Note 5 - Loans

The Company makes commercial, industrial, agricultural, residential, construction and consumer loans primarily to customers throughout North Central Pennsylvania and Southern New York. Although the Company had a diversified loan portfolio at March 31, 2012 and December 31, 2011, 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 and the allowance for loan losses as of March 31, 2012 and December 31, 2011 (in thousands):

March 31, 2012	Total Loans	Individually evaluated for impairment	Collectively evaluated for impairment
Real estate loans:
Residential	$ 183,703	$ 93	$ 183,610
Commercial and agricultural	186,815	8,374	178,441
Construction	8,912	-	8,912
Consumer	10,405	-	10,405
Commercial and other loans	45,620	459	45,161
State and political subdivision loans	55,837	-	55,837
Total	491,292	$ 8,926	$ 482,366
Less allowance for loan losses	6,545
Net loans	$ 484,747

December 31, 2011	Total Loans	Individually evaluated for impairment	Collectively evaluated for impairment
Real estate loans:
Residential	$ 184,034	$ 94	$ 183,940
Commercial and agricultural	185,050	8,270	176,780
Construction	8,481	-	8,481
Consumer	10,746	-	10,746
Commercial and other loans	44,299	517	43,782
State and political subdivision loans	54,899	-	54,899
Total	487,509	$ 8,881	$ 478,628
Less allowance for loan losses	6,487
Net loans	$ 481,022

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 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 unpaid principal balances and the associated allowance amount, if applicable for impaired financing receivables by class, (in thousands):

		Recorded	Recorded
	Unpaid	Investment	Investment	Total		Average	Interest
	Principal	With No	With	Recorded	Related	Recorded	Income
March 31, 2012	Balance	Allowance	Allowance	Investment	Allowance	Investment	Recognized
Real estate loans:
Mortgages	$ -	$ -	$ -	$ -	$ -	$ -	$ -
Home Equity	93	53	40	93	15	93	1
Commercial	9,617	5,514	2,860	8,374	563	8,228	18
Agricultural	-	-	-	-	-	-	-
Construction	-	-	-	-	-	-	-
Consumer	-	-	-	-	-	-	-
Commercial and other loans	505	29	430	459	23	479	-
Other Agricultural Loans	-	-	-	-	-	-	-
State and political
subdivision loans	-	-	-	-	-	-	-
Total	$ 10,215	$ 5,596	$ 3,330	$ 8,926	$ 601	$ 8,800	$ 19

		Recorded	Recorded
	Unpaid	Investment	Investment	Total		Average	Interest
	Principal	With No	With	Recorded	Related	Recorded	Income
December 31, 2011	Balance	Allowance	Allowance	Investment	Allowance	Investment	Recognized
Real estate loans:
Mortgages	$ -	$ -	$ -	$ -	$ -	$ -	$ -
Home Equity	94	36	58	94	13	36	1
Commercial	9,394	5,663	2,607	8,270	433	8,585	65
Agricultural	-	-	-	-	-	371	37
Construction	-	-	-	-	-	-	-
Consumer	-	-	-	-	-	-	-
Commercial and other loans	574	30	487	517	48	501	-
Other Agricultural Loans	-	-	-	-	-	160	20
State and political
subdivision loans	-	-	-	-	-	-	-
Total	$ 10,062	$ 5,729	$ 3,152	$ 8,881	$ 494	$ 9,653	$ 123

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 March 31, 2012 and December 31, 2011 (in thousands):

March 31, 2012	Pass	Special Mention	Substandard	Doubtful	Loss	Ending Balance
Real estate loans:
Commercial	$ 141,407	$ 9,272	$ 16,905	$ -	$ -	$ 167,584
Agricultural	14,676	2,394	2,161	-	-	19,231
Construction	8,912	-	-	-	-	8,912
Commercial and other loans	36,730	1,629	907	17	-	39,283
Other Agricultural Loans	4,361	770	1,206	-	-	6,337
State and political
subdivision loans	54,690	-	1,147	-	-	55,837
Total	$ 260,776	$ 14,065	$ 22,326	$ 17	$ -	$ 297,184

