10-Q 1 text10q093007.txt PFSC 10-Q 09 30 07 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ------------------ FORM 10-Q ------------------ |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2007 OR | | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 ------------------ Commission file number 000-23777 PENSECO FINANCIAL SERVICES CORPORATION Incorporated pursuant to the laws of Pennsylvania ------------------ Internal Revenue Service -- Employer Identification No. 23-2939222 150 North Washington Avenue, Scranton, Pennsylvania 18503-1848 (570) 346-7741 ------------------ Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No | | Indicate by checkmark 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 | | Accelerated filer |X| Non-accelerated filer | | Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes | | No |X| The total number of shares of the registrant's Common Stock, $0.01 par value, outstanding on October 26, 2007 was 2,148,000. ================================================================================ PENSECO FINANCIAL SERVICES CORPORATION Page ---- Part I -- FINANCIAL INFORMATION Item 1. Unaudited Financial Statements - Consolidated Balance Sheets: September 30, 2007.....................................3 December 31, 2006......................................3 Statements of Income: Three Months Ended September 30, 2007..................4 Three Months Ended September 30, 2006..................4 Nine Months Ended September 30, 2007...................5 Nine Months Ended September 30, 2006...................5 Statements of Cash Flows: Nine Months Ended September 30, 2007...................6 Nine Months Ended September 30, 2006...................6 Notes to Unaudited Consolidated Financial Statements.......7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.................................14 Item 3. Quantitative and Qualitative Disclosures About Market Risk....25 Item 4. Controls and Procedures.......................................25 Part II -- OTHER INFORMATION Item 1. Legal Proceedings.............................................26 Item 1A. Risk Factors..................................................26 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds...28 Item 3. Defaults Upon Senior Securities...............................28 Item 4. Submission of Matters to a Vote of Security Holders...........28 Item 5. Other Information.............................................28 Item 6. Exhibits......................................................28 Signatures ..............................................................28 Certifications ..............................................................29 PART I. FINANCIAL INFORMATION, Item 1 -- Financial Statements PENSECO FINANCIAL SERVICES CORPORATION CONSOLIDATED BALANCE SHEETS (unaudited) (in thousands, except per share amounts)
September 30, December 31, 2007 2006 ---------------- ---------------- ASSETS Cash and due from banks $ 12,358 $ 12,999 Interest bearing balances with banks 13,063 1,779 Federal funds sold 7,000 - ---------------- ---------------- Cash and Cash Equivalents 32,421 14,778 Investment securities: Available-for-sale, at fair value 72,804 91,705 Held-to-maturity (fair value of $69,887 and $75,120, respectively) 69,387 74,375 ---------------- ---------------- Total Investment Securities 142,191 166,080 Loans, net of unearned income 396,035 369,922 Less: Allowance for loan losses 4,600 4,200 ---------------- ---------------- Loans, Net 391,435 365,722 Bank premises and equipment 9,489 9,471 Other real estate owned - - Accrued interest receivable 3,632 3,632 Cash surrender value of life insurance 7,289 7,054 Other assets 3,348 3,084 ---------------- ---------------- Total Assets $ 589,805 $ 569,821 ================ ================ LIABILITIES Deposits: Non-interest bearing $ 78,187 $ 71,585 Interest bearing 345,245 342,215 ---------------- ---------------- Total Deposits 423,432 413,800 Other borrowed funds: Repurchase agreements 33,295 13,441 Short-term borrowings 625 5,486 Long-term borrowings 58,470 65,853 Accrued interest payable 1,386 1,472 Other liabilities 2,903 3,198 ---------------- ---------------- Total Liabilities 520,111 503,250 ---------------- ---------------- STOCKHOLDERS' EQUITY Common stock ($ .01 par value, 15,000,000 shares authorized, 2,148,000 shares issued and outstanding) 21 21 Surplus 10,819 10,819 Retained earnings 59,560 56,393 Accumulated other comprehensive income (706) (662) ---------------- ---------------- Total Stockholders' Equity 69,694 66,571 ---------------- ---------------- Total Liabilities and Stockholders' Equity $ 589,805 $ 569,821 ================ ================
(See accompanying Notes to Unaudited Consolidated Financial Statements) PENSECO FINANCIAL SERVICES CORPORATION CONSOLIDATED STATEMENTS OF INCOME (unaudited) (in thousands, except per share amounts)
Three Months Ended Three Months Ended September 30, 2007 September 30,2006 -------------------- -------------------- INTEREST INCOME Interest and fees on loans $ 6,769 $ 5,886 Interest and dividends on investments: U.S. Treasury securities and U.S. Agency obligations 896 1,267 States & political subdivisions 733 697 Other securities 84 86 Interest on Federal funds sold 129 - Interest on balances with banks 121 72 -------------------- -------------------- Total Interest Income 8,732 8,008 -------------------- -------------------- INTEREST EXPENSE Interest on time deposits of $100,000 or more 504 299 Interest on other deposits 1,858 1,679 Interest on other borrowed funds 840 816 -------------------- -------------------- Total Interest Expense 3,202 2,794 -------------------- -------------------- Net Interest Income 5,530 5,214 Provision for loan losses 308 143 -------------------- -------------------- Net Interest Income After Provision for Loan Losses 5,222 5,071 -------------------- -------------------- OTHER INCOME Trust department income 421 408 Service charges on deposit accounts 245 218 Merchant transaction income 1,482 1,387 Other fee income 325 319 Bank-Owned Life Insurance income 80 - Other operating income 112 120 Realized (losses) gains on securities, net (2) - -------------------- -------------------- Total Other Income 2,663 2,452 -------------------- -------------------- OTHER EXPENSES Salaries and employee benefits 2,108 2,132 Expense of premises and fixed assets 605 580 Merchant transaction expenses 1,149 1,089 Other operating expenses 1,238 1,298 -------------------- -------------------- Total Other Expenses 5,100 5,099 -------------------- -------------------- Income before income taxes 2,785 2,424 Applicable income taxes 604 551 -------------------- -------------------- Net Income 2,181 1,873 Other comprehensive income, net of taxes: Unrealized securities gains (losses) 156 831 -------------------- -------------------- Comprehensive Income $ 2,337 $ 2,704 ==================== ==================== Earnings per Common Share (Based on 2,148,000 shares outstanding) $ 1.01 $ 0.87 Cash Dividends Declared Per Common Share $ 0.37 $ 0.35
(See accompanying Notes to Unaudited Consolidated Financial Statements) PENSECO FINANCIAL SERVICES CORPORATION CONSOLIDATED STATEMENTS OF INCOME (unaudited) (in thousands, except per share amounts)
Nine Months Ended Nine Months Ended September 30, 2007 September 30, 2006 -------------------- -------------------- INTEREST INCOME Interest and fees on loans $ 19,621 $ 17,119 Interest and dividends on investments: U.S. Treasury securities and U.S. Agency obligations 2,859 4,178 States & political subdivisions 2,178 1,958 Other securities 322 250 Interest on Federal funds sold 433 - Interest on balances with banks 314 120 -------------------- -------------------- Total Interest Income 25,727 23,625 -------------------- -------------------- INTEREST EXPENSE Interest on time deposits of $100,000 or more 1,540 805 Interest on other deposits 5,585 4,638 Interest on other borrowed funds 2,485 2,585 -------------------- -------------------- Total Interest Expense 9,610 8,028 -------------------- -------------------- Net Interest Income 16,117 15,597 Provision for loan losses 528 297 -------------------- -------------------- Net Interest Income After Provision for Loan Losses 15,589 15,300 -------------------- -------------------- OTHER INCOME Trust department income 1,160 1,113 Service charges on deposit accounts 756 634 Merchant transaction income 3,402 3,227 Other fee income 908 877 Bank-Owned Life Insurance income 235 - Other operating income 229 294 Realized gains (losses) on securities, net 49 - -------------------- -------------------- Total Other Income 6,739 6,145 -------------------- -------------------- OTHER EXPENSES Salaries and employee benefits 6,813 6,912 Expense of premises and fixed assets 1,955 1,814 Merchant transaction expenses 2,644 2,543 Other operating expenses 4,031 3,785 -------------------- -------------------- Total Other Expenses 15,443 15,054 -------------------- -------------------- Income before income taxes 6,885 6,391 Applicable income taxes 1,334 1,383 -------------------- -------------------- Net Income 5,551 5,008 Other comprehensive income, net of taxes: Unrealized securities (losses) gains (44) 579 -------------------- -------------------- Comprehensive Income $ 5,507 $ 5,587 ==================== ==================== Earnings per Common Share (Based on 2,148,000 shares outstanding) $ 2.58 $ 2.33 Cash Dividends Declared Per Common Share $ 1.11 $ 1.05
(See accompanying Notes to Unaudited Consolidated Financial Statements) PENSECO FINANCIAL SERVICES CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) (in thousands)
Nine Months Ended Nine Months Ended September 30, 2007 September 30, 2006 -------------------- -------------------- OPERATING ACTIVITIES Net Income $ 5,551 $ 5,008 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 644 538 Provision for loan losses 528 297 Deferred income tax provision (benefit) 117 37 Amortization of securities, (net of accretion) 281 322 Net realized (gains) losses on securities (49) - (Gain) loss on other real estate - (7) Decrease (increase) in interest receivable - 179 (Increase) decrease in cash surrender value of life insurance (235) - (Increase) decrease in other assets (375) (536) Increase (decrease) in income taxes payable 74 205 (Decrease) increase in interest payable (86) 81 (Decrease) increase in other liabilities (486) (38) -------------------- -------------------- Net cash provided by operating activities 5,964 6,086 -------------------- -------------------- INVESTING ACTIVITIES Purchase of investment securities available-for-sale (12,496) (20,241) Proceeds from sales and maturities of investment securities available-for-sale 21,838 51,745 Purchase of investment securities to be held-to-maturity - - Proceeds from repayments of investment securities available-for-sale 9,665 11,824 Proceeds from repayments of investment securities held-to-maturity 4,717 5,591 Net loans (originated) repaid (26,317) (33,123) Proceeds from other real estate 76 98 Investment in premises and equipment (662) (416) -------------------- -------------------- Net cash (used) provided by investing activities (3,179) 15,478 -------------------- -------------------- FINANCING ACTIVITIES Net increase (decrease) in demand and savings deposits 22,213 (17,792) Net (payments) proceeds on time deposits (12,581) 20,836 Increase (decrease) in federal funds purchased - - Increase (decrease) in repurchase agreements 19,854 (11,822) Net (decrease) increase in short-term borrowings (4,861) (2,556) Repayments of long-term borrowings (7,383) (7,129) Cash dividends paid (2,384) (2,255) -------------------- -------------------- Net cash provided (used) by financing activities 14,858 (20,718) -------------------- -------------------- Net increase (decrease) in cash and cash equivalents 17,643 846 Cash and cash equivalents at January 1 14,778 11,573 -------------------- -------------------- Cash and cash equivalents at September 30 $ 32,421 $ 12,419 ==================== ====================
