NBT Bancorp 10-Q 09-30-2006
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
FORM 10-Q

(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2006.
OR
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 0-14703
 
NBT BANCORP INC.
(Exact Name of Registrant as Specified in its Charter)

DELAWARE
16-1268674
(State of Incorporation)
(I.R.S. Employer Identification No.)

52 SOUTH BROAD STREET, NORWICH, NEW YORK 13815
(Address of Principal Executive Offices) (Zip Code)

Registrant's Telephone Number, Including Area Code: (607) 337-2265

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 shorter periods 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 is a large accelerated filer, an accelerated filer, or a non-accelerated filer.
Large Accelerated Filer x
Accelerated Filer o
Non-Accelerated Filer o

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

As of October 31, 2006, there were 34,168,813 shares outstanding of the Registrant's common stock, $0.01 par value.
 

NBT BANCORP INC.
FORM 10-Q--Quarter Ended September 30, 2006

TABLE OF CONTENTS

 
     
 
     
   
     
   
     
   
     
   
     
   
     
   
     
 
     
 
     
 
     
 
     
 
 
 
 
 
 
 
     
 
     
 
 

NBT Bancorp Inc. and Subsidiaries
Consolidated Balance Sheets (unaudited)
  
September 30,
2006
  
December 31,
2005
  
September 30,
2005
  
(in thousands, except share and per share data)
              
               
ASSETS
              
Cash and due from banks
  
$
143,678
  
$
134,501
  
$
134,131
  
Short-term interest bearing accounts
    
7,999
    
7,987
    
7,515
  
Securities available for sale, at fair value
    
1,111,473
    
954,474
    
942,770
  
Securities held to maturity (fair value - $134,775, $93,701 and $89,887)
    
134,608
    
93,709
    
89,660
  
Federal Reserve and Federal Home Loan Bank stock
    
39,488
    
40,259
    
36,842
  
Loans and leases
    
3,369,732
    
3,022,657
    
3,003,103
  
Less allowance for loan and lease losses
    
50,646
    
47,455
    
47,550
  
Net loans and leases
    
3,319,086
    
2,975,202
    
2,955,553
  
Premises and equipment, net
    
66,988
    
63,693
    
63,611
  
Goodwill
    
102,858
    
47,544
    
47,544
  
Other intangible assets, net
    
12,873
    
3,808
    
3,950
  
Bank owned life insurance
    
41,344
    
33,648
    
33,306
  
Other assets
    
78,776
    
71,948
    
70,739
  
TOTAL ASSETS
  
$
5,059,171
  
$
4,426,773
  
$
4,385,621
  
                     
LIABILITIES AND STOCKHOLDERS’ EQUITY
Deposits:
                    
Demand (noninterest bearing)
  
$
634,308
  
$
593,422
  
$
583,289
  
Savings, NOW, and money market
    
1,577,510
    
1,325,166
    
1,409,114
  
Time
    
1,576,045
    
1,241,608
    
1,219,770
  
Total deposits
    
3,787,863
    
3,160,196
    
3,212,173
  
Short-term borrowings
    
324,461
    
444,977
    
356,193
  
Trust preferred debentures
    
75,422
    
23,875
    
18,720
  
Long-term debt
    
417,753
    
414,330
    
419,353
  
Other liabilities
    
54,123
    
49,452
    
47,014
  
Total liabilities
    
4,659,622
    
4,092,830
    
4,053,453
  
                     
Stockholders’ equity:
                    
Common stock, $0.01 par value. Authorized 50,000,000 shares at September 30, 2006, December 31, 2005 and September 30, 2005; issued 36,459,522, 34,400,925 and 34,400,946 at September 30, 2006, December 31, 2005 and September 30, 2005, respectively
    
365
    
344
    
344
  
Additional paid-in-capital
    
270,465
    
219,157
    
209,604
  
Retained earnings
    
185,375
    
163,989
    
166,731
  
Unvested stock awards
    
-
    
(457
)
  
(656
)
Accumulated other comprehensive loss
    
(6,631
)
  
(6,477
)
  
(3,733
)
Treasury stock at cost 2,398,600, 2,105,582, and 2,000,978 shares at September 30, 2006, December 31, 2005, and September 30, 2005, respectively
    
(50,025
)
  
(42,613
)
  
(40,122
)
Total stockholders’ equity
    
399,549
    
333,943
    
332,168
  
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
  
$
5,059,171
  
$
4,426,773
  
$
4,385,621
  
See notes to unaudited interim consolidated financial statements.

3

NBT Bancorp Inc. and Subsidiaries
  
Three months ended September 30,
  
Nine months ended September 30,
  
Consolidated Statements of Income (unaudited)
  
2006
  
2005
  
2006
  
2005
  
(in thousands, except per share data)
                  
Interest, fee and dividend income:
                  
Interest and fees on loans and leases
  
$
59,329
  
$
48,784
  
$
169,247
  
$
138,988
  
Securities available for sale
    
13,342
    
10,103
    
38,303
    
30,576
  
Securities held to maturity
    
1,293
    
860
    
3,321
    
2,494
  
Other
    
724
    
535
    
1,954
    
1,551
  
Total interest, fee and dividend income
    
74,688
    
60,282
    
212,825
    
173,609
  
                           
Interest expense:
                          
Deposits
    
24,052
    
12,842
    
62,146
    
35,580
  
Short-term borrowings
    
3,828
    
3,005
    
11,876
    
7,073
  
Long-term debt
    
4,603
    
4,176
    
12,972
    
12,016
  
Trust preferred debentures
    
1,285
    
308
    
3,423
    
851
  
Total interest expense
    
33,768
    
20,331
    
90,417
    
55,520
  
Net interest income
    
40,920
    
39,951
    
122,408
    
118,089
  
Provision for loan and lease losses
    
2,480
    
2,752
    
5,911
    
6,868
  
Net interest income after provision for loan and lease losses
    
38,440
    
37,199
    
116,497
    
111,221
  
                           
Noninterest income:
                          
Trust
    
1,425
    
1,292
    
4,242
    
3,795
  
Service charges on deposit accounts
    
4,460
    
4,314
    
13,172
    
12,554
  
ATM and debit card fees
    
1,888
    
1,631
    
5,322
    
4,575
  
Broker/dealer and insurance fees
    
1,024
    
571
    
2,899
    
2,659
  
Net securities gains (losses)
    
7
    
(737
)
  
(905
)
  
(690
)
Bank owned life insurance income
    
431
    
339
    
1,204
    
1,005
  
Retirement plan administration fees
    
1,450
    
1,195
    
4,112
    
3,214
  
Other
    
1,832
    
1,746
    
6,251
    
5,005
  
Total noninterest income
    
12,517
    
10,351
    
36,297
    
32,117
  
                           
Noninterest expenses:
                          
Salaries and employee benefits
    
15,628
    
15,438
    
47,711
    
46,142
  
Office supplies and postage
    
1,275
    
1,135
    
3,912
    
3,406
  
Occupancy
    
3,044
    
2,425
    
8,779
    
7,763
  
Equipment
    
2,040
    
1.971
    
6,263
    
5,998
  
Professional fees and outside services
    
1,627
    
1,447
    
5,259
    
4,503
  
Data processing and communications
    
2,637
    
2,613
    
7,988
    
7,801
  
Amortization of intangible assets
    
471
    
142
    
1,260
    
402
  
Loan collection and other real estate owned
    
222
    
115
    
722
    
724
  
Other operating
    
2,974
    
3,293
    
10,190
    
9,417
  
Total noninterest expenses
    
29,918
    
28,579
    
92,084
    
86,156
  
Income before income tax expense
    
21,039
    
18,971
    
60,710
    
57,182
  
Income tax expense
    
6,497
    
5,445
    
18,411
    
17,739
  
Net income
  
$
14,542
  
$
13,526
  
$
42,299
  
$
39,443
  
Earnings per share:
                          
Basic
  
$
0.43
  
$
0.42
  
$
1.25
  
$
1.21
  
Diluted
  
$
0.43
  
$
0.41
  
$
1.24
  
$
1.20
  
See notes to unaudited interim consolidated financial statements.

4
 
NBT Bancorp Inc. and Subsidiaries
  
Consolidated Statements of Stockholders’ Equity (unaudited)
  
   
Common Stock
  
Additional Paid-in- Capital
  
Retained Earnings
  
Unvested Stock Awards
  
Accumulated Other Comprehensive (Loss)/Income
  
Treasury Stock
  
Total
  
(in thousands, except per share data)
                          
                               
Balance at December 31, 2004
  
$
344
  
$
209,523
  
$
145,812
  
$
(296
)
$
4,989
  
$
(28,139
)
$
332,233
  
Net income
                
39,443
                      
39,443
  
Cash dividends - $0.57 per share
                
(18,524
)
                    
(18,524
)
Purchase of 868,743 treasury shares
                                  
(19,989
)
  
(19,989
)
Issuance of 387,337 shares to employee benefit plans and other stock plans, including tax benefit
          
121
                      
7,340
    
7,461
  
Grant of 24,675 shares of restricted stock awards
          
(40
)
        
(626
)
        
666
    
-
  
Amortization of restricted stock awards
                      
266
                
266
  
Other comprehensive loss
                            
(8,722
)
        
(8,722
)
Balance at September 30, 2005
  
$
344
  
$
209,604
  
$
166,731
  
$
(656
)
$
(3,733
)
$
(40,122
)
$
332,168
  
                                             
Balance at December 31, 2005
  
$
344
  
$
219,157
  
$
163,989
  
$
(457
)
$
(6,477
)
$
(42,613
)
$
333,943
  
Net income
                
42,299
                      
42,299
  
Cash dividends - $0.57 per share
                
(19,511
)
                    
(19,511
)
Purchase of 766,004 treasury shares
                                  
(17,111
)
  
(17,111
)
Issuance of 2,058,661 shares of common stock in connection with purchase business combination
    
21
    
48,604
                            
48,625
  
Issuance of 237,278 incentive stock options in purchase transaction
          
1,955
                            
1,955
  
Acquisition of 2,500 shares of company stock in purchase transaction
                                  
(55
)
  
(55
)
Issuance of 436,703 shares to employee benefit plans and other stock plans, including tax benefit
          
683
    
(1,402
)
              
8,315
    
7,596
  
Reclassification adjustment from the adoption of FAS123R
          
(457
)
        
457
                
-
  
Stock-based compensation
          
2,007
                            
2,007
  
Grant of 41,408 shares restricted stock
         
(1,499
)
                    
1,499
    
-
  
Forfeit 2,625 shares of restricted stock
          
15
                      
(60
)
  
(45
)
Other comprehensive loss
                            
(154
)
        
(154
)
Balance at September 30, 2006
  
$
365
  
$
270,465
  
$
185,375
  
$
-
  
$
(6,631
)
$
(50,025
)
$
399,549
  
See notes to unaudited interim consolidated financial statements.

5

NBT Bancorp Inc. and Subsidiaries
  
Nine Months Ended September 30,
  
Consolidated Statements of Cash Flows (unaudited)
  
2006
  
2005
  
(in thousands)
          
Operating activities:
          
Net income
  
$
42,299
  
$
39,443
  
Adjustments to reconcile net income to net cash provided by operating activities:
              
Provision for loan and lease losses
    
5,911
    
6,868
  
Depreciation of premises and equipment
    
4,618
    
4,747
  
Net amortization on securities
    
154
    
1,077
  
Amortization of intangible assets
    
1,260
    
402
  
Stock-based compensation
    
2,007
    
266
  
Tax benefit from the exercise of stock options
    
(301
)
  
1,057
  
Bank owned life insurance income
    
(1,204
)
  
(1,005
)
Proceeds from sales of loans held for sale
    
22,706
    
15,381
  
Origination of loans held for sale
    
(20,528
)
  
(17,254
)
Net gains on sales of loans
    
(64
)
  
(33
)
Net gain on sale of other real estate owned
    
(294
)
  
(325
)
Net gain on sale of branch
    
(470
)
  
-
  
Net security losses
    
905
    
690
  
Net decrease in other assets
    
423
    
1,160
  
Net increase (decrease) in other liabilities
   
2,728
    
(7,199
)
Net cash provided by operating activities
    
60,150
    
45,275
  
Investing activities:
              
Securities available for sale:
              
Proceeds from maturities
    
144,491
    
130,882
  
Proceeds from sales
    
42,292
    
53,044
  
Purchases
    
(197,524
)
  
(190,357
)
Securities held to maturity:
              
Proceeds from maturities
    
33,163
    
34,436
  
Purchases
    
(65,910
)
  
(42,386
)
Net sales of FRB and FHLB stock
    
771
    
-
  
Net cash paid for sale of branch
    
(2,307
)
  
-
  
Net cash used in CNB Bancorp, Inc. merger
    
(20,881
)
  
-
  
Cash paid for the acquisition of EPIC Advisor’s, Inc.
    
-
    
(6,129
)
Cash received for the sale of M. Griffith Inc.
    
