero-coupon U.S. Treasury strips with an applicable maturity as of the grant dates. The 9-year expected option life used for 2008 awards, and 8-year expected option life used for 2007 awards, were based on management’s estimates of the average term for all options issued under both plans. For the 2008 and 2007 awards, management assumed a 23% forfeiture rate for options granted under the Stock Incentive Plan, and a 0% forfeiture rate for the Directors Stock Incentive Plan. These estimated forfeiture rates were determined based on the Corporation’s historical experience.

Also, the Corporation awarded a total of 5,062 shares in January 2008 and 6,529 shares in January 2007 of restricted stock under the Stock Incentive and Independent Directors Stock Incentive Plans. Compensation cost related to restricted stock is recognized based on the market price of the stock at the grant date over the vesting period. Total restricted stock expense amounted to $24,000 in the first quarters of 2008 and 2007.

In the normal course of business, the Corporation may be subject to pending and threatened lawsuits in which claims for monetary damages could be asserted. In management’s opinion, the Corporation’s financial position and results of operations would not be materially affected by the outcome of such pending legal proceedings.

Certain statements in this section and elsewhere in this quarterly report on Form 10-Q 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.

Unless otherwise noted, all references to “2008” in the following discussion of operating results are intended to mean the three months ended March 31, 2008, and similarly, references to “2007” relate to the three months ended March 31, 2007.

Net income in 2008 was $3,116,000, or $0.35 per share – basic and diluted. First quarter 2008 earnings per share were 20.7% higher than first quarter 2007 results of $0.29 per share – basic and diluted, or $2,458,000. Net income per share – basic and diluted was unchanged at $0.35 per share from the fourth quarter 2007, when net income totaled $3,182,000. Return on average assets was 0.98% in 2008, up from 0.88% in 2007. Return on average equity was 8.99% for 2008, up from 7.50% in 2007.

The most significant changes in the components of earnings for the first quarter 2008, as compared to the first quarter 2007, were as follows:

The number of shares used in calculating net income per share for each quarter presented in Table I reflects the retroactive effect of stock dividends.

Management remains cautiously optimistic about the Corporation’s earnings prospects in 2008. Unlike most of 2005-2007, the yield curve has a positive shape, meaning that long-term rates are higher than short-term rates. As described in more detail in Item 3, Quantitative and Qualitative Disclosures About Market Risk, the Corporation is liability sensitive, meaning that its sources of funds (mainly deposits and borrowings) tend to re-price more quickly on average when interest rates change than do its earning assets (mainly loans and available-for-sale debt securities). Accordingly, the Corporation tends to generate lower earnings when short-term interest rates rise and higher earnings when short-term rates fall. With recent reductions in the Fed Funds target rate (which has fallen from 5.25% in August 2007 to its mid-April 2008 level of 2.25%), the Corporation has experienced some recent reductions in its cost of funds and improvement in its net interest margin.

The addition of Citizens Bancorp, Inc. is expected to be accretive to earnings in 2008, and inclusion of those operations for the full year in 2008 (as opposed to eight months in 2007) will lead to higher reported levels of

revenues and expenses. The addition of the Citizens Trust Company trust department has contributed significantly to growth in trust assets under management and revenue, and management expects continued strong trust revenue performance over the remainder of 2008.

In January 2008, the Corporation implemented an overdraft privilege program. This program is designed to provide customers an opportunity to have checks paid that would otherwise have been returned, and to avoid charges from merchants and other payees. As described later in the Earnings Overview section of Management’s Discussion and Analysis, the Corporation generated a significant increase in noninterest revenue as a result of implementing the overdraft privilege program in the first quarter 2008, and management expects to continue that trend for the remainder of the year.

In the second quarter 2008, consultants will begin working with the Corporation’s management and employees to identify opportunities for further improvements in earnings. Although there can be no guarantee that improvements will result, the consultants’ focus will be on identifying opportunities for revenue enhancements and reductions in expenses through improved efficiencies.

The provision for loan losses for the first quarter 2008 was $904,000, a level much higher than management anticipated going into the year. In comparison, the annual provision for loan losses was $529,000 in 2007, $672,000 in 2006 and $2,026,000 in 2005. The comparatively high loan loss provision in the first quarter 2008 resulted from circumstances related to two large commercial loan relationships. Issues related to its larger commercial borrowers significantly affect the Corporation’s provision for loan losses in any particular period. Accordingly, the amount of loan loss provision for the remainder of 2008 will depend substantially on the credit status of the commercial portfolio. Although management is concerned about reports that the national economy is in or near recessionary status, to date the Corporation has not experienced significant deterioration in loan delinquencies, nor a noticeable change in volume of activity related to troubled debts or foreclosures. The Corporation has not originated interest only mortgages, loans without documentation of the borrowers’ sources of income or net worth, or other types of exotic mortgage loans that have received negative publicity in the last several months of 2007 and early 2008.

