UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

þ		ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2008

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                     to                    .

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)

Securities registered pursuant to Section 12(b) of the Act:

Title of Each Class		Name of Exchange Where Registered
Common Stock Par Value $1.00		The NASDAQ Stock Market LLC

Securities registered pursuant to section 12(g) of the Act: None

Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes o No þ

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes o No þ

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 þ No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

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

Large accelerated filer o		Accelerated filer þ		Non-accelerated filer o		Smaller  reporting company o
				(Do not check if a 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 o No þ

The aggregate market value of the registrant’s common stock held by non-affiliates at June 30, 2008, the registrant’s most recently completed second fiscal quarter, was $144,878,257.

The number of shares of common stock outstanding at February 26, 2009 was 8,961,084.

Portions of the registrant’s proxy statement for the annual meeting of its shareholders to be held April 21, 2009 are incorporated by reference into Parts III and IV of this report.

 

 

PART I

ITEM 1. BUSINESS

Citizens & Northern Corporation (“Corporation”) is a holding company whose principal activity is community banking. The Corporation’s principal office is located in Wellsboro, Pennsylvania. The largest subsidiary is Citizens & Northern Bank (“C&N Bank”). In 2005, the Corporation acquired Canisteo Valley Corporation and its subsidiary, First State Bank, a New York State chartered commercial bank with offices in Canisteo and South Hornell, NY. The First State Bank banking offices are located in the southern tier of New York State, in close proximity to many of the Corporation’s northern Pennsylvania branch locations. Management considers the New York State branches to be part of the same community banking operating segment as the Pennsylvania locations; however, the separate New York State charter for First State Bank has been maintained because of certain regulatory advantages. The Corporation’s other wholly-owned subsidiaries are Citizens & Northern Investment Corporation and Bucktail Life Insurance Company (“Bucktail”). Citizens & Northern Investment Corporation was formed in 1999 to engage in investment activities. Bucktail reinsures credit and mortgage life and accident and health insurance on behalf of C&N Bank.

C&N Bank is a Pennsylvania banking institution that was formed by the consolidation of Northern National Bank of Wellsboro and Citizens National Bank of Towanda on October 1, 1971. Subsequent mergers included: First National Bank of Ralston in May 1972; Sullivan County National Bank in October 1977; Farmers National Bank of Athens in January 1984; and First National Bank of East Smithfield in May 1990. On May 1, 2007, the Corporation completed its acquisition of Citizens Bancorp, Inc. (“Citizens”) for an aggregate purchase price of $28,391,000 in cash and common stock. Also, Citizens Trust Company, the banking subsidiary of Citizens, was merged with and into C&N Bank as part of the transaction. C&N Bank has held its current name since May 6, 1975, at which time C&N Bank changed its charter from a national bank to a Pennsylvania bank.

C&N Bank and First State Bank (collectively, the “Banks”) provide an extensive range of banking services, including deposit and loan products for personal and commercial customers. The Banks also maintain a trust division that provides a wide range of financial services, such as 401(k) plans, retirement planning, estate planning, estate settlements and asset management. In January 2000, C&N Bank formed a subsidiary, C&N Financial Services Corporation (“C&NFSC”). C&NFSC is a licensed insurance agency that provides insurance products to individuals and businesses. In 2001, C&NFSC added a broker-dealer division, which offers mutual funds, annuities, educational savings accounts and other investment products through registered agents. C&NFSC’s operations are not significant in relation to the total operations of the Corporation.

All phases of the Banks’ business are competitive. The Banks primarily compete in Tioga, Bradford, Sullivan, Lycoming, Potter, Cameron and McKean counties in Pennsylvania, and Steuben and Allegany counties in New York. The Banks compete with local commercial banks headquartered in our market area as well as other commercial banks with branches in our market area. Some of the banks that have branches in the Banks’ market area are larger in overall size than the Banks. With respect to lending activities and attracting deposits, the Banks also compete with savings banks, savings and loan associations, insurance companies, regulated small loan companies and credit unions. Also, the Banks compete with mutual funds for deposits. C&N Bank competes with insurance companies, investment counseling firms, mutual funds and other business firms and individuals for trust, investment management, brokerage and insurance services. The Banks are generally competitive with all financial institutions in our service area with respect to interest rates paid on time and savings deposits, service charges on deposit accounts and interest rates charged on loans. The Banks serve a diverse customer base, and are not economically dependent on any small group of customers or on any individual industry.

Major initiatives over the last 5 years included the following:

•		expanded trust and financial services capabilities, including investment management, employee benefits and insurance services;
•		purchased and remodeled a former bank operations center in Williamsport, PA, and began offering trust and financial management, commercial lending, branch banking and other services, in 2004;
•		opened a branch office at a leased facility in South Williamsport, PA in 2004;
•		replaced the core banking computer system in 2004;
•		constructed and opened a branch facility in Jersey Shore, PA in 2005;
•		closed on the merger with Canisteo Valley Corporation in 2005;

•		constructed and opened a branch facility in Old Lycoming Township, PA, which opened in March 2006;
•		constructed an administration building in Wellsboro, PA, which opened in March 2006;
•		as described above, in May 2007, acquired Citizens Bancorp, Inc.;
•		implemented an overdraft privilege program in 2008;
•		underwent an operational process review in 2008, resulting in identification of opportunities for increases in revenue and decreases in expenses, including a net reduction in work force of 15.9%, to 297 full-time equivalent employees at December 31, 2008 from 353 at December 31, 2007

At December 31, 2008, C&N Bank had total assets of $1,225,003,000, total deposits of $825,039,000, net loans outstanding of $720,252,000 and 285 full-time equivalent employees. At December 31, 2008, First State Bank had total assets of $48,282,000, total deposits of $39,432,000, net loans outstanding of $15,435,000 and 12 full-time equivalent employees.

Most of the activities of the Corporation and its subsidiaries are regulated by federal or state agencies. The primary regulatory relationships are described as follows:

•		The Corporation is a bank holding company formed under the provisions of Section 3 of the Federal Reserve Act. The Corporation is under the direct supervision of the Federal Reserve and must comply with the reporting requirements of the Federal Bank Holding Company Act.
•		C&N Bank is a state-chartered, nonmember bank, supervised by the Federal Deposit Insurance Corporation and the Pennsylvania Department of Banking.
•		Canisteo Valley Corporation is the holding company for First State Bank. The Federal Reserve is the primary regulator for Canisteo Valley Corporation.
•		First State Bank is a state-chartered, Federal Reserve member bank, supervised by the Federal Reserve and the New York State Department of Banking.
•		C&NFSC is a Pennsylvania corporation. The Pennsylvania Department of Insurance regulates C&NFSC’s insurance activities. Brokerage products are offered through a third party networking agreement between C&N Bank and UVEST Financial Services, Inc.
•		Bucktail is incorporated in the state of Arizona and supervised by the Arizona Department of Insurance.

Participation in the Troubled Asset Relief Program Capital Purchase Program

On October 3, 2008, the Emergency Economic Stabilization Act (“EESA”) became law. The Troubled Asset Relief Program Capital Purchase Program (“TARP Capital Purchase Program”) was established pursuant to the EESA in order to facilitate the investment by the U.S. Department of the Treasury (“Treasury”) in senior preferred shares of qualifying banks, savings associations and certain bank and savings and loan holding companies. Pursuant to the TARP Capital Purchase Program, on January 16, 2009, the Corporation sold 26,440 shares of Series A preferred stock and a warrant to acquire 194,794 shares of common stock to the Treasury for an aggregate purchase price of $26.44 million.

As a result of the Corporation’s participation in the TARP Capital Purchase Program, the Corporation has agreed to certain limitations on executive compensation. For as long as the Treasury owns any debt or equity securities of the Corporation issued in connection with the TARP Capital Purchase Program, the Corporation will be required to take all necessary action to ensure that its benefit plans with respect to its senior executive officers comply in all respects with Section 111(b) of the EESA, and the regulations issued and in effect thereunder. This means that, among other things, while the Treasury owns debt or equity securities issued by the Corporation in connection with the TARP Capital Purchase Program, the Corporation must: (1) ensure that incentive compensation for senior executives does not encourage unnecessary and excessive risks that threaten the value of the financial institution; (2) require clawback of any bonus or incentive compensation paid to a senior executive based on statements of earnings, gains or other criteria that are later proven to be materially inaccurate; (3) prohibit making golden parachute payments to senior executives; and (4) agree not to deduct for tax purposes executive compensation in excess of $500,000 for each senior executive officer.

Additionally, on February 17, 2009 President Obama signed into law the American Recovery and Reinvestment Act of 2009 (“ARRA”), more commonly known as the economic stimulus or economic recovery package. ARRA includes a wide variety of programs intended to stimulate the economy and provide for extensive infrastructure, energy, health, and education needs. In addition, ARRA imposes certain new executive compensation and corporate expenditure limits on all current and future TARP recipients, including the Corporation, that are in addition to those previously announced by the Treasury. Such restrictions will be effective upon the adoption of regulations by the Treasury implementing such restrictions and will continue to apply to the Corporation until the Treasury no longer owns debt or equity securities issued by the Corporation in connection with the TARP Capital Purchase Program.

A copy of the Corporation’s annual report on Form 10-K, quarterly reports on Form 10-Q, current events reports on Form 8-K, and amendments to these reports, will be furnished without charge upon written request to the Corporation’s Treasurer at P.O. Box 58, Wellsboro, PA 16901. Copies of these reports will be furnished as soon as reasonably possible, after they are filed electronically with the Securities and Exchange Commission. The information is also available through the Corporation’s web site at www.cnbankpa.com.

ITEM 1A. RISK FACTORS

The Corporation is subject to the many risks and uncertainties applicable to all banking companies, as well as risks specific to the Corporation’s geographic locations. Although the Corporation seeks to effectively manage risks, and maintains a level of equity that exceeds the banking regulatory agencies’ thresholds for being considered “well capitalized” (see Note 18 to the consolidated financial statements), management cannot predict the future and cannot eliminate the possibility of credit, operational or other losses. Accordingly, actual results may differ materially from management’s expectations. Some of the Corporation’s significant risks and uncertainties are discussed below.

