Edgar Filing: COMMUNITY BANK SYSTEM INC

cbna10q2ndqtr2009.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended June 30, 2009

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

For the transition period from to .

Commission File Number 001-13695

	COMMUNITY BANK SYSTEM, INC.
	(Exact name of registrant as specified in its charter)

Delaware		16-1213679
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

5790 Widewaters Parkway, DeWitt, New York		13214-1883
(Address of principal executive offices)		(Zip Code)

(315) 445-2282

(Registrant's telephone number, including area code)

NONE

(Former name, former address and former fiscal year, if changed since last report)

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

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

Large accelerated filer o Accelerated filer x 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 x .

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

32,741,009 shares of Common Stock, $1.00 par value, were outstanding on July 31, 2009.

TABLE OF CONTENTS

		Page

Part I.	Financial Information

Item 1.	Financial Statements (Unaudited)

	Consolidated Statements of Condition
	June 30, 2009 and December 31, 2008	3

	Consolidated Statements of Income
	Three and six months ended June 30, 2009 and 2008	4

	Consolidated Statement of Changes in Shareholders' Equity
	Six Months ended June 30, 2009	5

	Consolidated Statements of Comprehensive Income
	Three and six months ended June 30, 2009 and 2008	6

	Consolidated Statements of Cash Flows
	Six Months ended June 30, 2009 and 2008	7

	Notes to the Consolidated Financial Statements
	June 30, 2009	8

Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	22

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	38

Item 4.	Controls and Procedures	39

Part II.	Other Information

Item 1.	Legal Proceedings	39

Item 1A	Risk Factors	39

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	39

Item 3.	Defaults Upon Senior Securities	39

Item 4.	Submission of Matters to a Vote of Securities Holders	40

Item 5.	Other Information	40

Item 6.	Exhibits	40

Part I. Financial Information

Item 1. Financial Statements

COMMUNITY BANK SYSTEM, INC.

CONSOLIDATED STATEMENTS OF CONDITION (Unaudited)

(In Thousands, Except Share Data)


	June 30,	December 31,
	2009	2008
Cash and cash equivalents	$474,372	$213,753

Available-for-sale investment securities, at fair value	1,225,004	1,317,217
Held-to-maturity investment securities	110,354	77,794
Total investment securities (fair value of $1,337,666 and $1,397,589, respectively)	1,335,358	1,395,011

Loans held for sale	3,860	0

Loans	3,091,605	3,136,140
Allowance for loan losses	(40,330)	(39,575)
Net loans	3,051,275	3,096,565

Core deposit intangibles, net	18,700	22,340
Goodwill	301,369	301,149
Other intangibles, net	4,567	5,135
Intangible assets, net	324,636	328,624

Premises and equipment, net	72,853	73,294
Accrued interest receivable	24,122	26,077
Other assets	50,511	41,228
Total assets	$5,336,987	$5,174,552

Liabilities:
Noninterest-bearing deposits	$697,612	$638,558
Interest-bearing deposits	3,166,811	3,062,254
Total deposits	3,864,423	3,700,812

Borrowings	756,649	760,558
Subordinated debt held by unconsolidated subsidiary trusts	101,987	101,975
Accrued interest and other liabilities	63,299	66,556
Total liabilities	4,786,358	4,629,901

Commitments and contingencies (See Note I)

Shareholders' equity:
Preferred stock $1.00 par value, 500,000 shares authorized, 0 shares issued	-	-
Common stock, $1.00 par value, 50,000,000 shares authorized;	33,575	33,468
33,575,407 and 33,468,215 shares issued at June 30, 2009 and December 31, 2008, respectively
Additional paid-in capital	214,383	212,400
Retained earnings	335,128	329,914
Accumulated other comprehensive income	(14,190)	(12,864)
Treasury stock, at cost (834,811 shares)	(18,267)	(18,267)
Total shareholders' equity	550,629	544,651

Total liabilities and shareholders' equity	$5,336,987	$5,174,552

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

COMMUNITY BANK SYSTEM, INC.

CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

(In Thousands, Except Per-Share Data)

		Three Months Ended		Six Months Ended
		June 30,		June 30,
		2009	2008	2009	2008
Interest income:
	Interest and fees on loans	$46,134	$45,691	$92,925	$92,206
	Interest and dividends on taxable investments	9,926	9,635	20,233	20,349
	Interest and dividends on nontaxable investments	5,895	5,744	11,896	11,666
	Total interest income	61,955	61,070	125,054	124,221

Interest expense:
	Interest on deposits	12,087	16,039	25,657	33,733
	Interest on borrowings	7,815	7,882	15,572	15,923
	Interest on subordinated debt held by unconsolidated subsidiary trusts	1,539	1,709	3,125	3,527
	Total interest expense	21,441	25,630	44,354	53,183

Net interest income		40,514	35,440	80,700	71,038
Less: provision for loan losses		2,015	1,570	4,825	2,350
Net interest income after provision for loan losses		38,499	33,870	75,875	68,688

Noninterest income:
	Deposit service fees	10,284	8,910	19,277	17,171
	Mortgage banking and other services	1,499	539	3,822	1,134
	Benefit plan administration, consulting and actuarial fees	6,599	5,933	13,606	12,245
	Trust, investment and asset management fees	2,267	2,324	4,300	4,487
	Gain (loss) on investment securities	0	(57)	0	230
Total noninterest income		20,649	17,649	41,005	35,267

Operating expenses:
	Salaries and employee benefits	23,154	19,772	46,116	40,158
	Occupancy and equipment	5,704	5,189	11,915	10,762
	Data processing and communications	5,171	4,100	10,021	8,085
	Amortization of intangible assets	2,103	1,645	4,208	3,176
	Legal and professional fees	1,318	902	2,602	2,200
	Office supplies and postage	1,472	1,237	2,847	2,515
	Business development and marketing	2,057	1,507	3,349	2,829
	FDIC insurance premiums	4,021	277	5,396	386
	Other	2,483	2,326	5,430	5,218
	Total operating expenses	47,483	36,955	91,884	75,329

Income before income taxes		11,665	14,564	24,996	28,626
Income taxes		2,510	3,277	5,376	6,441
Net income		$9,155	$11,287	$19,620	$22,185

Basic earnings per share		$0.28	$0.38	$0.60	$0.74
Diluted earnings per share		$0.28	$0.37	$0.60	$0.73
Dividends declared per share		$0.22	$0.21	$0.44	$0.42

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

COMMUNITY BANK SYSTEM, INC.

CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (Unaudited)

Six Months Ended June 30, 2009

(In Thousands, Except Share Data)

					Accumulated
	Common Stock		Additional		Other
	Shares	Amount	Paid-In	Retained	Comprehensive	Treasury
	Outstanding	Issued	Capital	Earnings	Loss	Stock	Total

Balance at December 31, 2008	32,633,404	$33,468	$212,400	$329,914	($12,864)	($18,267)	$544,651

Net income				19,620			19,620

Other comprehensive loss, net of tax					(1,326)		(1,326)

Dividends declared:
Common, $0.44 per share				(14,406)			(14,406)

Common stock issued under
Stock plan, including
tax benefits of $87	107,192	107	734				841

Stock options earned			1,249				1,249

Balance at June 30, 2009	32,740,596	$33,575	$214,383	$335,128	($14,190)	($18,267)	$550,629

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

COMMUNITY BANK SYSTEM, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

(In Thousands)

	Three Months Ended		Six Months Ended
	June 30,		June 30,
	2009	2008	2009	2008

Other comprehensive (loss) income, before tax:
Change in pension liabilities	$702	$200	$1,776	$55
Change in unrealized gains and losses on derivative instruments used in cash flow hedges	994	2,832	1,182	73
Unrealized (losses) gains on securities:
Unrealized holding losses arising during period	(362)	(21,281)	(4,602)	(17,001)
Reclassification adjustment for (gains) losses included in net income	0	57	0	(230)
Other comprehensive (loss) income, before tax:	1,334	(18,192)	(1,644)	(17,103)
Income tax benefit (expense) related to other comprehensive (loss) income	(681)	6,873	318	6,480
Other comprehensive (loss) income, net of tax:	653	(11,319)	(1,326)	(10,623)
Net income	9,155	11,287	19,620	22,185
Comprehensive income (loss)	$9,808	($32)	$18,294	$11,562

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

COMMUNITY BANK SYSTEM, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(In Thousands)

	Six Months Ended June 30,
	2009	2008
Operating activities:
Net income	$19,620	$22,185
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation	5,111	4,698
Amortization of intangible assets	4,208	3,176
Net accretion of premiums and discounts on securities, loans and borrowings	416	(406)
Stock-based compensation	1,705	1,393
Provision for loan losses	4,825	2,350
Gain on investment securities and debt extinguishments	0	(230)
Net loss on sale of other assets	19	31
Net change in loans originated for sale	(3,860)	0
Change in other operating assets and liabilities	(7,359)	(4,868)
Net cash provided by operating activities	24,685	28,329
Investing activities:
Proceeds from sales of available-for-sale investment securities	0	31,344
Proceeds from maturities of held-to-maturity investment securities	51,593	2,043
Proceeds from maturities of available-for-sale investment securities	166,906	220,460
Purchases of held-to-maturity investment securities	(84,561)	(3,849)
Purchases of available-for-sale investment securities	(79,292)	(133,515)
Net decrease (increase) in loans outstanding	40,466	(102,835)
Cash paid for acquisition (net of cash acquired of $0)	(281)	(479)
Expenditures for intangibles	0	(322)
Capital expenditures	(4,689)	(5,266)
Net cash provided by investing activities	90,142	7,581
Financing activities:
Net change in non-interest checking, interest checking and savings accounts	251,292	80,824
Net change in time deposits	(87,681)	(61,940)
Net change in short-term borrowings	(3,723)	(38,556)
Change in long-term borrowings (including payments of $186 and $402)	(186)	9,598
Payment on subordinated debt held by unconsolidated subsidiary trusts	0	(25,773)
Issuance of common stock	385	4,460
Cash dividends paid	(14,382)	(12,492)
Tax benefits from share-based payment arrangements	87	379
Net cash provided by (used in) financing activities	145,792	(43,500)
Change in cash and cash equivalents	260,619	(7,590)
Cash and cash equivalents at beginning of period	213,753	130,823
Cash and cash equivalents at end of period	$474,372	$123,233
Supplemental disclosures of cash flow information:
Cash paid for interest	$44,819	$53,799
Cash paid for income taxes	29	6,316
Supplemental disclosures of noncash financing and investing activities:
Dividends declared and unpaid	7,203	6,286
Transfers from loans to other real estate	1,451	354

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

COMMUNITY BANK SYSTEM, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

June 30, 2009

NOTE A: BASIS OF PRESENTATION

The interim financial data as of June 30, 2009 and for the three and six months ended June 30, 2009 and 2008 is unaudited; however, in the opinion of the Company, the interim data includes all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of the results for the interim periods. The results of operations for the interim periods are not necessarily indicative of the results that may be expected for the full year or any other interim period.

