Note 5 – Loans

The Company grants commercial, industrial, agricultural, residential, and consumer loans primarily to customers throughout North Central Pennsylvania and Southern New York. Although the Company had a diversified loan portfolio at September 30, 2011 and December 31, 2010, a substantial portion of its debtors' ability to honor their contracts is dependent on the economic conditions within these regions. The following table summarizes the primary segments of the loan portfolio as of September 30, 2011 and December 31, 2010 (in thousands):

September 30, 2011	Total Loans		Individually evaluated for impairment		Collectively evaluated for impairment
Real estate loans:
Residential	$	180,344	$	142	$	180,202
Commercial and agricultural		180,808		8,333		172,475
Construction		7,652		-		7,652
Consumer		11,080		-		11,080
Commercial and other loans		44,584		505		44,079
State and political subdivision loans		54,144		-		54,144
Total loans	$	478,612	$	8,980	$	469,632
Less allowance for loan losses		6,323
Net loans	$	472,289

December 31, 2010	Total Loans		Individually evaluated for impairment		Collectively evaluated for impairment
Real estate loans:
Residential	$	185,012	$	172	$	184,840
Commercial and agricultural		171,577		9,976		161,601
Construction		9,766		-		9,766
Consumer		11,285		-		11,285
Commercial and other loans		47,156		1,374		45,782
State and political subdivision loans		48,721		-		48,721
Total	$	473,517	$	11,522	$	461,995
Less allowance for loan losses		5,915
Net loans	$	467,602

The segments of the Bank's loan portfolio are disaggregated into classes to a level that allows management to monitor risk and performance. Residential real estate mortgages consists primarily of 15 to 30 year first mortgages on residential real estate, while residential real estate home equities are consumer purpose installment loans or lines of credit secured by a mortgage which is often a second lien on residential real estate with terms of 15 years or less. Commercial real estate loans are business purpose loans secured by a mortgage on commercial real estate. Agricultural real estate loans are loans secured by a mortgage on real estate used in agriculture production. Construction real estate loans are loans secured by residential or commercial real estate used during the construction phase of residential and commercial projects. Consumer loans are typically unsecured or primarily secured by something other than real estate and overdraft lines of credit connected with customer deposit accounts. Commercial and other loans are loans for commercial purposes primarily secured by non-real estate collateral. Other agricultural loans are loans for agricultural purposes primarily secured by non-real estate collateral. State and political subdivisions are loans for state and local municipalities for capital and operating expenses or tax free loans used to finance commercial development.

Management considers commercial loans, other agricultural loans, commercial real estate loans and agricultural real estate loans which are 90 days or more past due to be impaired. Management will also consider a loan impaired based on other factors it becomes aware of, including the customer's results of operations and cash flows. These loans are analyzed to determine if it is probable that all amounts will not be collected according to the contractual terms of the loan agreement. If management determines that the value of the impaired loan is less than the recorded investment in the loan (net of previous charge-offs, deferred loan fees or costs and unamortized premium or discount), impairment is recognized through an allowance estimate or a charge-off to the allowance.

The following table includes the recorded investment and unpaid principal balances for impaired financing receivables by class, with the associated allowance amount, if applicable (in thousands):

			Recorded		Recorded
	Unpaid		Investment		Investment		Total				Average		Interest
	Principal		With No		With		Recorded		Related		Recorded		Income
September 30, 2011	Balance		Allowance		Allowance		Investment		Allowance		Investment		Recognized
Real estate loans:
Mortgages	$	132	$	124	$	-	$	124	$	-	$	128	$	-
Home Equity		18		-		18		18		3		30		-
Commercial		9,376		121		8,212		8,333		393		8,659		48
Agricultural		-		-		-		-		-		494		37
Construction		-		-		-		-		-		-		-
Consumer		-		-		-		-		-		-		-
Commercial and other loans		561		33		472		505		96		495		-
Other agricultural loans		-		-		-		-		-		213		20
State and political
subdivision loans		-		-		-		-		-		-		-
Total	$	10,087	$	278	$	8,702	$	8,980	$	492	$	10,019	$	105