Credit Risk from Lending Activities — A significant source of risk is the possibility that losses will be sustained because borrowers, guarantors and related parties may fail to perform in accordance with the terms of their loan agreements. Most of the Corporation’s loans are secured, but some loans are unsecured. With respect to secured loans, the collateral securing the repayment of these loans may be insufficient to cover the obligations owed under such loans. Collateral values may be adversely affected by changes in economic, environmental and other conditions, including declines in the value of real estate, changes in interest rates, changes in monetary and fiscal policies of the federal government, wide-spread disease, terrorist activity, environmental contamination and other external events. In addition, collateral appraisals that are out of date or that do not meet industry recognized standards may create the impression that a loan is adequately collateralized when it is not. The Corporation has adopted underwriting and credit monitoring procedures and policies, including regular reviews of appraisals and borrower financial statements, that management believes are appropriate to mitigate the risk of loss. Also, as discussed further in the “Provision and Allowance for Loan Losses” section of Management’s Discussion and Analysis, the Corporation attempts to estimate the amount of losses that may be inherent in the portfolio through a quarterly evaluation process that includes several members of management and that addresses specifically identified problem loans, as well as other quantitative data and qualitative factors. Such risk management and accounting policies and procedures, however, may not prevent unexpected losses that could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity.

Interest Rate Risk — Business risk arising from changes in interest rates is an inherent factor in operating a banking organization. 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. Significant fluctuations in interest rates could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity. For additional information regarding interest rate risk, see Part II, Item 7A, “Quantitative and Qualitative Disclosures About Market Risk.”

Equity Securities Risk — The Corporation’s equity securities portfolio consists primarily of investments in stocks of banks and bank holding companies. Investments in bank stocks are subject to the risk factors affecting the banking industry, and that could cause a general market decline in the value of bank stocks. Also, losses could occur in individual stocks held by the Corporation because of specific circumstances related to each bank. These factors could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity. At December 31, 2008, the fair values of many of the Corporation’s equity securities were less than cost. For additional information regarding equity securities risk, including management’s assessment of equity securities for other-than-impairment as of December 31, 2008, see Part II, Item 7A, “Quantitative and Qualitative Disclosures About Market Risk.”

Debt Securities Risk – Pooled Trust-preferred Securities — Pooled trust-preferred securities are long-term instruments, mainly issued by banks, with 30 or more companies included in each pool. In 2008, trading volume of pooled trust-preferred securities became virtually nonexistent. Many of the Corporation’s pooled trust-preferred securities were downgraded by Moody’s during 2008, with securities with a total fair value of $35,995,000 at December 31, 2008 falling to ratings of less than investment grade.

Further, Moody’s and Fitch have placed many of the pooled trust-preferred securities on “Ratings Watch Negative,” meaning that an initial or further downgrade may be possible in the foreseeable future. In 2008, 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. The Corporation recorded other-than-temporary write-downs of the cost basis of pooled trust-preferred securities totaling $8,210,000 (pretax) to their estimated fair values as of December 31, 2008. As of December 31, 2008, the Corporation’s cost basis in pooled trust-preferred securities totaled $82.8 million, and the estimated fair value was $58.9 million. If the level of payment defaults by the underlying issuers of the pooled trust-preferred securities exceeds the amounts estimated by management in evaluating them for other-than-temporary impairment and calculating fair values at December 31, 2008, the Corporation would record additional other-than-temporary-impairment losses, and the amount of such losses could be significant. For additional information regarding debt securities risk, see Part II, Item 7A, “Quantitative and Qualitative Disclosures About Market Risk.”

Breach of Information Security and Technology Dependence — The Corporation relies on software, communication, and information exchange on a variety of computing platforms and networks and over the Internet. Despite numerous safeguards, the Corporation cannot be certain that all of its systems are entirely free from vulnerability to attack or other technological difficulties or failures. The Corporation relies on the services of a variety of vendors to meet its data processing and communication needs. If information security is breached or other technology difficulties or failures occur, information may be lost or misappropriated, services and operations may be interrupted and the Corporation could be exposed to claims from customers. Any of these results could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity.

Limited Geographic Diversification — The Corporation grants commercial, residential and personal loans to customers primarily in the Pennsylvania Counties of Tioga, Bradford, Sullivan, Lycoming, Potter, Cameron and McKean, and in Steuben and Allegany Counties in New York State. 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. Deterioration in economic conditions could adversely affect the quality of the Corporation’s loan portfolio and the demand for its products and services, and accordingly, could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity.

Growth Strategy — In recent years, the Corporation has expanded its operations by acquisitions and by building and opening new branches. The Corporation’s future financial performance will depend on its ability to execute its strategic plan and manage its future growth. Failure to execute these plans could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity.

Competition — All phases of the Corporation’s business are competitive. Some competitors are much larger in total assets and capitalization than the Corporation, have greater access to capital markets and can offer a broader array of financial services. There can be no assurance that the Corporation will be able to compete effectively in its markets. Furthermore, developments increasing the nature or level of competition could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity.

Government Regulation and Monetary Policy — The Corporation and the banking industry are subject to extensive regulation and supervision under federal and state laws and regulations. The requirements and limitations imposed by such laws and regulations limit the manner in which the Corporation conducts its business, undertakes new investments and activities and obtains financing. These regulations are designed primarily for the protection of the deposit insurance funds and consumers and not to benefit the Corporation’s shareholders. Financial institution regulation has been the subject of significant legislation in recent years and may be the subject of further significant legislation in the future, none of which is in the control of the Corporation. Significant new laws or changes in, or repeals of, existing laws could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity. Further, federal monetary policy, particularly as implemented through the Federal Reserve System, significantly affects short-term interest rates and credit conditions, and any unfavorable change in these conditions could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity.

Participation in the TARP Capital Purchase Program — Although the Corporation is well-capitalized (as described in more detail in the “Stockholders’ Equity and Capital Adequacy” section of Management’s Discussion and Analysis), current economic conditions are volatile. Accordingly, management and the Corporation’s Board of Directors decided to raise more capital by participating in the TARP Capital Purchase Program. On January 16, 2009, the Corporation issued 26,440 shares of Series A Preferred Stock (“Preferred Stock”) and a Warrant to purchase up to 194,794 shares of common stock at an exercise price of $20.36 per share. The Corporation sold the Preferred Stock and Warrant to the United States Department of the Treasury for an aggregate price of $26,440,000. Pursuant to participation in the TARP Program, the Corporation may continue to pay dividends on its common stock, subject to the following requirements and limitations: (1) all accrued and unpaid dividends for all past dividend periods on the preferred stock issued to the Treasury must be fully paid; and (2) consent of the Treasury is required for

any increase in the per share dividends on common shares until January 16, 2012, unless prior to that date, the Corporation has redeemed the preferred stock issued to the Treasury in whole or the Treasury has transferred all of the preferred stock to third parties. Also, until January 16, 2012 (unless prior to that date, the Corporation has redeemed the preferred stock issued to the Treasury in whole or the Treasury has transferred all of the preferred stock to third parties) the Treasury’s consent is required for any repurchases of common stock, except for repurchases of shares in connection with employee benefit plans in the ordinary course of business consistent with past practice.

Bank Secrecy Act and Related Laws and Regulations — These laws and regulations have significant implications for all financial institutions. They increase due diligence requirements and reporting obligations for financial institutions, create new crimes and penalties, and require the federal banking agencies, in reviewing merger and other acquisition transactions, to consider the effectiveness of the parties to such transactions in combating money laundering activities. Even innocent noncompliance and inconsequential failure to follow the regulations could result in significant fines or other penalties, which could have a material adverse impact on the Corporation’s financial condition, results of operations or liquidity.

ITEM 1B. UNRESOLVED STAFF COMMENTS

Not applicable.

ITEM 2. PROPERTIES

The Banks own each of their properties, except for the facility located at 2 East Mountain Avenue, South Williamsport, which is leased. All of the properties are in good condition. None of the owned properties are subject to encumbrance.

A listing of properties is as follows:

Main administrative offices:
90-92 Main Street                    or		10 Nichols Street
Wellsboro, PA 16901		Wellsboro, PA 16901
Facilities management office:
13 Water Street
Wellsboro, PA 16901
Branch offices – C&N Bank:
428 S. Main Street		Main Street		2 East Mountain Avenue
Athens, PA 18810		Laporte, PA 18626		South Williamsport, PA 17702
10 N. Main Street		4534 Williamson Trail		41 Main Street
Coudersport, PA 16915		Liberty, PA 16930		Tioga, PA 16946
111 W. Main Street		1085 Main Street		428 Main Street
Dushore, PA 18614		Mansfield, PA 16933		Towanda, PA 18848
Main Street		RR 2 Box 3036		Courthouse Square
East Smithfield, PA 18817		Monroeton, PA 18832		Troy, PA 16947
104 Main Street		3461 Route 405 Highway		90-92 Main Street
Elkland, PA 16920		Muncy, PA 17756		Wellsboro, PA 16901
135 East Fourth Street		100 Maple Street		1510 Dewey Avenue
Emporium, PA 15834		Port Allegany, PA 167		43 Williamsport, PA 17701
230 Railroad Street		24 Thompson Street		130 Court Street
Jersey Shore, PA 17740		Ralston, PA 17763		Williamsport, PA 17701
102 E. Main Street		1827 Elmira Street		Route 6

Knoxville, PA 16928		Sayre, PA 18840		Wysox, PA 18854
First State Bank offices:
3 Main Street 6		250 County Route 64, East Avenue Extension
Canisteo, NY 14823 H		Hornell, NY 14843

ITEM 3. LEGAL PROCEEDINGS

The Corporation and the Banks 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 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

A Special Meeting of the stockholders of Citizens & Northern Corporation (the “Corporation”) was held December 10, 2008, to consider and take action on a proposed amendment to the Corporation’s Articles of Incorporation to create 30,000 shares of preferred stock, $1,000 par value per share. The amendment was approved by a vote of 65.5% of the shares entitled to vote.

PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

QUARTERLY SHARE DATA

Trades of the Corporation’s stock are executed through various brokers who maintain a market in the Corporation’s stock. The Corporation’s stock is listed on the NASDAQ Capital Market with the trading symbol CZNC. As of December 31, 2008, there were 2,503 shareholders of record of the Corporation’s common stock.

The following table sets forth the high and low sales prices of the common stock during 2008 and 2007.

