4. LOANS AND RELATED ALLOWANCE FOR LOAN LOSSES

The Company grants commercial, industrial, agricultural, residential, and consumer loans primarily to customers throughout North central Pennsylvania and Southern New York. Although the Company has a diversified loan portfolio at December 31, 2012 and 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 well as how those segments are analyzed within the allowance for loan losses as of December 31, 2012 and 2011 (in thousands):

2012	Total Loans		Individually evaluated for impairment		Collectively evaluated for impairment
Real estate loans:
Residential	$	178,080	$	424	$	177,656
Commercial and agricultural		194,725		9,093		185,632
Construction		12,011		-		12,011
Consumer		10,559		-		10,559
Other commercial and agricultural loans		47,880		901		46,979
State and political subdivision loans		59,208		-		59,208
Total		502,463	$	10,418	$	492,045
Allowance for loan losses		6,784
Net loans	$	495,679

2011
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 agricultural 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

Real estate loans serviced for Freddie Mac and Fannie Mae, which are not included in the consolidated balance sheet, totaled $73,813,000 and $58,985,000 at December 31, 2012 and 2011, respectively.

As of December 31, 2012 and 2011, net unamortized loan fees and costs of $1,354,000 were included in the carrying value of loans.

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 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 are business purpose loans secured by a mortgage on commercial real estate. Agricultural real estate are loans secured by a mortgage on real estate used in agriculture production. Construction real estate 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 and other loans, commercial and agricultural real estate loans and state and political subdivision loans which are 90 days or more past due to be impaired. Certain residential mortgages, home equity and consumer loans that are cross collateralized with commercial relationships determined to be impaired maybe classified as impaired as well. 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 loans by class, with the associated allowance amount as of December 31, 2012 and 2011, if applicable (in thousands):

			Recorded		Recorded
	Unpaid		Investment		Investment		Total
	Principal		With No		With		Recorded		Related
	Balance		Allowance		Allowance		Investment		Allowance
2012
Real estate loans:
Mortgages	$	309	$	150	$	136	$	286	$	8
Home Equity		138		-		138		138		14
Commercial		10,669		6,476		2,617		9,093		559
Agricultural		-		-		-		-		-
Construction		-		-		-		-		-
Consumer		-		-		-		-		-
Other commercial loans		950		592		309		901		1
Other agricultural loans		-		-		-		-		-
State and political
subdivision loans		-		-		-		-		-
Total	$	12,066	$	7,218	$	3,200	$	10,418	$	582

2011
Real estate loans:
Mortgages	$	-	$	-	$	-	$	-	$	-
Home Equity		94		36		58		94		13
Commercial		9,394		5,663		2,607		8,270		433
Agricultural		-		-		-		-		-
Construction		-		-		-		-		-
Consumer		-		-		-		-		-
Other commercial loans		574		30		487		517		48
Other agricultural loans		-		-		-		-		-
State and political
subdivision loans		-		-		-		-		-
Total	$	10,062	$	5,729	$	3,152	$	8,881	$	494

The following table includes the average investment in impaired loans and the income recognized on impaired loans for 2012, 2011 and 2010 (in thousands):

	2012		2011		2010
Average investment in impaired loans	$	8,625	$	9,653	$	9,356
Interest income recognized on impaired loans		123		123		143
Interest income recognized on a cash basis on impaired loans		123		123		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 that 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 a sample of new commercial/agricultural 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 December 31, 2012 and 2011 (in thousands):

2012	Pass		Special Mention		Substandard		Doubtful		Loss		Ending Balance
Real estate loans:
Commercial	$	149,892	$	7,616	$	19,127	$	75	$	-	$	176,710
Agricultural		13,690		2,386		1,939		-		-		18,015
Construction		12,011		-		-		-		-		12,011
Other commercial loans		39,239		826		1,555		-		-		41,620
Other agricultural loans		4,833		589		838		-		-		6,260
State and political subdivision loans		58,120		-		1,088		-		-		59,208
Total	$	277,785	$	11,417	$	24,547	$	75	$	-	$	313,824

