UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

___________________

Form 10-Q

__________________

xQuarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

for the quarterly period ended September 30, 2006

Or

¨Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

for the transition period from ___________ to __________

Commission file number 0-15237

___________________

HARLEYSVILLE NATIONAL CORPORATION

(Exact name of registrant as specified in its charter)

___________________

Pennsylvania	23-2210237
(State or other jurisdiction of incorporation or organization)	(IRS Employer Identification No.)

483 Main Street

Harleysville, Pennsylvania 19438

(Address of principal executive office and zip code)

(215) 256-8851

(Registrant’s telephone number, including area code)

___________________

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.

Yes x No ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act). 

Large accelerated filer o Accelerated filer x Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ¨ No x

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: 28,960,133 shares of Common Stock, $1.00 par value, outstanding on November 3, 2006.

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HARLEYSVILLE NATIONAL CORPORATION
INDEX TO FORM 10-Q REPORT
	PAGE
Part I. Financial Information
Item 1. Financial Statements:
Consolidated Balance Sheets at September 30, 2006 (unaudited) and December 31, 2005	3
Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2006 and 2005 (unaudited)	4
Consolidated Statements of Shareholders’ Equity for the Nine Months Ended September 30, 2006 and 2005 (unaudited)	5
Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2006 and 2005 (unaudited)	6
Notes to Consolidated Financial Statements	7
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations	17
Item 3. Quantitative and Qualitative Disclosures about Market Risk	30
Item 4. Controls and Procedures	30
Part II. Other Information	31
Item 1. Legal Proceedings	31
Item 1A. Risk Factors	31
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	31
Item 3. Defaults Upon Senior Securities	31
Item 4. Submission of Matters to a Vote of Security Holders	31
Item 5. Other Information	31
Item 6. Exhibits	31
Signatures	32

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PART 1. FINANCIAL INFORMATION
HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands)		September 30, 2006			December 31, 2005
		(Unaudited)
Assets
Cash and due from banks	$	62,909		$	57,756
Federal funds sold and securities purchased under agreements to resell		176,500			35,000
Interest-bearing deposits in banks		3,463			2,455
Total cash and cash equivalents		242,872			95,211
Residential mortgage loans held for sale		1,125			2,028
Investment securities available for sale		863,357			841,653
Investment securities held to maturity (market value $59,301 and $59,753, respectively)		58,894			59,555
Loans and leases		2,033,148			1,983,465
Less: Allowance for loan losses		(21,303	)		(19,865	)
Net loans		2,011,845			1,963,600
Premises and equipment, net		33,269			27,570
Accrued interest receivable		14,894			13,282
Goodwill		42,956			31,552
Intangible assets, net		7,434			4,031
Bank-owned life insurance		61,125			59,334
Other assets		25,232			19,543
Total assets	$	3,363,003		$	3,117,359
Liabilities and Shareholders' Equity
Deposits:
Noninterest-bearing	$	326,851		$	363,440
Interest-bearing:
Checking accounts		571,444			387,374
Money market accounts		675,904			667,952
Savings		150,889			190,033
Time deposits		903,158			756,658
Total deposits		2,628,246			2,365,457
Federal funds purchased and securities sold under agreements to repurchase		113,086			88,118
Other short-term borrowings		1,438			1,752
Long-term borrowings		239,750			297,750
Accrued interest payable		29,123			28,276
Subordinated debt		51,548			51,548
Other liabilities		13,207			11,226
Total liabilities		3,076,398			2,844,127
Shareholders' Equity:
Series preferred stock, par value $1 per share;
Authorized 8,000,000 shares, none issued		-			-
Common stock, par value $1 per share; authorized 75,000,000
shares; issued 29,074,250 shares at September 30, 2006 and
27,500,407 shares at December 31, 2005		29,074			27,500
Additional paid in capital		194,818			167,418
Retained earnings		71,860			88,285
Accumulated other comprehensive loss		(7,300	)		(8,618	)
Treasury stock, at cost: 90,550 shares at September 30, 2006 and
64,700 shares at December 31, 2005		(1,847	)		(1,353	)
Total shareholders' equity		286,605			273,232
Total liabilities and shareholders' equity	$	3,363,003		$	3,117,359

See accompanying notes to consolidated financial statements.

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HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Unaudited)
	Three Months Ended				Nine Months Ended
	September 30,				September 30,
(Dollars in thousands, except per share information)		2006		2005		2006		2005
Interest Income:
Loans and leases, including fees	$	34,553	$	29,677	$	99,519	$	83,899
Investment securities:
Taxable		7,538		5,678		22,412		17,362
Exempt from federal taxes		2,643		2,797		7,842		8,476
Federal funds sold and securities purchased under agreements to resell		1,182		353		2,363		888
Deposits in banks		45		65		144		106
Total interest income		45,961		38,570		132,280		110,731
Interest Expense:
Savings and money market deposits		10,630		5,916		27,061		15,235
Time deposits		9,732		6,163		26,341		17,130
Short-term borrowings		1,385		1,299		3,889		3,153
Long-term borrowings		3,600		3,448		11,628		9,952
Total interest expense		25,347		16,826		68,919		45,470
Net interest income		20,614		21,744		63,361		65,261
Provision for loan losses		900		650		3,000		2,050
Net interest income after provision for loan losses		19,714		21,094		60,361		63,211
Noninterest Income:
Service charges		2,092		2,112		6,008		6,113
Gain on sales in investment securities, net		-		1,898		-		3,047
Gain on sale of credit card portfolio		-		-		1,444		-
Gain on sale of branch		-		-		-		690
Wealth management income		3,372		1,261		11,224		5,241
Bank-owned life insurance income		591		497		1,792		1,635
Other income		2,231		1,962		6,771		5,699
Total noninterest income		8,286		7,730		27,239		22,425
Net interest income after provision for loan losses and
noninterest income		28,000		28,824		87,600		85,636
Noninterest Expense:
Salaries, wages and employee benefits		11,487		9,189		32,860		28,869
Occupancy		1,379		1,277		4,278		3,911
Furniture and equipment		917		963		2,708		3,284
Marketing		493		617		1,422		2,018
Other expense		3,284		3,267		11,192		9,627
Total noninterest expense		17,560		15,313		52,460		47,709
Income before income tax expense		10,440		13,511		35,140		37,927
Income tax expense		2,533		3,349		8,997		8,910
Net income	$	7,907	$	10,162	$	26,143	$	29,017
Net income per share information:
Basic	$	0.27	$	0.35	$	0.90	$	1.00
Diluted	$	0.27	$	0.34	$	0.89	$	0.98
Cash dividends per share	$	0.19	$	0.17	$	0.55	$	0.50
Weighted average number of common shares:
Basic		29,011,903		28,897,869		28,940,119		28,921,613
Diluted		29,384,310		29,479,228		29,373,646		29,541,486

See accompanying notes to consolidated financial statements.

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HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

(Unaudited)

(Dollars and share information in thousands)

Nine Months Ended September 30, 2006
	Common Stock	Treasury Stock
	Number of	Number of			Par		Additional Paid		Retained			Accumulated Other Comprehensive			Treasury						Comprehensive
	Shares	Shares			Value		In Capital		Earnings			Income (Loss)			Stock			Total			Income
Balance, January 1, 2006	27,500	(64	)	$	27,500	$	167,418	$	88,285		$	(8,618	)	$	(1,353	)	$	273,232
Issuance of stock for stock options, net of excess tax benefits	192	193			192		1,862		-			-			4,020			6,074
Issuance of stock for stock awards	-	-			-		5		-			-			-			5
Stock based compensation expense	-	-			-		345		-			-			-			345
Stock dividend	1,382	-			1,382		25,188		(26,582	)		-			-			(12	)
Net income	-	-			-		-		26,143			-			-			26,143		$	26,143
Other comprehensive income, net of reclassifications and tax	-	-			-		-		-			1,318			-			1,318			1,318
Purchases of treasury stock	-	(219	)		-		-		-			-			(4,514	)		(4,514	)
Cash dividends	-	-			-		-		(15,986	)		-			-			(15,986	)
Comprehensive income																				$	27,461
Balance, September 30, 2006	29,074	(90	)	$	29,074	$	194,818	$	71,860		$	( 7,300	)	$	(1,847	)	$	286,605

Nine Months Ended September 30, 2005
	Common Stock	Treasury Stock
	Number of	Number of			Par		Additional Paid		Retained			Accumulated Other Comprehensive			Treasury						Comprehensive
	Shares	Shares			Value		In Capital		Earnings			Income (Loss	)		Stock			Total			Income (Loss	)
Balance, January 1, 2005	27,320	(1,043	)	$	27,320	$	160,039	$	99,730		$	1,243		$	(17,800	)	$	270,532
Issuance of stock for stock options, net of tax benefits	142	68			142		2,181		-			-			1,282			3,605
Issuance of stock for stock awards	-	-			-		5		-			-			-			5
Stock dividend	38	1,272			38		6,090		(29,535	)		-			23,392			(15	)
Net income	--	-			-		-		29,017			-			-			29,017		$	29,017
Other comprehensive loss, net of reclassifications and tax	-	-			-		-		-			(5,345	)		-			(5,345	)		(5,345	)
Purchases of treasury stock	-	(338	)		-		-		-			-			(7,743	)		(7,743	)
Cash dividends	-	-			-		-		(14,429	)		-			-			(14,429	)
Comprehensive income																				$	23,672
Balance, September 30, 2005	27,500	(41	)	$	27,500	$	168,315	$	84,783		$	(4,102	)	$	(869	)	$	275,627
See accompanying notes to consolidated financial statements.

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HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
	Nine Months Ended
(Dollars in thousands)	September 30,
		2006			2005
Operating Activities:
Net income	$	26,143		$	29,017
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		3,000			2,050
Depreciation and amortization		3,324			2,352
Net amortization of investment securities discounts/premiums		2,711			2,126
Deferred income tax benefit		(2,120	)		(2,892	)
Gains on sales of investment securities, net		—			(3,047	)
Gain on sale of credit card portfolio		(1,444	)		—
Gain on sale of branch		—			(690	)
Gain on sale of bank subsidiary		—			(287	)
Bank-owned life insurance income		(1,792	)		(1,635	)
Stock based compensation expense		345			—
Net increase in accrued interest receivable		(1,612	)		(642	)
Net increase (decrease) in accrued interest payable		847			(1,894	)
Net (increase) decrease in other assets		372			(2,380	)
Net decrease in other liabilities		(3,631	)		(2,598	)
Other, net		(88	)		(9	)
Net cash provided by operating activities		26,055			19,471
Investing Activities:
Proceeds from sales of investment securities available for sale		—			247,040
Proceeds from maturity or calls of investment securities held to maturity		617			5,870
Proceeds from maturity or calls of investment securities available for sale		121,486			144,473
Purchases of investment securities available for sale		(143,821	)		(362,435	)
Net increase in loans		(65,693	)		(102,787	)
Net cash paid due to acquisition, net of cash acquired		(14,525	)		—
Net proceeds from sale of credit card portfolio		16,705			—
Net cash paid in sale of branch		—			(7,431	)
Net cash received from sale of bank subsidiary		—			1,931
Purchases of premises and equipment		(8,241	)		(2,563	)
Proceeds from sales of premises and equipment		216			42
Purchase of bank-owned life insurance		—			(5,000	)
Proceeds from sales of other real estate		32			142
Net cash provided used in investing activities		(93,224	)		(80,718	)
Financing Activities:
Net increase in deposits		262,789			150,574
Increase (decrease) in federal funds purchased and securities sold under agreements to repurchase		24,968			(37,954	)
Decrease in short-term borrowings		(314	)		(45,507	)
Advances of long-term borrowings		10,000			20,000
Repayments of long-term borrowings		(68,000	)		—
Advances of subordinated debt		—			25,774
Cash dividends		(15,986	)		(14,429	)
Repurchase of common stock		(4,514	)		(7,743	)
Proceeds from the exercise of stock options		5,032			3,605
Excess tax benefits from stock based compensation		867			—
Other, net		(12	)		(15	)
Net cash provided by financing activities		214,830			94,305
Net increase in cash and cash equivalents		147,661			33,058
Cash and cash equivalents at beginning of period		95,211			106,990
Cash and cash equivalents at end of the period	$	242,872		$	140,048
Cash paid during the period for:
Interest	$	42,790		$	47,611
Income taxes	$	12,173		$	13,018
Supplemental disclosure of noncash investing and financing activities:
Transfer of assets from loans to net assets in foreclosure	$	114		$	279
See accompanying notes to consolidated financial statements.

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HARLEYSVILLE NATIONAL CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1- Summary of Significant Accounting Policies

Principles of Consolidation and Basis of Presentation

In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the consolidated financial position of Harleysville National Corporation (the Corporation) and its wholly owned subsidiaries - Harleysville National Bank (the Bank), HNC Financial Company and HNC Reinsurance Company, as of September 30, 2006, the results of its operations for the three and nine month periods ended September 30, 2006 and 2005 and the cash flows for the nine month period ended September 30, 2006 and 2005. The Cornerstone Companies’ (subsidiaries of the Bank) results of operations are included in the Corporation’s results beginning January 1, 2006 through September 30, 2006. Certain prior period amounts have been reclassified to conform to current year presentation. All significant intercompany accounts and transactions have been eliminated in consolidation. We recommend that you read these unaudited consolidated financial statements in conjunction with the audited consolidated financial statements of the Corporation and the accompanying notes in the Corporation's 2005 Annual Report on Form 10-K. The results of operations for the three and nine month periods ended September 30, 2006 and 2005 are not necessarily indicative of the results to be expected for the full year.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amount of assets and liabilities as of the dates of the balance sheets and revenues and expenditures for the periods presented. Actual results could differ from those estimates.