The Company paid interest and income taxes of $9,696 and $1,045 and $7,947 and $1,131, for the nine month periods ended September 30, 2007 and 2006, respectively. (See accompanying Notes to Unaudited Consolidated Financial Statements) NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS For the Quarter Ended September 30, 2007 (unaudited) These Notes to Unaudited Consolidated Financial Statements reflect events subsequent to December 31, 2006, the date of the most recent Report of Independent Registered Public Accounting Firm, through the date of this Quarterly Report on Form 10-Q. These Notes to Unaudited Consolidated Financial Statements should be read in conjunction with Parts I and II of this Report, in particular, (1) Part I, Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations for the three months ended September 30, 2007 and September 30, 2006 and for the nine months ended September 30, 2007 and September 30, 2006, with respect to the Company's net interest income, capital requirements and liquidity, (2) Part II, Item 6, Exhibits and (3) the Company's Annual Report on Form 10-K for the year ended December 31, 2006, which was filed with the Securities and Exchange Commission on March 16, 2007 and is incorporated herein by reference. FORWARD LOOKING INFORMATION This Form 10-Q contains forward-looking informational statements, in addition to the historical financial information required by the Securities and Exchange Commission. There are certain risks and uncertainties associated with these forward-looking statements which could cause actual results to differ materially from those stated herein. Such risks are discussed in the section entitled "Management Discussion and Analysis of Financial Condition and Results of Operations". These forward-looking statements reflect management's analysis as of this point in time. Readers should review the other documents the Company periodically files with the Securities and Exchange Commission in order to keep apprised of any material changes. The Company undertakes no obligation to publicly release the results of any revisions to those forward-looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. NOTE 1 -- Principles of Consolidation Penseco Financial Services Corporation (Company) is a financial holding company incorporated under the laws of Pennsylvania. It is the parent company of Penn Security Bank and Trust Company (Bank), a Pennsylvania state chartered bank. Intercompany transactions have been eliminated in preparing the consolidated financial statements. The accounting policies of the Company conform with accounting principles generally accepted in the United States of America and with general practices within the banking industry. NOTE 2 -- Basis of Presentation The unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information. In the opinion of management, all adjustments that are of a normal recurring nature and are considered necessary for a fair presentation have been included. They are not, however, necessarily indicative of the results of consolidated operations for a full year. All information is presented in thousands of dollars, except per share amounts. For further information, refer to the consolidated financial statements and accompanying notes included in the Company's Annual Report on Form 10-K for the year ended December 31, 2006. NOTE 3 -- Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for losses on loans and the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the allowances for losses on loans and foreclosed real estate, management obtains independent appraisals for significant properties. NOTE 4 -- Investment Securities Investments in securities are classified in two categories and accounted for as follows: Securities Held-to-Maturity Bonds, notes, debentures and mortgage-backed securities for which the Company has the positive intent and ability to hold to maturity are reported at cost, adjusted for amortization of premiums and accretion of discounts computed on the straight-line basis, which approximates the interest method, over the remaining period to maturity. Securities Available-for-Sale Bonds, notes, debentures, mortgage-backed securities and certain equity securities not classified as securities to be held to maturity are carried at fair value with unrealized holding gains and losses, net of tax, reported as a net amount in a separate component of stockholders' equity until realized. The amortization of premiums on mortgage-backed securities is based on management's estimate of the lives of the securities, adjusted, when necessary, for advanced prepayments in excess of those estimates. Realized gains and losses on the sale of securities available-for-sale are determined using the specific identification method and are reported as a separate component of other income in the Statements of Income. Unrealized gains and losses are included as a separate item in computing comprehensive income. The amortized cost and fair value of investment securities at September 30, 2007 and December 31, 2006 are as follows: Available-for-Sale Gross Gross Amortized Unrealized Unrealized Fair September 30, 2007 Cost Gains Losses Value -------------------------------------------------------------------------------- U.S. Agency securities $ 14,921 $ 55 $ 20 $ 14,956 Mortgage-backed securities 19,527 137 42 19,622 States & political subdivisions 30,729 875 - 31,604 -------------------------------------------------------------------------------- Total Debt Securities 65,177 1,067 62 66,182 Equity securities 6,163 696 237 6,622 -------------------------------------------------------------------------------- Total Available-for-Sale $ 71,340 $ 1,763 $ 299 $ 72,804 -------------------------------------------------------------------------------- Available-for-Sale Gross Gross Amortized Unrealized Unrealized Fair December 31, 2006 Cost Gains Losses Value -------------------------------------------------------------------------------- U.S. Agency securities $ 24,897 $ 9 $ 23 $ 24,883 Mortgage-backed securities 29,231 91 82 29,240 States & political subdivisions 29,281 939 - 30,220 -------------------------------------------------------------------------------- Total Debt Securities 83,409 1,039 105 84,343 Equity securities 6,764 628 30 7,362 -------------------------------------------------------------------------------- Total Available-for-Sale $ 90,173 $ 1,667 $ 135 $ 91,705 -------------------------------------------------------------------------------- Held-to-Maturity Gross Gross Amortized Unrealized Unrealized Fair September 30, 2007 Cost Gains Losses Value -------------------------------------------------------------------------------- Mortgage-backed securities $ 40,144 $ 2 $ 1,045 $ 39,101 States & political subdivisions 29,243 1,543 - 30,786 -------------------------------------------------------------------------------- Total Held-to-Maturity $ 69,387 $ 1,545 $ 1,045 $ 69,887 -------------------------------------------------------------------------------- Held-to-Maturity Gross Gross Amortized Unrealized Unrealized Fair December 31, 2006 Cost Gains Losses Value -------------------------------------------------------------------------------- Mortgage-backed securities $ 45,124 $ 4 $ 1,074 $ 44,054 States & political subdivisions 29,251 1,815 - 31,066 -------------------------------------------------------------------------------- Total Held-to-Maturity $ 74,375 $ 1,819 $ 1,074 $ 75,120 -------------------------------------------------------------------------------- The amortized cost and fair value of debt securities at September 30, 2007 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. September 30, 2007 Available-for-Sale Held-to-Maturity -------------------------------------------------------------------------------- Amortized Fair Amortized Fair Cost Value Cost Value -------------------------------------------------------------------------------- Due in one year or less: U.S. Agency securities $ 9,909 $ 9,900 $ - $ - After one year through five years: U.S. Agency securities 5,012 5,056 - - After five year through ten years: States & political subdivisions 460 494 1,793 1,893 After ten years: States & political subdivisions 30,269 31,110 27,450 28,893 -------------------------------------------------------------------------------- Subtotal 45,650 46,560 29,243 30,786 Mortgage-backed securities 19,527 19,622 40,144 39,101 -------------------------------------------------------------------------------- Total Debt Securities $ 65,177 $ 66,182 $ 69,387 $ 69,887 -------------------------------------------------------------------------------- The gross fair value and unrealized losses of the Company's investments, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at September 30, 2007 and December 31, 2006 are as follows:
Less than twelve months Twelve months or more Totals ------------------------------ ------------------------------ ------------------------------ Fair Unrealized Fair Unrealized Fair Unrealized September 30, 2007 Value Losses Value Losses Value Losses -------------------------------------------------------------- ------------------------------ ------------------------------ U.S. Agency securities $ - $ - $ 4,929 $ 20 $ 4,929 $ 20 Mortgage-backed securities 2,140 10 41,737 1,077 43,877 1,087 Equities 1,268 92 549 145 1,817 237 ------------- ------------- ------------- ------------- ------------- ------------- Total $ 3,408 $ 102 $ 47,215 $ 1,242 $ 50,623 $ 1,344 ============= ============= ============= ============= ============= =============
The table above at September 30, 2007, includes eleven (11) securities that have unrealized losses for less than twelve months and ten (10) securities that have been in an unrealized loss position for twelve or more months.
