CITIZENS & NORTHERN CORP - Annual Report: 2018 (Form 10-K)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

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

For the fiscal year ended December 31, 2018

OR

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

For the transition period from _______________ to _________________________.

Commission file number: 0-16084

CITIZENS & NORTHERN CORPORATION

(Exact name of Registrant as specified in its charter)

90-92 MAIN STREET, WELLSBORO, PA 16901

(Address of principal executive offices) (Zip code)

570-724-3411

(Registrant's telephone number including area code)

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

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

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

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

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

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

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

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

Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨ Smaller reporting company x Emerging growth company ¨

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨

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

The aggregate market value of the registrant's common stock held by non-affiliates at June 30, 2018, the registrant’s most recently completed second fiscal quarter, was $308,413,394.

The number of shares of common stock outstanding at February 14, 2019 was 12,392,682.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s proxy statement for the annual meeting of its shareholders to be held April 18, 2019 are incorporated by reference into Parts III and IV of this report.

TABLE OF CONTENTS

PART I

ITEM 1. BUSINESS

Citizens & Northern Corporation (“Corporation”) is a holding company whose principal activity is community banking. The Corporation’s principal office is located in Wellsboro, Pennsylvania. The largest subsidiary is Citizens & Northern Bank (“C&N Bank” or the “Bank”). The Corporation’s other wholly-owned subsidiaries are Citizens & Northern Investment Corporation and Bucktail Life Insurance Company (“Bucktail”). Citizens & Northern Investment Corporation was formed in 1999 to engage in investment activities. Bucktail reinsures credit and mortgage life and accident and health insurance on behalf of C&N Bank.

On September 28, 2018, the Corporation, along with Monument Bancorp, Inc. (“Monument”), announced the signing of an Agreement and Plan of Merger. Monument is the parent company of Monument Bank, a commercial bank which operates two community bank offices and one loan production office in Bucks County, Pennsylvania. As of December 31, 2018, Monument reported total assets of $363 million. Under the terms of the Agreement and Plan of Merger, Monument will merge into the Corporation, and Monument Bank will merge into C&N Bank. In the transaction, Monument shareholders will elect to receive either 1.0144 shares of Corporation common stock or $28.10 in cash for each share of Monument common stock owned, subject to proration to ensure that, overall, 20% of the Monument shares will be converted into cash and 80% of the Monument shares will be converted into Corporation stock. The estimated total purchase consideration would be valued at approximately $42.7 million based on the closing price of the Corporation’s common stock on September 27, 2018. The transaction, which has been approved by the Board of Directors of both companies, is expected to be completed during the second quarter 2019. Consummation of the Merger is subject to approval by Monument’s shareholders, regulatory approvals and other customary conditions of closing.

C&N Bank is a Pennsylvania banking institution that was formed by the consolidation of Northern National Bank of Wellsboro and Citizens National Bank of Towanda on October 1, 1971. Subsequent mergers included: First National Bank of Ralston in May 1972; Sullivan County National Bank in October 1977; Farmers National Bank of Athens in January 1984; and First National Bank of East Smithfield in May 1990. In 2005, the Corporation acquired Canisteo Valley Corporation and its subsidiary, First State Bank, a New York State chartered commercial bank with offices in Canisteo and South Hornell, NY. In 2010, the First State Bank operations were merged into C&N Bank and Canisteo Valley Corporation was merged into the Corporation. On May 1, 2007, the Corporation acquired Citizens Bancorp, Inc. (“Citizens”), with banking offices in Coudersport, Emporium and Port Allegany, Pennsylvania. Citizens Trust Company, the banking subsidiary of Citizens, was merged with and into C&N Bank as part of the transaction. C&N Bank has held its current name since May 6, 1975, at which time C&N Bank changed its charter from a national bank to a Pennsylvania bank.

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

In December 2017, C&N Bank established Northern Tier Holding LLC, to acquire, hold and dispose of real property acquired by the Bank. C&N Bank is the sole member of Northern Tier Holding LLC.

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

Major initiatives within the last 3 years included the following:

At December 31, 2018, C&N Bank had total assets of $1,276,158,000 total deposits of $1,041,526,000, net loans outstanding of $818,254,000 and 299 full-time equivalent employees.

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

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

ITEM 1A. RISK FACTORS

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

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

Interest Rate Risk - Business risk arising from changes in interest rates is an inherent factor in operating a banking organization. The Corporation’s assets are predominantly long-term, fixed-rate loans and debt securities. Funding for these assets comes principally from shorter-term deposits and borrowed funds. Accordingly, there is an inherent risk of lower future earnings or decline in fair value of the Corporation’s financial instruments when interest rates change. Significant fluctuations in interest rates could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity.

Limited Geographic Diversification - The Corporation grants commercial, residential and personal loans to customers primarily in the Pennsylvania counties of Tioga, Bradford, Sullivan, Lycoming, Potter, Cameron and McKean, and in Steuben and Chemung Counties in New York State. Although the Corporation has a diversified loan portfolio, a significant portion of its debtors’ ability to honor their contracts is dependent on the local economic conditions within the region. Deterioration in economic conditions could adversely affect the quality of the Corporation's loan portfolio and the demand for its products and services, and accordingly, could have a material adverse effect on the Corporation's financial condition, results of operations or liquidity.