Goodwill and Other Intangible Assets

Goodwill and identifiable intangibles were $43.0 million and $3.6 million, respectively at September 30, 2006, and $31.6 million and $0, respectively at December 31, 2005. In January 2006, the Corporation completed the acquisition of the Cornerstone Companies including $11.4 million of goodwill and $3.9 million of identifiable intangibles (with a weighted average amortization period of 9.3 years) allocated to the Wealth Management segment. The amortization of the identifiable intangibles related to the Wealth Management segment totaled $114,000 for the third quarter of 2006 and $336,000 for the first nine months of 2006. Amortization of other intangible assets, primarily core deposit intangible, allocated to the Community Banking segment were $62,000 for both the three months ended September 30, 2006 and 2005 and $185,000 for both the nine months ended September 30, 2006 and 2005. Management performed its annual review of goodwill at June 30, 2006 in accordance with SFAS No. 142 and determined there was no impairment of goodwill and identifiable intangible assets.

Stock Based Compensation

In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (SFAS 123(R)). SFAS 123(R) replaces SFAS No. 123, “Accounting for Stock-Based Compensation” and supersedes Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees.” SFAS 123(R) establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services and addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. SFAS 123(R) focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. Under SFAS 123(R), all forms of share-based payments to employees, including employee stock options, are treated the same as other forms of compensation by recognizing the related cost in the income statement. The expense of the award is generally measured at fair value at the grant date with compensation expense recognized over the service period, which is usually the vesting period. SFAS 123 required that the expense relating to so-called fixed plan employee stock options only be disclosed in the footnotes to the financial statements. SFAS 123(R) eliminates the ability to account for share-based compensation transactions using APB 25.

The Corporation adopted SFAS No. 123(R) on January 1, 2006 using the modified prospective application method of transition. Prior to January 1, 2006, the Corporation followed APB 25 and the disclosure requirements of FAS 123(R) with pro forma disclosures of net income and earnings per share, as if the fair value-based method of accounting defined in SFAS 123 had been applied. The Corporation’s consolidated financial statements as of September 30, 2006 and for the first nine months of 2006 reflect the impact of adopting FAS 123(R). In accordance with the modified prospective method, the consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of FAS 123(R). Effective January 1, 2006, the Corporation recognizes compensation expense for the portion of outstanding awards at January 1, 2006 for which the requisite service has not yet been rendered, based on the grant-date fair value of those awards calculated under SFAS 123 for pro forma disclosures. For new grants awarded on or after January 1, 2006, the Corporation has chosen to continue the use of the Black-Scholes option-pricing model (as used under SFAS 123) to estimate the fair value of each option on the date of grant. In accordance with SFAS 123(R), commencing January 1, 2006, the Corporation estimates the number of options for which the requisite service is expected to be rendered as compared to accounting for forfeitures as they occur under SFAS 123. The Corporation has chosen to recognize compensation expense for new grants using the

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Note 1- Summary of Significant Accounting Policies - Continued

straight-line method which spreads compensation expense for shares vesting evenly over the period of vesting. Pro forma disclosures under SFAS 123 have been based upon the accrual method which treats each vesting tranche as a separate award and amortizes expense evenly (prorated) from grant date to vest date for each tranche. The Corporation estimates that share-based compensation expense, net of tax, to be recognized during the year of 2006 will be approximately $407,000. The number and timing of options granted during 2006 and vesting criteria may alter this projected number. See Note 5 - Stock Based Compensation for additional information.

In October 2005, the FASB issued Staff Position (FSP) No. 123(R)-2, “Practical Accommodation to the Application of Grant Date as Defined in SFAS No. 123(R).” The FSP stipulates that assuming all other criteria in the grant date definition are met, a mutual understanding of the key terms and conditions of an award to an individual employee is presumed to exist upon the award’s approval in accordance with the relevant corporate governance requirements, provided that the terms and conditions of an award (a) cannot be negotiated by the recipient with the employer and (b) are expected to be communicated to an individual recipient within a relatively short time period from the date of approval. FSP 123(R)-2 applies upon initial adoption of SFAS 123(R). The adoption of this FSP did not have any impact on the Corporation’s financial position or results of operations.

In November 2005, the FASB issued FSP No. 123(R)-3, “Transition Election Related to Accounting for the Tax Effects of Share-Based Payments Awards.” The FSP provides an alternative transition method for accounting for the tax effects of share-based payment awards to employees for entities that do not have the necessary information to comply with the transition requirements of SFAS 123(R). An entity may take up to one year from the later of its initial adoption of SFAS 123(R) or the effective date of this FSP (November 10, 2005) to evaluate its available transition alternatives and make its one-time election.

In February 2006, the FASB issued FSP No. 123(R)-4, “Classification of Options and Similar Instruments Issued as Employee Compensation That Allow for Cash Settlement upon the Occurrence of a Contingent Event” to amend guidance in SFAS 123(R) on classifying options and similar instruments issued as part of employee compensation arrangements. Prior to amendment, SFAS 123(R) required the classification of such instruments as liabilities if the entity could be required under any circumstances to settle the option or similar instrument by transferring cash or other assets. FSP 123(R)-4 amends certain paragraphs of SFAS 123(R) to incorporate a practical accommodation similar to the probability approach provided in footnote 16 of the statement for shares subject to contingent cash settlement features. As a result, SFAS 123(R) requires options issued as compensation to employees to be classified as liabilities if the cash settlement feature can be exercised only upon the occurrence of a contingent event that is outside the employee's control, and such event is deemed probable to occur. Accounting for the modification of the option or similar instrument from equity to liability is similar to accounting for a modification from an equity to liability award. This FSP is applicable upon initial adoption of SFAS 123(R). FSP 123(R)-4 did not have any impact on the Corporation’s financial position or results of operations.

For additional information on other significant accounting policies, see Note 1 of the Consolidated Financial Statements of the Corporation’s 2005 Annual Report on Form 10-K.

Note 2 - Dispositions / Acquisition

On July 26, 2006, the Corporation entered into an agreement for the sale of the Bank’s Honesdale branch located in Wayne County, Pennsylvania with deposits of approximately $74.0 million as well as certain loans and other assets of approximately $25.0 million to the First National Community Bank. The transaction has been approved by the regulators and is expected to close in the fourth quarter of 2006. Harleysville National Bank anticipates recording a pre-tax profit on the sale of approximately $10.5 million, or approximately $.23 per share, diluted, net of tax during the fourth quarter of 2006⁽¹⁾. The sale of this single Wayne County location will allow the Corporation to focus on expanding within its core markets and also help to provide the resources required to support strategic initiatives.

On April 14, 2006, the Bank sold its existing credit card portfolio to Elan Financial Services, a national credit card issuer and established an agent issuing relationship with Elan Financial Services. Under the agreement, credit cards for the Bank will be issued under the Harleysville National Bank name. The Bank sold $15.3 million in credit card receivables resulting in a gain in the second quarter of 2006 from the sale of these credit cards, net of federal income taxes, of approximately $939,000 or $.03 per diluted share. The Bank continues to earn certain fees from ongoing portfolio activity. The sale agreement stipulates that any credit card accounts delinquent

__________________________________

⁽¹⁾ The statements above relating to anticipated pre-tax profit during the fourth quarter of 2006 are forward looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Whether or not the corporate and per share profits resulting from the transaction result as anticipated is subject to a variety of factors, including but not limited to consummation of the sale agreement and deposit attrition and legal, settlement and integration expenses greater than expected.

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Note 2 - Dispositions / Acquisition - Continued

over 30 days, overlimit accounts and petitioned bankruptcies will be guaranteed by the Bank for a period of one year. Of the $15.3 million in credit card receivables sold, $529,000 was sold with full recourse which was the total potential recourse exposure at the time of the sale. During the second quarter of 2006, the Bank recorded a recourse liability of $371,000 which was the entire recourse liability recorded. This estimate was based on our historic losses as experienced on similar credit card receivables. The Corporation will be subject to the full recourse obligations for a period of one year. At September 30, 2006, the total potential recourse exposure had been reduced to $266,000 with a current recourse liability of $126,000.

On January 13, 2006, the Corporation completed its acquisition of the Cornerstone Companies, registered investment advisors for high net worth, privately held business owners, wealthy families and institutional clients. Located in the Lehigh Valley, Pennsylvania, the firm specializes in providing sophisticated open architecture asset management platforms, business succession and estate planning services, life insurance sales and compensation and benefits consulting. The Cornerstone Companies had assets under management of approximately $1.5 billion at the acquisition date and serve clients throughout Pennsylvania and other mid-Atlantic states.

The acquisition was consummated pursuant to the Purchase Agreement dated November 15, 2005, by and among the Bank and Cornerstone Financial Consultants, Ltd., a Pennsylvania corporation (CFC), Cornerstone Institutional Investors, Inc., a Pennsylvania corporation (CII), Cornerstone Advisors Asset Management, Inc., a Pennsylvania corporation ((CAAM), and together with CFC and CII collectively, the Cornerstone Companies) and Cornerstone Management Resources, Inc., (CMR). Under the Purchase Agreement, the Bank acquired (i) all of the outstanding capital stock of CFC and CII, (ii) substantially all of the assets of CAAM, and (iii) certain limited assets of CMR. The purchase price consisted of $15.0 million in cash paid at closing and a contingent payment of up to $7.0 million to be paid post-closing. The contingent payment is based upon the Cornerstone Companies meeting certain minimum operating results during a five-year earn-out period, with a maximum payout of $7.0 million over this period.

The Cornerstone Companies acquisition was accounted for using the purchase method of accounting in accordance with SFAS No. 141, “Business Combinations.” The Cornerstone’s Companies results of operations are included in the Corporation’s results beginning January 1, 2006 through September 30, 2006. Goodwill and identifiable intangibles of $11.4 million and $3.9 million, respectively, were recorded in connection with the acquisition. During the third quarter of 2006, management finalized the process of evaluating the purchase accounting adjustments. The amortization of the identifiable intangibles totaled $114,000 for the third quarter of 2006 and $336,000 for the first nine months of 2006.

On June 30, 2005, the Bank sold its former subsidiary, Cumberland Advisors, Inc., to David R. Kotok and Associates, Inc. in a stock sale. The sale price was $2.0 million cash and resulted in a non-taxable gain of $287,000 recorded in the second quarter of 2005. Cumberland Advisors had assets of $1.8 million. Cumberland Advisors, based in Vineland, New Jersey, is an SEC registered investment advisor specializing in fixed income money management and equities with approximately $700 million in assets under management at June 30, 2005. It was acquired by the Corporation on April 30, 2004 as part of its Millennium Bank acquisition. Based upon management’s analysis of Cumberland Advisors’ results of operations and assets in comparison to the Corporation’s, management determined the impact of the sale of Cumberland Advisors is immaterial, and therefore the transaction is not presented as discontinued operations.

On April 1, 2005, the Bank completed the sale of its McAdoo branch located in Schuylkill County, Pennsylvania with deposits of $13.9 million as well as certain loans and other assets of $5.8 million to The Legacy Bank. In connection with the sale, the Bank paid net cash of $7.4 million and recorded a pre-tax profit of $690,000 during the second quarter of 2005.

Note 3 - Pension Plan

The Corporation has a non-contributory defined benefit pension plan covering substantially all employees. The plan’s benefits are based on years of service and the employee’s average compensation during any five consecutive years within the ten-year period preceding retirement.

Net periodic defined benefit pension expense for the nine months ended September 30, 2006 and 2005 included the following components:

	Nine Months Ended September, 30
(Dollars in thousands)		2006			2005
Service cost	$	780		$	789
Interest cost		491			481
Expected return on plan assets		(413	)		(393	)
Amortization of unrecognized net actuarial loss		88			70
Net periodic benefit expense	$	946		$	947

The Corporation has contributed $750,000 to its pension plan in 2006.

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Note 4 - Stock Dividend/Split

On September 15, 2006, the Corporation paid a five percent stock dividend to shareholders of record as of September 1, 2006. On September 15, 2005, the Corporation paid a five percent stock dividend to shareholders of record as of September 1, 2005. All prior period amounts were restated to reflect these stock dividends.

Note 5 - Stock Based Compensation

The Corporation has four shareholder approved fixed stock option plans that allow the Corporation to grant options up to an aggregate of 3,797,861 shares of common stock to key employees and directors. At September 30, 2006, 2,517,985stock options had been granted under the stock option plans. The options have a term of ten years when issued and typically vest over a five-year period. The exercise price of each option is the market price of the Corporation’s stock on the date of grant. Additionally, at September 30, 2006, the Corporation has an additional 328,310 granted stock options as a result of the Millennium Bank acquisition. The options have a term of ten years and are exercisable at prices ranging from $9.25 to $13.81.

At January 1, 2006, the Corporation began recognizing compensation expense for stock options with the adoption of SFAS 123(R) under the modified prospective application method of transition. Prior to January 1, 2006, the Corporation followed SFAS 123 and APB 25 with pro forma disclosures of net income and earnings per share, as if the fair value-based method of accounting defined in SFAS 123 has been applied. Effective January 1, 2006, the Corporation recognizes compensation expense for the portion of outstanding awards at January 1, 2006 for which the requisite service has not yet been rendered, based on the grant-date fair value of those awards calculated under SFAS 123 for pro forma disclosures. For new grants awarded on or after January 1, 2006, the Corporation has chosen to continue the use of the Black-Scholes option-pricing model (as used under SFAS 123) to estimate the fair value of each option on the date of grant. See Note 1 - Summary of Significant Accounting Policies for additional information.