Less than twelve months Twelve months or more Totals ------------------------------ ------------------------------ ------------------------------ Fair Unrealized Fair Unrealized Fair Unrealized December 31, 2006 Value Losses Value Losses Value Losses -------------------------------------------------------------- ------------------------------ ------------------------------ U.S. Agency securities $ 9,868 $ 9 $ 9,985 $ 14 $ 19,853 $ 23 Mortgage-backed securities - - 50,379 1,156 50,379 1,156 Equities 160 1 541 29 701 30 ------------- ------------- ------------- ------------- ------------- ------------- Total $ 10,028 $ 10 $ 60,905 $ 1,199 $ 70,933 $ 1,209 ============= ============= ============= ============= ============= =============
U.S. Agency Securities The unrealized losses on the Company's investments in these obligations were caused by recent interest rate increases. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the par value of the investment. Because the Company has the ability to hold these investments until a recovery of fair value, which may be maturity, the Company does not consider these investments to be other-than-temporarily impaired at September 30, 2007. Mortgage-Backed Securities The unrealized losses on the Company's investments in mortgage-backed securities were caused by recent interest rate increases. The contractual cash flows of these investments are guaranteed by an agency of the U.S. government. Accordingly, it is expected that these securities would not be settled at a price less than the amortized cost of the Company's investment. Because the decline in market value is attributable to changes in interest rates and not credit quality and because the Company has the ability to hold these investments until a recovery of fair value, which may be maturity, the Company does not consider these investments to be other-than-temporarily impaired at September 30, 2007. The Company's mortgage-backed securities portfolio does not contain any sub-prime or Alt-A credits. Marketable Equity Securities The unrealized losses on the Company's investments in marketable equity securities were caused primarily by recent interest rate increases and other market conditions. The Company's investments in marketable equity securities consist primarily of investments in common stock of companies in the financial services industry. Because the Company has the ability and intent to hold these investments for a reasonable period of time sufficient for a forecasted recovery of fair value, the Company does not consider these investments to be other-than-temporarily impaired at September 30, 2007. NOTE 5 -- Loan Portfolio Details regarding the Company's loan portfolio: September 30, December 31, As of: 2007 2006 ------------------------------------------------------------------------------ Real estate - construction and land development $ 24,953 $ 23,714 Real estate mortgages 308,042 284,323 Commercial 22,808 26,265 Credit card and related plans 3,249 3,282 Installment and other 30,540 25,532 Obligations of states & political subdivisions 6,443 6,806 ------------------------------------------------------------------------------ Loans, net of unearned income 396,035 369,922 Less: Allowance for loan losses 4,600 4,200 ------------------------------------------------------------------------------ Loans, net $ 391,435 $ 365,722 ------------------------------------------------------------------------------ The Company does not engage in any sub-prime or Alt-A credit lending. Therefore, the Company is not subject to any associated credit risks. NOTE 6 -- Loan Servicing The Company generally retains the right to service mortgage loans sold to others. The cost allocated to the mortgage servicing rights retained has been recognized as a separate asset and is being amortized in proportion to and over the period of estimated net servicing income. Mortgage servicing rights are evaluated for impairment based on the fair value of those rights. Fair values are estimated using discounted cash flows based on current market rates of interest and expected future prepayment rates. For purposes of measuring impairment, the rights must be stratified by one or more predominant risk characteristics of the underlying loans. The Company stratifies its capitalized mortgage servicing rights based on the product type, interest rate and term of the underlying loans. The amount of impairment recognized is the amount, if any, by which the amortized cost of the rights for each stratum exceed the fair value. NOTE 7 -- Long-Term Debt The Bank borrowed $100,000 from the Federal Home Loan Bank of Pittsburgh, in four loans with various maturity dates, to finance the purchase of a mortgaged-backed security. The loans are secured by a general collateral pledge of the Company. A summary of the long-term debt at June 30, 2007 is as follows: Note payable, due in monthly installments of $161, including principal and interest at a fixed rate of 2.73%, maturing March, 2008. $ 956 Note payable, due in monthly installments of $253, including principal and interest at a fixed rate of 3.22%, maturing March, 2010. 7,281 Note payable, due in monthly installments of $430, including principal and interest at a fixed rate of 3.74%, maturing March, 2013. 25,619 Note payable, due in monthly installments of $186, including principal and interest at a fixed rate of 4.69%, maturing March, 2023. 24,614 ------- Total long-term debt $58,470 ======= The Company has agreed to maintain sufficient qualifying collateral to fully secure the above borrowings. Aggregate maturities of long-term debt at September 30, 2007 are as follows: September 30, Principal ------------- --------- 2008 $ 9,181 2009 8,533 2010 7,325 2011 6,056 2012 6,299 Thereafter 21,076 --------- $ 58,470 ========= NOTE 8 -- Employee Benefit Plans The Company provides a defined benefit pension plan for eligible employees. The components of the net periodic benefit costs are as follows: Pension Benefits Other Benefits ---------------- ---------------- Nine months ended September 30, 2007 2006 2007 2006 ---------------------------------------------------------------------------- Service cost $ 327 $ 327 $ 3 $ 4 Interest cost 555 502 12 12 Expected return on plan assets (723) (668) - - Amortization of prior service cost - 1 6 6 Amortization of net loss (gain) 108 124 - - ---------------------------------------------------------------------------- Net periodic pension cost $ 267 $ 286 $ 21 $ 22 ---------------------------------------------------------------------------- Contributions ------------- The Company previously disclosed in its financial statements for the year ended December 31, 2006 that it expected to contribute $250 to its pension plan and $13 to its postretirement plan for 2007. As of October 15, 2007, $219 has been contributed to the pension plan for 2007. The pension and postretirement contribution estimates have not changed substantially since December 31, 2006. Readers should refer to the Annual Report on Form 10-K for further details on the Company's defined benefit pension plan. NOTE 9 -- Regulatory Matters The Company and the Bank are subject to various regulatory capital requirements administered by the Federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory--and possibly additional discretionary--actions by regulators that, if undertaken, could have a direct material effect on the Company and the Bank's consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Company's and the Bank's capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the Capital Adequacy table on the following page) of Tier I and Total Capital to risk-weighted assets and of Tier I Capital to average assets (Leverage ratio). The table also presents the Company's actual capital amounts and ratios. The Bank's actual capital amounts and ratios are substantially identical to the Company's. Management believes, as of September 30, 2007, that the Company and the Bank meet all capital adequacy requirements to which they are subject. As of September 30, 2007, the Federal Deposit Insurance Corporation (FDIC) categorized the Company as "well capitalized" under the regulatory framework for prompt corrective action. To be categorized as "well capitalized", the Company must maintain minimum Tier I Capital, Total Capital and Leverage ratios as set forth in the Capital Adequacy table. There are no conditions or events since that notification that management believes have changed the Company's categorization by the FDIC. The Company and Bank are also subject to minimum capital levels, which could limit the payment of dividends, although the Company and Bank currently have capital levels which are in excess of minimum capital level ratios required. The Pennsylvania Banking Code restricts capital funds available for payment of dividends to the Retained Earnings of the Bank. Accordingly, at September 30, 2007, the balances in the Capital Stock and Surplus accounts totalling $10,840 are unavailable for dividends. In addition, the Bank is subject to restrictions imposed by Federal law on certain transactions with the Company's affiliates. These transactions include extensions of credit, purchases of or investments in stock issued by the affiliate, purchases of assets subject to certain exceptions, acceptance of securities issued by an affiliate as collateral for loans, and the issuance of guarantees, acceptances, and letters of credit on behalf of affiliates. These restrictions prevent the Company's affiliates from borrowing from the Bank unless the loans are secured by obligations of designated amounts. Further, the aggregate of such transactions by the Bank with a single affiliate is limited in amount to 10 percent of the Bank's Capital Stock and Surplus, and the aggregate of such transactions with all affiliates is limited to 20 percent of the Bank's Capital Stock and Surplus. The Federal Reserve System has interpreted "Capital Stock and Surplus" to include undivided profits.