December 31, 2011	Pass	Special Mention	Substandard	Doubtful	Loss	Ending Balance
Real estate loans:
Commercial	$ 138,409	$ 10,372	$ 17,045	$ -	$ -	$ 165,826
Agricultural	14,628	2,412	2,184	-	-	19,224
Construction	8,481	-	-	-	-	8,481
Commercial and other loans	34,606	2,203	921	17	-	37,747
Other Agricultural Loans	4,509	809	1,234	-	-	6,552
State and political
subdivision loans	53,733	-	1,166	-	-	54,899
Total	$ 254,366	$ 15,796	$ 22,550	$ 17	$ -	$ 292,729

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 March 31, 2012 and December 31, 2011 (in thousands):

March 31, 2012	Performing	Non-performing	Total
Real estate loans:
Mortgages	$ 104,340	$ 439	$ 104,779
Home Equity	78,613	311	78,924
Consumer	10,402	3	10,405
Total	$ 193,355	$ 753	$ 194,108


December 31, 2011	Performing	Non-performing	Total
Real estate loans:
Mortgages	$ 102,238	$ 473	$ 102,711
Home Equity	81,143	180	81,323
Consumer	10,746	-	10,746
Total	$ 194,127	$ 653	$ 194,780

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 March 31, 2012 and December 31, 2011 (in thousands):

		30-59 Days	60-89 Days	90 Days	Total Past		Total Financing	90 Days and
March 31, 2012		Past Due	Past Due	Or Greater	Due	Current	Receivables	Accruing
Real estate loans:
Mortgages		$ 548	$ 74	$ 307	$ 929	$ 103,850	$ 104,779	$ 58
Home Equity		60	-	311	371	78,553	78,924	102
Commercial		424	-	2,743	3,167	164,417	167,584	180
Agricultural		-	-	-	-	19,231	19,231	-
Construction		-	-	-	-	8,912	8,912	-
Consumer		64	-	3	67	10,338	10,405	3
Commercial and other loans		14	-	446	460	38,823	39,283	-
Other Agricultural Loans		-	-	-	-	6,337	6,337	-
State and political
subdivision loans		-	-	-	-	55,837	55,837	-

	Total	$ 1,110	$ 74	$ 3,810	$ 4,994	$ 486,298	$ 491,292	$ 343

Loans considered non-accrual		$ 336	$ 74	$ 3,467	$ 3,877	$ 5,366	$ 9,243
Loans still accruing		774	-	343	1,117	480,932	482,049
	Total	$ 1,110	$ 74	$ 3,810	$ 4,994	$ 486,298	$ 491,292

		30-59 Days	60-89 Days	90 Days	Total Past		Total Financing	90 Days and
December 31, 2011		Past Due	Past Due	Or Greater	Due	Current	Receivables	Accruing
Real estate loans:
Mortgages		$ 428	$ 91	$ 398	$ 917	$ 101,794	$ 102,711	$ 60
Home Equity		339	-	180	519	80,804	81,323	39
Commercial		319	412	2,794	3,525	162,301	165,826	176
Agricultural		143	-	-	143	19,081	19,224	-
Construction		-	-	-	-	8,481	8,481	-
Consumer		86	7	-	93	10,653	10,746	-
Commercial and other loans		9	-	503	512	37,235	37,747	-
Other Agricultural Loans		-	-	-	-	6,552	6,552	-
State and political
subdivision loans		-	-	-	-	54,899	54,899	-

	Total	$ 1,324	$ 510	$ 3,875	$ 5,709	$ 481,800	$ 487,509	$ 275

Loans considered non-accrual		$ -	$ -	$ 3,600	$ 3,600	$ 5,565	$ 9,165
Loans still accruing		1,324	510	275	2,109	476,235	478,344
	Total	$ 1,324	$ 510	$ 3,875	$ 5,709	$ 481,800	$ 487,509

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 March 31, 2012 and December 31, 2011, respectively. The balances are presented by class of financing receivable (in thousands):