Benefits under the Corporation’s defined benefit pension plan were frozen, and a decision was made to terminate the Plan, effective December 31, 2007. The Corporation will record a realized loss from settlement of the defined benefit pension plan at the time it funds the final amounts necessary to extinguish its obligations under the Plan. The amount of settlement loss, which management expects will be incurred in 2008, has not yet been finally determined; however, management estimates a settlement loss in the income statement from termination of the plan in 2008 in an amount ranging from $500,000 to $1,000,000. As reflected in Note 6 to the consolidated financial statements, in the first quarter 2008, the Corporation recorded expense from the defined benefit plan of $76,000. For the year ended December 31, 2007, when a significant amount of service cost was still accruing, expense from the defined benefit plan (excluding a loss from curtailment of $77,000) totaled $495,000. Also in the first quarter 2008, employer matching contributions under the Corporation’s Employee Savings & Retirement Plan (a 401(k) plan), were increased, which will result in an estimated increase in expense of $150,000 for the year. Going forward after termination and settlement of the Plan, management expects the net impact of terminating the defined benefit plan and increasing the Savings & Retirement Plan contributions to be lower ongoing employee benefit expenses.

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. Throughout the first several years of this decade, the Corporation realized substantial gains from sales of bank stocks. From 2002-2006, the Corporation reported average annual realized gains from available-for-sale securities of $3,631,000. That trend continued in the first quarter 2007, as realized gains from available-for-sale securities totaled $1,161,000. However, in the second and third quarters of 2007, the Corporation restructured the debt securities portfolio, resulting in realized losses in excess of $2 million. For the year ended December 31, 2007, net realized gains from available-for-sale securities totaled $127,000. In the first quarter 2008, the Corporation reported net realized losses from available-for-sale securities of $110,000, including the effect of writing down an impaired bank stock by $249,000. Recently, market valuations of most financial stocks have been depressed, with some of the nation’s largest financial institutions reporting net losses in 2007 and the first quarter 2008, triggered by write-offs of sub-prime mortgages, collateralized debt obligations and other investments. Management believes this valuation issue to be cyclical; however, opportunities for realized gains from bank stocks are expected to be limited in 2008. Further, as discussed in more detail in Note 4 to the financial statements, the Corporation has significant unrealized losses on its holdings of municipal bonds, trust-preferred securities and some of its bank stocks as of March 31, 2008. Management has discussed the Corporation’s individual holdings of municipal bonds and trust-preferred securities with its investment advisors, and has concluded that no downgrades or deterioration in the credit quality of the securities has occurred that would warrant an other-than-temporary

impairment charge to the income statement. Also, management has reviewed its holdings of bank stocks as of March 31, 2008, and concluded that – with the exception of the security that was written down through earnings – none of them were other-than-temporarily
impaired. Management will continue to closely monitor the status of impaired securities throughout 2008.

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. 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 II, III and IV include information regarding the Corporation’s net interest margin for 2008 and 2007. 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 reflected in these tables exceed the amounts presented in the consolidated financial statements. The discussion that follows is based on amounts in the related Tables.

The fully taxable equivalent net interest margin was $10,542,000 in 2008, $1,818,000 (20.8%) higher than in 2007. As shown in Table IV, net increases in volume had the effect of increasing net interest income $939,000 in 2008 over 2007, and interest rate changes had the effect of increasing net interest income $879,000. Increases in volume of earning assets and interest-bearing liabilities were significantly affected by the acquisition of Citizens Trust Company on May 1, 2007. The most significant components of the volume changes in interest income in 2008 were an increase of $1,357,000 attributable to growth in the available-for-sale securities portfolio and an increase of $921,000 attributable to loan growth. The most significant volume change in interest expense in 2008 was an increase of $935,000 resulting from an increase in long-term borrowings. As presented in Table III, the “Interest Rate Spread” (excess of average rate of return on earning assets over average cost of funds on interest-bearing liabilities) was 3.06% in the first three months of 2008, as compared to 2.92% for the year ended December 31, 2007 and 2.80% in the first three months of 2007.

INTEREST INCOME AND EARNING ASSETS

Interest income totaled $19,198,000 in 2008, an increase of 14.8% over 2007. Income from available-for-sale securities increased $1,430,000, or 29.7%, and interest and fees from loans increased $1,064,000, or 9.0%. As indicated in Table III, total average available-for-sale securities in 2008 rose to $441,461,000, an increase of $96,210,000, or 27.9% from 2007. Throughout much of 2007, proceeds from sales and maturities of securities were used, in part, to help fund loans and pay off borrowings. In December 2007, the Corporation purchased approximately
$86,152,000 in mortgage-backed securities in connection with two repurchase agreements. The average rate of return on available-for-sale securities was 5.68% for 2008, in line with the 5.65% return for the year ended December 31, 2007 and 5.65% in the first three months of 2007.

The average balance of gross loans increased 7.0% to $733,102,000 in 2008 from $685,418,000 in the first three months of 2007. Excluding Citizens Trust Company, average total loans decreased $8,869,000, or 1.3%. Over the last several months of 2007 and the first quarter of 2008, the Corporation has experienced modest growth in the average balance of residential mortgage loans, while the balance of commercial loans has decreased as a result of payoffs of several individual commercial relationships. The average rate of return on loans was 7.05% in 2008, in line with the 7.10% return for the year ended December 31, 2007 and 6.97% in the first three months of 2007.

