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, 2011 and December 31, 2010, a substantial portion of its debtors' ability to honor their contracts is dependent on the economic conditions within these regions. The following table summarizes the primary segments of the loan portfolio as of June 30, 2011 and December 31, 2010 (in thousands):

June 30, 2011	Total Loans	Individually evaluated for impairment	Collectively evaluated for impairment
Real estate loans:
Residential	$ 180,817	$ 145	$ 180,672
Commercial and agricultural	175,118	8,532	166,586
Construction	7,095	-	7,095
Consumer	11,304	-	11,304
Commercial and other loans	49,551	652	48,899
State and political subdivision loans	53,027	-	53,027
Total	$ 476,912	$ 9,329	$ 467,583


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

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 loans are business purpose loans secured by a mortgage on commercial real estate. Agricultural real estate loans are loans secured by a mortgage on real estate used in agriculture production. Construction real estate loans are loans secured by residential or commercial real estate used during the construction phase of residential and commercial projects. Consumer loans are typically unsecured or primarily secured by something other than real estate and overdraft lines of credit connected with customer deposit accounts. Commercial and other loans are loans for commercial purposes primarily secured by non-real estate collateral. Other agricultural loans are loans for agricultural purposes primarily secured by non-real estate collateral. State and political subdivisions are loans for state and local municipalities for capital and operating expenses or tax free loans used to finance commercial development.

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

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

		Recorded	Recorded
	Unpaid	Investment	Investment	Total		Average	Interest
	Principal	With No	With	Recorded	Related	Recorded	Income
	Balance	Allowance	Allowance	Investment	Allowance	Investment	Recognized
June 30, 2011
Real estate loans:
Mortgages	$ 132	$ 127	$ -	$ 127	$ -	$ 129	$ -
Home Equity	18	-	18	18	3	36	-
Commercial	9,509	126	8,406	8,532	323	8,812	27
Agricultural	-	-	-	-	-	741	37
Construction	-	-	-	-	-	-	-
Consumer	-	-	-	-	-	-	-
Commercial and other loans	704	37	615	652	103	399	-
Other Agricultural Loans	-	-	-	-	-	319	20
State and political	-	-	-	-	-	-	-
subdivision loans	-	-	-	-	-	-	-
Total	$ 10,363	$ 290	$ 9,039	$ 9,329	$ 429	$ 10,436	$ 84

December 31, 2010
Real estate loans:
Mortgages	$ 132	$ -	$ 131	$ 131	$ 21	$ 55	$ -
Home Equity	72	41	-	41	-	56	-
Commercial	8,540	1,682	6,053	7,735	167	5,445	67
Agricultural	2,421	2,241	-	2,241	-	2,373	64
Construction	-	-	-	-	-	-	-
Consumer	-	-	-	-	-	-	-
Commercial and other loans	455	404	-	404	-	469	1
Other Agricultural Loans	1,040	970	-	970	-	958	11
State and political
subdivision loans	-	-	-	-	-	-	-
Total	$ 12,660	$ 5,338	$ 6,184	$ 11,522	$ 188	$ 9,356	$ 143

Credit Quality Information

Management uses a nine point internal risk rating system to monitor the credit quality of the overall loan portfolio. 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. Generally, residential real estate mortgages and home equities and loans to individuals for household, family and other purchases are included in the pass category, unless a specific action, such as bankruptcy, repossession, death or significant delay in payment occurs to raise awareness of a possible credit event. 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, 2011 and December 31, 2010 (in thousands):

	Pass	Special Mention	Substandard	Doubtful	Loss	Ending Balance
June 30, 2011
Real estate loans:
Mortgages	$ 95,722	$ 414	$ 549	$ -	$ -	$ 96,685
Home Equity	83,880	111	141	-	-	84,132
Commercial	130,707	10,623	15,835	-	-	157,165
Agricultural	12,909	1,041	4,003	-	-	17,953
Construction	7,095	-	-	-	-	7,095
Consumer	11,291	4	9	-	-	11,304
Commercial and other loans	38,142	3,663	1,047	18	2	42,872
Other Agricultural Loans	4,622	497	1,560	-	-	6,679
State and political
subdivision loans	51,824	-	1,203	-	-	53,027
Total	$ 436,192	$ 16,353	$ 24,347	$ 18	$ 2	$ 476,912

	Pass	Special Mention	Substandard	Doubtful	Loss	Ending Balance
December 31, 2010
Real estate loans:
Mortgages	$ 96,218	$ 628	$ 397	$ -	$ -	$ 97,243
Home Equity	87,359	175	202	33	-	87,769
Commercial	120,344	15,570	16,585	-	-	152,499
Agricultural	12,007	1,063	6,008	-	-	19,078
Construction	9,766	-	-	-	-	9,766
Consumer	11,265	4	16	-	-	11,285
Commercial and other loans	36,784	2,545	848	24	-	40,201
Other Agricultural Loans	4,024	469	2,462	-	-	6,955
State and political
subdivision loans	47,482	-	1,239	-	-	48,721
Total	$ 425,249	$ 20,454	$ 27,757	$ 57	$ -	$ 473,517

Age Analysis of Past Due Financing Receivables 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 financing receivables as of June 30, 2011 and December 31, 2010 (in thousands):

		30-59 Days	60-89 Days	90 Days	Total Past		Total Financing	90 Days and
		Past Due	Past Due	Or Greater	Due	Current	Receivables	Accruing
June 30, 2011