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions based on historical data used for grants for the nine months ended September 30, 2006 and 2005, respectively: weighted-average dividend yield of 3.52% and 2.86%; weighted-average expected volatility of 32.19% and 29.66%; weighted average risk-free interest rate of 4.64% (4.42% to 5.08%) and 4.04% (3.79% to 4.06%): and a weighted-average expected life of 7.28 years and 6.96 years. Expected volatility is based on the historical volatility of the Corporation’s stock over the expected life of the grant. The risk-free rate for periods within the expected life of the option is based on the U.S. Treasury strip rate in effect at the time of the grant. The life of the option is based on historical factors which include the contractual term, vesting period, exercise behavior and employee terminations. In accordance with SFAS 123(R), stock based compensation expense for the nine months ended September 30, 2006 is based on awards that are ultimately expected to vest and therefore has been reduced for estimated forfeitures. The Corporation estimates forfeitures using historical data based upon the groups identified by management. Prior to January 1, 2006, under SFAS 123, forfeitures were accounted for as they occurred. As a result of adopting FAS 123(R) on January 1, 2006, the Corporation’s income before income taxes and net income were lower than if it had continued to account for share based compensation under APB 25 by $97,000 and $93,000, respectively, for the third quarter of 2006 and $345,000 and $315,000, respectively, for the nine-month period ending September 30, 2006.

The following table illustrates the effect on net income and earnings per share if the Corporation had applied the fair value recognition provisions of SFAS 123(R) to stock-based employee compensation for the three and nine months ended September 30, 2005 (all per share information has been adjusted retroactively for the effect of stock dividends).

(Dollars in thousands, except per share amounts)		Three Months Ended			Nine Months Ended
	September 30, 2005
Net income
As reported	$	10,162		$	29,017
Stock-based compensation expense included in reported net income, net of related tax effects		-			-
Stock-based compensation expense determined under fair value based method for all awards, net of related tax effects		(106	)		(503	)
Pro forma	$	10,056		$	28,514
Earnings per share (Basic)
As reported	$	.35		$	1.00
Pro forma	$	.35		$	.99
Earnings per share (Diluted)
As reported	$	.34		$	.98
Pro forma	$	.34		$	.97

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Note 5 - Stock Based Compensation - Continued

A summary of option activity under the Corporation’s stock option plans as of September 30, 2006, and changes during the nine months ended September 30, 2006 is presented in the following table. The number of shares and weighted-average share information have been adjusted to reflect stock dividends.

Options	Shares			Weighted-Average Exercise Price	Weighted-Average Remaining Contractual Term (in years)		Aggregate Intrinsic Value (in thousands)
Outstanding at January 1, 2006	1,650,387		$	14.27
Granted	18,900			18.60
Exercised	(399,798	)		9.50
Forfeited (unvested)	(57,359	)		22.70
Cancelled (vested)	(26,260	)		17.67
Outstanding at September 30, 2006	1,185,870		$	15.46	5.61	$	7,333
Exercisable at September 30, 2006	1,011,614		$	14.26	5.10	$	7,327

The weighted-average grant-date fair value of options granted during the nine months ended September 30, 2006 and 2005 was $5.23 and $6.32, respectively. The total intrinsic value of options exercised during the nine months ended September 30, 2006 and 2005 was $4.3 million and $2.6 million, respectively.Intrinsic value is measured using the fair market value price of the Corporation’s common stock less the applicable exercise price.

A summary of the status of the Corporation’s nonvested shares as of September 30, 2006 is presented below:

Nonvested Shares	Shares			Weighted-Average Grant-Date Fair Value
Nonvested at January 1, 2006	229,671		$	6.24
Granted	18,900			5.23
Vested	(16,955	)		5.33
Forfeited	(57,359	)		6.27
Nonvested at September 30, 2006	174,257		$	6.21

As of September 30, 2006, there was a total of $829,000 of unrecognized compensation cost related to nonvested awards under stock option plans. This cost is expected to be recognized over a weighted-average period of 1.8 years. The total fair value of shares vested during the nine months ended September 30, 2006 and 2005 was $90,000 and $293,000, respectively.

Prior to the adoption of FAS 123(R), the Corporation presented all tax benefits of deductions resulting from the exercise of stock options as operating cash flows in the statement of cash flows. Statement 123(R) requires the cash flows resulting from tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as financing cash flows. The $867,000 excess tax benefit classified as a financing cash inflow would have been classified as an operating cash inflow if the company had not adopted FAS 123(R).

Note 6 - Earnings Per Share

Basic earnings per share exclude dilution and are computed by dividing income available to common shareholders by the weighted-average common shares outstanding during the period. Diluted earnings per share take into account the potential dilution that could occur if securities or other contracts to issue common stock were exercised and converted into common stock. All weighted average, actual shares and per share information in these financial statements have been adjusted retroactively for the effect of stock dividends.

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Note 6 - Earnings Per Share - Continued

The calculations of basic earnings per share and diluted earnings per share are as follows:

	Three Months Ended		Nine Months Ended
	September 30,		September 30,
(Dollars in thousands, except per share data)	2006	2005	2006	2005
Basic earnings per share
Net income available to common shareholders	$7,907	$10,162	$26,143	$29,017
Weighted average common shares outstanding	29,011,903	28,897,869	28,940,119	28,921,613
Basic earnings per share	$ .27	$ .35	$ .90	$ 1.00
Diluted earnings per share
Net income available to common shareholders and assumed conversions	$7,907	$10,162	$26,143	$29,017
Weighted average common shares outstanding	29,011,903	28,897,869	28,940,119	28,921,613
Dilutive potential common shares (1), (2)	372,407	581,359	433,527	619,873
Total diluted weighted average common shares outstanding	29,384,310	29,479,228	29,373,646	29,541,486
Diluted earnings per share	$ .27	$ .34	$ .89	$ .98

(1)   Includes incremental shares from assumed conversions of stock options.

(2)   Antidilutive options have been excluded in the computation of diluted earnings per share because the options’ exercise prices were greater than the average market price of the common stock. For the three and nine months ended September 30, 2006, there were 417,456 antidilutive options at an average price of $24.50. For the three and nine months ended September 30, 2005, there were 370,210 antidilutive options at an average price of $25.67 and 372,415 antidilutive options at an average price of $25.64.

Note 7 - Comprehensive Income

The components of other comprehensive income (loss) are as follows:

Comprehensive Income
(Dollars in thousands)		Before tax			Tax Benefit			Net of tax
Nine months ended September 30, 2006		Amount			(Expense)			Amount
Net unrealized gains on available for sale securities:
Net unrealized holding gains arising during period	$	2,035		$	(712	)	$	1,323
Less reclassification adjustment for net gains realized in net income		-			-			-
Net unrealized gains		2,035			(712	)		1,323
Change in fair value of derivatives used for cash flow hedges		(144	)		50			(94	)
Amortization of unrealized loss on termination of cash flow hedge		137			(48	)		89
Other comprehensive income, net	$	2,028		$	(710	)	$	1,318
(Dollars in thousands)		Before tax			Tax Benefit			Net of tax
Nine months ended September 30, 2005		Amount			(Expense	)		Amount
Net unrealized losses on available for sale securities:
Net unrealized holding losses arising during period	$	(5,533	)	$	1,937		$	(3,596	)
Less reclassification adjustment for net gains realized in net income		3,047			(1,066	)		1,981
Net unrealized losses		(8,580	)		3,003			(5,577	)
Change in fair value of derivatives used for cash flow hedges		552			(193	)		359
Unrealized loss on termination of cash flow hedge		(195	)		68			(127	)
Other comprehensive loss, net	$	(8,223	)	$	2,878		$	(5,345	)

Note 8 - Segment Information

The Corporation operates two main lines of business along with several other operating segments. SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” establishes standards for public business enterprises to report information about operating segments. Operating segments are components of an enterprise, which are evaluated regularly by the chief operating decision-maker in deciding how to allocate and assess resources and performance. The Corporation’s chief operating decision-maker is the President and Chief Executive Officer. The Corporation has applied the aggregation criteria set forth in SFAS No. 131 for operating segments establishing two reportable segments: Community Banking and Wealth Management.

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Note 8 - Segment Information - Continued

The Community Banking segment provides financial services to consumers, businesses and governmental units primarily in southeastern Pennsylvania. These services include full-service banking, comprised of accepting time and demand deposits, making secured and unsecured commercial loans, mortgages, consumer loans, and other banking services. The treasury function income is included in the Community Banking segment, as the majority of effort of this function is related to this segment. Primary sources of income include net interest income and service fees on deposit accounts. Expenses include costs to manage credit and interest rate risk, personnel, and branch operational and technical support.

The Wealth Management segment includes: trust and investment management services, providing investment management, trust and fiduciary services, estate settlement and executor services, financial planning, and retirement plan and institutional investment services; and the Cornerstone Companies, registered investment advisors for high net worth, privately held business owners, wealthy families and institutional clients. Major revenue components sources include investment management and advisory fees, trust fees, estate and tax planning fees, brokerage fees, and insurance related fees. Expenses primarily consist of personnel and support charges. Additionally, the Wealth Management segment includes an inter-segment credit related to trust deposits which are maintained within the Community Banking segment using a transfer pricing methodology.

The Corporation has also identified several other operating segments. These operating segments within the Corporation’s operations do not have similar characteristics to the Community Banking or Wealth Management segments and do not meet the quantitative thresholds requiring separate disclosure. These non-reportable segments include HNC Reinsurance Company, HNC Financial Company, and the parent holding company and are included in the “Other” category.

Information about reportable segments and reconciliation of the information to the consolidated financial statements follows:

(Dollars in thousands)		Community Banking		Wealth Management			All Other			Consolidated Totals
Three Months Ended September 30, 2006
Net interest income (expense)	$	21,060	$	118		$	(564	)	$	20,614
Provision for loan losses		900		-			-			900
Noninterest income		4,738		3,377			171			8,286
Noninterest expense		14,108		3,141			311			17,560
Income (loss) before income taxes (benefit)		10,790		354			(704	)		10,440
Income taxes (benefit)		2,698		132			(297	)		2,533
Net income (loss)	$	8,092	$	222		$	(407	)	$	7,907
Three Months Ended September 30, 2005
Net interest income	$	21,778	$	147		$	(181	)	$	21,744
Provision for loan losses		650		-			-			650
Noninterest income		5,761		1,268			701			7,730
Noninterest expense		13,937		1,315			61			15,313
Income (loss) before income taxes (benefit)		12,952		100			459			13,511
Income taxes (benefit)		3,228		34			87			3,349
Net income (loss)	$	9,724	$	66		$	372		$	10,162
Nine Months Ended September 30, 2006
Net interest income (expense)	$	64,495	$	383		$	(1,517	)	$	63,361
Provision for loan losses		3,000		-			-			3,000
Noninterest income		15,208		11,471			560			27,239
Noninterest expense		41,783		9,788			889			52,460
Income (loss) before income taxes (benefit)		34,920		2,066			(1,846	)		35,140
Income taxes (benefit)		8,899		864			(766	)		8,997
Net income (loss)	$	26,021	$	1,202		$	(1,080	)	$	26,143
Assets	$	3,310,306	$	18,706		$	33,991		$	3,363,003
Nine Months Ended September 30, 2005
Net interest income	$	65,037	$	464		$	(240	)	$	65,261
Provision for loan losses		2,050		-			-			2,050
Noninterest income		15,189		5,258			1,978			22,425
Noninterest expense		41,769		5,747			193			47,709
Income (loss) before income taxes (benefit)		36,407		(25	)		1,545			37,927
Income taxes (benefit)		8,580		(9	)		339			8,910
Net income (loss)	$	27,827	$	(16	)	$	1,206		$	29,017
Assets	$	3,087,114	$	-		$	33,024		$	3,120,138

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Note 8 - Segment Information - Continued

The accounting policies of the segments are the same as those described in the summary of significant accounting policies disclosed in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2005. Consolidating adjustments reflecting certain eliminations of inter-segment revenues, cash and investment in subsidiaries are included in the “All Other” segment.

Note 9 - Financial Instruments with Off-Balance Sheet Risk

The Bank is a party to 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 and standby letters of credit. Such financial instruments are recorded in the financial statements when they become payable. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The contract or notional amounts of those instruments reflect the extent of involvement the Bank has in particular classes of financial instruments.

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual or notional amounts of those instruments. The Bank uses the same stringent credit policies in extending these commitments as they do for recorded financial instruments and controls exposure to loss through credit approval and monitoring procedures.

The approximate contract amounts are as follows:

	Total Amount Committed at
Commitments	September 30, 2006	December 31,  2005
(Dollars in thousands)
Financial instruments whose contract amounts represent credit risk:
Commitments to extend credit	$730,535	$722,034
Standby letters of credit and financial guarantees written	25,821	21,661
Financial instruments whose notional or contract amounts exceed the amount of credit risk:
Interest rate swap agreements	57,100	22,100

The total committed amount included no credit card unused lines at September 30, 2006 and $44.4 million at December 31, 2005. In April 2006, the Corporation sold its existing credit card portfolio. See Note 2 - Dispositions / Acquisitions for addition information.

At September 30, 2006, the Corporation had cash flow hedges in the form of interest rate swaps totaling $45.0 million that have the effect of converting the rates on money market deposit accounts to a fixed-rate cost of funds. This strategy will cause the Bank to recognize, in a rising rate environment, a larger interest rate spread than it otherwise would have without the swaps in effect. In addition, the Corporation

had cash flow hedges for $10.0 million that have the effect of converting variable debt to a fixed rate. For these swaps, the Corporation recognized net interest income of $134,000 and $29,000 for the three months ended September 30, 2006 and 2005, respectively and $311,000 and $18,000 of net interest income for the nine months ended September 30, 2006 and 2005, respectively. During the first quarter of 2005, the Corporation terminated a cash flow hedge with a notional value of $25.0 million. The gross loss related to the termination of this swap is $310,000 which is being amortized through October 2006 in accordance with SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities.” The Corporation amortized into net interest income $46,000 for both the third quarter of 2006 and 2005 related to this swap. For the nine months ended September 30, 2006 and 2005, the Corporation amortized into net interest income $136,000 and $114,000, respectively, related to this swap. Periodically, the Corporation may enter into fair value hedges to limit the exposure to changes in the fair value of loan assets. During December 2005, the Corporation entered into a fair value hedge for $2.1 million with $3,000 of interest income recognized for the three and nine months ended September 30, 2006. The Corporation’s swap agreements have a positive fair market value totaling $502,000 at September 30, 2006 and $623,000 at December 31, 2005.