INTEREST EXPENSE AND INTEREST-BEARING LIABILITIES

Interest expense rose $656,000, or 8.2%, to $8,656,000 in 2008 from $8,000,000 in 2007. Table III shows that the overall cost of funds on interest-bearing liabilities fell to 3.45% in 2008, from 3.70% for the year ended December 31, 2007 and 3.72% in the first three months of 2007.

From Table III, you can calculate that total average deposits (interest-bearing and noninterest-bearing) increased 9.4%, to $829,593,000 in 2008 from $758,466,000 in the first three months of 2007. Excluding acquired Citizens Trust Company deposit accounts, total average deposits decreased $10,740,000 (1.4%). The average rates incurred on deposit accounts have decreased significantly in the first three months of 2008 as compared to the first three months of 2007. The decreases in rates reduced interest expense on deposits by $770,000.

The combined average total short-term and long-term borrowed funds increased $78,988,000 to $296,331,000 in 2008 from $217,343,000 in the first three months of 2007. In December 2007, the Corporation entered into two repurchase agreements totaling $80,000,000; the proceeds were used to purchase mortgage-backed securities as described above. In addition, the Corporation’s interest expense increased as several borrowings matured in 2007 and were replaced at higher rates. The average rate on long-term borrowings was 4.26% in 2008, up from 3.93% in the first three months of 2007.

Note: Interest income from tax-exempt securities and loans has been adjusted to a fully tax-equivalent basis, using the Corporation’s marginal federal income tax rate of 34%.

Total noninterest income increased $128,000 or 3.9%, in 2008 compared to 2007. Excluding realized gains and losses on available-for-sale securities, which are discussed in the “Earnings Overview” section of Management’s Discussion and Analysis, the increase is 67% in 2008 over 2007. Items of significance are as follows:

Total noninterest expense increased $217,000, or 2.6%, in 2008 over 2007. The increase in noninterest expense includes the effect of the May 2007 Citizens Bancorp acquisition, with additional personnel and other costs associated with adding three operating locations. Significant changes in 2008 as compared to 2007 include the following:

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. As discussed in more detail earlier within the “Prospects for the Remainder of 2008” section, recent economic conditions have impacted the market valuations of certain elements of the Corporation’s investment portfolio; however, management believes such conditions to be temporary. Other significant balance sheet items, including the allowance for loan losses and stockholders’ equity, are discussed in separate sections of Management’s Discussion and Analysis.

Total capital purchases for 2008 are estimated at approximately $1.2 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 2008.

The allowance for loan losses is maintained at a level that, 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.

There are two major components of the allowance – (1) 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 Special Mention, 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 SFAS 5 component of the allowance includes estimates of losses incurred on loans that have not been individually determined to be impaired. 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 impaired loans) by the ratio of net charge-offs to average quarterly loan balances for the previous three calendar years.

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 impaired loans) 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 VIII) includes the SFAS 114 component of the allowance on the line item called “Impaired Loans.” 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 VIII 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.

The allowance for loan losses totaled $8,948,000 at March 31, 2008, compared to $8,859,000 at December 31, 2007. As shown in Table VII, net charge-offs in the first quarter 2008 totaled $815,000, which is substantially higher than both the first quarter of 2007 and the historical levels for recent years shown in the table. In the first quarter 2008, the Corporation charged-off $780,000 due from three commercial loan relationships for which SFAS 114 allowances of $775,000 had been recorded as of December 31, 2007. Table VII also shows the provision for loan losses totaled $904,000 in the first quarter 2008, compared to $229,000 in the first quarter 2007. The total amount of the provision for loan losses in each period is determined based on the amount required to maintain an appropriate allowance in light of all of the factors described above. The first quarter 2008 provision for loan losses included the effects of establishing an SFAS 114 allowance of $250,000 on one commercial loan relationship, as well as increasing the SFAS 5 allowance from qualitative factors and increasing the unallocated portion of the allowance by $211,000.

Table IX presents information related to past due and impaired loans. Total impaired loans amounted to $6,159,000 at March 31, 2008, down slightly from $6,218,000 at December 31, 2007. Nonaccrual loans totaled $7,316,000 at March 31, 2008, up from $6,955,000 at December 31, 2007. The SFAS 114 valuation allowance on impaired loans totaled $1,723,000 at March 31, 2008, down from $2,255,000 at December 31, 2007. The decrease in the SFAS 114 valuation allowance was primarily attributed to the previously described charge-offs of $780,000 associated with three commercial loan relationships, partially offset by a SFAS 114 valuation allowance of $250,000 for one additional commercial relationship considered to be impaired. 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 estimated as of March 31, 2008. 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 VII, VIII, IX and X present an analysis of the allowance for loan losses, the allocation of the allowance, information concerning impaired and past due loans and a five-year summary of loans by type.