NOTE B: ACQUISITION AND OTHER MATTERS

Citizens Branches Acquisition

On November 7, 2008, the Company acquired 18 branch-banking centers in northern New York from Citizens Financial Group, Inc. (“Citizens”) in an all cash transaction. The Company acquired approximately $109 million in loans and $565 million in deposits at a blended deposit premium of 13%. The results of operations for the 18 branches acquired from Citizens have been included in the consolidated financial statements since that date. In support of the transaction, the Company issued approximately $50 million of equity capital in the form of common stock in October 2008.

Alliance Benefit Group MidAtlantic

On July 7, 2008, Benefit Plans Administrative Services, Inc. (“BPAS”), a wholly owned subsidiary of the Company, acquired the Philadelphia division of Alliance Benefit Group MidAtlantic (“ABG”) from BenefitStreet, Inc. in an all cash transaction. ABG provides retirement plan consulting, daily valuation administration, actuarial and ancillary support services. The results of ABG’s operations have been included in the consolidated financial statements since that date.

The estimated purchase price allocation of the assets acquired and liabilities assumed in the purchase of Citizens and ABG, collectively, including capitalized acquisition costs, is as follows:

(000’s omitted)
Cash and cash equivalents	$ 2,610
Loans, net of allowance for loan losses	108,633
Premises and equipment, net	2,051
Other assets	1,212
Core deposit intangibles	8,547
Customer list intangible	4,067
Goodwill	68,665
Total assets acquired	195,785
Deposits	565,048
Borrowings	14
Other liabilities	612
Total liabilities assumed	565,674
Net liabilities assumed	$ 369,889

Stock Repurchase Program

On July 22, 2009, the Company announced an authorization to repurchase up to 1,000,000 of its outstanding shares in open market transactions or privately negotiated transactions in accordance with securities laws and regulations through December 31, 2011. Any repurchased shares will be used for general corporate purposes, including those related to stock plan activities. The timing and extent of repurchases will depend on market conditions and other corporate considerations as determined at the Company’s discretion. There were no treasury stock purchases during the first six months of 2009.

NOTE C: ACCOUNTING POLICIES

Critical Accounting Policies

Allowance for Loan Losses

Management continually evaluates the credit quality of the Company’s loan portfolio and performs a formal review of the adequacy of the allowance for loan losses on a quarterly basis. The allowance reflects management’s best estimate of probable losses inherent in the loan portfolio. Determination of the allowance is subjective in nature and requires significant estimates. The Company’s allowance methodology consists of two broad components, general and specific loan loss allocations.

The general loan loss allocation is composed of two calculations that are computed on five main loan categories: commercial, consumer direct, consumer indirect, home equity and residential real estate. The first calculation determines an allowance level based on the latest seven years of historical net charge-off data for each loan category (commercial loans exclude balances with specific loan loss allocations). The second calculation is qualitative and takes into consideration eight qualitative environmental factors: levels and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards, and other changes in lending policies, procedure, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry condition; and effects of changes in credit concentrations. These two calculations are added together to determine the general loan loss allocation. The specific loan loss allocation relates to individual commercial loans that are both greater than $0.5 million and in a nonaccruing status with respect to interest. Specific losses are based on discounted estimated cash flows, including any cash flows resulting from the conversion of collateral. The allowance levels computed from the specific and general loan loss allocation methods are combined with unallocated reserves, if any, to derive the required allowance for loan loss to be reflected on the Consolidated Statement of Condition.

Loan losses are charged off against the allowance, while recoveries of amounts previously charged off are credited to the allowance. A provision for loan loss is charged to operations based on management’s periodic evaluation of the factors previously mentioned.

Investment Securities

The Company has classified its investments in debt and equity securities as held-to-maturity or available-for-sale. Held-to-maturity securities are those for which the Company has the positive intent and ability to hold to maturity, and are reported at cost, which is adjusted for amortization of premiums and accretion of discounts. Securities not classified as held-to-maturity are classified as available-for-sale and are reported at fair market value with net unrealized gains and losses reflected as a separate component of shareholders' equity, net of applicable income taxes. None of the Company's investment securities have been classified as trading securities at June 30, 2009. Equity securities are stated at cost and include restricted stock of the Federal Reserve Bank of New York and Federal Home Loan Bank of New York.

Investment securities are reviewed regularly for other-than-temporary impairment. In the second quarter of 2009, the Company adopted FASB Staff Position FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments (“FSP FAS 115-2 and FAS 124-2”). In accordance with this FSP an unrealized loss is generally deemed to be other-than-temporary and a credit loss is deemed to exist if the present value of the expected future cash flows is less than the amortized cost basis of the debt security. The credit loss component of an other-than-temporary impairment write-down is recorded in earnings, while the remaining portion of the impairment loss is recognized in other comprehensive income (loss), provided the Company does not intend to sell the underlying debt security and it is more likely than not that the Company will not be required to sell the debt security prior to recovery. In determining whether a credit loss exists and the period over which the fair value of the debt security is expected to recover management considers: the length of time and extent that fair value has been less than cost, the financial condition and near term prospects of the issuer, any external credit ratings, the level of excess cash flows generated from the underlying collateral supporting the principal and interest payments of the debt securities, the level of credit enhancement provided by the structure and the Company’s ability and intent to hold the security for a period sufficient to allow for any anticipated recovery in fair value. The adoption of FSP FAS 115-2 and FAS 124-2 did not have a material impact to the Company’s financial statements as of June 30, 2009.

The specific identification method is used in determining the realized gains and losses on sales of investment securities and other-than-temporary impairment charges. Premiums and discounts on securities are amortized and accreted, respectively, on a systematic basis over the period to maturity or estimated life of the related security. Purchases and sales of securities are recognized on a trade date basis.

Fair values for investment securities are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments, or a discounted cash flow model using market estimates of interest rates and volatility. In the second quarter of 2009, the Company adopted FASB Staff Position No. FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly (“FSP 157-4”). This FSP provides guidance for estimating fair value when the volume and level of trading activity for an asset or liability have significantly decreased. This FSP did not have a significant impact to the Company’s financial statements as of June 30, 2009.

Income Taxes

Provisions for income taxes are based on taxes currently payable or refundable, and deferred taxes which are based on temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements. Deferred tax assets and liabilities are reported in the financial statements at currently enacted income tax rates applicable to the period in which the deferred tax assets and liabilities are expected to be realized or settled.

Intangible Assets

Intangible assets include core deposit intangibles, customer relationship intangibles and goodwill arising from acquisitions. Core deposit intangibles and customer relationship intangibles are amortized on either an accelerated or straight-line basis over periods ranging from 8 to 20 years. The carrying value of goodwill and other intangible assets is based upon discounted cash flow modeling techniques that require management to make estimates regarding the amount and timing of expected future cash flows. It also requires use of a discount rate that reflects the current return requirements of the market in relation to present risk-free interest rates, required equity market premiums, and company-specific risk indicators.

Retirement Benefits

The Company provides defined benefit pension benefits and post-retirement health and life insurance benefits to eligible employees. The Company also provides deferred compensation and supplemental executive retirement plans for selected current and former employees and officers. Expense under these plans is charged to current operations and consists of several components of net periodic benefit cost based on various actuarial assumptions regarding future experience under the plans, including discount rate, rate of future compensation increases and expected return on plan assets.

New Accounting Pronouncements

SFAS No. 165

In May 2009, the FASB issued SFAS No. 165, Subsequent Events (“SFAS 165”). Under SFAS 165, companies are required to evaluate events and transactions that occur after the balance sheet date but before the date the financial statements are issued, or available to be issued in the case of non-public entities. SFAS 165 requires entities to recognize in the financial statements the effect of all events or transactions that provide additional evidence of conditions that existed at the balance sheet date, including the estimates inherent in the financial preparation process. Entities shall not recognize the impact of events or transactions that provide evidence about conditions that did not exist at the balance sheet date but arose after that date. SFAS 165 also requires entities to disclose the date through which subsequent events have been evaluated. SFAS 165 was effective for interim and annual reporting periods ending after June 15, 2009. The Company has evaluated subsequent events through the time of filing these financial statements with the SEC on August 6, 2009.

SFAS No. 166

In June 2009, the FASB issued SFAS No. 166, Accounting for Transfers of Financial Assets – an amendment of FASB Statement No. 140 (“SFAS 166”). SFAS 166 removes the concept of a qualifying special-purpose entity from SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” establishes a new “participating interest” definition that must be met for transfers of portions of financial assets to be eligible for sale accounting, clarifies and amends the derecognition criteria for a transfer to be accounted for as a sale, and changes the amount that can be recognized as a gain or loss on a transfer accounted for as a sale when beneficial interests are received by the transferor. Enhanced disclosures are also required to provide information about transfers of financial assets and a transferor’s continuing involvement with transferred financial assets. This statement must be applied as of the beginning of an entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter. Earlier application is prohibited. The Company is currently evaluating this new statement.

SFAS No. 167

In June 2009, the FASB issued SFAS No. 167, Amendments to FASB Interpretation No. 46(R) (“SFAS 167”). SFAS 167 amends FASB Interpretation No. 46 (revised December 2003), “Consolidation of Variable Interest Entities” (FIN 46(R)) to require an enterprise to qualitatively assess the determination of the primary beneficiary of a variable interest entity (“VIE”) based on whether the entity (1) has the power to direct the activities of a VIE that most significantly impact the entity’s economic performance and (2) has the obligation to absorb losses of the entity or the right to receive benefits from the entity that could potentially be significant to the VIE. Also, SFAS 167 requires an ongoing reconsideration of the primary beneficiary, and amends the events that trigger a reassessment of whether an entity is a VIE. Enhanced disclosures are also required to provide information about an enterprise’s involvement in a VIE. This statement shall be effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter. Earlier application is prohibited. The Company is currently evaluating this new statement.

SFAS No. 168

In June 2009, the FASB issued SFAS No. 168, The FASB Accounting Standards Codification TM and the Hierarchy of Generally Accepted Accounting Principles – a replacement of FASB Statement No. 162 (“SFAS 168”). SFAS 168 replaces SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles and establishes the “FASB Accounting Standards CodificationTM” (“Codification”) as the source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with generally accepted accounting principles in the United States. The Codification is not intended to change existing generally accepted accounting principles. On the effective date of SFAS 168, the Codification will supersede all then-existing non-SEC accounting and reporting standards. All other nongrandfathered non-SEC accounting literature not included in the Codification will become nonauthoritative. SFAS 168 is effective for financial statements issued for interim and annual periods ending after September 15, 2009. The Company has evaluated this new statement, and has determined that it will not have a significant impact on the determination or reporting of its financial results.

FSP FAS 132(R)-1

In December 2008, the FASB issued FSP FAS 132(R)-1, Employers’ Disclosures about Postretirement Benefit Plan Assets. This FSP amends SFAS No. 132 (revised 2003), Employers’ Disclosures about Pensions and Other Postretirement Benefits, to provide guidance on an employer’s disclosures about plan assets of a defined benefit pension or other postretirement plan on investment policies and strategies, major categories of plan assets, inputs and valuation techniques used to measure the fair value of plan assets and significant concentrations of risk within plan assets. This FSP shall be effective for fiscal years ending after December 15, 2009, with earlier application permitted. Upon initial application, the provisions of this FSP are not required for earlier periods that are presented for comparative purposes. The Company is currently evaluating the disclosure requirements of this new FSP.