The Bank also had commitments with customers to extend mortgage loans at a specified rate at September 30, 2006 and December 31, 2005 of $1.9 million and $1.8 million, respectively and commitments to sell mortgage loans at a specified rate at September 30, 2006 and December 31, 2005 of $1.3 million and $1.1 million, respectively. The commitments are accounted for as a derivative and recorded at fair value. The Bank estimates the fair value of these commitments by comparing the secondary market price at the reporting date to the price specified in the contract to extend or sell the loan initiated at the time of the loan commitment. The commitments had a positive fair value at September 30, 2006 of $10,000 and $320 at December 31, 2005, which was recorded as other income.

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Note 9 - Financial Instruments with Off-Balance Sheet Risk - Continued

During December 2004 and January 2005, the Bank sold lease financing receivables of $10.5 million. Of these leases, $1.2 million were sold with full recourse and the remaining leases were sold subject to recourse with a maximum exposure of ten percent of the outstanding receivable. The total recourse exposure at the time of the sale of the leases was $2.0 million. During the first quarter of 2005, the Bank recorded a recourse liability of $216,000 which was the entire recourse liability recorded. This estimate was based on our historic losses as experienced on similar lease financing receivables. After the first anniversary of the sale agreement, and on a quarterly basis thereafter, upon written request by the Bank, the purchaser will review the portfolio performance and may reduce the total exposure to an amount equal to ten percent of the outstanding net book value. The Corporation will be subject to the full and partial recourse obligations until all the lease financing receivables have been paid or otherwise been terminated and all equipment has been sold or disposed of. The final lease payment is due in 2010 with approximately 90% of the lease financing receivables estimated to be paid down by December 31, 2007. The outstanding balance of these sold leases at September 30, 2006 was $3.8 million with a total recourse exposure of $769,000 and a current recourse liability of $175,000.

Note 10 - Recent Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans¾an amendment of FASB Statements No. 87, 88, 106, and 132(R).” SFAS No. 158 requires an employer that is a business entity and sponsors one or more single-employer defined benefit plans to 1) recognize a plan’s overfunded or underfunded status as an asset or liability in its financial statements, 2) measure plan assets and obligations as of fiscal year-end, and 3) recognize as a component of other comprehensive income, net of tax, the gains and losses and prior service costs or credits that arise during the period but are not recognized as components of net periodic benefit cost. The statement is effective for fiscal years ending after December 15, 2006 with the exception of the requirement to measure plan assets and obligations as of the employer’s fiscal year-end which is effective for fiscal years ending after December 15, 2008. The Corporation is in the process of determining the impact this statement will have on its financial statements. If the provisions of SFAS No. 158 had been applied as of December 31, 2005, shareholder’s equity would have been reduced by approximately $1.8 million after tax. The Corporation’s current measurement date for plan assets and obligations is fiscal year-end.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 clarifies the definition of fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years, although earlier application is encouraged. Prospective application of the provisions of SFAS No. 157 is required as of the beginning of the fiscal year in which it is initially applied, except for certain circumstances specified in the Statement that require retrospective application. The Corporation is in the process of assessing the impact of the adoption of this statement on the Corporation’s financial statements.

In September 2006, the SEC issued Staff Accounting Bulletin (SAB) 108 to add section N, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” to Topic 1, Financial Statements, of the Staff Accounting Bulletin Series. Section N provides guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. These methods are referred to as the “roll-over” and “iron curtain” methods. The roll-over method quantifies the amount by which the current year income statement is misstated. Exclusive reliance on an income statement approach can result in the accumulation of errors on the balance sheet that may not have been material to any individual income statement, but which may misstate one or more balance sheet accounts. The iron curtain method quantifies the error as the cumulative amount by which the current year balance sheet is misstated. Exclusive reliance on a balance sheet approach can result in disregarding the effects of errors in the current year income statement that results from the correction of an error existing in previously issued financial statements. We currently use the roll-over method for quantifying identified financial statement misstatements. According to the guidance, a registrant must quantify the impact of correcting all misstatements on its current year financial statements, including both the carryover and reversing effects of prior year misstatements. Early application of the guidance in SAB No. 108 is encouraged in any report for an interim period of the first fiscal year ending after November 15, 2006, filed after the publication of this SAB. The Corporation is in the process of assessing the impact of applying the guidance in this SAB on the Corporation’s financial results.

In June, 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109.” FIN No. 48 clarifies the accounting and reporting for income taxes where interpretation of the tax law may be uncertain. FIN No. 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN No. 48 also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN No. 48 will apply to fiscal years beginning after December 15, 2006, with earlier adoption permitted. The Corporation is in the process of assessing the impact of the adoption of this statement on the Corporation’s financial results.

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Note 10 - Recent Accounting Pronouncements - Continued

In March 2006, the FASB issued SFAS No. 156, “Amending Accounting for Separately Recognized Servicing Assets and Servicing Liabilities,” to simplify accounting for separately recognized servicing assets and servicing liabilities. SFAS No. 156 amends SFAS No. 140, “ Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,”to require an entity to 1) separately recognize financial assets as servicing assets or servicing liabilities, each time it undertakes an obligation to service a financial asset by entering into certain kinds of servicing contracts, 2) initially measure all separately recognized servicing assets and servicing liabilities at fair value, if practicable and 3) separately present servicing assets and servicing liabilities subsequently measured at fair value in the statement of financial position and additional disclosures for all separately recognized servicing assets and servicing liabilities. Additionally, SFAS No. 156 permits an entity to choose either the amortization method or the fair value measurement method for measuring each class of separately recognized servicing assets and servicing liabilities. SFAS 156 applies to all separately recognized servicing assets and liabilities acquired or issued after the beginning of an entity's fiscal year that begins after September 15, 2006, although early adoption is permitted. The Corporation is in the process of assessing the impact of the adoption of this statement on the Corporation’s financial results.

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments¾an amendment of FASB Statements No. 133 and 140,” to simplify and make more consistent the accounting for certain financial instruments. SFAS 155 amends SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” to permit fair value re-measurement for any hybrid financial instrument with an embedded derivative that otherwise would require bifurcation, provided that the whole instrument is accounted for on a fair value basis. Prior to fair value measurement, interests in securitized financial assets must be evaluated to identify interests containing embedded derivatives requiring bifurcation. The amendments to SFAS 133 also clarify which interest-only and principal-only strips are not subject to the requirements of SFAS 133, and that concentrations of credit risk in the form of subordination are not embedded derivatives. SFAS 155 amends SFAS No. 140, “Accounting for the Impairment or Disposal of Long-Lived Assets,” to allow a qualifying special-purpose entity to hold a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS No. 155 applies to all financial instruments acquired or issued after the beginning of an entity's first fiscal year that begins after September 15, 2006, with earlier application allowed. The Corporation is in the process of determining the impact this statement will have on its financial statements.

In November 2005, the FASB issued FSP FAS Nos. 115-1 and FAS 124-1 “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” to give guidance on determining when investments in certain debt and equity securities are considered impaired, whether that impairment is other than temporary, and on measuring such impairment loss. This FSP nullifies certain requirements of EITF Issue 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” and supersedes EITF Topic No. D-44, “Recognition of Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value.” This FSP nullifies the requirements of paragraphs 10-18 of Issue 03-1, carries forward the requirements of paragraphs 8 and 9 of Issue 03-1 with respect to cost-method investments, carries forward the disclosure requirements included in paragraphs 21 and 22 of Issue 03-1 and related examples, and references existing other-than-temporary guidance. The guidance in this FSP applies to reporting periods beginning after December 15, 2005. The adoption of this FSP did not have a material impact on the Corporation’s results of operations or financial condition.

In November, 2005, the FASB issued FSP FIN 45-3, “Application of FASB Interpretation No. 45 to Minimum Revenue Guarantees Granted to a Business or Its Owners.” The guidance in this FSP amends FIN No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” to explicitly state that the recognition, measurement and disclosure provisions of FIN No. 45 apply to a minimum revenue guarantee. A minimum revenue guarantee is a guarantee granted to a business or its owners that the revenue of the business will be at least a specified minimum amount for a specified period of time. FSP FIN 45-3 is effective for new minimum revenue guarantees issued or modified on or after the beginning of the first fiscal quarter following November 10, 2005 (the date posted to the FASB website). The disclosure requirements are to be applied to all minimum revenue guarantees in financial statements of interim or annual periods ending after the beginning of the first fiscal quarter following November 10, 2005, although earlier application is permitted. FSP FIN 45-3 did not have a material impact on the Corporation’s financial position or results of operations.

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Item 2.                                                                                               MANAGEMENT'S DISCUSSION AND ANALYSIS OF

RESULTS OF OPERATIONS AND FINANCIAL CONDITION

The following is management’s discussion and analysis of the significant changes in the results of operations, capital resources and liquidity presented in its accompanying consolidated financial statements for the Corporation, the Bank, HNC Financial Company and HNC Reinsurance Company. The Corporation’s consolidated financial condition and results of operations consist almost entirely of the Bank’s financial condition and results of operations. Current performance does not guarantee, and may not be indicative, of similar performance in the future. These are unaudited financial statements and, as such, are subject to year-end audit review.

In addition to historical information, this Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. We have made forward-looking statements in this report, and in documents that we incorporate by reference, that are subject to risks and uncertainties. Forward-looking statements include the information concerning possible or assumed future results of operations of the Corporation and its subsidiaries. When we use words such as “believes,” “expects,” “anticipates,” “may,” “estimates,” or “intends” or similar expressions, we are making forward-looking statements. Forward-looking statements are representative only as of the date they are made, and the Corporation undertakes no obligation to update any forward-looking statement.

Shareholders should note that many factors, some of which are discussed elsewhere in this report and in the documents that we incorporate by reference, could affect the future financial results of the Corporation and its subsidiaries and could cause those results to differ materially from those expressed or implied in our forward-looking statements contained or incorporated by reference in this document. These factors include but are not limited to those described in Item 1A, “Risk Factors” in the Corporation’s 2005 Annual Report on Form 10-K and in this Form 10-Q.

Critical Accounting Estimates

The accounting and reporting policies of the Corporation and its subsidiaries conform to accounting principles generally accepted in the United States and general practices with the financial services industry. The Corporation’s significant accounting policies are described in Note 1 of the consolidated financial statements in this Form 10-Q and in the Corporation’s 2005 Annual Report on Form 10-K and are essential in understanding Management’s Discussion and Analysis of Results of Operations and Financial Condition. In applying accounting policies and preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amount of assets and liabilities as of the dates of the balance sheets and revenues and expenditures for the periods presented. Therefore, actual results could differ significantly from those estimates. Judgments and assumptions required by management, which have, or could have a material impact on the Corporation’s financial condition or results of operations are considered critical accounting estimates. The following is a summary of the policies the Corporation recognizes as involving critical accounting estimates: Allowance for Loan Loss, Goodwill and Other Intangible Asset Impairment, Stock-Based Compensation, Unrealized Gains and Losses on Debt Securities Available for Sale, and Deferred Taxes.

Allowance for Loan Losses: The Corporation maintains an allowance for loan losses at a level management believes is sufficient to absorb estimated probable credit losses. Management’s determination of the adequacy of the allowance is based on periodic evaluations of the loan portfolio and other relevant factors. However, this evaluation is inherently subjective as it requires significant estimates by management. Consideration is given to a variety of factors in establishing these estimates including current and anticipated economic conditions, diversification of the loan portfolio, delinquency statistics, results of internal loan reviews, borrowers’ perceived financial and management strengths, the adequacy of underlying collateral, the dependence on collateral, or the strength of the present value of future cash flows and other relevant factors. These factors may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provisions for loan losses may be required which may adversely affect the Corporation’s results of operations in the future.

Goodwill and Other Intangible Asset Impairment: Goodwill and other intangible assets are reviewed for potential impairment on an annual basis, or more often if events or circumstances indicate that there may be impairment, in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets.” Goodwill is tested for impairment at the reporting unit level and an impairment loss is recorded to the extent that the carrying amount of goodwill exceeds its implied fair value. The Corporation employs general industry practices in evaluating the fair value of its goodwill and other intangible assets. The Corporation calculates the fair value using a combination of the following valuations: deposit premiums based on market deals, current stock pricing tracking as a multiple of book value, discounted cash flow of earnings with a terminal value and market multiple of earnings. Management performed its annual review of goodwill at June 30, 2006 and determined there was no impairment of goodwill.No assurance can be given that future impairment tests will not result in a charge to earnings.