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

Growth Strategy –As described in Item 1, in September 2008, the Corporation entered into an agreement to acquire Monument Bancorp, Inc., a banking company with total assets of approximately $363 million as of December 31, 2018. Management expects the acquisition of Monument to close in the second quarter 2019. Further, management intends to continue to pursue additional acquisition opportunities. The Corporation’s future financial performance will depend on its ability to execute its strategic plan and manage its future growth. Failure to execute these plans could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity.

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

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

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

The Federal Home Loan Bank of Pittsburgh - Through its subsidiary (C&N Bank), the Corporation is a member of the Federal Home Loan Bank of Pittsburgh (FHLB-Pittsburgh), which is one of 11 regional Federal Home Loan Banks. The Corporation has a line of credit with the FHLB-Pittsburgh that is secured by a blanket lien on its loan portfolio. Access to this line of credit is critical if a funding need arises. However, there can be no assurance that the FHLB-Pittsburgh will be able to provide funding when needed, nor can there be assurance that the FHLB-Pittsburgh will provide funds specifically to the Corporation should its financial condition deteriorate and/or regulators prevent that access. The inability to access this source of funds could have a materially adverse effect on the Corporation’s financial flexibility if alternate financing is not available at acceptable interest rates. The failure of the FHLB-Pittsburgh or the FHLB system in general, may materially impair the Corporation’s ability to meet short- and long-term liquidity needs or to meet growth plans.

The Corporation owns common stock of the FHLB-Pittsburgh to qualify for membership in the FHLB system and access services from the FHLB-Pittsburgh. The FHLB-Pittsburgh faces a variety of risks in its operations including interest rate risk, counterparty credit risk, and adverse changes in its regulatory framework. In addition, the 11 Federal Home Loan Banks are jointly liable for the consolidated obligations of the FHLB system. To the extent that one FHLB cannot meet its obligations, other FHLBs can be called upon to make required payments. Such risks affecting the FHLB-Pittsburgh could adversely impact the value of the Corporation’s investment in the common stock of the FHLB-Pittsburgh and/or affect its access to credit.

Soundness of Other Financial Institutions - In addition to the FHLB-Pittsburgh, the Corporation maintains other credit facilities that provide it with additional liquidity. These facilities include secured and unsecured borrowings from the Federal Reserve Bank and third-party commercial banks. The Corporation believes that it maintains a strong liquidity position and that it is well positioned to withstand foreseeable market conditions. However, legal agreements with counterparties typically include provisions allowing them to restrict or terminate the Corporation’s access to these credit facilities with or without advance notice and at their sole discretion.

Financial institutions are interconnected because of trading, clearing, counterparty, and other relationships. Financial market conditions have been negatively impacted in the past and such disruptions or adverse changes in the Corporation's results of operations or financial condition could, in the future, have a negative impact on available sources of liquidity. Such a situation may arise due to circumstances that are outside the Corporation’s control, such as general market disruptions or operational problems affecting the Corporation or third parties. The Corporation’s efforts to monitor and manage liquidity risk may not be successful or sufficient to deal with dramatic or unanticipated reductions in available liquidity. In such events, the Corporation’s cost of funds may increase, thereby reducing net interest income, or the Corporation may need to sell a portion of its securities and/or loan portfolio, which, depending upon market conditions, could necessitate realizing a loss.

Securities Markets – The fair value of the Corporation's available-for-sale securities, as well as the revenues the Corporation earns from its Trust and Financial Management and brokerage services, are sensitive to price fluctuations and market events.

Declines in the values of the Corporation’s securities holdings, combined with adverse changes in the expected cash flows from these investments, could result in other-than-temporary impairment charges.

For additional information regarding debt securities, see the “Securities” section of Management’s Discussion and Analysis and Note 7 to the consolidated financial statements.

The Corporation's Trust and Financial Management revenue is determined, in part, from the value of the underlying investment portfolios. Accordingly, if the values of those investment portfolios decrease, whether due to factors influencing U.S. or international securities markets, in general, or otherwise, the Corporation's revenue could be negatively impacted. In addition, the Corporation's ability to sell its brokerage services is dependent, in part, upon consumers' level of confidence in securities markets.

Mortgage Banking – Since 2009, the Corporation has originated and sold residential mortgage loans to the secondary market through the MPF Xtra program. Since 2014, the Corporation has also originated and sold residential mortgage loans to the secondary market through the MPF Original program. Both of these programs are administered by the Federal Home Loan Banks of Pittsburgh and Chicago. At December 31, 2018, the total outstanding balance of residential mortgages sold and serviced through the two programs amounted to $171,742,000. The Corporation must strictly adhere to the MPF Xtra and MPF Original program guidelines for origination, underwriting and servicing loans, and failure to do so may result in the Corporation being forced to repurchase loans or being dropped from the program. As of December 31, 2018, the total outstanding balance of residential mortgage loans the Corporation has repurchased as a result of identified instances of noncompliance amounted to $2,146,000. If the volume of such forced repurchases of loans were to increase significantly, or if the Corporation were to be dropped from the programs, it could have a material adverse effect on the Corporation’s financial condition, results of operations or liquidity.

ITEM 1B. UNRESOLVED STAFF COMMENTS

Not applicable.