						2008												2007
										Dividend												Dividend
										Declared												Declared
										Per												per
		High				Low				Quarter				High				Low				Quarter
First quarter		$	21.00			$	16.85			$	0.24			$	23.21			$	20.30			$	0.24
Second quarter			20.50				15.82				0.24				21.13				19.36				0.24
Third quarter			25.80				16.13				0.24				19.82				17.82				0.24
Fourth quarter			25.45				17.18				0.24				20.19				17.28				0.24

In addition to the cash dividends reflected in the table above, the Corporation declared a 1% stock dividend in the 4^th quarter of 2007, which was issued in January 2008.

While the Corporation expects to continue its policy of regular quarterly dividend payments, future dividend payments will depend upon maintenance of a strong financial condition, future earnings and capital and regulatory requirements. Also, the Corporation, C&N Bank and First State Bank are subject to restrictions on the amount of dividends that may be paid without approval of banking regulatory authorities. These restrictions are described in Note 18 to the consolidated financial statements. Pursuant to participation in the TARP Program, the Corporation may continue to pay dividends on its common stock, subject to the following requirements and limitations: (1) all accrued and unpaid dividends for all past dividend periods on the preferred stock issued to the Treasury must be fully paid; and (2) consent of the Treasury is required for any increase in the per share dividends on common shares until January 16, 2012, unless prior to that date, the Corporation has redeemed the preferred stock issued to the Treasury in whole or the Treasury has transferred all of the preferred stock to third parties.

On August 21, 2008, the Corporation announced the extension and amendment of a plan that permits the repurchase of shares of its outstanding common stock, up to an aggregate total of $10 million, through August 31, 2009. The Board of Directors authorized repurchase from time to time at prevailing market prices in open market or in privately negotiated transactions as, in management’s sole opinion, market conditions warrant and based on stock availability, price and the Corporation’s financial performance. As of December 31, 2008, the maximum additional value available for purchases under this program is $8,860,480.

Pursuant to participation in the TARP Program, until January 16, 2012 (unless prior to that date, the Corporation has redeemed the preferred stock issued to the Treasury in whole or the Treasury has transferred all of the preferred stock to third parties) the Treasury’s consent is required for any repurchases of common stock, except for repurchases of shares in connection with employee benefit plans in the ordinary course of business consistent with past practice.

The following sets forth a summary of the Corporation’s purchases, on the open market, of its equity securities during the fourth quarter 2008:

										Total Number
										of Shares				Maximum Dollar
										Purchased as				Value of Shares
										Part of Publicly				that May Yet be
		Total Number								Announced				Purchased Under
		of Shares				Average Price				Plans or				the Plans or
Period		Purchased				Paid per Share				Programs				Programs
October 1 - 31, 2008			—								35,508			$	9,431,995
November 1 - 30, 2008			19,796			$	20.52				55,304			$	9,025,750
December 1 - 31, 2008			8,359			$	19.77				63,663			$	8,860,480

PERFORMANCE GRAPH

Set forth below is a chart comparing the Corporation’s cumulative return to stockholders against the cumulative return of the Russell 2000 and a Peer Group Index of similar banking organizations selected by the Corporation for the five-year period commencing December 31, 2003 and ended December 31, 2008. The index values are market-weighted dividend-reinvestment numbers, which measure the total return for investing $100.00 five years ago. This meets Securities & Exchange Commission requirements for showing dividend reinvestment share performance over a five-year period and measures the return to an investor for placing $100.00 into a group of bank stocks and reinvesting any and all dividends into the purchase of more of the same stock for which dividends were paid.

COMPARISON OF 5-YEAR CUMULATIVE RETURN

		Period Ending
Index		12/31/03				12/31/04				12/31/05				12/31/06				12/31/07			12/31/08
Citizens & Northern Corporation			100.00				104.56				103.64				93.60				79.64				93.66
Russell 2000			100.00				118.33				123.72				146.44				144.15				95.44
Citizens & Northern Peer Group*			100.00				111.35				107.98				115.94				98.96				79.60

The C&N peer group consists of banks headquartered in Pennsylvania with total assets of $500 million to $1.3 billion. This peer group consists of 1^st Summit Bancorp of Johnstown, Inc., Johnstown; ACNB Corporation, Gettysburg; American Bank Incorporated, Allentown; AmeriServ Financial, Inc., Johnstown; Bryn Mawr Bank Corporation, Bryn Mawr; CCFNB Bancorp, Inc., Bloomsburg; Citizens Financial Services, Inc., Mansfield; CNB Financial Corporation, Clearfield; Codorus Valley Bancorp, York; Comm Bancorp, Inc., Clarks Summit; DNB Financial Corporation, Downingtown; ENB Financial Corp., Ephrata; Fidelity D & D Bancorp, Inc., Dunmore; First Chester County Corporation, West Chester; First Keystone Corporation, Berwick; First National Community Bancorp, Inc., Dunmore; FNB Bancorp, Inc., Newtown; Franklin Financial Services Corporation, Chambersburg; Mid Penn Bancorp, Inc., Millersburg; Orrstown Financial Services, Inc., Shippensburg; Penns Woods Bancorp, Inc., Williamsport; Penseco Financial Services Corporation, Scranton; QNB Corp., Quakertown; Republic First Bancorp, Inc., Philadelphia; Tower Bancorp, Inc., Greencastle; and VIST Financial Corp., Wyomissing.

The data for this graph was obtained from SNL Financial L.C.

EQUITY COMPENSATION PLAN INFORMATION

The following table sets forth information concerning the Stock Incentive Plan and Independent Directors Stock Incentive Plan, both of which have been approved by the Corporation’s shareholders. The figures shown in the table below are as of December 31, 2008.

Number of

Number of

Weighted-

Securities

Securities to be

average

Remaining

Issued Upon

Exercise

for Future

Exercise of

Price of

Issuance Under

Outstanding

Outstanding

Equity Compen-

Options

Options

sation Plans

Equity compensation plans approved by shareholders

261,562

$

20.59

574,759

Equity compensation plans not approved by shareholders

0

N/A

0

More details related to the Corporation’s equity compensation plans are provided in Notes 1 and 13 to the consolidated financial statements.

ITEM 6. SELECTED FINANCIAL DATA

		As of or for the Year Ended December 31,
INCOME STATEMENT (In Thousands)		2008				2007				2006				2005				2004
Interest and fee income		$	74,237			$	70,221			$	64,462			$	61,108			$	57,922
Interest expense			31,049				33,909				30,774				25,687				22,606
Net interest income			43,188				36,312				33,688				35,421				35,316
Provision for loan losses			909				529				672				2,026				1,400
Net interest income after provision for loan losses			42,279				35,783				33,016				33,395				33,916
Noninterest income excluding securities (losses)/gains and gains from sale of credit card loans			12,883				10,440				7,970				7,636				6,922
Realized (losses) gains on available-for-sale securities			(9,338	)			127				5,046				1,802				2,877
Gain from sale of credit card loans			0				0				340				1,906				0
Noninterest expense			33,446				33,283				31,614				28,962				26,001
Income before income tax provision			12,378				13,067				14,758				15,777				17,714
Income tax provision			2,319				2,643				2,772				2,793				2,851
Net income		$	10,059			$	10,424			$	11,986			$	12,984			$	14,863
PER COMMON SHARE: (1)
Basic earnings per share		$	1.12			$	1.19			$	1.42			$	1.53			$	1.76
Diluted earnings per share		$	1.12			$	1.19			$	1.42			$	1.52			$	1.75
Cash dividends declared per share		$	0.96			$	0.96			$	0.96			$	0.93			$	0.89
Stock dividend		None					1	%			1	%			1	%			1	%
Book value at period-end		$	13.66			$	15.34			$	15.51			$	15.58			$	15.61
Tangible book value at period-end		$	12.22			$	13.85			$	15.13			$	15.18			$	15.61
Weighted average common shares outstanding — basic			8,961,805				8,784,134				8,422,495				8,458,813				8,433,494
Weighted average common shares outstanding — diluted			8,983,300				8,795,366				8,448,169				8,517,598				8,481,750
END OF PERIOD BALANCES (In Thousands)
Available-for-sale securities		$	419,688			$	432,755			$	356,665			$	427,298			$	475,085
Gross loans			743,544				735,941				687,501				653,299				579,613
Allowance for loan losses			7,857				8,859				8,201				8,361				6,787
Total assets			1,281,637				1,283,746				1,127,368				1,162,954				1,123,002
Deposits			864,057				838,503				760,349				757,065				676,545
Borrowings			285,473				300,132				228,440				266,939				305,005
Stockholders’ equity			122,026				137,781				129,888				131,968				131,585
AVERAGE BALANCES (In Thousands)
Total assets			1,280,924				1,178,904				1,134,689				1,144,619				1,114,041
Earning assets			1,202,872				1,090,035				1,055,103				1,065,189				1,036,535
Gross loans			743,741				729,269				662,714				618,344				551,352
Deposits			847,714				812,255				750,982				702,404				669,307
Stockholders’ equity			130,790				138,669				131,082				132,465				128,374
KEY RATIOS
Return on average assets			0.79	%			0.88	%			1.06	%			1.13	%			1.33	%
Return on average equity			7.69	%			7.52	%			9.14	%			9.80	%			11.58	%
Average equity to average assets			10.21	%			11.76	%			11.55	%			11.57	%			11.52	%
Net interest margin (2)			3.77	%			3.51	%			3.42	%			3.62	%			3.78	%
Efficiency (3)			57.40	%			68.39	%			71.73	%			62.68	%			56.35	%
Cash dividends as a % of diluted earnings per share			85.71	%			80.67	%			67.61	%			61.18	%			50.86	%
Tier 1 leverage			10.12	%			10.91	%			11.22	%			10.62	%			10.69	%
Tier 1 risk-based capital			13.99	%			15.46	%			16.51	%			16.52	%			17.17	%
Total risk-based capital			14.84	%			16.52	%			17.97	%			18.19	%			18.89	%

(1)		All share and per share data have been restated to give effect to stock dividends and splits.
(2)		Rates of return on tax-exempt securities and loans are calculated on a fully-taxable equivalent basis.
(3)		The efficiency ratio is calculated by dividing total noninterest expense by the sum of net interest income (including income from tax-exempt securities and loans on a fully-taxable equivalent basis) and noninterest income excluding securities gains and gains from sale of credit card loans.

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Certain statements in this section and elsewhere in this Annual Report on Form 10-K 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.