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Share-based Compensation: The Corporation adopted SFAS No. 123 (revised 2004), “Share-Based Payment” (FAS 123(R)) on January 1, 2006 using the modified prospective application method of transition. FAS 123(R) was issued by the FASB in December 2004, requiring all forms of share-based payments to employees, including employee stock options, be treated the same as other forms of compensation by recognizing the related cost in the income statement. The expense of the option is generally measured at fair value at the grant date with compensation expense recognized over the service period, which is usually the vesting period. Prior to January 1, 2006, the Corporation followed SFAS 123 and APB 25 with pro forma disclosures of net income and earnings per share, as if the fair value-based method of accounting defined in SFAS 123 has been applied. Effective January 1, 2006, the Corporation recognizes compensation expense for the portion of outstanding awards at January 1, 2006 for which the requisite service has not yet been rendered, based on the grant-date fair value of those awards calculated under SFAS 123 for pro forma disclosures. For new grants awarded on or after January 1, 2006, the Corporation has chosen to continue the use of the Black-Scholes option-pricing model (as used under SFAS 123) to estimate the fair value of each option on the date of grant. The Corporation estimates the fair value of options under the Black-Scholes model which takes into consideration the exercise price and expected life of the options, the current price of the underlying stock and its expected volatility, the expected dividends on the stock and the current risk-free interest rate for the expected life of the option. The Corporation’s estimate of the fair value of a stock option is based on expectations derived from historical experience and may not necessarily equate to its market value when fully vested. In accordance with SFAS 123(R), the Corporation estimates the number of options for which the requisite service is expected to be rendered as compared to accounting for forfeitures as they occur under SFAS 123. The Corporation has chosen to recognize compensation expense for new grants using the straight-line method which spreads compensation expense for shares vesting evenly over the period of vesting. Pro forma disclosures under SFAS 123 have been based upon the accrual method which treats each vesting tranche as a separate award and amortizes expense evenly (prorated) from grant date to vest date for each tranche. The Corporation estimates that share-based compensation expense, net of tax, to be recognized during the year of 2006 will be approximately $407,000. The number and timing of options granted during 2006 and vesting criteria may alter this projected number. During the third quarter of 2006, the Corporation recognized share-based compensation expense of $97,000 ($93,000 net of tax) and for the nine-month period ending September 30, 2006, recognized $345,000 ($315,000, net of tax). As of September 30, 2006, there was a total of $829,000 of unrecognized compensation cost related to nonvested awards under stock option plans ($798,000 net of tax). This cost is expected to be recognized over a weighted-average period of 1.8 years.

Unrealized Gains and Losses on Debt Securities Available for Sale: The Corporation receives estimated fair values of debt securities from independent valuation services and brokers. In developing these fair values, the valuation services and brokers use estimates of cash flows based on historical performance of similar instruments in similar rate environments. Debt securities available for sale are mostly comprised of mortgage-backed securities.

Deferred Taxes: The Corporation recognizes deferred tax assets and liabilities for the future effects of temporary differences, net operating loss carryforwards, and tax credits. Deferred tax assets are subject to management’s judgment based upon available evidence that future realizations are likely. If management determines that the Corporation may not be able to realize some or all of the net deferred tax asset in the future, a charge to income tax expense may be required to reduce the value of the net deferred tax asset to the expected realizable value.

The Corporation has not substantively changed its application of the foregoing policies, and there have been no material changes in assumptions or estimation techniques used as compared to prior periods.

Financial Overview

For the third quarter of 2006, the Corporation’s diluted and basic earnings per share were $.27 compared to $.34 and $.35, respectively, for the third quarter of 2005. Net income was $7.9 million for the third quarter of 2006 compared to $10.2 million during the third quarter of 2005.

For the nine months ended September 30, 2006, diluted and basic earnings per share were $.89 and $.90, respectively, as compared to $.98 and $1.00, respectively in the comparable period of 2005. Net income for the nine-month period ended September 30, 2006, was $26.1 million compared to $29.0 million during the nine months of 2005. The net interest margin compression for the Corporation, as well as the banking industry in general, continues to be challenging due to the interest rate environment. Wealth management income during the third quarter of 2006 rose to $3.4 million, an increase of $2.1 million from the comparable period in 2005. In addition, total deposits grew 11.1% from December 31, 2005. The earnings for 2006 reflected increases in interest expense on deposits and borrowings partially offset by increases in loan interest income and wealth management income.

The year-to-date financial results for 2006 include the favorable impact on operations from the acquisition of the Cornerstone Companies effective January 1, 2006 and the $1.4 million gain on the sale of the Bank’s credit card portfolio during the second quarter. The per share results also reflect the issuance of 1,382,000 shares of the Corporation’s common stock for a 5% stock dividend payable September 15, 2006. All share and per share information has been restated to reflect this stock dividend.

The Corporation’s consolidated total assets were $3.4 billion at September 30, 2006, an increase of 7.8% or $242.9 million over $3.1 billion in total assets reported at September 30, 2005. This increase was primarily attributable to loan growth of $92.4 million and an increase in cash and investments of $124.7 million. The growth in loans took place mainly in the Bank’s real estate portfolio. Total assets at September 30, 2006 increased $245.6 million compared to December 31, 2005 with $48.8 million growth in loans and a $168.7

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million net increase in cash and investments. Total deposits increased $262.8 million to $2.63 billion at September 30, 2006 from $2.37 billion at December 31, 2005 mostly attributable to growth in time deposits and interest-bearing checking accounts.

For the three months ended September 30, 2006, the annualized return on average shareholders’ equity and the annualized return on average assets were 11.10% and .96%, respectively. For the same period in 2005, the annualized return on average shareholders’ equity was 14.64% and the annualized return on average assets was 1.32%. The decrease in these ratios during 2006 was primarily the result of lower net income.

Nonperforming assets (including nonaccrual loans, net assets in foreclosure and loans 90 days or more past due) were .39% of total assets at September 30, 2006, compared to .27% at December 31, 2005, and .26% at September 30, 2005. The increase in nonperforming assets at September 30, 2006, in relation to December 31, 2005, was mainly due to commercial mortgage loans for two borrowers totaling $2.2 million, which were placed on nonaccrual of interest during the first quarter of 2006, commercial mortgage loans for another borrower totaling $803,000, which were placed on nonaccrual of interest during the second quarter of 2006 and commercial mortgage loans for three borrowers totaling $916,000 which became delinquent over 90 days during the third quarter of 2006. The increase in relation to September 30, 2005, was attributed to the previously aforementioned loans as well as an additional $657,000 attributed to commercial loan borrowers placed on nonaccrual of interest during the fourth quarter of 2005.

Results of Operations

Net income is affected by five major elements: (1) net interest income, or the difference between interest income earned on loans and investments and interest expense paid on deposits and borrowed funds; (2) the provision for loan losses, or the amount added to the allowance for loan losses to provide reserves for inherent losses on loans; (3) noninterest income, which is made up primarily of certain fees, wealth management income and gains and losses from sales of securities; (4) noninterest expense, which consists primarily of salaries, employee benefits and other operating expenses; and (5) income taxes. Each of these major elements will be reviewed in more detail in the following discussion.

Net Interest Income

Net interest income on a tax equivalent basis in the third quarter of 2006 decreased $1.2 million or 5.2% from the same period in 2005 and net interest income on a tax equivalent basis for the nine months ended September 30, 2006 decreased $2.3 million or 3.2% from the nine-month period ending September 30, 2005. These decreases during 2006 were mainly attributable to higher deposit and borrowing costs offset in part by higher loan and investment rates. Due to the market conditions, deposit and short-term borrowing rates have increased more quickly than loan rates have increased.

The rate volume variance analysis in the table below, which is computed on a tax-equivalent basis (tax rate of 35%), analyzes changes in net interest income for the three and nine months ended September 30, 2006 compared to September 30, 2005 by their volume and rate components. The change attributable to both volume and rate has been allocated proportionately.

Table 1—Analysis of Changes in Net Interest Income—Fully Taxable-Equivalent Basis

	Three Months Ended									Nine Months Ended
	September 30, 2006 compared to									September 30, 2006 compared to
(Dollars in thousands)	September 30, 2005									September 30, 2005
		Total		Due to change in:							Total		Due to change in:
		Change			Volume			Rate			Change			Volume			Rate
Increase in interest income:
Investment securities *	$	1,562		$	147		$	1,415		$	3,948		$	759		$	3,189
Federal funds sold and deposits in banks		809			473			336			1,513			554			959
Loans *		4,937			1,849			3,088			15,731			6,035			9,696
Total		7,308			2,469			4,839			21,192			7,348			13,844
Increase (decrease) in interest expense:
Savings and money market deposits		4,714			370			4,344			11,826			386			11,440
Time deposits		3,569			1,957			1,612			9,211			5,274			3,937
Borrowed funds		238			(676	)		914			2,412			(443	)		2,855
Total		8,521			1,651			6,870			23,449			5,217			18,232
Net increase (decrease) in net interest income	$	(1,213	)	$	818		$	(2,031	)	$	(2,257	)	$	2,131		$	(4,388	)
*Tax equivalent basis using a tax rate of 35%

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The following table presents the major asset and liability categories on an average basis for the periods presented, along with interest income and expense, and key rates and yields.

Table 2—Average Balance Sheets and Interest Rates¾Fully Taxable-Equivalent Basis

(Dollars in thousands)	Three Months Ended September 30,						Three Months Ended September 30,
	2006						2005
		Average			Average			Average			Average
Assets		Balance		Interest	Rate			Balance		Interest	Rate
Earning assets:
Investment securities:
Taxable investments	$	661,976	$	7,538	4.52	%	$	642,405	$	5,678	3.51	%
Nontaxable investments (1)		255,127		3,892	6.05			261,519		4,190	6.36
Total investment securities		917,103		11,430	4.94			903,924		9,868	4.33
Federal funds sold and deposits in banks		92,878		1,227	5.24			50,489		418	3.28
Loans (1) (2)		2,027,028		34,823	6.82			1,912,551		29,886	6.20
Total earning assets		3,037,009		47,480	6.20			2,866,964		40,172	5.56
Noninterest-earning assets		216,607						187,931
Total assets	$	3,253,616					$	3,054,895
Liabilities and Shareholders' Equity
Interest-bearing liabilities:
Interest-bearing deposits:
Savings and money market	$	1,305,618		10,630	3.23		$	1,232,136		5,916	1.90
Time		878,493		9,732	4.40			685,168		6,163	3.57
Total interest-bearing deposits		2,184,111		20,362	3.70			1,917,304		12,079	2.50
Borrowed funds		409,583		4,985	4.83			471,579		4,747	3.99
Total interest bearing liabilities		2,593,694		25,347	3.88			2,388,883		16,826	2.79
Noninterest-bearing liabilities:
Demand deposits		334,847						343,658
Other liabilities		42,397						46,904
Total noninterest-bearing liabilities		377,244						390,562
Total liabilities		2,970,938						2,779,445
Shareholders' equity		282,678						275,450
Total liabilities and shareholders' equity	$	3,253,616					$	3,054,895
Net interest spread					2.32						2.77
Effect of noninterest-bearing sources					0.57						.46
Net interest income/margin on earning assets			$	22,133	2.89	%			$	23,346	3.23	%
Less tax equivalent adjustment				1,519						1,602
Net interest income			$	20,614					$	21,744

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(Dollars in thousands)	Nine Months Ended September 30,						Nine Months Ended September 30,
	2006						2005
		Average			Average			Average			Average
Assets		Balance		Interest	Rate			Balance		Interest	Rate
Earning assets:
Investment securities:
Taxable investments	$	675,138	$	22,412	4.44	%	$	641,102	$	17,362	3.62	%
Nontaxable investments (1)		252,447		11,573	6.13			263,993		12,675	6.42
Total investment securities		927,585		33,985	4.90			905,095		30,037	4.44
Federal funds sold and deposits in banks		67,181		2,507	4.99			46,773		994	2.84
Loans (1) (2)		2,007,650		100,333	6.68			1,879,230		84,602	6.02
Total earning assets		3,002,416		136,825	6.09			2,831,098		115,633	5.46
Noninterest-earning assets		209,946						181,633
Total assets	$	3,212,362					$	3,012,731
Liabilities and Shareholders' Equity
Interest-bearing liabilities:
Interest-bearing deposits:
Savings and money market	$	1,264,577		27,061	2.86		$	1,234,032		15,235	1.65
Time		841,242		26,341	4.19			659,241		17,130	3.47
Total interest-bearing deposits		2,105,819		53,402	3.39			1,893,273		32,365	2.29
Borrowed funds		445,688		15,517	4.65			460,933		13,105	3.80
Total interest bearing liabilities		2,551,507		68,919	3.61			2,354,206		45,470	2.58
Noninterest-bearing liabilities:
Demand deposits		338,709						335,015
Other liabilities		42,918						50,590
Total noninterest-bearing liabilities		381,627						385,650
Total liabilities		2,933,134						2,739,811
Shareholders' equity		279,228						272,920
Total liabilities and shareholders' equity	$	3,212,362					$	3,012,731
Net interest spread					2.48						2.88
Effect of noninterest-bearing sources					0.54						.43
Net interest income/margin on earning assets			$	67,906	3.02	%			$	70,163	3.31	%
Less tax equivalent adjustment				4,545						4,902
Net interest income			$	63,361					$	65,261

(1)   The interest earned on nontaxable investment securities and loans is shown on a tax equivalent basis (tax rate of 35%).

(2)   Nonaccrual loans have been included in the appropriate average loan balance category, but interest on nonaccrual loans has not been included for purposes of determining interest income.

Interest income on a tax equivalent basis in the third quarter of 2006 increased $7.3 million, or 18.2% over the same period in 2005. This increase was primarily due to higher average rates earned on loans and investment securities of 62 basis points and 61 basis points, respectively, and an increase in average loans of $114.5 million, or 6.0%. Interest expense increased $8.5 million during the third quarter of 2006 versus the comparable period in 2005 mainly attributed to higher deposit and short-term borrowing rates as well as an increase in average time deposits of $193.3 million. The average rate paid on deposits during the third quarter of 2006 of 3.70% was 120 basis points higher compared to the same period in 2005 due to higher rates on most deposit products. The average rate paid on borrowings for the third quarter of 2006 of 4.83% was 84 basis points higher than the comparable period in 2005 mainly due to an increase in short-term borrowing rates.

Net Interest Margin

The net interest margin for the third quarter of 2006 was 2.89%, compared to 3.04% for the second quarter of 2006 and 3.23% for the third quarter of 2005. Due to market conditions, deposit and short-term borrowing rates have increased more quickly than loan rates resulting in a lower net interest margin.

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Interest Rate Sensitivity Analysis

In the normal course of conducting business activities, the Corporation is exposed to market risk, principally interest rate risk through the operations of its banking subsidiary. Interest rate risk arises from market driven fluctuations in interest rates that affect cash flows, income, expense and value of financial instruments.