-
    
1,016
  
Net increase in loans
    
(163,989
)
  
(135,826
)
Purchase of premises and equipment, net
    
(2,726
)
  
(4,424
)
Proceeds from sales of other real estate owned
    
723
    
966
  
Net cash used in investing activities
    
(231,897
)
  
(158,778
)
Financing activities:
              
Net increase in deposits
    
298,658
    
138,335
  
Net (decrease) increase in short-term borrowings
    
(120,516
)
  
17,370
  
Repayments of long-term debt
    
(19,132
)
  
(35,170
)
Proceeds from the issuance of trust preferred debentures
    
51,547
    
-
  
Proceeds from the issuance of long-term debt
    
-
    
60,000
  
Excess tax benefit from the exercise of stock options
    
301
    
-
  
Proceeds from issuance of treasury shares to employee benefit plans and other stock plans
    
6,700
    
6,404
  
Purchase of treasury stock
    
(17,111
)
  
(19,989
)
Cash dividends
    
(19,511
)
  
(18,524
)
Net cash provided by financing activities
    
180,936
    
148,426
  
Net increase in cash and cash equivalents
    
9,189
    
34,923
  
Cash and cash equivalents at beginning of period
    
142,488
    
106,723
  
Cash and cash equivalents at end of period
  
$
151,677
  
$
141,646
  

6

Consolidated Statements of Cash Flows, Continued
  
Nine Months Ended September 30,
  
Supplemental disclosure of cash flow information:
  
2006
  
2005
  
           
Cash paid during the period for:
          
Interest
  
$
87,269
  
$
54,488
  
Income taxes
    
15,160
    
19,574
  
Noncash investing activities:
              
Loans transferred to OREO
  
$
559
  
$
300
  
Dispositions:
              
Fair value of assets sold
  
$
3,453
  
$
1,405
  
Fair value of liabilities transferred
    
5,760
    
389
  
Acquisitions:
              
Fair value of assets acquired
  
$
422,097
  
$
6,565
  
Goodwill and identifiable intangible assets recognized in purchase combination
    
9,957
    
-
  
Fair value of liabilities assumed
    
360,648
    
435
  
Fair value of equity issued in purchase combination
    
50,525
    
-
  
               
See notes to unaudited interim consolidated financial statements.

7

           
   
Three months ended
September 30,
  
Nine months ended
September 30,
  
Consolidated Statements of Comprehensive Income (unaudited)
  
2006
  
2005
  
2006
  
2005
  
(in thousands)
          
Net income
  
$
14,542
  
$
13,526
  
$
42,299
  
$
39,443
  
                           
Other comprehensive income, net of tax
                          
Unrealized holding gains (losses) arising during period [pre-tax amounts of $17,443, $(10,672), $(780), and $(15,198)]
    
10,488
    
(6,415
)
  
(468
)
  
(9,137
)
Minimum pension liability adjustment
    
-
    
-
    
(229
)
  
-
  
Reclassification adjustment for net (gains) losses included in net income [pre-tax amounts of $(7), $737, $905 and $690]
    
(4
)
  
443
    
543
    
415
  
Total other comprehensive gain (loss)
    
10,484
    
(5,972
)
  
(154
)
  
(8,722
)
Comprehensive income
 
$
25,026
  
$
7,554
  
$
42,145
  
$
30,721
  
See notes to unaudited interim consolidated financial statements.

8

NBT BANCORP INC. and Subsidiary
NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2006

Note 1.
Description of Business

NBT Bancorp Inc. (the Company or the Registrant) is a registered financial holding company incorporated in the state of Delaware in 1986, with its principal headquarters located in Norwich, New York. The Company is the parent holding company of NBT Bank, N.A. (the Bank), NBT Financial Services, Inc. (NBT Financial), Hathaway Insurance Agency, Inc., CNBF Capital Trust I, NBT Statutory Trust I and NBT Statutory Trust II. Through these subsidiaries, the Company operates as one segment focused on community banking operations. The Company’s primary business consists of providing commercial banking and financial services to its customers in its market area. The principal assets of the Company are all of the outstanding shares of common stock of its direct subsidiaries, and its principal sources of revenue are the management fees and dividends it receives from the Bank and NBT Financial.

The Bank is a full service commercial bank formed in 1856, which provides a broad range of financial products to individuals, corporations and municipalities throughout the central and upstate New York and northeastern Pennsylvania market area. The Bank conducts business through two operating divisions, NBT Bank and Pennstar Bank.

Note 2.
Basis of Presentation

The accompanying unaudited interim consolidated financial statements include the accounts of NBT Bancorp Inc. and its wholly owned subsidiaries, NBT Bank, N.A., NBT Financial Services, Inc., Hathaway Insurance Agency, Inc., CNBF Capital Trust I, NBT Statutory Trust I and NBT Statutory Trust II. Collectively, the Registrant and its subsidiaries are referred to herein as “the Company”. All intercompany transactions have been eliminated in consolidation. Amounts in the prior period financial statements are reclassified whenever necessary to conform to current period presentation.
 
CNBF Capital Trust I is a Delaware statutory business trust formed in 1999, for the purpose of issuing $18 million in trust preferred securities and lending the proceeds to the Company. NBT Statutory Trust I is a Delaware statutory business trust formed in 2005, for the purpose of issuing $5 million in trust preferred securities and lending the proceeds to the Company. NBT Statutory Trust II is a Delaware statutory business trust formed in 2006, for the purpose of issuing $50 million in trust preferred securities and lending the proceeds to the Company to provide funding for the acquisition of CNB Bancorp, Inc. These three statutory business trusts are collectively referred herein as “the Trusts”. The Company guarantees, on a limited basis, payments of distributions on the trust preferred securities and payments on redemption of the trust preferred securities. The Trusts are variable interest entities (VIEs) for which the Company is not the primary beneficiary, as defined in Financial Accounting Standards Board Interpretation (“FIN”) No. 46 “Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51 (Revised December 2003) (FIN 46R).” In accordance with FIN 46R, which was implemented in the first quarter of 2004, the accounts of the Trusts are not included in the Company’s consolidated financial statements.

Note 3.
New Accounting Pronouncements

In February 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard 155 - Accounting for Certain Hybrid Financial Instruments (“SFAS 155”), which eliminates the exemption from applying SFAS 133 to interests in securitized financial assets so that similar instruments are accounted for similarly regardless of the form of the instruments. SFAS 155 also allows the election of fair value measurement at acquisition, at issuance, or when a previously recognized financial instrument is subject to a remeasurement event. Adoption is effective for all financial instruments acquired or issued after the beginning of the first fiscal year that begins after September 15, 2006. Early adoption is permitted. We are evaluating whether the adoption of SFAS 155 is expected to have a material effect on our consolidated financial position, results of operations or cash flows.

9

In March 2006, the FASB issued Statement of Financial Accounting Standard 156 - Accounting for Servicing of Financial Assets (“SFAS 156”), which requires all separately recognized servicing assets and servicing liabilities be initially measured at fair value. SFAS 156 permits, but does not require, the subsequent measurement of servicing assets and servicing liabilities at fair value. Adoption is required as of the beginning of the first fiscal year that begins after September 15, 2006. Early adoption is permitted. The adoption of SFAS 156 is not expected to have a material effect on our consolidated financial position, results of operations or cash flows.

In July 2006, the FASB posted the final Interpretation No. 48 - Accounting for Uncertainty in Income Taxes (“FIN 48”), which prescribes a minimum recognition threshold a tax position must meet before being recognized in the financial statements. FIN 48 concludes that recognition of a tax position, based solely on its technical merits, occurs when the tax position is more-likely-than-not to be sustained upon examination. The tax benefit is measured as the largest amount of benefit that is more-likely-than-not to be realized upon ultimate settlement. In addition, FIN 48 expands disclosure requirements to include a tabular roll-forward of the beginning and ending aggregate unrecognized tax benefits as well as detail regarding tax uncertainties for which it is reasonably possible the amount of unrecognized tax benefit will increase or decrease within 1 year. The Company is assessing the effect that FIN 48 will have on our consolidated financial position, results of operations or cash flows.

In September 2006, the FASB issued Statement of Financial Accounting Standard 157 - Fair Value Measurements (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. This Statement does not require any new fair value measurements, but the application of this Statement may change current practice. Adoption is required as of the beginning of the first fiscal year that begins after November 15, 2007. Early application of this Standard is encouraged. The Company is assessing the effect that SFAS 157 will have on our consolidated financial position, results of operations or cash flows.

In September 2006, the FASB issued Statement of Financial Accounting Standard 158 - Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans (“SFAS 158”), which requires an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income of a business entity or changes in unrestricted net assets of a not-for-profit organization. This Statement also improves financial reporting by requiring an employer to measure the funded status of a plan as of the date of its year-end statement of financial position, with limited exceptions. Adoption is required as of the end of the fiscal year ending after December 15, 2006. Early application of this Standard is encouraged. The Company is assessing the effect that SFAS 158 will have on our consolidated financial position, results of operations or cash flows.

In September 2006, the SEC published Staff Accounting Bulletin No. 108 (“SAB 108”) to provide guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. SAB 108 addresses the effects that unadjusted assets and liabilities of prior year errors have on current year financial statements. Registrants must quantify the impact of correcting all misstatements, including both the carryover and reversing effects of prior year misstatements, on the current year financial statements. A registrant’s financial statements would require adjustment when a misstatement is quantified as material, after considering all relevant quantitative and qualitative factors. Restating prior periods is not mandatory, but financial statements covering the first fiscal year ending after November 15, 2006 should reflect the effects of prior year misstatements.

10

Note 4.
Business Combination

On February 10, 2006, the Company completed the acquisition through merger of CNB Bancorp, Inc. (“CNB”). CNB was a bank holding company for City National Bank and Trust Company (“CNB Bank”) and Hathaway Insurance Agency, Inc. (“Hathaway”), headquartered in Gloversville, NY. CNB Bank conducted business from nine community bank offices in four upstate New York counties—Fulton, Hamilton, Montgomery and Saratoga. The stockholders of CNB received approximately $39 million in cash and 2,058,661 shares of NBT common stock. The aggregate transaction value was approximately $89.0 million. The transaction was accounted for under the purchase method of accounting. CNB had total assets of $399.0 million, loans of $197.6 million, deposits of $335.0 million and shareholders equity of $40.1 million. As part of the merger, the Company acquired approximately $10.0 million in goodwill. CNB was merged with and into the Company, CNB Bank was merged with and into NBT Bank and Hathaway became a direct subsidiary of the Company. The results of operations are included in the consolidated financial statements from the date of acquisition, February 10, 2006.

Note 5.
Use of Estimates

Preparing financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period, as well as the disclosures provided. Actual results could differ from those estimates. Estimates associated with the allowance for loan losses, pension expense, fair values of financial instruments and status of contingencies are particularly susceptible to material change in the near term.

The allowance for loan and lease losses is the amount which, in the opinion of management, is necessary to absorb probable losses inherent in the loan and lease portfolio. The allowance is determined based upon numerous considerations, including local economic conditions, the growth and composition of the loan portfolio with respect to the mix between the various types of loans and their related risk characteristics, a review of the value of collateral supporting the loans, comprehensive reviews of the loan portfolio by the independent loan review staff and management, as well as consideration of volume and trends of delinquencies, nonperforming loans, and loan charge-offs. As a result of the test of adequacy, required additions to the allowance for loan and lease losses are made periodically by charges to the provision for loan and lease losses.

The allowance for loan and lease losses related to impaired loans is based on discounted cash flows using the loan’s initial effective interest rate or the fair value of the collateral for certain loans where repayment of the loan is expected to be provided solely by the underlying collateral (collateral dependent loans). The Company’s impaired loans are generally collateral dependent. The Company considers the estimated cost to sell, on a discounted basis, when determining the fair value of collateral in the measurement of impairment if those costs are expected to reduce the cash flows available to repay or otherwise satisfy the loans.

Management believes that the allowance for loan and lease losses is adequate. While management uses available information to recognize loan and lease losses, future additions to the allowance for loan and lease losses may be necessary based on changes in economic conditions or changes in the values of properties securing loans in the process of foreclosure. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan and lease losses. Such agencies may require the Company to recognize additions to the allowance for loan and lease losses based on their judgments about information available to them at the time of their examination which may not be currently available to management.

11

Other real estate owned (OREO) consists of properties acquired through foreclosure or by acceptance of a deed in lieu of foreclosure. These assets are recorded at the lower of fair value of the asset acquired less estimated costs to sell or “cost” (defined as the fair value at initial foreclosure). At the time of foreclosure, or when foreclosure occurs in-substance, the excess, if any, of the loan over the fair value of the assets received, less estimated selling costs, is charged to the allowance for loan and lease losses and any subsequent valuation write-downs are charged to other expense. Operating costs associated with the properties are charged to expense as incurred. Gains on the sale of OREO are included in income when title has passed and the sale has met the minimum down payment requirements prescribed by GAAP.

Income taxes are accounted for under the asset and liability method. The Company files consolidated tax returns on the accrual basis. Deferred income taxes are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Realization of deferred tax assets is dependent upon the generation of future taxable income or the existence of sufficient taxable income within the available carryback period. A valuation allowance is provided when it is more likely than not that some portion of the deferred tax asset will not be realized. Based on available evidence, gross deferred tax assets will ultimately be realized and a valuation allowance was not deemed necessary at September 30, 2006 and 2005. The effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date.

Note 6.
Commitments and Contingencies

The Company is a party to financial instruments in the normal course of business to meet financing needs of its customers and to reduce its own exposure to fluctuating interest rates. These financial instruments include commitments to extend credit, unused lines of credit, and standby letters of credit. Exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to make loans and standby letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policy to make such commitments as it uses for on-balance-sheet items. Commitments to extend credit and unused lines of credit totaled $551.8 million at September 30, 2006 and $497.1 million at December 31, 2005. Since commitments to extend credit and unused lines of credit may expire without being fully drawn upon, this amount does not necessarily represent future cash commitments. Collateral obtained upon exercise of the commitment is determined using management’s credit evaluation of the borrower and may include accounts receivable, inventory, property, land and other items.