EARNINGS OVERVIEW

Following is an overview of the major fluctuations in the Corporation’s revenues and expenses in 2008 as compared to 2007, and in 2007 as compared to 2006. More detailed information is provided later in Management’s Discussion and Analysis.

2008 vs. 2007

Net income for the year ended December 31, 2008 was $10,059,000, or $1.12 per diluted share, as compared to net income of $10,424,000, or $1.19 per diluted share, in 2007. Return on average equity was 7.69% in 2008 and 7.52% in 2007. Return on average assets was 0.79% in 2008 and 0.88% in 2007. Excluding realized gains and losses on available-for-sale securities (discussed in the following paragraph), net of tax, and excluding the impact of reinvestment of proceeds from sales, net income per share was $1.81 (diluted) in 2008, as compared to $1.18 (diluted) in 2007.

Pre-tax losses from available-for-sale securities totaled $9,338,000 in 2008, including impairment charges of $9,872,000. In contrast, pre-tax gains from available-for-sale securities totaled $127,000 in 2007. Securities losses in 2008 included the effects of other-than-temporary impairment charges on pooled trust-preferred securities totaling $8,210,000 and bank stocks totaling $1,662,000. Pooled trust-preferred securities are long-term instruments, mainly issued by banks, with 30 or more companies included in each pool. The impairment charges on pooled trust-preferred securities resulted from management’s assessment that it is unlikely some of the previously anticipated principal and interest will be received on four of the securities. Accordingly, management wrote down the cost basis of these securities to their estimated fair values as of December 31, 2008. After the impact of the impairment charges, C&N’s cost basis in pooled trust-preferred securities totaled $82.8 million, and the estimated fair value at December 31, 2008 was $58.9 million.

Other significant changes in the components of earnings for 2008, as compared to 2007, were as follows:

•		The interest margin was $6,876,000, or 18.9%, higher in 2008. The improved interest margin includes the impact of the Citizens Bancorp, Inc. acquisition, which was effective May 1, 2007. The interest margin has also been positively impacted by lower market interest rates, which have reduced interest rates paid on deposits and borrowings, and by higher earnings on the investment portfolio resulting from higher average total holdings of securities.
•		Noninterest income increased $2,443,000, or 23.4%. Service charges on deposit accounts increased $1,888,000, or 73.8%, as a result of growth in deposit volumes from the Citizens Bancorp acquisition, as well as higher fees associated with a new overdraft privilege program. Also, in 2008, noninterest income included a gain of $533,000 from redemption of restricted shares of Visa, resulting from Visa’s initial public offering.

2007 vs. 2006

Net income was $10,424,000 in 2007, down from $11,986,000 in 2006. Net income per share (basic and diluted) was $1.19 (basic and diluted) in 2007 and $1.42 in 2006. Return on average equity was 7.52% in 2007 and 9.14% in 2006. Return on average assets was 0.88% in 2007 and 1.06% in 2006.

Annual earnings for 2007 were impacted by a substantial decline in realized gains from available-for-sale securities, as net (pre-tax) gains totaled $127,000 in 2007 as compared to $5,046,000 in 2006. The lower net securities gains in 2007 reflect two significant factors: (1) management’s decision in the second quarter 2007 to restructure the securities portfolio by selling mortgage-backed securities for a realized loss of $2,045,000, with the proceeds reinvested at higher yields, and (2) lower levels of realized gains from sales of bank stocks in 2007, due to lower market valuations of financial stocks. Excluding gains and losses on sales of available-for-sale securities, net of tax, and excluding the impact of reinvestment of proceeds from sales, net income per share (diluted) was $1.18 in 2007, as compared to $1.02 in 2006.

On May 1, 2007, the acquisition of Citizens Bancorp, Inc. became effective. Citizens Bancorp, Inc. was the parent company of Citizens Trust Company, with offices in Coudersport, Port Allegany and Emporium, PA. The Citizens Trust Company operations, which are now part of C&N Bank, contributed significantly to growth in total assets, including loans, as well as growth in deposits and trust assets under management, and increases in revenues and expenses in 2007.

In addition to the effects of lower net securities gains described above, other significant income statement changes between 2007 and 2006 were as follows:

•		The net interest margin increased $2,624,000, or 7.8%, in 2007 as compared to 2006. Most of the increase in the net interest margin between years occurred in the last six months of 2007. Factors contributing to improvements in the net interest margin in 2007 included: (1) the acquisition of Citizens Trust Company, which resulted in increased interest and fees on loans, and provided funding to help pay off borrowings, (2) a change in the shape of the yield curve, which became positive after remaining flat or inverted throughout 2006 and the first half of 2007, allowing the Corporation opportunities to earn a positive spread from borrowing and investing activities, and (3) the increase in yield on the investment portfolio resulting from the restructuring described above.
•		Noninterest income, excluding realized gains on available-for-sale securities, increased $2,130,000 (25.6%) in 2007 over 2006. Trust and Financial Management revenue increased $1,031,000 (42.8%). Assets under management by C&N’s Trust and Financial Management Group increased 27.3%, to $659,193,000 at December 31, 2007 from $517,775,000 at December 31, 2006. The increase in Trust assets under management resulted from the acquisition of Citizens Bancorp, Inc., market value appreciation and new business. There were also significant increases in other sources of noninterest revenue, including service charges on deposits and other revenues.
•		Noninterest expense increased $1,669,000 (5.3%) in 2007 as compared to 2006. The increase in expenses reflects the addition of Citizens Trust Company. Also, professional fees of $240,000 were incurred in 2007 related to the computer core system conversions of the First State Bank (New York) and Citizens Trust Company operations.
•		In 2007, the income tax provision was $2,643,000, or 20.2% of pre-tax income. In 2006, the income tax provision was $2,772,000, or 18.8% of pre-tax income. The higher income tax rate incurred in 2007 reflected management’s decision to reduce the amount of average investments in municipal bonds, in an effort to eliminate alternative minimum tax.

OUTLOOK FOR 2009

As described in the “Earnings Overview” section above, net income for 2008 was slightly lower than in 2007, primarily because of substantial securities write-downs. While the securities portfolio is a significant concern, management is optimistic about the expected impact on 2009 and future years of improvements made in “core” operations. These improvements include the successful implementation of an overdraft privilege program, as well as other enhancements to noninterest revenue sources resulting from a profitability review conducted by a nationally recognized consulting firm in 2008. In addition to revenue enhancements, the consulting firm worked with management to identify improvements in efficiency of various operational activities, which have resulted in significant expense reductions. The Corporation experienced a net reduction in work force of 15.9%, to 297 full-time equivalent employees at December 31, 2008 from 353 at December 31, 2007.

A major variable that affects the Corporation’s earnings is securities gains and losses. In 2008, the Corporation reported realized losses from available-for-sale securities of $9,338,000, including the effect of pre-tax write-downs of impaired trust-preferred securities by $8,210,000 and bank stocks by $1,662,000. The Corporation’s losses from trust-preferred securities and bank

stocks stem from the much-publicized economic problems affecting the national and international economy, which have particularly hurt the banking industry. Although management believes these conditions to be cyclical, opportunities for realized gains from bank stocks are expected to be limited in 2009, and (after the effect of the write-downs) the Corporation has significant unrealized losses on its available-for-sale securities as of December 31, 2008. Management has reviewed its holdings of bank stocks, trust-preferred securities and other securities as of December 31, 2008, and concluded that – with the exception of the trust-preferred securities and bank stocks that have been written down through earnings – the remaining unrealized losses are considered temporary. Notes 5 and 6 to the consolidated financial statements provide more detail concerning the Corporation’s processes for evaluating securities for other-than-temporary impairment, and for valuation of trust-preferred securities. Management will continue to closely monitor the status of impaired securities in 2009.

The provision for loan losses in 2008 was $909,000. The 2008 provision was less than the Corporation’s average provision for loan losses over the 5-year period ended December 31, 2008 of $1,107,000. During the last 5 years, the highest annual provision was $2,026,000 in 2005, and the lowest was $529,000 in 2007. Issues related to larger commercial borrowers significantly affect the Corporation’s provision for loan losses in any particular period. Accordingly, the amount of loan loss provision for 2009 will depend substantially on the credit status of the commercial portfolio. Although management is concerned about the condition of the national economy and the potential for problems in our market area, to date the Corporation has not experienced significant deterioration in loan delinquencies, or a noticeable change in volume of activity related to troubled debts or foreclosures. The Corporation has not originated interest only mortgages, loans without documentation of the borrowers’ sources of income or net worth, or other types of subprime mortgage loans that have received negative publicity in 2007 and 2008. If economic conditions deteriorate significantly in 2009, the Corporation may need to increase the provision for loan losses for the impact on the residential mortgage and consumer portions of the loan portfolio.

Despite the operational improvements cited above, the Corporation faces several factors that will negatively affect noninterest revenues and expenses in 2009. Management expects total noninterest operating expenses to increase slightly in 2009 as compared to 2008, mainly because FDIC premiums are expected to increase approximately $2.6 million, including a special assessment of approximately $1.6 million and a recurring increase of $1 million. Also, total noninterest revenue may be lower in 2009 than in 2008. In 2008, noninterest income included a gain of $533,000 from redemption of Visa shares, resulting from Visa’s initial public offering. Another source of revenue that is not expected to recur in 2009 is dividend income from the Federal Home Loan Bank of Pittsburgh restricted stock, which totaled $334,000 in 2008. The Federal Home Loan Bank of Pittsburgh has announced that its final 2008 financial results may be affected by significant losses on its securities portfolio, and that it has discontinued paying dividends for the foreseeable future. Based on the information that has become publicly available through late February 2009, management does not believe its investment in Federal Home Loan Bank of Pittsburgh restricted stock of $8.6 million to be impaired at December 31, 2008; however, management will monitor the situation for possible deterioration that could result in an impairment loss in 2009. In addition to these issues, the Corporation’s revenues from Trust and Financial Management activities are expected to fall slightly in 2009, because the market value of assets under management (which is used as the basis for determining the amount of fees for most Trust services) has fallen as a result of the significant declines in U.S. and international equity markets.

Management estimates total capital purchases for 2009 to be approximately $2 million, with computer software and hardware the largest planned categories of expenditure. Management has no current plans to acquire other financial institutions, or to build or acquire new branches in 2009, but will evaluate opportunities that arise if they seem likely to contribute positively to future earnings and shareholder value.