			Recorded		Recorded
	Unpaid		Investment		Investment		Total				Average		Interest
	Principal		With No		With		Recorded		Related		Recorded		Income
December 31, 2010	Balance		Allowance		Allowance		Investment		Allowance		Investment		Recognized
Real estate loans:
Mortgages	$	132	$	-	$	131	$	131	$	21	$	55	$	-
Home Equity		72		41		-		41		-		56		-
Commercial		8,540		1,682		6,053		7,735		167		5,445		67
Agricultural		2,421		2,241		-		2,241		-		2,373		64
Construction		-		-		-		-		-		-		-
Consumer		-		-		-		-		-		-		-
Commercial and other loans		455		404		-		404		-		469		1
Other agricultural loans		1,040		970		-		970		-		958		11
State and political
subdivision loans		-		-		-		-		-		-		-
Total	$	12,660	$	5,338	$	6,184	$	11,522	$	188	$	9,356	$	143

Credit Quality Information

For commercial real estate, agricultural real estate, construction, commercial and other and other agricultural loans, management uses a nine point internal risk rating system to monitor the credit quality. The first five categories are considered not criticized and are aggregated as “Pass” rated. The criticized rating categories utilized by management generally follow bank regulatory definitions. The definitions of each rating are defined below:

Pass (Grades 1-5) – These loans are to customers with credit quality ranging from an acceptable to very high quality and are protected by the current net worth and paying capacity of the obligor or by the value of the underlying collateral.

Special Mention (Grade 6) – This loan grade is in accordance with regulatory guidance and includes loans where a potential weakness or risk exists, which could cause a more serious problem if not corrected.

Substandard (Grade 7) – This loan grade is in accordance with regulatory guidance and includes loans that have a well-defined weakness based on objective evidence and be characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.

Doubtful (Grade 8) – This loan grade is in accordance with regulatory guidance and includes loans that have all the weaknesses inherent in a substandard asset. In addition, these weaknesses make collection or liquidation in full highly questionable and improbable, based on existing circumstances.

Loss (Grade 9) – This loan grade is in accordance with regulatory guidance and includes loans that are considered uncollectible, or of such value that continuance as an asset is not warranted.

To help ensure that risk ratings are accurate and reflect the present and future capacity of borrowers to repay loan as agreed, the Bank's loan rating process includes several layers of internal and external oversight. The Company's loan officers are responsible for the timely and accurate risk rating of the loans in each of their portfolios at origination and on an ongoing basis under the supervision of management. All commercial and agricultural loans are reviewed annually to ensure the appropriateness of the loan grade. In addition, the Bank engages an external consultant on at least an annual basis. The external consultant is engaged to 1) review a minimum of 60% of the dollar volume of the commercial loan portfolio on an annual basis, 2) review new loans originated in the last year, 3) review all relationships in aggregate over $500,000, 4) review all aggregate loan relationships over $100,000 which are over 90 days past due, classified Special Mention, Substandard, Doubtful, or Loss, and 5) such other loans which management or the consultant deems appropriate.

The following tables represent credit exposures by internally assigned grades as of September 30, 2011 and December 31, 2010 (in thousands):

September 30, 2011	Pass		Special Mention		Substandard		Doubtful		Loss		Ending Balance
Real estate loans:
Commercial	$	135,356	$	10,802	$	15,803	$	-	$	-	$	161,961
Agricultural		14,096		2,390		2,361		-		-		18,847
Construction		7,652		-		-		-		-		7,652
Commercial and other loans		34,489		3,044		786		17		-		38,336
Other agricultural loans		4,239		849		1,160		-		-		6,248
State and political
subdivision loans		52,959		-		1,185		-		-		54,144
Total	$	248,791	$	17,085	$	21,295	$	17	$	-	$	287,188

December 31, 2010	Pass		Special Mention		Substandard		Doubtful		Loss		Ending Balance
Real estate loans:
Commercial	$	120,344	$	15,570	$	16,585	$	-	$	-	$	152,499
Agricultural		12,007		1,063		6,008		-		-		19,078
Construction		9,766		-		-		-		-		9,766
Commercial and other loans		36,784		2,545		848		24		-		40,201
Other agricultural loans		4,024		469		2,462		-		-		6,955
State and political
subdivision loans		47,482		-		1,239		-		-		48,721
Total	$	230,407	$	19,647	$	27,142	$	24	$	-	$	277,220

For residential real estate mortgages, home equities and consumer loans, credit quality is monitored based on whether the loan is performing or non-performing, which is typically based on the aging status of the loan and payment activity, unless a specific action, such as bankruptcy, repossession, death or significant delay in payment occurs to raise awareness of a possible credit event. Non-performing loans include those loans that are considered nonaccrual, described in more detail below and all loans past due 90 or more days. The following table presents the recorded investment in those loan classes based on payment activity as of September 30, 2011 and December 31, 2010 (in thousands):