The Company guarantees the obligations or performance of customers by issuing stand-by letters of credit to third parties. These stand-by letters of credit are frequently issued in support of third party debt, such as corporate debt issuances, industrial revenue bonds, and municipal securities. The risk involved in issuing stand-by letters of credit is essentially the same as the credit risk involved in extending loan facilities to customers, and they are subject to the same credit origination, portfolio maintenance and management procedures in effect to monitor other credit and off-balance sheet products. Typically, these instruments have terms of five years or less and expire unused; therefore, the total amounts do not necessarily represent future cash requirements. Standby letters of credit totaled $39.5 million at September 30, 2006 and $42.9 million at December 31, 2005. As of September 30, 2006, the fair value of standby letters of credit was not material to the Company’s consolidated financial statements.

Note 7.
Earnings per share

Basic earnings per share excludes dilution and is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity (such as the Company’s dilutive stock options).

12

The following is a reconciliation of basic and diluted earnings per share for the periods presented in the consolidated statements of income.
           
Three months ended September 30,
 
2006
  
2005
  
(in thousands, except per share data)
          
           
Basic EPS:
          
Weighted average common shares outstanding
    
33,879
    
32,440
  
Net income available to common shareholders
  
$
14,542
  
$
13,526
  
Basic EPS
  
$
0.43
  
$
0.42
  
               
Diluted EPS:
              
Weighted average common shares outstanding
    
33,879
    
32,440
  
Dilutive potential common stock
    
318
    
289
  
Weighted average common shares and common Share equivalents
    
34,197
    
32,729
  
Net income available to common shareholders
  
$
14,542
  
$
13,526
  
               
Diluted EPS
  
$
0.43
  
$
0.41
  
 
           
Nine months ended September 30,
 
2006
  
2005
  
(in thousands, except per share data)
          
           
Basic EPS:
          
Weighted average common shares outstanding
    
33,824
    
32,478
  
Net income available to common shareholders
  
$
42,299
  
$
39,443
  
Basic EPS
  
$
1.25
  
$
1.21
  
               
Diluted EPS:
              
Weighted average common shares outstanding
    
33,824
    
32,478
  
Dilutive potential common stock
    
316
    
284
  
Weighted average common shares and common Share equivalents
    
34,140
    
32,762
  
Net income available to common shareholders
  
$
42,299
  
$
39,443
  
               
Diluted EPS
  
$
1.24
  
$
1.20
  

There were 361,379 stock options for the quarter ended September 30, 2006 and 8,996 stock options for the quarter ended September 30, 2005 that were not considered in the calculation of diluted earnings per share since the stock options’ exercise price was greater than the average market price during these periods.

There were 372,604 stock options for the nine months ended September 30, 2006 and 372,686 stock options for the nine months ended September 30, 2005 that were not considered in the calculation of diluted earnings per share since the stock options’ exercise price was greater than the average market price during these periods.

Note 8.
Stock-Based Compensation

Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment”, (“FAS 123R”) using the modified-prospective transition method. Under this transition method, compensation cost in 2006 includes costs for stock options granted prior to but not vested as of December 31, 2005, and options vested in 2006. Therefore, results for prior periods have not been restated.

13

The adoption of FAS 123R lowered income before income tax expense by approximately $0.4 million and $1.4 million for the three and nine-month periods ended September 30, 2006, respectively, compared to if we had continued to account for share-based compensation under APB No. 25, Accounting for Stock Issued to Employees.

The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of FAS 123 during the period presented. For the purpose of this pro forma disclosure, the value of options is estimated using a Black-Scholes option-pricing model and amortized to expense over the options’ vesting periods.
           
   
Three months ended September 30,
  
Nine months ended September 30,
  
(in thousands, except per share data)
  
2005
  
2005
  
Net income, as reported
  
$
13,526
  
$
39,443
  
Add: Stock-based compensation expense included in reported net income, net of related tax effects
    
49
    
160
  
Less: Stock-based compensation expense determined under fair value method for all awards, net of related tax effects
    
(329
)
  
(908
)
Pro forma net income
  
$
13,246
  
$
38,695
  
               
Net income per share:
              
Basic - as reported
  
$
0.42
  
$
1.21
  
Basic - Pro forma
  
$
0.41
  
$
1.19
  
               
Diluted - as reported
  
$
0.41
  
$
1.20
  
Diluted - Pro forma
  
$
0.40
  
$
1.18
  

As of September 30, 2006, there was approximately $2.5 million of unrecognized compensation cost related to unvested share-based stock option awards granted. That cost is expected to be recognized over the next four years.

In November 2005, the FASB issued Staff Position No. FAS 123(R)-3 (“FSP 123R-3”), Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards. FSP 123R-3 provides an elective alternative transition method for calculating the pool of excess tax benefits available to absorb tax deficiencies recognized subsequent to the adoption of FAS 123R. Companies may take up to one year from the effective date of FSP 123R-3 to evaluate the available transition alternatives and make a one-time election as to which method to adopt. We are currently in the process of evaluating the alternative methods.

Options are granted to certain employees and directors at prices equal to the market value of the stock on the dates the options were granted. The options granted have a term of ten years from the grant date and granted options for employees vest in the following manner: 40% in the first year and 20% per year for the subsequent three years. Generally, the fair value of each option is amortized into compensation expense on a straight-line basis between the grant date for the option and each vesting date. Options granted to retirement eligible employees are expensed in full on the date of grant. We have estimated the fair value of all stock option awards as of the date of the grant by applying the Black-Scholes pricing valuation model. The application of this valuation model involves assumptions that are judgmental and sensitive in the determination of compensation expense. The key assumptions used in determining the fair value of options granted during the nine month periods ended September 30, 2006 and 2005 are:

14

 
Nine months ended
September 30, 2006
Nine months ended
September 30, 2005
Dividend Yield
3.23% - 3.52%
3.05% - 3.70%
Expected Volatility
28.26% - 28.62%
29.15% - 30.00%
Risk-free interest rate
4.36% - 5.04%
3.85% - 4.22%
Expected life
7 years
7 years

Historical information was the primary basis for the selection of the expected volatility, expected dividend yield and the expected lives of the options. The risk-free interest rate was selected based upon yields of the U.S. treasury issues with a term equal to the expected life of the option being valued.

Stock option activity during the nine month period ended September 30, 2006 is as follows:

   
Number of Shares
 
Weighted Average Exercise Price
 
Weighted Average Remaining Contractual Term (in yrs)
 
Aggregate Intrinsic Value
 
                   
Outstanding at January 1, 2006
    
1,916,623
 
$
18.79
            
Granted
    
287,548
 
$
22.36
            
Assumed from CNB transaction
    
237,278
 
$
16.76
            
Exercised
    
(185,585
)
$
16.32
            
Lapsed
    
(22,641
)
$
21.82
            
Outstanding at March 31, 2006
    
2,233,223
 
$
19.21
          
Granted
    
36,800
 
$
22.18
            
Exercised
    
(37,765
)
$
14.30
            
Lapsed
    
(12,591
)
$
22.22
            
Outstanding at June 30, 2006
    
2,219,667
 
$
19.33
          
Granted
    
6,582
 
$
22.89
            
Exercised
    
(179,453
)
$
17.31
            
Lapsed
    
(27,165
)
$
22.05
               
Outstanding at September 30, 2006
    
2,019,631
 
$
19.48
    
6.40
  
$
7,634,205
  
                           
Exercisable at September 30, 2006
    
1,322,814
 
$
18.18
    
5.38
  
$
6,719,895
  
                           
Expected to vest
   
576,388
 
$
22.22
    
8.55
  
$
614,157
  
 
15

The weighted-average fair market value of stock options granted for the nine months ended September 30, 2006, was $5.26 per share. Total stock-based compensation expense for stock option awards totaled $1.4 million for the nine months ended September 30, 2006. Cash proceeds, tax benefits and intrinsic value related to total stock options exercised is as follows:

   
Nine months ended
  
(dollars in thousands)
  
Sept 30, 2006
  
Sept 30, 2005
  
Proceeds from stock option exercised
  
$
6,675
  
$
6,118
  
Tax benefits related to stock options exercised
    
851
   
473
 
Intrinsic value of stock options exercised
    
1,597
   
2,582
 

The Company has outstanding restricted and deferred stock awards granted from various plans at September 30, 2006. The Company recognized $0.3 million in stock-based compensation expense related to these stock awards for the three months ended September 30, 2006 and $0.2 million for the three months ended September 30, 2005. Unrecognized compensation cost related to restricted stock awards totaled $1.5 million at September 30, 2006. The following table summarizes information for unvested restricted stock awards outstanding as of September 30, 2006:

   
Number of Shares
 
Weighted-Average Grant Date Fair Value
 
           
Unvested Restricted Stock Awards
          
Unvested at January 1, 2006
    
37,935
 
$
21.46
  
Forfeited
    
(2,625
)
$
23.04
  
Vested
    
(9,886
)
$
20.26
  
Granted
    
29,817
 
$
21.74
  
Unvested at March 31, 2006
    
55,241
 
$
21.75
  
Forfeited
    
-
 
$
-
  
Vested
    
(14,746
)
$
21.29
  
Granted
    
18,391
 
$
21.75
  
Unvested at June 30, 2006
    
58,886
 
$
21.87
  
Forfeited
    
(1,100
)
$
21.74
  
Vested
    
(146
)
$
17.14
  
Granted
    
33,000
 
$
23.43
  
Unvested at September 30, 2006
    
90,640
 
$
22.45
  
 
16

Note 9.
Goodwill and Intangible Assets

A summary of goodwill by operating subsidiaries follows:

(in thousands)
  
January 1, 2005
  
Goodwill Acquired
  
Goodwill Disposed
  
September 30, 2005
  
NBT Bank, N.A.
  
$
44,520
    
-
   
-
  
$
44,520
  
NBT Financial Services, Inc.
    
1,050
    
3,024
    
1,050
    
3,024
  
Total
  
$
45,570
  
$
3,024
  
$
1,050
  
$
47,544
  

(in thousands)
  
January 1, 2006
  
Goodwill Acquired
  
Goodwill Disposed
  
September 30, 2006
  
NBT Bank, N.A.
  
$
44,520
    
55,110
    
-
  
$
99,630
  
NBT Financial Services, Inc.
    
3,024
    
-
    
-
    
3,024
  
Hathaway Agency, Inc.
    
-
    
204
    
-
    
204
  
Total
  
$
47,544
  
$
55,314
  
$
-
  
$
102,858
  

In February 2006, the Company acquired CNB. The acquisition resulted in increases to goodwill of $55.1 million, core deposit intangibles of $9.6 million and other intangibles of $0.5 million. The core deposit intangibles will be amortized over ten years on an accelerated basis.

In January 2005, the Company acquired EPIC Advisors, Inc., a 401(k) record keeping firm located in Rochester, NY. In that transaction, the Company recorded customer relationship intangible assets of $2.1 million and non-compete provision intangible assets of $0.2 million, which have amortization periods of 13 years and 5 years, respectively. Also in connection with the acquisition, the Company recorded $3.0 million in goodwill.

In March 2005, the Company sold its broker/dealer subsidiary, M. Griffith Inc. In connection with the sale of M. Griffith Inc., goodwill was reduced by $1.1 million and was allocated against the sales price. In the fourth quarter of 2004, the Company recorded a $2.0 million goodwill impairment charge in connection with the above mentioned sale. A definitive agreement was signed by the Company and the acquirer in the fourth quarter of 2004. The negotiation and resolution of sale terms for M. Griffith Inc. during the fourth quarter of 2004 resulted in the goodwill impairment charge in that same quarter.

The Company has finite-lived intangible assets capitalized on its consolidated balance sheet in the form of core deposit and other intangible assets. These intangible assets continue to be amortized over their estimated useful lives, which range from one to twenty-five years.

17

A summary of core deposit and other intangible assets follows:

   
Sept 30, 2006
  
Dec 31, 2005
  
Sept 30, 2005
  
(in thousands)
              
Core Deposit intangibles:
              
Gross carrying amount
 
$
11,806
  
$
2,186
  
$
2,186
  
Less: accumulated amortization
   
2,446
   
1,561
   
1,504
 
Net Carrying amount
   
9,360
   
625
   
682
 
                     
Other intangibles:
                   
Gross carrying amount
   
4,180
   
3,196
   
3,197
 
Less: accumulated amortization
   
1,032
   
530
   
446
 
Net Carrying amount
   
3,148
   
2,666
   
2,751
 
                     
Other intangibles not subject to amortization: Pension asset
   
365
   
517
   
517
 
                     
Total intangibles with definite useful lives:
                   
Gross carrying amount
   
16,351
   
5,899
   
5,900
 
Less: accumulated amortization
   
3,478
   
2,091
   
1,950
 
Net Carrying amount
 
$
12,873
  
$
3,808
  
$
3,950
  

Amortization expense on finite-lived intangible assets is expected to total $0.5 million for the remainder of 2006, $1.6 million for 2007, $1.5 million for 2008, $1.4 million for 2009, $1.2 million for 2010, and $6.3 million thereafter.

Note 10.
Defined Benefit Pension Plan and Postretirement Health Plan

The Company maintains a qualified, noncontributory, defined benefit pension plan covering substantially all employees. Benefits paid from the plan are based on age, years of service, compensation, social security benefits, and are determined in accordance with defined formulas. The Company’s policy is to fund the pension plan in accordance with ERISA standards. In addition, the Company provides certain health care benefits for retired employees. Benefits are accrued over the employees’ active service period. Only employees that were employed by NBT Bank, N.A. on or before January 1, 2000 are eligible to receive postretirement health care benefits. The Company funds the cost of the postretirement health plan as benefits are paid.