Although the Corporation is well-capitalized (as described in more detail in the “Stockholders’ Equity and Capital Adequacy” section of Management’s Discussion and Analysis), current economic conditions are volatile. Accordingly, management and the Corporation’s Board of Directors decided to raise more capital by participating in the TARP Capital Purchase Program. Management believes the additional capital raised through the TARP Capital Purchase Program provides a form of protection that should allow the Corporation to continue its normal lending and other operating activities, regardless of the possibility of securities losses, loan losses or other issues that could arise in the current economic environment. On January 16, 2009, the Corporation issued 26,440 shares of Series A Preferred Stock (“Preferred Stock”) and a Warrant to purchase up to 194,794 shares of common stock at an exercise price of $20.36 per share. The Corporation sold the Preferred Stock and Warrant to the United States Department of the Treasury for an aggregate price of $26,440,000. In 2009, the Corporation will record issuance of the Preferred Stock and Warrant as increases in stockholders’ equity. The Preferred Stock and Warrant qualify as Tier 1 capital for regulatory purposes. A more complete description of the terms and conditions surrounding the TARP Capital Purchase Program is provided in Note 21 to the consolidated financial statements.

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. 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. Accordingly, when selling debt securities, management typically obtains price quotes from more than one source.

As described in Note 5 to the consolidated financial statements, in 2008, the Corporation changed its method of valuing pooled trust-preferred securities from using price quotes received from pricing services, to a Level 3 (as described in SFAS No. 157) methodology, using discounted cash flows. At December 31, 2008, management calculated 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 6 to the consolidated financial statements, management evaluates securities for other-than-temporary impairment. 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) the intent and ability of the Corporation to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Management’s estimates of cash flows used to evaluate other-than-temporary impairment of pooled trust-preferred securities are based on sensitive assumptions, and use of different assumptions could produce different conclusions for each security. Also, management’s assessments of the likelihood and potential for recovery in value of equity securities (mainly, bank stocks) are subjective, and based on sensitive assumptions.

NET INTEREST MARGIN

The Corporation’s primary source of operating income is represented by the net interest margin. The net interest margin is equal to the difference between the amounts of interest income and interest expense. Tables I, II and III include information regarding the Corporation’s net interest margin in 2008, 2007 and 2006. 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 margin amounts presented in these tables exceed the amounts presented in the consolidated financial statements. The discussion that follows is based on amounts in the Tables.

In May 2007, the Corporation acquired Citizens Bancorp, Inc. Included in this acquisition were all loans and deposits of Citizens Trust Company, its banking subsidiary. At the date of acquisition, the Corporation recorded an increase of $60,151,000 in net loans and $99,636,000 in total deposits.

In December 2007, management entered into a significant leveraged investment purchase transaction for two purposes: (1) to generate incremental positive net interest income, and (2) to reduce the magnitude of the Corporation’s reduction in net interest income if interest rates rise significantly within the next few years. Specifically, the Corporation purchased mortgage-backed securities and a collateralized mortgage obligation for a total cost of approximately $86,000,000, which was funded mainly by two repurchase agreements (borrowings) of $40,000,000 each. The weighted-average initial book yield on the securities was 5.38%.

The borrowings have a weighted-average interest rate of 3.94%, and mature in 2017. One of the borrowings is putable by the issuer at quarterly intervals starting in December 2010, and the other is putable quarterly starting in December 2012. Each of these borrowings contains an embedded cap, providing that on the quarterly anniversary of the transaction settlement date, if three-month LIBOR is higher than 5.15%, the Corporation’s interest rate payable will decrease by twice the amount of the excess, down to a minimum rate of 0%. The embedded caps expire on the initial put dates in 2010 and 2012. Three-month LIBOR did not exceed 5.15% during 2008, and the embedded caps did not provide any reduction to overall interest expense. As of December 31, 2008, three-month LIBOR was 1.43%. If interest rates were to rise significantly during the lives of the embedded caps, the Corporation’s interest expense on the borrowings would decrease, which would be a mitigant to the Corporation’s overall liability-sensitive interest rate risk position.

2008 vs. 2007

The fully taxable equivalent net interest margin was $45,386,000 in 2008, $7,158,000 (18.7%) higher than in 2007. As shown in Table III, net increases in volume had the effect of increasing net interest income $2,417,000, and interest rate changes had the effect of increasing net interest income $4,741,000. Increases in volume of earning assets and interest-bearing liabilities were significantly affected by the acquisition of Citizens Bancorp as well as the leveraged investment purchase discussed above.

The most significant components of the volume changes in 2008 were an increase of $5,261,000 in interest income attributable to growth in the securities portfolio, an increase in interest income of $1,011,000 attributable to loan growth, and an increase in interest expense of $3,517,000 attributable to growth in long-term borrowings. Table III shows that changes in rates had the effect of decreasing interest income $2,062,000, and decreasing interest expense $6,803,000. As presented in Table II, the “interest rate spread” (excess of average rate of return on interest-bearing assets over average cost of funds on interest-bearing liabilities) was 3.30% in 2008, up significantly from 2.92% in 2007.

Interest income totaled $76,435,000 in 2008, an increase of 6.0%. Interest and fees from loans decreased $596,000, or 1.2%, while income from available-for-sale securities increased $5,009,000, or 25.1%. As indicated in Table II, the average balance of gross loans increased 2.0% to $743,741,000 in 2008 from $729,269,000 in 2007. Excluding the impact of the acquisition of Citizens Bancorp, average loans decreased 0.8%. The average rate of return on loans was 6.88%, down from 7.10% in 2007. Total average available-for-sale securities rose to $449,231,000, an increase of $96,423,000 or 27.3% from 2007. The leveraged investment purchase described above increased the average balance of securities by approximately $86,000,000. During 2008, proceeds from sales and maturities of securities were primarily reinvested into high-quality mortgage-backed and municipal securities. As a result of the turmoil in the municipal security market, the Corporation was able to grow its municipal security portfolio and increase its yield at attractive prices. The average rate of return on available-for-sale securities was 5.55%, down from 5.65% for 2007.

Interest expense fell $2,860,000, or 8.4%, to $31,049,000 from $33,909,000 in 2007. Table II shows that the overall cost of funds on interest-bearing liabilities fell to 3.05%, from 3.70% in 2007.

Total average deposits (interest-bearing and noninterest-bearing) increased 4.4%, to $847,714,000 from $812,255,000 in 2007. Excluding acquired Citizens Bancorp deposit accounts, total average deposits increased 1.2%. As short-term market interest rates fell throughout 2008, the Corporation’s rates fell on interest-bearing checking accounts, money market deposit accounts, certificates of deposit, and Individual Retirement Accounts. Rate changes caused a decrease in interest expense on deposits of $6,240,000, which was partially offset by an increase of $670,000 caused by increases in average balances.

The combined average total short-term and long-term borrowed funds increased $76,086,000 to $294,688,000 from $218,602,000 in 2007. This increase relates primarily to the leveraged investment purchase described above. Short-term borrowings are primarily customer repurchase agreements and overnight borrowings; the average rate on short-term borrowings fell to 2.37% from 3.98% in 2007. The average rate on long-term borrowings was 4.24%, up from 4.17% in 2007.

2007 vs. 2006

On a fully taxable-equivalent basis, net interest income rose 5.9%, to $38,228,000 from $36,105,000 in 2006. As reflected in Table III, interest rate changes had the effect of increasing net interest income $263,000 as compared to 2006, as short-term interest rates remained at comparatively high levels over the first nine months of 2007 then began to come down. Table III also shows that volume changes had the effect of increasing net interest income $1,860,000. The most significant components of the volume changes in 2007 were an increase of $4,677,000 attributable to loan growth and a decrease in interest expense on short-term and long-term borrowings of $1,007,000, partially offset by lower interest income of $2,029,000 from available-for-sale securities and an increase in interest expense of $1,150,000 on certificates of deposit. As presented in Table II, the interest rate spread increased slightly to 2.92% in 2007 from 2.90% in 2006.

Interest income totaled $72,137,000, an increase of 7.9% over 2006. Interest and fees from loans increased $6,625,000, or 14.7%, while income from available-for-sale securities decreased $1,421,000, or 6.7%. As indicated in Table II, the average balance of gross loans increased 10.0% to $729,269,000 from $662,714,000 in 2006. Excluding the impact of the acquisition of Citizens Bancorp, average loans increased 3.9%. The average rate of return on loans was 7.10% in 2007, up from 6.81% in 2006. Total average available-for-sale securities fell to $352,808,000, a decrease of $32,311,000 or 8.4% from 2006. Throughout the calendar year 2006 and the first nine months of 2007, proceeds from sales and maturities of securities were used, in part, to help fund loans and pay off borrowings. Within the available-for-sale securities portfolio, the average balance of tax-exempt municipal bonds decreased by $27,916,000. Management decided in mid-2006 to reduce the Corporation’s investment in municipal bonds in order to reduce the alternative minimum tax liability. The average rate of return on available-for-sale securities was 5.65%, up from 5.55% in 2006.

Interest expense rose $3,135,000, or 10.2%, to $33,909,000 from $30,774,000 in 2006. Table II shows that the overall cost of funds on interest-bearing liabilities rose to 3.70% in 2007, from 3.44% in 2006.

Total average deposits (interest-bearing and noninterest-bearing) increased 8.2%, to $812,255,000 from $750,982,000 in 2006. In July 2007, the former Citizens Trust Company trust operations were converted to the same operational platform as Citizens & Northern Bank, and the Corporation transferred $13,343,000 of money market deposits to another financial institution. Management utilizes a third-party provider for Trust & Financial Management money market allocations primarily for interest rate risk management reasons. Excluding acquired Citizens Bancorp deposit accounts, net of the transfers above, total average deposits increased 0.2% in 2007 over 2006. The average rate incurred on certificates of deposit increased to 4.44% from 3.96% in 2006. Also, the average rate on Individual Retirement Accounts increased to 4.50% from 4.28% in 2006.

The combined average total short-term and long-term borrowed funds decreased $26,081,000 to $218,602,000 in 2007 from $244,683,000 in 2006. The yield curve was flat or inverted throughout 2006 and the first half of 2007, creating limited opportunities for earning a positive spread by purchasing or holding investment securities as compared to interest costs associated with maintaining borrowed funds. Accordingly, throughout that period of time, the Corporation paid off many borrowings as they matured. The average rate on long-term borrowings was 4.17%, up from 3.59% in 2006.