September 30, 2011	Performing		Non-performing		Total
Real estate loans:
Mortgages	$	96,926	$	559	$	97,485
Home Equity		82,699		160		82,859
Consumer		11,080		-		11,080
Total	$	190,705	$	719	$	191,424

December 31, 2010	Performing		Non-performing		Total
Real estate loans:
Mortgages	$	96,830	$	413	$	97,243
Home Equity		87,460		309		87,769
Consumer		11,278		7		11,285
Total	$	195,568	$	729	$	196,297

Age Analysis of Past Due Financing Receivables

Management further monitors the performance and credit quality of the loan portfolio by analyzing the age of the portfolio as determined by the length of time a recorded payment is past due. The following table includes an aging analysis of the recorded investment of past due financing receivables as of September 30, 2011 and December 31, 2010 (in thousands):

	30-59 Days		60-89 Days		90 Days		Total Past				Total Financing		90 Days and
September 30, 2011	Past Due		Past Due		Or Greater		Due		Current		Receivables		Accruing
Real estate loans:
Mortgages	$	195	$	90	$	482	$	767	$	96,718	$	97,485	$	110
Home Equity		329		27		161		517		82,342		82,859		14
Commercial		1,975		-		2,783		4,758		157,203		161,961		129
Agricultural		-		-		-		-		18,847		18,847		-
Construction		-		-		-		-		7,652		7,652		-
Consumer		10		10		-		20		11,060		11,080		-
Commercial and other loans		63		315		205		583		37,753		38,336		-
Other agricultural loans		-		-		-		-		6,248		6,248		-
State and political subdivision loans		-		-		-		-		54,144		54,144		-
Total	$	2,572	$	442	$	3,631	$	6,645	$	471,967	$	478,612	$	253

Loans considered non-accrual	$	76	$	299	$	3,378	$	3,753	$	5,681	$	9,434
Loans still accruing		2,496		143		253		2,892		466,286		469,178
Total	$	2,572	$	442	$	3,631	$	6,645	$	471,967	$	478,612

	30-59 Days		60-89 Days		90 Days		Total Past				Total Financing		90 Days and
December 31, 2010	Past Due		Past Due		Or Greater		Due		Current		Receivables		Accruing
Real estate loans:
Mortgages	$	518	$	50	$	412	$	980	$	96,263	$	97,243	$	104
Home Equity		762		139		262		1,163		86,606		87,769		116
Commercial		188		1,647		1,827		3,662		148,837		152,499		426
Agricultural		-		-		-		-		19,078		19,078		-
Construction		-		-		-		-		9,766		9,766		-
Consumer		83		3		7		93		11,192		11,285		6
Commercial and other loans		111		6		398		515		39,686		40,201		40
Other agricultural loans		5		-		-		5		6,950		6,955
State and political subdivision loans		-		-		-		-		48,721		48,721		-
Total	$	1,667	$	1,845	$	2,906	$	6,418	$	467,099	$	473,517	$	692

Loans considered non-accrual	$	-	$	39	$	2,214	$	2,253	$	9,600	$	11,853
Loans still accruing		1,667		1,806		692		4,165		457,499		461,664
Total	$	1,667	$	1,845	$	2,906	$	6,418	$	467,099	$	473,517

Nonaccrual Loans

Loans are considered for non-accrual status upon reaching 90 days delinquency, although the Company may be receiving partial payments of interest and partial repayments of principal on such loans or if full payment of principal and interest is not expected. Additionally, if management is made aware of other information including bankruptcy, repossession, death, or legal proceedings, the loan may be placed on non-accrual status. If a loan is 90 days or more past due and is well secured and in the process of collection, it may still be considered accruing.