ITEM 2. PROPERTIES

The Bank owns each of its properties, except for the branch facilities located in Towanda, Williamsport and South Williamsport, PA, which are leased. All of the properties are in good condition. None of the owned properties are subject to encumbrance.

A listing of properties is as follows:

Loan production office of Citizens & Northern Bank:

250 East Water Street

Elmira, NY 14901

Facilities management office:

13 Water Street

Wellsboro, PA 16901

** designates leased branch facility

ITEM 3. LEGAL PROCEEDINGS

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

ITEM 4. MINE SAFETY DISCLOSURE

Not applicable.

PART II

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

QUARTERLY SHARE DATA

Trades of the Corporation’s stock are executed through various brokers who maintain a market in the Corporation’s stock. The Corporation’s stock is listed on the NASDAQ Capital Market with the trading symbol CZNC. As of December 31, 2018, there were 2,160 shareholders of record of the Corporation’s common stock.

The following table sets forth the high and low sales prices of the common stock during 2018 and 2017.

Future dividend payments will depend upon maintenance of a strong financial condition, future earnings and capital and regulatory requirements. Also, the Corporation and C&N Bank are subject to restrictions on the amount of dividends that may be paid without approval of banking regulatory authorities. These restrictions are described in Note 18 to the consolidated financial statements.

Effective April 21, 2016, the Corporation’s Board of Directors approved a treasury stock repurchase program. Under this program, the Corporation is authorized to repurchase up to 600,000 shares of the Corporation's common stock or slightly less than 5% of the Corporation's issued and outstanding shares at April 19, 2016. The Board of Directors’ April 21, 2016 authorization provides that: (1) the new treasury stock repurchase program shall be effective when publicly announced and shall continue thereafter until suspended or terminated by the Board of Directors, in its sole discretion; and (2) all shares of common stock repurchased pursuant to the new program shall be held as treasury shares and be available for use and reissuance for purposes as and when determined by the Board of Directors including, without limitation, pursuant to the Corporation’s Dividend Reinvestment and Stock Purchase Plan and its equity compensation program. To date, no purchases have been made under this repurchase program.

The following table sets forth a summary of purchases by the Corporation, in the open market, of its equity securities during the fourth quarter 2018:

PERFORMANCE GRAPH

Set forth below is a chart comparing the Corporation’s cumulative return to stockholders against the cumulative return of the Russell 2000 and a Peer Group Index of similar banking organizations selected by the Corporation for the five-year period commencing December 31, 2013 and ended December 31, 2018. The index values are market-weighted dividend-reinvestment numbers, which measure the total return for investing $100.00 five years ago. This meets Securities & Exchange Commission requirements for showing dividend reinvestment share performance over a five-year period and measures the return to an investor for placing $100.00 into a group of bank stocks and reinvesting any and all dividends into the purchase of more of the same stock for which dividends were paid.

Peer Group includes all publicly traded SEC filing Commercial Banks & Thrifts within NJ, NY, OH and PA with assets between $750M and $3.5B as of 9/30/18

Source: S&P Global Market Intelligence

© 2017

EQUITY COMPENSATION PLAN INFORMATION

The following table sets forth information concerning the Stock Incentive Plan and Independent Directors Stock Incentive Plan, both of which have been approved by the Corporation’s shareholders. The figures shown in the table below are as of December 31, 2018.

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

ITEM 6. SELECTED FINANCIAL DATA

ITEM 6. SELECTED FINANCIAL DATA (Continued)

(1) Rates of return on tax-exempt securities and loans are calculated on a fully-taxable equivalent basis.

(2) The efficiency ratio is calculated by dividing: (a) total noninterest expense excluding losses from prepayment of debt, by (b) the sum of net interest income (including income from tax-exempt securities and loans on a fully-taxable equivalent basis) and noninterest income excluding securities gains or losses.

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

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

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

EARNINGS OVERVIEW

In 2018, net income totaled $22,013,000, or $1.79 per diluted common share as compared to $1.10 per share in 2017. The results for 2018 represented a return on average assets of 1.72% and a return on average equity of 11.72%. Annual earnings for 2018 included a net benefit of $0.13 per share from gains on a restricted equity security (Visa Class B stock) and a loss on available-for-sale debt securities. Annual 2017 earnings were negatively impacted by a reduction in the federal corporate income tax rate to 21%, effective January 1, 2018, from the 35% marginal tax rate prior to the change. In 2017, the Corporation recorded additional income tax expense of $0.18 per share related to a reduction in the carrying value of the net deferred tax asset due to the change in tax rate. Annual 2017 earnings also included a net benefit of $0.02 per share from net gains on sales of available-for-sale debt securities.

As described in more detail below, the Corporation’s 2018 earnings results, as compared to 2017, include a significant benefit from the reduction in the federal income tax rate.

