Note 5 – Loans

The Company grants loans primarily to customers throughout North Central Pennsylvania and Southern New York. Although the Company had a diversified loan portfolio at March 31, 2013 and December 31, 2012, 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 how those segments are analyzed within the allowance for loan losses as of March 31, 2013 and December 31, 2012 (in thousands):

March 31, 2013	Total Loans		Individually evaluated for impairment		Collectively evaluated for impairment
Real estate loans:
Residential	$	178,461	$	491	$	177,970
Commercial and agricultural		195,083		8,550		186,533
Construction		11,697		-		11,697
Consumer		10,094		-		10,094
Other commercial and agricultural loans		49,192		1,985		47,207
State and political subdivision loans		59,196		-		59,196
Total		503,723	$	11,026	$	492,697
Allowance for loan losses		6,928
Net loans	$	496,795
December 31, 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

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 equity 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 commercial 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 or if the loan is modified in a troubled debt restructuring. 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 allocation of the allowance for loan losses or a charge-off to the allowance for loan losses.

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
	Principal		With No		With		Recorded		Related
March 31, 2013	Balance		Allowance		Allowance		Investment		Allowance
Real estate loans:
Mortgages	$	378	$	146	$	208	$	354	$	24
Home Equity		137		-		137		137		14
Commercial		10,157		5,911		2,639		8,550		528
Agricultural		-		-		-		-		-
Construction		-		-		-		-		-
Consumer		-		-		-		-		-
Other commercial loans		2,036		1,676		309		1,985		-
Other agricultural loans		-		-		-		-		-
State and political subdivision loans		-		-		-		-		-
Total	$	12,708	$	7,733	$	3,293	$	11,026	$	566

December 31, 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

The following table includes the average balance of impaired financing receivables by class and the income recognized on impaired loans for the three months ended March 31, 2013 and 2012 (in thousands):

	March 31, 2013						March 31, 2012
					Interest						Interest
	Average		Interest		Income		Average		Interest		Income
	Recorded		Income		Recognized		Recorded		Income		Recognized
	Investment		Recognized		Cash Basis		Investment		Recognized		Cash Basis
Real estate loans:
Mortgages	$	284	$	2	$	-	$	-	$	-	$	-
Home Equity		137		1		-		93		1		1
Commercial		8,785		45		14		8,228		18		18
Agricultural		-		-		-		-		-		-
Construction		-		-		-		-		-		-
Consumer		-		-		-		-		-		-
Other commercial loans		1,656		19		-		479		-		-
Other agricultural loans		-		-		-		-		-		-
State and political subdivision loans		-		-		-		-		-		-
Total	$	10,862	$	67	$	14	$	8,800	$	19	$	19

Credit Quality Information

For commercial real estate, agricultural real estate, construction, other commercial, 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 55% (60% during 2012) 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 or 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, 2013 and December 31, 2012 (in thousands):

March 31, 2013	Pass		Special Mention		Substandard		Doubtful		Loss		Ending Balance
Real estate loans:
Commercial	$	150,863	$	6,964	$	18,646	$	214	$	-	$	176,687
Agricultural		14,107		2,374		1,915		-		-		18,396
Construction		11,697		-		-		-		-		11,697
Other commercial loans		39,223		707		2,561		-		-		42,491
Other agricultural loans		5,141		740		820		-		-		6,701
State and political subdivision loans		58,128		-		1,068		-		-		59,196
Total	$	279,159	$	10,785	$	25,010	$	214	$	-	$	315,168
December 31, 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

For residential real estate mortgages, home equity 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, 2013 and December 31, 2012 (in thousands):

March 31, 2013	Performing		Non-performing		Total
Real estate loans:
Mortgages	$	108,005	$	592	$	108,597
Home Equity		69,670		194		69,864
Consumer		10,057		37		10,094
Total	$	187,732	$	823	$	188,555

December 31, 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

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, 2013 and December 31, 2012 (in thousands):

	30-59 Days		60-89 Days		90 Days		Total Past				Total Financing		90 Days and
March 31,2013	Past Due		Past Due		Or Greater		Due		Current		Receivables		Accruing
Real estate loans:
Mortgages	$	229	$	106	$	400	$	735	$	107,862	$	108,597	$	93
Home Equity		481		7		168		656		69,208		69,864		65
Commercial		1,267		24		1,974		3,265		173,422		176,687		171
Agricultural		50		-		-		50		18,346		18,396		-
Construction		-		-		-		-		11,697		11,697		-
Consumer		5		25		37		67		10,027		10,094		37
Other commercial loans		260		16		309		585		41,906		42,491		-
Other agricultural loans		-		-		-		-		6,701		6,701		-
State and political subdivision loans		-		-		-		-		59,196		59,196		-
Total	$	2,292	$	178	$	2,888	$	5,358	$	498,365	$	503,723	$	366