Real estate loans:
Mortgages		$ 278	$ 62	$ 486	$ 826	$ 95,859	$ 96,685	$ 110
Home Equity		295	20	174	489	83,643	84,132	23
Commercial		79	129	2,719	2,927	154,238	157,165	31
Agricultural		534	-	-	534	17,419	17,953	-
Construction		-	-	-	-	7,095	7,095	-
Consumer		25	11	3	39	11,265	11,304	3
Commercial and other loans		30	49	358	437	42,435	42,872	-
Other Agricultural Loans		-	-	-	-	6,679	6,679	-
State and political
subdivision loans		-	-	-	-	53,027	53,027	-

	Total	$ 1,241	$ 271	$ 3,740	$ 5,252	$ 471,660	$ 476,912	$ 167

		30-59 Days	60-89 Days	90 Days	Total Past		Total Financing	90 Days and
		Past Due	Past Due	Or Greater	Due	Current	Receivables	Accruing
December 31, 2010

Real estate loans:
Mortgages		$ 518	$ 50	$ 412	$ 980	$ 96,263	$ 97,243	$ 104
Home Equity		762	139	262	1,163	86,606	87,769	116
Commercial		188	1,647	1,827	3,662	148,837	152,499	426
Agricultural		-	-	-	-	19,078	19,078	-
Construction		-	-	-	-	9,766	9,766	-
Consumer		83	3	7	93	11,192	11,285	6
Commercial and other loans		111	6	398	515	39,686	40,201	40
Other Agricultural Loans		5	-	-	5	6,950	6,955
State and political
subdivision loans		-	-	-	-	48,721	48,721	-

	Total	$ 1,667	$ 1,845	$ 2,906	$ 6,418	$ 467,099	$ 473,517	$ 692

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 as noted above for impaired loans. In addition to the allowance for the pooled portfolios, management has developed a separate allowance for loans that are identified as impaired through a TDR. These loans are excluded from pooled portfolios and a separate allocation within the allowance for loan and lease losses is provided. Management continually evaluates loans that are considered troubled debt restructurings, 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 opertions. Based on this evaluation management would no longer consider a loan to be a troubled debt when the relevant facts support such a conclusion.

During the first six months of 2011, a loan modification for one customer, encompassing five loans, was completed that was considered a TDR. In exchange for additional collateral, the Bank agreed to lower the contractual interest rate on four of the loans through February 2020 at which time the loans will be paid in full or will pay an increased rate for an 11 additional years. All the loans associated with this customer are current through July 2011; however, the loans are considered non-accrual as of June 30, 2011.

The following table includes an analysis of loans modified that are considered TDR's and the primary modification made as of June 30, 2011 (in thousands):

	Recorded
	Investment, net of
	Allowance			Interest	Term
	Accruing	Non-accruing	Total	Modification	Modification
Real estate loans:
Mortgages	$ -	$ -	$ -	$ -	$ -
Home Equity	-	-	-	-	-
Commercial	-	5,845	5,845	5,730	115
Agricultural	-	-	-	-	-
Construction	-	-	-	-	-
Consumer	-	-	-	-	-
Commercial and other loans	-	3	3	-	3
Other Agricultural Loans	-	-	-	-	-
State and political	-	-	-	-	-
subdivision loans	-	-	-	-	-
Subtotal	-	5,848	5,848	5,730	118
Allowance	-	128	128	128	-
Total	$ -	$ 5,720	$ 5,720	$ 5,602	$ 118

Nonaccrual Loans

Loans are considered for non-accrual status upon reaching 90 days delinquency, unless the loan is well secured and in the process of collection, 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.

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

	June 30, 2011	December 31, 2010
Real estate loans:
Mortgages	$ 455	$ 309
Home Equity	151	193
Commercial	8,532	7,735
Agricultural	-	2,241
Construction	-	-
Consumer	-	1
Commercial and other	651	404
Other Agricultural	-	970
State and political subdivision	-	-
	$ 9,789	$ 11,853

Allowance for Loan Losses

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

	Six Months Ended
	June 30,
	2011	2010
Balance, at beginning of period	$ 5,915	$ 4,888
Provision charged to income	375	540
Recoveries on loans previously
charged against the allowance	36	124
	6,326	5,552
Loans charged against the allowance	(163)	(250)
Balance, at end of year	$ 6,163	$ 5,302

The Company allocates the allowance for loan and lease losses based on the factors described below, which conform to the Company's loan classification policy. In reviewing risk within the Bank's loan portfolio, management has determined there to be several different risk categories within the loan portfolio. The allowance for loan and lease losses 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.

We continually review the model utilized in calculating the required allowance. During the second quarter, 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 six months of 2011:

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

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

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

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

The changes in these qualitative factors resulted in a negative provision for residential real estate, construction and other commercial loans, while increasing the provision associated with commercial and agricultural real estate loans.

The following table rolls forward the balance of the allowance for loan and lease losses by portfolio segment from December 31, 2010 to June 30, 2011 and segregates the ending balance into the amount required for loans individually evaluated for impairment and the amount required for loans collectively evaluated for impairment as of June 30, 2011 (in thousands):

	Balance at December 31, 2010	Charge- offs	Recoveries	Provision	Balance at June 30, 2011	Individually evaluated for impairment	Collectively evaluated for impairment
Real estate loans:
Residential	$ 969	$ (101)	$ -	$ (190)	$ 678	$ 3	$ 675
Commercial and agricultural	3,380	(29)	-	561	3,912	323	3,589
Construction	22	-	-	(9)	13	-	13
Consumer	108	(33)	29	5	109	-	109
Commercial and other loans	983	-	7	(278)	712	103	609
State and political				-
subdivision loans	137	-	-	(18)	119	-	119
Unallocated	316	-	-	304	620	-	620
Total	$ 5,915	$ (163)	$ 36	$ 375	$ 6,163	$ 429	$ 5,734