UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q
(Mark One)
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT  OF 1934
For the quarterly period ended March 31, 2011
or

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _______________ to _________________________.

Commission file number: 000-16084

CITIZENS & NORTHERN CORPORATION
(Exact name of Registrant as specified in its charter)
PENNSYLVANIA
23-2451943
(State or other jurisdiction of
(I.R.S. Employer
incorporation or organization)
Identification No.)

90-92 MAIN STREET, WELLSBORO, PA 16901
(Address of principal executive offices)  (Zip code)
570-724-3411
(Registrant's telephone number including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes  x  No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  ¨  No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer ¨   Accelerated filer  x   Non-accelerated filer  ¨  Smaller reporting company ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ¨ No x

Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date.
Common Stock ($1.00 par value)
12,182,292 Shares Outstanding on May 5, 2011

 
 

 
 
CITIZENS & NORTHERN CORPORATION – FORM 10-Q
     
CITIZENS & NORTHERN CORPORATION
   
Index
   
     
Part I.  Financial Information
   
     
Item 1.  Financial Statements
   
     
Consolidated Balance Sheet – March 31, 2011 and December 31, 2010
 
Page    3
     
Consolidated Statement of Operations - Three Months Ended March 31, 2011 and 2010
 
Page    4
     
Consolidated Statement of Cash Flows - Three Months Ended March 31, 2011 and 2010
 
Page    5
     
Consolidated Statement of Changes in Stockholders’ Equity- Three Months Ended March 31, 2011 and 2010
 
Page    6
     
Notes to Consolidated Financial Statements
 
Pages 7 - 29
     
Item 2.  Management's Discussion and Analysis of Financial Condition and Results of Operations
 
Pages 30 - 45
     
Item 3.  Quantitative and Qualitative Disclosures About Market Risk
 
Pages 46 - 49
     
Item 4.  Controls and Procedures
 
Page  49
     
Part II.  Other Information
 
Pages  50 - 51
     
Signatures
 
Page  52
     
Exhibit 31.1.  Rule 13a-14(a)/15d-14(a) Certification - Chief Executive Officer
 
Page  53
     
Exhibit 31.2.  Rule 13a-14(a)/15d-14(a) Certification - Chief Financial Officer
 
Page  54
     
Exhibit 32.  Section 1350 Certifications
 
Page  55

 
2

 
 
CITIZENS & NORTHERN CORPORATION – FORM 10-Q

PART 1 - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS

CONSOLIDATED BALANCE SHEET (Unaudited)
 
March 31,
   
December 31,
 
(In Thousands Except Share Data)
 
2011
   
2010
 
             
ASSETS
           
Cash and due from banks:
           
Noninterest-bearing
  $ 14,797     $ 16,840  
Interest-bearing
    44,481       29,461  
Total cash and cash equivalents
    59,278       46,301  
Available-for-sale securities
    452,974       443,956  
Loans held for sale
    135       5,247  
                 
Loans receivable
    718,959       730,411  
Allowance for loan losses
    (8,846 )     (9,107 )
Loans, net
    710,113       721,304  
                 
Bank-owned life insurance
    21,944       21,822  
Accrued interest receivable
    5,357       4,960  
Bank premises and equipment, net
    22,186       22,636  
Foreclosed assets held for sale
    707       537  
Deferred tax asset, net
    12,807       16,054  
Intangible asset - Core deposit intangibles
    297       326  
Intangible asset - Goodwill
    11,942       11,942  
Other assets
    18,469       21,503  
TOTAL ASSETS
  $ 1,316,209     $ 1,316,588  
                 
LIABILITIES
               
Deposits:
               
Noninterest-bearing
  $ 180,824     $ 158,767  
Interest-bearing
    829,177       845,581  
Total deposits
    1,010,001       1,004,348  
Short-term borrowings
    16,068       18,413  
Long-term borrowings
    138,340       148,495  
Accrued interest and other liabilities
    5,747       6,388  
TOTAL LIABILITIES
    1,170,156       1,177,644  
                 
STOCKHOLDERS' EQUITY
               
Common stock, par value $1.00 per share; authorized 20,000,000 shares in 2011 and 2010; issued 12,420,365 at March 31, 2011 and 12,408,212 at December 31, 2010
    12,420       12,408  
Paid-in capital
    66,739       66,648  
Retained earnings
    69,894       65,920  
Treasury stock, at cost; 238,953 shares at March 31, 2011 and 254,614 shares at December 31, 2010
    (4,158 )     (4,431 )
Sub-total
    144,895       140,545  
Accumulated other comprehensive income (loss):
               
Unrealized gains (losses) on available-for-sale securities
    1,478       (1,351 )
Defined benefit plans
    (320 )     (250 )
Total accumulated other comprehensive income (loss)
    1,158       (1,601 )
TOTAL STOCKHOLDERS' EQUITY
    146,053       138,944  
TOTAL LIABILITIES & STOCKHOLDERS' EQUITY
  $ 1,316,209     $ 1,316,588  

The accompanying notes are an integral part of these consolidated financial statements.

 
3

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

CONSOLIDATED STATEMENT OF OPERATIONS
           
(In Thousands, Except Per Share Data)   (Unaudited)
 
Three Months Ended
 
 
 
March 31, 2011
   
March 31, 2010
 
INTEREST INCOME
           
Interest and fees on loans
  $ 10,868     $ 10,950  
Interest on balances with depository institutions
    16       38  
Interest on loans to political subdivisions
    375       398  
Interest on trading securities
    0       1  
Income from available-for-sale and held-to-maturity securities:
               
Taxable
    2,693       3,085  
Tax-exempt
    1,284       1,181  
Dividends
    62       80  
Total interest and dividend income
    15,298       15,733  
INTEREST EXPENSE
               
Interest on deposits
    2,568       3,157  
Interest on short-term borrowings
    6       100  
Interest on long-term borrowings
    1,442       2,003  
Total interest expense
    4,016       5,260  
Net interest income
    11,282       10,473  
(Credit) provision for loan losses
    (192 )     207  
Net interest income after (credit) provision for loan losses
    11,474       10,266  
OTHER INCOME
               
Service charges on deposit accounts
    1,131       1,093  
Service charges and fees
    218       193  
Trust and financial management revenue
    877       899  
Interchange revenue from debit card transactions
    452       375  
Net gains from sale of loans
    259       66  
Increase in cash surrender value of life insurance
    122       112  
Insurance commissions, fees and premiums
    68       60  
Impairment loss on limited partnership investment
    (948 )     0  
Other operating income
    376       750  
Sub-total
    2,555       3,548  
Total other-than-temporary impairment losses on available-for-sale securities
    0       (381 )
Portion of (gain) recognized in other comprehensive income (before taxes)
    0       (50 )
Net impairment losses recognized in earnings
    0       (431 )
Realized gains on available-for-sale securities, net
    1,839       489  
Net realized gains on available-for-sale securities
    1,839       58  
Total other income
    4,394       3,606  
OTHER EXPENSES
               
Salaries and wages
    3,401       3,078  
Pensions and other employee benefits
    1,306       939  
Occupancy expense, net
    732       699  
Furniture and equipment expense
    484       568  
FDIC Assessments
    325       404  
Pennsylvania shares tax
    319       305  
Other operating expense
    1,696       2,004  
Total other expenses
    8,263       7,997  
Income before income tax provision
    7,605       5,875  
Income tax provision
    2,064       1,437  
Net income
    5,541       4,438  
U.S. Treasury preferred dividends
    0       373  
NET INCOME AVAILABLE TO COMMON SHAREHOLDERS
  $ 5,541     $ 4,065  
NET INCOME PER SHARE - BASIC
  $ 0.46     $ 0.34  
NET INCOME PER SHARE - DILUTED
  $ 0.45     $ 0.34  

The accompanying notes are an integral part of the consolidated financial statements.

 
4

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

CONSOLIDATED STATEMENT OF CASH FLOWS
 
Three Months Ended March 31,
 
(In Thousands) (Unaudited)
 
2011
   
2010
 
CASH FLOWS FROM OPERATING ACTIVITIES:
           
Net income
  $ 5,541     $ 4,438  
Adjustments to reconcile net income to net cash provided by operating activities:
               
(Credit) provision for loan losses
    (192 )     207  
Realized gains on available-for-sale securities, net
    (1,839 )     (58 )
Loss on sale of foreclosed assets, net
    19       38  
Depreciation expense
    536       612  
Gain on disposition of premises and equipment
    0       (430 )
Accretion and amortization on securities, net
    446       609  
Accretion and amortization on loans, deposits and borrowings, net
    (8 )     (76 )
Amortization of mortgage servicing rights
    13       0  
Impairment loss on limited partnership investment
    948       0  
Increase in cash surrender value of life insurance
    (122 )     (112 )
Stock-based compensation
    192       13  
Amortization of core deposit intangibles
    29       44  
Deferred income taxes
    1,826       128  
Gains on sales of mortgage loans, net
    (259 )     (66 )
Origination of mortgage loans for sale
    (4,529 )     (5,606 )
Proceeds from sales of mortgage loans
    9,798       5,718  
Net decrease in trading securities
    0       1,045  
Decrease (increase) in accrued interest receivable and other assets
    1,396       (164 )
(Decrease) in accrued interest payable and other liabilities
    (844 )     (32 )
Net Cash Provided by Operating Activities
    12,951       6,308  
CASH FLOWS FROM INVESTING ACTIVITIES:
               
Proceeds from maturity of held-to-maturity securities
    0       300  
Proceeds from sales of available-for-sale securities
    15,950       9,140  
Proceeds from calls and maturities of available-for-sale securities
    26,781       44,617  
Purchase of available-for-sale securities
    (46,069 )     (97,858 )
Redemption of Federal Home Loan Bank of Pittsburgh stock
    408       0  
Net decrease in loans
    11,207       1,054  
Purchase of premises and equipment
    (86 )     (228 )
Proceeds from disposition of premises and equipment
    0       100  
Return of principal on limited partnership investment
    70       13  
Proceeds from sale of foreclosed assets
    0       221  
Net Cash Provided by (Used in) Investing Activities
    8,261       (42,641 )
CASH FLOWS FROM FINANCING ACTIVITIES:
               
Net increase in deposits
    5,648       25,677  
Net decrease in short-term borrowings
    (2,345 )     (2,786 )
Proceeds from long-term borrowings
    0       0  
Repayments of long-term borrowings
    (10,155 )     (149 )
Sale of treasury stock
    3       0  
Tax benefit from compensation plans
    15       0  
US Treasury preferred dividends paid
    0       (331 )
Common dividends paid
    (1,401 )     (969 )
Net Cash (Used in) Provided by Financing Activities
    (8,235 )     21,442  
INCREASE (DECREASE) IN CASH  AND CASH EQUIVALENTS
    12,977       (14,891 )
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR
    46,301       92,065  
CASH AND CASH EQUIVALENTS, END OF PERIOD
  $ 59,278     $ 77,174  
                 
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
               
Assets acquired through foreclosure of real estate loans
  $ 189     $ 55  
Interest paid
  $ 4,049     $ 5,340  
Income taxes paid
  $ 4     $ 28  

The accompanying notes are an integral part of these consolidated financial statements.

 
5

 
 
CITIZENS & NORTHERN CORPORATION – FORM 10-Q

Consolidated Statement of Changes in Stockholders' Equity
Three Months Ended March 31, 2011 and 2010
(In Thousands Except Per Share Data)
                         
Accum. Other
             
(Unaudited)
 
Preferred
   
Common
   
Paid-in
   
Retained
   
Comprehensive
   
Treasury
       
   
Stock
   
Stock
   
Capital
   
Earnings
   
Income (Loss)
   
Stock
   
Total
 
Three Months Ended March 31, 2011:
                                         
Balance, December 31, 2010
  $ 0     $ 12,408     $ 66,648     $ 65,920     $ (1,601 )   $ (4,431 )   $ 138,944  
Comprehensive income:
                                                       
Net income
                            5,541                       5,541  
Unrealized gain on securities, net of reclassification and tax
                                    2,829               2,829  
Other comprehensive loss related to defined benefit plans
                                    (70 )             (70 )
Total comprehensive income
                                                    8,300  
Cash dividends declared on common stock, $.13 per share
                            (1,582 )                     (1,582 )
Shares issued for dividend reinvestment plan
            12       169                               181  
Shares issued from treasury related to exercise of stock options
                    (1 )                     4       3  
Restricted stock granted
                    (272 )                     272       0  
Forfeiture of restricted stock
                    3                       (3 )     0  
Stock-based compensation expense
                    192                               192  
Tax benefit from employee benefit plan
                            15                       15  
Balance, March 31, 2011
  $ 0     $ 12,420     $ 66,739     $ 69,894     $ 1,158     $ (4,158 )   $ 146,053  
Three Months Ended March 31, 2010:
                                                       
Balance, December 31, 2009
  $ 25,749     $ 12,374     $ 66,726     $ 53,027     $ (891 )   $ (4,575 )   $ 152,410  
Comprehensive income:
                                                       
Net income
                            4,438                       4,438  
Unrealized loss on securities, net of reclassification and tax
                                    (196 )             (196 )
Other comprehensive income related to defined benefit plans
                                    119               119  
Total comprehensive income
                                                    4,361  
Accretion of discount associated with U.S. Treasury preferred stock
    42                       (42 )                     0  
Cash dividends on U.S. Treasury preferred stock
                            (331 )                     (331 )
Cash dividends declared on common stock, $.08 per share
                            (969 )                     (969 )
Restricted stock granted
                    (159 )                     159       0  
Forfeiture of restricted stock
                    13                       (13 )     0  
Stock-based compensation expense
                    13                               13  
Balance, March 31, 2010
  $ 25,791     $ 12,374     $ 66,593     $ 56,123     $ (968 )   $ (4,429 )   $ 155,484  
                                                         
The accompanying notes are an integral part of these consolidated financial statements.

 
6

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

Notes to Consolidated Financial Statements

1. BASIS OF INTERIM PRESENTATION

The consolidated financial information included herein, with the exception of the consolidated balance sheet dated December 31, 2010, is unaudited. Such information reflects all adjustments (consisting solely of normal recurring adjustments) that are, in the opinion of management, necessary for a fair presentation of the financial position, results of operations, cash flows and changes in stockholders’ equity for the interim periods; however, the information does not include all disclosures required by accounting principles generally accepted in the United States of America (“U.S. GAAP”) for a complete set of financial statements.  Certain 2010 information has been reclassified for consistency with the 2011 presentation.

Operating results reported for the three-months ended March 31, 2011 might not be indicative of the results for the year ending December 31, 2011. The Corporation evaluates subsequent events through the date of filing with the Securities and Exchange Commission.

2. PER COMMON SHARE DATA

Net income per share is based on the weighted-average number of shares of common stock outstanding.  The following data show the amounts used in computing basic and diluted net income per share.  As shown in the table that follows, diluted earnings per share is computed using weighted average common shares outstanding, plus weighted-average common shares available from the exercise of all dilutive stock options, less the number of shares that could be repurchased with the proceeds of stock option exercises based on the average share price of the Corporation's common stock during the period.  Weighted average common shares available from stock options and a warrant totaling 226,426 shares in the three-month period ended March 31, 2011 and 480,408 shares in the three-month period March 31, 2010 were not included in the calculation because their effects were anti-dilutive.

         
Weighted-
       
         
Average
   
Earnings
 
   
Net
   
Common
   
Per
 
   
Income
   
Shares
   
Share
 
Quarter Ended March 31, 2011
                 
                         
Earnings per common share – basic
  $ 5,541,000       12,174,935     $ 0.46  
                         
Dilutive effect of potential common stock arising from stock options:
                       
Exercise of outstanding stock options
            255,727          
Hypothetical share repurchase at $ 15.58
            (252,563 )        
Earnings per common share – diluted
  $ 5,541,000       12,178,099     $ 0.45  
                         
Quarter Ended March 31, 2010
                       
Earnings per common share – basic and diluted
  $ 4,065,000       12,113,584     $ 0.34  

 
7

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

3. COMPREHENSIVE INCOME

Comprehensive income is the total of (1) net income, and (2) all other changes in equity from non-stockholder sources, which are referred to as other comprehensive income.  The components of comprehensive income , and the related tax effects, are as follows:
 
(In Thousands)
 
3 Months Ended
 
   
March 31,
 
   
2011
   
2010
 
Net income
  $ 5,541     $ 4,438  
                 
Unrealized gains (losses) on available-for-sale securities:
               
Unrealized holding gains (losses) on available-for-sale securities
    6,125       (247 )
Reclassification adjustment for gains realized in income
    (1,839 )     (58 )
Other comprehensive gain (loss) before income tax
    4,286       (305 )
Income tax related to other comprehensive gain (loss)
    1,457       (109 )
Other comprehensive gain (loss) on available-for-sale securities
    2,829       (196 )
                 
Unfunded pension and postretirement obligations:
               
Change in items from defined benefit plans included in accumulated other comprehensive income
    (119 )     166  
Amortization of net transition obligation, prior service cost and net actuarial loss included in net periodic benefit cost
    13       14  
Other comprehensive (loss) gain before income tax
    (106 )     180  
Income tax related to other comprehensive (loss) gain
    (36 )     61  
Other comprehensive (loss) gain on unfunded retirement obligations
    (70 )     119  
                 
Net other comprehensive gain (loss)
    2,759       (77 )
                 
Total comprehensive income
  $ 8,300     $ 4,361  

In the three months ended March 31, 2010, the Corporation recognized other comprehensive income of $50,000 before income tax ($33,000 after income tax) related to available-for-sale debt securities for which a portion of an other-than-temporary impairment (OTTI) loss has been recognized in earnings.