TABLE I — ANALYSIS OF INTEREST INCOME AND EXPENSE

		Years Ended December 31,												Increase/(Decrease)
(In Thousands)		2008				2007				2006				2008/2007				2007/2006
INTEREST INCOME
Available-for-sale securities:
Taxable		$	20,347			$	15,954			$	15,504			$	4,393			$	450
Tax-exempt			4,604				3,988				5,859				616				(1,871	)
Total available-for-sale securities			24,951				19,942				21,363				5,009				(1,421	)
Held-to-maturity securities, Taxable			23				24				24				(1	)			0
Trading securities			129				98				0				31				98
Interest-bearing due from banks			33				87				91				(54	)			(4	)
Federal funds sold			120				211				251				(91	)			(40	)
Loans:
Taxable			48,933				49,670				43,247				(737	)			6,423
Tax-exempt			2,246				2,105				1,903				141				202
Total loans			51,179				51,775				45,150				(596	)			6,625
Total Interest Income			76,435				72,137				66,879				4,298				5,258
INTEREST EXPENSE
Interest checking			1,047				1,830				1,784				(783	)			46
Money market			4,162				6,018				5,809				(1,856	)			209
Savings			335				343				337				(8	)			6
Certificates of deposit			8,993				10,786				8,531				(1,793	)			2,255
Individual Retirement Accounts			4,777				5,906				5,240				(1,129	)			666
Other time deposits			6				7				7				(1	)			0
Short-term borrowings			986				1,923				2,318				(937	)			(395	)
Long-term borrowings			10,743				7,096				6,748				3,647				348
Total Interest Expense			31,049				33,909				30,774				(2,860	)			3,135
Net Interest Income		$	45,386			$	38,228			$	36,105			$	7,158			$	2,123

(1)		Interest income from tax-exempt securities and loans has been adjusted to a fully taxable-equivalent basis, using the Corporation’s marginal federal income tax rate of 34%.
(2)		Fees on loans are included with interest on loans and amounted to $1,061,000 in 2008, $985,000 in 2007 and $811,000 in 2006.

TABLE II — ANALYSIS OF AVERAGE DAILY BALANCES AND RATES

		Year				Rate of				Year				Rate of				Year				Rate of
		Ended				Return/				Ended				Return/				Ended				Return/
		12/31/2008				Cost of				12/31/2007				Cost of				12/31/2006				Cost of
		Average				Funds				Average				Funds				Average				Funds
(Dollars in Thousands)		Balance				%				Balance				%				Balance				%
EARNING ASSETS
Available-for-sale securities, at amortized cost:
Taxable		$	379,999				5.35	%		$	290,743				5.49	%		$	295,138				5.25	%
Tax-exempt			69,232				6.65	%			62,065				6.43	%			89,981				6.51	%
Total available-for-sale securities			449,231				5.55	%			352,808				5.65	%			385,119				5.55	%
Held-to-maturity securities, Taxable			408				5.64	%			412				5.83	%			418				5.74	%
Trading securities			2,069				6.23	%			1,665				5.89	%			0				0.00	%
Interest-bearing due from banks			2,385				1.38	%			1,864				4.67	%			2,272				4.01	%
Federal funds sold			5,038				2.38	%			4,017				5.25	%			4,580				5.48	%
Loans:
Taxable			709,377				6.90	%			696,667				7.13	%			631,969				6.84	%
Tax-exempt			34,364				6.54	%			32,602				6.46	%			30,745				6.19	%
Total loans			743,741				6.88	%			729,269				7.10	%			662,714				6.81	%
Total Earning Assets			1,202,872				6.35	%			1,090,035				6.62	%			1,055,103				6.34	%
Cash			19,299								19,485								19,027
Unrealized gain/loss on securities			(24,877	)							(324	)							3,151
Allowance for loan losses			(8,765	)							(8,697	)							(8,495	)
Bank premises and equipment			27,044								26,767								23,491
Intangible Asset — Core Deposit Intangible			1,113								1,287								389
Intangible Asset — Goodwill			12,023								8,864								2,912
Other assets			52,215								41,487								39,111
Total Assets		$	1,280,924							$	1,178,904							$	1,134,689
INTEREST-BEARING LIABILITIES
Interest checking		$	82,795				1.26	%		$	75,488				2.42	%		$	68,369				2.61	%
Money market			193,800				2.15	%			183,178				3.29	%			179,288				3.24	%
Savings			67,276				0.50	%			62,976				0.54	%			62,030				0.54	%
Certificates of deposit			238,316				3.77	%			242,822				4.44	%			215,460				3.96	%
Individual Retirement Accounts			139,321				3.43	%			131,158				4.50	%			122,459				4.28	%
Other time deposits			1,306				0.46	%			1,283				0.55	%			1,116				0.63	%
Short-term borrowings			41,524				2.37	%			48,373				3.98	%			56,606				4.09	%
Long-term borrowings			253,164				4.24	%			170,229				4.17	%			188,077				3.59	%
Total Interest-bearing Liabilities			1,017,502				3.05	%			915,507				3.70	%			893,405				3.44	%
Demand deposits			124,900								115,350								102,260
Other liabilities			7,732								9,378								7,942
Total Liabilities			1,150,134								1,040,235								1,003,607
Stockholders’ equity, excluding other comprehensive income/loss			147,535								140,035								129,004
Other comprehensive income/loss			(16,745	)							(1,366	)							2,078
Total Stockholders’ Equity			130,790								138,669								131,082
Total Liabilities and Stockholders’ Equity		$	1,280,924							$	1,178,904							$	1,134,689
Interest Rate Spread							3.30	%							2.92	%							2.90	%
Net Interest Income/Earning Assets							3.77	%							3.51	%							3.42	%

(1)		Rates of return on tax-exempt securities and loans are calculated on a fully-taxable equivalent basis, using the Corporation’s marginal federal income tax rate of 34%.
(2)		Nonaccrual loans are included in the loan balances above.

TABLE III — THE EFFECT OF VOLUME AND RATE CHANGES ON INTEREST INCOME AND INTEREST EXPENSE

		Year Ended 12/31/08 vs. 12/31/07												Year Ended 12/31/07 vs. 12/31/06
		Change in				Change in				Total				Change in				Change in				Total
(In Thousands)		Volume				Rate				Change				Volume				Rate				Change
EARNING ASSETS
Available-for-sale securities:
Taxable		$	4,788			$	(395	)		$	4,393			$	(234	)		$	684			$	450
Tax-exempt			473				143				616				(1,795	)			(76	)			(1,871	)
Total available-for-sale securities			5,261				(252	)			5,009				(2,029	)			608				(1,421	)
Held-to-maturity securities, Taxable			0				(1	)			(1	)			0				0				0
Trading securities			25				6				31				98				0				98
Interest-bearing due from banks			19				(73	)			(54	)			(18	)			14				(4	)
Federal funds sold			44				(135	)			(91	)			(30	)			(10	)			(40	)
Loans:
Taxable			896				(1,633	)			(737	)			4,559				1,864				6,423
Tax-exempt			115				26				141				118				84				202
Total loans			1,011				(1,607	)			(596	)			4,677				1,948				6,625
Total Interest Income			6,360				(2,062	)			4,298				2,698				2,560				5,258
INTEREST-BEARING LIABILITIES
Interest checking			163				(946	)			(783	)			178				(132	)			46
Money market			332				(2,188	)			(1,856	)			127				82				209
Savings			22				(30	)			(8	)			5				1				6
Certificates of deposit			(197	)			(1,596	)			(1,793	)			1,150				1,105				2,255
Individual Retirement Accounts			350				(1,479	)			(1,129	)			384				282				666
Other time deposits			0				(1	)			(1	)			1				(1	)			0
Short-term borrowings			(244	)			(693	)			(937	)			(329	)			(66	)			(395	)
Long-term borrowings			3,517				130				3,647				(678	)			1,026				348
Total Interest Expense			3,943				(6,803	)			(2,860	)			838				2,297				3,135
Net Interest Income		$	2,417			$	4,741			$	7,158			$	1,860			$	263			$	2,123

(1)		Changes in interest 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 amounts of the change in each.

NON-INTEREST INCOME
2008/2007/2006

Pre-tax losses from available-for-sale securities of $9,338,000 in 2008 were the most significant factor in the reduction of this income category in 2008 compared to net realized gains of $127,000 in 2007. As discussed in the Earnings Overview section of Management’s Discussion and Analysis, such losses primarily related to impairment charges on trust preferred securities and bank stocks totaling $9,872,000 for 2008. Excluding realized losses on sales of available-for-sale securities, total non-interest income increased significantly ($2,443,000 or 23.4%) in 2008 over 2007.

2008 vs. 2007

	•		Service charges on deposit accounts increased $1,888,000, or 73.8%, in 2008 as compared to 2007. A new overdraft privilege program implemented in early 2008 represents substantially all of the category increase.
	•		Service charges and fees increased $73,000, or 10.4%, in 2008 over 2007. The category increase reflects the effect of an increase in the number of ATMs, including those from the Citizens Trust acquisition. Also, the impact of a new fee schedule adopted in the last quarter of 2007 contributed to the increase in ATM fees.
	•		Trust and financial management revenue includes the trust operations acquired in 2007 as part of Citizens Trust, as well as the new trust operations (started in 2007) for the New York State operations. These new trust operations represent $570,000, or 16.6%, of the aggregate trust and financial management revenues in 2008. Aggregate trust revenues have been heavily impacted by the valuation of assets under management. Assets under management amounted to $550,496,000 at December 31, 2008. The current valuation is 16.5% lower than one year earlier primarily due to recent declines in the stock market.
	•		Insurance commissions, fees and premiums have decreased $114,000, or 25.6% in 2008 as compared to 2007. The decrease primarily relates to the reduction in credit-related insurance product revenues for Bucktail Life Insurance.
	•		The increase in the cash surrender value of life insurance increased $39,000, or 5.4%, in 2008 over 2007. Bank owned life insurance acquired with Citizens Trust increased $59,000 to represent a full year of earnings in 2008.
	•		Other operating income reflects a net increase of $554,000, or 21.5%, in 2008 over 2007. The most significant increase was a gain of $533,000 in 2008 from the redemption of restricted shares of Visa, resulting from Visa’s initial public offering. Also, interchange fees related to debit card transactions provided an increase of $238,000 (37.8%) in 2008, which is primarily attributed to the additional volume for the Citizens Trust Company branches. Other operating income was offset by a decrease in dividends on Federal Home Loan Bank of Pittsburgh stock of $196,000 in 2008 due to the suspension of such dividends during the last quarter.