NOTE D: INVESTMENT SECURITIES

The amortized cost and estimated fair value of investment securities as of June 30, 2009 and December 31, 2008 are as follows:

	June 30, 2009				December 31, 2008
		Gross	Gross	Estimated		Gross	Gross	Estimated
	Amortized	Unrealized	Unrealized	Fair	Amortized	Unrealized	Unrealized	Fair
(000's omitted)	Cost	Gains	Losses	Value	Cost	Gains	Losses	Value
Held-to-Maturity Portfolio:
U.S. Treasury and agency securities	$21,838	$1,843	$0	$23,681	$61,910	$2,358	$0	64,268
Obligations of state and political subdivisions	46,660	269	11	46,918	15,784	220	0	16,004
Government guaranteed mortgage-backed securities	41,766	207	0	41,973	0	0	0	0
Other securities	90	0	0	90	100	0	0	100
Total held-to-maturity portfolio	110,354	2,319	11	112,662	77,794	2,578	0	80,372

Available-for-Sale Portfolio:
U.S. Treasury and agency securities	312,429	19,729	32	332,126	382,301	29,482	0	411,783
Obligations of state and political subdivisions	519,988	12,711	4,353	528,346	538,008	13,537	3,606	547,939
Corporate debt securities	35,579	672	390	35,861	35,596	333	777	35,152
Collateralized mortgage obligations	14,032	457	0	14,489	25,464	236	0	25,700
Pooled trust preferred securities	71,813	0	17,252	54,561	72,535	0	22,670	49,865
Government guaranteed mortgage-backed securities	200,585	4,988	1,097	204,476	188,560	4,234	740	192,054
Subtotal	1,154,426	38,557	23,124	1,169,859	1,242,464	47,822	27,793	1,262,493
Federal Home Loan Bank of NY stock	38,500	0	0	38,500	38,056	0	0	38,056
Federal Reserve Bank stock	12,378	0	0	12,378	12,383	0	0	12,383
Other equity securities	4,273	2	8	4,267	4,285	0	0	4,285
Total available-for-sale portfolio	1,209,577	$38,559	$23,132	1,225,004	1,297,188	$47,822	$27,793	1,317,217

Net unrealized gain on available-for-sale portfolio	15,427			0	20,029			0
Total	$ 1,335,358			$1,337,666	$1,395,011			$1,397,589

A summary of investment securities that have been in a continuous unrealized loss position for less than or greater than twelve months is as follows:

As of June 30, 2009
	Less than 12 Months		12 Months or Longer		Total
		Gross		Gross		Gross
	Fair	Unrealized	Fair	Unrealized	Fair	Unrealized
(000's omitted)	Value	Losses	Value	Losses	Value	Losses

Held-to-Maturity Portfolio:
Obligations of state and political subdivisions/ Total held-to-maturity portfolio	$15,791	$11	$0	$0	$15,791	$11

Available-for-Sale Portfolio:
U.S. Treasury and agency securities	$970	$32	$0	$0	970	32
Obligations of state and political subdivisions	69,576	3,166	35,907	1,187	105,483	4,353
Pooled trust preferred securities	0	0	54,561	17,252	54,561	17,252
Corporate debt securities	0	0	10,609	390	10,609	390
Government guaranteed mortgage-backed securities	37,259	666	6,616	431	43,875	1,097
Other equity securities	21	8	0	0	21	8
Total available-for-sale portfolio	$107,826	$3,872	$107,693	$19,260	$215,519	$23,132

As of December 31, 2008
	Less than 12 Months		12 Months or Longer		Total
		Gross		Gross		Gross
	Fair	Unrealized	Fair	Unrealized	Fair	Unrealized
(000's omitted)	Value	Losses	Value	Losses	Value	Losses

Available-for-Sale Portfolio:
Obligations of state and political subdivisions	$61,879	$3,127	$7,419	$479	$69,298	$3,606
Corporate debt securities	10,897	680	1,903	97	12,800	777
Pooled trust preferred securities	0	0	49,865	22,670	49,865	22,670
Government guaranteed mortgage-backed securities	24,897	738	338	2	25,235	740
Total available-for-sale portfolio	$97,673	$4,545	$59,525	$23,248	$157,198	$27,793

Included in the available for sale portfolio are pooled trust preferred, class A-1 securities with a current par value of $71.8 million and unrealized losses of $17.3 million at June 30, 2009. The underlying collateral of these assets are principally trust-preferred securities of smaller regional banks and insurance companies. The Company’s securities are in the super-senior, cash flow tranche of the pools. All other tranches in these pools will incur losses before this tranche is impacted. An additional 41% - 45% of the underlying collateral would have to be in deferral or default concurrently to result in an expectation of non-receipt of contractual cash flows. The market for these securities at June 30, 2009 is not active and markets for similar securities are also not active. The inactivity was evidenced first by a significant widening of the bid-ask spread in the brokered markets in which these securities trade and then by a significant decrease in the volume of trades relative to historical levels. The fair value of these securities was determined using a discounted cash flow model that incorporated market estimates of interest rates and volatility, as well as, observable quoted prices for similar assets in markets that have not been active. These assumptions have a significant effect on the reported fair values. The use of different assumptions, as well as changes in market conditions, could result in materially different fair values. The Company does not intend to sell the underlying security and it is not more likely that not that the Company will be required to sell the debt security prior to recovery and does not consider these investments to be other-than temporarily impaired as of June 30, 2009. In determining if unrealized losses are other-than-temporary, management considers: the length of time and extent that fair value has been less than cost, the financial condition and near term prospects of the issuers, any external credit ratings, the level of excess cash flows generated from the underlying collateral supporting the principal and interest payments of the debt securities, the level of credit enhancement provided by the structure, and the Company’s ability and intent to hold the security for a period sufficient to allow for any anticipated recovery in fair value. To date, the Company has received all scheduled principal and interest payments and expects to fully collect all future contractual principal and interest payments. Subsequent changes in market or credit conditions could change those evaluations.

Management does not believe any individual unrealized loss as of June 30, 2009 represents an other-than-temporary impairment. The unrealized losses reported pertaining to government guaranteed mortgage-backed securities relate primarily to securities issued by GNMA, FNMA and FHLMC, who are currently rated AAA by Moody’s Investor Services and Standard & Poor’s and are guaranteed by the U.S. government. The debt securities held by the Company are general purpose obligations of various states and political subdivisions. The unrealized losses in the portfolios are primarily attributable to changes in interest rates. The Company does not intend to sell these securities, nor is it more likely than not that the Company will be required to sell these securities prior to recovery of the amortized cost.

The amortized cost and estimated fair value of debt securities at June 30, 2009, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

	Held-to-Maturity		Available-for-Sale
	Carrying	Fair	Carrying	Fair
(000's omitted)	Value	Value	Value	Value
Due in one year or less	$16,270	$16,426	$47,930	$48,780
Due after one through five years	11,192	12,106	242,484	253,788
Due after five years through ten years	12,275	13,306	363,590	377,229
Due after ten years	28,851	28,851	285,805	271,098
Subtotal	68,588	70,689	939,809	950,895
Collateralized mortgage obligations	0	0	14,032	14,488
Mortgage-backed securities	41,766	41,973	200,585	204,476
Total	$110,354	$112,662	$1,154,426	$1,169,859

Cash flow information on investment securities for the six months ended June 30 is as follows:

(000's omitted)	2009	2008
Proceeds from the sales of available-for-sale investment securities	$-	$31,344
Gross gains on sales of investment securities	-	550
Gross losses on sales of investment securities	-	320

NOTE E: INTANGIBLE ASSETS

The gross carrying amount and accumulated amortization for each type of intangible asset are as follows:

	As of June 30, 2009			As of December 31, 2008
	Gross		Net	Gross		Net
	Carrying	Accumulated	Carrying	Carrying	Accumulated	Carrying
(000's omitted)	Amount	Amortization	Amount	Amount	Amortization	Amount
Amortizing intangible assets:
Core deposit intangibles	$59,933	($41,233)	$18,700	$59,933	($37,593)	$22,340
Other intangibles	7,882	(3,315)	4,567	7,882	(2,747)	5,135
Total amortizing intangibles	67,815	(44,548)	23,267	67,815	(40,340)	27,475
Non-amortizing intangible assets:
Goodwill	301,369	0	301,369	301,149	0	301,149
Total intangible assets, net	$369,184	($44,548)	$324,636	$368,964	($40,340)	$328,624

No goodwill impairment adjustment was recognized in the second quarter of 2009. The estimated aggregate amortization expense for each of the succeeding fiscal years ended December 31 is as follows:

(000's omitted)		Amount
July-Dec 2009		$3,879
2010		5,801
2011		3,356
2012		2,793
2013		2,176
Thereafter		5,262
Total		$23,267

NOTE F: MANDATORILY REDEEMABLE PREFERRED SECURITIES

The Company sponsors two business trusts, Community Statutory Trust III and Community Capital Trust IV (“Trust IV”), of which 100% of the common stock is owned by the Company. The trusts were formed for the purpose of issuing company-obligated mandatorily redeemable preferred securities to third-party investors and investing the proceeds from the sale of such preferred securities solely in junior subordinated debt securities of the Company. The debentures held by each trust are the sole assets of that trust. Distributions on the preferred securities issued by each trust are payable quarterly at a rate per annum equal to the interest rate being earned by the trust on the debentures held by that trust and are recorded as interest expense in the consolidated financial statements. The preferred securities are subject to mandatory redemption, in whole or in part, upon repayment of the debentures. The Company has entered into agreements which, taken collectively, fully and unconditionally guarantee the preferred securities subject to the terms of each of the guarantees. The terms of the preferred securities of each trust are as follows:

	Issuance	Par		Maturity
Trust	Date	Amount	Interest Rate	Date	Call Provision	Call Price
III	7/31/2001	$24.5 million	3 month LIBOR plus 3.58% (4.62%)	7/31/2031	5 year beginning 2006	103.00% declining to par in 2011
IV	12/8/2006	$75 million	3 month LIBOR plus 1.65% (2.28%)	12/15/2036	5 year beginning 2012	Par

Upon the issuance of Trust IV, the Company entered into an interest rate swap agreement to convert the variable rate trust preferred securities into a fixed rate security for a term of five years at a fixed rate of 6.43%. Additional interest expense of $679,000 and $1,229,000 was recognized based on the interest rate swap agreement for the three and six months ended June 30, 2009, respectively, compared to $414,000 and $377,000 for the three and six months ended June 30, 2008.