	March 31, 2012	December 31, 2011
Real estate loans:
Mortgages	$ 381	$ 413
Home Equity	209	141
Commercial	8,194	8,094
Agricultural	-	-
Construction	-	-
Consumer	-	-
Commercial and other	459	517
Other Agricultural	-	-
State and political subdivision	-	-
	$ 9,243	$ 9,165

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 ended March 31, 2012 and 2011 were as follows:

	For the Three Months Ended March 31, 2012
	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
(Dollar amounts in thousands)
Real estate loans:
Commercial	-	2	$ -	$ 98	$ -	$ 98
Total	-	2	$ -	$ 98	$ -	$ 98

	For the Three Months Ended March 31, 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
(Dollar amounts in thousands)
Real estate loans:
Commercial	5	-	$ 5,912	$ -	$ 5,912	$ -
Total	5	-	$ 5,912	$ -	$ 5,912	$ -

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 March 31, 2012, that defaulted during the three month period ended March 31, 2012 were as follows:

(Dollar amounts in thousands)	Number of contracts	Recorded investment
Real estate loans:
Commercial	1	$ 48
Total recidivism	1	$ 48

Allowance for Loan Losses

The following tables roll forward the balance of the ALLL by portfolio segment for the three month periods ended March 31, 2012 and 2011, respectively, 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 March 31, 2012 (in thousands):

	Balance at December 31, 2011	Charge-offs	Recoveries	Provision	Balance at March 31, 2012	Individually evaluated for impairment	Collectively evaluated for impairment
Real estate loans:
Residential	$ 805	$ (49)	$ -	$ (3)	$ 753	$ 15	$ 738
Commercial and agricultural	4,132	(2)	-	206	4,336	563	3,773
Construction	15	-	-	1	16	-	16
Consumer	111	(8)	9	(16)	96	-	96
Commercial and other loans	674	-	3	(6)	671	23	648
State and political
subdivision loans	235	-	-	10	245	-	245
Unallocated	515	-	-	(87)	428	-	428
Total	$ 6,487	$ (59)	$ 12	$ 105	$ 6,545	$ 601	$ 5,944

	Balance at December 31, 2010	Charge-offs	Recoveries	Provision	Balance at March 31, 2011	Individually evaluated for impairment	Collectively evaluated for impairment
Real estate loans:
Residential	$ 969	$ (60)	$ -	$ 12	$ 921	$ -	$ 921
Commercial and agricultural	3,380	(17)	-	335	3,698	433	3,265
Construction	22	-	-	(9)	13	-	13
Consumer	108	(16)	17	(22)	87	-	87
Commercial and other loans	983	-	4	(86)	901	-	901
State and political
subdivision loans	137	-	-	2	139	-	139
Unallocated	316	-	-	(7)	309	-	309
Total	$ 5,915	$ (93)	$ 21	$ 225	$ 6,068	$ 433	$ 5,635

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 three months of 2012:

·	The qualitative factor for changes in values of underlying collateral was decreased for residential and commercial real estate loans due to the fact that the impact from the serious flooding experienced in our primary market in the third quarter of 2011 was not as severe as originally expected.

The qualitative factors for changes in levels of and trends in delinquencies, impaired/classified loans were increased for residential real estate and commercial real estate due to the increase in non-performing loans for residential real estate and due to the increase in the Company's internal watch list for commercial real estate loans since December 31, 2011.

The qualitative factor for the existence and effect of any credit concentrations and changes in the level of such concentrations was increased for commercial real estate and other commercial loans due to the fact that certain companies associated with the natural gas industry appear to be leaving our area due to the current spot price for the natural gas produced in our primary market.

·	The qualitative factors for changes in industry conditions was increased for agricultural real estate loans and other agricultural loans due to the decrease in milk prices.

Based on these qualitative factor changes for the three month period ended March 31, 2012 and the changes in size of the loan portfolios since December 31, 2011, we recorded a credit provision for residential real estate, consumer and other commercial loans. These changes also resulted in a decrease in the unallocated reserve.