18

The Components of pension expense and postretirement expense are set forth below (in thousands):

   
Three months ended September 30,
  
Nine months ended September 30,
  
Pension plan:
  
2006
  
2005
  
2006
  
2005
  
Service cost
  
$
521
  
$
469
  
$
1,544
  
$
1,407
  
Interest cost
    
590
    
561
    
1,719
    
1,683
  
Expected return on plan assets
    
(979
)
  
(947
)
  
(2,863
)
  
(2,841
)
Net amortization
    
179
    
374
    
537
    
1,122
  
Total
  
$
311
  
$
457
  
$
937
  
$
1,371
  

Postretirement Health Plan:
  
2006
  
2005
  
2006
  
2005
  
Service cost
  
$
1
  
$
9
  
$
3
  
$
27
  
Interest cost
    
51
    
67
    
153
    
201
  
Net amortization
    
(24
)
  
(15
)
  
(72
)
  
(45
)
Total
  
$
28
  
$
61
  
$
84
  
$
183
  

The Company is not required to make contributions to the Plan in the remainder of 2006 or 2007.

Note 11.
Trust Preferred Debentures

As of September 30, 2006, the CNBF Capital Trust I, NBT Statutory Trust I and NBT Statutory Trust II (“the Trusts”), all wholly-owned unconsolidated subsidiaries of the Company, had the following Trust Preferred Securities outstanding and the Company had the following issues of trust preferred debentures, all held by the Trusts, outstanding (dollars in thousands):

Description
  
Issuance Date
  
Trust Preferred Securities Outstanding
  
Interest Rate
  
Trust Preferred Debt Owed To Trust
  
Final Maturity date
  
CNBF Capital Trust I
    
August-99
    
18,000
   
3-month
LIBOR plus
2.75%
 
  
18,720
   
August-29
  
                                 
NBT Statutory Trust I
    
November-05
    
5,000
   
6.30% Fixed
    
5,155
   
December-35
  
                                 
NBT Statutory Trust II
    
February-06
    
50,000
   
6.195% Fixed
    
51,547
   
March-36
  

The Company owns all of the common stock of the three business trusts, which have issued trust preferred securities in conjunction with the Company issuing trust preferred debentures to the Trusts. The terms of the trust preferred debentures are substantially the same as the terms of the trust preferred securities. In February 2005, the Federal Reserve Board issued a final rule that allows the continued inclusion of trust preferred securities in the Tier 1 capital of bank holding companies. The Board’s final rule limits the aggregate amount of restricted core capital elements (which includes trust preferred securities, among other things) that may be included in the Tier 1 capital of most bank holding companies to 25% of all core capital elements, including restricted core capital elements, net of goodwill less any associated deferred tax liability. Large, internationally active bank holding companies (as defined) are subject to a 15% limitation. Amounts of restricted core capital elements in excess of these limits generally may be included in Tier 2 capital. The final rule provides a five-year transition period, ending March 31, 2009, for application of the quantitative limits. The Company does not expect that the quantitative limits will preclude it from including the trust preferred securities in Tier 1 capital. However, the trust preferred securities could be redeemed without penalty if they were no longer permitted to be included in Tier 1 capital.

19

NBT BANCORP INC. and Subsidiaries
Item 2 -- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The purpose of this discussion and analysis is to provide the reader with a concise description of the financial condition and results of operations of NBT Bancorp Inc. (Bancorp) and its wholly owned subsidiaries, NBT Bank, N.A. (the Bank), NBT Financial Services, Inc. (NBT Financial), Hathaway Insurance Agency, Inc., CNBF Capital Trust I, NBT Statutory Trust I and NBT Statutory Trust II. (collectively referred to herein as the Company). This discussion will focus on Results of Operations, Financial Position, Capital Resources and Asset/Liability Management. Reference should be made to the Company's consolidated financial statements and footnotes thereto included in this Form 10-Q as well as to the Company's 2005 Form 10-K for an understanding of the following discussion and analysis.

FORWARD LOOKING STATEMENTS

Certain statements in this filing and future filings by the Company with the Securities and Exchange Commission, in the Company’s press releases or other public or shareholder communications, contain forward-looking statements, as defined in the Private Securities Litigation Reform Act. These statements may be identified by the use of phrases such as “anticipate,” “believe,” “expect,” “forecasts,” “projects,” or other similar terms. There are a number of factors, many of which are beyond the Company’s control that could cause actual results to differ materially from those contemplated by the forward looking statements. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements include, among others, the following possibilities: (1) competitive pressures among depository and other financial institutions may increase significantly; (2) revenues may be lower than expected; (3) changes in the interest rate environment may effect interest margins; (4) general economic conditions, either nationally or regionally, may be less favorable than expected, resulting in, among other things, a deterioration in credit quality and/or a reduced demand for credit; (5) legislative or regulatory changes, including changes in accounting standards or tax laws, may adversely affect the businesses in which the Company is engaged; (6) competitors may have greater financial resources and develop products that enable such competitors to compete more successfully than the Company; (7) adverse changes may occur in the securities markets or with respect to inflation; (8) acts of war or terrorism; (9) the costs and effects of litigation and of unexpected or adverse outcomes in such litigation; (10) internal control failures; (11) the Company may fail to realize projected cost savings, revenue enhancements and the accretive effect of the CNB acquisition on our earnings; and (12) the Company’s success in managing the risks involved in the foregoing.

The Company wishes to caution readers not to place undue reliance on any forward-looking statements, which speak only as of the date made, and to advise readers that various factors, including those described above and other factors discussed in the Company’s annual and quarterly reports previously filed with the Securities and Exchange Commission, could affect the Company’s financial performance and could cause the Company’s actual results or circumstances for future periods to differ materially from those anticipated or projected.

Unless required by law, the Company does not undertake, and specifically disclaims any obligations to publicly release the result of any revisions that may be made to any forward-looking statements to reflect statements to the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.

20

Critical Accounting Policies

Management of the Company considers the accounting policy relating to the allowance for loan and lease losses to be a critical accounting policy given the uncertainty in evaluating the level of the allowance required to cover credit losses inherent in the loan and lease portfolio and the material effect that such judgments can have on the results of operations. While management’s current evaluation of the allowance for loan and lease losses indicates that the allowance is adequate, under adversely different conditions or assumptions, the allowance would need to be increased. For example, if historical loan and lease loss experience significantly worsened or if current economic conditions significantly deteriorated, additional provisions for loan and lease losses would be required to increase the allowance. In addition, the assumptions and estimates used in the internal reviews of the Company’s non-performing loans and potential problem loans has a significant impact on the overall analysis of the adequacy of the allowance for loan and lease losses. While management has concluded that the current evaluation of collateral values is reasonable under the circumstances, if collateral evaluations were significantly lowered, the Company’s allowance for loan and lease policy would also require additional provisions for loan and lease losses.

Management of the Company considers the accounting policy relating to pension accounting to be a critical accounting policy. Management is required to make various assumptions in valuing its pension assets and liabilities. These assumptions include the expected rate of return on plan assets, the discount rate, and the rate of increase in future compensation levels. Changes to these assumptions could impact earnings in future periods. The Company takes into account the plan asset mix, funding obligations, and expert opinions in determining the various rates used to estimate pension expense. The Company also considers the Moody’s AA and AAA corporate bond yields and other market interest rates in setting the appropriate discount rate. In addition, the Company reviews expected inflationary and merit increases to compensation in determining the rate of increase in future compensation levels. While differences in these rate assumptions could alter pension expense, given not only past history, it is not expected that such estimates could adversely impact pension expense. The Company must also alter its pension accounting policy upon adoption of SFAS 158 (See Note 3 of the Financial Statements for a summary of requirements of SFAS 158).

Overview

The Company earned net income of $14.5 million ($0.43 diluted earnings per share) for the three months ended September 30, 2006 compared to net income of $13.5 million ($0.41 diluted earnings per share) for the three months ended September 30, 2005. The quarter to quarter increase in net income from 2005 to 2006 was primarily the result of increases in net interest income of $1.0 million, noninterest income of $2.2 million and a decrease in provision for loan and lease losses of $0.3 million, partially offset by an increase in total noninterest expense of $1.3 million. The increase in net interest income resulted primarily from 15% growth in average earning assets during the three months ended September 30, 2006 compared to the same period in 2005 (driven by the CNB acquisition and organic loan growth). The increase in noninterest income resulted from increases in service charges on deposit accounts, ATM and debit card fees, retirement plan administration fees, broker/dealer and insurance revenue, trust administration fees, and other income. The increase in total noninterest expense was due primarily to increases in occupancy expense, office supplies and postage, professional fees and services, and amortization of intangible assets. For the three months ended September 30, 2006, the Company incurred $0.4 million in pre-tax salaries and benefits expense related to stock options resulting from the adoption of FAS 123R.

21

The Company earned net income of $42.3 million ($1.24 diluted earnings per share) for the nine months ended September 30, 2006 compared to net income of $39.4 million ($1.20 diluted earnings per share) for the nine months ended September 30, 2005. The increase in net income from 2005 to 2006 was primarily the result of increases in net interest income of $4.3 million, noninterest income of $4.2 million and a decrease in provision for loan and lease losses of $1.0 million, partially offset by an increase in total noninterest expense of $5.9 million. The increase in net interest income resulted primarily from 13% growth in average loans during the nine months ended September 30, 2006 compared to the same period in 2005 (driven by the CNB acquisition and organic loan growth). Included in noninterest income for the nine months ended September 30, 2006 and September 30, 2005 were $0.9 million and $0.7 million in net losses, respectively, from investment securities sales. Excluding the effect of these securities transactions, noninterest income increased $4.4 million or 13.4% compared to the same period in 2005. The increase in noninterest income resulted from increases in service charges on deposit accounts, ATM and debit card fees, retirement plan administration fees, trust administration fees, broker/dealer and insurance revenue, and other income. The increase in total noninterest expense was due primarily to increases in salaries and employee benefits, office supplies and postage, occupancy expense, amortization of intangible assets, professional fees and services, data processing and communications, and other operating expenses. For the nine months ended September 30, 2006, the Company incurred $1.4 million in pre-tax salaries and benefits expense related to stock options resulting from the adoption of FAS 123R.
 
Table 1 depicts several annualized measurements of performance using GAAP net income. Returns on average assets and equity measure how effectively an entity utilizes its total resources and capital, respectively. Net interest margin, which is the net federal taxable equivalent (FTE) interest income divided by average earning assets, is a measure of an entity's ability to utilize its earning assets in relation to the cost of funding. Interest income for tax-exempt securities and loans is adjusted to a taxable equivalent basis using the statutory Federal income tax rate of 35%.
 
Table 1
Performance Measurements
        
2006
First Quarter
Second Quarter
Third Quarter
Nine Months
Return on average assets (ROAA)
1.18%
1.15%
1.15%
1.16%
Return on average equity (ROE)
15.11%
14.71%
14.89%
14.93%
Net interest margin (Federal taxable equivalent)
3.86%
3.73%
3.60%
3.73%
         
2005
        
Return on average assets (ROAA)
1.23%
1.22%
1.23%
1.23%
Return on average equity (ROE)
15.74%
16.21%
16.06%
16.03%
Net interest margin (Federal taxable equivalent)
4.09%
4.02%
3.99%
4.04%

Net Interest Income

Net interest income is the difference between interest income on earning assets, primarily loans and securities, and interest expense on interest-bearing liabilities, primarily deposits and borrowings. Net interest income is affected by the interest rate spread, the difference between the yield on earning assets and cost of interest-bearing liabilities, as well as the volumes of such assets and liabilities. Net interest income is one of the major determining factors in a financial institution’s performance as it is the principal source of earnings. Table 2 represents an analysis of net interest income on a federal taxable equivalent basis.

Federal taxable equivalent (FTE) net interest income increased $1.3 million during the three months ended September 30, 2006 compared to the same period of 2005. The increase in FTE net interest income resulted primarily from 14.5% growth in average earning assets. The Company’s interest rate spread declined 52 bp during the three months ended September 30, 2006 compared to the same period in 2005. The Company’s net interest margin decreased 39 bp during this same period, to 3.60% for the quarter ended September 30, 2006 from 3.99% for the same period a year ago. The yield on earning assets for the period increased 50 bp, to 6.47% for the three months ended September 30, 2006 from 5.97% for the same period in 2005. Meanwhile, the rate paid on interest-bearing liabilities increased 101 bp, to 3.38% for the three months ended September 30, 2006 from 2.37% for the same period in 2005.

22

FTE net interest income increased $5.1 million during the nine months ended September 30, 2006 compared to the same period of 2005. The increase in FTE net interest income resulted primarily from 12.7% growth in average earning assets. The Company’s interest rate spread declined 44 bp during the nine months ended September 30, 2006 compared to the same period in 2005. The Company’s net interest margin decreased 31 bp during this same period, to 3.73% for the nine months ended September 30, 2006 from 4.04% for the same period a year ago. The yield on earning assets for the period increased 51 bp to 6.40% for the nine months ended September 30, 2006 from 5.89% for the same period in 2005. Meanwhile, the rate paid on interest-bearing liabilities increased 96 bp, to 3.16% for the nine months ended September 30, 2006 from 2.20% for the same period in 2005.

