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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

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

For the quarterly period ended   September 30, 2008

or

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

For the transition period from              to             

Commission File Number 0-21021

Enterprise Bancorp, Inc.

(Exact name of registrant as specified in its charter)

(978) 459-9000

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

x Yes   o No

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

o Yes  x No

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

November 3, 2008 Common Stock - Par Value $0.01:  7,999,089 shares outstanding

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ENTERPRISE BANCORP, INC.

INDEX

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ENTERPRISE BANCORP, INC.

Consolidated Balance Sheets

(unaudited)

See accompanying notes to the unaudited consolidated financial statements.

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ENTERPRISE BANCORP, INC.

Consolidated Statements of Income

(unaudited)

See accompanying notes to the unaudited consolidated financial statements.

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ENTERPRISE BANCORP, INC.

Consolidated Statement of Changes in Stockholders’ Equity

(unaudited)

Nine months ended September 30, 2008

See the accompanying notes to the unaudited consolidated financial statements

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ENTERPRISE BANCORP, INC.
Consolidated Statements of Cash Flows

(unaudited)

See accompanying notes to the unaudited consolidated financial statements.

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ENTERPRISE BANCORP, INC.

Notes to the Unaudited Consolidated Financial Statements

(1)           Organization of Holding Company

The consolidated financial statements of Enterprise Bancorp, Inc. (the “company”) include the accounts of the company and its wholly owned subsidiary Enterprise Bank and Trust Company (the “bank”). The bank is a Massachusetts trust company organized in 1989. Substantially all of the company’s operations are conducted through the bank.

The bank has five wholly owned subsidiaries.  The bank’s subsidiaries include Enterprise Insurance Services, LLC and Enterprise Investment Services, LLC, organized for the purposes of engaging in insurance sales activities and offering non-deposit investment products and services, respectively.  In addition, the bank has three subsidiary security corporations (Enterprise Security Corporation, Enterprise Security Corporation II, and Enterprise Security Corporation III), which hold various types of qualifying securities. The security corporations are limited to conducting securities investment activities that the bank itself would be allowed to conduct under applicable laws.

Through the bank and its subsidiaries, the company offers a range of commercial and consumer loan products, deposit and cash management products, investment advisory, trust and insurance services.  The services offered through the bank and subsidiaries are managed as one strategic unit and represent the company’s only reportable operating segment.

(2)           Basis of Presentation

The accompanying unaudited consolidated financial statements and these notes should be read in conjunction with the company’s December 31, 2007 audited consolidated financial statements and notes thereto contained in the company’s 2007 Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 14, 2008.  Interim results are not necessarily indicative of results to be expected for the entire year.

The company has not changed its significant accounting and reporting policies from those disclosed in its 2007 Annual Report on Form 10-K.

In the opinion of management, the accompanying consolidated financial statements reflect all necessary adjustments consisting of normal recurring accruals for a fair presentation.  All significant intercompany balances and transactions have been eliminated in the accompanying consolidated financial statements.

Certain fiscal 2007 information has been reclassified to conform to the 2008 presentation.

(3)           Critical Accounting Estimates

In preparing the consolidated financial statements in conformity with U.S. generally accepted accounting principles, management is required to exercise judgment in determining many of the methodologies, assumptions and estimates to be utilized.  These estimates and assumptions affect the reported amounts of assets and liabilities as of the balance sheet date and revenues and expenses for the period.  Actual results could differ should the assumptions and estimates used change over time due to changes in circumstances.

As discussed in the company’s 2007 Annual Report on Form 10-K, the two most significant areas in which management applies critical assumptions and estimates that are particularly susceptible to change relate to the determination of the allowance for loan losses and the impairment valuation of goodwill.  Refer to note 1 to the company’s consolidated financial statements included in the company’s 2007 Annual Report on Form 10-K for significant accounting policies.

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ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements

(4)           Supervision and Regulation

The company’s deposit accounts are insured by the Deposit Insurance Fund (the “DIF”) of the Federal Deposit Insurance Corporation (the “FDIC”) up to the maximum amount provided by law. The FDIC and the Massachusetts Commissioner of Banks (the “Commissioner”) have regulatory authority over the bank.  The business and operations of the company are subject to the regulatory oversight of the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”).  The Commissioner also retains supervisory jurisdiction over the company.

On October 3, 2008, the President signed the Emergency Economic Stabilization Act of 2008, which temporarily raises the basic limit on federal deposit insurance coverage from $100,000 to $250,000 per depositor. The temporary increase in deposit insurance coverage became effective upon the President’s signature. The legislation provides that the basic deposit insurance limit will return to $100,000 after December 31, 2009.  There were no increases to the FDIC assessment rate as a result of this increase in coverage.