The following table reflects the financing receivables on nonaccrual status as of September 30, 2011 and December 31, 2010, respectively. The balances are presented by class of financing receivable (in thousands):

	September 30, 2011		December 31, 2010
Real estate loans:
Mortgages	$	449	$	309
Home Equity		146		193
Commercial		8,333		7,735
Agricultural		-		2,241
Construction		-		-
Consumer		-		1
Commercial and other		506		404
Other agricultural		-		970
State and political subdivision		-		-

	$	9,434	$	11,853

Troubled Debt Restructurings

In situations where, for economic or legal reasons related to a borrower's financial difficulties, management may grant a concession for other than an insignificant period of time to the borrower that would not otherwise be considered, the related loan is classified as a Troubled Debt Restructuring (TDR). Management strives to identify borrowers in financial difficulty early and work with them to modify more affordable terms before their loan reaches nonaccrual status. These modified terms may include rate reductions, principal forgiveness, payment forbearance and other actions intended to minimize the economic loss and to avoid foreclosure or repossession of the collateral. In cases where borrowers are granted new terms that provide for a reduction of either interest or principal, management measures any impairment on the restructuring by calculating the present value of the revised loan terms and comparing this balance to the Company's investment in the loan prior to the restructuring. As these loans are individually evaluated, they are excluded from pooled portfolios when calculating the allowance for loan and lease losses and a separate allocation within the allowance for loan and lease losses is provided. Management continually evaluates loans that are considered TDR's, including payment history under the modified loan terms, the borrower's ability to continue to repay the loan based on continued evaluation of their operating results and cash flows from operations. Based on this evaluation management would no longer consider a loan to be a TDR when the relevant facts support such a conclusion.

Loan modifications that are considered TDR's completed during the three months and nine months ended September 30, 2011 were as follows:

	For the Three Months Ended September 30, 2011
	Number of contracts				Pre-modification Outstanding Recorded Investment				Post-Modification Outstanding Recorded Investment
	Interest Modification		Term Modification		Interest Modification		Term Modification		Interest Modification		Term Modification
(Dollars in thousands)
Real estate loans:
Commercial		-		1	$	-	$	47	$	-	$	47

	For the Nine Months Ended September 30, 2011
	Number of contracts				Pre-modification Outstanding Recorded Investment				Post-Modification Outstanding Recorded Investment
	Interest Modification		Term Modification		Interest Modification		Term Modification		Interest Modification		Term Modification
(Dollars in thousands)
Real estate loans:
Commercial		5		1	$	5,912	$	47	$	5,912	$	47

Recidivism, or the borrower defaulting on its obligation pursuant to a modified loan, results in the loan once again becoming a non-accrual loan. Recidivism occurs at a notably higher rate than do defaults on new origination loans, so modified loans present a higher risk of loss than do new origination loans. Loan modifications considered TDR's made during the twelve months ended September 30, 2011, that defaulted during the nine month period ended September 30, 2011 were as follows:

(Dollars in thousands)	Number of contracts		Recorded investment
Real estate loans:
Commercial		2	$	109
Commercial and other loans		1		2
Total recidivism		3	$	111

Allowance for Loan Losses

The following table rolls forward the balance of the allowance for loan and lease losses (ALLL) for the periods ended September 30, 2011 and 2010(in thousands):

	Three months Ended						Nine months Ended
	September 30,						September 30,
	2011			2010			2011			2010
Balance, at beginning of period	$	6,163		$	5,302		$	5,915		$	4,888
Provision charged to income		150			300			525			840
Recoveries on loans previously charged against the allowance		39			20			75			144
		6,352			5,622			6,515			5,872
Loans charged against the allowance		(29	)		(34	)		(192	)		(284	)
Balance, at end of year	$	6,323		$	5,588		$	6,323		$	5,588

The Company allocates the ALLL based on the factors described below, which conform to the Company's loan classification policy and credit quality measurements. In reviewing risk within the Bank's loan portfolio, management has determined there to be several different risk categories within the loan portfolio. The ALLL consists of amounts applicable to: (i) residential real estate loans; (ii) residential real estate home equity loans; (iii) commercial real estate loans; (iv) agricultural real estate loans; (v) real estate construction loans; (vi) commercial and other loans; (vii) consumer loans; (viii) other agricultural loans and (ix) state and political subdivision loans. Factors considered in this process include general loan terms, collateral, and availability of historical data to support the analysis. Historical loss percentages are calculated and used as the basis for calculating allowance allocations. Certain qualitative factors are evaluated to determine additional inherent risks in the loan portfolio, which are not necessarily reflected in the historical loss percentages. These factors are then added to the historical allocation percentage to get the adjusted factor to be applied to non classified loans. The following qualitative factors are analyzed:

Level of and trends in delinquencies, impaired/classified loans

Change in volume and severity of past due loans

Volume of non-accrual loans

Volume and severity of classified, adversely or graded loans;

Level of and trends in charge-offs and recoveries;

Trends in volume, terms and nature of the loan portfolio;

Effects of any changes in risk selection and underwriting standards and any other changes in lending and recovery policies, procedures and practices;

Changes in the quality of the Bank's loan review system;

Experience, ability and depth of lending management and other relevant staff

National, state, regional and local economic trends and business conditions

General economic conditions

Unemployment rates

Inflation / CPI

Changes in values of underlying collateral for collateral-dependent loans

Industry conditions including the effects of external factors such as competition, legal, and regulatory requirements on the level of estimated credit losses; and

Existence and effect of any credit concentrations, and changes in the level of such concentrations.