For the quarter ended September 30, 2006, total interest expense increased $13.4 million, primarily the result of the 150 bp increase in the Federal Funds rate since September 30, 2005, which impacts the Company’s short-term borrowing, money market account and time deposit rates. Additionally, average interest-bearing liabilities increased $556.0 million for the three months ended September 30, 2006 when compared to the same period in 2005, principally from strong organic deposit growth as well as deposits assumed from the CNB transaction. Total average interest-bearing deposits increased $555.1 million for the three months ended September 30, 2006 when compared to the same period in 2005. The rate paid on average interest-bearing deposits increased 107 bp from 1.96% for the three months ended September 30, 2005 to 3.03% for the same period in 2006. The increase in interest-bearing deposits resulted from strong organic deposit growth as well as the previously mentioned deposits assumed from the CNB transaction, which increased average interest bearing deposits approximately $263.2 million for the three months ended September 30, 2006. Excluding the effects of the CNB transaction, the Company experienced a shift in its deposit mix from savings and NOW accounts to money market and time deposit accounts, as interest sensitive customers shifted funds into higher paying interest bearing accounts. Excluding the CNB transaction, savings and NOW accounts collectively decreased approximately $102.7 million and money market and time deposit accounts collectively increased approximately $394.6 million (time deposits was the primary driver of the increase). If short-term rates continue to rise, the Company anticipates that this trend will continue placing greater pressure on the net interest margin.

For the nine month period ended September 30, 2006, total interest expense increased $34.9 million, primarily the result of the previously mentioned 150 bp increase in the Federal Funds rate since September 30, 2005, which impacts the Company’s short-term borrowing, money market account and time deposit rates. Additionally, average interest-bearing liabilities increased $448.9 million for the nine month period ended September 30, 2006 when compared to the same period in 2005, principally from strong organic deposit growth as well as deposits assumed from the CNB transaction. Total average interest-bearing deposits increased $382.3 million for the nine months ended September 30, 2006 when compared to the same period in 2005. The rate paid on average interest-bearing deposits increased 95 bp from 1.82% for the nine months ended September 30, 2005 to 2.77% for the same period in 2006. The increase in interest-bearing deposits resulted primarily from the previously mentioned deposits assumed from the CNB transaction, which increased average interest bearing deposits by approximately $226.6 million for the nine months ended September 30, 2006. Excluding the effects of the CNB transaction, the Company experienced a shift in its deposit mix from savings and NOW accounts to money market and time deposit accounts, as interest sensitive customers shifted funds into higher paying interest bearing accounts. Excluding the CNB transaction, savings and NOW accounts collectively decreased approximately $103.6 million and money market and time deposit accounts collectively increased approximately $196.6 million (time deposits was the primary driver of the increase). If short-term rates continue to rise, the Company anticipates that this trend will continue placing greater pressure on the net interest margin.

23

Total average borrowings, including trust preferred debentures, increased $0.9 million for the three months ended September 30, 2006 compared with the same period in 2005. Funding of the cash portion of the CNB transaction was offset by a decrease in average short-term borrowings from $367.7 million for the three months ended September 30, 2005 to $313.1 million for the same period in 2006. Despite this decrease, interest expense from short-term borrowings increased $0.8 million, driven by the increase in rate from 3.24% for the three months ended September 30, 2005 to 4.85% for the same period in 2006 (due to increases in short-term rates). Trust preferred debentures increased $56.7 million for the three months ended September 30, 2006, compared with the same period in 2005, primarily from the issuance of $51.5 million in trust preferred debentures in February 2006 to fund the cash portion of the CNB transaction and to provide regulatory capital. The rate paid on trust preferred debentures increased to 6.76% for the three months ended September 30, 2006, compared with 6.53% for the same period in 2005, driven primarily by $51.5 million in trust preferred debentures issued in February 2006 with a fixed rate of 6.195% and $18.7 million in trust preferred debentures that reprice quarterly at 3-month LIBOR plus 275 bp (3-month LIBOR is up approximately 131 bp since September 30, 2005).

Total average borrowings, including trust preferred debentures increased $66.6 million for the nine months ended September 30, 2006 compared with the same period in 2005, primarily from funding the cash portion of the CNB transaction. Average short-term borrowings increased $4.2 million for the nine months ended September 30, 2006, compared with the same period in 2005. Interest expense from short-term borrowings increased $4.8 million, driven by the increase in rate from 2.79% for the nine months ended September 30, 2005 to 4.63% for the same period in 2006 (due to increases in short-term rates). Trust preferred debentures increased $49.5 million for the nine months ended September 30, 2006, compared with the same period in 2005, primarily from the issuance of $51.5 million in trust preferred debentures in February 2006 to fund the cash portion of the CNB transaction and to provide regulatory capital. The rate paid on trust preferred debentures increased to 6.72% for the nine months ended September 30, 2006, compared with 6.09% for the same period in 2005, driven primarily by $51.5 million in trust preferred debentures issued in February 2006 with a fixed rate of 6.195% and $18.7 million in trust preferred debentures that reprice quarterly at 3-month LIBOR plus 275 bp (3-month LIBOR is up approximately 131 bp since September 30, 2005).

Another important performance measurement of net interest income is the net interest margin. Despite a 51 bp decrease in the Company’s net interest spread, the net interest margin only declined by 39 bp to 3.60% for the three months ended September 30, 2006, compared with 3.99% for the same period in 2005. The Company thus far has mitigated some of the margin pressure by growing noninterest bearing demand deposit accounts. Average demand deposits increased $52.8 million or 9.2% for the three months ended September 30, 2006, compared to the same period in 2005. This increase was driven mainly by the CNB transaction, which accounted for approximately $42.2 million of the increase and organic growth of $10.6 million (2% growth).

Despite a 44 bp decrease in the Company’s net interest spread, the net interest margin only declined by 31 bp to 3.73% for the nine months ended September 30, 2006, compared with 4.04% for the same period in 2005. The Company thus far has mitigated some of the margin pressure by growing noninterest bearing demand deposit accounts. Average demand deposits are up $76.9 million or 14.4% for the nine months ended September 30, 2006, compared to the same period in 2005. This increase was driven by organic growth of approximately $40.2 million (7% growth) as well as the CNB transaction, which accounted for approximately $36.8 million of the increase. Sustaining the growth rate for noninterest bearing demand deposits will be key factor in mitigating anticipated margin pressure from rising deposit costs.

24

Table 2
Average Balances and Net Interest Income
The following table includes the condensed consolidated average balance sheet, an analysis of interest income/expense and average yield/rate for each major category of earning assets and interest bearing liabilities on a taxable equivalent basis. Interest income for tax-exempt securities and loans has been adjusted to a taxable-equivalent basis using the statutory Federal income tax rate of 35%.

   
Three months ended September 30,
  
   
2006
  
2005
  
(dollars in thousands)
  
Average Balance
  
Interest
  
Yield/ Rates
  
Average Balance
  
Interest
  
Yield/ Rates
  
ASSETS
                          
Short-term interest bearing accounts
  
$
9,869
  
$
122
    
4.91
%
$
8,357
  
$
71
    
3.37
%
Securities available for sale (2)
    
1,134,668
    
13,950
    
4.88
%
  
944,062
    
10,589
    
4.45
%
Securities held to maturity (2)
    
126,654
    
1,934
    
6.06
%
  
87,663
    
1,275
    
5.77
%
Investment in FRB and FHLB Banks
    
40,070
    
602
    
5.96
%
  
37,965
    
464
    
4.85
%
Loans (1)
    
3,361,676
    
59,509
    
7.03
%
  
3,002,016
    
48,953
    
6.47
%
Total earning assets
    
4,672,937
    
76,117
    
6.47
%
  
4,080,063
    
61,352
    
5.97
%
Other assets
    
356,260
                
284,652
              
Total assets
  
$
5,029,197
                
4,364,715
              
                                       
LIABILITIES AND STOCKHOLDERS’ EQUITY
                                      
Money market deposit accounts
  
$
569,956
  
$
4,943
    
3.44
%
$
389,699
  
$
1,918
    
1.95
%
NOW deposit accounts
    
439,828
    
878
    
0.79
%
  
428,454
    
577
    
0.53
%
Savings deposits
    
533,940
    
1,195
    
0.89
%
  
564,967
    
1,018
    
0.72
%
Time deposits
    
1,611,141
    
17,036
    
4.20
%
  
1,216,631
    
9,329
    
3.04
%
Total interest bearing deposits
    
3,154,865
    
24,052
    
3.03
%
  
2,599,751
    
12,842
    
1.96
%
Short-term borrowings
    
313,099
    
3,828
    
4.85
%
  
367,736
    
3,005
    
3.24
%
Trust preferred debentures
    
75,422
    
1,285
    
6.76
%
  
18,720
    
308
    
6.53
%
Long-term debt
    
418,158
    
4,603
    
4.37
%
  
419,367
    
4,176
    
3.95
%
Total interest bearing liabilities
    
3,961,544
    
33,768
    
3.38
%
  
3,405,574
    
20,331
    
2.37
%
Demand deposits
    
625,282
                
572,450
              
Other liabilities
   
54,600
                
52,265
              
Stockholders’ equity
    
387,771
                
334,426
              
Total liabilities and stockholders’ equity
    
5,029,197
                
4,364,715
              
Net interest income (FTE basis)
          
42,349
                
41,021
        
Interest rate spread
                
3.08
%
              
3.60
%
Net interest margin
                
3.60
%
              
3.99
%
Taxable equivalent adjustment
          
1,429
                
1,070
        
Net interest income
        
$
40,920
              
$
39,951
        

 
(1)
For purposes of these computations, nonaccrual loans are included in the average loan balances outstanding.
 
(2)
Securities are shown at average amortized cost.

25

   
Nine months ended September 30,
  
   
2006
  
2005
  
(dollars in thousands)
  
Average Balance
  
Interest
  
Yield/ Rates
  
Average Balance
  
Interest
  
Yield/ Rates
  
ASSETS
                          
Short-term interest bearing accounts
  
$
8,327
  
$
294
    
4.73
%
$
7,171
  
$
158
    
2.95
%
Securities available for sale (2)
    
1,107,417
    
40,086
    
4.85
%
  
950,660
    
32,087
    
4.52
%
Securities held to maturity (2)
    
108,601
    
4,947
    
6.10
%
  
86,959
    
3,678
    
5.67
%
Investment in FRB and FHLB Banks
    
40,260
    
1,660
    
5.53
%
  
37,044
    
1,393
    
5.04
%
Loans (1)
    
3,271,095
    
169,800
    
6.96
%
  
2,941,292
    
139,430
    
6.35
%
Total earning assets
    
4,535,700
    
216,787
    
6.40
%
  
4,023,126
    
176,746
    
5.89
%
Other assets
    
343,085
                
280,455
              
Total assets
  
$
4,878,785
                
4,303,581
              
                                       
LIABILITIES AND STOCKHOLDERS’ EQUITY
                                      
Money market deposit accounts
  
$
519,063
  
$
12,534
    
3.24
%
$
402,086
  
$
5,002
    
1.67
%
NOW deposit accounts
    
437,820
    
2,255
    
0.69
%
  
441,313
    
1,616
    
0.49
%
Savings deposits
    
544,319
    
3,455
    
0.85
%
  
569,810
    
3,001
    
0.71
%
Time deposits
    
1,501,554
    
43,902
    
3.92
%
  
1,207,237
    
25,961
    
2.88
%
Total interest bearing deposits
    
3,002,756
    
62,146
    
2.77
%
  
2,620,446
    
35,580
    
1.82
%
Short-term borrowings
    
343,557
    
11,876
    
4.63
%
  
339,344
    
7,073
    
2.79
%
Trust preferred debentures
    
68,247
    
3,423
    
6.72
%
  
18,720
    
851
    
6.09
%
Long-term debt
    
421,463
    
12,972
    
4.12
%
  
408,628
    
12,016
    
3.94
%
Total interest bearing liabilities
    
3,836,023
    
90,417
    
3.16
%
  
3,387,138
    
55,520
    
2.20
%
Demand deposits
    
610,265
                
533,330
              
Other liabilities
   
52,757
                
53,372
              
Stockholders’ equity
    
379,740
                
329,741
              
Total liabilities and stockholders’ equity
    
4,878,785
                
4,303,581
              
Net interest income (FTE basis)
          
126,370
                
121,226
        
Interest rate spread
                
3.25
%
              
3.69
%
Net interest margin
                
3.73
%
              
4.04
%
Taxable equivalent adjustment
          
3,962
                
3,137
        
Net interest income
        
$
122,408
              
$
118,089
        

(1)
For purposes of these computations, nonaccrual loans are included in the average loan balances outstanding.
(2)
Securities are shown at average amortized cost.

26
 
The following table presents changes in interest income and interest expense attributable to changes in volume (change in average balance multiplied by prior year rate), changes in rate (change in rate multiplied by prior year volume), and the net change in net interest income. The net change attributable to the combined impact of volume and rate has been allocated to each in proportion to the absolute dollar amounts of change.
 