NOTE G: BENEFIT PLANS

The Company provides defined benefit pension benefits and post-retirement health and life insurance benefits to eligible employees. The Company also provides supplemental pension retirement benefits for several current and former key employees. During the first quarter, the Company made a contribution to its defined benefit pension plan of $15.0 million. No other contributions are required for regulatory purposes in 2009. The Company accrues for the estimated cost of these benefits through charges to expense during the years that employees earn these benefits. The net periodic benefit cost for the three and six months ended June 30 is as follows:

	Pension Benefits				Post-retirement Benefits
	Three Months Ended		Six Months Ended		Three Months Ended		Six Months Ended
	June 30,		June 30,		June 30,		June 30,
(000's omitted)	2009	2008	2009	2008	2009	2008	2009	2008
Service cost	$872	$780	$1,744	$1,559	$199	$175	$399	$350
Interest cost	918	819	1,836	1,638	154	150	308	300
Expected return on plan assets	(1,172)	(1,118)	(2,343)	(2,235)	0	0	0	0
Amortization of unrecognized net loss	688	165	1,377	330	15	25	30	50
Amortization of prior service cost	(31)	(27)	(61)	(55)	14	28	27	55
Amortization of transition obligation	0	0	0	0	11	10	21	20
Net periodic benefit cost	$1,275	$619	$2,553	$1,237	$393	$388	$785	$775

NOTE H: EARNINGS PER SHARE

The Company adopted FSP No. EITF 03-6-1, Determining Whether Instruments Granted in Share-Based Payment Transactions are Participating Securities effective January 1, 2009. This FSP addresses whether instruments granted in share-based payment transactions are participating securities prior to vesting and, therefore, need to be included in the earnings allocation in computing earnings per share under the two-class method. The adoption of this FSP had a minimal effect on the EPS calculation for the Company.

Basic earnings per share are computed based on the weighted-average common shares outstanding for the period. Diluted earnings per share are based on the weighted-average shares outstanding adjusted for the dilutive effect of restricted stock and the assumed exercise of stock options during the year. The dilutive effect of options is calculated using the treasury stock method of accounting. The treasury stock method determines the number of common shares that would be outstanding if all the dilutive options (those where the average market price is greater than the exercise price) were exercised and the proceeds were used to repurchase common shares in the open market at the average market price for the applicable time period. There were approximately 2.6 million weighted-average anti-dilutive stock options outstanding at June 30, 2009 compared to approximately 1.1 million weighted-average anti-dilutive stock options outstanding at June 30, 2008 that were not included in the computation below. The following is a reconciliation of basic to diluted earnings per share for the three and six months ended June 30, 2009 and 2008.

	Three Months Ended June 30,		Six Months Ended June 30,
(000's omitted, except per share data)	2009	2008	2009	2008
Net income	$9,155	$11,287	$19,620	$22,185
Income attributable to unvested stock-based compensation awards	(50)	(46)	(98)	(86)
Income available to common shareholders –basic	9,105	11,241	19,522	22,099
Weighted average common shares outstanding	32,665	29,885	32,659	29,802
Basic earnings per share	$0.28	$0.38	$0.60	$0.74

Net income	$9,155	$11,287	$19,620	$22,185
Income attributable to unvested stock-based compensation awards	(50)	(46)	(98)	(86)
Income available to common shareholders –basic	9,105	11,241	19,522	22,099
Weighted average common shares outstanding	32,665	29,885	32,659	29,802
Assumed exercise of stock options	102	373	120	341
Adjusted weighted-average shares – diluted	32,767	30,258	32,779	30,143
Diluted earnings per share	$0.28	$0.37	$0.60	$0.73

NOTE I: COMMITMENTS, CONTINGENT LIABILITIES AND RESTRICTIONS

The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments consist primarily of commitments to extend credit and standby letters of credit. Commitments to extend credit are agreements to lend to customers, generally having fixed expiration dates or other termination clauses that may require payment of a fee. These commitments consist principally of unused commercial and consumer credit lines. Standby letters of credit generally are contingent upon the failure of the customer to perform according to the terms of an underlying contract with a third party. The credit risks associated with commitments to extend credit and standby letters of credit are essentially the same as that involved with extending loans to customers and are subject to normal credit policies. Collateral may be obtained based on management’s assessment of the customer’s creditworthiness.

The contract amount of commitments and contingencies are as follows:

(000's omitted)	June 30, 2009	December 31, 2008
Commitments to extend credit	$532,716	$523,017
Standby letters of credit	18,746	13,209
Total	$551,462	$536,226

NOTE J: FAIR VALUE

SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS 159”) allows entities an irrevocable option to measure certain financial assets and financial liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. The Company has elected to value loans held for sale at fair value in order to more closely match the gains and losses associated with loans held for sale with the gains and losses on forward sales contracts. Accordingly the impact on the valuation will be recognized in the Company’s consolidated statement of income. All mortgage loans held for sale are current and in performing status.

SFAS No. 157, Fair Value Measurements (“SFAS 157”) establishes a common definition for fair value to be applied to generally accepted accounting principals requiring the use of fair value, establishes a framework for measuring fair value and expands disclosure about such fair value instruments. It defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). It also classifies the inputs used to measure fair value into the following hierarchy:

·	Level 1 –	Quoted prices in active markets for identical assets or liabilities.
·	Level 2 –	Quoted prices in active markets for similar assets or liabilities, or quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs other than quoted prices that are observable for the asset or liability.
·	Level 3 –	Significant valuation assumptions not readily observable in a market.

A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The following tables set forth the Company’s financial assets and liabilities that were accounted for at fair value on a recurring basis:

	June 30, 2009
(000's omitted)	Level 1	Level 2	Level 3	Total Fair Value
Available-for-sale investment securities:
U.S. Treasury and agency securities	$970	$331,156	$0	$332,126
Obligations of state and political subdivisions	0	528,346	0	528,346
Corporate debt securities	0	35,861	0	35,861
Collateralized mortgage obligations	0	14,489	0	14,489
Pooled trust preferred securities	0	0	54,561	54,561
Government guaranteed mortgage-backed securities	0	204,476	0	204,476
Other equity securities	28	0	1,143	1,171
Total available-for-sale investment securities	998	1,114,328	55,704	1,171,030
Forward sales contracts	0	174	0	174
Commitments to originate real estate loans for sale	0	0	142	142
Mortgage loans held for sale	0	3,860	0	3,860
Interest rate swap	0	(5,539)	0	(5,539)
Total	$998	$1,112,823	$55,846	$1,169,667

	December 31, 2008
(000's omitted)	Level 1	Level 2	Level 3	Total Fair Value
Available-for-sale investment securities:
U.S. Treasury and agency securities	$1,007	$410,776	$0	$411,783
Obligations of state and political subdivisions	0	547,939	0	547,939
Corporate debt securities	0	35,152	0	35,152
Collateralized mortgage obligations	0	25,700	0	25,700
Pooled trust preferred securities	0	0	49,865	49,865
Government guaranteed mortgage-backed securities	0	192,054	0	192,054
Other equity securities	28	0	1,161	1,189
Total available-for-sale investment securities	1,035	1,211,621	51,026	1,263,682
Interest rate swap	0	(6,721)	0	(6,721)
Total	$1,035	$1,204,900	$51,026	$1,256,961

The valuation techniques used to measure fair value for the items in the table above are as follows:

Available for sale investment securities – The fair value of available-for-sale investment securities is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using quoted market prices for similar securities or model-based valuation techniques. Level 1 securities include U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets. Level 2 securities include mortgage-backed securities issued by government-sponsored entities, municipal securities and corporate debt securities. Securities classified as Level 3 include pooled trust preferred securities in less liquid markets. The value of these instruments is determined using pricing models or similar techniques as well as significant judgment or estimation.

Mortgage loans held for sale – Mortgage loans held for sale are carried at fair value, which is determined using quoted secondary-market prices of loans with similar characteristics and, as such, have been classified as a Level 2 valuation. The unpaid principal value of mortgage loans held for sale at June 30, 2009 is $3.8 million. The unrealized gain on mortgage loans held for sale of $36,000 was recognized in mortgage banking and other income in the consolidated statement of income for the quarter ended June 30, 2009.

Forward sales contracts – The Company enters into forward sales contracts to sell certain residential real estate loans. Such commitments are considered to be derivative financial instruments and, therefore, are carried at estimated fair value in the other asset or other liability section of the consolidated balance sheet. The fair value of these forward sales contracts is primarily measured by obtaining pricing from certain government-sponsored entities. The pricing is derived from market observable inputs that can generally be verified and do not typically involve significant judgment by the Company and therefore, are classified as Level 2 in the fair value hierarchy.

Commitments to originate real estate loans for sale – The Company enters into various commitments to originate residential real estate loans for sale. Such commitments are considered to be derivative financial instruments and, therefore, are carried at estimated fair value in the other asset or other liability section of the consolidated balance sheet. The estimated fair value of these commitments is determined using quoted secondary market prices obtained from certain government-sponsored entities. Additionally, SAB No. 109 requires the expected net future cash flows related to the associated servicing of the loan to be included in the fair value measurement of the derivative. The expected net future cash flows are based on a valuation model that calculates the present value of estimated net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income. Such assumptions include estimates of the cost of servicing loans, appropriate discount rate and prepayment speeds. The determination of expected net cash flows is considered a significant unobservable input contributing to the Level 3 classification of commitments to originate real estate loans for sale.

Interest rate swap – The Company utilizes interest rate swap agreements to modify the repricing characteristics of certain of its interest-bearing liabilities. The fair value of these interest rate swaps traded in over-the-counter markets where quoted market prices are not readily available, are measured using models for which the significant assumptions such as yield curves and option volatilities are market observable and, therefore, classified as Level 2 in the fair value hierarchy.

The changes in Level 3 assets measured at fair value on a recurring basis are summarized in the following tables:

	Three Months Ended June 30,
	2009				2008
(000's omitted)	Pooled trust preferred securities	Other equity securities	Commitments to originate real estate loans for sale	Total	Pooled trust preferred securities	Other equity securities	Commitments to originate real estate loans for sale	Total
Beginning balance	$47,568	$1,135	$271	$48,974	$68,454	$1,130	$0	$69,584
Total gains (losses) included in earnings	27	0	(271)	(244)	20	(2)	0	18
Total gains (losses) included in other comprehensive income	7,387	0	0	7,387	(6,353)	0	0	(6,353)
Purchases	0	26	0	26	0	34	0	34
Sales/calls/principal reductions	(421)	(12)	0	(433)	(139)	0	0	(139)
Commitments to originate real estate loans held for sale	0	0	142	142	0	0	0	0
Ending balance	$54,561	$1,149	$142	$55,852	$61,982	$1,162	$0	$63,144

	Six Months Ended June 30,
	2009				2008
(000's omitted)	Pooled trust preferred securities	Other equity securities	Commitments to originate real estate loans for sale	Total	Pooled trust preferred securities	Other equity securities	Commitments to originate real estate loans for sale	Total
Beginning balance	$49,865	$1,165	$0	$51,030	$72,300	$1,142	$0	$73,442
Total gains (losses) included in earnings	53	0	0	53	38	(14)	0	24
Total gains (losses) included in other comprehensive income	5,419	0	0	5,419	(10,149)	0	0	(10,149)
Purchases	0	42	0	42	0	34	0	34
Sales/calls/principal reductions	(776)	(58)	0	(834)	(207)	0	0	(207)
Commitments to originate real estate loans held for sale	0	0	142	142	0	0	0	0
Ending balance	$54,561	$1,149	$142	$55,852	$61,982	1,162	$0	$63,144

Assets and liabilities measured on a non-recurring basis:

	June 30, 2009				December 31, 2008
(000's omitted)	Level 1	Level 2	Level 3	Total Fair Value	Level 1	Level 2	Level 3	Total Fair Value
Impaired loans	$0	$0	$1,922	$1,922	$0	$0	$850	$850
Goodwill	n/a	n/a	n/a	n/a	0	0	5,579	5,579
Mortgage servicing rights	0	0	1,498	1,498	n/a	n/a	n/a	n/a
Total	$0	$0	$3,420	$3,420	$0	$0	$6,429	$6,429

Originated mortgage servicing rights are recorded at their fair value at the time of sale of the underlying loan, and are amortized in proportion to and over the period of estimated net servicing income. In accordance with GAAP, the Company must record impairment charges, on a nonrecurring basis, when the carrying value of certain strata exceed their estimated fair value. The fair value of mortgage servicing rights is based on a valuation model incorporating inputs that market participants would use in estimating future net servicing income. Such inputs include estimates of the cost of servicing loans, appropriate discount rate and prepayment speeds. The amount of impairment recognizes is the amount by which the carrying value of the capitalized servicing rights for a stratum exceed estimated fair value. Impairment is recognized through a valuation allowance. Due primarily to an increase in the cost of servicing and an increase in the expected prepayment speed of the Company’s sold loan portfolio with servicing retained, the fair value of the Company’s mortgage servicing rights declined during the first half of 2009. As a result of this decline, the Company established a valuation allowance of $0.1 million at June 30, 2009. These inputs are considered to be unobservable and contribute to the Level 3 classification of mortgage servicing rights.