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 December 31, 2012 and 2011 (in thousands):

2012	Performing		Non-performing		Total
Real estate loans:
Mortgages	$	105,822	$	726	$	106,548
Home Equity		71,263		269		71,532
Consumer		10,555		4		10,559
Total	$	187,640	$	999	$	188,639

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 Loans by Class

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

		30-59 Days		60-89 Days		90 Days		Total Past				Total Financing		90 Days and
2012		Past Due		Past Due		Or Greater		Due		Current		Receivables		Accruing
Real estate loans:
Mortgages		$	636	$	294	$	493	$	1,423	$	105,125	$	106,548	$	244
Home Equity			267		17		222		506		71,026		71,532		88
Commercial			602		-		2,149		2,751		173,959		176,710		152
Agricultural			54		-		-		54		17,961		18,015		-
Construction			-		-		-		-		12,011		12,011		-
Consumer			45		43		4		92		10,467		10,559		4
Other commercial loans			962		-		317		1,279		40,341		41,620		18
Other agricultural loans			-		-		-		-		6,260		6,260		-
State and political subdivision loans			-		-		-		-		59,208		59,208		-
	Total	$	2,566	$	354	$	3,185	$	6,105	$	496,358	$	502,463	$	506
Loans considered non-accrual		$	73	$	69	$	2,679	$	2,821	$	5,246	$	8,067
Loans still accruing			2,493		285		506		3,284		491,112		494,396
	Total	$	2,566	$	354	$	3,185	$	6,105	$	496,358	$	502,463

	30-59 Days		60-89 Days		90 Days		Total Past				Total Financing		90 Days and
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		-
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 nonaccrual status upon reaching 90 days delinquency, unless the loan is well secured and in the process of collection, although the Corporation 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.

The following table reflects the loans on nonaccrual status as of December 31, 2012 and 2011, respectively. The balances are presented by class of loan (in thousands):

	2012		2011
Real estate loans:
Mortgages	$	482	$	413
Home Equity		181		141
Commercial		7,042		8,094
Agricultural		-		-
Construction		-		-
Consumer		-		-
Other commercial loans		362		517
Other agricultural loans		-		-
State and political subdivision		-		-
	$	8,067	$	9,165

Interest income on loans would have increased by approximately $531,000, $625,000, and $522,000 and during 2012, 2011 and 2010, respectively, if these loans had performed in accordance with their terms.

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 years ended December 31, 2012 and 2011 were as follows (dollars in thousands):

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		-		3		-		160		-		160
Other commercial loans		-		1		-		25		-		25
Total		1		5	$	48	$	256	$	48	$	256
2011	Interest Modification		Term Modification		Interest Modification		Term Modification		Interest Modification		Term Modification
Real estate loans:
Residential		2		-	$	76	$	-	$	76	$	-
Commercial		5		1		5,912		47		5,912		47
Other commercial loans		1		-		15		-		15		-
Total		8		1	$	6,003	$	47	$	6,003	$	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 during the previous twelve months considered TDR's that defaulted during the twelve month periods ended December 31, 2012 and 2011 were as follows (dollars in thousands):

	2012				2011
	Number of contracts		Recorded investment		Number of contracts		Recorded investment
Real estate loans:
Commercial		1	$	50		3	$	150
Total recidivism		1	$	50		3	$	150

Allowance for Loan Losses

The following tables roll forward the balance of the allowance for loan and lease losses for the years ended December 31, 2012, 2011 and 2010 and is segregated into the amount required for loans individually evaluated for impairment and the amount required for loans collectively evaluated for impairment as of December 31, 2012, 2011 and 2010 (in thousands):