The Corporation actively manages its interest rate sensitivity positions. The objectives of interest rate risk management are to control exposure of net interest income to risks associated with interest rate movements and to achieve consistent growth in net interest income. The Asset/Liability Committee, using policies and procedures approved by the Corporation’s Board of Directors, is responsible for managing the rate sensitivity position. The Corporation manages interest rate sensitivity by changing the mix and repricing characteristics of its assets and liabilities through the management of its investment securities portfolio, its offering of loan and deposit terms and through borrowings from the Federal Home Loan Bank of Pittsburgh (the FHLB). The nature of the Corporation’s current operations is such that it is not subject to foreign currency exchange or commodity price risk.

The Corporation only utilizes derivative instruments for asset/liability management. These transactions involve both credit and market risk. The notional amounts are amounts on which calculations and payments are based. The notional amounts do not represent direct credit exposures. Direct credit exposure is limited to the net difference between the calculated amounts to be received and paid, if any. Interest rate swaps are contracts in which a series of interest-rate flows (fixed and floating) are exchanged over a prescribed period. The notional amounts on which the interest payments are based are not exchanged.

At September 30, 2006, the Corporation had cash flow hedges in the form of interest rate swaps totaling $45.0 million that have the effect of converting the rates on money market deposit accounts to a fixed-rate cost of funds. This strategy will cause the Bank to recognize, in a rising rate environment, a larger interest rate spread than it otherwise would have without the swaps in effect. In addition, the Corporation

had cash flow hedges for $10.0 million that have the effect of converting variable debt to a fixed rate. For these swaps, the Corporation recognized net interest income of $134,000 and $29,000 for the three months ended September 30, 2006 and 2005, respectively and $311,000 and $18,000 of net interest income for the nine months ended September 30, 2006 and 2005, respectively. During the first quarter of 2005, the Corporation terminated a cash flow hedge with a notional value of $25.0 million. The gross loss related to the termination of this swap is $310,000 which is being amortized through October 2006 in accordance with SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities.” The Corporation amortized into net interest income $46,000 for both the third quarter of 2006 and 2005 related to this swap. For the nine months ended September 30, 2006 and 2005, the Corporation amortized into net interest income $136,000 and $114,000, respectively, related to this swap. Periodically, the Corporation may enter into fair value hedges to limit the exposure to changes in the fair value of loan assets. During December 2005, the Corporation entered into a fair value hedge for $2.1 million with $3,000 of interest income recognized for the three and nine months ended September 30, 2006. The Corporation’s swap agreements have a positive fair market value totaling $502,000 at September 30, 2006 and $623,000 at December 31, 2005.

The Corporation uses three principal reports to measure interest rate risk: (1) asset/liability simulation reports; (2) gap analysis reports; and (3) net interest margin reports. Management also simulates possible economic conditions and interest rate scenarios in order to quantify the impact on net interest income. The effect that changing interest rates have on the Corporation’s net interest income is simulated by increasing and decreasing interest rates. This simulation is known as rate shocking. The results of the September 30, 2006 net interest income rate shock simulations show that the Corporation is within guidelines set by the Corporation’s Asset/Liability Policy when rates increase or decrease 100 or 200 basis points.

The report below forecasts changes in the Corporation’s market value of equity under alternative interest rate environments as of September 30, 2006. The market value of equity is defined as the net present value of the Corporation’s existing assets and liabilities. The Corporation is within guidelines set by the Corporation’s Asset/Liability Policy for the percentage change in the market value of equity.

Table 3—Market Value of Equity

		Change in						Asset/Liability
		Market Value		Market Value		Percentage		Approved
(Dollars in thousands)		of Equity		of Equity		Change		Percent Change
+300 Basis Points	$	337,566	$	(106,586	)	-24.00	%	+/- 35	%
+200 Basis Points		376,394		(67,758	)	-15.26	%	+/- 25
+100 Basis Points		413,414		(30,738	)	-6.92	%	+/- 15
Flat Rate		444,152		-		0.00	%
-100 Basis Points		452,237		8,085		1.82	%	+/- 15
-200 Basis Points		442,927		(1,225	)	-0.28	%	+/- 25
-300 Basis Points		428,872		(15,280	)	-3.44	%	+/- 35

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In the event the Corporation should experience a mismatch in its desired gap ranges or an excessive decline in their market value of equity resulting from changes in interest rates, it has a number of options that it could use to remedy the mismatch. The Corporation could restructure its investment portfolio through the sale or purchase of securities with more favorable repricing attributes. It could also emphasize growth in loan products with appropriate maturities or repricing attributes, or attract deposits or obtain borrowings with desired maturities.

Provision for Loan Losses

The Bank uses the reserve method of accounting for loan losses. The balance in the allowance for loan and lease losses is determined based on management’s review and evaluation of the loan portfolio in relation to past loss experience, the size and composition of the portfolio, current economic events and conditions, and other pertinent factors, including management’s assumptions as to future delinquencies, recoveries and losses. Increases to the allowance for loan and lease losses are made by charges to the provision for loan losses. Credit exposures deemed to be uncollectible are charged against the allowance for loan losses. Recoveries of previously charged-off amounts are credited to the allowance for loan losses.

While management considers the allowance for loan losses to be adequate based on information currently available, future additions to the allowance may be necessary due to changes in economic conditions or management’s assumptions as to future delinquencies, recoveries and losses and management’s intent with regard to the disposition of loans. In addition, the Office of the Comptroller of the Currency (the OCC), as an integral part of their examination process, periodically reviews the Bank’s allowance for loan losses. The OCC may require the Bank to recognize additions to the allowance for loan losses based on their judgments about information available to them at the time of their examination.

The Bank’s allowance for loan and lease losses is the accumulation of various components that are calculated based on various independent methodologies. The components of the allowance for credit losses consist of both historical losses and estimates. Management bases its recognition and estimation of each allowance component on certain observable data that it believes is the most reflective of the underlying loan losses being estimated. The observable data and accompanying analysis is directionally consistent, based upon trends, with the resulting component amount for the allowance for loan losses. The Bank’s allowance for loan losses components includes the following: historical loss estimation by loan product type and by risk rating within each product type, payment (past due) status, industry concentrations, internal and external variables such as economic conditions, credit policy and underwriting changes and competence of the loan review process. The Bank’s historical loss component is the most significant component of the allowance for loan losses, and all other allowance components are based on the inherent loss attributes that management believes exist within the total portfolio that are not captured in the historical loss component.

The historical loss components of the allowance represent the results of analyses of historical charge-offs and recoveries within pools of homogeneous loans, within each risk rating and broken down further by segment, within the portfolio. Criticized assets are further assessed based on trends, expressed as percentages, relative to delinquency, risk rating and nonaccrual, by credit product.

The historical loss components of the allowance for commercial loans are based principally on current risk ratings, historical loss rates adjusted, by adjusting the risk window, to reflect current events and conditions, as well as analyses of other factors that may have affected the collectibility of loans. The Bank analyzes all commercial loans that have been identified as having potential risk. The review is accomplished via Watchlist Memoranda, and designed to determine whether such loans are individually impaired, with impairment measured by reference to the collateral coverage and/or debt service coverage. The historical loss component of the allowance for consumer loans is based principally on loan payment status, retail classification and historical loss rates adjusted, by adjusting the risk window, to reflect current events and conditions.

The industry concentration component is recognized as a possible factor in the estimation of loan losses. Two industries represent possible concentrations: commercial real estate and consumer loans relying on residential home equity. No specific loss-related observable data is recognized by management currently, therefore no specific factor is calculated in the reserve solely for the impact of these concentrations, although management continues to carefully consider relevant data for possible future sources of observable data.

The historic loss model includes a judgmental component (environmental factors) that reflects management’s belief that there are additional inherent credit losses based on loss attributes not adequately captured in the lagging indicators. Furthermore, given that past-performance indicators may not adequately capture current risk levels, allowing for a real-time adjustment enhances the validity of the loss recognition process. There are many credit risk management reports that are synthesized by credit management staff to assess the direction of credit risk and its instant effect on losses. It is important to continue to use experiential data to confirm risk as measurable losses will continue to manifest themselves at higher than normal levels even after the economic cycle has begun an upward swing and lagging indicators begin to show improvement. The judgmental component is allocated to the specific segments of the portfolio based on the historic loss component.

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For the third quarter of 2006, the provision for loan losses was $900,000, compared to $650,000 for the same period in 2005. For the nine months ended September 30, 2006, the provision for loan losses was $3.0 million compared to $2.1 million for the same period in 2005. The increase in the provision was primarily a result of inherent risk related to loan growth and the increase in nonperforming loans. Net loans charged off were $214,000 for the third quarter of 2006 compared to $335,000 for the same quarter in 2005.

A summary of the activity in the allowance for loan losses is as follows:

Table 4—Allowance for Loans Losses

	Nine Months Ended
	September 30,
(Dollars in thousands)		2006			2005
Average loans	$	2,007,650		$	1,879,230
Allowance, beginning of period		19,865			18,455
Loans charged off:
Commercial and industrial		469			282
Consumer		1,253			1,467
Real estate		483			144
Lease financing		18			31
Total loans charged off		2,223			1,924
Recoveries:
Commercial and industrial		48			65
Consumer		412			301
Real estate		114			197
Lease financing		87			61
Total recoveries		661			624
Net loans charged off		1,562			1,300
Provision for loan losses		3,000			2,050
Allowance, end of period	$	21,303		$	19,205
Ratio of net charge offs to average
loans outstanding (annualized)		0.10	%		0.09	%

The following table sets forth an allocation of the allowance for loan losses by loan category. The specific allocations in any particular category may be reallocated in the future to reflect then current conditions. Accordingly, management considers the entire allowance to be available to absorb losses in any category.

Table 5—Allocation of the Allowance for Loan Losses by Loan Type

	September 30, 2006				December 31, 2005
			Percent of				Percent of
(Dollars in thousands)		Amount	Reserve			Amount	Reserve
Real estate	$	7,802	37	%	$	6,422	32	%
Commercial
and industrial		8,895	42	%		8,534	43	%
Consumer		4,512	21	%		4,596	23	%
Lease financing		94	-	%		313	2	%
Total	$	21,303	100	%	$	19,865	100	%

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Nonperforming Assets

Nonperforming assets (including nonaccruing loans, net assets in foreclosure and loans past due 90 days or more past due) were .39% of total assets at September 30, 2006, compared to .27% at December 31, 2005, and .26% at September 30, 2005. The increase in nonperforming assets at September 30, 2006, in relation to December 31, 2005, was mainly due to commercial mortgage loans for two borrowers totaling $2.2 million, which were placed on nonaccrual of interest during the first quarter of 2006, commercial mortgage loans for another borrower totaling $803,000, which were placed on nonaccrual of interest during the second quarter of 2006 and commercial mortgage loans for three borrowers totaling $916,000 which became delinquent over 90 days during the third quarter of 2006. The increase in relation to September 30, 2005, was attributed to the previously aforementioned loans as well as an additional $657,000 attributed to commercial loan borrowers placed on nonaccrual of interest during the fourth quarter of 2005.

Net assets in foreclosure decreased $382,000 at September 30, 2006 from September 30, 2005 mainly due to proceeds received on disposals of foreclosed properties. Efforts to liquidate assets acquired in foreclosure proceed as quickly as potential buyers can be located and legal constraints permit. Foreclosed assets are carried at the lower of cost (lesser of carrying value of asset or fair value at date of acquisition) or estimated fair value. Loans past due 90 days or more and still accruing interest are loans that are generally well secured and are in the process of collection.

The following table presents information concerning nonperforming assets. Nonperforming assets include loans that are 90 days or more past due or in nonaccrual status and loans that are in the process of foreclosure.

Table 6—Nonperforming Assets

(Dollars in thousands)		September 30, 2006			December 31, 2005			September 30, 2005
Nonaccrual loans	$	10,806		$	7,493		$	6,388
Loans 90 days or more past due		2,262			846			1,125
Total nonperforming loans		13,068			8,339			7,513
Net assets in foreclosure		87			29			469
Total nonperforming assets	$	13,155		$	8,368		$	7,982
Allowance for loan losses to nonperforming loans		163.0	%		238.2	%		255.6	%
Nonperforming loans to total net loans		0.65	%		0.42	%		0.39	%
Allowance for loan and lease losses to total loans		1.05	%		1.00	%		0.99	%
Nonperforming assets to total assets		0.39	%		0.27	%		0.26	%

The following table presents information concerning impaired loans. Impaired loans are loans for which it is probable that all principal and interest will not be collected according to the contractual terms of the loan agreement.

Table 7—Impaired Loans

(Dollars in thousands)		September 30, 2006		December 31, 2005		September 30, 2005
Impaired Loans	$	3,260	$	3,317	$	1,330
Average year-to-date impaired loans	$	3,027	$	1,542	$	1,285
Impaired loans with specific loss allowances	$	3,260	$	3,317	$	1,330
Loss allowances reserved on impaired loans	$	483	$	675	$	151
Year-to-date income recognized on impaired loans	$	50	$	33	$	19

The Bank’s policy for interest income recognition on impaired loans is to recognize income under the cash basis when the loans are both current and the collateral on the loan is sufficient to cover the outstanding obligation to the Bank. The Bank will not recognize income if these factors do not exist.

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Noninterest Income

Noninterest income of $8.3 million for the third quarter of 2006 reflects an increase of $556,000 or 7.2% from the comparable period in 2005. For the nine-month period ended September 30, 2006, noninterest income rose to $27.2 million, up $4.8 million or 21.5% from the same period in 2005.

The acquisition of the Cornerstone Companies was the primary driver of increases in wealth management income of $2.1 million during the third quarter of 2006 and $6.0 million for the nine months ended September 30, 2006, over the comparable periods last year, partially offset by the sale of Cumberland Advisors, which was divested in the second quarter of 2005. Major revenue component sources of wealth management income include investment management and advisory fees, trust fees, estate and tax planning fees, brokerage fees, and insurance related fees.