Loans are generally not recorded at fair value on a recurring basis. Periodically, the Company records nonrecurring adjustment to the carrying value of loans based on fair value measurements for partial charge-offs of the uncollectible portions of those loans. Nonrecurring adjustments also include certain impairment amounts for collateral-dependent loans calculated in accordance with SFAS No. 114, Accounting by Creditors for Impairment of a Loan, when establishing the allowance for credit losses. Such amounts are generally based on the fair value of the underlying collateral supporting the loan and, as a result, the carrying value of the loan less the calculated valuation amount does not necessarily represent the fair value of the loan. Real estate collateral is typically valued using independent appraisals or other indications of value based on recent comparable sales of similar properties or assumptions generally observable in the marketplace, adjusted based on non-observable inputs and the related nonrecurring fair value measurement adjustments have generally been classified as Level 3. Estimates of fair value used for other collateral supporting commercial loans generally are based on assumptions not observable in the marketplace and, therefore, such valuations have been classified as Level 3.

The Company evaluates goodwill for impairment on an annual basis, or more often if events or circumstances indicate there may be impairment. The fair value of each reporting unit is compared to the carrying amount of that reporting unit in order to determine if impairment is indicated. If so, the implied fair value of the reporting units’ goodwill is compared to its carrying amount and the impairment loss is measured by the excess of the carrying value of the goodwill over fair value of the goodwill. In such situations, the Company performs a discounted cash flow modeling techniques that require management to make estimates regarding the amount and timing of expected future cash flows of the assets and liabilities of the reporting unit that enable the Company to calculate the implied fair value of the goodwill. It also requires use of a discount rate that reflects the current return requirement of the market in relation to present risk-free interest rates, required equity market premiums and company-specific risk indicators. As a result of significant declines the equity markets experienced in 2008, management determined a triggering event had occurred and the goodwill associated with Nottingham Advisors, one of the Company’s wealth management businesses, was tested for impairment during the fourth quarter of 2008. Based on the goodwill valuation performed in the fourth quarter of 2008 using Level 3 inputs, the Company recognized an impairment charge and wrote down the carrying value of the goodwill by $1.7 million to $5.6 million.

In June 2009, the Company adopted FASB Staff Position No. FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments (“FSP FAS 107-1 and APB 28-1”). This FSP requires disclosures about fair value of financial instruments for interim reporting periods. The Company determines fair values based on quoted market values where available or on estimates using present values or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument. SFAS 107, Disclosures about Fair Value of Financial Instruments, excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company. The fair value of investment securities has been disclosed in footnote D. The carrying amounts and estimated fair values of the Company’s other financial instruments at June 30, 2009 and December 31, 2008 are as follows:

	June 30, 2009		December 31, 2008
	Carrying	Fair	Carrying	Fair
(000's omitted)	Value	Value	Value	Value
Financial assets:
Net loans	$3,051,275	$3,086,795	$3,096,565	$3,135,832
Financial liabilities:
Deposits	3,864,423	3,883,755	3,700,812	3,719,557
Borrowings	756,649	829,197	760,558	869,162
Subordinated debt held by unconsolidated subsidiary trusts	101,987	67,302	101,975	61,409

The following is a further description of the principal valuation methods used by the Company to estimate the fair values of its financial instruments.

Loans – Fair values for variable rate loans that reprice frequently are based on carrying values. Fair values for fixed rate loans are estimated using discounted cash flows and interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. The allowance for loan losses is considered a reasonable discount for credit risk.

Deposits – The fair value of demand deposits, interest-bearing checking deposits, savings accounts and money market deposits is the amount payable on demand at the reporting date. The fair value of time deposit obligations are based on current market rates for similar products.

Borrowings - Fair values for long-term borrowings are estimated using discounted cash flows and interest rates currently being offered on similar borrowings.

Subordinated debt held by unconsolidated subsidiary trusts - The fair value of subordinated debt held by unconsolidated subsidiary trusts are estimated using discounted cash flows and interest rates currently being offered on similar securities.

Other financial assets and liabilities – Cash and cash equivalents, accrued interest receivable and accrued interest payable have fair values which approximate the respective carrying values because the instruments are payable on demand or have short-term maturities and present relatively low credit risk and interest rate risk.

NOTE K: SEGMENT INFORMATION

SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information (“SFAS 131”) has established standards for public companies relating to the reporting of financial and descriptive information about their operating segments in financial statements. Operating segments are components of an enterprise, which are evaluated regularly by the chief operating decision maker in deciding how to allocate resources and assess performance. The Company’s chief operating decision maker is the President and Chief Executive Officer of the Company.

The Company has identified “Banking” as its reportable operating business segment. The Banking segment provides full-service banking to consumers, businesses and governmental units in northern, central and western New York as well as northeastern Pennsylvania.

Immaterial operating segments of the Company’s operations, which do not have similar characteristics to the banking segment and do not meet the quantitative thresholds requiring disclosure, are included in the “Other” category. Revenues derived from these segments includes administration, consulting and actuarial services provided to sponsors of employee benefit plans, broker-dealer and investment advisory services, asset management services to individuals, corporate pension and profit sharing plans, trust services and insurance commissions from various insurance related products and services. The accounting policies used in the disclosure of business segments are the same as those described in the summary of significant accounting policies (See Note A, Summary of Significant Accounting Policies of the most recent Form 10-K for the year ended December 31, 2008 filed with the SEC on March 13, 2009).

Information about reportable segments and reconciliation of the information to the consolidated financial statements follows:

	For the Three Months Ended
	June 30, 2009			June 30, 2008
(000's omitted)	Banking	Other	Consolidated Total	Banking	Other	Consolidated Total

Net interest income	$40,502	$12	$40,514	$35,393	$47	$35,440
Provision for loan losses	2,015	0	2,015	1,570	0	1,570
Noninterest income excluding loss on investment securities and debt extinguishments	11,372	9,277	20,649	8,927	8,779	17,706
Loss on investment securities	0	0	0	(57)	0	(57)
Amortization of intangible assets	1,847	256	2,103	1,535	110	1,645
Other operating expenses	37,327	8,053	45,380	28,586	6,724	35,310
Income before income taxes	$10,685	$980	$11,665	$12,572	$1,992	$14,564


	For the Six Months Ended
	June 30, 2009			June 30, 2008
	Banking	Other	Consolidated Total	Banking	Other	Consolidated Total
Net interest income	$80,675	$25	$80,700	$70,908	$130	$71,038
Provision for loan losses	4,825	0	4,825	2,350	0	2,350
Noninterest income excluding loss on investment securities and debt extinguishments	22,482	18,523	41,005	17,393	17,644	35,037
Gain on investment securities	0	0	0	230	0	230
Amortization of intangible assets	3,693	515	4,208	2,956	220	3,176
Other operating expenses	71,480	16,196	87,676	58,456	13,697	72,153
Income before income taxes	$23,159	$1,837	$ 24,996	$24,769	$3,857	$ 28,626

Assets	$5,297,333	$39,654	$5,336,987	$4,621,743	$36,040	$4,657,783
Goodwill	$288,042	$13,327	$301,369	$221,322	$13,364	$234,686

NOTE L: DERIVATIVE INSTRUMENTS

On January 1, 2009, the Company adopted the provisions of SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities - an amendment of FASB Statement No. 133 (“SFAS 161”). SFAS No. 161 amended the disclosure requirements for derivative financial instruments and hedging activities. As SFAS No. 161 amended only the disclosure requirements for derivative financial instruments and hedged items, the adoption had no impact on the Company’s statements of income and condition.

The Company is party to derivative financial instruments in the normal course of its business to meet the financing needs of its customers and to manage its own exposure to fluctuations in interest rates. These financial instruments have been limited to interest rate swap agreements, commitments to originate real estate loans held for sale and forward sales commitments. The Company does not hold or issue derivative financial instruments for trading or other speculative purposes.

The Company enters into forward sales commitments for the future delivery of residential mortgage loans, and interest rate lock commitments to fund loans at a specified interest rate. The forward sales commitments are utilized to reduce interest rate risk associated with interest rate lock commitments and loans held for sale. Changes in the estimated fair value of the forward sales commitments and interest rate lock commitments subsequent to inception are based on changes in the fair value of the underlying loan resulting from the fulfillment of the commitment and changes in the probability that the loan will fund within the terms of the commitment, which is affected primarily by changes in interest rates and the passage of time. At inception and during the life of the interest rate lock commitment, the Company includes the expected net future cash flows related to the associated servicing of the loan as part of the fair value measurement of the interest rate lock commitments. These derivatives are recorded at fair value in accordance with SFAS 133.

The Company utilizes interest rate swap agreements as part of the management of interest rate risk to modify the repricing characteristics of certain of its borrowings. The interest rate swap has been designated as a qualifying cash flow hedge in accordance with SFAS 133. See further details of interest rate swap agreements in Note H to the consolidated financial statements as of December 31, 2008.

The following table presents the Company’s derivative financial instruments, their estimated fair values, and balance sheet location as of June 30, 2009:

	As of June 30, 2009
	Asset Derivatives			Liability Derivatives
(000's omitted)	Location	Notional	Fair Value	Location	Notional	Fair Value
Derivatives designated as hedging instruments under SFAS 133:
Interest rate swap agreement				Other liabilities	($75,000)	($5,539)
Derivatives not designated as hedging instruments under SFAS 133:
Commitments to originate real estate loans for sale	Other assets	$15,591	$142
Forward sales contracts	Other assets	14,862	174
Total derivatives			$316			($5,539)

The following table presents the Company’s derivative financial instruments and the location of the net gain or loss recognized in the statement of income for the three and six months ended June 30, 2009:

		Gain/(loss) Recognized in the Statement of Income
(000's omitted)	Location	Three Months Ending June 30, 2009	Six Months Ending June 30, 2009
Interest rate swap agreement	Interest on subordinated debt held by unconsolidated subsidiary trusts	$(679)	$(1,229)
Interest rate lock commitments	Mortgage banking and other services	(129)	142
Forward sales commitments	Mortgage banking and other services	277	174
Total		$(531)	$(913)

The amount of gain recognized during the three and six months ended June 30, 2009 in other comprehensive income related to the interest rate swap accounted for as a hedging instrument was approximately $612,000 and $727,000, respectively. The amount of loss reclassified from accumulated other comprehensive income into income (effective portion) amounted to $679,000 and $1,229,000 for the three and six months ending June 30, 2009, respectively, and is located in interest expense on subordinated debt held by unconsolidated trusts.