Excluding the effect of the income tax rate change on 2017 earnings and the after-tax impact of the gain on Visa Class B stock and net (losses) gains on available-for-sale debt securities as described above, adjusted annual 2018 net income of $20,407,000 exceeded adjusted net income for 2017 of $15,426,000 by $4,981,000 (32.3%). Pre-tax income, excluding the gain on Visa Class B stock and net (losses) gains on available-for-sale debt securities, totaled $24,230,000 in 2018, an increase of $3,897,000 (19.2%) over adjusted pre-tax income of $20,333,000 in 2017. Excluding the additional income tax provision in 2017 resulting from the change in the federal income tax rate as well as the gain on Visa Class B stock and net (losses) gains on available-for-sale debt securities, the effective tax rate was 15.8% in 2018, significantly lower than the comparative adjusted 2017 effective tax rate of 24.1%.

The following table provides a reconciliation of the Corporation’s 2018 and 2017 earnings under U.S. generally accepted accounting principles (U.S. GAAP) to comparative non-U.S. GAAP results excluding the 2017 impact of the change in the federal income tax rate as well as the 2018 gain on Visa Class B stock and gains and losses on available-for-sale debt securities in both years. Management believes disclosure of 2018 and 2017 earnings results, adjusted to exclude the impact of these items, provides useful information to investors for comparative purposes.

RECONCILIATION OF NET INCOME AND

DILUTED EARNINGS PER SHARE TO NON-U.S.

GAAP MEASURE

(Dollars In Thousands, Except Per Share Data)

Other significant earnings-related variances were as follows:

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

CRITICAL ACCOUNTING POLICIES

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

A material estimate that is particularly susceptible to significant change is the determination of the allowance for loan losses. The Corporation maintains an allowance for loan losses that represents management’s estimate of the losses inherent in the loan portfolio as of the balance sheet date and recorded as a reduction of the investment in loans. Management believes the allowance for loan losses is adequate and reasonable. Notes 1 and 8 to the consolidated financial statements provide an overview of the process management uses for evaluating and determining the allowance for loan losses, and additional discussion of the allowance for loan losses is provided in a separate section later in Management’s Discussion and Analysis. Given the very subjective nature of identifying and valuing loan losses, it is likely that well-informed individuals could make materially different assumptions, and could, therefore calculate a materially different allowance value. While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in future years. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation’s allowance for loan losses. Such agencies may require the Corporation to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination.

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

As described in Note 7 to the consolidated financial statements, management evaluates securities for other-than-temporary impairment (“OTTI”). In making that evaluation, consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) whether the Corporation intends to sell the security or more likely than not will be required to sell the security before its anticipated recovery. Management’s assessments of the likelihood and potential for recovery in value of securities are subjective and based on sensitive assumptions.

NET INTEREST INCOME

The Corporation’s primary source of operating income is net interest income, which is equal to the difference between the amounts of interest income and interest expense. Tables I, II and III include information regarding the Corporation’s net interest income in 2018 and 2017. In each of these tables, the amounts of interest income earned on tax-exempt securities and loans have been adjusted to a fully taxable-equivalent basis. Accordingly, the net interest income amounts reflected in these tables exceed the amounts presented in the consolidated financial statements. The discussion that follows is based on amounts in the tables.

The calculations of fully taxable-equivalent yields on tax-exempt loans and securities in Tables I, II and III reflect inherent tax benefit based on the Corporation’s marginal federal income tax rate of 21% for 2018 and a 35% marginal federal income tax rate for 2017. In 2018, the tax benefit from tax-exempt loans and securities was reduced as a result of the change to a 21% federal income tax rate.

Fully taxable equivalent net interest income was $47,004,000 in 2018, $2,296,000 (5.1%) higher than in 2017. Interest income was $3,006,000 higher in 2018 as compared to 2017; interest expense was also higher by $710,000 in comparing the same periods. As presented in Table II, the Net Interest Margin was 3.90% in 2018 as compared to 3.82% in 2017, and the “Interest Rate Spread” (excess of average rate of return on earning assets over average cost of funds on interest-bearing liabilities) increased to 3.72% in 2018 from 3.68% in 2017.

INTEREST INCOME AND EARNING ASSETS

Interest income totaled $51,629,000 in 2018, an increase of 6.2% from 2017. Interest and fees on loans receivable increased $3,474,000, or 9.1%, to $41,491,000 in 2018 from $38,017,000 in 2017. Table III shows the increase in interest on loans includes $2,039,000 attributable to an increase in volume and $1,435,000 related to an increase in average rate. The average balance of loans receivable increased $41,706,000 (5.3%) to $822,346,000 in 2018 from $780,640,000 in 2017. The increase in average balance reflects growth in the average balance of both commercial and residential mortgage loans. The average rate on taxable loans in 2018 was 5.18% compared to 4.90% in 2017 as current rates on variable rate loans and rates on recent new loan originations have increased, consistent with increases in market interest rates. The yield on tax-exempt loans receivable decreased to 3.71% in 2018 compared to 4.52% in 2017. This decrease reflects the reduced tax benefit on tax-exempt assets as compared to taxable assets resulting from the marginal tax rate being reduced to 21% in 2018 from 35% in 2017.

Interest income on available-for-sale debt securities totaled $9,687,000 in 2018, a reduction of $683,000 from the total for 2017. As indicated in Table II, average available-for-sale debt securities (at amortized cost) totaled $360,123,000 in 2018, a decrease of $11,702,000 (3.1%) from 2017. The average yield on available-for-sale debt securities decreased to 2.69% in 2018 from 2.79% in 2017. The reduction in yield on available-for-sale debt securities includes the impact of a reduced tax benefit on tax-exempt municipal bonds from the reduction in the federal income tax rate.