Table 3
Analysis of Changes in Taxable Equivalent Net Interest Income
Three months ended September 30,
  
   
Increase (Decrease)
2006 over 2005
  
(in thousands)
  
Volume
  
Rate
  
Total
  
               
Short-term interest bearing accounts
  
$
15
  
$
36
  
$
51
  
Securities available for sale
    
2,277
    
1,084
    
3,361
  
Securities held to maturity
    
593
    
66
    
659
  
Investment in FRB and FHLB Banks
    
27
    
111
    
138
  
Loans
    
6,158
    
4,398
    
10,556
  
Total FTE interest income
    
9,070
    
5,695
    
14,765
  
                     
Money market deposit accounts
    
1,143
    
1,882
    
3,025
  
NOW deposit accounts
    
16
    
285
    
301
  
Savings deposits
    
(58
)
  
235
    
177
  
Time deposits
    
3,554
    
4,153
    
7,707
  
Short-term borrowings
    
(498
)
  
1,321
    
823
  
Trust preferred debentures
    
966
    
11
    
977
  
Long-term debt
   
(12
)
  
439
    
427
  
Total interest expense
    
5,111
    
8,326
    
13,437
  
                     
Change in FTE net interest income
  
$
3,959
  
$
(2,631
)
$
1,328
  

       
Nine months ended September 30,
  
Increase (Decrease)
2006 over 2005
  
(in thousands)
  
Volume
  
Rate
  
Total
  
               
Short-term interest bearing accounts
  
$
29
  
$
107
  
$
136
  
Securities available for sale
    
5,557
    
2,442
    
7,999
  
Securities held to maturity
    
969
    
300
    
1,269
  
Investment in FRB and FHLB Banks
    
126
    
141
    
267
  
Loans
    
16,438
    
13,932
    
30,370
  
Total FTE interest income
    
23,119
    
16,922
    
40,041
  
                     
Money market deposit accounts
    
1,779
    
5,753
    
7,532
  
NOW deposit accounts
    
(13
)
  
652
    
639
  
Savings deposits
    
(139
)
  
593
    
454
  
Time deposits
    
7,249
    
10,692
    
17,941
  
Short-term borrowings
    
89
    
4,714
    
4,803
  
Trust preferred debentures
    
2,475
    
97
    
2,572
  
Long-term debt
   
385
    
571
    
956
  
Total interest expense
    
11,825
    
23,072
    
34,897
  
                     
Change in FTE net interest income
  
$
11,294
  
$
(6,150
)
$
5,144
  
 
27

Noninterest Income
Noninterest income is a significant source of revenue for the Company and an important factor in the Company’s results of operations. The following table sets forth information by category of noninterest income for the years indicated:

   
Three months ended
September 30,
  
Nine months ended
September 30,
  
   
2006
  
2005
  
2006
  
2005
  
(in thousands)
                  
Trust
  
$
1,425
  
$
1,292
  
$
4,242
  
$
3,795
  
Service charges on deposit accounts
    
4,460
    
4,314
    
13,172
    
12,554
  
ATM and debit card fees
    
1,888
    
1,631
    
5,322
    
4,575
  
Broker/dealer and insurance fees
    
1,024
    
571
    
2,899
    
2,659
  
Net securities gains (losses)
    
7
    
(737
)
  
(905
)
  
(690
)
Bank owned life insurance income
    
431
    
339
    
1,204
    
1,005
  
Retirement plan administration fees
    
1,450
    
1,195
    
4,112
    
3,214
  
Other
    
1,832
    
1,746
    
6,251
    
5,005
  
Total
  
$
12,517
  
$
10,351
  
$
36,297
  
$
32,117
  

Noninterest income for the quarter ended September 30, 2006 was $12.5 million, up $2.1 million or 20.9% from $10.4 million for the same period in 2005. Fees from service charges on deposit accounts and ATM and debit cards collectively increased $0.4 million from growth in demand deposit accounts and debit card base. Retirement plan administration fees for the three months ended September 30, 2006, increased $0.3 million compared with the same period in 2005 as a result of our growing client base. Trust administration income increased $0.1 million for the quarter ended September 30, 2006 compared to the same period in 2005. This increase stems from the increased market value of accounts generating greater fees, an increase in customer accounts as a result of the acquisition of CNB, and successful business development. Broker/dealer and insurance revenue for the three months ended September 30, 2006 increased $0.5 million in large part due to the growth in brokerage income from retail financial services as well as the addition of Hathaway Insurance Agency as part of the acquisition of CNB. Net securities gains for the three months ended September 30, 2006 were $7 thousand, compared to a $0.7 million loss in the 3rd quarter of 2005. This loss resulted from the sale of $25 million in securities available for sale. Excluding the effect of these securities transactions, noninterest income increased $1.4 million, or 12.8%, for the quarter ended September 30, 2006, compared with the same period in 2005.
  
Noninterest income for the nine months ended September 30, 2006 was $36.3 million, up $4.2 million or 13.0% from $32.1 million for the same period in 2005. Fees from service charges on deposit accounts and ATM and debit cards increased $1.4 million from solid growth in demand deposit accounts. Retirement plan administration fees for the nine months ended September 30, 2006, increased $0.9 million, compared with the same period in 2005, as our client base grew. Trust administration income increased $0.4 million for the nine months ended September 30, 2006, compared with the same period in 2005, stemming from the increased market value of accounts generating greater fees, an increase in customer accounts as a result of the acquisition of CNB and successful business development. For the nine months ended September 30, 2006, broker/dealer and insurance revenue increased by $0.2 million, compared with the same period in 2005. While the Company experienced growth in brokerage income from retail financial services and acquired Hathaway Insurance Agency during the period in 2006, these increases over 2005 were partially offset by the sale of M. Griffith, Inc. in the first quarter of 2005. Other noninterest income increased $1.2 million for the nine months ended September 30, 2006, compared with the same period in 2005, due primarily to an increase in loan fees, and increase in mortgage banking income, and a gain on the sale of a branch during the period. Included in noninterest income for the nine months ended September 30, 2006, and September 30, 2005, were $0.9 million and $0.7 million in net losses, respectively, from investment securities sales. Excluding the effect of these securities transactions, noninterest income increased $4.4 million or 13.4% for the nine months ended September 30, 2006, compared with the same period in 2005.

28

Noninterest Expense
Noninterest expenses are also an important factor in the Company’s results of operations. The following table sets forth the major components of noninterest expense for the periods indicated:

   
Three months ended
September 30,
  
Nine months ended
September 30,
  
   
2006
  
2005
  
2006
  
2005
  
(in thousands)
                  
Salaries and employee benefits
  
$
15,628
  
$
15,438
  
$
47,711
  
$
46,142
  
Office supplies and postage
    
1,275
    
1,135
    
3,912
    
3,406
  
Occupancy
    
3,044
    
2,425
    
8,779
    
7,763
  
Equipment
    
2,040
    
1,971
    
6,263
    
5,998
  
Professional fees and outside services
    
1,627
    
1,447
    
5,259
    
4,503
  
Data processing and communications
    
2,637
    
2,613
    
7,988
    
7,801
  
Amortization of intangible assets
    
471
    
142
    
1,260
    
402
  
Loan collection and other real estate owned
    
222
    
115
    
722
    
724
  
Other
    
2,974
    
3,293
    
10,190
    
9,417
  
Total noninterest expense
  
$
29,918
  
$
28,579
  
$
92,084
  
$
86,156
  

Noninterest expense for the quarter ended September 30, 2006, was $29.9 million, up from $28.6 million for the same period in 2005. Office expenses such as supplies and postage, occupancy, equipment and data processing and communications charges increased by $0.9 million for the quarter ended September 30, 2006, compared with the same period in 2005. This 10.5% increase resulted primarily from the acquisition of CNB Bancorp on February 10, 2006. Professional fees and services increased $0.2 million for the quarter ended September 30, 2006, compared with the same period in 2005. This increase was due to several factors, including an increase in courier service expenses due to the acquisition of CNB, as well as increasing transportation costs. In addition, item processing fees during the quarter ended September 30, 2006, increased over the same period in 2005 because the Company outsourced a portion of its item processing work as a result of flood-related damage to one of its processing centers. Amortization expense increased $0.3 million for the quarter ended September 30, 2006, over the same period in 2005. This increase was due primarily to the acquisition of CNB. Other operating expense for the quarter ended September 30, 2006, decreased $0.3 million compared with the same period in 2005, primarily due to flood-related insurance cost recoveries.

Noninterest expense for the nine months ended September 30, 2006, was $92.1 million, up from $86.2 million for the same period in 2005. Salaries and employee benefits for the nine months ended September 30, 2006, increased $1.6 million over the same period in 2005, mainly from higher salaries from merit increases, the acquisition of CNB and stock-based compensation costs associated with the adoption of FAS 123R. Office expenses such as supplies and postage, occupancy, equipment and data processing and communications charges increased by $2.0 million for the nine months ended September 30, 2006, compared with the same period in 2005. This 7.9% increase resulted primarily from the overall growth of the Company as well as the acquisition of CNB Bancorp on February 10, 2006. Professional fees and services increased $0.8 million for the nine months ended September 30, 2006, compared with the same period in 2005. This increase was due to several factors, including an increase in courier service expenses due to the acquisition of CNB as well as increasing transportation costs. In addition, item processing fees during the nine months ended September 30, 2006, increased over the same period in 2005 because the Company outsourced a portion of its item processing work as a result of flood-related damage to one of its processing centers. In addition, legal fees incurred during the period increased over the same period in 2005 as the Company was reimbursed during the second quarter of 2005 for legal fees associated with prior litigation. Amortization expense increased $0.9 million for the nine months ended September 30, 2006, over the same period in 2005. This increase was due primarily to the acquisition of CNB. Other operating expense for the nine months ended September 30, 2006, increased $0.8 million compared with the same period in 2005, due to several factors including flood related expenses, Pennstar advertising campaign, fixed asset write-off’s, increased community-based contributions, and merger expenses incurred as a result of the acquisition of CNB. These expenses were partially offset by flood-related insurance recoveries.

29

Income Taxes

Income tax expense for the quarter ended September 30, 2006, was $6.5 million, up from $5.4 million for the same period in 2005. The effective rate for the quarter ended September 30, 2006, was 30.9%, up from 28.7% for the same period in 2005. The increase in the effective tax rate during the second quarter of 2006 versus the same period in 2005 is due to the reversal in the quarter ended September 30, 2005, of a previously accrued $0.7 million liability that was determined to no longer be required. Income tax expense for the nine months ended September 30, 2006, was $18.4 million, up from $17.7 million for the same period in 2005. The effective rate for the nine months ended September 30, 2006, was 30.3%, down from 31.0% for the same period in 2005. The decrease in the effective tax rate for the nine months ended September 30, 2006, resulted primarily from an increase in interest income from tax-exempt sources.

ANALYSIS OF FINANCIAL CONDITION

Loans and Leases

A summary of loans and leases, net of deferred fees and origination costs, by category for the periods indicated follows:

   
September 30,
2006
  
December 31,
2005
  
September 30,
2005
  
(in thousands)
              
Residential real estate mortgages
  
$
747,309
  
$
701,734
  
$
692,528
  
Commercial and commercial real estate mortgages
    
1,198,575
    
1,032,977
    
1,036,748
  
Real estate construction and development
    
90,418
    
163,863
    
154,936
  
Agricultural and agricultural real estate mortgages
    
117,463
    
114,043
    
112,536
  
Consumer
    
589,377
    
463,955
    
471,179
  
Home equity
    
540,729
    
463,848
    
452,733
  
Lease financing
    
85,861
    
82,237
    
82,443
  
Total loans and leases
  
$
3,369,732
  
$
3,022,657
  
$
3,003,103
  

Total loans and leases were $3.4 billion, or 66.6% of assets, at September 30, 2006, $3.0 billion, or 68.3% of assets, at December 31, 2005, and $3.0 billion, or 68.5%, at September 30, 2005. Total loans and leases increased $366.6 million or 12.2% at September 30, 2006 over September 30, 2005. The year over year increase in loans and leases was driven mainly by the CNB transaction and organic loan growth. Home equity loans increased $88.0 million or 19.4%, from organic growth of approximately $74.5 million and the CNB transaction of approximately $13.5 million. Consumer loans, most notably indirect installment loans, increased $118.2 million or 25.1%, from organic loan growth of approximately $75.5 million and approximately $42.7 million from the acquisition of CNB. Commercial loans and commercial mortgages increased $161.8 million or 15.6%, driven by organic growth of approximately $109.8 million as well as the CNB transaction of approximately $52.0 million. Residential real estate mortgages increased $54.8 million when compared to September 30, 2005. The CNB transaction provided approximately $64.3 million in growth offset by a decline in the core portfolio of approximately $9.5 million. The decrease in the core residential mortgage portfolio resulted mainly from mortgage repayments exceeding originations retained for the loan portfolio as the Company began selling 20-year and 30-year residential mortgages from its pipeline in the second quarter 2005. Real estate construction and development loans decreased by $64.5 million at September 30, 2006, as compared to September 30, 2005. This decline was due to construction note payoffs exceeding new housing construction notes.

30

Securities

The Company classifies its securities at date of purchase as available for sale, held to maturity or trading. Held to maturity debt securities are those that the Company has the ability and intent to hold until maturity. Available for sale securities are recorded at fair value. Unrealized holding gains and losses, net of the related tax effect, on available for sale securities are excluded from earnings and are reported in stockholders’ equity as a component of accumulated other comprehensive income or loss. Held to maturity securities are recorded at amortized cost. Trading securities are recorded at fair value, with net unrealized gains and losses recognized currently in income. Transfers of securities between categories are recorded at fair value at the date of transfer. A decline in the fair value of any available for sale or held to maturity security below cost that is deemed other-than-temporary is charged to earnings resulting in the establishment of a new cost basis for the security. Securities with an other-than-temporary impairment are generally placed on nonaccrual status.

Average total earning securities increased $229.6 million for the three months ended September 30, 2006 when compared to the same period in 2005. The average balance of securities available for sale increased $190.6 million for the three months ended September 30, 2006 when compared to the same period in 2005, mainly from the CNB transaction. The average balance of securities held to maturity increased $39.0 million for the three months ended September 30, 2006, compared to the same period in 2005. The average total securities portfolio represents 27.0% of total average earning assets for the three months ended September 30, 2006, up from 25.3% for the same period in 2005.