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Introduction

This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) primarily reviews the financial condition and results of operations of Community Bank System, Inc. (the “Company” or “CBSI”) as of and for the three and six months ended June 30, 2009 and 2008, although in some circumstances the first quarter of 2009 is also discussed in order to more fully explain recent trends. The following discussion and analysis should be read in conjunction with the Company's Consolidated Financial Statements and related notes that appear on pages 3 through 21. All references in the discussion to the financial condition and results of operations are to those of the Company and its subsidiaries taken as a whole.

Unless otherwise noted, the term “this year” refers to results in calendar year 2009, “second quarter” refers to the quarter ended June 30, 2009, earnings per share (“EPS”) figures refer to diluted EPS, and net interest income and net interest margin are presented on a fully tax-equivalent (“FTE”) basis.

This MD&A contains certain forward-looking statements with respect to the financial condition, results of operations and business of the Company. These forward-looking statements involve certain risks and uncertainties. Factors that may cause actual results to differ materially from those proposed by such forward-looking statements are set herein under the caption, “Forward-Looking Statements,” on page 37.

Critical Accounting Policies

As a result of the complex and dynamic nature of the Company’s business, management must exercise judgment in selecting and applying the most appropriate accounting policies for its various areas of operations. The policy decision process not only ensures compliance with the latest generally accepted accounting principles (“GAAP”), but also reflects management’s discretion with regard to choosing the most suitable methodology for reporting the Company’s financial performance. It is management’s opinion that the accounting estimates covering certain aspects of the business have more significance than others due to the relative importance of those areas to overall performance, or the level of subjectivity in the selection process. These estimates affect the reported amounts of assets and liabilities and disclosures of revenues and expenses during the reporting period. Actual results could differ from those estimates. Management believes that critical accounting estimates include:

Allowance for loan losses - The allowance for loan losses reflects management’s best estimate of probable losses inherent in the loan portfolio. Determination of the allowance is inherently subjective. It requires significant estimates including the amounts and timing of expected future cash flows on impaired loans and the amount of estimated losses on pools of homogeneous loans which is based on historical loss experience and consideration of current economic and portfolio trends, all of which may be susceptible to significant change.

Investment securities - Investment securities are classified as held-to-maturity, available-for-sale, or trading. The appropriate classification is based partially on the Company’s ability to hold the securities to maturity and largely on management’s intentions with respect to either holding or selling the securities. The classification of investment securities is significant since it directly impacts the accounting for unrealized gains and losses on securities. Unrealized gains and losses on available-for-sale securities are recorded in accumulated other comprehensive income or loss, as a separate component of shareholders’ equity and do not affect earnings until realized. The fair values of the investment securities are generally determined by reference to quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments, or a discounted cash flow model using market estimates of interest rates and volatility. Marketable investment securities with significant declines in fair value are evaluated to determine whether they should be considered other-than–temporarily impaired. An unrealized loss is generally deemed to be other-than-temporary and a credit loss is deemed to exist if the present value of the expected future cash flows is less than the amortized cost basis of the debt security. The credit loss component of an other-than-temporary impairment write-down is recorded in earnings, while the remaining portion of the impairment loss is recognized in other comprehensive income (loss), provided the Company does not intend to sell the underlying debt security and it is not more likely than not that the Company will be required to sell the debt security prior to recovery.

·	Actuarial assumptions associated with pension, post-retirement and other employee benefit plans - These assumptions include discount rate, rate of future compensation increases and expected return on plan assets.

Provision for income taxes - The Company is subject to examinations from various taxing authorities. Such examinations may result in challenges to the tax return treatment applied by the Company to specific transactions. Management believes that the assumptions and judgments used to record tax related assets or liabilities have been appropriate. Should tax laws change or the taxing authorities determine that management’s assumptions were inappropriate, an adjustment may be required which could have a material effect on the Company’s results of operations.

Carrying value of goodwill and other intangible assets - The carrying value of goodwill and other intangible assets is based upon discounted cash flow modeling techniques that require management to make estimates regarding the amount and timing of expected future cash flows. It also requires use of a discount rate that reflects the current return requirements of the market in relation to present risk-free interest rates, required equity market premiums and company-specific risk indicators.

A summary of the accounting policies used by management is disclosed in Note A, “Summary of Significant Accounting Policies” on pages 49-54 of the most recent Form 10-K (fiscal year ended December 31, 2008) filed with the Securities and Exchange Commission on March 13, 2009.

Executive Summary

The Company’s business philosophy is to operate as a community bank with local decision-making, principally in non-metropolitan markets, providing a broad array of banking and financial services to retail, commercial and municipal customers.

The Company’s core operating objectives are: (i) grow the branch network, primarily through a disciplined acquisition strategy, and certain selective de novo expansions, (ii) build high-quality, profitable loan and deposit portfolios using both organic and acquisition strategies, (iii) increase the noninterest income component of total revenues through development of banking-related fee income, growth in existing financial services business units, and the acquisition of additional financial services and banking businesses, and (iv) utilize technology to deliver customer-responsive products and services and reduce operating costs.

Significant factors management reviews to evaluate achievement of the Company’s operating objectives and its operating results and financial condition include, but are not limited to: net income and earnings per share, return on assets and equity, net interest margins, noninterest income, operating expenses, asset quality, loan and deposit growth, capital management, performance of individual banking and financial services units, liquidity and interest rate sensitivity, enhancements to customer products and services, technology advancements, market share, peer comparisons, and the performance of acquisition and integration activities.

On November 7, 2008, the Company acquired 18 branch-banking centers in northern New York from Citizens Financial Group, Inc. (“Citizens”) in an all cash transaction. The Company acquired approximately $109 million in loans and $565 million in deposits at a blended deposit premium of 13%. The results of operations for the 18 branches acquired from Citizens have been included in the consolidated financial statements since that date. In support of the transaction, the Company raised approximately $50 million of equity capital in the form of common stock in October 2008.

On July 7, 2008, Benefit Plans Administrative Services, Inc. (“BPAS”), a wholly owned subsidiary of the company, acquired the Philadelphia division of Alliance Benefit Group MidAtlantic (“ABG”) from BenefitStreet, Inc. in an all cash transaction. ABG provides retirement plan consulting, daily valuation administration, actuarial and ancillary support services. The results of ABG’s operations have been included in the consolidated financial statements since that date.

Second quarter and June year-to-date 2009 net income of $9.2 million and $19.6 million, respectively, was $2.1 million or 18.9% and $2.6 million or 11.6% lower than the respective prior year periods. Earnings per share were $0.28 and $0.60 for the first three and six months of 2009, respectively, a decrease of $0.09 and $0.13, from the equivalent prior year periods. Higher operating expenses, principally from recently completed acquisitions, significantly higher FDIC insurance assessments and employee pension costs, and higher loan loss provisions were partially offset by higher net interest income generated through organic and acquired growth of both loans and core deposits, and higher noninterest income. Second quarter 2009’s results included the incurrence of an additional $3.7 million of FDIC-insurance related assessments, or $0.09 per share above the second quarter of 2008. Excluding these additional assessments, earnings per share for the quarter were equal to the reported results from last year’s second quarter.

Asset quality in the second quarter of 2009 remained stable and favorable, as compared to peer financial organizations. Loan charge-off and nonperforming loan ratios and the provision for loan losses were up versus the second quarter of 2008, but they improved from first quarter 2009 levels and continued to be below long-term historical levels. The delinquency ratio increased as compared to June 2008, but remains favorable compared to long-term historical levels. The Company experienced year-over-year loan growth in the consumer installment and business lending portfolios, due to organic and acquired growth. The investment portfolio, including cash equivalents, increased as compared to both the second quarter of 2008 and March 31, 2009 due to the net liquidity created from the acquisition of Citizens in the fourth quarter of 2008 and organic deposit growth. Average deposits increased in the second quarter of 2009 as compared to both the first quarter of 2009 and the second quarter of 2008, reflective of the Citizens acquisition and organic growth in core deposits. External borrowings decreased from the second quarter of 2008 and remained consistent with the first quarter of 2009.

Net Income and Profitability

As shown in Table 1, net income for the second quarter and June YTD of $9.2 million and $19.6 million, respectively, declined 19% and 12% versus the comparable periods of 2008. Earnings per share for the quarter of $0.28 were down 24% over the second quarter of 2008 and earnings per share of $0.60 for the first six months of 2009 declined 18% from the amount earned in the first half of 2008. As compared to the first quarter of 2009, net income declined $1.3 million or 12.5% and earnings per share declined $0.04 or 12.5%.

Second quarter net interest income of $40.5 million was up $5.1 million or 14% from the comparable prior year period and net interest income for the first six months of 2009 increased $9.7 million or 14% over the first half of 2008. The current quarter’s provision for loan losses increased $0.4 million as compared to the second quarter of 2008 and increased $2.5 million for the first six months of 2009 as compared to the same period of 2008, reflective of higher net charge-offs and the general deteriorating economic conditions. Second quarter noninterest income, excluding securities gains and losses, was $20.6 million, up $2.9 million or 17% from the second quarter of 2008, while year-to-date noninterest income of $41.0 increased $6.0 or 17% from the prior year level. Operating expenses of $47.5 million for the quarter and $91.9 million for the first six months of 2009 were up $10.5 million or 28% and $16.6 million or 22%, respectively, from the comparable prior year periods. A significant portion of the increase was attributable to the acquisitions of ABG and Citizens during the third and fourth quarters of 2008, as well as higher FDIC insurance assessments due to significant increases in premium rates and the special assessment in the second quarter, as well as the incurrence of higher pension related costs.

As reflected in Table 1, the primary reasons for lower earnings were higher operating expenses and loan loss provision, partially offset by higher noninterest income and net interest income. Net interest income for the second quarter and year-to-date period increased as compared to the comparable periods of 2008 as a result of acquired and organic loan growth and increased levels of investments including cash equivalents, partially offset by a slightly lower net interest margin. Excluding security gains and losses, noninterest income increased due to increased activity in the secondary mortgage banking business, growth in the Company’s employee benefits consulting and plan administration business, mostly as a result of the acquisition of ABG, as well as higher banking service fees and debit card related revenues from the acquired branches. Higher net charge-offs and an increase in total loans outstanding were the primary reasons for the increase in loan loss provision. Operating expenses increased for the quarter and year-to-date periods, primarily due to costs associated with the two acquisitions in the last year, as well as higher FDIC insurance assessments and higher pension costs related to the underlying asset performance in 2008.