Interest income from interest-bearing deposits in banks totaled $415,000 in 2018, an increase of $225,000 over the total for 2017. The most significant categories of assets within this category include interest-bearing balances held with the Federal Reserve and investments in certificates of deposit issued by other banks. The increase in interest income from interest-bearing deposits with banks includes the effects of an increase in yield to 1.90% in 2018 from 1.14% in 2017, consistent with market increases in short-term interest rates, and an increase in average balance to $21,800,000 in 2018 from $16,634,000 in 2017.

INTEREST EXPENSE AND INTEREST-BEARING LIABILITIES

Interest expense increased $710,000, or 18.1%, to $4,625,000 in 2018 from $3,915,000 in 2017. Table II shows that the overall cost of funds on interest-bearing liabilities increased to 0.56% in 2018 from 0.48% in 2017.

Total average deposit balances (interest-bearing and noninterest-bearing) increased 3.7%, to $1,027,831,000 in 2018 from $990,917,000 in 2017. Increases in the average balances of demand deposits, certificates of deposit, savings and interest checking were partially offset by reductions in money market and Individual Retirement Accounts.

Interest expense on deposits increased $1,299,000 in 2018 over 2017. The average rate on interest-bearing deposits increased to 0.48% in 2018 from 0.32% in 2017. Interest expense on certificates of deposit increased $580,000 in 2018 of which $420,000 is from an increase in average rate and $160,000 due to an increase in volume. Interest expense on interest checking accounts increased $476,000 and on money market accounts increased $194,000, in 2018 as compared to 2017, primarily due to increases in the average rates paid.

Interest expense on borrowed funds decreased $589,000 in 2018 as compared to 2017, including a reduction in interest expense on long-term borrowings partially offset by an increase in interest expense on short-term borrowings. Total average borrowed funds decreased $8,984,000 to $50,435,000 in 2018 from $59,419,000 in 2017. The average rate on total borrowed funds was 1.83% in 2018 compared to 2.54% in 2017.

Interest expense on short-term borrowings in 2018 exceeded interest expense in the same period of 2017 by $153,000 as result of a series of advances from FHLB-Pittsburgh that matured in monthly amounts of $3,000,000 through October 2018, as well as an increase in short-term interest rates. These short-term advances were originated in the third and fourth quarters of 2017 to pay off a portion of a total of $37,000,000 in long-term borrowings that matured during that time period. Average short-term borrowings totaled $25,226,000 in 2018, an increase of $1,465,000 over 2017. The weighted-average rate on short-term borrowings was 1.45% in 2018 as compared to 0.90% in 2017.

Interest expense on long-term debt decreased $742,000 in 2018 as compared to 2017, mainly from repayment of the $37 million in higher-cost borrowings (weighted-average rate of 3.65%) in the third and fourth quarters of 2017 referred to above. Borrowings are classified as long-term within the Tables based on their term at origination. The average balance of long-term borrowings in 2018 of $25,209,000 consisted mainly of FHLB advances with 13-month terms at origination and had a weighted-average rate of 2.21%. In comparison, average long-term borrowings in 2017 totaled $35,658,000, with an average rate of 3.64%.

TABLE I - ANALYSIS OF INTEREST INCOME AND EXPENSE

TABLE II - ANALYSIS OF AVERAGE DAILY BALANCES AND RATES

(Dollars in Thousands)

TABLE III - ANALYSIS OF VOLUME AND RATE CHANGES

(In Thousands)

NONINTEREST INCOME

The table below presents a comparison of noninterest income and excludes realized gains and losses on securities, which are discussed in the “Earnings Overview” section of Management’s Discussion and Analysis.

TABLE IV - COMPARISON OF NONINTEREST INCOME

(In Thousands)

Total noninterest income, excluding realized gains and losses on securities, increased $2,444,000 (15.1%) in 2018 compared to 2017. Changes of significance are discussed in the narrative that follows.

Total Trust and brokerage revenue increased $660,000 (10.7%), reflecting growth in the average value of assets under management as well as increased volume of brokerage transactions.

Service charges on deposit accounts increased $611,000 (13.4%), mainly due to increased fees from the overdraft privilege program and reflecting the benefit of operational improvements to the program that were instituted early in 2018.

Interchange revenue from debit card transactions increased $325,000 (14.6%), reflecting an increase in transaction volume.

Loan servicing fees, net, increased $103,000, as the fair value of mortgage loan servicing rights decreased $83,000 in 2018 as compared to a decrease of $168,000 in 2017.

Net gains from sales of loans decreased $136,000 (16.6%), as the dollar volume of residential mortgage loans sold decreased by approximately 12% in 2018 as compared to 2017. Gains on sales of loans totaled 3.2% of the origination cost of loans sold in 2018 as compared to 3.4% in 2017.

Other noninterest income increased $878,000, including $438,000 from a life insurance arrangement in which benefits were split between the Corporation and heirs of a former employee. Income from state tax credits totaled $322,000 in 2018, an increase of $122,000 over 2017, including $154,000 recorded in 2018 related to the donation of the Towanda facility described in the Earnings Overview section of Management’s Discussion and Analysis. Also, dividends on FHLB-Pittsburgh stock increased $146,000 to $320,000 in 2018 from $174,000 in 2017, interchange revenue from credit card transactions increased $105,000 to $126,000 in 2018 from $21,000 in 2017 and revenue from merchant services increased $50,000 to $374,000 in 2018 from $324,000 in 2017.