4. FAIR VALUE MEASUREMENTS AND FAIR VALUES OF FINANCIAL INSTRUMENTS

The Corporation measures certain assets at fair value on a recurring basis.  Fair value is defined as the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date.  FASB ASC topic 820, “Fair Value Measurements and Disclosures” (formerly Statement of Financial Accounting Standards No. 157) establishes a framework for measuring fair value that includes a hierarchy used to classify the inputs used in measuring fair value.  The hierarchy prioritizes the inputs used in determining valuations into three levels.  The level in the fair value hierarchy within which the fair value measurement falls is determined based on the lowest level input that is significant to the fair value measurement.  The levels of the fair value hierarchy are as follows:

Level 1 – Fair value is based on unadjusted quoted prices in active markets that are accessible to the Corporation for identical assets.  These generally provide the most reliable evidence and are used to measure fair value whenever available.

Level 2 – Fair value is based on significant inputs, other than Level 1 inputs, that are observable either directly or indirectly for substantially the full term of the asset through corroboration with observable market data.  Level 2 inputs include quoted market prices in active markets for similar assets, quoted market prices in markets that are not active for identical or similar assets and other observable inputs.

Level 3 – Fair value is based on significant unobservable inputs.  Examples of valuation methodologies that would result in Level 3 classification include option pricing models, discounted cash flows and other similar techniques.

 
8

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

At March 31, 2011 and December 31, 2010, assets measured at fair value on a recurring basis and the valuation methods used are as follows:

         
March 31, 2011
       
         
Market Values Based on:
       
   
Quoted Prices
   
Other
             
   
in Active
   
Observable
   
Unobservable
   
Total
 
   
Markets
   
Inputs
   
Inputs
   
Fair
 
(In Thousands)
 
(Level 1)
   
(Level 2)
   
(Level 3)
   
Value
 
                         
AVAILABLE-FOR-SALE SECURITIES:
                       
Obligations of U.S. Government agencies
  $ 0     $ 37,129     $ 0     $ 37,129  
Obligations of states and political subdivisions:
                               
Tax-exempt
    0       121,789       0       121,789  
Taxable
    0       11,507       0       11,507  
Mortgage-backed securities
    0       103,627       0       103,627  
Collateralized mortgage obligations, Issued by U.S. Government agencies
    0       153,558       0       153,558  
Corporate bonds
    0       1,019       0       1,019  
Trust preferred securities issued by individual institutions
    0       8,040       0       8,040  
Collateralized debt obligations:
                               
Pooled trust preferred securities - senior tranches
    0       0       9,038       9,038  
Other collateralized debt obligations
    0       681       0       681  
Total debt securities
    0       437,350       9,038       446,388  
Marketable equity securities
    6,586       0       0       6,586  
Total available-for-sale securities
  $ 6,586     $ 437,350     $ 9,038     $ 452,974  

         
December 31, 2010
       
         
Market Values Based on:
       
   
Quoted Prices
   
Other
             
   
in Active
   
Observable
   
Unobservable
   
Total
 
   
Markets
   
Inputs
   
Inputs
   
Fair
 
(In Thousands)
 
(Level 1)
   
(Level 2)
   
(Level 3)
   
Value
 
                         
AVAILABLE-FOR-SALE SECURITIES:
                       
Obligations of U.S. Government agencies
  $ 0     $ 44,247     $ 0     $ 44,247  
Obligations of states and political subdivisions:
                               
Tax-exempt
    4,574       115,301       0       119,875  
Taxable
    1,125       6,542       0       7,667  
Mortgage-backed securities
    0       118,386       0       118,386  
Collateralized mortgage obligations, Issued by U.S. Government agencies
    9,117       121,709       0       130,826  
Corporate bonds
    0       1,027       0       1,027  
Trust preferred securities issued by individual institutions
    0       7,838       0       7,838  
Collateralized debt obligations:
                               
Pooled trust preferred securities - senior tranches
    0       0       7,400       7,400  
Other collateralized debt obligations
    0       681       0       681  
Total debt securities
    14,816       415,731       7,400       437,947  
Marketable equity securities
    6,009       0       0       6,009  
Total available-for-sale securities
  $ 20,825     $ 415,731     $ 7,400     $ 443,956  

 
9

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q
 
Debt securities with a fair value of $14,816,000 at December 31, 2010 were transferred from Level 1 to Level 2 in the first quarter 2011 in the table above.  These securities were purchased in the month of December 2010, and their fair values at December 31, 2010 were determined based on the Corporation’s purchase prices.  The fair values of these securities were determined at March 31, 2011 based on price estimates provided by an independent valuation service based on Level 2 inputs.

Management determined there have been few trades of pooled trust-preferred securities since the first half of 2008, except for a limited number of transactions that have taken place as a result of bankruptcies, forced liquidations or similar circumstances.  Also, in management’s judgment, there were no available quoted market prices in active markets for assets sufficiently similar to the Corporation’s pooled trust-preferred securities to be reliable as observable inputs.  Accordingly, in the third quarter of 2008, the Corporation changed its method of valuing pooled trust-preferred securities from a Level 2 methodology that had been used in prior periods, based on price quotes received from pricing services, to a Level 3 methodology, using discounted cash flows.

Management has calculated the fair value of the Corporation’s senior tranche pooled trust-preferred security by applying a discount rate to the estimated cash flows.  At March 31, 2011, the estimate of cash flows from the senior tranche security changed significantly from the estimate as of December 31, 2010 based on the level and timing of assumed prepayments that changed for some of the underlying issuers. The change in prepayments resulted in an increase in fair value at March 31, 2011 as compared to December 31, 2010 as reflected in the unrealized gain on Level 3 assets of $1,658,000 in the first quarter 2011 in the table below.  Management used the cash flow estimates determined using the process described in Note 5 for evaluating pooled trust-preferred securities for other-than-temporary impairment (OTTI).  Management used a discount rate considered reflective of a market participant’s expectations regarding the extent of credit and liquidity risk inherent in the security.  In establishing the discount rate, management considered: (1) the implied discount rate as of the end of 2007, prior to the market for trust-preferred securities becoming inactive; (2) adjustment to the year-end 2007 discount rate for the change in the spread between indicative market rates over corresponding risk-free rates; and (3) an additional adjustment – an increase of 2% in the discount rate – for liquidity risk.  Management considered the additional 2% increase in the discount rate necessary in order to give some consideration to price estimates based on trades made under distressed conditions, as reported by brokers and pricing services.  Management’s estimate of cash flows and the discount rate used to calculate the fair value of the pooled trust-preferred security were based on sensitive assumptions, and market participants might use substantially different assumptions, which could result in calculations of a fair value that would be substantially different than the amount calculated by management.

Following is a reconciliation of activity for available-for-sale securities measured at fair value based on significant unobservable information:
   
Three Months Ended
 
   
Mar. 31,
   
Mar. 31,
 
   
2011
   
2010
 
   
(Current)
   
(Prior Year)
 
Balance, beginning of period
  $ 7,400     $ 9,114  
Accretion and amortization, net
    (20 )     (178 )
Proceeds from sales
    (25 )     0  
Realized gains, net
    25       0  
Unrealized losses included in earnings
    0       (421 )
Unrealized gains included in other comprehensive income
    1,658       37  
Balance, end of period
  $ 9,038     $ 8,552  

Unrealized losses included in earnings are from the Corporation’s other-than-temporary impairment analysis of securities, as described in Note 5, and are included in net impairment losses recognized in earnings in the consolidated statement of operations.
 
Assets measured at fair value on a nonrecurring basis include impaired commercial loans, foreclosed real estate assets held for sale and servicing rights.  All of the Corporation’s impaired commercial loans for which a valuation allowance was necessary at March 31, 2011 and December 31, 2010 were valued based on the estimated amount of net proceeds from liquidation of real estate and other collateral, or based on the estimated present value of cash flows to be received.  The Corporation considers the fair value of such impaired commercial loans to be based on unobservable inputs (Level 3), and the balance of impaired loans for which a valuation allowance was recorded, net of allowance for loan losses, was $2,841,000 at March 31, 2011 and $3,169,000 at December 31, 2010.  Similarly, the carrying values of foreclosed real estate assets held for sale were based on unobservable inputs (Level 3), with a balance of $707,000 at March 31, 2011 and $537,000 at December 31, 2010.  The carrying value of servicing rights was also based on unobservable inputs (Level 3) and was $293,000 at March 31, 2011 and $204,000 at December 31, 2010.

 
10

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q
 
Certain of the Corporation’s financial instruments are not measured at fair value in the consolidated financial statements.  In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument. Certain financial instruments and all nonfinancial instruments are excluded from disclosure requirements. Therefore, the aggregate fair value amounts presented may not represent the underlying fair value of the Corporation.

The Corporation used the following methods and assumptions in estimating fair value disclosures for financial instruments:

CASH AND CASH EQUIVALENTS - The carrying amounts of cash and short-term instruments approximate fair values.

SECURITIES - Fair values for securities, excluding restricted equity securities, are based on quoted market prices or other methods as described above. The carrying value of restricted equity securities approximates fair value based on applicable redemption provisions.

LOANS HELD FOR SALE - Fair values of loans held for sale are determined based on applicable sales price available under the Federal Home Loan Banks’ MPF Xtra program.

LOANS - Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, commercial real estate, residential mortgage and other consumer. Each loan category is further segmented into fixed and adjustable rate interest terms and by performing and nonperforming categories. The fair value of performing loans is calculated by discounting contractual cash flows, adjusted for estimated prepayments based on historical experience, using estimated market discount rates that reflect the credit and interest rate risk inherent in the loans. Fair value of nonperforming loans is based on recent appraisals or estimates prepared by the Corporation’s lending officers.

SERVICING RIGHTS – The fair value of servicing rights is determined through a discounted cash flow valuation.  Significant inputs include expected net servicing income, the discount rate and the expected life of the underlying loans.

DEPOSITS - The fair value of deposits with no stated maturity, such as noninterest-bearing demand deposits, savings, money market and interest checking accounts, is (by definition) equal to the amount payable on demand at March 31, 2011 and December 31, 2010. The fair value of all other deposit categories is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities.  The fair value estimates of deposits do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market, commonly referred to as the core deposit intangible.

BORROWED FUNDS - The fair value of borrowings is estimated using discounted cash flow analyses based on rates currently available to the Corporation for similar types of borrowing arrangements.

ACCRUED INTEREST - The carrying amounts of accrued interest receivable and payable approximate fair values.

OFF-BALANCE SHEET COMMITMENTS - The Corporation has commitments to extend credit and has issued standby letters of credit.  Standby letters of credit are conditional guarantees of performance by a customer to a third party.  Estimates of the fair value of these off-balance sheet items were not made because of the short-term nature of these arrangements and the credit standing of the counterparties.

 
11

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

The estimated fair values, and related carrying amounts, of the Corporation’s financial instruments are as follows:

(In Thousands)
 
March 31, 2011
   
December 31, 2010
 
   
Carrying
   
Fair
   
Carrying
   
Fair
 
   
Amount
   
Value
   
Amount
   
Value
 
Financial assets:
                       
Cash and cash equivalents
  $ 59,278     $ 59,278     $ 46,301     $ 46,301  
Available-for-sale securities
    452,974       452,974       443,956       443,956  
Restricted equity securities, included in other assets
    7,878       7,878       8,286       8,286  
Loans held for sale
    135       135       5,247       5,249  
Loans, net
    710,113       714,310       721,304       728,744  
Accrued interest receivable
    5,357       5,357       4,960       4,960  
Servicing rights
    293       293       204       204  
                                 
Financial liabilities:
                               
Deposits
    1,010,001       1,015,713       1,004,348       1,012,247  
Short-term borrowings
    16,068       15,803       18,413       18,240  
Long-term borrowings
    138,340       158,719       148,495       171,877  
Accrued interest payable
    392       392       430       430  

5. SECURITIES

Amortized cost and fair value of available-for-sale securities at March 31, 2011 and December 31, 2010 are summarized as follows:
         
March 31, 2011
       
         
Gross
   
Gross
       
         
Unrealized
   
Unrealized
       
   
Amortized
   
Holding
   
Holding
   
Fair
 
(In Thousands)
 
Cost
   
Gains
   
Losses
   
Value
 
                         
Obligations of U.S. Government agencies
  $ 36,963     $ 196     $ (30 )   $ 37,129  
Obligations of states and political subdivisions:
                               
Tax-exempt
    127,107       899       (6,217 )     121,789  
Taxable
    11,676       3       (172 )     11,507  
Mortgage-backed securities
    99,220       4,585       (178 )     103,627  
Collateralized mortgage obligations, Issued by U.S. Government agencies
    152,718       1,368       (528 )     153,558  
Corporate bonds
    1,000       19       0       1,019  
Trust preferred securities issued by individual institutions
    6,640       1,565       (165 )     8,040  
Collateralized debt obligations:
                               
Pooled trust preferred securities - senior tranches
    9,937       0       (899 )     9,038  
Other collateralized debt obligations
    681       0       0       681  
Total debt securities
    445,942       8,635       (8,189 )     446,388  
Marketable equity securities
    4,789       1,859       (62 )     6,586  
Total
  $ 450,731     $ 10,494     $ (8,251 )   $ 452,974  

 
12

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

    December 31, 2010  
         
Gross
   
Gross
       
         
Unrealized
   
Unrealized
       
   
Amortized
   
Holding
   
Holding
   
Fair
 
(In Thousands)
 
Cost
   
Gains
   
Losses
   
Value
 
                         
Obligations of U.S. Government agencies
  $ 44,005     $ 270     $ (28 )   $ 44,247  
Obligations of states and political subdivisions:
                               
Tax-exempt
    127,210       546       (7,882 )     119,874  
Taxable
    7,808       1       (141 )     7,668  
Mortgage-backed securities
    113,176       5,381       (171 )     118,386  
Collateralized mortgage obligations, Issued by U.S. Government agencies
    131,040       869       (1,083 )     130,826  
Corporate bonds
    1,000       27       0       1,027  
Trust preferred securities issued by individual institutions
    6,535       1,694       (391 )     7,838  
Collateralized debt obligations:
                               
Pooled trust preferred securities - senior tranches
    9,957       0       (2,557 )     7,400  
Other collateralized debt obligations
    681       0       0       681  
Total debt securities
    441,412       8,788       (12,253 )     437,947  
Marketable equity securities
    4,589       1,496       (76 )     6,009  
Total
  $ 446,001     $ 10,284     $ (12,329 )   $ 443,956  

The following table presents gross unrealized losses and fair value of available-for-sale securities with unrealized loss positions that are not deemed to be other-than-temporarily impaired, aggregated by length of time that individual securities have been in a continuous unrealized loss position at March 31, 2011 and December 31, 2010:

March 31, 2011
 
Less Than 12 Months
   
12 Months or More
   
Total
 
(In Thousands)
 
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
 
   
Value
   
Losses
   
Value
   
Losses
   
Value
   
Losses
 
                                     
Obligations of U.S. Government agencies
  $ 17,860     $ (30 )   $ 0     $ 0     $ 17,860     $ (30 )
Obligations of states and political subdivisions:
                                               
Tax-exempt
    48,318       (1,933 )     29,703       (4,284 )     78,021       (6,217 )
Taxable
    10,492       (172 )     0       0       10,492       (172 )
Mortgage-backed securities
    13,186       (178 )     0       0       13,186       (178 )
Collateralized mortgage obligations, Issued by U.S. Government agencies
    40,551       (528 )     0       0       40,551       (528 )
Trust preferred securities issued by individual institutions
    0       0       6,044       (165 )     6,044       (165 )
Collateralized debt obligations:
                                               
Pooled trust preferred securities - senior tranches
    0       0       9,038       (899 )     9,038       (899 )
Total debt securities
    130,407       (2,841 )     44,785       (5,348 )     175,192       (8,189 )
Marketable equity securities
    328       (62 )     0       0       328       (62 )
Total temporarily impaired available-for-sale securities
  $ 130,735     $ (2,903 )   $ 44,785     $ (5,348 )   $ 175,520     $ (8,251 )

 
13

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

December 31, 2010
 
Less Than 12 Months
   
12 Months or More
   
Total
 
(In Thousands)
 
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
 
   
Value
   
Losses
   
Value
   
Losses
   
Value
   
Losses
 
                                     
Obligations of U.S. Government agencies
  $ 10,230     $ (28 )   $ 0     $ 0     $ 10,230     $ (28 )
Obligations of states and political subdivisions:
                                               
Tax-exempt
    53,119       (2,533 )     28,622       (5,349 )     81,741       (7,882 )
Taxable
    6,542       (141 )     0       0       6,542       (141 )
Mortgage-backed securities
    13,141       (171 )     0       0       13,141       (171 )
Collateralized mortgage obligations,
                                               
Issued by U.S. Government agencies
    56,257       (1,083 )     0       0       56,257       (1,083 )
Trust preferred securities issued by individual institutions
    0       0       5,825       (391 )     5,825       (391 )
Collateralized debt obligations:
                                               
Pooled trust preferred securities - senior tranches
    0       0       7,400       (2,557 )     7,400       (2,557 )
Total debt securities
    139,289       (3,956 )     41,847       (8,297 )     181,136       (12,253 )
Marketable equity securities
    710       (76 )     0       0       710       (76 )
Total temporarily impaired available-for-sale securities
  $ 139,999     $ (4,032 )   $ 41,847     $ (8,297 )   $ 181,846     $ (12,329 )

Gross realized gains and losses from available-for-sale securities (including OTTI losses in gross realized losses) and the related income tax provision were as follows:
   
Three Months Ended
 
(In Thousands) 
 
Mar. 31,
   
Mar. 31,
 
   
2011
   
2010
 
Gross realized gains
  $ 1,840     $ 491  
Gross realized losses
    (1 )     (433 )
Net realized gains
  $ 1,839     $ 58  
Income tax provision related to net realized gains
  $ 625     $ 20  

The maturities of available-for-sale debt securities at March 31, 2011 are summarized as follows:

   
Amortized
   
Fair
 
(In Thousands)
 
Cost
   
Value
 
             
Due in one year or less
  $ 6,074     $ 6,120  
Due after one year through five years
    53,050       54,711  
Due after five years through ten years
    64,631       64,614  
Due after ten years
    322,187       320,943  
Total
  $ 445,942     $ 446,388  

Management evaluates securities for OTTI at least on a quarterly basis, and more frequently when economic or market conditions warrant such evaluation. Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) whether the Corporation intends to sell the security or more likely than not will be required to sell the security before its anticipated recovery.