Loans considered non-accrual	$	20	$	93	$	2,522	$	2,635	$	5,240	$	7,875
Loans still accruing		2,272		85		366		2,723		493,125		495,848
Total	$	2,292	$	178	$	2,888	$	5,358	$	498,365	$	503,723

	30-59 Days		60-89 Days		90 Days		Total Past				Total Financing		90 Days and
December 31, 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

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 non-accrual status as of March 31, 2013 and December 31, 2012, respectively. The balances are presented by class of financing receivable (in thousands):

	March 31, 2013		December 31, 2012
Real estate loans:
Mortgages	$	499	$	482
Home Equity		129		181
Commercial		6,890		7,042
Agricultural		-		-
Construction		-		-
Consumer		-		-
Other commercial loans		357		362
Other agricultural loans		-		-
State and political subdivision		-		-
	$	7,875	$	8,067

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, 2013 and 2012 were as follows (dollars in thousands):


	Number of contracts				Pre-modification Outstanding Recorded Investment				Post-Modification Outstanding Recorded Investment
March 31, 2013	Interest Modification		Term Modification		Interest Modification		Term Modification		Interest Modification		Term Modification
Real estate loans:
Residential		1		-	$	72	$	-	$	72	$	-
Commercial		-		2		-		1,365		-		1,365
Other commercial loans		-		2		-		1,530		-		1,530
Total		1		4	$	72	$	2,895	$	72	$	2,895

March 31, 2012
Real estate loans:
Commercial	-	2	$	-	$	98	$	-	$	98
Total	-	2	$	-	$	98	$	-	$	98

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, 2013 and 2012, that defaulted during the three month periods ended March 31, 2013 and 2012 were as follows (dollars in thousands):

	For the Three Months Ended
	March 31, 2013				March 31, 2012
	Number of contracts		Recorded investment		Number of contracts		Recorded investment
Real estate loans:
Commercial		-	$	-		1	$	48
Total recidivism		-	$	-		1	$	48

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 March 31, 2013 and December 31, 2012, respectively (in thousands):

	March 31, 2013						December 31, 2012
	Individually evaluated for impairment		Collectively evaluated for impairment		Total		Individually evaluated for impairment		Collectively evaluated for impairment		Total
Real estate loans:
Residential	$	38	$	875	$	913	$	22	$	853	$	875
Commercial and agricultural		528		3,888		4,416		559		3,878		4,437
Construction		-		78		78		-		38		38
Consumer		-		118		118		-		119		119
Other commercial and agricultural loans		-		700		700		1		727		728
State and political subdivision loans		-		303		303		-		271		271
Unallocated		-		400		400		-		316		316
Total	$	566	$	6,362	$	6,928	$	582	$	6,202	$	6,784

The following tables roll forward the balance of the ALLL by portfolio segment for the three month period ended March 31, 2013 and 2012, respectively (in thousands):

	Balance at December 31, 2012		Charge-offs			Recoveries		Provision			Balance at March 31, 2013
Real estate loans:
Residential	$	875	$	-		$	2	$	36		$	913
Commercial and agricultural		4,437		-			-		(21	)		4,416
Construction		38		-			-		40			78
Consumer		119		(20	)		12		7			118
Other commercial and agricultural loans		728		-			-		(28	)		700
State and political subdivision loans		271		-			-		32			303
Unallocated		316		-			-		84			400
Total	$	6,784	$	(20	)	$	14	$	150		$	6,928

	Balance at December 31, 2011		Charge-offs			Recoveries		Provision			Balance at March 31, 2012
Real estate loans:
Residential	$	805	$	(49	)	$	-	$	(3	)	$	753
Commercial and agricultural		4,132		(2	)		-		206			4,336
Construction		15		-			-		1			16
Consumer		111		(8	)		9		(16	)		96
Other commercial and agricultural loans		674		-			3		(6	)		671
State and political subdivision loans		235		-			-		10			245
Unallocated		515		-			-		(87	)		428
Total	$	6,487	$	(59	)	$	12	$	105		$	6,545

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 / Consumer Price Index

▪

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, 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. The following qualitative factors experienced changes during the first three months of 2013:

•

The qualitative factor for national, state, regional and local economic trends and business conditions was increased for all loan categories due to rising unemployment rates in the local economy as a result of the slowdown in the development of the Marcellus shale natural gas exploration activities.

The primary factor that resulted in a negative provision for the first quarter of 2013 for commercial and agricultural real estate loans and other commercial loans was the increase in impaired loans that were specifically reviewed as of March 31, 2013 that did not require a specific allowance.