As a result of recent bank failures, the DIF reserve ratio (DIF reserves as a percent of estimated insured deposits) declined to a level which requires the FDIC to establish and implement a plan to restore the DIF to the minimum reserve ratio within five years.   Therefore, on October 7, 2008 the Board of Directors of the FDIC voted to adopt a DIF restoration plan. Currently, insured institutions pay annual premium assessment rates of between 5 to 43 basis points of their deposit base. Under this proposed restoration plan, the assessment schedule would be raised uniformly by seven basis points beginning on January 1, 2009 for all insured institutions.  In addition, beginning with the second quarter of 2009, changes would be made to require riskier institutions to pay a larger share of premiums.  The proposed assessment system would include assessing higher rates to institutions with a significant reliance on secured liabilities, and higher rates for institutions with a significant reliance on brokered deposits but, for well-managed and well-capitalized institutions, only when accompanied by rapid asset growth. The proposal also would provide incentives in the form of a reduction in assessment rates for institutions to hold long-term unsecured debt and, for smaller institutions, high levels of Tier 1 capital. In 2008, the bank qualified as a FDIC Assessment Risk Category I institution (least risk) and is currently assessed deposit insurance premiums at an annualized assessment of 5.3 basis points of the bank’s deposit assessment base.  If the restoration plan is approved as proposed, management expects the bank’s FDIC insurance premiums to increase beginning in January 2009.  Management expects that the bank will again qualify as Risk Category I in 2009, and is currently assessing the impact of this proposal on the company’s results of operations.  The proposal is open for comment until November 17, 2008.

On October 14, 2008, the United States Treasury (the “Treasury”) and the FDIC jointly announced a new program to strengthen confidence and encourage liquidity in the nation’s banking system.  Under the Temporary Liquidity Guarantee Program, the FDIC will guarantee certain newly issued senior unsecured debt of banks, thrifts and certain holding companies.  In addition, the FDIC will provide participating depository institutions with full insurance coverage for non-interest bearing deposit transaction accounts, regardless of the dollar amount. Institutions opting to participate will be charged a 75-basis point fee to protect newly issued debt (issued on or before June 30, 2009) and a 10-basis point surcharge, on those non-interest bearing account balances over the existing insurance limit of $250,000, will be added to participating institutions deposit insurance assessment in order to fully cover the non-interest bearing deposit transaction accounts.  The company is currently evaluating participation in this program.

On October 14, 2008, the Treasury announced a voluntary Capital Purchase Program to support the U.S. economy, to encourage financial institutions to build capital, and to increase the flow of financing to businesses and consumers.  Under the program, the Treasury will purchase senior preferred shares from qualifying financial institutions that elect to participate.  The Treasury will determine eligibility and allocations for interested parties after consultation with the appropriate federal banking agency.  The newly issued senior preferred shares would qualify as Tier 1 capital, and have specific standardized terms set by the Treasury, including dividend rates, callable terms and attached warrants for the purchase of common stock.  Issuance of the senior preferred shares will not result in dilution for existing stockholders, but the exercise of warrants would result in some stockholder dilution.  The company is currently evaluating participation in this program.

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ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements

(5)           Accounting for Income Taxes

The company uses the asset and liability method of accounting for income taxes.  Under this method deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled.  As changes in tax laws or rates are enacted, deferred tax assets and liabilities will be adjusted accordingly through the provision for income taxes.

The company’s policy is to classify interest resulting from underpayment of income taxes as income tax expense in the first period the interest would begin accruing according to the provisions of the relevant tax law.  The company classifies penalties resulting from underpayment of income taxes as income tax expense in the period for which the company claims or expects to claim an uncertain tax position or in the period in which the company’s judgment changes regarding an uncertain tax position.

The company did not have any unrecognized tax benefits accrued as income tax liabilities or receivables or as deferred tax items at September 30, 2008.  The company’s tax years ending December 31, 2004 and later are open to federal and state income tax examinations.

On July 3, 2008, the Commonwealth of Massachusetts enacted a law that included reducing future tax rates on net income applicable to financial institutions. For tax years beginning on or after January 1, 2010, the tax rate drops from the current rate of 10.5% to 10%, for tax years beginning on or after January 1, 2011 the rate drops to 9.5%, and to 9% for tax years beginning on or after January 1, 2012 and thereafter.   Therefore, the company recorded additional income tax expense of approximately $130 thousand in the third quarter to adjust the company’s net deferred tax assets down to the future realizable tax rates.

(6)           Stock-Based Compensation

The company has not significantly changed the general terms and conditions related to stock compensation from those disclosed in the company’s 2007 Annual Report on Form 10-K.  The company’s stock-based compensation expense includes stock option awards and restricted stock awards to officers and other employees, and stock compensation in lieu of cash fees to directors. Total stock-based compensation expense was $128 thousand and $122 thousand for the three months ended September 30, 2008 and 2007, respectively, and $387 thousand and $442 thousand for the nine months ended September 30, 2008 and 2007, respectively.