During the second quarter of 2006, the Bank’s credit card portfolio of $15.3 million was sold for a pre-tax gain of $1.4 million. The Bank sold its exiting credit card portfolio on April 14, 2006 to Elan Financial Services, a national credit card issuer and established an agent issuing relationship with Elan Financial Services. Under the agreement, credit cards for the Bank will be issued under the Harleysville National Bank name. The Bank continues to earn certain fees from ongoing portfolio activity. Noninterest income during 2006 also included increases in net revenue resulting from credit card operations.

There were no gains on sales of investment securities during 2006 as compared to gains of $1.9 million during the third quarter of 2005 and $3.0 million for the nine-month period ended September 30, 2005. The net security gains were primarily the result of the sale of equity securities during the first quarter of 2005, the sale of trust-preferred securities with call provisions in the near term during the second quarter of 2005 and the sales of tax-exempt securities and equities securities during the third quarter of 2005.

Noninterest income for 2005 included gains of $690,000 and $287,000 on the sales of Harleysville National Bank’s McAdoo branch and Cumberland Advisors, Inc., respectively during the second quarter.

Noninterest Expense

Noninterest expense of $17.6 million for the third quarter of 2006 increased $2.2 million or 14.7% from $15.3 million in the third quarter of 2005, and increased $4.8 million or 10.0% for the nine months ended September 30, 2006, over the comparable period in 2005.

Salaries and benefits expense increased $2.3 million during the third quarter of 2006 and $4.0 million during the first nine months of 2006 from the comparable periods in 2005, primarily related to the acquisition of the Cornerstone Companies, partially offset by the sale of Cumberland Advisors in the second quarter of 2005, increased staffing levels resulting from growth, non-recurring compensation and severance charges primarily related to the former Chief Executive Officer’s contract which totaled approximately $740,000 and compensation expense of $97,000 for the quarter and $345,000 for the nine months resulting from recording the Corporation’s stock option expense in conformance with FAS 123(R), “Stock Based Compensation.”

Occupancy expense increased $367,000 for the nine months ended September 30, 2006 over the same period in 2005 mostly due to theCornerstone Companies acquisition and a new branch opening. Other expense increased $1.6 million for the nine months of 2006 mainly as a result of the Cornerstone Companies acquisition including amortization of identifiable intangibles of $336,000. Marketing expense decreased $596,000 for the nine months of 2006 from the comparable period in 2005 primarily due to a more targeted marketing strategy and use of more cost-effective means of advertising during 2006.

Federal Income Taxes

The effective federal income tax rate for the quarter ended September 30, 2006 was 23.7% and for the nine months ended September 30, 2006 was 24.6% versus the statutory rate of 35%. The Corporation’s effective rate during 2006 is lower than the statutory tax rate primarily as a result of tax-exempt income earned from state and municipal securities and loans and bank-owned life insurance. The effective income tax rate for the third quarter of 2005 was 24.6% and for the first nine months of 2005 was 23.0%. The Corporation’s effective rate during 2005 was lower than the statutory tax rate primarily as a result of tax-exempt income earned from state and municipal securities and loans and bank-owned life insurance as well as the non-taxable gain on the sale of Cumberland Advisors, Inc. during the second quarter of 2005.

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Balance Sheet Analysis

Total assets at September 30, 2006 of $3.4 billion increased $245.6 million compared to December 31, 2005 with $48.8 million growth in loans and a $168.7 million net increase in cash and investments. The growth in loans took place mainly in real estate loans. Federal funds sold to correspondent bank increased $146.5 million resulting from an increase in public fund checking accounts due to the annual tax collection season for municipalities. The balance of investment securities available for sale at September 30, 2006 of $863.4 million increased $21.7 million compared to December 31, 2005 primarily as a result of net additional purchases of tax-exempt securities. The increases in goodwill and intangible assets were primarily related to the acquisition of the Cornerstone Companies during the first quarter of 2006 which included $11.4 million of goodwill and $3.9 million of identifiable intangibles (with a weighted average amortization period of 9.3 years) allocated to the Wealth Management segment.

Total deposits increased $262.8 million to $2.63 billion at September 30, 2006 from $2.37 billion at December 31, 2005 mostly attributable to growth in time deposits and interest-bearing checking accounts. Core deposits (total deposits less time deposits) increased $116.2 million or 7.2% to $1.73 billion for the same periods. Total borrowings decreased $33.3 million to $405.8 million at September 30, 2006 from $439.2 million at December 31, 2005. The decrease was the result of reductions of $58.0 million in long-term Federal Home Loan Bank borrowings offset in part by increases of $25.0 million in short-term securities sold under agreements to repurchase and fed funds purchased.

Capital

Capital formation is important to the Corporation's well being and future growth. Capital for the period ending September 30, 2006 was $286.6 million, an increase of $13.4 million over the end of 2005. The increase was primarily the result of the retention of the Corporation's earnings and issuances of stock for stock options including tax benefits partially offset by dividends paid to shareholders. Management believes that the Corporation's current capital and liquidity positions are adequate to support its operations. Management is not aware of any recommendations by any regulatory authority, which, if it were to be implemented, would have a material effect on the Corporation's capital.

Table 8—Regulatory Capital

(Dollars in thousands)					For Capital Adequacy Purposes				To Be Well Capitalized Under Prompt Corrective Action Program
As of September 30, 2006		Actual Amount	Ratio			Amount	Ratio			Amount	Ratio
Total Capital (to risk weighted assets):
Corporation	$	317,653	12.26	%	$	207,326	8.00	%	$	259,158	-
Harleysville National Bank		272,675	10.58	%		206,122	8.00	%		257,653	10	%
Tier 1 Capital (to risk weighted assets):
Corporation		296,250	11.43	%		103,663	4.00	%		155,495	-
Harleysville National Bank		251,272	9.75	%		103,061	4.00	%		154,592	6	%
Tier 1 Capital (to average assets):
Corporation		296,250	9.24	%		128,251	4.00	%		160,313	-
Harleysville National Bank		251,272	7.92	%		129,905	4.00	%		158,631	5	%

(Dollars in thousands)					For Capital Adequacy Purposes				To Be Well Capitalized Under Prompt Corrective Action Program
As of December 31, 2005		Actual Amount	Ratio			Amount	Ratio			Amount	Ratio
Total Capital (to risk weighted assets):
Corporation	$	318,911	12.98	%	$	196,563	8.00	%	$	245,703	-
Harleysville National Bank		259,883	10.64	%		195,390	8.00	%		244,238	10	%
Tier 1 Capital (to risk weighted assets):
Corporation		298,946	12.17	%		98,281	4.00	%		147,422	-
Harleysville National Bank		239,918	9.82	%		97,695	4.00	%		146,543	6	%
Tier 1 Capital (to average assets):
Corporation		298,946	9.69	%		123,408	4.00	%		154,260	-
Harleysville National Bank		239,918	7.86	%		122,154	4.00	%		152,693	5	%

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Pursuant to the federal regulators’ risk-based capital adequacy guidelines, the components of capital are called Tier 1 and Tier 2 capital. For the Corporation, Tier 1 capital is the shareholders’ equity and Tier 2 capital is the allowance for loan losses. The minimum for the Tier 1 ratio is 4.0% and the total capital ratio (Tier 1 plus Tier 2 capital divided by risk-adjusted assets) minimum is 8.0%. At September 30, 2006, the Corporation’s Tier 1 risk-adjusted capital ratio was 11.43%, and the total risk-adjusted capital ratio was 12.26%, both well above the regulatory requirements. The risk-based capital ratios of the Bank also exceeded regulatory requirements at September 30, 2006.

The leverage ratio consists of Tier 1 capital divided by quarterly average total assets, excluding intangible assets. Banking organizations are expected to have ratios from 4% to 5%, depending upon their particular condition and growth plans. Higher leverage ratios could be required by the particular circumstances or risk profile of a given banking organization. The Corporation’s leverage ratios were 9.24% at September 30, 2006 and 9.69% at December 31, 2005. The lower leverage ratio of the Corporation at September 30, 2006 was mainly due to the decrease in Tier 1 capital from the additional disallowed goodwill and identifiable intangibles related to the acquisition of the Cornerstone Companies.

The year-to-date September 30, 2006 cash dividend per share of $.55 was 10.0% higher than the cash dividend for the same period in 2005 of $.50. The proportion of net income paid out in dividends for the first nine months of 2006 was 61.2%, compared to 49.73% for the same period in 2005. Activity in both the Corporation’s dividend reinvestment and stock purchase plan did not have a material impact on capital during the first nine months of 2006.

Liquidity

Liquidity is a measure of the ability of the Bank to meet its current cash needs and obligations on a timely basis. For a bank, liquidity provides the means to meet the day-to-day demands of deposit customers and the needs of borrowing customers. Generally, the Bank arranges its mix of cash, money market investments, investment securities and loans in order to match the volatility, seasonality, interest sensitivity and growth trends of its deposit funds. The Corporation’s decisions with regard to liquidity are based on projections of potential sources and uses of funds for the next 120 days under the Corporation’s asset/liability model. The resulting projections as of September 30, 2006 show the potential sources of funds exceeding the potential uses of funds. The accuracy of this prediction can be affected by limitations inherent in the model and by the occurrence of future events not anticipated when the projections were made. The Corporation has external sources of funds which can be drawn upon when funds are required. The primary source of external liquidity is an available line of credit with the FHLB. As of September 30, 2006, the Bank had borrowings outstanding with the FHLB of $239.8 million, all of which were long-term and pledged investment securities available for sale of $655.9 million. At September 30, 2006, the Bank had unused lines of credit at the FHLB of $606.5 million and unused federal funds lines of credit of $145.0 million.

Recent Federal Deposit Insurance Corporation (FDIC) Rules

Pursuant to the Federal Deposit Insurance Reform Act of 2005, the FDIC merged the Bank Insurance Fund (BIF) and Savings Insurance Fund (SAIF) to form the Deposit Insurance Fund (DIF) effective March 31, 2006.

On April 1, 2006, the FDIC issued an interim rule, made final in September 2006, to implement the deposit insurance coverage changes of the Federal Deposit Insurance Reform Act of 2005. The rule: (1) increases the deposit insurance limit for certain retirement plan deposits to $250,000 effective April 1, 2006 (the basic insurance limit for other depositors such as individuals, joint accountholders, businesses, government entities and trusts remains at $100,000), (2) provides per-participant insurance coverage to employee benefit plan accounts, even if the depository institution at which the deposits are placed is not authorized to accept employee benefit plan deposits and (3) allows the FDIC to consider inflation adjustments to increase the insurance limits for all deposit accounts every five years, beginning in 2010.

On November 2, 2006, the FDIC set the designated reserve ratio for the deposit insurance fund at 1.25% of estimated insured deposits, and adopted final regulations to implement the risk-based deposit insurance assessment system mandated by the Deposit Insurance Reform Act of 2005, which is intended to more closely tie each bank's deposit insurance assessments to the risk it poses to the deposit insurance fund. Under the new risk-based assessment system, the FDIC will evaluate each institution's risk based on three primary factors -- supervisory ratings for all insured institutions, financial ratios for most institutions, and long-term debt issuer ratings for large institutions that have them. An institution’s assessment rate will depend upon the level of risk it poses to the deposit insurance system as measured by these factors. The new rates for most institutions will vary between 5 and 7 cents for every $100 of domestic insurable deposits.

The new assessment rates will take effect at the beginning of 2007. However, the Deposit Insurance Reform Act of 2005 provides credits to institutions that paid high premiums in the past to bolster the FDIC's insurance reserves, as a result of which the FDIC has announced that a majority of banks will have assessment credits to initially offset all of their premiums in 2007. Due to the number of uncertain factors that could affect the assessment rate the FDIC will decide to apply to the Bank and the assessment credit that will actually be available to the Bank in 2007, management does not believe it is possible at this time to reliably estimate the net assessment cost, if any, that may be imposed on the Bank.

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Other Information

Pending Legislation

Management is not aware of any other current specific recommendations by regulatory authorities or proposed legislation which, if they were implemented, would have a material adverse effect upon the liquidity, capital resources, or results of operations, although the general cost of compliance with numerous and multiple federal and state laws and regulations does have, and in the future may have, a negative impact on the Corporation’s results of operations.

Effects of Inflation

Inflation has some impact on the Corporation and the Bank’s operating costs. Unlike many industrial companies, however, substantially all of the Bank’s assets and liabilities are monetary in nature. As a result, interest rates have a more significant impact on the Corporation’s and the Bank’s performance than the general level of inflation. Over short periods of time, interest rates may not necessarily move in the same direction or in the same magnitude as prices of goods and services.

Effect of Government Monetary Policies

The earnings of the Corporation are and will be affected by domestic economic conditions and the monetary and fiscal policies of the United States government and its agencies. An important function of the Federal Reserve is to regulate the money supply and interest rates. Among the instruments used to implement those objectives are open market operations in United States government securities and changes in reserve requirements against member bank deposits. These instruments are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, and their use may also affect rates charged on loans or paid for deposits.

The Bank is a member of the Federal Reserve and, therefore, the policies and regulations of the Federal Reserve have a significant effect on its deposits, loans and investment growth, as well as the rate of interest earned and paid, and are expected to affect the Bank’s operations in the future. The effect of such policies and regulations upon the future business and earnings of the Corporation and the Bank cannot be predicted.

Environmental Regulations

There are several federal and state statutes, which regulate the obligations and liabilities of financial institutions pertaining to environmental issues. In addition to the potential for attachment of liability resulting from its own actions, a bank may be held liable under certain circumstances for the actions of its borrowers, or third parties, when such actions result in environmental problems on properties that collateralize loans held by the bank. Further, the liability has the potential to far exceed the original amount of a loan issued by the bank. Currently, neither the Corporation nor the Bank are a party to any pending legal proceeding pursuant to any environmental statute, nor are the Corporation and the Bank aware of any circumstances that may give rise to liability under any such statute.