The Corporation recognized net impairment losses in earnings, as follows:
   
Three Months Ended
 
(In Thousands)
 
Mar. 31,
   
Mar. 31,
 
   
2011
   
2010
 
Trust preferred securities issued by individual institutions
  $ 0     $ (320 )
Pooled trust preferred securities - mezzanine tranches
    0       (101 )
Marketable equity securities (bank stocks)
    0       (10 )
Net impairment losses recognized in earnings
  $ 0     $ (431 )

 
14

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

A summary of information management considered in evaluating debt and equity securities for OTTI at March 31, 2011 is provided below.

Debt Securities

At March 31, 2011, management performed an assessment for possible OTTI of the Corporation’s debt securities on an issue-by-issue basis, relying on information obtained from various sources, including publicly available financial data, ratings by external agencies, brokers and other sources.  The extent of individual analysis applied to each security depended on the size of the Corporation’s investment, as well as management’s perception of the credit risk associated with each security.  Based on the results of the assessment, management believes impairment of these debt securities, including municipal bonds with no external ratings, at March 31, 2011 to be temporary.

The credit rating agencies have withdrawn their ratings on numerous municipal bonds held by the Corporation. At March 31, 2011, the total amortized cost basis of municipal bonds with no external credit ratings was $25,073,000, with an aggregate unrealized loss of $2,524,000.  At the time of purchase, each of these bonds was considered investment grade and had been rated by at least one credit rating agency. The bonds for which the ratings were removed were almost all insured by an entity that has reported significant financial problems and declines in its regulatory capital ratios.  However, the insurance remains in effect on the bonds, and none of the affected municipal bonds has failed to make a scheduled interest payment.

The following table provides information related to trust preferred securities issued by individual institutions as of       March 31, 2011:

(In Thousands)
                             
Moody's/
                         
Cumulative
   
S&P/
                   
Unrealized
   
Realized
   
Fitch
       
Amortized
   
Fair
   
Gain
   
Credit
   
Credit
Name of Issuer
 
Issuer's Parent Company
 
Cost
   
Value
   
(Loss)
   
Losses
   
Ratings
Astoria Capital Trust I
 
Astoria Financial Corporation
  $ 5,209     $ 5,187     $ (22 )   $ 0    
Baa3/BB-/BB-
Carolina First Mortgage Loan Trust
 
The Toronto-Dominion Bank
  $ 431     $ 1,996       1,565       (1,769 )  
NR
Patriot Capital Trust I
 
Susquehanna Bancshares, Inc.
  $ 1,000     $ 857       (143 )     0    
NR
Total
      $ 6,640     $ 8,040     $ 1,400     $ (1,769 )    

NR = not rated.

Management assesses each of the trust preferred securities issued by individual institutions for the possibility of OTTI by reviewing financial information that is publicly available.  Neither Astoria Financial Corporation nor Susquehanna Bancshares, Inc. has deferred or defaulted on payments associated with the Corporation’s securities.

The Corporation recognized OTTI charges in 2009 and 2010 related to the Carolina First Mortgage Loan Trust security. In the fourth quarter 2010, The Toronto-Dominion Bank acquired The South Financial Group, Inc., the parent company of Carolina First. After the acquisition, The Toronto-Dominion Bank made a payment for the full amount of previously deferred interest and resumed quarterly payments on the security. The Corporation recognized a material change in the expected cash flows in the fourth quarter 2010. The Corporation recorded $112,000 in accretion income during the first quarter 2011. Management expects to record accretion income to offset the previous OTTI charges over the security’s remaining life, through May 2012.

Pooled trust-preferred securities are very long-term (usually 30-year maturity) instruments, mainly issued by banks.  The Corporation’s investments in pooled trust-preferred securities are each made up of companies with geographic and size diversification.  Almost all of the Corporation’s pooled trust-preferred securities are composed of debt issued by banking companies, with lesser amounts issued by insurance companies.  Some of the issuers of trust-preferred securities that are included in the Corporation’s pooled investments have elected to defer payment of interest on these obligations (trust-preferred securities typically permit deferral of quarterly interest payments for up to five years), and some issuers have defaulted.

 
15

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

Management evaluated pooled trust-preferred securities for OTTI by estimating the cash flows expected to be received from each security, taking into account estimated levels of deferrals and defaults by the underlying issuers.  In determining cash flows, management assumed all issuers currently deferring or in default would make no future payments, and assigned estimated future default levels for the remaining issuers in each security based on financial strength ratings assigned by a national ratings service.  Management calculated the present value of each security based on the current book yield, adjusted for future changes in 3-month LIBOR (which is the index rate on the Corporation’s adjustable-rate pooled trust-preferred securities) based on the applicable forward curve. Management’s estimates of cash flows used to evaluate other-than-temporary impairment of pooled trust-preferred securities were based on sensitive assumptions regarding the timing and amounts of defaults that may occur, and changes in those assumptions could produce different conclusions for each security.

During the first quarter 2011, management evaluated the Corporation’s holdings of mezzanine tranche pooled trust preferred securities, which had all been completely written off as OTTI. This evaluation included updated estimates of future cash flows as adjusted for changes in expected prepayments resulting from recent regulatory changes affecting the issuers of trust preferred securities. After this evaluation, management solicited bids to sell the mezzanine tranche of MMCAPS Funding I, Ltd. The security was sold for aggregate pretax proceeds of $1,485,000, which was recorded as a gain on the sale of securities in the first quarter. The remaining securities continue to be carried at an amortized cost of zero.

The following table provides detailed information related to pooled trust preferred securities – mezzanine tranches held as of March 31, 2011:

   
Amortized
   
Fair
   
Unrealized
   
Cumulative
 
Description
 
Cost
   
Value
   
Gain
   
OTTI
 
U.S. Capital Funding II, Ltd. (B-1)
  $ 0     $ 0     $ 0     $ (1,992 )
U.S. Capital Funding II, Ltd. (B-2)
    0       0       0       (2,973 )
ALESCO Preferred Funding IX, Ltd.
    0       0       0       (2,988 )
Total
  $ 0     $ 0     $ 0     $ (7,953 )

As of March 31, 2011, the Corporation’s investment in a senior tranche security (the senior tranche of MMCAPS Funding I, Ltd.) had an investment grade rating.  The senior tranche security, with an amortized cost of $9,937,000, has been subjected to impairment analysis based on estimated cash flows (using the process described above), and management has determined that impairment was temporary as of March 31, 2011. The table that follows provides additional information related to the senior tranche of MMCAPS Funding I, Ltd.:

Number of Banks Currently Performing
    20  
Moody's/Fitch Credit Ratings
 
A3/BBB
(1) 
Actual Deferrals and Defaults as % of Outstanding Collateral
    27.7 %
Expected Additional Net Deferrals and Defaults as % of Performing Collateral
    20.9 %
Excess Subordination as % of Performing Collateral
    24.5 %

(1) Ratings information is as of March 31, 2011. Fitch has the senior tranche of MMCAPS Funding I, Ltd. on negative outlook.

In the table above, “Excess Subordination as % of Performing Collateral” (Excess Subordination Ratio) was calculated as follows:   (Total face value of performing collateral – Face value of all outstanding note balances not subordinate to our investment)/Total face value of performing collateral.

The Excess Subordination Ratio measures the extent to which there may be tranches within the pooled trust preferred structure available to absorb credit losses before the Corporation’s security would be impacted.  The positive Excess Subordination Ratio signifies there is some support from subordinate tranches available to absorb losses before the Corporation’s investment would be impacted.

The Corporation separates OTTI related to the trust-preferred securities into (a) the amount of the total impairment related to credit loss, which is recognized in the statement of earnings, and (b) the amount of the total impairment related to all other factors, which is recognized in other comprehensive income.  The Corporation measures the credit loss component of OTTI based on the difference between: (1) the present value of estimated cash flows, at the book yield in effect prior to recognition of any OTTI, as of the most recent balance sheet date, and (2) the present value of estimated cash flows as of the previous quarter-end balance sheet date based on management’s cash flow assumptions at that time.

 
16

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q
 
The Corporation recorded no OTTI losses related to pooled trust-preferred securities in the three months ended March 31, 2011. Total other-than-temporary impairment from pooled trust-preferred securities in the three months ended March 31, 2010 amounted to $51,000, including a pre-tax loss reflected in earnings of $101,000, with a gain of $50,000 included in other comprehensive income.

A roll-forward of the credit losses from securities for which a portion of OTTI has been recognized in other comprehensive income is as follows:

(In Thousands)
 
Three Months Ended
 
   
Mar. 31,
   
Mar. 31,
 
   
2011
   
2010
 
Balance of credit losses on debt securities for which a portion of OTTI was recognized in other comprehensive income, beginning of period
  $ 0     $ (10,695 )
                 
Reduction for securities losses realized during the period
    0       4,965  
                 
Additional credit loss for which OTTI was previously recognized when the Corporation does not intend to sell the security and it is not more likely than not the Corporation will be required to sell the security before recovery of its amortized cost basis
    0       (101 )
                 
Balance of credit losses on debt securities for which a portion of OTTI was recognized in other comprehensive income, end of period
  $ 0     $ (5,831 )

The line item labeled “Reduction for securities losses realized during the period” in the table immediately above includes  OTTI write-downs associated with securities the Corporation continues to hold, but which have been deemed worthless.

Equity Securities

The Corporation’s marketable equity securities at March 31, 2011 and December 31, 2010 consisted exclusively of stocks of banking companies.  The Corporation recorded no OTTI on bank stocks in the first quarter 2011 and recorded OTTI on bank stocks totaling $10,000 in the first quarter 2010.  Management’s decision to record OTTI losses on bank stocks in 2010 was based on a combination of: (1) significant market depreciation in market prices in the first quarter 2009 (with some improvement subsequent to March 31, 2009), and (2) management’s intent to sell some of the stocks to generate capital losses, which could be carried back and offset against capital gains generated in previous years to realize tax refunds.  At March 31, 2011, management did not intend to sell impaired bank stocks, and based on the intent to hold the securities for the foreseeable future and other factors specific to the securities, has determined that none of the Corporation’s bank stock holdings at March 31, 2011 were other than temporarily impaired.

Realized gains from sales of bank stocks totaled $2,000 in the first quarter 2011 and $349,000 in the first quarter 2010.  Realized gains from sales of bank stocks in the first quarter 2011 included no transactions involving stocks for which OTTI had been previously recognized. Realized gains from sales of bank stocks in the first quarter 2010 included net gains of $284,000 from stocks for which OTTI had been previously recognized.

C&N Bank is a member of the Federal Home Loan Bank of Pittsburgh (FHLB-Pittsburgh), which is one of 12 regional Federal Home Loan Banks.  As a member, C&N Bank is required to purchase and maintain stock in FHLB-Pittsburgh.  There is no active market for FHLB-Pittsburgh stock, and it must ordinarily be redeemed by FHLB-Pittsburgh in order to be liquidated.  C&N Bank’s investment in FHLB-Pittsburgh stock, included in Other Assets in the consolidated balance sheet, was $7,748,000 at March 31, 2011 and $8,156,000 at December 31, 2010.  The Corporation evaluated its holding of FHLB-Pittsburgh stock for impairment and deemed the stock to not be impaired at March 31, 2011 and December 31, 2010.  In making this determination, management concluded that recovery of total outstanding par value, which equals the carrying value, is expected.  The decision was based on review of financial information that FHLB-Pittsburgh has made publicly available.

 
17

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

6. LOANS

The loans receivable portfolio is segmented into consumer mortgage, commercial and consumer loans.  The consumer mortgage segment includes the following classes: first and junior lien residential mortgages, home equity lines of credit and residential construction loans.  The most significant classes of commercial loans are commercial loans secured by real estate, non-real estate secured commercial and industrial loans, loans to political subdivisions, commercial construction, and loans secured by farmland.

Loans outstanding at March 31, 2011 and December 31, 2010 are summarized as follows:

Summary of Loans by Type
                       
(In Thousands)
 
March 31,
   
% of
   
Dec. 31,
   
% of
 
   
2011
   
Total
   
2010
   
Total
 
Consumer mortgage:
                       
Residential mortgage loans - first liens
  $ 335,362       46.65 %   $ 333,012       45.59 %
Residential mortgage loans - junior liens
    30,403       4.23 %     31,590       4.32 %
Home equity lines of credit
    26,887       3.74 %     26,853       3.68 %
1-4 Family residential construction
    7,666       1.07 %     14,379       1.97 %
Total consumer mortgage
    400,318       55.68 %     405,834       55.56 %
Commercial:
                               
Commercial loans secured by real estate
    164,201       22.84 %     167,094       22.88 %
Commercial and industrial
    57,494       8.00 %     59,005       8.08 %
Political subdivisions
    36,226       5.04 %     36,480       4.99 %
Commercial construction
    23,340       3.25 %     24,004       3.29 %
Loans secured by farmland
    11,715       1.63 %     11,353       1.55 %
Multi-family (5 or more) residential
    7,600       1.06 %     7,781       1.07 %
Agricultural loans
    3,199       0.44 %     3,472       0.48 %
Other commercial loans
    862       0.12 %     392       0.05 %
Total commercial
    304,637       42.37 %     309,581       42.38 %
Consumer
    14,004       1.95 %     14,996       2.05 %
Total
    718,959       100.00 %     730,411       100.00 %
Less: allowance for loan losses
    (8,846 )             (9,107 )        
Loans, net
  $ 710,113             $ 721,304          

The Corporation grants loans to individuals as well as commercial and tax-exempt entities.  Commercial, residential and personal loans are made to customers geographically concentrated in the Pennsylvania and New York counties that comprise the market serviced by Citizens & Northern Bank.  Although the Corporation has a diversified loan portfolio, a significant portion of its debtors’ ability to honor their contracts is dependent on the local economic conditions within the region.  There is no concentration of loans to borrowers engaged in similar businesses or activities that exceed 10% of total loans at either March 31, 2011 or December 31, 2010.

The Corporation maintains an allowance for loan losses that represents management’s estimate of the losses inherent in the loan portfolio as of the balance sheet date and recorded as a reduction of the investment in loans.  The allowance for loan losses is maintained at a level considered adequate to provide for losses that can be reasonably anticipated. Management performs a quarterly evaluation of the adequacy of the allowance.  The allowance is based on the Corporation’s past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral, composition of the loan portfolio, current economic conditions and other relevant factors. This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant revision as more information becomes available. In the process of evaluating the loan portfolio, management also considers the Corporation’s exposure to losses from unfunded loan commitments.  As of March 31, 2011 and December 31, 2010, management determined that no allowance for credit losses related to unfunded loan commitments was required.

 
18

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

Transactions within the allowance for loan losses, summarized by segment and class, were as follows:

   
December 31,
                     
March 31,
 
(In Thousands)
 
2010
Balance
   
Charge-offs
   
Recoveries
   
(Credit)
Provision
   
2011
Balance
 
Allowance for Loan Losses:
                             
Consumer mortgage:
                             
Residential mortgage loans - first liens
  $ 2,745     $ (1 )         $ 406     $ 3,150  
Residential mortgage loans - junior liens
    334       (51 )           22       305  
Home equity lines of credit
    218                     (6 )     212  
1-4 Family residential construction
    208                     (146 )     62  
Total consumer mortgage
    3,505       (52 )     0       276       3,729  
Commercial:
                                       
Commercial loans secured by real estate
    3,314                       (196 )     3,118  
Commercial and industrial
    862               1       (21 )     842  
Political subdivisions
    0                       0       0  
Commercial construction
    590                       (319 )     271  
Loans secured by farmland
    139                       3       142  
Multi-family (5 or more) residential
    63                       14       77  
Agricultural loans
    32                       (3 )     29  
Other commercial loans
    0                       8       8  
Total commercial
    5,000       0       1       (514 )     4,487  
Consumer
    289       (45 )     27       4       275  
Unallocated
    313                       42       355  
                                         
Total Allowance for Loan Losses
  $ 9,107     $ (97 )   $ 28     $ (192 )   $ 8,846  

In the evaluation of the loan portfolio, management determines two major components for the allowance for loan losses – (1) a specific component based on an assessment of certain larger relationships, mainly commercial purpose loans, on a loan-by-loan basis; and (2) a general component for the remainder of the portfolio based on a collective evaluation of pools of loans with similar risk characteristics.  The general component is assigned to each pool of loans based on both historical net charge-off experience, and an evaluation of certain qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the above methodologies for estimating specific and general losses in the portfolio.