NONINTEREST EXPENSE

Total noninterest expenses increased $2,519,000 (6.8%) in 2018 as compared to 2017. Changes of significance are discussed in the narrative that follows.

TABLE V - COMPARISON OF NONINTEREST EXPENSE

(Dollars In Thousands)

Salaries and wages expense increased $1,385,000 (8.8%), including the effects of annual performance-based salary adjustments for employees along with an increase of $672,000 in cash and stock-based incentive compensation expense and an increase in the average number of full-time equivalent employees (FTEs) to 297 in 2018 from 292 in 2017.

Other noninterest expense increased $389,000. Donations expense increased $229,000, including $250,000 from the June 2018 donation of the Towanda banking facility to a nonprofit organization. The Corporation entered into a lease with the nonprofit organization and continues to provide banking services there until a new location in the Towanda market can be obtained and prepared for use. Other significant variances within this category include an increase of $118,000 in consulting expense related to the overdraft privilege program, an increase of $104,000 in credit card processing and rewards expenses, a decrease of $247,000 in net loan collection expense and a decrease in other taxes of $118,000 from sales tax refunds received.

Data processing expenses increased $344,000 (14.3%), including increases in costs associated with document imaging and a new loan origination system implemented in 2018.

Professional fees increased $268,000 (30.7%). The increase in professional fees expense included $158,000 related to the pending acquisition of Monument, along with consulting costs related to Board governance and committee structures, implementation of new accounting standards, certification of a compliance-related software system and other corporate projects.

Telecommunications expense increased $173,000, including higher costs associated with data lines from a new telephone system.

Occupancy expense increased $157,000 (6.7%), including the effects of accelerated depreciation on the Ralston, Pennsylvania branch closed in November 2018 and an increase in repairs and maintenance expense at several locations.

Furniture and equipment expense decreased $103,000 (7.9%), mainly due to a reduction in depreciation expense related to certain items of equipment still in service that became fully depreciated in 2017 and 2018.

Pensions and other employee benefits expense decreased $89,000, reflecting a reduction of $202,000 in health insurance expense due to lower claims from the Corporation’s partially self-insured plan.

INCOME TAXES

The effective income tax rate was 16.2% of pre-tax income in 2018, down from 34.8% in 2017. The Corporation’s effective tax rates differed from the statutory rate of 21% in 2018 and 35% in 2017 principally because of the effects of tax-exempt interest income. In 2018, the Corporation realized a decrease in the income tax provision (expense) due to the Tax Cuts and Jobs Act of 2017 enacted in December 2017 that, among other things, lowered the federal corporate income tax rate to 21% effective January 1, 2018, from the 35% marginal tax rate in effect for prior periods. Because of the change in the marginal tax rate, the Corporation was required to write-down deferred tax assets at December 31, 2017. Excluding the effect of the write-down, the effective income tax rate for the year ended December 31, 2017 would have been 24.3%.

The Corporation recognizes deferred tax assets and liabilities based on differences between the financial statement carrying amounts and the tax basis of assets and liabilities. At December 31, 2018, the net deferred tax asset was $4,110,000, an increase from the balance at December 31, 2017 of $3,289,000. The most significant change in temporary difference components was a net increase of $639,000 related to unrealized losses on available-for-sale securities. At December 31, 2018, the net deferred tax asset associated with the unrealized loss was $1,145,000, while at December 31, 2017, the deferred tax asset associated with the unrealized loss was $506,000, including $843,000 recorded as an offset to the pre-tax unrealized loss within accumulated other comprehensive loss, partially offset by $337,000 charged against retained earnings

The Corporation regularly reviews deferred tax assets for recoverability based on history of earnings, expectations for future earnings and expected timing of reversals of temporary differences. Realization of deferred tax assets ultimately depends on the existence of sufficient taxable income, including taxable income in prior carryback years, as well as future taxable income. Further, the value of the benefit from realization of deferred tax assets would be impacted if income tax rates were changed from currently enacted levels.

Management believes the recorded net deferred tax asset at December 31, 2018 is fully realizable; however, if management determines the Corporation will be unable to realize all or part of the net deferred tax asset, the Corporation would adjust the deferred tax asset, which would negatively impact earnings.

Additional information related to income taxes is presented in Note 14 to the consolidated financial statements.

SECURITIES

The objectives of the Corporation’s available-for-sale debt securities (investment) portfolio are to maintain high credit quality, achieve good portfolio balance, support liquidity needs, maximize return on earning assets within reasonable risk parameters, provide an adequate amount of pledgeable securities, support local communities by purchasing securities they issue for public projects and programs, provide a means to hedge the Corporation’s interest rate risk exposure, and minimize taxes. Management continually evaluates the size and mix of securities held in the available-for-sale debt securities portfolio while considering these objectives.