The Company also maintains an unallocated allowance to account for any factors or conditions that may cause a potential loss but are not specifically addressed in the process described above. The Company analyzes its loan portfolio each quarter to determine the appropriateness of its allowance for loan losses.

Loans determined to be TDR's are impaired and for purposes of estimating the ALLL must be individually evaluated for impairment. In calculating the impairment, the Company calculates the present value utilizing an analysis of discounted cash flows. If the present value calculated is below the recorded investment of the loan, an impairment is recognized by a charge to the provision for loan and lease losses and a credit to the ALLL.

We continually review the model utilized in calculating the required allowance. During the second quarter of 2011, management made a determination that special mention and substandard loans should have additional qualitative adjustments applied to them in comparison to pass graded loans. As a result of this and other factors discussed below, the following factors experienced changes during the first nine months of 2011:

The qualitative factors for changes in levels of and trends in delinquencies, impaired/classified loans were decreased for all loans portfolio types due to the decreases in nonaccrual loans from December 31, 2010 to September 30, 2011.

The qualitative factors for changes in the trends of charge-offs and recoveries were decreased for consumer loans, commercial and agricultural loans due to reduced losses over the most recent three year period.

The qualitative factors for changes in portfolio volumes during 2011 were reduced for agricultural loans due to the decreased size of the portfolio in relation to the total portfolio.

Separate factors for special mention and substandard loans were developed for each qualitative factor reviewed.

Based on these qualitative factor changes for the nine month period ended September 30, 2011, and the changes in size of the loan portfolios since December 31, 2010, we recorded a negative provision for residential real estate, construction and other commercial loans, while increasing the provision associated with commercial and agricultural real estate loans.

During the third quarter, the only qualitative factor that experienced a significant change was that related to collateral values, which increased for residential and commercial real estate loans due to flooding our marketplace experienced late in the third quarter.

Based on the one qualitative factor change for the three month period ended September 30, 2011, and the changes the loan portfolios since June 30, 2011, we recorded an increased provision for residential and commercial real estate projects and a negative provision for other commercial loans.

The following tables roll forward the balance of the ALLL by portfolio segment for the three and nine month periods ended September 30, 2011 and segregates the ending balance into the amount required for loans individually evaluated for impairment and the amount required for loans collectively evaluated for impairment as of September 30, 2011 (in thousands):

For the Three Months Ended September 30, 2011
	Balance at June 30, 2011		Charge-offs			Recoveries		Provision			Balance at September 30, 2011		Individually evaluated for impairment		Collectively evaluated for impairment
Real estate loans:
Residential	$	678	$	-		$	-	$	147		$	825	$	3	$	822
Commercial and agricultural		3,912		-			-		250			4,162		393		3,769
Construction		13		-			-		1			14		-		14
Consumer		109		(23	)		16		12			114		-		114
Commercial and other loans		712		(6	)		23		(40	)		689		96		593
State and political subdivision loans		119		-			-		1			120		-		120
Unallocated		620		-			-		(221	)		399		-		399
Total	$	6,163	$	(29	)	$	39	$	150		$	6,323	$	492	$	5,831

For the Nine Months Ended September 30, 2011
	Balance at December 31, 2010		Charge-offs			Recoveries		Provision			Balance at September 30, 2011		Individually evaluated for impairment		Collectively evaluated for impairment
Real estate loans:
Residential	$	969	$	(101	)	$	-	$	(43	)	$	825	$	3	$	822
Commercial and agricultural		3,380		(29	)		-		811			4,162		393		3,769
Construction		22		-			-		(8	)		14		-		14
Consumer		108		(56	)		45		17			114		-		114
Commercial and other loans		983		(6	)		30		(318	)		689		96		593
State and political subdivision loans		137		-			-		(17	)		120		-		120
Unallocated		316		-			-		83			399		-		399
Total	$	5,915	$	(192	)	$	75	$	525		$	6,323	$	492	$	5,831