In determining the larger loan relationships for detailed assessment under the specific allowance component, the Corporation uses an internal risk rating system.  Under the risk rating system, the Corporation classifies problem or potential problem loans as “Special Mention,” “Substandard,” or “Doubtful” on the basis of currently existing facts, conditions and values.  Substandard loans include those characterized by the distinct possibility that the Corporation will sustain some loss if the deficiencies are not corrected.  Loans classified as Doubtful have all the weaknesses inherent in those classified as Substandard with the added characteristic that the weaknesses present make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable.  Loans that do not currently expose the Corporation to sufficient risk to warrant classification as Substandard or Doubtful, but possess weaknesses that deserve management’s close attention, are deemed to be Special Mention.  Risk ratings are updated any time that conditions or the situation warrants.  Loans not classified are included in the “Pass” column in the table below.

 
19

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

The following tables summarize the aggregate credit quality classification of outstanding loans by risk rating as of both March 31, 2011 and December 31, 2010:

March 31, 2011:
                             
(In Thousands)
 
Pass
   
Special
Mention
   
Substandard
   
Doubtful
   
Total
 
Consumer mortgage:
                             
Residential mortgage loans - first liens
  $ 319,642     $ 2,644     $ 12,853     $ 223     $ 335,362  
Residential mortgage loans - junior liens
    28,958       532       905       8       30,403  
Home equity lines of credit
    26,596       40       251       0       26,887  
1-4 Family residential construction
    7,666       0       0       0       7,666  
Total consumer mortgage
    382,862       3,216       14,009       231       400,318  
Commercial:
                                       
Commercial loans secured by real estate
    149,215       6,792       6,544       1,650       164,201  
Commercial and industrial
    44,478       7,750       4,794       472       57,494  
Political subdivisions
    36,097       129       0       0       36,226  
Commercial construction
    21,814       265       1,261       0       23,340  
Loans secured by farmland
    8,534       2,170       971       40       11,715  
Multi-family (5 or more) residential
    7,584       16       0       0       7,600  
Agricultural loans
    2,959       196       44       0       3,199  
Other commercial loans
    862       0       0       0       862  
Total commercial
    271,543       17,318       13,614       2,162       304,637  
Consumer
    13,727       30       245       2       14,004  
                                         
Totals
  $ 668,132     $ 20,564     $ 27,868     $ 2,395     $ 718,959  


December 31, 2010:
                             
(In Thousands)
 
Pass
   
Special
Mention
   
Substandard
   
Doubtful
   
Total
 
Consumer mortgage:
                             
Residential mortgage loans - first liens
  $ 318,813     $ 2,197     $ 11,778     $ 224     $ 333,012  
Residential mortgage loans - junior liens
    30,072       551       959       8       31,590  
Home equity lines of credit
    26,569       32       252       0       26,853  
1-4 Family residential construction
    13,582       0       797       0       14,379  
Total consumer mortgage
    389,036       2,780       13,786       232       405,834  
Commercial:
                                       
Commercial loans secured by real estate
    152,157       6,671       6,472       1,794       167,094  
Commercial and industrial
    45,779       8,235       4,533       458       59,005  
Political subdivisions
    36,480       0       0       0       36,480  
Commercial construction
    22,430       314       1,260       0       24,004  
Loans secured by farmland
    8,877       1,248       1,188       40       11,353  
Multi-family (5 or more) residential
    7,781       0       0       0       7,781  
Agricultural loans
    3,219       209       44       0       3,472  
Other commercial loans
    260       132       0       0       392  
Total commercial
    276,983       16,809       13,497       2,292       309,581  
Consumer
    14,696       33       265       2       14,996  
                                         
Totals
  $ 680,715     $ 19,622     $ 27,548     $ 2,526     $ 730,411  

 
20

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

The general component of the allowance for loan losses covers pools of loans by loan class including commercial loans not considered individually impaired, as well as smaller balance homogeneous classes of loans, such as residential real estate, home equity lines of credit and other consumer loans.  Accordingly, the Corporation generally does not separately identify individual consumer and residential loans for impairment disclosures, unless such loans are subject to a restructuring agreement. The pools of loans for each loan segment are evaluated for loss exposure based upon three-year average historical net charge-off rates, adjusted for qualitative factors.  Qualitative risk factors (described in the following paragraph) are evaluated for the impact on each of the three distinct segments (consumer mortgage, commercial and consumer) within the loan portfolio.  Each qualitative factor is assigned a value to reflect improving, stable or declining conditions based on management’s judgment using relevant information available at the time of the evaluation. Any adjustments to the factors are supported by a narrative documentation of changes in conditions accompanying the allowance for loan loss calculation.

The qualitative factors used in the general component calculations are designed to address credit risk characteristics associated with each segment.  The Corporation’s credit risk associated with all of the segments is significantly impacted by these factors, which include economic conditions within its market area, the Corporation’s lending policies, changes or trends in the portfolio, risk profile, competition, regulatory requirements and other factors.  Further, the consumer mortgage segment is significantly affected by the values of residential real estate that provide collateral for the loans.  The majority of the Corporation’s commercial segment loans (approximately 69% at March 31, 2011) is secured by real estate, and accordingly, the Corporation’s risk for the commercial segment is significantly affected by commercial real estate values.  The consumer segment includes a wide mix of loans for different purposes, primarily secured loans, including loans secured by motor vehicles, manufactured housing and other types of collateral.

Loans are classified as impaired, when, based on current information and events, it is probable that the Corporation will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement.  Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due.  Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired.  Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of shortfall in relation to the principal and interest owed.  Impairment is measured on a loan-by-loan basis for commercial loans by the fair value of the collateral (if the loan is collateral dependent), by future cash flows discounted at the loan’s effective rate or by the loan’s observable market price.

The scope of loans evaluated individually for impairment include all loan relationships greater than $200,000 for which there is at least one extension of credit graded Special Mention, Substandard or Doubtful.  Also, loan relationships less than $200,000 in the aggregate, but with an estimated loss of $100,000 or more, are individually evaluated for impairment.  Loans that are individually evaluated for impairment, but which are not determined to be impaired, are combined with all remaining loans that are not reviewed on a specific basis, and such loans are included within larger pools of loans based on similar risk and loss characteristics for purposes of determining the general component of the allowance.  The loans that have been individually evaluated, but which have not been determined to be impaired, are included in the “Collective-ly Evaluated” column in the tables summarizing the allowance and associated loan balances as of March 31, 2011 and December 31, 2010.

 
21

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

The following tables present a summary of loan balances and the related allowance for loan losses summarized by portfolio segment and class for each impairment method used as of March 31, 2011 and December 31, 2010:

March 31, 2011
 
Individually
   
Collectively
       
(In Thousands)
 
Evaluated
   
Evaluated
   
Totals
 
Loans:
                 
Consumer mortgage:
                 
Residential mortgage loans - first liens
  $ 1,416     $ 333,946     $ 335,362  
Residential mortgage loans - junior liens
    136       30,267       30,403  
Home equity lines of credit
    0       26,887       26,887  
1-4 Family residential construction
    0       7,666       7,666  
Total consumer mortgage
    1,552       398,766       400,318  
Commercial:
                       
Commercial loans secured by real estate
    3,592       160,609       164,201  
Commercial and industrial
    938       56,556       57,494  
Political subdivisions
    0       36,226       36,226  
Commercial construction
    978       22,362       23,340  
Loans secured by farmland
    931       10,784       11,715  
Multi-family (5 or more) residential
    0       7,600       7,600  
Agricultural loans
    39       3,160       3,199  
Other commercial loans
    0       862       862  
Total commercial
    6,478       298,159       304,637  
Consumer
    56       13,948       14,004  
                         
Total Loans
  $ 8,086     $ 710,873     $ 718,959  

March 31, 2011
 
Individually
   
Collectively
       
(In Thousands)
 
Evaluated
   
Evaluated
   
Totals
 
Allowance for Loan Losses:
                 
Consumer mortgage:
                 
Residential mortgage loans - first liens
  $ 475     $ 2,675     $ 3,150  
Residential mortgage loans - junior liens
    30       275       305  
Home equity lines of credit
    0       212       212  
1-4 Family residential construction
    0       62       62  
Total consumer mortgage
    505       3,224       3,729  
Commercial:
                       
Commercial loans secured by real estate
    1,171       1,947       3,118  
Commercial and industrial
    244       598       842  
Political subdivisions
    0       0       0  
Commercial construction
    65       206       271  
Loans secured by farmland
    35       107       142  
Multi-family (5 or more) residential
    0       77       77  
Agricultural loans
    0       29       29  
Other commercial loans
    0       8       8  
Total commercial
    1,515       2,972       4,487  
Consumer
    58       217       275  
Unallocated
                    355  
                         
Total Allowance for Loan Losses
  $ 2,078     $ 6,413     $ 8,846  

 
22

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

December 31, 2010
 
Individually
   
Collectively
       
(In Thousands)
 
Evaluated
   
Evaluated
   
Totals
 
Loans:
                 
Consumer mortgage:
                 
Residential mortgage loans - first liens
  $ 442     $ 332,570     $ 333,012  
Residential mortgage loans - junior liens
    239       31,351       31,590  
Home equity lines of credit
    0       26,853       26,853  
1-4 Family residential construction
    994       13,385       14,379  
Total consumer mortgage
    1,675       404,159       405,834  
Commercial:
                       
Commercial loans secured by real estate
    3,818       163,276       167,094  
Commercial and industrial
    931       58,074       59,005  
Political subdivisions
    0       36,480       36,480  
Commercial construction
    1,197       22,807       24,004  
Loans secured by farmland
    931       10,422       11,353  
Multi-family (5 or more) residential
    0       7,781       7,781  
Agricultural loans
    39       3,433       3,472  
Other commercial loans
    0       392       392  
Total commercial
    6,916       302,665       309,581  
Consumer
    57       14,939       14,996  
                         
Total Loans
  $ 8,648     $ 721,763     $ 730,411  

December 31, 2010
 
Individually
   
Collectively
       
(In Thousands)
 
Evaluated
   
Evaluated
   
Totals
 
Allowance for Loan Losses:
                 
Consumer mortgage:
                 
Residential mortgage loans - first liens
  $ 98     $ 2,647     $ 2,745  
Residential mortgage loans - junior liens
    80       254       334  
Home equity lines of credit
    0       218       218  
1-4 Family residential construction
    100       108       208  
Total consumer mortgage
    278       3,227       3,505  
Commercial:
                       
Commercial loans secured by real estate
    1,335       1,979       3,314  
Commercial and industrial
    202       660       862  
Political subdivisions
    0       0       0  
Commercial construction
    380       210       590  
Loans secured by farmland
    36       103       139  
Multi-family (5 or more) residential
    0       63       63  
Agricultural loans
    0       32       32  
Other commercial loans
    0       0       0  
Total commercial
    1,953       3,047       5,000  
Consumer
    57       232       289  
Unallocated
                    313  
                         
Total Allowance for Loan Losses
  $ 2,288     $ 6,506     $ 9,107  

 
23

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

Summary information related to impaired and restructured loans as of March 31, 2011 and December 31, 2010 is as follows:
   
As of
   
As of
 
(In Thousands)
 
Mar. 31
   
Dec. 31
 
   
2011
   
2010
 
Impaired loans with a valuation allowance
  $ 4,919     $ 5,457  
Impaired loans without a valuation allowance
    3,167       3,191  
Total impaired loans
  $ 8,086     $ 8,648  
Valuation allowance related to impaired loans
  $ 2,078     $ 2,288  
                 
Restructured loans (troubled debt restructurings)
  $ 1,434     $ 645  

The average investment in impaired loans was $8,774,000 for the three months ended March 31, 2011 compared to $6,142,000 for the year 2010.  Interest income recognized on impaired loans was $50,000 for the three months ended March 31, 2011 compared to $204,000 for the year 2010 with all interest recognized on a cash basis.

Loans are placed on nonaccrual status for all classes of loans when, in the opinion of management, collection of interest is doubtful. Any unpaid interest previously accrued on those loans is reversed from income. Interest income is not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest payments received on loans for which the risk of further loss is greater than remote are applied as a reduction of the loan principal balance. Interest income on other nonaccrual loans is recognized only to the extent of interest payments received.  Generally, loans are restored to accrual status when the obligation is brought current, has performed in accordance with the contractual terms for a reasonable period of time (generally six months) and the ultimate collectability of the total contractual principal and interest is no longer in doubt.  The past due status of all classes of loans receivable is determined based on contractual due dates for loan payments.  Also, the amortization of deferred loan fees is discontinued when a loan is placed on nonaccrual status.

The breakdown by portfolio segment and class of nonaccrual loans and loans past due ninety days or more and still accruing is as follows:
   
March 31, 2011
   
December 31, 2010
 
   
Past Due
         
Past Due
       
       (In Thousands)
 
90+ Days and
         
90+ Days and
       
   
Accruing
   
Nonaccrual
   
Accruing
   
Nonaccrual
 
Consumer mortgage:
                       
Residential mortgage loans - first liens
  $ 289     $ 4,053     $ 571     $ 3,301  
Residential mortgage loans - junior liens
    0       115       0       218  
1-4 Family residential construction
    0       0       0       797  
Total consumer mortgage
    289       4,168       571       4,316  
Commercial:
                               
Commercial loans secured by real estate
    60       3,591       60       3,666  
Commercial and industrial
    86       618       0       611  
Commercial construction
    0       978       0       1,197  
Loans secured by farmland
    0       930       90       932  
Agricultural loans
    0       40       0       40  
Total commercial
    146       6,157       150       6,446  
Consumer
    18       46       6       47  
                                 
Totals
  $ 453     $ 10,371     $ 727     $ 10,809  

 
24

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

The table below presents a summary of the contractual aging of loans as of March 31, 2011 and December 31, 2010:

   
As of March 31, 2011
 
   
Current &
                   
(In Thousands)
 
Past Due
   
Past Due
   
Past Due
       
   
Less than
   
30-89
   
90+
       
   
30 Days
   
Days
   
Days
   
Total
 
Consumer mortgage:
                       
Residential mortgage loans - first liens
  $ 330,195     $ 3,473     $ 1,694     $ 335,362  
Residential mortgage loans - junior liens
    29,894       454       55       30,403  
Home equity lines of credit
    26,838       49       0       26,887  
1-4 Family residential construction
    7,666       0       0       7,666  
Total consumer mortgage
    394,593       3,976       1,749       400,318  
                                 
Commercial:
                               
Commercial loans secured by real estate
    160,669       745       2,787       164,201  
Commercial and industrial
    56,621       581       292       57,494  
Political subdivisions
    36,226       0       0       36,226  
Commercial construction
    23,252       88       0       23,340  
Loans secured by farmland
    10,685       139       891       11,715  
Multi-family (5 or more) residential
    7,553       47       0       7,600  
Agricultural loans
    3,106       53       40       3,199  
Other commercial loans
    862       0       0       862  
Total commercial
    298,974       1,653       4,010       304,637  
                                 
Consumer
    13,823       163       18       14,004  
                                 
Totals
  $ 707,390     $ 5,792     $ 5,777     $ 718,959  

   
As of December 31, 2010
 
   
Current &
                   
(In Thousands)
 
Past Due
   
Past Due
   
Past Due
       
   
Less than
   
30-89
   
90+
       
   
30 Days
   
Days
   
Days
   
Total
 
Consumer mortgage:
                       
Residential mortgage loans - first liens
  $ 325,567     $ 5,132     $ 2,313     $ 333,012  
Residential mortgage loans - junior liens
    30,997       436       157       31,590  
Home equity lines of credit
    26,744       109       0       26,853  
1-4 Family residential construction
    14,379       0       0       14,379  
Total consumer mortgage
    397,687       5,677       2,470       405,834  
                                 
Commercial:
                               
Commercial loans secured by real estate
    163,343       940       2,811       167,094  
Commercial and industrial
    58,474       319       212       59,005  
Political subdivisions
    36,480       0       0       36,480  
Commercial construction
    23,674       330       0       24,004  
Loans secured by farmland
    10,294       77       982       11,353  
Multi-family (5 or more) residential
    7,769       12       0       7,781  
Agricultural loans
    3,422       10       40       3,472  
Other commercial loans
    77       315       0       392  
Total commercial
    303,533       2,003       4,045       309,581  
                                 
Consumer
    14,686       289       21       14,996  
                                 
Totals
  $ 715,906     $ 7,969     $ 6,536     $ 730,411  

 
25

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

Nonaccrual loans are included in the contractual aging immediately above.  A summary of the contractual aging of nonaccrual loans at March 31, 2011 and December 31, 2010 is as follows:

   
Current &
                   
(In Thousands)
 
Past Due
   
Past Due
   
Past Due
       
   
Less than
   
30-89
   
90+
       
   
30 Days
   
Days
   
Days
   
Total
 
March 31, 2011 Nonaccrual Totals
  $ 4,546     $ 501     $ 5,324     $ 10,371  
December 31, 2010 Nonaccrual Totals
  $ 4,156     $ 844     $ 5,809     $ 10,809  

7. DEFINED BENEFIT PLANS

The Corporation sponsors a defined benefit health care plan that provides postretirement medical benefits and life insurance to employees who meet certain age and length of service requirements. This plan contains a cost-sharing feature, which causes participants to pay for all future increases in costs related to benefit coverage.  Accordingly, actuarial assumptions related to health care cost trend rates do not affect the liability balance at March 31, 2011 and December 31, 2010, and will not affect the Corporation's future expenses. The Corporation uses a December 31 measurement date for the postretirement plan.