The company recognized stock-based compensation expense related to stock option awards of $77 thousand and $225 thousand for the three and nine months ended September 30, 2008, compared to $75 thousand and $281 thousand for the same period in 2007.  Stock-based compensation expense recognized in association with a restricted stock award amounted to $12 thousand and $37 thousand for the three month and nine month periods ended September 30, 2008 and 2007.  Stock-based compensation expense related to Directors’ election to receive shares of common stock in lieu of cash fees for attendance at Board and Board Committee meetings amounted to $39 thousand and $125 thousand for the three and nine months ended September 30, 2008 compared to $35 thousand and $124 thousand for the same periods in 2007.  In January 2008, 10,739 shares of common stock were issued to directors in lieu of cash fees related to 2007 annual directors’ stock-based compensation expense of $165 thousand.

There were no stock option awards granted during either of the three months ended September 30, 2008 or 2007.  There were 132,000 stock option awards granted to employees during the nine month period ended September 30, 2008 and 127,600 stock option awards granted to employees during the nine month periods ended September 30, 2007.  All of the options granted in 2008 and 2007 become exercisable at the rate of 25% per year and provide for full vesting upon attainment of age 62 while remaining employed with the bank. All of the options granted in 2008 and 2007 expire seven years from the date of grant.

The per share weighted average fair value of stock options granted in 2008 was determined to be $2.47.  The weighted average fair value of the options was determined to be 19% of the market value of the stock at the date of grant.  The assumptions used in the valuation model for determining weighted average fair value of the 2008 stock option grants for the risk-free interest rate, expected volatility, dividend yield and expected life in years were 2.61%, 25%, 2.82% and 5.5 years, respectively.

The per share weighted average fair value of stock options granted in 2007 was determined to be $3.69.  The weighted average fair value of the options was determined to be 22% of the market value of the stock at the date of grant.  The assumptions used in the valuation model for determining weighted average fair value of the 2007 stock option grants for the risk-free interest rate, expected volatility, dividend yield and expected life in years were 4.43%, 21%, 2.03% and  5.5 years, respectively.

Refer to note 9 “Stock Based Compensation Plans” in the company’s 2007 Annual Report on Form 10-K for a further description of the assumptions used in the valuation model.

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ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements

(7)           Supplemental Retirement Plan and Other Postretirement Benefit Obligation

The following table illustrates the net periodic benefit cost for the supplemental executive retirement plan for the periods indicated:

Benefits paid amounted to $45 thousand and $65 thousand for the three and nine months ended September 30, 2008, respectively.  There were no benefits paid in 2007.  The company anticipates accruing an additional $82 thousand to the plan during the remainder of 2008.

On January 1, 2008, the company adopted the Financial Accounting Standards Board’s Emerging Issues Task Force Issue No. 06-4 (“EITF No. 06-4”) “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split Dollar Life Insurance Arrangements.”   EITF No. 06-4 requires that an employer recognize a liability for future benefits associated with an endorsement split-dollar life insurance arrangement that provides a benefit to an employee that extends to postretirement periods.  Upon adoption of EITF No. 06-4, the company recorded a cumulative-effect adjustment to retained earnings of $1.0 million.  The benefit expense of postretirement cost of insurance for split dollar insurance coverage amounted to $20 thousand and $61 thousand for the three months and nine months ended September 30, 2008.

(8)           Earnings Per Share

Basic earnings per share are calculated by dividing net income by the weighted average number of common shares outstanding during the period.  Diluted earnings per share reflects the effect on weighted average shares outstanding of the number of additional shares outstanding if dilutive stock options were converted into common stock using the treasury stock method.

The table below presents the increase in average shares outstanding, using the treasury stock method, for the diluted earnings per share calculation and the effect of those shares on earnings, for the periods indicated:

At September 30, 2008, there were additional options outstanding to purchase up to 648,206 shares which were excluded from the calculation of diluted earnings per share due to the exercise price of these options exceeding the average market price of the company’s common stock.  These options, which were not dilutive at that date, may potentially dilute earnings per share in the future.

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ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements

(9)           Fair Value Measurements

On January 1, 2008, the company adopted the Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS No. 157”).  This Statement provides a single definition of fair value and establishes a framework for measuring fair value in generally accepted accounting principles, with the intention of increasing consistency and comparability in fair value measurements. The application of this Statement expanded disclosure requirements about fair value measurements. However, the adoption of SFAS No. 157 did not require any new fair value measurements, as the Statement applies under other existing accounting pronouncements that require or permit fair value measurements.  In accordance with FASB Staff Position No. 157-2, “Effective Date of FASB Statement No. 157,” the company has deferred the application of SFAS No. 157 to non-financial assets such as goodwill and real property held for sale, and non-financial liabilities until January 1, 2009.

SFAS No. 157 defines the fair value to be the price which a seller would receive in an orderly transaction between market participants (an exit price).  This Statement also establishes a fair value hierarchy segregating fair value measurements using three levels of inputs: (Level 1) quoted market prices in active markets for identical assets or liabilities; (Level 2) significant other observable inputs, including quoted prices for similar items in active markets, quoted prices for identical or similar items in market that are not active, inputs such as interest rates and yield curves, volatilities, prepayment speeds, credit risks and default rates which provide a reasonable basis for fair value determination or inputs derived principally from observed market data; (Level 3) significant unobservable inputs for situations in which there is little, if any, market activity for the asset or liability. Unobservable inputs must reflect reasonable assumptions that market participants would use in pricing the asset or liability, which are developed on the basis of the best information available under the circumstances.