Actual Regulatory Requirements --------------------------------------------------------- -------------------------------------------- For Capital To Be Adequacy Purposes "Well Capitalized" ----------------- ------------------ As of September 30, 2007 Amount Ratio Amount Ratio Amount Ratio --------------------------------------------------------------------------------------------------------- Total Capital (to Risk Weighted Assets) PFSC (Company) $ 74,885 19.99% > $ 29,970 > 8.0% > $ 37,462 > 10.0% - - - - PSB (Bank) $ 69,927 18.77% > $ 29,808 > 8.0% > $ 37,260 > 10.0% - - - - Tier 1 Capital (to Risk Weighted Assets) PFSC $ 70,285 18.76% > $ 14,985 > 4.0% > $ 22,477 > 6.0% - - - - PSB $ 65,327 17.53% > $ 14,904 > 4.0% > $ 22,356 > 6.0% - - - - Tier 1 Capital (to Average Assets) PFSC $ 70,285 12.01% > $ * > * > $ 29,273 > 5.0% - - - - PSB $ 65,327 11.24% > $ * > * > $ 29,071 > 5.0% - - - -
PFSC - *3.0% ($17,564), 4.0% ($23,418) or 5.0% ($29,273) depending on the bank's CAMELS Rating and other regulatory risk factors. PSB - *3.0% ($17,442), 4.0% ($23,257) or 5.0% ($29,071) depending on the bank's CAMELS Rating and other regulatory risk factors.
Actual Regulatory Requirements --------------------------------------------------------- -------------------------------------------- For Capital To Be Adequacy Purposes "Well Capitalized" ----------------- ------------------ As of December 31, 2006 Amount Ratio Amount Ratio Amount Ratio --------------------------------------------------------------------------------------------------------- Total Capital (to Risk Weighted Assets) PFSC (Company) $ 71,235 19.65% > $ 28,998 > 8.0% > $ 36,248 > 10.0% - - - - PSB (Bank) $ 68,029 18.84% > $ 28,882 > 8.0% > $ 36,103 > 10.0% - - - - Tier I Capital (to Risk Weighted Assets) PFSC $ 67,035 18.49% > $ 14,499 > 4.0% > $ 21,749 > 6.0% - - - - PSB $ 63,829 17.68% > $ 14,441 > 4.0% > $ 21,662 > 6.0% - - - - Tier I Capital (to Average Assets) PFSC $ 67,035 11.93% > $ * > * > $ 28,105 > 5.0% - - - - PSB $ 63,829 11.36% > $ * > * > $ 28,083 > 5.0% - - - -
PFSC - *3.0% ($16,863), 4.0% ($22,484) or 5.0% ($28,105) depending on the bank's CAMELS Rating and other regulatory risk factors. PSB - *3.0% ($16,850), 4.0% ($22,466) or 5.0% ($28,083) depending on the bank's CAMELS Rating and other regulatory risk factors. PART 1. FINANCIAL INFORMATION, Item 2 -- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following commentary provides an overview of the financial condition and significant changes in the results of operations of Penseco Financial Services Corporation and its subsidiary, Penn Security Bank and Trust Company, for the three months ended September 30, 2007 and September 30, 2006 and for the nine months ended September 30, 2007 and September 30, 2006. All information is presented in thousands of dollars, except as indicated. Critical Accounting Policies The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Provision (allowance) for possible loan losses - The provision for loan losses is based on past loan loss experience, management's evaluation of the potential loss in the current loan portfolio under current economic conditions and such other factors as, in management's best judgment, deserve current recognition in estimating loan losses. The annual provision for loan losses charged to operating expense is that amount which is sufficient to bring the balance of the allowance for possible loan losses to an adequate level to absorb anticipated losses. Actuarial assumptions associated with pension, post-retirement and other employee benefit plans - These assumptions include discount rate, rate of future compensation increases and expected return on plan assets. Provision for income taxes - Management believes that the assumptions and judgments used to record tax related assets or liabilities have been appropriate. Fair value of certain investment securities - Fair value of investment securities are based on quoted market prices. Loan servicing rights - Mortgage servicing rights are evaluated for impairment based on the fair value of those rights. Fair values are estimated using discounted cash flows based on current market rates of interest and current expected future prepayment rates. For purposes of measuring impairment, the rights must be stratified by one or more predominant risk characteristics of the underlying loans. The Company stratifies its capitalized mortgage servicing rights based on the product type, interest rate and term of the underlying loans. The amount of impairment recognized is the amount, if any, by which the amortized cost of the rights for each stratum exceed the fair value. Premium amortization - The amortization of premiums on mortgage-backed securities is done based on management's estimate of the lives of the securities, adjusted, when necessary, for advanced prepayments in excess of those estimates. Executive Summary Penseco Financial Services Corporation reported an increase in net income of $308 or 16.4% for the three months ended September 30, 2007 to $2,181 or $1.01 per share compared with $1,873 or $.87 per share from the year ago period. Net interest income after provision for loan losses increased $151 or 3.0%, to $5,222 for three months ended September 30, 2007 compared to $5,071 for the same quarter of 2006. Largely, the increase came from higher interest and fees on loans of $883 or 15.0%, due to net loan growth of $41.1 million since September 30, 2006, including $25.7 million from December 31, 2006. Interest on investments declined $159 or 7.5%, due to maturing investments being redeployed to fund future loan demand. Other income increased $211 or 8.6%, for the three months ended September 30, 2007 to $2,663 compared with $2,452 for the three months ended September 30, 2006, mostly from increased merchant transaction income and other operating income. Total other expenses increased $1 to $5,100 for the three months ended September 30, 2007, compared with $5,099 for the same period of 2006. Applicable income taxes increased $53 or 9.6%, for the three months ended September 30, 2007, to $604 due to higher operating income. For the nine months ended September 30, 2007, net income increased $543 or 10.8%, to $5,551 or $2.58 per share compared with the year ago period of $5,008 or $2.33 per share. Net interest income after provision for loan losses increased $289 or 1.9%, to $15,589 for the nine months ended September 30, 2007 from $15,300 for the same period of 2006. Largely, the increase came from higher interest and fees on loans of $2,502 or 14.6%, as net loans increased $41.1 million since the year ago period. Interest on investments declined $400 or 6.1% for the nine months ended September 30, 2007, due to maturing investments being redeployed to fund future loan demand. Other income increased $594 or 9.7% for the nine months ended September 30, 2007, mostly in merchant transaction income as volumes increased from new business and higher service charge income. Total other expenses increased $389 or 2.6% for the nine months ended September 30, 2007, mainly due to an increase in other operating expense. Applicable income taxes decreased $49 or 3.5% for the nine months ended September 30, 2007, to $1,334 due to more tax free income included in overall operating income. Net Interest Income and Net Interest Margin Net interest income, the largest contributor to the Company's earnings, is defined as the difference between interest income on assets and the cost of funds supporting those assets. Average earning assets are composed primarily of loans and investments while deposits, short-term and long-term borrowings represent interest-bearing liabilities. Variations in the volume and mix of these assets and liabilities, as well as changes in the yields earned and rates paid, are determinants of changes in net interest income. Net interest income after provision for loan losses increased $151 or 3.0% to $5,222 for the three months ended September 30, 2007 compared to $5,071 for the three months ended September 30, 2006. The average yield on interest earning assets increased 30 basis points, largely from maturing investments redeployed to funds loan growth. Also, there was an increase of $47.8 million in average loans from the comparable period of 2006. The net interest margin represents the Company's net yield on its average interest earning assets and is calculated as net interest income divided by average interest earning assets. In the three months ended September 30, 2007, net interest margin was 3.99% increasing 8 basis points from 3.91% in the same period of 2006. Total average interest earning assets and average interest bearing funds increased in the three months ended September 30, 2007 as compared to 2006. Average interest earning assets increased $20.7 million or 3.9%, from $534.0 million in 2006 to $554.7 million in 2007 and average interest bearing funds increased $11.6 million, or 2.7%, from $423.9 million to $435.5 million for the same period, mainly due to higher loans and money market accounts, along with increased repurchase agreements. Long-term borrowings decreased $9.8 million or 14.1%. Average earning assets, including Bank-Owned Life Insurance (BOLI), increased to 96.0% for the three months ended September 30, 2007 from 95.6% for the year ago period. Changes in the mix of both interest earning assets and funding sources also impacted net interest income in the three months ended September 30, 2007 and 2006. Average loans as a percentage of average interest earning assets increased from 64.2% in 2006 to 70.4% in 2007, due in part to the increase of new and refinanced residential mortgages. Average investments decreased $41.7 million from 34.8% to 26.0% of interest earning assets. Average short-term investments, federal funds sold and interest bearing balances with banks, increased $14.6 million to $19.8 million from $5.2 million. Average time deposits increased $.7 million to $111.4 million from $110.7 million, average long-term borrowings decreased $9.8 million, while repurchase agreements increased $8.8 million. Shifts in the interest rate environment and competitive factors affected the rates paid for funds as well as the yields earned on assets. The investment securities tax equivalent yield increased 62 basis points from 5.18% for the three months ended September 30, 2006 to 5.80% for the three months ended September 30, 2007. Average loan yields increased 6 basis points, from 6.87% for the three months ended September 30, 2006 to 6.93% for the three months ended September 30, 2007. The average time deposit costs increased 36 basis points from 4.03% for the three months ended September 30, 2006 to 4.39% for the three months ended September 30, 2007, along with the average cost of money market accounts increasing 40 basis points from 2.77% for the three months ended September 30, 2006 to 3.17% for the three months ended September 30, 2007. Distribution of Assets, Liabilities and Stockholders' Equity / Interest Rates and Interest Differential The table below presents average balances, interest income on a fully taxable equivalent basis and interest expense, as well as average rates earned and paid on the Company's major asset and liability items for the three months ended September 30, 2007 and September 30, 2006.