The following details the composition of securities available for sale, securities held to maturity and regulatory investments for the periods indicated:

 
At September 30,
 
2006
2005
     
Mortgage-backed securities:
    
With maturities 15 years or less
28%
39%
With maturities greater than 15 years
4%
6%
Collateral mortgage obligations
18%
16%
Municipal securities
18%
15%
US agency notes
27%
20%
Other
5%
4%
Total
100%
100%

Allowance for Loan and Lease Losses, Provision for Loan and Lease Losses, and Nonperforming Assets

The allowance for loan and lease losses is maintained at a level estimated by management to provide adequately for risk of probable losses inherent in the current loan and lease portfolio. The adequacy of the allowance for loan and lease losses is continuously monitored. It is assessed for adequacy using a methodology designed to ensure the level of the allowance reasonably reflects the loan portfolio’s risk profile. It is evaluated to ensure that it is sufficient to absorb all reasonably estimable credit losses inherent in the current loan and lease portfolio.

31

Management considers the accounting policy relating to the allowance for loan and lease losses to be a critical accounting policy given the inherent uncertainty in evaluating the levels of the allowance required to cover credit losses in the portfolio and the material effect that such judgements can have on the consolidated results of operations.

For purposes of evaluating the adequacy of the allowance, the Company considers a number of significant factors that affect the collectibility of the portfolio. For individually analyzed loans, these include estimates of loss exposure, which reflect the facts and circumstances that affect the likelihood of repayment of such loans as of the evaluation date. For homogeneous pools of loans and leases, estimates of the Company’s exposure to credit loss reflect a thorough current assessment of a number of factors, which could affect collectibility. These factors include: past loss experience; the size, trend, composition, and nature of the loans and leases; changes in lending policies and procedures, including underwriting standards and collection, charge-off and recovery practices; trends experienced in nonperforming and delinquent loans and leases; current economic conditions in the Company’s market; portfolio concentrations that may affect loss experienced across one or more components of the portfolio; the effect of external factors such as competition, legal and regulatory requirements; and the experience, ability, and depth of lending management and staff. In addition, various regulatory agencies, as an integral component of their examination process, periodically review the Company’s allowance for loan and lease losses. Such agencies may require the Company to recognize additions to the allowance based on their judgment about information available to them at the time of their examination, which may not be currently available to management.

After a thorough consideration and validation of the factors discussed above, required additions to the allowance for loan and lease losses are made periodically by charges to the provision for loan and lease losses. These charges are necessary to maintain the allowance at a level which management believes is reasonably reflective of overall inherent risk of probable loss in the portfolio. While management uses available information to recognize losses on loans and leases, additions to the allowance may fluctuate from one reporting period to another. These fluctuations are reflective of changes in risk associated with portfolio content and/or changes in management’s assessment of any or all of the determining factors discussed above. The allowance for loan and lease losses to outstanding loans and leases at September 30, 2006 was 1.50% compared with 1.57% at December 31, 2005, and 1.58% at September 30, 2005. Management considers the allowance for loan losses to be adequate based on evaluation and analysis of the loan portfolio.

32

Table 4 reflects changes to the allowance for loan and lease losses for the periods presented. The allowance is increased by provisions for losses charged to operations and is reduced by net charge-offs. Charge-offs are made when the collectability of loan principal within a reasonable time is unlikely. Any recoveries of previously charged-off loans are credited directly to the allowance for loan and lease losses.

Table 4
Allowance for Loan Losses
      
   
Three months ended September 30,
  
(dollars in thousands)
  
2006
      
2005
      
Balance, beginning of period
  
$
50,148
        
$
46,411
        
Recoveries
    
946
          
936
        
Charge-offs
    
(2,928
)
        
(2,549
)
      
Net charge-offs
    
(1,982
)
        
(1,613
)
      
Provision for loan losses
    
2,480
          
2,752
        
Balance, end of period
  
$
50,646
        
$
47,550
        
Composition of Net Charge-Offs
                          
Commercial and agricultural
  
$
(1,001
)
  
51
%
$
(536
)
  
33
%
Real estate mortgage
    
27
    
-2
%
  
(37
)
  
2
%
Consumer
    
(1,008
)
  
51
%
  
(1,040
)
  
65
%
Net charge-offs
  
$
(1,982
)
  
100
%
$
(1,613
)
  
100
%
Annualized net charge-offs to average loans
    
0.23
%
        
0.21
%
      
                           
       
   
Nine months ended September 30,
  
(dollars in thousands)
  
2006
      
2005
      
Balance, beginning of period
  
$
47,455
        
$
44,932
        
Recoveries
    
3,211
          
3,348
        
Charge-offs
    
(8,341
)
        
(7,598
)
      
Net charge-offs
    
(5,130
)
        
(4,250
)
      
Allowance related to purchase acquisition
    
2,410
          
-
        
Provision for loan losses
    
5,911
          
6,868
        
Balance, end of period
  
$
50,646
        
$
47,550
        
Composition of Net Charge-Offs
                          
Commercial and agricultural
  
$
(2,505
)
  
49
%
$
(1,030
)
  
24
%
Real estate mortgage
    
(108
)
  
2
%
  
(214
)
  
5
%
Consumer
    
(2,517
)
  
49
%
  
(3,006
)
  
71
%
Net charge-offs
  
$
(5,130
)
  
100
%
$
(4,250
)
  
100
%
Annualized net charge-offs to average loans
    
0.21
%
        
0.19
%
      

Nonperforming assets consist of nonaccrual loans, loans 90 days or more past due and still accruing, restructured loans, other real estate owned (OREO), and nonperforming securities. Loans are generally placed on nonaccrual when principal or interest payments become ninety days past due, unless the loan is well secured and in the process of collection. Loans may also be placed on nonaccrual when circumstances indicate that the borrower may be unable to meet the contractual principal or interest payments. OREO represents property acquired through foreclosure and is valued at the lower of the carrying amount or fair market value, less any estimated disposal costs. Nonperforming securities include securities which management believes are other-than-temporarily impaired, carried at their estimated fair value and are not accruing interest.

Total nonperforming assets were $14.8 million at September 30, 2006, $14.6 million at December 31, 2005, and $13.6 million at September 30, 2005. Nonaccrual loans were $12.4 million at September 30, 2006, as compared to $13.4 million at December 31, 2005 and $12.4 million at September 30, 2005. The increase in nonperforming assets from September 30, 2005 to September 30, 2006 was due primarily from increases in loans 90 days or more past due and still accruing, most notably consumer and real estate mortgages. OREO increased from $0.2 million at September 30, 2005 to $0.4 million at September 30, 2006.

33

In addition to the nonperforming loans discussed above, the Company has also identified approximately $67.5 million in potential problem loans at September 30, 2006 as compared to $69.5 million at December 31, 2005. Potential problem loans are loans that are currently performing, but where known information about possible credit problems of the related borrowers causes management to have serious doubts as to the ability of such borrowers to comply with the present loan repayment terms and which may result in disclosure of such loans as nonperforming at some time in the future. At the Company, potential problem loans are typically loans that are performing but are classified by the Company’s loan rating system as “substandard.” At September 30, 2006, potential problem loans primarily consisted of commercial real estate and commercial and agricultural loans. Management cannot predict the extent to which economic conditions may worsen or other factors which may impact borrowers and the potential problem loans. Accordingly, there can be no assurance that other loans will not become 90 days or more past due, be placed on non-accrual, become restructured, or require increased allowance coverage and provision for loan losses.

Net charge-offs totaled $2.0 million for the three months ended September 30, 2006, up $0.4 million from the $1.6 million charged-off during the same period in 2005. The provision for loan and lease losses totaled $2.5 million for the three months ended September 30, 2006, compared with the $2.8 million provided during the same period in 2005.
 
Net charge-offs totaled $5.1 million for the nine months ended September 30, 2006, up $0.8 million from the $4.3 million charged-off during the same period in 2005. The provision for loan and lease losses totaled $5.9 million for the nine months ended September 30, 2006, compared with the $6.9 million provided during the same period in 2005.
 
The decrease in the provision for loan and lease losses for the three and nine month periods ending September 30, 2006, as compared to the same periods of 2005, was due primarily to a decrease in potential problems loans during the periods, partially offset by a slight increase in certain other asset quality indicators.

 
Table 5
Nonperforming Assets
              
(dollars in thousands)
  
September 30,
2006
  
December 31,
2005
  
September 30,
2005
  
Commercial and agricultural
  
$
8,625
  
$
9,373
  
$
8,810
  
Real estate mortgage
    
1,891
    
2,009
    
1,854
  
Consumer
    
1,887
    
2,037
    
1,748
  
Total nonaccrual loans
    
12,403
    
13,419
    
12,412
  
Loans 90 days or more past due and still accruing:
                    
Commercial and agricultural
    
65
    
-
    
-
  
Real estate mortgage
    
806
    
465
    
395
  
Consumer
    
1,176
    
413
    
518
  
Total loans 90 days or more past due and still accruing
    
2,047
    
878
    
913
  
Total nonperforming loans
    
14,450
    
14,297
    
13,325
  
Other real estate owned (OREO)
    
395
    
265
    
235
  
Total nonperforming loans and OREO
    
14,845
    
14,562
    
13,560
  
Total nonperforming assets
  
$
14,845
  
$
14,562
  
$
13,560
  
Total nonperforming loans to loans and leases
    
0.43
%
  
0.47
%
  
0.44
%
Total nonperforming assets to assets
    
0.29
%
  
0.28
%
  
0.31
%
Total allowance for loan and lease losses to nonperforming loans
    
350.49
%
  
331.92
%
  
356.85
%
 
34

Deposits

Total deposits were $3.8 billion at September 30, 2006, up $627.7 million from year-end 2005, and up $575.7 million, or 17.9%, from the same period in the prior year. The increase in deposits compared with September 30, 2005, was driven primarily by the CNB transaction, which provided approximately $302.5 million in deposits and organic deposit growth of approximately $273.2 million. Total average deposits for the three months ended September 30, 2006 increased $607.9 million, or 19.2%, from the same period in 2005. The Company experienced an increase in average time deposits of $394.5 million or 32%, for the three months ended September 30, 2006 compared to the same period in 2005. This increase was due to organic growth of approximately $269.5 million, as well as approximately $125.0 million resulting from the CNB transaction. The Company experienced a shift in its deposit mix from interest sensitive customers into higher paying time accounts. Excluding the effect of the CNB transaction, which provided approximately $83.1 million in average savings and NOW accounts for the three months ended September 30, 2006 from the same period in 2005, these deposit categories experienced a decrease of approximately $102.7 million. This decrease was the result of the previously mentioned shift in deposit mix from lower cost deposit accounts to higher cost deposit accounts with more attractive interest rates (which have increased due to the rising rate environment). Average money market accounts increased $180.3 million for the three months ended September 30, 2006 from the same period in 2005, as organic money market account growth totaled approximately $125.1 million and approximately $55.2 million was attributed to the acquisition of CNB. Average demand deposit accounts increased $52.8 million for the three months ended September 30, 2006 as compared to the same period in 2005. This was due primarily to the CNB transaction, which provided approximately $42.2 million of the increase.

Borrowed Funds

The Company's borrowed funds consist of short-term borrowings and long-term debt. Short-term borrowings totaled $324.5 million at September 30, 2006 compared to $445.0 million and $356.2 million at December 31, and September 30, 2005, respectively. Long-term debt was $417.8 million at September 30, 2006, and was $414.3 and $419.4 million at December 31, and September 30, 2005, respectively. For more information about the Company’s borrowing capacity and liquidity position, see the section with the title caption of “Liquidity Risk” on page 38 in this discussion.

Capital Resources

Stockholders' equity of $399.5 million represents 7.9% of total assets at September 30, 2006, compared with $332.2 million, or 7.6% as of September 30, 2005, and $333.9 million, or 7.5% at December 31, 2005. The increase in stockholders’ equity resulted mainly from the issuance of 2,058,661 shares of Company common stock in connection with the CNB transaction. Under previously announced stock repurchase plans, the Company acquired 766,004 shares of its common stock at an average price of $22.34 per share, totaling $17.1 million for the nine months ended September 30, 2006. At September 30, 2006, there were 737,147 shares available for repurchase under previously announced plans. The Company does not have a target dividend pay out ratio. The Board of Directors considers the Company's earnings position and earnings potential when making dividend decisions.

As the capital ratios in Table 6 indicate, the Company remains “well capitalized”. Capital measurements are significantly in excess of regulatory minimum guidelines and meet the requirements to be considered well capitalized for all periods presented. Tier 1 leverage, Tier 1 capital and Risk-based capital ratios have regulatory minimum guidelines of 3%, 4% and 8% respectively, with requirements to be considered well capitalized of 5%, 6% and 10%, respectively.

35

Table 6
      
Capital Measurements
      
2006
March 31
June 30
September 30
Tier 1 leverage ratio
7.77%
7.27%
7.38%
Tier 1 capital ratio
10.30%
9.90%
10.15%
Total risk-based capital ratio
11.56%
11.15%
11.40%
Cash dividends as a percentage of net income
48.20%
46.99%
46.13%
Per common share:
      
Book value
$ 11.22
$ 11.15
$ 11.73
Tangible book value
$ 7.84
$ 7.72
$ 7.90
2005
      
Tier 1 leverage ratio
6.89%
6.91%
6.99%
Tier 1 capital ratio
9.41%
9.23%
9.56%
Total risk-based capital ratio
10.67%
10.48%
10.82%
Cash dividends as a percentage of net income
48.57%
47.67%
46.97%
Per common share:
      
Book value
$ 9.85
$ 10.22
$ 10.25
Tangible book value
$ 8.25
$ 8.62
$ 8.66

The accompanying Table 7 presents the high, low and closing sales price for the common stock as reported on the NASDAQ Stock Market, and cash dividends declared per share of common stock. The Company's price to book value ratio was 1.98 at September 30, 2006 and 2.30 in the comparable period of the prior year. The Company's price was 14.2 times trailing twelve months earnings at September 30, 2006, compared to 14.9 times for the same period last year.

