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 June 30, 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 as of June 30, 2012 and December 31, 2011 (in thousands):

June 30, 2012	Total Loans		Individually evaluated for impairment		Collectively evaluated for impairment
Real estate loans:
Residential	$	181,409	$	351	$	181,058
Commercial and agricultural		189,705		7,475		182,230
Construction		10,328		-		10,328
Consumer		11,160		-		11,160
Other commercial and agricultural loans		47,067		457		46,610
State and political subdivision loans		57,463		-		57,463
Total		497,132	$	8,283	$	488,849
Allowance for loan losses		6,650
Net loans	$	490,482

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
Other commercial and agricultrual loans		44,299		517		43,782
State and political subdivision loans		54,899		-		54,899
Total		487,509	$	8,881	$	478,628
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 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. Other commerical 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
June 30, 2012	Balance		Allowance		Allowance		Investment		Allowance		Investment		Recognized
Real estate loans:
Residential mortgages	$	258	$	118	$	140	$	258	$	14	$	83	$	1
Home equity		93		18		75		93		15		93		2
Commercial		8,816		5,366		2,109		7,475		512		8,138		39
Agricultural		-		-		-		-		-		-		-
Construction		-		-		-		-		-		-		-
Consumer		-		-		-		-		-		-		-
Other commercial loans		504		28		429		457		21		468		-
Other agricultural Loans		-		-		-		-		-		-		-
State and political subdivision loans		-		-		-		-		-		-		-
Total	$	9,671	$	5,530	$	2,753	$	8,283	$	562	$	8,782	$	42

			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:
Residential 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		-		-		-		-		-		-		-
Other commercial 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, other agricultural and state and political subdivision 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 June 30, 2012 and December 31, 2011 (in thousands):

June 30, 2012	Pass		Special Mention		Substandard		Doubtful		Loss		Ending Balance
Real estate loans:
Commercial	$	141,568	$	10,496	$	18,739	$	75	$	-	$	170,878
Agricultural		16,219		623		1,985		-		-		18,827
Construction		10,328		-		-		-		-		10,328
Other commercial loans		36,982		1,806		1,016		16		-		39,820
Other agricultural loans		5,849		425		973		-		-		7,247
State and political subdivision loans		56,335		-		1,128		-		-		57,463
Total	$	267,281	$	13,350	$	23,841	$	91	$	-	$	304,563

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
Other commercial 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 June 30, 2012 and December 31, 2011 (in thousands):

June 30, 2012	Performing		Non-performing		Total
Real estate loans:
Residential mortgages	$	104,600	$	558	$	105,158
Home equity		76,080		171		76,251
Consumer		11,160		-		11,160
Total	$	191,840	$	729	$	192,569

December 31, 2011	Performing		Non-performing		Total
Real estate loans:
Residential 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 June 30, 2012 and December 31, 2011 (in thousands):

	30-59 Days		60-89 Days		90 Days		Total Past				Total Financing		90 Days and
June 30, 2012	Past Due		Past Due		Or Greater		Due		Current		Receivables		Accruing
Real estate loans:
Residential mortgages	$	164	$	9	$	455	$	628	$	104,530	$	105,158	$	57
Home equity		360		88		161		609		75,642		76,251		21
Commercial		717		104		2,063		2,884		167,994		170,878		180
Agricultural		-		-		-		-		18,827		18,827		-
Construction		-		-		-		-		10,328		10,328		-
Consumer		45		-		-		45		11,115		11,160		-
Other commercial loans		-		-		445		445		39,375		39,820		-
Other agricultural loans		100		-		-		100		7,147		7,247		-
State and political subdivision loans		-		-		-		-		57,463		57,463		-
Total	$	1,386	$	201	$	3,124	$	4,711	$	492,421	$	497,132	$	258

Loans considered non-accrual	$	-	$	-	$	2,866	$	2,866	$	5,537	$	8,403
Loans still accruing		1,386		201		258		1,845		486,884		488,729
Total	$	1,386	$	201	$	3,124	$	4,711	$	492,421	$	497,132

	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:
Residential 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		-
Other commercial 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 June 30, 2012 and December 31, 2011, respectively. The balances are presented by class of financing receivable (in thousands):

	June 30, 2012		December 31, 2011
Real estate loans:
Residential mortgages	$	501	$	413
Home equity		150		141
Commercial		7,295		8,094
Agricultural		-		-
Construction		-		-
Consumer		-		-
Other commercial loans		457		517
Other agricultural		-		-
State and political subdivision		-		-
	$	8,403	$	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 and six months ended June 30, 2012 and 2011 were as follows (dollars in thousands):

	For the Three Months Ended June 30, 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