The following table summarizes significant assets and liabilities carried at fair value at September 30, 2008 (there were no items measured using level 3 inputs):

(1)  Investment securities that are considered “available for sale” are carried at fair value in accordance with SFAS No. 115 (as amended).  The company utilizes third-party pricing vendors to provide valuations on its fixed income securities.  These vendors generally determine fair value prices based upon pricing matrices utilizing observable market data inputs for similar or benchmark securities.  The company’s equity portfolio fair value is measured based on quoted market prices for the shares.  Net unrealized appreciation and depreciation on investments available for sale, net of applicable income taxes, are reflected as a component of accumulated other comprehensive income. The bank is required to purchase Federal Home Loan Bank of Boston (“FHLB”) stock in association with outstanding advances from the FHLB; this stock is classified as a restricted investment and carried at cost.

(2)  Impaired loan balances in the table above represent those collateral dependent impaired loans where management has estimated the credit loss by comparing the loan’s carrying value against the expected realizable fair value of the collateral, in accordance with  SFAS No. 114 (as amended).  A specific allowance is assigned to the impaired loan for the amount of estimated credit loss.  The increase in specific allowances assigned to collateral dependent impaired loans was $604 thousand and $835 thousand for the three and nine months ended September 30, 2008, respectively.

Guarantees and Commitments

Standby letters of credit are conditional commitments issued by the company to guarantee the performance by a customer to a third party.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.  If the letter of credit is drawn upon the company creates a loan for the customer with the same criteria associated with similar loans.  The fair value of these commitments was estimated to be the fees charged to enter into similar agreements, and accordingly these fair value measures are deemed to be SFAS No. 157 Level 2 measurements.  In accordance with FASB Interpretation No. 45, the estimated fair values of these commitments are carried on the balance sheet as a liability and amortized to income over the life of the letters of credit, which are typically one year.  At September 30, 2008 and December 31, 2007, the estimated fair values of these commitments were immaterial.

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ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements

Interest rate lock commitments related to the origination of mortgage loans that will be sold are considered derivative instruments.  The company estimates the fair value of these derivatives using the difference between the guaranteed interest rate in the commitment and the current market interest rate. To reduce the net interest rate exposure arising from its loan sale activity, the company enters into the commitment to sell these loans at essentially the same time that the interest rate lock commitment on the loan is quoted.   The commitments to sell loans are also considered derivative instruments, with estimated fair values based on changes in current market rates.   These commitments represent the company’s only derivative instruments and are accounted for in accordance with SFAS No. 133 (as amended). The fair values of the company’s derivative instruments are deemed to be SFAS No. 157 Level 2 measurements.   At September 30, 2008 and December 31, 2007, the estimated fair value of the company’s derivative instruments was considered to be immaterial.

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Item 2 - Management’s Discussion and Analysis of Financial Condition and Results of Operations

Management’s discussion and analysis should be read in conjunction with the company’s consolidated financial statements and notes thereto contained in this report and the company’s 2007 Annual Report on Form 10-K.

Special Note Regarding Forward-Looking Statements

This report contains certain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, including statements concerning plans, objectives, future events or performance and assumptions and other statements that are other than statements of historical fact.  Forward-looking statements may be identified by reference to a future period or periods or by use of forward-looking terminology such as “anticipates”, “believes”, “expects”, “intends”, “may”, “plans”, “pursue”, “views” and similar terms or expressions. Various statements contained in Item 2 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 3 – “Quantitative and Qualitative Disclosures About Market Risk,” including, but not limited to, statements related to management’s views on the banking environment and the economy, competition and market expansion opportunities, the interest rate environment, credit risk and the level of future non-performing assets and charge-offs, potential asset and deposit growth, future non-interest expenditures and non-interest income growth, and borrowing capacity are forward-looking statements.  The company wishes to caution readers that such forward-looking statements reflect numerous assumptions and involve a number of risks and uncertainties that may adversely affect the company’s future results. The following important factors, among others, could cause the company’s results for subsequent periods to differ materially from those expressed in any forward-looking statement made herein: (i) changes in interest rates could negatively impact net interest income;  (ii) changes in the business cycle and downturns in the local, regional or national economies, including deterioration in the local real estate market, could negatively impact credit and/or asset quality and result in credit losses and increases in the company’s reserve for loan losses; (iii) changes in consumer spending could negatively impact the company’s credit quality and financial results; (iv) increasing competition from larger regional and out-of-state banking organizations as well as non-bank providers of various financial services could adversely affect the company’s competitive position within its market area and reduce demand for the company’s products and services; (v) deterioration of securities markets could adversely affect the value or credit quality of the company’s assets and the availability of funding sources necessary to meet the company’s liquidity needs; (vi) changes in technology could adversely impact the company’s operations and increase technology-related expenditures;  (vii) increases in employee compensation and benefit expenses could adversely affect the company’s financial results;  (viii) changes in laws and regulations that apply to the company’s business and operations could increase the company’s regulatory compliance costs and adversely affect the company’s business environment, operations and financial results; (ix) changes in accounting standards, policies and practices, as may be adopted or established by the regulatory agencies, the Financial Accounting Standards Board (the “FASB”) or the Public Company Accounting Oversight Board could negatively impact the company’s financial results; and (x) some or all of the risks and uncertainties described in Item 1A of the company’s 2007 Annual Report on From 10-K could be realized, which could have a material adverse effect on the company’s business, financial condition and results of operation.  Therefore, the company cautions readers not to place undue reliance on any such forward-looking information and statements.