In 2007, the Corporation assumed the Citizens Trust Company Retirement Plan, a defined benefit pension plan for which benefit accruals and participation were frozen in 2002.  Information related to the Citizens Trust Company Retirement Plan has been included in the table that follows.  The Corporation uses a December 31 measurement date for this plan.

The components of net periodic benefit costs from these defined benefit plans are as follows:

Defined Benefit Plans
                       
(In Thousands)
 
Pension
   
Postretirement
 
   
Three Months Ended
   
Three Months Ended
 
   
March 31,
   
March 31,
 
   
2011
   
2010
   
2011
   
2010
 
Service cost
  $ 0     $ 0     $ 21     $ 17  
Interest cost
    18       17       23       22  
Expected return on plan assets
    (18 )     (17 )     0       0  
Amortization of transition (asset) obligation
    0       0       9       9  
Amortization of prior service cost
    0       0       3       4  
Recognized net actuarial loss
    1       1       0       0  
Net periodic benefit cost
  $ 1     $ 1     $ 56     $ 52  

In the first three months of 2011, the Corporation funded postretirement contributions totaling $14,000, with estimated annual postretirement contributions of $58,000 expected in 2011 for the full year.  The Corporation made a contribution to the defined benefit pension plan of $4,000 in the first quarter of 2011.  Based upon the related actuarial reports, the Corporation has no required further contributions to the Citizens Trust Company Retirement Plan for the 2011 plan year; however, the Corporation may elect to make discretionary contributions later in 2011.

 
26

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

8. STOCK-BASED COMPENSATION PLANS

In the first quarter 2011, the Corporation granted options to purchase a total of 93,674 shares of common stock through its Stock Incentive and Independent Directors Stock Incentive Plans.  The exercise price for the 2011 awards is $15.06 per share, based on the market price as of the date of grant.  In 2010, the Corporation made no awards of stock options.  Stock option expense is recognized over the vesting period of each option.  The Corporation expects total stock option expense for the year ending December 31, 2011 to be $279,000.

The Corporation records stock option expense based on estimated fair value calculated using an option valuation model.  In calculating the 2011 fair value, the Corporation utilized the Black-Scholes-Merton option-pricing model.  The calculated fair value of each option granted, and significant assumptions used in the calculations, are as follows:

   
2011
   
2010
 
Fair value of each option granted
  $ 4.26    
Not applicable (N/A)
 
Volatility
    37 %   N/A  
Expected option lives
 
8 Years
    N/A  
Risk-free interest rate
    3.10 %   N/A  
Dividend yield
    3.86 %   N/A  

In calculating the estimated fair value of 2011 stock option awards, management based its estimates of volatility and dividend yield on the Corporation’s experience over the immediately prior period of time consistent with the estimated lives of the options.  The risk-free interest rate was based on the published yield of zero-coupon U.S. Treasury strips with an applicable maturity as of the grant dates.  The 8-year expected option life was based on management’s estimates of the average term for all options issued under both plans.  Management assumed a 33% forfeiture rate for options granted under the Stock Incentive Plan, and a 0% forfeiture rate for the Directors Stock Incentive Plan.  These estimated forfeiture rates were determined based on the Corporation’s historical experience.

In the first quarter 2011, the Corporation awarded a total of 15,622 shares of restricted stock under the Stock Incentive and Independent Directors Stock Incentive Plans.  Compensation cost related to restricted stock is recognized based on the market price of the stock at the grant date over the vesting period.  For restricted stock awards granted under the Stock Incentive Plan, the Corporation must meet an annual targeted return on average equity (“ROAE”) performance ratio, as defined, in order for participants to vest.  Management has estimated restricted stock expense in the first three months of 2011 based on an assumption that the ROAE target for 2011 will be met.  In the first quarter 2010, the Corporation awarded 9,125 shares of restricted stock to the Chief Executive Officer under the Stock Incentive Plan.  This award provides that vesting will occur upon the earliest of (i) the third anniversary of the date of grant, (ii) death or disability or (iii) the occurrence of a change in control of the Corporation.

Total stock-based compensation expense is as follows:

(In Thousands)
 
3 Months Ended
 
   
March 31,
   
March 31,
 
   
2011
   
2010
 
Stock options
  $ 156     $ 0  
Restricted stock
    36       13  
                 
Total
  $ 192     $ 13  

 
27

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

9. INCOME TAXES

The net deferred tax asset at March 31, 2011 and December 31, 2010 represents the following temporary difference components:
   
March 31,
   
Dec. 31,
 
(In Thousands)
 
2011
   
2010
 
Deferred tax assets:
           
Unrealized holding losses on securities
  $ 0     $ 695  
Defined benefit plans - ASC 835
    170       134  
Net realized losses on securities
    3,466       5,755  
Allowance for loan losses
    3,096       3,186  
Credit for alternative minimum tax paid
    3,469       3,287  
Net operating loss carryforwards
    2,843       2,794  
General business credit carryforwards
    815       815  
Other deferred tax assets
    1,615       1,347  
Total deferred tax assets
    15,474       18,013  
                 
Deferred tax liabilities:
               
Unrealized holding gains on securities
    762       0  
Bank premises and equipment
    1,609       1,649  
Core deposit intangibles
    104       114  
Other deferred tax liabilities
    192       196  
Total deferred tax liabilities
    2,667       1,959  
Deferred tax asset, net
  $ 12,807     $ 16,054  
 
Realization of deferred tax assets ultimately depends on the existence of sufficient taxable income, including taxable income in prior carryback years, as well as future taxable income.  The deferred tax asset from realized losses on securities resulted primarily from OTTI charges for financial statement purposes that are not deductible for income tax reporting purposes through March 31, 2011.  Of the total deferred tax asset from realized losses on securities, a portion is from securities that, if the Corporation were to sell them, would be classified as capital losses for income tax reporting purposes.   The Corporation currently expects to fully realize all available tax benefits from the carryforward losses.
 
The Corporation has available an estimated $2.8 million of total unused operating loss carryforwards at March 31, 2011, including a capital loss carryforward of $156,000 expiring in 2015, and an estimated ordinary loss carryforward of $2,687,000 almost all of which expires in 2030.
 
The Corporation has available, unused tax credits of $815,000 at March 31, 2011 arising from investments in low income and elderly housing projects.  These tax credits may provide future benefits and, if unused, would expire in varying annual amounts from 2024 through 2030.
 
The provision for income tax for the 3-month periods ended March 31, 2011 and 2010 is based on the Corporation’s estimate of the effective tax rate expected to be applicable for the full year.  The effective tax rates are as follows:
 
   
Three Months Ended
 
(In thousands)
 
March 31,
 
   
2011
   
2010
 
   
(Current)
   
(Prior Year)
 
Income before income tax provision
  $ 7,605     $ 5,875  
Income tax provision
    2,064       1,437  
                 
Effective tax rate
    27.14 %     24.46 %

 
28

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

The effective tax rate for each period presented differs from the statutory rate of 35% principally because of the effects of tax-exempt interest income.

The Corporation has no unrecognized tax benefits, nor pending examination issues related to tax positions taken in preparation of its income tax returns.  The Corporation is no longer subject to examination by the Internal Revenue Service for years prior to 2006.

10.  IMPAIRMENT OF LIMITED PARTNERSHIP INVESTMENT

In the three-month period ended March 31, 2011, the Corporation reported an impairment loss of $948,000 related to an investment in a real estate limited partnership.  This investment had been included in Other Assets in the consolidated balance sheet at December 31, 2010.  In addition to the limited partnership investment, the Corporation has a loan receivable from the limited partnership of $1,047,000 at March 31, 2011.  Based on updated financial information, management prepared an estimated valuation based on cash flow analysis.  That analysis showed the estimated return to the Corporation would be sufficient to repay the loan in full, but would not provide sufficient additional cash flow for return on the limited partnership investment.  Accordingly, management made the decision to completely write-off the limited partnership investment in the three-month period ended March 31, 2011.

11.  CONTINGENCIES

In the normal course of business, the Corporation may be subject to pending and threatened lawsuits in which claims for monetary damages could be asserted.  In management’s opinion, the Corporation’s financial position and results of operations would not be materially affected by the outcome of such pending legal proceedings.

 
29

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Certain statements in this section and elsewhere in this quarterly report on Form 10-Q are forward-looking statements. Citizens & Northern Corporation and its wholly-owned subsidiaries (collectively, the Corporation) intend such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Reform Act of 1995. Forward-looking statements, which are not historical facts, are based on certain assumptions and describe future plans, business objectives and expectations, and are generally identifiable by the use of words such as, "should", “likely”, "expect", “plan”, "anticipate", “target”, “forecast”, and “goal”.  These forward-looking statements are subject to risks and uncertainties that are difficult to predict, may be beyond management’s control and could cause results to differ materially from those expressed or implied by such forward-looking statements.  Factors which could have a material, adverse impact on the operations and future prospects of the Corporation include, but are not limited to, the following:

·
changes in monetary and fiscal policies of the Federal Reserve Board and the U. S. Government, particularly related to changes in interest rates
·
changes in general economic conditions
·
legislative or regulatory changes
·
downturn in demand for loan, deposit and other financial services in the Corporation’s market area
·
increased competition from other banks and non-bank providers of financial services
·
technological changes and increased technology-related costs
·
changes in accounting principles, or the application of generally accepted accounting principles.

These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements.

REFERENCES TO 2011 AND 2010

Unless otherwise noted, all references to “2011” in the following discussion of operating results are intended to mean the three months ended March 31, 2011, and similarly, references to “2010” relate to the three months ended March 31, 2010.

EARNINGS OVERVIEW

In the first quarter 2011, net income available to common shareholders was $5,541,000 which represents $0.46 per share – basic and $0.45 per share - diluted.  In the previous quarter ended December 31, 2010, net income available to common shareholders was $4,884,000 or $0.40 per share – basic and diluted.  For the first quarter of 2010, the Corporation was still a participant in the U.S. Treasury Department TARP Capital Purchase Program with an obligation of $373,000 for U.S. Treasury preferred dividends.  Net income available to common shareholders for the first quarter 2010 was $4,065,000, or $0.34 per share - basic and diluted.

Some of the more significant fluctuations in the components of earnings are as follows:

 
·
Pre-tax gains from available-for-sale securities totaled $1,839,000 in the first quarter 2011, up from $64,000 in the fourth quarter 2010 and $58,000 in the first quarter 2010.  In the first quarter 2011, the Corporation realized gains of $1,510,000 from two pooled trust-preferred securities that had been written off in prior periods.

 
·
Net interest income was $11,282,000 in the first quarter 2011, up $92,000 from the fourth quarter 2010 and $809,000 over the first quarter 2010.  Net interest income has increased over the past several months, reflecting ongoing reductions in cost of funds.

 
·
The (credit) for loan losses (a reduction in expense) was ($192,000) in the first quarter 2011, including the effect of reversing an allowance of $150,000 on loans to an individual borrower that were repaid in full.  The provision for loan losses was $719,000 in the fourth quarter 2010 and $207,000 in the first quarter 2010.

 
30

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

 
·
Non-interest revenue was $2,555,000 in the first quarter 2011, down from $3,480,000 in the fourth quarter 2010 and $3,548,000 in the first quarter 2010.  The reduction in non-interest revenue in the first quarter 2011 resulted from an impairment loss of $948,000 related to an investment in a real estate limited partnership.

 
·
Non-interest expense totaled $8,263,000 in the first quarter 2011, up from $7,720,000 in the fourth quarter 2010 and $7,997,000 in the first quarter 2010.    Total compensation-related expenses, including salaries and wages, payroll taxes, employee benefits and related costs, were higher in the first quarter 2011 than in the fourth quarter 2010 or first quarter 2010.  The increase in compensation related expense in the most recent quarter included stock option compensation of $122,000, with none in 2010, as well as higher payroll taxes and estimated 401(k) and ESOP costs related to incentive compensation paid in January 2011 for 2010 performance.  Also, first quarter 2010 expense was reduced $215,000 as a result of total self-funded health insurance costs for 2009 being lower than previously estimated amounts.

 
·
The provision for income taxes totaled $2,064,000, or 27.1% of pre-tax income in the first quarter 2011, up from  22.4% of pre-tax income in the fourth quarter 2010 and 24.5% of pre-tax income in the first quarter 2010.  The provision for income tax in the fourth quarter 2010 included a benefit (reduction in expense) of $148,000 resulting from a reduction in a valuation reserve.

More detailed information concerning fluctuations in the Corporation’s earnings results are provided in other sections of Management’s Discussion and Analysis.

TABLE I - QUARTERLY FINANCIAL DATA
(In Thousands)

   
Mar. 31,
   
Dec 31,
   
Sept. 30,
   
June 30,
   
Mar. 31,
 
   
2011
   
2010
   
2010
   
2010
   
2010
 
Interest income
  $ 15,298     $ 15,500     $ 15,495     $ 15,386     $ 15,733  
Interest expense
    4,016       4,310       4,639       5,036       5,260  
Net interest income
    11,282       11,190       10,856       10,350       10,473  
(Credit) provision for loan losses
    (192 )     719       189       76       207  
Net interest income after provision for loan losses
    11,474       10,471       10,667       10,274       10,266  
Other income
    2,555       3,480       3,575       3,314       3,548  
Net gains on available-for-sale securities
    1,839       64       388       319       58  
Other expenses
    8,263       7,720       8,095       7,757       7,997  
Income before income tax provision
    7,605       6,295       6,535       6,150       5,875  
Income tax provision
    2,064       1,411       1,671       1,281       1,437  
Net income
    5,541       4,884       4,864       4,869       4,438  
US Treasury preferred dividends
    0       0       729       372       373  
Net income available to common shareholders
  $ 5,541     $ 4,884     $ 4,135     $ 4,497     $ 4,065  
Net income per common share – basic
  $ 0.46     $ 0.40     $ 0.34     $ 0.37     $ 0.34  
Net income per common share – diluted
  $ 0.45     $ 0.40     $ 0.34     $ 0.37     $ 0.34  

 
31

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

CRITICAL ACCOUNTING POLICIES

The presentation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect many of the reported amounts and disclosures. Actual results could differ from these estimates.

A material estimate that is particularly susceptible to significant change is the determination of the allowance for loan losses.  Management believes that the allowance for loan losses is adequate and reasonable. Analytical information related to the Corporation’s aggregate loans and the related allowance for loan losses is summarized by loan segment and classes of loans in Note 6 to the consolidated financial statements. Additional discussion of the Corporation’s methodology for determining the allowance for loan losses is described in a separate section later in Management’s Discussion and Analysis.  Given the very subjective nature of identifying and valuing loan losses, it is likely that well-informed individuals could make materially different assumptions, and could, therefore calculate a materially different allowance value.  While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in future years. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation’s allowance for loan losses. Such agencies may require the Corporation to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination.

Another material estimate is the calculation of fair values of the Corporation’s debt securities.  For most of the Corporation’s debt securities, the Corporation receives estimated fair values of debt securities from an independent valuation service, or from brokers.  In developing fair values, the valuation service and the brokers use estimates of cash flows, based on historical performance of similar instruments in similar interest rate environments.  Based on experience, management is aware that estimated fair values of debt securities tend to vary among brokers and other valuation services.

As described in Note 4 to the consolidated financial statements, management calculates the fair values of pooled trust-preferred securities by applying discount rates to estimated cash flows for each security.  Management estimated the cash flows expected to be received from each security, taking into account estimated levels of deferrals and defaults by the underlying issuers, and used discount rates considered reflective of a market participant’s expectations regarding the extent of credit and liquidity risk inherent in the securities.  Management’s estimates of cash flows and discount rates used to calculate fair values of pooled trust-preferred securities were based on sensitive assumptions, and use of different assumptions could result in calculations of fair values that would be substantially different than the amounts calculated by management.

As described in Note 5 to the consolidated financial statements, management evaluates securities for OTTI.  In making that evaluation, consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) whether the Corporation intends to sell the security or more likely than not will be required to sell the security before its anticipated recovery.  Management’s assessments of the likelihood and potential for recovery in value of securities are subjective and based on sensitive assumptions.  Also, management’s estimates of cash flows used to evaluate OTTI of pooled trust-preferred securities are based on sensitive assumptions, and use of different assumptions could produce different conclusions for each security.

NET INTEREST INCOME

The Corporation’s primary source of operating income is net interest income, which is equal to the difference between the amounts of interest income and interest expense.  Tables II, III and IV include information regarding the Corporation’s net interest income for the three-month periods ended March 31, 2011 and March 31, 2010.  In each of these tables, the amounts of interest income earned on tax-exempt securities and loans have been adjusted to a fully taxable-equivalent basis.  Accordingly, the net interest income amounts reflected in these tables exceed the amounts presented in the consolidated financial statements.  The discussion that follows is based on amounts in the related Tables.