A condensed income statement is as follows:

Table 1: Summary Income Statements

	Three Months Ended		Six Months Ended
	June 30,		June 30,
(000's omitted, except per share data)	2009	2008	2009	2008
Net interest income	$40,514	$35,440	$80,700	$71,038
Provision for loan losses	2,015	1,570	4,825	2,350
Noninterest income excluding security gains/losses	20,649	17,706	41,005	35,037
(Loss) gain on sales of investment securities	0	(57)	0	230
Operating expenses	47,483	36,955	91,884	75,329
Income before taxes	11,665	14,564	24,996	28,626
Income taxes	2,510	3,277	5,376	6,441
Net income	$9,155	$11,287	$19,620	$22,185

Diluted earnings per share	$0.28	$0.37	$0.60	$0.73

Net Interest Income

Net interest income is the amount by which interest and fees on earning assets (loans, investments and cash) exceed the cost of funds, primarily interest paid to the Company's depositors and interest on external borrowings. Net interest margin is the difference between the gross yield on earning assets and the cost of interest-bearing funds as a percentage of earning assets.

As shown in Table 2a, net interest income (with nontaxable income converted to a fully tax-equivalent basis) for the second quarter of 2009 was $44.4 million, a $5.2 million increase from the same period last year. A $599 million increase in second quarter interest-earning assets versus the prior year had a greater impact than the $505 million increase in average interest-bearing liabilities and a five-basis point decrease in the net interest margin. As reflected in Table 3, the volume increase from interest bearing assets and the rate decrease on interest bearing liabilities had a $16.2 million favorable impact on net interest income, while the volume increase from interest bearing liabilities and rate decrease on interest bearing assets had a $11.0 million unfavorable impact on net interest income. The lower yields on interest bearing assets had a greater unfavorable impact on net interest margin than the decrease in the cost of funding. June YTD net interest income of $88.6 million increased $9.9 million or 13% from the year-earlier period. A $563 million increase in interest bearing assets more than offset a $474 million increase in interest bearing liabilities and a two-basis point decrease in the net interest margin. The increase in interest earning assets and the lower rate on interest bearing liabilities had a $32.0 million favorable impact that was partially offset by a $22.1 million unfavorable impact from the decrease in rate on interest bearing assets and the increase in interest-bearing liability balances.

Higher second quarter and June year-to-date average loan balances were attributable to $113 million of organic loan growth since the second quarter of 2008, driven by growth in all portfolios: consumer installment, consumer mortgage and business lending. The remaining contribution to the increase in the average second quarter loan balance was the $111 million of loans acquired in the Citizens acquisition and $12.9 million of growth at those branches since the date of acquisition. Average investments and cash equivalents for the second quarter and YTD periods were $363 million and $286 million higher than the respective periods of 2008, reflective of the net liquidity generated from the Citizens acquisition and organic deposit growth. In comparison to the prior year, total average deposits were up $625 million or 19% for the quarter primarily as a result of the November 2008 acquisition of Citizens. Second quarter average deposits from the Citizens acquisition were $583 million, as compared to $565 million at the date of acquisition. On an organic basis, average interest bearing deposits for the second quarter decreased slightly from the second quarter of 2008, a result of the Company’s objective of lowering its overall funding costs by reducing higher cost time deposits. Organic growth in average noninterest bearing deposits was $42.1 million over the second quarter of 2008. Quarterly average borrowings decreased $11.2 million as compared to the second quarter of 2008 as a portion of the net liquidity from the branch acquisition was used to eliminate short-term borrowings.

The net interest margin of 3.73% for the second quarter and 3.77% for the year to date period decreased five basis points and two basis points, respectively, versus the same periods in the prior year. The decline was primarily attributable to a 72-basis point and a 69-basis point decrease in the earning asset yield for the quarter and year-to-date periods, respectively, as compared to the prior year periods. The decrease in the earning asset yield is due to a 114 basis point and 99 basis point decline in the investment yields for the second quarter and YTD periods, respectively and a 46 basis point and 52 basis point decline in the loan yields for the second quarter and YTD periods, respectively, as compared to the like periods in 2008. The change in the earning-asset yield is primarily a result of variable and adjustable-rate loans repricing downward due to the decline in interest rates, as well as the Company’s increased holdings of lower yielding cash instruments as it maintains a liquid position in anticipation of improved investment opportunities in future periods.

Partially offsetting these declines was a 69-basis point and a 70-basis point decline in the cost of funds for the quarter and year-to-date periods, respectively, as compared to the same periods of 2008. The second quarter cost of funds decreased 69 basis points versus the prior year quarter due to a 90-basis point decrease in interest-bearing deposits rates and a six-basis point decrease in the average interest rate paid on external borrowings. The decreased cost of funds was reflective of disciplined deposit pricing, whereby interest rates on selected categories of deposit accounts were lowered throughout 2008 and the first half of 2009 in response to market conditions. Additionally, the proportion of customer deposits in higher cost time deposits has declined 6.5 percentage points over the last twelve months, while the percentage of deposits in non-interest bearing and lower cost checking accounts has increased. The rate paid on long-term borrowings was impacted by the approximately 200 basis point decrease in the three-month LIBOR (London Interbank Offered Rates) over the last twelve months, from which the interest rate on $25 million of the mandatorily redeemable preferred securities is based.

Tables 2a and 2b below sets forth information related to average interest-earning assets and interest-bearing liabilities and their associated yields and rates for the periods indicated. Interest income and yields are on a fully tax-equivalent basis using marginal income tax rates of 38.46% in 2009 and 38.49% in 2008. Average balances are computed by accumulating the daily ending balances in a period and dividing by the number of days in that period. Loan yields and amounts earned include loan fees. Average loan balances include nonaccrual loans and loans held for sale.

Table 2a: Quarterly Average Balance Sheet

	Three Months Ended			Three Months Ended
	June 30, 2009			June 30, 2008
			Avg.			Avg.
	Average		Yield/Rate	Average		Yield/Rate
(000's omitted except yields and rates)	Balance	Interest	Paid	Balance	Interest	Paid
Interest-earning assets:
Cash equivalents	$315,444	$202	0.26%	$29,138	$140	1.93%
Taxable investment securities (1)	793,909	9,991	5.05%	750,820	9,775	5.24%
Nontaxable investment securities (1)	558,278	9,379	6.74%	524,454	9,063	6.95%
Loans (net of unearned discount)	3,105,247	46,248	5.97%	2,869,338	45,837	6.43%
Total interest-earning assets	4,772,878	65,820	5.53%	4,173,750	64,815	6.25%
Noninterest-earning assets	540,396			466,196
Total assets	$5,313,274			$4,639,946

Interest-bearing liabilities:
Interest checking, savings and money market deposits	$1,802,845	2,863	0.64%	$1,304,146	2,519	0.78%
Time deposits	1,379,982	9,224	2.68%	1,362,278	13,520	3.99%
Short-term borrowings	593,533	6,347	4.29%	420,392	4,258	4.07%
Long-term borrowings	265,169	3,007	4.55%	449,474	5,333	4.77%
Total interest-bearing liabilities	4,041,529	21,441	2.13%	3,536,290	25,630	2.92%
Noninterest-bearing liabilities:
Demand deposits	671,615			563,045
Other liabilities	50,027			51,167
Shareholders' equity	550,103			489,444
Total liabilities and shareholders' equity	$5,313,274			$4,639,946

Net interest earnings		$44,379			$39,185
Net interest spread			3.40%			3.33%
Net interest margin on interest-earnings assets			3.73%			3.78%

Fully tax-equivalent adjustment		$3,865			$3,745

(1) Averages for investment securities are based on historical cost basis and the yields do not give effect to changes in fair value that is reflected as a component of

shareholders’ equity and deferred taxes.

Table 2b: Year-to-Date Average Balance Sheet

	Six Months Ended			Six Months Ended
	June 30, 2009			June 30, 2008
			Avg.			Avg.
	Average		Yield/Rate	Average		Yield/Rate
(000's omitted except yields and rates)	Balance	Interest	Paid	Balance	Interest	Paid
Interest-earning assets:
Cash equivalents	$235,817	$298	0.26%	$36,933	$458	2.49%
Taxable investment securities (1)	818,068	20,532	5.06%	757,527	20,492	5.44%
Nontaxable investment securities (1)	558,809	18,958	6.84%	532,724	18,396	6.94%
Loans (net of unearned discount)	3,122,788	93,156	6.02%	2,845,719	92,509	6.54%
Total interest-earning assets	4,735,482	132,944	5.66%	4,172,903	131,855	6.35%
Noninterest-earning assets	538,997			468,079
Total assets	$5,274,479			$4,640,982

Interest-bearing liabilities:
Interest checking, savings and money market deposits	$1,747,305	5,914	0.68%	$1,282,540	5,234	0.82%
Time deposits	1,405,921	19,743	2.83%	1,380,464	28,499	4.15%
Short-term borrowings	535,680	11,275	4.24%	423,254	8,678	4.12%
Long-term borrowings	324,680	7,422	4.61%	453,326	10,772	4.78%
Total interest-bearing liabilities	4,013,586	44,354	2.23%	3,539,584	53,183	3.02%
Noninterest-bearing liabilities:
Demand deposits	661,512			559,486
Other liabilities	51,253			55,815
Shareholders' equity	548,128			486,097
Total liabilities and shareholders' equity	$5,274,479			$4,640,982

Net interest earnings		$88,590			$78,672
Net interest spread			3.43%			3.33%
Net interest margin on interest-earnings assets			3.77%			3.79%

Fully tax-equivalent adjustment		$7,890			$7,634

(1) Averages for investment securities are based on historical cost basis and the yields do not give effect to changes in fair value that is reflected as a component of

shareholders’ equity and deferred taxes.

As discussed above and disclosed in Table 3 below, the quarterly change in net interest income (fully tax-equivalent basis) may be analyzed by segregating the volume and rate components of the changes in interest income and interest expense for each underlying category.

Table 3: Rate/Volume

	2nd Quarter 2009 versus 2nd Quarter 2008			Six Months Ended June 30, 2009 versus June 30, 2008
	Increase (Decrease) Due to Change in (1)			Increase (Decrease) Due to Change in (1)
	Volume	Rate	Net Change	Volume	Rate	Net Change
(000's omitted)
Interest earned on:
Cash equivalents	$279	($217)	$62	$567	($727)	($160)
Taxable investment securities	548	(332) )	216	1,575	(1,535)	40
Nontaxable investment securities	573	(257) )	316	889	(327)	562
Loans (net of unearned discount)	3,629	(3,218)	411	8,605	(7,958)	647
Total interest-earning assets (2)	8,719	(7,714)	1,005	16,691	(15,602)	1,089

Interest paid on:
Interest checking, savings and money market deposits	847	(503)	344	1,677	(997)	680
Time deposits	174	(4,470)	(4,296)	517	(9,273)	(8,756)
Short-term borrowings	1,840	249	2,089	2,360	237	2,597
Long-term borrowings	(2,099)	(227)	(2,326)	(2,954)	(396)	(3,350)
Total interest-bearing liabilities (2)	3,321	(7,510)	(4,189)	6,489	(15,318)	(8,829)

Net interest earnings (2)	5,573	(379)	5,194	10,528	(610)	9,918

(1) The change in interest due to both rate and volume has been allocated in proportion to the relationship of the absolute dollar amounts of such change in each component.