Table VI shows the composition of the available-for-sale debt securities portfolio at December 31, 2018 and 2017. Comparison of the amortized cost totals of available-for-sale debt securities at each year-end presented reflects an increase of $10,408,000 to $368,725,000 at December 31, 2018 from $358,317,000 at December 31, 2017. The Corporation’s holdings of mortgage-backed securities issued or guaranteed by U.S. Government agencies or sponsored agencies increased to $244,572,000 at December 31, 2018 from $221,187,000 at December 31, 2017. Total amortized cost of tax-exempt obligations of states and political subdivisions (municipal bonds) decreased to $84,204,000 at December 31, 2018 from $103,673,000 at December 31, 2017. The reduction in tax-exempt municipal bonds resulted from market conditions, as management identified opportunities to reinvest proceeds from maturities and sales of municipal bonds into other types of debt securities, considering the Corporation’s liquidity and interest rate risk management needs and current market yields for various categories of securities.

As reflected in Table VI, the fair value of available-for-sale securities as of December 31, 2018 was $5,452,000, or 1.5%, less than the total amortized cost basis. In comparison, the aggregate unrealized loss position at December 31, 2017 was $2,380,000, or 0.7% of the total amortized cost basis. Increases in interest rates over the course of 2018 and 2017 were the major cause of the decrease in fair values of debt securities. Also, the fair values of tax-exempt municipal bonds have been negatively impacted by the reduced benefit of their tax-exempt nature resulting from the reduction in the federal corporate income tax rate. The Corporation had net realized losses from sales of available-for-sale debt securities of $288,000 in 2018, as management identified opportunities to sell selected securities with the proceeds reinvested in securities with higher yields. In comparison, net realized gains from sales of available-for-sale debt securities totaled $257,000 in 2017.

Management has reviewed the Corporation’s holdings as of December 31, 2018 and concluded that unrealized losses on all of the securities in an unrealized loss position are considered temporary. Notes 6 and 7 to the consolidated financial statements provide more detail concerning the Corporation’s processes for evaluating securities for other-than-temporary impairment. Management will continue to closely monitor the status of impaired securities in 2019.

TABLE VI - INVESTMENT SECURITIES

The following table presents the contractual maturities and the weighted-average yields (calculated based on amortized cost) of investment securities as of December 31, 2018. Yields on tax-exempt securities are presented on a fully taxable-equivalent basis. Actual maturities may differ from contractual maturities because counterparties may have the right to call or prepay obligations with or without call or prepayment penalties.

The Corporation’s mortgage-backed securities and collateralized mortgage obligations have stated maturities that may differ from actual maturities due to borrowers’ ability to prepay obligations. Cash flows from such investments are dependent upon the performance of the underlying mortgage loans and are generally influenced by the level of interest rates. As rates increase, cash flows generally decrease as prepayments on the underlying mortgage loans decrease. As rates decrease, cash flows generally increase as prepayments increase due to increased refinance activity and other factors. In the table above, the entire balances and weighted-average rates for mortgage-backed securities and collateralized mortgage obligations are shown in one period.

FINANCIAL CONDITION

This section includes information regarding the Corporation’s lending activities or other significant changes or exposures that are not otherwise addressed in Management’s Discussion and Analysis. Significant changes in the average balances of the Corporation’s earning assets and interest-bearing liabilities are described in the “Net Interest Income” section of Management’s Discussion and Analysis. Other significant balance sheet items, including securities, the allowance for loan losses and stockholders’ equity, are discussed in separate sections of Management’s Discussion and Analysis. There are no significant concerns that have arisen related to the Corporation’s off-balance sheet loan commitments or outstanding letters of credit at December 31, 2018, and management does not expect the amount of purchases of bank premises and equipment to have a material, detrimental effect on the Corporation’s financial condition in 2019.

Gross loans outstanding (excluding mortgage loans held for sale) were $827,563,000 at December 31, 2018, up 1.5% from $815,713,000 at December 31, 2017. The total outstanding balances of residential mortgage segment loans at December 31, 2018 increased $9,520,000 (2.1%) as compared to December 31, 2017, and the total outstanding balances of commercial segment loans of $353,627,000 at December 31, 2018 was flat compared to December 31, 2017. Average total loans outstanding increased 5.3% in 2018 over 2017. Table VII shows the composition of the loan portfolio as of the end of the years 2014 through 2018. Over that period, the overall mix by segment has remained fairly constant, with residential mortgage loans of approximately 55% to 58% of the portfolio at each year-end, and commercial loans of 40% to 44% of the portfolio. Total loans outstanding were $197,018,000 (31.2%) higher at December 31, 2018 as compared to December 31, 2014.

While the Corporation’s lending activities are primarily concentrated in its market area, a portion of the Corporation’s commercial loan segment consists of participation loans. Participation loans represent portions of larger commercial transactions for which other institutions are the “lead banks”. Although not the lead bank, the Corporation conducts detailed underwriting and monitoring of participation loan opportunities. Participation loans are included in the “Commercial and industrial,” “Commercial loans secured by real estate”, “Political subdivisions” and “Other commercial” classes in the loan tables presented in this Form 10-K. Total participation loans outstanding amounted to $67,340,000 at December 31, 2018, up from $61,245,000 at December 31, 2017. At December 31, 2018, the balance of participation loans outstanding includes a total of $52,623,000 to businesses located outside of the Corporation’s market area, including $8,032,000 from participations in loans originated through the Corporation’s membership in a network that originates loans throughout the U.S. The Corporation’s participation loans originated through the network consist of loans to businesses that are larger than the Corporation’s typical commercial customer base. The loans originated through the network are considered “leveraged loans,” meaning the businesses typically have minimal tangible book equity and the extent of collateral available is limited, though at the time of origination the businesses have demonstrated strong cash flow performance in their recent histories. Total leveraged participation loans, including loans originated through the network and two loans originated through another lead institution, totaled $13,315,000 at December 31, 2018 and $15,328,000 at December 31, 2017.