Fully taxable equivalent net interest income was $12,085,000 in 2011, $858,000 (7.6%) higher than in 2010.  As shown in Table IV, net changes in volume had the effect of increasing net interest income $1,138,000 in 2011 compared to 2010, and interest rate changes had the effect of decreasing net interest income $280,000. The most significant components of the volume change in net interest income in 2011 were: an increase in interest income of $491,000 attributable to growth in the balance of available-for-sale securities and a decrease in interest expense of $500,000 attributable to a reduction in the balance of long-term borrowed funds. The most significant components of the rate change in net interest income in 2011 were: a decrease in interest income of $738,000 attributable to lower rates earned on available-for-sale securities and a decrease in interest expense of $518,000 due to lower rates paid on interest-bearing deposits. As presented in Table III, the “Interest Rate Spread” (excess of average rate of return on earning assets over average cost of funds on interest-bearing liabilities) was 3.77% in 2011, as compared to 3.49% in 2010.

 
32

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

INTEREST INCOME AND EARNING ASSETS

Interest income totaled $16,101,000 in 2011, a decrease of 2.3% from 2010.  Income from available-for-sale securities decreased $247,000 (5.0%), while interest and fees from loans decreased $113,000, or 1.0%.  As indicated in Table III, total average available-for-sale securities (at amortized cost) in 2011 increased to $454,077,000, an increase of $39,254,000, or 9.5% from 2010.  During 2010 and 2011, the Corporation increased the size of its tax-exempt municipal security portfolio. Net growth in the taxable available-for-sale securities portfolio came primarily in 2011 and was primarily made up of U.S. Government agency collateralized mortgage obligations. The Corporation’s yield on taxable securities fell in 2010 and 2011 primarily because of low market interest rates, including the effects of management’s decision to limit purchases of taxable securities to investments that mature or are expected to repay a substantial portion of principal within approximately four years or less.  The average rate of return on available-for-sale securities was 4.16% for 2011 and 4.80% in 2010.

The average balance of gross loans increased 0.5% to $724,048,000 in 2011 from $720,264,000 in 2010. In spite of the challenging economic environment, the Corporation has experienced growth in the average balance of commercial loans. This growth has been partially offset by modest contraction in the balance of the residential mortgage and consumer loan portfolios, primarily resulting from management’s decision to sell a portion of newly originated residential mortgages on the secondary market. The Corporation’s yield on loans fell as rates on new loans as well as existing, variable-rate loans have decreased. The average rate of return on loans was 6.40% in 2011 and 6.50% in 2010.

The average balance of interest-bearing due from banks decreased to $31,750,000 in 2011 from $66,887,000 in 2010. This has consisted primarily of balances held by the Federal Reserve.  Although the rates of return on balances with the Federal Reserve are low, the Corporation has maintained relatively high levels of liquid assets in 2010 and 2011 (as opposed to increasing long-term, available-for-sale securities at higher yields) in order to maximize flexibility for dealing with possible fluctuations in cash requirements, and due to management’s concern about the possibility of substantial increases in interest rates within the next few years.  Also, in 2010, management maintained a portion of the balance with the Federal Reserve in anticipation of repurchasing the TARP Preferred Stock and Warrant.  These repurchases were completed during the third quarter 2010.

INTEREST EXPENSE AND INTEREST-BEARING LIABILITIES

Interest expense fell $1,244,000, or 23.7%, to $4,016,000 in 2011 from $5,260,000 in 2010.  Table III shows that the overall cost of funds on interest-bearing liabilities fell to 1.63% in 2011 from 2.07% in 2010.

Total average deposits (interest-bearing and noninterest-bearing) increased 7.6%, to $1,002,017,000 in 2011 from $931,223,000 in 2010.  This increase came mainly in interest checking, savings accounts, and demand deposits; the increases were partially offset by a decrease in the average balance of certificates of deposit. Consistent with continuing low short-term market interest rates, the average rates incurred on deposit accounts have decreased significantly in 2011 as compared to 2010.

Total average borrowed funds decreased $70,664,000 to $162,667,000 in 2011 from $233,331,000 in 2010.  During 2010 and 2011, the Corporation has paid off long-term borrowings as they matured using the cash flow received from loans, mortgage-backed securities, and growth in deposit balances. The average rate on borrowed funds was 3.61% in 2011, down from 3.66% in 2010.  This change primarily reflects lower rates being paid on customer repurchase agreements, which make up most of the Corporation’s short-term borrowed funds.

 
33

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

TABLE II - ANALYSIS OF INTEREST INCOME AND EXPENSE

   
Three Months Ended
       
   
March 31,
   
Increase/
 
(In Thousands)
 
2011
   
2010
   
(Decrease)
 
                   
INTEREST INCOME
                 
Available-for-sale securities:
                 
Taxable
  $ 2,755     $ 3,163     $ (408 )
Tax-exempt
    1,905       1,744       161  
Total available-for-sale securities
    4,660       4,907       (247 )
Held-to-maturity securities,
                       
Taxable
    0       2       (2 )
Trading securities
    0       2       (2 )
Interest-bearing due from banks
    16       38       (22 )
Federal funds sold
    0       0       0  
Loans:
                       
Taxable
    10,868       10,950       (82 )
Tax-exempt
    557       588       (31 )
Total loans
    11,425       11,538       (113 )
Total Interest Income
    16,101       16,487       (386 )
                         
INTEREST EXPENSE
                       
Interest-bearing deposits:
                       
Interest checking
    130       207       (77 )
Money market
    151       249       (98 )
Savings
    56       44       12  
Certificates of deposit
    1,041       1,426       (385 )
Individual Retirement Accounts
    1,189       1,230       (41 )
Other time deposits
    1       1       0  
Total interest-bearing deposits
    2,568       3,157       (589 )
Borrowed funds:
                       
Short-term
    6       100       (94 )
Long-term
    1,442       2,003       (561 )
Total borrowed funds
    1,448       2,103       (655 )
Total Interest Expense
    4,016       5,260       (1,244 )
                         
Net Interest Income
  $ 12,085     $ 11,227     $ 858  

Note: Interest income from tax-exempt securities and loans has been adjusted to a fully tax-equivalent basis, using the Corporation’s marginal federal income tax rate of 34%.

 
34

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

Table IIl - Analysis of Average Daily Balances and Rates
(Dollars in Thousands)

   
3 Months
         
3 Months
       
   
Ended
   
Rate of
   
Ended
   
Rate of
 
   
3/31/2011
   
Return/
   
3/31/2010
   
Return/
 
   
Average
   
Cost of
   
Average
   
Cost of
 
   
Balance
   
Funds %
   
Balance
   
Funds %
 
EARNING ASSETS
                       
Available-for-sale securities, at amortized cost:
                       
Taxable
  $ 327,104       3.42 %   $ 306,966       4.18 %
Tax-exempt
    126,973       6.08 %     107,857       6.56 %
Total available-for-sale securities
    454,077       4.16 %     414,823       4.80 %
Held-to-maturity securities,
                               
Taxable
    0       0.00 %     154       5.27 %
Trading securities
    0       0.00 %     116       6.99 %
Interest-bearing due from banks
    31,750       0.20 %     66,887       0.23 %
Federal funds sold
    0       0.00 %     60       0.00 %
Loans:
                               
Taxable
    688,975       6.40 %     683,899       6.49 %
Tax-exempt
    35,073       6.44 %     36,365       6.56 %
Total loans
    724,048       6.40 %     720,264       6.50 %
Total Earning Assets
    1,209,875       5.40 %     1,202,304       5.56 %
Cash
    16,985               16,922          
Unrealized gain/loss on securities
    (588 )             (204 )        
Allowance for loan losses
    (9,201 )             (8,410 )        
Bank premises and equipment
    22,474               24,164          
Intangible Asset - Core Deposit Intangible
    315               484          
Intangible Asset - Goodwill
    11,942               11,942          
Other assets
    60,758               79,191          
Total Assets
  $ 1,312,560             $ 1,326,393          
                                 
INTEREST-BEARING LIABILITIES
                               
Interest-bearing deposits:
                               
Interest checking
  $ 163,479       0.32 %   $ 127,117       0.66 %
Money market
    203,439       0.30 %     197,023       0.51 %
Savings
    92,625       0.25 %     71,581       0.25 %
Certificates of deposit
    212,133       1.99 %     236,951       2.44 %
Individual Retirement Accounts
    161,174       2.99 %     161,127       3.10 %
Other time deposits
    956       0.42 %     990       0.41 %
Total interest-bearing deposits
    833,806       1.25 %     794,789       1.61 %
Borrowed funds:
                               
Short-term
    16,865       0.14 %     37,189       1.09 %
Long-term
    145,802       4.01 %     196,142       4.14 %
Total borrowed funds
    162,667       3.61 %     233,331       3.66 %
Total Interest-bearing Liabilities
    996,473       1.63 %     1,028,120       2.07 %
Demand deposits
    168,211               136,434          
Other liabilities
    6,461               7,465          
Total Liabilities
    1,171,145               1,172,019          
Stockholders' equity, excluding other comprehensive income/loss
    142,054               154,897          
Other comprehensive income/loss
    (639 )             (523 )        
Total Stockholders' Equity
    141,415               154,374          
Total Liabilities and Stockholders' Equity
  $ 1,312,560             $ 1,326,393          
Interest Rate Spread
            3.77 %             3.49 %
Net Interest Income/Earning Assets
            4.05 %             3.79 %
                                 
Total Deposits (Interest-bearing and Demand)
  $ 1,002,017             $ 931,223          

(1) Rates of return on tax-exempt securities and loans are presented on a fully taxable-equivalent basis.
(2) Nonaccrual loans have been included with loans for the purpose of analyzing net interest earnings.

 
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CITIZENS & NORTHERN CORPORATION – FORM 10-Q

TABLE IV - ANALYSIS OF VOLUME AND RATE CHANGES

(In Thousands)
 
3 Months Ended 3/31/11 vs. 3/31/10
 
   
Change in
   
Change in
   
Total
 
   
Volume
   
Rate
   
Change
 
EARNING ASSETS
                 
Available-for-sale securities:
                 
Taxable
  $ 198     $ (606 )   $ (408 )
Tax-exempt
    293       (132 )     161  
Total available-for-sale securities
    491       (738 )     (247 )
Held-to-maturity securities,
                       
Taxable
    (1 )     (1 )     (2 )
Trading securities
    (1 )     (1 )     (2 )
Interest-bearing due from banks
    (18 )     (4 )     (22 )
Federal funds sold
    0       0       0  
Loans:
                       
Taxable
    81       (163 )     (82 )
Tax-exempt
    (21 )     (10 )     (31 )
Total loans
    60       (173 )     (113 )
Total Interest Income
    531       (917 )     (386 )
                         
INTEREST-BEARING LIABILITIES
                       
Interest-bearing deposits:
                       
Interest checking
    48       (125 )     (77 )
Money market
    8       (106 )     (98 )
Savings
    12       0       12  
Certificates of deposit
    (139 )     (246 )     (385 )
Individual Retirement Accounts
    0       (41 )     (41 )
Other time deposits
    0       0       0  
Total interest-bearing deposits
    (71 )     (518 )     (589 )
Borrowed funds:
                       
Short-term
    (36 )     (58 )     (94 )
Long-term
    (500 )     (61 )     (561 )
Total borrowed funds
    (536 )     (119 )     (655 )
Total Interest Expense
    (607 )     (637 )     (1,244 )
                         
Net Interest Income
  $ 1,138     $ (280 )   $ 858  

(1) Changes in income on tax-exempt securities and loans are presented on a fully taxable-equivalent basis, using the Corporation’s marginal federal income tax rate of 34%.

(2) The change in interest due to both volume and rates has been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amount of the change in each.

 
36

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

RECOVERY ON IMPAIRED INVESTMENT SECURITY

In 2009, the Corporation recorded OTTI of $3,209,000 on its holding of a trust preferred security issued by Carolina First Mortgage Loan Trust, a subsidiary of The South Financial Group, Inc., and the Corporation also ceased accruing interest income on the security. In January 2010, The South Financial Group, Inc. began deferring its interest payments on the security.  In April 2010, the Corporation sold half of its investment in the security, and in the first quarter 2010 recorded OTTI of $320,000 to further write down amortized cost based on the selling price of the April transaction.

In the fourth quarter 2010, The Toronto-Dominion Bank acquired The South Financial Group, Inc., made a payment for the full amount of previously deferred interest, and resumed quarterly payments on the security. The Corporation recognized a material change in the expected cash flows and began recording accretion income (included in interest income) to offset the previous OTTI charges as an adjustment to the security’s yield over its remaining life. The estimated yield to maturity is 146.70%. The security has a face amount of $2 million, matures in May 2012, and has an interest rate which adjusts quarterly based on 3-month LIBOR. The security had an amortized cost of $431,000 and a fair value of $1,996,000 at March 31, 2011.

The actual and estimated future amounts of accretion income from this security are as follows:

   
Accretion of
 
   
Prior OTTI
 
4th Quarter 2010 (Actual)
  $ 83  
1st Quarter 2011 (Actual)
    111  
2nd Quarter 2011 (Estimated)
    160  
3rd Quarter 2011 (Estimated)
    229  
4th Quarter 2011 (Estimated)
    325  
1st Quarter 2012 (Estimated)
    457  
2nd Quarter 2012 (Estimated)
    398  
Total
  $ 1,763  

TABLE V - COMPARISON OF NON-INTEREST INCOME
           
(In Thousands)
 
Three Months Ended
 
   
March 31,
   
March 31,
 
   
2011
   
2010
 
             
Service charges on deposit accounts
  $ 1,131     $ 1,093  
Service charges and fees
    218       193  
Trust and financial management revenue
    877       899  
Interchange revenue from debit card transactions
    452       375  
Net gains from sale of loans
    259       66  
Increase in cash surrender value of life insurance
    122       112  
Insurance commissions, fees and premiums
    68       60  
Impairment loss on limited partnership investment
    (948 )     0  
Other operating income
    376       750  
Total other operating income, before realized gains on available-for-sale securities, net
  $ 2,555     $ 3,548  

 
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CITIZENS & NORTHERN CORPORATION – FORM 10-Q

Table V excludes realized gains (losses) on available-for-sale securities, which are discussed in the “Earnings Overview” section of Management’s Discussion and Analysis.  Total non-interest income shown in Table V decreased $993,000 or 28.0%, in 2011 compared to 2010.  Items of significance are as follows:

 
·
Interchange revenue from debit card transactions increased in 2011 compared to 2010, reflecting the ongoing trend for consumers’ increasing usage of debit cards.  Management believes this source of revenue could be greatly reduced in the future, perhaps as early as the third quarter 2011, depending on the resolution of a Federal Reserve proposal that would greatly reduce the rate paid to financial institutions.

 
·
Net gains from the sale of loans increased $193,000 in 2011 compared to 2010.  In 2010, management began to sell a significant amount of residential mortgage originations into the secondary market.  The increase in the net gains from sales of loans is almost entirely associated with the Corporation’s participation in the MPF Xtra program administered by the Federal Home Loan Banks of Pittsburgh and Chicago.  The increased volume of mortgage loans sold in the first quarter 2011 includes the impact of significant refinancing activity in the last several months of 2010.  In the first quarter 2011, new activity was reduced from the last several months of 2010, as evidenced by the reduction in the outstanding balance of loans held for sale to $135,000 at March 31, 2011 from $5,247,000 at December 31, 2010.

 
·
In 2011, the Corporation reported an impairment loss of $948,000 related to an investment in a real estate limited partnership.  This investment had been included in Other Assets in the consolidated balance sheet at December 31, 2010.  In addition to the limited partnership investment, the Corporation has a loan receivable from the limited partnership of $1,047,000 at March 31, 2011.  Based on updated financial information, management prepared an estimated valuation based on cash flow analysis.  That analysis showed the estimated return to the Corporation would be sufficient to repay the loan in full, but would not provide sufficient additional cash flow for return on the limited partnership investment.  Accordingly, management made the decision to completely write-off the limited partnership investment in 2011.

 
·
Other operating income decreased $374,000, or 49.9%, in 2011 as compared to 2010.  In 2010, the category includes a first quarter gain of $448,000 from the sale of a parcel adjacent to one of the bank operating locations. The sale proceeds include $390,000 associated with long-term privileges within a municipal parking facility currently under construction.  In 2011, this category included income of $108,000 from a limited liability equity investment in an entity performing title insurance services throughout Pennsylvania.  No similar income was recognized for the Corporation’s investment in this entity in 2010.

TABLE VI- COMPARISON OF NON-INTEREST EXPENSE
 
(In Thousands)
 
3 Months Ended
 
   
March 31,
   
March 31,
 
   
2011
   
2010
 
             
Salaries and wages
  $ 3,401     $ 3,078  
Pensions and other employee benefits
    1,306       939  
Occupancy expense, net
    732       699  
FDIC Assessments
    325       404  
Furniture and equipment expense
    484       568  
Pennsylvania shares tax
    319       305  
Other operating expense
    1,696       2,004  
Total Other Expense
  $ 8,263     $ 7,997  

 
38

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

Total non-interest expense in Table VI increased $266,000 or 3.3% in 2011 from 2010.  Significant changes in 2011 as compared to 2010 include the following:

 
·
Salaries and wages increased $323,000, or 10.5%.  In 2011, salaries and wages expense includes officers’ incentive stock option compensation of $122,000; however, since no stock options were awarded in 2010, there was no officers’ incentive stock option expense incurred in 2010.  In addition, salaries and wages expense in 2011 include an estimated accrual for incentive bonuses of $300,000 which is $88,000 higher than the comparable 2010 amount.  Excluding performance based stock and bonus compensation incentives, total salaries and wages amount to $2,944,000 in 2011, up 3.1%, compared to $2,855,000 in 2010.
 