---------------------------------------------------------------------------------------------------------- September 30, 2007 September 30, 2006 ASSETS Average Revenue/ Yield/ Average Revenue/ Yield/ Balance Expense Rate Balance Expense Rate ---------------------------------------------------------------------------------------------------------- Investment Securities Available-for-sale: U.S. Agency obligations $ 36,900 $ 426 4.62% $ 75,000 $ 731 3.90% States & political subdivisions 30,243 341 6.83% 26,269 306 7.06% Federal Home Loan Bank stock 3,784 59 6.24% 4,562 60 5.26% Other 3,089 25 3.24% 3,086 26 3.37% Held-to-maturity: U.S. Agency obligations 40,963 470 4.59% 47,748 536 4.49% States & political subdivisions 29,245 392 8.12% 29,253 391 8.10% Loans, net of unearned income: Real estate mortgages 327,745 5,526 6.74% 278,160 4,655 6.69% Commercial 22,992 489 8.51% 27,925 542 7.76% Consumer and other 39,969 754 7.55% 36,788 689 7.49% Federal funds sold 10,207 129 5.06% - - - Interest on balances with banks 9,565 121 5.06% 5,222 72 5.52% ---------------------------------------------------------------------------------------------------------- Total Interest Earning Assets/ Total Interest Income 554,702 $ 8,732 6.30% 534,013 $ 8,008 6.00% ---------------------------------------------------------------------------------------------------------- Cash and due from banks 10,648 10,158 Bank premises and equipment 9,646 9,378 Accrued interest receivable 3,430 3,038 Cash surrender value of life insurance 7,237 - Other assets 4,228 5,797 Less: Allowance for loan losses 4,320 3,896 ---------------------------------------------------------------------------------------------------------- Total Assets $ 585,571 $ 558,488 ---------------------------------------------------------------------------------------------------------- LIABILITIES AND STOCKHOLDERS' EQUITY Deposits: Demand-Interest bearing $ 57,406 $ 148 1.03% $ 63,148 $ 106 0.67% Savings 82,751 229 1.11% 81,866 206 1.01% Money markets 96,410 763 3.17% 79,787 552 2.77% Time - Over $100 40,913 504 4.93% 33,767 299 3.54% Time - Other 70,512 718 4.07% 76,906 815 4.24% Federal funds purchased - - - - - - Repurchase agreements 27,609 231 3.35% 18,763 121 3.00% Short-term borrowings 273 4 5.86% 310 4 5.16% Long-term borrowings 59,633 605 4.06% 69,402 691 3.98% ---------------------------------------------------------------------------------------------------------- Total Interest Bearing Liabilities/ Total Interest Expense 435,507 $ 3,202 2.94% 423,949 $ 2,794 2.64% ---------------------------------------------------------------------------------------------------------- Demand - Non-interest bearing 76,587 64,047 All other liabilities 4,363 4,928 Stockholders' equity 69,114 65,564 ---------------------------------------------------------------------------------------------------------- Total Liabilities and Stockholders' Equity $ 585,571 $ 558,488 ---------------------------------------------------------------------------------------------------------- Interest Spread 3.36% 3.36% ---------------------------------------------------------------------------------------------------------- Net Interest Income $ 5,530 $ 5,214 ---------------------------------------------------------------------------------------------------------- FINANCIAL RATIOS Net interest margin 3.99% 3.91% Return on average assets 1.49% 1.34% Return on average equity 12.62% 11.43% Average equity to average assets 11.80% 11.74% Dividend payout ratio 36.63% 40.23% ----------------------------------------------------------------------------------------------------------
Net interest income after provision for loan losses increased $289 or 1.9% to $15,589 for the nine months ended September 30, 2007, compared to $15,300 for the nine months ended September 30, 2006. The average yield on interest earning assets increased 37 basis points, largely from maturing investments redeployed to fund loan growth and the average loan portfolio of $47.0 million from the similar period of 2006. The net interest margin represents the Company's net yield on its average interest earning assets and is calculated as net interest income divided by average interest earning assets. For the nine months ended September 30, 2007, net interest margin was 3.90% increasing 3 basis points from 3.87% in the same period of 2006. Total average interest earning assets and average interest bearing funds increased for the nine months ended September 30, 2007 as compared to the nine months ended September 30, 2006. Average interest earning assets increased $13.1 million or 2.4%, from $537.9 million in 2006 to $551.0 million in 2007 and average interest bearing funds increased $18.2 million, or 4.4%, from $415.2 million to $433.4 million for the same period. Average earning assets, including BOLI, increased to 96.0% for the nine months ended September 30, 2007 from 95.8% for the year ago period. Changes in the mix of both interest earning assets and funding sources also impacted net interest income in the nine months ended September 30, 2007 and 2006. Average loans as a percentage of average interest earning assets increased from 61.9% in 2006 to 69.0% in 2007, due in part to the increase of new and refinanced residential mortgages as well as an increase in commercial loans secured by real estate. Average investments decreased $50.1 million from 37.5% to 27.5%. Average short-term investments, federal funds sold and interest bearing balances with banks, increased $16.2 million to $19.3 from $3.1 and also increased as a percentage of average interest earning assets from .6% in 2006 to 3.5% in 2007. Average time deposits increased $11.0 million or 10.1% from 26.3% of interest bearing liabilities in 2006 to 27.7% in 2007. Average short-term borrowings decreased $2.9 million; average long-term borrowings decreased $9.7 million, while repurchase agreements increased $5.1 million. Shifts in the interest rate environment and competitive factors affected the rates paid for funds as well as the yields earned on assets. The investment securities tax equivalent yield increased 81 basis points from 4.89% for the nine months ended September 30, 2006 to 5.70% for the nine months ended September 30, 2007. Also, average loan yields increased two basis points, from 6.86% for the nine months ended September 30, 2006 to 6.88% in the same period of 2007. The average time deposit costs increased 65 basis points from 3.73% for the nine months ended September 30, 2006 to 4.38% for the nine months ended September 30, 2007, along with the average cost of money market accounts increasing 54 basis points from 2.57% for the nine months ended September 30, 2006 to 3.11% for the nine months ended September 30, 2007. Distribution of Assets, Liabilities and Stockholders' Equity / Interest Rates and Interest Differential The table below presents average balances, interest income on a fully taxable equivalent basis and interest expense, as well as average rates earned and paid on the Company's major asset and liability items for the nine months ended September 30, 2007 and September 30, 2006.