2007 vs. 2006

In 2007, net realized gains on sales of available-for-sale securities were much lower than in 2006, totaling $127,000 in 2007 as compared to $5,046,000 in 2006. Excluding realized gains on sales of available-for-sale securities, total noninterest income increased significantly ($2,130,000 or 25.6%) in 2007 over 2006.

	•		Trust and financial management revenue increased $1,031,000 (42.8%), including an increase of 22.3% excluding Citizens Trust Company, and a contribution to revenue from Citizens Trust Company of $493,000. Trust and financial management revenues are heavily affected by the amount of assets under management. Assets under management totaled $659,193,000 at December 31, 2007, an increase of 27.3% over year-end 2006, which reflects the impact of the addition of Citizens Trust Company, as well as significant appreciation in equity markets.
	•		Service charges on deposit accounts increased $525,000, or 25.8%, in 2007 as compared to 2006, including $436,000 from Citizens Trust Company.
	•		Service charges and fees increased $258,000 in 2007 over 2006. Among the types of fees included in this category are ATM-related fees, which increased $132,000 in 2007 over 2006, and letter of credit fees, which increased $125,000 in 2007 because of a few large, commercial transactions.
	•		In 2006, there was a gain from sale of credit card loans of $340,000, with no corresponding gain or loss in 2007.
	•		Other operating income increased $589,000, or 29.7%, in 2007 over 2006. Included in this category were increases in interchange fees related to debit card transactions of $158,000, higher broker-dealer revenues of $108,000, gain on sale

of a restricted equity security of $80,000, higher fees from credit card agent bank activity of $61,000, training grant revenue of $43,000 and higher check sales of $39,000.

TABLE IV — COMPARISON OF NON-INTEREST INCOME

(In Thousands)		2008				% Change				2007				% Change				2006
Service charges on deposit accounts		$	4,447				73.8			$	2,559				25.8			$	2,034
Service charges and fees			777				10.4				704				57.8				446
Trust and financial management revenue			3,443				0.1				3,440				42.8				2,409
Insurance commissions, fees and premiums			332				(25.6	)			446				(4.7	)			468
Increase in cash surrender value of life insurance			758				5.4				719				14.1				630
Gain on sale of credit card loans			0				0.0				0				(100.0	)			340
Other operating income			3,126				21.5				2,572				29.7				1,983
Total other income before realized gains on securities, net			12,883				23.4				10,440				25.6				8,310
Realized (losses) gains on available-for-sale securities, net			(9,338	)			(7,452.8	)			127				(97.5	)			5,046
Total Other Income		$	3,545				(66.5	)		$	10,567				(20.9	)		$	13,356

NON-INTEREST EXPENSE
2008/2007/ 2006

In the second half of 2008, the Corporation initiated actions to improve the efficiency of certain operational activities. The implementation plan was established with the assistance of a nationally recognized consulting firm, and included a net reduction of the workforce. As a result, total non-interest expense increased only $163,000, or 0.5%, in 2008 compared to 2007. In 2007, total non-interest expense increased $1,669,000, or 5.3% over 2006. The 2007 increase was primarily the result of the May 2007 acquisition of Citizens Trust Company with three branch locations and a Trust department operation.

2008 vs. 2007

Salaries and wages increased $259,000, or 1.8%. The primary increase in salaries is associated with the 2008 accruals for various incentive compensation programs of $816,000 more than the related 2007 incentives. Other compensation costs, primarily severance related costs, increased $174,000 in 2008. Salaries and wages associated with staff additions from the Citizens Bancorp acquisition have been more than fully offset by reductions in personnel that have taken place over the last half of 2007 and during the year 2008.

Pensions and other employee benefits decreased $2,000; however, within this category, there were several significant changes, summarized as follows:

	•		Group health insurance expense was $271,000 higher in 2008, mainly because an experience-related refund reduced expense in 2007.
	•		Employer contributions expense associated with the Savings & Retirement Plan (a 401(k) plan) and Employee Stock Ownership Plan was $184,000 higher in 2008 than in 2007. The increased expense relates primarily to the Corporation’s increase in employer matching contributions in connection with its decision, discussed earlier, to terminate its defined benefit pension plan.
	•		Payroll tax expense decreased $99,000. In the first quarter 2007, the Corporation recorded payroll tax expense associated with incentive bonuses that were determined based on 2006 performance and paid in January 2007. There were no incentive bonuses awarded based on 2007 performance, and accordingly, no bonus-related payroll tax expense was recorded in 2008. In addition, reduced payroll taxes for 2008 were associated with the reductions in personnel discussed above.
	•		Defined benefit pension plan expense decreased $415,000, as a result of the decision to freeze and terminate the plan, effective December 31, 2007. The Corporation funded and settled its obligations under the Plan, and recorded a gain of $71,000 from settlement, in 2008.

Occupancy expense increased $227,000, or 8.6%. Approximately $110,000 of the increase relates to the addition of the Citizens Trust Company operations. Also, utility costs, real estate taxes and building maintenance costs were higher in 2008 compared to 2007.

Pennsylvania shares tax expense increased $227,000, or 24.1%, mainly due to the addition of Citizens Trust Company’s historic asset and equity values to the tax base.

Other operating expense decreased $420,000, or 5.0%. This category includes many varieties of expenses, with significant increases and decreases in some of the individual expenses, as follows:

	•		Decrease in operating expenses of $348,000 from the recovery of $174,000 in 2008 from an insurance claim related to costs recorded in the third quarter of 2007.
	•		Decrease of $221,000 related to core system conversion expense incurred in 2007 to convert the computer systems used for both the New York State locations and the Citizens Bancorp locations to the same core computer system used by C&N Bank.
	•		Decrease of $145,000 related to a loss on disposition of telephone equipment recorded in 2007.
	•		Settlement of certain sales tax issues in 2008 reduced overall costs by $94,000 associated with recovered costs or related consulting fees in 2007.
	•		Costs associated with other real estate (OREO) property activity decreased $50,000 due to improved disposition activity and one large recovery of $21,000 in 2008.
	•		Professional services increased $403,000 in 2008, mainly because $530,000 was incurred for two projects initiated to enhance non-interest income (overdraft privilege program discussed above) and to improve the bank operating structure, as well as future efficiency and profitability.
	•		FDIC insurance costs increased to $308,000 in 2008, or $213,000 higher than in 2007.
	•		Amortization of core deposit intangibles increased $107,000, including an increase of $128,000 attributable to the Citizens Bancorp acquisition.

2007 vs. 2006

Salaries and wages reflect a net increase of $597,000, or 4.4%, in 2007 over 2006. Increases of $856,000 are associated with expanded operations, primarily at locations associated with the acquisition of Citizens Trust Company. As described in the “stock-based compensation plans” section of Note 13 to the consolidated financial statements, the Corporation made awards of stock options and restricted stock in 2007, with no awards in 2006. Stock option expense was recognized over the six-month vesting period for the 2007 awards. The Corporation also incurred $139,000 of severance costs in connection with a reduction in workforce initiated during the second half of 2007. In 2007, based on performance results, the Corporation did not incur incentive bonus expense, as compared to $750,000 in 2006.

Total pensions and other employee benefits expense decreased $75,000, or 1.8%. Total contributions to the Employee Stock Ownership Plan (ESOP) were $177,000 lower in 2007 than in 2006. In 2007, ESOP contributions were made at the required level provided for in the Plan (2% of compensation, as defined in the Plan), while in 2006 total ESOP contributions were based on 4% of compensation (including the required 2%, plus an additional discretionary 2%). The Corporation also received a refund in 2007 on its health insurance based on favorable claims experience from a prior year. The health insurance refund reduced 2007 health care costs by $225,000 from 2006. Excluding the impact of the reduced ESOP expense and the health insurance refund, the cost of pensions and other employee benefits is 9.1% higher in 2007 than in 2006. The increases in this category primarily relate to the additional costs of benefits for employees associated with the Citizens Trust Company locations. Note 13 to the consolidated financial statements provides information concerning some of more significant elements of this category, including the defined benefit pension and postretirement health plans, the 401(k)/ESOP and the supplemental executive retirement plan.

Occupancy costs increased $325,000, or 14.1%, in 2007 over 2006. The primary increase in this category is associated with the Citizens Trust Company locations with $259,000 of such costs in 2007, and a full year of operation of the Corporation’s new administration building.

Furniture and equipment expense increased $182,000, or 7.0%, including $225,000 attributed to Citizens Trust Company operations.

Other operating expense increased $674,000, or 8.7%. This category includes many varieties of expenses, with significant increases and decreases in some of the individual expenses, as follows:

	•		Increase of $705,000 from the acquisition of Citizens Trust Company, including $360,000 for amortization of the core deposit intangible, and excluding computer system conversion costs.
	•		Increase of $240,000 from professional and other fees associated with converting First State Bank and Citizens Trust Company locations to the same core computer system used by C&N Bank.
	•		Increase of $172,000 in cash-based Director fees, Director stock options and restricted stock.
	•		Incurred $145,000 in 2007 associated with a loss on the disposition of telephone equipment that was disposed in conjunction with efforts to provide improved, compatible communications at all locations.
	•		Increase in computer-related services of $152,000, including services related to a new internet banking platform, branch deposit capture software and an employee time and attendance system.
	•		Decrease in certain expense categories for which management has some discretion over spending, including a total reduction of $354,000 in education and training, public relations and donations, office supplies and advertising.
	•		Decrease in comparative 2007 expense because results for 2006 included a $168,000 impairment write-down related to a leased building which management decided to vacate.
	•		Decrease in expenses associated with other real estate properties of $101,000.
	•		Decrease of $100,000 in Bucktail Life Insurance Company expenses associated with loss experience.