 
·
Pensions and other employee benefits increased $367,000, or 39.1%.  Within this category, group health insurance expense was $215,000 lower in 2010 primarily due to favorable rate adjustments based on 2009 claims experience.  In addition, increased payroll taxes and employer contributions expense associated with the Savings & Retirement Plan (a 401(k) plan) and Employee Stock Ownership Plan were incurred in 2011 related to incentive compensation paid in January 2011 based on 2010 performance.

 
·
FDIC Assessments decreased $79,000, or 19.6% in 2011.  The favorable decline is primarily associated with rate changes attributed to improvements in financial ratios of the banking operations.

 
·
Furniture and fixtures expense decreased $84,000, or 14.8% in 2011 with the decrease primarily associated with reductions in depreciation for the Corporation’s core banking systems.

 
·
Other operating expense decreased $308,000 or 15.4%.  The category includes a variety of expenses, with the most significant decreases in 2011 of $102,000 associated with collection costs and losses on disposition of certain foreclosed properties.  Other operating costs also includes certain professional consulting fees, which are substantially discretionary, that are lower by $ 75,000 in 2011 than in 2010.

FINANCIAL CONDITION

Significant changes in the average balances of the Corporation’s earning assets and interest-bearing liabilities are described in the “Net Interest Income” section of Management’s Discussion and Analysis.  Other significant balance sheet items, including the allowance for loan losses and stockholders’ equity, are discussed in separate sections of Management’s Discussion and Analysis.

Management does not expect capital expenditures to have a material, detrimental effect on the Corporation’s financial condition in 2011.

PROVISION AND ALLOWANCE FOR LOAN LOSSES

The Corporation maintains an allowance for loan losses that represents management’s estimate of the losses inherent in the loan portfolio as of the balance sheet date and recorded as a reduction of the investment in loans.  Note 6 to the consolidated financial statements provide an overview of the process management uses for evaluating and determining the allowance for loan losses.

While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in future years. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation’s allowance for loan losses. Such agencies may require the Corporation to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination.

 
39

 

CITIZENS & NORTHERN CORPORATION – FORM 10-Q

The allowance for loan losses was $8,846,000 at March 31, 2011 down from $9,107,000 at December 31, 2010.  As presented in Table VIII, the specific component of the allowance on impaired loans decreased to $2,078,000 at March 31, 2011 from $2,288,000 at December 31, 2010.  The change included the impact of the Corporation being paid off in full on a commercial loan relationship for which an allowance of $150,000 had been established at December 31, 2010.  Table VIII also shows that the collectively determined components of the allowance fell slightly as of March 31, 2011 compared to December 31, 2010, mainly because total outstanding loans decreased for each segment of the portfolio.  The average net charge-off percentages and average qualitative factors used in determining the collectively evaluated components of the allowance did not change significantly at March 31, 2011, as compared to the December 31, 2010 analysis. Table VII shows a credit for loan losses of $192,000 for the first three months of 2011, in comparison to a provision for loan losses of $207,000 in the first quarter 2010 and the average annual provision over the previous five years of $796,000. The total amount of the provision for loan losses for each period is determined based on the amount required to maintain an appropriate allowance in light of all of the factors described above. Note 6 to the consolidated financial statements includes a summary of the provision for loan losses and activity in the allowance for loan losses, by segment and class, for the first quarter 2011.

Table IX presents information related to past due and impaired loans.  As of March 31, 2011, total impaired loans were $8,086,000, down from $8,648,000 at December 31, 2010, though up from the comparable annual average level of $6,898,000 for the last five years.  Nonaccrual loans decreased to $10,371,000 at March 31, 2011 from $10,809,000 at December 31, 2010, and total loans past due 90 days or more and still in accrual status also decreased to $453,000 at March 31, 2011 from $727,000 at December 31, 2010.  Interest continues to be accrued on loans 90 days or more past due that management deems to be well secured and in the process of collection, and for which no loss is anticipated.  Over the period 2006-2010 and the first three months of 2011, each period includes a few large commercial relationships that have required significant monitoring and workout efforts.  As a result, a limited number of relationships may significantly impact the total amount of allowance required on impaired loans, and may significantly impact the amount of total charge-offs reported in any one period.

Management believes it has been conservative in its decisions concerning identification of impaired loans, estimates of loss, and nonaccrual status; however, the actual losses realized from these relationships could vary materially from the allowances calculated as of March 31, 2011. Management continues to closely monitor its commercial loan relationships for possible credit losses, and will adjust its estimates of loss and decisions concerning nonaccrual status, if appropriate.

Tables VII through X present historical data related to the allowance for loan losses.

TABLE VII - ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES
                         
                                           
    
Qtr. Ended
   
Qtr. Ended
                               
(In Thousands)
 
March 31,
   
March 31,
   
Years Ended December 31,
 
   
2011
   
2010
   
2010
   
2009
   
2008
   
2007
   
2006
 
Balance, beginning of year
  $ 9,107     $ 8,265     $ 8,265     $ 7,857     $ 8,859     $ 8,201     $ 8,361  
Charge-offs:
                                                       
Consumer mortgage
    (52 )     (87 )     (340 )     (146 )     (173 )     (149 )     (611 )
Commercial
    0       (24 )     (91 )     (39 )     (1,607 )     (174 )     (200 )
Consumer
    (45 )     (70 )     (188 )     (293 )     (259 )     (221 )     (281 )
Total charge-offs
    (97 )     (181 )     (619 )     (478 )     (2,039 )     (544 )     (1,092 )
Recoveries:
                                                       
Consumer mortgage
    0       0       55       8       19       5       11  
Commercial
    1       96       113       77       22       31       159  
Consumer
    27       30       102       121       87       50       90  
Total recoveries
    28       126       270       206       128       86       260  
Net charge-offs
    (69 )     (55 )     (349 )     (272 )     (1,911 )     (458 )     (832 )
Allowance for loan losses recorded in acquisition
    0       0       0       0       0       587       0  
(Credit) provision for loan losses
    (192 )     207       1,191       680       909       529       672  
Balance, end of year
  $ 8,846     $ 8,417     $ 9,107     $ 8,265     $ 7,857     $ 8,859     $ 8,201  

 
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CITIZENS & NORTHERN CORPORATION – FORM 10-Q

TABLE VIII - COMPONENTS OF THE ALLOWANCE FOR LOAN LOSSES

(In Thousands)
 
As of
                               
   
March 31,
   
As of December 31,
 
   
2011
   
2010
   
2009
   
2008
   
2007
   
2006
 
ASC 310 - Impaired loans
  $ 2,078     $ 2,288     $ 1,126     $ 456     $ 2,255     $ 1,726  
ASC 450 - Collective segments:
                                               
Commercial
    2,972       3,047       2,677       2,654       1,870       2,372  
Consumer mortgage
    3,224       3,227       3,859       3,920       4,201       3,556  
Consumer
    217       232       281       399       533       523  
Unallocated
    355       313       322       428       0       24  
Total Allowance
  $ 8,846     $ 9,107     $ 8,265     $ 7,857     $ 8,859     $ 8,201  

TABLE IX  - PAST DUE AND IMPAIRED LOANS AND NON-PERFORMING ASSETS

(In Thousands)
 
As of
                               
   
March 31
   
As of December 31,
 
   
2011
   
2010
   
2009
   
2008
   
2007
   
2006
 
Impaired loans with a valuation allowance
  $ 4,919     $ 5,457     $ 2,690     $ 2,230     $ 5,361     $ 5,337  
Impaired loans without a valuation allowance
    3,167       3,191       3,257       3,435       857       2,674  
Total impaired loans
  $ 8,086     $ 8,648     $ 5,947     $ 5,665     $ 6,218     $ 8,011  
Restructured loans (troubled debt restructurings)
  $ 1,434     $ 645     $ 326     $ 0     $ 0     $ 111  
Total loans past due 30-89 days and still accruing
  $ 5,291     $ 7,125     $ 9,445     $ 9,875     $ 10,822     $ 8,580  
                                                 
Nonperforming assets:
                                               
Total nonaccrual loans
  $ 10,371     $ 10,809     $ 9,092     $ 7,200     $ 6,955     $ 8,506  
Total loans past due 90 days or more and still accruing
    453       727       31       1,305       1,200       1,559  
Foreclosed assets held for sale (real estate)
    707       537       873       298       258       264  
Total nonperforming assets
  $ 11,531     $ 12,073     $ 9,996     $ 8,803     $ 8,413     $ 10,329  
Total nonperforming assets as a % of assets
    0.88 %     0.92 %     0.76 %     0.69 %     0.66 %     0.78 %

 
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CITIZENS & NORTHERN CORPORATION – FORM 10-Q
 
TABLE X - SUMMARY OF LOANS BY TYPE

Summary of Loans by Type
 
(In Thousands)
 
March 31,
   
As of December 31,
 
   
2011
   
2010
   
2009
   
2008
   
2007
   
2006
 
Consumer mortgage:
                                   
Residential mortgage loans - first liens
  $ 335,362     $ 333,012     $ 340,268     $ 353,909     $ 363,467     $ 325,107  
Residential mortgage loans - junior liens
    30,403       31,590       35,734       40,657       40,392       30,074  
Home equity lines of credit
    26,887       26,853       23,577       21,304       20,542       18,472  
1-4 Family residential construction
    7,666       14,379       11,452       11,262       4,742       0  
Total consumer mortgage
    400,318       405,834       411,031       427,132       429,143       373,653  
Commercial:
                                               
Commercial loans secured by real estate
    164,201       167,094       163,483       165,979       144,742       178,260  
Commercial and industrial
    57,494       59,005       49,753       48,295       52,241       39,135  
Political subdivisions
    36,226       36,480       37,598       38,790       33,013       32,407  
Commercial construction
    23,340       24,004       15,264       13,730       17,755       10,365  
Loans secured by farmland
    11,715       11,353       11,856       9,140       8,287       6,968  
Multi-family (5 or more) residential
    7,600       7,781       8,338       8,367       9,004       6,790  
Agricultural loans
    3,199       3,472       3,848       4,495       3,553       2,705  
Other commercial loans
    862       392       638       884       1,010       1,226  
Total commercial
    304,637       309,581       290,778       289,680       269,605       277,856  
Consumer
    14,004       14,996       19,202       26,732       37,193       35,992  
Total
    718,959       730,411       721,011       743,544       735,941       687,501  
Less: allowance for loan losses
    (8,846 )     (9,107 )     (8,265 )     (7,857 )     (8,859 )     (8,201 )
Loans, net
  $ 710,113     $ 721,304     $ 712,746     $ 735,687     $ 727,082     $ 679,300  

LIQUIDITY

Liquidity is the ability to quickly raise cash at a reasonable cost.  An adequate liquidity position permits the Corporation to pay creditors, compensate for unforeseen deposit fluctuations and fund unexpected loan demand.  At March 31, 2011, the Corporation maintained overnight interest-bearing deposits with the Federal Reserve Bank of Philadelphia and other correspondent banks totaling $44,481,000.

The Corporation maintains overnight borrowing facilities with several correspondent banks that provide a source of day-to-day liquidity.  Also, the Corporation maintains borrowing facilities with the Federal Home Loan Bank of Pittsburgh, secured by various mortgage loans.

The Corporation has a line of credit with the Federal Reserve Bank of Philadelphia’s Discount Window. Management intends to use this line of credit as a contingency funding source. As collateral for the line, the Corporation has pledged available-for-sale securities with a carrying value of $27,803,000 at March 31, 2011.

The Corporation’s outstanding, available, and total credit facilities are presented in the following table.

   
Outstanding
   
Available
   
Total Credit
 
(In Thousands)
 
Mar. 31,
   
Dec. 31,
   
Mar. 31,
   
Dec. 31,
   
Mar. 31,
   
Dec. 31,
 
   
2011
   
2010
   
2011
   
2010
   
2011
   
2010
 
Federal Home Loan Bank of Pittsburgh
  $ 45,840     $ 55,995     $ 326,680     $ 304,584     $ 372,520     $ 360,579  
Federal Reserve Bank Discount Window
    0       0       26,498       26,274       26,498       26,274  
Other correspondent banks
    0       0       25,000       25,000       25,000       25,000  
Total credit facilities
  $ 45,840     $ 55,995     $ 378,178     $ 355,858     $ 424,018     $ 411,853  

 
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CITIZENS & NORTHERN CORPORATION – FORM 10-Q

At March 31, 2011 and December 31, 2010, the Corporation’s outstanding credit facilities with the Federal Home Loan Bank of Pittsburgh consisted of long-term borrowings. No letters of credit were outstanding at either date.

Additionally, the Corporation uses repurchase agreements placed with brokers to borrow funds secured by investment assets, and uses “RepoSweep” arrangements to borrow funds from commercial banking customers on an overnight basis.  If required to raise cash in an emergency situation, the Corporation could sell non-pledged investment securities to meet its obligations. At March 31, 2011, the carrying value of non-pledged available-for-sale securities was $55,397,000.

Management believes the Corporation is well-positioned to meet its short-term and long-term obligations.

STOCKHOLDERS’ EQUITY AND CAPITAL ADEQUACY

The Corporation and C&N Bank are subject to various regulatory capital requirements administered by the federal banking agencies.  Details concerning capital ratios at March 31, 2011 and December 31, 2010 are presented below.  Management believes, as of March 31, 2011 and December 31, 2010, that the Corporation and subsidiary banks meet all capital adequacy requirements to which they are subject.
                           
Minimum To Be Well
 
(Dollars in Thousands)
             
Minimum
   
Capitalized Under
 
               
Capital
   
Prompt Corrective
 
   
Actual
   
Requirement
   
Action Provisions
 
   
Amount
   
Ratio
   
Amount
   
Ratio
   
Amount
   
Ratio
 
March 31, 2011:
                                   
Total capital to risk-weighted assets:
                                   
Consolidated
  $ 135,593       18.49 %   $ 58,678       ³8 %     n/a       n/a  
C&N Bank
    124,342       17.11 %     58,151       ³8 %   $ 72,689       ³10 %
Tier 1 capital to risk-weighted assets:
                                               
Consolidated
    125,938       17.17 %     29,339       ³4 %     n/a       n/a  
C&N Bank
    115,460       15.88 %     29,076       ³4 %     43,613       ³6 %
Tier 1 capital to average assets:
                                               
Consolidated
    125,938       9.72 %     51,807       ³4 %     n/a       n/a  
C&N Bank
    115,460       8.99 %     51,392       ³4 %     64,240       ³5 %
                                                 
December 31, 2010:
                                               
Total capital to risk-weighted assets:
                                               
Consolidated
  $ 128,527       17.17 %   $ 59,874       ³8 %     n/a       n/a  
C&N Bank
    117,576       15.85 %     59,342       ³8 %   $ 74,177       ³10 %
Tier 1 capital to risk-weighted assets:
                                               
Consolidated
    118,781       15.87 %     29,937       ³4 %     n/a       n/a  
C&N Bank
    108,445       14.62 %     29,671       ³4 %     44,506       ³6 %
Tier 1 capital to average assets:
                                               
Consolidated
    118,781       9.20 %     51,664       ³4 %     n/a       n/a  
C&N Bank
    108,445       8.50 %     51,063       ³4 %     63,828       ³5 %

Management expects the Corporation and C&N Bank to maintain capital levels that exceed the regulatory standards for well-capitalized institutions for the next 12 months and for the foreseeable future.  Planned capital expenditures are not expected to have a significantly detrimental effect on capital ratios.

Future dividend payments will depend upon maintenance of a strong financial condition, future earnings and capital and regulatory requirements.  The Corporation and C&N Bank are subject to restrictions on the amount of dividends that may be paid without approval of banking regulatory authorities.

 
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CITIZENS & NORTHERN CORPORATION – FORM 10-Q

The Corporation’s total stockholders’ equity is affected by fluctuations in the fair values of available-for-sale securities.  The difference between amortized cost and fair value of available-for-sale securities, net of deferred income tax, is included in “Accumulated Other Comprehensive Income (Loss)” within stockholders’ equity.  The balance in Accumulated Other Comprehensive Income (Loss) related to unrealized gains or losses on available-for-sale securities, net of deferred income tax, amounted to $1,478,000 at March 31, 2011 and ($1,351,000) at December 31, 2010.  Changes in accumulated other comprehensive income are excluded from earnings and directly increase or decrease stockholders’ equity.  If available-for-sale securities are deemed to be other-than-temporarily impaired, unrealized losses are recorded as a charge against earnings, and amortized cost for the affected securities is reduced.  Note 5 to the consolidated financial statements provides additional information concerning management’s evaluation of available-for-sale securities for other-than-temporary impairment at March 31, 2011.

Stockholders’ equity is also affected by the underfunded or overfunded status of defined benefit pension and postretirement plans.  The balance in Accumulated Other Comprehensive Income (Loss) related to underfunded defined benefit plans, net of deferred income tax, was ($320,000) at March 31, 2011 and ($250,000) at December 31, 2010.

INCOME TAXES
The effective income tax rate was 27.14% of pre-tax income for the three months ended March 31, 2011 compared to 24.46% of pre-tax income for the first quarter 2010.  The provision for income tax for the 3-month periods ended March 31, 2011 and 2010 is based on the Corporation’s estimate of the effective tax rate expected to be applicable for the full year.  The Corporation’s effective tax rates differ from the statutory rate of 35% principally because of the effects of tax-exempt interest income.