Overview

The current year net income continues to be impacted by the margin compression caused by market interest rate reductions, which began in September 2007 and continued through April 2008; however, the company’s net interest income has improved in recent quarters.  The margin compression has been partially alleviated by strong loan growth.  The company has achieved consistent loan growth during the year, with quarterly growth of approximately $25 million per quarter, resulting in year-to-date loan growth of $75 million, or 9%.  Other key items impacting the current results were an increase in the provision for loan losses and lower levels of security gains realized in 2008 than in 2007. Additionally, the company benefited from a decrease in its effective income tax rate in 2008; however, third quarter income taxes were impacted by approximately $130 thousand related to legislative changes in future tax rates applicable to Massachusetts financial institutions.

· Results of Operations

Net income for the quarter ended September 30, 2008 was $1.7 million compared to $2.6 million for the quarter ended September 30, 2007.  Diluted earnings per share were $0.21 for the third quarter compared to $0.33 for the same period in 2007.  The quarterly results represented decreases of 34% and 36% in net income and diluted EPS, respectively, compared to the same period in the prior year.

Net income for the nine months ended September 30, 2008 amounted to $5.5 million compared to $7.2 million for the same period in 2007.  Diluted earnings per share were $0.69 for the nine months ended September 30, 2008 compared to $0.91 for the comparable 2007 period.   The year to date results represented decreases of 23% and 24% in net income and diluted EPS, respectively, compared to the same period in the prior year.

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· Net interest income and margin

The company’s earnings are largely dependent on its net interest income, which is the difference between interest earned on loans and investments and the cost of funding (primarily deposits and borrowings).  Net interest income expressed as a percentage of average interest earning assets is referred to as net interest margin.  The re-pricing frequency of the company’s assets and liabilities are not identical, and therefore subject the company to the risk of adverse changes in interest rates. This is often referred to as “interest rate risk” and is reviewed in more detail in Item 3, “Quantitative and Qualitative Disclosures About Market Risk,” of this Form 10-Q.

Although, the rapid reduction in market rates from September 2007 through April 2008 have reduced margins compared to the prior year, net interest margin improved during the current quarter as deposit rates declined, higher-cost brokered CDs matured, and rates paid on wholesale funding (particularly short-term FHLB rates) continued to decline.  In addition, strong loan growth helped to partially offset the reduction in asset yields. Net interest margin was 4.21% for the quarter ended September 30, 2008 compared to 4.11% and 4.36% for the quarters ended June 30, 2008 and September 30, 2007, respectively.

The nine-month net interest margin decreased as a result of asset yields repricing downward, due to the market rate reductions referenced above. Deposit and funding costs also declined over this period, but initially at a slower pace due to tight credit markets and a highly-competitive marketplace for deposits during that period.    Net interest margin was 4.14% for the nine months ended September 30, 2008, compared to 4.45% for the same period in 2007, and 4.40% for the year ended December 31, 2007.

Net interest income for the quarter ended September 30, 2008 amounted to $10.9 million, compared to $10.3 million in the September 2007 quarter.  For the nine months ended September 30, 2008, net interest income amounted to $31.0 million, compared to $30.4 million year-to-date September 2007.  The increase in net interest income over the prior-year periods was due to strong loan growth which was partially offset by the margin compression, as noted above.

· Provision for loan losses

The provision for loan losses amounted to $1.2 million for the third quarter of 2008, as compared to $215 thousand in the third quarter of 2007.  The provision for loan losses for the nine months ended September 30, 2008 amounted to $2.0 million, compared to $350 thousand for the same period in 2007.  The increases over the prior-year periods were primarily due to loan growth and the effect of net charge-offs and specific reserves.   Total loans have increased $75.0 million, or 9%, since December 31, 2007. Year-to-date, the company recorded 2008 net charge-offs of $387 thousand, compared to 2007 year-to-date net recoveries of $109 thousand.  The current quarter also reflected additional specific reserves of approximately $600 thousand, comprised primarily of reserves for three larger commercial relationships. However, in light of the current economic environment, overall asset quality remains strong with annualized year-to-date net charge-offs amounting to only 0.06% of average total loans, and non-performing assets to total assets of 0.63% at September 30, 2008.  The allowance for loan losses to total loans ratio was 1.67% at September 30, 2008, compared to 1.60% at June 30, 2008, and 1.62% at December 31, 2007.