---------------------------------------------------------------------------------------------------------- September 30, 2007 September 30, 2006 ASSETS Average Revenue/ Yield/ Average Revenue/ Yield/ Balance Expense Rate Balance Expense Rate ---------------------------------------------------------------------------------------------------------- Investment Securities Available-for-sale: U.S. Agency obligations $ 40,943 $ 1,404 4.57% $ 91,989 $ 2,516 3.65% States & political subdivisions 30,227 1,011 6.76% 23,084 782 6.84% Federal Home Loan Bank stock 3,983 190 6.36% 4,754 169 4.74% Other 4,661 132 3.78% 3,096 81 3.49% Held-to-maturity: U.S. Agency obligations 42,647 1,455 4.55% 49,657 1,662 4.46% States & political subdivisions 29,247 1,167 8.06% 29,253 1,176 8.12% Loans, net of unearned income: Real estate mortgages 316,650 15,877 6.69% 261,265 13,289 6.78% Commercial 23,237 1,476 8.47% 33,428 1,749 6.98% Consumer and other 40,092 2,268 7.54% 38,264 2,081 7.25% Federal funds sold 11,112 433 5.20% - - - Interest on balances with banks 8,203 314 5.10% 3,068 120 5.22% ---------------------------------------------------------------------------------------------------------- Total Interest Earning Assets/ Total Interest Income 551,002 $ 25,727 6.23% 537,858 $ 23,625 5.86% ---------------------------------------------------------------------------------------------------------- Cash and due from banks 10,446 9,952 Bank premises and equipment 9,675 9,472 Accrued interest receivable 3,311 3,000 Cash surrender value of life insurance 7,160 - Other assets 4,099 4,749 Less: Allowance for loan losses 4,238 3,858 ---------------------------------------------------------------------------------------------------------- Total Assets $ 581,455 $ 561,173 ---------------------------------------------------------------------------------------------------------- LIABILITIES AND STOCKHOLDERS' EQUITY Deposits: Demand-Interest bearing $ 55,419 $ 406 0.98% $ 44,751 $ 221 0.66% Savings 81,376 683 1.12% 83,055 557 0.89% Money markets 89,535 2,088 3.11% 83,727 1,611 2.57% Time - Over $100 41,709 1,540 4.92% 30,882 805 3.48% Time - Other 78,416 2,408 4.09% 78,265 2,249 3.83% Federal funds purchased - - - - - - Repurchase agreements 24,478 588 3.20% 19,424 318 2.18% Short-term borrowings 396 15 5.05% 3,288 137 5.56% Long-term borrowings 62,107 1,882 4.04% 71,797 2,130 3.96% ---------------------------------------------------------------------------------------------------------- Total Interest Bearing Liabilities/ Total Interest Expense 433,436 $ 9,610 2.96% 415,189 $ 8,028 2.58% ---------------------------------------------------------------------------------------------------------- Demand - Non-interest bearing 75,164 77,413 All other liabilities 4,698 3,565 Stockholders' equity 68,157 65,006 ---------------------------------------------------------------------------------------------------------- Total Liabilities and Stockholders' Equity $ 581,455 $ 561,173 ---------------------------------------------------------------------------------------------------------- Interest Spread 3.27% 3.28% ---------------------------------------------------------------------------------------------------------- Net Interest Income $ 16,117 $ 15,597 ---------------------------------------------------------------------------------------------------------- FINANCIAL RATIOS Net interest margin 3.90% 3.87% Return on average assets 1.27% 1.19% Return on average equity 10.86% 10.27% Average equity to average assets 11.72% 11.58% Dividend payout ratio 43.02% 45.03% ----------------------------------------------------------------------------------------------------------
Investments The Company's investment portfolio consists primarily of two functions: To provide liquidity and to contribute to earnings. To provide liquidity the Company may invest in short-term securities such as Federal funds sold, interest bearing deposits with banks, U.S. Treasury securities and U.S. Agency securities all with maturities of one year or less. These funds are invested short-term to ensure the availability of funds to meet customer demand for credit needs. The Company enhances interest income by securing long-term investments within its investment portfolio, by means of U.S. Treasury securities, U.S. Agency securities, municipal securities and mortgage-backed securities generally with maturities greater than one year. The Company's mortgage-backed securities portfolio does not contain any sub-prime or Alt-A credits. Investments in securities are classified in two categories and accounted for as follows: Securities Held-to-Maturity Bonds, notes, debentures and mortgage-backed securities for which the Company has the positive intent and ability to hold to maturity are reported at cost, adjusted for amortization of premiums and accretion of discounts computed on the straight-line basis, which approximates the interest method, over the remaining period to maturity. Securities Available-for-Sale Bonds, notes, debentures, mortgage-backed securities and certain equity securities not classified as securities to be held to maturity are carried at fair value with unrealized holding gains and losses, net of tax, reported as a net amount in a separate component of stockholders' equity until realized. The amortization of premiums on mortgage-backed securities is based on management's estimate of the lives of the securities, adjusted, when necessary, for advanced prepayments in excess of those estimates. Gains and losses on the sale of securities available-for-sale are determined using the specific identification method and are reported as a separate component of other income in the Statements of Income. Deposits The Company is largely dependent on its core deposit base to fund operations. Management has competitively priced its deposit products in checking, savings, money market and time deposits to provide a stable source of funding. As the economy shows strength and improves, there is migration of some deposits, mainly to higher costing time deposits, as consumers become more prone to increased yields. Historically, such changes in the Company's deposit base have been minimal. Provision for Loan Losses The provision for loan losses represents management's determination of the amount necessary to bring the allowance for loan losses to a level that management considers adequate to reflect the risk of future losses inherent in the Company's loan portfolio. The process of determining the adequacy of the allowance is necessarily judgmental and subject to changes in external conditions. The allowance for loan losses reflects management's judgment as to the level considered appropriate to absorb such losses based upon a review of many factors, including historical loss experience, adverse situations that may affect the borrower's ability to repay (including the timing of future payments), economic conditions and trends, loan portfolio volume and mix, loan performance trends, the value and adequacy of collateral, and the Company's internal credit review process. Accordingly, there can be no assurance that existing levels of the allowance will ultimately prove adequate to cover actual loan losses. The quarterly provision for loan losses charged to operating expense is that amount which is sufficient to bring the balance of the allowance for possible loan losses to an adequate level to absorb anticipated losses. Based on this ongoing evaluation, management determines the provision necessary to maintain an appropriate allowance. For the three months ended September 30, 2007, the provision for loan losses increased to $165 from $143 in the three months ended September 30, 2006 to $308 in the three months ended September 30, 2007. Loans charged off totaled $28 and recoveries were $0 for the three months ended September 30, 2007. In the same period of 2006, loans charged off totaled $43 and recoveries were $0. For the nine months ended September 30, 2007, the provision for loan losses was $528, an increase from $297 in the first nine months of 2006. Loans charged-off totaled $130 and recoveries were $2 for the nine months ended September 30, 2007. In the same period of 2006 loans charged off were $100, offset by recoveries of $3. At September 30, 2007 the allowance for loan losses was $4,600, or 1.16% of gross loans, based upon the Bank's analysis. Other Income The following table sets forth information by category of other income for the Company for three months ended September 30, 2007 and September 30, 2006, respectively: September 30, September 30, Three Months Ended: 2007 2006 ---------------------------------------------------------------------------- Trust department income $ 421 $ 408 Service charges on deposit accounts 245 218 Merchant transaction income 1,482 1,387 Other fee income 325 319 Bank-Owned Life Insurance income 80 - Other operating income 112 120 Realized (losses) gains on securities, net (2) - ---------------------------------------------------------------------------- Total Other Income $ 2,663 $ 2,452 ---------------------------------------------------------------------------- Other income increased $211 or 8.6% for the three months ended September 30, 2007 to $2,663 compared with $2,452 for the three months ended September 30, 2006. Service charges on deposit accounts increased $27 or 12.4% primarily due to increased service charge collections during 2007. Merchant transaction income increased $95 or 6.8% due to higher transaction volume and new business. Bank-Owned Life Insurance (BOLI) income increased $80. The Company entered into a BOLI investment during the fourth quarter of 2006. The following table sets forth information by category of other income for the Company for nine months ended September 30, 2007 and September 30, 2006, respectively: September 30, September 30, Nine Months Ended: 2007 2006 ---------------------------------------------------------------------------- Trust department income $ 1,160 $ 1,113 Service charges on deposit accounts 756 634 Merchant transaction income 3,402 3,227 Other fee income 908 877 Bank-Owned Life Insurance income 235 - Other operating income 229 294 Realized gains (losses) on securities, net 49 - ---------------------------------------------------------------------------- Total Other Income $ 6,739 $ 6,145 ---------------------------------------------------------------------------- Other income increased $594 or 9.7% to $6,739 during the first nine months of 2007 from $6,145 for the same period of 2006. Service charges on deposit accounts increased $122 or 19.2% primarily due to increased service charge collections during 2007. Merchant transaction income increased $175 or 5.4%, mainly due to higher transaction volume and new business. Bank-Owned Life Insurance income increased $235. The Company entered into a BOLI investment during the fourth quarter of 2006. Other operating income decreased $65 mainly from lower brokerage income of $32 along with a reduction in general operating income. The Company realized a gain of $49 due to the sale of equity securities during the first nine months of 2007. Other Expenses The following table sets forth information by category of other expenses for the Company for the three months ended September 30, 2007 and September 30, 2006, respectively: September 30, September 30, Three Months Ended: 2007 2006 ---------------------------------------------------------------------------- Salaries and employee benefits $ 2,108 $ 2,132 Expense of premises and fixed assets 605 580 Merchant transaction expenses 1,149 1,089 Other operating expenses 1,238 1,298 ---------------------------------------------------------------------------- Total Other Expenses $ 5,100 $ 5,099 ---------------------------------------------------------------------------- Total other expenses remained relatively unchanged at $5,100 for the three months ended September 30, 2007. Salaries and employee benefits decreased $24 or 1.1%. The decrease was largely due to a refund of $144 from a health insurance provider. Premises and fixed assets expense increased $25 or 4.3%, mainly due to higher depreciation expense related to the conversion to a new computer system during 2006. Merchant transaction expense increased $60 or 5.5% due to higher transaction volume and new business. Other operating expenses decreased $60 or 4.6%. Applicable income taxes increased $53 or 9.6% to $604 due to due to higher operating income. The following table sets forth information by category of other expenses for the Company for the nine months ended September 30, 2007 and September 30, 2006, respectively: September 30, September 30, Nine Months Ended: 2007 2006 ---------------------------------------------------------------------------- Salaries and employee benefits $ 6,813 $ 6,912 Expense of premises and fixed assets 1,955 1,814 Merchant transaction expenses 2,644 2,543 Other operating expenses 4,031 3,785 ---------------------------------------------------------------------------- Total Other Expenses $ 15,443 $ 15,054 ---------------------------------------------------------------------------- Total other expenses increased $389 or 2.6% to $15,443 during the first nine months of 2007 compared with $15,054 for the same period of 2006. Salaries and employee benefits expense decreased $99 or 1.4%. The decrease was largely due to a refund of $144 from a health insurance provider. Premises and fixed assets expense increased $141 or 7.8%, mainly due to the increased depreciation expense related to the new computer system completed during 2006. Merchant transaction expenses increased $101 or 4.0% due to higher transaction volume. Other operating expenses increased $246 or 6.5% from general operating expenses related to the promotion of our Totally Free Checking program. Applicable income taxes decreased $49 or 3.5% to $1,334 due to increased tax-free income and BOLI income included in overall operating income. Loan Portfolio Details regarding the Company's loan portfolio: September 30, December 31, As of: 2007 2006 ------------------------------------------------------------------------------ Real estate - construction and land development $ 24,953 $ 23,714 Real estate mortgages 308,042 284,323 Commercial 22,808 26,265 Credit card and related plans 3,249 3,282 Installment and other 30,540 25,532 Obligations of states & political subdivisions 6,443 6,806 ------------------------------------------------------------------------------ Loans, net of unearned income 396,035 369,922 Less: Allowance for loan losses 4,600 4,200 ------------------------------------------------------------------------------ Loans, net $ 391,435 $ 365,722 ------------------------------------------------------------------------------ The Company does not engage in any sub-prime or Alt-A credit lending. Therefore, the Company is not subject to any associated credit risks. Loan Quality The lending activities of the Company are guided by the comprehensive lending policy established by the Board of Directors. Loans must meet criteria which include consideration of the character, capacity and capital of the borrower, collateral provided for the loan, and prevailing economic conditions. Regardless of credit standards, there is risk of loss inherent in every loan portfolio. The allowance for loan losses is an amount that management believes will be adequate to absorb possible losses on existing loans that may become uncollectible, based on evaluations of the collectibility of the loans. The evaluations take into consideration such factors as change in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, industry experience, collateral value and current economic conditions that may affect the borrower's ability to pay. Management believes that the allowance for loan losses is adequate. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for loan losses. Such agencies may require the Company to recognize additions to the allowance based on their judgment of information available to them at the time of their examination. The allowance for loan losses is increased by periodic charges against earnings as a provision for loan losses, and decreased periodically by charge-offs of loans (or parts of loans) management has determined to be uncollectible, net of actual recoveries on loans previously charged-off. Non-Performing Assets The following table sets forth information regarding non-accrual loans and loans past due 90 days or more and still accruing interest:
September 30, December 31, September 30, As of: 2007 2006 2006 ------------------------------------------------------------------------------------------------------ Non-accrual loans $ 406 $ 3,180 $ 4,165 Other real estate owned - - 80 ------------------------------------------------------------------------------------------------------ Total non-performing assets $ 406 $ 3,180 $ 4,245 ------------------------------------------------------------------------------------------------------ Loans past due 90 days or more and accruing: Secured by real estate $ 285 $ 177 $ 190 Guaranteed student loans 461 251 302 Credit card loans 17 6 8 Other loans to individuals for household, family, and other personal expenditures 2 - - ------------------------------------------------------------------------------------------------------ Total loans past due 90 days or more and accruing $ 765 $ 434 $ 500 ------------------------------------------------------------------------------------------------------
Non-accrual loans decreased $3,759 to $406 at September 30, 2007 from $4,165 at September of 2006. This decrease was due to two borrowing relationships being resolved during the third quarter of 2007. Loans are generally placed on a non-accrual status when principal or interest is past due 90 days or when payment in full is not anticipated. When a loan is placed on non-accrual status, all interest previously accrued but not collected is charged against current income. Loans are returned to accrual status when past due interest is collected and the collection of principal is probable. Loans on which the accrual of interest has been discontinued or reduced amounted to $406 and $4,165 at September 30, 2007 and September 30, 2006, respectively. If interest on those loans had been accrued, such income would have been $253 and $190 for the nine months ended September 30, 2007 and September 30, 2006, respectively. Interest income on those loans, which is recorded only when received, amounted to $143 and $84 for September 30, 2007 and September 30, 2006, respectively. There are no commitments to lend additional funds to individuals whose loans are in non-accrual status. The management process for evaluating the adequacy of the allowance for loan losses includes reviewing each month's loan committee reports which list all loans that do not meet certain internally developed criteria as to collateral adequacy, payment performance, economic conditions and overall credit risk. These reports also address the current status and actions in process on each listed loan. From this information, adjustments are made to the allowance for loan losses. Such adjustments include both specific loss allocation amounts and general provisions by loan category based on present and past collection experience, nature and volume of the loan portfolio, overall portfolio quality, and current economic conditions that may affect the borrower's ability to pay. As of September 30, 2007 there were no significant loans as to which management has serious doubt about their collectibility other than what is included above. At September 30, 2007 and December 31, 2006, the Company did not have any loans specifically classified as impaired. Most of the Company's lending activity is with customers located in the Company's geographic market area and repayment thereof is affected by economic conditions in this market area. Loan Loss Experience The following tables present the Company's loan loss experience during the periods indicated: September 30, September 30, Three Months Ended: 2007 2006 ----------------------------------------------------------------------------- Balance at beginning of period $ 4,320 $ 3,900 Charge-offs: Real estate mortgages - 34 Commercial and all others 10 - Credit card and related plans 18 5 Installment loans - 4 ----------------------------------------------------------------------------- Total charge-offs 28 43 ----------------------------------------------------------------------------- Recoveries: Real estate mortgages - - Commercial and all others - - Credit card and related plans - - Installment loans - - ----------------------------------------------------------------------------- Total recoveries - - ----------------------------------------------------------------------------- Net charge-offs (recoveries) 28 43 ----------------------------------------------------------------------------- Provision charged to operations 308 143 ----------------------------------------------------------------------------- Balance at End of Period $ 4,600 $ 4,000 ----------------------------------------------------------------------------- Ratio of net charge-offs (recoveries) to average loans outstanding 0.007% 0.013% ----------------------------------------------------------------------------- September 30, September 30, Nine Months Ended: 2007 2006 ----------------------------------------------------------------------------- Balance at beginning of period $ 4,200 $ 3,800 Charge-offs: Real estate mortgages 84 34 Commercial and all others 10 8 Credit card and related plans 34 37 Installment loans 2 21 ----------------------------------------------------------------------------- Total charge-offs 130 100 ----------------------------------------------------------------------------- Recoveries: Real estate mortgages - - Commercial and all others - - Credit card and related plans 1 3 Installment loans 1 - ----------------------------------------------------------------------------- Total recoveries 2 3 ----------------------------------------------------------------------------- Net charge-offs (recoveries) 128 97 ----------------------------------------------------------------------------- Provision charged to operations 528 297 ----------------------------------------------------------------------------- Balance at End of Period $ 4,600 $ 4,000 ----------------------------------------------------------------------------- Ratio of net charge-offs (recoveries) to average loans outstanding 0.034% 0.029% ----------------------------------------------------------------------------- The allowance for loan losses at September 30, 2007 was $4,600 or 1.16% of total loans compared to $4,000 or 1.13% of total loans at September 30, 2006. Management believes the loan loss reserve is adequate. The allowance for loan losses is allocated as follows:
As of: September 30, 2007 December 31, 2006 September 30, 2006 ---------------------------------------------------------------------------------------------------- Amount %* Amount %* Amount %* ---------------------------------------------------------------------------------------------------- Real estate mortgages $ 1,300 84% $ 1,200 83% $ 1,200 82% Commercial and all others 2,780 7% 2,500 9% 2,300 10% Credit card and related plans 250 1% 250 1% 250 1% Personal installment loans 270 8% 250 7% 250 7% ---------------------------------------------------------------------------------------------------- Total $ 4,600 100% $ 4,200 100% $ 4,000 100% ----------------------------------------------------------------------------------------------------
* Percent of loans in each category to total loans Liquidity The objective of liquidity management is to maintain a balance between sources and uses of funds in such a way that the cash requirements of customers for loans and deposit withdrawals are met in the most economical manner. Management monitors its liquidity position continuously in relation to trends of loans and deposits for short-term as well as long-term requirements. Liquid assets are monitored on a daily basis to assure maximum utilization. Management also manages its liquidity requirements by maintaining an adequate level of readily marketable assets and access to short-term funding sources. Management does not foresee any adverse trends in liquidity. The Company remains in a highly liquid condition both in the short and long term. Sources of liquidity include the Company's U.S. Agency bond portfolios, additional deposits, earnings, overnight loans to and from other companies (Federal Funds) and lines of credit at the Federal Reserve Bank and the Federal Home Loan Bank of Pittsburgh. The Company is not a party to any commitments, guarantees or obligations that could materially affect its liquidity. The Company offers collateralized repurchase agreements, which have a one day maturity, as an alternative deposit option for its customers. The Company also has long-term debt outstanding to the FHLB, which was used to purchase a Freddie Mac pool of residential mortgages, as described earlier in this report. The Company maintains a collateralized maximum borrowing capacity of $178,321 with the Federal Home Loan Bank of Pittsburgh. Commitments and Contingent Liabilities In the normal course of business, there are outstanding commitments and contingent liabilities, created under prevailing terms and collateral requirements such as commitments to extend credit, financial guarantees and letters of credit, which are not reflected in the accompanying Financial Statements. The Company does not anticipate any losses as a result of these transactions. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the Balance Sheets. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have expiration dates of one year or less or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Related Parties The Company does not have any material transactions involving related persons or entities, other than traditional banking transactions, which are made on the same terms and conditions as those prevailing at the time for comparable transactions with unrelated parties. The Bank has issued standby letters of credit for the accounts of related parties in the amount of $6,248. Capital Resources A strong capital position is important to the continued profitability of the Company and promotes depositor and investor confidence. The Company's capital provides a basis for future growth and expansion and also provides additional protection against unexpected losses. Additional sources of capital would come from retained earnings from the operations of the Company and from the sale of additional common stock. Management has no plans to offer additional common stock at this time. The Company's total risk-based capital ratio was 19.99% at September 30, 2007. The Company's risk-based capital ratio is more than the 10.00% ratio that Federal regulators use as the "well capitalized" threshold. This is the current criteria which the FDIC uses in determining the lowest insurance rate for deposit insurance. The Company's risk-based capital ratio is more than double the 8.00% limit, which determines whether a company is "adequately capitalized". Under these rules, the Company could significantly increase its assets and still comply with these capital requirements without the necessity of increasing its equity capital. PART 1. FINANCIAL INFORMATION, Item 3 -- QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company currently does not enter into derivative financial instruments, which include futures, forwards, interest rate swaps, option contracts and other financial instruments with similar characteristics. However, the Company is party to traditional financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, financial guarantees and letters of credit. These traditional instruments involve to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the Consolidated Balance Sheets. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party up to a stipulated amount and with specified terms and conditions. Commitments to extend credit and standby letters of credit are not recorded as an asset or liability by the Company until the instrument is exercised. The Company's exposure to market risk is reviewed on a regular basis by its Asset/Liability Committee. Interest rate risk is the potential of economic losses due to future interest rate changes. These economic losses can be reflected as a loss of future net interest income and/or a loss of current fair market values. The objective is to measure the effect on net interest income and to adjust the balance sheet to minimize the inherent risk while at the same time maximizing income. Management realizes certain risks are inherent and that the goal is to identify and minimize the risks. Tools used by management include the standard GAP report and an interest rate shock simulation report. The Company has no market risk sensitive instruments held for trading purposes. It appears the Company's market risk is reasonable at this time. PART 1. FINANCIAL INFORMATION, Item 4 -- CONTROLS AND PROCEDURES Under the supervision and with the participation of our management, including our Chief Executive Officer and Controller, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) under the Securities Exchange Act of 1934. Based upon this evaluation, our Chief Executive Officer and our Controller concluded that our disclosure controls and procedures were effective as of the end of the period covered by this quarterly report. The Company continually assesses the adequacy of its internal control over financial reporting and enhances its controls in response to internal control assessments, and internal and external audit and regulatory recommendations. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate due to changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. PART II. OTHER INFORMATION Item 1 -- Legal Proceedings None. Item 1A -- Risk Factors In addition to the other information set forth in this report, you should carefully consider the factors discussed below, which could materially affect our business, financial condition or future results. The risks described below are not the only risks that the Company faces. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and /or operating results. RISKS RELATED TO OUR BUSINESS Credit Risk Changes in the credit quality of our loan portfolio may impact the level of our allowance for loan losses. We make various judgments about the collectibility of our loans, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for our loans. In determining the amount of the allowance for loan losses, we review our loans and our loan loss and delinquency experience, and we evaluate economic conditions. If our judgments are incorrect, our allowance for loan losses may not be sufficient to cover future losses, which will result in additions to our allowance through increased provisions for loan losses. In addition, bank regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs. Increased provisions for loan losses would increase our expenses and reduce our profits. Nonetheless, to the best of management's knowledge, there are also no particular risk elements in the local economy that put a group or category of loans at increased risk. Also the Company is not dependent upon a single customer, or a few customers, the loss of one or more of which would have a material adverse effect on its operations. The operations and earnings of the Corporation are also not materially affected by seasonal changes. Market Risk Changes in interest rates could affect our investment values and net interest income. At September 30, 2007, the Company owned approximately $72.8 million of marketable securities available for sale. These securities are carried at fair value on the consolidated balance sheet. Unrealized gains or losses on these securities, that is, the difference between the fair value and the amortized cost of these securities, are reflected in stockholders' equity, net of deferred taxes. As of September 30, 2007, the Company's available for sale marketable securities portfolio had a net unrealized gain, net of taxes, of $966. The fair value of the Company's available for sale marketable securities is subject to interest rate change, which would not affect recorded earnings, but would increase or decrease comprehensive income and stockholders' equity. The principal component of the Company's earnings is net interest income, which is the difference between interest and fees earned on interest-earning assets and interest paid on deposits and other borrowings. The most significant impact on net interest income between periods is derived from the interaction of changes in the volume of and rates earned or paid on interest-earning assets and interest-bearing liabilities. The volume of earning dollars in loans and investments, compared to the volume of interest-bearing liabilities represented by deposits and borrowings, combined with the spread, produces the changes in net interest income between periods. The Company continually monitors the relationship of its interest rate sensitive assets and liabilities through its Asset/Liability Committee. Strong competition within our market could affect our profits and growth. The Bank operates in a competitive environment in which it must share its market with many local independent banks as well as several banks which are affiliates or branches of very large regional holding companies. The Bank encounters competition from diversified financial institutions, ranging in size from small banks to the nationwide banks operating in its region. The competition includes commercial banks, savings and loan associations, credit unions, other lending institutions and mortgage originators. The principal competitive factors among the Company's competitors can be grouped into two categories: pricing and services. In the Company's primary service area, interest rates on deposits, especially time deposits, and interest rates and fees charged to customers on loans are very competitive. From a service perspective, the Bank competes in areas such as convenience of location, types of services, service costs and banking hours. Compliance Risk We operate in a highly regulated environment and may be affected by changes in laws and regulations. The Company is registered as a financial holding company under the Bank Holding Company Act of 1956, as amended, and, as such, is subject to supervision and regulation by the Board of Governors of the Federal Reserve System ("FRB"). The Company is required to file quarterly reports of its operations with the FRB. As a financial holding company, the Company is permitted to engage in banking-related activities as authorized by the Federal Reserve Board, directly or through subsidiaries or by acquiring companies already established in such activities subject to the FRB regulations relating to those activities. Our banking subsidiary, Penn Security Bank and Trust Company, as a Pennsylvania state-chartered financial institution, is subject to supervision, regulation and examination by the Commonwealth of Pennsylvania Department of Banking and by the Federal Deposit Insurance Corporation (the "FDIC"), which insures the Bank's deposits to the maximum extent permitted by law. Operational Risk The Company needs to continually attract and retain qualified personnel for its operations. High quality customer services, as well as efficient and profitable operations, are dependent on the Company's ability to attract and retain qualified individuals for key positions within the organization. As of September 30, 2007, the Company employed 159 full-time equivalent employees. The employees of the Company are not represented by any collective bargaining group. Management of the Company considers relations with its employees to be good. Our operations could be affected if we do not have access to modern and reliable technology. The Company operates in a highly-automated environment, wherein almost all transactions are processed by computer software to produce results. To remain competitive, the Company must continually evaluate the adequacy of its data processing capabilities and make revisions as needed. The Company regularly tests its ability to restore data capabilities in the event of a natural disaster, sustained power failure or other inability to utilize its primary systems. Liquidity Risk Increased needs for disbursement of funds on loans and deposits can affect our liquidity. The objective of liquidity management is to maintain a balance between sources and uses of funds in such a way that the cash requirements of customers for loans and deposit withdrawals are met in the most economical manner. Management monitors its liquidity position continuously in relation to trends of loans and deposits for short-term as well as long-term requirements. Liquid assets are monitored on a daily basis to assure maximum utilization. Management also manages its liquidity requirements by maintaining an adequate level of readily marketable assets and access to short-term funding sources. Management does not foresee any adverse trends in liquidity. Our future pension plan costs and contributions could be unfavorably impacted by the factors that are used in the actuarial calculations. Our costs of providing non-contributory defined benefit pension plans are dependent upon a number of factors, such as the rates of return on plan assets, discount rates, the level of interest rates used to measure the required minimum funding levels of the plans, future government regulation and our required or voluntary contributions made to the plans. Without sustained growth in the pension investments over time to increase the value of our plan assets and depending upon the other factors impacting our costs as listed above, we could be required to fund our plans with higher amounts of cash than are anticipated by our actuaries. Such increased funding obligations could have a material impact on our liquidity by reducing our cash flows. Item 2 -- Unregistered Sales of Equity Securities and Use of Proceeds None. Item 3 -- Defaults Upon Senior Securities None. Item 4 -- Submission of Matters to a Vote of Security Holders None. Item 5 -- Other Information None. Item 6 -- Exhibits 31 Certifications required under Section 302 of the Sarbanes-Oxley Act of 2002 32 Certifications required under Section 906 of the Sarbanes-Oxley Act of 2002 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. PENSECO FINANCIAL SERVICES CORPORATION By /s/ CRAIG W. BEST ------------------------------ Craig W. Best President and CEO Dated: October 31, 2007 By /s/ PATRICK SCANLON ------------------------------ Patrick Scanlon Senior Vice President, Controller Dated: October 31, 2007