Table 7
Quarterly Common Stock and Dividend Information
  
Quarter Ending
  
High
  
Low
  
Close
  
Cash Dividends Declared
  
2005
                  
March 31
  
$
25.66
  
$
21.48
  
$
22.41
  
$
0.190
  
June 30
    
24.15
    
20.10
    
23.64
    
0.190
  
September 30
    
25.50
    
22.79
    
23.58
    
0.190
  
December 31
    
23.79
    
20.75
    
21.59
    
0.190
  
2006
                          
March 31
  
$
23.90
  
$
21.02
  
$
23.25
  
$
0.190
  
June 30
    
23.24
    
21.03
    
23.23
    
0.190
  
September 30
    
24.57
    
21.44
    
23.26
    
0.190
  
 
36

Liquidity and Interest Rate Sensitivity Management

Market Risk

Interest rate risk is among the most significant market risk affecting the Company. Other types of market risk, such as foreign currency exchange rate risk and commodity price risk, do not arise in the normal course of the Company’s business activities. Interest rate risk is defined as an exposure to a movement in interest rates that could have an adverse effect on the Company’s net interest income. Net interest income is susceptible to interest rate risk to the degree that interest-bearing liabilities mature or reprice on a different basis than earning assets. When interest-bearing liabilities mature or reprice more quickly than earning assets in a given period, a significant increase in market rates of interest could adversely affect net interest income. Similarly, when earning assets mature or reprice more quickly than interest-bearing liabilities, falling interest rates could result in a decrease in net interest income.

In an attempt to manage the Company's exposure to changes in interest rates, management monitors the Company’s interest rate risk. Management’s Asset Liability Committee (ALCO) meets monthly to review the Company’s interest rate risk position and profitability, and to recommend strategies for consideration by the Board of Directors. Management also reviews loan and deposit pricing, and the Company’s securities portfolio, formulates investment and funding strategies, and oversees the timing and implementation of transactions to assure attainment of the Board’s objectives in the most effective manner. Notwithstanding the Company’s interest rate risk management activities, the potential for changing interest rates is an uncertainty that can have an adverse effect on net income.

In adjusting the Company’s asset/liability position, the Board and management attempt to manage the Company’s interest rate risk while minimizing net interest margin compression. At times, depending on the level of general interest rates, the relationship between long- and short-term interest rates, market conditions and competitive factors, the Board and management may determine to increase the Company’s interest rate risk position somewhat in order to increase its net interest margin. The Company’s results of operations and net portfolio values remain vulnerable to changes in interest rates and fluctuations in the difference between long- and short-term interest rates.

The primary tool utilized by ALCO to manage interest rate risk is a balance sheet/income statement simulation model (interest rate sensitivity analysis). Information such as principal balance, interest rate, maturity date, cash flows, next repricing date (if needed), and current rates is uploaded into the model to create an ending balance sheet. In addition, ALCO makes certain assumptions regarding prepayment speeds for loans and leases and mortgage related investment securities along with any optionality within the deposits and borrowings.

The model is first run under an assumption of a flat rate scenario (i.e. no change in current interest rates) with a static balance sheet over a 12-month period. Two additional models are run with static balance sheets: (1) a gradual increase of 200 bp, (2) and a gradual decrease of 200 bp takes place over a 12 month period with a static balance sheet. Under these scenarios, assets subject to prepayments are adjusted to account for faster or slower prepayment assumptions. Any investment securities or borrowings that have callable options embedded into them are handled accordingly based on the interest rate scenario. The resultant changes in net interest income are then measured against the flat rate scenario.

In the declining rate scenario, net interest income is projected to decrease when compared to the forecasted net interest income in the flat rate scenario through the simulation period. The decrease in net interest income is a result of earning assets repricing downward at a faster rate than interest bearing liabilities. The inability to effectively lower deposit rates will likely reduce or eliminate the benefit of lower interest rates. In the rising rate scenarios, net interest income is projected to experience a decline from the flat rate scenario. Net interest income is projected to remain at lower levels than in a flat rate scenario through the simulation period primarily due to a lag in assets repricing while funding costs increase. The potential impact on earnings is dependent on the ability to lag deposit repricing. If short-term rates continue to increase, the Company expects competitive pressures will likely lead to core deposit pricing increases, which will likely continue compression of the net interest margin.

37

Net interest income for the next 12 months in the + 200/- 200 bp scenarios, as described above, is within the internal policy risk limits of not more than a 7.5% change in net interest income. The following table summarizes the percentage change in net interest income in the rising and declining rate scenarios over a 12-month period from the forecasted net interest income in the flat rate scenario using the September 30, 2006 balance sheet position:

Table 8
Interest Rate Sensitivity Analysis
  
Change in interest rates
(in basis points)
Percent change in
net interest income
+200
(4.18%)
-200
0.48%

The Company has taken several measures to mitigate net interest margin compression. The Company began originating 20-year and 30-year residential real estate mortgages with the intent to sell at the end of the second quarter of 2005. Over time, the Company has shortened the average life of its investment securities portfolio by limiting purchases of mortgage-backed securities and redirecting proceeds into short-duration CMOs and US Agency notes and bonds. Lastly, the Company will continue to focus on growing noninterest bearing demand deposits and prudently managing deposit costs.

38

Liquidity Risk

Liquidity involves the ability to meet the cash flow requirements of customers who may be depositors wanting to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs. The ALCO is responsible for liquidity management and has developed guidelines which cover all assets and liabilities, as well as off balance sheet items that are potential sources or uses of liquidity. Liquidity policies must also provide the flexibility to implement appropriate strategies and tactical actions. Requirements change as loans and leases grow, deposits and securities mature, and payments on borrowings are made. Liquidity management includes a focus on interest rate sensitivity management with a goal of avoiding widely fluctuating net interest margins through periods of changing economic conditions.

The primary liquidity measurement the Company utilizes is called the Basic Surplus which captures the adequacy of its access to reliable sources of cash relative to the stability of its funding mix of average liabilities. This approach recognizes the importance of balancing levels of cash flow liquidity from short- and long-term securities with the availability of dependable borrowing sources which can be accessed when necessary. At September 30, 2006, the Company’s Basic Surplus measurement was 6.07% of total assets or $306 million, which was above the Company’s minimum of 5% or $252 million set forth in its liquidity policies.

This Basic Surplus approach enables the Company to adequately manage liquidity from both operational and contingency perspectives. By tempering the need for cash flow liquidity with reliable borrowing facilities, the Company is able to operate with a more fully invested and, therefore, higher interest income generating, securities portfolio. The makeup and term structure of the securities portfolio is, in part, impacted by the overall interest rate sensitivity of the balance sheet. Investment decisions and deposit pricing strategies are impacted by the liquidity position. At September 30, 2006, the Company Basic Surplus improved compared to December 31, 2005, Basic Surplus of 5.2%, driven primarily by the CNB transaction.

The Company’s primary source of funds is from its subsidiary, NBT Bank. Certain restrictions exist regarding the ability of the Company’s subsidiary bank to transfer funds to the Company in the form of cash dividends. The approval of the Office of Comptroller of the Currency (OCC) is required to pay dividends when a bank fails to meet certain minimum regulatory capital standards or when such dividends are in excess of a subsidiary bank’s earnings retained in the current year plus retained net profits for the preceding two years (as defined in the regulations). At September 30, 2006, approximately $55.1 million of the total stockholders’ equity of NBT Bank was available for payment of dividends to the Company without approval by the OCC. NBT Bank’s ability to pay dividends also is subject to the Bank being in compliance with regulatory capital requirements. NBT Bank is currently in compliance with these requirements. Under the State of Delaware Business Corporation Law, the Company may declare and pay dividends either out of accumulated net retained earnings or capital surplus.

Item 3.
Quantitative and Qualitative Disclosure About Market Risk

Information called for by Item 3 is contained in the Liquidity and Interest Rate Sensitivity Management section of the Management Discussion and Analysis.

39

Item 4.
Controls and Procedures
 
The Company's management, including the Company's Chief Executive Officer and Chief Financial Officer evaluated the effectiveness of the design and operation of the Company's disclosure controls and procedures (as defined in Rule 13a-15(e) and 15(d)-15(e) under the Securities Exchange Act of 1934, as amended) as of September 30, 2006. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the Evaluation Date, the Company's disclosure controls and procedures were effective in timely alerting them to any material information relating to the Company and its subsidiaries required to be included in the Company's periodic SEC filings.

There were no changes made in the Company's internal controls over financial reporting that occurred during the Company's most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect the Company's internal controls over financial reporting.

40

PART II. OTHER INFORMATION

Item 1 -- Legal Proceedings

There are no material legal proceedings, other than ordinary routine litigation incidental to business to which the Company is a party or of which any of its property is subject.

Item 1A -- Risk Factors

Management of the Company does not believe there have been any material changes in the risk factors that were disclosed in the Form 10-K filed with the Securities and Exchange Commission on March 15, 2006.

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

(a)
Not applicable
 
(b)
Not applicable
 
(c)
The table below sets forth the information with respect to purchases made by the Company (as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934), of our common stock during the quarter ended September 30, 2006:

Period
Total Number of Shares Purchased
Average Price Paid Per Share
Total Number of Shares Purchased As Part of Publicly Announced Plans
Maximum Number of Shares That May Yet Be Purchased Under The Plans (1)
7/1/06 - 7/31/06
27,500
22.15
27,500
737,147
8/1/06 - 8/31/06
-
-
-
737,147
9/1/06 - 9/30/06
-
-
-
737,147
Total
27,500
$22.15
27,500
737,147

(1)
On January 23, 2006, NBT announced that the NBT Board of Directors approved a new repurchase program whereby NBT is authorized to repurchase up to an additional 1,000,000 shares (approximately 3%) of its outstanding common stock from time to time as market conditions warrant in open market and privately negotiated transactions. At that time, there were 503,151 shares remaining under a previous authorization that was combined with the new repurchase program.

Item 3 -- Defaults Upon Senior Securities

None

Item 4 -- Submission of Matters to a Vote of Security Holders

None

Item 5 -- Other Information

On October 23, 2006, NBT Bancorp Inc. announced the declaration of a regular quarterly cash dividend of $0.19 per share. The cash dividend will be paid on December 15, 2006 to stockholders of record as of December 1, 2006.

41

Item 6 -- Exhibits

3.1
Certificate of Incorporation of NBT Bancorp Inc. as amended through July 23, 2001 (filed as Exhibit 3.1 to Registrant's Form 10-K for the year ended December 31, 2001, filed on March 29, 2002 and incorporated herein by reference).

3.2
By-laws of NBT Bancorp Inc. as amended and restated through July 23, 2001 (filed as Exhibit 3.2 to Registrant's Form 10-K for the year ended December 31, 2001, filed on March 29, 2002 and incorporated herein by reference).

3.3
Rights Agreement, dated as of November 15, 2004, between NBT Bancorp Inc. and Registrar and Transfer Company, as Rights Agent (filed as Exhibit 4.1 to Registrant's Form 8-K, file number 0-14703, filed on November 18, 2004, and incorporated by reference herein).

3.4
Certificate of Designation of the Series A Junior Participating Preferred Stock (filed as Exhibit A to Exhibit 4.1 of the Registration's Form 8-K, file Number 0-14703, filed on November 18, 2004, and incorporated herein by reference).

4.1
Specimen common stock certificate for NBT's common stock (filed as exhibit 4.1 to the Registrant's Amendment No. 1 to Registration Statement on Form S-4 filed on December 27, 2005 and incorporated herein by reference).

31.1
Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2
Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1
Written Statement of the Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2
Written Statement of the Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.


SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized, this 9th day of November 2006.
 

 
NBT BANCORP INC.
  
     
     
 
By: /s/ MICHAEL J. CHEWENS
  
 
Michael J. Chewens, CPA
  
 
Senior Executive Vice President
  
 
Chief Financial Officer and Corporate Secretary
  
 
42

EXHIBIT INDEX

3.1
  
Certificate of Incorporation of NBT Bancorp Inc. as amended through July 23, 2001 (filed as Exhibit 3.1 to Registrant's Form 10-K for the year ended December 31, 2001, filed on March 29, 2002 and incorporated herein by reference).
     
3.2
  
By-laws of NBT Bancorp Inc. as amended and restated through July 23, 2001 (filed as Exhibit 3.2 to Registrant's Form 10-K for the year ended December 31, 2001, filed on March 29, 2002 and incorporated herein by reference).
     
3.3
  
Rights Agreement, dated as of November 15, 2004, between NBT Bancorp Inc. and Registrar and Transfer Company, as Rights Agent (filed as Exhibit 4.1 to Registrant's Form 8-K, file number 0-14703, filed on November 18, 2004, and incorporated by reference herein).
     
3.4
  
Certificate of Designation of the Series A Junior Participating Preferred Stock (filed as Exhibit A to Exhibit 4.1 of the Registration's Form 8-K, file Number 0-14703, filed on November 18, 2004, and incorporated herein by reference).
     
4.1
  
Specimen common stock certificate for NBT's common stock (filed as exhibit 4.1 to the Registrant's Amendment No. 1 to Registration Statement on Form S-4 filed on December 27, 2005 and incorporated herein by reference).
     
 
Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
     
 
Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
     
 
Written Statement of the Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
     
 
Written Statement of the Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 
43