Branching

The Corporation is currently planning to open new locations in Warminster (Bucks County), Plymouth Meeting (Montgomery County) and Warrington (Bucks County) during 2007. In addition, the Corporation is planning to relocate its Blue Bell and Collegeville offices in Montgomery County during 2007. These plans are subject to change as management continues to evaluate its market and its business needs. The Corporation continues to evaluate potential new branch sites that are contiguous to our current service area and will expand the Bank’s market area and market share of loans and deposits.

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Item 3 - Qualitative and Quantitative Disclosures About Market Risk

 In the normal course of conducting business activities, the Corporation is exposed to market risk, principally interest risk, through the operations of its banking subsidiary. Interest rate risk arises from market driven fluctuations in interest rates that affect cash flows, income, expense and values of financial instruments. The Asset/Liability Committee, using policies and procedures approved by the Bank’s Board of Directors, is responsible for managing the rate sensitivity position.

 No material changes in market risk strategy occurred during the third quarter of 2006. A detailed discussion of market risk is provided on pages 22 and 23 of this Form 10-Q.

Item 4 - Controls and Procedures

(i) Management’s Report on Disclosure Controls

Our management evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) or 15(d)-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this report. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and regulations and are operating in an effective manner.

(ii) Changes in Internal Controls

In connection with the ongoing review of the Corporation’s internal controls over financial reporting as defined in rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended, the Corporation regularly 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. There have been no changes in the Corporation’s internal control over financial reporting during the third quarter of 2006 that have materially affected, or are reasonably likely to materially affect, the Corporation’s internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 1.Legal Proceedings

Management, based upon discussions with the Corporation's legal counsel, is not aware of any litigation that would have a material adverse effect on the consolidated financial position of the Corporation. There are no proceedings pending other than the ordinary routine litigation incident to the business of the Corporation and its subsidiaries - the Bank, HNC Financial Company and HNC Reinsurance Company. In addition, no material proceedings are pending or are known to be threatened or contemplated against the Corporation and its subsidiaries by government authorities.

Item 1A.Risk Factors

There have been no material changes in risk factors from those disclosed under Item 1A, “Risk Factors.” in the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2005.

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

The following table presents the repurchase activity of the Corporation’s stock repurchase programs during the third quarter of 2006 (all share information has been restated retroactively for the effect of stock dividends and splits). The repurchased shares will be used for general corporate purposes.

	Total Number of Common Shares Purchased		Weighted Average Price Paid Per Share	Total Number of Shares Purchased as Part of Publicly Announced Plans(1)	Maximum Number of Shares that may yet be Purchased under the Plans(1)
July 1-31, 2006	-	$	-	-	1,046,661
August 1-31, 2006	-		-	-	1,046,661
September 1-30, 2006	127,400		20.39	127,400	919,261
Total	127,400	$	20.39	127,400

(1)   On December 14, 2000, the Board of Directors authorized a program to purchase up to 1,377,023 shares (restated for stock dividends and splits), or 5%, of its outstanding common stock. This repurchase plan was completed during the second quarter of 2005. On May 12, 2005, the Board of Directors authorized a plan to purchase up to 1,416,712 shares (restated for five percent stock dividend paid on September 15, 2006 and September 15, 2005) or 4.9%, of its outstanding common stock.

Item 3.Defaults Upon Senior Securities

Not applicable

Item 4.Submission of Matters to a Vote of Security Holders

Not Applicable

Item 5.Other Information

(a)   None to report.

(b)   There were no changes in the manner shareholders may recommend nominees to the Registrant’s Board of Directors.

Item 6.Exhibits

The exhibits listed on the Exhibit Index at the end of this Report are filed with or incorporated as part of this Report (as indicated in connection with each Exhibit).

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SIGNATURES

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

HARLEYSVILLE NATIONAL CORPORATION

Date: November 8, 2006/s/ Demetra M. Takes         

Demetra M. Takes, President, Chief Executive Officer and Director

            (Principal executive officer)

Date: November 8, 2006/s/ George S. Rapp         

George S. Rapp, Executive Vice President and Chief Financial Officer

(Principal financial and accounting officer)

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EXHIBIT INDEX

Exhibit NoDescription of Exhibits

(2.1)	Purchase Agreement, dated as of November 15, 2005, by and among Harleysville National Bank and Trust Company, Cornerstone Financial Consultants, Ltd., Cornerstone Advisors Asset Management, Inc., Cornerstone Institutional Investors, Inc., Cornerstone Management Resources, Inc., John R. Yaissle, Malcolm L. Cowen, II, and Thomas J. Scalici. The schedules and exhibits to the Purchase Agreement are listed at the end of the Purchase Agreement but have been omitted from the exhibit to Form 10-K. The Registrant agrees to supplementally furnish a copy of any omitted schedule or exhibit to the Securities and Exchange Commission upon request. (Incorporated by reference to Exhibit 2.1 of the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2005, filed with the Commission on March 15, 2006.)
(2.2)	Branch Purchase Agreement and Deposit Assumption Agreement, dated as of July 26, 2006, by and among First National Community Bank and Harleysville National Bank and Trust Company, filed herewith. The attachments, schedules and exhibits to the Branch Purchase and Deposit Assumption Agreement are listed at the end of the Branch Purchase and Deposit Assumption Agreement but have been omitted from the exhibit to Form 10-Q. The Registrant agrees to supplementally furnish a copy of any omitted attachment, schedule or exhibit to the Securities and Exchange Commission upon request.
(3.1)	Harleysville National Corporation Amended and Restated Articles of Incorporation. (Incorporated by reference to Exhibit 3.1 to the Corporation’s Registration Statement No. 333-111709 on Form S-4, as filed on January 5, 2004.)
(3.2)	Harleysville National Corporation Amended and Restated By-laws. (Incorporated by reference to Exhibit 3.1 to the Corporation’s Current Report on Form 8-K, filed with the Commission on February 14, 2005.)
(10.1)	Harleysville National Corporation 1993 Stock Incentive Plan.** (Incorporated by reference to Exhibit 4.3 of Registrant’s Registration Statement No. 33-69784 on Form S-8, filed with the Commission on October 1, 1993.)
(10.2)	Harleysville National Corporation Stock Bonus Plan.*** (Incorporated by reference to Exhibit 99A of Registrant’s Registration Statement No. 333-17813 on Form S-8, filed with the Commission on December 13, 1996.)
(10.3)	Supplemental Executive Retirement Plan.* (Incorporated by reference to Exhibit 10.3 of Registrant’s Annual Report in Form 10-K for the year ended December 31, 1997, filed with the Commission on March 27, 1998.)
(10.4)	Walter E. Daller, Jr., Chairman and former President and Chief Executive Officer’s Employment Agreement dated October 26, 1998.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on March 25, 1999.)
(10.5)	Consulting Agreement and General Release dated November 12, 2004 between Walter E. Daller, Jr., Harleysville National Corporation and Harleysville National Bank and Trust Company.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on November 16, 2004.)
(10.6)	Amendment to Supplemental Executive Retirement Benefit Agreement dated March 14, 2005 by and among Harleysville Management Services, LLC and Walter E. Daller, Jr.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on March 14, 2005.)
(10.7)	Employment Agreement dated October 26, 1998 by and among Harleysville National Corporation, Harleysville National Bank and Trust Company and Demetra M. Takes, President and Chief Executive Officer of Harleysville National Bank and Trust Company.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on March 25, 1999.)
(10.8)	Amendment to Supplemental Executive Retirement Benefit Agreement dated March 14, 2005 by and among Harleysville Management Services, LLC and Demetra M. Takes, President and Chief Executive Officer of Harleysville National Bank and Trust Company.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on March 14, 2005.)
(10.9)	Harleysville National Corporation 1998 Stock Incentive Plan.** (Incorporated by reference to Registrant’s Registration Statement No. 333-79971 on Form S-8, filed with the Commission on June 4, 1999.)
(10.10)	Harleysville National Corporation 1998 Independent Directors Stock Option Plan, as amended and restated effective February 8, 2001.** (Incorporated by reference to Appendix “A” of Registrant’s Definitive Proxy Statement, filed with the Commission on March 9, 2001.)
(10.11)	Supplemental Executive Retirement Benefit Agreement dated February 23, 2004 between Michael B. High, Executive Vice President and former Chief Financial Officer, and Harleysville Management Services, LLC.* (Incorporated by reference to Registrant’s Quarterly Report on Form 10-Q, filed with the Commission on May 10, 2004.)
(10.12)	Employment Agreement effective April 1, 2005 between Michael B. High, Executive Vice President and Chief Operating Officer of the Corporation, and Harleysville Management Services, LLC.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on November 16, 2004.)
(10.13)	Amendment to Supplemental Executive Retirement Benefit Agreement dated March 14, 2005 by and among Harleysville Management Services, LLC and Michael B. High, Executive Vice President and Chief Operating Officer of the Corporation.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on March 14, 2005.)

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(10.14)	Employment Agreement dated March 9, 2004 between Mikkalya Murray, Executive Vice President and Harleysville Management Services, LLC.* (Incorporated by reference to Registrant’s Quarterly Report on Form 10-Q, filed with the Commission on May 10, 2004.)
(10.15)	Amendment to Supplemental Executive Retirement Benefit Agreement dated March 14, 2005 by and among Harleysville Management Services, LLC and Mikkalya Murray, Executive Vice President.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on March 14, 2005.)
(10.16)	Harleysville National Corporation 2004 Omnibus Stock Incentive Plan.** (Incorporated by reference to Exhibit B of Registrant’s Definitive Proxy Statement, filed with the Commission on March 5, 2004).
(10.17)	Employment Agreement dated August 23, 2004 between James F. McGowan, Jr., Executive Vice President & Chief Credit Officer and Harleysville Management Services, LLC.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on August 25, 2004.)
(10.18)	Supplemental Executive Retirement Benefit Agreement dated August 23, 2004 between James F. McGowan, Jr., Executive Vice President & Chief Credit Officer, and Harleysville Management Services, LLC.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on August 25, 2004.)
(10.19)	Amendment to Supplemental Executive Retirement Benefit Agreement dated March 14, 2005 by and among Harleysville Management Services, LLC and James F. McGowan, Jr., Executive Vice President & Chief Credit Officer.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on March 14, 2005.)
(10.20)	Employment Agreement dated September 27, 2004 between John Eisele, Executive Vice President & President of Millennium Wealth Management and Private Banking, and Harleysville Management Services, LLC.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on September 29, 2004.)
(10.21)	Supplemental Executive Retirement Benefit Agreement dated September 27, 2004 between John Eisele, Executive Vice President & President of Millennium Wealth Management and Private Banking, and Harleysville Management Services, LLC.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on September 29, 2004.)
(10.22)	Amendment to Supplemental Executive Retirement Benefit Agreement dated March 14, 2005 by and among Harleysville Management Services, LLC and John Eisele, Executive Vice President & President of Millennium Wealth Management and Private Banking.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on March 14, 2005.)
(10.23)	Employment Agreement effective January 1, 2005 between Gregg J. Wagner, President and Chief Executive Officer of the Corporation, and Harleysville Management Services, LLC.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on November 16, 2004.)
(10.24)	Amendment to Supplemental Executive Retirement Benefit Agreement dated March 14, 2005 by and among Harleysville Management Services, LLC and Gregg J. Wagner, the current President and Chief Executive Officer of the Corporation.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on March 14, 2005.)
(10.25)	Employment Agreement dated May 18, 2005, between George S. Rapp, Senior Vice President and Chief Financial Officer, and Harleysville Management Services, LLC.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on May 20, 2005.)
(10.26)	Stock Purchase Agreement dated June 30, 2005, between David R. Kotok & Associates, Inc., Harleysville National Corporation and Harleysville National Bank and Trust Company. (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on July 1, 2005.)
(10.27)	Amended and Restated Declaration of Trust for HNC Statutory Trust III by and among Wilmington Trust Company, as Institutional Trustee and Delaware Trustee, Harleysville National Corporation, as Sponsor, and the Administrators named therein, dated as of September 28, 2005. (Incorporated by reference to Registrant’s Quarterly Report on Form 10-Q/A, filed with the Commission on November, 9, 2005.)
(10.28)	Indenture between Harleysville National Corporation, as Issuer, and Wilmington Trust Company, as Trustee, for Fixed/Floating Rate Junior Subordinated Debt Securities, dated as of September 28, 2005. (Incorporated by reference to Registrant’s Quarterly Report on Form 10-Q/A, filed with the Commission on November, 9, 2005.)
(10.29)	Guarantee Agreement between Harleysville National Corporation and Wilmington Trust Company, dated as of September 28, 2005. (Incorporated by reference to Registrant’s Quarterly Report on Form 10-Q/A, filed with the Commission on November, 9, 2005.)
(10.30)	Employment Agreement effective July 12, 2006 between Lewis C. Cyr, Chief Lending Officer of the Corporation, and Harleysville Management Services, LLC.* (Incorporated by reference to Registrant’s Current Report on Form 8-K, filed with the Commission on July 12, 2006.)
(11)	Computation of Earnings per Common Share, incorporated by reference to Note 6 of the Consolidated Financial Statements of this Report on Form 10-Q.
(31.1)	Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, filed herewith.
(31.2)	Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, filed herewith.
(32.1)	Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, furnished herewith.

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(32.2)   Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, furnished herewith.  

* Management contract or compensatory plan arrangement.

** Shareholder approved compensatory plan pursuant to which the Registrant’s Common Stock may be issued to employees of the Corporation.

*** Non-shareholder approved compensatory plan pursuant to which the Registrant’s Common Stock may be issued to employees of the Corporation.

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