In the third quarter the bank acquired three properties through foreclosures.  Included in the charge-off amount above, was $158 thousand charged to the allowance related to these foreclosures.  The total value of the properties carried as OREO was $375 thousand at September 30, 2008.

· Non-interest income and expense

Excluding security gains, non-interest income increased $252 thousand, or 12%, and $875 thousand, or 14%, over the comparable three and nine-month periods, respectively, in the prior year.  Non-interest income including security gains, amounted to $2.6 million for the quarter ended September 30, 2008, an increase of $81 thousand, or 3%, over the same quarter in the prior year.  Non-interest income for the nine months ended September 30, 2008 was $7.4 million, an increase of $273 thousand, or 4%, compared to the same period in 2007.  The increases were due primarily to an increase in deposit-service fees, partially offset by lower levels of security gains realized in 2008 than in 2007.

Non-interest expense was $9.6 million for the quarter ended September 30, 2008, an increase of $1.0 million, or 12%, over the comparable period in 2007.  For the nine months ended September 30, 2008, non-interest expense amounted to $28.3 million, an increase of $2.2 million, or 8%, compared to the same period in 2007.  The increases in non-interest expense were primarily related to the company’s strategic growth initiatives resulting in increases primarily in the areas of compensation-related costs, advertising, and training expenses.  In addition, in 2008 the company’s deposit insurance premiums increased due to changes in the FDIC insurance assessment rates, related to 2005 legislation, which applied to all insured banks.

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· Effective tax rates

The effective tax rate for the nine months ended September 30, 2008 was 31.7% compared to 35.4% in the 2007 period. The decrease in the effective tax rate was primarily due to the impact of non-taxable income on lower earnings and a reduction in state income tax rates as a result of the formation of two security corporations, as bank subsidiaries, that were formed in the fourth quarter of 2007.

On July 3, 2008 the Commonwealth of Massachusetts enacted a law that included reducing future tax rates on net income applicable to financial institutions, beginning in 2010.  Applicable accounting guidance requires that deferred tax assets and liabilities be adjusted in the period of enactment for changes in tax laws or tax rate. Therefore, in the third quarter, additional tax expense of approximately $130 thousand was recorded to adjust the company’s net deferred tax asset down to the future realizable tax rates.

· Sources and Uses of Funds

The company’s primary sources of funds are deposits, brokered certificates of deposit (“brokered CDs”), borrowings from the Federal Home Loan Bank of Boston (the “FHLB”), repurchase agreements, current earnings and proceeds from the sales, maturities and paydowns on loans and investment securities.  The company uses these funds to originate loans, purchase investment securities, conduct operations, expand the branch network, and pay dividends to shareholders.

Total assets amounted to $1.137 billion at September 30, 2008, an increase of 7.5% since December 31, 2007. The company’s core asset strategy is to grow loans, primarily commercial loans. Total loans increased $75.0 million since December 31, 2007 and amounted to $908.8 million, or 80% of total assets. Commercial loans represented 85% of total loans outstanding at September 30, 2008.

The investment portfolio is the other key component of the company’s earning assets and is primarily used to invest excess funds, provide liquidity and to manage the company’s asset-liability position. The fair value of total investments amounted to $137.5 million at September 30, 2008, or 12% of total assets, and has decreased $8.0 million since December 31, 2007.

Management’s preferred strategy for funding asset growth is to grow low cost deposits (comprised of demand deposit, interest checking and business checking accounts and traditional savings accounts). Asset growth in excess of low cost deposits is typically funded through higher cost deposits (comprised of money market accounts, commercial tiered rate or “investment savings” accounts and certificates of deposit or “CDs”), customer repurchase agreements, wholesale funding (brokered CD’s and FHLB borrowings), and investment portfolio cash flow.

Deposits, excluding brokered CDs, amounted to $876.9 million, and increased $78.8 million, or 10%, since December 31, 2007. Deposit growth was noted in all categories, with the largest increase in higher-cost deposit account balances as customers have sought more competitive higher yielding bank deposit products.

Wholesale funding amounted to $149.2 million at September 30, 2008, compared to $143.9 million at December 31, 2007.  At September 30, 2008, wholesale funding included $67.4 million in brokered CDs, a reduction of $3.3 million, or 5%, since December 31, 2007, and FHLB borrowings amounting to $81.8 million, an increase of $8.7 million, or 12%, since December 31, 2007.

· Opportunities and Risks

Recent global economic events have had a severe impact on nationwide financial markets and the financial services industry. The financial crisis has included the collapse of the sub-prime mortgage-backed securities market and resulted in the failure of large national mortgage brokers and investment banks, the government takeover of the national mortgage agencies, and federal legislation aimed at rescuing the financial industry. Nationwide, the crisis had led to increased volatility in financial markets, the tightening of credit between large national banks, reduced liquidity for corporations and further weakening of the real estate market, among many other issues.  Continuation of these national trends could further weaken the local economy and have long-term adverse consequences in the local housing, construction and banking industries, negatively impacting the company’s financial condition and performance in a variety of ways.  In addition, any changes in federal, state or supervisory regulations resulting from this financial crisis could substantially affect the financial service industry and the company in many ways, which may include restrictions on business activities or additional operating and compliance costs in the future.