The Corporation recognizes deferred tax assets and liabilities based on differences between the financial statement carrying amounts and the tax bases of assets and liabilities. At March 31, 2011, the net deferred tax asset was $12,807,000, down from the balance at December 31, 2010 of $16,054,000.  The net deferred tax asset balance at March 31, 2011 attributable to realized securities losses was $3,466,000. The deferred tax asset related to realized securities losses at March 31, 2011 was significantly lower than the balance at December 31, 2010 of $5,755,000.  As described in Note 5 to the consolidated financial statements, in the first quarter 2011, the Corporation sold a pooled trust-preferred security that had been written off in 2009 and 2010 for financial statement purposes, resulting in a book gain of $1,485,000.  The loss for income tax purposes from this transaction is $5,295,000, with the large book/ tax difference representing the main reason for the reduction in the deferred tax asset.

The Corporation has available at March 31, 2011 an estimated $2.8 million of total unused operating loss carryforwards, including a capital loss carryforward of $156,000 expiring in 2015, and an estimated ordinary loss carryforward of $2,687,000 expiring mainly in 2030.

The Corporation regularly reviews deferred tax assets for recoverability based on history of earnings, expectations for future earnings and expected timing of reversals of temporary differences. Realization of deferred tax assets ultimately depends on the existence of sufficient taxable income, including taxable income in prior carryback years, as well as future taxable income. Of the total deferred tax asset from realized losses on securities, a portion is from securities that, if the Corporation were to sell them, would be classified as capital losses for income tax reporting purposes.  Management believes the recorded net deferred tax asset at March 31, 2011 is fully realizable; however, if management determines the Corporation will be unable to realize all or part of the net deferred tax asset, the Corporation would adjust the deferred tax asset, which would negatively impact earnings.

In the fourth quarter 2009, the Corporation sold some securities for which other-than-temporary impairment losses (OTTI) had been recognized for financial reporting purposes in 2008 and the first nine months of 2009.  As a result of these sales, the Corporation realized both ordinary and capital tax losses for 2009, and filed net operating loss carryback returns resulting in tax refunds totaling $4,352,000 received in 2010 from recovery of some of the taxes previously paid for 2006, 2007 and 2008.  In late 2010, the Internal Revenue Service (IRS) sent the Corporation an information document request related to the Corporation’s 2009 federal return, as part of an evaluation to determine whether the return will be examined or accepted without examination.  The Corporation has responded to the information document request, and has not yet received a determination from the IRS.

Additional information related to income taxes is presented in Note 9 to the consolidated financial statements.

 
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CITIZENS & NORTHERN CORPORATION – FORM 10-Q

INFLATION

The Corporation is significantly affected by the Federal Reserve Board’s efforts to control inflation through changes in short-term interest rates. Beginning in September 2007, in response to concerns about weakness in the U.S. economy, the Federal Reserve lowered the fed funds target rate numerous times; in December 2008, it took the unusual step of establishing a target range of 0% to 0.25%, which it has maintained through 2010 and the first three months of 2011.  Also, the Federal Reserve has injected massive amounts of liquidity into the nation’s monetary system through a variety of programs. The Federal Reserve has purchased large amounts of securities in an effort to keep interest rates low and stimulate economic growth. Recent commodity price increases have sparked concern that inflation may become a concern in the near future, but Federal Reserve officials have publicly stated that the current inflation level is within an acceptable range.

Despite the current low short-term rate environment, liquidity injections, and commodity price increases, inflation statistics indicate that the overall rate of inflation is unlikely to significantly affect the Corporation’s operations within the near future. Although management cannot predict future changes in the rates of inflation, management monitors the impact of economic trends, including any indicators of inflationary pressures, in managing interest rate and other financial risks.

RECENT ACCOUNTING PRONOUNCEMENTS

Since January 1, 2011, the FASB has issued additional FASB Accounting Standards Updates (ASUs) to the FASB Accounting Standards Codification (ASC).  This section provides a summary description of recent ASUs that have significant implications (elected or required) within the consolidated financial statements, or that management expects may have a significant impact on financial statements issued in the near future.

In April 2011, the FASB issued ASU 2011-02, Receivables (Topic 310) - A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring. The Update amends ASC Topic 310 to provide guidance in evaluating whether a restructuring constitutes a Troubled Debt Restructuring.  The main provisions conclude that a creditor must separately conclude that both of the following exist – (1) the restructuring constitutes a concession, and (2) the debtor is experiencing financial difficulties.  The amendments then provide guidance on a creditor’s evaluation of each of the requirements for a Troubled Debt Restructuring.  For public entities, the Update is effective for the first interim or annual period beginning on or after June 15, 2011, including retrospective application to the beginning of the annual period of adoption.  Management does not believe that the adoption of this ASU will have a significant impact on the Corporation’s ongoing financial position, or results of operations.  Additional disclosure requirements related to Troubled Debt Restructurings will be effective, starting with the Corporation’s June 30, 2011 Form 10-Q

 
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CITIZENS & NORTHERN CORPORATION – FORM 10-Q

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

MARKET RISK

Market risk is the risk of loss arising from adverse changes in market rates and prices of the Corporation’s financial instruments. In addition to the effects of interest rates, the market prices of the Corporation’s debt securities within the available-for-sale securities portfolio are affected by fluctuations in the risk premiums (amounts of spread over risk-free rates) demanded by investors.

Management cannot control changes in market prices of securities based on fluctuations in the risk premiums demanded by investors, nor can management control the volume of deferrals or defaults by other entities on trust-preferred securities. However, management attempts to limit the risk that economic conditions would force the Corporation to sell securities for realized losses by maintaining a strong capital position (discussed in the “Stockholders’ Equity and Capital Adequacy” section of Management’s Discussion and Analysis) and ample sources of liquidity (discussed in the “Liquidity” section of Management’s Discussion and Analysis).

The Corporation’s two major categories of market risk are interest rate risk and equity securities risk, which are discussed in the following sections.

INTEREST RATE RISK

Business risk arising from changes in interest rates is an inherent factor in operating a bank. The Corporation’s assets are predominantly long-term, fixed rate loans and debt securities. Funding for these assets comes principally from shorter-term deposits and borrowed funds. Accordingly, there is an inherent risk of lower future earnings or decline in fair value of the Corporation’s financial instruments when interest rates change.

The Corporation uses a simulation model to calculate the potential effects of interest rate fluctuations on net interest income and the market value of portfolio equity. For purposes of these calculations, the market value of portfolio equity includes the fair values of financial instruments, such as securities, loans, deposits and borrowed funds, and the book values of nonfinancial assets and liabilities, such as premises and equipment and accrued expenses. The model measures and projects potential changes in net interest income, and calculates the discounted present value of anticipated cash flows of financial instruments, assuming an immediate increase or decrease in interest rates. Management ordinarily runs a variety of scenarios within a range of plus or minus 50-300 basis points of current rates.

The Corporation’s Board of Directors has established policy guidelines for acceptable levels of interest rate risk, based on an immediate increase or decrease in interest rates. The policy provides limits at +/- 100, 200 and 300 basis points from current rates for fluctuations in net interest income from the baseline (flat rates) one-year scenario. The policy also limits acceptable market value variances from the baseline values based on current rates.

Table XI, which follows this discussion, is based on the results of the simulation model as of February 28, 2011 and October 31, 2010. As indicated in the table, the Corporation is liability sensitive, and therefore net interest income and market value generally increase when interest rates fall and decrease when interest rates rise. The table shows that as of February 28, 2011, the changes in net interest income and changes in market value were within the policy limits in all scenarios. As of October 31, 2010, the changes in net interest income and changes in market value were within the policy limits in all scenarios except an immediate rate decrease of 300 basis points, which management considers to be highly unrealistic.

After preparation of the October 31, 2010 modeling results presented in Table XI, management engaged an outside consultant to study the Corporation’s non-maturity deposits: checking, savings, and money market accounts. The consultant examined historical data provided by management to estimate the average life of each type of deposit account and the sensitivity of each type of account to changes in interest rates. The results of the study indicated that the Corporation’s non-maturity deposits had significantly longer average lives than previously estimated. These updated estimates are included in the February 28, 2011 data presented and result in higher market values in all of the rate scenarios and in smaller percentage declines in value in rising rate scenarios. The study also indicated that the Corporation’s interest rates on non-maturity deposits were slightly more sensitive to market changes than had previously been assumed, which contributed to the larger declines in net interest income in rising rate scenarios based on February 28, 2011 data.

 
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CITIZENS & NORTHERN CORPORATION – FORM 10-Q

In December 2007, the Corporation entered into repurchase agreements (borrowings) totaling $80 million to fund the purchase of investment securities. The borrowings include embedded caps providing that, if 3-month LIBOR were to exceed 5.15%, the interest rate payable on the repurchase agreements would fall, down to a minimum of 0%, based on parameters included in the repurchase agreements. Three-month LIBOR has not exceeded 5.15% since the embedded caps were acquired; therefore, they have not affected interest expense to date. The embedded cap on one of the $40 million borrowings expired in December 2010, and the embedded cap on the other $40 million borrowing expires in December 2012. The 3-month LIBOR was 0.31% at February 28, 2011 and 0.29% at October 31, 2010. Since the embedded caps are effective only when 3-month LIBOR exceeds 5.15%, the Corporation would be unable to realize an interest expense reduction in any of the scenarios shown in Table XI at February 2011 or October 2010.

The model makes estimates, at each level of interest rate change, regarding cash flows from principal repayments on loans and mortgage-backed securities and call activity on other investment securities. Actual results could vary significantly from these estimates, which could result in significant differences in the calculations of projected changes in net interest income and market value of portfolio equity. Also, the model does not make estimates related to changes in the composition of the deposit portfolio that could occur due to rate competition, and the table does not necessarily reflect changes that management would make to realign the portfolio as a result of changes in interest rates.

 
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CITIZENS & NORTHERN CORPORATION – FORM 10-Q

TABLE XI - THE EFFECT OF HYPOTHETICAL CHANGES IN INTEREST RATES
February 28, 2011 Data
                             
(In Thousands)
       
Period Ending February 29, 2012
       
                               
   
Interest
   
Interest
   
Net Interest
   
NII
   
NII
 
Basis Point Change in Rates
 
Income
   
Expense
   
Income (NII)
   
% Change
   
Risk Limit
 
                               
+300
  $ 66,018     $ 28,477     $ 37,541       -16.0 %     20.0 %
+200
    63,558       23,464       40,094       -10.3 %     15.0 %
+100
    60,909       18,539       42,370       -5.2 %     10.0 %
0
    58,292       13,618       44,674       0.0 %     0.0 %
-100
    55,034       12,128       42,906       -4.0 %     10.0 %
-200
    52,326       11,771       40,555       -9.2 %     15.0 %
-300
    51,503       11,759       39,744       -11.0 %     20.0 %
                                         
   
Market Value of Portfolio Equity
                 
   
at February 28, 2011
                 
   
Present
   
Present
   
Present
                 
   
Value
   
Value
   
Value
                 
Basis Point Change in Rates
 
Equity
   
% Change
   
Risk Limit
                 
                                         
+300
  $ 146,371       -20.4 %     45.0 %                
+200
    160,193       -12.9 %     35.0 %                
+100
    172,570       -6.2 %     25.0 %                
0
    183,967       0.0 %     0.0 %                
-100
    183,235       -0.4 %     25.0 %                
-200
    185,520       0.8 %     35.0 %                
-300
    200,320       8.9 %     45.0 %                
                                         
October 31, 2010 Data
                                       
(In Thousands)
 
Period Ending October 31, 2011
 
   
Interest
   
Interest
   
Net Interest
   
NII
   
NII
 
Basis Point Change in Rates
 
Income
   
Expense
   
Income (NII)
   
% Change
   
Risk Limit
 
                                         
+300
  $ 66,098     $ 27,402     $ 38,696       -9.3 %     20.0 %
+200
    63,465       23,146       40,319       -5.5 %     15.0 %
+100
    60,661       18,891       41,770       -2.1 %     10.0 %
0
    57,307       14,638       42,669       0.0 %     0.0 %
-100
    54,005       13,794       40,211       -5.8 %     10.0 %
-200
    51,995       13,732       38,263       -10.3 %     15.0 %
-300
    51,507       13,732       37,775       -11.5 %     20.0 %
                                         
   
Market Value of Portfolio Equity
                 
   
at October 31, 2010
                 
   
Present
   
Present
   
Present
                 
   
Value
   
Value
   
Value
                 
Basis Point Change in Rates
 
Equity
   
% Change
   
Risk Limit
                 
                                         
+300
  $ 90,782       -28.4 %     45.0 %                
+200
    104,337       -17.7 %     35.0 %                
+100
    116,495       -8.1 %     25.0 %                
0
    126,789       0.0 %     0.0 %                
-100
    135,342       6.7 %     25.0 %                
-200
    162,919       28.5 %     35.0 %                
-300
    194,064       53.1 %     45.0 %                

 
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CITIZENS & NORTHERN CORPORATION – FORM 10-Q

EQUITY SECURITIES RISK

The Corporation’s equity securities portfolio consists of investments in stock of banks and bank holding companies. Investments in bank stocks are subject to risk factors that affect the banking industry in general, including credit risk, competition from non-bank entities, interest rate risk and other factors, which could result in a decline in market prices. Also, losses could occur in individual stocks held by the Corporation because of specific circumstances related to each bank. As discussed further in Note 5 of the consolidated financial statements, the Corporation recognized no OTTI charges on bank stocks in the first three months of 2011. The Corporation recognized OTTI charges on bank stocks totaling $10,000 in the first three months of 2010.

Equity securities held as of March 31, 2011 and December 31, 2010 are presented in Table XII. Table XII presents quantitative data concerning the effects of a decline in fair value of the Corporation’s equity securities of 10% or 20%. The data in Table XII does not reflect the effects of any appreciation in value that may occur, nor does it present the Corporation’s maximum exposure to loss on equity securities, which would be 100% of their fair value as of March 31, 2011.

TABLE XII - EQUITY SECURITIES RISK
           
(In Thousands)
           
             
   
Mar. 31,
   
Dec. 31,
 
   
2011
   
2010
 
Cost
  $ 4,789     $ 4,589  
Fair Value
    6,586       6,009  
Hypothetical 10% Decline In Market Value
    (659 )     (601 )
Hypothetical 20% Decline In Market Value
    (1,317 )     (1,202 )

ITEM 4. CONTROLS AND PROCEDURES

The Corporation’s management, under the supervision of and with the participation of the Corporation’s Chief Executive Officer and Chief Financial Officer, has carried out an evaluation of the design and effectiveness of the Corporation’s disclosure controls and procedures as defined in Rule 13a-15(e) and Rule 15d-15(e) of the Securities Exchange Act of 1934 as of the end of the period covered by this report.  Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Corporation’s disclosure controls and procedures are effective to ensure that all material information required to be disclosed in reports the Corporation files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms.

There were no significant changes in the Corporation’s internal control over financial reporting that occurred during the period covered by this report that have materially affected, or that are reasonably likely to affect, our internal control over financial reporting.

 
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CITIZENS & NORTHERN CORPORATION – FORM 10-Q

PART II – OTHER INFORMATION

Item 1.   Legal Proceedings
The Corporation and C&N Bank are involved in various legal proceedings incidental to their business.  Management believes the aggregate liability, if any, resulting from such pending and threatened legal proceedings will not have a material, adverse effect on the Corporation’s financial condition or results of operations.

Item 1A.   Risk Factors
There have been no material changes from the risk factors previously disclosed in Item 1A of the Corporation’s Form 10-K filed March 1, 2011.

Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds

 
c.
Issuer Purchases of Equity Securities
None

Item 3.   Defaults Upon Senior Securities
None

Item 4.   Removed and Reserved

Item 5.   Other Information
None

 
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CITIZENS & NORTHERN CORPORATION – FORM 10-Q

Item 6. Exhibits
2. Plan of acquisition, reorganization, arrangement, liquidation or succession
 
Not applicable
     
3. (i) Articles of Incorporation
 
Incorporated by reference to Exhibit 3.1 of the Corporation's Form 8-K filed September 21, 2009
     
3. (ii) By-laws
 
Incorporated by reference to Exhibit 3.2 of the
   
Corporation's Form 8-K filed September 21, 2009
     
4. Instruments defining the rights of security holders, including indentures
   
     
   
Not applicable
     
11. Statement re: computation of per share earnings
 
Information concerning the computation of earnings per share is provided in Note 2 to the Consolidated Financial Statements, which is included in Part I, Item 1 of Form 10-Q
     
15. Letter re: unaudited interim financial information
 
Not applicable
     
18. Letter re: change in accounting principles
 
Not applicable
     
19. Report furnished to security holders
 
Not applicable
     
     
22. Published report regarding matters submitted to vote of security holders
 
Not applicable
     
23. Consents of experts and counsel
 
Not applicable
     
24. Power of attorney
 
Not applicable
     
31. Rule 13a-14(a)/15d-14(a) certifications:
   
31.1 Certification of Chief Executive Officer
 
Filed herewith
31.2 Certification of Chief Financial Officer
 
Filed herewith
     
32. Section 1350 certifications
 
Filed herewith
     
99. Additional exhibits
 
Not applicable
     
100. XBRL-related documents
 
Not applicable

 
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CITIZENS & NORTHERN CORPORATION – FORM 10-Q

Signatures

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 
CITIZENS & NORTHERN CORPORATION
   
May 6, 2011
By:
/s/ Charles H. Updegraff, Jr.
Date
 
President and Chief Executive Officer
   
May 6, 2011
By:
/s/ Mark A. Hughes
Date
 
Treasurer and Chief Financial Officer

 
52