Table VIII presents loan maturity data as of December 31, 2018. The interest rate simulation model used to prepare Table VIII classifies certain loans under different categories from the categories that appear in Table VII. Fixed-rate loans are shown in Table VIII based on their contractually scheduled principal repayments, and variable-rate loans are shown based on the date of the next change in rate. Table VIII shows that fixed-rate loans are approximately 36% of the loan portfolio. Of the 64% of the portfolio made up of variable-rate loans, a significant portion (71%) will re-price after more than one year. Variable-rate loans re-pricing after more than one year include residential and commercial real estate secured loans. The Corporation’s substantial investment in long-term, fixed-rate loans and variable-rate loans with extended periods until re-pricing is one of the concerns management attempts to address through interest rate risk management practices.

Short-term borrowings totaled $12,853,000 at December 31, 2018, down from $61,766,000 at December 31, 2017. Within this category, overnight borrowing from FHLB-Pittsburgh of $7,000,000 was down from $29,000,000 at December 31, 2017. In 2017, the Corporation paid off two higher-cost borrowings totaling $37,000,000, including an advance from FHLB-Pittsburgh of $10,000,000 with a rate of 3.81% in October and repurchase agreements totaling $27,000,000 with a rate of 3.595% in December. Repayment of these borrowings was funded by a series short-term advances from FHLB-Pittsburgh totaling $29,000,000, including advances maturing monthly from January through October 2018 with a weighted average interest rate of 1.69% and rates ranging from 1.23% to 1.89%.

Long-term borrowings of $35,915,000 at December 31, 2018 were up from the balance at December 31, 2017 of $9,189,000. As the short-term advances described above matured through 2018, they were renewed at FHLB Pittsburgh with long-term advances, generally with 13-month terms, utilizing the FHLB’s Community Lending Program (CLP). These advances have a weighted average rate of 2.40% with rates ranging from 1.83% to 2.77%.

Since 2009, the Corporation has originated and sold residential mortgage loans to the secondary market through the MPF Xtra program administered by the Federal Home Loan Banks of Pittsburgh and Chicago. Residential mortgages originated and sold through the MPF Xtra program consist primarily of conforming, prime loans sold to the Federal National Mortgage Association (Fannie Mae), a quasi-government entity. In 2014, the Corporation began to originate and sell residential mortgage loans to the secondary market through the MPF Original program, which is also administered by the Federal Home Loan Banks of Pittsburgh and Chicago. Residential mortgages originated and sold through the MPF Original program consist primarily of conforming, prime loans sold to the Federal Home Loan Bank of Pittsburgh.

For loan sales originated under the MPF Xtra and Original programs, the Corporation provides customary representations and warranties to investors that specify, among other things, that the loans have been underwritten to the standards established by the investor. The Corporation may be required to repurchase a loan and reimburse a portion of fees received or reimburse the investor for a credit loss incurred on a loan, if it is determined that the representations and warranties have not been met. Such repurchases, or reimbursements generally result from an underwriting or documentation deficiency. At December 31, 2018, the total outstanding balance of loans the Corporation has repurchased as a result of identified instances of noncompliance amounted to $2,146,000, and the corresponding total outstanding balance of repurchased loans at December 31, 2017 was $1,805,000.

At December 31, 2018, outstanding balances of loans sold and serviced through the two programs totaled $171,742,000, including loans sold through the MPF Xtra program of $96,841,000 and loans sold through the Original program of $74,901,000. At December 31, 2017, outstanding balances of loans sold and serviced through the two programs totaled $169,725,000, including loans sold through the MPF Xtra program of $107,117,000 and loans sold through the Original Program of $62,608,000. Based on the fairly limited volume of required repurchases to date, no allowance has been established for representation and warranty exposures as of December 31, 2018 and December 31, 2017.

For loans sold under the Original program, the Corporation provides a credit enhancement whereby the Corporation would assume credit losses in excess of a defined First Loss Account (“FLA”) balance, up to specified amounts. The FLA is funded by the Federal Home Loan Bank of Pittsburgh based on a percentage of the outstanding balance of loans sold. At December 31, 2018, the Corporation’s maximum credit enhancement obligation under the MPF Original Program was $4,157,000, and the Corporation has recorded a related allowance for credit losses in the amount of $328,000 which is included in “Accrued interest and other liabilities” in the accompanying consolidated balance sheets. At December 31, 2017, the Corporation’s maximum credit enhancement obligation under the MPF Original Program was $5,742,000, and the related allowance for credit losses was $260,000. The Corporation does not provide a credit enhancement for loans sold through the Xtra program.

TABLE VII - Five-year Summary of Loans by Type

(Dollars In Thousands)