TABLE V — COMPARISON OF NON-INTEREST EXPENSE

(In Thousands)		2008				% Change				2007				% Change				2006
Salaries and wages		$	14,561				1.8			$	14,302				4.4			$	13,705
Pensions and other employee benefits			4,202				(0.0	)			4,204				(1.8	)			4,279
Occupancy expense, net			2,861				8.6				2,634				14.1				2,309
Furniture and equipment expense			2,661				(4.6	)			2,789				7.0				2,607
Pennsylvania shares tax			1,169				24.1				942				(3.5	)			976
Other operating expense			7,992				(5.0	)			8,412				8.7				7,738
Total Other Expense		$	33,446				0.5			$	33,283				5.3			$	31,614

INCOME TAXES

The income tax provision was $2,319,000, or 18.7% of pre-tax income in 2008, as compared to 20.2% in 2007 and 18.8% in 2006. The fluctuations in the tax provision/pre-tax income rate for these periods include the impact of changes in the average holdings of tax-exempt securities and loans. A more complete analysis of income taxes is presented in Note 14 to the consolidated financial statements.

FINANCIAL CONDITION

Significant changes in the average balances of the Corporation’s earning assets and interest-bearing liabilities are described in the Net Interest Margin section of Management’s Discussion and Analysis. That discussion provides useful information regarding changes in the Corporation’s balance sheet over the 2-year period ended December 31, 2008, including discussions of available-for-sale securities, loans, deposits and borrowings. Other significant balance sheet items — the allowance for loan losses and stockholders’ equity — are discussed in separate sections of Management’s Discussion and Analysis.

Table VI shows the composition of the investment portfolio at December 31, 2008, 2007 and 2006. Comparison of the amortized cost totals of available-for-sale securities at each year-end presented reflects an increase from $353,954,000 at December 31,

2006, to $442,835,000 at December 31, 2007, and an additional increase to $454,707,000 at December 31, 2008. The increase in the investment portfolio in 2007 resulted mainly from a leveraged investment purchase of securities in December 2007, as discussed in more detail in the Net Interest Margin section of Management’s Discussion and Analysis. Prior to the yield curve changing to a more positive shape in the latter part of 2007, management had been “shrinking the balance sheet,” meaning that proceeds from principal payments on the investment portfolio were not being reinvested; instead, proceeds were used mainly to pay off borrowings or to fund loans. In 2008, the main increases were in mortgage-backed securities and municipal bonds. At December 31, 2008, the amortized cost of the available-for-sale securities portfolio exceeded the estimated fair value by $35,019,000. In comparison, the amortized cost was $10,080,000 higher than fair value at December 31, 2007, and fair value exceeded amortized cost by $2,711,000 at December 31, 2006. As discussed in more detail in Notes 5 and 6 to the financial statements, arm’s-length trading activity for pooled trust-preferred securities came to a virtual halt in 2008, and the Corporation has adopted a Level 3 methodology (as defined in SFAS No. 157, as amended) for calculating fair values for these instruments. Based on its calculations, the Corporation has recorded significant unrealized losses on its holdings of trust-preferred securities as of December 31, 2008. Also, many other categories of available-for-sale securities, for which the Corporation determines fair value based on information provided by pricing services or broker quotes, have fallen in value in 2008, including municipal bonds, equities and AAA-rated private label mortgage backed securities. In 2008, the Corporation reported realized losses from available-for-sale securities of $9,338,000, including the effect of other-than-temporary impairment write-downs of trust-preferred securities by $8,210,000 and bank stocks by $1,662,000. Management has reviewed its holdings as of December 31, 2008, and concluded that — with the exception of the trust-preferred securities and bank stocks that have been written down through earnings — the remaining unrealized losses are considered temporary. Notes 5 and 6 to the consolidated financial statements provide more detail concerning the Corporation’s processes for evaluating securities for other-than-temporary impairment, and for valuation of trust-preferred securities. Management will continue to closely monitor the status of impaired securities in 2009.

The balance of loans outstanding (without consideration of the allowance for loan losses) has grown $163,941,000 from the balance at December 31, 2004 to the total outstanding of $743,544,000 at December 31, 2008. Of the total increase, $83,693,000 came from balances acquired from Citizens Bancorp, Inc. (2007) and First State Bank (2005). Excluding the effects of acquisitions, total loans grew slightly (1.0%) in 2008, fell slightly (1.7%) in 2007, and grew 5.2% in 2006, and 8.7% in 2005. Loan volumes are heavily dependent on economic conditions in the Corporation’s market area, and are significantly influenced by interest rates. Overall, the Corporation has experienced growth in commercial and consumer mortgage lending over the past 4 years. The Corporation has not originated interest only mortgages, loans without documentation of the borrowers’ sources of income or net worth, or other types of exotic mortgage loans that have made headlines in recent months, and which have led some lenders and investors to realize significant losses from these types of instruments.

Table VIII presents loan maturity data as of November 30, 2008 (the last date in 2008 for which the Corporation ran the interest rate simulation model used to generate the loan maturities information included in Table VIII). The interest rate simulation model classifies certain loans under different categories than they appear in Table VII. Fixed rate loans are included in Table VIII based on their contractually scheduled principal repayments, while variable rate loans are included based on contractual principal repayments, with the remaining balance reflected in the Table as of the date of the next change in rate. Table VIII shows that approximately 49% of the loan portfolio is fixed rate. Of the 51% of the portfolio made up of variable rate loans, a significant portion (30%) will re-price after more than one year. Variable rate loans re-pricing after more than one year include significant amounts of residential and commercial real estate loans. The Corporation’s substantial investment in long-term, fixed rate loans and variable rate loans with extended periods until re-pricing is one of the major concerns management attempts to address through interest rate risk management practices. See Part II, Item 7A for a more detailed discussion of the Corporation’s interest rate risk.

Total capital purchases in 2009 are estimated at approximately $2 million. Management does not expect capital expenditures to have a material, detrimental effect on the Corporation’s financial condition during 2009.

TABLE VI — INVESTMENT SECURITIES

		As of December 31,
		2008								2007								2006
		Amortized				Fair				Amortized				Fair				Amortized				Fair
(In Thousands)		Cost				Value				Cost				Value				Cost				Value
AVAILABLE-FOR-SALE SECURITIES:
Obligations of other U.S. Government agencies		$	15,500			$	16,201			$	32,199			$	32,723			$	26,000			$	25,568
Obligations of states and political subdivisions			80,838				74,223				63,340				60,449				70,027				70,478
Mortgage-backed securities			171,453				173,856				149,796				150,416				110,049				107,331
Collateralized mortgage obligations			70,619				68,234				70,080				69,505				39,178				38,244
Other securities			94,892				68,324				104,975				96,915				84,670				84,332
Total debt securities			433,302				400,838				420,390				410,008				329,924				325,953
Marketable equity securities			21,405				18,850				22,445				22,747				24,030				30,712
Total		$	454,707			$	419,688			$	442,835			$	432,755			$	353,954			$	356,665
HELD-TO-MATURITY SECURITIES:
Obligations of the U.S. Treasury		$	304			$	320			$	307			$	321			$	310			$	315
Obligations of other U.S. Government agencies			100				104				99				105				99				104
Mortgage-backed securities			2				2				3				3				5				5
Total		$	406			$	426			$	409			$	429			$	414			$	424

The following table shows the amortized cost and maturity distribution of the available-for-sale debt securities portfolio, along with weighted-average yields, at December 31, 2008:

		Within								One-								Five-								After
		One								Five								Ten								Ten
(In Thousands, Except for Percentages)		Year				Yield				Years				Yield				Years				Yield				Years				Yield				Total				Yield
AVAILABLE-FOR-SALE SECURITIES:
Obligations of other U.S. Government agencies		$	0				0.00	%		$	500				4.63	%		$	15,000				5.88	%		$	0				0.00	%		$	15,500				5.84	%
Obligations of states and political subdivisions			180				3.54	%			401				3.84	%			1,810				4.99	%			78,447				4.64	%			80,838				4.64	%
Mortgage-backed securities			0				0.00	%			379				3.56	%			3,945				5.24	%			167,129				5.32	%			171,453				5.31	%
Collateralized mortgage obligations			0				0.00	%			707				4.46	%			7,967				4.76	%			61,945				5.27	%			70,619				5.21	%
Other securities			0				0.00	%			5,011				6.77	%			0				0.00	%			89,881				5.73	%			94,892				5.79	%
Total		$	180				3.54	%		$	6,998				6.04	%		$	28,722				5.42	%		$	397,402				5.27	%		$	433,302				5.29	%
HELD-TO-MATURITY SECURITIES:
Obligations of the U.S. Treasury		$	0				0.00	%		$	304				5.28	%		$	0				0.00	%		$	0				—			$	304				5.28	%
Obligations of other U.S. Government agencies			100				7.16	%			0				0.00	%			0				0.00	%			0				—				100				7.16	%
Mortgage-backed securities			0				0.00	%			0				0.00	%			0				0.00	%			2				6.54	%			2				6.54	%
Total		$	100				7.16	%		$	304				5.28	%		$	0				0.00	%		$	2				6.54	%		$	406				5.75	%

TABLE VII — FIVE-YEAR SUMMARY OF LOANS BY TYPE

		2008				%				2007				%				2006				%				2005				%				2004				%
Real estate — residential mortgage		$	433,377				58.29			$	441,692				60.02			$	387,410				56.35			$	361,857				55.39			$	347,705				59.98
Real estate — commercial mortgage			165,979				22.32				144,742				19.67				178,260				25.93				153,661				23.52				128,073				22.10
Real estate — construction			24,992				3.36				22,497				3.06				10,365				1.51				5,552				0.85				4,178				0.72
Consumer			26,732				3.60				37,193				5.05				35,992				5.24				31,559				4.83				31,702				5.47
Agricultural			4,495				0.60				3,553				0.48				2,705				0.39				2,340				0.36				2,872				0.50
Commercial			48,295				6.50				52,241				7.10				39,135				5.69				69,396				10.62				43,566				7.52
Other			884				0.12				1,010				0.14				1,227				0.18				1,871				0.29				1,804				0.31
Political subdivisions			38,790				5.21				33,013				4.48				32,407				4.71				27,063				4.14				19,713				3.40
Total			743,544				100.00				735,941				100.00				687,501				100.00				653,299				100.00				579,613				100.00
Less: allowance for loan losses			(7,857	)							(8,859	)							(8,201	)							(8,361	)							(6,787	)
Loans, net		$	735,687							$	727,082							$	679,300							$	644,938							$	572,826