In contrast to the Wall Street investment banks, national banks, and mortgage companies, the company has concentrated on community lending with traditional mortgages and commercial loans to local business, professionals, non-profit organizations and individuals.  Management believes that the company’s disciplined and consistent lending and credit review practices, and the

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prudent investment strategies that have been in place since the company was established twenty years ago have served to provide quality asset growth over varying economic cycles.

While the company has consistently had a growth strategy since its inception, several times in its history management has strategically increased and accelerated investments in growth, including in the early 1990s and the late 1990s/2000 when turbulent times, similar to current economic conditions, opened up market share and growth opportunities for the company.  Over the past several months, the company has chosen to make significant investments in various growth initiatives, including the following: hiring of key personnel; opening of new branch locations; consistent marketing; and increased investments in our service culture and employee development.  The company opened its fifteenth branch location in Methuen Massachusetts this past June.  In addition, the company has obtained regulatory approvals to establish two new branches, to be located in Derry, New Hampshire and Acton, Massachusetts, and expects that these offices will be open for business in 2009.  Such expansion typically increases the company’s operating expenses in the short-term, primarily in salary and benefits, marketing, and occupancy, before the long-term growth benefits are fully realized in those markets.

The company’s primary market area is the Merrimack Valley and North Central regions of Massachusetts and the South Central region of New Hampshire. Management recognizes that substantial competition exists in the marketplace and views this as a key business risk.  Market competition includes the expanded commercial lending capabilities of credit unions, the shift to commercial lending by traditional savings banks, the presence of large regional and national commercial banks with greater financial resources, and the products offered by non-bank financial services competitors.

Management continually strives to differentiate the company and provide a unique customer experience through highly competitive commercial lending, deposit and cash management products, investment advisory and management services, and insurance products.  The company delivers these products and services through consistent, responsive and personal service based on an understanding of the financial needs of its customers.  Advances in, and the increased use of, technology, such as internet banking, electronic transaction processing and information security, are expected to have a significant impact on the future competitive landscape confronting financial institutions.  Management continually examines new products and technologies in order to maintain a highly competitive mix of product offerings and to target product lines to customer needs.

Management believes the company’s business model, strong service and technology cultures, experienced banking professionals, in-depth knowledge of our markets and reputation within the community create opportunities for the company to be the leading provider of banking and investment management services in its growing market area.  Management believes that the company is well positioned, both financially and strategically, to capitalize on opportunities created by the current challenging banking landscape.

In addition to competition, growth and economic unease, the company’s significant challenges continue to be the effective management of interest rate, credit and operational risk.

The re-pricing frequency of interest earning assets and liabilities are not identical, and therefore subject the company to the risk of adverse changes in interest rates. This is often referred to as “interest rate risk” and is reviewed in more detail under Item 3, “Quantitative and Qualitative Disclosures About Market Risk,” contained in this Form 10-Q.

The risk of loss due to customers’ non-payment of loans or lines of credit is called “credit risk.”  Credit risk management is reviewed below in this Item 2 under the heading “Credit Risk/Asset Quality and the Allowance for Loan Losses.”

Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people or systems, or from external events. Operational risk management is also a key component of the company’s risk management process, particularly as it relates to technology administration, information security, vendor management and business continuity.

Management utilizes a combination of third party security assessments, key technologies and ongoing internal evaluations in order to protect non-public customer information and continually monitor and safeguard information on its operating systems and those of third party service providers.  The company contracts with outside parties to perform a broad scope of both internal and external security assessments on the company’s systems on a regular basis. These third parties test the company’s network configuration and security controls, and assess internal practices aimed at protecting the company’s operating systems.  In addition, the company contracts with an outside service provider to monitor usage patterns and identify unusual activity on bank issued debit/ATM cards.  The company also utilizes firewall technology and a combination of software and third-party monitoring to detect intrusion, protect against unauthorized access and continuously scans for computer viruses on the company’s information systems.

The company has a Business Continuity Plan that consists of the information and procedures required to enable rapid recovery from an occurrence that would disable the company for an extended period.  The plan establishes responsibility for assessing a

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disruption of business, contains alternative strategies for the continuance of critical business functions, assigns responsibility for restoring services, and sets priorities by which critical services will be restored.

Refer to Item 1A, “Risk Factors” included in the company’s 2007 Annual Report on Form 10-K for additional factors that could adversely affect the company’s future results of operations and financial condition.

Financial Condition

Total assets increased $78.9 million, or 7.5%, since December 31, 2007, to $1.137 billion at September 30, 2008.  The increase was primarily attributable to increases in total loans funded, primarily through deposit growth.

Short-term investments

As of September 30, 2008, short-term investments amounted to $14.3 million, an increase of $6.5 million compared to December 31, 2007. Short-term investments carried as cash equivalents consist of overnight and term federal funds sold and money market mutual funds.  The balance of these investments will fluctuate depending on the short-term deposit inflows and the immediate liquidity needs of the company.