(2) Changes due to volume and rate are computed from the respective changes in average balances and rates and are not a summation of the changes of the

components.

Noninterest Income

The Company’s sources of noninterest income are of three primary types: 1) general banking services related to loans, deposits and other core customer activities typically provided through the branch network and electronic banking channels (performed by Community Bank, N.A. and First Liberty Bank and Trust); 2) employee benefit plan administration, actuarial and consulting services (performed by BPAS); and 3) wealth management services, comprised of trust services (performed by the trust unit within CBNA), investment and insurance products (performed by Community Investment Services, Inc. or CISI and CBNA Insurance Agency, Inc.) and asset management (performed by Nottingham Advisors or Nottingham). Additionally, the Company has periodic transactions, most often net gains (losses) from the sale of investment securities and prepayment of debt instruments.

Table 4: Noninterest Income

	Three Months Ended		Six months Ended
	June 30,		June 30,
(000's omitted)	2009	2008	2009	2008
Deposit service fees	$10,284	$8,910	$19,277	$17,171
Benefit plan administration, consulting and actuarial fees	6,599	5,933	13,606	12,245
Wealth management services	2,267	2,324	4,300	4,487
Other banking services	541	367	846	740
Mortgage banking	958	172	2,976	394
Subtotal	20,649	17,706	41,005	35,037
(Loss)/gain on sales of investment securities	0	(57)	0	230
Total noninterest income	$20,649	$17,649	$41,005	$35,267

Noninterest income/total income (FTE)	31.8%	31.1%	31.6%	30.8%

As displayed in Table 4, noninterest income (excluding securities gains) was $20.6 million in the second quarter and $41.0 million for the first half of 2009. This represents an increase of $2.9 million or 17% for the quarter and $6.0 million or 17% for the YTD period in comparison to one year earlier. A significant portion of the growth was attributable to higher residential mortgage banking revenues, which grew by $0.8 million for the second quarter and $2.6 million for the first six months of 2009 in comparison to the year earlier periods. Residential mortgage banking income consists of realized gains or losses from the sale of residential mortgage loans and the origination of mortgage loan servicing rights, unrealized gains and losses on residential mortgage loans held for sale and related commitments, mortgage loan servicing fees and other mortgage loan-related fee income. Residential mortgage loans sold to investors, primarily Fannie Mae, totaled $44.1 million in the second quarter of 2009 and $142.7 million for the first six months of 2009 as compared to $0.7 million and $1.1 million for the respective periods in 2008. Residential mortgage banking income totaled $1.0 million and $3.0 million for the second quarter and year-to-date periods of 2009, respectively. Residential mortgage loans held for sale recorded at fair value at June 30, 2009 totaled $3.9 million. The continuation of the level of revenue experienced in the first six months of 2009 from mortgage banking will be dependent on market conditions and the trend in long-term interest rates.

General recurring banking fees of $10.8 million and $20.1 million for the second quarter and first six months of 2009 were up $1.5 million or 17% and $2.2 million or 12%, respectively, as compared to the prior year periods, driven by organic core deposit account growth, higher electronic banking related revenues, and incremental income generated from the acquired Citizens branches. Benefit plan administration, consulting and actuarial fees increased $0.7 million and $1.4 million for the three and six months ended June 30, 2009 as compared to the prior periods due to the acquisition of ABG in mid July 2008 which generated approximately $1.2 million and $2.3 million of revenue growth in the quarter and first six months of 2009. Asset-based benefit plan administration fees declined as compared to the second quarter and first six months of 2008 due to the overall decline in the financial market valuations over the last year. Second quarter wealth management services revenue decreased $0.1 million or 2.5% for the second quarter and $0.2 million or 4.2 % for the first six months, primarily attributable to the adverse conditions prevalent throughout the financial markets.

The ratio of noninterest income to total income (FTE basis) was 31.8% for the quarter and 31.6% for the year-to-date period versus 31.1% and 30.8% for the comparable periods in 2008. This improvement is a function of increased noninterest income, primarily mortgage banking and acquisition related, combined with proportionally smaller increases in net interest income, mostly due to net interest margin contraction.

Operating Expenses

Table 6 below sets forth the quarterly results of the major operating expense categories for the current and prior year, as well as efficiency ratios (defined below), a standard measure of expense utilization effectiveness commonly used in the banking industry.

Table 5: Operating Expenses

	Three Months Ended		Six months Ended
	June 30,		June 30,
(000's omitted)	2009	2008	2009	2008
Salaries and employee benefits	23,154	19,772	46,116	40,158
Occupancy and equipment	5,704	5,189	11,915	10,762
Data processing and communications	5,171	4,100	10,021	8,085
Amortization of intangible assets	2,103	1,645	4,208	3,176
Legal and professional fees	1,318	902	2,602	2,200
Office supplies and postage	1,472	1,237	2,847	2,515
Business development and marketing	2,057	1,507	3,349	2,829
FDIC insurance premiums	4,021	277	5,396	386
Other	2,483	2,326	5,430	5,218
Total operating expenses	47,483	36,955	91,884	75,329

Operating expenses/average assets	3.57%	3.20%	3.50%	3.26%
Efficiency ratio	65.6%	62.1%	65.5%	63.4%

As shown in Table 5, second quarter 2009 operating expenses were $47.5 million, up $10.5 million or 28% from the prior year level. Year-to-date operating expenses of $91.9 million rose $16.6 million or 22% compared to the same period in 2008. A significant portion of the increase was attributable to incremental operating expenses related to the ABG and Citizens acquisitions. Additionally, the increase in operating expenses can be attributable to an increased level of FDIC-insurance assessments ($3.7 million for the quarter, $5.0 million YTD), higher retirement costs primarily related to the underlying asset performance in 2008 ($0.8 million for the quarter, $1.7 million YTD), higher volume-based data processing and communication costs ($0.8 million for the quarter, $1.4 million YTD), and increased amortization of intangibles related to the two acquisitions completed in the last year ($0.5 million for the quarter, $1.0 million YTD). During 2007 and the first half of 2008, FDIC premiums were principally met through the application of a credit balance created in prior years. This credit balance was depleted in the second quarter of 2008 and resulted in higher FDIC premiums in subsequent quarters. Additionally, the FDIC’s reserve fund has declined over the past year due to costs associated with recent bank failures and is expected to continue to decline in the future. In late 2008, the FDIC basic insurance coverage limit was temporarily increased to $250,000 through December 31, 2009 (on May 20, 2009 this was extended until 12/31/13). These actions have resulted in significant increases in the FDIC assessment charge rates (240% above the first quarter of 2008) that are expected to remain at similar levels during the second half of 2009. The Company is also participating in the FDIC’s Temporary Liquidity Guarantee Program (TLGP) that provides unlimited coverage for transaction deposit accounts and for which a supplemental 10-basis point premium is assessed. In the second quarter of 2009, the FDIC assessed an emergency special assessment equal to five basis points on a bank’s assets less Tier 1 capital. This amounted to $2.5 million of additional premiums recognized in June 2009. The final rule also permits the FDIC to levy additional five-basis point special assessments if needed in the third and fourth quarters of 2009. Several expense category increases continue to be impacted by the Company’s investment in strategic technology and business development initiatives to grow and enhance its service offerings.

The Company’s efficiency ratio (recurring operating expenses excluding intangible amortization, acquisition expenses and the special FDIC assessment divided by the sum of net interest income (FTE) and recurring noninterest income) was 65.6% for the second quarter, 3.5 percentage points above the comparable quarter of 2008. This resulted from operating expenses (as described above) increasing 20.9% primarily due to the acquisitions in the last year and the increased levels of FDIC premium and pension related expense, while recurring operating income increased at a slower rate of 14.3% due to a $5.2 million or 13.3% increase in net interest income and $3.0 million or 17.0% increase in noninterest income excluding security gains year over year. The efficiency ratio of 65.5% for the first half of 2009 was up 2.1 percentage points from a year earlier due to core operating expenses increasing 17.6% while recurring operating income increased at a slower rate of 14.0%. Operating expenses, excluding acquisition expenses, as a percentage of average assets increased 37 basis points and 24 basis points for the quarter and year to date periods, respectively, as operating expenses increased 28% and 22%, respectively, while average assets increased 15% and 14%, respectively, during the same time periods. The increased level of FDIC premiums and pension related costs, which do not enhance revenue growth, impacted both ratios.

Income Taxes

The first quarter effective income tax rate was 21.5%, compared to the 22.5% effective tax rate in the second quarter of 2008. The lower effective tax rate for 2009 was principally a result of a higher proportion of income being generated from tax-exempt securities and loans.

Investments

As reflected in Table 6 below, the carrying value of investments (including unrealized gains on available-for-sale securities) was $1.34 billion at the end of the second quarter, a decrease of $59.7 million from December 31, 2008 and an increase of $76.6 million from June 30, 2008, respectively. The book value (excluding unrealized gains) of investments decreased $55.1 million from December 31, 2008 and increased $61.1 million from June 30, 2008, respectively. During the fourth quarter of 2008 and continuing in the first six months of 2009, the Company invested a portion of the net liquidity received in the Citizens acquisition into mortgage-backed securities and obligations of state and political subdivisions. The overall mix of securities within the portfolio over the last year has changed, with an increase in the proportion of mortgage-backed securities and obligations of state and political subdivisions and small decreases in all other security categories. The change in the carrying value of investments is impacted by the amount of net unrealized gains in the available for sale portfolio at a point in time. At June 30, 2009, the portfolio had a $15.4 million net unrealized gain, a decrease of $4.6 million from the unrealized gain at December 31, 2008 and an increase of $15.5 million from the unrealized loss at June 30, 2008. This fluctuation is indicative of the liquidity risk associated with the pooled trust preferred securities, interest rate movements during the respective time periods and the changes in the size and composition of the portfolio.

Table 6: Investments

	June 30, 2009		December 31, 2008		June 30, 2008
	Amortized		Amortized		Amortized
	Cost/Book	Fair	Cost/Book	Fair	Cost/Book	Fair
(000's omitted)	Value	Value	Value	Value	Value	Value
Held-to-Maturity Portfolio:
U.S. Treasury and agency securities	$21,838	$23,681	$61,910	$64,268	$126,983	$126,800
Government guaranteed mortgage-backed securities	41,766	41,973	0	0	0	0
Obligations of state and political subdivisions	46,660	46,918	15,784	16,004	7,978	8,042
Other securities	90	90	100	100	110	110
Total held-to-maturity portfolio	110,354	112,662	77,794	80,372	135,071	134,952

Available-for-Sale Portfolio:
U.S. Treasury and agency securities	312,429	332,126	382,301	411,783	245,971	250,800
Obligations of state and political subdivisions	519,988	528,346	538,008	547,939	515,893	523,835
Corporate debt securities	35,579	35,861	35,596	35,152	35,613	35,349
Collateralized mortgage obligations	14,032	14,489	25,464	25,700	29,978	30,243
Pooled trust preferred securities	71,813	54,561	72,535	49,865	72,920	61,981
Government guaranteed mortgage-backed securities	200,585	204,476	188,560	192,054	169,923	168,040
Subtotal	1,154,426	1,169,859