	Balance at December 31, 2011		Charge-offs			Recoveries		Provision			Balance at December 31, 2011		Individually evaluated for impairment		Collectively evaluated for impairment
Real estate loans:
Residential	$	805	$	(95	)	$	-	$	165		$	875	$	22	$	853
Commercial and agricultural		4,132		(2	)		9		298			4,437		559		3,878
Construction		15		-			-		23			38		-		38
Consumer		111		(54	)		33		29			119		-		119
Other commercial and agricultural loans		674		(21	)		7		68			728		1		727
State and political subdivision loans		235		-			-		36			271		-		271
Unallocated		515		-			-		(199	)		316		-		316
Total	$	6,487	$	(172	)	$	49	$	420		$	6,784	$	582	$	6,202
	Balance at December 31, 2010		Charge-offs			Recoveries		Provision			Balance at December 31, 2011		Individually evaluated for impairment		Collectively evaluated for impairment
Real estate loans:
Residential	$	969	$	(101	)	$	-	$	(63	)	$	805	$	13	$	792
Commercial and agricultural		3,380		(29	)		15		766			4,132		433		3,699
Construction		22		-			-		(7	)		15		-		15
Consumer		108		(71	)		57		17			111		-		111
Other commercial and agricultural loans		983		(6	)		32		(335	)		674		48		626
State and political subdivision loans		137		-			-		98			235		-		235
Unallocated		316		-			-		199			515		-		515
Total	$	5,915	$	(207	)	$	104	$	675		$	6,487	$	494	$	5,993
	Balance at December 31, 2009		Charge-offs			Recoveries		Provision			Balance at December 31, 2010		Individually evaluated for impairment		Collectively evaluated for impairment
Real estate loans:
Residential	$	801	$	(76	)	$	4	$	240		$	969	$	21	$	948
Commercial and agricultural		2,864		(124	)		21		619			3,380		167		3,213
Construction		20		-			-		2			22		-		22
Consumer		131		(88	)		79		(14	)		108		-		108
Other commercial and agricultural loans		918		(120	)		76		109			983		-		983
State and political subdivision loans		93		-			-		44			137		-		137
Unallocated		61		-			-		255			316		-		316
Total	$	4,888	$	(408	)	$	180	$	1,255		$	5,915	$	188	$	5,727

As discussed in Footnote 1, management evaluates various qualitative factors on a quarterly basis. The following are factors that experienced changes:

2012

The qualitative factors for changes in levels of and trends in delinquencies and impaired/classified loans were increased for residential real estate loans and other commercial loans due to increases in the amount of loans past due.

The qualitative factor for changes in the quality of the loan review system was increased for all portfolio types due to personnel changes.

The qualitative factor for changes in values of underlying collateral was decreased for residential and commercial real estate loans as flooding experienced in our primary market area of north central Pennsylvania at the end of 2011 was not as severe as estimated for the year ended December 31, 2011.

The qualitative factor for changes in unemployment rates was increased for all loan types due to rising unemployment rates in the Bank's primary market during 2012.

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 loans and other commercial loans due to the increased size of these loans in regards to the Company's loan portfolio.

2011:

Separate factors were created for special mention, substandard and doubtful loans for each qualitative factor reviewed to more accurately reflect the risks inherent in the Bank's loan portfolio.

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 and total past due loans.

The qualitative factors for changes in the trends of charge-offs and recoveries were decreased for residential, consumer loans, commercial and agricultural loans due to reduced net charge-offs in 2011.

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

The qualitative factor for changes in values of underlying collateral was increased for residential and commercial real estate loans due to flooding that occurred in our primary market area of north central Pennsylvania. The Company is continuing to monitor the impact, if any, this will have on the loan portfolio.

The qualitative factor for the existence and effect of any credit concentrations and changes in the level of such concentrations was increased for municipal loans and commercial loans due to the increased size of these loans in regards to the Company's loan portfolio, while this factor was reduced for agricultural loans.

The negative provision associated with commercial and other loans of $335,000 for 2011 was primarily driven by the $2,857,000 or 6.1% decrease in the loan portfolio balance from December 31, 2010 and the $1,164,000 decrease in commercial and other loans, including other agricultural loans classified as special mention or substandard. These items resulted in certain qualitative factors being reduced as discussed above, which resulted the negative provision for 2011.