Investments

At September 30, 2008, the investment portfolio’s fair market value was $137.5 million, representing a decline of $8.0 million since December 31, 2007.  The fair market value of the investment portfolio represented 12% of total assets at September 30, 2008 and 14% at December 31, 2007.  As of the dates indicated below, all investment securities (other than FHLB stock) were classified as available for sale and were carried at fair market value.

The following table summarizes the fair market value of investments at the dates indicated:

(1)            Federal agency obligations include securities issued by government-sponsored enterprises such as Fannie Mae, Freddie Mac, and the FHLB.  These securities do not represent obligations of the U.S. government and are not backed by the full faith and credit of the United States Treasury.

(2)            The bank is required to purchase FHLB stock in association with outstanding advances from the FHLB; this stock is classified as a restricted investment and carried at cost.

See Note 8, “Fair Value Measurements” to the company’s unaudited consolidated financial statements contained in this Form 10-Q for further information regarding the company’s fair value measurements for available-for-sale securities.

The company has not purchased sub-prime mortgage backed securities and has never invested in the stock of Fannie Mae or Freddie Mac or purchased any corporate debt.

During the nine months ended September 30, 2008, the company sold $4.7 million in municipal investment securities, and recognized gains of $267 thousand.  During the same period, the total principal paydowns, calls and maturities amounted to $27.5 million.  These portfolio cash flows were partially utilized to purchase $27.1 million in securities and to fund loan growth over the period. The net unrealized loss on the portfolio at September 30, 2008 was $2.6 million compared to a net unrealized gain of $382 thousand at December 31, 2007.  The net unrealized loss at September 30, 2008 was comprised of net unrealized losses of $754 thousand on the fixed income portfolio and net unrealized losses on the equity portfolio of $1.9 million.  Unrealized gains or losses will be recognized in the statements of income if the securities are sold. However, if an unrealized loss is deemed to be other than temporary, the company marks the investment down to its carrying value through a charge to earnings.

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The net unrealized gain or loss in the company’s fixed income portfolio fluctuates as market interest yields rise and fall.  Due to the fixed rate nature of this portfolio, as market yields fall the value of the portfolio rises, and as market yields rise, the value of the portfolio declines.  The unrealized gains or loss on fixed income investments will also decline as the securities approach maturity.  Included in the net unrealized loss on the fixed income portfolio noted above were unrealized gains of $958 thousand and unrealized losses of $1.7 million.  Management determined that the declines in market value on the fixed income portfolio at September 30, 2008 were due to market volatility.  Management does not believe that any securities in the fixed income portfolio had material declines in credit quality.   Therefore, these unrealized losses were not considered other than temporary in nature at September 30, 2008.  At September 30, 2008, management had the intent and ability to hold the fixed income securities in the portfolio with unrealized losses until the recovery of fair value, which may be the date of maturity.

The net unrealized gain or loss on equity securities will fluctuate based on changes in the market value of the individual securities and mutual funds in the portfolio. The unrealized losses on the equity portfolio at September 30, 2008, were due to the market volatility during the period.  Management regularly reviews the portfolio for securities with unrealized losses that may be other than temporarily impaired.  Management’s assessment includes evaluating if any equity security or mutual fund exhibits fundamental deterioration and whether it is unlikely that the security or fund in question will recover its unrealized loss in the foreseeable future.  Upon such review, there were no equity securities or mutual funds that were considered other-than-temporarily impaired at September 30, 2008.

From time to time the company may pledge investments from the portfolio as collateral for various municipal deposit accounts, repurchase agreements and treasury, tax and loan deposits.  The fair value of securities pledged as collateral was $38.7 million and $24.5 million at September 30, 2008 and December 31, 2007 respectively.  Securities designated as qualified collateral for FHLB borrowing capacity amounted to $38.0 million and $54.2 million at September 30, 2008 and December 31, 2007 respectively.

Loans

The company specializes in lending to business entities, non-profit organizations, professionals and individuals. The company’s primary lending focus is on the development of high quality commercial relationships achieved through active business development efforts, strong community involvement and focused marketing strategies.  Loans made by the company to businesses include commercial mortgage loans, construction and land development loans, secured and unsecured commercial loans and lines of credit, and standby letters of credit.  The company also originates equipment lease financing for businesses. Loans made to individuals include conventional residential mortgage loans, home equity loans, residential construction loans on primary residences, secured and unsecured personal loans and lines of credit.  The company does not have a “sub-prime” mortgage program.

The company continues to grow its loan portfolio.  Total loans amounted to $908.8 million at September 30, 2008, an increase of $75.0 million, or 9%, compared to December 31, 2007, and 12% since September 30, 2007.  Total loans represented 80% of total assets at September 30, 2008 and 79% of total assets at December 31, 2007.  The majority of the growth since December has been focused in the commercial portfolio, as total commercial loans have increased $66.8 million over the period.

The following table sets forth the loan balances by certain loan categories at the dates indicated and the percentage of each category to gross loans.