Real estate loans:
Residential mortgage		1		1	$	48	$	71	$	48	$	71
Total		1		1	$	48	$	71	$	48	$	71

	For the Six Months Ended June 30, 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

Real estate loans:
Residential mortgage		1	1		$	48	$	71	$	48	$	71
Commercial		-		2		-		98		-		98
Total		1		3	$	48	$	169	$	48	$	169

For the Three Months Ended June 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

Real estate loans:

Commercial

Total

	For the Six Months Ended June 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

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 June 30, 2012, that defaulted during the three and six month periods ended June 30, 2012 were as follows (dollars in thousands):

	Number of contracts		Recorded investment
Real estate loans:
Residential mortgage		1	$	71
Commercial		1		48
Total recidivism		2	$	119

Allowance for Loan Losses

The following table segregates the allowance for loan losses (ALLL) into the amount required for loans individually evaluated for impairment and the amount required for loans collectively evaluated for impairment as of June 30, 2012 and December 31, 2011, respectively (in thousands):

	June 30, 2012						December 31, 2011
	Individually evaluated for impairment		Collectively evaluated for impairment		Total		Individually evaluated for impairment		Collectively evaluated for impairment		Total
Real estate loans:
Residential	$	29	$	758	$	786	$	13	$	792	$	805
Commercial and agricultural		512		3,893		4,405		433		3,699		4,132
Construction		-		19		19		-		15		15
Consumer		-		108		108		-		111		111
Other commercial and agricultral		21		663		685		48		626		674
State and political subdivision loans		-		246		246		-		235		235
Unallocated		-		401		401		-		515		515
Total	$	562	$	6,088	$	6,650	$	494	$	5,993	$	6,487

The following tables roll forward the balance of the ALLL by portfolio segment for the three and six month periods ended June 30, 2012 and 2011, respectively (in thousands):

	Balance at March 31, 2012		Charge-offs			Recoveries		Provision			Balance at June 30, 2012
Real estate loans:
Residential	$	753	$	-		$	-	$	33		$	786
Commercial and agricultural		4,336		-			6		63			4,405
Construction		16		-			-		3			19
Consumer		96		(16	)		7		21			108
Other commercial and agricultrual loans		671		-			3		11			685
State and political subdivision loans		245		-			-		1			246
Unallocated		428		-			-		(27	)		401
Total	$	6,545	$	(16	)	$	16	$	105		$	6,650

	Balance at December 31, 2011		Charge-offs			Recoveries		Provision			Balance at June 30, 2012
Real estate loans:
Residential	$	805	$	(49	)	$	-	$	30		$	786
Commercial and agricultural		4,132		(2	)		6		269			4,405
Construction		15		-			-		4			19
Consumer		111		(24	)		16		5			108
Other commercial and agricultrual loans		674		-			6		5			685
State and political subdivision loans		235		-			-		11			246
Unallocated		515		-			-		(114	)		401
Total	$	6,487	$	(75	)	$	28	$	210		$	6,650

	Balance at March 31, 2011		Charge-offs			Recoveries		Provision			Balance at June 30, 2011
Real estate loans:
Residential	$	921	$	(41	)	$	-	$	(202	)	$	678
Commercial and agricultural		3,698		(12	)		-		226			3,912
Construction		13		-			-		-			13
Consumer		87		(17	)		12		27			109
Other commercial and agricultrual loans		901		-			3		(192	)		712
State and political subdivision loans		139		-			-		(20	)		119
Unallocated		309		-			-		311			620
Total	$	6,068	$	(70	)	$	15	$	150		$	6,163

	Balance at December 31, 2010		Charge-offs			Recoveries		Provision			Balance at June 30, 2011
Real estate loans:
Residential	$	969	$	(101	)	$	-	$	(190	)	$	678
Commercial and agricultural		3,380		(29	)		-		561			3,912
Construction		22		-			-		(9	)		13
Consumer		108		(33	)		29		5			109
Other commercial and agricultrual loans		983		-			7		(278	)		712
State and political subdivision loans		137		-			-		(18	)		119
Unallocated		316		-			-		304			620
Total	$	5,915	$	(163	)	$	36	$	375		$	6,163

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. The following factors experienced changes during the first six 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 commercial real estate due to the increase in the Company's internal watch list for commercial real estate loans since December 31, 2011.

The qualitative factors for changes in industry conditions were increased for agricultural real estate and other agricultural loans due to decreases in milk prices from December 31, 2011 to June 30, 2012.

During the second quarter of 2012, there were no significant changes in any qualitative factor. As a result, the change in the allocation of the allowance from March 31, 2012, is mainly attributable to the changes in the loan portfolio balances since that date.